What do you make of this latest triage of the broken financial system? It keeps things ticking over. But how do you fix a nation that has too much debt by adding more debt? The U.S. government, through its various agency paramedics, is injecting money and buying equity all over the economic shop. But it’s not cheap.

Bloomberg tallied up the various commitments, loans, and guarantees made on behalf of the U.S. taxpayer by various Federal agencies and non-elected officials. It was not a small number. It came to U.S. $7.76 trillion, a vaguely patriotic sum, echoing the year the Declaration of Independence was proclaimed in 1776.

You can read the Bloomberg article as an explication of dependence. Or better yet, a pledge of eternal subservience to the power of debt. The $7 trillion plus figure is nearly half of annual U.S. GDP. Just under half of it — $3.18 trillion — is money tapped by financial firms through various auction facilities. It goes to rebuild balance sheets, rather than building factories, bridges, or new sources of power.

The Federal Reserve is the biggest instrument of this ramp up in commitments. The Fed has pledged $4.74 trillion on behalf of Americans. That’s 61% of the total amount, and $24,000 for every man, woman, and child in America (born free, but now everywhere in debt). More on this in a moment.

Here in Australia, local shares should get a boost from rising commodity prices (provided no more margin loans get called on insiders and short sellers cover). Oil was up $4.50 to $54.43 for a 9% gain on the day. Gold shot up nearly $30 to $821.90 for almost a four percent gain. Copper was up 6%, nickel 7%, zinc 6.4%, and tin 11.3%. And what, pray tell, may have led to that move?

Chinese monthly refined copper imports were up 15% in October, an eight month high. But what China gives it may also take a way. Cochilco, China’s state-run copper outfit, cut is forecast for copper prices in 2009. Where does that leave us with the base metals and with base metal shares? We asked Diggers and Drillers editor Al Robinson.

“China’s resurgent demand for raw materials is already surprising the market,” he wrote to us via e-mail from 2 metres away. “It reverted to ‘net importer’ status in all base metals for October, according to the London Metal Exchange (LME). China already needs more resources than it can get its hands on.”

“It’s buying more rock than it’s selling, in other words. That’s great news for the Australian resource sector in 2009.

“But this story goes further,” he adds. “China isn’t experiencing some sort of meek comeback, following the Olympic slowdown. It actually imported enough copper in October to offset the rest of the LME’s inventory rise. The ‘rest of the world’ may not be setting commodity demand ablaze. But China is already starting to fill in the gaps created by Western recession — on its own.”

While China fills the gaps, you may also start to see some short covering from traders who went short the base metals. That short covering could lead to big one day moves in the shares (which are appallingly over-sold). But it may not quite mark the bottom in metals prices. That’s going to be a function of supply and demand (with supply tightening as projects are shelved and demand idling).

The other thing to look for is bargain hunting. Investors and fund managers who liquidated long positions in the resource sector earlier this year to raise cash may begin nibbling if they find the right share at the right price. Take China for example.

Recently the Australian reported that “Rio may sell stakes to china to reduce debt.” Rio’s Chairman Paul Skinner was in Melbourne to discuss, among other things, the possibility of Rio selling assets or an equity stake to China Inc. in order to help pay off some of Rio’s U.S. $9 billion in debt that matures in 2009. Maybe Rio should first ask the Fed before giving up equity to China. Bernanke can be pretty accommodating, we hear.

And now it is time to bring that U.S. $7.76 trillion back into the picture and put it in the context of Australian resource equities. The Citigroup bailout deal prompted a rally in stocks and a rise in U.S. bond yields on Monday. The yield on two-year U.S. notes rose as the government auctioned another U.S. $36 billion of them into the market.

It’s hard to believe the Citigroup deal unleashed a lot of pent up bullishness on U.S. financial stocks. It’s easier to believe that the ever-increasing supply of U.S. government bonds is prompting investors who’ve rushed into them to look around for other, more desirable assets. Chinese investors, for instance, might decide than an equity stake in Rio Tinto — with its portfolio of iron ore, coal, and other assets — is a better investment than more promises to pay by the U.S. government.

Perhaps we’ve been hasty, though, in calling the pricking of the bond bubble in the past. It could be that the U.S. dollar becomes the clear winner in the global currency wipe out currently taking place. The dollar could end up being the preferred liquid currency in which to ride out the global crisis, despite the inflationary nature of U.S. monetary and fiscal policy.

If that’s the case, then the U.S. Treasury market will continue to suck up the world’s supply of available savings and capital the way a bush fire sucks up oxygen. A fire sucking up all the oxygen in a system leads to a massive destruction of life. Hence the Greek word “holokaustos.”

According to the Merriam-Webster dictionary, a holocaust is a “sacrifice consumed by fire,” or, “a thorough destruction involving extensive loss of life especially through fire.” The holocaust of the Treasuries, then, is what we’re getting at. First crowd all the world’s capital into the U.S. bond market. Then burn it up.

Smart money generally goes where it’s treated best (for yield and capital appreciation). In times of fear, what’s safe is smart. And so now the world’s investors and savers have an interesting choice: is the U.S. bond market safer than cash? Is it smart to play it safe? Or are equities safer than bonds? Or are equity stakes in projects with tangible assets better bets still, even in a world with a shrinking economy?

Our guess is that the printing of the Treasuries (increasing in the supply of U.S. bonds to fund the mega bailout, fuelling the eventual inflationary fire) will gradually spook investors now and into 2009. The leading edge of bargain hunters may already be finding their way into over-sold resource stocks for refuge. And will they find it? Or will their courage end in more losses?

It wouldn’t be surprising to see big one-day gains in over-sold resource stocks in the coming months. But we reckon the real story is that investors are rethinking their long-term asset allocation and will execute a new strategy after reviewing their 2009 performance.

More cash, fewer shares. And of the money that remains in shares, it will probably be parked in long-term positions that are selling at cheap valuations, perhaps with a nice yield. Expectations will be lowered and time horizons-for equities anyway-will be lengthened. You’ll have to expect less and be willing to wait longer.

Not that being in the equity market during the most serious financial crisis since 1929 is a sure thing. We live in dangerous times. Not much is certain. But for investors, the actions taken by U.S. monetary officials are starting to lead to movements in global capital. This could signal the beginning of the bottom in commodity prices, and the beginning of bargain hunting in resource shares.

Regards,
Dan Denning

Parting Shot: Well, you can’t say you haven’t been warned. You know full well that the fed is gathering wood and squirting accelerant all over the place. They are going to make sure this currency burns till there is nothing left.

Possible Holocaust in U.S. Bonds was originally featured on Whiskey and Gunpowder

He did that to get your attention.

Fed chairs rarely ever say that word, for reasons that Greenspan learned on his first days in office back in 1987 — the same reasons that CEOs rarely comment on their stock’s valuation.

Bernanke’s original remarks came before Friday’s unemployment report rained on Wall Street.

But just in case anyone thought the weak report might have softened his stance over the weekend, on Monday, he repeated his determination to tackle increases in long-term inflation expectations, and to fix the dollar. The rhetoric helped boost the currency and splashed cold water on gold’s recovery.

I say “helped” because the Saudis did most of the work by announcing an output hike (500,000 bpd).

Let me tell you right out of the gate that, as a rule, the Fed talks tougher than it is capable of acting, especially with a new administration around the corner. Bernanke has nothing more in mind than taking away the interest rate stimulus, as Greenspan did after 2004 — gradually and marginally…if that!

What’s more, the consensus doesn’t expect any action near term. Even more crucially, ultimately, his resolve rests on the correctness of his premise that the risks to economic growth have abated.

The Fed is not ideologically equipped to tackle the duality of rising unemployment and rising prices. Do you really think it is going to hike rates while stocks are reeling?

No. It just assumes that won’t be happening at the same time that prices are generally still rising.

But what is most important to understand is the factor that stirred the hawkish rejoinder.

For it is obvious that the Fed is reacting to market sentiments. And those sentiments are what I want to bring to your attention.

Is This the Crackup?

Back in March, oil prices were just breaking through $100, and the Fed hinted that it was probably finished cutting interest rates. Investors started looking for a big commodity and oil price correction.

It wasn’t to be.

Oil continued charging higher, egged on by bullish calls from America’s biggest investment dealers.

It is now backing off a high of about $139 in the nearest futures contract. That’s up 40 percent in three months, 100 percent in 12 months and nearly 200 percent in fewer than two years. It’s up more than 1,000 percent over the past 10 years. The moves in crude have been nothing short of spectacular.

On May 21, when the front month was breaking through $130, I got a call from a friend of mine — an oil analyst who runs his own investment service out of New Jersey. Like me, he’s been bullish since the turn of the millennium, but neither of us expected anything like this. Is this the crackup, he asked?

That’s the first time someone asked me if this was it…you know, “it.”

The crackup is a stage of the inflationary boom that occurs late in the cycle — when the market gets the idea that money grows on trees…and it finally abandons the idea that “prices will one day drop.”

Fear marks this final stage — in particular, of the erosion in monetary values.

It is born of a revelation, according to its author: “Finally, the masses wake up” to the fact that “inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crackup boom appears.”

However, it is the final stage of the boom. It is relatively short. It could last days, weeks, maybe even months, but the author (Mises) did not have much more in mind than that.

It is literally the death of that particular money.

Importantly, Ludwig von Mises concludes, “If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds.”

The laws of supply and demand determine money’s value, as with anything else. And if the supply of something is unlimited, it’s not usually worth much. So the Fed likes to downplay the fact that it can or will print money “beyond all bounds.”

I doubt we are seeing the crackup.

But we are seeing some of the things that characterize the onset of the late stages of a long-in-the-tooth inflationary cycle — in which prices rise because people expect them to rise, and the demand for money drops as confidence in the economy and the world’s common medium of exchange erodes.

As Market Focus Shifts to Money Relation…

Bernanke senses that the market is making a dangerous transition.

If I could point to one catalyst, it would be that the commodity markets are making moves that make the situation difficult to explain in terms of regular supply-and-demand fundamentals. That is, people are finally asking questions like how could the total demand for oil have doubled in just 12 months?

As Dr. Benn Steil, an economist at the Council on Foreign Relations, on May 20 stated:

“If you want to explain this terrifying apparent shortage of food that we now have in the world, I don’t think you could possibly explain it based upon enormous growth in the world’s appetite for food over the past three quarters. It just can’t be done.”

Indeed, although it was completely unrelated to this speech, the question of crack-up came the day after Steil’s speech to the Committee on Homeland Security, in which he pinned the commodity bull market almost entirely on fiat money inflation, and drew attention to gold’s relative stability as money:

“Whereas the prices of oil and wheat measured in dollars have soared over the course of this decade, they have, on the other hand, been remarkably stable when measured in terms of gold — gold having been the foundation of the world’s monetary system until 1971. It is, therefore, reasonable to conclude not that we are  experiencing a commodities bubble, but, rather, the end of what might usefully be termed a ‘currency bubble.’”

George Soros’ subsequent comments last week regarding doubts about the dollar’s reserve status were like a beacon to the Fed. Undoubtedly, they provoked Bernanke’s rebuttal. For they reflect sentiments the Fed would rather discourage, as they are difficult to “control.”

For the past eight years, the big money has explained the commodity bull market in terms of events like Sept. 11, growth in Asia and other developing frontiers, previous underinvestment or the finiteness of commodities. The Fed has succeeded in discouraging the market from pointing its invisible finger at it.

But the commodity bull market is about to take on a whole new form…

Regards,
Ed Bugos
June 18, 2008

P.S.: With gold still readying itself for another historic run, there has never been a better time to begin investing in the miners that bring this gold to market. Readers of my Gold & Options Trader service have already heard the word on a new miner that has a new take on the process of mining itself.

Inflation and Commodity Prices was originally featured on Whiskey and Gunpowder

“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

John Maynard Keynes, an early 20th century economist, was the most influential advocate of government influence in the economy. Thanks to him, an entire generation of voters thinks the president “manages” the economy. Keynes’ followers, who populate the halls of government and academia, think the government needs to act when the free market “fails.” They propose government solutions to problems like “liquidity traps” and “insufficient demand.”

These alleged problems became so feared that the U.S. government decided it was necessary to move the dollar to a completely paper, faith-based system — despite historical evidence that every paper money system fails. The Federal Reserve has cemented its role as price fixer for short-term interest rates. It fuels speculative bubbles when the economy slows, and denies all responsibility when bubbles burst. The cycle then repeats.

The New Deal was Keynes’ idea. The era of colossal government — the New Deal — began as a popular reaction to the Great Depression. The Depression started when an inflation-fueled bubble popped, and worsened in the mid-1930s, when the government taxed capital away from entrepreneurs and reinvested it into “make work” programs.

This is one of many examples in which government power grew at the expense of the more efficient free market. These ideas, and the proposed solutions to them, distort the free market’s investment cycles and have gotten the U.S. to the point where it simply cannot function without asset inflation.

Today, the government proposes solutions to problems caused by government interference. Specifically, it and the Fed are throwing more money and credit at a problem that was caused by their own past initiatives to stimulate money and credit. Even a mere recession has become politically unacceptable.

China’s Success Hinges on Its Support for Free Markets

Keynesian economists tend to deny the free market the respect it deserves. It has had an amazing track record in recent centuries. Despite the destructive influences of nutty paper money schemes, deficits, taxation, regulation, and wars, most countries have progressed from subsistence farming to modern living standards at a stunning pace.

The free market rests on a foundation of mutual trust, price signals, profits, free trade, and property rights. It’s important for government to respect this foundation. Communist governments simply destroy it and, predictably, get chaos and poverty. Even in some capitalist countries, popular support for this foundation is shaky.

The Chinese, still Communist in name, but hardly in action, have gained some respect for the foundation of free markets. Their leaders are executing policies that promote better living standards, and they are using free market principles to achieve it. As a result, they prosper. But prosperity doesn’t advance without occasional setbacks. China is dealing with one right now: A shortage of above-ground coal.

In China’s highly publicized winter storm delays, we see an example of how slower economic growth can lead to higher consumer price inflation. Most economists would have you believe that growth causes inflation, when in reality, it’s the opposite. Real economic growth increases the supply of goods and services. So consumer prices would fall if the money supply were held constant. The Wall Street Journal recently reported:

The coal shortage has rippled through other commodity markets, hurting China’s output of steel, copper, zinc, and aluminum as electricity is being diverted for domestic industry and household heat and electricity. China’s largest copper producer, Jiangxi Copper Co., shut down some plants, contributing to higher U.S. copper futures:

Even though the Chinese government supports free markets to achieve its political goals, it still distorts investment cycles with monetary inflation and regulation. Its manufacturing capacity has grown beyond its power grid capacity. This slows real economic growth, which is cutting the supply and raising the price of copper in the U.S. futures market.

Chinese monetary policy, like that in the U.S., ensures that money supply can grow limitlessly at zero cost. No wonder prices for nearly everything are going up. Central banks have pushed inflationary policies beyond all reasonable limits. A recent issue of Grant’s Interest Rate Observer explains why this could be the top financial market story in 2008:

In the dollar and its institutions, there is a deep-seated contradiction. The Fed is America’s central bank, but the dollar is the world’s currency. More than a billion people work and save and spend in the non-American portion of the U.S. dollar bloc. It seems fair to guess that more than a few of them are fed up, if not with the distant institution that sets an interest rate, then with an inflation problem over which they seem to be powerless.

One of the top financial stories for 2008 just might be the dawning of this unwelcome truth on the average American central banker, bondholder, and consumer. Recently, The New York Times, in a dispatch from Shanghai, speculated that China was now exporting inflation, not deflation, and that, on account of this sea change, the American CPI would presently begin to tick higher.

The onset of recession would likely push back the return of what economists will eventually learn to call the “21st century secular inflation” (mark my words). A friend of mine muses that the dramatic re-pricing of ultra-cheap oil transformed the markets and economies of the 1970s. So, too, he speculates, will the dramatic re-pricing of ultra-cheap Asian labor deliver a seismic jolt to the markets and economies of the present day. If so, the dollar, no less than the euro, is likely to suffer impairment against the kind of assets that central banks just can’t print.

If you’re a regular reader of Whiskey & Gunpowder, you probably agree that individuals make better spending and investing decisions than governments. Yet Keynesian plans to “fix” the economy — whether through regulation or inflation — remain uncomfortably popular. The conditions are set for a dramatic consumer price inflation reawakening — if not in 2008, then over the next decade. Long-term bonds are priced to provide negative real after-tax returns over the next decade. Invest accordingly.

Regards,
Dan Amoss, CFA
March 19, 2008

How Paper Money Distorts Investment Cycles was originally featured on Whiskey and Gunpowder

Complicating matters is the fact that both adversaries have powerful allies. The Fed has the Treasury and the government, as well as the Wall Street elite, as allies. The government could implement massive tax cuts in order to stimulate economic activity; the Treasury could bail out financial institutions, which in reality should be punished by bankruptcy; and the moneyed Wall Street elite will ensure that politicians and the Fed make it possible for them to continue their con game.

The private sector has allies in the form of inflation, a weak dollar, and a dissatisfied public (declining consumer confidence and lack of trust in government, which is reflected in the strong showing of Ron Paul), all of which form a powerful phalanx when battling the Fed’s reflation attacks. Inflation is a powerful ally for the private sector, because it squeezes corporate profits and curbs personal consumption.

The war between the Fed and the private sector will, in my opinion, be very protracted. The Fed will win some battles, which — along with much brouhaha in the media — will see Pyrrhic victories such as the stock market rally of August-early October, which led in dollar terms to new highs, but failed to do so in euro and gold terms, and was followed in euro terms by renewed severe weakness.

Other battles will be won by the private sector, which through its contraction (recession) amid inflation will lead to sharp downward movements in equity prices. I am well aware that the Bureau of Labor Statistics and the Bureau of Economic Analysis will continue to use bogus figures when reporting inflation, and hence real GDP growth, but they won’t be able to hide the squeeze on corporate profits and the consumer from rising prices.

Cost of living increases vastly exceed the reported inflation figures and are squeezing the consumer, which leads to revenue pressure for the corporate sector. According to the Kaiser Family Foundation, health insurance premiums have risen 78% since 2001, while wages have gained only 19%. At the same time, corporations are faced with a squeeze on margins due to rising costs. Cost pressures contributed to the dismal performance of earnings in the third quarter of 2007.

For example, Starbucks increased coffee prices by an average of nine cents per cup in July. However, customer visits to U.S. stores fell 1% for the quarter ended Sept. 30. According to the CFO, “Unbeknownst to us, we saw economic head winds that, quite frankly, came up probably stronger than I thought.” Earlier, Starbucks’ CEO had remarked: “The consumer is being faced with rising costs in every sector of their lives, and so part of that is reflecting on us.” An informed friend of ours suggested that declining traffic at Starbucks stores in the U.S. is of particular concern, since Starbucks serves all income levels. Therefore, declining traffic is not just a “subprime problem”!

This rate of economic contraction would seem to be consistent with the impending slump in corporate profits, and with the observation that the U.S. economy is already in recession.

Investment Observations

On one side of the new inflation war, the Fed is pumping liquidity into the system via rate cuts and repurchase agreements. On the other, the financial sector is withdrawing liquidity from the system via huge write-offs and newly timid lending policies. This war should lead to increased volatility. Ten percent market moves will be the order of the day.

As was the case in the 1970s, we can expect the stock market to sell off by more than 20%. At the time, the two adversaries facing each other were “easy monetary policies by the Fed” and “consumer price inflation.”

Nobody won that war decisively, since stocks in 1982 were at about the same level they had been in 1964. However, since U.S. equities had declined in real terms by 70% from their real 1966 peak to their real August low, one can now assume that the Fed lost that war. Today, the adversaries are the private sector, which with its inflated asset values now wants to deflate, and the Fed, which under Bernanke and Greenspan, never quite understood that larger and larger injections of liquidity into the system, leading to excessive debt growth, brings about a gross misallocation of capital.

I have no doubt that the Fed will lose this war as well — if not in nominal terms, then in real terms, or adjusted for the sinking value of the U.S. dollar. More to the point, the Fed has already lost this war: U.S. equities fully recovered after October 2002 and made an all-time high in October 2007 in dollar terms, but even at their recent highs they were down by 37% in Euro terms (measured by the S&P 500) and by 60% in gold terms.

Still, we have to be mindful that even if the present economic and financial environment doesn’t look particularly enticing, as was the case between 1964 and 1982 when the market didn’t make any headway, plenty of investment opportunities will present themselves from time to time for the nimble trader and for the long-term investor who will be positioned in the few asset classes that will perform well.

Moreover, it would be wrong to simply assume that recession and slumping corporate profits will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed Funds rate, a weak dollar, and “bubbly” emerging markets could make U.S. equities a relatively attractive proposition compared to other financial assets.

With Bernanke at the Fed and Paulson at the Treasury, and a Euro that could face some problems (a breakup, some believe) because of badly deteriorating economic conditions in Italy, Spain, Portugal, and Greece — precious metals are likely to outperform financial assets for some years to come, resulting in the persistent decline of the Dow/gold ratio.

As Michael Berry remarked, “Gold is no friend to the world’s central bankers. The printing press is their friend.” In fact, I would be very surprised if the Dow Jones Industrials/Gold Ratio didn’t decline to between 5 and 10 within the next three years. Therefore, I should like to reiterate my recommendation to accumulate gold.

Other commodities that could come to life this year are sugar, cotton, natural gas, and palladium. Moreover, uranium is unlikely to disappoint the longs. In general, some special situations aside, I am not positive on industrial commodities in a slow growth or recession type of environment.

Among commodities and currencies, my preferred asset remains physical gold held outside the U.S., for the simple reason that — depression or inflation — it is very likely to outperform financial assets. For gold, I believe the best is yet to come!

Best regards,
Marc Faber
March 4, 2008

The Struggle Between Inflation and Lending was originally featured on Whiskey and Gunpowder