Hera : central bank

Rent Seeking and the Flight of Capital

Ron Hera — Tue, 20 Jul 2010 01:00:00 GMT

The productive elements of the US economy are caught between powerful financial interests, e.g., banks seeking speculative gains, political constituencies seeking entitlements and government entities at all levels whose budgets and deficits are too large compared to their revenues. All three factions are competing for the same economic resources and all three are net consumers of wealth. The triumph of any one faction or of any combination thereof, promises to erode capital and to encumber production and economic growth in the future. As a consequence, capital can be expected to flow away from the United States to other parts of the world.

If banks dominate over government, for example, ever larger shares of tax revenues will likely flow to banks as a consequence of interest payments and taxes will certainly rise despite inevitable austerity measures. If government triumphs at the expense of banks, setting aside questions related to bank failures, bailouts or sovereign defaults, there is no reason to believe that government entities will become fiscally responsible or that the pattern of government expansion, as a percent of GDP, will reverse in the foreseeable future. The banking and financial services industries also represent a disproportionate share of US GDP. Political constituencies seeking entitlements are, in part, a reaction against and a consequence of disproportionate growth of government and of the banking and financial services industries. In advocating for or against any of the above factions, what seems to be ignored is where sustainable economic growth will come from in the future.

Surrounded on all sides are entrepreneurs and private capital, which are the historical engines of US economic growth. As the nation struggles to recover from the unprecedented global recession and the financial crisis that began in 2008, the competition between banks, government entities and political constituencies seeking entitlements represents a diversion of wealth and future production into economically unsustainable pursuits, such as bank profits, government stimulus or social welfare programs. In economic terms, the relationship of banks, government entities and political constituencies seeking entitlements to the productive elements of the economy can be described as one of rent seeking.

Rent seeking is a relationship where an individual, company or other organization seeks income by capturing the production of others through manipulation or exploitation of the financial, legal or political environment, rather than through ordinary market participation or the production of wealth. Analogous to parasitism in biology, rent seeking means obtaining an economic gain at the expense of others without any reciprocal benefit. Common examples of rent seeking include tariffs sought by industries for no purpose other than to boost profit margins and efforts by special interest groups to redistribute wealth in their favor by shifting tax burdens or government spending where there is no reciprocal benefit to any other group in society.

Businesses that produce physical goods, i.e., real production, along with labor and existing capital derived from past production surpluses are the targets of rent seeking strategies. The central question for economists is whether rent seeking is sustainable as an economic paradigm, i.e., as the dominant form of economic relationship in an economy. If so, spending by those who successfully gain control of wealth will stimulate economic activity in a sustainable way and the economy will return to genuine growth. For example, economic growth might return as bank profits trickle down through the economy; or as government borrowing and spending or expansion stimulate the economy and create jobs, e.g., government jobs; or as social entitlements, such as guaranteed retirement incomes or medical care, prove to be more efficient and less costly to society when provided by government and funded by tax revenues rather than by private industry. If it turns out, however, that rent seeking is not a sustainable economic paradigm, then the future of the US economy will be characterized by an erosion of capital and an absence of sustainable economic growth. One question that might arise in the latter scenario is whether capital will stay in the US or migrate to other parts of the world. The answer to this question lies in the nature of capitalism, as well as in the historical origins of American capitalism.

Property and Liberty
In terms of both economics and political philosophy, there are links between rent seeking where government is involved, the fundamental relation of individual citizens to the institution of the state, and macroeconomic developments in the US particularly since 1971. These links became increasingly clear since the start of the global financial crisis that began in 2008.

History bears out that capitalism, compared to other economic systems, has created more wealth, raised the living standards of more people, and has increased individual liberty to a greater extent. The reasons for the success of capitalism lie not only in economics but also in philosophy. The historical innovation and entrepreneurship and the immense industrial production of the United States in the past occurred both in the context of capitalism and in a social and legal framework established by the US Constitution. Going back to the American Revolution and before, the ownership of an individual person of their own body and of the labor that it can produce literally distinguished a free person from a slave. This concept is the common root of private property and of capitalism. The natural right of a person to the fruits of their labor, i.e., to own property, is, therefore prerequisite to other rights. In his seminal book, The Road to Serfdom, F. A. Hayek explained the interdependence of private property, the division of labor and freedom.

“... [T]he system of private property is the most important guaranty of freedom. It is only because the control of the means of production is divided among many people acting independently that we as individuals can decide what to do with ourselves. When all the means of production are vested in a single hand, whether it be nominally that of "society" as a whole or that of a dictator, whoever exercises this control has complete power over us. In the hands of private individuals, what is called economic power can be an instrument of coercion, but it is never control over the whole life of a person. But when economic power is centralized as an instrument of political power it creates a degree of dependence scarcely distinguishable from slavery. It has been well said that, in a country where the sole employer is the state, opposition means death by slow starvation.” – F. A. Hayek, The Road to Serfdom (1944)

Of course, a human being is much more than an economic unit and the natural rights of individuals do not end with the absence of slavery, thus private property can be viewed as the keystone of all human rights. In fact, provisions of the American Bill of Rights, such as the prohibition against unreasonable search and seizure are an elaboration and enumeration of private property rights vis-à-vis the rights of government. Interestingly, the American Bill of Rights contains broad prohibitions against actions by government, rather than positive rights, such as the right of an individual to a particular social benefit. In the modern world, private property and, therefore, other rights are not threatened directly by violence and coercion as they were prior to the American Revolution, but they are threatened today by excessive growth of government, by private concerns pursuing rent seeking profit strategies and by political constituencies seeking entitlements.

Taxes levied on privately owned businesses or on private individuals for the purposes of social welfare programs function as a proxy for rent seeking in that they affirm a positive right to an economic benefit for one group at the expense of another group that receives no reciprocal benefit. For example, the establishment of a legal right of a person with no means to pay for it, to obtain medical care, takes precedence over the property rights of individuals who have the means to pay for medical care on their own behalf. In the example of medical care, it is likely that those upon whom the financial burden falls have little or no objection to the arrangement because a majority of individuals probably believe that their contribution is for a worthy cause, but the precedent of government intervention over volunteerism is a dangerous one from the standpoint of individual rights.
While one group bears the economic cost, even if the only cost is reduced access to medical care or reduced quality of care, there is a more broad cost to society in terms of the erosion of individual rights. In a rent seeking economic relationship where government is the agent of wealth transfers, it is not only exploited groups that loose rights but, in fact, all citizens. When wealth is transferred or redistributed by government, rights removed from exploited groups are not transferred to groups that receive the resultant economic benefits but rather accrue to the government itself, thus diminishing the rights of all and expanding the power of government, i.e., the power to claim the wealth of it’s citizens for whatever purposes are deemed worthy.

“The preservation of freedom is the protective reason for limiting and decentralizing governmental power. But there is also a constructive reason. The great advances of civilization, whether in architecture or painting, in science or in literature, in industry or agriculture, have never come from centralized government.” – Milton Friedman, Capitalism and Freedom (1962)

While wealth transfers may be undertaken with the best intentions, over time, the eventual consequence is an aggregation and concentration of power in government at the expense of individuals. Among other things, a precedent is established whereby rights are granted by government to citizens and not the reverse. Wealth transfers by government, therefore, result in the expansion and centralization of economic and legal power in the government at the expense of the rights of individual citizens.

In the extreme, the flow of rights from individuals to government may eventually result in a totalitarian state structure where rights per se no longer exist, or exist in name only, replaced, in practice, by privileges granted by government at its sole discretion. In terms of political philosophy, a constitutional republic aims to prevent totalitarianism (historically referred to as tyranny) by establishing that the people are sovereign and that the limited rights of government are granted to it at the sole discretion of the people. In contrast, an economic system, based on government redistribution of wealth, is ultimately incompatible with a structure where the people are sovereign, i.e., a constitutional republic, simply because wealth redistribution requires that the rights of government take precedence over the property rights of individuals.

There’s been one underlying basic fallacy in this whole set of social security and welfare measures, and that is the fallacy - this is at the bottom of it - the fallacy that it is feasible and possible to do good with other people’s money. That view has two flaws. If I want to do good with other people’s money, I first have to take it away from them. That means that the welfare state philosophy of doing good with other people’s money, at its very bottom, is a philosophy of violence and coercion. It’s against freedom, because I have to use force to get the money. In the second place, very few people spend other people’s money as carefully as they spend their own. The real problem with government is not the deficit. The real problem with government is the amount of our money that it spends. – Milton Friedman

If the basic economic rights of individuals are undermined and government power expands, becoming more centralized, then controlling government spending may be problematic, particularly if doling out entitlements is central to the political goals of the regime in power, e.g., remaining in power. As has been seen in Europe, government spending for the purposes of expanding entitlements is constrained only by the capacity to borrow and to service debt, which is a pattern that can lead to economic collapse.

“A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury. After that, the majority always votes for the candidate promising the most benefits with the result the democracy collapses because of the loose fiscal policy ensuing, always to be followed by a dictatorship, then a monarchy.” – Scottish historian Alexander Fraser Tytler, Lord Woodhouselee (1747-1813), unverified attribution

Totalitarianism: Public or Private?
Wealth redistribution is not the exclusive domain of government. Inflationary policies by the US Federal Reserve erode the value of money and dilute the share of wealth held by those who depend on the monetary system while transferring wealth either to banks or to those who first receive newly created money. The institution of central banking is itself a form of rent seeking where governments borrow their own currencies into existence from private banks passing the burden of repayment with interest on to taxpayers, e.g., as a value added or income tax, rather than maintaining the national currency as a public facility. Central banking is associated both with economic rent seeking insofar as private interests successfully influence the central bank in their favor, and with political philosophy where the rights of individuals are concerned, e.g., monetary inflation deprives savers of the right to spend tomorrow money obtained in exchange for labor today at a value consistent with the terms of the exchange. In the latter case, the central bank produces a de facto breach of contract that is technically legal. As John Maynard Keynes famously said, “By a continuing process of inflation, government [or private interests that control the central bank] can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” In this regard, one can see the extent of the powers abdicated by governments to central banks. Central banks have the power to redistribute wealth and can do so either at the behest of government or, more importantly, in the service of private concerns.

The advent of bank bailouts, amounting to roughly $4 trillion in the US officially, but perhaps as much as $23.7 trillion, during the global financial crisis that began in 2008 was remarkable for two reasons other than the danger of systemic collapse thus averted and the amounts of money involved. First, it became apparent that large banks, and central banks, had more influence over governments than their own citizens. In fact, a majority of Americans opposed bank bailouts. Second, the power of central banks to transfer wealth was laid bare by the Federal Reserve’s purchase of mortgage backed securities which traded newly created money for what most observers agree was little more than worthless paper in an attempt to render otherwise bankrupt financial institutions solvent again.

The independent actions of the US federal government and Federal Reserve produced record profits and bonuses in the banking sector while, at the same time, household wealth in America fell significantly, creating the popular impression that Wall Street was somehow looting Main Street. The mechanism of wealth transfer, however, was actually the Federal Reserve, which had then been in place for 94 years prior to the crisis and during which, arguably, a similar process of wealth transfer had taken place gradually on a smaller scale. The arbitrary and sweeping nature of the emergency actions taken by the federal government and Federal Reserve in response to the financial crisis revealed the extent to which the powers of both the federal government and Federal Reserve had quietly expanded and become more centralized over a period of less than 100 years to a point of near absolute control over the wealth, i.e., the property, of US citizens. The roots of these developments, however, lay not in the economic bubbles leading up to the financial crisis that began in 2008 but in the 1913 Federal Reserve Act and in the New Deal that followed the resulting Great Depression.

“Legal plunder can be committed in an infinite number of ways; hence, there are an infinite number of plans for organizing it: tariffs, protection, bonuses, subsidies, incentives, the progressive income tax, free education, the right to employment, the right to profit, the right to wages, the right to relief, the right to the tools of production, interest free credit, etc., etc. And it is the aggregate of all these plans, in respect to what they have in common, legal plunder, that goes under the name of socialism.” – Frederic Bastiat, The Law (1848)

After World War II, the United States had embraced labor unions and social programs partly in response to the ideological struggle between the US and the Soviet Union, which was a totalitarian state, but the US, while fighting totalitarianism, planted the seeds of totalitarianism in its own backyard. Following decades during which social welfare programs expanded, and during which both the federal government and the financial sector grew dramatically as percentages of US GDP, the centralization of power revealed in 2008 indicated a largely unrecognized shift in political philosophy toward a totalitarian state structure.

A Monetary Empire in Decline
Perhaps every empire in decline witnesses a transition from surplus production to excess consumption and that is precisely what happened in the United States in the 1970s, marked first (after the establishment of the US Federal Reserve and then of a welfare state by President Franklin Delano Roosevelt) by the final abandonment of the gold standard in 1971 then by the 1975 shift from trade surplus to trade deficit. Both events were a consequence of spending in excess of real wealth production. These events ushered in the era of offshoring in the 1980s and of outsourcing to foreign firms in the 1990s. The idea was simple: exchange higher domestic costs for lower costs abroad and sell virtually the same products to the same domestic customers at higher margins, lower prices to gain market share, or simply hold prices at competitive levels by cutting costs. Under the banner of free trade, and later of globalization, the US government did virtually nothing to curtail these trends and the US economy appeared to expand as US dollars flooded the world in an unprecedented period of monetary expansion. As the accompanying deindustrialization of the United States progressed, two developments, in addition to the then accumulated capital in the US, mitigated the impact of declining US industrial production: (1) growth in service industries and (2) a combination of asset appreciation and increased consumer borrowing and spending (eventually reaching an unsustainable 70% of GDP), but both were fundamentally linked to monetary expansion and neither proved to be sustainable.

Replacing industrial production with a service economy was a flawed concept because as domestic production fell, it was, in fact, debt expansion that replaced the creation of real wealth, thus the US trade deficit soared. As factories closed and as jobs departed US shores for Taiwan, China, India and elsewhere, the selling of equivalent foreign-made goods and offshore services to Americans into a domestic market that included a growing number of displaced workers, became less and less plausible. The idea that displaced American workers would eventually embark upon new, service industry careers and, therefore, maintain their spending levels, in retrospect, was plainly wrong. While perhaps viable in a perfectly balanced global economy, it is difficult to imagine a sustainable domestic economy, in itself, comprising a majority of services since it would have to rely on material goods from abroad, i.e., it would suffer a chronic trade deficit. The answer for American businesses was to expand into global markets but this did little for the domestic economy, thus the US service economy failed to replace declining industrial production. What happened, in reality, was that the percentage of the total US population in the work force simply declined, flooding welfare roles and producing a growing political constituency favoring wealth redistribution.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

One way to characterize the sequence of events in the US is to say that a paradigm shift took place where the US economy moved from production to consumption; from an industrial economy to a (so-called) service economy; from wealth creation to wealth extraction; from increasing living standards to wealth redistribution; from a nation of citizens and workers to a nation of “consumers,” all the while transitioning from the largest lender in the world to the largest debtor nation in the entire history of the world. In terms of US government spending, unsustainable growth in entitlements and pork barrel politics became business as usual in Washington D.C., while Wall Street shifted from investing, in order to participate in dividends and capital gains resulting from production and value creation, to trading based on technical indicators; a competition where participants seek to extract wealth from investors and other traders in what amounts to a casino game, i.e., a rent seeking structure. Flash trading using automated trading systems and high-frequency trading algorithms, for example, is pure rent seeking in the garb of high technology.

Other advanced economies, in varying degrees, have followed the American example, resulting in the emergence of rent seeking as the dominant economic paradigm of Western countries. To make matters worse, rent seeking by private concerns has become confused with capitalism.

The Flight of Capital
In the past, capital and individual entrepreneurs flowed into the United States from around the world because it represented two related things: freedom and economic opportunity. The post bailout world is one where large banks have, to some degree, hijacked the emergent totalitarian powers of governments in a model where perpetual sovereign debt represents a virtually unlimited flow of wealth from the subjects of totalitarian states to the banks that, through the institution of central banking, exert considerable influence over each nation’s government. The post bailout economy seems to be a veritable frenzy of rent seeking activity by banks, governments and political constituencies seeking entitlements. In all three cases, individual liberty, e.g., the right to own property is an impediment and the success of any of the three factions promises to encumber or to prevent entirely future economic growth. It makes little difference to individuals if the fruits of their labor are confiscated by inflation, by taxes to fund unsustainable government expansion, or by taxes to fund social welfare programs. In all three cases, the impetus toward entrepreneurship and the incentives for putting private capital, i.e., private property, at risk in new business ventures are reduced or eliminated. Regardless of which rent seeking faction wins, capitalism, which has created more wealth, raised the living standards of more people and which, because of its intrinsic compatibility with private property, has increased individual liberty more than any other economic system in the history of the world, is set to lose.

Capitalism, rather than ceasing to exist, will obviously adapt, thus capital will migrate away from economies characterized by rent seeking, i.e., by the consumption of wealth, to parts of the world characterized by the production of wealth. Capital may also be driven into black markets as seen under the former Soviet Union. All other things being equal, the next decade is likely to see a massive flight of capital from the United States to countries where property rights are respected (or where government is simply smaller) and where the values of investments are less vulnerable to the ravages of excess monetary expansion, counterproductive taxation and sovereign debt risk or redistribution by government in the service of political constituencies seeking entitlements. Within the latter constraints, China and emerging economies that are rich in natural resources and that produce commodities or physical goods will surely become the new bastions of capitalism.

Bernanke’s Dilemma: Hyperinflation and the US Dollar

Ron Hera — Wed, 10 Mar 2010 13:13:00 GMT

Ben Bernanke, Chairman of the US Federal Reserve, faces a Sisyphean task because US banks are experiencing debt deflation and, because lending is now at much lower levels, monetary deflation is encumbering the domestic US economy as existing debts continue to be serviced. Government deficit spending can only offset lower consumer spending to a degree, and the mushrooming debt of the US government raises the question of whether the US can repay or roll over its debt obligations, given that tax receipts are likely to fall. Despite deflationary pressure, the value of the US dollar is in a downtrend pointing to higher prices for imported goods and energy. Devaluing the US dollar will reduce the value of debts in real terms, thus it can make debt levels sustainable, but higher prices will exacerbate debt defaults, worsening the condition of US banks. Mr. Bernanke's dilemma is how to salvage the balance sheets of US banks without sparking high inflation or unleashing hyperinflation.

Where the US dollar is concerned, opinions on hyperinflation range from the view that hyperinflation of the world reserve currency is impossible in principle (because, for example, the values of other currencies are linked to that of the US dollar), to the view that hyperinflation of the US dollar has already happened and that all that remains are the consequences. The two most widely accepted theories of hyperinflation are the monetary model, where a positive feedback cycle is caused by a disproportionate increase in the velocity of money as a consequence of increasing the money supply too quickly, and the confidence model, where the monetary authority issuing a given currency is perceived to be insolvent or no longer legitimate.

The view that hyperinflation is the inevitable result of a central bank issuing too much money or of a government taking on too much debt, while correct, both states the obvious and presupposes that some previously known or predictable limit is reached. The ability to service debt is one such measure, but the value of a debt in real terms depends on the value of the currency. In practice, hyperinflation is recognized only after the inexorable death spiral of a currency has begun. Detecting it in advance is another matter entirely.

Mathematical models of hyperinflation, such as predicting years between redenomination based on inflation rates or applying the quantity theory of money, describe what is happening but not why. Using the monetary model alone makes it difficult to explain apparent counterexamples where high levels of sovereign debt compared to a nation's gross domestic product (GDP) or monetization did not result in hyperinflation.

The confidence model seems to suggest that hyperinflation can be explained by crowd psychology where hyperinflation is analogous to a market mania or is an example of mass hysteria. The idea that hyperinflation is only a crisis of confidence, i.e., that it is a psychological phenomenon, not only lacks predictive value but implies that hyperinflation can be prevented by manipulating public opinion regardless of mathematical realities.

When a nation's bond market collapses, so does its currency. The view that hyperinflation is fundamentally caused by failed bond issues suggests that what is of interest are the reasons why a nation's bond market breaks down, along with indications of developing bond market distress.

One fact that is clear in every historical example of hyperinflation is the rejection of the currency of a given country either by other countries or by its own citizens. The simplest explanation of hyperinflation is that when the credibility of a government, or of its central bank, breaks down, the recognition of this fact is expressed as a race to shed the currency and to divest of the government's bonds. One way to evaluate the possibility of hyperinflation is therefore to gauge the transparency, completeness and veracity of government and central bank statements regarding their balance sheets, budgets and bond issues. Incomplete or inaccurate information and propaganda contrary to empirical evidence are proverbial red flags signaling that credibility may be lacking and that confidence is therefore misplaced.

Between Scylla and Charybdis

Growth in the US monetary base has been cited as evidence of incipient hyperinflation but, while a distortion in the US financial system is apparent, the currency in question is not in circulation and the effect is that of re-inflation since US banks have suffered massive losses linked to the US mortgage market.

Chart courtesy of Federal Reserve Bank of St. Louis

The growth in the US monetary base by over $1 trillion since 2008 represents currency held within the banking system on reserve, which increases the ability of US banks to absorb further losses.

Chart courtesy of Federal Reserve Bank of St. Louis

While more than doubling the US dollar monetary base in less than 2 years is viewed by some as printing too much money, high inflation or hyperinflation have yet to strike. Although money has shifted out of the broad US economy and into the banking system, the excess liquidity exists in the form of bank reserves and, despite the fact that inflation is always and everywhere a monetary phenomenon, if bank reserves are considered separately from interest rates and lending activity they have little direct impact on prices in the broad US economy. In fact, the widest measure of the US money supply is contracting and the broad US economy is in the grip of debt and monetary deflation.

Chart courtesy of Shadow Government Statistic

In terms of monetary policy, Mr. Bernanke faces an impossible choice. With interest rates near 0% and with unprecedented government debt and deficit spending beyond sustainable levels there is a clear risk of high inflation or hyperinflation if inflationary forces are not counterbalanced with a heavy hand. In theory, high inflation or hyperinflation could be prevented by restricting the flow of money and credit to consumers and businesses. Such a policy would exert deflationary pressure on the US dollar within the domestic US economy since principal and interest payments on existing debt would drain money from circulation. While preventing inflation temporarily, such a policy would not succeed in the long run because, in addition to offsetting inflation, deflation depresses economic activity and results in debt defaults. Concurrent government borrowing and central bank QE to recapitalize banks and sustain government deficit spending (in a Keynesian attempt to compensate for declining consumer and business borrowing), would cause the value of the US dollar to decline against other currencies thus the prices of imported goods would rise. The resulting combination of rising prices for imported goods (energy in particular) and a scarcity of money in the domestic US economy is a formula for business failures and debt defaults that would ultimately worsen the condition of the US economy and US banks regardless of lower prices for domestic goods and services.

Structural Decay

In a mathematically perfect world, growth in the money supply with a constant interest rate and level of lending is a simple exponential function. In theory, this is not problematic but in practice monetary expansion (and the associated debt) tends to grow faster than population or sustainable economic activity and even periodic deflationary episodes are insufficient to maintain a stable currency value.

Chart courtesy of Wikimedia Commons

The tendency to create currency in excess of what is required to support sustainable economic activity causes unsustainable booms where debt rises out of proportion to the ability to service or eventually repay, meaning that total debt in the economy grows faster than the GDP. The result is that for every boom artificially created by monetary expansion there is a corresponding episode of debt and monetary deflation. Nonetheless, the overall pattern of monetary expansion remains clear.

Chart courtesy of Federal Reserve Bank of St. Louis

From a policy standpoint, restraining debt issuance by private, profit-oriented banks to sustainable levels is impossible in practice because sustainable growth in GDP is an unknown when the interest rates and reserve ratios that moderate lending activity are set. In fact, the goals of the US Federal Reserve, "to promote ... stable prices and moderate long-term interest rates" require the money supply to expand faster than sustainable economic activity:

Sometimes, however, upward pressures on prices are developing as output and employment are softening-especially when an adverse supply shock, such as a spike in energy prices, has occurred. Then, an attempt to restrain inflation pressures would compound the weakness in the economy, or an attempt to reverse employment losses would aggravate inflation. In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output. Adding to the difficulty is the possibility that an expectation of increasing inflation might get built into decisions about prices and wages, thereby adding to inflation inertia and making it more difficult to achieve price stability.

Deflation is anathema because debt defaults harm lenders and governments have no mechanism to tax gains in the value of currency, thus monetary policy always errs toward inflation and over time the result approximates an exponential function. Among the results is the long term devaluation of the currency, which can also be expressed as an exponential function, i.e., exponential decay.

Chart courtesy of Wikimedia Commons

Exponential decay occurs when a quantity, such as the value of a unit of currency, decreases at a rate proportional to its own value. The decay can be expressed as a differential equation where a quantity N decays at a constant rate (a positive number) (lambda) within a given interval of time t.

Central banks implicitly manage the exponential decay in value of their respective currencies while they focus on interest rates, reserve ratios and inflation targets. Although the exponential decay in the value of the US dollar since 1913 has been distorted by episodes of deflation and variations in monetary policy, the overall pattern continues to reflect the structural reality of exponential decay.

Chart courtesy of Federal Reserve Bank of St. Loui

The combination of fiat currency, where currency is created arbitrarily, and central banking, where money and credit are centrally controlled and where there is an inescapable inflationary bias, suggests that all such regimes have a limited lifespan, but this does not allow a hyperinflationary outcome to be predicted. For example, if US citizens had been asked in 1913, when the Federal Reserve was established, if they would use the Federal Reserve's legal tender knowing that $1 would be roughly $0.05 in less than 100 years they would certainly have responded in the negative, but Federal Reserve Notes have not been rejected by the American people. Similarly, there is no necessary or obvious point where the US dollar will be rejected as it continues to decline in value for the same structural reasons. The logical outcome is an eventual redenomination.

Patterns of Hyperinflation

From the perspective of sovereign debt, the commonly understood process of hyperinflation is that if a government responds to declining foreign appetite for its debt with monetization (or in a historical context direct currency debasement) rather than immediate budget cuts, its currency looses value, at first in proportion to the dilution of the money supply and then more quickly as foreign bond holders and the nation's own citizens seek shelter from inflation in other asset classes. The cost of the government's future obligations then tends to rise in nominal terms, creating an apparent need for larger bond issues while bond yields rise, i.e., the cost of borrowing increases since monetization signals greater risk to investors. Exacerbating the problem, tax receipts tend to lag behind as domestic price inflation sets in. Further monetization is the path of least resistance. Although officials certainly believe that monetization is only a temporary measure both confidence in and the credibility of the government fail. Insolvency is eventually recognized as a reality and the nation's currency then collapses entirely.

Economists assume that consumers and businesses respond predictably based on economic incentives and disincentives, but this presupposes that the value of money is stable (at least over the short term). If users of a currency find that it looses value such that savings and wages are perceptibly eroded before they can be utilized at fair value, the rational course of action is to shed the currency as quickly as possible. This sparks a competition to shed currency in favor of real goods and, once the process begins, the rational course of action is to participate in the proverbial rush to the exits. Interestingly, a panic is not required to explain this phenomenon.

In the context of a national economy, the cycle of hyperinflation is driven not precisely by the supply of money but by its velocity because the competition to shed currency concentrates purchasing activity in successively shorter time periods. Within a given interval, more consumers and businesses seek to buy a limited supply of available goods using all available currency, including savings, thus demand is pulled forward while the velocity of money accelerates. If monetary authorities respond by increasing the money supply, the process feeds on itself.

In terms of the quantity theory of money, which is that the money supply has a direct, positive relationship to prices, the equilibrium of prices with the number of items purchased and the money supply with the velocity of money is maintained (where M is the money supply, V is the velocity of money, P is the average price level, and Q is the number of items purchased over a given interval).

The relation holds true even as the value of a currency approaches zero while prices approach infinity. However, while there is no theoretical limit to the money supply, the supply of goods is limited in various ways and shortages of goods spur prices higher, exacerbating the problem.

The competition to shed currency first interacts with prices then with the availability of currency and with the supply of goods. Rising prices result in rising demand for larger amounts and denominations of currency producing a genuine shortage, but increasing the money supply only intensifies the competition to shed currency, like pouring gasoline on a fire.

Crisis of Credibility

A gradual decline in the value of a currency is generally accepted by consumers and businesses because it has little immediate impact and can have short-term benefits, such as making money more accessible and stimulating economic activity and growth. However, when debt increases disproportionately, a deflationary bust is inevitable and if it is postponed by further credit expansion systemic instability results.

Chart courtesy of Karl Denninger

In 1949 Ludwig von Mises pointed out in Human Action (Chapter XX, section 8) 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 a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Among other things, excessive monetary inflation means that the US dollar cannot function as a store of value. Mounting evidence points to systemic instability, a lower US dollar and ultimately to a hyperinflationary outcome:

US federal government debt of $12.3 trillion, unfunded liabilities of $63 trillion, deficit spending of $1.35 trillion for fiscal 2010, and the Obama administration's $3.83 trillion budget all set new records, while federal income tax revenues are expected to fall for a second consecutive year.
It has been reported that to reduce the cost of borrowing, the maturity of debt issued by the US Department of the Treasury has shifted from the long end of the spectrum toward short term debt. At the same time, episodic flights to the perceived safety of the US dollar by global investors favor short-term Treasuries. This situation creates an escalating risk that the US Treasury will be unable to roll over short term debt and that it will resort to monetization.
7 US states are worse off than the financially troubled European nations of Greece, Ireland, Portugal and Spain resulting in warnings of a US credit rating downgrade possibly indicating an eventual sovereign default.
Unemployment in the US, where more than 2/3 of GDP is consumer spending, should be viewed as a leading, rather than a trailing indicator, thus the perception of recovery based on slowing unemployment is premature. Reported unemployment data seem to exhibit unusually pronounced disparities between initial claims and later revisions and seasonally adjusted numbers.
The widely reported recovery of the US economy is anemic at best since most of the reported forth quarter 2009 GDP growth is not sustainable and preliminary government economic data remains subject to revision by the US Bureau of Economic Analysis (BEA).
The imminent retirement of the so-called baby boomer generation comes with a combined Social Security and Medicare price tag of more than $60 trillion.
US bank failures and balance sheet deterioration together with the inability of banks to mark assets to market due to a growing commercial real estate problem and ongoing residential mortgage loan problems suggest that the financial crisis that began in 2008 is not over.
The suspension of the US Financial Accounting Standards Board's mark to market rule means that the value of mortgage loan portfolios and mortgage-backed securities (MBS) reported by banks are incorrect, which obfuscates leverage and risk while magnifying apparent profits.
Toxic assets still cripple bank balance sheets since the US Department of the Treasury has been unable to successfully carry out its Public-Private Investment Program (PPIP) making taxpayer money available to select investors that can use the money to buy toxic mortgage-backed securities, retaining any profits while putting little of their own money at risk.
The largest US Banks remain the largest holders of financial derivatives, e.g., credit default swaps (CDSs), which suggests that they may hold liabilities far in excess of amounts that can be paid or that can be bailed out if significant losses occur. The CDS market, which is the single largest class of financial derivatives, represents over $600 trillion dollars, a roughly 10x multiple of world GDP.
The Federal Reserve's plans to phase out some of its emergency programs, adding up to roughly $2 trillion currently, leaves other emergency measures in place. The Term Asset-backed Securities Loan Facility (TALF) is set to expire on June 30, 2010 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral but existing loans will not be retired for some time.
Downward pressure on the US dollar caused by the Federal Reserve's near 0% interest rates and ongoing QE has caused a US dollar carry trade affecting asset prices in global markets. While the value of the US dollar has rallied in response to episodic flights to perceived safety in US Treasuries reflecting comparative weakness in the Euro and other currencies, the overall downtrend is persistent, thus the prices of imported goods can be expected to rise.

Rather than a crisis of confidence, hyperinflation results from a crisis of credibility. Hyperinflation results when the social, legal and political structures that create the value of paper money break down. When a government borrows excessively and its promises to repay are contradicted by mathematical realities, the value of its currency cannot be maintained. If a government so lacks credibility that it cannot issue bonds because there are no buyers other than its own central bank, the value of its currency declines faster than money is printed to cover its obligations. Perhaps the most important indicator of impending hyperinflation is whether the statements of a government or of its central bank, e.g., with respect to the government's budget or the central bank's balance sheet, are evidence based or ideological. If they are not evidence based, the credibility of the government or central bank, and its currency, will weaken and eventually fail.

Ordinarily, supply and demand factors govern the value of money and the prices of goods, but money has another, deeper level of value apart from its role as a medium of exchange and unit of account. When money is not redeemable, it is, in effect, a contract and, as such, it can instantly become more worthless than the paper it is printed on if the agreement that gives it value is null and void.

In 1999, referring to the sale of British gold reserves, Alan Greenspan, then Chairman of the US Federal Reserve, said that "Fiat money paper in extremis is accepted by nobody." The reason for this is that there are two fundamental kinds of value. De jure value exists because of, and is dependent upon, social, political and legal arrangements between human beings. In extremis, agreements are often broken and unenforceable. The value of fiat currency and of government bonds are examples of de jure value. Ultimately, de jure value actually exists only in the minds of human beings and does not exist in an absolute sense, in the real world, independent of human belief. De facto value, on the other hand, exists in reality, independent of human thought, e.g., lumber or farmland. The value of real, tangible things of value ultimately devolves to biological survival and to material standards of living. Possessing a physical asset that supports survival does not require human belief in order to have biological value.

When social, political and legal arrangements are strong, reliable and endure over generations de jure value may be preferable for any number of reasons. However, when social, political and legal arrangements prove to be unstable, or fail, de facto value trumps de jure value in every case.

When the balance sheets of US banks are maintained by suspending accounting rules and when banks hold financial derivatives liabilities greater than world GDP, both the stability and credibility of the banks are questionable. When US economic data consistently seems to reflect a Pollyanna bias and the US federal budget contains unrealistic projections of GDP growth and tax revenues, while public debt and government liabilities (which now include unlimited bailouts for government sponsored entities Fannie Mae and Freddie Mac) are obviously unworkable and the US government's own central bank is already a major buyer of US Treasuries, the federal government's credibility is questionable. When private financial losses and toxic financial assets are transferred to taxpayers while profits and bonuses abound on Wall Street thanks to accounting rule changes in the midst of the worst economic contraction since the Great Depression, the credibility and competency of the US Treasury and Congress, with respect to the finances of the nation, are questionable. When the US Federal Reserve defies the US Congress, resists independent auditing, engages in ongoing QE and is the lender of last resort for banks that under normal conditions would be insolvent, its credibility is questionable. When the Chairman of the Federal Reserve, who failed to detect the largest asset price bubble in the history of the world and who has been consistently wrong in his assessment of the US economy is reappointed following the worst financial and economic disaster in generations, both his credibility and that of the Obama administration are questionable. The plethora of red flags spewing from Wall Street, from the Federal Reserve and from the federal government point to a breakdown of de jure value that is already in progress, thus to a hyperinflationary outcome for the US dollar.

Madmen, Gamblers, Alcoholics, the US Dollar and Gold

Ron Hera — Tue, 01 Dec 2009 14:55:00 GMT

If a lawless gang of madmen, gamblers and alcoholics seized control of a large company, how would you expect the business to perform? How would you expect the story to end? What if, instead of a company, they seized control of the world's largest economy, thus, to some extent, the world financial system?

Unsound monetary policy, reckless risk taking, and out-of-control spending are what characterize the US economy today. The proverbial madmen are central bankers, i.e., the US Federal Reserve, whose polices, inspired by Johannes Gutenberg, threaten to destroy the US dollar in the name of saving US banks from their own irresponsibility and greed. The compulsive gamblers are Wall Street investment banks, along with the largest US banks, which have gone so far as to speculate with government bailout money, having learned little from the near collapse of the world financial system in 2008. If money were liquor, the US federal government would be a band of raging alcoholics in charge of a liquor store. These are the tragic characters upon whom Americans depend for their jobs, for their college and retirement funds, for the financing of their educations, homes and business ventures, for the stability of prices and US financial markets, and for the value of their hard earned savings.

The triangle of dysfunction has not gone without notice. Foreign purchases of US Treasury bonds are being made, essentially, under duress while demand for Treasuries remains tepid and quantitative easing by the Federal Reserve continues. The US dollar has fallen from new low to new low and the skyrocketing price of gold is sounding the alarm, but between Washington DC and Wall Street nary an ear can hear.

The Madmen

The incurable incapacity of a central autocracy to accurately match interest rates and the money supply to the requirements of the diverse, complex markets that make up the US economy is a fundamental flaw in US monetary policy. While the ideology may be different, central economic planning under the name of central banking produces no better result than central economic planning under the name of communism. A series of ever larger economic bubbles coupled with an ever weaker currency is ultimately little better than the economic stagnation of the former Soviet system. Low interest rates may stimulate economic activity, for example, but they may also result in high inflation, unsustainable levels of debt, and asset price bubbles.

For every intervention in the free market, whether by government edict or monetary policy, there are unintended consequences. Government intervention in the US housing market, for example, intended to increase opportunities for home ownership among less successful members of society, played a key role in undermining lending standards. Combined with the Federal Reserve's policy of low interest rates, which fueled speculation in real estate and mortgage backed securities, government intervention ultimately proved disastrous.

Markets have existed since the dawn of human civilization without the blessings either of government subsidies and guarantees or of central banking. An economy is best described as an organic system rather than a machine. Interventions purporting to be the processes required to 'operate' the economy are at best futile if not inevitably disruptive and destructive. Like a living organism, the economy is largely self organizing and self regulating. When governments collapse, for example, currencies may fail but trade marches on. The behavior of an economy is an infinitely complex aggregate of individual human actions driven by self-interest and, while it may be characterized at different times either by rationality or by irrationality, it is self correcting (unlike interventions, which know no bounds). As a result, it is not possible for a small group of experts, no matter how intelligent or well intentioned, who have an imperfect understanding and incomplete, inevitably out-of-date information to successfully control the economy without unintended, unexpected and usually destructive consequences.

The notion that a central authority, even one equipped with sophisticated computer models, can successfully substitute a mathematically-based view from on high for the individual judgments of millions of businesses, entrepreneurs, and consumers across countless regions and industries is not merely the height of hubris but quite simply mad. Fundamentally, it is entrepreneurs deploying private capital, not bankers or economists that create the products, services, business, and jobs that make up the economy. Whether for the sake of social welfare or for the purposes of monetary policy, intervention in the free market invariably distorts the distribution of wealth, causes a net reduction of wealth for society as a whole, and misdirects entrepreneurs into activities eventually revealed as uneconomic. Perhaps the best argument for the futility of central bank monetary policy is that of Federal Reserve Chairman Ben Shalom Bernanke, Ph.D., who said to graduates of the Boston College School of Law on May 22, 2009:

"As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy. The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make."

Mr. Bernanke's comments are not remarkable only for their clarity and candor, or because they are a stark admission of the failure of central bank monetary policy, but because they echo the founding principles of the Austrian school of economics. In fact, Mr. Bernanke provides excellent reasons for the repeal of the US Federal Reserve Act. Despite common misconceptions of economics as a branch of mathematics or as a hard science, economics is in fact a social science, similar to psychology. For example, when we speak of economic incentives we are referring to the manipulation of human behavior through artificial means to achieve policy objectives such as increasing consumer spending, just as pairing the sound of a bell with the introduction of dog food will produce dogs that salivate at the sound of a bell when no food is present (of course the salivation response can eventually be extinguished if no food is provided for an extended period of time).

Psychology, it turns out, has a great deal to say about economics, investment banking, and public finance. Indeed, key psychological themes are common to all three areas of endeavor.

The Illusion of Control

There may be a simple explanation, rooted in human nature, for the ever larger disasters brought about by government interventions in the economy and by the institution of central banking. The illusion of control is persistence in the belief that a given outcome can be controlled when no demonstrable influence exists or where, as Mr. Bernanke stated, outcomes cannot be accurately predicted. Whether intervention is the result of central bank monetary policy or of government legislation, taxation or regulation, it is the inherent unpredictability of the outcomes of intervention that belies the philosophy of interventionism itself. Former Federal Reserve Chairman Alan Greenspan, Ph.D., grappled with this fact in the wake of the financial crisis when, in testimony before the US Congress on October 24, 2008, he said:

"... an ideology is [...] a conceptual framework with the way people deal with reality. Everyone has one. You have to -- to exist, you need an ideology. The question is whether it is accurate or not. And what I'm saying to you is, yes, I found a flaw. I don't know how significant or permanent it is, but I've been very distressed by that fact. [That there is a] flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak. ... I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well."

Mr. Greenspan accurately refers to the dominant economic theory, not as a science, but as an ideology that ultimately does not conform to reality. In psychological terms, an irrational belief that cannot be modified by reason or evidence is precisely the definition of the term "delusion." Despite his having been confused for 40 years, Mr. Greenspan clearly recognized and acknowledged a limitation of his economic ideology. In retrospect, perhaps Mr. Greenspan regrets having departed from his original views. Sadly, the same cannot be said for the majority of economists, central bankers and US government officials who do not recognize, as Albert Einstein pointed out, that "the definition of insanity is doing the same thing over and over again and expecting different results."

The Gamblers

Gambling addiction and belief in the paranormal, e.g., psychokinesis, are examples of the illusion of control. When rolling dice in the casino game craps, for example, people tend to throw harder for high numbers and softer for low numbers when there is no connection between the force with which the dice are thrown and the result. Experimental subjects can even be made to believe that they can affect the outcome of a coin toss through their level of concentration. The illusion of control is a key factor in gambling addiction because it is reinforced by occasional successes and, as has been long established by behavioral psychologists, behaviors conditioned by intermittent reinforcement are the most difficult to extinguish.

Warning signs of gambling addiction include defensiveness, secrecy, and desperation: precisely the attitudes exhibited by Wall Street bankers seeking bailouts from the US government in 2008. Like US banks transferring private losses to taxpayers, gambling addicts may hold others responsible for their financial problems and they may adamantly insist that they be trusted. Gambling addicts tend to be secretive about finances, while at the same time irrationally insisting on having control over money, just as Federal Reserve Chairman Ben Bernanke has insisted that Congressional review of the Federal Reserve's books. i.e., to find out what financial institutions received taxpayer dollars, would compromise its vaunted independence and harm the US economy. The more gambling addicts are in debt, the more they feel the need to defend gambling and they often defend a specific theory or model that "guarantees" winning (if only they can get more money to continue gambling).

A gambling addict's savings and assets may mysteriously dwindle, perhaps like crumbling bank balance sheets laden with sub-prime mortgages or bank losses associated with risky financial derivatives, and there may be unexplained loans or cash advances, perhaps like the Federal Reserve's Term Asset-Backed Loan Facility (TALF) program. Like banks jacking up credit card interest rates, gambling addicts become increasingly desperate for money to fund further gambling. The debts of gambling addicts may increase sharply, reflecting a "bet more, win more" mentality that inevitably leads to the gambler going bust. Gambling addicts seek money with increasing desperation, perhaps like former US Treasury Secretary (and former Chairman and Chief Executive Officer of Goldman Sachs) Henry M. Paulson's dire warnings of financial Armageddon in 2008. Items easily sold or pawned for money may mysteriously disappear, perhaps like the US government's Fort Knox gold, which is surrounded by rumors and speculation that a long sought (e.g., by the Gold Anti-Trust Action Committee) independent audit could easily dispel.

The Alcoholics

The original Twelve Steps published by Alcoholics Anonymous include admitting that one's life, or in this case the US economy has become unmanageable and that a power beyond one's self (i.e., beyond current economic theories and government policies) is necessary to restore sanity. Contrary to the views of current Goldman Sachs CEO Lloyd Blankfein, the Higher Power cannot be one's self. The self regulating dynamics of a free market, for example would certainly adjust US housing prices to sustainable levels and promote sound lending standards, but this has been prevented by the interventions of the Federal Reserve and US government. Not coincidentally, it was the Federal Reserve and the US government, respectively, that originally caused the inflation of housing prices and undermined lending standards.

Breaking the grip of alcohol addiction requires a searching and fearless moral inventory, admitting the exact nature of one's wrongs, and an unreserved willingness to change and to make amends with those who have been harmed. Sadly, neither the Federal Reserve, nor Wall Street bankers, nor the US Congress, which is committed to borrowing its way out of debt, seem likely to repent.

The destructive behavior of alcoholics is often enabled by dysfunctional, co-dependent relationships. A dysfunctional relationship is one that creates more emotional turmoil than satisfaction, or in the case of the US economy, more destruction of wealth than creation. Warning signs of a dysfunctional relationship include, for example, addictive or obsessive attitudes, an imbalance of power, or a superiority complex on the part of one person. Co-dependency is a pattern of detrimental behavioral interactions within a dysfunctional relationship, most commonly a relationship with an alcohol or drug abuser, but equally possible in a relationship with a gambling addict. The co-dependent is a person who perpetuates the addiction or pathological condition of someone close to them in a way that impedes recovery.

The US government appears trapped, together with the Federal Reserve and Wall Street banks, in a destructive web of dysfunctional, co-dependent relationships. The US government is addicted to the easy money created by the Federal Reserve at the expense of taxpayers who eventually suffer a loss of purchasing power. According to Mr. Greenspan's 1966 article Gold and Economic Freedom, "deficit spending is simply a scheme for the confiscation of wealth." Wall Street bankers depend on US government bailouts and guarantees, as well as on the Federal Reserve's lax monetary policy, and the Federal Reserve depends directly on the US government for the legalization of its unaccountable monopoly and indirectly on the continuation of the largest US banks. While a dysfunctional triangle of co-dependency is merely descriptive, the interdependence of the Federal Reserve, the largest US banks and the US government is a fact in reality.

Unfortunately, it is no more possible to spend one's way to prosperity or to borrow one's way out of debt than it is to drink one's self sober. Nonetheless, thanks to the Federal Reserve's 7 day per week, 24 hour per day money printing service, the US government plans to do precisely this. If creating wealth were as simple as printing money, the dominant school of economics would be led by Robert Mugabe, President of Zimbabwe, and Gideon Gono, governor of Zimbabwe's Reserve Bank (and winner of the 2009 Ig Nobel Prize in Mathematics), who share with Mr. Bernanke a love for the feel of crisp paper and for the smell of fresh ink.

As Milton Friedman once said "The real problem with government is not the deficit. The real problem with government is the amount of our money that it spends."

The wealth destroyed by the collapse of the US real estate bubble and the stock market crash of 2008 has not been and cannot be brought back by bailouts, stimulus spending or outright money printing. While averting a deflationary spiral is necessary, propping up asset prices by dropping money from a helicopter redistributes wealth and interferes with the price mechanism of the free market. Devaluing the US dollar may help to hold up asset prices but it also prevents housing prices from falling to sustainable levels while at the same time adding the risk of eventually far higher prices, or, in the worst case, hyperinflation. There is no historical example of a successfully re-inflated economic bubble. What is more important, however, is that the unintended consequences of currency debasement, i.e., the result of an inflationary monetary policy marked by near 0% interest rates, are likely to outweigh the goals of the policy even if they are achieved.

Reducing the value of debts in real terms through currency debasement requires a commensurate loss of purchasing power, thus while housing prices may be prevented from falling further, savings will be destroyed and wages will lag behind prices once they inevitably begin to rise. Although consumer prices in the US currently lag behind the downtrend of the US Dollar Index (USDX), an inflation tax will eventually be levied. Under the name "economic stimulus", wealth is being dissipated by the US government at an alarming rate with no sustainable benefit. US government programs like Cash for Clunkers only impact short-term economic data while, in reality, destroying wealth, increasing debt and diverting consumer spending into already bankrupt industries. At the same time, the US government is eager to increase tax revenues to offset deficit spending and it has all manner of businesses, as well as wealthy individuals in its crosshairs. German-born Presbyterian clergyman William Boetcker (1873-1962) wrote:

"You cannot bring about prosperity by discouraging thrift. You cannot help small men by tearing down big men. You cannot strengthen the weak by weakening the strong. You cannot lift the wage-earner by pulling down the wage-payer. You cannot help the poor man by destroying the rich. You cannot keep out of trouble by spending more than your income..."

Boetcker's words are profound. It is not possible to repair the US economy through stimulus spending or to increase the wealth of consumers by inflating asset values via currency debasement. Supporting asset prices, thus bank balance sheets, via currency debasement, in the best case, can spread debt defaults over time, perhaps delaying the collapse of bankrupt financial institutions. However, currency debasement promises to move Americans closer to the financial status of Zimbabweans due to the destruction of the purchasing power of the US dollar. A less valuable US dollar will reduce consumer spending in real terms, and reduced consumer spending will impact businesses and, therefore, jobs.

The US Dollar and Gold

The price of gold indicates a lack of confidence in the US dollar and in the US economy and it reflects poorly on the credibility of the Federal Reserve and of the US government. The changing composition of central bank reserves, e.g., increasing gold holdings, is a direct effect of the currently weak US economy and US dollar, which has lost considerable value in recent months. In contrast, gold is the only financial asset, in fact a currency that has no counterparty risk. This simple, but often overlooked fact goes a long way to explain current investment demand for gold.

Chart courtesy of StockCharts.com

All other things being equal, strong economies offer investors superior returns and lower risk compared to weak economies, thus the currencies of stronger economies are always preferred over those of weaker ones and have a higher relative value as a function of supply and demand. Of course, monetary inflation and monetary deflation also influence the value of a currency in terms of supply.

In a world financial system composed entirely of fiat currencies, where no currency is redeemable in terms of hard assets, money is an abstract claim on production and the value of one national currency relative to another can only, ultimately be a reflection of the performance of the underlying economy that the currency represents (performance being inclusive of the consequences of its monetary policy), i.e., a claim on its production. Thus, if an economy is in decline, i.e., its production is falling, its currency, over time, must also decline. Conversely, there can be no doubt that if the US economy were exhibiting credible and significant growth, i.e., if production were increasing, the US dollar would certainly gain value, but that is not the case.

Chart courtesy of StockCharts.com

The fact that central banks are reducing US dollar holdings and increasing holdings of other currencies, including gold, is simply a matter of preserving the value of their reserves in the face of developments influencing the value of the US dollar, such as the burgeoning US dollar carry trade. Having gone "all in" to save the largest banks, the Federal Reserve and US government continue to assume that the crisis can be managed, despite the fact that their policies are making the situation worse in terms of sustainable housing prices, public debt and the value of the US dollar. In the mean time, Wall Street bankers have gone back to the casino, nonchalantly cashing in their bailout chips and pocketing the gains.

The rationale of buying time for US banks and of supporting US real estate prices seems reasonable on its face but this probably doomed policy is already proving counterproductive. Despite the patina of economic recovery sprinkled over the news media like fairy dust, small business and commercial real estate failures, as well as ongoing residential mortgage and credit card defaults, are rippling through the weak US economy, while unemployment continues to rise undermining consumer spending thus, ultimately, bank balance sheets. Setting aside the understandable reluctance of US banks to make new loans, no amount of tenuous good news, no matter how exaggerated, has been able to rekindle the frenzy of consumer borrowing that formerly characterized the US economy.

The illusion of control is a temporary state of affairs. The triangle of dysfunction and co-dependency formed by the Federal Reserve, Wall Street banks, and the US government is like a story about a madman, a gambler and an alcoholic, where each traps the others in their respective downward spirals. The illusion of control, common to all three, is gradually bringing about a situation that will inevitably be entirely out of control, but, as with gambling addicts and alcoholics, the point where control is lost can only become apparent after the fact, just as the financial crisis of 2008 caught the vast majority of experts by surprise.

Investors, governments and central banks around the world are seeking safety outside the US dollar, particularly in gold, as well as outside of the US stock market, e.g., in emerging economies. The more borrowed money the US government spends, the more money the Federal Reserve prints and the longer zombie banks are kept on life support, the worse the eventual condition of the US economy, the weaker the US dollar and the higher the price of everything in US dollars will ultimately be, particularly gold.

Ganesha and the Price of Gold

Ron Hera — Sat, 14 Nov 2009 02:26:00 GMT

The fact that investors around the world are turning to gold is remarkable. Unlike a bond, stored gold offers no yield and, unlike a stock, gold provides no leverage to the performance of an enterprise. Buying gold is not an investment per se, compared, for example, to buying a gold mining stock, where a company's financial performance is linked to its resources and production, at the same time providing leverage to the gold price. In fact, industrial applications for gold consume far less than the annual supply, thus investing in gold is fundamentally different from other commodities. According to the World Gold Council (WGC), investment demand for gold, e.g., from Exchange Traded Funds (ETFs), was up 46% in the third quarter of 2009.

Gold is commonly viewed as an inflation hedge and, because it is the only financial asset with no counterparty risk, as a safe haven, but the spectacular rise in the gold price indicates more than caution on the part of investors. Gold hit a low of $713.50 per troy ounce on November 13, 2008 (London Bullion Market Association PM Fixing) and closed at a 52-week high of $1,115.25 on November 11, 2009, up an astounding 56.31% from its 52-week low.

Chart courtesy of StockCharts.com

Central bank gold is the proverbial elephant in the room that no one wants to talk about. With official gold holdings of 29,633.9 tonnes of gold worldwide, compared to world gold production of roughly 2,400 tonnes per year, central bank gold sales, leases and purchases, have a huge influence over the gold price. Central banks are changing their reserve asset compositions and a number of central banks, led by India and China (which has been the world's largest gold producer since 2008), are buying gold. Evidently, the full faith and credit of the United States of America isn't what it used to be. Faced with a weakening world reserve currency, the questionable status of the world's largest economy, and unsustainable US government spending, central banks are rendering a quiet vote of no confidence on the US dollar.

The US economy, the US government, US banks, and US stock markets exhibit various problems including unemployment, looming commercial real estate defaults, the US budget deficit, a massive public debt and huge unfunded liabilities, residual toxic assets on bank balance sheets, mounting mortgage defaults and credit card delinquencies, an emerging stock market bubble, etc. Unless the economic problems of the US can be addressed, the US dollar will quite probably loose its status as world reserve currency. Whether a transition to a new world reserve currency would take place in a cooperative manner, e.g., a managed retreat of the US dollar, or in a more disruptive way is unclear.

Gold Supply and Demand in 2009

Under ordinary economic conditions, a rising gold price might reflect, for example, increased demand, the effects of currency debasement or inflation expectations, but a sustained rise in the gold price characterized by growing global investment demand indicates something more. New York University Professor of Economics Nouriel Roubini has suggested that commodity prices reflect an emerging global asset price bubble fueled by the fast-growing US dollar carry trade. While Professor Roubini's "mother of all carry trades" thesis accounts for the effects of low US interest rates driving global speculation and a decline in the US dollar, it does not specifically consider gold, which has unique supply and demand characteristics.

Based on data provided by the WGC, Gold Fields Mineral Services Ltd. (GFMS), and the US Geological Survey, the world gold supply is expected to be approximately 2,400 tonnes in 2009. Gold demand is expected to exceed supply by roughly 1032 metric tonnes (1 metric tonne is the equivalent of 32,150.7466 troy ounces), a large shortfall equal to 43% of the gold supply.

Assuming the average decline in industrial consumption for all of 2009, compared to 2008, will be roughly the same as that of the most recent quarter:

The jewelry industry, by far the largest industrial consumer of gold, is expected to consume roughly 1,705 tonnes of gold by the end of 2009. Jewelry demand was down 22% in the third quarter and is expected to account for only 71.04% of the 2009 gold supply.
The electronics industry, where consumption was down 25% in the third quarter, is expected to consume roughly 76.1 tonnes of gold by the end of 2009.
The field of dentistry, where consumption was down 11% in the third quarter, is expected to consume roughly 49.75 tonnes of gold by the end of 2009.
For all other industries, where consumption was down in the third quarter an average of 9%, total consumption is expected to reach 79.08 tonnes of gold by the end of 2009.

Total industrial demand is, therefore, expected to reach 1,909.93 tonnes of gold by the end of 2009, or approximately 79.58% of the estimated 2009 gold supply.

Although gold is not actually circulated as money, gold coins and bullion bars are in high demand and investment demand was up 46% in the third quarter. Investment demand is expected to account for roughly 1,727 tonnes of gold in 2009, an amount that exceeds the demand of any single industry.

Outside of the electronics industry, where scrap gold recovery is high, and the field of dentistry, gold is not typically consumed destructively. As a result, unlike any other commodity, the vast majority of gold mined throughout history, estimated at 162,780 tonnes by the end of 2009, remains in existence today.

Central Bank Gold and the US Dollar

Despite the fact that it is not generally used as money, gold is held by central banks as a currency reserve and official central bank gold holdings amount to 29,633.9 tonnes worldwide. Official gold holdings represent roughly 18.2% of all gold ever mined and the expected 2009 gold supply is equivalent to roughly 8.1% of official gold holdings.

Since gold no longer served an official monetary purpose after 1971, which marked the end of the Bretton Woods system, central banks began to sell and to lease gold based on their individual requirements and continued to do so until 1999. Prompted by the UK Treasury's planned sale of 415 tonnes of gold (58.04% of UK gold reserves at the time), the Washington Agreement on Gold was established in 1999 to maintain the value of remaining central bank gold reserves by coordinating central bank gold sales. Under what is now the Central Bank Gold Agreement (CBGA), central banks have sold gold in limited quantities (400 tonnes annually between 1999 and 2004, 500 tonnes annually between 2004 and 2009, and 400 tonnes in 2009). However, official sales do not account for gold leasing.

Central banks lease gold to earn interest thus offsetting storage costs by leveraging what had been until this year an otherwise marginalized financial asset to generate cash flow. Rather than borrowing cash at higher interest rates, gold producers, for example, may lease gold and sell it to raise cash, paying the lessor in physical gold from future production. Gold dealers may wish to lease gold in order to cover derivative positions, such as options or futures, either paying the lessor in physical gold or settling contracts in cash. In cases where leased gold is sold by a lessee into the open market, the gold supply is affected, which might affect the gold price. Although gold lease rates, which have been historically lower than interest rates, and central bank participation in gold leasing arrangements are documented by the London Bullion Market Association (LBMA) and other organizations, gold leasing remains an unregulated market. Since gold leases can be settled either in gold or in cash, it is difficult to calculate the effects of gold leasing on the supply and demand dynamics of gold or on the gold price. In any case, since 2008, central banks have reduced gold leasing at traditionally low rates, e.g., rates below 1%.

What is more important is that central bank gold sales had begun falling short of the annual sales allotment of the CBGA in 2006, declining to an estimated 345.5 tonnes in 2008. Since 1999, the gold supply has averaged approximately 2495 tonnes per year, while central bank gold sales through 2008 averaged an estimated 394 tonnes, equivalent to 15.8% of annual supply on average. In 2009, however, central banks became net buyers of gold and some central banks began to repatriate gold reserves. China, for example, began adding gold to its reserves and India recently agreed to purchase 200 tonnes of gold from the International Monetary Fund (IMF).

Setting aside gold leasing, central bank gold sales, having effectively added an estimated 15.8% annually to the gold supply for the past decade, can only have had a dampening effect on the gold price and as well as on gold investing. Therefore, the effect of central banks rather suddenly switching from net sellers of gold to net buyers of gold is equivalent to a reduction in the 2009 gold supply of approximately 15.8%.

In addition to the projected 43% shortfall in the 2009 gold supply, the US dollar's precipitous decline led to a rise in commodity prices across the board. The US Dollar Index hit a 52-week low of 74.93 on November 9, 2009, down approximately 16.39% from its 52-week high of 89.624 on March 4, 2009.

Chart courtesy of StockCharts.com

Demand for gold in 2009 is expected to exceed the supply by 43%, including a reduction in supply of approximately 15.8% due to the effective termination of central bank gold sales, while the US dollar is down approximately 16.39%. At the same time, there has been a fundamental shift in central bank policy. Eastern central banks in particular, led by India and China, are buying gold, while Western central banks have cut back gold sales and have reduced gold leasing at traditionally low rates.

Setting a Gold Price Target

The 16.39% decline of the US dollar tends to be reflected rather directly in commodity prices, thus the gold price, considering that the demand for gold is global, could reasonably be expected to rise approximately 16.39% from its 52-week low in 2009 based solely on the decline in the US dollar.

The effect on the gold price of the 2009 supply shortfall of 1032 metric tonnes could be extraordinary if obvious shortages were to occur, or it might be nominal if consumers of gold were to substitute another commodity, e.g., silver. Substitution, however, seems very unlikely both in terms of industrial uses for gold and in terms of investment demand. Thus, a naive estimate of the impact of the supply shortfall on the gold price might assume that the gold price would rise no more than the shortfall in supply, i.e., by no more than 43% (inclusive of the estimated 15.8% reduction in supply due to the effective termination of central bank gold sales and setting aside entirely the subject of gold leasing).

Combining the 16.39% decline of the US dollar and the estimated 43% shortfall in supply might suggest a gold price approximately 62.6% higher than the 52-week low of $713.50 (London PM Fix), which occurred on November 13, 2008, 1 year ago, i.e., a naive price target of 1,160.15 as of November 2009. The 52-week high of $1,115.25 on November 11, 2009 was approximately 56.31% higher than the 52-week low, thus the actual gold price at that point was lower by roughly 6.29% compared to the 52-week low than the naive price target of 1,160.15. Based on these estimates, the gold price does not seem to indicate an asset price bubble.

Which Way is the Elephant Going?

The proverbial elephant in the room is on the move and the room is not very big in comparison. It seems likely that Western central banks are holding off further gold sales, at least while discussions on a new world reserve currency, i.e., IMF Special Drawing Rights (SDRs), are taking place. Led by India and China, key IMF members want gold included as a component of the a world reserve currency. As long as using gold as a component of a new world reserve currency is a possibility, not only are central bank gold sales on hold but central banks will almost certainly continue to buy gold in the foreseeable future.

There is no fundamental reason for the current gold price trend to reverse in the foreseeable future, and, despite the steep rise of the gold price in 2009, gold does not appear overvalued. It seems possible, although unlikely, that if gold were to again be marginalized in a new world reserve currency regime, as it was under the US dollar standard after 1971, central banks might again start selling and more aggressively leasing gold at some point in the distant future. In that case, the gold price would eventually fall, perhaps to some stable, lower level, once again reflecting the conflicting desires of central banks to both leverage their gold reserves and also maintain their value. However, given the global financial crisis stemming from of the US dollar's 64-year reign as world reserve currency, it seems much more likely that central banks will guard their hoards jealously in coming decades.

Alternatively, if a new world reserve currency were to emerge having a significant gold component, what would then be a certainly higher gold price would likely remain at a higher level indefinitely. It also remains possible that the decline of the US dollar could accelerate or that the apparent differences between Eastern and Western central banks could become more acute, in which case the gold price could rise more rapidly and the process of deploying a new world reserve currency might be accelerated as well as potentially disruptive.

The Hindu deity Ganesha, widely revered as the Remover of Obstacles, is readily recognizable because he has the head of an elephant. Gold languished from 1971 until 2009 as a commodity that central banks had little better to do with than to systematically dissipate through sales and leases, while the most significant problem they thought they faced was the risk of dishoarding too much too quickly. From 1971 until 2009, central bank gold entering the market was a factor of the gold price and a risk for investors. After 38 years, the effective termination of central bank gold sales has rather abruptly removed that obstacle.

Desiring to mitigate risks associated with the US dollar, central banks, led by India and China, have, in effect, promoted gold from its 38-year status as a non-financial commodity once again to its historical role as the premier global financial asset. This historic change in central bank policy signifies a profound break with the past and broadcasts a clear message: gold is a world-class financial asset fairly valued at more than $1,000.00 per troy ounce. With this momentous event, the words "as good as gold" again have meaning.

An analysis of supply and demand fundamentals suggests that the current gold price does not indicate an asset price bubble, and the historic change in the status of gold by central banks implies a major revaluation not yet reflected in the gold price. As the restructuring of the global economy continues, particularly with respect to the world reserve currency, there is a clear possibility that the gold price will move up sharply from current levels.