TRADE UPDATE 2/17: Gold break out above $950 - bullish sign
TRADE UPDATE 2/3: Gold needs a rest. Look for a retracement to $860
TRADE UPDATE 1/30: $925 reached overnight, avoiding new buys. Chart
For those not familiar, deflation is the contraction of both money supply and credit. I invite you to view the video: Fractional Reserve Lending - The mother of all Ponzi schemes to better understand how money supply and credit are linked. Popular media refers to our financial crisis as a "credit crunch" as if it were a mere inconvenience. This "credit crunch" is actually an outright destruction of money supply caused primarily by credit defaults, deleveraging and a refusal to lend and due to rapid asset depreciation. The purchasing power of remaining money becomes more valuable. Witness the sharp rise in the US Dollar since July 2008. If the US Dollar has more purchasing power, then by definition the assets it can buy become cheaper. Witness the plunge in all commodity classes in the past 6 months.
Deflation caused the Great Depression. Governments fear deflation and are doing all they can to prevent it. They are buying bad assets, providing stimulus and reducing interest rates - all in a vain attempt to prevent the awesome power of deflation. They will ultimately win this battle. Fiat money can (and is) be created out of thin air. Right now that money is staying within banks who are merely trying to stay afloat. The Trillions (yes Trillions) of Dollars being extended to banks in various forms now are being used to preserve their leveraged balance sheets. Here's the catch....it's still not working. So how can governments, and particularly the US Federal Reserve ultimately win the battle against Deflation? If all else fails they can use the "nuclear option".
In 2002 speech Ben Bernanke outlined clearly the options the Federal Reserve has at its disposal to fight deflation. The speech highlighted the challenges faced by the US in the 1930's as well as Japan in the 1990's. Ironically 6 years later Mr. Bernanke is having to implement almost all those deflation fighting measures. Just as he stated in 2002, the Fed is buying bad assets, buying Treasuries, reducing interest rates to zero. So what else can be done when these measures are not winning? Two excepts provide an answer:
"But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
"Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation." - Ben Bernanke, 2002 Deflation: Making Sure "It" Doesn't Happen Here
"intervening to affect the exchange value" means purposeful devaluation of the currency in order to keep prices and wages from falling. If lowering interest rates, the overnight rate and buying Treasuries fail, a remaining option is to devalue the Dollar either through massive printing, a one time devaluation or a combination of these. In 1934 FDR devalued the Dollar against Gold by 41%. Notice how highly Bernanke speaks of this remedy.
The bottom line is Gold has been acting as a commodity. Gold retreated from it's $1000 high and succumbed (albeit mildly) to deleveraging and deflation along with the rest of commodities. However, now Gold is beginning to act like money. Financial Sense has also picked up on a recent divergence in Gold's behavior - Link. As currencies like the Icelandic Krone, the Russion Ruble, the British Pound and others fall under the force of deflation and deleveraging investors seek somewhere safe to put their money. So far that has been the worlds reserve currency - US Dollar. However, as the future of the Dollar and the fiat money system becomes questionable, more people are again looking to civilizations oldest and most reliable store of value - Gold. Savers in Iceland, Russia, Eastern Europe and now Great Britain who held their savings in Gold instead of the Krone's, Ruble's, or Pounds were/are unaffected by their currency plunge.
Is the Dollar the next shoe to drop? That is the question the world's wealthy are now asking, and you should too. For many it's not a question of if, but when. Thus the interest in Gold.
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