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Economics: ZERO
New York: December 22, 2008
By John R. Stephenson

"But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

Ben S. Bernanke—Remarks Before the National Economists Club, November, 2002

This past week, the U.S. central bank, the Fed, took the unprecedented step of cutting its benchmark rate to near zero. In the announcement accompanying the decision, the Fed said it would use “all available tools” to combat deflation, or falling prices. The Fed is worried, that the U.S. could enter into the same deflationary spiral that hit the Japanese economy hard when it undertook this dramatic action to try and get consumers buying again.

With the prospect of deflation looming and with massive job losses in the not too distant future, the governors of the Fed pledged to keep the benchmark rate at these low levels “for some time” in an all-out effort to stimulate the economy. But desperate times call for desperate measures and in the December 16 th announcement the Fed spelled out their game plan.

So fragile is America 's economic health, that the Fed made it clear that it would pump virtually unlimited amounts of money into the financial system to stabilize the economy. After slashing interest rates to a target range of 0 to ¼ per cent, the Fed, now fully in crisis mode, will have to adopt so-called quantitative easing — a program to bring down rates on mortgages and loans by dramatically expanding the cash flowing into the credit markets.

By pumping cash into the credit markets, the Fed hopes to make it cheaper for commercial banks to lend. To inject cash into the credit markets, the Fed intends to buy up huge quantities of mortgage bonds and the debt issued by Fannie Mae and Freddie Mac and stands ready to buy mortgage-backed securities, the very same securities that started this crisis. Already, the crisis has seen the balance sheet of the Fed double in size and with an enormous program of quantitative easing underway, the size of the balance sheet will only increase while the quality of the balance sheet decreases.

The purpose of such dramatic action is to try and get banks lending and consumers spending. With stock prices and house prices falling, not to mention commodities, the Fed is worried that consumers will go on strike — refusing to spend. And that could be a dangerous thing. Once deflation sets in and prices are falling, as they did in Japan for over a decade, there is no incentive for consumers to spend today, since prices tomorrow will be lower. In a deflationary environment, the price of borrowing soars, investment plummets, all of which contribute to worsening the economic downturn.

That is the nightmare scenario that the Fed is trying to avoid. But if the interest rate cuts don't work in stimulating the economy, the Fed will embark on flooding the credit markets with cash — a situation Bernanke himself described in a 2002 speech about the then hypothetical policy responses to deflation in America . In essence, he has signaled the course of action that the Fed will take — once interest rates have been slashed to zero the next step is to devalue the currency to stimulate demand in dollar terms.

In this now famous 2002 speech, Bernanke said that in a paper money system “deflation is always reversible.” His solution —print money. He went on to cite a parable: “Today an ounce of gold sells for $300, more or less. Now suppose a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet.”

Today, the U.S. economy is in unchartered waters. The country's debts are at historic levels, its banks have been propped up by the federal government and they have a chairman of the Federal Reserve who is willing to use “all available tools” to promote economic stability — including debasing the currency.

For my money, gold is about to have its day in the sun. Typically, gold outperforms when the U.S. dollar is under pressure and financial crises are under way. Today, the stars have aligned for gold and gold stocks and savvy investors should consider allocating a portion of their portfolios toward gold.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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