But we’re not…yet.

Classic economic theory says that money supply can be used to stimulate the economy and our central bankers seem to agree. That’s why they’ve pumped more than $1 trillion dollars into the economy, engineered countless bailout bonanzas for zombie institutions, put Detroit on life support, and delivered a bunch of financial Band-Aids to the trauma ward — all in a desperate bid to make Americans feel better about the global financial crisis.

To their way of thinking, the trillions of dollars have been a success. That’s why any meeting of the Group of Eight (G8) nations looks more like a mutual affection society with central bankers anxious to claim credit and backslap each other in congratulations for having avoided the “Great Depression II.”

But by taking the Federal balance sheet to more than $2 trillion from $928 billion 2008, they’ve created a situation that should have resulted in an epic inflationary spike to accompany the 137% increase in liabilities.

Yet that hasn’t quite happened.

Core inflation — which denotes consumer prices without food and energy costs — has actually decreased from 2.5% in 2008 to 1.5% presently. And that has many investors who have heard the siren call of the doom, gloom and boom crowd wondering if they’re worried about nothing.

So what gives?

Well, there are four reasons we haven’t yet seen hyperinflation:

Banks are hoarding cash. Despite having received trillions of dollars in taxpayer funded bailouts and lived through a litany of shotgun weddings designed to reinvigorate the shattered lending markets, most banks are actually hoarding cash. So instead of lending money to consumers and businesses like they’re supposed to, banks have used taxpayer dollars to boost their reserves by nearly 20-fold according to the Federal Reserve. The money the bailout was supposed to make available to the system is actually not passing “Go,” but rather getting stopped by the very institutions that are supposed to be lending it out. Three-year average annualized loan growth rates were 9.6% before the crisis; now they are shrinking by 1.8%, according to Money Magazine.

The United States exports inflation to China, which remains only too happy to continue to absorb it. What this means is that low priced products from China help keep prices down here. And this is critical to something that many in the “China-is-manipulating-their-currency” crowd fail to grasp. If China were to un-peg the yuan and let it rise by the 60% or more it’s supposedly undervalued by, we’d see jump in prices here in everything from jeans to tennis shoes, toys, medical equipment, medicines, and anything else we import in bulk from China. Chances are, the shift would not be dollar-for-dollar or even dollar-for-yuan, but there’s no doubt it would be significant. Many economists I’ve talked to privately think 25%-35% is probable. So the next time you hear a “Buy American” extremist, you might want to share this little inconvenient truth.

Consumers are still cutting back. Therefore, the spending that normally helps pull demand through the system is simply not there. I don’t how things are in your neighborhood, but where I live, people are still cutting back. Indeed, data from the U.S. Department of Commerce and the Federal Reserve Board shows that consumer spending growth averaged 1.4% a year prior to the crisis and is now shrinking at a rate of 0.7%. What this means is that people have figured out that it’s more important to save money than it is to spend it. And, given that consumer spending makes up 70% or more of the U.S. economy, this is a monumental change in behavior that all but banishes the last vestiges of the “greed is good” philosophy espoused by Michael Douglas as Wall Street pirate Gordon Gekko in 1987.

Businesses continue to cut back rather than hire new workers. Therefore, wages and wage inflation figures are lower than they would be if the economy was truly healthy and the stimulus was working. This is especially tough to stomach because it means people are still being marginalized, laid off and “part-timed” instead of being hired. And that means that most of the earnings growth we’ve seen this season has come from expense reductions rather than top line sales growth — and those are two very different things. But while this is tough, it’s also helped keep inflation lower than it would otherwise be. Prior to the financial meltdown, job growth averaged about 1% a year over the last three years whereas now it’s falling by 4.2%.

The upshot?

Any one of these factors could change at any time. And that means investors who are relying on the Fed’s version that everything is okay and that the government is managing inflation may be in for a rude awakening.

The only thing the Fed is doing is managing to manipulate is the data, and even then, not very well.

Regards,
Keith Fitz-Gerald

November 16, 2009

P.S.: For the last several years I’ve made my insights about the Asian markets and the true nature of the global capital markets available to investors via my daily columns in Money Morning and its monthly affiliate, The Money Map Report. Now I’m making those insights available through my new book, “Fiscal Hangover: How to Profit from the New Global Economy,” which can be purchased here.

Editor’s Note: This article originally appeared in Money Morning as “Four Reason Hyperinflation Hasn’t Hit the U.S. Economy Yet.” To view the original article, please click here.

Four Reasons Hyperinflation Hasn’t Hit the U.S. Economy Yet was originally featured on Whiskey and Gunpowder

First, let’s check out the chart below from the 2008 annual budget audit by the U.S. Government Accountability Office. It shows that the U.S. government must roll over $3.4 trillion in debt over the next four years. This $3.4 trillion does not include any additional borrowing that may be required for other government programs (wars, healthcare, wars, school lunches).

What’s the big deal? $3.4 trillion is a small number by today’s standards, isn’t it? Not exactly.

The chart shows how incredibly interest-rate sensitive U.S. government borrowing now is. Not only is it a big ask to ask the world’s creditors to continue funding such large deficits (there are only so many savings available to borrow, after all), but the interest expense on that debt is likely to go up as the fiscal position of America deteriorates.

And if America can’t find anyone willing to finance its deficits, what then? Well, the luxury of issuing debts in the currency you also print is that you can print money to pay for them. Technically, you can never become insolvent when you enjoy this privilege. The Fed, for example, can create new money to buy debt issued by the Treasury, funding deficits ad infinitum.

But this monetisation of the debt is another way of saying that international creditors are no longer willing to pick up America’s spending tab. They will be betting against the American economy, not on it. Even if the Fed takes the unusual step of moving out further along on the yield curve to set interest rates (and keep the bond vigilantes from sending yields to the moon) this is a clear signal to owners of dollar-denominated assets and holders of dollar currency reserves to get out.

Another scenario to watch for is when creditors begin asking the U.S. to issue debts in currencies other than its own (Yuan, Euros). That would be something. In the meantime, they will look to lessen their dollar reserves.

That may not be such an orderly process. And the urgency to get out of the greenback and into something better will only pick up pace as it becomes clear the politicians in America (along with the Fed) are not likely to suddenly rediscover fiscal prudence.

You never know. The Fed may assert its independence and baulk at more quantitative easing. But we wouldn’t count on it. And we reckon tangible assets and possibly emerging market equities would be the biggest beneficiaries of capital flows out of the dollar…and into anything else.

The next chart is for you, Paul Krugman. Krugman, among others, continues to insist that larger public sector deficits are necessary if the Western world is to avoid a Japanese-style deflationary “Lost Decade.” He claims the government must increase spending as households and businesses deleverage and reduce debts.

Advocates of this idea claim that public sector deficits, as a percentage of GDP, have no real limits. And the example they cite is Japan. As you can see from the chart below, Japan’s debt to GDP ratio is nearing 200%. America’s isn’t even half of that yet (it’s about 98%, or $13 trillion). If Japan can finance a deficit at 200% of GDP, then why are we worried that U.S. deficits half that size would threaten interest rates or the dollar?

First off, it’s worth pointing out that high public sector-debt-to GDP ratios haven’t worked in Japan, if by work you mean pave the way to a stable recovery. Advocates might say-as advocates of the stimulus here in Australia often say-that the public spending made things less worse. But the opposite is true. It’s made things more bad!

Or just worse, if you prefer. We mean that the public spending has done two things, neither of which is productive, and both of which, in fact, waste capital and resources. First, public sector spending to prop up financial firms with dodgy assets prevents the needed reckoning in asset prices that would produce market clearing prices for commercial and residential real estate. You get zombie banks and a zombie economy and zombie house prices.

Secondly, there’s no indication that all the infrastructure spending in Japan has produced any kind of lasting growth for the economy. It may have built some great roads and bridges. But we wonder if it solved any of the underlying problems? What’s more, the capital and resources that went into those projects was directed by political considerations and not available for the private sector, which could have put them to some use at least designed to produce a return on the capital.

The underlying problem which deficit spending does not solve is compounded by demographics. Japan’s government is hoping that continued borrowing can be financed at low rates by pensioners who will be cashing out of their pensions but seeking safety. However, we suspect that Japanese pensioners will begin to consume their savings as they downsize their lives into their twilight years (which tend to last much longer in Japan, as the number of Japanese centenarians shows).

That means interest on Japanese bonds-which already one fifth of the Japanese budget-will consume even more of the nation’s resources, if the older population clams up with its money. And like in the U.S., you’ll see the government borrowing more and more of every new yen spent, with more of that borrowed yen going to pay a previous creditor. That’s bordering on Ponzidom.

Japan has been able to run a higher-than-average public debt-to-GDP ratio because it has had such a high personal savings rates. This kept borrowing costs low for the government. But we’d expect that to change soon. A debt-to-GDP ratio of 200% will be very difficult to finance in the world as it is-much less in a world where those rates begin to rise and when Japanese savers begin to consume their savings.

Finally, what about Europe? Our argument here is simple: Europe’s monetary union is going to come unstuck. Why? Europe has one interest rate for twelve different economies. That does not leave national governments with the flexibility to print money and inflate away political problems. This will be intolerable, the monetary union will break up.

The sign to watch for is a spike in the yields on euro-denominated debt. As the chart below (from Stratfor) shows, earlier this year bond yields did in fact begin to widen. Germany Bunds have the most stable rates, as Germany has traditionally the most stable fiscal and monetary policies in Europe (they did not go hog wild for stimulus).

But for Spain, Ireland, Greece, Portugal, Italy and Austria (whose banks lent large for real estate in Eastern Europe), another round of falling asset values really would show that the GFC has become a sovereign debt crisis. And will Germany bail out these nations? Can it afford to?

We don’t know the answer to those questions. But it is worth pointing out that by assuming or guaranteeing the liabilities of the financial sector, national governments have also assumed the risk. And the bond markets will be left to decide how to price this risk.

How it ends is anyone’s guess. But our take is that the Super Cycle in fiat money is at its peak. And as it unwinds, it’s going to take national governments and their financing model with it. They will be forced to adopt a new model and take a new form to survive.

This means a great deal of political and economic upheaval. It’s no coincidence that the last time the world faced such monetary upheaval was when it went off the gold standard and straight into essentially thirty-two years of military and economic conflict (1913-1945). If the world is about to become that disordered again, you’ll need a plan to deal with it.

Regards,
Dan Denning
Daily Reckoning Australia

November 5, 2009

Debt to GDP Ratios Indicate Governments Going Bankrupt was originally featured on Whiskey and Gunpowder

Our views are different, but not extraterrestrial. Once upon a time, not so long ago, they were even respectable. The gist of our message two weeks ago was that debt is dangerous. It feels good at first. But give a society too much debt – either in its private sector or the public sphere – and someone’s going to get killed. That’s why the present situation is such a delight to serious economists; it offers more data points. We get to see how much straw the feds can add before the poor camel’s back breaks.

What’s the best way to get through a debt crisis? Straight through was our advice last week. For at least a thousand years, the business cycle went round and round without help from central bankers or economists. It is only since these geniuses have been on the case that really serious problems have arisen. The Panic of 1920 – in which the US government did nothing but cut taxes and spending – was quickly forgotten. The Panic of 1929, on the other hand, was followed by massive rigging and jiving by the authorities. It took 20 years and a world war to overcome; today it is still remembered today as the Great Depression.

Martin Wolf, speaking, gravely, for the world’s intelligentsia in The Financial Times last week, proclaimed that: “the only thing worse than rescuing the system would have been not rescuing it.” But he is wrong; of all the many blessings economists may bestow upon a grateful people, improving the economy is not one of them. An economy is a natural thing. It can be improved by the striving of entrepreneurs, the prudence of bankers, and the sweating of field hands. But when it comes to the macro-economic policy, forbearance is the quality that pays. Any initiative on the feds’ part inevitably makes things worse.

The Bubble Era, like the Great Depression, was largely -but not completely – the result of government initiative. Artificially low interest rates – intended to counter the modest downturn of 2001 – sent the wrong message. Consumers – notably those in Britain and America – bought things they couldn’t afford. Producers – notably those in Asia – made things for which there was no real market. Debt piled up. Mountains of it.

As consumers bought more and producers made more the economy grew. But much of the economic “growth” of the 2001-2007 period was fraudulent. It was based on debt spending, not on genuine increases in purchasing power. Debt pretends to be real money. It looks like the real thing, but it is not. It stimulates the economy like counterfeit money. It causes production and consumption, but of the wrong sort. Former Reagan era Office of Management and Budget director David Stockman estimates the level of “counterfeit GDP” at $4 trillion in the US alone.

The fraud was discovered, though misunderstood, when sub-prime debt began to implode. The economy had been kissed hard; millions of houses had been built, bought and sold. Now, owners couldn’t pay for them. All of sudden, the counterfeit money began to shrivel up. Lenders, investors, and householders all began to de-leverage; paying down the debts as fast as they could, defaulting on those they couldn’t.

Rather than come to the obvious conclusion, that they should never have meddled with the economy in the first place, the feds began rescue operations on a breathtaking scale. The British government increased spending to 140% of revenues. America now runs a stimulus program nearly equivalent, in economic impact, to WWII. Not since 1945 have the two pages of its ledgers – debits and credits – told such different stories, with almost $2 of spending for ever $1 in tax receipts. Britain will add almost 50% to its government debt in the next three years. David Stockman expects the publicly held US national debt to almost double in the next five years.

Even at those levels, many economists think the government should do more. Nobel Prize winner, Paul Krugman is one. Richard Koo is another. They’ve warned that the US (and by extension much of the rest of the world) could suffer a Lost Decade, like Japan, if the government slacks off before consumers have finished de-leveraging. At least they understand what is going on. Too bad they missed the point of it. The problem is too much debt, not too little spending. Leveraging up the public sector doesn’t help. Even government debts must be paid – if not by the borrower, then by the lender. The feds are smooching more ardently than any debt lover in history; next, we get to see who dies…or at least who defaults.

Regards,
Bill Bonner

November 4, 2009

Editor’s Note: The above article originally appeared in The Daily Reckoning as “The Kiss of Debt.”

Debt Is Dangerous, Especially of the Government Kind was originally featured on Whiskey and Gunpowder

I find it perplexing that only 20 years after the collapse of the Berlin Wall, the West continues to implement laws that mimic all of the failed policies of our former “communist” foes. In fact, our current president won the election by promising to “spread the wealth around.” But… truth be told… we don’t have to look to Eastern Europe or the Soviet Union to find a society destroyed by coercion, socialism, and the overreaching power of the State. We could just look at Detroit…

In 1961, the last Republican mayor of Detroit lost his re-election bid to a young, intelligent Democrat, with the overwhelming support of newly organized black voters. His name was Jerome Cavanagh. The incumbent was widely considered to be corrupt (and later served 10 years in prison for tax evasion). Cavanagh, a white man, pandered to poor underclass black voters. He marched with Martin Luther King down the streets of Detroit in 1963. (Of course, marching with King was the right thing to do… It’s just Cavanagh’s motives were political not moral.) He instated aggressive affirmative action policies at City Hall. And most critically, he greatly expanded the role of the government in Detroit, taking advantage of President Lyndon Johnson’s “Model Cities Program” – the first great experiment in centralized urban planning.

Mayor Cavanagh was the only elected official to serve on Johnson’s task force. And Detroit received widespread acclaim for its leadership in the program, which attempted to turn a nine-square-mile section of the city (with 134,000 inhabitants) into a “model city.” More than $400 million was spent trying to turn inner cities into shining new monuments to government planning. In short, the feds and Democratic city mayors were soon telling people where to live, what to build, and what businesses to open or close. In return, the people received cash, training, education, and health care.

The Model Cities program was a disaster for Detroit. But it did accomplish its real goal: The creation of a state-supported, Democratic political power base. The program also resulted in much higher taxes – which were easy to pitch to poor voters who didn’t have to pay them. Cavanagh pushed a new income tax through the state legislature and a “commuter tax” on city workers.

Unfortunately, as with all socialist programs, lots of folks simply don’t like being told what to do. Lots of folks don’t like being plundered by the government. They don’t like losing their jobs because of their race.

In Detroit, they didn’t like paying new, large taxes to fund a largely black and Democratic political hegemony. And so, in 1966, more than 22,000 middle- and upper-class residents moved out of the city.

But what about the poor? As my friend Doug Casey likes to say, in the War on Poverty, the poor lost the most. In July 1967, police attempted to break up a late-night party in the middle of the new “Model City.” The scene turned into the worst race riot of the 1960s. The violence killed more than 40 people and left more than 5,000 people homeless. One of the first stores to be looted was the black-owned pharmacy. The largest black-owned clothing store in the city was also burned to the ground. Cavanagh did nothing to stop the riots, fearing a large police presence would make matters worse. Five days later, Johnson sent in two divisions of paratroopers to put down the insurrection. Over the next 18 months, an additional 140,000 upper- and middle-class residents – almost all of them white – left the city.

And so, you might rightfully ask… after five years of centralized planning, higher taxes, and a fleeing population, what did the government decide to do with its grand experiment, its “Model City”? You’ll never guess….

Seeing it had accomplished nothing but failure, the government endeavored to do still more. The Model City program was expanded and enlarged by 1974’s Community Development Block Grant Program. Here again, politicians would decide which groups (and even individuals) would receive state funds for various “renewal” schemes. Later, Big Business was brought into the fold. In exchange for various concessions, the Big Three automakers “gave” $488 million to the city for use in still more redevelopment schemes in the mid-1990s.

What happened? Even with all of their power and all of the money, centralized planners couldn’t succeed with any of their plans. Nearly all of the upper and middle class left Detroit. The poor fled, too. The Model City area lost 63% of its population and 45% of its housing units from the inception of the program through 1990.

Even today, the crisis continues. At a recent auction of nearly 9,000 seized homes and lots, less than one-fifth of the available properties sold, even with bidding starting at $500. You literally can’t give away most of the “Model City” areas today. The properties put up for sale last week represented an area the size of New York’s Central Park. Total vacant land in Detroit now occupies an area the size of Boston – Detroit properties in foreclosure have more than tripled since 2007.

Every single mayor of Detroit since 1961 has been a Democrat. Every single mayor of Detroit since 1974 has been black. Detroit has been a major recipient of every major social program since the early 1960s and has received hundreds of billions of dollars in government grants, loans, and programs. We now have a black, Democrat president, who is promising to do to America as a whole what his political mentors have done to Detroit.

Those of you with a Democratic political affiliation may think what I’ve written above is biased or false. You may think what you like. But there is no way to argue that what the government has done to Detroit is anything but a horrendous crime. You may think what I’ve written above is merely a political analysis. Perhaps so, but politicians drive macroeconomic policy. And macroeconomic policy determines key financial metrics, like the trade-weighted value of a currency and key interest rates.

The likelihood America will become a giant Detroit is growing – rapidly. Politicians now control the banking sector, most of the manufacturing sector (including autos), a large amount of media, and are threatening to take over health care and the production of electricity (via cap and trade rules). These are the biggest threats to wealth in the history of our country. And these threats are causing the world’s most accomplished and wealthy investors to actively short sell the United States – something that is unprecedented in my experience.

Regards,
Porter Stansberry

November 2, 2009

Editor’s Note: A big thanks to Porter Stansberry for this article. We here at Whiskey were very eager to run it. If you would like to read more from Porter and find out about his investment research, just take a look here.

Detroit’s Socialist Nightmare Is America’s Future was originally featured on Whiskey and Gunpowder

An insight on this question came from an unexpected quarter.

A gentleman by the name of Fernando Aguirre, who posts on Internet forums and his blog as FerFAL, has written voluminously about his experiences as an Argentine citizen during and after the economic cataclysm that wracked his country in 2001. I first found a long forum post, and then a Google search of “FerFAL” revealed a larger web presence, including a recently published book.

Mr. Aguierre shares his thoughts on all sorts of related subjects, from food storage to guns to politics (he appears to really like Rep. Ron Paul). I personally found a great deal of value among what I’ve seen so far.

One brief passage struck me, however, because it related to the mechanism by which middle-class people become poor during an economic meltdown. The mechanism may be obvious, but it is important to see how theory actually worked in the real world.

Mr. Aguierre shares (in “Part IV”) how, while studying architecture following the 2001 crisis, a social studies teacher illustrated Argentina’s middle class’ slide into poverty. Quoting the teacher from memory, Mr. Aguierre writes,

“[Those in the] middle class suddenly discover that they are overqualified for the jobs they can find and have to settle for anything they can obtain, therefore unemployment sky rockets: too much to offer, too little demand. You see they prepare, study for a job they are not going to get. You kids, you are studying Architecture because you simply wish to do so. Only 3 or 4 percent of you will actually find a job related to architecture.”

We all sat there, letting it all sink in. After a few months, it all proved to be true. Even the amount of students that dropped out of college increased to at least 50%. They either [saw] no point in studying something that would not make much of a difference in their future salaries, had no money to keep themselves in college, or simply had to drop college to work and support their families.

This reads like a premonition.

The USA’s middle-class includes lots of people whose careers rest on higher education and specialized certification. While plumbers, electricians, factory employees and truck drivers typically are among the middle-class, most of those populating suburbia are accountants, middle managers, sales people, financial consultants, teachers, nurses, writers, etc. In other words, as manufacturing and now building activity contract, more of the middle class is made up of the college-educated in white-collar careers.

Factor in our current economic pickle and it’s easy to see the most likely path ahead.

With the economic expansion built on mass optimism and debt rolling over, conditions are now fertile for questioning the college degree system as jobs for the college-educated evaporate en masse. The ability of technology to replace white-collar jobs is widespread, and an increasing need to cut costs is finally driving its use, just as changing economic (and regulatory) conditions also drive the replacement of manpower with robotics in the factory.

Across the economy, the need to cut employment costs (not just payroll, but payroll taxes and benefits) is resulting in mass layoffs of sales people and white-collar office staff. When one considers how much work can be replaced now by accounting software, electronic sales presentations, flatter organizational structures, and “news persons” filing reports for free on the Internet via blogs, it is obvious that vast numbers of middle-class Americans teeter on the precipice of unemployability, not just unemployment.

When the “unique” skill sets that commanded $50,000 to $100,000 (or more) annual salaries turn out to be in vast oversupply, the only course left is to compete with those with neither a college degree nor technical education for jobs that can’t support a middle-class lifestyle.

Hands-on service occupations like nursing and medicine are also far from safe. At the end of the day, it is productivity that pays for such work to be done, and when vast numbers of people cannot find economically productive work, economic reality will land on these occupations, too.

When the economic tide goes out, all boats sink into the mud.

Too many people were goaded into illusory occupations by tax subsidies for higher education, government (rather than market) demand, and other distortions like the credit-without-prior-production of the central bank. Political pandering and central planning replaced the natural balance of an economy growing organically through the honest signals of the price system.

As long as there was enough optimism and ignorance to sustain the illusion, the distortions only grew larger.

Though the ignorance largely remains, there’s no more blind denial left to sustain the burden of all that wasted effort. If your job disappears, it may not come back.

This time it really is different. The final stages of that blind denial included fiscal imprudence that bordered on insanity. The mirage economy can’t return until after the pendulum has swung its full travel to the other side of the arc. That path leads through the valley of a crushing economic depression, one that will radically and permanently alter the lives of middle-class Americans who are almost universally unaccustomed to hardship.

Regards,
David Calderwood

October 29, 2009

Economic Collapse Permanently Destroys Middle Class Jobs was originally featured on Whiskey and Gunpowder

The forward P/E multiple on the broad stock market is not nearly as high as it was during the Internet bubble, but it’s at extreme highs if one accurately diagnoses the unsustainable stimuli currently driving global economic activity.

Just like low-quality earnings paint a misleading picture of a company’s value, this low-quality economic activity destroys wealth and promotes a dependence on sustained fiscal largesse.

Such a diagnosis would filter out how fiscal and monetary policies are distorting the efficient allocation of capital. Investors should interpret government spending as noise and interpret private sector behavior as the signal. In today’s state-sponsored economy, you cannot totally separate one from the other, but it’s still important to acknowledge the distorting influence that stimulus programs have on capital spending and hiring decisions.

What happens when the stimulus wears off? Why, we have even more excess capacity in sectors where stimulus was directed. Exhibit A: cash for clunkers. Exhibit B: the tax credit for homebuyers that will exacerbate the structural glut in housing supply. In the financial media, I’ve seen investor after investor defend these programs as valuable and necessary, which demonstrates their ignorance of sound economics.

We’re propping up zombie institutions, throwing good money after bad, and rewarding incompetence — all at the expense of prudent people’s savings and the capital that will be needed to fund the industries of the future. Top investors don’t tolerate low- or negative-return-on-capital decisions by the executives running their companies, so it’s puzzling to me why so many of these investors advocate the same type of economic malpractice on the part of government policymakers.

The latest sideshow for public consumption — a “paymaster” regulating pay at large banks — is another example of the government’s misdiagnosis of the problem.

Rather than regulate pay in the hopes that it discourages risky banking behavior, we should be phasing out the government guarantees of the banking system’s liabilities. That, I assure you, would discourage foolish risk-taking among bankers. Case in point: Goldman Sachs behaved in a much more responsible, sustainable manner when it was a privately owned partnership without government guarantees, rather than the high frequency trading, TLGP-hogging, heavily lobbying institution that it is today.

Like an addictive drug, today’s fiscal and monetary policies have made everyone feel better, but have further weakened the structural health and sustainability of the economy. If you doubt this, just look at the horror in most investors’ eyes when they are confronted with the prospect of a Fed Funds rate above, say, 2% — up from today’s range of zero percent. The addiction to E-Z credit and government support everywhere you look is one of the clearest reasons that this economic recovery is an elaborate illusion.

Yet we still see examples of extreme inefficiencies in the valuation of certain stocks. It feels eerily similar to the tech bubble, with investors behaving as if today is the last chance they’ll ever get to buy Amazon.com stock at less than 80 times earnings.

Whether it’s the sky-high multiple on Amazon’s maturing business, which seems to be discounting that every Chinese citizen will own a Kindle within 5 years, or the expectation that banks employing creative accounting have seen the worst of their credit losses, many investors are putting real money behind their belief in a super-bullish economic environment.

The reasons to be cautious and bearish are overwhelming. A market correction back to more normalized valuations may happen at any point.

Lastly, I attended the Value Investing Congress in New York last week, along with Addison Wiggin and Chris Mayer.

The most important takeaway for me was the audience’s apparent skepticism towards the two most bearish presenters: David Einhorn and Eric Sprott. Both hedge fund managers are bullish on gold and critical of Washington, D.C.’s wealth-diluting fiscal and monetary policies. The tone of the Q&A sessions after these presentations tells me that most investors are still very, very skeptical of investing in gold. That’s good news for gold bulls.

It’s also good news for stock market bears that so many believe in the Keynesian theories they read in their college economics textbooks. GDP growth driven by government spending is misleading, and damaging to capital formation. Much of today’s top line growth is coming at the expense of future profits — when mal-investments will be written off.

Regards,
Dan Amoss

October 28, 2009

Economic Misdiagnosis Due to Government Stimulus was originally featured on Whiskey and Gunpowder

The quote comes from Ben Franklin. But it was recalled to us neither by America’s president, nor Britain’s Prime Minister. Instead, the Telegraph in London reported it from the mouth of Cheng Siwei, a “top member of the Communist hierarchy.”

What goes around comes around. The Anglo-Saxons have forgotten what makes a successful economy. The Chinese have remembered.

Just look up Warren Harding on Wikipedia. The first entry you will find is not the 29th president of the United States of America, but a rock climber with the same name. But what do you expect? History is nothing but a long list of disasters in chronological order. Historians love calamity. And they reserve their highest accolades for those who cause them. The same is true in financial history. Those who make it big are those who make it worse.

It is safe to assume that no one working at the Federal Reserve or at the White House has a picture of Warren Gamaliel Harding over his desk. Yet, if American presidents were ranked on the basis of how well they faced up to financial disaster, Warren G. Harding might be somebody. His handsome face would be carved on Rushmore. His likeness would grace the $100 bill. Harding was the last American president to deal honestly with a major financial crisis. Every president since has tried to scam his way out of it.

By the time Harding took office in ‘21 the Panic of 1920 was taking the unemployment rate from 4% to nearly 12%. GDP fell 17%. Then, as now, the president’s subordinates urged him to intervene. Secretary of Commerce Herbert Hoover wanted to meddle – as he would 10 years later. But Harding resisted. No bailouts. No stimulus. No monetary policy. No fiscal policy. Harding had a better approach; he cut government spending and went out to play poker:

“We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity…it will be an example to stimulate thrift and economy in private life.

“Let us call…for a nationwide drive against extravagance and luxury, to a recommittal to simplicity of living, to that prudent and normal plan of life which is the health of the republic.”

Within a decade, Harding’s views were collectibles. But in 1921, he still saw the economic world as a moral world ordered not by man, but by God. This was not the result of long study or deep reflection on his part. He was probably the dummy everybody said he was. As Keynes pointed out, politicians are always in thrall of some dead economist. At least Harding was in thrall to the good ones.

“No statute enacted by man can repeal the inexorable laws of nature,” he announced. “Our most dangerous tendency is to expect too much of government…”

Harding was not the first to see the economy as a ‘natural’ order…one that you disturbed at your peril. A Taoist named Zhuangzi, who lived about the same time as Alexander, observed: “Good order results spontaneously when things are let alone.”

Later, economists of the Scottish enlightenment, notably Adam Smith and Adam Ferguson elaborated. Smith, like Harding, saw the economy ordered by the invisible hand of God. Ferguson saw markets as a ’spontaneous order,’ which were the “result of human action, but not the execution of any human design”.

The same basic insight led Irving Fisher – the greatest economist of the 1920s – to come up with his debt-deflation theory of depressions. After people had borrowed, they needed to pay back. Busts followed booms; there was no getting around it.

Warren Harding may never have been the brightest bulb on the White House porch, but intuitively he understood that proper macro-economic policies were more the product of virtue than of genius. Debt led to trouble; that’s all he needed to know.

Keynes came along a few years later. Keynes was a genius; everybody said so. And he had an answer for everything. Nature? Government could do better. Debt? Don’t worry about it, he said. Why not just let capitalism sort itself out? Without government intervention, it will only get worse, said Keynes.

But Harding had already proved him wrong. Harding did the very opposite of what Keynes recommended. Instead of increasing government spending, he reduced it. He cut the budget almost in half. He slashed taxes too…and cut the national debt by a third.

Japan at the time struggled with the same downturn. But it had no Harding at the helm. Instead, its masters prefigured Keynes, trying to stay the correction using price controls and other interventions. The result was a long-drawn-out affair that lasted until 1927 and ended in a bank crisis. In America, meanwhile, by 1922 unemployment was back down to 6.7%. By 1923 it was down further – to 2.4%.

This lesson was entirely lost on the world’s economists. When the next crisis hit a decade later, they turned to Keynes. Of course, it turned out to be a moral world after all. They got what they deserved.

Regards,
Bill Bonner

October 26, 2009

Macroeconomics for the Keynesian Dummies in Government was originally featured on Whiskey and Gunpowder

Say like Coca Cola re-launches New Coke, but people actually like it. Would that mean the laws of physics had been repealed? Or would you need to change what you think…?

“Gold and bonds do not usually go up or down together. But try telling that to the markets over the last two months,” writes Mark Hulbert at MarketWatch.

“Since early August, in fact, gold bullion has risen by around 10% and the Treasury’s 10-year yield, which moves inversely with Treasury prices, has fallen by nearly 15%.

“These moves are substantial, in other words, and more than just day-to-day noise in the data. What’s going on?”

Put another way, “If the gold price is so high, why are 10-year Treasury yields so low?” asks a columnist at EuroWeek, the capital markets newspaper.

To repeat: Rising gold says people fear inflation. Or so both Hulbert and EuroWeek reckon, along with pretty much the rest of the planet. But inflation fears would mean rising interest rates and falling Treasury bonds…and that’s the very opposite of what’s actually happening to government debt.

“Either way you look at it then, recent trends are unsustainable,” says Hulbert. “Something’s got to give” apparently. And it won’t be his assumption that gold and bonds shouldn’t rise together.

“If central banks take the punch bowl away at the wrong time,” says EuroWeek, “those who have bought Treasuries will have been on the right track and we will face deflation. Whereas if they let the party go on for too long the gold hoarders will have been right…and we’ll be wheeling our cash for bread around in wheelbarrows.”

The key assumption that makes these two things impossible, of course, is that gold only goes higher on strong inflation…a demonstrably idiot claim given a quick glance at the 1930s. Or this decade’s four-fold gains. Or the 50% surge of fall/winter 2008.

Back to gold in a moment, however. Because while bonds say deflation, “Equities say reflation” as the Pragmatic Capitalist notes, together with David Rosenberg at Gluskin Sheff and pretty much everyone else. “The stock market is telling a very different story from the bond market,” TPC explains, and “unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors.”

Yet again, these two things “don’t typically rise alongside” each other. Yet stocks have risen more than 11% since mid-June, while the 10-year Treasury yield (which moves inversely to bond prices, remember) has dropped nearly 0.7%.

“There have been 4 famous cases of such bond and stock divergences in the last 20 years. The most famous is the summer of 1987. We all know what occurred then.  The other three cases were fall ‘94, summer ‘98 and winter 2000. All three preceded declines in the market. Of all 4 instances, three of them preceded 15% declines in the S&P 500.”

Now throw in rising gold prices, and we’ve got rising stocks…rising bonds…AND rising gold. Hell, since Wednesday this week they’ve even pulled back together, too!

Is the moon made of cheese or what?

The curve-ball in all this – or so we guess here at BullionVault tonight – is not gold, nor stocks, nor even bonds. It’s the underlying guess-work, intuition, assumptions.

That gold only rises when the cost of living soars…or bonds only rise when stocks go down…or that a flood of money, created at zero per cent rates, can’t drive all things higher together, even the promise of cash redeemed in the future…lapped up by a pensions and finance industry faced with $11 trillion in Treasury-debt supplied, but a central bank vowing to step in if buying fails and cap any rise in rates.

Because right alongside, hedge funds are buying futures and options with virtually free finance. What’s not to love in this über-Reflation Rally redux…?

Regards,
Adrian Ash
BullionVault

October 21, 2009

Inflation, Deflation and Reflation at Once was originally featured on Whiskey and Gunpowder

They talking, of course, about the Australians decision to hike their central bank index rate. And instantly the howls of recovery were on the lips of all the pundits.

But the recovery at large is still not on the horizon.

We may be facing a serious battle with deflation, and that the evidence is all around us, Australia notwithstanding. And now we have seen more than just anecdotal evidence.

A few days ago, the United Kingdom, which has been struggling with a weakening currency, released inflation numbers far below expectations. Not only was inflation lower than expected; the figures were actually negative.

What does that mean? Well, when inflation numbers turn negative, that is deflation. And England wasn’t alone.

The number one economy in the Eurozone, Germany, released numbers that said the same thing. Prices are not increasing, they are decreasing… and at a surprising rate!

That’s contrary to conventional wisdom, which says that the bloated money supply should be raising prices. But as I explained last week, that money supply isn’t natural — it’s being created on a whim by the central back and being pushed into its member banks.

From there, it is being held against the mountain of derivative losses, bad loans and investments, instead of flowing into the economy at large through lending.

That lack of lending is what’s preventing inflation. It won’t show up until the money is released to the public. Until then, the money supply has not effectively changed or expanded… and we’ll continue to see deflation.

Deflation, in turn, will lead to longer periods of extended “non-growth” and lower interest rates — at least in the places where they can be lowered. Where they cannot be lowered, “stimulus ad nauseam” will remain the protocol of the day.

But, of course, a flat-broke country can’t stimulate unless it can borrow. We are not like China with $2 trillion in reserves. Staying afloat requires borrowing unparalleled in history. The problem is, now that we aren’t buying the world’s widgets, the world is far less inclined to loan us anything. After all, that’s the way the game has been played. They lend to us — we buy from them. And everybody was happy. But you just can’t borrow forever.

So if deflation is going to be the name of the game, what happens to the currency markets?

Thomas Jefferson Fears the Federal Reserve

To answer that question, first we need to determine which currencies are going to move in which direction. That will continue to unfold over time. But it will likely lead to the currencies of the West doing a slow gyrating dance. Neither currency is better than any of the others, so they will just move back and forth until one of them gets their debt and banking situation under control.

Very possibly, the first nation to get rid of its central bank will be the first to really break out.

Because as we all should be well aware by now, central banks exist for one purpose and one purpose only: to bailout their banker buddies who, in the pursuit of greater profit, have made risky loans… to bail out large industries in order to preserve the job base… and to make sure that the taxpayers foot the bill. They will masquerade it in the best of terms, but at the end of the day, we are paying for their foolish business practices.

The sooner we do away with a central bank, the richer we all will be. This is not our first experiment with a central bank in the United States, but it has been our most costly. Our forefathers vehemently opposed the idea of a central bank for just this reason.

They believed that such a cartel would rape and pillage the public and increase poverty on a massive scale, until there is nothing left to take.

“I believe that banking institutions are more dangerous to our liberties than standing armies,” Thomas Jefferson wrote. “The issuing power of money should be taken away from the banks and restored to the people to whom it properly belongs. The modern theory of the perpetuation of debt has drenched the earth with blood and crushed its inhabitants under burdens ever accumulating.”

Amazing, isn’t it? Here’s a man who, two centuries ago, understood why central banks brought themselves into existence. The Federal Reserve in the United States has done nothing to improve our lot and has done everything it can to extort our wealth by the tax of inflation, then to export it to economies and dictators who live like massive welfare recipients off of the taxes your fathers have paid, and you continue to pay, and your children will have to pay.

And it will remain like this until the Fed is abolished again. As I mentioned, the population of the United States has closed more than one central bank. Former presidential hopefuls even lost their bids to the White House over their stand in favor of a central bank. Until such a day as we are sufficiently educated again to see them as a menace to our wealth and way of life, until we take it in hand to dismantle the Fed as it is, we will continue to suffer the expropriation of our hard-earned money to those who act as our overlords.

Problem is, I seriously doubt that will happen within our lifetimes. Look how long it’s taken us just to consider a bill that audits the Fed.

In the meantime, I recommend you take your capital to the place it’s treated best.

That specific place, however, is yet to be determined. Will it be Australia — the first ones to hike rates? Will be China – the almighty ones holding a financial nuclear option?

I can’t say for sure.

But I can say that, over the long run, it won’t be the greenback.

If you’re looking for a way out, diversifying your savings into another currency through the FOREX markets is an easy way to do it.

Regards,
Bill Jenkins

October 15, 2009

Who Needs a Central Bank? was originally featured on Whiskey and Gunpowder

Twenty-five years ago the Russians found themselves in a hole.

They had an official price for petrol (gasoline) of 1 ruble. But the cost of providing it, for example by buying it on world markets, was 8 rubles. Insofar as the state could supply any petrol to anyone at all, it was definitely going to be at a big loss. Yet they obstinately refused to accept that their price was wrong.

How we laughed at this dogmatic denial of the discipline of the market! We put it down to some sort of political imperative, but in fact it was much simpler than that.

Rather than lose money at a world-record rate, the Russian state responded by distributing official petrol in limited quantities, and only to favored clients, which in their society meant party members. The members used to fill up their Zil limousines with this cheap petrol, and effect a supply chain to retail via the simple device of draining their tanks into the jerry cans of local teenaged entrepreneurs – at 6 rubles per liter. That left the last 2 rubles to the entrepreneur, who sold it on the side of the street at 8, with hardly a murmur from official sources.

Party members were getting rich, after all, and the taxpayer was footing the bill.

Now substitute USA for Russia, and credit for petrol, and you have the essence of what is going on today. Can you get a mortgage in America or the UK at 2%, even if you pay a 50% deposit on your house? Certainly not. In America, only government mortgage agencies (Fannie and Freddie) and megabanks which are too big to fail have access to the 0.25% credit provided by the Fed. And once again, those megabanks are making very large sums, much of which gets distributed via bonus pools to those with an unremarkable talent for re-selling this cheap credit at market rates of 5.0% or more.

Political leaders regularly rail against greedy bankers, but the problem – all that cheap money – has for the last five years come directly from the false market in credit extended by ultra-low rate policies sourced in the Treasuries of the West.

Who’s at fault is academic. The issue now is that this artificially low interest rate environment can set off a hyperinflation chain reaction, just as it did in Russia once market forces prevailed. Not much is different from previous hyperinflation episodes, save that the melting of a glacially frozen stockpile of $50 trillion in government bonds performs the role traditionally played by the printing press.

In the end, those who have saved for their futures could form our own Babushka generation of pensioners. Paid out monthly, and in full, their pension will buy them a sandwich or two. The nominal value of sovereign debt will not decline, but the value of it will inflate away, taking with it the value of all those bonds.

We could end up needing to remove a couple of zeros from banknotes, because otherwise the coinage will be melted back into nickel and copper ingots as soon as it is issued, and then sold to the Chinese…

Regards,
Paul Tustain
BullionVault

October 12, 2009

Hyperinflation and Our Bankrupt Babushka Future was originally featured on Whiskey and Gunpowder