• Bring Out Your Dead

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    by David Galland: Government
    Mules

     

     
     

    Last week, the price of gold again broke below its new base at
    $1,200, and the U.S. stock market was again under strong pressure,
    due to a confluence of fears, most of which point to a deflationary
    double-dip. The fears were fanned by disappointment in the just-released
    early quarterly results, by the latest CPI reports that show inflation
    continuing to moderate, and by yet another poll revealing faltering
    consumer confidence.

    The market is also spooked, no doubt, by notes from the latest
    Fed Beige Book that make it clear that the Fed is (finally) beginning
    to understand the entrenched and endemic nature of this crisis.
    While the notes are written in shamanic double-speak, the point
    is unambiguous – members of the Fed don’t expect the economy
    to get back on track until 2015 or 2016.

      "Participants generally anticipated that, in light of the
      severity of the economic downturn, it would take some time for
      the economy to converge fully to its longer-run path as characterized
      by sustainable rates of output growth, unemployment, and inflation
      consistent with participants’ interpretation of the Federal Reserve’s
      dual objectives; most expected the convergence process to take
      no more than five to six years."

    The simple reality the Fed is waking up to is that the structural
    underpinnings of the economy are damaged beyond any quick or easy
    fix.

    That’s because until the debt is wrung out of the system, either
    through default or raging inflation – there’s no chance of
    it actually being paid in anything remotely resembling current dollars
    – the equivalent of an economic Black Death is going to plague
    the land.

    Each new government initiative, the latest being financial reform,
    that doesn’t decisively address the debt, but rather tightens the
    dead hands of politicians around GDP, only serves to spread the
    wasting disease like so many flea-infested rats running through
    the economy.

    And so, each new day will find the carts freshly laden with failed
    homeowners, businesses, and banks that have succumbed.

    Pundits are fond of saying that things are never really "different
    this time around"… yet there is something truly unusual now
    going on. See if you can spot the disconnect in the following descriptions
    of the current economy.

    • Record total debt.
    • Record government deficits.
    • Record trade deficits.
    • Massive additional government
      debt financing required to keep the doors open and avoid reneging
      on social contracts directly affecting the quality of lives of
      millions of people around the globe – the U.S., Japan, and
      Europe especially.
    • Near record-low interest rates.

    Anything strike you as out of place?

    The current setup with massive debts and low, low interest rates
    is like making an uncollateralized loan to an acquaintance at a
    very friendly, low interest rate. Then he comes back again for more,
    and more, and more. Because you live in a small town, you know he’s
    putting the touch on a bunch of other people too. And because you
    know his loose-lipped accountant, you also know what his income
    is, and even what his total debts are – and it is blatantly
    obvious that he won’t be able to repay his debts in a dozen lifetimes.

    So would you keep lending him money? And, if you did, would you
    do it at the same friendly interest rates?

    Not hardly. And therein lies the almost Twilight Zone
    caliber disconnect in the world as we know it.

    In a conversation yesterday, my dear partner and friend of several
    decades, Doug Casey, made just that point – that the situation
    today should only exist if the fundamental laws of economics had
    been suspended. Interest rates should be going up, but they aren’t
    – rather, they are bumping along at the very bottom of the
    possible range.

    In my view, this is testimony to the truly extraordinary lengths
    – involving trillions of dollars – that the U.S. Treasury
    and the Fed have gone to in recent years. But they can only suspend
    reality for so long before the fundamentals again rule – and
    when that happens, the entire system could literally collapse. Not
    to sound dramatic, but it could happen almost overnight.

    As frustrating as it may be to all of us, the world is still locked
    firmly in the jaws of a powerful bear market. While the bear may
    loosen its bite now and again, it’s really only temporary –
    to get a better grip.

    That being the case, it’s worth remembering the single most important
    thing about bear market investing – it’s hard. Or, put another
    way, it’s hard to make a decent return without taking extraordinary
    risk.

    As Doug points out, in the current environment, everything –
    including commodities – is overvalued. And they are going to
    remain that way until they aren’t. Maybe the Fed actually has it
    right this time, and the bottom won’t be reached until 2015 or 2016?
    I wouldn’t discount it at this point.

    But what of the inflation we see as inevitable? And gold, in the
    interim?

    Let me quickly tackle the second question first.

    In any debt crisis, the foremost concern of creditors is to get
    paid back. Compared to that, returns on investment come in a weak
    second. In a sovereign debt crisis, the question of repayment is
    complicated by the fact that the debtors control the creation of
    the currency units that will ultimately be used for payments.

    Individual and institutional holders of U.S. Treasuries, along
    with other assets amounting to trillions of U.S. currency units,
    can see with their own eyes what’s going on. To continue holding
    such large quantities of instruments denominated in these unbacked
    currency units – or those labeled "euros" or "yen"
    – is to risk being left with a lot of worthless paper as the
    governments try to repay debtors by creating the stuff, literally,
    out of thin air.

    And so these holders diversify their portfolios into alternative,
    and far more tangible, assets – gold and silver included. That
    is the fuel that has sent gold higher over the last ten years and
    that will keep it high – short-term corrections notwithstanding.

    It is, however, when the inflation from all the money creation
    starts to appear that we’ll begin to see the shift into gold begin
    in earnest, and the price will really take off. When might that
    occur? Rather than trying to answer that question myself, I’ll refer
    you to the latest, excellent edition of, Conversations
    with Casey
    , in which Louis James interviews Casey
    Report
    co-editor Terry Coxon on the outlook for inflation.

    Here’s an excerpt…

      Coxon: …the operations that began
      in late 2008 have about doubled the monetary base. It was very
      roughly a trillion dollars. Nothing like that had ever happened
      before. Most of the new cash went to buy troubled assets from
      commercial banks. The first goal was to prevent the commercial
      banks from collapsing. If the Federal Reserve had done nothing
      else, the result would have been a doubling of the money supply
      within a few months, and we would have had South American-style
      price inflation.

      L: So they changed the rules so they
      could create a huge amount of money to keep the banks open, while
      trying to avoid hyperinflation.

      Coxon: Yes. The money supply grew by
      about 20%, which, I suppose, they thought would be enough. To
      keep it from growing any further, they started paying interest
      on excess reserves, effectively sequestering those excess reserves.

      L: That’s a lot of sequestered cash.
      But the U.S. government has done more than directing or allowing
      the Fed to buy toxic paper. There’s Cash for Clunkers and all
      sorts of other insane ideas coming out of Washington, with Congress
      seemingly willing to spend "whatever it takes" to get
      Boobus americanus to imagine he’s rich enough to start
      spending again.

      And yet, the average Joe in the street doesn’t see inflation.
      Life hasn’t really gotten any cheaper, but gas is still way below
      its previous $5 high-water mark. Joe is worried about losing his
      job and cutting his expenses, which is price-deflationary. Why
      isn’t he seeing more inflation?

      Coxon: Joe isn’t seeing inflation because,
      so far, the Federal Reserve has not allowed the money supply to
      grow enough to trigger inflation. You’re mixing apples and oranges
      when you talk about Congress and the Federal Reserve. All of the
      runaway deficit spending is not, in and of itself, inflationary.
      The government spending borrowed money does not increase the money
      supply – it doesn’t change the amount of cash people have.

      L: Ah. You’re saying that out-of-control
      government spending isn’t inflationary, but sets the stage for
      future inflation, when money has to be created to pay the government’s
      debts?

      Coxon: What it does is create a political
      motive and economic need for inflation. These huge deficits may
      have slowed the recession that began in 2008, but to keep the
      recession from worsening, the Federal Reserve will have to prevent
      interest rates from rising for months or years to come. And to
      do that, it will have to start printing money to buy up debt instruments
      whenever the economy starts recovering, to keep interest rates
      down to levels that will not choke off the recovery.

      L: So more money creation will be necessary
      to keep interest rates low, but at some point, the foreigners
      holding dollars, believing it to be a sound currency, will have
      to get worried about all this dilution of the dollar – and
      that would tend to force interest rates up, as it will take more
      and more to convince those people to keep buying T-bills and such.

      Coxon: The world outside the U.S. has become like a giant
      capacitor for U.S. inflation. The charge that’s building up is
      the accumulation of dollars and dollar-denominated assets in the
      hands of foreigners. When the outside world wakes up to the threat
      of inflation in the U.S., they will start unloading U.S. dollars,
      which will suppress the dollar’s value in foreign exchange markets,
      which will make prices of imports (including oil) go up, and that
      will be a separate vector feeding price inflation in the U.S.

    For now, the key is to get through this period in the best possible
    shape. That means watching your debt, keeping well cashed up, buying
    gold on dips, and, when you venture into investment markets, it’s
    never been more important to understand what you are investing in
    and why.

    There’s no need to chase anything – which means you have the
    luxury of building your portfolio over time, on exactly the terms
    you want.

    While it may sound contradictory, I think this is also a good time
    to learn more about speculating. In the simplest terms, a speculator
    risks just 10% of their portfolio in the hopes of receiving a 100%
    return. By comparison, most investors put 100% of their portfolio
    at risk in the hopes of getting a 10% return (actually, these days,
    most people would be happy with just 5%).

    In the case of the speculator, 90% of their portfolio can be largely
    kept in cash and gold. So, who’s more at risk – the investor
    or the speculator?

    And where are the best speculations found today? Personally, I
    like energy, and I very much like bottom fishing in the junior gold
    sector. That’s because there are some terrific micro-cap Canadian
    junior exploration and mining companies (which you can buy using
    your U.S. discount broker) sitting on large known deposits
    – but their share prices periodically fall back based on nothing
    more than investor emotion. That’s called a buying opportunity.

    (For our best bets in this sector, check out a risk-free 3-month
    trial to the International Speculator – it’s no coincidence
    that every single stock Senior Editor Louis James picked in 2009
    has turned out to be a winner. Details
    here
    .)

    David Galland
    is the managing editor of Casey
    Research
    .

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