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

Not to crunch too many metaphors right here at the top, but a consensus seems to be firming up in the animate jello of the Internet that we have entered the Season of the Witch. An odor of ripeness fills the virtual air — something between dead carp and apples baking. Whatever else appears to be going on in the upper stories and verdigris-tinged turrets of capital finance — currency rackets, gold switcheroos, interest rate arbitrage games, concealment of losses under rugs and behind curtains, Chinese fire drills performed by Spanish prisoners, executive three-card-monte set-ups, boardroom work-arounds, accounting quicksteps, Peter-to-Paul-shuffles, check kitings, pigeon drops, Ponzi schemes, hugger-muggers, bezels, shucks, jives, and enough monkeyshines to make Lord Greystroke cry for mercy — apart, in other words, from business-as-usual, such as it is these days, on Wall Street, there is a rising collective sense of anxious expectation that things are about to shake loose in the sad-ass shell of what remains of our economy. And the most perplexing part is that there hardly seems any safe place to preserve one’s savings.

The showmen over at the Financial Sense website, have put on an excellent month-long series of interviews and debate podcasts between leading inflationistas and deflationistas — Daniel Amerman, Peter Schiff, Robert Prechter, Mark Faber, Michael “Mish” Shedlock, Harry Dent — and after weeks of sedulous listening I still remain flummoxed as to where to stash the dwindling cash.

Harry Dent was a curious case in point this week. He has made some howlingly wrong calls before (e.g. in 2006, predicting a Dow 40,000 at the conclusion of the post-2001 bubble). Perhaps he missed the crack-up aspect of the most recent boom. He did not foresee the long gruesome meltdown of late 2007 to March 2009, or rather, his timing was off, since he called for the commencement of a new Great Depression in 2010. (And I hasten to insert here that my own timing of events has not been so great either.) Anyway, Dent sees a “winter” of finance and economy looming from here forward, characterized by extreme deflation, based on his view that the amount of private debt going bad (est. $40 trillion) far outweighs government’s ability to create new “money” (a few measily trillion) and hence that there is no chance in hell we’ll find ourselves in an inflationary situation for some time ahead. The private debt workout has to be completed first.

Most curious, though, was when the interviewer, Jim Puplava, probed Dent about his views on Peak Oil. Dent said he didn’t believe in it; that when he was in college in the 1970s (remember the OPEC oil embargo of ‘73), he learned to disregard any suggestions that we are “running out of oil.” He stated this, by the way, as a simple assertion, without any further explanation, and Puplava didn’t belabor him with arguments. But it was a weird moment. Of course, it hardly need be said that Peak Oil story has never been about “running out of oil” per se, but rather about declining flows, geopolitical management of flows, and the effects of depletion on industrial economies — in particular the effect on regular, expected, cyclical “growth” of the type that financial markets utterly depend on to power the trade in investment paper.

It is exceedingly odd that this does not factor into Dent’s thinking, because what Peak Oil inescapably does is introduce the very sobering idea of discontinuity — that is, that the game has changed radically, especially where all our assumptions about continued “growth” are concerned. In that brief exchange on Peak Oil, Dent seemed to take the position that the “winter” part of any historical financial cycle always produced “new technology” that invariably saves the day, putting this seemingly very smart man in the camp of so many techno-cornucopian triumphalists all wishing for the same outcome: that some mythical “they” will “come up with” a set of rescue remedies to keep all the cars circulating on the freeways, and all the WalMarts groaning with swag.

Like so many major league prognosticators, Dent arrives at his ideas by building models of reality, assembling “data” to create charts of trends in prices, interest rates, and especially demographics – what age group of people are buying a lot of what in which stage of their lives. The whole business seems very rational and reasonable except when you realize that it is just another “narrative” — to borrow one of Nassim Nicholas Taleb’s terms — girded with statistical justification. One can hardly fault it from a strictly procedural point of view — since, in our culture, conclusions ought to proceed from evidence — but one can’t escape the feeling that it amounts to little more than old-fashioned augury… that someone examining the entrails of a dead chicken, spread over the front page of The Wall Street Journal, might arrive at very similar conclusions. All that said, Dent was an appealingly confident personality on-the-air, the kind of authoritative voice you’d like to believe, if only it were possible.

Prechter was much the same a few weeks earlier, and he, too, foresees a darker American future, based on a different set of models called Elliot Wave principles. His forecasts derive from a picture of “social mood” as much as economic data flows. He, too seems to disregard the Peak Oil story and its implications as the master resource driving growth in industrial economies.

Personally, I am not at all sure that the Peak Oil story, or its associated general resource scarcity story, will shed a whole lot of light on the question of inflation-or-deflation. I say this because I think it is a short way down the road of depletion-and-scarcity before the major complex systems we depend on for daily life become so unstable that general socio-economic collapse ensues. After all, capital finance is only one of these many complex systems — some other biggies being food production, trade and manufacture, transportation, electric power distribution, infrastructure maintenance, the military, and governance. Inflation-or-deflation will only be symptomatic of larger failures and instabilities in these systems necessary for modern, civilized life.

All of it begs the question not only whether you or I will have two nickels to rub together, or two gold eagles, or a bundle of six month US Treasury bills, or a zillion shares of Apple, or a gainful vocation, or a roof over our heads, or a hot meal at the end of the day, or a safe place to sleep, or a country we can recognize. I’ve done my share of forecasting, with some episodes of notably bad timing. I don’t do it for grandstanding effect but to provide some basis for knowing what to do in the years directly ahead, so we can hope to construct lives worth living. I’m impatient with models, charts, and statistical analysis. Perhaps this is childish. I’d rather tell a story or paint a picture. So, I’m going to spend the rest of the week finishing the last chapter of World Made By Hand Two: The Witch of Hebron while the US economy wanders where it will.

Regards,
James Howard Kunstler

September 29, 2009

Inflation, Deflation, Peak Oil and Complex Systems was originally featured on Whiskey and Gunpowder

-Jude Wanniski, former Reagan advisor, April 1982

So does the price of gold rise or fall in a deflation?

Hint: It’s a trick question, already tripping up plenty of would-be advisors. Because gold must fall during deflation, since it rose during the ’70s inflation. Right?

“Gold prices, in real inflation-adjusted terms, unsurprisingly tended to increase during inflationary times,” nods one commentator, writing in London but posted at the Business Times in Singapore. “Its purchasing power tended to sag during depressions and deflation.”

The source for this claim? Besides syllogism (”The ’70s gave us inflation and a gold bull market; ergo, the opposite must be bad for gold…”) it was apparently Roy Jastram’s The Golden Constant, that dusty study of gold’s enduring stability across the very, very long run by the end of which we will all be deader than Austrian disco hits.

First published by Wiley in 1977, The Golden Constant has just been updated by Jill Leyland, former chief economist at the World Gold Council, for Edward Elgar Publishing. I’ve not seen the re-issue yet (not at £72 a pop! Some $120). But unless Jill’s scrapped Jastram’s research entirely and written a wholly new monograph, the conclusions should in fact be precisely the opposite.

Gold, like silver, gained in purchasing power during deflation but lost out to inflation. The only things to rise during commodity-price inflations were commodity prices and social unrest.

Three centuries of data are hard to ignore, but it seems they can be misread – not least when skim-reading for a quick book review. (If you care for the big picture, Jastram’s charts are available free at the Golden Sextant.) Those three centuries of data can also prove a real bore to analysts without a library pass, as Jastram apparently makes for “a very dense read” says a recent Seeking Alpha post. And all those numbers can also mislead the unwary if the key point’s neglected:

Gold, like silver, rose in value during deflations when it was still used as money. It lost out to inflation back when that role applied, too. But since the end of WWII, we’ve not suffered the first and only endured the second…and gold has risen sharply in purchasing power as the supply of what we’ve come to call “money” has swelled by an order of magnitude or twenty.

Meantime – and not coincidentally – gold ceased being money beyond offering a store of value (and free from default risk, as well). Little wonder that inflation really took off after the limits to money-supply growth set by the post-war Bretton Woods deal were cut by the Nixon White House at the start of the ’70s.

And we all know where that little trick got us…

“What the press and policymakers are calling ‘disinflation’ is simply deflation, the deterioration of the monetary standard characterized by falling prices,” wrote Jude Wanniski, former Wall Street Journal editor and advisor to Ronald Reagan, in 1982 – slap bang in the middle of what he’d come to call the “Volcker Deflation” in honor of the tall, cigar-wielding inflation-fighting Fed chairman.

Volcker took US rates to double-digits and left them there, wringing inflation out of the system and squashing the gold price—then (as now) a key marker for the stable value (or not) of money.

“There is a confusion because commodity prices [in 1982] are falling even as the cost of living continues to rise. [But] the price of gold, the ‘commodity money par excellence’ is the surest proxy for all prices, goods and bonds…[and] the recession that threatens to become depression could also swiftly turn into a major bull market if the Fed arrests the gold-price decline at $300, signaling an end to continued deflation and the monetarist policies that have guided the open-market desk.”

Fast forward the best part of three decades, and here we are again, trying to heat-treat the mutant spawn of a new “monetarist experiment” that’s also broken out of the lab and started to munch bystanders on the corner of Wall Street and Main.

Wanniski’s point back then was that, to prevent the end of the world, the gold price should be forced higher, making dollar devaluation explicit and pumping cash into the economy that could then be lent and spent to unwind that “deterioration of the monetary standard characterized by falling prices.” And only an idiot would pick a fight with Wanniski’s terms of reference.

So please – if you’ll glance at that chart of gold both sinking and rising as deflation failed to hit during the ’80s. Then hold my jacket a second…

Gold is no longer money, not as a means of exchange. Anyone who tells you it should be forgets that the Pound, Dollar, Yen and Euro have yet to expire. Whereas gold has signally failed in that role, not being used to make payment anywhere in the world today. The gold-money survival rate is zero, and so are the chances of a near-term return to any kind of gold-backed currency. (What do you think politicians and central-bank chiefs read for fun if not Brad DeLong and Barry Eichengreen?)

Absent the money-supply limits which the gold standard imposed on the world, people rightly guess that double-digit inflation would prove rocket-fuel for the bull market in gold. Yet the purchasing power of gold nearly doubled during the Great Depression, and it’s risen four-fold during this decade’s low consumer-price inflation as well.

Why? Because both those periods of low price-inflation saw the money-issuing authorities devalue the currency, first with explicit reference to gold but now without daring to name it. Roosevelt in the mid-30s slashed the dollar’s gold content by 40%; the Greenspan/Bernanke Fed devalued the Dollar again to sidestep a DotCom Depression, keeping real interest rates at less than zero, between 2002-2005.

The maestro’s apprentice applied the same trick in the back-half of 2008, but so far to no avail. And now even the European Central Bank is pumping out money – a near half-trillion euros today alone – in a bid to revive bank lending, swamp the currency markets, and pull Germany out of its first flirt with deflation since the 1930s.

Just such a devaluation – and again, absent any stated reference to gold – was attempted by the Bank of Japan a little less than a decade ago.

Indeed, Japan is the only developed nation since the end of the gold standard to have suffered an extended deflation in prices. So far, at least. Germany and Switzerland look set to try for a re-wind, and unless the dollar can outpace the euro’s descent, we might yet see truly sub-zero inflation in the United States, too.

But whatever that should mean for gold prices, all other things being equal, just doesn’t matter. Because the gold price will not get a chance. All other things are not equal, and the policy solution – rank devaluation – can only make gold more appealing to investors and savers, whether the “monetarist experiment” of TARP, quantitative easing or a half-trillion euros proves successful or not.

Japan’s slump into deflation coincided with the Bank of Japan’s “zero interest rate policy” (ZIRP) at the start of this decade. It also saw the gold price worldwide hit rock-bottom and turn higher, a move that analysts (including us) have typically linked to US monetary moves and investment cash looking for safety as the Dotcom Bubble exploded.

But zero-rate money from the world’s second-largest economy shouldn’t be ignored. And today, zero-rate money is all the developed world has to offer – a trick that might not beat deflation, but might just spur a whole new rush into gold.

Regards,
Adrian Ash
BullionVault

June 29, 2009

Gold and Deflation: A Trick Question was originally featured on Whiskey and Gunpowder

It’s common knowledge that gold bullion proved the most reliable wealth-store during the vicious inflation of the late 1970s. Yet almost un-noticed, gold has once again been the best-performing asset bar none this decade, too.

Gold has dominated the 21st century so far, in fact – something which will look plain to future investors, although only a handful appreciate it today.

Whether gold can now extend or repeat this performance, of course, is less clear. But “People rightly buy gold when they fear inflation ahead,” as William Rees-Mogg, a keen historian of gold, puts it. And just as during the Great Depression of the 1930s, many people now fear inflation, sparked by the very threat of deflation driving government interventions and central-bank money creation.

That’s why global demand for gold jumped throughout 2008, rising 26% on the GFMS consultancy’s data, just as the US, British and Swiss central banks moved to begin quantitative easing – a.k.a. printing money.

Gold prices had already trebled and more against the world’s major currencies, gaining an average 14% per annum in Sterling terms since the start of 2000.

Yet gold still remains a “fringe” asset class for most funds and advisors. High-margin offers and outright scams are starting to trap the unwary, while good information about how to buy, own and trade the metal remains scarce. Quite how much of your wealth you allocate to this “ultimate insurance” is something to decide for yourself. But buying and selling gold can now be much simpler and safer than during gold’s last multi-year run. It should be dramatically cheaper as well.

The Story So Far

The spark for this decade’s bull market in gold? It came from the huge central-bank gold sales of the late 1990s. Because whatever Gordon Brown sells, a few bloody-minded investors agreed, must be worth buying. It wasn’t just the UK Treasury, however.

Gold sales by those central banks about to join the Euro reached such levels, they signed a deal (the so-called Washington Agreement) to cap annual sales and limit uncertainty on the open-market price. (Renewed in 2004, the Central Bank Gold Agreement expires in September this year. Annual sales undershot the 500-tonne ceiling by one-third or more in both 2007 and 2008. The Agreement may be rolled over to accommodate the sale of 400 tonnes by the International Monetary Fund (IMF), first proposed in February 2008.)

At the same time, in the mid- to late-90s, the Financial Times and Economist both declared “the death of gold”, tempting a similar fate to the famous “death of equities” cover published by BusinessWeek just before the US stock market began its two-decade bull market of the 1980s and ’90s. The Dot.Com Crash that followed between 2000 and 2003 led a growing number of people to seek out alternative wealth stores. Whilst institutional funds overwhelmingly chose fixed-income bonds, a growing number of private investors began to buy gold, especially as the central bank fix – led by the Bank of Japan and US Federal Reserve – was to encourage a tide of cheap credit into all asset markets via (then) record-low interest rates of just 1.0%.

This flood of money washed into house prices, debt investments and emerging stock markets, and it also pushed gold higher thanks to two key events:

1. Leveraged speculation

Financed by the prime brokerage departments of the big investment banks, hedge funds the world over piled into gold derivatives as interest rates fell behind inflation in the middle of this decade. Between 2004 and 2008, they doubled the outstanding volume of US futures and options contracts, for instance, helping gold prices to double as well.

2. Exchange-traded gold funds (gold ETFs)

As early as 1999, research for mine-industry marketing group the World Gold Council (WGC) showed that very large investment portfolios could have made better returns with reduced risk if they had included a four to seven per cent allocation to gold, even during the gold bear market of the previous two decades. Many retirement and mutual funds, however, were blocked under the terms of their deeds from owning physical property, especially in the United States, and derivatives were seen as too risky.

How could these large institutions gain exposure to gold prices? The WGC responded by sponsoring a series of funds that hold physical gold bullion in trust, securitising it for shareholders and thus tracking the gold price. First launched in Australia in 2003, and soon followed by South Africa, the UK and then the United States, these exchange-traded gold funds (gold ETFs) can be traded only during stock market hours. They charge 0.40% per year for storage (typically at HSBC’s bank vaults in London), reducing the gold backing each share down to 98.3% and below of the nominal value.

Already surging by 30% in 2009 to a total valuation of $38 billion, gold ETFs are clearly attracting significant new allocations from mainstream pension and mutual funds. Yet the metal remains “institutionally under-owned” according to James Montier, London strategist for Societe Generale. Pointing to conflicting signals about whether the global economy now faces inflation or deflation, Montier recommends gold as “insurance” against both outcomes. Because while “gold is the one currency that can’t be debased” by inflationary policy, “a significant prolonged deflation would see what’s left of our financial system likely to collapse. Holding a money substitute isn’t such a bad idea against this cataclysmic outcome.”

A Case of Mistaken Identity

Several big-name hedge fund managers have also taken sizeable positions in gold so far this year, including John Paulson of Paulson & Co. (who bet against sub-prime mortgages in 2007) and David Einhorn of Greenlight Capital (who bet against Lehman Brothers’ stock while publicising its 40-to-1 leverage). But the broader universe of hedge-fund investors, however, has been pulling in the other direction, reducing their exposure to gold amid the collapse of Bear Stearns, Merrill Lynch and then Lehman Brothers. Gold futures and options were sold off alongside crude oil, emerging markets and non-Dollar currencies as hedge funds were forced to unwind their leveraged positions, first by their investment-bank brokers raising the level of margin calls and rolling costs, before withdrawing credit entirely, but also by their clients withdrawing funds and demanding redemptions.

Call it “mistaken identity”, as John Hathaway of Tocqueville Asset Management has said. Because while the boom in gold derivatives required credit that was both cheap and freely available, physical gold in contrast only grew more attractive as the banking crisis wore on.

No one’s obligation and no one’s liability, gold owned outright is quite literally the opposite of debt, giving you the same tangible security as owning real estate free of a mortgage, but instantly priced in a 24-hour international market with deep liquidity. London’s gold bullion market, still the centre of professional gold-dealing worldwide, turns over $60 billion per day, and this wholesale dealing in physical gold would be the least likely market to lose liquidity in a true financial crisis. That’s why, largely as a result of the crisis in the credit markets, a small but growing number of high-net worth individuals have already begun investing heavily in physical metal.

Rush to Physical Gold

By March 2008, the very earliest gold buyers had seen its price move from $250 above $1,000 an ounce, making newspaper headlines alongside the collapse of Northern Rock, Countrywide and Bear Stearns. Come July of last year, a sharp drop in price from the all-time dollar-high then drove many existing physical gold owners, especially coin buyers, to accumulate more gold as the world economy slowed and financial markets went into a tailspin. The leading metals refineries, however, weren’t expecting a rush until the usual autumn-time spree, typically driven by India’s usual post-harvest surge of gold buying at Diwali. (Rural India has no formal banking system, so “investment” gold jewellery acts as a hard-money savings account for many millions of people, making India the world’s No.1 consumer market.)

Last summer’s sudden jump in gold-coin demand also caught the world’s largest mints napping as well, and so their clients, especially coin shops in Germany, the UK and United States, hit a genuine shortage of gold coins and bars. The upshot today is that gold-coin supplies remain tight the world over, pushing the average premium charged above professional “spot” market prices by US retail dealers up from five to ten per cent and more – even for the most heavily-minted coins such as the South Africa Krugerrand. (The Rand Refinery has issued well over 50 million gold Krugers since launching in 1969. So there’s little rarity value compared to the plain “lump” of gold you can buy in large bar form.) German-based Heraeus says furnaces worldwide are still booked solid to try and catch up. But with stock-market investors still bruised after the crash of 2008, demand from new buyers only continues to grow, thanks not least to “the biggest interest-rate cuts in history…an unprecedented fiscal expansion,” as Gordon Brown put it at the recent G20 summit in London.

Injecting $5 trillion into the world economy between them by 2010, the world’s leading economies are receiving “more money than ever before,” said Brown. These historic doses of cash, plus the money creation of quantitative easing, lead many new and existing gold buyers to feel that “price falls should be seen as buying opportunities,” say London professional dealers Mitsui, “given the impact of global spending programs on long-term inflation.”

The plan, remember, is to reflate the economy – and asset prices – by weakening the value of money. That’s what central banks mean by “fighting deflation”. The concern amongst gold investors, however, is that reflation will tip into inflation long before global spending programs and central-bank money creation face any genuine attempts to cap, curb or reduce them.

The last decade of gold prices might then prove only a prelude to the price gains ahead.

Regards,
Adrian Ash
BullionVault

May 18, 2009

Gold: The Best Insurance Against Inflation and Deflation was originally featured on Whiskey and Gunpowder

The upside of a severe and painful depression is that the much needed adjust in the economy would finally happen. The flow of credit to productive enterprise and real risk-taking (value creating) activities could resume. Or, if you like, new “production possibility frontiers” would open (like terraforming the great red centre of Australia so that its climate is habitable, or reengineering the national energy grid to be less centralized and more resilient).

But history suggests policy makers will not allow the supply of money and credit to contract, or for the mistakes of the last bubble to be liquidated. That would mean someone has to take the losses. And if that happened right now, you’d have a lot of insolvent banks and foreclosed homeowners (especially in America, but perhaps later this year and next in Australia).

In fact, history shows that policy makers will do the exact opposite, pouring good money after bad into a market sorely in need of a return to the mean. Case in point is the way Congress treated the U.S. mortgage market in 2007 and 2008. It has led to the nationalization of the U.S. mortgage market, where the government now originates nine out of every ten new mortgage loans.

In 2007, the Congress passed the Federal Housing Authority Act. The Act loosened underwriting standards for Federal housing agencies in the U.S. It also allowed them to cut down payments in half (from 3% of a loans value to 1.5%) and loosened regulatory capital requirements. What’s more it raised the maximum value of loans the FHA could insure up to $417,000.

This was important. This was the size limit on loans that Fannie Mae and Freddie Mac could buy in the secondary mortgage market. But in market with inflated home values, with many home owners in desperate need of financing, the GSEs would be unable to step and provide what the private sector would not without a change in the conforming loan values.

The primary goal was to kick-start lending the U.S. mortgage market. It had to be kick-started because the non-bank lenders that sent prices soaring from 2004-2007 were out of the market. Private investors-seeing the bubble for what it was-were no longer funding the market. But that was just the beginning.

Next up was the Economic Stimulus Act of 2008, signed by President Bush on February 13th of that year. One little-discussed feature of that act raised the conforming loan limit for the GSEs from $417,000 to a maximum of $729,000 in some markets. This enabled the GSEs to buy or insure mortgages up to $720,000. This was designed to prevent mortgage activity in places like California, Nevada, and Florida from all but grinding to a halt.

The measure was pushed by folks in Congress who argued that median home values in some parts of the States were much higher than the national median. They argued that if the GSEs were to achieve their new mission of being the primary source of mortgage funds in the U.S., the size of the loans they could buy or insure would have to be raised. So it was, even though the original mission of the GSEs was to make housing more accessible to low-income and marginal buyers and NOT to prop up house prices in the most over-inflated markets.

The result, despite the subtle change of mission, was still pretty impressive. According to Inside Mortgage Finance, the GSE’s originated 73% of all mortgages in the U.S. in 2008. At the height of the mortgage bubble, non-bank lenders were stealing market share from the GSEs.

But as those lenders failed, the GSEs (Fannie and Freddie) once again find themselves as the only pillar holding up mortgage financing in the U.S. In the fourth quarter alone, if you include the FHA and the Department of Veterans Affairs, the government accounted for 92% of mortgage originations.

Did the GSEs massive expansion into the mortgage market keep U.S. house prices from falling even further? And let’s not forget the Fed, which is now buying GSE bonds in a further effort to prop up mortgage activity in the U.S. You can see the massive amount of new resources and capital that have been poured into keeping the market afloat, and by extension, preventing further deterioration on bank balance sheets that are chock-a-block filled with residential and commercial housing.

The bad news for the U.S market is that the provision to expand the conforming loan limit expired in December of 2008. Fortunately, for those interested in perpetuating the misery of the U.S. housing collapse, the American Recovery and Reinvestment Act signed by President Obama in February again raises conforming loan limits for the FHA and the GSEs to $729,750.

It’s enough to make you sick at your stomach. The U.S government is actively preventing an adjustment in U.S. house prices that would bring about a market-clearing price and lead the way to a recovery. House prices are falling anyway. So all the government has really achieved is the nationalization of the mortgage market, putting millions of Americans in mortgage purgatory.

What’s worse, you could credibly argue that the U.S. housing market is worse off today than it was two years ago-even after a 20% fall in national median home prices. More people have been sucked back into mortgages at values that are not sustainable. Look for higher default and foreclosure rates. And for the banks? You don’t even want to know…

As for Congress and Bush and Obama: nice work, fellas. Hope you’re proud of yourselves. If you wanted to put a whole generation into massive debt-above and beyond the Federal budget-you couldn’t have come up with a more devious series of laws to do it.

Here in Australia, the government is being coy about how long the First Home Buyers grant will be available to prop up home prices. However, the big story was consumer prices not house prices. And there were conflicting signs from the Australian Bureau of Statistics and the Reserve Bank about the real rate of consumer price inflation in Australia.

The ABS showed consumer price inflation increasing 0.1% month-over-month and 2.5% from the same time last year. But the RBA’s trimmed mean measure of inflation showed inflation up 4.4% year-over-year. That exceeds the RBA’s goal of between 2-3% inflation per year.

In any event, this should put to rest the “deflation” bogeyman for a while. And by the way, what is so bad about falling retail prices anyway? Nothing, as far as we can tell. If you’re a consumer, it means your dollar is stretching further and further.

It’s odd that people consider high prices and high wages a sign of a healthy economy. And besides, it’s not the number that matters. It’s what real wages actually are. Real wages are wages adjusted for inflation. If consumer prices are falling and real wages staying the same, consumers benefit with enhanced purchasing power.

The trouble for policy makes is that not all prices move in the same direction. If financial asset prices fall, this is “bad” because the value of shares and property are falling. That’s why we hear the deflation argument in consumer prices used as scare tactic to lower interest rates and prop up financial asset prices (good inflation).

But it does raise an interesting point: some prices can rise while others fall, even during a period where the general price level is rising. For example, the ABS reported that pharmaceuticals were up 13% in the March quarter. Secondary education fees were up 7.6%. Vegetables were up 6% and electricity was up 3.6%.

But some of those everyday higher prices were offset by the 14.1% fall for “deposit and loan facilities” and the 8.1% fall in prices for automotive fuel. Prices for domestic and holiday travel fell by 5.1% and overseas and holiday travel prices fell 4%.

That paints a picture of an economy in which prices for every day real expenses (food and medicine and rent) are rising, while prices for discretionary items (loan and vacations) are falling. So what?

Well, it means that in a hyperinflationary period, you could have plummeting stock and bond prices (in real terms) AND rising food, energy, and other prices (in real terms). So don’t go buy that house just because you think inflation is going to boost house prices. In real terms, a hyperinflation destroys value. It doesn’t add it.

Here’s the thing to remember: all the physical capital stock that gets built in an inflationary boom doesn’t go away. The factories are still there. The houses are still there. The capital goods are still there. And the cars are still there. But the value of that capital stock has to fall once the inflationary boom goes bust.

Mind you, not all of the capital stock will be productive in the future. How bad the bust is depends on how much capital was sunk into boom-time investments that don’t produce any return-ever. There are some people, for example, who argue that housing is a wasting asset, a sunk cost, or even the largest generational misallocation of capital ever [like Whiskey contributor James Howard Kunstler—ed.].

Whether it is or it is not is beside the final point in our notes. What we’re watching for now is whether it’s really possible to sustain the inflationary boom in financial assets and the consumer economy with an even greater amount of credit and debt. We suspect it is not. And that’s what’s scary.

Ever since the early part of this century, governments have been managing the contracting phase of the business cycle with the introduction of more credit. The ripple effects of the monetary expansion have steadily widened over the years, drawing more of the globe into the game. It culminated in the 200-2007 worldwide boom in all asset classes across the planet-the blow off top of 90 years of rising fiat money, if you will.

Once a global inflationary boom has been expanded to include every market everywhere, how do you keep expanding it? Is this what an IMF-backed global currency is about? The ultimate expansion of fiat money worldwide for a global policy of inflation? Is that the final frontier of fiat money? We’ll explore that space next week.

Regards,
Dan Denning
www.dailyreckoning.com.au

April 24, 2009

Vagaries of Price Movement Amid Inlation and Deflation was originally featured on Whiskey and Gunpowder

Now that it’s here, we turn our attention to trying to discern, “How bad can it get?” and “How long can it last?”

While such questions can never be answered with anything approaching absolute certainty, there are methods that can be used to assess what may lurk over the horizon. With that goal in mind, this article focuses on – and then expands upon – the recent work of two economists who painstakingly analyzed a substantial number of previous banking and currency crises in an attempt to derive potentially useful lessons. I have then taken their data and applied them to the current circumstances to see where we are, relative to those other experiences.

The Data

The data are from a study called “The Aftermath of Financial Crises” by Carmen M. Reinhart of University of Maryland and Kenneth S. Rogoff of Harvard University. In their study, the authors summarize the results of a broad sampling of banking crises, with between 13 to 22 crises analyzed for each of the variables.

The Reinhart/Rogoff study is based, in turn, on data extracted from an even more comprehensive study of events in 66 countries, titled “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” by the same authors.

I’ve summarized the findings from the latest study in the table below:

The economic measures in the left column show how far the U.S. situation has deteriorated so far. The next columns show the average historical deterioration and the worst case of the crisis analyzed.

I then applied these data to calculate the levels that the U.S. could reach if it followed the path of the historical examples. The projected level is based on the measure analyzed, either from the peak prior to the downturn (e.g., the S&P 500) or from the bottom prior to the downturn (e.g., the lows in unemployment). Thus, as you can see in the table here, the S&P 500 has already dropped from its October 2007 peak of 1565 down to 766. If this crisis were to end up being only “average,” then it would drop to 690.

If, however, the worst case of a 90% drop were to occur, as it did in Iceland last year, then the S&P 500 would trade down to the shocking level of 157. For further reference, if the current crisis were to cause the stock market to fall as sharply as in the Great Depression, the S&P would touch 469.

Duration of Crisis

As you can see in the summary table below, it took 3.4 years, on average, for the stock market to fall from the peak to the bottom. In the worst case, it took five years. With the recent peak in the S&P 500 occurring in October 2007 – just one and a half years ago – the crisis is likely to have some time to go before reaching even an average duration. More specifically, if this crisis turns out to be just “average,” we would not expect to see the low before the first quarter of 2011.

Crisis Horizon: Some Conclusions

The global economic situation continues to deteriorate on all fronts (see charts below).

Housing prices are down 28% from their bubble peak in 2006 but still have a ways down to go to get back to their pre-bubble levels. Even an average downturn will mean that housing remains a problem for several more years. Unless, of course, the government steps in to stave off those resets… a “solution” that carries with it a separate set of problems, making things worse. We continue to expect very serious problems in the commercial real estate sector.

The stock market is approaching a 50% decline, the average of what has been observed in past crises. Further slowing in U.S. corporate activities and profits means additional increases in unemployment, establishing a negative feedback loop that pushes corporate profits – and stock prices – even lower.

The only growth trend at this point is in government bailouts, which are in high gear, indicating we’ll experience the serious growth of outstanding debt seen in other crises. The elevated levels of government borrowing required to fund that spending are absorbing all available credit from foreigners, directly competing with business in need of the new financing that will be required to expand the economy. The combination of declining business activity, coupled with declining levels of household income, will result in declining tax revenues, increasing the budget deficit beyond the size of the new bailout programs. State and municipal governments across the nation are already being confronted with large shortfalls in their budgets, shortfalls that will only widen as the crisis worsens.

The combined business slowing and jobs contraction assure that the GDP will decline. Components of GDP having to do with necessities like food and shelter will continue to bump along regardless of the economic conditions, but the lack of growth in GDP could extend for years as it did in Japan and as it did after the 1929 stock crash.

Inflation/Deflation

Given that we are currently in a deflationary phase, it is easy to dismiss the case for inflation – and many do. We think that is a mistake. Even a summary tabulation of the unprecedented increases in government debt at this relatively early stage in the crisis make a compelling case for higher inflation, if for no other reason than that it shows clear intent on the part of the government to spend “whatever it takes” to offset the deflationary forces now stalking the land.

The research paints a dismal story of years of economic stagnation. In our view, the trend is now firmly established for dollar debasement, a debasement that will eventually overwhelm the deflationary pressures from collapsing asset values. Therefore, don’t listen to the happy faces on CNBC spouting off, for the umpteenth time since this crisis began, that now is the time to jump back in and buy stocks. It isn’t.

Be extremely skeptical when you hear some pundit pronouncing that this piece of short-term good news or another is an “all clear” signal. Until we start seeing a systematic improvement in the economic fundamentals – for example, an upward movement in consumer confidence – the only signal the economy will be hearing is that of a runaway train coming straight at it.

Regards,
Bud Conrad

April 23, 2009

Assessing How Serious the Financial Crisis Can Get was originally featured on Whiskey and Gunpowder

Before we get to the chicanery, what’s shaking in the local market? The banks were up. Australia’s banks never had the chance to gorge themselves on the stuff that’s choking their counterparts in Europe and North America. They were stuck, instead, with large portfolios of residential mortgages. Plus, you can’t short sell them anyway. So how low could they go?

Markets are still in a kind of suspended animation, waiting to see if there is any coherent, intelligent, effective response by the financial players or their regulators to…you know…solve the problems. It could be a long wait.

All hole and no donut. That about sums up the response of the economists and officials trying to un-freeze credit markets and get the economy going. Why on earth is the President of the United States taking time to sort out how much people at AIG get paid? Probably because he wants to distract attention away from how much money he plans to spend, and spend ineffectively.

Look, there’s Elvis! Hey king!

That’s what distractions are, attempts to change the subject or divert focus.

Distract from what? Huge inflation. Yes. Yes. We know. There is no huge inflation now. In fact, industrial production in the United States fell for the fourth month in a row. It hasn’t been this low since 2002. But then, why would output grow when demand is falling and credit remains tight?

Money supply is not falling. Yet the good people who write the Bank of England’s Quarterly Bulletin are still warning of a “debt deflation trap.” You’ll find all the good stuff beginning on page 39. The Bank warns that the cost of debts is rising relative to everything else, making it harder for heavily indebted Britons to pay off debts. Britons are, by the way, heavily indebted.

But are falling prices really so inherently evil? Really…whoever complained about a cheaper cheeseburger? When was the last time you bellyached about the ever-declining price of a pint of beer?

The Bank study resurrects the last period of sustained deflation and connects it with the economic misery of the times, in the 1930s. Then, too, output collapsed. The world’s productive capacity far exceeded its demand. And money supply, for a time, briefly shrank as banks (who create most of the money in the fiat system) went out of business.

But all of this talk about the evil of falling prices is just a ruse. Excess capacity exists because the preceding inflationary bubble helped build factories to produce goods sold to people who bought them with credit. The demand was illusory. Unfortunately, the factories were real…it took real labour, real energy, and real raw materials to build them. They remained idle and unproductive unstill something else came along (World War Two) to reignite demand the and the need for war time production.

Falling prices aren’t inherently evil. If prices fall low enough, low cost producers of a given good or service are driven out of business. Supply tightens. Prices rise.

No…what the BoE and the Fed are doing is evoking the nightmare of the Depression to justify the coming inflation. The fiat money system can’t function without just a little inflation. The gradual erosion of purchasing power is what makes it unnoticeable and thus tolerable to private citizens. They don’t really notice it 2-3% at a time.

The trouble for the global system now is the tower of debts looming over the public and private sector in many economies. It’s all well and good if the general price level falls. But it’s no good if, while asset values like stocks and homes fall, debts remain fixed. An increase in the preference for cash makes debts a lot harder to pay off.

Of course, as you know by now, the preferred government answer is to inflate. This is what made the Chinese nervous last week as they reviewed Obama’s budget. But the BoE and the Fed have been quite clear about their intentions. They will inflate as much as they need to in order to get nominal asset prices stable.

There are some investors who buy the Fed’s bogus line that it can withdraw liquidity and sterilize its money printing before it leads to inflation in the economy. Believing this is a serious mistake that could cost you a lot of money.

The hedge against these inflationary policies (including here in Australia) is to invest in assets priced in dollars which cannot be created by a printing press. That includes oil, precious metals, and other energy commodities. The nominal price of these assets should rise as the money supply rises.

More on that tomorrow.

Regards,
Dan Denning
www.dailyreckoning.com.au

March 18, 2009

Huge Inflation was originally featured on Whiskey and Gunpowder

The 1970s didn’t just curse the world with cheap German wine and the Bay City Rollers.

That decade gave us soaring inflation, too.

Gold’s stellar run up to $850 per ounce, rising more than 24 times over, also came in the ’70s. So gold, therefore, must deliver its strongest returns when the cost of living shoots higher. Right?

Wrong. “In the long run, stocks have thrashed gold as great long-term hedges against inflation,” says Jeremy Siegel, professor of finance at Wharton University, Pennsylvania. What’s more, the eight-year bull run in gold prices so far this decade has come against the lowest average consumer-price inflation since the early 1960s.

In short, the common opinion of gold as first and foremost a defense from inflation is wildly amiss. Just look at the last 30 years.

Consumer prices in the United States, even on Washington’s data, have pretty much trebled since 1980. But starting at what was then an all-time high of $850 per ounce, gold simply failed to keep pace. In fact, it dropped half of its purchasing power (monthly data) over that time.

At its lowest point, back in 2001, gold’s loss of purchasing power for US investors reached beyond 85%. The broad S&P index, on the other hand, stood more than eleven times higher, even as the Tech Crash pushed US equities into a nosedive.

Sure, things have reversed a little since then. But not enough to reverse the cold fact of gold’s losses during the long inflation of the late 20th century. How can we square it with gold’s huge returns amid the inflationary ’70s?

“Well,” you might guess, “perhaps gold only responds to rapid inflation – the nasty kind we got 30 years ago, rather than the ‘mild’ case our money has suffered ever since?”

But again, you’d be wrong – or very close to it. Between 1980 and ‘81, consumer price inflation in the US destroyed 17 cents of the Dollar’s purchasing power, a severe depreciation by any reckoning. Yet the Dollar price of gold dropped 40% during that same period. Longer term over the 1980s and ’90s – a truly horrific period of sustained inflation, then averaging 4.6% per year and vicious by any historical comparison – the real value of gold sank by more than four-fifths.

Look further back – even to when physical gold stored in government vaults underpinned the Dollar, just as it underpinned all major currencies – and you’ll find that gold almost always made a poor hedge against rising prices. In the mid-70s, Professor Roy Jastram at the University of California at Berkeley found that gold failed to keep pace with the cost of living during seven inflations in Britain across more than three centuries. In the United States, Jastram spied six inflationary periods between 1808 and 1976. On average, they saw the purchasing power of gold fall by more than one-fifth!

Only the final period in Jastram’s study – beginning in 1951 – saw the metal gain value, and it continued to gain purchasing power for the next 30 years. By the end of 1980, the average annual price of gold had risen more than 17 times over. But right from that top it was downhill for the next twenty years.

How come?

What changed at the start of the ’80s? Two things in short order, which were entirely connected.

First, Paul Volcker – the famously tall cigar-loving chairman of the US Federal Reserve – raised Dollar interest rates to nearly 20%. So secondly, and as a direct result, the rate of inflation sank from that record peace-time spike above 14%.

Volcker’s strong medicine took nearly two years to slow the rate of inflation. But it killed the gold price almost instantly. Before Volcker hiked rates – and before he and his successors gained ample room to cut them year after year – “There was a kind of great speculative pressure,” as Volcker since said. The Fed noted how “speculative activity” in the gold market was spilling into other commodities. One official at the US Treasury called the gold rush “a symptom of growing concern about world-wide inflation.”

So yes, people piled into gold as double-digit inflation and collapsing bond prices destroyed their savings at the end of ’70s. And yes, it took a record return paid to cash for the devaluation of money to slow down, allowing a cautious return to risk assets like corporate debt, listed equities and new private ventures – assets whose long-term appeal rests on stable costs and expenses, rather than a speculative guess at how the central bank might set its interest rates from one month to the next.

But now, in contrast, Britain stands on the brink, the United States will likely confirm it on Friday, and Japan’s pretty much there – yet again – suffering the horrors of inflation’s bleak evil twin, deflation.

How come gold just keeps hitting new record highs?

Before the 20th century, short periods of falling prices were as common as scurvy, and just as harmless for the long-term value of money and assets. Indeed, deflation is a good thing, for savers at least. Provided their savings institutions stay solvent. And provided their cost of living actually goes down faster than the value of the assets they’ve saved. Which is not what’s happening today. And that brings gold’s other key feature – the one investors should note if they buy it as a tightly supplied metal that shot higher in price when inflationary panic struck in the late ’70s.

Because fact is, gold also offers a deep, liquid market (if held in its internationally tradable form of large wholesale bars) with no risk of counter-party default (if owned outright, rather than through a trust or a fund or a similar financial structure).

In our debt-deprived world today – where the outstanding value of what retirees and savers are owed is deflating much faster than costs – it’s this attraction of gold…it’s “off risk” advantage…which is fast-gaining appeal amongst large funds and private investors alike.

Inflation and deflation – both a crisis in money – both also force business and growth to give up. What remains, paying zero and promising nothing, is the need to simply store wealth and savings for a better future, whenever it shows.

Regards,
Adrian Ash
BullionVault

February 20, 2009

Gold Amid Inflation and Deflation was originally featured on Whiskey and Gunpowder

For at least a year several story-lines have been slugging it out inconclusively for supremacy of the Web-waves. The main event has been the Deflationists versus the Inflationists. The first group basically says that so much “money” is being welshed out of existence that it dwarfs the new “money” being shoveled into existence in the form of bail-outs, tarps, and office re-decoration stipends. The Deflationists see the tattered remnants of the consumer credit economy auguring ever deeper into a hole until it is buried so far down that all the back-hoes ever sold will not be able to dig it out. The competing Inflationists say that the massive truckloads of shoveled-in “money” will soon overtake vanishing “wealth” and, in the process, make the US dollar worthless.

Some of us see both outcomes in sequence: the deflationary “work out” of bad debt currently underway — of loans that will will never be paid back, of acronymic paper securities revealed as frauds, of “non-performing” contracts entering the swamps of foreclosure, of banks pretending to still exist, of hallucinated “wealth” rushing into the cosmic worm-hole of oblivion — can only go for so long before everyone who can go broke will go broke. Then, just as we find ourselves a nation of empty pockets, the tsunami of shoveled-in “money” designed to “reboot the consumer” (created not from productive activity but just printed recklessly), will start churning through the “economy,” chasing products and commodities that became scarce during the deflationary phase — and the result is hyper-inflation, the eraser of debt, destroyer of fortunes, and suicide pill of feckless governments.

I guess the basic difference is that the hardcore Deflationists seem to think that their process can go on forever. The society just gets poorer and poorer until we’re back at something like a scene out of Pieter Bruegel the Elder. The Inflationists see a fork in the road leading to more overt destruction, especially political turmoil as a lot of negative emotion joins the work-out orgy and overwhelms government.

But in this moment, the week after a new president’s inauguration, the deadly fog has rolled in and absolutely everyone dreads what lurks on the other side of it, without being able to discern the path through it. For example, the “bail-out fatigue” being reported suggests that congress may just call a halt to money-shoveling. Where would that leave Mr. Obama’s urgent call for “stimulus?” Not to mention further TARP injections for redecorating bank offices.

I’ve been skeptical of the “stimulus” as sketched out so far, aimed at refurbishing the infrastructure of Happy Motoring. To me, this is the epitome of a campaign to sustain the unsustainable — since car-dependency is absolutely the last thing we need to shore up and promote. I haven’t heard any talk so far about promoting walkable communities, or any meaningful plan to get serious about fixing passenger rail and integral public transit. Has Mr. Obama’s circle lost sight of the fact that we import more than two-thirds of the oil we use, even during the current price hiatus? Or have they forgotten how vulnerable this leaves us to the slightest geopolitical spasm in such stable oil-exporting nations as Nigeria, Mexico, Venezuela, Libya, Algeria, Columbia, Iran, and the Middle East states? And we’re going to rescue ourselves by driving cars?

I know it is difficult for Americans at every level to imagine a different way-of-life, but we’d better start tuning up our imaginations, because endless motoring is not our destiny anymore. The message has not moved from the grassroots up, and so at this perilous stage the message had better come from the top down. Mr. Obama needs to go on TV and tell the American public that we’re done cruisin’ for burgers. He could do that by drastically reviving his stimulus proposal as it currently stands.

Putting aside whether this “stimulus” represents reckless money-printing in an insolvent society, let’s just take it at face-value and ask where the “money” might be better directed:

– We have to rehabilitate thousands of downtowns all over the nation to accommodate the new re-scaled edition of local and regional trade that will follow the death of national chain-store retail of the WalMart ilk. Reactivated town centers and Main Streets are indispensable features of walkable communities. The Congress for the New Urbanism (CNU.org) ought to be consulted on the procedures for accomplishing this and for rehabilitating the traditional neighborhoods connected to our Main Streets.

– We have to reform food production (a.k.a. “farming”). Petro-dependent agri-biz will go the same way as the chain stores. Its equations will fail, especially in a credit-strapped society. That piece of the picture is so dire right now, as we prepare for the planting season, that many crops may not be put in for lack of front-money. This portends, at least, much higher food prices at the end of the year, if not outright scarcities and shortages. And the new government wants to gold-plate highway off-ramps instead? Earth to Rahm Emanuel: screw your head back on.

– As mentioned above, we have to get passenger rail going again because the airlines are going to die the next time there is an uptick in oil prices, or a spot shortage of oil. Let’s not be too grandiose and attempt to build expensive high-speed or mag-lev networks — certainly not right now — because they require entirely new track systems. Let’s fix those regular tracks already out there, rusting in the rain, or temporarily replaced by bike trails.

Those are three biggies for the moment and enough to keep this society busy for a couple of years. But more to the point of this blog, observers of all stripes are having trouble imagining any way out of our multiple predicaments. All the possible actions tried so far have seemed absurd. Why even try to prop up inflated house values when the single most crucial need in this sector is for house prices to return to parity with incomes so the shrinking pool of ordinary people still employed can begin to think about buying one? Well, the obvious explanation is that politicians can’t bear the pain of watching mass foreclosures and the ruination of families. This is pretty understandable, and it is tragic indeed. Frankly, I don’t know of any political narcotic that can mitigate the pain that results from having made poor choices in life — even if those choices were promoted and reinforced by the mighty ideology of “American Dreaming.” Anyway, the foreclosures are well underway now, and perhaps the salient question is how long will the public’s fury remain constrained while they hear about Wall Street executives buying $80,000 area rugs? Surely there is a tipping point of collective distress that is not too far from where we’re at now.

In the realm of TARPS and other continued bail-outs aimed at the banks, the car-makers, and a host of other corporate special pleaders, I wonder if we have already reached the saturation point. But opinion on the Web is starkly divided and a prime manifestation is the debate over whether it was a terrible blunder or the right thing to let Lehman Brothers sink into bankruptcy. Both sides make valid arguments, but virtually all the other super-banks right now have lurched to death’s door and we have no clear guidance on what we should do about them. Each one is touted as “too big to fail,” as well as being interlocked with the others on credit default swaps that would bring them all crashing down if one counter party truly failed. It seems to me that this is what lies at the heart of the present situation. Nobody I’ve encountered in the sphere of opinion-and-comment thinks that these banks will survive, and this outcome beats a short path to the conclusion that the entire banking system is fatally ill — leading directly to a super-major crisis of political economy in which the whole reeking, leaking system just crashes. I think this is what lies behind Mr. Obama’s appeals for very urgent action.

But then we’re back to square one: nobody, including Mr. O himself, has really proposed a set of actions that have not already been tried in the way of money-shoveling. So this will be a week in which, perhaps, some wise and intrepid figures — perhaps even the president — will articulate something we haven’t heard before, perhaps even something like bearing our hardships bravely. It’ll be a very interesting week, I’m sure.

Regards,
Jim Howard Kunstler

January 29, 2009

State of Cringe was originally featured on Whiskey and Gunpowder

This is very good news. It means you will have a chance to buy gold at lower prices before it goes up higher later this year. Much higher, in fact, according to the 2009 forecast made by Diggers and Drillers editor Al Robinson.

Not everyone agrees that gold is going higher, mind you. “The deflationary scenario is still incredibly intact, even though the government has thrown trillions of dollars at it,” one Leonard Kaplan told Bloomberg. Kaplan is the president of Prospector Asset Management in Evanston, Illinois. “Gold has a long ways to go down,” he added.

Daloob. Seriously daloob. Daloob is a word that means whatever you’d like.

But what does it mean to say that the deflationary scenario is “incredibly” intact? Does this mean that the scenario is “not credible?” Or does it mean the scenario explains and predicts what’s ahead? The statement is incredibly opaque.

Either way, the deflationary scenario that Kaplan refers to is worth a few lines. The scenario is one where commodity and stock prices fall as the credit depression gets its hands around the neck of the economy and squeezes. Under that scenario, gold would fall. And under that scenario, the cost of paying off debts would rise massively as cash gained value. Old debts would become economy-killing burdens for households, businesses, and, dare we say it, governments too.

In fact, the real economic consequences from this kind deflation are so destructive that we would bet our left big toe that the Federal Reserve is going to do everything in its power (and perhaps some things not in its power) to prevent it. It’s not a risky bet. The Fed is firmly moving down the path to monetary weirdness. We are well and truly down the rabbit hole in 2009.

In the meantime, falling commodities prices are telling you that the forecast for the economy in 2009 is not good. Gold, oil, metals, and grains all moved down yesterday while the U.S. dollar moved up. It will be worth watching if commodity shares follow commodity prices down. Commodity shares, as we know all too well, were decimated in 2008.

But based on some analysis from our old friend Dr. Marc Faber in his latest Gloom, Boom, Doom report, commodities as an asset class are about the only stocks actually in a similar position to where stocks found themselves in 1987. That is, while the entire market was savaged last year, commodities may be the only sector worth taking a punt on in 2009, based on Dr. Faber’s analysis of previous bull and bear cycles in various asset classes.

What cycles? Faber says that the length of the cycle immediately preceding a correction or crash has a lot to do with what you can expect next. “If an up-cycle was brief,” he writes, “the down-cycle is also likely to be brief. If the up-cycle lasted a very long time and was accompanied by huge excesses, the downturn from the peak of such a cycle is likely to be lengthy-as was the case for gold after 1980, and for the Nikkei and the Japanese economy post-1990. Similarly, if a down-cycle lasted a long time (20-30 years), the up-cycle is also likely to last for an extended period of time.”

The bull market in commodities began in 1999 and was preceded by an infamous 20-year bear market. Equities, on the other hand, enjoyed an 18-year bull market from 1982 to 2000, but have been in a bear market since then (with a robust, credit-induced bear market rally from 2003 to 2007).

By that logic, the down-cycle in equities should be a lot longer because the up-cycle preceding it lasted so long. On the other hand, the down-cycle in commodities should be shorter because it was preceded by a much shorter up-cycle and a very long down-cycle. Stocks down. Commodities up. Got it?

But is it right? The reasoning makes sense, especially if you compare it with the historic numbers Dr. Faber presents (which we will not replicate here for the sake of space). But there is a simple objection that must be dealt with. What if the commodities cycle is itself a function of an even larger cycle, namely the credit cycle?

If you argue that the bull market in credit began in 1973 and a world of floating exchange rates and competitive currency devaluations (or 1913 when the Federal Reserve was founded, or 1694 if we want to go all the way back to the Bank of England again), then the direction of asset prices would be dictated by whether credit was in an up-cycle or down-cycle.

It’s pretty safe to say that credit appears to be in a down-cycle, starting in August of 2007. What’s more, it was preceded by a massive “up-cycle” in which the supply of money and credit grew globally. That “up-cycle” drove up all assets in all countries simultaneously. We will find out this year if another “up-cycle” can be artificially spurred by Obama and Bernanke.

But if we are now in the “down-cycle” for credit-the Credit Depression-then how can commodities possibly outperform equities and rally while stocks fall?

Well, the only possible way for commodities to go up in price during a credit depression when global economic activity shrinks…is if we experience massive, central-bank backed money printing and the inflation that ensues. Not that this is an outcome we find desirable. But it’s clear as day from the Fed’s actions and words that it will produce inflation at any cost to prevent being crushed by debt and deflation. For all its real wealth destruction, the Fed appears to prefer hyperinflation to credit depression.

And don’t worry that the Fed is out of interest rate bullets in its pursuit of reinflating the credit bubble. There are other weapons. It will mail checks directly to people or buy assets directly on stock markets. You can expect the debt-to-GDP ratio in the United States to approach and exceed 100% before Obama’s first term is over. You can also expect to see more direct government asset purchases and intervention in markets.

How can we be so sure that we’re on the verge of a brave new world of government-managed markets and economies? It’s simple. Central banks and national governments the world over face an existential crisis: the loss of public confidence in paper money. Action must be taken to restore confidence or real economic activity (lending, borrowing, spending, and investing) will grind to a halt.

Perversely, the monetary authorities will destroy public confidence completely through massive inflation. It will also unleash a great deal of social and political disorder. But the authorities appear to prefer this chaotic result (which they can then police and manage with new rules) to another Great Depression characterised by too little money and price deflation. The excesses of the credit bubble will not be liquidated. Instead, they will be perpetuated and subsidised. The resulting economic and social disorder will be met with more State activity in your personal and economic life.

All of this is a long way of explaining why the current lull in the gold price is a great buying opportunity. You know the tactics and strategy of the central bankers. And you have a pretty good idea that any rally in the stock market is a fake out rally, not sustainable based on the economic forecast OR previous cycles (where markets are coming off 20-years of rising prices). What you don’t know is if gold prices are going to fall further before eventually heading higher.

To find the answer to that, you can consult 1974. At that time, stock markets looked oversold and gold had begun to move and was on the verge of a correction. “If someone really felt that the similarities between the 1974 low and the current market conditions are overwhelming,” Dr. Faber adds, “he should consider purchasing gold and oil rather than U.S. equities (and also shorting U.S. bonds)…Gold corrected between the end of 1974 and the summer of 1976 by 40%, while the stock market surged. But from its August 1976 low, the gold price increased eight-fold.

“If we are really in an environment such as we were in at the 1974 lows (and I have serious reservations about this assumption), then we should expect some further weakness in gold prices when equities rebound. Such weakness would then provide an excellent buying opportunity.

“However, keep in mind that even if you bought gold at its 1974 high at US$196 per ounce, by 1980 you would still have quadrupled your money, which was far better than the return the stock market provided. So even if you endorse the view that we are in a similar situation as in 1974, I would be reluctant to stay out of the gold market entirely in the hope of buying it at lower prices.

“Another reason why gold may not sell off as much as it did between 1974 and 1976 is that governments’ interventions with monetary and fiscal measures around the world are unprecedented. ..Therefore, based on my time/cycle analysis above, commodities and commodity-related shares would also seem to be in a far more favourable position to resume their up-trend than broad U.S. equity indices, which (a sharp rebound aside) are unlikely to enter a sustained longer-term bull market.”

If Faber is right, what will it mean for Australia’s broad equity indices? Well, you’d expect them to go higher as commodity prices react to the increase in global money supply. It certainly seems like most of the deleveraging is done in commodity stocks, meaning it would take something monstrous for mining shares to retest the 2003 lows.

Monsters are real though, so we can’t completely discount the possibility that 2009 will be worse for resource shares than 2008. However, one needn’t be a raging bull on Aussie resource stocks to see that the case for gold looks good. It’s distressing that gold looks so good because the outlook for the economy is so bad. More on that tomorrow.

Regards,
Dan Denning

January 15, 2009

Cheering Gold’s New One-Month Low was originally featured on Whiskey and Gunpowder