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First Inflation then Deflation? - Financial Markets Crash

Economics / Analysis & Strategy Mar 01, 2007 - 11:38 AM GMT

By: Christopher_Laird


With gold up at $680, it looks like $700 is around the corner. So then, if a big gold surge is around the corner, one may ask, what is a longer term prognosis for not only gold but financial markets? Answer: first inflation and then deflation.

Right now, the world is inflating like mad. Money growth in most of the major world economies is near or exceeding 10% a year, and China is the biggie at 18% plus. That, combined with historically low interest rates is causing huge finance and asset bubbles. Central banks are way behind the inflation/interest rate curve right now, and are basically stuck in that rut because if any of them combat inflation by raising interest rates, they find their currencies strengthen, and lose market share.

Inflation resides in financial markets now

One could ask, aside from commodities and oil, where is the inflation going? Well, much of the answer lies in stock and financial bubbles right now. Now, people are concerned about inflation rearing, and the economies world wide are ‘talking' about inflation – thereby warning of higher interest rates, and talking interest rate expectations up.

But, in fact, what is happening is that:

  • Central banks are merely talking of inflation worries, but are not really acting, only using baby step and relatively meaningless interest rate hikes of .25% a shot. Japan is the worst in this regard. 
  • Central banks everywhere are way behind the inflation curve. So, asset/finance bubbles keep rising. But, the majority of the inflation is finding its way into financial bubbles like stocks.
  • Gold is reflecting this inflation by rising in all currencies

Currencies co debasing

In effect, currencies are debasing competitively – with Japan and China leading the way. Now people are saying that the Chinese Yuan/RMB is rising, but that is only relative to other currencies. What is happening in fact is there is a great deal of already existing Chinese currency undervaluation. China's interest rates are similar to the US, but are way to low to stop their emerging stock bubbles. Japan of course is case number one of a way out of balance interest rate, having a now ‘higher' rate of .5%. Low interest rates keep currencies low. Those paltry interest rate hikes by Japan do little to quell the Yen carry, since the other nations are having to raise in tandem anyway, or raise more. With Japan so intent on a weak Yen, Yen carry has little reason to fear more significant interest rate hikes by Japan.

The US currency is being kept higher than it should relative to our trade partners by them. The trouble is, if the US were to allow it to drop much, we would have a bond collapse.

What is happening is that, while central banks talk tough on inflation, there is little meaningful action to quell things – and in particular, those things are stock and finance bubbles. They are locked in a competition to keep their currencies low, and all have excessively low interest rates. 

This means that a great deal of all that loose central bank money of roughly 10% or more money growth world wide a year is finding its way into stock bubbles. 

Of course, gold is up significantly in the past years, and commodities as well. But actual inflation in the EU, Japan, and the US – at least on paper is roughly in the 2% range. So where did all that excess CB money go? Into stocks and financial markets, and since borrowing is so cheap now, you can add a great deal of leverage back of all that new money every year.

With such an easy money machine, how can stocks not go up? For example, consider that there is a stock boom in China, where the Shanghai exchange for Chinese people rose 140% in the last year. Valuations of Chinese stocks are at a PE of roughly 40.

Of course the, US stocks continue to rise without end. Again, there is so much easy money floating around that investors can borrow cheap Yen in the ridiculously low Yen carry trade, and invest in all the ‘Hot' markets with their borrowed hot money.

The question then arises, what is the evolution of all this? 

First, inflation is finding its way into markets of all kinds, made worse with leverage. That situation will not be stopped until Japan raises interest rates to calm the Yen carry trade. Japan acts as a de facto central banker to the world with a virtual zero .5% rate. But it is not only Japan, the worst easy money offender of all, but other central banks of any significance are all way behind the curve with interest rates in the range of 3 to 5.5% (overnight rates). This is highly simulative and keeps their currencies low and stock bubbles rising, two things economies like.

Finance bubbles will continue to inflate until a crash

However, at these interest rates, there is no hope of slowing the stock bubbles of the last several years. This whole mess, of ever increasing stock bubbles fed by easy money started with Japan after its stock and real estate crashes of the early 90's. They dropped their interest rates drastically to literally zero, and have not been able to get their economy off that easy money drug. 

Then, the US created its own version of an easy money drug habit after the Tech crash and 911, dropping our interest rates to virtually 1%, and caused our real estate bubble. That caused a consumption boom here, and China then found its way into big trade growth/surplusses, stock and real estate bubbles. Basically, all this easy money from Japan and the US is sloshing around the globe causing asset and finance bubbles.

Easy money regime we are stuck in

The EU and other nations also dropped their interest rates in that period drastically. In effect, what has happened world wide is an ultra easy money regime everywhere that is behind inflation, and these rates are now so carefully choreographed that the currency exchange rates are locked in a synchronism of simultaneous devaluation, or what could be called competitive devaluations in effect – and driven by Japan's and China's lead. Gold reflects this by rising in all currencies for the last several years.

Japan is hooked on virtually zero rates just to stay out of deflation. And China is hooked to a way undervalued Yuan/RMB. They are so dependent on export growth to employ millions of new Chinese every year in its manufacturing boom. China cannot afford to just stay even in employment, its jobs must grow by huge numbers every year or they risk a catastrophe of angry unemployed 800 million rural peasants who are increasingly restive due to an income gap compared to the cities. China has 50,000 violent demonstrations a year by these people. Why do you think China is so resistant to letting their currency rise?

So, China and Japan are both locked into ultra easy/cheap money regimes.

Excess trade generated reserves make it worse

Now, Asia is finding that their excess foreign reserves must be also employed somewhere, and they have to sterilize those reserves into local currency. Most of that money finds its way into their local financial markets, and is used to speculate. This machine then causes endless asset and finance bubbles.

So, using China and Japan as an example, we see that by having undervalued currencies they increase exports, which increases excessive trade surpluses, which forces them to sterilize money into local currencies, or to just accumulate US bonds, for example.

The bottom line here is that every major economy is inflating madly, and afraid not to, lest their currencies increase in value compared to the other inflators. That money finds its way into asset and finance bubbles through either monetary inflation and or borrowing easy local money which just amplifies the whole thing.

In short, the world economies are locked into easy money and finance bubbles. Inflation then finds its way mostly into stock and finance bubbles (right now).

Gold in this situation 

Gold is being affected bullishly in two ways by all this. First, as nations inflate their money supply at 10% globally, gold will find a related increase in all of these currencies. That is happening for the last several years.

Second, the ultra easy money is finding its way into every financial market, and that includes commodities. There is a whole lot of speculative money back of the commodity market, and yes, even gold.

The evolution

The evolution of synchronized easy money world wide will be first increasing finance/stock bubbles and then, when these let go, a great destruction of paper wealth in a gigantic finance/stock crashes. These will likely be synchronized world wide.

That destruction of paper wealth will be highly deflationary. First, as stock prices drop, for example, the valuations will drop like a stone, and trillions of dollars of paper money will literally disappear like smoke.

Since interest rates are already so low, central bankers will have a very hard time trying to drop interest rates low enough and fast enough to stay ahead of the emerging financial crash. They will not be able to stay ahead of collapsing demand this time, as the US did after 911 with its interest rate drops that just barely staved off a deflation here. We will explain why.

Easy money fails this time

Using mass printing of their currencies will fail to stave off a massive drop in demand economically, Japan found this out in the 90's. Even if ultra cheap money is pushed out, there will be massive layoffs world wide, in China in particular, but of course in the US as well. Every major economy will face huge simultaneous job losses. Once consumer confidence is hurt enough, even offers of free money (borrowed) will fail to attract buyers back into the economy because prices will start falling, and even at zero rates, people don't want to buy something now, if they see prices dropping. This is what Japan found out.

The end result is a huge world depression.

Gold in this

Initially, commodity stocks will collapse. Gold will be dragged down with them. But, since gold is also money, it will not suffer the fate of commodities, because its value will rise relative to real things as prices drop. Initially, gold will drop in price, but real goods and things like housing will drop far faster because these are not as fungible (tradable for like kind – or better put are not transportable and useful as money) hence gold will retain or increase its value in real goods even if the nominal price in currencies falls.

Gold will fare well relatively in real terms, but could drop nominally in price. (precious metals)

Commodities will collapse to historically low levels- on the order of 80% in price if there is a depression of the like I am discussing.

Between now and the depression/stock collapse

Of course, we are somewhere between this collapse and a now rising gold price. What will happen is gold will continue to rise drastically in the future until this stock/financial collapse happens. World central banks will continue to do competitive devaluations (they are basically doing that now through inflation) and that inflation is finding its way into finance and stock bubbles. 

At some point, the collapse will happen, and at that point you will want to have actual physical gold/precious metals. Paper gold will take a big hit. While paper gold can evaporate, a gold coin will not. All that could happen is its currency price might drop. But the thing won't disappear like smoke, as most financial assets and many paper gold vehicles will – leveraged paper or ETFs that are not actual physically vaulted but are more like price trackers. Money will flee these price tracking ETFs. And, ETFs have made a huge stamp on the gold / metals markets now.

One Key to surviving

In this crash scenario, you will have to do several things.

In a deflationary situation you must not have debt. The typical argument that the government will inflate like mad will likely not work, and prices will drop for the reasons I put up above, namely people won't borrow/spend if prices are dropping, even at zero interest rates.

You will need enough cash type assets (that includes gold bullion in your possession) to survive a loss of income. No matter how you slice it, in a depression you will either lose your job or your income from investments or your savings if they are all in stocks and such. You need to be positioned already in cash type assets in the stronger currencies.

Bonds can be good in this situation since interest rates will drop drastically, that is if you buy these bonds beforehand. However, right now there is a slightly rising interest rate environment. That does not have to stop you from buying bonds now, just be aware of that. Buy quality sovereign bonds (as if there are any, but find the better ones). 

Eventually, bonds have risk due to default risk by governments as their tax base collapses and public benefits skyrocket. Bonds are a short/mid term solution to get some income.

Have a paid off residence, or real estate. If you have a paid off residence in a cheap area, and at least a little income and are thrifty you may survive fine. That and some savings will help cushion you for years. All you would have to pay is some property taxes and utilities. It is far better to have a paid off residence than money in the markets – at least that box is checked off – you have no mortgage payments or rent. 

Cut all expenses. You can cut most of your monthly expenses right now. There are many sources of waste in family budgets of all levels. Learn to be super frugal now, not when you are on the verge of starving or losing your home!

Drive old vehicles, not new expensive ones. 


If you do all these things, your peace of mind will rise immeasurably, even before such a crash. And, if it commences, you will not be afraid of it. 

The Prudent Squirrel Newsletter is Chris Laird's macro economic gold newsletter. While many of my subscribers have told me they subscribe specifically for the macro gold picture, the newsletter also focuses often on financial survival. We also send email alerts of pending changes in the gold market, and subscribers got about a half day's advance notice of gold's $20 price rise yesterday in such an alert.

Stop by and have a look.

By Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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