Felix Zulauf on Inflation vs Deflation

This week in our musings, we focus on just one interview of Felix Zulauf by Eric King (I apologize for the short article this week – I’m crook!)…

• FELIX ZULAUF SPEAKS

Once again, Eric King at King World News has achieved an astonishing coup, by scoring an interview with Felix Zulauf, of Barrons Round Table fame. Felix (almost) never gives interviews… and when this man speaks, it pays to listen carefully. You will find a full bio for Felix over at Eric’s site; suffice it to say here that he has been a member of the famed Barrons Round Table for over 20 years. Personally, I find his understanding of monetary and financial history to be particularly acute. His vision of the future that is about to unfold is both plausible and apocalyptic. I urge you to listen to the interview in full ( http://www.kingworldnews.com/kingworldnews/Broadcast/Entries/2010/5/28_Felix_Zulauf.html), however to save you some time I paraphrase the main points below, together with some observations of my own, in parentheses.

• Gold’s role in the current crises

Almost all industrialized countries have too much debt relative to the size of the economy. Greece is acting as the canary in the coalmine; it is a pointer to the disease that is afflicting the developed world.
For the last 20 years, we have been living under the delusion that we could borrow ourselves into sustainable prosperity. However, the world is realizing that we have an unmanageable problem – we cannot continue as before. Serious doubts about the validity of our currencies have arisen. A number of high wealth investors and institutions have realized that they must have an alternative store for their wealth other than the fiat currencies – hence their interest in gold, the ultimate currency.

Unlike paper money, the amount of above ground gold cannot be increased at the press of a computer key, but only by hard work getting it out of the ground. (Also the supply from mines is increasingly limited). The ongoing bull market in gold is really a bear market in all the paper currencies. The supply and demand dynamics for gold are very interesting – historically, the driving demand for gold has come from the jewelry market. (Note, however, that gold jewelry in many parts of Asia and the Middle East is viewed as a store of wealth, as we have discussed in previous editions of Weekly Wanderings (WW)). However, over the last two or three years, the driving factor on the demand side has become investment (In previous WW we have discussed the activities in the gold market of such high profile investors as John Paulson, David Einhorn, George Soros and Paul Tudor Jones, all of whom are greatly increasing their gold holdings). On the other hand the supply side for gold is decidedly inelastic. Central banks that sold a lot of gold at much lower levels in the market now appear to have been stupid, to put it mildly, and they have recently, in total, become net buyers, (as we have noted several times).  We also have declining production rates of gold from mines.

• Inflation versus Deflation

(I have been puzzled for some time about the inflation/deflation debate that continues on the Internet. I found Felix’s discussion below to be most helpful)

Will this be like the 70’s? NO – the situation is completely different. Today, our problem is not inflation but DEFLATION – due to too much debt outstanding. (As we observed last week), more and more debt means more and more income required to pay interest, or service the debt. This is a Ponzi-type scheme, and it also implies less and less discretionary income to spend on things other than debt servicing. Thus we have an increasing drag on economic growth – so we will not be able to grow enough to service our outstanding debt. (As discussed in these columns, particularly with reference to the work of Chris Martenson, we also face the headwind of developing commodity shortages. If anyone is in any doubt about the desperate lengths to which oil companies are having to go to obtain more oil, just look at the tragedy unfolding now in the Gulf of Mexico).

WE ARE THEREFORE IN THE ENDGAME OF THE SYSTEM AS WE HAVE KNOWN IT over the past 70 years or so. Now the policy makers are trying desperately to fight the deflationary tide, by adopting highly inflationary policies, (printing money without limit, as Greenspan and Bernanke have told us they would do). So we now have an highly unstable equilibrium, which will morph into either a deflationary collapse, or hyperinflation, (as, for example, John Williams of ShadowStats thinks).

Felix believes the deflationary storm is likely to increase in intensity over the next few years, until a climactic collapse occurs with a failure of such magnitude that the banking system in Europe and the US will be bust. In this situation, governments would be unable to bail out the offending institutions, because many of those governments themselves are already perceived as bust. At that point the central banks would come in big-time – their balance sheets would expand not by a factor of 2 or 3, but by a factor of 50 or 100. Within a few weeks, the paper currencies of those countries would become essentially worthless, thus forcing an immediate currency reform that would have become inevitable. As with all financial prophecies, the timeline is uncertain; however Felix sees the above scenario as highly likely within the next 5 years, but maybe as far away as 10.

The result will be that part of outstanding debt will be destroyed, together with part of existing wealth. What is different about this scenario from any we have seen over the last 70 years is that previously such events have been contained within a relatively small part of the world economy; this time it is likely that a number of industrialized countries will enter the process virtually at the same time, because of the interconnectedness of our current global financial system. (Just imagine what NZ’s position would be. We are inextricably linked to the financial system abroad, given our enormous borrowing requirement, relative to our GDP). 

• Protecting yourself

IF YOU WANT TO PROTECT YOUR ASSETS, SOMEHOW YOU HAVE TO GET OUTSIDE THE CURRENT BANKING AND FINANCIAL SYSTEM – THAT’S WHERE THE ROT IS.

Owning gold, a farm, real estate, is probably a good thing. We are in a transition between the Old World of finance as we have known it – into the New World and we will get it, whether we like it or not.

• Whither interest rates?

The short end is likely to remain at or near stay at zero until we have the new currency. At the long end, Government bond yields are either at lows or approaching lows, and this process should terminate over the next 12 months – marking the end of the 30 year bull market in Govt bonds.

• US equities

Since 2000 we have been in a secular bear market for equities. We are probably beginning the third leg down… heading towards a low on the S&P of maybe less than 500, within the next 5 years.

• China and India

Firstly, what happens in China is vastly more important than what happens in India. The Chinese economy appears to be definitely overheated; a severe cyclical recession is likely to ensue as the credit boom over the last few years bursts.  However China does not have the internal financial decay that the West has – according to Felix, they are one generation behind – therefore they are likely to undergo a severe recession next year, which would be akin to what happened to Western economies in the 1970s. A consequence if this were to ensue would be a concomitant bear market in commodities, maybe as much as halving the price of copper and other raw materials of which China is such a voracious consumer.
(I am not so certain about this outcome – China is building new cities at a furious rate – if these cities remain empty at the moment, there is a high likelihood that they will be occupied in a year or two. One of the facts that has stuck in my mind is the requirement for China to re-house the equivalent of the population of Australia each year every for the next 15 years at least. This is being forced on the Chinese government because they are well aware of the destabilizing effect on their own position if extreme social unrest were to develop).

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