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The DJIA (DIA), S&P 500 (SPY) and NASDAQ (QQQQ) have fallen deeply.  Many people had previously believed that although the stock market would fall, gold (GLD), silver (SLV), and most commodities would rise.  That belief has proven incorrect.  Stocks and commodities are interconnected.  A bustling economy maintains demand for commodities.  Of all the commodities, only gold and, also, silver (but only because it is produced mostly as a byproduct of base metal refining) have any probability of rising in the midst of a deflating economy.  Because of various temporary conditions, both metals are severely depressed in price, but that will change once the direction of the world economy becomes clear, one way or another.

At any rate, many investors have accepted a widespread and growing belief that we are entering a period of deflation.  It sure looks like it, at this particular moment in time.  Some even believe that we are about to enter a new Great Depression. There is an explosion of mainstream business writers who are feeding the idea, so it is natural that many people would believe it.  We have recently experienced a fast rising dollar,

After years of slow collapse, the dollar has suddenly soared into the stratosphere.  This process started on July 15, 2008, and has fueled market chatter about deflation.  The rising dollar proves, but only to those who are not familiar with the nature of derivative creation, that deflation makes sense.  What they do not consider is the desire of the G7 central banks to temporarily prop up the U.S. dollar, and the ease by which that can be done by paying interest on dollars to temporarily remove them from circulation in the stream of commerce.  On top of that, the temporary reluctance of banks to lend to other banks has also raised the dollar’s value, because dollar based interest rates have risen, in spite of the Fed’s action in lowering the rate available inside the borders of the United States. 

But, a rising dollar contradicts fundamental world money flows.  China’s export business has slowed a bit, but the USA still has a huge and growing current account deficit, and huge numbers of dollars continue to flow out of the USA.  Fewer are flowing back, as American exports dry up in the wake of a rapidly rising dollar.  Exports were recently the only bright spot in the economy.  In part a result of the G7 dollar pump and the collapse of exports, the American Institute for Supply Management (ISM) manufacturing index fell to 38.9% in October from 43.5% in September.  The huge continuing currency flows out of the U.S.A. will eventually win their struggle with the G7 central bank currency manipulators.  Now that central bankers have guaranteed the debts of even the most mismanaged banks and insurers, lending will soon resume normal levels. Then, the U.S. dollar’s value will fall again. 

Former Princeton economics professor, Ben Bernanke, is a prolific journal writer.  He’s repeatedly expressed interest in the Great Depression, and expounded on ways to avoid another one. He’s concocted a number of schemes to stop deflation over the years.  Some of these appear to be “cures” that are worse than the disease.  For example, he wrote most often about “quantitative easing” after bringing interest rates down to zero.   That is nice name for simply printing more paper money, the same tactics used by Zimbabwe in recent times.

The words “Federal Reserve Note” have been printed at the top since the creation of that organization in 1913.  A “note”, in legal terms, is a promise to pay.  The Fed promises to pay one dollar to anyone who holds one dollar.  Since you already have one dollar, what does that mean?  In our paper money system, the dollar’s value exists only because the government says it does.  It is a “fiat” currency, which exists by virtue of “declaration” of the government. 

Backing the U.S. dollar, in theory, however, are a large number of debt instruments purchased by the Federal Reserve.  These include treasury bills, as well as now defaulting subprime mortgages, shaky commercial paper, as well as loans to Lehman Brothers, and AIG that are likely never to be repaid.  To create dollars, the Federal Reserve buys this debt, and issues debits against them, without regard to the likelihood that the debt instruments will default.  By buying and selling this debt, the Federal Reserve increases and decreases the money supply. 

However, some of the debt held by the Federal Reserve is unlikely to ever be repaid.  For example, Lehman Brothers sold many subprime backed bonds to the Fed, while it was struggling to survive.  That bankrupt bank probably owes billions beyond the collateral.  Those billions will never be repaid.  The newly issued dollars are now backed by these shaky debt instruments, making the dollar, itself, very shaky.  Of course, with each Fed-held subprime mortgage CDO default, the U.S. dollar will lose a percentage of its value.

Balance sheet discipline is required to maintain fiat currency values.  Currencies maintain value only by virtue of rarity. Two factors can affect the value of the debt that backs the U.S. dollar and, therefore, the value of the U.S. dollar itself.  The first, as described above, is the overall number of dollars released by the Fed.  The second is the willingness of investors to buy dollar denominated debt.  If China, for example, decided to stop buying, or to sell dollar denominated debt, the value of dollar debt would fall.  Interest rates would need to rise in order to attract other buyers.  The debt instruments already held by the Federal Reserve would be worth less because they pay less interest and, therefore, they would devalue, and the U.S. dollar would devalue with them.   

Let’s ignore, for the moment, the idea that China or other investors might suddenly stop investing in dollar denominated debt instruments.  The dollars from the Fed balance sheet regularly enter banking, and these same dollars are serially borrowed, loaned, deposited, loaned, and deposited, again and again.  Assuming no outside disruption of the equilibrium, the money supply may end up being 50 – 100 times larger than the Fed’s balance sheet. 

The extent of the expansion is based on how willing banks are to lend, and how willing customers are to borrow.  As the Fed balance sheet grows, however, it is easier to expand the money supply.  Let's assume, for example, that the Fed balance sheet is $1 trillion, and the money supply is $50 trillion.  It means that the money has been lent, borrowed and deposited back about 50 times. 

If the base is $2 trillion, however, and the aggregate money supply is still $50 trillion, it means that the money has only been multiplied by 25 times, and that means banks are less willing to lend money, or customers are less willing to borrow. The multiplication factor represents the end result of the “velocity” of the money, which, in turn, is merely a calculation of how many people or companies are making claims on the same money.  In other words, by doubling the Fed balance sheet, you can supply the same amount of money to the overall economy, even in an environment in which banks may be 50% less willing to lend. 

In the last two months, there has been a frightening increase in the Fed balance sheet.  Fed dollar liabilities, as of October 30, 2008 stood at over $1.92 trillion dollars.  As late as September 11, 2008, the Fed’s balance sheet was only $932 billion.  On August 29, 2007, 14 months before, the balance sheet totaled only $902 billion. You can see all the Fed’s balance sheets, week by week, for yourself, at .  The number of dollars, floating about, inside the U.S. economy has literally doubled in the last 2 months, and is rising very fast from there.  As noted, the M2 and M3 money supply statistics are ultimately derivatives of the Fed balance sheet.  Over the past year, both have expanded rapidly, indicating that, excluding the multi-week “blip” after the bankruptcy of Lehman Brothers, most banks are still very willing to lend. 

The political pressure on bureaucrats, like Bernanke, on the part of large insolvent banks and insurers, crying out for bailouts, is intense.  Instead of a mild increase to offset the probability of mild deflation, therefore, the Fed has vastly overreacted, more than doubling the number of dollars in circulation, electronically printing over $1 trillion new dollars.  This will have a profound effect on the level of inflation.  It will not happen overnight, but it will eventually filter through the system, once business and industry fully utilize the incredible number of dollars that are now inside the United States, ready to be loaned, borrowed and deposited.  For example, the amount of commercial paper sold in the seven days ending Wednesday was up by $100.6 billion, to $1.5 trillion, according to an October 30th report by the Federal Reserve. 

To have deflation, we would need a long term reduction of more than 50% in the propensity of financial institutions to lend and borrow. There is no evidence that anything remotely like that has happened.  Indeed, up until the failure of Lehman Brothers, the velocity of money has remained very nearly the same in 2008 as it was in 2007.  Because that is the case, with the base number of dollars doubled, inflation should run wild.  It is a mathematical certainty.

Making matters worse, the Federal Reserve is not yet finished.  There will be new bailouts, expansions of existing bailouts like the one to AIG, more multi-billion dollar injections to support the stock market, and so forth and so on. Indeed, the Fed is now considering the idea of buying up more bonds issued by the U.S. Treasury, if investors don't want them. All of this will result in the printing of yet more new dollars.  We can reasonably expect the Fed to continue to massively print dollars, on its electronic printing presses, as the recession progresses.  Before this is over, it is entirely likely that the Federal Reserve will attempt to prevent any additional large financial institution from imploding.  Among others, the biggest American bank, Citigroup, is probably still on the brink of insolvency, if it is not yet there.  Some analysts are already saying that it “won’t make it.”   Hundreds of billions more in bail out money will eventually be needed to save Citigroup, and its highly paid executives. 

Based upon the anticipated losses from subprime, Alt-A, credit card debt, car loans, and so on, it seems to me that yet another $2 trillion worth of dollars to the Fed balance sheet. In the end, the Fed’s final balance sheet liability is likely to reach over $4.8 trillion, or an expansion of 5.43 times from where it was at the beginning of the credit crisis.  If we take the buying power of a dollar in August, 2007 as 100, the buying power within 3 years will be 1/5.43rds of that, or a total of 18 cents.  If the Fed stops right now, and does not continue to expand its balance sheet, however, the U.S. dollar will have a long term value of about $0.47, compared to its value in August 2007.   The U.S. Treasury is already making arrangements to inflate the government out of its debt.  This year and in the future, for example, the Treasury reduced the maximum allowable purchase of Federal I-Bonds (inflation adjusted bonds) by 12 times, or to a maximum of $5,000 per person.  The only rational reason behind such a move, at a time the Federal government has an increasing need to raise money, is to avoid having the government in the position of being forced to pay interest on its debt at the rate of inflation. 

In the long run, therefore, the dollar will fall and inflation will rage.  A small part, but not most of the fall of the dollar, will be against other world currencies, like the Euro, pound or yen.  All these are being heavily printed, just like the dollar.  All major currencies are likely to fall deeply against the price of real things, including real estate (once the froth is removed), hard goods, food, medicine, medical care, furniture, salaries, gold, silver, and so on.  In short, the chance of deflation and a “traditional” depression is vcry close to zero.  There is a one hundred percent probability of inflation.  Here are some predictions for the year 2012.


  • DJIA = 27,000+
  • S&P 500 COMPOSITE = 3,000+
  • GOLD = $4,300+ per ounce
Source: Coming Inflation To Boost Stocks, Gold