Over the last 12 months the world has witnessed the greatest market volatility since the 1930s.

Banks in several industrialized countries, including the United States, are effectively bust, credit markets have frozen, unemployment has soared and real estate remains in a freefall. Domestic consumption in the United States – vital to global export growth – has collapsed amid a consumer recession while individual balance sheets have been crushed by a deflation gripping real estate, stocks, non-Treasury debt, commodities, foreign currencies (except the yen) and even fine art.

Since January 2008 gold prices have risen 8% in dollars and far more when measured in local currencies in Europe, Latin America, Asia and elsewhere. Only the Japanese yen has managed to gain over this period and due mostly to the unwinding of leverage amid economic carnage over this period.

Gold prices logged their eighth consecutive year of positive returns in 2008. I expect that to continue in 2009.

The Dollar Blip

The U.S. dollar, amazingly, has violently turned the corner since July 2008 posting huge gains versus most currencies as investors deleverage, sell foreign assets and bring their dollars home.

The dollar is the world’s reserve currency. It is also the single largest unit used for institutional accounting purposes, including the valuation of mutual funds, hedge funds and other investment products. As markets have crashed, investors have converted their foreign assets back into dollars to meet redemptions (at record highs for mutual funds and hedge funds) and to raise cash levels amid market hysteria since Lehman Brothers failed in September.

The dollar has also benefited from the demise of the infamous “carry-trade,” or borrowing low yielding Japanese yen from 2003 to 2007 to finance leveraged trades worldwide. That game is over.

Commodities have also been trashed for similar reasons.

As expected, commodities, which perform inversely to the dollar, have collapsed from their all-time highs last summer with oil prices down a spectacular 68% and a host of other raw materials down more than 50% from their highs. Only cocoa prices have rallied over the same period.

Commodity funds have not been spared by the spectacular cycle of redemptions. And, like other assets, commodities are being sold and converted back into dollars or short-term T-bills to meet liquidity needs or investor redemptions.

Deflation Now, Inflation Tomorrow

For patient investors, gold will ultimately head through the roof as unprecedented global government fiscal spending and industry bailouts inevitably invite the worst dose of inflation since the early 1970s and possibly, reminiscent of Weimar Germany in the 1920s when hyper-inflation wreaked total havoc.

The United States will print money like there’s no tomorrow to rescue the financial system and the American Way. This is already happening since late 2007 as the Fed, Treasury and the government unleash a wave of spending. The Federal Reserve’s balance sheet has already exceeded $2 trillion dollars in January 2009 and continues to soar.

If the Federal Reserve fails to quickly drain the excess liquidity when this crisis stabilizes, then gold prices will literally skyrocket as paper money becomes near worthless. This is a distinct possibility, a scenario that might unfold as we head into the great economic unknown in 2009.

Investors will pay an awful price for the ongoing credit crisis and its resultant consequences – the destruction of the dollar, the end of Pan-American military domination and the end of U.S. capitalism. If you subscribe to this view then gold’s finest hour has yet to arrive.

Gold Tied to Liquidity Cycle

But in the meantime, deflation remains short-term dollar bullish.

The global unwinding of leverage and the flight to safety will continue to support the dollar at a time when other economies are behind the U.S. economic cycle and likely to deteriorate further. This includes monetary chaos now underway in Europe, Scandinavia, Russia and a host of other countries in the industrialized and emerging economies.

Many institutions, namely hedge funds, have been forced to sell gold over the last several months to meet redemptions; gold is highly liquid and among the only asset to have appreciated over the last eight years.

Aside from hedge funds, the rest of the world is taking refuge in dollars and gold.

Where individuals can afford the metal, gold sales (excluding fabrication demand) have surged over the last six months; the U.S. Mint has stopped selling Eagles since last summer while in Europe private banks require up to three weeks to fill orders to purchase physical gold (coins, bars and wafers).

In poorer countries, however, the dollar is still viewed as a “safe haven,” a frightening contradiction considering its unlimited supply and gargantuan liabilities. Gold, however, is the only asset that is completely outside of the credit system and the only asset that has no liability.

In a world whereby currencies are literally a “bunch of drunks” competitively devaluing against each other, the dollar is currently viewed as the most sober unit. But don’t be duped into thinking the American dollar is at the cusp of a secular bull market similar to 1994 when it last bottomed.

Deficits out of Control

The U.S. government recently announced a record fiscal first quarter deficit of $485 billion dollars – a staggering amount of debt that’s likely to top $1 trillion dollars, if not more, in 2009. On top of fiscal spending, bank rescues, auto bailouts and probably other spending to boost a rapidly deflating economy, the U.S. will pile on another $2 trillion dollars of debt in fiscal 2009 and 2010. Again, this is a conservative estimate.

Gold is a Deflation Hedge

As an investor, short-term swings in gold prices are meaningless. We all know the United States and other governments worldwide will spend tremendous sums of money to inflate the financial system in 2009 and if they’re unsuccessful, will spend even more money in 2010.

It’s “inflate or die” for the global economy.

Previous periods of deflation saw official gold prices frozen by the government and in some cases, confiscated with the exception of numismatic gold coins. We really don’t know if gold will appreciate in this environment; thus far, inflation rates remain slightly positive but as the year progresses the odds are growing that U.S. CPI (consumer price index) will turn negative.

Judging by the rapid destruction of asset values across a wide spectrum of investments last year, gold prices fared impressively well. I imagine the same will be true in 2009.

Regardless, I suspect the war against gold is now in earnest as governments strive to protect the financial system and safeguard paper money. Ultimately, they should succeed in arresting deflation but at an enormous cost that will invite future inflation and more monetary debasement.