We don’t have a government-created central repository that plans and manages shoe distribution. The market takes care of that. We don’t have one for cabbage, keyboards or curtains. Somehow, we get books, clothes, tree-cutting services and everything else we need and want without a central planning agency that manages the quantity available, fixes the prices of the products and bails out the firms when they overextend themselves.

Why should money and banking be any different? Money is a commodity. Banking is a business. They both originated in the market, not the state. They should have been left that way, so that the quality of the product could be subject to market discipline. In a market economy, things work themselves out. There is supply and there is demand. Entrepreneurs take notice of profit opportunities and jump in to pull the two together.

This is how the world works for us. This is how it has always worked. This is how we get our software, coffee, sheet music and beef. It’s how we get our cars, the parts that keep them running and the gas that fuels them.

The world is man-made in every respect, and the hands that made it productive, efficient, dynamic and socially beneficial operated within the market matrix. The simple relationships of learning, exchanging and competing gave rise to a glorious system that manages to sustain a global population of 7 billion people.

The Fed is a nonmarket institution, much like public housing and the space shuttle. It is a Dark Age creation that still exists for no apparent reason. By Dark Age, I mean, of course, the world before 1995, when the Web — meaning all information — became accessible to the world. Before that, the world remained mostly in the dark, when government controlled the information we could access and private truth had to be shared through paper sent through the government mail system.

During the Dark Age, only geniuses like Ludwig von Mises and F.A. Hayek knew that the Fed was a hoax. Most everyone else imagined that the people at the Fed were doing magical, wonderful things inside hallowed walls so that the economy would be stable and grow. Its board of governors was populated by people who knew the economic future and held the power to steer it in a way that benefited everyone.

Thanks to the digital age, we now have access to what really goes on. In the last 12 months alone, we’ve been inundated by reports of what actually goes on at the Fed. In 2006, according to released transcripts of its board meetings, its wise men were busy reassuring themselves that absolutely nothing was fundamentally wrong with real estate and that all other economic structures were humming along beautifully.

It is fascinating to read those candid transcripts. Far from being an open forum for discussion, Greenspan and Bernanke preside with all power to determine results, practically daring any of their subordinates to disagree with the consensus they arrive at beforehand. The Fed economist sometimes pops up his head to say that all is not well, but it’s like a game of Whac-A-Mole: He gets the hammer on the head every time.

It’s the worst case of bad corporate management you can find on record. It makes Dilbert’s world look like a paragon of management success. There is no openness, no truthfulness. If the chairman makes a joke, you must laugh. If the chairman says all is well, you must agree. If the chairman says he knows the future, you must be in awe of his insight. All dissent must be coached within a puffy framework that raises only a slight and probably irrelevant concern, and it is still likely to be punished.

Then there is the problem that it is not entirely clear, even to the people in the room: what precisely they can do about anything. They know what they are doing is important and want to believe that they have tremendous power. But here’s the problem…The Fed really has only one significant power: to create the conditions intended to encourage a change in the supply of money and credit.

That’s a huge power, but it is not a precise one. The money supply is a lot like an unruly child. Lots of times, the kid will obey you. Sometimes, and unpredictably, it will not. It depends on the mood, the context, the prevailing temperament, the rewards and punishments. And even when the kid obeys, the results are not always what you intend. The council of parents can meet and plan all day, but in the end, the kid has a mind of its own.

Two notable examples follow. In the early 1930s, the Fed was desperate to expand the money supply as a matter of both policy and practice. There was no intention to let the supply collapse, as Murray Rothbard has shown. The problem was that the Fed had to depend on the banking system to make it happen through the loan markets. But the system was broke, and it never happened.

The same thing happened again from 2008 and forward. The Fed did everything possible to manufacture a far-reaching monetary inflation, but failed to make it profitable for the banking system to cooperate. Contrary to the Fed’s wishes, it never fully materialized. Their efforts only ended up subsidizing failure and preventing a much-needed and deep market correction.

The sheer power of the Fed was in full display in 2008, and all the public records indicate what it was used for. The Fed provided liquidity for its friends. They said that they did it all for the nation, but it is unclear that the nation got anything at all from the deal. What is clear is that its friends survived and thrived, whereas many institutions should have gone belly up, as the capitalist system would dictate. That’s the essence of its power and the core of what the Fed does.

This is nothing new at all. It’s just that it is now on full display for all the world to see. And this is one reason that the Fed is now under fire as never before. The digital age has pulled back the curtain. Instead of the mighty Oz, we find a few people pulling levers with smoke and mirrors.

Before 1989, the world was strewn with such central planning agencies. They were all over Eastern Europe and the old empire called the Soviet Union. Then one day, the whole thing melted away and the absurdity and arrogance of the central planners were revealed to the world. The Fed is no different in structure from these institutions. The whole thing is based on a lie that it takes government power to have a good monetary system.

In what sense is it good? The depreciation of the dollar since 1913 has been catastrophic for prosperity. The dollar is now worth less than a nickel. Savings have been expropriated. The Fed’s interest rate policy has negated any real advantage of saving money. Business cycles have become national, international and extended, rather than local and short-lived as they were in the 19th century. The moral hazard that the Fed has built into the system is that financial systems no longer take proper account of risk.

In the digital age, the opportunity costs of the money monopoly have been huge. We might have had a competitive money system emerge by now. It could have been based on gold, silver or any other commodity. But the market has not been allowed to work. The Fed, working with the government that created and sustains it, has cracked down hard on every attempt by the market to make something better than the Fed-managed dollar. People now languish in jail for the crime of trying to restore money and banking back to the market.

What is the worst cost of the Fed? It has made the federal government, no matter how big it gets, beyond failure. This is the ultimate moral hazard. It has puffed up the leviathan state beyond anything that should ever exist in the world. It’s not taxes that have done this. It is the Fed. In this way, it has made itself the ultimate enemy of freedom itself. And as goes freedom, so goes human rights.

The whole catastrophe is no longer possible to ignore. Ron Paul has made it a political issue. Newt Gingrich has jumped on the bandwagon to scrap the Fed. The former CEO of BB&T gave an interview in which he said, “As long as the Fed exists, Congress can effectively print money. And it doesn’t matter whether they are Democrats or Republicans, they would rather print money than tax people. They want to spend because that effectively buys votes, and they don’t want to tax people because that loses votes.”

The problem of ending the Fed is not a technical one. It is not much of an intellectual one, either. It takes only a few minutes to figure out that the whole thing is rooted in myth. The problem of ending the Fed is entirely political. The government is dependent on its powers. So yes, it makes some sense that the political class and its friends — let’s call them the 1%, for short — think the Fed should exist. The rest of us should know better by now.

Regards,

Jeffrey Tucker

The Fed’s Men Behind the Curtain was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is a government’s last resort when it can no longer ease monetary policy by lowering interest rates. And with an official rate of 0%-.25%, there is really no room for the Fed to go lower. In fact, the Fed seems to have an inherent dislike of saying our official rate IS actually 0%. So they keep this charade of a rate “range” in place for a little window dressing… and quickly turn to quantitative easing.

By pouring money directly into the economy, effective rates are supposedly made lower, money is made cheaper and everybody has more of it. That, of course, makes people feel wealthier (whether they are or not), so they spend more money. This creates more sales. More sales create more jobs. More jobs create bigger companies. Bigger companies create bigger profits. Bigger profits make companies less nervous about taking out corporate loans. Corporate loans helps companies expand.

Expansion makes Wall Street think the company will have bigger future profits.  Wall Street’s hopes drive up the company’s stock price, and their bond rating. This helps the company borrow more money at an even better rate, and the expansion cycle continues.

But all of this is contingent on the cheap price of money.

You may have heard the term “cheap money” before. And it’s not easy to wrap your head around the concept. After all, isn’t a dollar always a dollar? Not exactly…

Whether money is “cheap” or “expensive” depends on what it costs to borrow money. When interest rates are high, the cost to borrow is high — and money is said to be expensive. When rates are low, the cost to borrow is low — so money is said to be cheap.

Common monetary theory says that cheap money jumpstarts an economy. People feel like they have more money, so the cycle gets going, just in the way I described earlier.

However, there is a hidden cost to cheap money — and it’s called inflation. When a government pumps too much money into the economy, it will overheat. More money chasing the same amount of products raises prices.

Now, to the first recipients of this new money, it doesn’t matter. When the money first enters the system, prices have not adjusted upward yet. So people have new purchasing power without price increases.

The last people who receive the money (after it trickles down) are the worst off. They have seen prices rise already, but by the time the new money gets to them, it has less purchasing power. So you have some pretty angry folks.

Then a day eventually comes when the government has to turn off the money faucet. Prices continue to rise, but everybody has less cash to buy things with. The masses begin complaining and wanting the government to “do something.”

So the government starts raising rates, and everybody complains some more. But by that time, the pinch is on, and the yeast has started working its way through the bread. It is much easier started than stopped, and everybody hurts until it does. There are no winners in inflationary periods. There are only people who lose less than others because they were better prepared.

The Fed’s quantitative easing will try to lower the cost of money by pushing it through the economy. The question is, how much is too much? At what point do people stop feeling wealthy and only feel the squeeze of higher prices?

The whole circus is beginning to happen now. When the Fed announced its plans, traders, investors, institutions and governments around the world began selling off the dollar. Hard. It fell 6.3% in 24 hours against the euro. Every major currency appreciated against the U.S. dollar. Simply put, traders were saying that the Fed’s actions made the dollar worth less.

But two big concerns remain. First, why did the Fed decide to take this action? As I said, this is usually a tactic of last resort… so what piece of news or indicator mandated this huge policy change?

Perhaps more importantly, how much longer will the Fed take this course? The monetizing (inflating) of trillions of dollars in debt calls into question the safe-haven status of the U.S. currency. Devaluing makes it seem less like a stable reserve currency and a lot more vulnerable.

On a broader view, the European Central Bank may attempt to do the same. They have publicly stated they are nearly at the end of their rate adjustments, although their rate is currently more than a full point higher than the United States. Honestly, it is questionable whether the European Union can perform a Quantitative Easing operation across all 16 member countries. It would be technically difficult to pull off… and next to impossible politically.

But if they do attempt quantitative easing, it will mute the Fed’s actions, blowing through trillions of dollars more with little or nothing to show for it.

So to sum up, if the ECB does not inflate, the dollar looks very bad going forward. If they do, the prospects for an inflationary “recovery” for the United States are slim to none. And slim just left town…
And now we have to add in another piece of the puzzle…the People’s Republic of China.

Red Storm Rising

China has been attempting to flex its newfound economic muscle. Chinese Premier Wen Jiabao’s veiled warning that the United States had better watch its step and keep its promises.

Last Monday, the nation fired another warning shot across the bow. Zhou Xiaochuan, president of China’s central bank, issued a very well-written and forceful essay to the World Bank. Without naming names, he expressed concern about the world’s dependence on just a few reserve currencies. www.pbc.gov.cn/english/detail.asp?col=6500&id=178

He called for the introduction of a world reserve currency, based not on a sovereign country’s currency, but rather on an IMF-based note. He suggested basing it on the IMF’s SDRs, or Special Drawing Rights, a unit of account that the IMF has been using since the 1960s. The proposed currency could also be grounded upon a basket of commodities for the backing of its value, and member countries would make “contributions” to this universal monolith.

Of course, other nations would have to be open to such an arrangement, and even if they were, developing this idea would likely take a long time. But that’s not really the point. The point is, China is expressing its displeasure at what it perceives to be a real inequity between itself and the rest of world. While China is doing its best to weather the downturn, the collapsing demand for its exports has closed many factories and put 20 million people out of work.

What China wants is for its investments to be spared. And for it to be considered above our own national agenda. Because right now our agenda of inflation and their agenda of a stable or appreciating dollar are at odds.

And this provides some of the background for our Australian play. Take a look…

Looking for Thunder from Down Under

I have said before that the likely winners in this worldwide economic crisis will be countries like Canada and Australia. They have an edge because of their commodity-related economies and currencies. Oftentimes you’ll hear them called the CommDolls (commodity dollars) for short.

Of the two, I like Australia better. Canada is inextricably tied to its neighbor to the south (namely, us), and that’s more than just a little problematic. Australia, on the other hand, is not tied to the United States and has many other real positives going for it.

Keep in mind, the U.S. dollar devaluation is under way. And the words of warning from China’s top officials suggest the country is already considering moving its investments to whatever other possibilities exist. Indeed, is has already begun doing so — mainly, into its own economy.

It has produced a stimulus that has been roughly estimated at somewhere just above $550 million, or 14% of the country’s GDP. Its infrastructure expansion is already up 30% from last year, hoping to boost domestic demand. Bank lending is up 24% due to its own monetary easing. Yes, exports are off substantially, and I think will likely continue to drop, but even so, the personal savings rates there are much higher, and China does have the reserves to continue moving things along with little to no borrowing. Plus, they have promised to do more stimulus if it appears to be necessary.

As China attempts to lift itself up by its own bootstraps, Australia comes into the picture. It has been widely understood that Australia is a little China. Not in culture, custom or language, but in economics. A significant part of Australia’s commodities flow into China, and the more the Chinese move ahead, the better it is for Australia.

Also, let’s consider that Australia’s central bank is still holding its interest rates at 3.25%. In a fairly stable country, with a fairly stable currency, that is one heck of an attractive rate. Why, it is downright appealing! It is true that they have followed other developed countries in lowering their national rates. But I think it is the propensity of all central banks to err in their “corrections” of the market. That is, they often lower rates too quickly and too far — as I think is the case here — then they raise them far too slowly to stave off the coming of inflation.

Indeed, Australia may now become the benefiting member of the next carry trade.  After all, if can you borrow money at .25% and invest it at 3.25%, you stand to make a decent haul. And as risk appetite re-enters the market, you can bet your bottom dollar that Australia will likely be a real beneficiary.

More importantly, the continent’s economy has not been too rattled by the worldwide crisis. Wages are up 5.7% by official statistics. That’s great, especially when you consider that full-time employment is up. Now some people may question the importance of Australian employment given that the recent figures showed only a marginal improvement in job numbers. But inside the figure, we have a strong drop in temporary employment, but a surge in full-time filled positions. Going forward, this is good!

Business investment is up 6% over the last quarter — also a sign of good health. As business expands, so does the work force, followed by wages… and next thing you know, interest rates are headed north as well.
Retail sales are up 0.8% this quarter. Even their housing market has only suffered a 3% decline. On top of all that, it has recently run a trade surplus, another sign of a healthy economy.

Now this does not mean it is just smooth sailing ahead, or that there aren’t downside risks. Its central bank could continue to overreact. That would be detrimental. Or commodity prices could take another hit. After all, many producer contracts were locked up last June, and many producers are still protected by them. This June could be an entirely different story. Producers may have to take a big hit compared to last year. That would be detrimental. And the China factor may not pan out as quickly or as well as it appears.

But all things considered, a long position in the Australian dollar doesn’t seem like too bad of a bet.

Regards,
Bill Jenkins

March 30, 2009

Devaluation and a Chinese Warning Shot was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

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. Visit Laissez Faire Books for the best selection of libertarian book titles.

Born and raised in rural Tennessee, Sir John was the first person in his town to go to college. He went to Yale during the great depression and when things got tight, his father could no longer keep him there. So he helped pay his own way through college with his poker winnings, which sort of adds to his legend. He eventually went on and won a Rhode Scholarship, went to Oxford and set up in Wall Street in 1937.

Now, you can imagine what the world look like in 1937; a lot of bad news, the Great Depression, war looming on the horizon. And in this environment of chaos, Sir John got to work.

One of his famous bets came to him in 1935 when he bought 100 shares of every stock trading for less than a dollar in the NYSE. He made four times his money in the next four years. That was sort of a pattern throughout his career. He was always an investor who was able to find the opportunity during times of market upheaval. He famously bought stocks the day after the ‘87 crash, for example. He also bought airlines after 9/11 and made a lot of money in a short amount of time. So I think he is a good investor to focus on these days because, as investors, we have so many problems to deal with in the marketplace.

I also want to say he started his famous fund in 1954 and it was incorporated in Canada because there was no capital gains tax there at the time. And during 1954–1992 he racked up an average return of 15% a year. That’s a great track record over a long period of time.

He also offered a lot of phrases that we take for granted as common sayings today. “‘It’s different this time,’ are the most expensive words in the English language” — That’s Templeton’s. Maybe his most famous saying is, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” He later added that the best time to buy is during points of “maximum pessimism.”

When I think of Templeton’s influence on me, I think of two things. One is that he was one of the first really successful investors to invest overseas. He was an early investor in Japan, for example, and he drove home the idea that a quality investment idea doesn’t have to be large, U.S. blue-chip company. He was equally at home investing in South Africa, Australia, Japan, wherever. The second thing I think of is that he had this focus on finding great opportunities even when markets seemed like a really bad place to be.

He wrote this when he was approaching his 95th birthday: “Throughout history, people have focused too little on the opportunities that problems present, both in investment and in life in general. The 21st century offers great hope and glorious promises. It is perhaps a golden age of opportunity.”

Now, you might think he’s nutty saying that. And when you look, there is a lot of bad news out there. I think the U.S. economy is probably in recession and Wall Street is a disaster. The dollar is in the tank, debts are high and taxes are going up. My state of Maryland, for instance, just passed the largest tax increase in state history last year. That is pretty amazing considering all the things people get hit with nowadays. And now we are getting hit with higher taxes too. California also had an increase in taxes by some large amount, and Sacramento already has higher taxes than NYC. So to top it all off — as if that’s not bad enough — it’s also an election year! So we have to listen to all the politicians tell us how they are going to solve our problems with a wave of their magic pen.

Today, the big issue is scarcity. When you think about how the prices of everything from food to gasoline are rising, you might think we face scarcity in a lot of things. This may or may not be the case. One thing we don’t have scarcity of, however, is paper money. The money and credit growth for the last 12 months is really incredible. The Australian dollar, the Canadian dollar, the Chinese Yuan, the euro…all these currencies are increasing at 22%, 21% 18%. The only major currencies that are not increasing at a double-digit rate are the Japanese yen and the Swiss franc. So, when we look at market prices, this distorts what we see:

For example, let’s look at oil. Every time I hear that oil is in a bubble, I think of this chart [above]. Basically what it tells you is that as money supply increase, the price of oil has increased along with it. In fact, roughly 87% of the increase in crude oil can be explained just by the increase in money supply. So when you see oil make this huge jump, you have to put it in context. This is true for all commodities. It looks like we have skyrocketing prices, but what we are in fact seeing is the collapse of the dollar. It is just another factor that makes investing difficult, another factor we have to consider.

Regards,
Chris Mayer
August 14, 2008

P.S.: Do you think John Templeton would let the current market get him down? I don’t, and neither should you. Sure, it seems like good opportunities are hard to find these days, but believe me they’re still there. In fact, I know of one investments that will actually pay you income checks. That’s money you can count on. And it may never run out

Crisis Breeds Opportunity was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“It’s getting increasingly evident that this is a once-in-a-century type of phenomenon,” he told the ever-fragrant Maria Bartiromo in an interview with CNBC this week, “not the standard type of liquidity crisis that we have seen in the past.

“It’s verging on the issue of solvency.”

To gauge the true scale of this crisis, Greenspan went on, just consider the fact that it took sovereign credit to stabilize first the U.K. and then U.S. financial systems. When Northern Rock went belly-up last Sept. and then Bear Stearns blew up this spring, Treasury bonds had to be lent out like adjustable-rate home loans circa 2006, covering short-term black holes with government debt.

Without these loans of government bonds, the banks simply wouldn’t lend to each other. They needed securitized tax payments to gain the credibility needed for raising new funds in the market. Short of offering government debt to put up as collateral, they found the cost of borrowing money — when they found any money to borrow — simply too high to bear.

“It’s still very evident from [inter-bank lending] spreads that we have not gotten closure yet,” Dr. Greenspan continued, pointing to the ongoing premium charged for loans backed by anything other than sovereign credit. So to fix the problem — or at least tease it out for months if not years — clearly the world needs more government bonds for the big banks to borrow and put up against cash loans in the market.

“It’s essentially, fundamentally the price of homes in the United States which are determining…the ultimate collateral of mortgage-backed bonds, pretty much around the world.”

Looking ahead, he concluded that “we’re still nowhere near the bottom of the home-price thing” — the word “thing” standing in for “crash…collapse…crisis…deflation” and all the other phenomena Greenspan must still believe can never apply to real-estate prices.

As key contractor, if not the architect, of today’s pan-global banking crisis, he chose to keep U.S. interest rates way below the rate of inflation — making debt pay and savings a suck of real value — for three years straight starting in August 2002:

That period marked the first run of sub-zero returns paid-to-cash since the inflationary ‘70s, back when loose money worldwide led to a bubble in prices that needed 20% interest rates to revive the world’s faith in the dollar.

The start of this decade also saw the gold price — dormant-to-dead ever since the U.S. took that strong medicine at the start of the ‘80s — double inside five years.

“First warning,” as Marc Faber wrote in his Gloom, Boom & Doom Report of Sept. ‘07, of trouble ahead.

“Ultra-expansionary U.S. monetary policies with artificially low interest rates led to bubbles all over the world and in every imaginable asset class. The price of gold more than doubled in nominal terms and against the Dow Jones Industrial Average.”

So why didn’t gold take a dive when Greenspan’s successor — Ben Bernanke — tip-toed his way back to 4% real rates of interest in late 2006…? Because early gold buyers never believed the Fed would succeed in keeping rates there. With housing now a political issue — and home ownership a god-given right for even the flakiest debtors — the first sign of trouble would cause a collapse in real rates, destroying the value of money in the hope of achieving “Reflation Part II.”

Hey, it worked after the Tech Stock bubble blew up. Why not again? And faced with a much greater crisis, or so Ben Bernanke believes, he’s managed to out-Greenspan the Maestro…pushing real U.S. interest rates way down to minus 3% and worse.

Take gold as a marker of stress, and the true extent of today’s crisis becomes clearer still. Bear Stearns’ firesale to J.P.Morgan in mid-March — which required an open-ended loan of $29 billion from the Federal Reserve — saw gold jump to $1,032 per ounce. We think it’s a signal that Alan Greenspan ignores it.

“Central banks, of necessity, determine what the money supply is,” as he told Congress in a 1999 hearing. “If you are on a gold standard or other mechanism in which the central banks do not have discretion, then the system works automatically.

“The reason there is [now] very little support for the gold standard is the consequences of those types of market adjustments are not considered to be appropriate in the 20th and 21st century. I am one of the rare people who have still some nostalgic view about the old gold standard, as you know, but I must tell you, I am in a very small minority among my colleagues on that issue.”

Today, almost a decade later, the Federal Reserve and its peers across the world are trying to prevent the money supply from shrinking again. That was the fear amid the “Deflation Scare” of 2002, which caused the Fed to ordain sub-zero rates, creating not only the bubble in housing but also the collapse of true money values against oil, food and pretty much all raw materials.

The world’s nostalgia for gold, in response, has seen it treble in price vs. the dollar and more than double against the Euro, Yen and British Pound. But the cheerleader for cheap money when running the Fed, Alan Greenspan points instead to government bonds when gauging the size of today’s crisis. A true policy wonk, Greenspan thinks only of political bailouts to protect the system, rather than considering how private investors might choose to protect themselves and their wealth.

Heaven knows they won’t get any help from Bernanke’s repeat of the Maestro’s “reflationary” error.

Regards,
Adrian Ash
BullionVault
August 11, 2008

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

I believe the charts I have in this column contain some powerful insights. You will want to keep them handy when things get rocky. They come courtesy of Barry Bannister, an analyst at Stifel Nicolaus, who delivered an interesting talk in Baltimore recently.

I’ll focus on oil, though a similar story holds true throughout the commodity sector. I don’t put a lot of faith in macro predictions — as no one can predict the future. But you can study track records. You can look at history. History reveals some interesting clues about what the future may hold.

The quick take? It doesn’t look like the party is over just yet. But even if it is, past peaks in oil give us clues. When you dig a little deeper into those relationships, you find a great road map for making money.

If you look at the price of oil, you find something interesting. Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply, as this next chart shows:

Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.

The other thing to remember — and people forget this by worrying excessively about a U.S. recession — is that the story of oil is no longer a U.S.-centric story. You’ve surely heard about how the rapid growth in China and other emerging markets drives oil demand. Well, it’s good to keep that in mind. See the chart below:

China and India are only beginning to consume oil at any meaningful level. Right now, they are consuming oil at a rate the U.S. did in the early years of the 20th century. But look, we don’t need China to start guzzling oil like we do. Even if it moves half the distance between it and Hong Kong, that’s a lot of extra demand. The way I look at it is this: What’s more likely, China stays at 1910 oil usage or moves somewhere closer to, say, 1950s U.S. oil usage? I think the latter.

Even if oil has already peaked, that doesn’t mean oil is headed back to $40 per barrel or lower. In fact, if this oil boom follows history at all, we’re looking at years of oil prices right around $100 per barrel.

After studying the history of other recent oil booms, what you learn is that in no prior oil boom did the price of oil retreat rapidly toward where it was before the boom began. In each case, the price of oil stayed up for years after the peak. If you’ve got investments tied to the booming oil prices, that means you’ve got plenty of years to make more money.

So where do you go to make that money?

The one obvious place people will automatically look is to own oil and gas producers. That’s not a bad idea at all. But I’ve got another angle here. If you look at the capital and exploration spending of both Exxon and Chevron from 1928-2007, they show spending bottoms in 1948 and 1974. After each bottom, there was a long run of spending.

Spending peaked nine years after 1948. Spending peaked seven years after 1974. If 2005 proves to be the bottom on capital spending — and it seems so, since Exxon only recently announced it would increase its capital spending to $25-30 billion over the next few years, a 25% increase — we won’t see capital spending peak until 2012 at the earliest.

Now, why is this important? Think about what the oil companies spend money on. Where do they go shopping? They go shopping at the oil field services and equipment companies.

So that is where you want to be. Because even if oil has peaked, we’re still looking at years of strong spending by the oil companies. You want to have some exposure to the receiving end of all that spending. Such companies will mint cash. And they give you a little different payoff than owning a straight producer. As Bannister pointed out, it can sometimes be better to own the picks and shovels. You don’t actually own or produce the oil or gas, but your equipment is vital to those that do.

He used Newmont Mining, the big gold producer, as an example of a producer that has profoundly disappointed investors amid what may be the greatest gold bull market in history. Newmont’s costs rose so fast and so much that it never really enjoyed (at least not so far) the higher price in gold. But if you were in some mining equipment manufacturer, you got paid.

So the key takeaways here are these: The price of oil has room to run yet, in part because of the growth in money supply and in part because of pressing international demand. Secondly, even if we already saw oil peak, history says that prices won’t retreat by much over the next several years. And finally, the capital-spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies.

Regards,
Chris Mayer
May 20, 2008

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

Today, with progressive calls for action in the face of crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets. This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s “plan.”

The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain “growth.”

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke’s moniker, “Helicopter” Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! “It’s not such a sure thing.” At least that’s what I thought I heard…from a voice in the wilderness. “What do you mean it’s not a sure thing? Look at ‘em flood the markets with liquidity. $100 billion here, a few hundred there.”

As I was about to sign off, the voice continued: “No, they are not inflating. They’re just creating confidence in the credit markets. Look at the ‘money’ numbers,” said the voice. “Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven’t grown since August. The Bernanke Fed is just pretending to inflate!”

Perhaps I already knew what the voice was telling me. Like the title character in Tolstoy’s classic novel, The Death of Ivan Ilych, I was doing some soul searching and discovering hidden truths buried deep beneath the surface. The voice was my own, and it was telling me something I had yet to consider.

It has not escaped my attention that the narrow constituents of money supply are not expanding. I’ve written about it.

This disinflation was first apparent as far back as 2005, under Alan Greenspan’s tenure, when M1 growth hit zero percent on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for U.S. M1 has not changed in three years. But our “voice” insists that Bernanke is running a different, more deflationary policy than Greenspan — even though under Bernanke’s reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed.

Clearly, the Bernanke Fed is running a different policy.

But it is difficult to call it a more deflationary one:

Okay, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived.

If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk.

At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market’s confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there aren’t any deflationary forces in the system — just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you’d have seen a few more Bear Stearns by now — and it is unlikely that the broader credit aggregates like M3 and money with zero maturity (MZM) would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed hasn’t had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market’s current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.

The Deflation Equation Doesn’t Add Up

So deflation has not set in yet, but our normally credible source is still convinced that Bernanke is secretly pursuing a policy of deflation while pretending to inflate. But from the central bank’s point of view, the costs of such a policy are prohibitive. So why am I still listening to this “voice”?

Because it believes the Fed wants to hijack the gold market… In other words, the Fed is trying to quell the rise in the gold price.

A central bank’s general incentive to dampen gold fever is a given, but why would it want to so bad that it would be willing to risk political suicide? Our voice explains that some of the large bullion banks still hold massive derivative short positions in gold, which they borrowed from the central banks to sell into the market in the ‘90s. We have not heard any of them report large losses on those positions yet.

They are potentially huge.

But are they huge enough to motivate the Federal Reserve to orchestrate a deflation policy in order to save these banks from ruin?

The last genuine deflation in the U.S. (1929-33) wiped out almost all the banks. Are you telling me that the gold shorts held by a few select bullion banks can cause more total pain than a deflation policy?

I doubt it, especially since the central banks are so forgiving on the terms of the gold loans.

This voice is right that the Fed is not expanding narrow money.

It is wrong about the Fed targeting deflation.

So Is the Fed Targeting Gold?

It should be. Bernanke may well be trying to keep the monetary base stable to discourage speculation in the gold and oil markets, while at the same time boosting confidence in dollar-denominated assets.

This kind of a balancing act (or “sterilized” inflation) is not foreign to the Fed’s modus operandi.

In fact, it was well accomplished by Bernanke’s predecessor.

While the idea that the Fed is deliberating deflation in order to undermine gold makes little sense, the fact that the monetary base is not growing is relevant and deserves further monitoring. Regardless of the explanation, when the central bank is not inflating, it is not bullish for gold. I say this even though, empirically, the relationship between money (i.e., M1) growth rates and gold prices is not cut and dry.

If you bought and sold gold based on the requisite changes in M1 growth rates, you’d be on the wrong side of the trade most of the time, at least since the ‘80s. You’d have turned bearish after 2004, missing the last $400 rally. It is important to monitor. But we live in a global world today. The effects of inflation produced by China’s central bank are felt in America, and vice versa.

It’s especially a bad idea to short gold. But it is a good time to pick away at values created by the “Chicken Littles” on the way up to $2,000 — if you believe that the Fed is inflating.

I’m not going to tell you that gold is going to go up whether we have deflation or more inflation. I don’t believe that. I believe gold prices would fall in a monetary deflation. But I don’t expect one soon.

Regards,
Ed Bugos
April 3, 2008

How the Fed Effects Gold was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Every morning, when you look in the mirror, I want you to think, ‘What am I going to do today to increase the money supply?’”

— John Ehrlichman, assistant to President Richard Nixon,
apocryphally speaking to Charles Pardee,
a Federal Reserve governor,
sometime in the early 1970s

SO WE’RE ALL AGREED, THEN.

“This is clearly the worst financial problem we’ve had since the Great Depression,” as Joseph Stiglitz said on a radio show in New Zealand on Wednesday morning. (He’s there attending a conference.)

The Nobel-winning economist lined up behind Countrywide Financial (July ‘07), Wells Fargo (November ‘07), former Treasury adviser Nouriel Roubini (December ‘07), the National Association of Homebuilders (March ‘08), and pretty much everyone else in saying this is as bad as it gets.

As in, the worst ever — like finding nothing besides Of Mice and Men to order from Amazon and nothing but Seabiscuit to rent at Blockbuster.

The men now pulling the Fed’s monetary levers sure agree. And while Ben Bernanke might see the shadow of depression where the rest of us glimpse a shade, liquidating the malinvestments of 2002-2007 is certainly hurting.

Imagine the U.S. Treasury paid your wages each month; you’d jump to increase the money supply every chance you got, too. See, it’s the only way to stop the Nazis from taking over. Or the commies.

Or maybe even — oh, horror! — the Democrats…

“Involuntary unemployment,” as John F. Kennedy put it way back in 1962, “is the most dramatic sign and disheartening consequence of underutilization… We cannot afford to settle for any prescribed level of unemployment.”

Barely a generation after the worst recession in U.S. history, backing labor over capital like this — and thereby nabbing labor’s far weightier vote — meant JFK got to kick Richard Nixon around at the ballot box.

When his turn at the top finally came around at the end of the ‘60s, Tricky Dick didn’t forget the kicking. In fact, “I [already] knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate,” as Nixon himself wrote in 1962.

So come December 1968, when Herbert Stein first met with Nixon as head of his Council of Economic Advisers — and Nixon asked Stein to name the biggest problem they faced — “I started with inflation,” said the economist.

“[Nixon] agreed, but immediately warned me that we must not raise unemployment,” Stein was to recall nearly 15 years later. “I didn’t at the time realize how deep this feeling was or how serious its implications would be…”

Fast-forward to the brink of Easter ‘08, and the “serious implication” of the Great Depression once again is the cost of not acting to prevent it. Or so everyone says.

And I mean everyone…

“[The liquidationists] turned the 1930 recession into a slump,” says Ambrose Evans-Pritchard for The Daily Telegraph here in London:

“They insisted with Puritan zeal — or malice — that speculators should be driven to the wall amid a cathartic purge of the Roaring ‘20s.

“Among them were top bureaucrats at the U.S. Federal Reserve and some of Europe’s central banks.

“The consequence was the Bruning deflation in Germany, ushering in the Nazis. Democracies snapped across half of Europe. If it had not been for the towering figure of Franklin Roosevelt, America might have splintered into a bedlam of prairie populists, Coughlin fascists and Huey Long extremism.”

Better anything — even a bailout of Wall Street’s hated bankers today — than jackboots and Benzedrine addicts with Chaplin moustaches, right? And where better to start in getting the voters onside than with Ben Bernanke’s complete collection of The Waltons, seasons 1-9, on DVD…?

“During the major contraction phase of the Depression, between 1929-1933,” as Bernanke said in a speech in 2004, “real output in the United States fell nearly 30 percent.

“During the same period, according to retrospective studies, the unemployment rate rose from about 3 percent to nearly 25 percent, and many of those lucky enough to have a job were able to work only part time.”

By comparison, the 1973-75 recession — “perhaps the most severe U.S. recession of the World War II era,” according to Ben “John-Boy” Bernanke — real output fell 3.4 percent and the unemployment rate merely doubled, from four percent to nine percent.

So never mind about the double-digit inflation. Never mind that by the end of the ‘70s, “every business decision [had become] a speculation on monetary policy,” as J. Bradford DeLong put it in a 1996 essay. Never mind that business can’t function if money becomes a flickering variable, making the trade-off between inflation and jobs…bailouts and growth…a loser both ways.

“Other features of the 1929-33 decline included a sharp deflation,” Bernanke went on in his speech, soup ladle in hand and a Baker Boy flat cap on his head, “prices fell at a rate of nearly 10 percent per year during the early 1930s — as well as a plummeting stock market, widespread bank failures, and a rash of defaults and bankruptcies by businesses and households.”

So no matter the cost, deflation must be defeated long before it arrives. Indeed, the higher the cost, the better!

“In 1938, Congress enacted the Fair Labor Standards Act,” writes David Hackett Fischer in The Great Wave — his sweeping review of history’s longest inflations — “which set the first national minimum wage. It also briefly considered a maximum wage, but that idea was quickly forgotten.”

Over the next 30 years, this upward bias in wages — all floor and no ceiling — was “built into the American economy,” Hackett Fisher goes on. “Floors under wages, pensions, and compensation for the unemployed; floors beneath farm prices, steel prices, liquor prices, and milk prices; floors for airline fares, trucking charges, doctors’ bills, and lawyers’ fees…”

Come Nixon’s first term, the high cost of living was mandated by government, corporations, unions, and householders alike. Falling prices could not be allowed (“You remember the ‘30s, don’t you?”) and — as yet — rising prices were no more than a puzzler at the grocery store every Saturday morning.

Convinced by economists of a trade-off between rising prices and jobs, governments everywhere watered and tended inflation, thinking they could always prune it if the foliage got out of control. And feeding its roots, deep below ground, was the rich, manure mulch of the Great Depression.

“At the surface level,” DeLong explains, the destruction of money during the ‘70s happened because no one in power “placed a high enough priority on stopping inflation.” Worse than that, Nixon and his successors — Gerald Ford and then Jimmy Carter — inherited “painful dilemmas with no attractive choices.” The ‘60s battle to grow jobs at the expense of sound money had already locked in that problem.

Look deeper again, and “no one had a mandate to do what was necessary,” our Berkeley professor goes on. “It took the entire decade for the Federal Reserve as an institution to gain the power and freedom of action necessary to control inflation.”

But at the very deepest level, “the truest cause of the 1970s inflation was the shadow cast by the Great Depression,” DeLong concludes. “It took the 1970s to persuade economists and policymakers that ‘frictional’ and ‘structural’ unemployment were far more than 1-2 percent of the labor force. It took the 1970s to convince [them] that the political costs of even high single-digit inflation were very high.”

In short, the developed world balked at the chance to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate” — as U.S. Treasury Secretary Andrew Mellon had urged in the ‘30s — when the liquidation wouldn’t have washed so deep or so hard at the start of the ‘70s.

Scared by the ghost of a Greater Depression instead, the West pushed ahead with big budget deficits, negative real interest rates, and a destruction of money that almost bankrupted Treasury bond holders. The runaway inflation that failed to back off when Richard Nixon nudged the Fed about defending jobs before the dollar (for what else is “inflation” if not a loss of purchasing power?) proved a hard-won lesson all told.

Reaching double digits across the developed world and causing a flight into commodities that in turn led to a huge bubble of malinvestments in the early 1980s, the “sustained spurt” of ‘70s inflation equaled the worst wartime price increases by the time double-digit interest rates could be used — with broad voter approval — to kill it off.

It all ended — guess what! — with a forced liquidation at the start of the ‘80s. And today?

“Ben Bernanke is smarter than I am and thinks about this 24/7, which I do not,” says Bradford DeLong on his blog this week. “He leads a superb committee. He is backed by the best monetary policy technical economic staff in the world. If I disagree with Ben’s FOMC on an issue of monetary policy, I am probably wrong.”

Either that, or Bernanke’s still stuck on Walton’s Mountain nostalgia…just as TV audiences were back in the ‘70s.

Regards,
Adrian Ash
BullionVault
March 21, 2008

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

“The U.S. recession is sure to send inflation to zero — just as it didn’t in four of the last five recessions.”

WORRIED ABOUT INFLATION? Oh, stop your carping and set an extra place at dinner for the fast-looming recession instead.

See, your cost of living can’t possibly keep rising now that Europe and the United States are plunging into a credit-led slowdown. Inflation is dead, killed by the slump. The value of money is going to stop sliding, even as interest rates fall.

Says who? Says just about everyone.

“A U.S. recession is now an even bet as job losses and the housing contraction jeopardize the longest-ever expansion in consumer spending,” says Bloomberg, reporting its latest survey of professional number crunchers.

“The world’s largest economy will grow at a 0.5% annual rate from January-March, capping the weakest six months since the last economic slump in 2001, according to the median estimate of 62 economists polled from Jan. 30-Feb. 7.”

And your cost of living can NEVER go up during a recession, right?

Oh, sure, inflation in U.S. consumer prices accelerated by one-half during the recession of 1973-75. It then hit an all-time peak during the short recession of 1980.

Inflation went on to beat its previous 30-year average during every month of the 1981-82 recession. (Don’t misread that “fall” from 10% to 5% year on year; the dollar’s buying power still shrank by almost one-tenth inside 16 months.) And the cost of living then spiked higher again when recession next struck, in 1991.

But this time, well…this time it’s just going to be different, OK? Think 2001, rather than the four previous U.S. recessions. And not just in the United States, either.

“The eurozone economy is now clearly slowing down,” says Michael Hennigan, founder and editor of Finfacts, the leading financial news site in Ireland. “Oil prices are also off their peak, [so] combined, these factors should act to dampen inflationary pressures in the economy. In particular, it should help prevent excessive wage increases that could endanger price stability.”

Here in the United Kingdom — the world’s fourth or fifth largest economy, depending on how you count China’s boom — growth just slid to 0.5% in the three months ending January, says the National Institute of Economic and Social Research. And that slowdown, the worst rate of growth since 2005, gives the Bank of England “room for further cautious reductions in interest rates,” reckons Martin Weale, the NIESR’s director in London.

“I don’t see the risk of inflation being a constraint.”

Back across the Atlantic, “The economy is rapidly slowing on all fronts, Wal-Mart [is] slashing prices again, and rising unemployment and delinquencies are going to further restrict bank lending,” says Mike Shedlock in his Global Economic Trend Analysis blog.

Hands down, inflation — properly defined as an increase in the money supply — continues to rise. Growth in the M2 measure “is running at almost a 6% year on year,” admits David Rosenberg at Merrill Lynch. But “Of course it is,” he then spits.

“Most of [this new money] is situated in nontransaction savings accounts, and these are up almost 8% from a year ago. So transaction balances are falling and precautionary balances are rising — what does that tell you about consumer spending and saving behavior?

“This is all, from our lens, very deflationary. Not the other way around.”

Big picture, even the euro-crats of the European Central Bank agree: Slower growth will result in lower inflation — even if the ECB did sit on the eurozone’s 4% interest rates once more on Thursday. Pressured to repeat the magic words “vigilant on inflation” at the press conference that followed, Jean-Claude Trichet managed instead to send the euro plunging to a near three-week low by hinting at cheaper money to come.

“Some of the menace behind [his] anti-inflation comments in previous months seems to have been softened,” as David Brown at Bear Stearns noted to Thomson Finance, “and there appears to be greater stress on the downside risks to growth.”

Put another way, lower growth — if not recession — will take the heat of prices. Because lower growth means falling demand. And only rising demand can ever push prices higher. Or so everyone says. Which is odd, given the facts.

“Few empirical regularities in economics are so well documented as the comovement of money [supply] and inflation,” as Mervyn King, now governor at the Bank of England in London, said in a late 2001 speech.

And the world’s supply of money is surging right now, even as “deflation” hits U.S. housing and stocks:

“Over the 30 year horizon 1968-98,” King went on back in 2001, “the correlation coefficient between the growth rates of both narrow and broad money, on the one hand, and inflation, on the other, was 0.99.”

Narrow money means cash in circulation, but as King said, the relationship with cost-price inflation holds just the same for “broad money” (shown above) — meaning all notes and coins; cash on deposit; and short-term bills, notes and bonds.

0.99 is as near perfect as you’ll find in any pair of data. An absolute 1.00 only ever exists for the very same thing measured against itself — say, the cost of living mapped onto the cost of living, or gold prices correlated with gold prices, for example.

Yet if we now race back to the present, and reappoint Mervyn King for his second term running U.K. monetary policy, “The disruption to global financial markets has continued,” explained the Bank of England — with King at the helm — when it cut U.K. rates on Thursday.

“Credit conditions for households and businesses are tightening,” the BoE explained. “Consumer spending growth appears to have eased…Output growth has moderated to around its historical average rate, and business surveys suggest that further slowing is in prospect.”

In sum, “These developments pose downside risks to the outlook for inflation.”

Phew! And to think that five- and 10-year bond yields had finally shot higher just before the credit crunch bit in summer 2007 because inflation — whether in prices or the money supply — had finally became the No.1 worry for fixed-income investors.

“Underscoring inflation concerns, the benchmark 10-year U.S. Treasury note last week had its biggest decline in price in more than two years, as investors abandoned projections the Fed would need to lower rates by year-end to stimulate growth,” reported Bloomberg on June 11.

“Mounting concerns about U.S. inflation levels have sent short-term bond yields in Australia to their highest level since mid-2002,” said The Australian Financial Review on June 20.

“The global economy in 2007 is still expected to register close to 5% growth for the fourth year in a row,” added Fidelity Investments on July 20. “In response to this rapid growth, central banks around the world have continued to tighten their monetary policies, with the eurozone, United Kingdom, Japan, China, and India all raising short-term rates.”

You might wonder whether that sudden surge in bond yields sparked the banking crisis of August. But either way, here in Feb. ‘08, “Persistent fears over a possible U.S.-led global slowdown [have] fueled further profit taking in crude oil,” as one London analyst told Agence France-Presse at the start of this week.

And here starts the chain of logic linking the housing slump to falling inflation and bypassing the impact of monetary inflation altogether.

“Between January 2003-January 2008 alone,” as the Financial Times quotes Goldman Sachs, “the world price of metals rose by 180% and of energy by 170%…in good part because of China’s demand.” That demand in turn came thanks to America’s credit-led bubble in consumer spending, but now the U.S. consumer’s tapped out — and his house keys are back with the lender.

So China can’t grow, because the U.S. can’t shop. Therefore, oil prices and base metals will sink and inflation worldwide will now vanish.

Who knows? Things might just pan out that way. But ignoring the flood of money — first created as credit and now stacked up in Treasury bonds across the emerging economies — would mean ignoring the connection between growth in the money supply and inflation in prices.

• The People’s Bank of China is rumored to want money supply growth of 15% per year, down from the current 18% plus
• India’s broad M3 money supply is rising 22.4% per year
• Singapore’s money supply increased by 14% in 2007
• Britain’s broad M4 measure of money has expanded by 12.3% since Jan. ‘07
• Western Europe is “enjoying” monetary inflation of 11.5% per year, three times the central bank’s target
• Last year saw 16% money supply growth in Australia, 13% in Canada and 22% in Saudi Arabia
• The U.S. money supply — if the Fed still reported M3 — is now guesstimated to be showing 15% annual expansion.

Remember, that near-perfect connection between money supply growth and consumer-price inflation is one of the few clearly established facts in economics. Over a 30-year horizon, they match each other almost exactly. Which is to say they won’t necessarily move together this week or next.

Similarly, the last time runaway inflation hit, the cost of living for Western consumers raced ahead AFTER raw commodity prices had begun to slow down:

During the inflationary ‘70s, the price of commodities — as measured by the Reuters/CRB continuous index — peaked out in November 1980. For the next 21 years, it was then downhill all the way.

Adjusted for inflation, however, the price of raw materials had, in fact, been falling since February 1974. That was when the rate of U.S. consumer-price inflation overtook growth in the CRB index, surging on the previous commodity price hikes and feeding into service prices and wage demands. Inflation in the cost of living finally peaked out in April 1980, hitting an all-time record high of 14.7% year on year.

How did consumer-price inflation keep soaring for more than five years after commodity-price inflation began slowing? No doubt things really are different today, starting with the fact that the current bull market in commodity prices — beginning in 2002 — represents the only real secular bull run for raw materials since the Reuters/CRB index began in 1956.

The 1973 doubling of commodity prices came thanks to the first OPEC oil shock. Might the Federal Reserve be taking things a little too coolly — not least with the value of dollars — by saying it “expects inflation to moderate in coming quarters” as it cuts the returns paid to dollar holders?

“The OPEC [oil cartel] would trim output if oil prices slip to $80 per barrel,” according to a Bloomberg report. It cites one unnamed OPEC delegate for the price target; two other members told the newswire that $70 would be “unacceptable.”

Says Johannes Benigni of JBC Energy in Vienna, “It wasn’t OPEC’s fault it moved above $80, but now it’s there, they justify keeping it.”

And then there’s the pile of dollars stashed away by the central bank in Beijing…up from $156 billion at the start of 2000 to more than $1.5 trillion at last count. If the sorry demise of the U.S. consumer really does dent the buying power of China, might the Chinese government not step in — and bid for crude oil, copper, soybeans and grain — to keep the fastest growing economy growing just as fast as it can?

Conjecture and guesswork are no substitutes for an answer, of course. And for as long as gold prices keep screaming that somewhere something is amiss between inflation and bond yields, that dumb lump of metal might just keep finding a bid.

Gold has now risen in 18 of the last 24 weeks. On Friday alone, it hit new record highs against both pounds sterling and euros.

Still, nothing to worry about. The U.S. recession is sure to send inflation to zero — just as it didn’t in four of the last five recessions.

Regards,
Adrian Ash
BullionVault
February 13, 2008

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

The Conference Board publishes various lists of Business Cycle Indicators. Those indicators are categorized as "leading," "coincident," or "lagging." This post will take a look at indicators 6-10 on the list of leading economic indicators. Indicators 1-5 will be covered in a second post at a later date.

Leading Indicators

1. Average weekly hours, manufacturing
2. Average weekly initial claims for unemployment insurance
3. Manufacturers’ new orders, consumer goods, and materials
4. Vendor performance, slower deliveries diffusion index
5. Manufacturers’ new orders, nondefense capital goods
6. Building permits, new private housing units
7. Stock prices, 500 common stocks
8. Money supply, M2
9. Interest rate spread, 10-year Treasury bonds less federal funds
10. Index of consumer expectations.

S&P 500

Looking at the above chart, I find it hard to believe that anyone thinks the stock market is a valid indicator of anything.

Starting in 1960 and using a decline of 10% as some sort of leading indicator would have generated five false positives, one miss, and one success. At the start of the 1980 recession, the S&P was up year over year about 5%; at the start of the 1982 double-dip recession, the S&P was up close to 30%; at the start of the 1991 recession, the S&P was up over 10%; and at the start of the 2001 recession, the S&P was nearly flat. The S&P did not decline 10% before, during, or after the 1960 recession. As a coincident indicator, the results would have picked up 1982 and 1991, but would still have missed 1960 and 1980. In 1987 and 2003, the stock market declined nearly 20%, but there was no recession.

Just for fun, let’s take a look at the Dow Jones home construction index:

Did the above chart "lead anything," or did the index peak a month or so after the June 13, 2005, Time magazine Home $weet Home cover?

Time and time again I hear, "The stock market acts six months in advance." Six months in advance of what? I fail to see how it is acting six months in advance of anything. If one is looking for leading economic indicators, the stock market is surely not one of them.

Also note that if one wants a stock market indicator, the economy is surely not it. Look at the plunging GDP in comparison with the stock market for recent proof. Look at the homebuilder chart above for recent proof. Look at the historic S&P 500 chart for proof. Seriously, the S&P is a hopeless leading economic indicator, and the economy is an equally hopeless stock market indicator.

Yet the myth (and the weighting) that the stock market is a leading indicator still persists. It’s no wonder that nearly everyone is confused, given that nearly everyone is looking for correlations that simply do not exist.

Consumer Sentiment

This chart of the University of Michigan consumer sentiment index seems to have some merit as a coincident indicator, but little as a leading indicator, at least in the time frame for which this data is available. The indicator also suffers from what seems to be a high percentage of false positives per correct call. As a coincident indicator, it has three false positives and four successes. One could draw the trigger line differently to avoid the false positives, but then the big recession in 1982 would be entirely missed.

Housing Permits

Seven out of the last eight times the annual rate of change on permits was negative 20% or lower, the economy went into a recession (not counting the current situation). Currently, the chart shows that building permits in November dropped 31% from the year-earlier level.

In all seven recessions since 1959, building permits declined year over year. Using the 0% line as a threshold would have picked up the recession in 2001, but would have also resulted in false signals in 1965, 1985, 1987, and 1996. This can be summarized as seven out of seven with four false positives.

Using 20% as the threshold, the only false signal was 1987, but there would have also been a missed signal in 2001. This can be summarized as six out of seven with one false positive and one miss.

This is actually a reasonably good performance, especially if one uses a cross of the 0% line as a strong warning signal while waiting for continued confirmation. Note that dips below the 0% line tend to occur well before the onset of recessions. Leading indicators are supposed to lead, and this one does. A crossover of 0% is a strong warning, and a continuation below the zero line shows that a recession is likely.

Money Supply

In "Money Supply and Recessions," I introduced "M’" (M Prime) as a leading indicator based on sound Austrian principles and definitions of money. Those who have not seen how or why I came up with M’ can click on the above link to see just what M’ is all about. What follows now is a recap of M’ versus M2 as a leading indicator.

M Prime

Leaving the current status as unknown, six of the last six recessions were marked by a major dip in M’. Note how the indicator clearly led the recession. Also note that six of eight sustained dips below an annual growth rate of 5% in M’ led to a recession. On that basis, we have two potential false signals (1985 and 1995).

M2

Unlike M’, the direction of M2 does not seem to give clear economic signals. Note that M2 was rising into the double-dip recession of 1982 and the 1991 recession. Also note that the single largest dip in M2 was in 1993, while M’ was soaring. The years between 1992-1995 are all problematic. Finally, note that unlike M’, where a dip below 5% annual growth was a huge warning sign, the dotted line above shows no such significance. M’ seems to be far superior to M2 as a leading indicator.

M Prime CPI Adjusted

On a CPI-adjusted basis, we see that there has been a recession on six of seven sustained dips below the zero line of year-over-year growth in M’. The 1985 excursion below 0% was extremely brief, in stark contrast to all of the labeled recessions, and thus can be discounted. 1995 is still a miss, but nowhere nearly as pronounced compared with M’ unadjusted. 1995 also happens to correspond to the start of a huge ramp-up in sweeps. Perhaps that is significant, and perhaps not. Nonetheless, M’ CPI-adjusted gives a cleaner signal, arguably calling for seven recessions, of which six happened.

The above chart clearly shows M’ CPI-adjusted to be a strong leading economic indicator.

M2 CPI-Adjusted

M2 CPI-adjusted is certainly an improvement over M’ CPI-unadjusted. Note, however, that the 1982 and 2001 signals are not as strong as the corresponding M’ CPI-adjusted signals. The M2 adjusted signal for 2001 was particularly weak. More problematic for M2 adjusted versus M’ adjusted is the mass of Jell-O between 1988-1996. M’ adjusted was clearly giving an all-clear zero cross-signal by 1992, while M2 adjusted gyrated for years and did not really give an all-clear until 1998. Furthermore, M2 adjusted actually dipped back below the zero line in 1997, while M’ adjusted was soaring upward. Both M2 and M’ missed around the 1996 time frame, but even then, M2 did worse both in terms of an actual low and the Jell-O that preceded it.

10-Year Treasury Minus FF Rate Spread

A dip below zero preceded six of six recessions since 1965. Unfortunately, it generated five false positives, as well. Of course, one can set the line at negative 1, in which there were only three false positive. Or one can set the line at negative 2, in which case there was one false positive and one miss. Still, it would be much nicer if we did not have such curve-fitting. Can we do better than this indicator?

The Yield Curve

The above chart was generated by subtracting the symbol $IRX from $TNX where $IRX is a 13-week discount and the latter a 10-year yield. Ideally, both would be yields, but the difference is not that great on the 13 week. We use free data when available, and that data not only works well, it also happens to be free.

This chart is almost perfect. A three month-to-10-year inversion is six for six with one false positive in 1966. The current situation is considered unknown.

Note how the above chart does not confirm the false signal on the 0% line cross in 1995 on the previously shown real (CPI-adjusted) M’ chart. Unfortunately, the false signal in 1967 on this chart predates the beginning of our M’ series of charts, but I suspect there was nonconfirmation in the other direction, with M’ not confirming this chart.

Comments From Paul Kasriel

• The "real" unadjusted monetary base (bank reserves plus currency) seems to provide fewer false recession signals than does real M2 growth. That does not necessarily mean that the real base does a better overall job of forecasting real GDP, just that it does a better job of forecasting official recessions. Mish Note: "Real" in this case means inflation-adjusted via the PCE price deflator, and "unadjusted monetary base" means a nonseasonally adjusted monetary base
• I have used the PCE price deflator to get "real," rather than the CPI, for purely arbitrary reasons here, not theoretical — I don’t have time to explain now, but it is not a big issue. Mish Note: There is a potentially confusing mix of terminology here, but none of the charts in this post were seasonally adjusted (except perhaps for consumer sentiment, and on that, I am unsure). Our inflation adjustments used the CPI, and any references to "real" in what I wrote (as opposed to what Kasriel wrote) means CPI-adjusted. As Kasriel suggests, there is little difference between the two. We tried both and settled on using the CPI, because that is what Shostak did, as explained in "Money Supply and Recessions"
• Starting with the recession of 1970, a negative spread on the 10-year Treasury minus the fed funds rate in conjunction with a contracting year-over-year change in monetary base/CPI has predicted recessions with no false signals. In Q3 and Q4 of 2005, the real monetary base contracted, but the interest rate spread still was positive. Now, the interest rate spread has turned negative, but the real monetary base is no longer contracting — just barely. Mish Note: The 10-year minus the three-month spread by itself has no false positives and no misses since 1970.

Final Thoughts

• Real M’ is a very good leading indicator. It also performs better in theory and practice in comparison with Real M2. Real M2 performs better than M2, and M’ performs better than M2. M’ is thus a better indicator than M2, no matter how it is compared (real or not)
• The 10-year minus the three-month is an exceptional leading indicator. It works better in practice than using the 10-year minus the FF rate
• No false signals have been given by the 10-year minus the three-month spread since 1970. False signals were given by spreads using the FF rate alone
• No false signals were given by a combination of real monetary base and the 10-year minus the FF rate spread (as per Kasriel, but not shown)
• Housing permits provide a valid leading signal. When the 0% line is decisively penetrated, a recession usually follows
• The S&P 500 is simply not a valid leading economic indicator. It is at best a marginal coincident indicator and perhaps should be ignored altogether. There are just too many false and/or missed signals
• Consumer sentiment may have some value as a coincident indicator, but it does not function well as a leading indicator.

This post is an attempt to find a methodology that makes theoretical sense and works well in practice, too. Five of the 10 widely used leading indicators were reviewed, one of which should be discarded outright, one redefined as a coincident indicator, and one (housing permits) seen as valid as it stands. Two leading indicator components had substitutes that seem to work far better in both theory and practice.

The charts show that M’ and the 10-year minus the three-month spread are both superior to similar indicators on the list. As time permits, I will take a look at the remaining five widely used leading indicators. Thanks once again to Bart at NowAndFutures for providing many charts based on specifications that I requested, and also to Paul Kasriel at Northern Trust for his time and comments.

Regards,
Mike Shedlock ~ "Mish"

January 15. 2007

Leading Economic Indicators was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.