DEFLATION AND THE DOLLAR / SEEKING ALPHA ( VERY HIGHLY RECOMMENDED READING )

Deflation and the Dollar

by: David Goldman*

November 24, 2010

North Korea fires on South Korea and the gold price falls. Counter-intuitive? Not quite. As I’ve been arguing for the past two weeks, a chill wind of deflation is blowing through world markets. The European Community is rescuing Ireland (and probably Portugal and then Spain) because $1.3 trillion of bank assets are in jeopardy. American banks’ loan quality is not that great, either. China is tired of capital inflows from the US bubbling through its rather primitive financial system and has slapped higher reserve requirements on its banks.


A prospective global contraction of the balance sheets of banks is deflationary. That means cash becomes scarcer. The dollar goes up and risk asset prices go down. The Euro declines as the depth of the PIIGs problem comes to light, and, despite the miserable state of the American economy and the Fed’s determination to degrade the dollar, the US dollar remains the place to hold cash.


As I wrote last week, the Tea Party has gone global. There is a limit to the ability of governments to issue unsecured IOU’s, and in many cases it has been exceeded. So politics intervenes to stop it. American voters send a message to Washington (along with Germany and China) that Washington can’t print money to issue debt indefinitely. The Germans and French send a message to Ireland (echoing through the Club Med countries) that they have to bite the bullet. The Chinese tighten their financial belt.


American bank profits for the last couple of quarters stemmed mostly from reducing loan loss reserves. That may have been a tad aggressive. During the mid-2000s, when spreads were paper-thin and banks had to compensate for miserable lending margins by pumping up the volume, bankers were selling commercial real estate loans with the enthusiasm of a time-share boiler room at a Cancun hotel. There’s well over a trillion dollars of such trash up for refinancing during the next two years, and a lot of it can’t be good.


What evil lurks in the hearts of Spanish banks barely can be guessed. Spain was a giant real estate bubble, even more so than the US, and the real estate market remains utterly frozen. And it is getting worse by the day.


That’s deflation. The gold price is simply impossible to read in this context. As long as Ben Bernanke’s behavior was predictable (weak economy = more dollars off the Fed photocopiers) the markets had a one-way bet on gold. No more.


As I wrote Nov. 15, “The prudent thing is to increase cash positions.”


*David P. Goldman was global head of debt research for Banc of America Securities and earlier global head of credit strategy at Credit Suisse. He was until July 2008 the strategist for a credit hedge fund, Asteri Capital, one of the few credit funds to show a profit between July 2007 and July 2008. He is now Associate Editor of First Things (www.firstthings.com) and a columnist (under the byline "Spengler") for Asia Times Online.