-->How will the exit of the dollar play out? There are thoughtful arguments on both sides of the issue of deflation versus inflation. A serious erosion of the dollar's international exchange value will force the US to become self-financing. Our trading partners do not need to reject the dollar outright but merely to reduce their buying on the margin as has been the case over the last several months. As of this writing, the trade-weighted dollar is at the low end of its range of three years. The dollar has been against the ropes before and has managed to rally. It will probably rally again, but within the context of a well-established downtrend. Aside from a countertrend rally, a probe to new lows would trigger higher interest rates, lower equity market valuations, and higher inflation, as the President of the Dallas Fed has observed.

Dollar weakness could prove stimulative to the economy in the short run as our hollowed-out industrial base is called upon to produce what we can no longer afford to buy abroad. Corporate earnings might rise sharply amidst a contraction of valuations. In short, this would be something of a replay of 1970's stagflation triggered by the unwillingness of foreign bankers to finance our deficits in 1971 and again in 1979 in the absence of interest rate and exchange rate adjustments. The difference between the 1970's and today is that the magnitude and proportion of our foreign indebtedness is far greater.

The all too popular bearish view of the dollar deserves a contrarian response. The deflationist camp notes that there is global overcapacity owing to direct investment driven by the well-known arbitrage of labor rates between Asia and the developed economies. Wages and prices are capped as long as our Asian trading partners choose to finance our debt at current exchange rates. The misallocation of capital on a grand scale has been financed by a buildup of debt on an even grander scale. The debt position functions as a synthetic short against the dollar, which will drive up its international exchange value as business returns falter because excess capacity drives prices lower and forces widespread repayment of dollar-denominated debt. A flight to safety results in miniscule government bond yields, exploding credit spreads, and imploding capital markets.

Beware that the preponderance of bearish opinion on the dollar at this moment could signal a conviction-shattering rally. The obvious peril to the dollar may have been sufficiently discounted for the moment, or may still be too distant to preclude a fake out countermove.

To many, the possibility of a rising gold price in a deflationary setting is unlikely. For example, in a recent article titled"Gold is not Signaling Inflation or Deflation...Yet" published October 18th by Bianco Research LLC, the writer states that:

"Gold's nominal price changes are a function of the relationship between the expected rate of inflation and the short-term interest rate costs of carrying inventory, plus or minus changes in the supply/demand balance."

The accompanying chart in the article only goes back to 1997. This sort of thinking equates the symptom of a general fall in the level of prices with deflation but overlooks the root causes and dynamics of a deflationary meltdown. It is easy to think that if all commodity prices are falling, then gold must also. The article later states:"If the price of gold starts to fall more rapidly than the dollar index increases, deflationary pressures exist and an appropriate policy response is indicated." The direction of the general price level cannot be confused an inflation or deflation of credit. Secular credit cycles are beyond the control of central bankers, although central banks can certainly augment the process of credit expansion if they already under way. A general fall in prices can occur quite normally during a period of economic growth that is not deflationary. However, falling prices in a deflation are only a side effect of a general paralysis of credit. The more telling symptoms are very low nominal interest rates, high real interest rates, and failing household and corporate credits. Investor behavior shifts from risk taking to risk avoidance. In a secular credit contraction, such as we are in the midst of at the moment, the gold price rises as a measure of the demand for safety. Central bank attempts to counter the contraction take the form of excessive paper issuance, which for a time can inflate asset values due to surplus liquidity. Ultimately, the market sees these actions for what they are, monetary debasement. While nominal price levels may rise in response, as in the 1970's, economic activity stagnates.

In our view, both inflationary and deflationary scenarios explain how and why the gold price will rise, not only in dollars, but in all currencies. The dollar's predicament allows for more than one plausible outcome. Our contrarian instincts at first guide us towards the deflationary camp, since it seems under-represented in discussions of this sort. But the deflationary camp omits an important consideration, which in our view makes a precise repeat of the 1930's impossible. That factor is best summed up in the notion of Beardsley Ruml: sophisticated central bankers and enlightened government policies can always create desirable outcomes. Disrespect for market outcomes is not limited to central bankers and policy makers. It is integral to the post World War II social compact. Dollar trashing therefore exists not only as a notional last resort for desperate policy makers, but also constitutes an option that would be widely applauded. According to Bob Hoye of Chartworks:

The purpose of sound money has always been to"manage" the ambitions of the state...In 1900, all levels of government were taking only 10% of GDP and the public was skeptical about big government. In the last part of the 20th Century, the government take was approaching 50% and the public had visions of government as a wish machine. (Address to the Committee for Monetary Reform and Education, October 2004)

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