I have significantly increased the cash component of my portfolio, however, I am not holding the cash in US dollars, Canadian dollars, or any other fiat currency -- it’s held as physical gold.

My current investment objective is capital preservation. While capital preservation has always been difficult, I think it’s going to be even more so going forward. I am quite convinced that we are already well into an inflationary economic depression.

As if coping with either an economic depression or rampant inflation is not difficult enough, the data that the media reports, and that the governments and central banks want you to pay attention to, is not telling the correct story. That is going to compound the difficulties of capital preservation.

In the February 8th letter I wrote about the fact that banks in aggregate, in the US, had negative reserves. They have been borrowing more than 100% of their reserve requirements from the Federal Reserve since January. I was not alone in highlighting that this was a clear sign of trouble in the banking sector but some commentators have tried to make light of the banks’ borrowing. I suggest you take it seriously. It is one of the main reasons why I am holding my cash in physical, segregated gold bars and not in bank or brokerage accounts.

In the United States, bank deposits are guaranteed by the Federal Deposit Insurance Corporation (FDIC). The FDIC announced this week that it is bringing 25 retirees from its division of resolutions and receiverships out of retirement. I suspect that most of these people likely worked for the FDIC in the 1980s and early 90s when more than a thousand financial institutions failed during the savings-and-loan crisis. The FDIC is also trying to hire outside firms that could help manage mortgages, commercial loans and other assets at insolvent banks. On its website the FDIC is advertising job positions for people with experience in dealing with a financial institution closing, such as receivership management, resolutions and asset disposition.

FDIC Chairman, Sheila Bair, Comptroller of the Currency, John Duggan, and the Director of the Office of Thrift Supervision, John Reich, have warned of an increase in bank failures ahead. I guess I am not the only one who’s worried about the banks.

The Bank of England’s Deputy Governor, Rachel Lomax, described current events as the “largest ever peacetime liquidity crisis”.

Now, many people will stick their heads in the sand and hope that by the time they look up all the problems will have blown away in the wind. If they keep their heads down long enough it could happen, but their standard of living will also have been blown away. So will the buying power of their retirement savings, eroded away by inflation.

Perhaps the most ridiculous thing I have heard in a long time is Ben Bernanke’s assertion that inflation is not caused by an increase in money supply, but rather is a result of people’s expectations. I hesitate to even write about this, since it is so preposterous that I cannot fathom how anyone with such ideas can be taken seriously -- never mind become the Chairman of the Board of Governors of the United States Federal Reserve.

According to modern dogma, then, inflation occurs because people expect prices to rise and the cure for inflation is to manage people’s expectations. When they no longer expect inflation there will not be any inflation.

To quote the Fed Chairman: “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability.” Bernanke’s problem, therefore, is how to manage people’s expectations of future inflation. He goes on to say that: “So, for example, if the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored. If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.”

Let me understand this: if the public does not react to new information suggesting higher inflation then they are correctly anchored; but if they do respond to new data suggesting higher inflation by believing there might actually be higher inflation then they are not well anchored. In other words, if the Fed says there is no inflation and people believe it regardless of what hard data suggests otherwise, then they are well anchored. However, if people believe the data and not the Fed, they are poorly anchored. I guess I am poorly anchored then -- I must be adrift.

The logic, according to the really smart economists, is that if the people who set prices and wages do not believe there will be much inflation they will not raise prices or wages, and therefore prices and wages won’t increase. Conversely, if they do expect higher inflation they will raise prices and wages and therefore prices and wages will rise.

I am not smart enough to understand all this. In my simple mind there are numerous reasons why prices could rise, one of them is monetary inflation, which is primarily what I am concerned with since it is rather predictable and easy to understand. It’s really quite simple: if they supply of money increases then the value of money decreases, regardless of people’s expectations or how well they seem to be anchored.

It seems to me that the increase in the amount of dollars is causing an increase in the prices of both oil and gold. I doubt that it had much to do with expectations. In fact, I am quite sure it didn’t. As I recall there was very little talk ten years ago about the oil price increasing 600% or the gold price increasing almost 300%. Quite the opposite: almost nobody expected it or. Yet it happened.

James Turk (www.goldmoney.com) uses the following chart to describe much the same thing. It’s the price of oil both in US dollars and in terms of gold.

As you can see, the price of oil in US dollars has risen considerably while the price of oil in terms of gold has barely budged. Could it have something to do with the fact that the average annual inflation rate of the US dollar was approximately 8% while the inflation rate of gold was less than 2%?

It happens to be that the inflation rate of gold is approximately equal to the inflation rate of people -- meaning the increase in global population growth -- which is approximately equal to real production increases in the world. That is why gold retains its value relative to the goods and services that the people produce and consume. In fact, as a result of productivity increases, gold’s buying power actually increases over time.

On the other hand, the US dollar and virtually every other fiat currency in existence lose a considerable amount of value over time. Just look at the oil chart again. It’s not OPEC’s fault the oil price is rising -- it’s Washington that’s doing it. They are devaluing the US dollar by creating more and more dollars all the time. In the chart above the average annual increase in US dollars as measured by M3 was approximately 8%. M3 is currently increasing at an annual rate of approximately 16% - twice as fast as its fifty-year average.