What do Halloween and the Fed have in common? They are both scary.

A Guest Blog For All My Gold Bug Friends.

December 31, 1999. I was in the Olathe, Kansas Toyota dealership waiting for an oil change when the midnight struck in Moscow. The dreaded Y2K bug, a feared failure of computers to function correctly when the 2-digit year-counter on which so many archaic software programs relied would become confused by the sudden change from ’99 (meaning 1999) to ’00 which would appear to be “1900” instead of “2000”. Gold was at $290.25 an ounce. The Dow closed at 11,484.66. More than 10 years later, as I started writing, on October 6, the Dow closed at 10,967.65 and gold closed at $1345 an ounce. Unemployment continues to flirt with 10% and a great cloud hangs over the economy. If cashed in your gold to buy a “share” in the Dow, in 1999 you would need 39.5 ounces. In 2010, you need 8.1 ounces. In other words, the dollar now has approximately 1/5 the sustained purchasing power as a like amount of gold bought in 1999.

If all other things you could buy rose in price like gold, we would have faced an 80% erosion in a purchasing power over the last decade. Why hasn’t the price of the stuff you buy at Wal-Mart increased by as much as gold? The answer is simple: China.

China, for more than a decade has pursued an extremely expensive policy of absorbing dollars to prop up the dollar’s purchasing power so Americans could continue to buy more Chinese exports. It works like this: The Federal Reserve controls the U.S. Mint. When it wants more money, it simply fires up the printing press. Until recently, most people assumed the treasury just serviced the money supply by requiring banks to maintain their reserves with the Fed and loaning money to the banks to facilitate lending. A few people knew that the Fed would occasionally fiddle with the money supply by buying or selling U.S. Treasuries according to needs of the market.

The Fed has figured out, however, that it can expand the money supply endlessly without much fear of inflation. This is because the Chinese offset the Fed’s purchasing of T-bills by stockpiling dollars spent by Americans to purchase things at Wal-Mart that are made in China. The Fed recently completed an approximately $1 trillion buying spree with newly printed money. The Fed calls it “quantitative easing” but it really means that the Fed is taking money from the printing press and buying things (usually bonds). Some of these bonds are “asset backed” meaning that if the debtors default, the bondholders might end up with shopping malls or residential property. In fact, it is well known the Fed is holding such assets on its balance sheet because of such defaults. The Fed also holds gold and currencies from other countries. It’s estimated that the Fed holds 8,133 tons of gold or about 5% of all the gold ever mined anywhere in the world. China holds about 1000 tons.

I read that the Fed is about to embark on a second round of “quantitative easing” which means it will undertake another buying spree. One trillion dollars will fly off the printing presses in huge sheets, cut into little rectangles, and then will be exchanged for bonds. The Fed will then stash these bonds away in its secure vaults while the dollars continue to circulate in the real economy.

But something has to give. The Fed cannot continue to siphon off value from the economy in exchange for newly-printed money. The price of gold seems to be a dire warning that something is about to give. Will it be hyper-inflation when the Chinese decide that the dollars we send them are no longer worth stockpiling? Will the recession deepen as austerity measures are put in place to ward off inflation? The word “stagflation” is starting to appear in the news again. When one looks at the price of gold relative to the dollar, one can’t help but wonder whether the price of everything else will eventually catch up to gold and the dollar will lose 80% of its value or more. How does one store wealth? How does one save for the future? Or will the storm clouds suddenly part and everything will recover with the exception of gold which will collapse like so many other bubbles.

I think we are paying the bill for two assaults on the dollar. First, the U.S. Government’s massive expenditures on transfer payments (Social Security, Medicare, Medicaid, etc.) and the Fed’s massive purchasing of assets on the open market using printed dollars. China has been a popular whipping boy recently of various politicians who have accused China of “manipulating” its currency. The theory is that if China stopped hoarding dollars and allowed its currency to float against the dollar; American manufacturers would be better positioned to lead a recovery. The truth is, however, that the Americans are manipulating currency far more than the Chinese. On December 31, 1999, the dollar bought 8.2795 Chinese Yuan. On October 6, 2010 a dollar bought 6.69118 Yuan. The Chinese aren’t causing the current crisis. Investments have lost trillions in value in a stealthy inflation that the Chinese have helped mitigate by propping up the dollar’s purchasing power.

The solution is simple but it will require the government relinquishing some of its massive power over the economy. First, the Fed needs to stop printing money and let asset prices float naturally. The market is trying to recover from the popping of the real estate bubble. The Fed continues to interfere by depressing interest rates and sloshing more money into the economy. Second, interest rates need to go up. There needs to be an economic reward for saving and a reliable basis for storing wealth. Otherwise, there is no point in creating more wealth if all available investments continue to be dissipated by bad economic policies. Third, taxes need to flatten and go down. The wealth-redistribution agenda is having the opposite of its intended effect. More people are unemployed for longer periods of time. The rich won’t hire if they can’t make a return from their investment. Fourth, the government needs to severely limit entitlements which will someday turn America into another Greece.

The Y2K bug never materialized. But 1999 does seem to have been the end of the reliable dollar.

This blog was written by a guest editor David P. Dawson. If you wish to have your guest blog appear, send your blog to me for consideration. We cover lots of issues from economics to sports.