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*** Jay Taylor On US Markets & Gold ***

Taylor On US Markets & Gold

FINANCIAL MARKETS

Inflation/Deflation Insights from a Subscriber

Dear Mr. Taylor,

At your suggestion I have begun reading The Creature from Jekyll Island. The clear assertion of this book is that with ongoing currency de-basement there is likely to be hyper-inflation as dollar-based assets currently held overseas are dumped back into the U.S. market once foreigners realize that their dollar-based assets are unstable, and the current interest rates can not compensate for the erosion of purchasing power of their assets due to excessive money creation by the Fed. I believe the current administration or any administration to follow will debase the currency at even more extreme levels than we are currently seeing, rather than face reality. With this I believe hyper stagflation is virtually assured. The inability to service debt from current income will lead to decreased economic activity and stagnation, and the extreme creation of new debt in an ineffectual effort to salvage the system will ultimately lead to inflation in unheard of levels.

Sincerely,
Peter D'Addario M.D.

Answer: Dr. D'Addario's line of thinking is along the lines of most investors. It is the natural thought process of most of us because we cannot imagine that our government and bankers combined cannot increase the money supply. Dr. D'Addario and most everyone else, including Keynesian and economists from the monetarist school, all assume that the money supply can forever be expanded at will to overcome deflation.

To understand why that is a fallacy, you have to understand how money is magically created out of thin air in our fiat banking system. It starts with the Fed buying U.S. Treasuries from the banks that hold these instruments. Having sold their Treasuries, the banks now hold cash. But banks don't make any money holding cash, so they make all kinds of loans. They make corporate, personal, credit card, mortgage, auto loans, etc. And when a bank makes a loan, the money supply immediately increases by the amount of the loan.

Let's say the Fed buys $1 billion worth of U.S. Treasuries from J.P. Morgan Chase. In the old days, when I was a banker, banks were restricted in the amount they could loan by 1-RR (Reserve Requirements). My good friend Dr. Larry Parks recently informed me that for all practical purposes there are no longer any reserve requirements imposed on U.S. commercial banks, which means that in theory, the $1 billion that the Fed "pumps" into Chase could result in an infinite amount of new money created through the following process: Company A borrows $1 billion and deposits it at Mellon Bank, whereupon Mellon Bank makes a new billion-dollar loan to Company B. Two billion dollars have now been created out of thin air. Company B then places the $1 billion in the Bank of America, which then makes another $1 billion loan to Company C. Magically, the money supply has now grown from $1 billion to 3 billion. This process can go on infinitely, given no reserve requirements. But even if there are reserve requirements of say 5% or 10%, the Fed can still create endless amounts of money out of thin air, though with reserve requirements, there is a practical limit to the amount of new money that can be created from each initial new infusion by the Fed. It seems logical to almost everyone that this process could go on forever without any end to money creation and inflation.

But wait a minute! Remember the banks are in business to earn (perhaps "steal" is a more fitting verb) a profit, which means they have to have their dollars, plus interest, returned to them. What happens when companies become so indebted that they cannot repay their loans and when companies can no longer pay each other, thereby leading to failures on the part of major companies to repay their bankers? When so much debt begins to strangle the cash flow of companies and individuals en masse, a giant "tsunami default wave" is being constructed in order to wipe out or repudiate the loans on the books. Just as one loan piled upon another results in the multiplication of the money supply out of thin air, so too the reverse is true. One default can lead to a chain reaction of defaults both inside and outside of the banking industry. Gold and silver based money systems do not experience this problem because unlike paper money, the worth of this "real" money is intrinsic and does not depend on the ability or willingness of others to pay their debts.

Of course you are going to say that banks no longer fail because of FDIC insurance which assures depositors their dollars will be there for them when they wish to have them. Afterall, the Fed can always "print" more money to cover any bank panic. No doubt the day of reckoning has been delayed for many years by the regulation post-1930s Depression and market manipulation put into effect by policymakers. But note I said delayed, not eliminated. In fact, Japan discovered that deposit insurance was at the heart of that country's inability to turn its economy around. With deposit insurance in place, there was no reason for Japanese banks to worry about making bad loans, so that's exactly what they did. Were the bankers to face the risk of going out of business due to bad loans, mal-investment in the Japanese economy would never have reached the enormous levels it reached, and that country's depression would never have lasted so long or perhaps might never have happened in the first instance.

Recognizing this problem a couple of years back, a fresh administration in Japan was set to reduce deposit insurance from its unlimited level to some limited level, perhaps along the lines of the U.S. limit of $100,000. The Japanese people knew full well that many, if not most, of their banks were virtually insolvent-so what did they do in this DEFLATIONARY environment? They rushed to the banks to pull out yen and they bought gold. Realizing that a panic in the banking system was inevitable if natural market forces were allowed to take hold, the Japanese government backed away from this right-minded remedy because it was simply too painful. But the result for Japan was that they have dug themselves even deeper into the pit such that they continue to rely on the U.S. continuing to live way beyond its means. As Richard Duncan so aptly pointed out in his book, The Dollar Crisis, the end to what Morgan Stanley economist Stephen Roach calls the "U.S. Centric Global Economy" will be a collapse of the dollar. Indeed the U.S. is now pushing the envelope on balance-of-payments deficits to levels that have not before been breached without national defaults.

A Dollar Collapse, Rising Interest Rates, and Debt Implosion

The U.S. now relies on foreign capital to fund 46% of its Treasury debt. This is absurd. I believe we must watch the dollar for a clue as to when the debt default spiral may get underway, at which time it is likely to set off what Ian Gordon describes as the "Kondratieff Winter." Indeed, calls for China to revalue its currency upward might set off a run out of the dollar. Now think for a moment what is likely to happen when foreigners stop recycling their $1.5 billion of trade surplus dollars into the U.S., given our enormous reliance on foreign capital. Interest rates are likely to rise dramatically, which could well trigger a massive run out of stocks and the housing markets. At that point in time, the major bull market in U.S. Treasury instruments, which is pictured below and which, as Ian Gordon points out, is the hallmark of the Kondratieff autumn, would be over.

Interest Rates During the Kondratieff Autumn

As you can see form the above chart, notwithstanding the recent sharp rise in longer-term interest rates, the Treasury bull market remains technically intact. A rise above and through this long-term channel, would signify that the bull market in U.S. Treasuries is over, at which time our creditors may quickly turn against the dollar. When that day arrives is when I believe deflation will become our greatest threat. Sooner or later that will be our problem no matter what happens on the global scene, because mal-investment combined with huge and growing interest expense is most surely sapping the life out of our economy. Mal-investment has led to plunging profit margins, which in turn leads to layoffs and reduced capital expenditures. And debt service requirements are taking more and more money out of the income stream of companies and consumers with the result being that demand continues to decline.

Indeed, despite the most rampant rise in monetary and fiscal stimulus, we learned last week that the year-over-year inflation rate (CPI) is now the lowest in 37 years! Sure, we agree with our beloved Congressman Ron Paul that the government is fudging inflation to make it look lower than it really is. But the trend of lower and lower inflation rates over time is, in my view, undeniable.

Another very disturbing trend that is very similar to the 1930s has been picking up a head of steam. The trend I speak of is a "beggar-thy-neighbor" policy of a growing number of governments around the world. Asian countries in particular are doing all they can to cheapen their own currency, vis-à-vis the U.S. dollar, and thereby gain a trade advantage against the U.S. They print their own currency with which they buy dollars to manipulate the currency exchange rate so they can continue to win the global trade wars. As a result of this policy along with the U.S. addiction to consumerism, it seems we are now on an inevitable collision course that might well end in a very sharp contraction of global trade and commerce, which might also trigger or at least add to growing defaults and an implosion or deflation of the global money supply.

I am also watching commodity prices for a hint of deflationary pressures. Over the past couple of weeks, we have seen a sharp decline in commodity prices. This may or may not hint at deflation, but it is worth watching; at some point, excessive global debt will weaken demand to such an extent that no matter how much money the policy makers attempt to create, it will fail to lead to a growth in the money supply as defaults on loans begin to implode the money supply, just as new loan issuances expanded it during the bubble creation process.

If the dollar is so important in the overall scheme of things, how does the dollar look at this time? Actually, during the past several weeks, the buck has fallen below all its moving averages and is close to declining below an important trend line. Longer term, the dollar has been falling very dramatically. Its slide was halted only by the Clinton Strong dollar policy which we are confident was underwritten by dishording much of the world's central bank gold supply and very likely also the U.S. gold supply.

GOLD

A subscriber sent me an e-mail today and asked what I thought the following news might mean for gold.

"ODJ Europe Precious Metals: Spot Gold Firm; Awaits News On Gold Pact By Chanyaporn Chanjaroen

"London, Sept. 19 (OsterDowJones) - Spot gold was firm Friday, with gains capped at $378 a troy ounce ahead of the International Monetary Fund meeting this weekend in Dubai, the United Arab Emirates.

"After a decent rally Thursday driven by the currency factory, players in the bullion market paused to monitor the meeting due to a wide speculation that European central banks may decide on whether to renew the Washington Agreement due to expire September 2004.

"The existing agreement places a limit on gold sales by European central banks? and was a big boost to gold prices when it was launched in 1999. At 11:47 GMT, spot gold was at $377.05/oz., slightly up from $376.30/oz. at London morning fix.

"A renewal of the Washington Agreement could lead to higher gold prices, with a long-term target for spot metal pegged around $400/oz., analysts said."

First of all, I think the popular press knows next to nothing about gold. Aside from Thom Calandra, I know of no one in the mainstream press who has even begun to talk of and investigate the very credible information assembled by the Gold Anti-Trust Action Committee. Most reporters do very little digging into what is really going on in the gold markets, which are among the least transparent markets on earth. Funny how our government preaches to the private sector about revealing all their activities to the public, while refusing to allow an audit of the U.S. gold supply. Funny also how our Treasury dodges questions from Congressman Ron Paul and others about the Exchange Stabalization Fund's involvement in gold.

We think market forces are getting away from western policy makers and that western banks begin to look very foolish for having sold their gold at prices dramatically lower than the market. There is likely to be a cessation of gold dishording by western banks. In fact, there could be demands from these banks to have some of the gold they leased out returned to their coffers.

There are growing reasons to own gold. Central banks like the Bank of China and now, I hear, Japan, are starting to buy big time amounts of gold. These countries understand the U.S. dollar's days are limited, so they are diversifying into gold. "Just a little" buying of gold (in percentage terms) has a dramatic effect on the price of gold because of the enormous amount of paper money that is being created, compared to the very slow growth of gold and silver. So as trillions upon trillions of dollars are being printed by foreign governments in an attempt to keep the dollar strong and as the U.S. prints money like crazy to try to keep its economy alive, the supply of dollars available to buy real and honest money, an asset money like gold or silver expands very, very rapidly such that even a small percentage of growth in demand for gold has a major impact on its price.

In support of our contention that the gold markets are getting away from western policy makers, check out the following information posted by Bill Murphy at www.lemetropolecfe.com on Friday:

"Gold came in stronger than expected on the Comex opening, which is almost always a very constructive development. It left a $1 gap and quickly shot up all morning, topping $383 at one point. Then the requisite Gold Cartel $6 price-capping rule went into play. That was all she wrote. The cabal regrouped and held gold in check the rest of the trading session and then did their requisite slam, knocking gold down a buck ON THE BELL. These no-good low-lifes are pitiful. Ah for the day when we can get our stretchers out, pick them off the mat, and then dump them in the sewer! "The big news is for Café members only. I received a call from London about The Stalker and learned a bit more about this "gold buying group." Two goodies for you:

"In addition to the $4.6 billion order, The Stalker is buying well in excess of another billion dollars worth of bullion and gold coins. The MIDAS analysis over these past months of huge new buying interests entering the gold arena looks better by the day.

"The orders are emanating out of New Zealand and Australia. My source believes it is Asian money and most likely CHINESE!

"This is wonderful news as it would mean the Asian (Chinese) gold buy program is competing with Indian, Turk, and Arab buying. Put them all together and it is easy to comprehend why The Gold Cartel has not been able to flush out the massively long specs. The Eastern buyers are always there on dips competing against one another for a diminishing supply of gold.

"It also explains why gold has been moving up in price with a corresponding, but lagging, move in the dollar. Gold is leading the way and doing so for the reason John Brimelow and I have articulated for so long. The key to the gold price is the surging physical gold market taking on the corrupt and devious Gold Cartel.

"These buyers are very sophisticated, worldly and certainly know what GATA knows. They could ascertain the veracity of the work of Reg Howe, James Turk, Frank Veneroso, and the rest of the GATA camp in a week. It is all on the Internet. These big new buyers know half the central bank gold is gone and they are making their move.

"Contrast their maneuvering to that of the West, which continues to lie and deceive the investing public about the true state of the gold market. You have nothing but disingenuous gold propaganda coming out of The Gold Cartel, bullion banks, western central banks, and the western financial market press. They are a disgrace as they have, for the most part, censored free speech by not allowing GATA to be heard or read in the mainstream financial press.

"The Café Sentiment Indicator works again. It has only moved up to a 4 or 5. Never seen anything like this in all my years of commodity trading. The efforts by The Gold Cartel to keep excitement over gold to a minimum is working. This is very good news for Café members. It means a stupendous gold share buying panic is on the way as the duped western investor will stampede into gold and the gold shares at the same time when they realize what they're missing. A GOLD SHARE BUYING PANIC IS COMING. There is no way the little gold share market will be able to handle this buying without the shares SOARING, "To The Moon Alice, To The Moon!""

September 23, 2003
Jay Taylor, Editor of J Taylor's Gold & Technology Stocks

http://www.gold-eagle.com/gold_digest_03/taylor092303.html