A Scary Debt Outcome Very Few Expect

05/25/2012 9:30 am EST

Focus: STRATEGIES

J.W. Jones

Chief Options Strategist, Technical Traders, Ltd.

The herd is rarely right about the markets and economy, writes JW Jones, posing an alternate ending to the inflation/deflation debate that would catch the world and economists by storm.

The more often you hear the same message coming from financial pundits and experts, the more cynical you should become. Either scenario, be it inflation or deflation, will likely not end well. The question is whether the reason for the crash will be deflation, inflation, or a combination of both scenarios.

Longtime readers know that I have been and still remain bullish on gold and gold stocks in the longer term, however, the reasons why I believe gold and silver will perform well long term are a bit different than what many economists and pundits are expecting.

Read Part 1, “Know When the Bottom Is in for Metals

I am a contrarian by nature. I generally try to do the opposite of the crowd in every situation regardless of whether I am in a movie theater or trading options.

Before getting into the gold and gold miners analysis, I thought I would explain my position publicly to readers. I do not consider myself an expert economist, but I try to read those who many consider to be experts, looking for similarities in their viewpoints and expectations.

The herd mentality exists in financial markets, and a similar behavior exists among economists. Most economists in the mainstream media today tend to be Keynesians or neo-classical economists. Both viewpoints are generally accepted as the correct interpretation of economic and monetary policies by academia.

However, the academic world can actually reduce open thought through ridicule and persecution. In the world of academia, the herd is right until someone proves that they are wrong using logic-based reasoning.

Very similar to political ideologies, economic ideologies are deeply rooted. Paul Krugman is a great example of a Keynesian economist. Like it or not, the majority of economists believe his views are correct regardless of whether they are based on fact, history, or dare I say, “common sense.”

This leads me to the reason why precious metals and commodities in general may be approaching a major bottom and the potential for a monster rally. The reasoning stems from the fact that across the world, central bankers generally share the same views as Paul Krugman: they believe that the modern finance system does not need gold and that fiat currency is the answer even though history argues in their face across multiple millennia.

Most economists and financial pundits believe that sovereign debt is going to bring down the economy, and they may be correct. Many believe that the debt will unleash a massive deflationary spiral that will consume fiat valuations, specifically on risk assets and debt obligations.

I do not necessarily disagree that this is a likely outcome, but what concerns me is the number of people that believe this is true. This is the herd’s idea, and as I have said many times before, the herd is rarely right. This time may be different, although it rarely is. For inquiring minds, I offer a rather different potentiality.

What if the debt crisis causes a totally different outcome that very few economists envision? What if they follow Dr. Krugman’s ideas and create massive amounts of debt to stimulate the economy while printing vast quantities of fiat money to prop up failing financial institutions? Clearly, increasing debt levels and debasing the currency do not imply a long-term positive scenario.

Central banks do not have a strong track record when it comes to reducing liquidity or increasing liquidity at the appropriate times. Thus, these actions are likely to facilitate some sort of crisis in the future whether it is a result of runaway deflation or inflation.

I believe that should a deflationary crisis caused by massive debt levels and diminishing economic strength present itself, central bankers around the world will behave exactly the same way. They will act simultaneously and through dovish monetary policy, central bankers will flood the world with massive sums of freshly printed fiat currency with the intent to print away issues with a liquidity-induced, risk-on orgy.

Should that be their ultimate choice, risk assets will rally sharply higher initially. Paper assets like stocks will produce huge gains in a short period of time, while supposedly “safe” assets such as Treasuries would likely arrive at negative interest rates across the yield curve in nominal terms.

The next phase is the scary part and why I am bullish long term on precious metals specifically.

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The devaluation of fiat currencies simultaneously around the world will result in a monster economic crash when the masses realize that the majority of the major worldwide currencies are becoming worth less and less. The resulting crash would be caused by the opposite force of runaway inflation, while the herd mentality that anticipates a deflationary debt spiral espoused by most experts and pundits would be proven materially false.

Under those circumstances, precious metals will be the true safe haven. Gold and silver will prove to be the true store of wealth that they have been for centuries. So many so-called “experts” fail to recognize that gold and silver are currencies. Yes, they have industrial uses, but gold and silver represent the last unequivocal bastion of wealth preservation against the constant debasement procured by central bankers and their minions.

Under the scenario whereby central bankers flood financial markets with cheap, freshly printed fiat currency, one would expect other essential commodities such as oil to also perform well. Furthermore, agricultural commodities would also flourish under those economic conditions. Investors would be in much better fiscal condition owning things that they could hold in their hands versus stocks or bonds.

I present this potentiality not to say that this is exactly what is going to happen, but to challenge readers to open their minds. The crowd is usually wrong. The central bankers and most economists generally share the same viewpoints, and their behavior is literally a giant groupthink.

Is it possible that they are a herd which ultimately will be proven wrong? Will the herd mentality of economists and central bankers cause a massive currency crisis as they attempt to stem the tide of a deflationary debt crisis?

The two possible outcomes go hand in hand. I do not know what is going to happen, but neither outcome in the longer term is especially optimistic. Should either scenario come to pass, the human condition will likely be threatened by a decrease in the standard of living across multiple developed countries and ultimately the threat of revolution and military action on a scale not seen in several decades could eventuate.

See also: A Trip Down Ugly Memory Lane

Clearly, I have simplified the issues at hand presently for ease of reading, but the ultimate endgame will likely be one or a combination of both a debt crisis and/or a currency crisis. They will likely occur in close proximity to one other in terms of time, but the precise outcome will likely be different than what is commonly expected.

Regardless of which scenario occurs, precious metals will eventually be sought for their protection against the constant devaluation of fiat currencies by central banks around the world. For this reason, I remain a long-term precious metals bull.

By JW Jones of Options Trading Signals

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