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Posted on February 3, 2009 -
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By John Reizner |

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In an earlier article written during the heat of the current financial crisis I posited four possible scenarios regarding the outlook for our general economic future. Of those four scenarios, it may be that we are experiencing the most chaotic and potentially destructive scenario, one that may be difficult for many to envisage:

That is the third outcome posited in the article: "In this case, the deflationary forces would win the battle against Federal Reserve easing and government action, at least temporarily. In response to a deflationary calamity, the Federal Reserve may run the printing presses until an inflationary recovery could take place. Gold may do well under this chaotic scenario."

The four inflation scenarios that I allude to above are discussed here..
Currently, U.S. consumer demand for goods is abetting and consumers are retrenching as a result of the drying up of the credit spigot. Credit is now only available to the soundest of borrowers. Money may not be readily available to many borrowers to buy new homes, refrigerators, and automobiles. The consequent deleveraging of the average consumer (who is over his head in debt and who cannot borrow more to finance purchases) is a powerful wave in the U.S. Without the proposed mortgage and bank bailout by the Obama administration, millions more Americans might be on the cusp of losing their homes. I referenced the potential of a housing disaster in my August 8th, 2007 report on Ken Heebner's forecast of housing prices in my article, Bad Banks, Good Banks during a Credit Crunch: Opportunity Knocks.
In addition, significant layoffs (from the likes of IBM, Intel, and Macy's) have the potential to lead us into a downward economic spiral of decreasing demand and employment. Further, in this economy, we are also experiencing price decreases caused by retailers selling off goods as they liquidate their businesses. In a normal economy where credit is available, these retailers might have been able to go into bankruptcy and then receive financing to operate until they emerged out of it, saving valuable jobs.
Weakened banks are receiving huge cash injections of Federal money, turning them into partial wards of the State. Tens or hundreds of billions of dollars may ultimately be spent by government authorities in bailing out the countless owners of three- or four-bedroom houses whose mortgages are under water.

The Federal Reserve under Chairman Bernanke and the Obama Administration has used and may utilize further the myriad tools at their disposal to extricate our economy from this slump that has shown deflationary characteristics. The Fed can simply print all the dollars that are necessary to stimulate domestic growth, which in the long run makes the dollar worth less. The dollar may simply be inflated away, with the current deflation turning into a great inflation in the coming years, damaging the dollar's local and international purchasing power. It may be that the "cure" for our disease--massive government spending and easy money from the Federal Reserve--will be our undoing.
A demonstration of how quickly an economy can change is in the example of the Icelandic financial calamity of 2008. As reported on Wikipedia, the nation's three largest banks failed and their government's central bank was not large enough to guarantee the banks' bad debts (something that may not happen here: theoretically, our Federal Reserve's balance sheet is infinite). 

Iceland's stock market fell 90%, the local currency inflation rate rose into double digits and the value of the Icelandic krona sharply declined. Unemployment increased. The savings of many citizens were decimated. The movement of capital to and from the country is permitted only with permission from the authorities. Citizens who hold foreign currencies must hold them in an Icelandic bank. Iceland's transition from an enviable success story to utter financial collapse all happened in the span of less than a year.
Great Britain's government authorities have effectively nationalized much of the banking sector in response to insolvencies among many formerly powerful banking institutions. The British currency has fallen 30% from about $2.00 to $1.40 per Pound. The Pound does not have world reserve currency status, which may explain why so many market participants are more able to bet against it: it is not widely owned throughout the world and may be available in the scheme of the currency market to be sold heavily. Britain is seen as a declining power in the midst of crisis and its currency is merely reflecting this.
However, Britain suffered mightily from the stagflation years of the mid 1970's, when inflation rose to 25%, but its economy was later revived by the free market policies of Margaret Thatcher. So I would not count Britain out just yet. Much will depend on future U.K. economic policy. That said, I would not be surprised to see a short term rally in the Pound as the difficult reality of the current situation has been well broadcast and has been absorbed by almost all players. The Pound may be oversold.
Since the dollar is still the world's primary reserve currency (though that is in a state of adjustment), it is unlikely at this time that countries such as China and Japan who buy our Treasuries and sell us manufactured goods (taking our dollars in return as I.O.U's, increasing the supply of dollars outside the U.S.), will give up on us completely. However, they may look upon their massive U.S. investments with trepidation as we have lowered our living standards by accumulating massive public and private debt which must now be deleveraged. And there is no guarantee that the deleveraging will go smoothly. It certainly has not up until this point.
Our foreign creditors may shudder when they see us run our printing presses to stimulate our domestic economic growth, which may turn the current whiff of deflation in our economy into a galloping inflation and gold price, with double digit interest rates, and may result in the fall of the dollar in future years. During a time of severe stress on the dollar, the Obama administration could conceivably restrict the movement of U.S. capital to and from our shores. As has happened with nations who have followed such a policy, our stock market and the dollar might react badly.
On the subject of free trade, should we enact a protectionist trade policy, such as the trade barriers enacted in the 1930's, we could see additional shuttered storefronts and increases in unemployment, amplifying the current recession. Demand for goods by displaced workers could dry up. Given that so many of the goods used in this country have been produced entirely or in part outside the U.S., the net effect of increased protectionism could be inflationary, reflecting the higher costs of producing more goods by better paid American workers. The big risk is that our tariffs might be reciprocated by our trading partners, which could be a real disaster for the world economy.
A misguided Obama administration might enact strict regulations or increase taxes on industries that are currently performing well (at least relatively): the oil industry and the railroads are possible targets. Some see the railroads as price gougers because they are making excellent profits on hauling a variety of commodities. And last time I checked, at least one railroad was hiring. Before they were deregulated in 1980, the rails stagnated for decades and many rail lines were unprofitable. The deregulation allowed the industry to dynamically alter its business: reducing costs and improving service performance, laying the foundation for a deregulation success story.
Reregulation may restrict the railroads' profits and would likely lead to more layoffs and cuts in service. I believe that under some circumstances, regulation can be effective, but the problem lies when regulations stay on the books for many years or even decades, hamstringing the industries they were meant to "help" as the old regulations become increasingly obsolete. It appears to me that more regulation leads to less overall potential in the economy and could result either in inflation or deflation. The case of the struggling airlines is instructive. Prior to deregulation, airline profits were guaranteed and the public had to swallow the cost. In this instance regulation inflated airfares.
In conclusion, the deflation of many asset class values and some prices at the retail level that we currently see may be followed by a longer period of increasing price inflation caused by excessive growth in the money supply. This scenario could further destabilize our stock market, economy, and our currency markets. If the Obama administration makes economic policy blunders as I have discussed, many market participants may lose confidence in U.S. policy and continue selling the stock market.
However, if there are limited economic policy mistakes, the stock market may find a bottom in 2009 and may rally powerfully from that trough, and then may continue in a trading range (a similar pattern occurred in the rally after the nearly 50% 1973-1974 decline). Reflation winners who may benefit most from the rally are major oil firms and gold firms as well as physical gold. Gold is also insurance should the unthinkable occur and the economy melt down into a broad deflation without near term recovery in sight.
In Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things WorseThomas E. Woods, with foreword by free market thinker Ron Paul, describes the real causes of the current economic and stock market collapse. Woods, "a senior fellow at the Ludwig von Mises Institute and winner of the 2006 Templeton Enterprise Award," shows how government is not the solution to the current economic crisis, but is actually making the slump worse. Buy this one to gain greater insight into today's economic disaster.



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