Watch gold prices continue to rise, even accelerate, as the US economy goes into recession, then depression, while inflationary and deflationary forces will battle each other like two vultures fighting over which one gets to devour the juicier part of the carcass.

Since this scenario utterly defies conventional wisdom, the most obvious question that arises is: "how?" How can inflation and deflation happen at the same time? How can the money supply both shrink and increase, how can prices both rise and fall at the same time?

It can, because each condition will occur in different segments of the economy. Let's first take a look at the current situation as it presents itself:

Between A "Hard and A Soft Place"

As everyone is sufficiently aware now, the US Fed is stuck. Fears of mounting consumer price inflation keep it from lowering the federal funds rate as desired, while recession fears keep it from raising the rate as needed. As a result, the Fed is faced with having to choose between a hard decision on the one hand and a soft economy on the other.

As an economy goes into a recession and then into full-fledged deflationary depression, the usual view is that the price of gold will level out and then decline. Under ordinary circumstances - as they existed until 1999 or so - that may have been true, but this is no longer so. The reason is that this view fails to take the enormous external USD overhang into account. That overhang threatens to flow back into the US economy at an accelerating rate as the domestic economy is throttled and then thrown into reverse.

It is important to understand exactly how this will happen because that reveals in which segments of the US economy this external dollar-backwash will primarily make itself felt.

Where Will All Those Dollars Go?

When a foreign individuals want to lose their dollar reserves, they go to their bank and exchange them for another currency. The banks passes the dollars along to the country's central bank, which then has the option of buying US T-Bonds or some other US product. As the current trend away from T-bonds broadens, the "other" category is the most likely target.

What would that be?

How about controlling shares in oil or other fossil fuel refineries? Gold mines, maybe? Or how about banks and other financial institutions with a desperate need for cash in the current credit-crunch environment? As you know, the latter is already happening. 'Sovereign wealth funds' are injecting much-needed cash in US financial institutions threatening to go bankrupt.

Naturally, these companies will then have to spend those repatriated dollars on something else before the money appears in the regular economy. What would that be?

Oh, maybe gold? Or US gold stocks? Or gold ETFs? They certainly won't go grocery shopping with those backwashed dollars. The finance companies also won't invest in each others' stock as they don't even like to loan money to each other. In an economy where everything else is going down the tubes, yeah, I do think gold would be a reasonable choice.

If foreign countries spend the money on other productive assets, the same consideration would come into play. Will these companies use the money to expand production in a shrinking economy? Unlikely. Keeping the money in ash would also be suicidal because of the rapidly losing domestic buying power and forex value. Therefore, gold would be a natural beneficiary.

Volcker's Legacy - Squandered

Not that it constitutes much of an asset to begin with, but former Fed chief Paul Volcker was able to lift the US out of its 70's stagflation funk by ratcheting up the federal funds rate to the point where investors could no longer resist the huge interest gains luring international assets back out of gold and into dollars.

That was only possible because in the late 70's and early 80's, the US was still a creditor nation and Americans had plenty of savings. When interest rates are high and stocks are floundering, saving money makes sense, of course, but as this situation was soon reversed by consistently dropping rates as the 90's arrived, saving was "out", stock buying was "in", and the construction of a 100 percent delusionary wealth-edifice was in full swing.

No 'Intentional Crash' Planned

There is a view out there taking the position that any crash necessarily following an attempt to raise rates at all from here on might be 'planned' by certain elements because it would aid in the institution of the western hemispheric version of the euro currency, or the "amero."

Proponents of that view therefore believe that the Fed will soon raise rates dramatically in order to induce just such a crash. This view fails to take into consideration the unbelievable losses that would be incurred by the world's financial institutions, the so-called bankers' guild or "banksters."

Since they are the ones normally credited with being behind such plans, an actual execution of the same would amount to more than these gentlemen just shooting themselves in the foot..It would be tantamount to the entire bankers guild strapping itself to the front of a bunch of howitzers and pulling the trigger.

Ergo, nothing could be further from their collective minds than the idea of intentionally raising rates to crash the economy. Not gonna happen.

The Dow Empties its Cup

The Dow may not be as broad an index as the NYSE, and may not be as typical of the ordinary companies out there as the S&P 500, but it is and remains the world's most watched stock index, which is why the much-vaunted working group on financial markets aka "plunge protection team" has always concentrated its efforts there.

There is an old saying among martial arts teachers. They often remind students that, in order to learn a new style or movement or concept that "you must empty your cup." The idea is, of course, that a cup already full cannot receive new "tea" (i.e., information), so it must first be emptied.

The Dow is certainly full of something at its current levels, although it may not exactly be tea -or even value. Its one-year chart reveals a picture-perfect inverted cup pattern. The Dow simply can no longer hold whatever it held until recently. If there was any value in those 30 stocks before, it is now gone.

In perfect confirmation of the above, after the most recent quarter point drop the Dow tanked - big time - because Bernie neither gave nor promised the markets the desired overdose of low-interest-rate narcotic that its depraved nervous system craved so badly. Only yesterday, Bernie tried to make up for that slight, indicating that the forthcoming rate cut may be more substantial. The Dow barely budged on the day of the announcement, and today it exhibits all the signs of a "morning after" hangover - without even having had a binge the night before!

When the actual half-point rate cut finally comes, its effects will already have been priced in. To really move the markets higher, nothing short of a full point cut will do - but that will reveal the degree of utter fear that reigns in the halls of the building on 20th and Constitution Avenue. If you heard Bernie's voice shake as he tried to conceal his emotions while delivering his speech yesterday, you know what I mean.

Tax Breaks to the Rescue?

As noted in the previous essay, when the Fed runs out of gas the politicians have to step up to the plate. If lower interest rates won't stimulate the economy anymore, then tax breaks will have to do it. Ironically, this is not in the interest of the banking overlords. A lighter tax burden tends to remind people of their inborn rights and their God-given freedom too much, but hey, gotta do what you gotta do, right?

However, with Congress' tendency to spend like a drunken sailor in a "horizontal service" establishment, tax cuts will naturally be followed by more borrowing from the Fed, and that will nix any benefits these tax cuts might otherwise bestow on the economy. They may work in the hsort run, but they wot cure the underlying ill.

What Will Happen to Gold?

As already noted, the common view is that gold prices will suffer like all others during a deflationary depression. That does not need to be the case, though, for a number of reasons.

1. Gold is more than just an industrial commodity. When production and economic activity recede, commodities generally suffer. Gold, however, has far less industrial demand than any other metal. Even so-called "jewelry demand" in India and elsewhere in Asia is really just investment demand, if you think about it. The negative effects of shrinking aggregate demand on gold will therefore be limited.

2. At a time of declining and generally threatened stock prices, people who sell their stocks need some other place to put their money. In a declining economy profit, though, opportunities are few and far in between, and many of those carry huge amounts of risk. Just like an aging hooker, risk quickly loses its appeal the closer you get to examine it. The credit crunch is bringing this street-walker uncomfortably close to our prying eyes. In fact, we are getting close enough to it that even our nostrils are beginning to engage - and they don't like what they are engaging.

3. The Fed may not want to raise interest rates, but the market most certainly will, sooner rather than later. Investors will soon realize how closely US treasuries are related to our putrid lady of the night - and will want to keep a healthy distance. Long term rates will skyrocket as investors run the other way, holding their noses.

4. What lies in that "other" direction? They will not be running back to stocks, since both equities and debt instruments carry too much of our risk-harlot's odious perfume. Non-gold commodities will likely decline as well. Even oil will suffer - and under circumstances like that, only gold will shine without overpowering investors' sense of smell.

5. In a true deflation, demand for cash will be high, so investments tend to get liquidated - but much of what is being invested is tied up in 401Ks and IRAs, and those are not easy to liquidate; too costly to cash out.

   So, where will the money flow?

6. Not into cash, as the dollar will continue to suffer from its homecoming hangover and the flood of dollars cycling back though the US economy, with little impetus to go abroad again, will drive up prices despite an otherwise deflationary environment. Holding cash will be a losing proposition. Yet, because therre is so much of it, that cash will need a place to go. With ordinary stocks and treasuries out of the question, where would it possibly go? Into gold shares.

7. Gold mining companies are are very, very few in the world. Although a huge amount of market capitalization will be lost as investors exit non-gold stocks, whatever remains will, for lack of a better alternative, go into gold shares as those represent the only shares with any reasonably achievable upside. Think of a huge funnel connected to a tiny balloon, and plenty of water coming down the funnel...

8. Few if any 401Ks that I am aware of allow for investment in gold shares directly. Most will allow exposure through gold mutual funds, however. Gold mutual funds are even fewer in number than gold shares, to they will have the same funnel/balloon effect as gold shares. Although I am generally bearish on gold shares and mutual funds due to the gold mines declining ore grades and spiraling production costs, under this funnel-effect there can be considerable upside, at least for a while. Euro vs Dollar Gold Monitor members wil know how long that "while" is likely to last and when it will be time to get out.

The US is the most deflation-exposed of the world's major economies (except for maybe China). Even if deflationary effects will eventually put downward pressure on gold prices in the US itself, the EU and most non-Chinese Asian economies will continue to produce satisfactory results for a while, even in a global downturn. That will further serve to keep pressure under the price of gold as their investors, too, will be looking for a safe and profitable place to put their money.

In fact, even the ECB and the member states' central banks maybe tempted to buy gold en masse in order to dampen the euro's burgeoning forex value and thereby avoid the resulting loss of international trade competitiveness. The euro will not crash from this as badly as the dollar would if the US tried the same thing. The reason: gold reserves in the euro zone are revalued at market prices every quarter, while the US official price is locked in at a little over $40 per ounce. Something to think about for EU central bankers.

Gold will be the place to be, and physical gold and bullion ETFs will be the coziest of all golden environments.

Got gold?