Montreal, Canada

Increasingly, the domino-effect of highly indebted sovereign borrowers struggling to secure financing amid a deflationary noose will trigger the next financial panic. Greece and Dubai are small examples of what lies ahead if governments fail to reduce spending and control their finances. And gold smells trouble.

The next global financial crisis is likely to be in the sphere of government financing. Since this is where the most financial leverage is accumulating, it would seem plausible that some sort of major dislocation will rattle major market government bonds in the years ahead.

The United States is not immune to a global bond market panic. Just because it's a reserve currency and has the deepest and most liquid financial markets doesn't mean it can continue to write blank checks to finance its bloated spending. No nation, not even a reserve currency, can continue to spend into oblivion in the absence of domestic savings and a credible deficit reduction plan.

The CBO (Congressional Budget Office) estimates the budget deficit will hit a record $1.6 trillion dollars in the year ending September 30 and total $5.1 trillion dollars over the next five years. The $1.4 trillion dollar deficit in 2009 was equal to 9.9% of GDP – the largest share of the economy since the end of WW II. It is literally exploding and nobody cares. Keep in mind the CBO is a government body; these figures might be too conservative.

At some point, the United States, like other sovereign borrowers, will face limits on just how much they can raise from international creditors. And quantitative easing will probably return as the Fed's primary weapon to secure whatever capital Treasury can't sell to foreigners. Interest rates will rise, bond markets will crash and inflation will surge. These developments aren't inevitable but certainly in the cards if the United States doesn't change its financial doomsday flight path.

Gold, of course, senses more than just imminent inflation. As a surrogate currency it also senses the ongoing struggle among sovereign nations and weak national currencies, representing debt infested government IOUs.

All along, I've made the case for gold (and silver) because it's very clear to me that the global exchange rate system is increasingly becoming hostage to out of control fiscal deficits in the West that will be hard to reduce at a time when unemployment is high and civil strife increasing – especially in Europe. Greece will eventually be joined by Spain, Portugal and goodness knows whoever else. Europe is now suffering from its own version of subprime as economies start to fall like dominos.

The prescription by Germany and the EU (European Union) at large for Greece and other troubled eurozone members is to cut spending right away. Yet this sets the course for more social and economic discord, as austerity comes at a stiff price – deflation.

The IMF, or International Monetary Fund, isn't a distressed nation's friend; the IMF forces borrowers to dramatically cut deficits at a steep price. I suspect the IMF is already in a bull market with tentacles spread out across several European countries since 2008, including Iceland, Hungary, Ukraine and, possibly, several more in Western Europe.

I also believe that gold can rally sharply even amid a deflation IF central banks fail to rescue the financial system. The credit crisis has entered a new phase as sovereign debt markets grow increasingly unstable. There isn't a single central bank in the world that isn't attempting to inflate the money supply or trying to grow bank credit.

The problem is that both of the world's largest currency areas – the United States and Europe – are failing to grow the money supply over the last 12 months. Bank credit is still contracting for industrial and commercial loans over the last 3, 6 and 12 months. How can you have a sustainable economic expansion without bank credit?

The fact is that most investors, especially institutions, have no clue what's happening to paper money. Institutions are fixated on the S&P 500 Index and other benchmarks without understanding how fiat money is declining almost on a weekly basis vis-à-vis gold since 2005.

Investment demand for gold has clearly overwhelmed fabrication demand since gold passed $800, or so, an ounce in late 2008. This trend will only intensify as more investors climb aboard the bull market, including hedge funds and pension funds. I imagine that most investors still fail to appreciate what's happening to the global exchange rate system, their respective purchasing power and how the endgame is likely to be played out in Washington.

Gold is not in a bull market only because of inflation or fears thereof. It is rising because the big money knows that high levels of government indebtedness can't last indefinitely and that currency devaluations must accelerate if the global economy is to produce a sustainable expansion. Currency devaluations reduce purchasing power and produce long-term inflation. Also, major central banks in the United States, Europe and Japan will be slow to hike interest rates as consumption stalls and labor markets struggle to recover. Central bank policies will remain bullish for gold for the foreseeable future.

The emerging markets hold the key to the future as they harbor budget and trade surpluses while having reduced deficits since the financial crisis in 1997-1998. They will command a greater share of world output in the years ahead and deserve a premium compared to Western currencies, which are still overvalued. Some of these central banks, including China, Russia and India, have already started to accumulate gold.

The smart money is buying gold. This is likely to continue until the next financial crisis erupts, which typically occurs in the areas where leverage is growing the fastest, currently in government finances.