From a July 9 letter to a friend inquiring about my thoughts on gold:

I think everyone needs to own some physical gold now, since the dollar will flameout eventually, though I don’t think just yet. Also, things could get really hairy, so along with gold I’d have an account or two outside the country and a list of favorite safe-havens. If it gets so bad that you might need guns and gold coins, it’s better to get out and watch it on TV!

On the other hand, crazy as it seems, I do not think of this as an inflationary period right now, but deflationary. The best way to think of inflation is not as price increases, but as credit expansion–easy money–which happens to result in higher prices. Credit expansion has turned to credit contraction in the US and most of the rest of the world, though China and some other eastern countries are lagging. The UK and Europe and Latin America are very close on the heels of the US–Spain is a bloodbath right now, and the UK is about where we were last fall.

As credit is withdrawn (no more HELOCs or CC offers), people have less money to spend and many are levered to the gills already so it is all they can do not to default, let alone take on more debt. They can’t and don’t feel like splurging on cars and vacations and consumer goods anymore. And the Banks’ balance sheets have been laid to waste from all the defaults on under-collateralized loans, so they can’t lend, and would be too afraid to if they could.

In an economy like the US, when credit dries up, whole industries crash–housing, autos, retailers, restaurants, airlines, and people get laid off. They stop shopping and start defaulting, and the banks get hit even harder, so they can make even fewer loans, and the shit gets deeper. This goes on and on until all of the reckless borrowers and reckless banks are bust. Usually, they are just a few, but things got so crazy lately that it is going to keep spreading to include almost every consumer and every bank in some way.

This is a long-winded way of saying that nobody has any money anymore. So far just in the West, but soon in Asia too, since this is one global economy. With everyone broke or tight-fisted, how can people keep bidding prices up on anything? Already stocks, houses, cars, clothing, electronics and other toys are getting cheaper. All that is still going up are commodities, since China is still booming and building a new Milwaukee a week. But they have borrowed too much and built too fast just like us, so will feel the hurt before long. Their exports are slowing by double digits, and their stock market is down by 50% since last summer, so I think this is already happening.

So while Obama will channel FDR and try to spend us out of this mess (and make it worse), those programs will be slow in coming and actually pale in comparison to the credit destruction and loss of wealth that is going on right now. Crazy as it seems, dollars are great to have right now, though Swiss Francs are better.

I like physical gold, though I’ve been selling my gold shares. I think gold topped out for now back in March at 1000, when advisors were about 98% bullish on it, and I think it could drop under 700 before long if not to 600, so I’ve hedged what I have with puts on GLD. But everything else will drop a lot more than gold, so gold’s real purchasing power should continue to increase for a long time.

So I think this inflation scare will pass soon. The bond market is way smarter than the stock market and it has been signalling deflation with falling yields across the curve. I think we’ll see 1.5% T-bill rates again soon.

I’m very aggressively short so I don’t have much cash myself, but I think cash will be king. The markets tend to inflict maximum pain on the maximum number, so it doesn’t bother me that almost nobody else is thinking deflation right now. One great blogger who is is Mish Shedlock: globaleconomicanalysis.blogspot.com. I’ve learned a lot about the credit cycle from him and from Bob Prechter. The other side of the inflation/deflation argument is held by guys like Jim Grant, Jim Rogers, Doug Casey, Marc Faber, and Peter Schiff, all of whom I read and respect a lot.

Won’t the Fed print? Yes, but not fast enough or nearly enough, when you consider that there is about 40 Trillion in private debt (govt debt is another 60 Trillion including entitlements) in the US and the Fed’s balance sheet is less than 900 billion. They just don’t have the ammo to make much difference in the short-run (2-3 years), though they certainly will destroy the dollar before this is all over many years from now. This is why when I am done shorting in a year or two I’m going to put my proceeds in gold.

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