Quote:

we think the commodity theory of gold is as wrong as the State Theory of Money. We turn once more to Professor Jastram, and while we get no joy from his view that gold is not money, we take comfort from his empirical evidence that gold acts like money. We turn also to common sense, and note the fundamental economic difference between other commodities and gold: all other commodities are produced for consumption, whereas gold, precisely as a function of its money-like qualities, is produced for accumulation. [10] Virtually all the gold ever produced still exists somewhere, albeit not necessarily where governments claim it does. Set aside for the moment the massive empirical evidence marshaled by Professor Jastram that demonstrates how differently gold and other commodities have behaved over time. How is it even reasonable to expect such fundamentally different things to act alike? ...

Quote:

The commodity theory of gold has a twisted sister, the “dollar short” theory. Mr. Saville alludes to it, but to his credit doesn’t hang much on it. The theory, which recently enjoyed a brief vogue among several prominent investment letters, holds that in a deflation, fiat dollars, not gold, will become precious and rare, because everyone will need them to pay off the gargantuan dollar-denominated debts that lard the planet. Effectively, the credit expansion will have left the world in a short position vis-à-vis dollars...

Quote:

As I understand that view being propounded by its advocates, the idea is that during a period of intense deflation, American citizens who have managed to amass significant amounts of indebtedness will attempt to reduce their debt by selling their goods or possessions in an attempt to raise cash with which to pay off their debts. This will result in increased demand for dollars as people will tend to hoard cash as the deflationary spiral worsens. In a deflationary environment of falling prices, the purchasing power of the U.S. Dollar will actually increase since falling prices will allow holders of cash to actually obtain more goods for the same amount of money. The claim is that this increased demand for dollars will result in the dollar actually strengthening much to the consternation and surprise of many who are expecting a severe decline in the dollar.

Let me first deal with this assertion. There are two obvious flaws as I see it. The first is that while this may have been true at one time in American history, it is no longer true today...

The second and most obvious flaw in this reasoning piggybacks upon what was just stated. The synthetic short dollar theory's failure to deal with the influence of the fundamental factors detailed above, most notably trade flows and capital flows from abroad, is a serious omission of two of the most critical factors that go into determining the value of a currency and cannot be overlooked. Let me explain...

Quote:

The “dollar short” scenario of an increasing value of the dollar assumes that the supply of goods remains approximately unaffected by the liquidity crisis. But if both money and goods are contracting, the purchasing power of money can only increase if increase the money supply contracts faster than the supply of goods...

Quote:

A second facet of this problem that I believe is missing from the “dollar short” analysis is the role of foreign holdings of US debt. If the US were a closed economy with no foreign exchange, a domestic scramble for liquidity would work itself out along the lines analyzed above, possibly resulting in an increase in the domestic purchasing power of the dollar. But the US is not a closed economy – there is an enormous flow of both goods and financial assets between America and the rest of the world...

The buildup of dollar-denominated debt relies on the willingness of foreigners, mostly foreign central banks, to fund an increasing amount of US indebtedness each year. Overlooked by the deflationist analysis is the huge supply overhang of US dollars that constantly threaten a collapse in its foreign exchange value. The dollar is vulnerable should the largest holders, who already own too many of them, decide to sell. What keeps them from doing so is (at least in part) that doing so would spark a mad rush for the exits that would destroy the value of their own remaining reserves...

For every other country that has had a banking crises, it has been accompanied by a collapsing currency (think: Argentina) and international bond defaults because the ability of the country to produce goods for export (with which to buy foreign exchange) is reduced as the recession or depression works its way through the country’s real (non-financial) economy...

Quote:

What happened therefore this February, when it became clear that some Mortgage Lenders would go bust, that Home Inventories would rise, and home prices fall? Did the dollar strengthen? No. Quite the contrary. The Yen strengthened, and strengthened very hard. The Dollar crumpled, and started a new leg down. Why did this happen? Because the world is long dollars.

Quote:

The onset, or even the threat, of a deflationary collapse would surely be resisted by authorities with an inflationary policy response. Deflationists emphasize that component of money creation occurring within the commercial banking system. Noting that this money creation is accompanied by a corresponding debt creation, they argue correctly that this process is inherently self-limiting due to the ever-increasing burden of debt service payments. The requirement to make interest payments on existing debt eventually limits the ability of borrowers to take on more debt.

Deflationists argue from this, that debt deflation will always trump inflation. The problem with this argument is that it proves too much. If this were universally true, then how could there ever be a hyperinflation? Debt would choke it off before it got started. And yet there have been many historical instances of hyperinflation...

Quote:

The current monetary system is effectively a Ponzi scheme whose survival relies on the total supply of credit and money -- the so-called US$ short position -- continuing to expand (the way the system is designed there can never be enough money to pay-off existing debts). So, don't expect that the major stakeholders in the system (the US Government, the Fed, the commercial banks, the GSEs, the money-market funds, the Wall St financial houses) will decide to just hunker down and weather a brief period of deflation. That's really not an option for them...

Quote:

Something else that needs to be considered is that there is no precedent throughout history of a country at war experiencing deflation. The US is presently at war, the only difference being that this war is not being fought against a specific enemy. Rather, it is being fought against a methodology (terrorism).