Hera : deflation

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.

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

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Duration: 12:09

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.

QE2 and its Consequences (Part II)

Ron Hera — Mon, 21 Feb 2011 13:59:00 GMT

Investors understand that the Federal Reserve’s ongoing purchase of U.S. Treasuries in the open market, known as quantitative easing two (QE2), injects newly created money into the U.S. financial system and economy, but the actual means by which newly created money monetizes U.S. government debt, stimulates the U.S. economy and flows into the U.S. stock market are involved. Proponents of QE2, namely Ben Shalom Bernanke, Ph.D., Chairman of the Federal Reserve, deny that the Federal Reserve is monetizing U.S. government debt and claim that QE2 promotes price stability, stimulates economic growth and helps to create jobs. Critics charge that QE2 is causing price inflation in the U.S. and abroad, as well as a currency war. Given the amount of debt owed by the U.S. federal government, as well as by U.S. states and municipalities, investors are, understandably, liquidating U.S. Treasuries and other government bonds and buying equities and commodities, thus, supporting the U.S. stock market rally and driving commodity prices higher. The Federal Reserve’s purchase of U.S. Treasuries is amplifying the U.S. stock market rally and absorbing the U.S. federal government’s debt.

Chart courtesy of Josh Staiger (www.multpl.com)

The effect of QE on the U.S. Stock market is, to a large extent, accidental, i.e., an unintended consequence. The primary goal of QE2, which is widely misunderstood, is to rebalance the broad money supply with economic activity and debt levels in the U.S. economy, but the Federal Reserve has little control over the flow of funds from QE2.

The Real Reasons for QE2

Understanding QE2 requires a basic knowledge of fractional reserve banking and economics. In an economic recession, the broad money supply contracts and underlying economic activity declines. In a shrinking economy, borrowers come under increasing pressure as money becomes less available and may default on loans, destroying the financial assets of banks, which are loans, and causing banks to fail, which is deflationary. In effect, carrying debt becomes more expensive when money is scarce. Since bank deposits are leveraged through loans, when banks fail, the effects are similar to an old fashioned run on a bank. In a fractional reserve banking system, banks loan out much more money than they have on deposit and when borrowers default, banks may have insufficient capital to cover their liabilities, i.e., their deposits. When banks fail, money in the financial system—on the books of banks—is literally destroyed leaving less money available. In other words, the money supply mathematically shrinks, which is the literal meaning of the word deflation. Setting aside the fact that a shrinking money supply tends to cause prices to fall, when less money is available in the economy, interest rates, which reflect the cost of borrowing money, tend to rise as a function of supply and demand. Since borrowing is the engine of money creation in a fractional reserve banking system, rising interest rates exacerbate declines in economic activity, which is the reason why the Federal Reserve cuts interest rates during recessions.

If debt levels in the economy are excessive, debt service can drain money from the economy faster than money can be created through new borrowing and a deflationary spiral can result. Specifically, a contracting money supply triggered by bank failures, e.g., linked to excessive leverage and financial speculation on the part of banks, results in an increase in defaults while debt service creates a net drain of money from the economy, leading to more bank failures and to a further contraction of the money supply, and so forth. Setting aside the inherently inflationary, cyclical and ultimately unstable nature of the fractional reserve system, if left unchecked, a deflationary spiral will end in an economic depression.

Normally, bad debts are liquidated in a recession and banks are allowed to fail, but that changed in 2008. To prevent the failure of the largest banks, and to head off a deflationary spiral, the Federal Reserve began injecting newly created money into the U.S. financial system and is continuing to do so via QE2. Banks were bailed out in 2008 and the value of their assets was preserved, at least on paper, thus debt levels were largely maintained while the U.S. economy and money supply contracted. In the absence of sufficient new borrowing to maintain the money supply, debt service began to drain money from the broad U.S. economy, threatening to plunge the U.S. into a depression. Since the U.S. dollar, which is a Federal Reserve bank note, is a debt instrument created through the execution of loan contracts, it is logical, at least from a macroeconomic perspective, to alleviate the excessive debt levels in the economy by creating additional money that has no corresponding debt. Obviously, when the Federal Reserve writes a proverbial check, the funds are not debited against any account but, instead, money is created ex nihilo. This is the ultimate reason for QE2.

QE2 is an attempt to rebalance the broad money supply and, eventually, economic activity levels with debt levels, otherwise there would be many more loan defaults, banks would fail and both the money supply and the U.S. economy would contract further. It would be equally fair to say that QE2 is currency debasement, which will reduce the real value of debt. As a scholar of the Great Depression, Bernanke certainly knows that a new, and perhaps greater, depression has been averted only temporarily and has only been held at bay by the Federal Reserve’s printing press. This is the key to understanding Bernanke’s famous helicopter speech. The problem, of course, is finding an exit from money printing before the currency collapses. It follows that QE2 (or QE3, etc.) cannot and will not stop until the broad money supply, i.e., money circulating in the real economy rather than locked in the financial system, along with the level of economic activity, come approximately back in line with debt levels. As guideposts, self sustaining GDP growth, absent radical government deficit spending, should be apparent and unemployment levels should be coming down steadily before stopping QE2.

Chart courtesy of Karl Denninger

Critics of QE2, although they may be correct regarding its unintended consequences, often do not seem to understand the gravity of the situation in terms of debt levels versus economic activity and the money supply, i.e., they underestimate the risks associated with deflation. With respect to unintended consequences, the Federal Reserve has no way to make newly created money flow into sectors of the economy where they can be effective in achieving specific goals such as job creation. In other words, Bernanke is pushing on a proverbial string. Thus, one valid criticism of QE2 is that money seems to be flowing everywhere except where it most needs to go. Amplifying the rebound of the U.S. stock market into a rally that is not adequately supported by economic fundamentals is merely a byproduct of QE2 and excessive government debt, i.e. investors seeking an exit from U.S. Treasuries and other government bonds. Similarly, the debasement of the U.S. dollar is unavoidable, thus rising prices for imported goods in the U.S., disruptive inflows of U.S. dollars into foreign economies, and rising global commodity prices will persist as long as QE2 continues. By the same token, precious metals prices, i.e., silver, gold, platinum and palladium (each of which has an ISO 4217 currency code), will not only continue to rise but, the longer QE2 continues, the more investment demand for precious metals will grow.

Debt and Systemic Liquidity

Primary Dealers, e.g., Goldman Sachs & Co. and JP Morgan Securities, Inc., purchase Treasuries in the open market and when holders of U.S. Treasuries sell them to the Primary Dealers as a consequence of QE2, they receive cash. Primary Dealers buying Treasuries on behalf of the Federal Reserve sell them to the Federal Reserve in exchange for newly created money, thus money is injected at the level of investors that sell Treasuries to the Primary Dealers.

QE2 effectively destroys Treasuries, i.e., it removes them from the marketplace to the balance sheet of the Federal Reserve, replacing them with cash at a rate of roughly $2.5 billion per day. However, Treasury purchases by the Federal Reserve are not taking place at a rate faster than the U.S. Treasury issues new debt, thus, the effect of QE2 is to slow the rate at which the supply of Treasuries in the market increases. Theoretically, this should hold Treasury yields down, but QE2 has not been entirely effective as a means of keeping the borrowing costs of the U.S. federal government down.

Chart courtesy of Doug Short, Ph.D.

Another effect of QE2 is to distort the distribution of money over the U.S. economy. As the Federal Reserve creates new money, it flows into the financial system and creates the false appearance of a transfer of money from the broad U.S. economy to financial markets, i.e., from so called Main Street to Wall Street. In fact what is happening is that excessive debt levels in the U.S. economy are causing a net drain of money from the broad U.S. economy, versus normal money creation through lending. In other words, monetary deflation over the whole economy is being offset by monetary inflation in financial markets.

Chart courtesy of Shadow Government Statistics

Direct bidders, e.g., domestic funds and depository institutions, Primary Dealers, as well as foreign investors, participate in U.S. Treasury auctions. Some Treasuries are held to maturity at which time investors receive cash, but the money paid by the U.S. Treasury for Treasuries held to maturity is derived from new borrowing. The total of all new Treasuries to be issued in fiscal year 2011 has been estimated to be $2.25 trillion in net debt, which is more than $800 billion more than the U.S. federal budget deficit.

Chart courtesy of Zero Hedge

As a result of QE2, overall systemic liquidity is increased, thus investors have more cash than they would otherwise have, and the cash they have, either literally or in effect, has been newly created. Of course, funds can also flow into the U.S. Treasury and out again as federal government deficit spending, i.e., government debt can be monetized by the Federal Reserve through transactions intermediated by the Primary Dealers and through multiple other parties that purchase new Treasury debt with funds derived from QE2. In any case, QE2 represents an increased but artificial demand for U.S. Treasuries which, directly or indirectly, helps to fund the U.S. federal government’s deficit spending, and deficit spending temporarily, stimulates the economy.

How QE2 Funds the U.S. Government and Inflates the U.S. Stock Market

Without auditing the Federal Reserve and its Primary Dealers, it is not possible to determine the complete flow of funds or the sums of money involved in all transactions resulting from QE2, aside from the announced rate of U.S. Treasury purchases of $75 billion per month. As newly created money, through successive transactions, circulates further from the point of injection, both the flow of funds and causal relationships become less clear. Closer to the point of injection, however, either the data are known or a higher confidence level is possible.

An outsider analysis of the QE2 flow of funds devolves into (1) known transactions, where the exact sums of money involved in particular transactions may or may not be known, followed by (2) deducible transactions, i.e., transactions that must logically occur but where the sums of money involved are unknown, and (3) a variety of transactions that are possible but that may or may not occur (no probabilities are assumed) and where any sums of money that might be involved are also unknown. Given these limitations, there appear to be no less than seven ways that funds created through QE2 can flow into the U.S. stock market assuming the minimal possible number of transactions so as to remain as close as possible to the point of injection.

When the Primary Dealers buy U.S. Treasuries in the open market on behalf of the Federal Reserve, they either use funds from the Federal Reserve or pre-existing money [1a] to make purchases, and then sell the Treasuries they acquire [2a] to the Federal Reserve, receiving newly created money [3a]. Between U.S. Treasury auctions, the Primary Dealers could invest the new funds in the stock market [3b], liquidating these investments or taking profits [6b] only as needed to make further U.S. Treasury purchases from investors.

U.S. Treasuries are sold at auction to a combination of the Federal Reserve’s Primary Dealers [4a], which re-sell Treasuries to domestic investors [4c] and foreign [4d] investors, and to direct bidders to the U.S. Treasury [4b]. As the Primary Dealers purchase Treasuries in the open market their capital is replaced by new money from the Federal Reserve. In theory, Primary Dealers that purchase new Treasuries at auction could, in effect, if not literally, use newly created money to do so [3c and 6c]. Treasuries sold at auction by the U.S. Treasury [4a, 4b] not only cover current U.S. federal government deficit spending but also roll over debt for Treasuries reaching maturity, thus generating profits for investors, i.e., profits from Treasuries reaching maturity represent additional, newly created money in the hands of investors [5a ,5b, 5c].

Newly created money also flows from the U.S. Treasury to the Primary Dealers [5a] and, directly or indirectly (through Primary Dealers), to both domestic [5b] and foreign investors [5c]. Treasuries reaching maturity, i.e., U.S. government debt that is being rolled over, represent an estimated $800 billion or more annually, above and beyond the U.S. federal government’s budget deficit, which is currently $1.5 trillion. Both profits from Treasuries held to maturity and interest payments could flow into the U.S. stock market [5d, 5e, 5f], back into U.S. Treasuries [5a`, 5b`, 5c`], or elsewhere, e.g., into emerging markets, commodities, etc.

When the U.S. federal government spends borrowed money into the U.S. economy [3d], it supports government employee salaries, payments to government contractors, etc. Money spent into the U.S. economy becomes part of the Gross Domestic Product (GDP) and contributes to U.S. economic growth statistics. Pension funds and individual retail investors [3f, 3g] can invest money derived from U.S. federal government deficit spending in the U.S. stock market, in US Treasuries, etc.

Finally, as the U.S. stock market rises, profits flow back to investors [6a, 6b, 6d] which can then be recycled in myriad forms of investment or spending. One can imagine the financial system as a hydraulic system where increasing pressure will affect the whole system but it’s not precisely a closed system thus the pressure falls off with distance from its source. Ideally, increased spending on the part of investors taking profits would create a wealth effect where money would trickle down through the economy and stimulate economic activity. Unfortunately, the majority of U.S. financial assets are held by a relatively small percentage of the population, which makes it difficult to substitute investor trickle down for reduced consumer spending.

Chart courtesy of StockCharts.com	Chart courtesy of StockCharts.com
Chart courtesy of StockCharts.com	Chart courtesy of the Federal Reserve Bank of St. Louis

Since the start of QE2, the rate of increase in some of the major U.S. stock market indices is similar to that of the Federal Reserve’s M1 monetary aggregate over the same interval. The evidence suggests that increased liquidity, flowing from QE2, is amplifying, and perhaps manufacturing, the U.S. stock market rally.

The End of U.S. Dollar as the World Reserve Currency

U.S. federal government deficit spending represents a $1.5 trillion component of U.S. GDP, which is approximately 10%, while U.S economic growth remains anemic and unemployment remains high. At the same time, annual U.S. federal government borrowing represents approximately 3% of world GDP and willingness to lend to the U.S. federal government is waning. It is, therefore, difficult to see how or when QE2 can be stopped without the U.S. economy either stagnating or tipping back into recession, or without the U.S. federal government becoming insolvent pursuant to Treasury auction failures.

Chart courtesy of Shadow Government Statistics

In contrast to poor economic fundamentals, the S&P 500 P/E ratios are above their historical average by approximately 50%, most probably pointing, if not to an imminent correction, to a decoupling of the U.S. stock market from the broad U.S. economy, reinforcing the view that the current stock market rally is artificially enhanced or largely manufactured.

All other things being equal, as long as QE2 continues, the U.S. stock market will most probably remain in an overall rally while the U.S. dollar will continue in an overall decline. Of course, weakness in other currencies can mask the decline of the U.S. dollar and increase exchange rate volatility, but the prices of commodities, as well as precious metals, provide an elucidating standard of comparison.

Chart courtesy of StockCharts.com

In the long term, QE2 is obviously not a sustainable course. Nonetheless, QE2 can continue as long as (1) the United States remains politically stable, (2) the U.S. dollar remains the world reserve currency and (3) the value of the U.S. dollar strengthens, remains flat or decays in a controlled manner, i.e., at a relatively stable, gradual rate. Although Bernanke clearly believes that the risks are contained, the Federal Reserve’s policies are, in fact, debasing the U.S. dollar and have already guaranteed the end of the U.S. dollar as the world reserve currency.

The unintended consequences of QE2 indicate a countdown to the hyperinflationary collapse of the U.S. dollar. In other words, if QE2 is not stopped, the U.S. dollar will eventually fail. The main risk is that (1) a double dip recession in the U.S. that shatters confidence in U.S debt, (2) a rush on the part of domestic or foreign investors to exit U.S. Treasuries, (3) a rapid and widespread rejection of the U.S. dollar abroad, (4) a large, rapid decline in the value the U.S. dollar, regardless of the cause, or (5) runaway price inflation, i.e., cost push inflation, could trigger the collapse of the U.S. dollar. What is important about the risk of a U.S. dollar collapse, is that QE2 escalates all but one of the potential triggers, i.e., QE2 is countering deflation, albeit in a distorted way, thus it is technically preventing a double dip recession, or a depression, in the U.S.

Interview: Jim Rickards on Inflation and Currency Wars

Ron Hera — Fri, 04 Feb 2011 08:31:00 GMT

The Hera Research Newsletter (HRN) is pleased to present an eye opening interview with James G. Rickards, Senior Managing Director of Tangent Capital Partners, a merchant bank specializing in alternative asset management solutions, and also Chief Operating Officer of Oro Capital Advisors, LLC, a commercial real estate advisory firm and Tangent Capital affiliate. He is a counselor, economist and investment advisor with 35 years experience in global capital markets.

Mr. Rickards has held senior executive positions at Citibank, RBS, Long-Term Capital Management and Caxton Associates. In 1998, he was the principal negotiator of the rescue of LTCM sponsored by the Federal Reserve Bank of New York. His clients include private funds, investment banks and government directorates in national security and he is an advisor on global capital markets to the U.S. Office of the Director of National Intelligence. He is a frequent speaker at conferences on derivatives and hedge funds and is active in the International Bar Association. He has been interviewed in The Wall Street Journal and the Economist, has appeared on CNBC, Fox, CNN, BBC and NPR and is an Op-Ed contributor to the Financial Times, New York Times and the Washington Post.

Mr. Rickards, who is a visiting lecturer at the Kellogg School and the School of Advanced International Studies, has delivered papers on econophysics at the Applied Physics Laboratory and the Los Alamos National Laboratory and has written articles on cognitive diversity, network science and risk management. Mr. Rickards holds an LL.M. (Taxation) from the New York University School of Law; a J.D. from the University of Pennsylvania Law School; an M.A. in international economics from the School of Advanced International Studies and a B.A. (with honors) from The Johns Hopkins University.

Hera Research Newsletter (HRN): Thank you for taking the time to speak with us today. Let’s talk about the Federal Reserve’s quantitative easing program (QE2). Is there a risk of price inflation?

Jim Rickards: I think there is a definite and highly significant danger of inflation coming from QE and QE2 specifically. A lot of people have said, in fact, the Fed has said, that, if you look at the key price indices, the Producer Price Index (PPI), Consumer Price Index (CPI), and the Personal Consumption (PC) price deflator, they are very, they use the phrase, “well behaved”. For the past year and a half, the critics, and I would include myself, have been saying that this situation is dangerous and unstable. The Fed has been pointing to the price indices and saying that you can’t find inflation under a rock, you can’t find inflation with a microscope, so what are you worried about?

HRN: Why do you think the situation is unstable?

Jim Rickards: There is a lot of inflation, but it is being offset by deflation. I compare it to an arm wrestling match. If you’ve ever seen an arm wrestling match with two really powerful participants, nothing really happens for a long time. The two arms just kind of sit there, then all of a sudden it starts to tip, then one guy just breaks and his arm is slammed down on the table. Just because nothing is happening at the surface doesn’t mean that a lot of things aren’t happening below the surface. In a depression, such as the one that began in 2007, you have very, very strong deflationary forces. I call it a natural deflation that’s being offset by policy inflation. So the fact that the price indices are around zero doesn’t mean that they’re well behaved, it just means that they’re masking the two tectonic forces that are pushing against each other.

HRN: Do you think deflation will win, or will it be inflation?

Jim Rickards: For the past year and a half, I’ve wondered which way it’s going to tip. If I’m right about those two forces, one of them is going to prevail at the end of the day and, on which one it’s going to be, I really reserve judgment because I could argue it both ways. I am now coming down on the side of inflation because the inflation is becoming very, very apparent. So, the first thing is that the well behaved indices are masking more than they’re telling us because, below the surface, there are powerful deflationary and inflationary forces fighting each other.

HRN: Why do you think inflation will win?

Jim Rickards: It’s been known since the 1950’s, as Milton Friedman pointed out, inflationary effects occur with the lag. The fact that you saw QE in 2009 and inflation didn’t show up until the end of 2010 really should not give you a lot of comfort because an 18 to 24 month lag is normal and would be expected. Sure enough, right on schedule, 18 months after QE1 was announced in mid-2009 we’re starting to see the inflation.

HRN: What does inflation in foreign countries have to with QE2?

Jim Rickards: There are some new forces in play since Friedman did his seminal work and, of course, it’s the result of globalization. What has been happening is that what would otherwise have been U.S. inflation is showing up in China and Taiwan and Korea and places like that because of the exchange rate mechanism. I put this under the heading of currency wars. In effect, China has been importing all of our inflation through the peg between the dollar and the yuan.

HRN: How does the yuan-dollar currency peg cause inflation in China?

Jim Rickards: Just think about the mechanics of it. There’s a lot of deleveraging going on, which is where the deflation comes from, so the Fed goes out and prints a whole bunch of dollars and spreads them around. Americans take a lot of those newly printed dollars and buy foreign goods so the dollars go to China, but China doesn’t want the yuan to appreciate because they want to maintain the peg, or at least they have until very recently. So, what do they do? They have to buy up the dollars. Well, in order to buy up the dollars they have to print yuan and basically give the yuan to the exporters in exchange for the dollars. Well, that’s basically flooding China with yuan and so the Fed’s printing press was being sterilized in America by the Chinese who were flooding their own country with their own local currency. So, through the exchange rate mechanism, and through the peg between the dollar and the yuan, our inflation was showing up in China and now it’s showing up in Vietnam, South Korea, Taiwan and other places.

HRN: Can the U.S. keep exporting its inflation?

Jim Rickards: Like I said, inflation in the U.S. was being offset by natural deflation and there is a time lag before inflation shows up. It has taken a while for inflation to show up in China because they also had a lag. U.S. inflation was being exported through the currency exchange rate mechanism, but all good things come to an end. These things are now coming to an end for two specific reasons. Number one, the time lag just works its way through, and I think commodity prices, input prices, are where the inflation is really starting to show up and it will work its way through the supply chain and eventually show up in retail. Number two, the Chinese have now thrown in the towel on the appreciation or revaluation of the yuan and the reason for that is inflation.

HRN: So, the Chinese yuan will rise versus the U.S. dollar?

Jim Rickards: Inflation is just another form of revaluation. What do you do when you revalue your currency? Well, you increase your cost structure relative to other countries. You make your goods more expensive from the view of a U.S. purchaser, let’s say. Well, inflation does the same thing, inflation increases your cost structure. So, inflation and revaluation are the same thing economically with one very important difference; revaluation you can control, but inflation very quickly gets out of control. The Chinese, once they saw the inflation, said, well, look, this is going to happen anyway, our cost structure is going up and there’s nothing we can do about it. Our choice is between control and lack of control and, of course, they’re control freaks, so they’re going to go with control, which means they’re going to go with the revaluation and try to stay ahead of the inflation.

HRN: Do the Chinese have any other option?

Jim Rickards: They thought they had an ability to keep a lid on their domestic inflation through price controls. We all know that price controls always ultimately fail, but they can work in the short run, especially if you have a more coercive society and I would put China in that category. Whether there was going to be a black market or offshore money or the inability to enforce their rules at the local level, I think they quickly realized price controls were a losing battle.

HRN: What about other export nations, like Brazil?

Jim Rickards: The Fed is flooding the world with dollars and, as former U.S. Treasury Secretary John Connally famously said in the 1970’s, “it may be our currency, but it’s your problem”. Raising interest rates, currency debasement and capital controls are all tools in the toolbox that exporters can use to deal with Fed monetary policy and QE2. We’re seeing capital controls in Brazil, for example. Brazil couldn’t really control the appreciation of the real, there was just too much demand, too much hot money flowing into emerging markets, Brazil in particular. So there wasn’t much they could do about it from a currency point of view, so they’re putting in capital controls. The next step down that road, you pretty quickly go from currency wars to trade wars and trade wars lead to tariffs and then export quotas. We’re seeing a little bit of that in China with rare earth elements (REEs), although there’s another agenda with respect to REEs having to do with encouraging manufacturers to put their plants in China so they can get guaranteed access to the REEs.

HRN: Will the revaluation of the yuan and capital controls in other countries cause prices to rise in the U.S.?

Jim Rickards: The inflationary chickens are coming home to roost in the United States. Once the Chinese throw in the towel and revalue the yuan, all of that inflation that Bernanke has been trying to get, but which has been going to China, etc. will show up in the U.S. I think, we’re looking at significant inflationary forces, for all of the reasons I just mentioned, and that’s probably going to be the story of 2011.

HRN: So, the Federal Reserve caused inflation in Asia, South America and elsewhere resulting in currency wars and now there’s a risk of trade wars?

Jim Rickards: Correct.

HRN: If the U.S. economy is recovering, why doesn’t the Federal Reserve stop QE2?

Jim Rickards: When you see data that point in a positive direction, you have to take a step back and say, OK, objectively, the data points in a positive direction but how much of that is policy induced and how much of that is self sustaining? My view is that almost all of it is policy induced and very little of it is self sustaining. I reach that conclusion by looking at data where, if we were in a self sustaining recovery, other things would be getting better and they’re not, such as unemployment. That suggests to me that it’s not a self sustaining recovery, therefore, I conclude that it’s mostly policy induced, which means the Fed is going to have to keep going.

HRN: Can inflation help the U.S. economy to grow and help to reduce unemployment?

Jim Rickards: The main reason the Fed wants inflation has very little to do with growth and everything to do with the debt overhang and the fragility of the banking system. People forget that the Fed exists to help the banks. It’s the whole reason for the Fed.

HRN: Isn’t the purpose of the Federal Reserve to promote price stability and full employment?

Jim Rickards: The Fed was created by banks and it exists to prop up the banking system. The idea that it’s somehow a benign moderator of economic conditions, in my view, is nonsense. The Fed is first and foremost a device to prop up banks and, right now, the biggest problem in the banks is their bad assets.

HRN: Didn’t the bailouts and the Federal Reserve’s purchases of mortgage-backed securities clean up the bad assets?

Jim Rickards: The bad assets haven’t gone anywhere. They were identified in 2007, but they had been there all along. The bad loans were made in 2004, 2005 and 2006 because Greenspan and the Fed’s Board of Governors kept interest rates too low too long, so that’s when the bad loans were made. They were identified as such in 2007 and then we had the panic of 2008, but what’s important to understand is that the bad loans haven’t gone anywhere. It’s not as if they’ve been magically transformed into good loans, it’s not as if they’ve been marked down, it’s not as if they’ve moved from weak hands to strong hands. What’s happened is, they’ve basically been locked in amber, frozen on the balance sheets of the banks.

HRN: So, the Federal Reserve wants inflation to help banks that made bad loans?

Jim Rickards: The Fed is hoping for a couple of things. First of all, they’re hoping that inflation comes back so that, at least, the nominal values get back somewhere closer to where the loans were originated. Of course, the real value has all been eroded, but who cares? If you’re a bank, you just want that nominal value so you don’t have to take the loss and the hit to capital. Second, they’re hoping that, because of the steepness of the yield curve, the banks could eventually earn their way out of the problem and make provisions for the bad loans. Obviously, they’re going to the zero interest rate policy and so, with those two things in mind, the Fed wants the inflation to come and help the banks and give them time to recover.

HRN: Wouldn’t inflation also reduce the real value of the U.S. federal government’s debt?

Jim Rickards: The United States has well over $100 trillion in obligations. Now, that’s not all bonded debt, the actual debt is significantly less than that, but when you throw in contingent obligation arising from Social Security, Medicare, Medicaid, Fannie Mae, Freddie Mac, Federal Housing Authority (FHA), Federal Home Loan Bank, student loans, etc., etc. The point is, you can just go on and on with these obligations. The number is well north of $100 trillion. Now, it’s not all due and payable in the next couple of years, these are 20 year obligations, but then you have to say where are we going to get growth for the next 20 years to meet these obligations? That’s very hard to see.

HRN: So, the U.S. economy can’t grow its way out of debt?

Jim Rickards: I don’t see any feasible combination of growth and taxes that will generate enough income to pay off the debt. People warn about the debt trap, to me it’s already too late. We’ve already fallen into a hole where, mathematically, it’s impossible to earn enough to pay off the debt. The debt is compounding faster than growth is being generated and raising taxes is not a solution because that will kill growth, so you just can’t get there.

HRN: What can the U.S. federal government do about its debt?

Jim Rickards: There are two ways to deal with the debt. One is to just default; I just won’t pay you. The other one, of course, is the one that governments prefer which is inflation. You say, OK, here’s your trillion dollars and good luck buying a loaf of bread with it; it’s just not going to be worth very much. So, that’s what we’re doing and that’s another reason why Bernanke wants inflation. Of course, he doesn’t want hyperinflation, he doesn’t want 10%, but he doesn’t need 10%. If you do 4% a year for 17 years, you cut the value of the debt in half. So, that $100 trillion figure I referred to, in real terms, becomes something more like $50 trillion, which is still a big number, but much more manageable than $100 trillion. He says he wants 2% or slightly less. I think that’s disingenuous, I think what he would like is something more like 3% or 4% where, over a 15 to 20 year period, you could really reduce the value of the debt in real terms very significantly.

HRN: If the U.S. is debasing the dollar, why is there strong demand for U.S. Treasuries?

Jim Rickards: The reason the Treasury auctions are going well is because the Fed is buying. Think about what quantitative easing really is. The amount of quantitative easing over the 6 month period from November to June is approximately equal to the federal deficit. In other words, the federal deficit is running about $1.4 trillion a year, so half of it would be $700 billion and the Fed is out to buy $600 billion. By the way, I don’t think it’s going to end in June and they never said it was going to end in June. What they said was, we propose to buy $600 billion of treasury obligations between November and June, but they never said it was capped at $600 billion. They just said we’re going to buy about $75 billion a month for the next 6 months. I don’t think they will stop there. I view this as much more likely to be a trillion dollar plus program, not $600 billion.

HRN: How does the Federal Reserve’s purchase of U.S. Treasuries in the open market monetize U.S. government debt?

Jim Rickards: These things are pretty fungible. Dollars are totally fungible and Treasury securities are quasi fungible because it’s the same credit in the same currency. So, imagine you’re an institutional investor and you’re holding an off-the-run 7 year note with 5 years to maturity and the government is issuing a new 5 year note. Obviously, the primary dealers mediate this and are the interface between the Fed and the institutional investor. So, the Fed goes out and buys an off-the-run 7 year note from an insurance company, let’s say, and the insurance company replaces that in their portfolio by buying a new 5 year note. From the insurance company’s point of view, they got rid of a 5 year treasury and they bought a 5 year treasury, so nothing happened. From the Fed’s point of view, they bought the 5 year treasury with newly printed money and so there’s some intermediation and there’s multiple parties involved, but the net effect is exactly as if the Fed was monetizing the new debt.

HRN: Let’s get back to inflation. Can’t the Federal Reserve control inflation if prices start rising?

Jim Rickards: I think these processes are dynamically unstable and once you let the inflation genie out of the bottle, you don’t get 2% or 3%, you go straight to 10% and that’s what happened in the 1970’s. If you look at the late 60’s and early 70’s, inflation was 1% or 2% and then one year it pumped up to 3% and they said, oh my goodness, it’s 3%. After that, it went to 5%, then to 8%, then to 10% and then to 13%. In other words, between 1977 and 1981, in that five year period, cumulative inflation was 50%. The value of the dollar was cut in half over that very short 5-year period of time. So, that’s how it accelerates and gets out of control. I think that’s what’s going to happen again.

HRN: How much will prices go up in the U.S.?

Jim Rickards: Bernanke says 2%, but he actually wants something closer to 4%. I think what he’s going to find is that it goes very quickly to 8% or 9% or 10%, which is borderline hyperinflationary and that’s going to be a huge problem. It’s going to be a shock that the American people are not ready for.

HRN: What can the Federal Reserve do if price inflation starts to accelerate?

Jim Rickards: Well, Bernanke says, oh, don’t worry about high inflation because we have the ways and means of controlling that. If you take Bernanke at his word, which I don’t totally do, but if you do take Bernanke at his word and he says I want 2% and inflation goes to, let’s say, 3% or 4%, he’s saying, well, we can dial it back down to 2%. Well, how are you going to do that? One way is by raising interest rates, but are you really going to raise interest rates when unemployment is close to 10%? Bernanke says he can raise rates, and legally he can, but he’s not actually, politically or economically, going to be able to do it because he’ll be raising interest rates in the face of the greatest sustained period of high unemployment since the Great Depression. So, it’s just not going to be politically possible.

HRN: Couldn’t the Federal Reserve remove liquidity from financial markets to counter inflation?

Jim Rickards: There’s another problem with QE2, which is that the Fed is probably insolvent today if you applied some rigorous mark-to-market tests and that will become more apparent as this process goes forward. Let’s just say Bernanke gets what he wants, and, all of a sudden, inflation starts to creep up and he says; OK, now we have to put on the brakes. Well, how do you do that? The way you do it is by reversing QE. In other words, QE is creating money to buy bonds. The way to reverse that is to sell bonds into the market and take the money out. Well, the problem is you’re going to have massive mark-to-market losses on those bonds. First of all, there’s the Bear Sterns junk and, remember, QE1 was not treasury securities, it was mortgage backed securities. They’re not going to be able to liquidate the bonds without going broke.

HRN: How can the Federal Reserve go bankrupt?

Jim Rickards: The Fed is on its way to a $3 trillion balance sheet. Their capital, in round numbers, is about $60 billion. With $3 trillion on the balance sheet and $60 billion of capital, they’re leveraged 50 to 1. That’s worse than Long-Term Capital Management when they got in trouble in 1998. If you’re leveraged 50 to 1 and you have a 2% decline in assets, just 2%, and the stock market sometimes moves 2% in a single day, you just wiped out your capital. A 2% hair cut on $3 trillion is $60 billion and that takes your capital to zero and the Fed is broke.

HRN: Could the Federal Reserve’s primary dealers sell Treasuries to remove liquidity from the market and help keep inflation in check?

Jim Rickards: The primary dealers can’t create money through auctions or open market operations. The primary dealers can buy and sell securities but they’re doing it with money that already exists whereas when the Fed buys securities or sells securities they are creating or destroying money. The primary dealers can prop up the market in government securities, but they can’t create money the way that the Fed does or make money disappear the way the Fed does.

HRN: So, there’s nothing the Federal Reserve can do to control price inflation?

Jim Rickards: They’ve got to be looking down the road and saying, gee, we say we can get inflation under control, but the tools that we have to do that will basically be raising interest rates with 10% unemployment, which is not going to happen, or selling bonds and going broke, which is not going to happen. So, it’s all talk. The Fed won’t actually be able to keep inflation under control and it’s going to very quickly fly out of control.

HRN: Won’t rising prices make most Americans poorer?

Jim Rickards: The Fed doesn’t care about that. The Fed doesn’t care about people. They don’t care about workers. They don’t care about wages. They say they do, but the Fed only cares about banks.

HRN: Bernanke has been in the media, saying that inflation will stimulate the U.S. economy and help create jobs without causing prices to go up.

Jim Rickards: It’s propaganda. I had a discussion with former Fed governor, no reason to mention the name, who is a very well known economist, and what he said was that behind closed doors the Federal Open Market Committee spends about 10% of their time on policy and 90% of their time on communication. They very quickly arrive at what they’re going to do and then spend the vast majority of their time thinking about messaging and wordsmithing. Well, there’s a name for that. It’s called propaganda.

HRN: Thank you for sharing so many of your insights with us today.

Jim Rickards: It’s my pleasure.

After Words

Jim Rickards is one of the most astute intellectuals today in economics, financial markets and monetary systems, as well as an increasingly outspoken critic of the Federal Reserve’s monetary policies. The debasement of the U.S. dollar—the world reserve currency—through QE2, and due to monetary expansion resulting from low interest rates, is exporting U.S. inflation abroad, disrupting economies in Asia, South America and elsewhere. In addition to putting upward pressure on food prices globally, with potentially disastrous consequences, inflation is a hidden tax on savings and wages and, as prices rise, the living standards of most Americans will decline. Currency wars, caused by the Federal Reserve’s policies, could lead to trade wars or, in the worst case, to economic and political chaos as has been seen in Tunisia and Egypt.

Interview: Jim Rogers on Currencies and Inflation

Ron Hera — Fri, 04 Jun 2010 19:26:00 GMT

The Hera Research Newsletter (HRN) is pleased to present the following exclusive interview with legendary international investor, best selling author, adventurer and family man Jim Rogers, Chairman of Rogers Holdings and founder of the Rogers International Commodity Index (RICI). Jim Rogers’ commentaries on economics and finance have been featured in Time, The Washington Post, The New York Times, Barron’s, Forbes, Fortune, The Wall Street Journal, The Financial Times and other major publications, and he appears regularly on television networks around the world.

After growing up in Demopolis, Alabama, and earning degrees from Yale and Oxford Universities, where he studied politics, philosophy and economics, Jim Rogers co-founded the Quantum Fund in 1970, which gained 4200% over a 10-year period, during which the S&P advanced approximately 47%. After retiring at age 37, he managed his own portfolio while serving as a guest professor of finance at the Columbia University Graduate School of Business and as the moderator of WCBS’ “The Dreyfus Roundtable” and host of the Financial News Network’s (FNN) “The Profit Motive with Jim Rogers.”

Between 1990 and 1992, Jim Rogers fulfilled his lifelong dream of motorcycling across six continents in a 150,000 kilometer journey that won him a place in the Guinness Book of World Records. He also undertook a Millennium Adventure in which he traveled around the world in 1101 days, passing through 116 countries and traversing more than 245,000 kilometers.

Jim Rogers’ English language books include Investment Biker: On the Road with Jim Rogers (1994), Adventure Capitalist: The Ultimate Road Trip (2003), Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market (2007), A Bull in China (2008), and A Gift to My Children: A Father's Lessons for Life and Investing (2009).

Hera Research Newsletter (HRN): Thank you for speaking with us today. Let’s start with the world reserve currency. What do you think about the International Monetary Fund (IMF) replacing the US dollar as the world reserve currency with Special Drawing Rights (SDRs)?

Jim Rogers: The world didn’t have an IMF for a few thousand years. The IMF was founded after the Second World War to take care of any short-term currency needs that countries might have. It turned out pretty quickly that they didn’t have very many as the world recovered from the war, so the IMF found other things to do. They now have thousands of employees and have manufactured jobs for themselves. They’ve not had much success, if you look back over the past 60 years. Nearly everything they’ve done was wrong. Why do we need the IMF? It’s not 1945 anymore.

HRN: Rather than using a national currency as the world reserve currency, what about a global central bank?

Jim Rogers: That’s not what the IMF is, first of all, but even if they were, we certainly don’t need a central bank for the whole world. We never had one and the world got along pretty well for thousands of years without bureaucrats taking the world’s money. I’ve never added up how much the IMF has spent during the last 60 years but it must be a staggering amount, and for what good? I mean, we certainly haven’t gotten anything out of it. We haven’t gotten nearly as much for our money as they have spent.

HRN: So, you wouldn’t agree with using IMF SDRs as the world reserve currency?

Jim Rogers: I’m sure the world does need to replace the US dollar. I’m not the only one who knows that. The US dollar is a terribly, terribly flawed currency. The US is the largest debtor nation in the history of the world. Something has got to be done. We cannot continue with a currency which is so deeply flawed and something is going to have to be changed. Special Drawing Rights, I don’t know. It could work. I don’t know what’s going to work. Most people, however, want to have something in their hands that they think they can spend. A Special Drawing Right is pretty amorphous and, while some professors and some bankers may understand them, I suspect that most people in the world will not understand Special Drawing Rights and will not be terribly enthusiastic, if that’s what happens. So, I would suspect it wouldn’t last. You know, I cannot imagine that a Special Drawing Right, which has no real existence, could survive a crisis or two. Human beings just don’t think that way, I’m afraid.

HRN: Would you advocate a commodity-backed reserve currency instead?

Jim Rogers: Reserve currencies can be anything that you want. The problem with paper money is that it’s easy to debase and abuse. As I said, the US is the largest debtor nation in the history of the world. They keep printing the stuff. The UK, once upon a time, had the world reserve currency. They abused it mightily. Eventually the world just said “no, we’re not going to take sterling anymore” and rightly so. So, in my view, that’s the problem with paper money. Now, gold has its own problems too. Gold didn’t survive very long either as the world reserve currency since politicians kept changing the rules. Unfortunately, politicians know how to abuse and destroy. One can think of various and sundry solutions. My only worry is that, no matter what mankind has come up with in the past, politicians have always found a way to abuse it and debase it.

HRN: Do you think a return to the gold standard would constrain government abuse?

Jim Rogers: Well, it never has. The Romans had precious metals as their currency and do you know the term “debase”? The Roman politicians had the brilliant idea that if a coin was 100% pure precious metal, they could slip a little base metal in and, over a couple of hundred years, they went from 100% pure precious metal to almost 0%. That’s where the term “debase” comes from. So, we’ve tried it.

HRN: You mentioned that the US is the largest debtor nation in the history of the world. Do you think that will lead to high inflation or hyperinflation in the US?

Jim Rogers: Well, there will be inflation. First, you have to have inflation before you can have hyperinflation. I mean, we have inflation now. If you go to the shop, whether it’s groceries, or education or insurance or health care, prices are going up for everything. The government lies about it in the US. Some countries lie, many countries don’t: Australia, China, India and Norway. Many countries don’t lie about it and acknowledge that we have inflation. Others lie about it, the UK and the US, but if you go shopping you know prices are up.

HRN: Are you saying that the American Consumer Price Index (CPI) published by the US Bureau of Labor Statistics is a lie?

Jim Rogers: In my opinion, yes, of course it is. Have you looked at it? They’ve changed their accounting several times in the past few decades. When housing was 20% to 25% of the CPI and housing was going up, they didn’t count it, saying rents weren’t going up, and then when home prices started going down, they counted it. It’s the same with many things. It’s staggering some of the tortuous reasoning that the BLS has used over the past 25 or 30 years. When the price of gasoline goes up, they say it’s not really going up because it’s better gasoline, better quality, therefore you’re getting more for your money. I mean, it’s endless, the stuff that they say and for some reason people sit there, although more and more people are catching on, and accept what the government says. As I said, in other countries, they acknowledge that there’s inflation. I don’t know how there could be inflation in Australia and not in the US; how you can have inflation in Norway or India and not in the US, but the US says there’s no inflation.

HRN: An article in the Telegraph by Ambrose Evans-Pritchard reported this week that the US Federal Reserve’s M3 monetary aggregate is estimated to be contracting at an accelerating rate, in other words, deflation.

Jim Rogers: What’s going down in price in the US economy? I’d like to know where you shop. We know home prices are down. Oil prices are down to $73 per barrel, if you’re talking about a monthly or quarterly basis, or even an annual basis. I’m talking about what’s going on in the big picture. Where is the deflation in the US?

HRN: Some people believe a contraction of M3 indicates deflation.

Jim Rogers: Is M3 something you buy in a shop? M3 can lead to changes in the price structure, but M3 is not price inflation or deflation.

HRN: That’s a good point. Inflation is a concern in Europe and the Euro seems to be in trouble. Can the Euro survive?

Jim Rogers: I certainly expect the Euro to be around in 2012 or 2013, but whether it’ll be around in 2023, I don’t know. It’s becoming more and more a political currency. It wasn’t always. In the beginning, it wasn’t a political currency. It was designed to be a rock solid currency, but, since then, it’s become a political currency and most political agreements or political institutions don’t last. No currency union has ever lasted. It’s been tried before. I wish the Euro would survive. The world needs something to compete with the dollar. The Euro, on paper, makes enormous sense, but, unfortunately, the people who wrote that contract back in 1992 are all gone now and the new guys all want to buy votes. So, I would like to see the Euro survive, but, in reality, I don’t see how it can.

HRN: So, you expect more inflation in Europe?

Jim Rogers: Yes. Printing money has always led to inflation, eventually. When things go wrong, governments have always printed money, at least in the last few decades. That’s all they know and they will do it again. There will be times, obviously, when the printing presses slow down or even stop but when things get bad again they start over, and that’s all they know.

HRN: I’ve read that China is experiencing high inflation.

Jim Rogers: There is inflation in China. There are many places that are reporting inflation. It’s dumbfounding to me that many countries have inflation and the US doesn’t. That’s because some governments lie and some governments don’t.

HRN: It’s been widely reported that Chinese real estate is in a bubble. Do you think that’s true?

Jim Rogers: In urban, coastal real estate there certainly was a bubble. That’s not the whole of China. Have you ever looked at a map of China? Do you consider urban, coastal real estate the Chinese economy? Where’s the bubble? Other real estate in China has, for the most part, had very little movement.

HRN: Do you think China’s economic growth is sustainable?

Jim Rogers: Is it sustainable, yes; every quarter, every year, of course not. You know, in the United States in the 19^th century, we had 15 depressions, a horrible civil war, no human rights, massacres in the streets and very little rule of law, and yet, out of that, we had a pretty successful 20^th century. China is going to have many, many problems as they rise. I don’t know what and I don’t know when, but I know it’s going to happen. I don’t see any other country on the horizon that is going to have, long term, a sustainable, good future in the 21^st century.

HRN: You’ve talked about inflation, pointed out problems with the US dollar and the Euro, and described the rise of China. How can citizens of Western countries protect their wealth?

Jim Rogers: Historically, the best way is to own commodities. Throughout history, the way you protect yourself when currencies are being debased is that you own real goods. Whether that’s silver or cotton or natural gas or whatever it happens to be, you own something that’s a real good. As the value of money is debased, some things will maintain their value and some will even increase.

HRN: Investors seem to be turning to gold as a way to preserve their wealth.

Jim Rogers: Gold has been, historically, a good way to preserve wealth, but so have other things as well. I own gold. Gold is making all-time highs. It certainly has been a way to preserve wealth in the last decade. Whether there are better things in the next decade or not, and I suspect that there will be better things, I do own gold.

HRN: You mentioned silver as a way to preserve wealth but gold seems to be in the spotlight.

Jim Rogers: Let’s put it this way, silver is about 70% below its all-time high. Gold is making all-time highs. Often, one is better off investing in things that are down 70%, rather than things that are making all-time highs.

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

Jim Rogers: Thank you very much. Contact me any time.

After Words

Jim Rogers doesn’t mince words. When a person as remarkably successful and accomplished as Jim Rogers, and having long experience, states that the official statistics produced by government economists and views expressed in mainstream financial news outlets are incorrect, or disingenuous, one must take pause. Objectively speaking, for a majority of investors, views that are at odds with those of Jim Rogers are probably wrong.

According to Jim Rogers, the US dollar is deeply flawed because the US is the biggest debtor nation in the history of the world and, although an alternative currency is needed, the Euro will not survive in the long run because it has become political and IMF SDRs will probably not last as a reserve currency in the face of significant global economic crises. Long-term trends point to inflation and to the sustainability of China’s economic growth, as well as to China’s ascent as a world power. As prices inevitably, eventually rise due to inflation, real goods stand out as a time tested way to preserve wealth and to profit from changing economic conditions. In simple terms, currencies can be printed but real things cannot.

Into the Abyss: The Cycle of Debt Deflation

Ron Hera — Wed, 02 Jun 2010 12:46:00 GMT

One of the most famous quotations of Austrian economist Ludwig von Mises is 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 involved.” In fact, the US economy is in a downward spiral of debt deflation despite the bold actions of the federal government and of the US Federal Reserve taken in response to the financial crisis that began in 2008 and the associated recession. Although the vicious circle of debt deflation is not widely recognized, precisely what von Mises described is happening before our eyes.

A variety of positive economic data has been reported in recent months. Retail sales rose 0.4% in April 2010 as consumer spending rose and the US gross domestic product (GDP) grew at a rate of 3%. In May 2010, home sales rose to a five-month high and consumer confidence rose 17% (from 57.7 to 63.3). Industrial production rose 0.8% and durable goods orders rose 2.9%, more than had been forecast. However, the modest gains reported represent the continuing adaptation of economic activity at dramatically lower levels compared to the pre-recession period and most of the reported gains have been substantially manufactured by massive government deficit spending.

Despite the widely reported green shoots, in May, the unemployment rate rose to 9.9% while paychecks in the private sector shrank to historic lows as a percentage of personal income, and personal bankruptcies rose. Roughly 14% of US mortgages are delinquent or in foreclosure, credit card defaults are rising and consumer spending hit 7 month lows. To make matters worse, the reported increase in consumer credit, in fact, points to a further deterioration because consumers appear to be borrowing to service existing debt. Outside of the federal government, which is borrowing at record levels and expanding as a percentage of GDP, and outside of the bailed out financial sector, debt deflation has continued unabated since 2008.

Money Supply vs. Debt Service

A contraction of the broad money supply is taking place because the influx of money into the US economy, i.e., lending to consumers and non financial businesses, has fallen below the rate at which money is flowing out of general circulation as a function of debt service (interest and principle payments on existing debt), thus a net drain of money from the broad US economy is taking place. As a result, additional borrowing, as consumer spending falls, appears to be servicing existing debt in a pattern that is clearly unsustainable and that signals a further rise in debt defaults in coming months.

^{Chart courtesy of}^{Shadow Government Statistics}

The estimate of the broad money supply (the Federal Reserve’s M3 monetary aggregate) is crashing and the Federal Reserve’s M1 Money Multiplier, a measure of how much new money is created through lending activity, fell off of a cliff in 2008, and remains practically flat-lined.

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

The contraction of the broad money supply points to a potential slowing of economic activity and indicates that consumers and non financial businesses will be less able to service existing debt. Despite easing somewhat in March 2010, credit card losses are expected to remain near 10% over the next year and mortgage delinquencies, are currently at a record highs, and these dismal predictions implicitly assume a stable or growing money supply.

A tsunami of eventual mortgage defaults seems to be building and loan modifications have been a failure thus far. There have been only a small number of permanent loan modifications (295,348) under the Home Affordable Modification Program (HAMP) in 2009, out of 3.3 million eligible (60 days delinquent) loans and more than half of modified loans default.

^{Chart courtesy of}^{Calculated Risk}

Although it has been reported that American consumers are saving at a rate of 3.4%, the contraction of the broad money supply suggests savings liquidation. Given a contracting money supply, ongoing debt defaults and declining consumer spending, the increase in non-mortgage consumer loans indicates that consumers are borrowing where possible to consolidate debts, cover debt service, or borrowing to continue operating financially as their total debt grows, thus as they approach insolvency.

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

The increase in non-mortgage consumer loans has not prevented an overall decline in total household debt attributed to ongoing deleveraging by consumers. While deleveraging (paying down debt) has been interpreted as caution on the part of consumers, or as low consumer confidence, the decline in outstanding credit reflects a reduced ability to borrow, i.e., to service additional debt. This suggests that the recovery of the US economy may be illusory and that the economy is likely to contract further in coming months.

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

Commercial borrowing has declined more sharply than household debt suggesting that the nominal return to growth estimated at 3% has not been matched by debt financed expansion in the private sector.

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

The broad US money supply is no longer being maintained or expanded by normal lending activity. If federal government deficit spending ($1.5 trillion annually), debt monetization and emergency actions by the Federal Reserve (totaling an estimated $1.5 trillion since 2008) to recapitalize banks are considered separately, there remains a net drain effect on the broad money supply. The scarcity of money hampers economic activity, i.e., money is less available for investment, and directly exacerbates debt defaults as consumers and businesses experience cash shortfalls, while at the same time being less able to borrow. Since unemployment is a key indicator of recession, then if the US economy were contracting, it would be evident in unemployment statistics.

Structural Unemployment

Unemployment and labor force data suggest that the US labor market is in a structural decline, i.e., millions of jobs have been and are being permanently eliminated, perhaps as a long term consequence of offshoring, outsourcing to other countries and the ongoing deindustrialization of the United States. However, the immediate meaning of the term “structural” has to with the fact that jobs created or sustained during the unprecedented expansion of debt leading to the financial crisis that began in 2008, e.g., a substantial portion of service sector jobs created in the past two decades now appear not to be viable outside of a credit expansion.

Officially, the US unemployment rate rose to 9.9% in April 2010, which represents the percentage of workers claiming unemployment benefits. However, the total number of unemployed or underemployed persons, including so-called “discouraged workers” (Bureau of Labor Statistics U-6), rose to 17.1%. Using the same methods that the BLS had used prior to the Clinton administration, U-6 would be approximately 22%, rather than the official 17.1% statistic.

^{Chart courtesy of}^{Shadow Government Statistics}

With official U-6 unemployment of 17.1% and a workforce of 154.1 million there are roughly 26,197,000 people officially out of work. Using the pre-Clinton U-6 unemployment calculation of approximately 22%, there would be 33.9 million unemployed. If the average US household consists of 2.6 persons and if 33% of the unemployed are sole wage earners, then 55.5 million US citizens currently have no means of financial support (17.9% of the population).

^{Chart courtesy of}^{Calculated Risk}

While it has been reported that the labor force is shrinking, the characterization of workers permanently exiting the workforce by choice may be inaccurate. While a shrinking workforce could reflect demographic changes, the rate of change suggests that tens of millions of Americans are simply unemployed.

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

Setting aside the question of whether or not those “not in the workforce” are, in fact, permanently unemployed, the workforce, as a percentage of the total US population, is currently at 1970s levels. Since many more households today depend on two incomes to meet their obligations, compared to the 1970s, a marked drop in the percentage of the population in the workforce points to a decline in the labor market more significant than official unemployment statistics suggest. What is more important, however, is that structural unemployment suggests structural government deficits, e.g., unemployment benefits, welfare, food stamps, etc. Since more than 2/3 of US GDP (roughly 70%) consists of consumer spending, a sustainable recovery from recession seems improbable if unemployment is worsening or if the labor force is in a structural decline, since that would imply unsustainable government deficits, whether or not they are masked by nominal GDP gains thanks to economic stimulus measures.

Government and GDP Growth

The US federal government is a growing portion of GDP, thus reported GDP growth is largely a byproduct of government deficit spending and stimulus measures, i.e., reported GDP growth is unsustainable. Total government spending at the local, state and federal levels accounts for as much as 45% of GDP, thus nominal gains would be expected when government deficit spending increases. According to some measures, reported gains in GDP are a byproduct of relatively new statistical methods and, using earlier methods of calculation, GDP remains negative.

^{Chart courtesy of}^{Shadow Government Statistics}

Government borrowing and spending may have offset declines in the private sector but only to a degree and only temporarily. The resulting growth in US public debt has an eventual mathematical limit: insolvency. Of course, the actual limit to US borrowing remains unknown. The continuing solvency of the US depends on the ability and willingness of governments, banks and investors around the world to lend to the US, which in turn depends on the tolerance of lenders for the US government’s profligacy and money printing by the Federal Reserve, e.g., quantitative easing and exchanging new cash for worthless bank assets. US Treasury bond auctions will fail if lenders conclude that a sufficiently large portion of their investment will be diluted into oblivion by proverbial money printing. In that event, the US dollar will surely plummet, despite deflationary pressures within the domestic US economy, and the cost of foreign goods, e.g., oil, will rise causing high inflation or triggering hyperinflation.

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

According to the Bank for International Settlements (BIS), the federal budget deficit increased from 3.1% of GDP in 2007 to 9.2% in 2010. Rather than being the result of one-time expenses, such as temporary stimulus measures, much of the deficit represents permanent increases in government spending, e.g., due to the growing number of federal employees. If increased government spending is removed, GDP appears to be declining significantly.

^{Chart courtesy of}^{Karl Denninger}

Of course, sustainability has more to do with total debt than with deficit spending because a deficit assumes that there is an underlying capacity to service additional debt.

Unsustainable Debt

While asset prices have declined, e.g., real estate and equities, debt levels have remained high due to the federal government’s policy of preserving bank balance sheets, which had ballooned prior to the financial crisis to the point that overall debt in the US economy reached unsustainable levels.

^{Chart courtesy of}^{Karl Denninger}

The absolute debt to GDP ratio of the US economy peaked in 2007 when debt levels exceeded the ability of the economy to service debt from income based on production, even at low interest rates. Although US GDP began to decline prior to the advent of the global financial crisis, debt coverage had been in decline approximately since the 1970s, coincidentally, around the time that the US dollar was decoupled from gold.

^{Chart courtesy of}^{Karl Denninger}

Government deficit spending cannot correct the situation because, for every dollar of new borrowing, the gain in GDP is negligible and some have argued that the US economy has passed the point of “debt saturation.”

^{Chart courtesy of}^{Nathan A. Martin}

In a growing economy, additional debt can result in a net gain in GDP because the money supply grows and economic activity is stimulated by transactions that flow through the economy as a result. The debt saturation hypothesis is that, as debt levels rise, additional debt has less impact on GDP until a point is reached where new debt causes GDP to decline, i.e., the capacity of the economy to service debt has been exceeded and, not only is it impossible for the economy to grow at a rate sufficient to service existing debt (since interest compounds), but economic activity actually declines further as a function of additional debt.

A Downward Spiral

The process of debt deflation is straightforward. New lending at levels that would maintain or expand the broad money supply is impossible for two reasons: (1) asset values and incomes have fallen and millions remain unemployed; and (2) debt levels remain excessive compared to GDP, i.e., real economic activity (outside of the government and financial services industry) cannot service additional debt. The inability to lend, actually the result of prior excess lending, results in a net drain of money from the economy. The drain effect, in turn, leads to further defaults as cash strapped consumers and businesses fail to service existing debt, and as debt defaults impact bank balance sheets, putting a damper on new lending and completing the cycle of debt deflation.

Keynesian economic policies, i.e., government deficit spending, are irrelevant vis-à-vis excessive debt levels in the economy and bailing out banks is not a solution since it cannot stop the deterioration of their balance sheets. The process is self-perpetuating and cannot be stopped by any government or monetary policy because it is not a matter of policy, but rather one of mathematics.

Since the presence of excess debt (beyond what can be supported by a stable GDP, or by sustainable GDP growth) impacts the broad money supply, efforts to preserve bank balance sheets, i.e., to keep otherwise bad loans on the books of banks at full value, will ultimately cause bank balance sheets to deteriorate more than they would have otherwise. The fact that US banks issued trillions in bad loans cannot be corrected by changing accounting rules, nor can the consequences be avoided by government deficit spending or by unlimited bailouts, and the problem cannot be papered over by dropping freshly printed money from helicopters flying over Wall Street. The major problems facing the US economy today—a tsunami or debt defaults, structural unemployment, massive government budget deficits, a contraction of the broad money supply outside of the federal government and the financial system, and a lack of sustainable growth—cannot be addressed as long as excess debt levels are maintained. As von Mises clearly understood, sound economic conditions cannot be restored unless and until the excess debt, which resulted from a boom brought about by credit expansion, is purged from the system. The alternative, and the current policy of the United States, is a downward spiral into a bottomless economic abyss.

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.

Faces of Death: The US Dollar in Crisis

Ron Hera — Sun, 11 Oct 2009 08:45:00 GMT

The US economy has been in crisis since 2008 and despite optimistic statements by officials and commentators there are no fundamental signs that the crisis will end in the foreseeable future. Current economic data suggests a number of diverging and unsustainable...(read more)