From Don Luskin -- buy gold.
Published October 31, 2008
AHEAD OF THE CURVE by Donald Luskin
Inflation, Not Deflation, Is Looming Threat
HERE'S THE DIRTY little secret of all the rescue operations that have been carried out this month by government financial authorities around the world. They all take money. Lots of money. And that money has to come from somewhere.
So when the U.S. Treasury says it will invest $700 billion to support the banking system, it has to be able to issue $700 billion in Treasury bonds. Someone has to buy those bonds. Someone has to think they're a good investment, at a time when most people don't think anything is a good investment. The Treasury's effort to restore confidence in banks depends on people having confidence in the Treasury.
When the Federal Reserve says it will invest $500 billion in the commercial paper to support the short-term financing market, it has to print the money. People have to think that money's worth something, even though it's been freshly printed for the occasion. For the Fed to restore confidence by making money available, people have to have confidence in money.
These two things are closely related. A Treasury bond is an iron-clad commitment to pay interest every six months, and to pay the face amount at maturity. To pay in the form of money, that is. It's a riskless security, because the government has the power to print the money required to make the payments. But if the money is worthless, then the bonds are worthless.
The way the credit crisis has unfolded over the last two years, it seems that the focus of the trouble has moved from company to company, from security to security, from country to country. One problem gets solved, then another one crops up. Like leaks springing up in a dam, they just can't all get plugged. When all the problems have been solved, there's only one place for the credit crisis to go: to money. If that happens, then it's not just another leak in the dam; it's a dam break.
If people lose confidence in money, then it's all over. Money is all the rescuers have. When the money itself loses value, there's no one to rescue the rescuers.
What is money, anyway? It's a claim-check that can be presented for goods and services. If you're Joe the Plumber, then money is a claim-check on your plumbing services. Someone hands you a $100 bill, you have to give them some plumbing.
So the amount of money in the world must bear some reasonable proportion to the amount of goods and services that it might claim, now and in the reasonably foreseeable future. If there's too little money, then there's not enough to buy all the plumbing services that are being offered, and the price of plumbing has to fall. That's called deflation. When there's too much money, then there aren't enough plumbing services to go around, and the price of plumbing goes up. That's called inflation.
See where I'm going here?
The Treasury is borrowing a ton to support this year's stimulus program, the housing bailout, the Fannie Mae (FNM1) and Freddie Mac (FRE2) bailout, and now the banking bailout. It all totals something like $1.5 trillion. The Fed's balance sheet has simply exploded over just the last eight weeks. It's gone from about $850 billion to about $2 trillion.
There isn't enough plumbing in the entire universe to use all that money. The only possible outcome is inflation.
I understand if you think I'm completely crazy at this point. How can there possibly be any danger of inflation whatsoever when the price of oil has been more than halved in the last three months? How can there possibly be inflation when the whole world is suddenly in a deep recession, and consumers have stopped spending?
How can there possibly be inflation when the spread between regular Treasury bonds and inflation-protected Treasurys, or TIPS, has gone negative? It's true. The yield on a five-year TIPS is actually higher than the yield on a regular bond, which means the market is forecasting deflation, not inflation, for the first time since TIPS started trading a decade ago.
That's certainly how Ben Bernanke sees it. In the Fed's public statement this week when it cut interest rates to 1%, it pretty much said that inflation is dead and buried, with a wooden stake driven through its heart.
What can I say? If you believe all that, I'm delighted that you have such confidence. I'm delighted you're so optimistic. Confidence and optimism are in short supply right now, to be sure.
But I think you're wrong. The U.S. Treasury is borrowing so much money — as are the treasuries of all the major countries — in order to support banking rescue operations, there's just no way that bond yields aren't going to have to go up. When that happens, the Fed and the other central banks of the world will probably decide to buy some of that debt, to keep rates low, so that the world can more easily pull out of recession.
That's called "monetization" of debt. It means that, effectively, instead of borrowing real money, the governments of the world will just print it. That always causes inflation. But the governments will do it, because they believe inflation is dead, so they'll think they can get away with it.
But the fact that they think inflation is dead will bring inflation to life. If you print enough money, you will get inflation. No matter how much the price of oil has fallen.
So what if the oil price drops by 50%? If the governments of the world print enough money, that drop won't last long. Neither will the recent drops in other commodities. That's the way inflation works. It's the way it always works. Governments print too much money. The price of everything goes up. That's inflation.
Now I'm not saying it has to rise to crisis proportions. It will happen slowly. A little bit at a time. We'll have plenty of time to see it, and avoid the worst.
But we'll see it later than we should. We'll see the first signs, and the second, and we'll ignore them. We always do. Then it will get worse, and finally we'll react. Hopefully, that day will come before inflation gets so out of control that we really do have a crisis on our hands.
The best way to play it is with gold. Lately gold has been acting more like lead. It's fallen along with everything else. Cash is king right now.
But gold is the single most inflation-sensitive thing in the world. I think before a year has passed, gold is going to start sensing the inflationary threat I'm talking about. When it goes back to the old highs around $1,000, and then just keeps on going, remember: You heard it here first.http://www.smartmoney.com/investing/eco ... /?cid=1108