The pound closed in on its lowest value against the dollar in almost two years yesterday; meanwhile, in the US, inflation hit a 17-year high. The two are connected, and their connection throws light on what may well happen next as Stage 2 in the credit crunch unfolds.

Economists once coined the phrase Dutch Disease to describe what happens when an economy's currency is driven so high by one particular sector - in the case of Holland it was oil - that the rest of the economy is rendered uncompetitive. Well, in the UK too, oil drove up the price of the pound. Such was the jump in sterling and the resulting loss of competitiveness for UK manufacturing that some have argued North Sea oil was a mixed blessing for the UK.

The pound surely stopped being a petro currency two or three years ago now, yet it stayed high. It stayed high despite surging consumer spending, and the resulting massive deficit in the UK's current account. Many have argued, including this publication, that sterling is due a sharp correction.

For the last few years, though, it seems that the pound ceased being a petro currency and became a kind of bankers' currency instead. Money surged into the UK, and was lent to British banks and business at low interest rates. The UK was considered low risk, so money lent to the UK carried a low premium.

The UK, on the other hand, enjoyed much higher returns on assets its citizens held abroad.

But during the credit crunch, this changed. Post credit crunch, presumably it will change some more. Less money is flowing into the UK, and much of the money that is coming in is being invested via sovereign wealth funds into buying assets on the cheap. The result will be a much greater flow of dividends leaving the UK in future years.

It seems then there are good reasons to think the pound has been due a correction, and that once corrected the change will stay in place for the foreseeable future.

It may be this correction is what we are witnessing, right now.

The pound has of course been falling against the euro for some time, but until recently actually rose against the dollar. Now even this has gone into sharp reverse.

It seems likely that the main reason why the pound initially gained against the dollar, even though the two economies have similar structural problems, is that the US economic cycle is 18 months to 2 years ahead of the UK. Maybe we are now simply seeing the UK experience the kind of falls the US suffered from earlier in 2007.

It is both good and bad news. It is bad news for Brits travelling abroad, and it is bad news for inflation. As the pound falls, foreign goods become more expensive, pushing up prices yet again. This will in turn make it much harder for the Bank of England to lower interest rates.

On the other hand, our exporters should experience a healthy boost as a result. It won't happen straight away, for as long as the Eurozone is contracting, it is difficult to see how the UK can enjoy export-led expansion. But if the Eurozone recovers, as was predicted in the article above, the result will then be surging exports.

The pressure a falling pound will exert on the Bank of England to up interest rates may be a good thing in the long-run too. The savings ratio in the UK is too low. It may be that this can only be corrected through higher interest rates - well, that and a shortage of credit. So a weaker pound will at least help in that respect.

But it is difficult to see how the UK economy can continue to expand if its high-spending consumers turn to thrifty savers.

That is why exports are so important. And that is why the telling point will be how rapidly the Eurozone can recover, in an environment where its two main external customers are losing steam.

As for the dollar, this has of course risen sharply in recent days, not just against the pound, but against the euro. This has largely been caused by the bad economic news from the Eurozone and Japan.

But, if the analysis above on an imminent Eurozone recovery is right, the dollar's resurgence may be short-lived, at least against the euro - maybe not against the pound.

US inflation hit a 17-year high in July. The annual US consumer price index was 5.6 per cent higher than a year ago last month. Prices surged by 0.8 per cent in July alone. Even if you strip out food and energy, prices rose by 0.3 per cent in the month.

Then again, with oil and food falling in price, there are good reasons for thinking the index will fall soon. For that reason, it seems unlikely the Fed will tighten interest rates.

The US is simply seeing the same inflation picture that the rest of us are experiencing. The fight against inflation is in full flow. It is being fought in the form of falling real income levels, meaning the resulting fall in demand will lead to lower prices in the future.

The US has avoided recession so far, and the Eurozone experienced recession for two simple reasons. The US government gave out a huge tax credit - something that most Eurozone governments are unable to do because the EU Stability Pact does not allow them the scope to up their borrowing by the amount required to fund this credit. Secondly, the ECB has been much firmer with inflation.

There is one of two possible outcomes. Either the ECB has been foolishly tough on inflation and the Stability Pact is unnecessarily restrictive with its rules. Or rather, this tighter approach will pay dividends in the longer-term.

Right now, it seems the odds are with the latter possibility; this suggests the Eurozone will recover while the US and UK remain in the doldrums. If that is right, then presumably the dollar will fall back against the euro.

©2008 Investment and Business News. All Rights Reserved.

During the first stage in the credit crunch gold was popular with investors. It is not difficult to see why. It has always been seen as a safe haven, and let’s face it, anything relatively safe is greeted with open arms by all investors, as if it was some kind of Shangri-La.

But it has been argued here that there were other factors driving up the price of gold. For example, its popularity in India as a form of jewellery, and its peculiar properties as a conductor for electricity making it ideal for semi-conductors.

But as the price rose and rose, and anecdotal evidence suggested Indians had as a result turned from buyers to sellers of gold, it seemed the yellow metal had reached top.

But, now there is a view that as the credit crunch deepens gold will come back into fashion again. There are three main, but related, reasons for this:

Firstly, there's the continuation of fears over inflation - in the past high inflation has spelt high gold. But then, as has been argued here many times, there are good reasons for thinking the current inflation scare might be short-lived.

Secondly, there's the turmoil in the currency markets. The US and UK are in a right mess, but the Eurozone is in even worse shape, and things are dire in Japan. So, it has been suggested currencies will experience a kind of race to bottom, no one wants to hold any of the major currencies, the result will be a search for an alternative - and that alternative will be gold. Well, that may be true - but then again, this theory overlooks the nature of business cycles. As the economies of the developed world slow, food and oil will fall in price, helping to create the next up-phase in the economic cycle. If the Eurozone recovers, then the race to bottom could change to a race to buy Euros.

Finally, there is something called Fiat money. You may know that banks can create credit. Apologies for those who know this, but here is a brief, but important, digression.

Assume there is only one bank. And this bank knows that at any one time its customers will never want to hold more than 10 per cent of their money in cash. So, assume for a moment, it has £10m deposited in the bank, that's hard cash. It knows that at any one time customers will never want more than, say, ten per cent of this money as cash to spend. So, in that case, the bank can actually afford to lend out a further £9m. So that in total its customers now have £19m worth of money; they will never want more £1m of this as cash, the rest will sit in the vaults of this one and only bank. Providing the bank has enough cash to cover customers’ demand for paper money, it can happily lend out more money than it actually has.

But what do we mean by money? If money is the amount that sits in our bank, plus our cash, then actually this £9m the bank has lent out is actually new money. By creating credit, the bank has created money.

Now remove the assumption about there only being one bank. Providing all the banks cooperate with each other and there are central banks to smooth out any difficulties that may arise from time to time, then the banking system, by lending out money it doesn't have, actually creates new money.

Now, in recent years, this system has seen a growing number of critics. They say the whole economy is based on debt, that debt carries an interest rate and that, as a result, we live in a system that is based on very shaky foundations. Furthermore, goes the argument, debt has to carry on rising, just for the system to sustain itself.

It is then argued, only a monetary system that is based on something solid, like gold, can survive in the longer-term, and that is why gold is sure to make a comeback.

This theory, though, is quite dangerous.

For one thing, it seems to have given rise to a rather unpleasant surge in anti-Semitism on some Internet sites as bankers are blamed for our ills.

Secondly, it misses rather an important point. When we borrow money we are in effect hoping to repay this money from an anticipated growth in our future stream of income. Providing the money we borrow is used to help create this extra flow of future income, then the system is sustainable.

So, Farmer Giles expects a new tractor to enable him to grow more corps. The extra money these crops bring in pay for the tractor. That's why he needs a loan.

And this is the point. Economic growth relies on debt. Karl Marx theorized that without the gold found in the New World, the Industrial Revolution would never have been funded, and so would not have got off the ground. If economic growth is determined by innovation and then investment, then we have no choice but to borrow from future earnings. The economic depression of the 1930s was perhaps caused because our production potential created by the great discoveries of the earlier decades was not matched a rising demand. Back then, more debt was required. That's what Keynes advocated.

The single biggest threat to the economy today is that we overreact to the credit crunch; that Democrats in the US try to enforce new tariffs, leading to a worldwide trade war; that, somehow, the US blames China for all its ills, and the backlash leads to a downward spiral.

But maybe an even bigger danger is that we turn on the banks, and in the process bite the very hand that could feed the recovery.

It may be that all this talk about gold surging in price is an early sign of this dangerous backlash. But as the central banks are run by savvy individuals such as Ben, Mervyn and Jean-Claude, this will not happen. And be grateful that it won't.

©2008 Investment and Business News. All Rights Reserved.

At first glance it all seems rather alarming. The Eurozone was supposed to take up the fiery torch of economic growth, and run with it before once again setting the UK and US economies alight, this time with an export based recovery. At first this seemed to be happening, with a string of positive economic stories emerging earlier this year from the region - especially from Germany. But now, it is as if the one thing the Chinese dreaded the most as their Olympic torch travelled the world has happened, and the fire has gone out.

In the second quarter of this year the economies of Germany, France, Italy and Ireland all contracted. Spain managed to avoid contraction - but more and more are now predicting recession is imminent for the Spanish economy.

This was not supposed to happen. Sure, the Irish and Spanish economies suffered from an unsustainable housing boom and debt bubble, but most of the region was a paragon of prudent export and investment led growth. It had been a similar story in Japan, by the way. Savings are up, consumer spending modest, yet the economy of the Rising Sun has also suffered a contraction in GDP during the second quarter.

So how has it happened? Well in answering that question, we can at last reveal some good news.

Okay, Italy is a basket case. It seems likely the Italian economy will continue to lurch from one crisis to the next for the foreseeable future. Ireland and Spain are very Anglo Saxon in their economic challenges - both economies seem set to see a nasty fall in house prices which will spill over to the economy at large.

But closer examination of the big two, France and Germany, reveals a more promising story.

In the case of Germany, it appears growth was too high in the previous quarter - and we have just seen a reaction to this. Q1 saw the economy expand by a very impressive 1.3 per cent. The second quarter, on the other hand, contracted by 0.5 per cent, but remember this is quarter-on-quarter data. Combine the two quarters, then overall the growth rate was pretty respectable.

But the Eurozone suffered from an additional problem, and it was this that caused such turmoil in France. The Eurozone is struggling because the cost of living is rising fast. It seems the high cost of oil and food is really taking its toll on many Eurozone economies. At the same time, the European Central Bank (ECB) is the most hawk-like of all the world's major central bankers. While the Fed has slashed rates, and the Bank of England has made soft noises about interest rates, the ECB and its president Jean-Claude Trichet have been swooping over the interest rates landscape like a hawk planning a feast of doves for its ravenous family.

It is true that, in addition to Ireland and Spain, house prices are too high in many Eurozone economies. Capital Economics recently predicted French house prices would fall by 10 per cent, but then again, the UK, Spain, Ireland and the US would love it if the prognosis for their own markets were that good.

Some have argued that the recent news of the Eurozone contraction is proof its central bank misread the situation, and that it should have taken a leaf out of the Fed's book, and slashed rates. But that is only true if you take a short-term view.

Surely the ECB, by focusing on inflation, is getting the pain over with more quickly. The recovery should be all the more rapid, as a result.

If you consider the reasons for the Eurozone slowdown, then it seems reasonable to assume that if oil and other commodity prices fall, then the economy will soon pick up. As was argued above, there are very good reasons for believing oil will fall. Food, too, is showing signs of dropping off.

But, even if commodity prices don't fall, but instead merely stop rising, then because the ECB has been so tough with interest rates, it seems Eurozone inflation will go into reverse much sooner than in the US and UK; as a result, Eurozone interest rates will then be able to fall more rapidly.

And that is where the potential recovery can come from in the US and UK. Well, at least partially anyway. China, India, and Japan and the rest of Asia will play their part too. For Japan, the story is much the same as Europe. Just like Europe there are good reasons to believe the contraction will be short-lived. As for China, well it was told here earlier this week that there is strong evidence to suggest China is consuming more and importing more.

But there is a fly in the ointment. It often feels as if many economists have underestimated how serious the problems in the US and UK are.

The fact is, the US and UK are Germany's second and third biggest customers. The US is Japan's biggest customer. For France, neither the UK nor US are so important, but there must surely be a question mark on the prospects of a Eurozone recovery if these two big consumers of the world's products hit the buffers.

It is now time to turn our attention to the two big economic developments yesterday which hit the two big Anglo Saxon economies.

©2008 Investment and Business News. All Rights Reserved.

Imagine a piece of elastic. Or better still, imagine a spring. At the end there is a heavy weight; no offence, we are not suggesting you are unduly heavy, but let's say it is you at the end. And with that spring tied to you via some kind of a harness, you jump. And you fall. Just before you hit the ground, the spring reaches its limit, and you bounce back up again. There's a law in physics which describes this: Hooke's Law. It is just possible we have now reached that stage in the credit crunch when the bungee jump that is the global economy has reached the bottom for the first time.

This does not mean, of course, that the world is set to boom again. The bungee jump has several more rises and falls yet before it finally stops. In any case, it all happens in very slow motion.

But it appears that something very significant is happening about now. There are good reasons to believe the credit crunch has reached a new stage - the last few days have seen some of the most dramatic developments to date. It was told earlier this week that the world appears to be re-aligning; well even stronger evidence has now emerged to support that view.

The credit crunch stage 2 has begun. To find out why and what this means, we need first to pay a visit to the banks of the river Seine, just a hundred yards or so from the Eiffel Tower, to the head office of the International Energy Agency. For yesterday saw news from that organisation which has significant implications indeed.

Demand for oil in the West is falling. And it is falling fast. Global demand is still growing, but by nowhere near as fast as was recently expected.

It seems that at last we may be seeing the consequences of what happens when oil becomes too expensive.

According to the International Energy Agency (IEA), the OECD is on course to consume 48.6 million barrels of oil per day this year, compared to 49.2 million in 2007. Across the globe, oil consumption per day is likely to be around 800,000 barrels a day higher than last year. According to an article by Ed Morse, chief energy economist at Lehman Brothers in the FT earlier this week, last October, the International Energy Agency expected global demand for oil to be 2.1 million barrels a day more than in 2007. In other words, growth in demand this year is barely a third as fast as previously forecast. Demand from the OECD is 600,000 barrels a day less than last year.

Ed Morse said in the FT: “In our judgment, the IEA's forecasts for emerging markets will turn out to have been far too optimistic by year's end and OPEC countries will again complain about the inability of oil importers to guarantee sufficient demand growth to warrant investments in expanded production capacity.”

Mr Morse went on to expand on a theme expressed here many times over the last few months, that when prices get too high, demand falls. We start looking for alternative products. We start looking for efficiencies.

Sometimes there are false dawns before a bubble bursts. The Dotcom boom saw many mini crashes followed by new peaks after the point when people started fearing a crash was inevitable. In 1928 and 1929, the stock market had several big falls that were then reversed before the crash. The current sell off in oil may well prove to be temporary, but sooner or later the oil and wider commodity bubble is set to burst.

The report from the IEA illustrates why this is so.

But in the slow tick-tock of economic change, the path will be gradual. First to feel the benefit will be those who were first to feel the pain. It seems that just as the Eurozone and Japan have surprised all by seeing GDP contract before the US and UK, they are likely to recover first.

But before we see the full tale unfold, let's first take a look at what is happening in Europe and Japan - where recession currently threatens to descend from on high, like a poorly aimed mallet on an innocent finger, trying to hold the economic foundations in place.

©2008 Investment and Business News. All Rights Reserved.

At first glance it all seems rather alarming. The Eurozone was supposed to take up the fiery torch of economic growth, and run with it before once again setting the UK and US economies alight, this time with an export based recovery. At first this seemed to be happening, with a string of positive economic stories emerging earlier this year from the region - especially from Germany. But now, it is as if the one thing the Chinese dreaded the most as their Olympic torch travelled the world has happened, and the fire has gone out.

In the second quarter of this year the economies of Germany, France, Italy and Ireland all contracted. Spain managed to avoid contraction - but more and more are now predicting recession is imminent for the Spanish economy.

This was not supposed to happen. Sure, the Irish and Spanish economies suffered from an unsustainable housing boom and debt bubble, but most of the region was a paragon of prudent export and investment led growth. It had been a similar story in Japan, by the way. Savings are up, consumer spending modest, yet the economy of the Rising Sun has also suffered a contraction in GDP during the second quarter.

So how has it happened? Well in answering that question, we can at last reveal some good news.

Okay, Italy is a basket case. It seems likely the Italian economy will continue to lurch from one crisis to the next for the foreseeable future. Ireland and Spain are very Anglo Saxon in their economic challenges - both economies seem set to see a nasty fall in house prices which will spill over to the economy at large.

But closer examination of the big two, France and Germany, reveals a more promising story.

In the case of Germany, it appears growth was too high in the previous quarter - and we have just seen a reaction to this. Q1 saw the economy expand by a very impressive 1.3 per cent. The second quarter, on the other hand, contracted by 0.5 per cent, but remember this is quarter-on-quarter data. Combine the two quarters, then overall the growth rate was pretty respectable.

But the Eurozone suffered from an additional problem, and it was this that caused such turmoil in France. The Eurozone is struggling because the cost of living is rising fast. It seems the high cost of oil and food is really taking its toll on many Eurozone economies. At the same time, the European Central Bank (ECB) is the most hawk-like of all the world's major central bankers. While the Fed has slashed rates, and the Bank of England has made soft noises about interest rates, the ECB and its president Jean-Claude Trichet have been swooping over the interest rates landscape like a hawk planning a feast of doves for its ravenous family.

It is true that, in addition to Ireland and Spain, house prices are too high in many Eurozone economies. Capital Economics recently predicted French house prices would fall by 10 per cent, but then again, the UK, Spain, Ireland and the US would love it if the prognosis for their own markets were that good.

Some have argued that the recent news of the Eurozone contraction is proof its central bank misread the situation, and that it should have taken a leaf out of the Fed's book, and slashed rates. But that is only true if you take a short-term view.

Surely the ECB, by focusing on inflation, is getting the pain over with more quickly. The recovery should be all the more rapid, as a result.

If you consider the reasons for the Eurozone slowdown, then it seems reasonable to assume that if oil and other commodity prices fall, then the economy will soon pick up. As was argued above, there are very good reasons for believing oil will fall. Food, too, is showing signs of dropping off.

But, even if commodity prices don't fall, but instead merely stop rising, then because the ECB has been so tough with interest rates, it seems Eurozone inflation will go into reverse much sooner than in the US and UK; as a result, Eurozone interest rates will then be able to fall more rapidly.

And that is where the potential recovery can come from in the US and UK. Well, at least partially anyway. China, India, and Japan and the rest of Asia will play their part too. For Japan, the story is much the same as Europe. Just like Europe there are good reasons to believe the contraction will be short-lived. As for China, well it was told here earlier this week that there is strong evidence to suggest China is consuming more and importing more.

But there is a fly in the ointment. It often feels as if many economists have underestimated how serious the problems in the US and UK are.

The fact is, the US and UK are Germany's second and third biggest customers. The US is Japan's biggest customer. For France, neither the UK nor US are so important, but there must surely be a question mark on the prospects of a Eurozone recovery if these two big consumers of the world's products hit the buffers.

It is now time to turn our attention to the two big economic developments yesterday which hit the two big Anglo Saxon economies.

©2008 Investment and Business News. All Rights Reserved.

The pound closed in on its lowest value against the dollar in almost two years yesterday; meanwhile, in the US, inflation hit a 17-year high. The two are connected, and their connection throws light on what may well happen next as Stage 2 in the credit crunch unfolds.

Economists once coined the phrase Dutch Disease to describe what happens when an economy's currency is driven so high by one particular sector - in the case of Holland it was oil - that the rest of the economy is rendered uncompetitive. Well, in the UK too, oil drove up the price of the pound. Such was the jump in sterling and the resulting loss of competitiveness for UK manufacturing that some have argued North Sea oil was a mixed blessing for the UK.

The pound surely stopped being a petro currency two or three years ago now, yet it stayed high. It stayed high despite surging consumer spending, and the resulting massive deficit in the UK's current account. Many have argued, including this publication, that sterling is due a sharp correction.

For the last few years, though, it seems that the pound ceased being a petro currency and became a kind of bankers' currency instead. Money surged into the UK, and was lent to British banks and business at low interest rates. The UK was considered low risk, so money lent to the UK carried a low premium.

The UK, on the other hand, enjoyed much higher returns on assets its citizens held abroad.

But during the credit crunch, this changed. Post credit crunch, presumably it will change some more. Less money is flowing into the UK, and much of the money that is coming in is being invested via sovereign wealth funds into buying assets on the cheap. The result will be a much greater flow of dividends leaving the UK in future years.

It seems then there are good reasons to think the pound has been due a correction, and that once corrected the change will stay in place for the foreseeable future.

It may be this correction is what we are witnessing, right now.

The pound has of course been falling against the euro for some time, but until recently actually rose against the dollar. Now even this has gone into sharp reverse.

It seems likely that the main reason why the pound initially gained against the dollar, even though the two economies have similar structural problems, is that the US economic cycle is 18 months to 2 years ahead of the UK. Maybe we are now simply seeing the UK experience the kind of falls the US suffered from earlier in 2007.

It is both good and bad news. It is bad news for Brits travelling abroad, and it is bad news for inflation. As the pound falls, foreign goods become more expensive, pushing up prices yet again. This will in turn make it much harder for the Bank of England to lower interest rates.

On the other hand, our exporters should experience a healthy boost as a result. It won't happen straight away, for as long as the Eurozone is contracting, it is difficult to see how the UK can enjoy export-led expansion. But if the Eurozone recovers, as was predicted in the article above, the result will then be surging exports.

The pressure a falling pound will exert on the Bank of England to up interest rates may be a good thing in the long-run too. The savings ratio in the UK is too low. It may be that this can only be corrected through higher interest rates - well, that and a shortage of credit. So a weaker pound will at least help in that respect.

But it is difficult to see how the UK economy can continue to expand if its high-spending consumers turn to thrifty savers.

That is why exports are so important. And that is why the telling point will be how rapidly the Eurozone can recover, in an environment where its two main external customers are losing steam.

As for the dollar, this has of course risen sharply in recent days, not just against the pound, but against the euro. This has largely been caused by the bad economic news from the Eurozone and Japan.

But, if the analysis above on an imminent Eurozone recovery is right, the dollar's resurgence may be short-lived, at least against the euro - maybe not against the pound.

US inflation hit a 17-year high in July. The annual US consumer price index was 5.6 per cent higher than a year ago last month. Prices surged by 0.8 per cent in July alone. Even if you strip out food and energy, prices rose by 0.3 per cent in the month.

Then again, with oil and food falling in price, there are good reasons for thinking the index will fall soon. For that reason, it seems unlikely the Fed will tighten interest rates.

The US is simply seeing the same inflation picture that the rest of us are experiencing. The fight against inflation is in full flow. It is being fought in the form of falling real income levels, meaning the resulting fall in demand will lead to lower prices in the future.

The US has avoided recession so far, and the Eurozone experienced recession for two simple reasons. The US government gave out a huge tax credit - something that most Eurozone governments are unable to do because the EU Stability Pact does not allow them the scope to up their borrowing by the amount required to fund this credit. Secondly, the ECB has been much firmer with inflation.

There is one of two possible outcomes. Either the ECB has been foolishly tough on inflation and the Stability Pact is unnecessarily restrictive with its rules. Or rather, this tighter approach will pay dividends in the longer-term.

Right now, it seems the odds are with the latter possibility; this suggests the Eurozone will recover while the US and UK remain in the doldrums. If that is right, then presumably the dollar will fall back against the euro.

©2008 Investment and Business News. All Rights Reserved.

During the first stage in the credit crunch gold was popular with investors. It is not difficult to see why. It has always been seen as a safe haven, and let’s face it, anything relatively safe is greeted with open arms by all investors, as if it was some kind of new Shangri-La.

But it has been argued here that there were other factors driving up the price of gold. For example, its popularity in India as a form of jewellery, and its peculiar properties as a conductor for electricity making it ideal for semi-conductors.

But as the price rose and rose, and anecdotal evidence suggested Indians had as a result turned from buyers to sellers of gold, it seemed the yellow metal had reached top.

But, now there is a view that as the credit crunch deepens gold will come back into fashion again. There are three main, but related, reasons for this:

Firstly, there's the continuation of fears over inflation - in the past high inflation has spelt high gold. But then, as has been argued here many times, there are good reasons for thinking the current inflation scare might be short-lived.

Secondly, there's the turmoil in the currency markets. The US and UK are in a right mess, but the Eurozone is in even worse shape, and things are dire in Japan. So, it has been suggested currencies will experience a kind of race to bottom, no one wants to hold any of the major currencies, the result will be a search for an alternative - and that alternative will be gold. Well, that may be true - but then again, this theory overlooks the nature of business cycles. As the economies of the developed world slow, food and oil will fall in price, helping to create the next up-phase in the economic cycle. If the Eurozone recovers, then the race to bottom could change to a race to buy Euros.

Finally, there is something called Fiat money. You may know that banks can create credit. Apologies for those who know this, but here is a brief, but important, digression.

Assume there is only one bank. And this bank knows that at any one time its customers will never want to hold more than 10 per cent of their money in cash. So, assume for a moment, it has £1m deposited in the bank, that's hard cash. It knows that at any one time customers will never want more than, say, ten per cent of their money as cash to spend. So, in that case, the bank can actually afford to lend out a further £9m. So that in total its customers now have £10m: £1mn in cash, £9mn in debt. They will never want more £1m of this total £10mn as cash. In other words, providing this bank has enough cash to cover customers’ demand for paper money, it can happily lend out more money than it actually has.

But what do we mean by money? If money is the amount that sits in our bank, plus our cash that we can see and touch, then actually this £9m the bank has lent out is new money. By creating credit, the bank has created money.

Now remove the assumption about there only being one bank. Providing all the banks cooperate with each other and there are central banks to smooth out any difficulties that may arise from time to time, then the banking system, by lending out money it doesn't have, actually creates new money.

Now, in recent years, this system has seen a growing number of critics. They say the whole economy is based on debt, that debt carries an interest rate and that, as a result, we live in a system that is based on very shaky foundations. Furthermore, goes the argument, debt has to carry on rising, just for the system to sustain itself.

It is then argued, only a monetary system that is based on something solid, like gold, can survive in the longer-term, and that is why gold is sure to make a comeback.

This theory, though, is quite dangerous.

For one thing, it seems to have given rise to a rather unpleasant surge in anti-Semitism on some Internet sites as bankers are blamed for our ills.

Secondly, it misses rather an important point. When we borrow money we are in effect hoping to repay this money from an anticipated growth in our future stream of income. Providing the money we borrow is used to help create this extra flow of future income, then the system is sustainable.

So, Farmer Giles expects a new tractor to enable him to grow more corps. The extra money these crops bring in pay for the tractor. That's why he needs a loan.

And this is the point. Economic growth relies on debt. Karl Marx theorized that without the gold found in the New World, the Industrial Revolution would never have been funded, and so would not have got off the ground. If economic growth is determined by innovation and then investment, then we have no choice but to borrow from future earnings. The economic depression of the 1930s was perhaps caused because our production potential created by the great discoveries of the earlier decades was not matched a rising demand. Back then, more debt was required. That's what Keynes advocated.

The single biggest threat to the economy today is that we overreact to the credit crunch; that Democrats in the US try to enforce new tariffs, leading to a worldwide trade war; that, somehow, the US blames China for all its ills, and the backlash leads to a downward spiral.

But maybe an even bigger danger is that we turn on the banks, and in the process bite the very hand that could feed the recovery.

It may be that all this talk about gold surging in price is an early sign of this dangerous backlash. But as the central banks are run by savvy individuals such as Ben, Mervyn and Jean-Claude, this will not happen. And be grateful that it won't.

©2008 Investment and Business News. All Rights Reserved.