I often get this question after I presented my case against our fiat money system, and I sense there is a trace of frustration in it, a bit along the lines of, you are telling us that we are in quite a mess but you offer no policy prescriptions. That is a fair point, I guess. Most writers who lament the economic ills of our time usually have a bag of policy advice on offer. Indeed, whispering new policy ideas into the ears of those in power is what most of these writers aspire to. I reckon what separates them from me is that they believe in government and I don’t.

The mess we are in is the result of policy, of the very idea – the silly idea – that the field of money and finance would work better if it were supervised, managed, guided and controlled by the state; that if we had clever, powerful and astute policymakers, consulted by economist philosopher kings, we could enjoy a smoother, better functioning economy. And if ever things were not running so smoothly, we would change the policy.

“So what is your policy, Mr. Schlichter? Could you not be a bit more…constructive?”

My conclusion is straightforward. There should be no policy. The existence of policy is already the problem. What we need is proper capitalism in money and finance. We do not have that now. What we have is limitless state fiat money, quantitative easing, systematic market manipulation, bailouts, regulations, the IMF, the World Bank, the FSA, FDIC, TARP and LTRO. We need proper markets, not more policy, not more manipulation, and not more bureaucracy. And not more fiat money. We need the state to exit the field of money and banking. Completely.

The main problem with monetary policy is that there is such a thing as monetary policy.

The state is the problem. It will not be part of the solution.

Before I tell you what I think should be done, let me give you another reason why I have been so reluctant to offer policy advice. The aim of my book Paper Money Collapse was to expose widespread fallacies and debunk erroneous common wisdom concerning money. It was not to provide a program for reform. The book is meant to be an eye-opener.

Almost the entire discussion on money and banking today is based on deeply flawed theories. This is true of the financial markets industry where I worked for 19 years. It is equally true of most of the discussion in the media and, as far as I can see, academia. The book was meant to debunk a lot of this misinformation.

My intention was to challenge the present consensus and the established orthodoxy. I think this is what needs to happen before we can even talk about the drastic changes that our system requires. Any policy debate of the type you read in The Economist or The Financial Times occurs within the boundaries of the established consensus. Questions of a more fundamental nature cannot be addressed in the context of policy debates.

But I am not going to evade the question about policy. So let me talk a bit about policy and reform.

The big mistake has already been made. The gold standard was abandoned, in a step-by-step process that began around the time of World War I and that culminated in Nixon’s closing of the gold window in August 1971. For more than 40 years, gold has played no official role in global monetary affairs. State paper money ruled. Everywhere.

This was the era of the central banker, the monetary bureaucrat, of artificially cheap credit, of stimulus, of big equity rallies, of bigger real estate bubbles, of constant debasement, of the quick buck and the big bonus, of growing banks and of ever more sovereign debt. The global financial system got unhinged. After four decades of persistent inflationism we have an overstretched finance industry gravely addicted to the constant drip-feed of cheap money and an out-of-control public sector constantly issuing debt that will never get repaid. Capital misallocations and asset mispricing are gargantuan. The establishment prescribes itself ever more easy money to keep the show on the road.

So the first conclusion is, there is no painless exit. The cleansing crisis is inevitable. Simply being honest about the mess we are in would not be a bad starting point for policymakers.

And to acknowledge that this can’t go on forever. Because it certainly won’t go on forever.

Okay, but what next? If you could design policy, what would it be? What is the number one thing that we need to change to restore financial sanity?

Fiat money critics have floated a whole range of policy proposals. There is the return to some form of gold standard. Also, there is the rather fiercely contested debate about whether fractional-reserve banking should be banned or at least restricted. Recently, colleagues of mine at the Cobden Centre in London have introduced a bill to Parliament that would make board members of banks personally liable for bank losses, which is supposed to reduce or eliminate moral hazard. Thus we are already faced with a range of policy proposals. What is my position on them?

I think we can have it much easier. My proposal is more effective and more easily communicated: Let us separate state and money completely. That is the one thing that needs to change. Capitalism is the only economic system that works in the real world [at least if you want to keep on improving the human condition--Ed.]. But what we have today is monetary socialism, albeit a socialism predominantly to the benefit of the rich and well-connected.

We need to get the state out of the economy completely. To achieve this we must get the state out of ALL monetary affairs. The monetary sphere of society should be a no-go area for politicians and bureaucrats. State involvement in finance is the problem. Let us get the state out. Period. That is the one goal we should have. That is the one policy I recommend.

My enthusiasm for any other policy proposal varies considerably and is dependent on how much state intervention the policy still allows or in some cases even requires.

As an opponent of fiat money I am naturally positively inclined to a return to a gold standard. I believe that Mises was right when he wrote:

“If in the coming years or decades our civilization is not to collapse completely the gold standard will be restored.”

But what type of gold standard should be implemented? Would there still be central banks that would ‘administer’ that gold standard? Under any form of gold standard, the central bank would most certainly be more confined in its monetary operations than central banks are today but there could still be considerable room for manipulation. The US Fed was founded in 1913 under what was officially still the Classical Gold Standard but that didn’t stop it from funding the US government’s military spending in World War I and from initiating credit bubbles and business cycles.

By 1933, the dislocations introduced by cheap money were so big that their dissolution – mandatory and normally automatic under a gold standard and indeed inconceivable under a proper gold standard – had become politically unacceptable. The Fed’s mission was accomplished and the gold standard was abandoned. The rest is history as they say.

An official, government-directed return to a gold standard also raises a lot of questions about implementation that would invite lobbying and horse-trading by various pressure groups.

* How much of the existing money stock – obscenely inflated after decades of money printing and fiat money debasement – should be backed by gold, or to put the same question in a different way, what should the new exchange rate between the money in circulation and gold be?

* How much should the existing money stock be devalued? Should banks be allowed to create deposits that are not backed by gold? Should fractional-reserve banking be permitted?

Questions over questions, and the room for political maneuvering and for political abuse are massive. Do we really want politicians, central bankers, bureaucrats, and their economic advisors make all these decisions? I don’t think so.

I know somebody who is best equipped to make all these decisions.

Mr. Market.

We may not all agree on the merits or demerits of fractional-reserve banking but as capitalists we should agree on the benefits, indeed the necessity, of free competition.

So how do we get from A to B? How do we get from the present system of finance socialism, of interest rates fixed by the central bank and asset prices manipulated by the central bank, of nominally private banks operating with the protection of a lender-of-last resort, to a system that again deserves the label capitalist?

Step 1: Privatize the central bank.

Do not even introduce a gold standard. Just transfer ownership of the central bank officially to the banks that have an account with the central bank. This is the first step for the state to exit the sphere of money. The central bank is no longer a public institution run by bureaucrats and politicians but an entirely private undertaking. It is owned and operated by the banks.

The central bank administers bank reserves and provides certain clearing functions. The banks need this, for now at least. Shutting the central bank down is not that easy. But its most pernicious aspect is that it is a policy tool. This would end abruptly with its privatization.

Step 2: The state revokes with immediate effect ALL laws and policies that relate specifically to banking and money.

From this moment on, banks are capitalist enterprises just like any other normal business. There is no lender of last resort (at least not one run by the state), there is no inflation target or other official monetary policy for which the banks function as conduits, which under the present system puts them in the strange position of being profit-seeking enterprises and policy-transmission mechanisms simultaneously. But equally, there is no backstop for the banks from the state any longer. No guarantees, no deposit insurance or taxpayer bailouts. If a deposit insurance institution exists, it is handed over to the banks, similar to the central bank. Again, the state has exited the business of regulating, supervising, licensing, subsidizing and backstopping the banking industry.

Entry into the field of banking is now free. You do not need a license. You do not need an account with the now privately owned central bank (although without such an account clearing with other banks might be difficult). There are no legal tender laws anymore, so if anybody has any bright new ideas about money (Liberty Dollars, bitcoin) they are most welcome to try them. The consumer alone will decide over success and failure.

Monetary policy has ended. Bernanke testimonies on TV will be replaced with reruns of old Simpson episodes. Senators and congressmen will have to find new soapboxes from which to propound their personal economic theories.

Step 3: The state’s gold hoard is handed over to the banks.

What? A gift to the bankers? – I do not consider this a gift to the banks but more a return of property to the bank depositors. The bank depositors are the ones that should benefit from this transfer most.

The present monetary system could only have come about because it was once based on gold. Deposit banking spread at a time when banks still promised to repay deposits or banknotes in specie, and when all banks were thus required to hold (some) gold reserves – reserves that no political entity could create at will. Only slowly and gradually was the gold backing removed and replaced with various implicit or explicit state guarantees, all of which are now practically failing.

Of course, just like investment genius Warren Buffett, the bankers may not know what to do with a pile of gold and may thus be tempted to simply put it on a big heap. I suspect, however, that the bankers will have a very good use for the gold. Their customers – the holders of bank deposits – may be very unsettled by the exit of the state and thus the taxpayer from the business of underwriting the banking industry. Most people only consider their bank deposits safe because they believe the state would not allow Bank XYZ to default, not because they have any confidence that Bank XYZ is run prudently. Now that the state has exited the field of money and banking, the banks are likely to use the gold as additional backing for their balance sheets. They will use the gold as it has been used for thousands of years – to gain trust. And to avoid bank runs.

Will the gold hoard be sufficient?

I don’t know.

Presently, the US government sits on 260 million ounces of gold. At the present gold price of $1,655 per ounce, we are talking $430 billion. The monetary base is presently $2,673 billion; M1 is $2,220 billion and M2 minus money market funds is $9,163 billion. The gold hoard is thus only 16%, 19%, and 5% of these money stocks, respectively. Hardly a proper gold standard but it could be a start. Through proper balance sheet deleveraging and through additional gold purchases the private banks are obviously free to improve these ratios. (Again it is not for bureaucrats or economists to decide what is appropriate. This is the role of the banking entrepreneur.)

But now that the private banks own the central bank, would they not put the printing press into overdrive and create inflation?

I don’t think so. Through quantitative easing the central bank accumulates assets from the banking sector and expands the money supply. The central bank leverages its own balance sheet in the process. The Fed is already levered more than 50 to one, which is more than Lehman and Bear Stearns were when they collapsed. But now the banks own the capital of the Fed. They foot the bill, not the taxpayer. The banks can no longer dump unwanted assets on the central bank. They own the central bank. They cannot transfer risk to it.

Additionally, the public will be very suspicious of an overtly expansionary central bank. They know it is operated by the private banks and entirely for their own benefit. Any inflation concerns will translate into higher interest rates and that is detrimental to the highly leveraged banking sector. I would expect the private banks, now operating without any safety net from the state but under the suspicious gaze of their own customers, to be very cautious about how much money they print.

Easy money is great for the banks for as long as they can lower reserve and capital ratios. That was much easier when they could rely on government backstops or when meeting official regulatory requirements already gave their balance sheet policy an official seal of approval. Now that they are on their own, monetary expansion and thus debt accumulation and leverage are a double-edged sword. It will pay again to run a bank prudently and even advertise your higher capital and reserve ratios.

Furthermore, the relatively sounder banks (if we assume for a moment that those indeed exist) have little interest in running the jointly owned central bank for the benefit of the weakest banks. To the contrary, it is in the interest of the stronger banks to see weaker banks fail and exit the market. At the same time, it is not in the interest of even the strongest banks to see widespread bank runs or a general distrust in banks as that could quickly come to haunt them, too.

I think it is very reasonable to assume that under my plan of complete privatization the key challenge of allowing corporate failure in banking on the one hand but avoiding a complete collapse of the banking system on the other will be managed much better. The reason is that this task is now given to bankers as entrepreneurs who have a keen interest in getting that balance right. As long as banking is under the protection of the state, monetary and banking policy will be conducted for the benefit of the weakest banks, and the strongest banks will simply reap windfall profits.

Does the state get off too lightly?

The state no longer has any responsibility for the banks or money. No more setting of policy, no big hearings in Washington, no bailouts, no IMF, no World Bank. A lot of money will be saved and many explicit and implicit claims on the taxpayer will be eliminated. But also, the state can no longer tell the banks that government bonds are safe and encourage the banks through bank regulation and official capital requirements to invest in them.

There is no longer any bank regulation from the state. Banks will be regulated by the market, which means ultimately by the consumer. The state also loses the central bank and can thus no longer create an artificial demand for its securities. Remember, last year 61% of new Treasuries were placed with the Fed. Why should the banks, which now own the central bank, continue to accept this?

Government bonds everywhere benefit from the idea that states can’t go bankrupt because they can always print the money. This idea is fundamentally wrong as I have argued repeatedly. Once the debt load reaches a certain level, it can no longer be inflated away. If this is still tried, currency disaster will ensue. Be that as it may, with the state officially separated from the field of money and banking, it would have to manage its finances like any other entity, like a private corporation or a household (or almost like any other entity as it still benefits from the privilege of taxation). We would certainly see higher state borrowing costs, lower levels of spending and smaller deficits. This would be an important step to what Doug Casey calls “starving the beast”.

Of course, in such an environment we would not have to worry at all about how the banks arrange their executive pay, how their bonus schemes work, or if bank shareholders hold their board members at all responsible for their mistakes and failures. These are internal affairs of entirely private and capitalist enterprises. If bank shareholders get this wrong and set the wrong incentives, only they will bear the consequences. The idea that banking is a public service for which a specific set of rules and regulations must be designed and administered by the state does no longer apply.

Come to think of it, this proposal looks much better in terms of consistency and clarity than any other, in my humble opinion. Those who argue for an official gold standard are asking the state to design and implement a new monetary order. Those who ask for a ban on fractional-reserve banking ask the state to define what constitutes legitimate banking business and then enforce it. Those who want to introduce new legislation in response to executive pay and bonus schemes, ask the state to interfere in the relationship between shareholder (principal) and manager (agent).

I ask the state to do just one thing: Get the hell out of money and banking! Now!

Regards,

Detlev Schlichter
Paper Money Collapse

The Separation of Money and State was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The last time there was talk about this issue was more than 30 years ago, after the devastating inflation of the late 1970s robbed an entire generation of their savings, upended American family life and launched a debt addiction that has destabilized economies all over the world. The Nixon administration promised a rose garden after the paper dollar; the results were very different.

The crisis in our times is not (yet) hyperinflation, but it is just as serious. The problems of the Fed-managed paper dollar system are too many to name, but they can be reduced to three that hit the average person most seriously.

First, it is no longer possible to earn a conventional return on saving money. That reality pretty much undermines the whole practice and ethics that built prosperity as we know it. The reason is directly related to the quality of money: Lacking any independent substance at all, its value and yield is managed by a small group of technocrats in a marble palace. They have used that power to impose the ultimate price control on the relationship between time and money.

Second, the problem of unemployment and the ever-shrinking labor participation rate has hit the young generation in a way that we’ve never seen before. This has terrible economic effects but just as devastating cultural ones. It attacks the core hope that people have for the future. Again, the paper dollar, as the generating force behind the bust and boom, is a cause.

Third, there is a growing movement against the power, secrecy and insider racketeering by the Federal Reserve, which prints and throws around inconceivable volumes of loot to its friends and clients in total disregard for the political process or the fate of the American middle class. This angers people of all political persuasions. The opening up of the records and dealings of the Fed has not calmed people down, but rather has confirmed the worst possible fears.

In the 1970s, writers like Henry Hazlitt struggled mightily to get people to see the connection between monetary policy and the falling value of the dollar. While the Ford and Carter administrations lashed out at business and speculators, Hazlitt and others pointed to the real cause. His message stuck. By 1980, even the Republican platform included a call for a sound dollar. Congress formed a gold commission.

The connection between the Fed’s paper money and our economic plight is even more difficult to make this time around. But the intellectual foundations have been in place for years, and they have been given voice in the relentless hammering away at this issue by Ron Paul in interview after interview. He never misses a chance to talk about this previously unspeakable subject.

A tricky issue for the movement now is dealing with the diverse political coalition coming together against the current monetary system. The biggest critics of the Fed, for example, agree that the current system is a mess but don’t seem to agree about what to do about it.

This week in D.C., I debated Dean Baker of the Center for Economic and Policy Research. The setting was fantastic: a speak-easy environment sponsored by the beautifully named Empire Unplugged. Baker is a strong critic of the Fed for reasons both good and bad. On the good side, he is as appalled as Ron Paul at the insider racketeering of the central bank. On the bad side, he would like to see its powers transferred to a body with more political oversight and democratic influence.

This is the exact opposite of what I argued for: the complete depoliticization of the entire system. We went back and forth for an hour on these topics, agreeing on the great evil, but disagreeing on what should replace it. As is typical of progressive critics of the Fed, he raised fears that market control of money and banking would revive the wildcat banking of the 19th century. This camp conveniently forgets that the age of the gold standard (which was never perfectly adhered to) also happened to produce history’s largest and most-positive economic transformation, propelling the creation and entrenchment of what is called the middle class.

Do these debates matter that much? On the level of theory, yes. In practice, not so much. These mirror the kinds of debates in the middle stages of the collapse of socialism in Eastern Europe. Recall that the movement against Polish central planning began not as a movement for private ownership of capital, but rather as a labor union protest against power and privilege of state-connected oligarchs.

This tendency made the champions of free markets squeamish, for good reason. Replacing a state monopoly with a state-protected labor monopoly does not necessarily look like improvement. But that’s not what ended up happening in Poland. Solidarity was the major vehicle that wrecked the regime as it stood. At one point, the major labor organization Solidarity had 9.5 million members. That mass movement upended history. Today, Solidarity is a normal union like any other, with membership at half a million and declining and no serious power. The result was not a labor monopoly, but a beautifully prosperous market society.

The lesson here: Sometimes you have to topple the system that exists and see what happens. This is why Ron Paul has been tolerant of a wide divergence of views within the anti-Fed movement. He is right to be so. Writers at The Wall Street Journal and elsewhere wring their hands about the dangers of political control of money in the post-Fed age. But history shows that the reform is not so easily managed. Breaking up the current monopoly is the most-important priority right now.

If the Fed were an Eastern European socialist government, the year would be about 1987. If the economy takes another dive after the fake boomlet that Bernanke’s printing presses have manufactured, he should make sure that the helicopter on the roof is in good working order.

Regards,

Jeffrey Tucker

The Great Monetary Debate was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The fact stands to reason. During our most recent fiscal upheaval in the United States, one out of every two economists with a job drew his or her paycheck from a government institution.

Your economist, your elected official and your friendly neighborhood bureaucrat, your policy wonk, and even your favorite mainstream journalist believes that you — the individual — couldn’t possibly know what you are doing with your own money.

They think you’re too stupid to make the right decision when faced with choices in the marketplace. If you agree with them, then I’d respectfully advise you to stop reading right now. You’ll only take offense at what Mr. Schlichter has to say.

If, on the other hand, you believe that you’re capable of making a decision on your own…if you believe you can safely buy the goods and services you need when you need (or want) them, then you’ll take to and welcome Detlev Schlichter right away.

“The market economy is not a superior organism that has its own goals,” Detlev writes. The economy does not exist to “generate positive GDP” for the good of a nation. Nor are we servants subject to the whim of the formerly omnipotent “Masters of the Universe” who run trading desks on Wall Street.

We use money — our money — to make transactions. That’s it. All else that follows in this book begins from that simple starting point.

Once you ignore the conventional method of viewing the economy…of measuring growth and counting the unemployed…a funny thing happens. “Failure” and “bankruptcy” become natural events even in a smoothly sailing economy. Viewed in proper context, “failure” is not something to be prevented. It’s a vital tool on the way to success. We all make mistakes from time to time. There’s no one to blame. But there’s a heck of a lot to be learned…

Blasphemy, for some. A godsend, for others. I’ll assume that for the time being, you’re in the latter group.

In this book, Detlev doesn’t hold back any punches in exposing the flawed concept that is paper currency. I admire his rigor and clarity as he straddles this unpleasant territory with ease. He doesn’t name names. He doesn’t bog us down with details. He doesn’t enlist GDP charts from across the globe. He leaves the devilish details to other books boasting “financial crisis” in their title.

He’s not likely to land an HBO contract for the effort, so I suggest you get started with Chapter 1.

If you’re of the right mind-set, it will be a pleasant experience, I assure you. Detlev’s crisp algebraic prose recalls one of the best systematic financial writers to tackle banking: Murray Rothbard, whose The Mystery of Banking offers a succinct account of what began ailing the economy in the 20th century.

Unlike Rothbard, Detlev is a practitioner, not an academic.

You have to admire a man from the City who worked 19 years in high-yield income, pursuing the oft-maligned Austrian economics as a hobby at night.

Sometime in 2007, the hobby became his vocation. But his first real wakeup call came in 1998, post-ruble collapse and the LTCM failure. The events themselves weren’t the problem, Detlev began to see. How government-supported firms reacted is; they got bailed out and sought to manipulate interest rates.

A decade on…and “bailouts” have become the norm. Bankers expect them. And place their bets accordingly. The implied “safety net” has become the Achilles’ heel of the entire system.

Today, even as economists, the media and policymakers search for causes of the financial collapse in 2008 (and dream up new regulations to “prevent it from ever happening again”), those same imbalances and misperceptions are building to yet another climax.

In this fine work Detlev bursts through the notion that “everybody” benefits from stimulus. And he sets out to dethrone the economic god of the 20th century: monetary policy.

Not only is the present monetary system less than optimal, it’s also unsustainable. To put it in the words of the technically literate: GIGO — garbage in, garbage out. The current monetary system can lead only to volatile and unsustainable economics. Forget all the macroeconomic theories and statistical validations for this or that political motive.

In a chapter in my own Demise of the Dollar, I had an eye-opening, if entertaining, experience documenting what I ultimately entitled the “Short Unhappy Episodes in Monetary History.” The first “modern” experiment with paper money occurred in ninth-century China. After several hundred years, the Chinese gave up on “flying money” because it proved to be subject to political whims and gave rise to disastrous inflation in consumer prices.

And yet even with numerous examples at our fingertips — France in 1717-1720 under John Law’s scheme, in which paper money lost 90% of its value; Abe Lincoln’s financing of the Civil War sparking inflation, which turned Americans off paper money until 1913; Peron’s Argentinian coup in 1943, which ushered in paper and destroyed gold reserves; and, of course, Weimar-era hyperinflation — we have engaged in another experiment with paper money, this time on an epic scale.

The litany of crises we’ve endured from LTCM through the mortgage meltdown share DNA. Other books seeking to understand the precarious situation we find ourselves in miss the single root: our ongoing currency crisis. Digging deep, Detlev explains why we’re more in danger today than ever before. This fact alone should place this book at the top of the pile at your bedside you’ve been “meaning to read.”

Detlev’s work could be the resource for a new generation of young economists.

As the next crises unfold, we’ll need a hearty breed ready to pick apart the myths and turn toward clear, basic tenets of what keeps money working for us — not politicians and central bankers.

Regards,

Addison Wiggin

Detlev Schlichter and Paper Money Collapse was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In deciding to make hardly any changes to its interest rate policy or even the language from its last statement, the Fed is encouraging traders to resume the dollar carry trade. For now, it looks safe to borrow in low-yielding currencies like the U.S. dollar and invest in higher-yielding assets like the Australian dollar, emerging market stocks, and some bonds.

Go, you bubble beauties!

It’s hard to believe the Fed is willfully stupid. The market, through the price of gold, has clearly communicated that it thinks U.S. monetary and fiscal policy is lousy. But rather than defend the U.S. dollar – indeed the integrity of U.S. monetary policy itself – the Fed is choosing to support asset prices through easy credit.

It’s also possible that the Fed thinks a weak dollar will reduce America’s trade deficit, boost its export competitiveness, and lead to higher employment. We think this is a pipe dream. And we’re not talking about a lead pipe. We’re talking William Blake-style opium.

But smoke and mirrors aside, does this mean there will be no end to the dollar carry trade? If the U.S. dollar index rallied, we expected to see a falling Aussie dollar, falling Aussie stocks, and (even though it’s strange) rising U.S. bond prices. All the leveraged risk trades would unwind a bit as dollar shorts covered.

But now what? Is this the all clear for stock indices to make new highs as traders borrow money and plow it into markets to engineer huge returns for the end-of-year statements to investors? The early returns are inconclusive. The Dow was all over the shop, unable to make heads or tails of what the Fed’s non-change means. Gold futures made a new nigh, though. And about that…

Gold is very popular lately. It’s not returning our calls anymore. And when we see it in public, all it does is glitter and bask in the glow of so many newfound admirers. That makes us very nervous, and perhaps a bit hurt. We stood by it all those years when no one loved it.

We like it all the same, although we’re just friends now and it’s based on gold’s ability to preserve the purchasing power of our wealth, not any inherent beauty it may or may not have. But as a practical matter, when you enter a position as the asset is making a new high, you usually get hammered.

That’s what happens when you go along with the crowd. It’s an axiom that an asset has to make new highs…to make new highs. But it would be nice to buy gold on a correction. Perhaps, though, we are seeing a big shift in market psychology with respect to gold. India’s purchase of IMF gold is just one sign of that shift.

One interesting result from the events of 2009, Murray Dawes mentioned last week, is that gold is decoupling from the U.S. dollar. He sent over the chart below. It shows that two times in the last five years, gold (the black line) has strengthened eve as the U.S. dollar index (the blue line) rallied. And each time after this period of dollar strength, gold then took off to a new move up.

Why does that matter? Well, gold usually moves up when the U.S. dollar moves up, and down when the U.S. dollar moves up. For gold to show strength when the dollar is strong shows that gold itself may be breaking out of its correlation to the greenback. And what would that tell you?

The bigger picture: gold breaking its negative correlation with the USD would tell you that gold is being remonetized in the world financial system. It would tell you gold is appreciating against nearly all paper currencies. And it would tell you that even if we do see a U.S. dollar rally, you could still new highs in the gold price.

Above all, it shows you how valuable it is to own an asset that is not anyone else’s liability. We are entering a global sovereign debt crisis because the world’s large economies have been engaged in a multi-decade long competition to devalue their currencies. The cheaper your currency is relative to your trading partners, the cheaper your goods are and the higher your exports.

Overly the last fifty years, nearly every country in the world has engaged in some kind of currency manipulation to keep its currency cheap relative to the American dollar. That’s because the American economy was the world’s largest, and everyone wanted to sell into it.

America’s economy is still big, of course. But a lot is changing, yet the currency manipulation has not caught up with the new economy reality. And Western Welfare states are still borrowing money as if emerging market creditors will be happy to fund fundamentally flawed fiscal policies for ever. Not likely. But tomorrow is another day.

Regards,
Dan Denning
The Daily Reckoning Australia

November 10, 2009

Editor’s Note: This article originally appeared in The Daily Reckoning Australia as “Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy.” To view the original article, please click here.

Gold Price Says U.S. Monetary and Fiscal Policy Stinks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Oil is the energy life-blood of all modern economies. So when a nation debauches its currency, the oil markets react instantly. And oil will not accept monetary malpractice, certainly not by the U.S. Federal Reserve. If traders perceive that the dollar is declining, this perception lights the fuse for oil prices to rise.

There is an old saying that “You can’t fight the Fed.” But oil is fighting the Fed. In fact, oil is scoring a knockout, like Muhammad Ali over Sonny Liston. Oil is floating like a butterfly and stinging like a bee — landing body blows and pinning the Fed against the ropes.

The Fed can no longer cheat with the money supply and get away with it. There is a new gold standard and it’s called “oil.” This may not be a monetary “fact” that central bankers would acknowledge publicly. But it is a monetary fact of life out in the trading pits.

Even the President himself is powerless to alter this new fact of life. He cannot simply fortify the dollar’s supremacy by seizing the world’s oil at $20.67 a barrel, like Franklin Roosevelt seized America’s privately held gold for $20.67 an ounce in 1933. And even if the President could confiscate the world’s oil at below-market prices, he might not understand how such a confiscation would influence the dollar’s value.

The “oil connection” to monetary policy is a new and poorly understood development. It’s not what people expect. It’s not how we all grew up. It sure did not used to be this way.

For the past 149 years, it has been a fairly safe bet that the world’s oil supply would grow. The only truly difficult period for oil was between 1979 and 1981, when the Iranian oil industry collapsed in the wake of revolution. The world supply-chain lost nearly five million barrels per day of output. And that loss helped produce the worst recession in the U.S. since the 1930s.

But even back in the early 1980s, new oil sources were coming online. Everybody could see it. The fields of Alaska, the North Sea, Mexico, Angola and other places were just kicking into gear. So the price of oil could not go “too high” because there was a clear indication in the marketplace that there would be more oil coming down the pipes.

And that’s exactly what happened. By the mid-1980s, oil was selling for less than $15 per barrel. Cheap energy made a lot of things look easy, from growing the economy to winning the Cold War.

There was a dark side to cheap oil, however. It produced and nurtured the illusion that oil would be cheap forever…or at least for a very long time. But looking ahead from today, it is crystal clear that it will be more difficult to grow the worldwide oil supply than in the past. We may be at Peak Oil right now, but we won’t know that for a while.

Oil-producing areas like Alaska, the North Sea and Mexico, are in decline. Meanwhile, as worldwide oil demand grows quickly, oil output is at a measurable plateau. There is almost no “spare” capacity anywhere outside of Saudi Arabia, and the Saudi margin is smaller than most people think. At the same time, net oil exports are decreasing from most oil-producing nations. Internal demand is rising in almost all oil-producing states. So there is simply less oil to go around. And unlike in the early 1980s, there’s no relief in sight.

Oil supplies are severely constrained. Dollar supplies aren’t. Perhaps these related facts are what inspired Alexey Miller, the CEO of Russia’s oil giant, Gazprom to predict that oil would rise to $250 a barrel in “the foreseeable future.” The Fed can “talk” a strong dollar all it wants, but as long as the supply of dollars and dollar-denominated credit continues to grow, the oil price will continue to climb.

In the era of Bretton Woods, the global monetary system followed the golden rule: “He who has the gold makes the rules.” But today, the “rule of crude” dominates. Thus we are left to ask, what is the meaning of crude oil at $137? It means that the reign of the dollar is coming to a close. The dollar has reached the end of its post-Second World War period of dominance as the world’s reserve currency.

That’s why today’s oil buyers, like the late French President Charles de Gaulle, are so eager to exchange their dollars for a tangible asset. De Gaulle shipped France’s dollar reserves across the Atlantic in exchange for gold bars from the vaults of Fort Knox. Today oil traders are shipping their excess dollars to the New York Mercantile Exchange in exchange for barrels of oil. The motives are identical. Only the underlying monetary asset has changed.

So what of the U.S. dollar? Well, a man named Lazarus once rose from his deathbed. But Lazarus had some help. Could the dollar be as fortunate as Lazarus? These words come to mind, from the Book of Luke at 17:37: “Wheresoever the body is, thither will the eagles be gathered together.”

Until we meet again…
Byron W. King
June 16, 2008

P.S.: The economic principles behind what you’ve just read are really quite simple. Oil is gaining in value while the dollar is losing, and it all comes down to one word: scarcity. Oil is becoming scarce while the dollar is increasingly more abundant. Savvy investors realize this when investing in commodity markets, especially the energy sector. And that’s the main focus behind my investment research service, Energy & Scarcity Investor.

Peak Oil and Inflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

There has not been a chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Volcker who brought the dollar back from the brink of hyperinflation in 1987.

On May 14, Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of central bankers who admire Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the governor of the Bank of England.

Volcker testified that the Fed ought now tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of “stagflation” of the 1970s. The Bank of England also expects that the next two years will see the pressure of rising inflation combined with low rates of growth. In the 1970s, this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid-1970s.

Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory, some emphasis is given to the initial phases of inflation, in which an increasing money supply funds economic expansion and tends to cause booms, bubbles, and speculation.

Less attention is usually given to the second stage of inflation, in which prices rise; interest rates are increased; and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage.

Volcker warned Congress that he saw a “resemblance” between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency toward rising prices, including big increases in energy and agricultural prices. He observed, “If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary presses and to sustain confidence in the dollar, we’ll be in real trouble.”

On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The bank’s inflation projections will not return to the 2% target figure until early 2010, which suggest that it will have no room for rate cuts until then.

Britain and the United States have different political cycles. The next presidential election in the United States will come nearly two years earlier than the next British general election; the latest date for a British general election will be June 2010. The Bank of England’s economic forecast suggests that there is little chance of interest rate cuts much before that time. The government’s reluctant tax cut on the lowest income tax band will strengthen the bank’s hand in keeping interest rates at their present level.

Mervyn King observed that “The consequences of price increases would be a squeeze on real take-home pay that will slow consumer spending and output growth, perhaps sharply.”

There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England, and the European Central Bank. It does not include Ben Bernanke, the Fed, or the current president of the United States. After November, we may find out whether it includes the next president of the U.S.

Regards,
Lord William Rees-Mogg
May 15, 2008

The Danger of Stagflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“…Just like the Bank of England, the U.S. Fed seems to have Britney-sized ‘issues’ with its core stock-in-trade — money itself…”

PROFESSOR TIM BESLEY, one of the nine people chosen to set interest-rate policy at the Bank of England in London, gave a speech on Tuesday about “Inflation and the Global Economy.”

For a central banker talking about commodity prices and the cost of living, he managed a remarkable feat.

He didn’t use the word “money” once.

Nor did his BoE colleague Charles Bean when he spoke about the “prospects for the U.K. economy” on 17th April.

Nor did the deputy governor, John Gieve, when he spoke on “global imbalances” at the Sovereign Wealth Fund conference in London last month.

In fact, if you ignore the phrase “money market(s),” seven different members of the Bank’s policy team used the word “money” just three times in nine speeches over the last 10 weeks.

Their chosen topics included “policy dilemmas,” “the return of the credit cycle,” and even — on Wednesday this week — “Sterling and monetary policy.” But of money itself, the very thing the Old Lady issues? It got three name-checks only.

The Federal Reserve seems to have Britney-sized “issues” with its core stock-in-trade, too. Issues verging on the neurotic, in fact. Allowing for one bizarre exception (in which Fred Mishkin claimed that the Dollar’s forex collapse won’t create any Main Street inflation), some 23 speeches from five Fed policy-makers since mid-February mentioned “money” a total of only eight times. Four of those mentions came in the phrase “money market(s).”

And this from a team charged with providing a “flexible currency” — meaning money, of course — to the citizens of the United States. So why hide from the issue? Is the Fed scared of naming its very purpose? It can’t surely fear a pile of paper, can it?

The Fed’s Open Market Committee wields so much power, according to Robert Reich, former U.S. secretary of labor, it should be classed the “fourth branch of government.” Forget about Congress, the White House, the courts; the Fed holds “more power over your daily life than your congressman and senator, maybe even your president,” Reich writes in his blog.

In short, the Federal Reserve “can do amazing things…” according to Reich, but from our review of Fed speeches, it can’t talk about money. Things like:

• “Decide one big bank, JP Morgan, is going to take over another, Bear Stearns, backed by $29 billion of taxpayer money…
• “Expose taxpayers to hundreds of billions of dollars of potential losses without a single appropriation hearing, as it did when it allowed Wall Street’s major investment banks to exchange tainted mortgage-backed securities for nice clean loans from the Treasury…
• “Deciding the threat of recession is bigger than inflation, so it’s been lowering interest rates.”

This last super-heroic ability, notes Reich — now professor of public policy at Berkeley — “has made the Dollar drop further and faster, which means you’re paying more for gas and food.

“Can you imagine if Congress caused this to happen?”

A cynic might add that Congress does plenty to depress the value of dollars as well. But if you can’t guess what would happen in Washington if Congress set out to destroy the currency, the Fed most likely can. It simply needs to turn history upside down for a moment.

At the start of the 1980s, former chairman Paul Volcker was burnt in effigy by an angry crowd on the steps of the Capitol for hiking short-term interest rates to 19 percent. His policies aimed to quell inflation, of course, defending the value of dollars. Looking at Ben Bernanke’s decisions today, you may wonder if he intends precisely the opposite.

Volcker’s infamous weekend announcement of sharp hikes in the cost of money — and therefore in its future discounted value — was a huge political gamble. Already sliding into recession, could the U.S. bear such a high cost of borrowing? To judge just what was at stake, ask if America could bear it today.

So to hold America’s nose and get his strong medicine down, Volcker made plain he was in fact looking to target not growth but “money” — meaning the quantity of credit and cash flowing through the economy. He was simply following the monetarist tactics of the German and Swiss central banks, stemming the flood of cheap credit and reducing the excess piled up during the 1970s.

As the value of each remaining dollar bill stopped falling, the cost of living would ease off. And at first, it worked like a charm.

Breaking out of the lecture theatre, the idea of whipping the money supply made sense to politicians and voters alike. It had first been put forward by the “Bullion School” of British economists at the start of the 19th century. Milton Friedman confirmed it with his “monetarist” theories of the 1950s. The German Bundesbank and Swiss National Bank then applied it — successfully — to keep inflation at bay right through the late ‘70s. U.S. and U.K. households, meantime, suffered double-digit growth in the cost of living each year.

Now in spring 2008, Zimbabwe offers the latest example of monetary inflation in action. There the cost of living is rising by 165,000 percent per year as the central bank prints 10 million-dollar notes. But here in the developed West’s inflation-free dream world, the idea of targeting money itself — its supply and quantity — has lost out entirely to the idea of controlling its outcome, the cost of living, instead.

“Most people think economics is the study of money, but there is a paradox in the role of money in economic policy,” as Mervyn King, now governor at the Bank of England, noted in a lecture first given at the University of Birmingham, England, in Oct. 2001.

King repeated his findings the following spring at the Banque de France in Paris. But not even he was listening.

“As central banks became more and more focused on achieving price stability [in the ‘80s and ‘90s], less and less attention was paid to movements in money,” he explained. “Indeed, the decline of interest in money appeared to go hand in hand with success in maintaining low and stable inflation.”

This Zen Buddhist approach to monetary policy — ignoring money and thereby controlling it — was also noted by Prof. Glyn Davies in his A History of Money (University of Wales, 2002). During “the overt acceptance of monetarist policies, inflation [was] far worse than when Keynesian policies prevailed.” Overlooking the money supply seems the answer to delivering low, stable inflation.

Well, stable in a way that nobody noticed. The U.S. Dollar, along with the Pound Sterling, still lost half its value for consumers and savers between 1981 and today. But annual rates of inflation held below three percent, with occasional dips towards one percent growing evermore frequent at the start of this decade.

And all this while, with no one daring to mention it beyond a few cranks at the European Central Bank in Frankfurt, the supply of money worldwide has surged once again.

Over the last 12 months, the money supply in Australia has expanded by 16 percent, in Canada by 13 percent and in the United Kingdom by 12 percent. China’s supply of money grew 18 percent, Singapore’s 14 percent, and in both India and Saudi Arabia it grew 22 percent.

The Eurozone, stuck with those old Bundesbank cranks, got a mere 11 percent surge in money supplies. The United States, which stopped reporting such outdated things in March of 2006, is estimated to have got a 15 percent expansion.

Might it matter? On Mervyn King’s analysis, yes. The correlation between annual money-supply growth and rates of inflation, he found, reaches 0.99 if you track the three-decade period ending in 1999. It would stand at 1.00 if they moved absolutely in lock-step.

But that research was done before King got top-dog position at the Bank of England. Since then, he’s overseen (and overlooked?) double-digit growth in the U.K.’s money supply, running now for a full 37 months.

“Habits of speech not only reflect habits of thinking, they influence them too,” King went on in that long-forgotten speech about money. “So the way in which central banks talk about money is important.

“My own belief is that the absence of money in the standard models which economists use will cause problems in future… It would be unfortunate if the change in the way we talk led to the erroneous belief that we could turn Milton Friedman on his head, and think that ‘Inflation is always and everywhere a real phenomenon.’

“Money, I conjecture, will regain an important place in the conversation of economists,” the current Bank of England chief concluded six years ago.

That day still remains a long way off yet. Meaning there’s plenty more room for mayhem in money ahead.

Regards,
Adrian Ash
BullionVault
April 24, 2008

The Secret Subject of Money was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.