How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices

In this article I will discuss the financial crisis, gold, oil, and my view of the relationship between them, possible causes behind their current state, and how I believe an individual investor can possibly profit from this knowledge. The information should be a good starting point for digging deeper in your own research to learn and understand more about the topics presented. In investing & economics, there are many differing perspectives surrounding the issues I will discuss, and its difficult to say which are right and wrong. The best is to learn of the many different perspectives, and accumulate enough knowledge to make decisions.

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FIAT MONEY

Fiat money/currency is money/currency that is declared by a government to be legal tender. It has no intrinsic value and is not based on any physical commodity such as gold. It is not backed by reserves and there is also no guarantee that it can be converted into any physical commodity or another currency. Most of the world’s paper money is fiat money.

The US abandoned the gold standard in 1933. As a consequence, the CPI rose dramatically in the decades that followed. Monetary policy was freed from the constraint of domestic gold convertibility, and the fiat money system & central banking system allowed for issuance/growth of fiat money for financial stability & economic performance.

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MONEY SUPPLY

Under the current Federal Reserve’s system, the federal government and its central bank has the sole power to expand the nation’s money supply. Short explanation:

M0 = Physical currency. Cash or assets that can be quickly converted to currency.
M1 = M0 and demand deposits (checking accounts).
M2 = M1 and small denomination (less than $100K) time deposits, and non-institutional money market funds.
M3 = M2 and large denomination time deposits, institutional money-market funds, short-term repurchase agreements, larger liquid assets. Broadest measure of money (used to estimate entire money supply within economy).

Wikipedia’s explanation is more detailed: http://en.wikipedia.org/wiki/Money_supply

In 1980 during the savings & loans crisis, the US central bank and the Federal Reserve with the support of the then president, had to take drastic measures to slow the growth of money dramatically. The Fed had developed a model & restrictive monetary policies to control inflation in a fiat system. The economy fell into recession and eventually inflation cooled.

M3 Money supply growth (rate) in the US has declined in the 80s and 90s, but has risen back up to the same levels in recent years at double digit growth rates. However, this time it is on a global basis, as the global money supply has been expanding well over 10% (differing estimates from 12%, 15%, to 18%).

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EXCESSIVE LENDING & THE FINANCIAL CRISIS

Time and time again we see excessive credit & lending of money that the banks they do not have (they essentially “borrow” it from the Federal Reserve & other sources). Money is lent and risk taking becomes larger & larger based on expected potential/future earnings. This time around it was the high yielding but more risky asset backed securities & mortgages. The potential returns of the high yields were favored even with the associated higher risks. Irresponsible mortgage lending at high interest rates were made. At the time of the tech bust, banks were lending to any company who had a dot com at the end of their name. In 1970s-1980, it was the high-interest rate money market funds & mortgages, by the savings & loan institutions (S&Ls, or thrifts).

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INFLATION & DEBASEMENT OF FIAT MONEY

A drawback of being able to increase the money supply without any real limits, is that it deteriorates the value of the currency, and causes prices of goods & services to increase. Energy, food, & metal prices will also rise. The result is inflation & the debasement of money.

We may further see deterioration of the US dollar as the Fed continues to bail out and “print more money” to pour into the financial markets. This will result in global currency debasement. We will likely see more interest rate increases and the cost of financing rise, leading to a cycle of inflation.

If the dollar continues to decline, foreign investors may also dump the US dollar, which puts the recovery of the financial markets into question. It may be a lot longer than most people think. The US has a trade deficit & budget deficit of sizable concern, and the declining US dollar does not help the two problems. The trade imbalance between the US and China is especially an issue. China holds over $1 trillion US dollars. Other nations also hold a considerable amount of US dollars. This puts a lot of pressure on the US to raise interest rates in an attempt to do something about the declining currency. Increasing interest rates at a time of economic weakness is not easy and can send the economy down further.

Paper based assets & fiat money are no longer a save haven. When inflation increases by 1%, one dollar is essentially worth less than $1.

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GOLD

– Historically & currently, gold is commonly seen as a hedge against inflation, and against the weakening or decreasing value of fiat money.
– It has risen as fiat currencies are being debased and inflation rises.
– Lets not forget that the US and other nations were once on the gold standard.
– It is also the most intuitive for a majority of the world’s population, as it is something physical and has a similar value placed upon it by people across the globe.
– It may be no where near peak if you adjust for inflation.
– At this point in time and going forward, it may likely continue to increase for at least one decade . After that, events & results of change are more pronounced as the time line is pushed out.
– Gold is back above $950, up from its 3 month lows.

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OIL

– In energy, the current dependency of the world on oil (in its various refined stages) and its by-products more than any other energy source is quite evident.
– Its used for transportation, machinery & tools (construction, mining, agriculture, industrial production, etc), plastics, asphalt, etc,
– It has been increasingly expensive to extract, produce & refine (energy, financing, mine setup, exploration, & labour costs).
– Conventional and cheap oil is running out, and the more expensive oil sands and other areas are now the focus.
– No economically friendly alternatives for widespread acceptance. We are at least 5 years away from the adoption of new technologies. The pace at which new technologies become available on a large scale basis, or affordable for the average end user, is inherently slow.
– Widespread acceptance is more than 5 years for emerging markets.
– Emerging markets are industrializing, and their demand for oil may increase.
– Price of oil is pushed up as the demand and cost increases, with no short term solution available.
– Oil has hit another record last week at $147 a barrel.

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HOW CAN THE INDIVIDUAL INVESTOR POTENTIALLY PROFIT FROM THIS?
Gold investments
– Gold ETF
(iShares COMEX Gold Trust, SPDR Gold ETF, Horizons BetaPro Gold Bull Plus ETF, etc.)

– Gold mining companies/stocks.

Oil investments
– Oil ETF
(United States Oil Fund, Horizons BetaPro Crude Bull Plus ETF, etc.)

– Oil exploration companies/stocks.

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CLOSING NOTES

Not all gold & oil ETFs or companies are alike. Research on each potential investment, and the subject area in general are always necessary.

It is very difficult to correctly predict the price trends of commodities. Both gold & oil has already risen significantly in the last few years. The trading prices of both commodities are at high levels as well. However, I believe that the economics are present for a continued rise in both commodities in the long term, as we head into uncertain economic times, & a time of commodity shortages. You will need to investigate and determine if Gold or Oil is a suitable investment for you, and if this perspective is one that you should follow or disregard. Also, do not be afraid to change your perspective often as your knowledge grows. Again, economics trends is a highly debated topic, with no clear right or wrong answer visible until the events occur years later in the future.

I did not really mention real estate (one of my favorite investments), as that can take up an article in itself. However, I do want to note that as the general population in the US is fleeing from real estate, they forget that real estate & property are hard assets that have an underlying intrinsic value. It is very similar to a commodity, in that it is a quantifiable, physical, & limited. Real estate at this point in time in the US is a no-brainer investment!

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Update: Article title changed to better describe the content.

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Thanks & Happy Investing! — The Investment Blogger ©

Let me know if you found this article useful, or if there is a topic you would like me to write a future article on.

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4 thoughts on “How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices

  1. I like reading your articles. thanks. But funny reading this now, today, real estate is so cheap, it’s not funny.

    1. Thanks for the comment.

      Since the time I wrote the article over a year ago, real estate prices have continued to decline. Back then it had already declined to very low levels, with many bargains to be had. Right now, the prices are at incredible lows and the situation for investors has not changed. Borrowing costs have also declined making real estate even more attractive!! Oddly enough, people are still afraid to buy real estate because of the depressed prices. The general population tends only to buy when sellers start hiking the prices. Real Estate today in the US is still a no-brainer, although one still needs to do their homework.

      Regarding oil, its price has experienced a dramatic decline to the $40 mark in late 2008 and early 2009, but has quickly risen to above $70. I still think its price will continue to rise much further, especially when the world economies recover, and their consumption increases. Whether or not it will be sustainable at the old record price levels is another story. But there will still be a lot of money to be made in the oil industry. Unfortunately, the world is not ready to significantly remove oil from everyday use.

      Gold has fluctuated, and today is again near the $950 level. Although not as fully utilized as other base metals, we have seen the world’s fixation on gold does not change easily.

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