Why More QE Is Inevitable
Source: Julian Phillips, Gold Forecaster (7/30/10)
"The U.S. economy, at best, is in an 'L'-shaped recovery."
The U.S. economy can, at best, be described as in an 'L'-shaped recovery. It is anemic, faced with unyieldingly high unemployment and overburdened with debt; but worst of all, the average consumer has little to no confidence in the economy or housing for the next couple of years.
Fed Chairman Bernanke tells us the future of the U.S. economy is "unusually uncertain," sapping confidence further. In such a climate a slight push to the negative will see the economy slip back into a recession. Like, 'depression,' 'recession' has become an unacceptable word, because its use would drain confidence even more heavily. The housing market is already tipping into another negative slide with new house sales falling and mortgage rates at record lows. What can be done? We, like most other qualified commentators, free of political bias, see more quantitative easing as being unavoidable within three months, if the bad news continues. But this time, we have to ask, can it be managed without frightening side effects?
The U.S. Debt Crisis
Forty-eight U.S. states will be in deficit this year and the combined shortfall will probably exceed $300 billion. That puts Greece's expected 2010 budget shortfall of around $28 billion and the Eurozone crisis into perspective. Greece's shortfall is put at around 13.6% of G.D.P., whereas there are a good number of U.S. states anticipating deficits of more than 20% this year, including some, like California (that has already declared an emergency), New York, Florida and Illinois, with far bigger economies than Spain, Greece and Portugal lumped together. There are around a dozen U.S. states with bigger economies than Greece and most of these anticipate 2010 deficits at this kind of level! The result is going to have to be massive Federal Government bailouts in the midst of quantitative easing.
Deflation Attacked by Inflation
The net effect is the threat of default and massive deflation. The word 'depression' will be heard if there is no, almost unlimited, quantitative easing. While such measures may stave off the worst economically, the impact on confidence will be remarkable, but not in a good way. We believe that the Fed and government will accept that inflation is the lesser of two evils and overall, will lessen the threat of deflation, recession and bad debts. When all else fails, and a crisis demands extreme measures, extreme measures and consequences will come. Look back at the early eighties after inflation had run towards 25%, Volker emasculated it with interest rates of 25% leading to the next 20+ years of boom times. Can't this be done again? (The author was working for Chase Manhattan at the time and pointed out that interest rates and inflation in terms of Technical forecasts pointed to this level a year before it happened. Senior management ridiculed the prospect at that time.)
Certainly, it will result in the devaluation of the USD both internally and externally. But the rescue of the U.S. economy will be the top priority of the Fed and the government, irrespective of external consequences.
Inside the U.S. the current thriftiness of the consumer will turn to spending as he realizes that his savings are also being devalued, as is his debt. This will speed the velocity of money again as well as stimulate retail sales, inventory building, investment in capital goods and growth. Wonderful! Just what is wanted! Should inflation run amok, they always have the Volker solution. Such consequences will be seen as more than justifying the debilitation of the dollar.
Outside the U.S. the scene will be different. Externally the dollar will be devalued too.
Trade-dependent satellite nations will have to follow suit to keep exports at constant levels. Competitive devaluations of these currencies will become rampant. Even the Swiss franc will devalue to keep in line with the dollar (to keep international trade competitiveness), just as it did a couple of years ago, when it lowered interest rates for that reason.
Europe will be very unhappy to see the euro hold value while the dollar devalues and will attempt to follow suit. We do not believe any other currencies will be safe havens from USD devaluation. Indeed, we would not be surprised to see international cooperation to make currency devaluations act in synch.
But that's not the worst of it. Foreign surplus holders who form the backbone of U.S. Treasury Bills and Bondholders will be very unhappy with such devaluation after being castigated by the U.S. for holding their currencies down.
The Chinese have, in the past, sought reassurances that their holdings were safe from such devaluations. What recourse do they have? Very little, but they may simply not invest or acquire new dollar holdings, thereafter. If that or part of that happens the Treasury markets will suffer badly. These nations will prefer to price their exports in other currencies. No matter what happens to exchange rates, the lowering of the demand for the dollar from these sources will hit the U.S. very hard. After that rising interest rates alongside runaway inflation will be forced onto the U.S. public.
The Real Danger
But this is not where the real danger lies. It lies with the potential for runaway inflation and interest rates. The careful balancing act needed to manage such an environment may be too much for the Fed with its limited tools. If it acts too early to slow inflation, deflation resurges. If they act too late, inflation will be rocketing, so subsequent cooling of inflation will once again have a devastating effect on the economy, bringing much heavier deflation and an environment of mortally wounded confidence, back again. Letting these forces loose will catch the tiger by the tail and they may not be able to let go.
The Consequences for Gold in and Outside the States
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