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Gold Friendly Deflation Is Here-Get Used to It! Part III
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This is the third in a series of five articles relating to current trends of deflation and how it relates to gold. Today we look at the stated commitment of Fed Chairman Ben Bernanke to print as much money as needed and distribute it by helicopter if need by to avoid deflation. However, as stated yesterday, we believe the size of the debt problem is simply so large that policy makers may not be able to create enough inflation to overcome the deflationary process that is now well underway.
From the point of view of an investor, deflation as opposed to inflation is absolutely the best environments for gold mining companies because the cost of production falls relative to the price of the product, thus enhancing profit margins for gold miners. This was true in the 1930s and we believe these pro-gold mining dynamics are starting to reappear as we enter 2009.
Deflation: Making Sure “It” Doesn’t Happen Here
 Regardless of whether other Austrian leaning thinkers and I believe market forces can be overcome with massive monetary and fiscal stimulus, policy makers certainly believe it can be overcome. In 2002 when Japan continued to suffer through their deflation, Fed Chairman Alan Greenspan was starting to pump the gasoline into the economy that would lead to the housing bubble. On November 21, 2002, Ben Bernanke made a speech titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In his speech he said that with enough money pumped into the economy and by using all manner of unconventional policies a deflation could definitely be overcome.
At Milton Friedman’s 90th birthday celebration, Ben Bernanke quoted him as saying, “The Great Depression was deep and protracted because the Fed failed to inflate enough to stop it.” Bernanke reportedly said to Freidman, “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
Well, here we are with unbelievable amounts of money being pumped into the system and all manner of unconventional policies implemented both by the Fed and by the Treasury, and what do we get? As noted above, we are getting some of the biggest deflation readings in the past 60 years! The response of course is not to acknowledge that the assumptions under which Bernanke and Paulson are operating are wrong, but rather that still more of the same plus much more vigorous fiscal policy is needed. When will it end? Trillions of dollars of financing that the government does not have will have to either be bid away from the productive private sector and/or printed to meet these new unconventional funding commitments, on top of Social Security and Medicare funding that, by themselves, threatened to bankrupt the system.
Could the basic assumptions upon which policy is being set be wrong? Could it be that Milton Friedman’s assumption the 1930s depression was caused because the Fed did not pump enough money into the system early enough and fast enough is the reason for the Great Depression? Or could it be that massive credit creation was the cause?
I think the evidence suggests that is likely the case. After all, the Fed was very aggressively pumping money into the banking system very early on after the October 24, 1929, stock market crash. By early 1930, the rediscount rate had fallen to 2% from 4.5% at the time of the crash. Some $116 million was pumped into the system. Controlled reserves increased to $218 million, and the gold reserve (which allowed the money system to expand, as the dollar was backed by gold then) rose by $309 million after England detached the pound from gold. Yet, despite these efforts on the part of the Fed to stimulate growth through an excessively easy money policy, the money supply actually shrank from $73.52 billion to $73.27 billion. Hence the “pushing on a string” analogy.
 The same thing is happening now. Huge reserves are being pumped into the system. For example the money base has been rising very dramatically, yet banks are not lending that money out which is required to expand the economy through the fractional reserve banking system. And now with deflation numbers starting to hit us hard, it does not inspire confidence that our policy makers can avert a depression any more effectively than they did in the 1930s. Indeed, the headwinds in terms of GDP from which to fund debt are much stronger now than they were during the 1930s. As indicated in the chart on your left, from the November 11 article of MoneyAndMarkets, we can see that the total debt is now 350% of GDP, whereas it was only about 260% in 1932. Note how sharply debt to GDP dropped during the 1930s, thus indicating attempts by policy makers then to increase debt, failed utterly. Once that debt was run off the system and with WWII, the last K-winter finally ended.
As Austrian economic thinkers understand, what will allow things to turn around in the economy is for debt to be reduced rather than increased, as is currently the goal. With the decline in markets taking place so suddenly (since mid September), the current failure to expand the system isn’t pictured on the chart above. But in fact that is what is reportedly happening. Banks are not lending, despite huge reserves pumped into the system. And without an expansion of the money supply, it’s hard to make a case for inflation at this point in time. We don’t suggest that some horrendously aggressive fiscal policy can’t yet overcome this deflationary binge. But the heart of the problem, as I see it, is that the analysis of what caused the 1930s depression is wrong. With an incorrect analysis, policy makers are not going to offer solutions that work. In fact, as we see it, policies are making the system worse by increasing debt rather than allowing it to work itself out of the system. Only then will we be able to enjoy the happier early seasons of the Kondratieff cycle.
As Ludwig von Mises said, “There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.”
J. Taylor
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Jay Taylor is editor of J Taylor’s Gold, Energy & Tech Stocks weekly and monthly newsletter. Jay provides stock recommendations with a major focus on the mining and energy sectors and also provides strategies designed to profit from major trends. Visit (www.miningstocks.com) for more information and/or call Claudio Bassi in Jay’s office at 718 457-1426 Monday through Friday between 9:00AM and 4:00 PM Eastern time
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