Here is an edited transcript of Martin D. Weiss and Jack Crooks discussing deflation and the dollar. It should be an interesting read for those wondering why some investors keep piling into treasuries and the dollar.

(emphasis mine) [my comment]

Jack: So precisely how much longer do you think the deflation will continue in the U.S.?

Martin: Nobody knows. But it's clear that this is not a short-term situation that will be resolved in the foreseeable future. It could take years to flush out the bad debts and restore confidence. [the dollar has already begun to collapse. Deflation isn't beginning, it is ending.]

The key is the debt liquidation. That's the main engine behind the deflation and a major element in vicious cycles that are just beginning to gain momentum. Consider the housing market, for example. The more debts are liquidated, the more prices fall … and the more prices fall, the more people abandon their homes and mortgages, leading to more debt liquidation.

This is what's happening all around the country right now — not only in housing, but also in every asset imaginable. These vicious cycles are like hurricanes striking every city and state in the country. Until they exhaust themselves, the deflation will continue.

Like you said at the outset, deflation is falling asset prices across the board. Not just falling home prices, but falling prices on land and commercial properties. Not just stocks and bonds, and commodities, but also collectibles — art, antiques, stamps and, soon, rare coins as well. There may be some exceptions. But overall, unless you have some very convincing evidence to the contrary, you must assume the value of your assets are going down and going down hard.

Jack: So what's a person to do?

Martin: If you don't need something, seriously consider selling it. Real estate. Stocks. Corporate bonds. Even collectibles if you consider them an investment.

Jack: Even if it has already gone down a lot?

Martin: Don't look back at what the price was. Just look ahead to what the price will be after a massive deflation. You don't have to sell everything all at once at any price. Every time the government inspires a rally in the stock market, use that as a selling opportunity. Every time the government stimulates some activity in real estate or in the economy, grab that chance as well.

Jack: Suppose market conditions are so severe, there are no buyers. Then what?

Martin: Then, you can afford to wait for a temporary stabilization or recovery. Markets never go straight down. And even in some of the worst markets, there are ways to sell most assets.

Jack: What about antiques and art?

Martin: For the first time in many years, you're seeing a contraction in major auctions sales. For example, annual sales of contemporary art at Sotheby's and Christie's auctions in New York and London are down 17% in 2008. In the two years before that, they doubled in sales. So that's not a huge decline yet. But it's a sign.

You won't get peak prices. However, if you act swiftly, you can still sell. If you wait, you'll get caught. Ditto for stamps and rare coins.

Jack: Gold is holding its value the best compared to the much larger percentages you cited earlier for other commodities. But I believe it's only a matter of time before gold succumbs to the deflation as well. What do you think?

Martin: This is hard for a lot of people to accept, but it's also hard to envision a situation in which gold defies gravity for much longer. It's still a good insurance policy against governments that could run amuck. But I suggest you reduce your holdings to a bare minimum.

No matter what, the key is to pile up as much cash as you possibly can. Then put that cash into the safest place you possibly can — short-term Treasury securities. You can buy them from the Treasury Department directly, through their Treasury Direct Program. Or for even better liquidity, I recommend a Treasury-only money market fund. [worst advice ever] Our favorites are Capital Preservation Fund and the Weiss Treasury Only Money Market Fund . There are many more to choose from and they all provide the same safety.

Jack: Last week, there were some Treasury bills auctioned off at zero yield. Doesn't that discourage you?

Martin: Not in the slightest. As long as your cash is in a safe place, the deeper the deflation, the more your money is worth. My last word: Just make sure you keep it safe!

Jack: Martin, I'm going to assume that's my cue to jump in and take us beyond just safety and protection, so we can talk about turning this deflation into a profit opportunity.

Martin: Yes, please do.

Jack: There is just one thing that always goes up with deflation: The U.S. dollar! By DEFINITION, when the price of investments or goods and services goes down , the value of each dollar goes UP . That's the essence of deflation. And here's the key: When the value of the dollar goes up in the United States, it inevitably goes up abroad as well. [I just love the circular logic of this argument. You need to think this over a few times to realize how dumb it is. Here is how the argument goes:

1) We have debt deflation because the credit bubble has burst.
2) Deflation means falling prices.
3) In order for prices to fall, the dollar has to become stronger (to keep import costs down). Therefore the dollar must be in a bull market.

Notice how there is no analysis of the dollar's long term prospects (like mentioning the trade deficit). The conventional wisdom is simply that, since prices must fall because of deflation, the dollar must rally.

This is pure wishful thinking. It doesn't explain why the Chinese will keep loaning us money when we are so broke. If they stop financing our trade deficit, the dollar will fall, and we will have inflaton.]

Martin: Please explain that connection more specifically.

Jack: Virtually everything that matters in the global economy — trade, commodities, GDP, debts — is measured in U.S. dollars. The dollar is the world's reserve currency. So just as we see domestically, when your dollar buys more, its value also rises internationally.

Martin: There was a lot of talk about other currencies replacing the dollar as a reserve currency.

Jack: Talk, yes; action, no. It never happened. And now, it's going the other way: Your dollars now buy more than two gallons of gas for every one gallon they bought just a few months ago. The dollar now buys three times more oil and copper than just a few months ago. Not just 20% more or 50% more, but three times more!

We're seeing the same thing happen against currencies. The dollar is in a massive, long-term uptrend against the euro, the British pound and virtually every currency in the world. Yes, we've witnessed a temporary dollar setback in recent days, but it does nothing to change the big trend. [wow, this is so delusional!]

Martin: It certainly does not change the deflation. But please give us specific reasons why the dollar is rising against currencies in particular.

Jack: There are three big reasons. The main one is that, as I said, the dollar is the global measure of virtually everything. So when there's global deflation , the dollar is the prime beneficiary. [pure wishful thinking.]

Look. We've had decade after decade of inflation and global expansion. During most of that period, the worldwide supply of dollars and dollar-based credit expanded dramatically. And those dollars became the key funding source of bubbles in nearly every major asset class — real estate, stocks, commodities, energy and metals. As the supply of dollars expanded, the dollar lost value.

Now we have deflation and global contraction . So now everything is turning the other way. Despite the Fed's efforts to lower interest rates, credit — dollar credit — is drying up all over the world. The overall supply of dollars is contracting . So U.S. dollars are suddenly scarce and their value is going up. [that was two reasons, wasn't it?]

Martin: Still many people in the U.S. don't see that. They think: “If the U.S. economy is in so much trouble, isn't that bad for the dollar?” [yes it is]

Jack: No, that's simply not how it works. A country's currency is never valued based on how well or how poorly that particular economy is doing in isolation. It's always measured against another country's currency. So it is always valued based on how a particular economy is doing relative to another economy.

It's not the U.S. dollar vs. some other measure. It's the U.S. dollar versus the euro, the British pound, the Aussie dollar, etc. So the relevant question is never, “How well is the U.S. economy doing?”

The question is, “How is the U.S. economy doing compared to the European economy, the U.K. or Australia?” In this environment, it's not a beauty contest. It's a contest of which economy is the least ugly … which leads me to the second reason the dollar is rising: The U.S. is winning the least ugly contest hands down. [What? Is this guy paying any attention to what is going on in our economy? Also, why is he comparing the US to the UK? We are running huge trade deficits with Asia, and it's there that the true threat to the dollar lies!]

Martin: Please elaborate.

Jack: Europe's banks have lent more than $2.7 trillion to the high-risk emerging markets, and those emerging markets are being crushed by deflation. Europe's banks have big exposure to Hungary, and Hungary is collapsing. They have big exposure to the Ukraine and to Russia, which are also collapsing.

Europe's economy is in much worse shape than ours. In Germany, export demand has vanished. So it's just now starting to accelerate downward.

Worst of all, the Eurozone's governing bodies are a mess. You've got each member nation making its own monetary policy and each going off on a different course with its economic stimulus plans. For example, the European Central Bank wants to retain some semblance of moderation in its monetary policy. But the leaders in countries like Italy, Greece, Spain, Portugal and Ireland are scared. So they're going to whatever it takes to try to prop up demand, no matter what the central banks says.

Martin: It's adding political chaos to financial chaos.

Jack: Precisely. These are the reasons the euro has been falling and, despite a sharp rally, will likely continue to fall — probably down to parity with the dollar, or lower.

Martin: That's a huge drop — over 30% from these levels. What about the U.K.?

Jack: Worse. Their housing bust is more extreme than ours. Their reliance on revenues from a sinking financial center — London — is far worse than ours. Their consumers have more debt than almost any other developed country.

Martin: And the Australian dollar?

Jack: Solid as long as commodities were going up … but a disaster with commodities going down! In just the last five months, the Australian dollar has lost 31% of its peak value. Other currencies tied to commodities are also getting killed: The New Zealand dollar is down 39% from its peak; the Brazilian real, 35%; the Canadian dollar, 23%.

Martin: And going forward?

Jack: Deflation means more declines in commodities. And the more commodities fall, the more these commodity currencies plunge. It's that simple.

Martin: You said you had three reasons for the dollar's surge.

Jack: The third reason is the flight to the center. Think of the world currency market as a solar system. The dollar is the sun; the other currencies, the planets. As the system expands, investors migrate from the core currency, the U.S. dollar, to the inner planets — currencies like the euro, the Swiss franc or the pound. [I would like to mention here that everyone was flocking into stocks in October 2007 and into commodities in June 2008. That didn't turn out so well for those investors. JUST BECAUSE EVERYONE IS FLOCKING SOMEWHERE DOESN'T MAKE IT A GOOD IDEA!]

And as the system expands even more, they migrate to the next tier of currencies, like the Australian dollar or the Canadian dollar … and then, still further, to the system's periphery — outer planets like the Brazilian real, the Mexican peso or the South African rand. At each step of the way, they take more risk with less stable economies, use more leverage, go for bigger returns — all fueled by abundant dollar credit.

Martin:
OK. What happens when the global economy contracts?

Jack: Precisely the reverse. As the global economy begins to come unglued, they rush back to the center, creating a massive flight back to the U.S. dollar. They have no love affair with the dollar. They just see the peripheral economies going down and they dump those currencies. These are the first risky investments they sell, almost invariably switching back to U.S. dollars.

The U.S. economy, despite all its troubles, is still the dominant world economy. Militarily, it's the only remaining superpower. Financially, it's still the world's capital. So it's natural that when investors are running from risk, they rush back to the dollar, bidding up its value. [just like they bid up the Dow to 14000 and oil to 147. These things are called bubbles, and they don' t end well.]

Martin: Is this true across the board, regardless of the currency?

Jack: No. There's one notable exception: The Japanese yen. Japan is the world's second largest economy and also one of the world's largest sources of capital. So when the other currencies go down, a lot of that money goes back to Japan, boosting the yen. [stay away from the yen. Japan has a huge car industry that is in trouble, and they have started running a trade deficit]

But the main point is this: The single most consistent consequence of global deflation is a rising dollar. [The US's biggest export is debt. We use it to finance our consumption of oil and cheap consumer goods. Deflation is bad for the value of debt, which is why the world will stop accepting our IOUs. This will be very bad for the dollar. Deflation is going to kill the dollar, not help it.]

Martin: So in the midst of all these bear markets, if you're looking for a big bull market …

Jack: You've found it! It's the U.S. dollar. I think the U.S. dollar is in the early stages of a powerful bull market that could last for years. It's the single cleanest way to make windfall profits from the deflation.

Martin: A year or two ago, you were betting against the dollar, and you were right. Now you're betting on a rising dollar. That's a big change. [A year of ago, the conventional wisdom was to be bearish on the dollar. Today, the conventional wisdom is to be bullish on the dollar. Jack and Martin are just following the crowd, and that hasn't worked out so well lately.]

Jack: You're darn right it is! It goes hand-in-hand with the big sea change you've so clearly illustrated today.

My reaction: Why is the conventional wisdom always wrong (at least lately)? Anyway, notice that they don't even mention our massive trade deficit, or explain why in the world foreigners would keep lending us money to buy stuff when we are so clearly broke. This reminds me of all the bullish articles in 2007 which predicted stocks would rise but never explained how we were going to get around the housing problem. In the end, we never did get around the housing problem, and stocks tanked. The moral of all this is don't believe any argument that doesn't address the biggest underlying problem facing the economy, which right now is: who is going to finance our trade deficit?

Investors should be selling treasuries and buying gold, not the other way around.


UPDATE: December 26, 2008 8:21 PM

China has begun to move away from the dollar. Most importantly, they have said they will not "promote export through currency depreciation". China's "currency depreciation" (buying large amount of treasuries to keep the yuan weak) is what has been financing our trade deficit, and, without it, the dollar will fall.