Nolan Chart ~ Topic: Monetary Policy Flight Into Dollars

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With Dow Jones futures triggering a stock market hold that suspended trading automatically today, combined with the Dow’s 300+ point drop, some hard money folks are wondering why gold and silver are doing so badly. Here’s why.

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by Walt Thiessen (Libertarian) Friday, October 24, 2008

This is an extraordinary time in monetary history. A major financial crisis driven by overextended mortgage lending on a global basis (no, it’s not just Fannie and Freddie) has led to a set of events that is confounding many hard money advocates.

In theory, gold is where panicked investors run to historically, but as the stock market began its government-controlled plunge once again today, gold and silver prices were falling, not rising. Gold did end up on the plus side for the day, but it has a lot of gold bugs shaking their heads. Gold is down over 25% compared to its high a few months back, and silver is down 50% from its high. How could this be happening? Shouldn’t their values be going up, and not down?

In order to understand, there are two critical points that must be made. First, gold is no longer a legal currency. Neither is silver. They should be, but they’re not. The result is that the world’s investors know that they can’t be treated as currencies of last resort. They are only commodities in our crazy monetary system, and so they are behaving like the rest of the commodities markets. Investors are expecting recession and deflation, and so commodities are losing their price value.

The problem here is that the huge influxes of cash coming into the money supply from the Fed, both on its own and via the $700 billion buyout, will total roughly one to one-and-a-half trillion dollars so far, and I have no doubt that the Fed isn’t done yet. This is deliberate inflation, a policy pursued by the Fed to offset the deflationary affects of banks losing so many billions of dollars in delinquent mortgages. The reason I say this is a problem is that we can be very sure that the Fed is going to put much more newly created money into the pot than the banks are losing, because Chairman Ben Bernanke, who is well known for having studied the Great Depression of the 1930s, has concluded that lack of liquidity is why that depression happened. He’s partly right.

Normally, the Fed’s monetary injections should have a net-inflationary impact on the money supply, and it will...eventually. However, the effects of inflation take time to manifest, and the current situation is no exception. In the meantime, stock, bond, and futures investors are trying to figure out where to put their remaining equity now. Since gold and silver are no longer legal currencies, investors are forced to choose among fiat currencies, and despite the horrendous shape that the dollar is in, it’s much better off than the European currencies. Europe has been playing the over-investment game even more than the U.S. has over the past few years. This makes the dollar an attractive "safe haven" for investors right now. U.S. Treasury notes are currently in high demand, despite relatively poor yields in most cases.

I said there are two critical points. In addition to the dollar’s relative strength compared to other fiat currencies in an era where gold and silver are not legally permitted to be currencies, there’s also the fact that the U.S., for all its heavy indebtedness, is far better off than Europe is where national debt and mortgage debt are concerned. Two weeks ago, the New York Times ran an article entitled, "The World’s Banks Could Prove Too Big to Fail - or to Rescue." The article includes a clickable chart which shows a very interesting picture of the debt situation in the U.S. and Europe.

Briefly, what the chart shows is that the U.S.’s short-term credit problem amounts to 15% of the country’s total Gross Domestic Product (GDP), and the national debt is 43% of the GDP.

By comparison, Great Britain’s short-term debt problem is 156% of their GDP, and their national debt is 368% of their GDP. France’s short-term debt problem is 60% of GDP and their national debt is 128% of GDP. Germany is at 60% and 167% respectively. Iceland: 211% and 480% respectively. Switzerland: 260% and 1,273% respectively, and Belgium: 285% and 367% respectively.

In other words, as bad as things are here in the U.S., Europe’s finances are completely in the toilet. That’s the price for all that welfare state activity they’ve been pursuing for decades. This leaves the dollar in a very strange place. As bad as it is, it’s far stronger than the Euro, and it is holding is own against the Yen. Thus, it still maintains its place as the base currency in the global fiat money circus.

Fiat money advocates are giggling behind their hands at the glory of the dollar’s relative strength. We will likely hear them crow over the next few months about how strong the dollar is. Don’t believe them.

When the law is perverted to make it illegal for people to seek the safe haven of hard money, their initial inclination is to forget about hard money. Right now, prices in the U.S. aren’t climbing out of control. Indeed, oil prices have dropped in half as the market calculates that global demand is going to shrink due to the global recession everyone is anticipating, but what all this is really doing is lining up the sheep for shearing. All those people who are placing their trust in U.S. Treasuries are banking on the vain hope that all that newly created money isn’t going to show up as higher prices at some point. That can’t happen.

It’s not a question of if inflation is going to hit us. It’s only a question of when, and it could take quite some time to happen. After all, the Crash of 1929 didn’t lead immediately to the Great Depression. That didn’t show up for another 2-3 years. Nor is it likely, given the fact that the Fed chairman is so pro-liquidity, that there will be another Great Depression II. Instead, as I’ve stated before, we stand on the doorway to hyperinflation.

Is hyperinflation a sure thing? No. Is inflation a sure thing? Yes. We don’t (and can’t) know how much inflation there is going to be. All we can be sure is that it’s coming, and it’s going to wreak havoc.

It’s only a question of time.

In the meantime, what should gold bugs and silver investors do? Strange as it may sound, they should stay in dollars as much as possible for now. Eventually, we’ll get to the point when overall prices start going up again. When that happens, it’ll be a good time to look for bargain prices in gold and silver.