This is what is happening...

What started out as a "credit crisis" due to huge volumes of bad debt has become a different animal. We now have:

a) Huge quantities of bad debt around the world that will have to be written off.

b) A deepening recession affecting all major economies with signs of increasing severity. Pointers are that this will be deeper than the 1930s.

c) A banking crisis caused by banks having lost a large part of their capital due to bad debts. This is why many banks are being taken into whole or part state ownership.

d) A dire liquidity crisis - a shortage of the world's Reserve Currency, the US Dollar which led to the "Paulson Plan", the $700 billion bailout.

Governments, banks, businesses and individuals around the world are hoarding US Dollars. That is why the Interbank lending rate has been high and that is why governments are pumping tens of billions of dollars a day of surplus liquidity into the system.

Due to the recession, businesses are de-stocking and instead of making more products to replace stocks (which would be normal in a flat economy) or continuing to increase stocks (which would be normal in a growing economy such as we have enjoyed for the last decade) companies are selling off their stock and using the income to pay off debt or hold on account.

We are now awaiting yet another stimulus package to be presented to Congress while the UK has announced its own massive state spending programme including new nuclear weapons, and massive infrastructure investment. All of these packages are being presented to the public as 'essential' with no analysis of the long term issues - how the debt is to be repaid.

At some stage this process will reverse but there is no mechanism to remove this vast surplus and the world will be flooded with US Dollars. To describe this as 'inflationary' would be like describing lung cancer as 'a bit chesty'. When the process has bottomed and starts its reverse we will see commodities and factory prices start to rise. There will still be a deep recession which will hinder workers from getting matching pay rises. Pensioners will be on reducing incomes as the value of underlying stocks and the income therefrom has fallen to about one third to one quarter of their previous highs. The 'Boomer' generation will be heading for retirement and age-related health issues at the same time, making conditions for a 'Perfect Storm'.

I'm sorry to be so terribly gloomy this morning but it is better to understand what is happening than to be left in ignorance. Please don't shoot the messenger (me!). Timeframes are very, very hard to estimate. Over the last decade or two even the most lauded economists have found that the economy moves slower than they expected (see Alan Greenspan's book 'The Age of Turbulence' and ask yourself why he chose that title, back in 2007).

I shall be watching the development on this blog and you can look for certain pointers yourself. Watch commodity prices and factory prices. Look for signs of increasing inflation. The de-hoarding could happen very quickly when the process starts and if it does, we could see almost a step-function with the US Dollar taking a plunge more akin to a devaluation than inflation per se.

What about gold? Gold is the perfect hedge against this. At the moment it is very hard to obtain gold bullion; the major bullion dealers in London are now reporting zero availability of coins and bars with delays of months for silver, platinum and other precious metals. So why has the price of gold fallen back from its highs? This is almost certainly due to government intervention; as reported by a previous Governor of the Bank of England, at times of crisis it had been essential to keep the price of gold down to prevent a rush from currencies into gold. This is what he said in his memoirs....

"We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore, at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The U.S. Fed was very active in getting the gold price down. So was the U.K." Eddie George, Bank of England, September 1999

Today, we are staring into a far deeper abyss. Private holdings of gold have soared and we have the incredible situation where you cannot buy physical gold because the price is too low - holders of gold are not prepared to sell. This is what happens when governments intervene in free markets. As courtiers to King Canute found, even the king couldn't hold back the tide.