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A Knight's Tale in 3 Acts   (Dan K., November 25, 2008)

I rarely find myself in disagreement with you, but on this column I certainly do. ( This Week's Theme: The Coming Great Depression November 24, 2008)

The most probable correct path from past to future would be one of Inflation -- Deflation(Dis-inflation) -- Hyper-inflation.

Let's look back at where we were only a short year or so ago. Oil was well up there in price, inflation was 'the rage', and growth was everywhere. However, all this growth was built on 'funny money' -- leverage of the FIRE economy that was not really 'productive' but allowed us nonetheless to be very 'consumptive' in nature here in the grand ol' USA.

Then things started to crack and the foundations of all this leverage started to crumble. The Fed was slow to respond (and I might add still slow in some ways) and Congress showed it's ineptitude when it waitied to pass the TARP only after loading it full of tradional 'pork' stuffing.

So here we are, in a 'credit crisis' that really has not abated, and money has become dear. If you have good credit, why you can have all the credit you want. But if you have bad credit, you can't have any credit. Leverage is unwinding at break-neck speed as hedge-funds, mutual funds, you name it try to meet redemptions. Freely traded assets such as stocks, oil, gold, silver are sold off for whatever can be had for them to meet the demands of investors running for the 'cash is king' hills. The dreaded monsters of Defaltion or Depression may well sour the good people of the USA. HELP!

Meanwhile, on Capitol (maybe it should be Capital??) Hill, our elected officials fret about how Paulson spends his $700B instead of addressing real issues like pre-packaged bankrupcy for the Big Three to keep them alive, or meaningful tax reform, or a host of other issues that could right this good land. And the people repond to such inaction and ineptitude by giving them an approval rating of 9%.

But there is a new knight coming to town. And this knight has the same political pedigree as the minions in the high houses. This knight knows that he does not want to be the one to be labelled with having presided over a Depression. He knows that his power will only last so long as he can 'create jobs' and 'stimulate' the economy.

And this knight comes not alone to do battle -- he brings warriors with pedigree as well. From Harvard and similar such institutions, and from the trenches of such far- off places as the New York Fed. His call and mantra is 'change', and change is not going to be for the worse under his reign.

So we shall get 'spending' and 'stimulus' and 'borrowing'. The 'new leverage' will be the Fed's balance sheet, which will ballon up from watermelon to Hindenberg size. Together with the knight and his new warriors, the Fed as well shall do it's share to win the battle against the most dreaded of foes -- deflation and depression.

I expect the battle to be won -- at any cost. The war? In the end that shall be lost.

From the time the new knight gets to town he will use his mandate of 'change' to bully the minions to do as he says. And I expect them to comply. Money will begin to flow again. Things will get tough for a while, but then they will get a bit easier. Unemplyment up to high single digits, then slowly down. Jobs will be 'created' just like the money on the Fed's balance sheet -- out of thin air. And I fully expect the foundation of all this creation to be about as solid as that thin air as well. But nonetheless, the knight and his 'round table' will win this battle in the end. The 'numbers' will look better, and we will stave off the dreaded D's.

For a while at least. And if we are lucky, the 'investments' we make will end up being solid ones that will replace the air foundations with future rock solid ones. This will be the true challenge going forward for the knight. For his political minions will want 'bread and circus' as much as they want 'real change'. If the knight keeps the bread and circus at bay, and the hard labor and borrowed money go to real foundations, the US could well be on the way to 'recovery' in the course of the next 7-10 years.

However, I fear 'change' may slowly get trampled by the minions. In which case we will not get Depression (though no matter what path they all take we will continue to get asset Deflation), but a long bout of ever increasing stag-flation and most probably hyper-inflation.

If you think about it in the broader context, any government would rather inflate it's way out of debt than deflate. Certainly under deflation taxes cannot be raised and penance to the governmental coffers will surely decrease. So we must at least TRY to get inflation back again. Even if it is only 1-2%. Even if we all know it is truly unattainable for the knight, the Fed, the round table or anyone else to control the printed money once it makes it into the broader economy.

That is the war we will eventually lose -- the inability to control the inflationary spiral we will create to win the current battle. The Hindenberg Fed will hit the tower at some point, and all will come crashing down. And the knight will hope that happens some 8 years from now when the next knight comes to rule the territory and he moves on to warmer and more hospitable climates.

We have had our inflation, mostly borne upon the back of rising commodity prices. We will have our deflation, mostly in asset prices. And our hyper-inflation is yet to come when we have to print our way out of the current mess. Our stag-flation will occur in relation to tangibles such as oil, which we have no control over, and whose prices will rocket to the moon as the dollar drops in response to all this monetary printing. We all know real wage growth will never keep up, and hasn't for many years now.

All those people taking comfort in the curent strength of the dollar and dollar repatriation fail to note these dollars have come home to roost in very short term instruments. Any mis-fire on the part of the knight and his troops and they can fly away as quickly as they came home. At that point, we will again see $150+ bbl oil, gold climbing to $2000/oz or more, and the 'smart money' dropping dollars to get ahold of anything 'tangible' vs. holding paper. Cash will again be trash.

I expect this whole cycle to take about 2-3 years from present to climax.

And the markets? Buy oil, coal and gas energy stocks -- especially those with 'assets in the ground' as owning reserves will be as valuable as owning gold. America is not going out of business for some time to come, and windmills and sunshine will not replace enough of our fossil fuel energy to make any kind of difference in the next decade -- especially with low prices now making the last run-up look like it really was just 'speculators'.

Cash as trash will not be as welcome in foreign ports for oil or much of anything else. The war will then be lost. We will be poorer and slowly sink into the dustbin of history. Our standard of living will start a slow march of dcline for a long time to come.

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