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July 19, 2004

Economic Whiplash
by Alex Wallenwein

Is there anything new to report in the world of gold investing and international finance/currency movements?

Not really, except maybe for two things:

1. Many of the things we predicted earlier this year are now coming to pass (i.e., proof that the US economic dead-cat bounce was simply fueled by tax breaks, emergency-level interest rates, and "zero down/zero interest" car deals), and

2. The threat of deflation, after having been trumped by inflation concerns for a while, is shifting back into full gear. In other words, we are back to the old "two-way-flation" thing again.

Point two is a prime example of what we call "economic flatulence" - the sound made by hot air escaping from a certain bodily orifice, causing it to open and close in rather rapid fashion, emitting a most peculiar and patently ridiculous sound.

This new (or rather renewed) deflationary bias is demonstrated by recent government figures that others have written about in great detail and so need not be restated here. This bias, however, means that any significant near-term Fed rate hikes are simply out of the question - and that means that the dollar's relatively brief interlude of "strength" is over for some time to come. The reason? The very last thing Greenspan wants to do right now is raise rates in any meaningful way.

If any real rate hikes were to occur in the next six months to a year or so, the entire US economic engine would be thrown into reverse. But a failure on the Fed's part to raise rates does not by itself guarantee that the economy will just continue to chug-along as expected, and as so widely predicted.

In truth, whichever way the switch ends up being thrown, forward or reverse, or even if it's left undisturbed, this economy of ours is about to jump out of gear altogether, and that will cause the Fed's money-engine to rev up into the red zone while showing no appreciable effect "on the ground." When that happens, the Fed's money-engine will no longer drive the wheels of this economic vehicle. An added problem lies in the fact that this vehicle is currently trying to go "uphill" (i.e., trying to stage a lasting economic recovery).

What happens when your car jumps out of gear while climbing a steep mountain side? The engine revs like crazy, your car slows down, and then it starts to roll backwards, back down the hill, until you either slam on the brakes and throw it back into gear - or ...

You know what happens then. Now imagine that your car doesn't just jump out of gear, but that your transmission goes completely 'kaput' up on that mountain side, with no mechanic shop anywhere in sight. Then what do you do?

Let's hone in on this analogy for the moment, because it represents a strikingly close approximation of our current economic dilemma here in the US:

Your "car" is the US economy. The Fed's inflationary policy and proverbial electronic printing press, together with recent tax-break stimuli, are the "engine" that currently powers your car. You, I, and all the other US workers, business owners, and consumers/investors collectively represent the "driver" of the car. The "mountain" to be climbed is the economic recovery that everyone is hoping to finally take hold. The "transmission/clutch" component of our car is the public's demand for the Fed's cheap money. The economic vehicle will only move forward if people actually go for the make-believe easy-money carrot that bobs up and down in front of them.

That's where the problem lies.

If the domestic and international demand for dollars doesn't keep pace with US money-creation, then all the money creation in the world will not translate into economic growth. It's like that old peacenik-slogan: "Imagine they are having a war, and nobody's going!" Imagine they are having an easy loan orgy - and nobody wants any.

So here we are, up on this mountain road, chugging up that hill that seems to get steeper and steeper every few hundred yards, and suddenly our crankshaft breaks or the car jumps out of gear and just won't go back in. So you slam on your brakes, right?

But what if there aren't any brakes?

You push the brake pedal down to the hilt. There's no resistance. You pull the emergency brake - and find that you are holding it in your hand - broken!

Just like in the example, our real-life economy has no "brakes."

We have a "cooling system" (or rather a throttle) that keeps the engine from overheating on its way up that recovery-hill. This is the Fed's ability to raise rates and slow down its monetary stimulus in case of wide-spread price rises. But the Fed has no way of keeping the economy from rolling backwards down that hill (and possibly over the embankment and down the cliff) in case the transmission fails!

Compare the US situation with that of Japan from 1989 to the present. Unlike today's US economy, the Japanese economy did have "brakes." Its brakes were the tremendous personal savings amassed by Japanese investors before and during their decade-long economic malaise. These savings are what literally saved the Japanese economy (and even more importantly, the Japanese themselves) from going over the rim. But Americans have near-zero savings!

Whatever Americans ordinarily 'save' is locked up in the stock-market while they are desperately hoping for a return to the 'good times' of the late nineties. Whatever is not in stocks is in treasury debt paper - not exactly the "safehaven" it used to be in the nineties, either. Back then, the dollar was the safehaven currency to park your money in if you were a foreign investor. In the minds of paper-investors (about 98 percent of the investing public), there was simply no alternative.

Since the advent of the euro, though, what used to be a safehaven has rather turned into quicksand. Verbal pronouncements by the two reserve-banking chieftains of the world (Trichet and Greenspan) early in the year have lent dollar-investors a helping "tree branch" for a few months, temporarily halting their descent into the bowels of the monetary desert - but that branch has already broken off now, sorry to say.

You can see this clearly in what has happened to the dollar in the last two weeks or so. While before then, elevated inflation-expectations supported the dollar because of expected rate hikes, now that we have "subdued inflation" and a molasses-like Fed response, the dollar suffers because rate hikes are out the window. And you know what that means for gold.

The reason the "transmission mechanism" of US monetary and fiscal stimulus packages is breaking down is the fact that even such jaw-dropping emergency measures as those we have seen in recent years have only barely succeeded in reigniting some parts of the economy - and whatever was thus "reignited" is now already fizzling out.

The following excerpt from Dr. Richard Appel's most recent essay summarizes the situation best:

"Employment figures have begun to weaken and corporate earnings are beginning to disappoint the market. Also, the Purchasing Manager's Index fell from its May level of 68, to 56.4 in June. Further, economists are becoming concerned by the numerous earning projection reductions. This has accompanied a waning level of investment by what appears to be an increasing number of technology companies, as well as a fall-off in orders for non-defense capital items. Added to this is the troubling sudden slowdown in employment combined with a retrenchment in hourly salaries, and the recently announced 1.1% decline in retail sales."

This fizzling-out comes at a time when long term rates are on the rise whether or not price inflation keeps rising, and all of this happens during a time when hourly wages are starting to suck, corporate earnings go flat, the employment picture has lost its dazzle, and Americans are hocked up to the hilt with home equity loans. Demand for new loans (new money) will therefore fall, reducing money velocity, and severing the link between money creation and economic performance.

The saying that goes "you can't have it both ways" seems to apply only to the things you want. On the other hand, when it comes to the things you don't want, having (or rather getting it) both ways appears to be a given. We can have both inflation and deflation at the same time. We are now in the early stages of seeing this.

It is this breakdown of the monetary transmission mechanism that exposes the fiat and fractional reserve banking-based monetary-stimulus concept as what it really is: a bunch of hot air, and little else. That hot air now has to escape our collective 'body economic' - in one way or another.

The way it is currently escaping causes the above-mentioned auditory phenomenon induced by what is otherwise known as flatulence - Inflation and deflation occurring at the same time in different sectors of the economy, or in increasingly rapid succession back and forth across the economy. In other words: economic whiplash.

To come back to our car-analogy, what will happen when the drive shaft breaks or the transmission fails, and there are no brakes? The "car" will of course roll backwards until it finally runs over the edge and falls off the cliff, for there is nothing to hold it back.

If you are fully invested in paper assets, your wealth is literally trapped in that car as it rolls over that edge, and your portfolio's rather rapid descent along with it is an inevitability. If you own precious metals (in bullion form, hopefully), they will be at once your escape hatch from this paper-crunch - and they will function as your wealth's 'golden parachute' as well.

A life-saver, in any case!

Got gold?

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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