I keep yammering on about inflation, because there are alot of bozo’s our there (see: Market Analysts) who keep telling people to trade in FOREX. Heres the deal, if there is a ship in the center of a fleet of ships and it is sinking in inflation (picture the USA), and there are a bunch of other ships around it and they are sinking as well, then it doesnt matter which ship the rats jump to, its still going down the crapper!

The only solid ground right now is in commodities! Gold, Silver, Energy, and Food. 15 year run.

The United States is the center of the deflationary economic slowdown, inflation is more of a worldwide phenomenon. Inflation rates in China, for example, are higher than they are in the United States. Prices of apartments in Buenos Aires…subway tickets in Paris…hamburgers in Singapore – everything is going up.

In the past, inflation has always had a national identity card. The inflation of the ‘20s was concentrated in Germany, where hyperinflation wiped out the middle class and set the country on the road to ruin. Investors…like Jewish refugees 10 years later…had to move their savings to France or England to escape it. Likewise, in Argentina, the inflation of the ‘80s was easily avoided – just put your money in a Miami bank.

Traditionally, the dollar was a haven for people wishing to protect themselves from inflation – even though the dollar itself was losing value rapidly . In 1935, a U.S. dollar had about the same purchasing power as a U.S. dollar from 1800. Then, it began a steep decline…erasing 95% of its value over the next 70 years. Still, people with money usually preferred to keep their money in dollars, rather than in…say…australs or zlotys. The dollar may have been losing value, but at least it was doing so in a gentle, “controlled” manner.

But times have changed. Now, there’s a new kind of inflation – it is practically everywhere…in every country…and it risks spinning out of control. That is why gold is hitting new highs – against almost every currency…and every other market…in the world.

News came yesterday, that the Fed has quietly lent some $50 billion to member banks using a new method – an “auction facility” that allows banks to put up unconventional collateral. The government no longer reports a figure for M3, the broadest measure of the money supply, but shadow analysts say it is going up at 15% per year – about six times faster than GDP growth.

Most of this money ends up outside the United States. That’s where most U.S. Treasury debt ends up too. The dollar is America’s leading (and highest margin) export. This has forced foreign central banks to create more of their own currencies to buy up the dollars; otherwise they would face a competitive disadvantage, in that the dollar would fall against their local currencies, making their exports more expensive on the world market.

And so, the whole world is being smothered in paper. Paper dollars…paper euros…paper rand…paper cordobas…paper money of all sorts. Where can the investor go to get away from this paper? What can he buy to protect himself from inflation? How can he get some air?

That’s right. Gold. And it’s why this bull market in gold could be even bigger than the last one. Then, in the late ‘70s, it was primarily the U.S. dollar that suffered from inflation…and primarily Americans, and perhaps Arab oil exporters, who were buying gold. The Russians were still building cars that didn’t run. The Chinese were still recovering from their Great Leap Forward of the ‘60s and dismantling their backyard steel mills. And the Indians weren’t even awake yet.

Now, the whole world is different. It is full of more paper money than ever before…and full of billions of alert people who will want to protect themselves from it. They might try stocks…or property…or Rembrandts…but traditionally, the surest, simplest solution is gold.

For those of you out there thinking that the yellow metal is too expensive to buy now, you are halfway right. But youre a smart cookie, and you will see a good opportunity for what it is. Get a FREE Beginners Guide to Gold and Silver Investing, and register to receive a crash course in why some people will benefit while others are losing their shirts, and a little known secret on how to seriously cash in on gold.

Jeremy Grantham says he thinks housing prices in the United States will go down 20% to 30% from their peak. That’s a potential loss to Americans’ implied wealth of as much as $6 trillion. This is part of what leads Financial Times columnist Martin Wolf to describe the coming slump in the United States as the “mother of all meltdowns .”

Wolf refers to the work of New York University economist Nouriel Roubini, who argues that the housing decline will put 10 million homeowners upside down, with more mortgage than house. It will lead to collapsing credit…defaults…and huge losses to lenders. It will also bring about a big cutback in consumer spending and unavoidably push the United States into a deep recession.

One of the wild cards of the doomsday scenario is the performance of the derivatives market. No one knows exactly what is in some of these instruments…and no one knows how they will hold up in a crisis.

One thing we do know here at The Daily Reckoning is that they will not hold up as expected. We know that because the assumptions behind them were, fundamentally, nonsense. The most sophisticated mathematical model in the world is not worth a campaign promise if the theory behind it is wrong. And the idea that you can model future prices on the basis of past prices with any predictive reliability is simply wrong. Speaking loosely, it is the problem noticed by Heisenberg when was trying to observe and measure atomic particles at the same time…or ethnologists when they are watching savages gootchy goo. The act of observation causes distortions. As soon as you notice “stocks outperform bonds over the long-term,” for example…you cause a distortion in the stock market. People buy stocks, expecting better performance. Buying drives up prices. Then, higher initial prices bring lower rates of return over the long run.

Using Black-Scholes pricing model…and other sophisticated tricks…the salesmen proved that they could produce higher yields with lower risk. The models, of course, depended on the future being like the past. But never before had investors been offered such opportunities to distort the price curve!

The derivative market exploded in the 2001-2006 period, with annual rates of growth (from memory) of nearly 100%. But then, subprime debt blew up…and buyers started asking questions. In 2007, the derivatives market fell apart. And so far this year, new derivative sales are off 93% from the year before. CDOs, SIVs, Monolines…they’ve all had big trouble.

“Many CDOs could be worth less than 5 cents on the dollar,” Strategic Short Report ’s Dan Amoss tells us. “Final values won’t be clear until the loans supporting these securities go through the default and recovery process.

“Many Wall Street firms cannot simply confess their final losses, because delinquencies have just started picking up from generational lows. Also, these firms may soon discover that the insurance covering defaults of their CDO holdings is worthless.”

And now comes the Financial Times with more trouble. “CPDOs are at risk,” say the FT . What are CPDOs, we had to ask? They are Constant Proportion Debt Obligations…a kind of derivative on a derivative…a bet on the derivative index.

Not knowing anything about them ourselves, we turn to someone who does for an opinion:

“If these [structured products] do get unwound en masse, the effect on the market will be horrible,” said credit strategist Barnaby Martin at Merrill Lynch. “Between $1,000bn and $2,000bn of synthetic CDOs have been issued over the last four years. Any unwinding will likely be crammed into a much shorter time period.”

Bottom line is, we have a ways to go before its all clear, and when ships cant see the harbor through the fog, smart captains buy Gold and Silver.

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This entry was posted on Saturday, February 23rd, 2008 at 1:05 pm and is filed under 1 - Gold, 3 - Understanding The Economy, 4 - Inflation, Currencies. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.