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The asset of first resort

Today the world is in the throes of an extreme liquidity squeeze. There is plenty of money in the banks but that money is not getting into the hands of borrowers for a variety of reasons. It could be likened to a fraternity party of 100 with five kegs of beer and only one bathroom.

Therefore we have entered a deflationary loop that will not be broken until the Fed forces the banks to make loans. Many banks don’t want to lend money given there are few qualified borrowers. And many people are scared to borrow given they may not have a job if the recession gets deeper and prolonged.

Deflation can be just as damaging as inflation to the economy as falling asset values weaken balance sheets for both corporations and individuals. Businesses have problems making profit as they must reduce prices to stimulate sales.

But the real dilemma is that 70 percent of the U.S. GDP is consumer-driven, and with prices dropping, consumers put off major purchases anticipating lower prices. Corporate spending is another component of GDP that has dried up as capital expenditures generally are done with borrowed money from corporate bonds or lines of credit. Credits lines have been pulled or reduced dramatically. U.S. exports make up another portion of the GDP. The recent strength in the dollar causes exports to drop, thus adding more negative pressure on GDP growth.

That leaves only the U.S. government’s spending to boost GDP, and spend it will. However, government spending must go through a lot of time-consuming red tape. Time the economy can ill afford but that is life in D.C. Delays will ultimately create pent-up demand.

Once consumer spending restarts and banks are lending, I believe we will see that huge pent-up demand act like a slingshot on inflation and GDP growth. However, the Fed is far less worried about overheating the economy than they are about the economy remaining frozen. That current lack of concern regarding inflation could create massive inflation in the future.

I suspect things will be so bad by quarter two and quarter three in 2009 that Ben Bernanke will not use a helicopter to drop money over the public but instead a C-130 air cargo transport to carry the massive amount necessary for real stimulus.

Bottom line: As the world loses more and more confidence in all paper currencies, the price of gold and other commodities will go higher. Keep in mind that the DJIA took a quarter century (1929-1954) to recover from the last major liquidity crisis. That recovery was a direct result of America’s manufacturing base selling equipment to the world to fight World War II, not just government spending.

Today we do not have a manufacturing base to make up for the loss in GDP slow consumer spending will create. In addition, the de-leveraging of personal and corporate balance sheets will not allow the level of profits that occurred over the last 10 years. 5:1, 10:1 and even 15:1 leveraging distorted the real growth of the overall economy. A de-leveraged economy will grow much slower.

So where do you put your money?

Think about a 10-year T-Bond. Totally safe but totally illiquid for a decade and zero potential for profit. Real estate may have another 20-25 percent to go before bottoming and housing is totally illiquid right now given there is no lending.

That is why gold makes so much sense.

In reality I do not see U.S. stocks improving for perhaps 5-10 years and possibly longer to get back to the previous high of 14,168. Stocks are okay if you are a gambler. But people are turning to gold en masse because nothing else out there offers gold’s safety, liquidity and profit potential. Gold is the smart investor’s asset of first resort when the government becomes the consumer of last resort.