Source: Times Online

Visitors to America might have noticed the television ads urging us to buy gold. One such “spokesman”, formerly in charge of managing the government’s hoard of the yellow stuff, including the ingots buried at Fort Knox, points out that the value of gold has never fallen to zero. Why investors are expected to find such a modest claim reassuring I can’t imagine. But something is persuading people to buy gold, driving the price to and past $1,100 per ounce, from about $270 at the beginning of this decade, and around $700 when the financial crisis first hit.

This is not mere panic buying by a herd of small investors trying to benefit from what is called a momentum play. John Paulson (no relation to Hank), the investor who made $20 billion for his hedge fund between 2007 and 2009 by betting on a collapse of the financial and housing markets, is betting on gold in a big way. Paulson & Co already holds $3 billion in gold-related investments (including AngloGold Ashanti and Kinross Gold), and Paulson has just seeded a new gold-related fund with some $250m of his own funds. His modest objective: appreciation at a rate higher than the increase in the price of gold itself.

All of this means that investors do not believe that President Barack Obama will respond to the enormous pressure put on him during his visit to Beijing and take steps to strengthen the dollar. The president and Treasury secretary Timothy Geithner might talk the talk of a strong dollar but they walk the walk of a declining one. A weak dollar should lift exports and cut imports, which in White House terms means jobs for American workers. And it is jobs that the president asks his aides about first thing every morning. With reason.

Should the unemployment rate remain in double digits when elections roll round a year from now, Republicans would gain congressional seats by making the plausible claim that the Democrats’ deficit spending served only to create a debt burden that will weigh down the living standards of our children and grandchildren.

The economics are every bit as simple as taught in elementary classes. The government is running huge deficits, upwards of 12% of GDP (3% is considered sustainable), and selling its IOUs to pay its bills. The very accommodating Federal Reserve Board is buying those IOUs, printing dollars with which to pay for them. The flood of dollars will, economists argue, some day trigger inflation. That would enable the government to pay off the holders of its bonds and notes in depreciated dollars, which is what the Chinese, holders of over $1 trillion in such paper, fear.

Of course, that hasn’t happened yet. There is simply too much excess capacity in the economy to permit producers to raise prices, and too much unemployment for workers to hold out for higher wages. That will change when the recovery takes hold and the economy starts to grow again. Then, says Ben Bernanke, chairman of the Fed, I will sell all of the notes and other assets I have accumulated for dollars, and withdraw those dollars from circulation. Meanwhile, says the president, that is when I will take steps to cut the deficit. So don’t worry, be happy.

Not many seem to believe either man. Bernanke is famous for academic work emphasising the danger of tightening too soon, and so might wait so long that inflationary expectations take root. Obama would have to cut spending or raise taxes to reduce the deficit, neither of which he will be inclined to do.

Indeed, he returned from China announcing his concern about the size of the deficit — and proceeded to push hard to get Congress to pass a $1 trillion healthcare bill and a $250 billion raise for doctors, after approving renewal of the about-to-expire $8,000 credit for new home buyers, and before pressing for passage of a very expensive energy bill. As for tax increases, he has promised not to raise the taxes of families earning less than $250,000 per year, and there aren’t enough higher earners to tap to cut substantially into the deficit.

Which means the printing presses will continue to run, creating the threat of inflation. When that happens, and the dollar depreciates, people flock to commodities — oil (which already has $20 built into its price to reimburse producers for the decline in the value of each dollar), gold, art, property. Arab oil producers can protect themselves by raising the price of oil, John Paulson will rake in another odd billion or so, Goldman Sachs will figure out how to profit from the new inflation, the US and others who have run up large debts will pay back in cheap money, and pensioners will scour supermarket shelves for bargains they can afford with their withered dollars.

America has been there before, and not so long ago. It took Ronald Reagan and then-Fed chairman Paul Volcker to wring inflation out of the system they inherited from Jimmy Carter in the early 1980s. Oh yes, the price of gold promptly fell in half. Which means that investors in gold are betting that the spending policies of the Obama administration and the easy money policy of Bernanke’s Fed will remain in place. If they are wrong, they might end up unloading $1,100 gold and related investments at half that price. There are no sure things when it comes to investing.

But there is an almost sure thing in the currency market. For as far ahead as a reasonable person can see, the Chinese will continue to peg the renminbi to the dollar. That means that a lower dollar cannot make imports from China more expensive. It also means that countries that allow their currencies to float will have greater difficulty competing with China in the US market. Which might, only might, bring together a large coalition of nations, ranging from the US and the EU to Asian and Latin American countries that compete with China for markets, to pressure China to allow its currency to float upward. Their threat: that they will band together and protect themselves from Chinese imports with tariffs and other measures. That would get President Hu Jintao’s attention.

Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute