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Gold was on course to breaching the magical $1000 threshold again at the end of May

when Goldman Sachs published a Research Note 'The US Dollar - As Good as Gold.' The

report set out why, at current prices, they were not recommending gold. Unsurprisingly,

the gold price retreated within days of the research being published falling from $975 on

May 29th to $919 on 22nd June. I say 'unsurprisingly' not because Goldman's Wall Street

consensus analysis was specially insightful or revealing. Rather, because packs of

speculators and all too often also investors get carried away when they scent blood in the

air. Then, when they hear a warning shot, they panic.

The 'Dollar As Good As Gold Report' concluded: 'With the average cost of production

estimated at $500 per ounce, the marginal cost of demand at $700 per ounce and no

shortage of gold for real long term use, a price of $950 seems enough to provide mining

companies with very attractive returns on their capital.' The analysts added 'if worries

about the debasement of paper currencies persist, or any signs of inflation appear, the

demand for additional gold could push prices above $1,250. Between March 1973 and

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August 1975, the moving 3-year average of year-on-year inflation was 10% and gold

rallied 27%. Between May 1978 and November 1981, when inflation measured 12% per

annum, gold rallied 47%. So clearly, unanticipated inflation is favourable for gold prices.'

As they didn't expect either inflation shocks or that the dollar would will be debased by

lax monetary policy when global economies recovered Goldman were not recommending

gold. They noted, however, 'just like crude oil in mid-2008, if enough people worry about

the dollar and inflation, momentum can carry gold to much higher levels beyond any

measure of fair value.'

Though not everyone will agree gold production cost is as low as $500 an

ounce Goldman's arguments were in line with a general Wall Street consensus on gold

and with 'conventional wisdom.' We all generally expect gold to perform well when

inflationary pressures build up. The statistics quoted above confirm this view. However

contrarians and out of the box thinkers won't be impressed by analysis that doesn't

address deflation. Many among them, including the writer of this article, see both

deflation and global overcapacity as menaces to the global economy.

We all have a pretty good understanding of the effects of inflation. But most of us know

literally nothing about deflation and that's only to be expected. It's three quarters of a

century since the deflation associated with the Great Depression. Other than

knowing that since the 1980s Japan has endured a multi decade deflation experience

most people aren't familiar with the causes and effects of deflation, don't know

when there is a real danger of deflation or understand why gold is ultra important when

there is a chance of deflation.

Leading economists, including Nobel Laureate Dr Paul Krugman are questioning old views

on Japan and warning 'we may or may not be about to face our own lost decade, but the

sheer misery millions of Americans will face in the near future probably exceeds anything

that happened in Japan during the 90s.'

The comments that follow are from an exceptionally thorough, well informed and insightful

article written in 1986 by Dr. Sam Hewitt, founder of Sun Valley Gold Company. The

essential message from the analysis is the 'conventional wisdom' that because gold

performed badly during recent decades in a period of disinflation it will do even worse

during deflation is flawed. The lesson from history is that currency hoarding is a common

feature in deflationary episodes and 'the interaction between declining credit quality and

currency hoarding is key to understanding the role of gold as an alternative

currency. Each historical episode of deflation confirms that whenever confidence has

declined in the issuer of paper currency gold was favoured over paper currency as a capital

preservation asset.'

Deflation is defined in the Sun Valley report as : 'Falling levels in economic activity and

falling price levels on an absolute basis. Contraction of economic activity is generally

preceded by an unsustainable boom period and usually kicked off by an event which

causes economic confidence to be lost. Characteristic of most deflationary periods are

deteriorating credit quality and the shift by investors from capital growth to capital

preservation. Deflations typically end after crisis conditions force policymakers to enact

large-scale inflationary policies designed to counteract deflationary conditions.'

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Reading the definition of deflation it

To describe the global financial collapse commentators have used the analogy of Humpty

Dumpty's fall and have been questioning whether he can be put together again. A

Goldwatcher blog "Has Bernanke whizzed the Humpty Dumpty economy into a Hunky-Dory

economy? dates back to March 2008.

How little we knew about Humpty then! In their recently published book 'Animal Spirits'

the celebrated economists Nobel Laureate Dr. George Akerlof and Dr. Robert Shiller inform

us Humpty's misfortune hails from a time before children's story books were illustrated.

This explains why over the years we have forgotten Humpty was an egg. The authors

conclude, 'all the King's horses and all the King's men could not put him back together

again.' And, they add 'that tale well describes the current financial crisis.' Out of the box

analysis in their book 'Animal Spirits,' discussed later in this article, contributes to a better

understanding of the crisis and suggests innovative solutions.

Also discussed in The Goldwatcher is Nobel prize winner Paul Krugman's comment on

prospects for a dollar plunge resembling the bad tempered road runner cartoon character

Wile E Coyote at the moment he stepped over the edge of a cliff with his legs flailing in

thin air and realized, alas too late, he was about to plunge into a chasm.

Dr. Krugman concluded if creditors find they had been myopic there may yet be a Wile E

Coyote moment for the dollar. Ironically, it wasn't the dollar that faced a Wile E Coyote

moment when the financial crisis hit. It was the global economy. And, as the crisis

developed, the dollar has remained in demand as a perceived safe haven.

Debtor creditor imbalances between the U.S., China and other dollar surplus

countries are often cited as a root cause of global economic instability. In whitewashing

President George W. Bush's borrowing binge Fed Chairman Ben Bernanke made the case

that a global savings glut had literally foisted trillions of dollars of cheap money on U.S.

consumers. Indeed, as cheerleader for the global savings glut theory Bernanke may

have been the most myopic of all concerned parties. Commenting on his whitewash The

Goldwatcher quoted the well respected investment banker and economist Donald Coxe's

acerbic comment that it was really a case of a global savings glutton gobbling up the

savings of the rest of the world. In any event the global savings glut story is now history.

While Bernanke and others were hyping the global savings glut and other patently flawed

theories contrarians and other out of the box thinkers were anticipating and warning of a

pending crisis. In his book Debt and Delusion, published in 1999, a British economist Dr

Peter Warburton made the case that central bankers were so obsessed with rooting out

inflation they only looked at credit statistics relating to banks - ignoring the

enormous, burgeoning and largely unregulated credit explosion taking place in what we

now call the 'shadow banking' system. As a consequence in the boom years linkages

between reported expansion of credit in the major Western economies and real world

money were grossly understated and misleading. Further the impressive reduction in

inflation reported was an illusion 'obtained largely by substituting one set of serious

problems for another.' The effect was tipping economies into over capacity and deflation.

Warning now of an imminent return to inflation Warburton is again running contrary to

the consensus view that a global excess capacity glut and deflationary pressures will keep

inflation at bay. He accepts consumers can expect to be the beneficiary of inventory

liquidation for an extended period of time. But lean inventories and 'the fracturing of the

supply chain mean that obtaining products will become not only more difficult but also

more expensive.' It's worth remembering that when Chrysler & G.M.

sought bailout taxpayer funds among the most compelling reasons for support were

repercussions that would follow for the industry's component supply chain if they went

out of business. Even Ford, still able to survive without government support, informed

Congress if G.M. or Chrysler went our of business they would be vulnerable to supply

interruptions and would also require government support. Foreign owned auto

manufacturers in the US were in the same boat.

Auto component suppliers remain vulnerable as, apart from dire industry conditions, they

have been obliged to accept an expanded role in the supply chain involving finance for

just-in-time manufacturing programs and associated customer support obligations.

The message from Dr Warburton's analysis is a Keynsian focus on the consumer will not

be sufficient for economic revival. The supply chain can't be ignored. If it's broken the

economics of the industry will be affected and prices are likely to rise.

In spite of a cash for clunkers scheme introduced to support car sales in the U.K.

manufacturers put their prices up. Many, including Ford have already increased prices

twice this year It's unlikely now auto prices will ever be as low as they were over the last

few years. So, while there is a strong case to make that deflationary pressures will keep

inflation tame, there are also instances where inflationary pressures will prevail.

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The phrase 'animal spirits' was introduced into the economics lexicon by Lord Maynard

Keynes who recognized people are not always rational in their financial decisions. They

also act following their animal spirits - ' a spontaneous urge to action rather than

inaction... our innate urge to activity that makes the wheel go round.' In their book

'Animal Spirits' mentioned above Akerlof and Shiller approach macroeconomics from the

perspective of human behaviour and find conventional macroeconomists failed to

anticipate and prevent the financial crisis because they ignored essential behavioural

characteristics. These include confidence, fairness, concerns over corruption, bad faith,

and money illusions. I can add with some satisfaction that the chapter in The Goldwatcher

addressing gold prices starts with a quote from Lord Keynes on animal spirits followed by

the sub heading 'Introduction : A crisis of Confidence.' Not only do Akerlof and

Shiller make a convincing case for the imperative to restore confidence but they also find

confidence and lack of confidence have multiplier effects.

Bantering with the phrase animal spirits in a book addressing economics and

behaviour makes for some entertaining reading and also for some confusion. But the key

conclusions Akerlof and Shiller reach are substantial contributions to improving monetary

policy. They identify the credit crunch as 'the overwhelming threat to the current

economy, and argue 'it will be difficult and perhaps even impossible to achieve the goal of

full employment if credit falls considerably below its normal levels.' To bridge the gap they

propose a credit target for policy makers and note 'achieving the credit target is urgent for

several reasons. Most pressing is that firms that count on outside finance will go bankrupt

if they cannot obtain credit and, if the credit crunch continues and many firms go

bankrupt, it would take an impossibly large fiscal and monetary stimulus to achieve full

employment.' Akerlof and Shiller approach issues of credit and unemployment from a

different perspective to Dr. Warburton but their conclusions aren't far apart. Talk of green

shoots in the economy isn't convincing while unemployment is rising and while firms that

can't access credit are going out of business.

Dr. Nouriel Roubini, the economist who has most consistently identified the causes

and evolution of the financial and economic crises has written that while he sees light at

the end of the tunnel with the U.S. and global recessions over by late 2009 he also

forecasts an anemic and vulnerable recovery with a peak unemployment rate of close to

11% in 2010. Such a large unemployment rate he notes will have negative effects on

labour, income, consumption and growth; will postpone the bottoming out of the housing

sector; will lead to larger defaults and losses on bank loans (residential and commercial

mortgages, credit cards, auto loans, leveraged loans); will increase the size of the budget

deficit (even before any additional stimulus is implemented); and will increase

protectionist pressures.'

Against this uncertainty and doubt, gold has already made a comeback in central bank

reserves. This is after years when its retention in their vaults was often seen as pointless.

The revived interest in gold is because of concerns over the stability of fiat currencies.

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David Rosenburg, former Chief Economist for Merrill Lynch and now chief economist and

strategist with Gluskin Sheff & Associates, comments the US dollar ".. is the only policy

tool that has not budged one iota since the crisis erupted two years ago. But we are sure

that as the unemployment rate makes new highs and increasingly poses a political hurdle

in a mid-term election year, it would make perfect sense for a country that always

operates in its best interest - even if it may not be in everyone's best interest - to sanction

a US dollar devaluation as a means to stimulate the domestic economy." With downside

potential for the dollar he suggests investors protect their portfolios from the

consequences of a declining dollar with a range of investments including gold.

David Rosenberg's analysis is consistent with the view that to escape the consequences of

unsustainable booms policy makers are prone to take whatever steps they can to revive

economic growth - even if they devalue their currencies in the process. Gold attracts

again as an investment that retains purchasing power regardless of manipulations eroding

the value of fiat currencies.'

Reports from national mints and gold dealers in all major centers confirm that physical

gold is in short supply and the reasons why are obvious. Currencies are vulnerable to

debasement and when confidence declines in the issuers of paper currency gold is

favoured as a capital preservation asset.

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The views expressed in this Newsletter are those of the author(s). They are offered to readers for information and

general guidance only. Nothing in this Newsletter is intended, and should not be taken, to constitute economic or

investment advice.

The author(s) of this Newsletter or the owners of Stock Research DD Inc. (the owner of

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