I had an interesting discussion today with one of my closest friends about what is going on with the economy. He seems to think that there is more pain ahead. The dollar continues to lose value, the credit crisis continues, and inflation is here. Meanwhile, commodities are in their own bull market.
I consider this to be one of the most beautiful examples of how an economy really works. Not that many people can appreciate this environment for the great educational opportunity it is. If you can understand what is happening today in the markets, you've got a good grasp of the basics of how an economy is structured.
Not that many people really understand that the basic structure of an economy relies on trust and bonds between individuals or entities within that economy. When you take your dollar to the store, you use it to pay with the trust that it will be accepted by the merchant. The merchant in turn takes it to the bank with the trust that it will be deposited, be accessible, and be valued as the same dollar that he put in.
Similarly, when you borrow money from the bank with your good credit score, you've promised to pay it back. You've purchased something of value as evidenced by an appraiser or by the bank or by comparison value, and in return you've given some collateral but more importantly, you've given your promise to pay it back. That promise in itself has value. If you've never broken a promise, that promise is worth a heck of a lot more than if you are a liar.
What's happening today in the credit markets is that the true value of loans and promises are questionable. That AAA grade promise that you gave to the bank to pay back X dollars is not considered AAA by everyone else. No one will pay for it as if it is top grade because whatever you bought with it (perhaps a house) isn't worth that much anymore. Thus all around us people's promises are declining in value (grade) and worth because lots of people can't pay and because other lenders are too scared to buy those promises for face value.
To compound that problem, this creates an environment where no one will lend anymore. If I lend you 100,000 and you write me a promissory note, the second you walk out the door with my money, it's gone. That note is not worth much to anyone. Whatever you buy with that 100,000 is probably not going to be worth that 100,000 anyways.
In addition to the current environment signaling that promises are worthless, the US dollar is declining in value. Is it declining in value because people outside of this country think our promises are worthless? Or is it declining because we can't produce? That's tough to say because it's likely a lot of both.
So that's why you are seeing commodities like oil and gold in a bull market. We have a falling dollar and we have a bunch of crap promises (debt, CDOs, loans, mortgages, paper, notes - whatever you want to call them). About the only thing that you can bring to the bank as collateral is literally a pot of gold or barrels of oil. If you go to the bank for a loan and you have a high salary with lots of money in the bank, they probably won't lend it to you unless you have enough collateral to cover the whole loan. If that were the case, you wouldn't need the loan in the first place.
I'm obviously exaggerating in the last example, but the point is that in an environment of illiquidity, credit defaults, and currency devaluation, people soon find out that most things have no worth. That piece of paper that we call the dollar is really just a piece of paper. What happens if the next time you try and buy something with that paper, the merchant won't accept it? What will you pay with? Well, you'll have to find something that he values. Perhaps you'll barter services or goods? Perhaps you'll pay with gold.