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Deflation and the U.S. Economy
Gold still the best indicator of our economy

By Scott Gillette


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Itís been six months since the once invincible US economy has plunged into significant weakness. A recession has yet to take place, nor is one inevitable or even likely, although it remains a significant possibility. What is especially alarming is the size of the downturn: the economy has gone from 5% real growth to almost 0% very, very quickly.

The ongoing downturn should be kept in perspective: the economy has leveled off for the time being, and most of its fundamentals remain strong.  Unfortunately, the most alarming aspect of our current woes is the fact that few analysts attribute our economic problems to its true source. Bob Novak recently wrote that Alan Greenspan was flummoxed by the weakness in consumer confidence in spite of respectable spending levels. What could explain this discrepancy? Whatís going on?

In a word: deflation.

The term deflation at its most basic level means the opposite of inflation, which is what worries economic watchers most of the time. Inflation can be described as a situation in which too much money chases too few goods. Conversely, deflation is when not enough money chases too many goods. During a deflation, the money in circulation is insufficient in satisfying all the exchanges that are occurring in the economy at any given time. It is not unlike a runner that cannot go faster or farther because he does not have enough oxygen to breathe.

Inflation tends to occur with far greater frequency because of the temptation for central bankers to print more money in an effort to cure a recession, or fund a war, or bail out a politically connected investment group that loaned out far too much dough. Deflations often occur by accident, or when the central bank is so overzealous in avoiding inflation that they end up causing the opposite problem. During inflation, the dollar in your wallet loses its value as a unit of account, so people who work and save and do the right thing see their efforts vanish before their eyes.  During a deflation, the dollar in your wallet actually increases in value, and just holding onto the dollar actually reaps a small return on investment.

We have been in a global deflation for a few years, as a consequence of the policies of Fed Chairman Alan Greenspan. Put simply, he has not provided sufficient liquidity (currency and bank reserves) into the US economy, and by default the world economy, which uses the US dollar as the monetary standard time. This had some positive repercussions for the US economy for a while, as ours is a service economy that likes lower prices. However, the lower prices have been devastating to food and commodity producers. Furthermore, the deflation contributed to, and may have even caused, the Asian crisis in 1998, as overextended banks saw many of their investments default, which in turn caused an economic meltdown. (A deflation favors creditors over debtors, but creditors cannot benefit if they canít get their loans repaid.)  

What about higher energy prices? Well, if you recall, the price of oil hit $10 a barrel in 1998, and gas was less than $1.00 a gallon in some places. But this caused oil and gas companies to cut back in exploration and production, and the stuff does not come out of the ground without a lot of investment. Consequently, there was an insufficient supply of the stuff to meet growing demand, which is why prices are so high.

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The incontrovertible evidence that proves a deflation is occurring is the gold price. Remember, gold is the incipient indicator which determines whether there is too much or too little liquidity in the US and world economy. Gold always has and always will tell us the overall state of our monetary system, because gold is the commodity that has served the world since the dawn of civilization as measuring the value of every other good and service on the planet.

Gold stands at $260 an ounce at the present time, when the optimal price should be between $300-$350, based on calculations of what the price level would be in equilibrium, without inflation or deflation. Until Greenspan and company put more liquidity into the system, however, the price of gold will remain lower than its optimal level, and the deflation will remain. This means the Federal Reserve must supply the necessary liquidity by intervening in the market without focusing on the interest rate alone.

Cutting interest rates have not helped matters so far. Although cutting the federal funds rate, which is the primary instrument at the Fedís disposal, can reduce the cost of credit, it has an indirect and sometimes unintended effect on the liquidity in circulation. Indeed, in the past months the Federal Reserve has actually had to take money out of the system in order to meet the lower federal funds target. The interest rate cuts have increased the demand for liquidity more than they have increased the supply of liquidity, and so the interest rate cuts have actually been tightening monetary policy, the exact opposite of what the interest rate cuts were intended to do!

This is a lot to chew on, I know. However, understanding monetary policy is not impossible. Once you understand monetary policy, you will be able to understand not only what is happening around the world, but how to create the conditions to improve the world as well. I assert that there is no way to underestimate the good that will come to the world when the dollar links itself to gold once again.

I highly recommend that everyone read the following:
Jude Wanniski:  A Gold Polaris
Bob Novak: Snap Out of It, Bush
Jude Wanniski:
No Reason to Hold Equities

Buy Books 

Deflation: Strategies for Building Wealth in the Coming Wave of Deflation
by A. Gary Shilling

The Crash of the Millennium: Surviving the Coming Inflationary Depression
by Raveendra N. Batra & Ravi Batra

Deflation; Why It's Coming, Whether It's Good or Bad, and How It Will Affect Your Investments, Business, and Personal Affairs
by A. Gary Shilling

Lost Boys: Why Our Sons Turn Violent and How We Can Save Them
by James Garbarino

Kids Who Kill: Confronting Our Culture of Violence
by Mike Huckabee

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© Scott Gillette, 2001, All rights reserved.

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