Dow down slightly
yesterday. Oil falling further below $100. And gold still going
up.

What is most
interesting is the movement in the price of gold. It seems to be
heading up again – almost no matter what else is happening.

So, letÂ’s
look at what might be going onÂ…

If investors
sensed a recoveryÂ…they would expect banks to lend more freelyÂ…people
to shop more freelyÂ…and prices to rise.

This would
raise consumer prices; the price of gold should go up.

But if the
market sees growth and inflation ahead, why is oil slipping? And
why is the Baltic Dry Index – which measures shipping prices
– at a 25-year low? And how come last month’s employment
figures were disappointing? And why arenÂ’t stock market prices
going up?

Most important,
if the economy is really recovering, why is the 10-year note yielding
only 1.82%? And what about the long bond? ShouldnÂ’t it be trading
at a yield higher than 3%?

And how come
house prices fell over the last yearÂ…and the last month?

And how come
incomes are falling?

Or, to look
at it from the opposite point of view, how is it possible for a
real recovery to take root in the hard, barren soil of falling house
prices and slipping consumer earnings?

But if the
economy is not improvingÂ…then there should be no increase in
inflationÂ…and no pressure on the price of gold, right?

Maybe investors
donÂ’t anticipate a recovery at all. Maybe theyÂ’re buying
gold because they see the economy getting worse, not better. We
associate a rise in the price of gold with inflation. But gold is
much more versatile than we think. It protects your wealth when
paper money loses its value. It also protects your wealth when paper
money gains in value. It protects you when you are rightÂ…and
when you are wrong.

How so?

During the
Great Depression, for example, the price of gold roseÂ…against
dollarsÂ…even though the prices of food, clothing and other
consumer itemsÂ…as well as the prices of investment assetsÂ…were
falling in dollar terms. Why? Because money gains value – relative
to things – in a depression. Gold is money. It is the best
money. It is the only money that has stood the test of time.

Besides, there
is more going on. In a financial crisisÂ…or a depressionÂ…investors
begin to doubt that their counterparties will make good. Banks fail.
Investors go broke. You own a mortgage, and then you discover that
the homeowner has left townÂ…and the house has lost half its
value. You own a note, and then you discover than the payer is bankrupt;
your note is worthless. You own shares in a company; and then the
company goes out of business.

When you are
in a de-leveraging phase, you discover that many of the assets of
the previous credit bubble are not assets at all. And while youÂ’re
waiting to find out, the best thing to have in your safe is gold.

As uncertainty
rises; so does the price of gold.

The price of
gold also rises when the return on other assets declines. At 1.82%,
the real return on a 10-year T-note is negative. Consumer prices
are rising faster. So, the reward for lending to the government
is less than zero.

Normally, holding
gold costs you money. You give up the return you could get from
‘risk free’ investments (Treasury debt). Now, you give
up the risk from reward-free investments.

Gold goes nowhere.
It produces no yield. It pays no dividends. It makes no profits.
You canÂ’t live in it. You canÂ’t drive it. You canÂ’t
hang it on your wall and admire it.

But when the
return on Treasury debt is negative, what do you give up by owning
gold? You give up a loss!

You also give
up the risk of a much bigger loss. The Fed is bound and determined
to bring up the inflation rate. Ben Bernanke has suggested that
he might set the inflation target higher than 2%. He has announced
that he will keep the FedÂ’s key lending rate near zero for
the next 3 years. He has hinted that he is ready to print more money
– QEIII – if conditions warrant.

Holding gold
protects you from BernankeÂ’s success. For if he succeeds in
raising the rate of inflation, gold will surely soar. And there
is substantial risk – bordering on certainty – that he
will be no better at creating moderately more inflation than he
has been at creating moderately more GDP growth.

It is quite
possible that he will overshoot.

Normally, inflation
is a feature of the banking system. The system takes the FedÂ’s
monetary grubstake and parleys it into the nationÂ’s money supply.
Banks magnify the money supply by lendingÂ…and thereby create
more demand, which raises prices. They do this by making loansÂ…to
people who then spend the money.

This sort of
inflation is controllable, by raising interest rates and tightening
banking credit rules. But thereÂ’s another form of inflation.
The kind that starts with an “h.”

Hyperinflation
happens when the banking system breaks down. People lose faith in
the money itselfÂ…and the people who control it. Foreign dollar
holders may worry that the Fed is printing too much money. It may
even be good economic news that causes them distress; they may anticipate
higher inflation rates, and a sell-off of the dollar, which would
lower the value of their dollar reserves. They may figure that they
are better off diversifying into yuanÂ…or gold.

Then, when
other investors and householders see the dollar fallingÂ…they
get panicky too. Pretty soon, people are digging around in drawers,
bank accounts and mattresses…looking for dollars – just
so they can get rid of them.

That is when
dollars hit the hyperinflationary fan. Our old friend Michael Checkan
tells what it was like in Argentina in the late Â’80s:

“Imagine
a $2.00 gallon of milk spiking to $775.40 within a year – like
in Argentina, 1988.”

February
7,
2012

Bill
Bonner is the author, with Addison Wiggin, of Financial
Reckoning Day: Surviving the Soft Depression of The 21^st
Century and
The New Empire of Debt: The Rise Of An Epic Financial Crisis
and the co-author with Lila Rajiva of Mobs,
Messiahs and Markets (Wiley, 2007). His
latest book is Dice
Have No Memory.
Since 1999, Bill has been a daily contributor and the driving force
behind The Daily Reckoning.

Copyright
© 2012 Daily Reckoning

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Best of Bill Bonner