What deflation really does to an economy!
Deflation is a particularly pernicious economic condition. It is far worse than inflation. Prices decline in deflation. The impact of this is that a person with cash sees the buying power of that cash increase, whereas the owner of assets with declining values sees the cash value of those assets decline. This is the superficial picture.
As bankers and business owners are well aware, it takes a long time to establish and grow a business, but something a little as a shortage of immediate cash [it could be a relatively small amount of working capital] or its availability, is all it takes to destroy all that hard work. It's terrific business for a bank to take over such a business, if the business can't raise cash [and the banks can control that availability] then continue to do business and get it for a throw away price. It's a bit like a big man having a blood circulation problem. Interrupt that flow and the man dies, but that blood volume can be so little compared to the mass of the entire body. That's what happens in deflation. The carpetbaggers move in. But with that comes loss of economic momentum and momentum equals growth. Lose that and even solid huge businesses are destroyed [car manufacturers?].
In inflation, the buying power of cash declines, whereas the cash value of assets rises. Those who can keep their prices rising in line with inflation [wages too] actually appear to be enjoying greater wealth. Inflation promotes growth of business, provided it is not in a runaway state. Debts lose value over time as the volume of money rises and become easier to repay, making borrowing attractive. So tempering the availability of that cash [by Central Banks, usually through interest rates] is all it takes to wind down inflation and without that much damage to the economy, particularly once growth has momentum.
Economic growth can be controlled in inflationary times far better than in deflation and leave an economy fairly healthy and growing. Deflation destroys businesses, which take several years of a healthy economic climate to replace. Simply put, if you retrench one worker, you would have to employ two to raise confidence to the previous level. And you need confidence to keep an economy cruising. This is now dying. Momentum is starting to slow and threatens a gearshift down.
The Fed and global central banks have realized that deflation threatens and are right now taking action to boost liquidity to counter this. The formula to be used is monetary inflation, which is now being harnessed to counter deflation.
When to fight deflation.
Central banks just cannot afford to wait for deflation to take hold if they are to beat it. They have to act before it strikes in a forceful manner to raise confidence in the economy and convince the consumer and all above him that deflation will be averted. If the fight is left too long, the efforts and measure to counteract it have to be considerably greater than if action is taken before it takes hold. That's why Bernanke and Paulson are staying up late at nights right now. That's why China is flooding their economy with growth projects now rather than later. That's why the G-20 [20 of the world's richest nations] agreed that concerted action must be taken now to turn inflation up to fight deflation last week.
Why Bernanke is right to expand money supply through Quantative Easing.
The banks have been slaughtered by the credit crunch to date, with the bright stars of Wall Street tumbling out of the sky and why one of the world's biggest banks, Citigroup, is now fighting for its very survival. The deliverance they got from the Fed will not inspire them to go out to the broad economy and issue loans to re-invigorate the economy. Their guiding principles of "prudence with profits" looks at the threat of deflation and says, conserve assets restrain loans until the turn around back to growth is firm on the ground. This roughly translates into, "we got saved by the Fed, but we're not lending because it's too risky". The Fed realizes that and must get loans out there to stop risks rising in deflation.
So now that interest rates are dropping and borrowing is not increasing, what's to do? The concept of zero or negative interest rates seems ridiculous and abnormal and inspires as much confidence in you having your bank manager paying you to borrow his money. So how does one avoid extreme measures?
Chairman Bernanke, an expert on avoiding Depressions, is instituting a system of "Quantative Easing" of the money supply, without dropping interest rates further. By dramatically expanding the money supply and keeping interest rates at near to current levels, bankers now have an incentive to get that money out to the broad economy and resuscitate growth. That's what's happening now, ahead of the iron grip of deflation. A rebuilding of economic confidence is vital right now and all other methods have not succeeded yet. There's no time to wait for them to do so either.
Yes, "Quantative Easing" is inflationary, but it is hoped that it will conquer deflation in the process even if inflation overwhelms deflation. Inflation can be cured later, once confidence is restored in economic growth.
How gold will reap a rich reward.
With gold now beginning to recover from its 27.5% drop, as oil prices reach a third of their peak level, confidence is evaporating in the global economy and uncertainty coloring all decisions. Indeed, today's financial scene is dramatically different to that of July 2007. Indeed, if we had described today's scene to you then, you would have said, impossible!
Gold fell, as we all know, due to the process loosely described as de-leveraging. This led to aggressive sellers pushing prices down, triggering stop loss points, creating more selling, alongside margin calls. People with investments acquired to a greater or lesser extent, against borrowed funds, sold, despite their belief that the trend remained up. The initiating aggressive sellers closed their positions on the way down then re-opened them on the rallies. But despite this gold's fall has been little, particularly when placed against other commodities.
Some believe that gold is simply a counter to the $ or an item that will rise in the face of inflation. Yes, it is these, but of immediate significance, it is also a counter-deflationary investment, much as cash itself is. This is even truer in a global context. Gold is no one's promise to pay and is saleable anywhere in this world, for cash. But like cash itself, it gains in value as asset values drop. One has only to look at the fall of the Dow Jones Industrial index or the S & P and look at the steadiness of gold [in the face of forced selling] to see that demonstrated. Or look at that most precious of assets that we live in, houses, to see how gold is holding its value. But what is the reason gold could hold its own or rise in deflation, apart from its cash-value-holding-power? It is a hedge against uncertainty. When the basis for valuing paper assets, including money, become unclear, discredited or confusing, gold is a solid, nationality-free asset, a 'shelter from the storm' investment. So wait for the past, relied-upon formulae to cease to work properly and you will see demand for gold rise remarkably and with it the price.
As we look at the market, particularly the source of that aggressive selling, COMEX, we see that the net speculative long position in gold has dropped amazingly from well over 600 tonnes to close to 150 tonnes of gold. The aggressive sellers look as though they are now exposed 'naked shorts' for even when gold was at $300 the net speculative long position was 300 tonnes. Now as 'forced selling' peters out, uncertainty rises as we face deflation attacked by inflationary expansion of the money supply, we will see gold's value rise and strongly.
As most sellers have exited the gold market, what are we left with, going forward?
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