Hera

Why Financial Repression Will Fail

Ron Hera — Fri, 16 Nov 2012 17:53:00 GMT

Excessive leverage and risk in the financial system, e.g., using customer funds to speculate, never ends well. Stock market crashes, bank and investment firm failures or economic recessions are all potential consequences. Following the failure of the United States to regulate over the counter (OTC) derivatives and the repeal of the Glass-Steagall Act, U.S. banks became the largest financial business entities in history. The U.S. real estate bubble, sub-prime lending and mortgage backed securities (MBS), along with unregulated OTC derivatives, then lead to bank insolvencies, a historic stock market crash and a near collapse of the global financial system.

Central banks and governments intervened to prevent systemic collapse but governments were saddled with enormous debts due to bank bailouts, lost tax revenues and massive social welfare costs. Rather than systemic collapse, and perhaps another Great Depression, the post crisis period came to be characterized by (1) market interventions, (2) direct government control over the economy, and (3) ongoing monetization by central banks. Longer term solutions that would have allowed a return to putatively free markets failed to emerge and government debt, particularly in Europe, became a crisis in its own right.

Measures that began as emergency interventions became routine suggesting a new economic paradigm. In the new paradigm, big banks, politicians and academics would decide what market outcomes, e.g., bankruptcies, interest rates or bond yields, would be permitted, as well as when to apply accounting rules, regulations and laws. Despite increased centralization of decision making and greatly expanded powers, however, policymakers were unable to repair the financial system. Instead, mounting government debt led to de facto financial repression.

Financial repression occurs when governments channel funds into their own sovereign bonds in order to reduce debt levels through mechanisms such as directed lending, caps on interest rates, capital controls, debt monetization, or by other means. Economist Carmen M. Reinhart, et al., brought the term back into popular usage in 2011 after a long hiatus. Past examples of financial repression include several South American countries, such as Argentina. The promise of financial repression is that it will hold down government borrowing costs and reduce government debt levels, but critics argue that financial repression merely targets the producers of society, i.e., the middle class, and therefore harms the economy.

The Liquidation of Government Debt , Carmen M. Reinhart and M. Belen Sbrancia (NBER 16893, 2011)

Debt monetization, which can be a tool of financial repression, destroys savings while a zero percent interest rate policy (ZIRP), which reduces government borrowing costs, deprives savers and pensioners of interest income and can lead to inflation. What is more important, however, is that financial repression prevents capital formation. Of particular concern in the U.S. is the link between capital formation and new business creation, which is primarily a middle class phenomenon. The vast majority of corporations in the U.S. are small businesses and they account for the majority of jobs. By preventing capital formation, financial repression short circuits the engine of new business creation, increases unemployment and threatens to bring down the middle class.

Governments cannot supply entrepreneurship or innovation in the marketplace, nor can they effectively replace savings (genuine capital derived from surplus production) or private investment with bank credit or with public funds, which represent debt and a transfer of wealth, respectively. The deployed capital, inventions, products and services of new businesses drive innovation, fuel competition, provide jobs and increase the wealth of society. In contrast, financial repression can only produce economic stagnation and result in a net loss of wealth to society.

Crisis and Consequence

Substantially as a consequence of the financial crisis and global recession, Europe was engulfed in a sovereign debt crisis characterized in the European periphery by austerity measures and Great Depression levels of unemployment. In the U.S., the real estate collapse and stock market crash represented a direct loss of household wealth while bank bailouts represented a transfer of wealth from proverbial Main Street to literal Wall Street. Deficit spending, debt monetization and the Federal Reserve’s purchases of MBS and U.S. Treasury bonds expressed a radically inflationary monetary policy and, although much of the money is idle in the banking system, the overall increase in the supply of U.S. dollars is concerning. The True Money Supply (TMS), formulated by famed economist Murray Rothbard, represents the amount of money in the economy that is available for immediate use in exchange.

Despite the 2008 financial crisis, global recession and inflationary policies, confidence in the U.S. dollar, the U.S. stock market, the U.S. federal government and the U.S. economy remained largely intact. Inflationary policies reduced certain risks, such as the risk of a deflationary collapse, and increased liquidity from central bank monetization lifted financial markets, but the effects were only temporary. Confidence was also boosted in Europe by the European Central Bank’s (ECB) outright monetary transactions (OMT) program and in the U.S. by the Federal Reserve’s quantitative easing III (QE3) program. In Europe, the risks of sharply rising sovereign bond yields, sovereign defaults and the potential breakup of the euro were muted by OMT while European leaders putatively moved toward a permanent solution, such as a fiscal union. Thanks in part to the Federal Reserve’s ZIRP and ongoing “operation twist,” U.S. Treasury yields remained near historic lows.

On the surface, the fallout of the 2008 financial crisis was effectively managed, but the basic causes of the crisis were never addressed. The lines between depository institutions and securities firms, erased in the U.S. by the final repeal of the Glass-Steagall Act in 1999, were not restored and the U.S. Financial Accounting Standards Board’s (FASB) mark-to-market rule was never reinstated.

Although bank capital ratios have improved, leverage remains excessive, bank balance sheet assets remain troubled and economic conditions have deteriorated compared to the pre-crisis period. Banks deemed “too big to fail” in 2008 have become bigger and the gross credit exposure associated with high risk OTC derivatives is roughly as large as it was before the financial crisis. By the end of 2013, the Federal Reserve’s balance sheet will have exceeded $3.4 trillion. At the same time, the U.S. federal government faces a so-called “fiscal cliff.”

The Road to Stagflation

For 2012, the International Monetary Fund (IMF) projects GDP 2.2% growth in Japan and the U.S. and 3.5% globally. Based on the Baltic Dry Index (BDI), which reflects the price of moving major raw materials by sea, the global economy has slowed in 2012. Nonetheless, there has been some improvement in comparison to the depths of the global recession in 2009.

The BDI is a leading indicator of economic growth because it reflects the demand of manufacturers for raw materials. A decline in the BDI signals falling global demand for manufactured goods. In the U.S., rail carloads also indicate falling demand.

In contrast, removing potentially optimistic projections, the U.S. Energy Information Administration’s (EIA) liquid fuels consumption data suggests an anemic recovery in the U.S. on a par with 2011.

Despite the recent uptick in U.S. manufacturing, manufacturing currently accounts for only 11.7% of U.S. GDP. In the past few decades, U.S. corporations moved production offshore, eliminating domestic jobs. Credit expansion masked the lost income of U.S. consumers but the process inexorably reached its logical conclusion in 2007. The shift of U.S. workers to often lower paying service sector jobs was counterproductive because debt levels rose while income flowed out of the U.S. following on the heels of jobs.

Although policymakers, including Federal Reserve Chairman Ben Bernanke, deny it, in fact, U.S. unemployment is a long term, structural problem linked to the still ongoing outflow of U.S. consumer incomes to net exporter countries such as India and China.

The current surplus of U.S. labor, abundant capital and somewhat less expensive energy (partly due to advances in hydraulic fracturing that have increased U.S. domestic oil production) are insufficient to stimulate a broad-based economic recovery. In addition to the U.S. federal government’s growing debt and need for increased tax revenues, U.S. consumers remain burdened with high debt levels.

A U.S. manufacturing renaissance, for example, is unlikely to take hold unless the U.S. dollar weakens significantly and global demand also rises. In a global slowdown it remains unclear where new customers might come from for new U.S. products or services.

Although the financial system has continued to function due to massive infusions of liquidity, economic activity, with some exceptions, has not generally recovered or has continued to deteriorate, e.g., the shrinking number of U.S. citizens participating in the official workforce. Ignoring improvements in the unemployment rate related to the shrinking size of the workforce, much of the U.S. economic recovery in the post crisis period can be attributed to government deficit spending.

U.S. GDP has been boosted by government deficit spending in excess of $1 trillion per year. Removing the temporary effects of extraordinary deficits, U.S. GDP remains negative. Compounding the problem, loose monetary policies, rather than spurring lending to consumers or small businesses, have created inflationary pressures and have lead to stagflation.

Rather than putting Americans back to work, inflationary policies have helped to push prices higher. Based on U.S. Consumer Price Index (CPI), the official inflation rate in the U.S. is roughly 2%, but the CPI does not accurately measure the cost of maintaining a constant standard of living. Using the same methodology as in 1980, the CPI should be 9.3% currently.

Inflationary central bank policies support government borrowing and the banking system but increased liquidity resulting from low interest rates, central bank asset purchases or debt monetization can have destabilizing effects. Excess liquidity can result in price inflation, fuel financial speculation or asset price bubbles, or provoke competitive devaluations (currency wars). Asset purchases and debt monetization by central banks alter the distribution of money, thus of purchasing power over the economy and therefore redistribute wealth. Monetary inflation erodes the value of savings replacing genuine capital distributed throughout the economy with credit concentrated in banks. In the U.S., one of the Federal Reserve’s policy assumptions is that asset purchases will help small businesses by making more credit available. While it is true that small businesses rely on bank credit for operations and expansion, it is savings, not credit that fuels small business creation and therefore job growth. Since most U.S. jobs are in small businesses, QE3 and similar policies destroy jobs by redistributing wealth from savers, entrepreneurs and investors to banks and stifling new business creation. The combination of reduced new business creation, continuing high unemployment and inflationary price pressures set against a backdrop of high debt levels precisely defines stagflation.

Reign of Repression

The stagflationary environment in the U.S. is a mild example of financial repression. Countries in the European periphery, e.g., Greece, Italy, Spain, Portugal and Ireland, where high taxes and austerity measures are already in place, are more pointed examples. In the case of Greece, which has descended into an economic depression, the natural market outcome would have been a Greek default and an exit from the European Monetary Union (EMU) accompanied by losses for European banks and quite probably a number of European bank failures, along with the systemic impact of associated OTC derivatives, such as Credit Default Swaps (CDS). To prevent bank losses and failures, however, policy decisions replaced market outcomes. The normalization of market interventions, direct government control over the economy and ongoing monetization by central banks represented a transition from a market based status quo to a policy based status quo which maintained or increased otherwise unworkable government debt levels. Maintaining the status quo, however, requires financial repression.

Like the emergency measures that preceded it, financial repression has become a fixture in a new economic paradigm, but it is no more likely to provide a permanent solution. Financial repression will remain in place as long as bank failures and sovereign defaults continue to be prevented, e.g., through bailouts, asset purchases or debt monetization by central banks. Overall economic conditions in Western countries can therefore be expected to remain stagnant or to deteriorate. The continued debasement of major currencies, such as the U.S. dollar and the euro, will reduce the real value of debts but monetary inflation cannot create a genuine economic recovery as long as bank balance sheets and government finances remain impaired. Without robust economic growth, however, both the banking system and the finances of Western governments certainly will remain impaired. In other words, financial repression in the U.S. and in Europe is set to remain in place indefinitely.

Under an ongoing regime of financial repression, savings, jobs, economic opportunity and living standards will all suffer. The middle class will be reduced as generations of socioeconomic progress are gradually reversed. Younger people, mired in stagflation, will be left behind in terms of income and economic opportunity, which will have a long term negative impact. Since U.S. banks stand to profit from financial repression, it will increase income disparity and the concentration of wealth. The destructive forces set in motion by financial repression will greatly increase the burden on government social welfare programs. Thus, financial repression will fail to alleviate government debt unless tax increases and austerity measures follow, which could turn the United States into another Greece. In theory, financial repression, together with other measures, can liquidate government debt but, in practice, it is a destructive and highly destabilizing approach that will result in a net loss of wealth to society.

Financial Crime Is A Systemic Risk

Ron Hera — Tue, 23 Oct 2012 11:38:00 GMT

Famed Austrian economist Ludwig von Mises wrote in his seminal work, Human Action (originally published by the Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” The collapse of a historic credit bubble occurred in 2008. However, despite years of further credit expansion, “a final and total catastrophe” of the U.S. dollar system has yet to occur.

While an inflationary U.S. monetary policy has serious consequences, hyperinflation is not an immediate result. There are three general ways in which the U.S. dollar system could break down: (1) rejection of the U.S. dollar as the world reserve currency, or (2) as an eventual consequence of U.S. federal government insolvency and (3) a domestic failure of confidence. Of the three, U.S. federal government insolvency is the most serious because it would result in both the loss of the U.S. dollar’s world reserve currency status and also in a failure of domestic confidence. However, a new threat to the U.S. dollar has emerged which could trigger a hyperinflationary collapse before the U.S. federal government’s finances become unworkable, e.g., when debt service begins to crowd out military and Social Security spending. Specifically, the perceived legitimacy of the U.S. financial system has not merely been tarnished by recent scandals but is in danger of collapsing. The consequences of a domestic breakdown of confidence and trust in the U.S. financial system cannot be overstated.

World Reserve Currency Status

The most commonly cited challenge to the U.S. dollar system relates to its waning status as the world reserve currency. The BRIC countries (Brazil, Russia, India and China), along with South Africa, no longer use the U.S. dollar for trade settlement amongst one another. The Chinese have internationalized the renminbi (RMB), which is now used in trade settlement with the other BRIC countries, as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African countries under bilateral agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars in exchange for crude oil since 2009. While European countries utilize the euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready to settle international trade using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant.

At the global level, the implicit crude oil backing of the U.S. dollar by the Organization of the Petroleum Exporting Countries (OPEC) remains in place and the U.S. military remains dominant. As long as OPEC backs the U.S. dollar, and as long as there is no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example, is a troubled currency and its future is questionable. China’s economic ascent is likely to continue and the RMB can be redeemed for Chinese-manufactured goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency and China’s military is not ready to take on the role of a global superpower.

At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there is no consensus regarding its eventual replacement. However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against inflation.

OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were no longer viable, i.e., if the prices of global commodities, and especially the price of gold, were to rise at an accelerating rate measured in U.S. dollars. China and Russia, for example, are significant buyers of gold and crude oil can be purchased with gold instead of U.S. dollars pursuant to bilateral agreements, if not on world markets generally. An eventual return to the gold standard is possible but seems unlikely in the near term.

Governments, banks and corporations around the world hold trillions of U.S. dollars along with U.S. dollar denominated financial assets, such as U.S. stocks and U.S. Treasury bonds. Even countries hostile to the United States cannot benefit by refusing U.S. dollar transactions or by dumping U.S. Treasury bond holdings in the market. Ignoring the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support the U.S. dollar, retaining the majority of the value of U.S. dollar holdings is always a superior alternative in the short run, particularly if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s collapse, a 100% loss.

In other words, the tolerance of the world financial system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions, i.e., Operation Twist, and quantitative easing is far greater than is commonly believed. The U.S. dollar certainly will be replaced as the world reserve currency at some point in the future, but claims that the U.S. dollar is in danger of imminent collapse as a result of international rejection are exaggerated.

U.S. Federal Government Debt and Unfunded Liabilities

Setting aside the world reserve currency status of the U.S. dollar, the largest threat lies in the risk of U.S. federal government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases or government budget cuts will allow it to pay back its public debt and also meet its unfunded liabilities.

As a percentage of GDP, total U.S. federal government debt is larger than that of Spain and nearly as large as that of Portugal and Ireland.

The U.S. federal government’s budget deficit, which stands at approximately 8.7% of U.S. GDP, is as high as that of Greece and higher than those of Spain, Portugal and Italy.

Total U.S. government spending at all levels is approximately 40% of GDP and, unless economic conditions improve, will increase further. Unfunded liabilities of the U.S. federal government total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion) and obligations for Medicare ($24.8 trillion), Social Security ($21.4 trillion), military retirement and disability benefits ($3.6 trillion), federal employee retirement benefits ($2 trillion) as well as state and local government obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected U.S. federal government insolvency and, as a result, hyperinflation, as soon as 2014. Mr. Williams’ projections do not include the fact that numerous U.S. states, counties and cities are insolvent or at risk for bankruptcy.

The insolvency of a sovereign nation becomes inevitable once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency. The more unworkable U.S. federal government finances become, the more likely a hyperinflationary collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of the U.S. dollar is increasing at an accelerating rate.

An inevitable outcome is not necessarily an immediate one and U.S. policymakers are masters of “kicking the can down the road.” Another financial crisis or a further economic decline in the U.S. could accelerate the financial breakdown of the U.S. federal government, but a robust U.S. economic recovery, technological breakthroughs and other decelerating factors could delay it.

Despite the fact that Mr. Williams’ Hyperinflation Special Report 2012 is required reading, the timing of the predicted outcome assumes a low international tolerance for the monetization of U.S. federal government debt. Mr. Williams implicitly assumes that the market for U.S. treasuries is a free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse, but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate U.S. Treasury bond yields and the value of the U.S. dollar for an indefinite period of time. On one hand, according to Herbert Stein’s Law, “If something cannot go on forever, it will stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except for all the rest.’

Since the start of the Federal Reserve System, the U.S. dollar has passed one apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is imminent. The roots of the arguments generally date back to 1971 when Nixon closed the gold window. Severing the link to gold was a crucial point of no return, but, more than forty years later, a hyperinflationary collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead for the U.S. dollar.

Domestic Confidence in the U.S. Dollar

Within the United States, outside of Wall Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure. In other words, private sector debt levels remain high and money is relatively scarce in the ‘real economy’. Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young people.

A scarcity of physical notes or a race to shed currency in favor of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by the U.S. federal government and by the Federal Reserve has thus far proven sufficient to prevent a panic. U.S. households do not generally have cash and often rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered hyperinflation in recent history, U.S. citizens have no practical alternative currency. In the absence of runaway inflation, the impetus to flee the banking system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless of U.S. monetary policy.

An outlying but growing problem is the risk of a breakdown of confidence and trust in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement pose a serious threat to the U.S. dollar system.

Before the 2008 financial crisis, confidence in the U.S. financial system was shaken by fraudulent sub-prime mortgage lending and securitization practices. The collapse of the housing bubble and the 2008 financial crisis revealed profound systemic risks. In 2010, the so-called “Flash Crash” reopened questions about the stability of U.S. financial markets and, in 2011 “robo-signing” and other foreclosure frauds were reminiscent of sub-prime lending.

In late 2011 and 2012 perception of the U.S. financial system suffered a staccato of blows, including the failure of MF Global Holdings Ltd., with the loss of $1.6 billion in customer funds; JPMorgan Chase & Co.’s $6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest), with the loss of over $200 million in customer funds; money laundering by HSBC for drug cartels, including Mexico’s most violent criminal organization, Los Zetas, and for states that sponsor terrorist organizations; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440 million; as well as a growing number of civil and criminal cases linked to mortgage, foreclosure and securities fraud.

Scandals elsewhere in the world, such as the rigging of the London Interbank Offered Rate (LIBOR) by Barclays, in cooperation with other banks, including JPMorgan Chase & Co. and Citigroup, Inc. in the U.S., further undermine confidence in the U.S. financial system.

A Black Swan?

Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement could trigger a hyperinflationary collapse. The result of a domestic breakdown of confidence and trust in the U.S. financial system would not be a traditional run on banks or a rush into cash due to mistrust of banks (creating demand for physical notes) or a rush out of dollars into hard goods due to runaway inflation but rather a run on financial markets. If investors, pensioners, private institutions and fund managers withdraw from the markets in order to preserve their capital, it could potentially cause not merely a stock market decline but a crash. In the worst case, a domestic breakdown of confidence and trust could lead to a near total collapse of U.S. financial markets. The failure of financial firms, the accelerated disintegration of the U.S. dollar’s world reserve currency status and the final bust of the U.S. government’s finances would follow. Neither the federal government nor the Federal Reserve can fix the U.S. financial system if its perceived legitimacy were to fail. An inflationary policy response, at that point, would only exacerbate the problems of the U.S. dollar. History may record yet again that “there is no means of avoiding the final collapse of a boom brought about by credit expansion” because the escalating moral hazard engendered by limitless bailouts is itself a cause of collapse.

Neil Barofsky: Another Financial Crisis All But Inevitable

Ron Hera — Tue, 18 Sep 2012 15:24:00 GMT

Hera Research is pleased to present a sobering interview with Neil Barofsky, Senior Research Scholar, Senior Fellow and Adjunct Professor of Law at the New York University School of Law. From December 2008 until March 2011 Mr. Barofsky served as the Special Inspector General for the $700 billion U.S. Troubled Asset Relief Program (TARP) that bailed out the U.S. banking system in 2008.

In his role as Inspector General, Mr. Barofsky’s mandate was to root out and prosecute waste, fraud and abuse. He gained nationwide recognition for his courage and willingness to stand up to the most powerful people and institutions in Washington D.C. and on Wall Street and for his relentless criticism of U.S. Treasury Department officials, including U.S. Treasury Secretary Tim Geithner.

Prior to his role as Inspector General, Mr. Barofsky served as a federal prosecutor in the United States Attorney’s Office for the Southern District of New York for more than eight years. In that office, he headed the Mortgage Fraud Group as Senior Trial Counsel, to investigate and prosecute all aspects of mortgage fraud, from retail mortgage fraud cases to investigations involving potential securities fraud with respect to collateralized debt obligations (CDOs).

During his tenure as a member of the Securities and Commodities Fraud Unit, Mr. Barofsky gained extensive experience as a line prosecutor leading white collar prosecutions including the case that led to the conviction of Refco Inc. executives. For his work on the Refco matter, Mr. Barofsky received the U.S. Attorney General’s John Marshall Award.

Mr. Barofsky also led the investigation that resulted in the indictment of the top 50 leaders of the Revolutionary Armed Forces of Colombia (FARC) on narcotics charges, which is the largest narcotics indictment filed in U.S. history.

Mr. Barofsky’s critically acclaimed book, “Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street,” is a play-by-play, behind-the-scenes account of insider-dealing and mishandling of financial bailouts by the U.S. Treasury Department.

Mr. Barofsky is a magna cum laude graduate of the New York University School of Law.

Hera Research (HR): Thank you for joining us today. Why do you remain a critic of the TARP when the $700 billion has been paid back?

Neil Barofsky: To talk about the TARP only in terms of saving banks is revisionist history. When the financial crisis hit in 2008, then Treasury Secretary Henry Paulson went down on bended knee before the Speaker of the House, Nancy Pelosi, and essentially begged Congress to enact a bailout program in the measure of $700 billion. It was pitched as a bailout program to buy troubled assets including mortgages and mortgage related assets.

HR: Did the TARP go beyond saving banks?

Neil Barofsky: Yes. As the conversation between the Bush administration and Congress continued and the legislation was submitted, voted down, rewritten and eventually passed, a lot of things changed. First, the authority that Secretary Paulson got went well beyond buying mortgage related assets. Second, demands that Congress put on Treasury to authorize the $700 billion included helping homeowners and the economy. When the bill was passed it had sections that dealt with mortgage modifications and stimulating the economy.

HR: So the goals of the TARP changed?

Neil Barofsky: Yes. You have to go back and look at what the initial goals were; at what Treasury said it intended to accomplish and at the promises that Congress required Treasury to make.

HR: Were the original goals ever accomplished?

Neil Barofsky: No. If you look at the original goals, you can only conclude that the TARP was a failure.

HR: How could that happen?

Neil Barofsky: I think many members of Congress didn’t realize how much the definitions in the legislation were expanded so that a troubled asset could be almost anything and a financial institution could be any regulated company, basically any public company and most private companies.

HR: Are you saying that it was bait and switch?

Neil Barofsky: By no means. The leadership in Congress was well aware that the legislation was giving Treasury a lot more latitude. The whole concept of using the money to fill in capital holes by buying shares of stock in the banks instead of buying mortgage related assets was specifically contemplated and in some quarters even encouraged by members of Congress. However, some members of Congress, those who were not in leadership positions, felt like it was bait and switch where instead of buying troubled assets, the program became a giveaway for banks.

HR: Did the TARP help to stem the financial crisis?

Neil Barofsky: Absolutely. It helped deal with a very acute, short term problem. There was a presumption in the market after Bear Stearns was bailed out in a sweetheart deal with JPMorgan Chase—I mean Bear Sterns’ creditors were bailed out—and after Fannie Mae and Freddie Mac were taken into conservatorship, that the U.S. government would stand behind “too big to fail” financial institutions. When Lehman Brothers Holdings was allowed to collapse, the presumption of bailout was removed and it caused an incredible panic. The government had painted itself into a corner by encouraging the growth of financial institutions and the presumption of bailout. So when Lehman Brothers collapsed it caused runs on large financial institutions that certainly would have caused some of them to fail. There was a perceived need for the U.S. government to make a bold statement that they would never let any of these institutions fail. The TARP along with other extraordinary programs undertaken by the FDIC and the Federal Reserve all worked together to prevent the financial crisis from becoming much larger.

HR: How was the Bear Stearns acquisition a sweetheart deal for JPMorgan Chase?

Neil Barofsky: The U.S. government took off about $30 billion of the most toxic assets in Bear Stearns and then, having shifted the toxic assets to American taxpayers, facilitated the purchase of the company by JPMorgan Chase for a song without any risks. They paid $10 per share when it was trading a week before at $69.75 and no longer had those toxic assets.

HR: Did the TARP help to restore confidence in U.S. institutions and financial markets?

Neil Barofsky: Yes, but it was intended and required by Congress to do much more than that and Treasury said that it was going to deploy the money into banks to increase lending, which it never did.

HR: Were the initial goals of the TARP realistic?

Neil Barofsky: First, if the goals were unachievable, Treasury officials should never have promised to undertake them as part of the bargain. Second, even if the goals were not entirely achievable, it would have been worth trying. Treasury officials didn’t even try to meet the goals.

HR: Can you give a specific example?

Neil Barofsky: The justification for putting money into banks was that it was going to increase lending. Having used that justification, there was an obligation, in my view, to take policy steps to achieve that goal, but Treasury officials didn’t even try to do it. The way it was implemented, there were no conditions or incentives to increase lending.

HR: What policy steps could the U.S. Department of the Treasury have taken to help the economy?

Neil Barofsky: There are all sorts of things that Treasury could have done. For example, they could have reduced the dividend rate—the amount of money that the banks had to pay in exchange for being bailed out—for lending over a baseline, which would have decreased the bank’s obligations. Or, they could have insisted on greater transparency so that banks had to disclose what they were doing with the funds. Treasury chose not to do any of these things.

HR: Weren’t there other housing programs like the Home Affordable Modification Program (HAMP)?

Neil Barofsky: Yes, but there were choices made to help the balance sheets of struggling banks rather than homeowners. The HAMP program was a massive failure but it wasn’t preordained. It was the result of choices made by Treasury officials.

HR: What could have been done differently in the HAMP?

Neil Barofsky: HAMP was deeply flawed with conflicts of interest baked into the program. The management of the program was outsourced to the mortgage servicers, which were thoroughly unprepared and ill equipped. The program encouraged servicers to extend out trial modifications. It was supposed to be a three month period but it often turned into more than a year. The servicers, because they could accumulate late fees for each month during the trial period, were incentivized to string the trial periods out then pull the rug out from under the homeowner, putting them into foreclosure, without granting a permanent mortgage modification. The servicers could make more money doing that then by doing mortgage modifications. If they had done permanent mortgage modifications, the banks couldn’t have kept the late fees.

HR: Are you saying that the program encouraged banks to extract as much cash as possible from homeowners before foreclosing on them anyway?

Neil Barofsky: Yes. The mortgage servicers exploited the conflicts of interest that were in the program, and blatantly broke the rules, and Treasury did nothing.

HR: When you were serving as Inspector General for TARP, you issued a report indicating that government commitments totaled $23.7 trillion. What was that about?

Neil Barofsky: $23.7 trillion was simply the sum of the maximum commitments for all the financial programs related to the financial crisis. The number was misconstrued as a liability but the government never stood to lose that much. For example, the government guarantee of money market funds was a multi-trillion dollar commitment. Of course, not all of that money could have been lost because it would have required every fund to go to zero. The government guaranteed commercial paper but, again, for that commitment to have been wiped out, every company would have had to have defaulted. But the numbers were very important in terms of transparency. All of the data were provided by the agencies responsible for the various programs, so the $23.7 trillion number was simple arithmetic. It was important to understand the scope of the extraordinary actions that were being taken.

HR: What are the potential future losses that the U.S. government—that taxpayers—might have to absorb?

Neil Barofsky: The real issue is the potential for another financial crisis because we haven’t fixed the core problems of our financial system. We still have banks that are “too big to fail.” Standard & Poor’s estimated last year that the up-front cost of another crisis, including bailing out the biggest banks yet again, would be roughly 1/3 of the U.S. gross domestic product (GDP) or about $5 trillion. The resulting problems will be even bigger.

HR: What were the problems resulting from the 2008 financial crisis?

Neil Barofsky: When you look at the fiscal impact of the 2008 crisis, you have to look at it not only in terms of lost tax revenues and increased government debt, but also in terms of the loss of household wealth. People who became unemployed suffered tremendous losses and the government’s social benefit costs expanded accordingly. One of the reasons we had the debt ceiling debate last year, when the U.S. credit rating was downgraded, and why we are facing a fiscal cliff ahead is the legacy of the 2008 crisis. We have a lot less dry powder to deal with a new crisis and we almost certainly will have one.

HR: Why do you expect another financial crisis?

Neil Barofsky: It just comes down to incentives. A normally functioning free market disciplines businesses. The presumption of bailout for “too big to fail” institutions changes the incentives of a normally functioning free market. In a free market, if an institution loads up on risky assets with too little capital standing behind them, it will be punished by the market. Institutions will refuse to lend them money without extracting a significant penalty. Counterparties will be wary of doing business with companies that have too much risk and too little capital. Allowing “too big to fail” institutions to exist removes that discipline. The presumption is that the government will stand in and make the obligations whole even if the bank blows up. That basic perversion of the free market incentivizes additional risk.

HR: Are “too big to fail” banks taking more risks today than they did before?

Neil Barofsky: Bailouts give bank executives an incentive to max out short term profits and get huge bonuses, because if the bank blows up, taxpayers will pick up the tab. The presumption of bailout increases systemic risk by taking away the incentives of creditors and counterparties to do their jobs by imposing market discipline and by incentivizing banks to act in ways that make a bailout more likely to occur.

HR: Is it just a matter of the size of banking institutions?

Neil Barofsky: The big banks are 20-25% bigger now than they were before the crisis. The “too big to fail” banks are also too big to manage effectively. They’ve become Frankenstein monsters. Even the most gifted executives can’t manage all of the risks, which increases the likelihood of a future bailout.

HR: Since bank executives are accountable to their shareholders, won’t they regulate themselves?

Neil Barofsky: The big banks are not just “too big to fail,” they’re ‘too big to jail.’ We’ve seen zero criminal cases arising out of the financial crisis. The reality is that these large institutions can’t be threatened with indictment because if they were taken down by criminal charges, they would bring the entire financial system down with them. There is a similar danger with respect to their top executives, so they won’t be indited in a federal criminal case almost no matter what they do. The presumption of bailout thus removes for the executives the disincentive in pushing the ethical envelope. If people know they won’t be held accountable, that too will encourage more risk taking in the drive towards profits.

HR: So, it’s just a matter of time before there’s another crisis?

Neil Barofsky: Yes. The same incentives that led to the 2008 crisis are still in place today and in many ways the situation is worse. We have a financial system that concentrates risk in just a handful of large institutions, incentivizes them to take risks, guarantees that they will never be allowed to fail and ensures that the executives will never be held accountable for their actions. We shouldn’t be surprised when there’s another massive financial crisis and another massive bailout. It would be naïve to expect a different result.

HR: Didn’t the Dodd-Frank bill fix the financial system?

Neil Barofsky: Nothing has been done to remove the presumption of bailout, which is as damaging as the actual bailout. Perception becomes reality. It’s perception that ensures that counterparties and creditors will not perform proper due diligence and it’s perception that encourages them to continue doing business with firms that have too much risk and inadequate capital. It’s perception of bailout that drives executives to take more and more risk. Nothing has been done to address this. The initial policy response by Treasury Secretaries Paulson and Geithner, and by Federal Reserve Chairman Bernanke, was to consolidate the industry further, which has only made the problems worse.

HR: The Dodd-Frank bill contains 2,300 pages of new regulations. Isn’t that enough?

Neil Barofsky: There are tools within Dodd-Frank that could help regulators, but we need to go beyond it. The parade of recent scandals and the fact that big banks are pushing the ethical and judicial envelopes further than ever before makes it clear that Dodd-Frank has done nothing, from a regulatory standpoint, to prevent highly unethical and likely criminal behavior.

HR: Is the Dodd-Frank bill a failure?

Neil Barofsky: The whole point of Dodd-Frank was to end the era of “too big to fail” banks. It’s fairly obvious that it hasn’t done that. In that sense, it has been a failure. Dodd-Frank probably has been helpful in the short term because it increased capital ratios, although not nearly enough. If we ever get over the counter (OTC) derivatives under control, that would be a good thing and Dodd-Frank takes some initial steps in that direction. I think that the Consumer Financial Protection Bureau is a good thing. Nonetheless, the financial system is largely in the hands of the same executives, who have become more powerful, while the banks themselves are bigger and more dangerous to the economy than before.

HR: How are OTC derivatives related to the risk of a new financial crisis?

Neil Barofsky: Credit default swaps (CDS) were specifically what brought down AIG, and synthetic CDOs, which are entirely dependent on derivatives contracts, contributed significantly to the financial crisis. When you look at the mind numbing notional values of OTC derivatives, which are in the hundreds of trillions, the taxpayer is basically standing behind the institutions participating in these very opaque and, potentially, very dangerous markets. OTC derivatives could be where the risks come from in the next financial crisis.

HR: Can anything be done to prevent another financial crisis?

Neil Barofsky: We have to get beyond having institutions, any one of which can bring down the financial system. For example, Wells Fargo alone does 1/3rd of all mortgage originations. Nothing can ever happen to Wells Fargo because it could bring down the entire economy. We need to break up the “too big to fail” banks. We have to make them small enough to fail so that the free market can take over again.

HR: Does the political will exist to break up the largest banks?

Neil Barofsky: The center of neither party is committed to breaking up “too big to fail” banks. Of course, pretending that Dodd-Frank solved all our problems, as some Democrats do, or simply saying that big banks won’t be bailed out again, as some Republicans have suggested, is unrealistic. Congress needs to proactively break up the “too big to fail” banks through legislation. Whether that’s through a modified form of Glass-Steagall, size or liability caps, leverage caps or remarkably higher capital ratios, all of which are good ideas, we need to take on the largest banks.

HR: Do you think the U.S. presidential election will change anything?

Neil Barofsky: No. There’s very little daylight between Romney and Obama on the crucial issue of “too big to fail” banks. Romney recently said, basically, that he thinks big banks are great and the Obama Administration fought against efforts to break up “too big to fail” banks in the Dodd-Frank bill. Geithner, serving the Obama White House, lobbied against the Brown-Kaufman Act, which would have broken up the “too big to fail” banks.

HR: What will it take for U.S. lawmakers to finally take on the largest banks?

Neil Barofsky: Some candidates have made reforms like reinstating Glass-Steagall part of their campaigns but the size and power of the largest banks in terms of lobbying campaign contributions is incredible. It may well take another financial crisis before we deal with this.

HR: Thank you for your time today.

Neil Barofsky: It was my pleasure.

After Words

According to Neil Barofsky, another financial crisis is all but inevitable and the cost will be even higher than the 2008 financial crisis. Based on the way that the TARP and HAMP programs were implemented, and on the watering down of the Dodd-Frank bill, it appears that big banks are calling the shots in Washington D.C. The Dodd-Frank bill left risk concentrated in a few large institutions while doing nothing to remove perverse incentives that encourage risk taking while shielding bank executives from accountability. Neither of the two main U.S. political parties or presidential candidates are willing to break up “too big to fail” banks, despite the gravity of the problem. The assumption that another financial crisis can be prevented when the causes of the 2008 crisis remain in place, or have become worse, is unrealistic. In the mean time, what Mr. Barofsky describes as a “parade of scandals” involving highly unethical and likely criminal behavior is set to continue unabated. Although the timing and specific areas of risk are not yet known, there is no doubt that U.S. taxpayers will be stuck with another multi-trillion dollar bill when the next crisis hits.

No End in Sight to Financial Crime Wave | Ron Hera on Greg Hunter’s USAWatchdog.com (video)

Ron Hera — Fri, 20 Jul 2012 02:41:00 GMT

By Greg Hunter's USAWatchdog.com - "We are in a computer generated dream world . . . because everything is rigged." That's what Ron Hera of Heraresearch.com said this week when interviewed about living in an age he calls "The end of cheap everything." The system isn't going to collapse, it already has. Hera says, "I think the system failed in 2008, and we are essentially living on borrowed time." As far as the LIBOR rate rigging fraud, Hera says, "Workers, savers and taxpayers will pay for Libor rate rigging."

http://www.youtube.com/embed/KtDmPh22j_o

View Video
Format: ???
Duration: 12:09

Steve Forbes: How to Bring Back America

Ron Hera — Fri, 06 Jul 2012 13:50:00 GMT

Steve Forbes has a message for a nation dominated by increasingly short-term decisions made on Wall Street and in Washington D.C., and by ever greater economic, financial and currency instability. As long as America continues moving away from sound money; away from sound financial and economic policies; and, ultimately, away from freedom, its future grows more dim. The dot-com and housing bubbles followed by the 2008 financial crisis and the most severe economic decline since the Great Depression serve as powerful lessons. A future of bigger government, higher taxes, more burdensome regulations, less consumer choice and more unrealistic government promises requires more and more Federal Reserve play money. Steve Forbes has a quintessentially American policy prescription rooted in American history. The answer to America’s economic problems is—and has always been—new wealth creation. New wealth creation doesn’t come from the government or from the Federal Reserve’s printing press. New wealth creation is what happens naturally with stable money based on the gold standard, lower taxes on individuals, a simplified tax code, reduced bureaucracy and free markets....(read more)

John Embry on Gold, Silver, Currencies and Commodities

Ron Hera — Sun, 01 Jul 2012 20:14:00 GMT

The Hera Research Newsletter is pleased to present the following insightful interview with John Embry, Chief Investment Strategist of Sprott Asset Management LP, where he plays an instrumental role in the corporate and investment policy of the firm. Mr. Embry, who is a world renowned expert on the gold market and on gold and precious metals mining shares, currently focuses on the Sprott Gold and Precious Minerals Fund. Mr. Embry has researched the gold sector since 1963 and has more than thirty years of industry experience as a portfolio management specialist.

After graduating from the University of Manitoba with a Bachelor of Commerce degree, Mr. Embry began his investment career as a stock selection analyst and Portfolio Manager at Great West Life, where he later became Vice President of Pension Investments for the entire firm. After 23 years with the company, he became a Partner in United Bond and Share, an investment counseling firm acquired by Royal Bank in 1987.

At Royal Bank, Mr. Embry was named Vice-President, Equities and Portfolio Manager at RBC Global Investment Management, a $33 billion organization where he oversaw $5 billion in assets, including the flagship $2.9 billion Royal Canadian Equity Fund and the $250 million Royal Precious Metals Fund, which was the #1 ranked fund in Canada for its 2002 net performance of 153%.

Hera Research Newsletter (HRN): Thank you for joining us today. Let's talk about gold stocks.

John Embry: Gold stocks represent a tremendous value in relation to the price of gold and to the fundamentals of the sector. There has been tremendous shorting activity by hedge funds and, as a result, dedicated gold funds have experienced redemptions. Retail investors, who are natural buyers of these stocks, have been annihilated by the price action. This has created one of the finest opportunities, if not the finest opportunity, that I have ever seen.

HRN: Do you have a short term price target?

John Embry: I don't look at short term price charts for gold. In a market as heavily interfered with as this one, charts can be made to look any way you want in the short run. As I see it, if you don't like gold at these prices, then you must like currencies. My partner Eric Sprott often says, the U.S. dollar is the best looking horse in the glue factory. If the U.S. dollar is the world's strongest currency, that's the best endorsement for gold that I can think of.

HRN: Do you believe that currencies are losing value?

John Embry: The fact is that economies are slowly melting down. The problem is excessive debt in almost every corner of the world. The only way to deal with the debt is through aggressive growth, but fabricating growth through more debt won't work. The idea that you can get the economy to move forward by creating even more debt just doesn't wash. We can't service the existing debt, even at artificially low interest rates. I don't see any easy way out. We have to get the excessive debt out of the financial system. Either policy makers are going to create mounting inflation or there will be a deflationary debt collapse.

HRN: Europe seems to be a case in point. Do you think the Euro will break up?

John Embry: The Eurocrats who constructed the currency aren't going to give it up easily. The key is how much the Germans are going to go along with. They realize that there's a huge loss for them if the Euro falls apart. I wouldn't want to be in German Chancellor Angela Merkel's shoes. Germany is trapped in the Euro because it relies on exports and German banks hold the debt of other European countries. Despite the bailouts and the inflationary policies of the European Central Bank (ECB), Germany doesn't have much choice.

HRN: How can European governments solve their debt problems?

John Embry: The problem is that it would take a horrific debt collapse to set the stage for future expansion. There is no politician on earth that wants that to happen on their watch. Consequently, policy makers will resist deflation and we're going down the opposite road, which means mounting inflation or possibly hyperinflation. I don't think politicians will change the system. I think the system will change the politicians.

HRN: Can the economy recover in a high inflation scenario?

John Embry: Creating even more debt is not going to work. To me, high inflation is the most corrosive thing that can happen to an economy or to a country. I'm really worried that neoclassical, Keynesian economists like Paul Krugman, who are prescribing even more debt, will bring about a collapse.

HRN: Are these problems the result of Keynesian economics?

John Embry: If you really applied Keynesianism as Keynes originally envisioned it, the government was supposed to run surpluses when the economy was growing to pay for the deficits that would be created during downturns. That's been conveniently forgotten. We've had an astounding build up of debt. I don't think people fully realize how serious this is. I'm amazed at how complacent people are. We've never been in a position like this in the entire history of the world.

HRN: Why do you think people are so complacent?

John Embry: I think it's cognitive dissonance. When confronted with something that's really unpleasant, and to which there's no easy solution, the average person will basically block it out and look for somebody to tell them that everything is fine. The mainstream news media and the government are doing that as we speak. Consequently, the average person doesn't have a chance of understanding what's going on. The man in the street doesn't have a clue what's coming.

HRN: What about investment professionals?

John Embry: I have a lot of close friends who have been in the investment business for 40 years and they don't want to hear it.

HRN: Won't the Federal Reserve and other central banks simply bail out the system?

John Embry: They think that printing money will buoy the markets and that that's good, but it won't solve any of the problems. Although you may get a momentary lift in the financial markets, when it plays itself out we'll be back in the same situation, but with money that's being systematically destroyed.

HRN: Does printing money work in the short term?

John Embry: There are nominal prices and real prices. Printing money is very deceptive and people are confused by its effects. I am only interested in real returns, not nominal returns. If you have a nominal return that's caused by inflation, you're losing money because governments tax nominal gains.

HRN: Can governments inflate their way out of debt?

John Embry: The U.S. federal government, for example, has reached a stage where forty cents of every dollar spent at the federal level is borrowed and a lot of that money has been printed. There has never been a case in history where that hasn't led to financial disaster. If you study any empirical evidence, they're in a hopeless position. They've only been able to get away with it so far because the U.S. dollar is the world reserve currency. If the United States wasn't able to print money and was trapped in the European Union, it would just be a massive Spain.

HRN: So, governments can't inflate away their debt?

John Embry: Inflation is the easier, more expedient route to take, but I would not rule out an accident. For example, if policy makers push austerity too far they could trigger a deflationary spiral that would be impossible to reverse. I subscribe to the Austrian theory of economics. In his book Human Action, Ludwig von Mises wrote that there is no way to avoid the collapse of a credit boom and that more credit expansion simply destroys the currency.

HRN: Don't inflationary policies help banks and support the financial system?

John Embry: The ECB could do another Long-Term Refinancing Operation (LTRO) or the Federal Reserve could buy more U.S. Treasuries in the open market but that's not really solving the problem. If you actually evaluated the banking system and marked all the assets to market, the system would be insolvent.

HRN: And the basic problem is too much debt and leverage?

John Embry: The over the counter (OTC) derivatives situation is so surreal I can't begin to express it. Correctly calculated, the notional value of all OTC derivatives is in excess of one quadrillion dollars globally. The vast majority are related to interest rates. Central banks have to keep creating liquidity to prevent these instruments from collapsing.

HRN: What can the Federal Reserve and other central banks do?

John Embry: They're lost either way. They're running a massive lab experiment with monetary policy and don't have a clue what the outcome is going to be.

HRN: Do you think the U.S. economy can grow its way out of debt?

John Embry: When I was a kid back in the 1950's, most women didn't work. Americans maintained their standard of living by putting a second person to work. When that was expended they made up the difference by going into debt and, eventually, they used their homes as cash machines. Now student loans total more than $1 trillion. I just don't see where the consumer demand is going to come from going forward. You can't get blood out of a stone.

HRN: What do you think the outcome is going be?

John Embry: I believe that before this is over we'll have a new currency system, probably backed by gold.

HRN: Do you support the gold standard?

John Embry: One of the greatest periods of wealth creation was when we had a gold standard in the second half of the 19th century. It's hard to believe that it's going to be 41 years since there has been gold backing for any of the major currencies in the world. That is what has allowed the massive build up of debt that we have today. If there had been a gold standard, we wouldn't be in the position we are in. Western governments don't want the gold standard because it restricts their ability to dole out favors.

HRN: But the gold standard doesn't prevent financial panics.

John Embry: There are always going to be financial panics, but, under the gold standard they tend to be short term. If we had had a gold standard, there would have been a number of cleansing periods where excess debt was eliminated. The Federal Reserve allowed the build up of debt that led to the stock market bubble and crash of 1929 and to the Great Depression, which was followed by World War II. It took about a decade to build up the debt and more than a decade to deal with the fallout. It's taken more than 40 years to build up the debt we have today and I don't know how long it's going to take to correct it.

HRN: What does this mean for the average person?

John Embry: I think living standards of most people in the world, particularly in the West are going to decline precipitously. The Federal Reserve recently reported that the net worth of the median American family has fallen nearly 40% since 2007 after adjusting for inflation. Before this all plays out, I think the percentages are going to be far larger.

HRN: Do you foresee any wider impact on society?

John Embry: When I was growing up in the United States after World War II, I didn't realize how remarkably fortunate we were as a society to have such a strong middle class. Seldom in history has there been a middle class to equal what transpired in the U.S. and Canada from the 1950s to the 1980s. We basically took it for granted because that's all we ever knew. The middle class in the United States is disappearing. What happens is that you have massive poverty and a small wealthy class. It's one of the worst things that can happen to a society and it can lead to civil unrest. If there's no reason to buy into the system, people will act up.

HRN: Do you view gold and silver as commodities?

John Embry: I view gold and silver as monetary metals. The mainstream news media conflates gold and silver with industrial commodities, but they're really a competitor to the currency system. Gold is the antithesis of paper money.

HRN: I've read that central banks are buying gold.

John Embry: Confidence in currencies is misplaced. There is a strong flow of gold from West to East. The Chinese, Indians, Russians and Vietnamese know perfectly well what's going on with the U.S. dollar and the Euro. They are buying physical gold and the West has been stupid enough to sell it to them.

HRN: What's your view on China?

John Embry: I'm not optimistic on China in the short run. The People's Bank of China (PBoC) recently cut bank reserve requirements by 150 basis points to stimulate 1.2 trillion yuan ($190 billion) of new lending because they don't want growth to fall from around 8% to 7%. As I see it, they've dined out on Western profligacy for 20 years and have become the most unbalanced economy in the world. An inordinate amount of China's economic activity is generated by exports and by all manner of capital spending on manufacturing, real estate, infrastructure and more. The slowdown in the world economy has revealed massive overcapacity in many sectors.

HRN: Can China develop a consumer-driven economy?

John Embry: The idea that China's economy can morph into a consumer-driven economy is preposterous. The very same consumers are employed in sectors like manufacturing where there is massive overcapacity. If the world slides into another global recession, which is not beyond the realm of possibility, I don't see how China stays out of it and if they don't then there's no engine of growth left in the world.

HRN: So, even with a rising middle class, China remains dependent on exports?

John Embry: The fact is that China has become the world's manufacturer but the ability of their two largest customers, Europe and the United States, to consume is being constrained. China is not going to be able to keep selling more year over year. The HSBC manufacturing index has fallen to recessionary levels.

HRN: It has been predicted that China will become the world's largest economy. Do you think that's true?

John Embry: I think China will probably dominate the 21st century. The U.S. dominated the 20th century but it went through some very tough times in the first half of the century.

HRN: With a slowdown in China, what's your view on commodities like copper or crude oil?

John Embry: In the short term, I'm worried about commodities. In a deep global recession, I expect there will be extreme monetary debasement, which will hold up the nominal prices of commodities more than supply and demand factors would suggest.

HRN: Do you foresee a bear market in commodities?

John Embry: We are in a short-term bear market that will be arrested by monetary debasement.

HRN: But there are value buying opportunities?

John Embry: Given my views on currencies, commodities that are already depressed could be decent repositories for wealth. I like agricultural products. As the global economy continues to develop, I think the supply of food is going to be a major issue.

HRN: How can investors protect their assets in a global recession?

John Embry: The only things I'm comfortable holding are precious metals and, because they are so cheap now, precious metals mining shares.

HRN: Where do you think the price of gold will end up?

John Embry: I'm more concerned with how many ounces I own than with how many U.S. dollars I can get for them at any given point in time. Gold and paper money are going in opposite directions.

HRN: Thank you for your valuable time.

John Embry: It was my pleasure.

After Words

John Embry doesn't mince words and his track record speaks for itself. A defender of the gold standard, John Embry sees gold and silver as currencies competing against the U.S. dollar and the Euro, which are losing value because of extreme debt levels, weak economic fundamentals and policy induced inflation. According to John Embry, abandoning the gold standard has led to unprecedented debt levels that could take decades to unwind. In the mean time, inflation seems likely to wipe out the middle class. While his outlook for commodities is bearish, John Embry believes that gold and silver and related mining shares remain the best way for investors to preserve their wealth.

The War at the End of the Dollar

Ron Hera — Sun, 01 Jul 2012 20:12:00 GMT

The history of the U.S. dollar is closely linked to U.S. involvement in a series of wars. The Bretton Woods Accord and the resulting world reserve currency status of the U.S. dollar were both byproducts of World War II (1939-1945). The Korean War (1950-1953) was followed six years later by the Vietnam War (1959-1975) which led to the end of the Bretton Woods system. Unfettered by the constraint of gold backing after 1971, the U.S. dollar became a weapon in the Cold War (1945-1991) between the U.S. and the former Union of Soviet Socialist Republics (U.S.S.R.). Each war corresponded with an increase in the U.S. money supply. The Gulf War (1990-1991) was followed by wars in Afghanistan, beginning in 2001, and in Iraq, beginning in 2003, and, simultaneously, by the U.S.-led War on Terror that began in 2001. Like the wars that came before them, the recent staccato of U.S. wars is correlated with increases in the U.S. money supply. The Iraq war, for example, is estimated to have cost as much as $4 trillion.

The loss of value in the U.S. dollar caused by excessive expansion of the money supply, together with rising demand for raw materials from emerging economies, has led to permanently higher global commodity prices. Higher crude oil prices, in particular, have put pressure on the U.S. economy, which is putatively in a gradual recovery from the recession that began in 2007. At the same time, international trade has begun to move away from the U.S. dollar, threatening its world reserve currency status. Given the history of the U.S. dollar, it seems likely that an eventual end of the U.S. dollar's reign as the world reserve currency will be marked by war.

U.S. politicians are clamoring for war with Iran, the third largest oil exporter in the world. Iran refuses to sell its oil for U.S. dollars. If Iranian oil were traded in U.S. dollars, it would moderate the U.S. dollar price of crude oil and ease pressure on the U.S. economy, as well as extend the world reserve currency status of the U.S. dollar and give the U.S. economic leverage over consumers of Iranian oil, which include China and India.

The U.S. news media is preparing the American public for a war with Iran with reports about the dangers of Iran becoming a nuclear power. Television news reports have speculated that Iran would immediately wipe out Israel if it obtained a nuclear weapon, despite the fact that a thermonuclear exchange would wipe out Iran. It has also been reported that Iran might carry out nuclear strikes on U.S. soil using intercontinental ballistic missiles (ICBMs), although Iran possesses neither nuclear warheads nor ICBMs. In fact, there is no evidence that Iran is currently building a nuclear weapon. One concern that is valid, however, is that no nuclear power has ever been invaded in a conventional war.

Forged in the Fire of War

The approaching end of World War II led to the creation of the Bretton Woods system in July 1944, although fighting in Europe and in the Pacific continued into 1945. The U.S. dollar, which was convertible into gold, became the dominant mechanism for international trade settlement. The price of gold was set to the pre-war price of $35 per troy ounce, which was deflationary at the time. There was nothing in the Bretton Woods Accord, however, that prevented the U.S. from issuing more currency than was backed by gold other than the threat of a run on U.S. gold reserves.

The Bretton Woods system worked as intended for roughly 17 years. The London gold market, which had been closed during World War II, reopened in 1954. By 1961, upward pressure on the price of gold prompted the establishment of the London Gold Pool by the U.S. Federal Reserve and major European central banks (including the central banks of the United Kingdom, Belgium, France, Italy, the Netherlands, Switzerland and West Germany). The London Gold Pool defended the $35 per troy ounce price through interventions in the London gold market, but upward pressure on the price of gold grew. In July of 1962, Americans were forbidden by then president Kennedy to own gold abroad by Executive Order 11037. In a 1965 press conference, then president of France, Charles de Gaulle publicly denounced the U.S. for abusing the world reserve currency status of the U.S. dollar. The London Gold Pool collapsed in March of 1968 after France withdrew from the group setting off a surge in gold demand that caused the London gold market to shut down for a two week period.

By 1971, substantially due to the cost of the Vietnam War, the U.S. had leveraged its gold reserves to the breaking point. The expansion of the U.S. money supply caused the U.S. Consumer Price Index (CPI) to increase by more than 6% in 1970 and it remained above 4% in 1971. When U.S. President Nixon "closed the gold window" in August 1971 and instituted price controls, the Bretton Woods system ended and an ad hoc floating exchange system resulted. From their peak during World War II to 1971, U.S. gold holdings fell from approximately 20,205 tonnes to approximately 8,134 tonnes. In February 1973, the U.S. devalued the dollar and raised the official dollar price of gold to $42.22 per troy ounce. By June of the same year, the market price in London had skyrocketed to more than $120 per ounce.

Although CPI inflation was below 4% at the start of 1973, it rapidly accelerated, reaching 9% at the start of 1974. With the last vestiges of gold backing having been removed from the U.S. dollar, Americans were once again allowed to own gold as a hedge against inflation. Against a backdrop of runaway U.S. dollar inflation, Arab members of the Organization of the Petroleum Exporting Countries (OPEC), along with Egypt, Syria and Tunisia proclaimed an oil embargo in October of 1974. Officially, U.S. support of Israel in the Yom Kippur War was the reason for the embargo, but it was also a challenge to the un-backed U.S. dollar's position as the world reserve currency, i.e., as an exclusive medium for crude oil sales.

After the end of the Yom Kippur War in 1974, OPEC members, including Iran before the Iranian Revolution in 1979, began to accumulate hundreds of billions of devalued U.S. dollars due to current account surpluses linked to rising oil prices. Arab "petrodollars" were recycled into US Treasuries, invested in financial markets around the world and loaned to commercial banks.

By 1979, oil prices had roughly quadrupled and the price of gold was increasing rapidly. Then Federal Reserve Chairman, Paul Volcker raised the Federal Reserve's funds rate to an average of 11.2% in 1979. Nonetheless, in 1980 CPI inflation soared to 13.5% and the stagnant U.S. economy also slipped into recession. The price of gold hit $850 per troy ounce and the price oil averaged $37.42 per barrel, more than ten times the average price of $3.60 per barrel less than a decade before in 1971.

In a desperate bid to save the U.S. dollar, Volcker increased the funds rate to an unprecedented 20% in mid 1981, pushing the prime interest rate to a usurious 21.5% by the middle of 1982. Finally, Volcker's radical intervention slowed the rate of CPI inflation and restored confidence in the U.S. dollar. It also brought the price of crude oil down and smashed the prices of gold and silver.

The Committee to Flood the World

Post Volcker, the Federal Reserve's dilemma was how to bring down interest rates while managing the CPI independent of increases in the money supply, e.g., to neutralize the Triffin Dilemma (a conflict between domestic monetary policy and the demands placed on a currency by international trade) and to support U.S. federal government borrowing during the Cold War. The first key to the solution was to look at inflation strictly in terms of its effects on prices and not as an increase in the money supply, which is a function of interest rates. When interest rates are low, prices tend to rise because the money supply expands more quickly, thus the second key was to de-couple prices and interest rates. The third and final key was to manage the psychology of the consumer in terms of inflation expectations. While altering the CPI to reflect relatively stable prices and managing consumer inflation expectations were easily accomplished, de-coupling prices and interest rates was a more difficult problem because the prices of global commodities were not entirely under U.S. control. Ultimately, managing the CPI required managing global commodity prices, especially the price of crude oil.

A crucial breakthrough came in 1988. The article, "Gibson's Paradox and the Gold Standard" by Robert B. Barsky and Lawrence ("Larry") H. Summers in the Journal of Political Economy, showed that the price of gold was inversely correlated to interest rates. Since gold is not industrially consumed in significant quantities, the price of gold changes relative to the value of major currencies. Specifically, the price of gold had proven to be a barometer of U.S. dollar inflation after 1971. What was more important was that the prices of gold and crude oil tended to correlate. The implication of Gibson's Paradox was that interest rates could remain low as long as the price of gold did not rise. If interest rates could remain low without causing an accelerating increase in the CPI, as had happened in the 1970s, the money supply could be expanded indefinitely.

A few years after Alan Greenspan took the helm as Chairman of the Federal Reserve in 1987, interest rates were slashed and the resulting increase in the U.S. money supply began to pull away from the increase in the CPI. For roughly two decades, beginning with Volcker's success in the early 1980s, the price of gold declined while oil prices remained relatively stable, despite the fact that interest rates had come down.

The innovations in U.S. monetary policy developed principally by Summers and Greenspan helped to make it possible for the United States to up the ante in the Cold War, which ended with the collapse of the U.S.S.R. in 1991. Setting aside all other issues, the U.S.S.R. had arguably been spent into oblivion by the U.S. The fall of the U.S.S.R. seemed to guarantee the hegemony of the U.S. dollar for decades to come.

During the 1990s, Greenspan, together with Larry Summers, who was Deputy Secretary of the U.S. Treasury under Robert Ruben at the time, championed financial deregulation. Confident in their ideas, the so-called "committee to save the world" prevented regulation of over the counter (OTC) derivatives and succeeded in effectively repealing the Banking Act of 1933 (the Glass-Steagall Act).

In hindsight, Greenspan held interest rates too low for too long in the 1990s resulting in the dot-com bubble. The bursting of the dot-com bubble was a shot across the bow of the "committee to save the world" but the warning went unheeded. The Federal Reserve moderated the downturn beginning in 2000 by lowering interest rates and they remained low. U.S. banks took advantage of deregulation and low interest rates to speculate and to increase their leverage, especially in the mortgage market, while hedging the additional risks in the fast growing OTC derivatives market. As the resulting real estate bubble grew, the notional value of OTC derivatives exceeded $600 trillion on a global basis (more than ten times world GDP) and financial services industry profits expanded to 40% of S&P 500 business profits.

The price of gold had begun to move up after having made a historic low in June of 2001 and, in 2006, the price of crude oil began to rise at an accelerating rate revealing a fundamental flaw of de-coupling interest rates from prices. The flaw was that the Federal Reserve had absolutely no control over the flow of increased liquidity resulting from its policies. The "committee to save the world" was flooding the world with cheap U.S. dollars. Increased liquidity linked to low interest rates was fueling unprecedented levels of financial speculation and increasing the risk and magnitude of asset price bubbles, such as the dot-com bubble and the real estate bubble. To make matters worse, excessive monetary expansion was weakening confidence in the U.S. dollar.

Pressured by rising oil prices, the U.S. economy began to roll over in 2007. As the U.S. housing bubble began to burst, beginning with sub-prime loans, the price of West Texas Intermediate (WTI) crude oil hit an all-time high of $145 in June 2008. Roughly four months later, a financial crisis far larger than that of 1929 began to take place, i.e., the bursting of the largest credit bubble and monetary expansion in the history of the world. In October 2008 Greenspan testified before the U.S. Congress saying "...I found a flaw...in the model that I perceived is the critical functioning structure that defines how the world works..."

Quantifying the Crisis

The policy responses of the U.S. federal government and of the Federal Reserve (under Chairman Ben S. Bernanke since 2005) to the financial crisis and to the so-called Great Recession were radically inflationary. The Federal Reserve loaned $16 trillion to financial institutions worldwide and $7.77 trillion to U.S. banks and corporations. The Federal Reserve also purchased roughly $1 trillion worth of toxic mortgage backed securities (MBS) from banks and monetized a total of roughly $800 billion of U.S. federal debt, expanding its balance sheet from $900 billion before the crisis to $2.7 trillion.

In the face of the most severe economic decline since the Great Depression, the U.S. federal government embarked on a $700 billion economic stimulus plan, despite the fact that tax revenues were falling. In addition to an initial $800 billion bailout package, government sponsored entities Fannie Mae and Freddie Mac were taken into receivership, making the U.S. federal government liable for roughly $5 trillion of mortgage debt. In 2009, the total liabilities of the federal government were estimated to be as high as $23.7 trillion by then Special Inspector General for the Troubled Asset Relief Program (SIGTARP), Neil Barofsky. As a result, U.S. federal government debt increased sharply and, in 2011, the U.S. credit rating was downgraded for the first time in history.

Loss of value in the U.S. dollar, caused by radically inflationary monetary policies, set off a global currency war in 2009 and pushed global commodity prices higher than they would otherwise have been. Higher crude oil prices, despite lower demand, slowed economic recovery. At the same time, high debt levels, bank bailouts, soaring government budget deficits and falling tax revenues produced a sovereign debt crisis in Europe. Although the focus of the still developing sovereign debt crisis remains on Europe, the skyrocketing debt and unfunded Social Security and Medicare liabilities of the U.S. federal government, estimated to be more than $63 trillion, foreshadow a similar crisis in America.

The Trap of Financial Warfare

One of the key reasons why the U.S. has yet to experience a sovereign debt crisis is that the world reserve currency status of the U.S. dollar supports demand for the U.S. dollar and for U.S. federal government debt. However, the U.S. dollar is in the process of gradually losing its world reserve currency status. Global trade is fragmenting into increasingly autonomous trading blocks defined by currencies and trade relations, such as the BRIC nations (Brazil, Russia, India and China), together with South Africa.

Demand from emerging economies, particularly China, is placing steady upward pressure on the price of crude oil. Higher oil prices resulting from a combination of a weaker U.S. dollar and increased global demand threaten to push the U.S. economy back into recession. Setting aside flat to declining supplies of sweet light crude oil (Peak Oil), the fact that the price of gold has risen roughly 500% in a single decade suggests much higher oil prices in the future.

Iran, which is the world's third largest oil exporter and a major supplier of oil to China, lies outside of U.S. control. Iran refuses to sell oil for U.S. dollars, partly as a consequence of the overthrow of the democratically elected government of Iran in 1953, orchestrated by the U.S. Central Intelligence Agency, and partly as a consequence of current U.S. policies in the Middle East.

In March of 2012, the U.S. unilaterally removed Iran from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system, effectively cutting it off from world commerce. However, wielding the U.S. dollar's world reserve currency status as a blunt instrument could be counterproductive in the current international climate. If the U.S. dollar were to lose its world reserve currency status over a short period of time, a U.S. sovereign debt crisis would be certain and a catastrophic collapse of the U.S. dollar, i.e., hyperinflation, would be possible.

Having taken a decision to act unilaterally against Iran, the U.S. may be forced to resort to more extreme measures if the world reserve currency status of the U.S. dollar begins to break down. Of course, the U.S. does not control the oil trade solely through financial means. With Israel as a close ally, Iraq and Afghanistan occupied by U.S. forces, close ties with Turkey, Saudi Arabia, Kuwait, Qatar and other Middle Eastern countries, Iran is surrounded by more than 40 U.S. military installations.

A successful invasion of Iran would eliminate the largest non U.S. dollar oil exporter, delaying the breakdown of the U.S. dollar's status as the world reserve currency. Although a war with Iran would cause a spike in oil prices, U.S. control of Iran's oil would increase the supply of oil available for purchase in U.S. dollars, which would bring the U.S. dollar price of oil down and enhance the ability of the U.S. to manage the price of oil to meet the needs of the U.S. economy. Controlling a major supplier of crude oil to China and India would give the U.S. additional leverage to support the U.S. dollar and U.S. debt, as well as a means of influencing the policies and economic growth of the two largest nations. The option of invasion, however, may be time limited. If Iran were to eventually obtain nuclear weapons, the risks involved in a U.S. invasion would escalate.

As an alternative to invasion, a limited U.S. military action might involve surgical strikes on Iranian nuclear research and power facilities, as well as on Iranian military forces that pose a threat to the U.S. military. Destroying Iranian nuclear facilities and suppressing potential counterstrikes also suggests neutralizing Iran's threat of disrupting the oil trade by closing the Straight of Hormuz. Thus, a limited U.S. military action would involve military operations on a scale not seen since the invasion of Iraq in 2003.

A limited U.S. military action might leave a weakened Iranian regime in place after the conflict and reignite the moderate, pro-democracy Green Movement that was brutally suppressed in 2009. Regime change from within might restore democracy to Iran after twenty six years of U.S.-imposed monarchy and more than three decades of quasi-democratic religious oligarchy. However, regime change is unlikely to result in the sale of Iranian oil in U.S. dollars or to extend the reign of the U.S. dollar as the world reserve currency. A preemptive strike by the U.S. could also strengthen political support for the current Iranian regime.

There seems to be no political will in Washington D.C. to change course from a U.S. military conflict with Iran, despite the fact that a U.S. attack on Iran will increase anti-U.S. sentiment in the region and amplify the Islamic extremist dimension of the U.S.-led War on Terror. The drumbeat to war in the U.S. news media is loud and clear and, if history is any guide, the U.S. will soon, e.g., after the 2012 presidential election, "cry havoc and let slip the dogs of war".

Value Subjectivism and Monetary Instability

Ron Hera — Sun, 01 Jul 2012 20:09:00 GMT

Subjectivism is the philosophy that reality is what we perceive to be real and that no underlying, true reality exists independent of human perception. In other words, the nature of reality for an individual person is dependent on that individual's own consciousness. It follows that each person experiences their own reality that is not shared with others. What is true and what seems moral to one person may not be true or moral for another person, i.e., truth and morality are relative. In contrast, objectivism is the philosophy that reality exists independent of human consciousness; that human beings have direct contact with reality through sense perception; and that objective knowledge of reality can be obtained through perception, evidence and logic, e.g., through scientific methods.

A subjectivist might view the stock market as a perpetual bubble floating on the hopes and dreams of entrepreneurs and investors who invest in stocks in the same way that gamblers place chips on a craps table in a casino, without any concept of an objective economic reality outside of the game. A subjectivist might view technical analysis, which is based purely on trading activity in the stock market, as the ideal tool to understand financial markets, despite the fact that is has no direct connection to the objective economic realities of the companies that stocks represent. In contrast, an objectivist might view the stock market as a venue for participation in business ownership where stocks have value as a function of the particular businesses that they represent and because of the goods and services that the businesses provide in the objective world. A subjectivist might say that "everything is relative" (although the statement is self contradictory), while an objectivist might say that they "...believe in justification, not by faith, but by verification" (Thomas H. Huxley 1825-1895). Although they may not know it, Keynesian economists, bankers and day traders are often philosophical subjectivists while Austrian economists, advocates of the gold standard and value investors are often philosophical objectivists.

An objectivist interpretation of morality is that morality flows naturally from people pursuing their own interests and that immorality results from coercion. For the vast majority of individuals, "self interest" includes supporting their own family and community, simply because human beings are social animals. Parents naturally care for their own children, for example. Morality is a natural phenomenon, not a product of coercion. Human beings naturally live peacefully together in communities and the vast majority of individuals experience empathy. Both charity and resistance to coercion occur naturally and voluntarily in human communities. Those who do not experience empathy (sociopaths) and who disregard the interests of their fellow human beings or act in ways that harm the community are extremely rare. Philosopher Ayn Rand wrote "Force and mind are opposites; morality ends where a gun begins." Human beings do not act morally because they are being watched by police or because a gun is held to their heads. In all cultures and at all times and places throughout recorded history, and certainly before, what is immoral is initiating violent force or coercion without cause, most especially when it harms the community. Although particular rules vary from one culture to another, morality is neither subjective nor relative.

Ironically, the objectivist view of morality has been widely misconstrued as a sanction for selfishness. Selfishness typically results in the deprivation or coercion of others. In contrast, pursuing their own self interest is what human beings naturally and voluntarily do in the absence of coercion. In fact, the idea that what is moral arises in a natural way based on the freedom to pursue one's own self interest, i.e., freedom from coercion, is precisely the moral doctrine of the 1776 American Declaration of Independence:

"We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness."

Where money is concerned, there are two fundamentally different concepts of "value", one rooted in subjectivism and one rooted in objectivism. In a monetary context, value subjectivism means that money has value simply because people believe that it does and that whatever people can be persuaded or coerced into using as money, such as a piece of paper bearing a government stamp, therefore has "value". In other words, value subjectivism is the view that the only "value" that exists resides in the minds of human beings as a concept or belief and that, therefore, "value" can be created ex nihilo by persuasion or coercion, i.e., by influencing or controlling (through coercion or fear of coercion) the minds of human beings. Value objectivism means that money has value because it contains the resources and labor required to produce it in the same way that clothing or shelter have value for the survival requirements of human life.

Of course, subjective value, e.g., the value of a Picasso painting to an art lover, does indeed exist but it is different in kind compared to value linked to biological survival (literally, life and death). The former refers to subjective mental states, while the latter refers to an objective biological reality that exists independent of human consciousness. Residents of the Warsaw Ghetto in 1943, for example, didn't value guns in the same way they valued Picasso paintings. Generally, a product of human labor that has real-world utility, such as a physical tool, will be recognized by human beings as having value relative to the material needs and survival requirements of human life. This "survival value" is absolutely pragmatic and is rooted in the natural understanding that human beings have about their biological needs and their physical relationship to the objective world.

Commodity money comes about in a natural and voluntary way and does not depend on governments or banks. Natural money develops wherever and whenever human beings obtain things that they do not strictly need purely for the purpose of exchanging them for something else. The good most commonly used as a tool of exchange is de facto money. The Greek philosopher Aristotle first defined the characteristics of a commodity that can be used as money as (1) divisibility, (2) durability, (3) portability and (4) scarcity, i.e., rare and valuable. More recently, money has been described as a medium of exchange, a unit of account, e.g., a standard weight of gold or silver, and a store of value. Of course, money must also be widely accepted, which can be accomplished either through natural forces or through coercion.

The supply of commodity money naturally remains constrained in proportion to the production of other goods. The resources and labor required to produce natural commodity money exist in relation to other economic resources needed for the survival requirements of human life. Production of commodity money subtracts resources that have direct survival value from other economic activities. Therefore, the law that regulates the production of commodity money is the law of survival. The law of survival is not a proscriptive law (declared by a human authority) but a descriptive law based on observation. The production of commodity money is regulated automatically according to the biological needs of human beings. Thus, commodity money is tightly coupled or "tethered" to physical economic activity in the objective world in the same way as building shelter. Human beings very rarely build more shelter than they need because the economic inputs required to do so are better spent elsewhere once sufficient shelter exists. The price mechanism in modern economics is a reflection of this underlying reality.

While it is commonly believed that any token can be used as money, this refers only to the medium of exchange, i.e., currency. Currency is precisely a "money substitute", which is a convenience, but is not, strictly speaking, money. Land deeds, for example, can circulate as a currency but they are not the land itself. Creating more currency units in a vacuum, in this case un-backed "land deeds" with no land attached, does not create more land or any other form of wealth in the objective world even if it increases the number of transactions and the size of the economy measured in "land deeds".

Throughout history, schemes have been attempted whereby currencies that cost virtually nothing to produce, and that have no survival value, have been substituted for commodity money. Artificial money, known as 'fiat currency' has putative "value" simply because it is declared to have a value by a government or central bank. Fiat currency schemes replace the survival value of commodity money with subjective value and substitute a mere medium of exchange for natural commodity money. Modern currencies, including the U.S. dollar, the British pound, the euro and the Japanese yen, are all fiat currency schemes. As a practical matter, a fiat currency unit is worth whatever it can purchase but it is not a standard by which value can be measured because its purchasing power is unstable. In fact, there are several fundamental problems with fiat currencies.

1. There Is No Spoon - In the popular 1999 film The Matrix, written by Lana and Andy Wachowski ("The Wachowski Brothers"), the protagonist, Neo, has the following conversation with a gifted child who can bend spoons with his mind:

Child: Do not try and bend the spoon. That's impossible. Instead... only try to realize the truth.

Neo: What truth?

Child: There is no spoon.

Neo: There is no spoon?

Child: Then you'll see, that it is not the spoon that bends, it is only yourself.

There is a difference between an abstraction and an abstract concept. "Money" is an abstraction in the same way that "container" encompasses both a bottle and a jar. Abstractions are artifacts of language that generally describe the world. In contrast, an abstract concept is the mental representation of an idea, such as liberty. Abstract concepts are literally ideas that exist in the human mind. Law, for example, expresses the concept of justice but an arbitrary law is not just merely because it is law. Unjust laws certainly exist. Declaring that a stone is a seafaring vessel does not imbue it with the ability to float on water, even if it can skip on the surface if it has enough spin. Such a declaration would be an illogical misuse of language masking an obvious absurdity. Nonetheless, the same obvious absurdity underlies fiat currencies. The erroneous conflation of "money", which is an abstraction, and "value", which is an abstract concept, is an example of sophistry; a trick of words played on unsophisticated minds. In fact, fiat currencies which exist today, not principally as notes or coins, but as electronic digits in computers, have no value.

2. Coercion - Coercion characterizes fiat currencies because most people would not accept them unless forced to do so against their will. In the United States, for example, the replacement of gold-backed money in 1933 required the use of legal force (criminal penalties of $10,000, ten years in prison, or both) to compel U.S. citizens to accept irredeemable Federal Reserve Notes in place of gold certificates.

3. Rent Seeking - Fiat currency schemes extract economic rents by forcing commerce to take place in the fiat currency system. Since human beings trade with one another to survive, the ability to freely exchange value for value is a natural right having the same moral foundation as the right to life, liberty and the pursuit of happiness. In a marketplace based on voluntary arrangements, there is no middleman extracting an economic rent in exchange for permission to participate in commerce.

4. Immorality - Fiat currency schemes are immoral because the primary thing that makes them acceptable is coercion. Forcing people to accept artificial money that has no objective value against their will and self interest is an immoral act. Additionally, fiat currency schemes allow those who control the currency to redistribute wealth by altering the availability, quantity and distribution of the currency, which is little more than legalized theft.

5. Central Planning - Since fiat currencies are based on coercive, rather than voluntary market relationships, a central authority is required that has the power to eliminate competing currencies, i.e., to establish a monopoly. Central economic planning is not only anti-democratic and the antithesis of a free market, but also inevitably fails. Human society is not blessed with the omniscient and infallible individuals required to make financial and economic decisions in place of the decisions of millions of individuals, households, entrepreneurs and businesses. The record of history, e.g., the USSR, is absolutely clear. Central planning of an economy produces a never ending stream of unintended consequences that lead to never ending interventions and that ultimately destroy economic activity.

6. Price Instability - Fiat currencies, because they require relatively insignificant physical economic inputs, have no direct relationship to the survival requirements of human life. Since it is decided by central planners, the quantity of currency in a fiat currency scheme is always and inevitably incorrect. This causes price instability and artificially stimulates or depresses economic activity as a function of how much currency is produced and of how it is distributed. As a practical matter, price stability can never be achieved in a fiat currency scheme.

7. Economic Volatility - Since fiat currencies are loosely coupled to physical economic activity in the objective world, they tend to become increasingly de-coupled and eventually "un-tethered" over time. An economy is the aggregate of millions of independent, individual human actors and there is no way that those responsible for a fiat currency can guess the correct quantity, although they can recognize incorrect quantities after the fact by their consequences, e.g., credit booms, recessions, large-scale price bubbles and economic collapses, such as the Great Depression, which began only sixteen years after the U.S. Federal Reserve was established. Of course, economies can be volatile for many reasons. The effect of fiat currencies, however, is to greatly magnify economic volatility.

8. Currency Debasement - Voltaire famously wrote that "Paper money eventually returns to its intrinsic value-zero." Fiat currencies issued by governments or central banks represent intangible, subjective concepts of value like "full faith and credit" but the currency itself has no lasting value. Specifically, fiat currencies have a built-in tendency to decline in purchasing power over time as more currency is produced, particularly in fractional reserve and debt-based fiat currency schemes. In debt-based fiat currency schemes, the currency must be constantly inflated or a deflationary vicious circle (a collapse of debt) will set in. Those responsible for the currency predictably produce more than is necessary to maintain stable prices or to sustain stable economic activity, e.g., to diminish the risk of deflation, for political promises and favors, to wage war, etc. Price instability and economic volatility are the result. Currency debasement eventually undermines the basic economic structure of society. In The Economic Consequences of the Peace (1919), John Maynard Keynes wrote:

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

9. Wealth Redistribution - Arbitrarily increasing the quantity of currency in an economy distorts the distribution of money and, therefore, redistributes purchasing power, effectively stealing wealth from the majority, e.g., savers and wage workers, to serve the interests of a privileged minority. Redistribution of wealth, as opposed to production of wealth, causes a net loss of wealth to society. Government deficit spending, although it may be motivated by good intentions, changes the quantity of currency and results in currency debasement. Thus, government deficit spending operates as a dishonest, hidden tax on savers and wage workers. In his well known 1966 essay, Gold and Economic Freedom, former Federal Reserve Chairman Alan Greenspan, wrote:

"Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."

10. Concentration of Wealth - Over time, fiat currency schemes cause wealth and property to accrue to those who enjoy the extraordinary privilege of creating the currency, thus increasing the concentration of wealth in society. Extreme concentration of wealth is economically and ultimately politically destabilizing. An individual with a one million dollar income, for example, will not buy as many consumer products, cars or appliances as ten households with incomes of one hundred thousand dollars. In his remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming (August 28, 1998), then Federal Reserve Chairman Alan Greenspan pointed out that:

"Ultimately, we are interested in the question of relative standards of living and economic well-being. Thus, we need also to examine trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume..."

11. Moral Hazard - Baron Acton observed in 1887 that "Power tends to corrupt, and absolute power corrupts absolutely." Since fiat currencies are created by monetary monopolies ex nihilo, e.g., through loan contracts, they provide a legal means of obtaining something for virtually nothing. As a result, those responsible for fiat currencies enjoy almost unlimited influence over economic and, therefore, political life. Sadly, human beings can never be good stewards of a currency system that provides one group in society with the means to obtain something for nothing. In fact, societies dominated by immoral fiat currency schemes eventually develop a something-for-nothing culture; a culture of entitlement in which, rather than producing wealth, everyone endeavors to live at the expense of everyone else.

12. Corruption and Cronyism - As a consequence of moral hazard, fiat currencies tend to encourage cronyism and corruption and ultimately produce a culture of corruption. The Roman poet Juvenal wrote "Quis custodiet ipsos custodes?" ("Who will guard the guards themselves?"). History is replete with the horrors of absolute power and with monetary abuses resulting in economic collapse. Just as democide has been a leading cause of death in the last one hundred years, fiat currencies have been a leading cause of poverty. Fiat currency schemes redistribute and concentrate wealth, resulting in a tiny and exceedingly wealthy minority, but they do not produce wealth. Francisco d'Anconia, one of the central characters in the novel Atlas Shrugged by Ayn Rand, explains the following in his famous "money speech":

"...Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears, or the looters who take it from you by force. Money is made possible only by the men who produce... Not an ocean of tears nor all the guns in the world can transform those pieces of paper in your wallet into bread you need to survive tomorrow... Whenever destroyers appear among men, they start by destroying money, for money is men's protection and the base of a moral existence. Destroyers seize gold and leave its owners a counterfeit pile of paper. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values... Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims..."

13. Confidence Failure - Since the value of fiat currencies is essentially subjective, maintaining the perception of "value" in the face of economic decline and despite rising prices can be challenging. Fiat currencies are ultimately dependent on confidence and trust in those responsible for the currency. When fiat currencies are abused, confidence fails and they revert to their intrinsic value (zero). Thus, monetary policy in a fiat currency scheme focuses directly on maintaining confidence. Behavioral economics, for example, has become a primary tool of monetary and economic policy implementation. As a consequence, economic reporting by governments and central banks, and by the news media, does not reflect an objective viewpoint. Management of perception has the effect of influencing the subjective mental states of those who use a particular fiat currency so as to maintain the perception of "value". However, in the best case, perception management is one-sided "spin", and, in the worst case, it is propaganda that is contrary to fact and that simply prevents ordinary people from recognizing the steps they need to take in order to protect their financial interests against currency debasement and other risks associated with fiat currencies. Nonetheless, cognitive dissonance (a psychological tension between conflicting cognitions) can result in the sudden collapse of fiat currencies when economic conditions deteriorate sufficiently or when prices rise too quickly, i.e., the spell of value subjectivism is broken.

14. Counterparty Risk - The "value" of fiat currencies requires trust in counterparties, but trust, like confidence, is an ephemeral, subjective mental state. In the objective world, agreements between governments and central banks and those who rely on their fiat currency schemes can be arbitrarily modified or broken. In fact, they are implicitly broken whenever a currency is debased. The promises of deposed governments and failed banks become instantly worthless.

15. Transaction Settlement - A transaction in commodity money is a direct exchange of value for value. When a fiat currency transaction is performed, one party holds fiat currency and the other is the recipient of goods or services, but, like a retroactive breach of contract, the value of the fiat currency can be changed and may even become zero. Since there is always a residual third party to the transaction, i.e., a government or central bank, transactions remain unsettled.

Fiat currency schemes are philosophically misguided, fundamentally immoral and ultimately unstable. Fiat currencies are premised on value subjectivism and erroneously conflate money and value. They represent a mere medium of exchange and rely on unstable subjective mental states such as confidence and trust. As a result, they are ultimately fragile and prone to fail suddenly when those using them wake from the dream of value subjectivism.

Fiat currencies are immoral because they are forced on people against their will and contrary to their self interest and because they are a mechanism for legalized theft through currency debasement. Monetary monopolies extract economic rents by holding hostage the rights of individuals to freely exchange value for value. Central economic planning, redistribution of wealth and concentration of wealth undermine economic activity and encourage a culture of entitlement. Since fiat currency schemes are the source of exorbitant power, they engender extreme moral hazard, produce cronyism and corruption and foster a culture of corruption.

Fiat currencies are subject to the decisions of central planners and are invariably debased producing price instability and increasing economic volatility. Governments and central banks that promulgate fiat currency schemes remain as perpetual counterparties to transactions posing a constant and unlimited risk. Resulting transactions are not fully settled because the value of the currency can be arbitrarily altered after the fact.

History has shown that fiat currencies are always debased and that confidence in them eventually fails causing vast economic disruptions, losses of wealth, social and political chaos and even loss of life. The inevitable disasters caused by fiat currency schemes are usually followed by a return to commodity money but, once stability is achieved, a new fiat currency scheme is put in place repeating an unnecessary and destructive cycle that benefits few and harms many. Ironically, while commodity money is denigrated by those who benefit from fiat currency schemes, former Federal Reserve Chairman Alan Greenspan noted as recently as 1999 that "Gold still represents the ultimate form of payment in the world. Fiat money in extremis is accepted by nobody. Gold is always accepted."

Defenders of fiat currency schemes claim that they promote stable prices and moderate economic volatility. In fact, the opposite is true. Fiat currencies not only destabilize economies but undermine the moral basis of society. Without exception, in every historical case when a currency has been de-coupled from the objective world, i.e., from commodity money, the result has been disaster. Fiat currency schemes guarantee unending monetary and resulting economic, social and political chaos marked by brief periods of calm between inevitable abuses, bubbles and collapses.

Martin Armstrong on the Sovereign Debt Crisis

Ron Hera — Sun, 01 Jul 2012 20:06:00 GMT

The Hera Research Newsletter is pleased to present a fascinating interview with Martin A. Armstrong, founder and former Head of Princeton Economics, Ltd. In the 1980s, Princeton Economics became the leading multinational corporate advisor with offices in Paris, London, Tokyo, Hong Kong and Sydney and in 1983 Armstrong was named by the Wall Street Journal as the highest paid advisor in the world.

As a top currency analyst and frequent contributor to academic journals, Armstrong's views on financial markets remain in high demand. Armstrong was requested by the Presidential Task Force (Brady Commission) investigating the 1987 U.S. stock market crash and, in 1997, Armstrong was invited to advise the People's Bank of China during the Asian Currency Crisis.

Based on a study of historical gold prices and financial panics, Armstrong developed a cyclical theory of commodity prices, which lead to the pi-cycle economic confidence model (ECM), used to make long term forecasts. Using the ECM, Armstrong predicted both the high-water mark of the Nikkei in 1989, months ahead of time, and the July 20, 1998 high in the U.S. equities market, as well as a major top in financial markets on February 27, 2007. The ECM was called "The Secret Cycle" by the New Yorker Magazine and Justin Fox wrote in Time Magazine that Armstrong's model "made several eerily on-the-mark calls using a formula based on the mathematical constant pi." (Pg 30; Nov. 30, 2009).

Hera Research Newsletter (HRN): Thank you for joining us today. Considering the Federal Reserve swap lines and the European Central Bank's (ECB) Long Term Refinancing Operation (LTRO), what's the outlook for the Euro?

Martin Armstrong: The structure of the Euro is fundamentally flawed. To put it in American terms, it would be as if all fifty states were able to issue federal bonds. It would be total, absolute chaos. What they did, to be politically correct, was to say that, since every member issues its own federal type bonds, they all have to be reserves and the large banks have to fairly allocate among them all. It's completely crazy. As countries like Greece and Spain and Italy crumble under the debt, it feeds back into the banking system. In the United States, we had the Long Term Capital Management (LTCM) collapse and we saw the government bail out a hedge fund so that they wouldn't be seen bailing out the New York banks. They have the same problem in Europe. Basically, the ECB bailing out European banks is really going through the back door to support European sovereign bonds.

HRN: Would it be fair to say that the bailouts of Greece have really been bank bailouts while the LTRO is a sovereign debt bailout?

Martin Armstrong: Sure. The two words "political" and "economy" should have been divorced when they first met. Politicians always do this. In the U.S. Savings and Loan (S&L) crisis, the politicians encouraged lending into local real estate markets by allowing thrifts to be federally chartered in 1980 and insuring them with public dollars. So the S&Ls concentrated their portfolios in real estate. Then the politicians needed money so they reduced the schedule for write-offs in real estate. And they didn't think that would change the market? They basically expanded credit for real estate, incentivized S&Ls to invest in real estate, then passed the Tax Reform Act of 1986. So then about a quarter of S&Ls went bankrupt and they had an S&L bailout and wanted to lock everybody up when they had created the problem in the first place. It's the same type of thing in Europe.

HRN: European politicians created the European sovereign debt crisis by rating all European sovereign bonds as reserves?

Martin Armstrong: Yes. By making all European sovereign bonds reserves and requiring banks to hold reserves, they made European banks hold the debt of countries like Greece and Spain. Greece, for example, was able to borrow at substantially lower rates than they would have normally. This year, €600 billion in debt has to be rolled forward only for Spain and Italy. All these bonds were issued at a very low rate. Now they have to be rolled forward and the new rates are around six or seven percent. The government budgets are going to grow dramatically and this is going to cause the real economic crisis.

HRN: Will the European Financial Stabilization Mechanism (EFSM) help to solve that problem?

Martin Armstrong: No. I told them in 1997 or 1998, when they were creating the Euro, that they couldn't do this and they had to have a single debt. They felt that it would be perceived as a bailout of members that had more debt at the time. The EFSM, which is part of the European Financial Stability Fund (EFSF), is moving in that direction but it's more of a bailout mechanism, not a consolidation. It's a half measure. They need to convert the existing debt into federal bonds and whatever new debt is issued by European Union member countries would be the equivalent of U.S. state debt and not acceptable for reserves.

HRN: Can the Euro survive?

Martin Armstrong: I don't think it will go off the boards. I think they will do everything in their power to keep it there. Politicians never want to admit a mistake. If they have to inflate they will inflate. Germany has capitulated.

HRN: Will this cause another financial crisis?

Martin Armstrong: The next crisis we're going to see will be from 2015 on. It doesn't take more than a three year old with a pocket calculator to see the long term trends.

HRN: Do you mean the European sovereign debt crisis?

Martin Armstrong: It's not just the Euro zone. The entire idea that you can borrow perpetually year after year and never pay anything back and that, somehow, that's less inflationary than if you just print money is absolutely insane. In the U.S., if we had just printed the money, the national debt would only be 40% as much as it is today. We're both creating currency and also paying interest on it.

HRN: Do you see Japan as having the same problem as well?

Martin Armstrong: Japan's debt is slightly below 300% of GDP. The only reason the yen has remained strong is because money is being drawn back into Japan. I think we're approaching a bottom in Japan that will be followed by inflation and that will probably be the last straw.

HRN: How would you compare the U.S. dollar to the Euro and the yen?

Martin Armstrong: The U.S. dollar is the best looking of the three ugly sisters. Europe is a basket case because of its structure. They'd have to federalize Europe and I don't think there's a political will to do that. Japan is totally hopeless at this stage.

HRN: Does this call into question the whole concept of central banking?

Martin Armstrong: Central banks can step up and add cash to the system when necessary, taking in the longer term assets. That was basically the original idea of the Federal Reserve.

HRN: Isn't the Federal Reserve System the main reason why the U.S. national debt is so high compared to what would have happened if the U.S. government issued its own currency?

Martin Armstrong: When the Federal Reserve was created there really wasn't any national debt. The U.S. national debt began with World War I and then World War II. When the Federal Reserve wanted to stimulate the economy it bought corporate paper not federal bonds and that really did stimulate the economy. The politicians have completely distorted what the Federal Reserve was supposed to be. In order to issue all the debt for the wars, the politicians instructed the Federal Reserve not to buy corporate paper but to buy federal paper. Throughout World War II they also instructed that the Federal Reserve maintain the par value of those bonds.

HRN: Politicians altered the role of the Federal Reserve?

Martin Armstrong: When the Federal Reserve was created, in 1913, it really was a kind of an insurance mechanism to help manage the banks and it was owned by them. It wasn't as sinister as many people have portrayed it. It was closer to something like the Securities Investor Protection Corporation (SIPC) or the Federal Deposit Insurance Corporation (FDIC). It was World War I that changed the role of the Federal Reserve. They came up with this theory that inflation was an increase in the money supply and, since the Federal Reserve was in charge of the money supply, the politicians basically said to the Federal Reserve that inflation was their problem. The vast majority of the members of Congress don't think they have any responsibility for the economy. They throw their hands up in the air and say "well, that's the Fed's job."

HRN: Fractional reserve banking systems are inherently inflationary.

Martin Armstrong: Well, it's really a leveraging system. You're increasing the money supply by taking the same money and lending it out several times, so if I deposit $100 and the bank lends you $100 we both think we have $100 but there's only one $100 deposit. Take the mortgage market where the Federal Reserve created trillions by buying mortgage backed securities (MBS). The mortgage market contracted by maybe $5 trillion from the top. So, you have deleveraging at the same time. If the Federal Reserve created $3 trillion when there was no deflation then that would be inflationary, but, in this type of system, every time you get a decline in the economy it's deflation and deleveraging. In a deflation, everyone wants cash so asset values fall. The cash is only a small fraction of the total asset value at the peak. If Bill Gates sold all his Microsoft stock at once it wouldn't be worth as much as it is on paper. It's a yin and yang between leverage and deflation.

HRN: What's the difference between leveraging deposits to loan out $10 for every $1 on deposit and creating money out of thin air?

Martin Armstrong: The current banking system that we have in the world today is really a fraud. You used to pay the bank as a storage facility to store your money but they began lending it out to make more money. They figured out a long time ago that they only needed to keep 6% or 10% of deposits. When the economy goes down it's a kind of a run on the bank. But the real problem is that they borrow short term on demand deposits and lend long term to make the spreads. When a crisis comes, their assets are tied up for ten or twenty or thirty years but they've got short term demand saying 'give me my money now'. So the system doesn't really work on a perpetual basis.

HRN: Let's talk about the gold standard. Would it have prevented the European sovereign debt crisis?

Martin Armstrong: No. In the U.S., they could have kept the gold standard but they had to raise the price of gold. They kept the official price at $35 and went to a two tier system in 1968 where the free market also had a price. They continually issued more paper but didn't change the ratio. They didn't think, at some point, it was going to go bust? Politicians always spend more than they have. We had a gold standard and they blew it up. It's "vote for me and I'll give you a chicken in every pot." Nothing is funded. In the U.S., there has been no planning for Social Security. It's just politicians standing up and saying "vote for me and I'll give you this and that" but nobody pays for it.

HRN: Do you favor returning to a gold standard?

Martin Armstrong: We have to deal directly with the government spending. Eliminate the ability to borrow. That's more important than what you are going to call money. In theory, what are they trying to do with the gold standard? They are trying to say, if we put the gold standard in then you can't create money beyond what you have in gold, but they did that the last time. I don't see where that is some sort of magic bean that's going to stop them from doing it again. It gets to a stage where it doesn't matter if you use conch shells for money or gold. There is no fiscal responsibility in government. We have to eliminate the core problem and eliminate government borrowing except in time of war.

HRN: Is that an argument for smaller government?

Martin Armstrong: Absolutely. During the Great Depression, unemployment had only gotten up to where it is now but then we had the Dust Bowl. It was what Schumpeter called creative destruction. It started the American workforce on a path to skilled labor. Before the Great Depression nearly half of the workforce was in agriculture. By 1980 only 3% was in agriculture. We are facing the same problem now only 40% of the workforce is in government. They produce nothing and don't contribute anything at all to the gross domestic product (GDP). Of course, the government statistics include both the government's spending and also the wages of government employees, so, if the government hires someone, the GDP goes up twice as fast.

HRN: That would suggest that the debt to GDP situation is worse than it appears.

Martin Armstrong: Yes. The government basically finagles every number under the sun. We're looking at a very, very serious situation. The only country that has funded its pension plan is Australia. The U.S. has $60 trillion in unfunded liabilities. At the peak, in 2007, the total of U.S. mortgages was $15 trillion. We are facing dire circumstances ahead. This is why the government is going after what they call the rich, etc. The rich now include anyone with household income of $250,000 or more. If you and your wife both have a job that pays $125,000 per year you're part of the rich. Since young people are staying with their parents longer, their income may be a part of household income too.

HRN: Isn't that what's left of the middle class?

Martin Armstrong: They always bring out people like Warren Buffett or Bill Gates but there aren't that many of those people and if the government took everything they had it wouldn't even balance the budget for a year. This is effectively a war against the American middle class. The ceiling will start to cave in when they can't sell bonds anymore. At that point, the bond market will be absolutely devastated.

HRN: Do you expect the Federal Reserve to continue monetizing U.S. Treasuries: QE3, for example?

Martin Armstrong: They are forced into monetization but it won't stimulate the economy. It isn't only Americans that own 30 year bonds. Maybe the Chinese sell their bonds to the Federal Reserve and then say thanks and take the money back to China. You can't stimulate just a domestic economy. The theories the Federal Reserve has are antiquated. They're based on the domestic economy and even on the old gold standard. These are theories based on things that don't even exist anymore. Look at the universities. They don't even teach hedging at the London School of Economics. It's amazing.

HRN: Do you think we'll see U.S. dollar hyperinflation?

Martin Armstrong: No, because the economy would not survive long enough to reach the stage of hyperinflation. Everything would collapse before that happens. What's important to understand is that Americans tend to focus on American numbers but Europe is in far more serious trouble. A lot of the European banks are still owned by the governments.

HRN: What can the U.S. government do to get the economy back on track?

Martin Armstrong: It's hard to get them to do anything that's actually going to be beneficial to the economy. They don't get it. There are also record highs in terms of corporate cash in the U.S. because the politics are so bad.

HRN: What is it that members of Congress don't understand?

Martin Armstrong: I testified before the House Committee on Ways and Means in 1996 and they wanted to know why no American companies had gotten any of the contracts to build the Yellow River dam. I said that the U.S. and Japan are the only countries in the world that tax worldwide income. We hear about companies paying their fair share, but if they're not in the United States, what is a fair share? As far as the U.S. government is concerned, you're an economic slave. If you're born in the United States, you owe taxes in the U.S. even if you're not in the U.S. and don't receive any benefits. Other countries don't do that. A German company, for example, bidding on the same contract in China is automatically cheaper than an American company.

HRN: Are you saying that the U.S. federal government's tax policies have driven companies offshore?

Martin Armstrong: In order to compete internationally, American companies have to leave the United States. It isn't just because of the labor costs because you have to have a skilled labor force. I helped take a lot of companies into Europe. You have to balance the type of labor force versus tax advantages. You can't just put an automaker in Zimbabwe. It's much more of a delicate balance than what politicians tend to say.

HRN: Is there anything that policymakers can do to bring companies back to the U.S.?

Martin Armstrong: One of the primary things is that the tax rate should be cast in stone and it should not change for every election. That is why corporate cash is at record highs. Why should a company start to hire people when all you hear is "we're going to get the rich", "we're going to get the corporations" and they're going to have to pay more. This is why corporate cash is at an all time high. Why should you start hiring people now and then next year you might have to pay 20% more? You can't do things that way. No one, on a personal level, would go sign a lease on an apartment where the lease said the landlord can change your rent at any time he wants if he spent too much money for himself. A contract is a contract and you're not going to have stability until you have something set in stone. A lot of countries have attracted capital by doing precisely this. If you go there and set up a plant, they guarantee not to increase taxes for 20, 30, 40 years. If you're going to do a business plan then you need to know what your costs are. It can't be maybe $1 mill this year and next year it's 25% more. Business plans don't work like that. The politicians need to just cast it in stone and that's it; take it off the table. Stop the rhetoric. They're not going to create jobs without that. Why should anyone build a plant in the U.S. if the government can change everything in 6 months? That's not the way to build an economy.

HRN: So, uncertainty is one of the main problems with the U.S. economy?

Martin Armstrong: The major problem is the whole debt structure. Uncertainty is why cash is at record levels and it's been that way for at least 2 years now. Lack of stability dampens confidence. In order for somebody to invest, there has to be confidence. This is why interest rates can go to 0%, but if you don't think you can make 1% then you're not going to borrow at 0%. Interest rates always go down dramatically during a depression because no one is willing to borrow. There is a lack of confidence in the future, so you're not going to have somebody opening a new restaurant or hiring a bunch of people. Small companies, in particular, are not hiring because they can't get a loan from a bank. They're cut off more than a large company. A large company, if it's public, has shares and banks will lend more against them then they will against a small business owner. Small businesses create the most jobs but they get bashed the most by the banks and they are less likely to hire because they can't borrow to do so.

HRN: What else should the U.S. government do to get the economy back on track?

Martin Armstrong: The government has to stop the perpetual borrowing and we have to really deal with the national debt. It would have to change the tax policies and they would have to cast it in stone that it can't change. It can't flip back and forth for every election because when you do that then you are undermining confidence. Why should somebody build a plant or hire more people until after the next election?

HRN: How can monetary policy help?

Martin Armstrong: As soon as something happens the politicians throw their hands up in the air and say it's the Federal Reserve's fault. It's not the Fed's fault. The politicians are the ones actually doing the spending. The Federal Reserve can't control Congressional spending. There's not much it can do to change the dynamics of the problem. The Fed can seize any company it thinks is too big to fail, so now we're outside the scope of banking. They can seize Ford Motor Company if they want to. We are so far from what the Federal Reserve was supposed to be, it's just insane. It wasn't supposed to be in charge of the money supply. It wasn't supposed to be in charge of inflation or bailing out companies that are too big to fail. It was never designed to do this, it was simply there as an insurance fund for banks, period. The Congress assumes they have no responsibility. Nobody takes responsibility. It's just one big party down in D.C.

HRN: Thank you for your time.

Martin Armstrong: It's my pleasure.

After Words

Martin Armstrong, founder of Princeton Economics, Ltd. is one of the most sought after experts in the world on financial markets, global capital flows and currencies. His frank assessment of the monetary and economic problems facing the U.S., the EU and Japan today points to government spending, tax policies and meddling in the banking system by politicians as the root causes. The solution starts with cutting government spending, instituting consistent, long term tax rates and tackling the real reasons why American companies have moved offshore. Without fundamental changes, out of control spending, failure to take responsibility, lack of accountability and crippling uncertainty will prolong poor economic conditions and high unemployment indefinitely.

The Unholy Alliance of John Maynard Keynes

Ron Hera — Sun, 01 Jul 2012 20:03:00 GMT

Perhaps the greatest modern champion of central economic planning was the 20th century English economist John Maynard Keynes. Keynes, who was a political socialist and for a time a central banker, advocated the idea that the government should play a large, active role in the economy. Among the consequences of Keynes' economic theories, whether intended or unintended, is the fact that Western economies today are characterized by large, central governments, central banks and massive debts.

According to Dr. Andrew Gelman, Professor of Statistics and Political Science at Columbia University, "the law of unintended consequences is what happens when a simple system tries to regulate a complex system. The political system is simple. It operates with limited information (rational ignorance), short time horizons, low feedback, and poor and misaligned incentives. Society, in contrast, is a complex, evolving, high-feedback, incentive-driven system. When a simple system tries to regulate a complex system you often get unintended consequences." Professor Gelman's statement seems equally apropos to central banking.

Government policies based on Keynesian theories and the institution of central banking form a nexus of central economic planning. Control of the central planning process is a winner-take-all proposition for businesses. In the U.S., the result is an unholy alliance of the U.S. federal government, the Federal Reserve (along with the largest U.S. banks) and the largest U.S. corporations. The logical chain beginning with Keynes' fundamental idea that government, supported by a central bank, should play a large and active role in the economy sets the stage for a centrally planned economy and ultimately produces a corporate state.

The U.S. economy is locked in a downward spiral of economic decline. By growing in size, and by engaging in ever larger economic interventions, the U.S. federal government became itself a material cause of the recession that began in 2007. By attempting to grow the economy through monetary expansion, i.e., consumer spending fueled by debt, the Federal Reserve destroyed savings and fueled a series of disastrous economic bubbles, culminating in the housing bubble. At the same time, the largest U.S. banks engaged in reckless lending and high-stakes gambling on hundreds of trillions in over the counter (OTC) derivatives. OTC derivatives, which amount to risky, largely un-backed wagers, were the root cause of the "too big to fail" doctrine that has virtually bankrupted Western governments since 2008. By seeking ever greater influence over Washington D.C. and by seeking to generate higher profits by cutting production in the U.S., the largest U.S. corporations undermined the U.S. market and economy. The U.S. federal government did virtually nothing to prevent the destructive developments because of the influence of the largest U.S. corporations.

Following Keynesian economic theories, the policy response of the U.S. federal government to the recession that began in 2007 and of the financial crisis that began in 2008 was to expand the government further and at a more rapid pace. In other words, some of the root causes of the economic imbalances that lead to the recession and financial crisis (the relative size of the government and the resulting economic distortions) were compounded. As a consequence, the so-called "double dip recession" in the U.S. that began in the second half of 2011 will be longer and ultimately more severe than the economic downturn of 2007-2009.

The Baltic Dry Index (BDI) indicates international shipping returning to crisis levels. Since the U.S. is the world's largest economy and has a large trade deficit, the BDI suggests that the U.S. is in a recession.

Leviathan: The Size of the State

Originally a sea monster referred to in the Bible and, in demonology, one of the seven princes of Hell, as well as its gatekeeper, the name Leviathan was adopted by the English philosopher Thomas Hobbes to refer to an artificial political order, i.e., to the institution of the state. Hobbes was concerned with the distinction between individual rights and the powers of sovereign governments and he elaborated the idea of the social contract. When a government taxes its citizens, it implicitly asserts the right of the government over the property rights of individuals and presupposes that the government can make better use of economic resources than households, individual entrepreneurs, businesses and private investors.

In theory, the government's use of economic resources accomplishes goals that privately owned businesses cannot, such as national defense or emergency response services, i.e., things that, by their nature, are not economically productive or profitable but still necessary for society. In contrast, embarking upon idealistic projects such as "creating jobs" or "expanding home ownership" encroaches on the productive elements of the economy. However, governments are inefficient compared to privately owned businesses due to the absence of competition. Further, the record of history suggests an inability on the part of central planners to make superior economic decisions.

Government encroachment on the private sector, like a self fulfilling prophecy, often magnifies the reasons why government intervention was originally believed to be necessary. For example, when the U.S. federal government became involved in education through federally guaranteed student loans, the result was that the cost of a college education rose towards the limit of what students could borrow and repay during their careers simply because the loans were guaranteed by the government. The guarantees produced more and riskier loans, larger loans and higher education costs.

When the U.S. federal government promoted home ownership for minorities and the poor, mortgage loan guarantees resulted in higher home prices and contributed to the sub-prime lending debacle where banks originated loans to unqualified borrowers in order to sell them to government sponsored entities (GSEs), i.e., to Fannie Mae and Freddie Mac, and to investors as collateralized debt obligations (CDOs) and other mortgage backed securities (MBS).

Banks were certainly to blame for knowingly making bad loans, which is fraud, but the conditions that made the problem possible existed substantially because of government intervention in the housing market, i.e., opening the door to fraud was an unintended consequence of policies intended to increase lending to unqualified, low income borrowers. Of course, the U.S. federal government did not compel lenders to commit fraud, thus accountability for the U.S. mortgage disaster is shared by the federal government, which interfered with the free market, pursued misguided policies and failed in terms of regulatory oversight and law enforcement, and by banks, which engaged in widespread mortgage related fraud.

Governments redistribute wealth and manipulate economic activity through taxes, subsidies, guarantees, regulations and so forth, but they do not produce new wealth. Government spending may be for good purposes, or at least stem from good intentions, but it unavoidably favors businesses with close ties to the government over those that are taxed but that do not benefit. Despite the theoretically higher moral purposes of lofty government undertakings, government programs that overlap the private sector divert economic resources to businesses that have the favor of politicians minus the cost of government, thus producing economic distortions and a net loss of wealth for society.

The Rahn curve is an economic theory proposing that there is an optimal level of government spending, 15% to 25% of gross domestic product (GDP), to maximize economic growth. As the government grows larger, economic growth is curtailed and, eventually, the economy contracts, crushed under the burden of government. As the government grows in size relative to the economy, not only is economic growth compromised, but the potential for, and the cost of, government waste, fraud and abuse increases.

How the Government Destroys Jobs

While politicians extol the theoretical benefits of ever more government control of the economy, e.g., through increased regulation, from the standpoint of individual entrepreneurs, businesses and private investors, the government is a nuisance, an impediment to wealth creation, and the source of countless costs and risks. The larger the government becomes relative to the size of the economy, the more it tends to discourage economic activity. Although roughly 70% of U.S. jobs are created by small businesses, ranging from family owned businesses to high technology startups, the burden of government falls disproportionately on them because they have fewer resources with which to administer and to demonstrate compliance with government regulations.

When large companies are audited or investigated by any of several government agencies, their accounting, legal and compliance departments are well equipped to deal with such matters. However, when a small company faces the same hurdles or seeks government permits, licenses or certifications, its operations are directly impacted and the associated accounting, legal and regulatory compliance costs can cause the business to lose money or to fail. In the event of an audit or investigation, small business owners in the U.S. generally seek to comply immediately and often pay fines or penalties without contest in order to end the government's interference. While large companies can afford to dispute the government, small businesses face the equivalent of extortion.

As a practical matter, small businesses in the U.S. are permitted to operate at the sole discretion of government bureaucrats that can effectively shut down small businesses without any evidence of wrongdoing. Setting aside the fact that small business owners live in constant and well justified fear of their own government, the result is a stifling of economic activity and a net loss of jobs. For example, traditional small businesses in the U.S., i.e., sole proprietorships, increasingly avoid hiring employees.

Free market competition and the inherent uncertainty of economic conditions provide ample risk for startup businesses. A disproportionately large government relative to the size of the economy damages economic activity and discourages investment in new businesses. The aggregate overhead of government regulations and regulatory compliance, along with taxes and potential penalties, e.g., the 2010 Patient Protection and Affordable Care Act ("Obamacare"), increases business costs, amplifies business risks and further increases the burden of regulatory compliance. The result of systematically increasing the costs and risks of doing business-in lock step with the size of government-is to reduce the rate of business formation and to encourage investors to look elsewhere to find returns.

If the U.S. government, currently almost 45% of GDP, desired to create jobs, the correct policy would be to greatly reduce the countless regulations, taxes and fees that encumber small businesses. The path to job creation is for the government to reduce job destruction. Since no political will to reduce the size of the government exists, however, continued shrinking real GDP and permanent workforce reduction can be expected.

Money Out of Thin Air

Central banks, such as the Federal Reserve, are examples of central economic planning, i.e., they control the money supply and exercise centralized control over the value and cost of money through interest rates, bank reserve ratios, monetary inflation and by other means. In contrast to the government's central planning for the putative public good, the Federal Reserve engages in central planning for the benefit of banks. Like the U.S. federal government, the Federal Reserve, through monetary mechanisms, distorts spending and investment patterns, redistributes wealth and preempts the financial and economic decisions of households, individual entrepreneurs, businesses and private investors.

When a central bank increases the money supply beyond the level necessary to support a sustainable economy or population growth, it destroys the value of savings and wages by diluting the value of money and causing prices to rise. Wall Street embraces the Federal Reserve because easy monetary policies provide an inexpensive way to finance operations and to expand, but there is a cost. Inflationary monetary policies favor speculators over savers and debt over genuine capital formation.

Banks do not create wealth. The structure of the financial system, where debt-based money is created ex nihilo, virtually guarantees banks a piece of the action whenever wealth is created. When debt service (principal and interest payments) is attached to the income streams of consumers and businesses, excess production is diverted from capital formation into the coffers of banks. The Federal Reserve, therefore, is at the core of a system where, over time, wealth accrues to banks while capital formation is reduced, ironically increasing the need to borrow. The majority of entrepreneurs and businesses have little choice but to borrow and, even if they are successful, the economy as a whole may still suffer due to increased debt levels relative to GDP.

Keynesians embrace the Federal Reserve's un-backed, fiat money because it permits the government to borrow and spend freely based on the theory that stimulating the economy through deficit spending produces economic growth at a faster pace than debt accumulates. However, as a function of debt service, the number of dollars that must be borrowed and spent to generate each new dollar of GDP becomes larger as the total amount of debt grows.

The result is debt saturation where further debt funded increases in GDP are impossible and where, therefore, existing government debt cannot be retired, i.e., the result of Keynes' theory, taken to an extreme, is government insolvency and sovereign default. Default, of course, can take the form of monetary inflation in order to debase the currency and reduce the real value of debt, e.g., the Federal Reserve's monetary easing and continued accommodative monetary policy.

Keynes and The Corporate State

The U.S. economy is anything but a free market today. In fact, the U.S. government increasingly resembles an oligarchy in which the oligarchs are large corporations, i.e., a "corporatocracy". Thus, the illegitimate offspring of the grand government envisaged by Keynes and the institution of central banking is a corporate state.

Without a large government, businesses have little incentive to influence it, but with the government (local, state and federal) representing nearly half of the U.S. economy, influencing the government is a mission-critical objective for every company. The size of government implied by Keynesian economics provides motive and opportunity but only the largest corporations have the means to succeed.

The goals of businesses seeking to influence the government include winning government business, mandating consumption of products and services (from child car seats to health insurance), avoiding taxes, guaranteeing profits, creating regulatory loopholes, protecting markets, eliminating competition, socializing losses and so forth.

Obama		Romney
Citigroup Inc	$736,771	Citigroup Inc	$57,050
Columbia University	$547,852	Bain & Co	$52,500
General Electric	$529,855	Bain Capital	$74,500
Goldman Sachs	$1,013,091	Goldman Sachs	$367,200
Google Inc	$814,540	Bank of America	$126,500
Harvard University	$878,164	Barclays	$157,750
IBM Corp	$532,372	Blackstone Group	$59,800
JPMorgan Chase & Co	$808,799	JPMorgan Chase & Co	$112,250
Latham & Watkins	$503,295	Credit Suisse Group	$203,750
Microsoft Corp	$852,167	EMC Corp	$117,300
Morgan Stanley	$512,232	Morgan Stanley	$199,800
National Amusements Inc	$563,798	HIG Capital	$186,500
Sidley Austin LLP	$600,298	Kirkland & Ellis	$132,100
Skadden, Arps et al	$543,539	Marriott International	$79,837
Stanford University	$595,716	PriceWaterhouseCoopers	$118,250
Time Warner	$624,618	Sullivan & Cromwell	$79,250
UBS AG	$532,674	UBS AG	$73,750
University of California	$1,648,685	The Villages	$97,500
US Government	$513,308	Vivint Inc	$80,750
WilmerHale LLP	$550,668	Wells Fargo	$61,500
Total Primary Dealers:	$3,603,567	Total Primary Dealers:	$810,050
Political campaign contributions indicating U.S. Federal Reserve Primary Dealers (Source: opensecrets.org)

The influence of Wall Street over Washington D.C. through political campaign contributions, corporate lobbyists and revolving doors (where the same individuals alternate between closely linked private sector jobs and government posts) is almost absolute. Lobbyists are intimately involved in writing legislation that is often rubberstamped by the U.S. Congress, i.e., passed without reading or meaningful debate. The largest corporations support political candidates through campaign contributions and by funding political action committees that, among other things, use corporate public relations tools for political purposes, i.e., propaganda. Key government posts are consistently held by individuals with clear conflicts of interest and the existence of such conflicts is routinely ignored.

The current reality of the United States is that the largest corporations have hijacked the Keynesian central planning powers of the federal government and have used these powers to encourage ever larger and more direct interventions in the economy for their own benefit, as well as laws and regulations that serve as a barrier to free market competition. U.S. regulators, such as the Securities and Exchange Commission (SEC), Commodities and Futures Trading Commission (CFTC) and the Food and Drug Administration (FDA) appear to have been captured by the industries they are intended to regulate. Government regulators selectively enforce regulations, often against small businesses and growing companies, such as organic dairy farmers, protecting the interests of the largest corporations from small businesses, free market competition and consumer choice.

The largest U.S. corporations (including oil companies like ExxonMobil and Chevron; drug companies like Johnson & Johnson, Pfizer and GlaxoSmithKline; agribusiness companies like Archer Daniels Midland, which are heavily subsidized by the U.S. federal government; agricultural biotechnology companies like Monsanto; military contractors like Lockheed Martin, Northrop Grumman, Boeing, Raytheon and General Dynamics; and banks like Bank of America, J. P. Morgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) have not only been the beneficiaries of government expansion, deficit spending and central economic planning, but, considering political campaign funding practices, have become the de facto oligarchs of America.

Sliding Into the Keynesian Abyss

The decline of the U.S. economy is the logical outcome of Keynesian economics, which enshrines central economic planning and embraces central banking. The unholy alliance of the federal government, the Federal Reserve and Wall Street has all but eliminated capitalism and has transformed the United States from a burgeoning free market economy into a failing corporate state.

The U.S. federal government, the Federal Reserve and Wall Street each played a role in the progression from central economic planning and central banking to a corporate state. Politicians used Keynesian economics to justify big government, a welfare state and budget deficits. The Federal Reserve sought to grow the economy through monetary expansion, focusing on consumption but ignoring debt levels and inadvertently encouraging financial speculation. At the same time, Wall Street sought higher profits both by eliminating production (and jobs) in the U.S. and by sparing no expense to influence the government. The resulting corporate state undermined capitalism and the free market in the United States and produced a downward spiral of economic decline from which there is no escape without fundamental reforms.

Keith Neumeyer: The Silver Market Lacks Integrity

Ron Hera — Sun, 01 Jul 2012 19:59:00 GMT

The Hera Research Newsletter (HRN) is pleased to present an incredibly powerful interview with Keith Neumeyer, Chief Executive Officer, President and Director of First Majestic Silver Corp. (TSX:FR / NYSE:AG). Mr. Neumeyer began his career at the Vancouver Stock Exchange and worked in the investment community for 26 years beginning his career in a series of Canadian national brokerage firms including McLeod Young Weir (now Scotia McLeod), then Richardson Greenshields and then Walwyn Stogell McCuthchen (which became Midland Walwyn).

Mr. Neumeyer moved on to work with several publically traded companies in the natural resource and high technology sectors. His roles have included senior management positions and directorships in the areas of finance, business development, strategic planning and corporate restructuring. Mr. Neumeyer, who has listed a number of companies on the Toronto Stock Exchange, has extensive experience dealing with financial, regulatory, legal and accounting issues.

Hera Research Newsletter (HRN): Thank you for joining us today. Let's begin by talking about silver supply and demand.

Keith Neumeyer: Silver mine production was around 736 million ounces in 2010. Demand was around 1 billion ounces. Scrap silver recycling and some government sales filled the gap. We're at historic lows in terms of above ground silver. Eric Sprott recently said there are 1 billion ounces of triple nine silver left aboveground. Unlike gold, silver gets used. We're at historic highs in supply when it comes to gold, but the exact opposite is true for silver.

HRN: Is there a deficit in terms of mine supply?

Keith Neumeyer: We've had a supply deficit for the past 13 years. 2009 was the first year we created equilibrium. We only went into a surplus in 2010, in terms of industrial and jewelry fabrication demand. The surplus mine supply was purchased by investors, obviously. A lot of mining companies are showing lower production because a lot of silver comes from base metals and, with lower base metals prices, it's becoming more difficult. I don't see any major supply drivers for silver in the next several years.

HRN: Do you expect more scrap silver to enter the market?

Keith Neumeyer: That's what happened in 2009 when gold rallied over $1,200 and then corrected to below $1,100. It was primarily caused by scrap gold entering the market. I believe the same thing was happening for silver. We'll see that again as the metals make new highs. It's the same as a stock. You replace part of the shareholder base at different levels.

HRN: Are you optimistic about future demand?

Keith Neumeyer: Yes, I've been optimistic about silver since 2002 because silver is a strategic metal. I think it's more important than gold.

HRN: Are there new applications that could increase demand?

Keith Neumeyer: We're seeing all kinds of new applications. A recent report by Barclays forecast that 120 million ounces of silver will be used for solar power generation in 2012 versus 40 million ounces in 2009. The battery industry is growing as well. Zinc-silver batteries provide very stable capacity-their output doesn't degrade like lithium batteries-and they deliver 40% more energy compared to nickel metal-hydride batteries. They're safer than water-based chemical batteries because they don't heat up or explode. They're also mercury free and 95% recyclable. Lithium-ion batteries in cell phones, for example, need to be replaced after 12 to 18 months. I'm very optimistic about battery technology. There are also robotics and other applications on the horizon.

HRN: What's your long term price target for silver?

Keith Neumeyer: Silver will reach a value based on its natural ratio of 15:1 with gold. I expect to see at least $2,000 gold and most likely $3,000 in the next 3 to 5 years, so silver will be between $130 and $200. It's a big number from where we are today but that's where I think we're headed. We're dealing with a market that needs to be corrected.

HRN: Isn't the price of silver set by supply and demand?

Keith Neumeyer: I don't think supply and demand has anything to do with the price, unfortunately. The world we live in today is a paper environment where silver is priced by financial circumstances. Banks, traders and investors around the world move markets to where they want them to be. Governments and commercials-big banks like HSBC and JP Morgan-all have a piece of the action. They alternately work together or sometimes against each other. All these forces price the metal. That's one reason we're seeing the volatility that we're seeing today.

HRN: How can supply and demand be irrelevant?

Keith Neumeyer: In short term trading, the price is financially driven. Eventually, markets do correct themselves over time. In the long run, supply and demand does have influence. That's why the price will ultimately return to its natural ratio of 15:1.

HRN: How is the price of silver financially driven?

Keith Neumeyer: It has to do with the financial instruments that we trade in and with the fact that silver trades a billion ounces per day on the COMEX alone when there are 26 to 30 million ounces of silver available for delivery. With that kind of leverage, you just don't have a proper market.

HRN: It has been reported that there are 100 ounces under contract for every ounce in the COMEX warehouse.

Keith Neumeyer: The governments, regulators and bullion banks have let the silver market get more and more leveraged. We've seen a lot of wealth destruction as a result of this leverage and we're going to see a lot more until, finally, the governments decide to change the system.

HRN: Isn't the COMEX guaranteeing market integrity, by raising margins, for example?

Keith Neumeyer: I don't buy the argument on margin hikes at all.

HRN: Don't margin hikes prevent dangerous asset price bubbles?

Keith Neumeyer: It's not up to them to decide what is parabolic. They're not investors themselves. They don't have money in the market. They decide a bubble is going to happen if they don't raise margins but no one knows when a bubble is forming. It is only apparent after it's already happened. By hiking the margins, they create the appearance of a bubble bursting. They create the bubble. They create the proof that it was a bubble. If they let it alone, the market would stabilize by itself.

HRN: What should the Commodities and Futures Trading Commission (CFTC) do?

Keith Neumeyer: The job of the regulators is to protect the retail investor. That's their only job. It's not to protect the banks or the brokerage firms. The little guy is the primary taxpayer. Why were the Securities and Exchange Commission (SEC) and the CFTC put in place? They were put in place to protect retail investors. Prior to regulation, the banks controlled the market. Today, the banks control the market again. Who should control the market? Retail investors. Who's protecting them? No one.

HRN: Are you saying that the CFTC does nothing while the COMEX caters to banks and brokerage firms?

Keith Neumeyer: Yes.

HRN: And the COMEX doesn't serve retail investors?

Keith Neumeyer: No. Absolutely not.

HRN: Do you foresee a return to a free market in the future?

Keith Neumeyer: I'm an optimist. I believe one day that governments will rewrite the rules and force the regulators to protect investors. That's where we were back in the '70s and that's where I think we have to be again to correct the problems that have arisen over the past 40 years. Silver is being revalued. It's going to affect a lot of people along the way and it will change the financial system. Ultimately, we're going to have a new financial system and, hopefully, we'll go back to natural markets, completely driven by supply and demand. It may take another 20 years but I think it will happen.

HRN: A new financial system?

Keith Neumeyer: If I'm wrong, the banks will run the world, even more so than they do today, 10 or 20 years from now. God forbid that we ever get there because that's a one currency, one government world that would absolutely be a disaster for the human race. There would be no freedoms at all to move or to invest. It would be like having shackles on our ankles. There is a movement to go in that direction, unfortunately. There are a number of very wealthy people that want to see that. I hope that we can find the politicians to prevent that type of world from coming to pass.

HRN: Thank you for your time and for your candor.

Keith Neumeyer: It was a pleasure.

After Words

Keith Neumeyer, Chief Executive Officer, President and Director of First Majestic Silver Corp. (TSX:FR / NYSE:AG) is an industry leader who analyzes the silver market with the gloves off. In the wake of the failure of commodities trading firm MF Global, Mr. Neumeyer's lack of confidence in the CFTC and in the integrity of the COMEX appears to be justified.

First Majestic Silver, which is one of a small number of primary silver producers, has consistently increased its production, cash margins and mineral resources while lowering production costs. With three operating mines and a fourth mine under construction, the company is growing steadily from a junior producer to a mid-tier producer that expects to produce 10 million ounces of silver in 2012.

Editor's Note: Hera Research, LLC or its Directors are shareholders in First Majestic Silver Corp.

Hugo Salinas-Price: What Every Politician Needs to Know About Silver

Ron Hera — Sun, 01 Jul 2012 19:53:00 GMT

The Hera Research Newsletter (HRN) is proud to present a vitally important interview with Hugo Salinas-Price, Founder, Director and Honorary President of Grupo Elektra, S.A.B. de C.V., which is now run by his son, Ricardo Salinas-Pliego. Grupo Elektra is a part of Grupo Salinas, which owns businesses in the television industry, the telecommunications sector, banking and financial services, and other industries. Grupo Salinas companies include TV Azteca, Azteca América, Grupo Elektra, Banco Azteca, Afore Azteca, Seguros Azteca, Iusacell, Azteca Internet, GS Motors and Italika y la Asociación del Empresario Azteca. Each of the Grupo Salinas companies operates independently, with its own management and board of directors.

Born in 1932, Mr. Salinas-Price became a follower of Austrian economics at a young age and is the author of three books and of numerous articles, both in Spanish and in English, on the use of silver as legal tender in parallel with paper money.

Mr. Salinas-Price serves as President of the Asociación Cívica Mexicana Pro Plata A.C. (Mexican Civic Association for Silver), which promotes the use of silver as legal tender in México. Mr. Salinas-Price is an outspoken proponent of sound financial and monetary policies in the country of México.

Hera Research Newsletter (HRN): Thank you for joining us today. Would you tell our readers about your efforts to make silver coins legal tender in México?

Hugo Salinas-Price: México is the first and only country where we have a Congress that is conscious of an alternative to paper money and that is favorable to it. México is the only country where this type of reform is being contemplated at the national level. The rest of the world is stagnating completely in the morass of un-backed paper money without considering any alternative.

HRN: Why do you think that's the case?

Hugo Salinas-Price: We had, not too long ago, the experience of severe inflation in México. I used to graph the inflation but to keep that graph on the same scale I'd have to have a roll of paper hundreds of yards high. That's what's facing the United States right now. The U.S. is doing the same thing that México did, even worse.

HRN: Can you comment on the Utah Legal Tender Act?

Hugo Salinas-Price: The Utah Legal Tender Act was heralded with optimism and any effort to recognize gold and silver as money is praiseworthy, but it falls short because simply making gold and silver coins legal tender gives them no stable value that will be recognized by everybody.

HRN: Do you mean the value of the coins fluctuates, like a commodity, with metals prices?

Hugo Salinas-Price: Yes. In order for something to work on a large scale, it has to be very simple. In 1979 the President of México, José López Portillo y Pacheco, had a one ounce silver coin declared legal tender and asked the central bank to assign it a monetary value. The trouble was that the value was not stable. One day the value was X then, the next day, it was X minus a few pesos and the day after that it was X plus a couple of pesos. This created a great deal of confusion and the law was allowed to lapse. The mistake was that the monetary value wasn't stable.

HRN: And that's an issue for the Utah Legal Tender Act?

Hugo Salinas-Price: Yes. It's almost as if gold and silver were not monetized.

HRN: So, people who buy gold or silver coins are merely speculating on metals prices?

Hugo Salinas-Price: In México the majority of people are poor and cannot afford to speculate. If they buy a coin for 500 pesos and it goes down to 480 pesos and they've lost 20 pesos, that's a lot to them. That is why there is relatively little silver in the savings of the Mexican people. People are afraid of speculating. They can't afford to speculate.

The Asociación Cívica Mexicana Pro Plata, based in México City, is actively lobbying the Mexican Congress to institute a new, one ounce silver "Libertad" coin with no engraved monetary value as legal tender in México. Making silver legal tender will provide a stable store of value for Mexican citizens to save money so that savings cannot be destroyed by inflation.

To prevent savers from becoming speculators on metals prices, the monetary value, in Mexican pesos, of the new silver Libertad coin will be set by the Banco de México slightly higher than the commodity price of silver. The monetary value of the new silver Libertad coin can be raised by the Banco de México if the price of silver rises, but must remain fixed if the price of silver falls.

HRN: Precious metals prices seem to be extremely volatile.

Hugo Salinas-Price: Of course, volatility is constantly reported. They never talk about the fact that silver has gone up seven times in the last twelve years because of inflation. Volatility in gold and silver is artificially induced precisely to scare off savers. It's really very cruel, but that's central banking for you.

HRN: Are you saying that central banks actively discourage people from exiting fiat currencies?

Hugo Salinas-Price: Of course.

HRN: Can monetizing silver work?

Hugo Salinas-Price: Unless the value of a legal tender coin is stable it cannot be used as money. It has to be given a firm value. What we are proposing is that the quote from the central bank be a stable quote. The value of the new one ounce silver Libertad coin will remain fixed unless the price of silver rises to a point where the value should be increased. The Utah Legal Tender Act does not address this. It has to be done at the federal level, not at the state level.

HRN: But what will happen if the price of silver falls?

Hugo Salinas-Price: Nothing will happen. If the silver coin is valued at 500 pesos and the price of silver falls, it's still worth 500 pesos.

HRN: Won't that encourage speculation?

Hugo Salinas-Price: A speculator might sell his silver coins if the price of silver falls and perhaps invest in silver bullion, but speculators are a small number of people. The majority of people would keep the coins because they are better than a 500 peso paper note.

HRN: So, people would hoard silver coins?

Hugo Salinas-Price: That's right. They would have savings. That's the important thing. We need people to get off the drug habit of constant spending. People have to save again.

HRN: You want to encourage saving?

Hugo Salinas-Price: Absolutely. What we want is to create a refuge where those who can save-the middle class-can do so in a medium that will retain its purchasing power. There is no safe harbor for the middle class today. The middle class is being financially raped and decimated.

HRN: Do you believe the same thing is happening in the U.S.?

Hugo Salinas-Price: Yes. The U.S. needs a law like this too.

HRN: Is saving the foundation of small businesses, jobs and of the middle class?

Hugo Salinas-Price: Of course. The withering away of the middle class is a terrible situation for the economy.

HRN: What is the current status of the Mexican legal tender legislation?

Hugo Salinas-Price: In México we have a Congress that is quite well aware of the importance of this legislation and it has broad support both in the Senate and in the Chamber of Deputies, which is like the House of Representatives in the U.S. The idea is well understood and approved, but there is a problem.

HRN: What is the obstacle?

Hugo Salinas-Price: Under our party system, members of Congress rely on the guidance of the party leaders. If they fall into disfavor with their party leader, they will be denied the benefits that the party leader is authorized by law to distribute. The three most important party leaders are under great pressure from the central bank, Banco de México, to prevent party members from voting in favor of this measure.

Excerpt from the bill awaiting a vote in the Mexican Congress:

"In order to palliate the financial crisis and the economic recession, central banks and governments have reacted by injecting more liquidity and credit; these actions have intensified the causes that provoked the instability, further weakened the whole system, caused a world crisis of deficits and sovereign debt and further increased penury and scarcity in the majority of the population.

These "rescues" and emergency repairs have succeeded in prolonging for some additional months the life of the financial system, but they will cause its collapse to be much more dramatic and painful. The International Monetary Fund has itself warned that "the risk of a double recession has increased" (IMF Report, June 1, 2010).

For families, the inflationary rise in prices, the evaporation of savings and the loss of purchasing power are causing a distressing situation of tightness and anxiety which are depressing and negative for interpersonal relations, as well as setting up a vicious circle of want and scarcity.

The ultimate origin of the financial and economic problems of today dates to August 1971 when real money - backed by precious metal - was substituted by fictitious money, which can be issued exorbitantly because it consists of nothing other than paper and computer digits."

HRN: Banco de México is blocking the legislation?

Hugo Salinas-Price: If it wasn't for the central bank, this measure would have passed a long time ago. The party leaders are afraid to jeopardize their careers by becoming enemies of the central bank.

HRN: What do you think might change the situation?

Hugo Salinas-Price: The Congressional Finance Committee will hold a hearing this month, before the Congress goes into recess, to hear the objections of the central bank. It is possible they may decide that the objections are not materially important and they may approve the bill. In that case, the bill will be sent to the house for a vote. The party leaders will be able to vote for the bill if the Committee approves the law.

HRN: Do you think it will pass if the Finance Committee approves it?

Hugo Salinas-Price: We would be hesitant to submit the bill to a vote without assurances from the party leaders that they will give it a green light.

HRN: If México passes this law, do you think other countries in Latin America will follow México's example?

Hugo Salinas-Price: Yes. I think they would and they would do it soon after.

HRN: Thank you for being so generous with your time.

Hugo Salinas-Price: I hope what I've said will be of some use.

After Words

With the encouragement of Hugo Salinas-Price, the country of México may become the first country to provide its citizens with a guaranteed store of value. Enabling citizens to save hard money offsets the inflationary power of the central bank and protects the savings of ordinary people from financial system turmoil and profligate government policies. Savings represents capital formation and capital, in the hands of ordinary citizens, is the foundation of small businesses, jobs and of the middle class. Without savings, there can be no middle class. A strong middle class is a fundamental requirement for higher living standards and for a strong and vibrant economy. Without a middle class, the overall wealth of society is reduced, upward mobility evaporates and the economy becomes less resilient. While the United States seems to be heading in the direction of a 3rd world country, México may soon lead the way to a brighter future for the Mexican people and for Latin America.

How the U.S. Will Become a 3rd World Country (Part 2)

Ron Hera — Sun, 01 Jul 2012 19:50:00 GMT

The United States is quickly coming to resemble a post industrial neo-3rd-world country. Unemployment, lack of economic opportunity, falling real wages and household incomes, growing poverty and increasing concentration of wealth are major trends in the U.S. today. Behind these growing problems are monetary inflation created by the Federal Reserve's monetary policies, federal government deficit spending and the dominant influence of "too big to fail" banks and large corporations in Washington D.C., which has altered the direction of law in the United States. To make matters worse, the U.S. government faces a historic fiscal crisis.

High unemployment, lack of economic opportunity, low wages, widespread poverty, extreme concentration of wealth, unsustainable government debt, control of the government by international banks and multinational corporations, weak rule of law and counterproductive policies are defining characteristics of 3rd world countries. Other factors include poor public health, nutrition and education, as well as lack of infrastructure-factors that deteriorate rapidly in a failing economy.

Apparently ineffective regulation and relatively little law enforcement action by the federal government in the wake of the sub-prime mortgage meltdown resulted in widespread speculation that special interests had taken priority over the rule of law. Critics have also charged that the federal government's policies threaten to eliminate what remains of the American middle class.

Accelerating Concentration of Wealth

In response to the economic downturn that began in 2007 and the start of the financial crisis in 2008, the U.S. federal government and the Federal Reserve resorted to a radically inflationary policy intended to save banks and to shepherd the U.S. economy through a recession. Instead, radically inflationary policies greatly increased the concentration of wealth.

Under ordinary circumstances, monetary inflation has the effect of redistributing wealth in favor of those who receive newly created money first. The value of money is reduced as a function of the number of currency units in the economy but recipients of newly created money can spend it before it loses value. In a declining economy, however, the wealth redistribution effects of inflation are magnified.

When the Federal Reserve or the federal government supports banks and financial markets through liquidity injections, bailouts, asset purchases, quantitative easing, etc., the lion's share of financial support, i.e., newly created money, is captured by the largest financial institutions and by the wealthiest 1% of Americans. Money printing skews the distribution of money over the economy while the value of money, i.e., the purchasing power of wages and savings, is reduced. The overall effect is a wealth transfer from proverbial Main Street to literal Wall Street.

Looming Fiscal Crisis

U.S. government debt and deficit spending have markedly accelerated over the past decade. For example, The U.S. Department of Homeland Security (DHS) was created and the U.S. military grew to 3 million active duty and reserve personnel, not including contractors. Since 2001, the U.S. spent approximately $1 trillion on military expansion while the total cost of the U.S. wars in Afghanistan and Iraq has been estimated to exceed $3.7 trillion.

Although the U.S. federal government remains in denial, the Congressional debt ceiling debate and subsequent U.S. credit rating downgrade on August 5, 2011 were only the tip of the iceberg. In fact, the United States faces a historic fiscal crisis.

As of 2012, the majority of new federal government debt will stem from interest on existing debt. Treasury bond issues totaled $2.55 trillion in 2010, roughly 2x the federal budget deficit of $1.3 trillion. Artificially low U.S. Treasury bond yields, created by the Federal Reserve's quantitative easing (QE1 and QE2) programs and by its current "Operation Twist," only slow the rate at which the federal debt balloons.

The U.S. federal government's fast growing debt is $14.94 trillion, approximately 100% of GDP. Additionally, future liabilities total $66.6 trillion based on generally accepted accounting principles (GAAP accounting) and using official data from the Medicare and Social Security annual reports and from the audited financial report of the federal government.

Medicare: $24.8 trillion
Social Security: $21.4 trillion
Federal debt: $10.2 trillion* (not including intra-governmental obligations)
State, local government obligations: $5.2 trillion
Military retirement/disability benefits: $3.6 trillion
Federal employee retirement benefits: $2 trillion

The eventual insolvency of the U.S. federal government cannot be averted through any combination of taxes, budget cuts or realistic GDP growth. Inflationary policies, i.e., increasing deficit spending by the federal government and debt monetization by the Federal Reserve, would devalue the U.S. dollar and potentially trigger a hyperinflationary collapse of the currency. To stave off the inevitable, interim measures might include tax increases, exchange controls, nationalization of pension funds or other measures similar to those taken in 3rd world countries.

Dominant Corporate Influence

In a 2009 radio interview on Elmhurst, Illinois' WJJG 1530 AM, Senator Dick Durbin (D-Ill.) explained that "...the banks-hard to believe in a time when we're facing a banking crisis that many of the banks created-are still the most powerful lobby on Capitol Hill. And they frankly own the place." Senator Durbin was unequivocal in saying that the federal government of the United States is controlled by banks. Simon Johnson, former chief economist of the International Monetary Fund (IMF), had reached the same conclusion one month earlier in his widely read article The Quiet Coup. Johnson explained that the finance industry had effectively captured the U.S. government, a state of affairs typical of 3rd world countries.

Corporate influence over the political process, as well as over the tax and regulatory policies of the United States, is at an all time high. The federal government is the largest single customer in the U.S. economy and, through taxation or regulation, the government can grant or deny market access to private companies and can either prevent or mandate the consumption of their products and services. As a result, virtually every large corporation in the United States seeks to win the government's business and to steer government tax policies and regulations in their favor. Naturally, politicians who accede to the wishes of particular corporations are given campaign funds to ensure their reelection. In the past decade, the amount of money spent on lobbying has more than doubled and there are currently 24 lobbyists for every 1 member of Congress.

The interdependence of elected officials and the largest U.S. corporations reached a new high with the 2008 bank bailouts. The influence of private corporations and de facto industrial cartels (comprising the largest corporations in each major industry) over tax and regulatory policies creates significant economic distortions that ultimately compromise the sustainability and the stability of the economy. Ideally, the government would be an impartial referee, rather than an active business partner that overwhelmingly favors large businesses over small businesses, despite the fact that small businesses account for the vast majority of American jobs.

Impact on the Rule of Law

Corruption, cronyism and weak rule of law are typical of 3rd world countries. The United States exhibits a clear corporate influence over elections and legislation and, arguably, relatively little law enforcement action where large, legally well-equipped corporations are concerned. Reports of so-called crony capitalism have appeared in the U.S. news media, but the term "corruption" has been avoided, along with discussion of fundamental reforms.

A cursory examination of legal developments over roughly the past decade evidences a pattern in which U.S. federal law systematically favors the largest financial institutions, as well as a paradigm in which financial institutions heavily influence both the regulations that putatively govern their activities and the laws that apply to consumers of their products and services. The financial crisis that began in 2008 and the subsequent response of the federal government appear to follow logically from prior legislative events:

1999 Gramm-Leach-Bliley Act (GLB). The Act repealed key provisions of the Banking Act of 1933, commonly known as the Glass-Steagall Act. In the aftermath of the Great Depression, the Glass-Steagall Act prevented depository institutions from engaging in high risk financial speculation.
2000 The Commodity Futures Modernization Act (CFMA). The Act deregulated over-the-counter (OTC) derivatives, such as credit default swaps, referred to by Warren Buffett as "financial weapons of mass destruction." OTC derivatives were at the heart of the financial crisis that began in 2008 and are the root cause of the "too big to fail" doctrine. The Act preempted state gaming laws that had prevented banks from speculating in OTC derivatives with no connection to underlying assets.
2001 USA PATRIOT Act. The financial provisions of the Act allow banks to collect additional financial information about account holders, for example, linking business accounts to the personal financial records of business owners, thus weakening both financial privacy and the corporate veil. The Act enhances the ability of creditors to collect and allows federal authorities to monitor financial transactions and to obtain financial records without a subpoena.
2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The Act, which was sponsored by banks and credit card companies, effectively eliminated the concept of a "fresh start" by allowing banks and credit card companies to engage in collections activities, in effect, forever. As a result, small business owners who end in bankruptcy are less likely to ever start another business. The Act places banks in front of bankruptcy courts, creates liabilities for bankruptcy attorneys and contains many widely criticized, anti-consumer provisions.
2008 Emergency Economic Stabilization Act. The Act, commonly referred to as a "bank bailout," authorized the United States Secretary of the Treasury to spend $700 billion to purchase distressed assets, especially mortgage-backed securities (MBS). Instead, the funds were given to foreign and domestic banks to offset their risky MBS, OTC derivatives and other losses. The bank bailout set a precedent of socializing losses but keeping gains private. The Act effectively bound the fate of the U.S. Treasury to that of the largest U.S. financial institutions.
2010 Citizens United v. Federal Election Commission. The Supreme Court of the United States held that corporate funding of independent political broadcasts in candidate elections cannot be limited under the First Amendment, overruling prior case law and guaranteeing the ability of corporations to influence elections without meaningful restrictions. The Court's decision gave carte blanche to corporations to influence elections, legitimized the interdependence of elected officials and large corporations and created a precedent under which the rights of corporations supersede those of citizens.
2010 The Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act failed to restore critical provisions of the Glass-Steagall Act, significantly regulate OTC derivatives, break up "too big to fail" banks, prevent another financial crisis and prevent further bailouts. The Act created a Consumer Financial Protection Bureau, but did not repeal any provision of BAPCPA or restore the financial privacy of U.S. citizens removed by the USA PATRIOT Act. The Act failed to provide adequate funding to the government's watchdogs, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Federal Bureau of Investigation (FBI), potentially hobbling enforcement. The Act has also been criticized for the burden it places on smaller competitors in the financial sector, which could ultimately result in an increased concentration of financial power in "too big to fail" banks.

Critics have alleged that, underlying the sub-prime mortgage meltdown that triggered the financial crisis in 2008 was rampant fraud. Fraud has been alleged at virtually every level from the assessment of property values and credit risk; to the loans themselves and to their securitization as MBS assets; to the ratings of MBS assets as AAA; to hedging or betting against MBS assets in the OTC derivatives market (perhaps including financial firms allegedly betting against MBS assets that they themselves created and sold to clients as AAA assets). After the crisis, a seeming pattern of fraud continued apparently unabated in the robo-signing foreclosure scandal where documents submitted to courts were falsified. Despite an avalanche of alleged crimes under existing federal law, no firm or individual of any significance in the financial crisis has yet been prosecuted.

President Barack Obama said in October 2011 that the mortgage finance practices leading to the economic meltdown were "immoral, inappropriate and reckless ... but not necessarily illegal." Since fraud is, in fact, illegal, critics claim that the U.S. federal government has simply failed to enforce the law. Adding fuel to the fire, the Solyndra loan scandal could be construed to suggest corruption at high levels and the MF Global debacle could be construed as indicative of weak regulation and law enforcement and even of questionable market integrity.

In theory, selective enforcement of the law risks the creation of two sets of laws: one for big banks and corporations, and for their executives, i.e., those with connections in Washington D.C. or on Wall Street, and one for everyone else. Among other things, failure to enforce the law could create an environment in which crime pays, but, for ordinary citizens, hard work, prudent financial decision making, saving and investing for the long term do not.

More than any other aspect of America's progression towards 3rd world status, the federal government's low level of law enforcement action where "too big to fail" banks are concerned is perhaps the most insidious because it raises questions of legitimacy and of the social contract. A financial and legal system of moral hazard implies that victims face double jeopardy while they are deprived of legal recourse, i.e., those allegedly defrauded might face inflation and tax burdens stemming from preferential treatment of favored corporations or from further bailouts.

Destructive Tax Policies

In the face of rising government debt, the rapidly shrinking American middle class is the primary target of the U.S. federal government's tax policies. The eventual extinction of the American middle class would be a key milestone along the road to 3rd world status. Current U.S. tax policies favor the largest corporations and this is unlikely to change in the foreseeable future. Although tax increases exacerbate economic downturns, several tax options have been or are being discussed. However, none of them are likely to be put in place.

Increasing taxes on corporate profits would result in job losses in the short term and would affect dividends and share prices in the stock market. Lower dividends or share prices would affect pension funds, including government pension funds.
Increasing taxes on capital gains would impact the non-tax-exempt investments of the now retiring "baby boomer" generation and would reduce capital formation thus reducing investment in new businesses or business expansion and hampering job growth.
Increasing payroll taxes would cause companies to downsize resulting in job losses and would have a chilling effect on hiring.
A Value Added Tax (VAT) is impractical in the United States because countless special taxes already exist at all levels of the supply chain. To prevent unpredictable, disruptive consequences, implementing a VAT would require years of study and comprehensive tax reform.
A national sales tax is undesirable because it would overlap and interfere with already existing state sales taxes, which are highly inconsistent across states.
Carbon taxes remain possible but they would encumber businesses and result in job losses or reduce hiring.

Chief among the remaining possibilities is the income tax but, according to the Tax Policy center at the Urban Institute, Brookings Institution, 46% of American households will pay no federal income tax in 2011. The reasons include income tax exemptions for subsistence level income, dependents and nontaxable tax expenditures for senior citizens and low-income working families with children.

Assuming that big banks, multinational corporations and the wealthiest 1% of Americans remain off limits in terms of tax policy, the range of income taxed is likely to widen from the current tax on households earning more than $250,000 per year to progressively lower income levels. In fact, the government's intended revenue source is precisely what remains of the once much larger middle class: professionals, small business owners and dual income families in urban areas, etc. These are the households that have managed to stay ahead of inflation, declining real wages and falling household incomes.

Among other things, U.S. tax policies will erode capital formation within the remnants of the middle class, which is the engine of small business creation and the source of most American jobs. The eventual result will be a three-tier socioeconomic structure consisting of a super rich wealthy class, a much poorer working class and a massive, politically and financially disenfranchised underclass, similar to that of a 3rd world country.

Via Dolorosa

The United States increasingly resembles a 3rd world country in terms of unemployment, lack of economic opportunity, falling wages, growing poverty and concentration of wealth, government debt, corporate influence over government and weakening rule of law. Federal Reserve monetary policies and federal government economic, regulatory and tax policies seem to favor the largest banks and corporations over the interests of small businesses or of the general population. The potential elimination of the middle class could reshape the socioeconomic strata of American society in the image of a 3rd world country. It seems only a matter of time before the devolution of the United States becomes more visible. As the U.S. economy continues to decline, public health, nutrition and education, as well as the country's infrastructure, will visibly deteriorate. There is little evidence of political will or leadership for fundamental reforms. All other things being equal, the U.S. will become a post industrial neo-3rd-world country by 2032.

How the U.S. Will Become a 3rd World Country (Part 1)

Ron Hera — Sun, 01 Jul 2012 19:44:00 GMT

The United States is increasingly similar to a 3rd world county in several ways and is accelerating towards 3rd world status. Economic data indicate a harsh reality that obviates mainstream political debate. The evidence suggests that, without fundamental reforms, the U.S. will become a post industrial neo-3rd-world country by 2032.

Fundamental characteristics that define a 3rd world country include high unemployment, lack of economic opportunity, low wages, widespread poverty, extreme concentration of wealth, unsustainable government debt, control of the government by international banks and multinational corporations, weak rule of law and counterproductive government policies. All of these characteristics are evident in the U.S. today.

Other factors include poor public health, nutrition and education, as well as lack of infrastructure. Public health and nutrition in the U.S., while below European standards, stand well above those of 3rd world countries. American public education now ranks behind poorer countries, like Estonia, but remains superior to that of 3rd world countries. While crumbling infrastructure can be seen in cities across America, the vast infrastructure of the United States cannot be compared to a 3rd world country. However, all of these factors will rapidly deteriorate in a declining economy.

Unemployment and Lack of Economic Opportunity

Unemployment, which is a deep, structural problem in the U.S., is a fundamental challenge to economic opportunity. The U.S. labor market is in a long-term downward trend linked to globalization, i.e., offshoring of manufacturing, outsourcing of jobs and deindustrialization.

The U.S. workforce has declined by approximately 6.5% since its year 2000 peak to roughly 58.2% of working age adults and the U.S. now suffers chronic unemployment of 9.1%. Although the workforce grew in the 1980s and 1990s, as dual income families became the norm, the size of the workforce is shrinking due to a lack of economic opportunity.

Officially, long-term unemployment is 16.5% and the ranks of the long-term unemployed (those jobless for 27 weeks and over) include 5.9 million, 42.4% of those unemployed. However, prior to the Clinton administration, unemployment measures included workers who are now no longer counted as part of the workforce. Using the more accurate pre-Clinton criteria, unemployment exceeds 22%, only 3% below the worst point (24.9%) of the Great Depression. For countries with populations greater than 2 million, Macedonia leads the world with 33.8% unemployment, followed by Armenia at 28.6%, Algeria at 27.3% and the West Bank and the Gaza Strip both at 25.7%.

Compounding the unemployment problem is the fact that an entire generation of young Americans is being left behind in terms of economic opportunity. Student loans exceed $1 trillion while the labor force participation rate for those aged 16 to 29 who are working or looking for work fell to 48.8% in 2011, the lowest level ever recorded. Lack of economic opportunity among the youth, including millions of unemployed college graduates, is a political wildcard reminiscent of countries like Tunisia.

The structural decline of the U.S. labor market will continue as American workers are merged into a global labor pool in which they cannot yet directly compete for jobs with workers in countries like China and India. In China, for example, gross pay, in terms of purchasing power parity, is equivalent to approximately $514 per month, 57% below the U.S. poverty line. According to the Economic Policy Institute, the U.S. trade deficit with China alone caused a loss of 2.8 million U.S. jobs since 2001.

Falling Real Wages and Household Incomes

Workers earning more dollars are actually poorer in terms of purchasing power when the cost of living rises faster than wages,. In fact, if household income is adjusted for inflation, most American families have grown significantly poorer over the past ten years. In 2010, for example, real median household income fell 2.3%. Although the average wage has risen steadily in nominal terms, dwindling purchasing power is a reality for most Americans. When adjusted for inflation, the wages of most Americans have not kept up with the Consumer Price Index (CPI).

According to famed economist Milton Friedman, "inflation is always and everywhere a monetary phenomenon." In other words, prices rise when the money supply is increased faster than population or sustainable economic activity. Apparent economic growth created through credit expansion, i.e., by increasing the money supply, has a temporary stimulative effect but also causes prices to rise. True Money Supply is an accurate measure of inflation.

Although CPI is sufficient to illustrate declining real wages, CPI does not measure the cost of living in a realistic way. According to economist John Williams of Shadow Government Statistics, CPI systematically understates inflation.

The decline in real household income has set Americans back to 1996 levels, despite many households now having two incomes rather than one. Dual income families accounted for much of the increase in real median household income during the 1980s and 1990s, but, today, two incomes are barely better than one income was three decades ago. The decline in real wages was obfuscated in the 1980s and 1990s by growth in the workforce, e.g., by women entering the workforce. Real median household income rose while real wages declined because more households had two incomes. As U.S. wages and household income continue to fall in real terms, both poverty and reliance on government assistance programs will continue to rise.

Growing Poverty

According to the U.S. Census Bureau, the poverty rate in the United States rose to 15.7% in 2011, with 47.8 million Americans living in poverty (1 in 6). The official poverty line, determined by the U.S. Department of Health and Human Services, is $22,314 for a family of four. The number of families living in poverty has risen sharply since 2006 and continues to climb. The U.S. Department of Agriculture's Supplemental Nutrition Assistance Program (SNAP), commonly known as "food stamps," serves 45.8 million households as of May 2011. The program now feeds 1 in 8 Americans and nearly 1 in 4 children.

Based on the outlook for employment and wages, both poverty and reliance on government assistance programs will continue to grow. However, the negative trends in employment, wages and poverty have not affected all Americans equally. In fact, the household income and wealth of the wealthiest Americans has increased sharply, despite the overall deterioration of the U.S. economy.

Increasing Concentration of Wealth

Alan Greenspan, former Chairman of the Federal Reserve, warned that, "Ultimately, we are interested in the question of relative standards of living and ... trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume." In other words, concentration of wealth undermines the consumer base of the economy, causing GDP to decline and resulting in unemployment, which reduces living standards. Obviously, the total wealth of society is reduced when wealth is highly concentrated because there is a lower overall level of economic activity.

Economic data from several sources, including the Congressional Budget Office (CBO), show that wealth and income in the United States have become increasingly concentrated with the wealthiest 1% of Americans owning 38.2% of stock market assets, e.g., shares of businesses. For the wealthiest 1% of Americans, household income tripled between 1979 and 2007 and has continued to increase while household wealth in the United States has fallen by $7.7 trillion. The Gini Coefficient illustrates the growing disparity in income distribution. In terms of the Gini Coefficient, the United States is now at parity with China and will soon overtake Mexico, a still developing country. It should be noted, of course, that the U.S. remains a far wealthier country overall. If the current trend continues, however, the U.S. will resemble a 3rd world country, in terms of the disparity in income distribution, in approximately two decades, i.e., by 2032.

Welcome to the 3rd World

The United States is quickly becoming a post industrial neo-3rd-world country. Partly as a consequence of worsening unemployment and lack of economic opportunity, falling real wages and household incomes, growing poverty and increasing concentration of wealth, the U.S. government faces a historic fiscal crisis. Dominant corporate influence over the U.S. government, particularly by large banks, weakening rule of law at the federal level and destructive tax policies are compounding the economic problems facing the United States. Barring fundamental reforms or a hyperinflationary collapse of the U.S. dollar (due to the fiscal problems of the U.S. government), the deterioration of the U.S. economy will continue and accelerate. As the U.S. economy continues its decline, public health, nutrition and education, as well as the country's infrastructure, will visibly deteriorate and the 3rd world status of the United States will become apparent.

States Can Financially Break Away from Federal Government

Ron Hera — Sun, 01 Jul 2012 19:39:00 GMT

As you may know, the state of Utah passed a Legal Tender Act last year authorizing the use of federally minted gold and silver coins as money in the state of Utah. Now, legislators in other states, many of whom attended the Monetary Summit, are evaluating similar legislation.

Among other things, this means the United States is approaching a Constitutional crisis because states are beginning to financially break away from the federal government. This is no less serious than the American War of Independence or the War Between the States. The Utah Monetary Declaration (below) is a financial declaration of independence whereby states are beginning to opt out of the Federal Reserve System. A major confrontation seems inevitable.

The issues underlying this historic development include:

The unsound condition of large U.S. banks, which have inaccurate and crumbling balance sheets along with $250 trillion in high-risk OTC derivatives contracts;
The unstable nature of the U.S. and world financial systems, characterized by unworkable levels of sovereign debt and private debt and by over $600 trillion in OTC derivatives liabilities;
The excessive levels of federal government debt and unfunded liabilities combined with falling federal tax revenues prior to the start of the double-dip recession that began in the second half of 2011;
The radically inflationary monetary policies of the federal government and of the Federal Reserve, which promise high inflation or hyperinflation in the future;
The worsening condition of the real U.S. economy outside of large banks, multinational corporations, and Wall Street firms, where federal government bailouts and Federal Reserve monetary easing (money printing) transfer wealth from proverbial Main Street to literal Wall Street;
The rapidly escalating polarization of the distribution of wealth, which threatens not only the economic stability of the United States but also its social and political stability; and
The fact that the current, highly inflationary monetary system is plainly unfair and fundamentally immoral.

As a consequence of these grave, ongoing and growing problems, which are being largely ignored by the mainstream news media, state governments must take immediate action to ensure the functioning of local economies and of state governments, should the federal government / Federal Reserve System break down. Specifically, there is an urgent requirement for an alternative currency to the privately issued Federal Reserve Note, which is erroneously referred to as the "U.S. dollar."

Replacing a stable form of money with ever expanding debt and inflation undermines capitalism and destroys jobs. The monopolistic monetary system of the United States today is inherently inflationary because it must continually expand in order to prevent a deflationary collapse. The underlying structure and root cause of the monetary system's inherent and inescapable inflationary bias is the legal construction of money as debt with no direct link to real economic activity. Debt levels in the economy and bank profits are simply out of line with reality.

In addition to the unsustainable and unstable nature of such a system, an inherently inflationary monetary system destroys savings by devaluing the currency. Savings, which are the result of excess production, precisely define the term "capital." Replacing capital with debt, while highly beneficial for banks that create money out of thin air (through lending), is a deeply flawed concept responsible for the systematic and ongoing breakdown of capitalism in America. This deep, structural problem is the absolute root cause of chronic, irremediable unemployment. As a consequence, there will be no genuine economic recovery in the U.S. and jobs will not return unless and until the monetary system is fundamentally reformed.

An ultimately more important issue is also garnering attention among state legislators, prominent (non Keynesian) economists, religious leaders, political activists and voters. Inflation, particularly if it is systematically understated by the federal government or Federal Reserve, robs savers of the proceeds of past labor and robs workers of the spending power of their wages, living standards and financial futures. Inflation robs the elderly of their retirement and robs investors of their capital by facilitating taxes on alleged gains created solely by currency debasement. Legal tender, created as debt, results in ever larger debt burdens thrust upon innocent future generations that will experience progressively lower living standards and reduced economic opportunity. Generations to come will be born into debt bondage, thus the monetary system is at the center of a profound moral crisis.

The morally and literally bankrupt nature of the current U.S. financial system is transforming America into a dog-eat-dog society where every person seeks to live at the expense of someone else rather than by producing wealth, because production is systematically stolen by the federal government and by banks through the clever device of an inflationary monetary system. The monetary system operates by exchanging fictitious "wealth" (debt based money created out of thin air by private banks) for the real wealth of borrowers, i.e., the proceeds of their labor. In effect, the monetary system is a massive scam purported to be legal but lacking any demonstrable legal authority. Specifically, there is no Constitutional or other legal basis upon which the federal government can force a private monetary monopoly on the states. In fact, the Constitution of the United States explicitly establishes the exact opposite.

The oversized banking system and federal government have grown in an unholy alliance in lock-step and now consume so much of the U.S. economy that, together, they not only pillage the real economy but threaten to kill, once and for all, what is left of the free country founded by the Declaration of Independence. The moral precedent and example set at the highest levels of the federal government and of the banking cartel is that profit, fame, success and wealth are (either directly or indirectly) rewards for immoral acts rather than for honesty in business. Moral corruption at the top-embedded in the very structure of the monetary system-has slowly spread its gangrenous effect, undermining totally the founding principles of the United States of America, enshrined in the Constitution of the United States and in the Bill of Rights. Rather than liberty, America's legacy is fast becoming one of moral turpitude enshrined in financial injustice and oppression.

The challenge before our nation today-our moment in history-is not merely a financial or economic or political or a legal or Constitutional crisis. It is also, and primarily, a moral crisis that could literally destroy the United States of America and all that it has stood for in more than two centuries. A stable society requires sound principles. A moral society requires sound money. Today, the United States of America has neither.

In the words of poet Dylan Thomas, let us say for America "Do not go gentle into that good night / Rage, rage against the dying of the light." I am personally asking you to read the Utah Monetary Declaration (below), which I, among many others, signed on Monday evening, September 26, 2011, in the Post Chapel on the University of Utah campus at Salt Lake City, and to forward it to your state officials.

Utah Monetary Declaration

WHEREAS, money, as a medium of exchange, a store of value, and a unit of measure promotes economic activity, growth and productivity by facilitating specialization and trade, the accumulation of wealth and its long-term investment, as well as accountability in setting prices, tracking progress, and settling accounts;

WHEREAS, natural money - precious metal coin - by virtue of its inherent qualities of recognizability, measurability, uniformity, divisibility, durability, portability and scarcity has reliably retained its purchasing power, notwithstanding periodic fluctuations, over the centuries and millennia of human history, serving as an effective medium of exchange and store of value often without any governmental declaration to require, legitimize or perpetuate its adoption and operation as such;

WHEREAS, sound money, by retaining stable purchasing power over time, best serves societal needs by substantially reducing the uncertainty of inflation risk for creditors and deflation risk for debtors as well as encouraging saving and investment among the general populace and benefiting the economic zone in which it circulates by stimulating the economy and by attracting foreign capital and commerce to the region;

WHEREAS, history attests that monopolistic monetary systems frequently engender currency debasement, resulting in serious consequences such as lost purchasing power, inequitable wealth redistributions, misallocation of productive resources, and chronic unemployment, and that, as the cornerstone of a free market and society, the right to choose, whether between suppliers of goods and services, political parties and candidates, or between alternative media of exchange, effectively promotes the general welfare;

WHEREAS, for the equal protection of all people, rich and poor, the open circulation of complementary and competing currencies should be fostered and promoted by every sovereign state, including those of The United States of America pursuant to their monetary powers (expressly reserved in article 1, § 10 and in the 10th amendment of the United States Constitution) to monetize gold and silver coin as an alternative, voluntary medium of exchange, and as an effective check and balance against debasement of the national currency by the national government which is constitutionally precluded from demonetizing state legal tender, through disparate tax treatment, discriminatory regulation, the threat of suppression and seizure, or otherwise;

NOW THEREFORE, we the undersigned hereby declare and affirm that:

As an essential element of true liberty and of the pursuit of happiness in a free society, all people enjoy the inherent and unalienable right to lawfully acquire, hold and use as a medium of exchange whatever form or forms of money they may prefer, including especially gold and silver coin.
All free and sovereign states bear the moral, political and legal obligation not only to refrain from debasing their own currencies (except under the most exigent circumstances) and from erecting barriers to the unfettered circulation of monies issued under the authority of their sovereign trading partners, but also to affirmatively defend and protect against fraud, counterfeiting, uttering, passing off, embezzlement, theft or neglect by requiring full transparency and accountability of all state chartered financial institutions.
No tax liability nor any regulatory scheme promoting one form of money over another should apply to: (a) the holding of any form of money, in a financial institution or otherwise; (b) the exchange of one form of money for any other; or (c) the actual or imputed increase in the purchasing power of one form of money as compared to another.
Except in the case of governmentally assessed taxes, fees, duties, imposts, excises, dues, fines or penalties, the authority of government should never be used to compel payment of any obligation, contract or private debt in any specific form of money inconsistent with the parties' written, verbal or implied agreement, or to frustrate the intent of contracting parties or impair contractual obligations by invalidating the application of a discount or surcharge agreed to be dependent upon the particular medium of exchange or method of payment employed.
The extent and composition of a person's monetary holdings, including those on deposit with any financial institution, should not be subject to disclosure, search or seizure except upon adherence to due process safeguards such as requiring an adequate showing of probable cause to support the issuance by a court of competent jurisdiction of a lawful warrant or writ executed by legally authorized law enforcement officers.

We hereby urge business leaders, educators, members of the media, legislators, government officials as well as judicial and law enforcement officers to use their best combined efforts to reinstate and promote the legal and commercial framework necessary to establishing and maintaining well-functioning, sound monetary systems based on choice in currency.