Hera : inflation

Why Financial Repression Will Fail

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

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

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

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

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

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

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

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

Crisis and Consequence

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

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

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

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

The Road to Stagflation

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

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

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

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

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

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

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

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

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

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

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

Reign of Repression

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

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

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

Financial Crime Is A Systemic Risk

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

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

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

World Reserve Currency Status

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

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

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

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

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

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

U.S. Federal Government Debt and Unfunded Liabilities

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

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

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

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

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

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

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

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

Domestic Confidence in the U.S. Dollar

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

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

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

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

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

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

A Black Swan?

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

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.

Jim Sinclair: The Financial System Is Less Stable Today Than It Was in 2008

Ron Hera — Sat, 07 May 2011 11:35:00 GMT

The Hera Research Newsletter is pleased to present an in-depth interview with Jim Sinclair, Chairman and CEO of Tanzanian Royalty Exploration and founder of Jim Sinclair's MineSet, which hosts his gold commentary as a free service to the gold investment community.

Jim Sinclair is primarily a precious metals specialist and a commodities and foreign currency trader. He founded the Sinclair Group of Companies in 1977, which offered full brokerage services in stocks, bonds, and other investment vehicles. The companies, which operated branches in New York, Kansas City, Toronto, Chicago, London and Geneva, were sold in 1983.

From 1981 to 1984, Mr. Sinclair served as a Precious Metals Advisor to Hunt Oil and the Hunt family for the liquidation of their silver position as a prerequisite for the $1 billion loan arranged by the Chairman of the Federal Reserve, Paul Volcker.

He was also a General Partner and Member of the Executive Committee of two New York Stock Exchange firms and President of Sinclair Global Clearing Corporation (a commodity clearing firm) and Global Arbitrage (a derivative dealer in metals and currencies).

In April 2002, shareholders of Tanzanian Royalty Exploration (formerly Tan Range Exploration) approved the acquisition of a Sinclair managed private company, Tanzania American International, and its exploration assets in Tanzania. Subsequently, Mr. Sinclair became Chairman of Tanzanian Royalty and now leads its efforts to become a gold royalty and development company.

He has authored three books and numerous magazine articles dealing with a variety of investment subjects, including precious metals, trading strategies and geopolitical events and their relationship to world economics and the markets. He is a frequent and popular commentator on financial and market related issues in various news publications, and has been profiled in the New York Times.

In January 2003 Mr. Sinclair launched, Jim Sinclair's MineSet, which now hosts his gold commentary and is intended as a free service to the gold community.

Hera Research Newsletter (HRN): Thank you for speaking with us today. You are one of very few people who have tried to warn investors about OTC derivatives. Why are OTC derivatives a problem in your opinion?

Jim Sinclair: Over the counter (OTC) derivatives are the reason we are going through what we are going through now. An OTC derivative is a kind of wager on what something will do. Up until 2009, most of these wagers had very little, if any, money behind them and, if the direction you bet on didn't come to fruition, the amount of leverage resulted in extraordinary losses. There was a major rollover in derivatives tied to real estate in 2008, as well as in other types, such as those tied to sub-prime auto loans.

HRN: Did OTC derivatives destabilize the financial system in 2008?

Jim Sinclair: Absolutely.

HRN: Don't financial institutions use risk cancellation models to hedge risks using OTC derivatives?

Jim Sinclair: Before the failure of Lehman Brothers, OTC derivatives losses would have almost netted out to zero. You can consider derivatives like a string in a circle with various knots representing all the derivatives transactions. When Lehman went broke, the string broke. When Lehman couldn't meet its obligations on derivatives, they could no longer be netted out to zero. That's why the banks went down, and that's why you had the government bailouts and quantitative easing (QE).

HRN: OTC derivatives are the real reason for the bank bailouts?

Jim Sinclair: That is a fact which can in no way be argued away.

HRN: Hasn't the problem been cleaned up by the Dodd-Frank Wall Street Reform and Consumer Protection Act?

Jim Sinclair: The pile of OTC derivatives is over $1 quadrillion. After 2008, the International Monetary Fund (IMF) adopted a new method of valuing them called value to maturity. Value to maturity assumes all of them will function, which is a cartoon. The derivatives pile hasn't contracted. Basically, it has expanded, but value to maturity reduced the notional value from over $1 quadrillion to under $700 trillion. The amount outstanding is the same as it was in the first place.

The flavor of the present moment is credit default swaps against the solvency, or lack thereof, of sovereign nations. New derivatives have some margin behind them, but they only work if they are not called upon. If a nation's debt was in fact to default, it would happen very quickly without a great deal of run up before. Most people would expect a rescue to be coming. Let's say a rescue didn't come, those credit default swaps would simply not be able to function and down again would come the banking system.

HRN: Are you saying that the financial system is less stable today than it was in 2008?

Jim Sinclair: It appears more stable but that's only an appearance. The entire equity rally took place almost to the day from when the Financial Accounting Standards Board (FASB) relaxed the mark-to-market rule. It allowed financial institutions to make up whatever value they wanted for their worthless pieces of paper. If they used the real values, the banks would have come down.

HRN: Wasn't the FASB change a temporary measure to halt the decline in mortgage-backed securities?

Jim Sinclair: It wasn't just mortgage-backed securities. It was all the paper on bank balance sheets. The balance sheets of banks appear to be in good shape but they're not. In fact, they will need a lot more funds.

HRN: Then the financial system is still vulnerable?

Jim Sinclair: They've kicked the can down the road. The purpose of QE, in other words the printing of money, is to maintain some degree of integrity in the financial system. Bear in mind that the grease for the wheels of equity markets is liquidity, meaning that if you create a lot of money, it goes into the hands of banking institutions and international investment houses. So, the equity out of thin air market has been sustained by QE.

HRN: What can the government do to prevent another crisis?

Jim Sinclair: You can assume that what's been done already will be done again. There are no other tools in a practical sense. The idea that there won't be a continuation of QE is nonsense.

HRN: Can the government bail out the banks again?

Jim Sinclair: The central banks will buy the government debt. That's called quantitative easing.

HRN: Doesn't QE undermine the dollar?

Jim Sinclair: The dollar is an exercise in psychology. It's a piece of paper with a promise to pay but there's nothing in which it can be paid. It's legal settlement for debt but there's nothing that it's convertible into. To maintain confidence, it's necessary to maintain the stature of a currency. In an arithmetic sense, if you go into a market to sell a supply of apples, and if you're the only seller, you can get a nice price. If more sellers, meaning more apples, come into the market, there goes the price of apples. QE creates more dollars, which increases the supply.

HRN: If the dollar is losing value because of QE, what about the euro?

Jim Sinclair: If you look at the dollar or the euro or the yen, or even the Swiss franc, it's a race to the bottom amongst all currencies. All countries everywhere are creating more paper every day. It's a relative valuation, rather than a valuation based on an objective reference. What happens in the European Union immediately affects the dollar.

HRN: You mean the sovereign debt crisis?

Jim Sinclair: There's too much focus on the euro countries. There's no difference between the economic union of Europe and the union of the states in the United States. The states of europe have been revealed to be insolvent. How about the states of the United States? Out of New York, Illinois, California, etc., how many are solvent? The focus of the media has been on the euro. The U.S. should stand in front of a mirror. The states of the economic union of America are in no better shape.

HRN: The news media is ignoring the U.S. sovereign debt crisis?

Jim Sinclair: In George Orwell's Nineteen Eighty-Four, there were loud speakers constantly teaching the people what Big Brother wanted. The loudspeakers today are financial television. How much attention has financial TV put on the insolvency of U.S. states? It's been mentioned, but not like the solvency problems of Portugal, Greece, Spain and Ireland, which have gotten hours, days, weeks and months of constant coverage. The solvency of New York, Illinois and California has been brought up but fleetingly at best.

HRN: So, the solvency problems of U.S. states are like an elephant in the room that no one is talking about?

Jim Sinclair: How can you say that the euro is a disaster based on the financial condition of the states of the economic union of Europe, when the states of the economic union of the United States are in equally bad shape and in some cases worse? There's no difference. If you want to analyze the euro based on the weakness of its member states, how can the dollar be strong when the states of the United States are as weak or weaker?

HRN: So, the euro could rise against the U.S. dollar, despite the European sovereign debt crisis?

Jim Sinclair: Sure it can. The question is, can the dollar go lower? The euro could go to $1.50 or higher.

HRN: But the U.S. dollar is the world reserve currency. Doesn't that guarantee its value?

Jim Sinclair: Only by default. It remains so because central banks own dollars. If central banks could exchange them for gold or other currencies without a major dislocation, they would.

HRN: Then, as a practical matter, central banks can't get out of the dollar?

Jim Sinclair: The only one that's gotten out of it is China. They've made deals all around the world for metals, materials, energy and manufacturing. If you add it all up, China is no more stuck in the dollar than the man in the moon.

HRN: Doesn't the U.S. maintain a strong dollar policy?

Jim Sinclair: The strong dollar policy has only been a moderate, long-term downtrend that continues lower.

HRN: Don't central banks manage currency exchange rates to prevent disruptive changes, like the recent Japanese yen intervention?

Jim Sinclair: In the Japanese yen intervention, the central banks intervened but how long can they intervene? They have to create money to intervene, which comes back to QE.

HRN: Do you mean the overall affect of currency interventions is to create new money?

Jim Sinclair: Anything that happens around the world, for instance, the Bank of Japan's response to the horrible disaster in Japan, was to go straight to QE. Money is being created everywhere without any discipline but the problems of financial institutions remain because they have make-believe balance sheets with improper values for their OTC derivatives.

HRN: Doesn't the suspension of the FASB mark to market rule buy time for banks to repair their balance sheets?

Jim Sinclair: There are five million homes for sale in the United States if you include the off-market shadow inventory, which is a real inventory. There's no repair coming in the real estate market, therefore, there's no repair coming in the OTC derivatives based on that. That means there's no repair coming in the underlying paper that the banks now value at much higher levels than they could possibly sell them for, if they could sell them at all.

HRN: Will bank balance sheets eventually get better?

Jim Sinclair: As long as confidence remains in place, which depends on the equity market and that comes back to QE.

HRN: Are you saying that the U.S. stock market rally is driven by QE?

Jim Sinclair: There's an inability to stop QE without the whole house of cards coming down on itself. There's no other choice. It's the only tool left. The Federal Reserve can't take a hawkish position on monetary policy and interest rates without this whole thing rolling over. They can talk about it constantly and might have more back-door QE than front-door QE.

HRN: If QE doesn't stop soon, what will happen?

Jim Sinclair: The end game is a virtual reserve currency linked to gold. It will be based on an average of major currencies, which will slow down the movement in the index. The IMF is moving in that direction with Special Drawing Rights (SDRs). The dollar will be just another currency. The dollar's not going to zero. It could loose a significant part of its buying power, which it already has and could again.

HRN: How would a virtual currency work?

Jim Sinclair: There would have to be a broad measure of the money supply, such as M3 used to be for the U.S. dollar, but on an international basis. The price of gold would be related to that measure. Central banks would have to value their gold according to their contribution to or extraction of international liquidity, so the price of gold would rise or fall on its own.

HRN: Wouldn't that be a gold standard?

Jim Sinclair: There'll never be a return to a gold standard in my opinion. The end of all hyperinflations has been a commodity currency. That's exactly what happened in Germany, for example. Gold has the capacity to give confidence to people if there's some relationship between the currency and gold. The virtual currency will be linked to gold but not convertible into gold.

HRN: So, a gold component will restore confidence?

Jim Sinclair: The answer is a commodity currency. That's what happened every time there was this type of situation in monetary history. The rentenmark, which ended the German hyperinflation in 1923, was supposedly backed by all the real estate in Germany, but the government didn't own that real estate. The point is that it wasn't true. There was no great commodity backing for the rentenmark, but it was enough. It was a period when people were searching for anything to restore confidence in the currency.

HRN: Do you expect high inflation in U.S. dollar terms?

Jim Sinclair: The deed is done. Inflation is a pregnancy. The conception has already taken place. There's a delayed effect but if you do the crime, you do the time. The Federal Reserve could stop QE tomorrow and it wouldn't stop what's going to happen because of what they've already done.

HRN: Won't inflation reduce the real value of debt and help to repair bank balance sheets?

Jim Sinclair: Inflation is the way debt will be taken care of. The value of the currency will be so reduced as to reduce the debt load. It will also change the political scene. Whoever has power going into this will not have power coming out of it.

HRN: In other words, inflation is politically destabilizing?

Jim Sinclair: People really haven't seen the big picture. Currency induced cost push inflation is already here. Look at what's going on right now in the Middle East. We are moving from order to lack of order.

HRN: Would you say that inflation in food prices is indirectly driving oil prices higher?

Jim Sinclair: Oil goes right through from fertilizers to farm equipment to transportation and to food prices. The price of food is going to go even higher than we are seeing this year. The price of oil is headed decidedly higher. Peak Oil was a concept of the future. Now it's a concept of now. A car getting 25 miles per gallon will probably be too expensive for the average person to drive.

HRN: How will high oil prices affect the prices of other things?

Jim Sinclair: There will be dislocation in the means of delivery of products. There may be shortages of goods, not because there are no available goods but because the means of distribution breaks down. It's not that there won't be corn or wheat, but the fuel needed to deliver it will be too expensive and people who work in transportation will demand higher pay so they can live. That's where hyperinflation comes in.

HRN: And money to maintain the distribution of goods will be printed out of thin air?

Jim Sinclair: Every nation that has ever done this has turned into a banana republic. People can live in banana republics but there will be few wealthy people. There will be a few super wealthy people and an enormous amount of poverty. You can see it across the border in Nogales, Mexico, where people continue to live in extreme poverty.

HRN: America is becoming like Mexico?

Jim Sinclair: The standard of living is going much lower. People have to realize that the damage is already done. It's not a question of whether the U.S. can be pushed over the edge. We are over the edge. We are watching the consequences play out now.

HRN: What can people do to protect their wealth from inflation?

Jim Sinclair: People have to try to maintain their buying power. Each person can become their own central bank and, to the best of their abilities, focus on the assets that benefit from the disorder that's taking place and that will continue to take place.

HRN: Do you mean buying precious metals or commodities?

Jim Sinclair: I've spoken to people who, over the last ten years, have had this perspective. They have done very well. Even doing it now could protect your wealth.

HRN: What about gold? Do you see gold as a currency that can't be debased?

Jim Sinclair: What is real money? Gold is a currency that has no liability attached to it. It's a measure of value and a store of wealth that's universally acceptable.

HRN: So, gold is an alternative to dollars or euros?

Jim Sinclair: Physical gold is the answer. An individual who holds gold will have more time and ability to function.

HRN: How much higher do you think the price of gold could go?

Jim Sinclair: What's the exchange rate of a currency with no liability attached to it? Gold is going much higher. We could see shocking gold prices, maybe Alf Fields' target of $10,000 per ounce or Martin Armstrong's target of $12,000 per ounce. I think that my price target of $1,650 per ounce gold is going to be so low it will be considered silly.

HRN: Thank you for your time today.

Jim Sinclair: It was my pleasure.

Nicknamed "Mr. Gold" for his incredible timing of the gold market in the 1970's, when he called the top of the market in 1980 to the day, Jim Sinclair, is a legendary precious metals, commodities and currency trader. Mr. Sinclair was influenced by his father, Bert Seligman, who was the business partner of Jesse Livermore, "The Great Bear of Wall Street" famous for short selling in the stock market crashes of 1907 and 1929. Currently Chairman, President and CEO of Tanzanian Royalty Exploration Corporation, part of Mr. Sinclair's strategy to protect his interests from the effects of currency debasement, is to acquire as much gold in the ground as possible without rushing to production because, he believes, the price of gold will go much higher. Mr. Sinclair's famous 2001 gold price target of $1,650 per ounce in 2011-a prediction ten years into the future-fell within 22% of the gold price in January 2011 after a phenomenal 511% increase over a ten year period, from an average price of $265.49 in January 2001 to an average price of $1,356.40 in January 2011 (London p.m. Fix)-one of the most astonishing calls in the history of precious metals trading. As a commentator on precious metals, commodities and currencies, investors ignore Jim Sinclair at their peril.

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.

QE2 and its Consequences (Part I)

Ron Hera — Tue, 18 Jan 2011 01:35:00 GMT

The Federal Open Market Committee (FOMC) announced on November 3, 2010 that it would purchase longer-term Treasury securities at a pace of $75 billion dollars per month through the Federal Reserve’s Permanent Open Market Operations (POMO) facility by the end of the second quarter 2011 and potentially beyond. The Quantitative Easing Two (“QE2”) program, championed by Ben Shalom Bernanke, Ph.D., Chairman of the US Federal Reserve, is expected to total at least $600 billion and the program may total more $600 billion, if Dr. Bernanke and the FOMC deem it to be necessary. Currently, QE2 is expected to continue until the end of 2011, i.e. up to $1.2 trillion, although there is ongoing policy debate within the Federal Reserve amidst growing fears that the policy may backfire.

Chart courtesy of Shadow Government Statistics

Monetary inflation is one result of QE2 because when the Federal Reserve buys US Treasuries it injects newly created money into the financial system, which, in turn, reduces the value of the US dollar (due to the increase in the quantity of dollars). A lower US dollar could stimulate US exports but could have unintended consequences, such as creating excess liquidity that could lead to asset price bubbles in the US. Low interest rates are already fueling a US dollar carry trade that seems likely to create asset price bubbles abroad. In 2010, borrowing in the US and investing abroad yielded significant returns, thus, there is a profitable carry trade in the world’s reserve currency, which has been called the mother of all carry trades by New York University economist Nouriel Roubini because of the US dollar’s increasingly tenuous status as the world reserve currency.

Global Outcry against QE2

The announcement of QE2 touched off an international firestorm of controversy. QE2 has been widely criticized by financial and political leaders representing US creditors, exporters and emerging economies. Nobel laureate Joseph Stiglitz has become an outspoken critic of QE2, warning that it poses a risk to emerging economies where asset price bubbles are already apparent. European Central Bank (ECB) President Jean-Claude Trichet expressed the same concern. The growing consensus on the part of emerging economies, such as Brazil, India, China, Argentina, Taiwan, Thailand, South Korea, Peru and Indonesia, is that capital controls are necessary to prevent excessive capital inflows, which can be highly inflationary. The International Monetary Fund (IMF), which bailed out a number of smaller countries in 2008, has supported capital controls since February 2010. The dilemma for exporters is that they must seek to control inflation, e.g., by raising interest rates, but must also debase their currencies to maintain their exports. The only other option is to institute capital controls. One of many critics, Brazil’s Finance Minister, Guido Mantega, warned that the US-led currency war “…is turning into a trade war.”

The growing consensus is that inflation in Asia will damage Asian economies before Western countries, which are debasing their currencies, fully recover from the recession that began in 2007. The trade relationship of the US and China is in the eye of the storm and fears of a trade war are growing. Debasing the US dollar reduces the value of China’s US Treasury holdings while China relies on exports to the US, totaling between $200 and $300 billion annually. For exporters, QE2 is a doubly destructive policy since capital inflows are inflationary while exports are reduced due to currency appreciation. The potential effects of a downturn in manufacturing resulting from falling exports, coincident with the bursting of an asset price bubble, is a formula for disaster. As more countries begin to conduct international trade without using US dollars, the world could be split into two camps. For example, talks are taking place between the US and Japan regarding the establishment of trans-Pacific free trade.

Interestingly, QE2 has the potential to “cash out” favored holders of US Treasuries in exchange for US dollars at their current value, i.e., before the US dollar declines further. China, Russia and Brazil are already reducing their US Treasury holdings and could be favored sellers of US Treasuries to the Federal Reserve (through its intermediaries). However, given the size of the US federal deficit, the simplest explanation is that the Federal Reserve is simply funding the US government.

Keeping the Wolfpack at Bay

While it may stimulate US exports and help to create conditions for renewed economic growth in the US (rather than relying mainly on the stimulation of consumer spending), QE2 represents a debasement of the US dollar and suggests that demand for US debt may be weakening. The current facts regarding the US economy do not justify the AAA rating of US sovereign debt. In February 2010, Moody’s publicly warned that it might have to cut the rating on US government debt. The warning was reiterated in December, while American politicians debated tax policy, and surfaced again in January. Until the US economy shows stronger growth, and until the US federal government gets its budget deficit under control, confidence in US sovereign debt and in the US dollar will continue to deteriorate.

US Treasury yields began to rise after the announcement of QE2 and, in December, US Treasuries experienced an unprecedented sell-off causing speculation that the US may become the next target of the so-called wolfpack, comprising short sellers of sovereign debt that are also OTC derivatives (credit default and interest rate swaps) traders. Artificial demand for US Treasuries created by QE2 could potentially head off the shorting of US Treasury bonds to generate credit default and interest rate swap related profits. Short sellers seeking to drive up yields run the risk that the Federal Reserve will step in and buy aggressively to drive yields back down, thus QE2 may preempt the wolfpack. The United States is not immune to such predatory practices might because the notional value of OTC derivatives is currently more than $605 trillion (approximately 10 times world GDP).

Chart courtesy of StockCharts.com

Artificial demand for US Treasuries could hold down bond yields thus supporting an inflationary monetary policy but the Federal Reserve’s own Primary Dealers forecast higher bond yields for 2011. The Federal Reserve’s control over US Treasury bond yields appears to be limited, ironically, as a consequence of currency debasement. Even if US Treasury bond yields rise, however, QE2 might still provide a means of keeping the wolfpack at bay.

Let them Eat Dollars

While QE2 has been generally positive for equities in the short term, the FOMC announcement in November 2010 triggered a sharp rise in commodity prices with gold closing over $1400 and silver closing over $30 at the end of 2010 and with the Commodity Channel Index (CCI) and global food prices at new highs. Rapidly rising global food prices pose an escalating risk of food shortages or worse, particularly in poorer countries, leading analysts to conclude that the world is one poor harvest away from chaos. President of the World Bank, Robert Zoellick, warned that rising food prices are “a threat to global growth and social stability.” Food riots, for example, have already begun to break out in Africa. In the US, consumers and businesses paid an additional $25 billion for gasoline between September 2010 and January 2011 and gasoline prices have continued higher.

Chart courtesy of StockCharts.com

Since the corrosive effects of expanding the money supply in excess of the rate of increase in sustainable economic activity, i.e., inflation, could not so quickly have resulted from QE2, QE2 seems to have damaged global confidence in the US dollar and in US Treasury debt. The January pullback in gold and silver showed that the sharp rise in prices after the announcement of QE2, in November 2010, was in part reactionary. Nonetheless, the strengthening of the US dollar can be largely attributed to the ongoing debt crisis in Europe and the ongoing bull market in commodities and precious metals points to a continuing influx of capital and to a reduced preference for the US dollar and US Treasuries. Had it not been for the revelation of Ireland’s economic troubles along with those of other European countries, the US dollar would certainly have fallen further compared to the Euro towards the end of 2010. What is more important is that the Euro, the US dollar and the Japanese yen have the same fundamental problem in common, which is a combination of high debt levels and economic fundamentals that, in the best case, do not inspire confidence.

Chart courtesy of StockCharts.com

All other things being equal, if the QE2 program were terminated, the US dollar would certainly rally and demand for US debt would certainly strengthen, lowering demand for commodities and precious metals. The termination of QE2 or an announcement of its impending termination is a potential short term risk for investors. Conversely, as QE2 continues indefinitely, the current commodities bull market, which has been amplified by the weakening US dollar, will continue And precious metals prices, which are currently consolidating, will move higher.

The emerging pattern since the announcement of QE2 is bullish for commodities and precious metals. Episodic flights to safety have tended to cause the US dollar to rally, despite poor economic conditions in the US, i.e., in response to economic instability in countries such as Dubai, Greece, Ireland or Spain. The pattern of US dollar-centric flights to safety has begun to break down, suggesting that investors may increasingly favor commodities and precious metals over US dollars and US Treasuries as hedges against inflation and sovereign debt risk.

Diminishing US Credibility

The credibility of the US government and the Federal Reserve is gradually deteriorating. In the worst case, a total collapse of confidence could trigger a race to divest of US Treasuries and to shed US dollars, i.e., a hyperinflationary currency event. The declining US dollar and the diminishing desirability of US debt and of the Federal Reserve bode well for commodities and precious metals while warning away any sane investor from US Treasuries.

In the face of indefinite QE2, it remains unclear (1) when the disintegration of the US dollar’s status as the world reserve currency might accelerate and a new reserve currency will be established, (2) if and when holders of US Treasuries seeking a way out might reach critical mass potentially triggering a proverbial rush to the exits (i.e., a collapse of US Treasuries despite the Federal Reserve’s artificial demand), or (3) if and when a race, whether global or domestic, to shed US dollars in favor of equities, hard assets, alternative currencies, precious metals or other real goods might begin. The first and second processes (removal of the US dollar’s world reserve status and the divestment of US Treasuries) are already under way and the Federal Reserve’s current policies are on track to eventually trigger the third.

Fundamentally, the Federal Reserve cannot prevent rising prices while the US dollar moves lower due to QE2 and due to the US’ deteriorating creditworthiness and credibility, nor can it control the flow of liquidity resulting from its actions or, therefore, resulting asset price bubbles, whether in the US or abroad. In light of the Federal Reserve’s current policies, it seems likely that, in the next 12 months, global economic volatility related to inflation, currency debasement and, potentially, developing currency and trade wars will increase while the financial stability of the US and of the Eurozone countries continues to decline and while commodity and precious metals prices continue to move higher.

Interview: Eric Sprott on Gold and QE2

Ron Hera — Mon, 18 Oct 2010 09:23:00 GMT

The Hera Research Newsletter (HRN) is pleased to present the following exclusive interview with Eric Sprott, Chairman, Chief Executive Officer and Chief Investment Officer of Sprott Asset Management LP and Chairman and CEO of Sprott Money, Ltd. With over 35 years of experience in the investment industry, Mr. Sprott is the Senior Portfolio Manager for numerous funds comprising several billion dollars in assets.

After earning his designation as a chartered accountant, Eric entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities (now called Cormark Securities Inc.), which today is one of Canada’s largest independently owned securities firms. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees.

Eric’s investment abilities are well represented by his track record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II, Sprott Bull/Bear RSP Fund, Sprott Offshore Funds, Sprott Canadian Equity Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2004, the Sprott Hedge Fund L.P. was awarded the Opportunistic Strategy Hedge Fund Award at the Canadian Investment Awards. In addition, the Sprott Offshore Fund Ltd. won the 2006 MarHedge Annual Performance Award under the Canada-Based Manager category. Furthermore, in October 2006, Eric was the recipient of the 2006 Ernst & Young Entrepreneur of the Year Award (Financial Services) and the 2006 Ernst & Young Entrepreneur of the Year for Ontario. In December 2007, Eric was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisers. In October 2008, the Sprott Offshore Fund Ltd. won the award for the Best Long/Short Hedge Fund globally by HFM Week, a leading publication for the global hedge fund industry.

Eric’s predictions on the state of the North American financial markets have been captured throughout the last several years in a series of investment strategy articles entitled “Markets At A Glance”.

Hera Research Newsletter (HRN): Thank you for taking the time to talk to us today. You’ve commented in your articles and elsewhere that the financial problems of the United States are much more serious than one might imagine based on the official statements of the US government.

Eric Sprott: The situation goes back at least to 2000 when we saw the Nasdaq rolling over. Before it rolled over, we’d written about it, in fact, we almost to the day published an article entitled “Speculation is Rampant, Don’t be a Part of It”. From that point on, I’ve believed we’re in a secular bear market. The Nasdaq certainly has been in a secular bear market since then. Somehow they resurrected the S&P and the Dow but in order to do it they had to start a housing mania and a lending mania and now, a government spending mania. We still think that the situation peaked in 2000 and continues today in a secular bear market, but it’s morphing into a bigger problem.

HRN: What is the bigger problem?

Eric Sprott: The bigger problem that we have today is where the sovereign risk stands and the size of the US deficit and I think that the question today is “Does Keynesianism work?” In other words, if you spend money it’s supposed to stimulate your economy, but there have been a number of reports suggesting that the opposite happens, that you get a negative return for government spending. One study was done in Canada by the Fraser Institute and another was done by three Harvard professors and their conclusions were that government spending was not good for private enterprises, period. You can see this if you look at a chart showing the marginal value of each dollar spent by the US government from 1960 to today.

HRN: Do you mean the marginal return on a dollar of debt?

Eric Sprott: The marginal value of government expenditures, yes, debt, essentially the deficit spending. The economic effect of running deficits is now something like negative 40 cents on the dollar. I think Keynesianism is sort of being stood on its ear and it seems quite likely that there is a negative return on deficit spending. For example, if the US government extended unemployment insurance benefits yet again, what do we all think the people receiving unemployment benefits would do? Would they be rushing out to get a job or not rushing out to get a job? You see, deficit spending almost always works against the system. When I look at US GDP, which I think last year probably went up by $400 billion, but, at the end of the day, there was an extra debt of $1.5 trillion and this year it will probably go up by the same amount, any thinking person would realize that if you tack on $3 trillion of debt and you’ve got less than $1 trillion of GDP growth, that’s a formula for bankruptcy.

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

HRN: Are you saying government stimulus doesn’t work because debt rises faster than GDP?

Eric Sprott: Yes, it doesn’t work. I’m not even including debt at the state and municipal levels. I’m just using federal debt. Debt at other levels of government in the US is going up too, but not at the rate the federal government debt is increasing.

HRN: What sort of outcome or endgame do you foresee?

Eric Sprott: A few months ago, I wrote an article entitled “Surreality Check Part Two… Dead Government Walking” where I specifically zeroed in on the US government. When I wrote Surreality Check … Dead Men Walking back in November of 2007, I predicted that some companies—I pointed out Citigroup, GM, Fannie, Freddie—were all broke. They had pretty good market caps at the time, but the reality was that they were broke and I think the reality is that the US government is broke. If you take all of the unfunded liabilities—the number is something like $60 trillion or $100 trillion—there’s absolutely no way that it can be repaid. They’re going to have to repudiate some obligation, just as other governments are doing now. For example, the UK and France and maybe even Germany all extended the number of years you have to work before you get a pension. There is a sense of repudiation of what they promised and that will have to happen in the US as well.

HRN: Is debt monetization a repudiation of debt?

Eric Sprott: All of history says we shouldn’t trust government, so why do we trust the money that the government says is worth something when the history of governments is one broken promise after another? The only thing they’ve done, over the last 90 years or so, is to keep gouging the taxpayer, while at the same time racking up increasing debt. There’s very little responsibility at the government level for the financial well being of a country in the long run. Fiat money will all go back to its intrinsic value, which is zero. You need real things to support the valuation of currencies. I find it absolutely shocking that we trust government.

HRN: Since you expect fiat currencies to fall in value, do you also expect real assets to rise in price?

Eric Sprott: I think it depends on the class of the real asset and what determines its value. For example, I always question real estate because a lot of real estate is so indebted. If people have to pay their debts back you can have real estate going down, even though you might be in QE2 or QE3 by the time, because there’s just not enough cash flow being generated. I think of things like agricultural products, oil and gas. I think of things that can be used as a medium of exchange, such as gold and probably silver, or maybe other precious metals but that’s the category I think is the most survivable in terms of holding its value.

HRN: Is that why you’ve invested in precious metals and gold in particular, to survive the bear market?

Eric Sprott: My history with gold goes back to about 2000 when things were bottoming out there and, in fact, coincided with our belief that we were going into a bear market. When you look at any bear market, you think “How do you survive it?” We’ve thought ‘you’ve got to have gold and gold stocks’ and it’s worked out so beautifully that it’s shocking. To think that the markets over the last 10 years are down and gold is up something like 500% and gold stocks are up something like 1200% from their lows. That’s been the place to be.

HRN: It seems a lot of money is flowing into the Sprott Physical Gold Trust (NYSE:PHYS).

Eric Sprott: As it applies to US residents, the tax rate on a capital gain in the Sprott Physical Gold Trust is 15% today whereas if you own the ETF, because gold is considered a collectible by the IRS, the tax rate is 28%. That’s a big reason for people to choose this vehicle versus an ETF. In addition to the tax benefits for US investors, the gold is held at the Royal Canadian Mint in Ottawa and to some people in the US that’s a good thing, because they’d like to see it out of the country. Also, the trustee is not a levered financial institution. The trustees for the gold and silver ETFs are levered financial institutions and therefore, when you have leverage there’s always potential risk. Of course, the reason we started it was that a lot of people realized there’s so much paper gold around that when you go to claim your gold it’s not going to be there.

HRN: I understand there’s a premium of between 5% and 10% for shares in PHYS over the spot price of gold.

Eric Sprott: We wanted people to be able to literally get their physical gold, so there’s a mechanism where, if you can buy a bar, which is 400 ounces, we will deliver it. The physical quality of it—the knowledge that the gold is there—in addition to the tax advantages, creates the premium. I think it’s justified. There are certainly no other North American vehicles where you can get physical gold. That’s why we created this vehicle.

HRN: So, there’s a level of insurance that’s just not there with ETFs like GLD. Do you view gold purely as insurance or do you also view gold as currency?

Eric Sprott: When I first got involved in gold, I came to the conclusion, based on Frank Veneroso’s book, The Gold Book Annual 1998 (Jefferson Financial, 1998), that the gold market was being suppressed by central banks and that that logjam had to break. Veneroso proved that there were sellers of about 400 tons a year. Given enough time, their willingness to sell gold had to run out. Now we are in a situation where central banks, which used to be sellers of gold, have become buyers of gold. The gold market is very small. The mines produce, let’s say, 2,600 tons per year and the central banks used to sell 400 tons. That’s a lot of tons in a 2,600 ton a year market. Now, central banks are buyers of probably 200 tons or more. I think the World Gold Council estimated that central banks bought as much as 400 tons last year. Imagine a shift of going from a seller of 400 to a buyer of 400 in a mine supplied market of 2,600 tons. Where are all of the normal users of gold going to get gold with this huge change at the central bank level?

HRN: It’s curious that central banks would have sold gold as the price was declining and are now buying when the price is rising.

Eric Sprott: Now we have gold ETFs, that didn’t even exist 10 years ago, and they are now among the largest owners of gold in the world. There are also funds like ours and Paulson & Co. or David Einhorn’s fund, Greenlight Capital, as well as various pension funds that now own gold but that never owned gold 10 years ago. Where are these funds getting all of their gold when they weren’t even part of the supply and demand equation 10 years ago? I wonder where all of this gold is coming from. I’ve always been suspicious that it’s surreptitiously coming out of the central banks.

HRN: Central banks manage the exchange rates of currencies, which is no secret. If gold is still treated as a currency, the gold exchange rate might be managed, as it was under the London Gold Pool.

Eric Sprott: Central banks can also influence bond markets, and not just government bonds. Last year the US Federal Reserve bought $1.2 trillion worth of mortgage backed securities.

HRN: That was a huge injection of liquidity.

Eric Sprott: We’ve had a huge shot in the arm both in the financial markets and in the fiscal markets, but we took on huge debts as well. The hand of government in everything has been unbelievable and what do we have to show for it as we sit here today? We’ve seen the economic data fall off a cliff: retail sales, new home sales, consumer confidence, the Baltic Dry Index, the Chinese stock market index. I mean, the things that have fallen off the table have been so dramatic and over such a short time.

^{Chart courtesy of} ^{InvestmentTools.com}

HRN: We’re not seeing much of a recovery in the US.

Eric Sprott: In some of the data you’re seeing, no recovery. Housing, for example, is at a dead, flat bottom. I expect that car sales are going to start doing the same thing. In fact, we’re going negative right now: the leading economic indicators, the ECRI Index, I mean everything. You’ve got to think we’re just going straight down, not even slowly.

HRN: You mentioned the heavy hand of government in these massive interventions.

Eric Sprott: The conclusive evidence is that when governments get involved with things, the impact is negative because you get a misuse of funds. It’s like the Fed goes in and buys a bunch of mortgage-backed securities (MBS) so the housing market stays together but if they stop, the housing market collapses because it was a misallocation of resources. We should not have been encouraging people to be buying houses. We should have been doing the opposite: saving money. We have to learn to save here both at the individual level, the corporate level and at the government level. The government is giving all the wrong signals, they’re getting the wrong people to do exactly the wrong things and it makes the problem that much bigger.

HRN: Would it be fair to say that, in your view, central planning and the economy is just sort of an ineffective strategy?

Eric Sprott: You know, I think we’d all agree when we hear that statement. Central planning doesn’t work, but then when it comes to our own government, all they want to do is centrally plan even though they don’t think they’re centrally planning, but, by god, they are. The US government is saying that to make the economy go they’re going to run a trillion and a half dollar deficit. If that’s not central planning, I don’t know what it is.

HRN: I think the US national debt is expected to reach $20 trillion. Do you think the US is going to be able to borrow and roll over debt at those levels?

Eric Sprott: Where does the money come from? Theoretically, the money has to come from companies or individuals. If we just took one country and said that they should fund themselves from the earnings of companies and savings of individuals and if there were no way, between the individuals and the companies, that they had the money every year to throw into government, it wouldn’t work. The US government funded itself with debt all of last year and certainly into March of this year. The thinking is that between the Fed buying financial assets in the market and the banks buying government debt and not lending, that they’ve been able to fund the government, but we’re going to find that it’s not sustainable. The process of asking people to be indebted to the tune of a trillion and a half dollars per year just at the federal level is impossible; and to do it several years in a row with the growing legacy of the debt is not sustainable. What if interest rates were where they really should be?

HRN: Do you think that, with a weakening dollar, the real interest rate could be negative right now?

Eric Sprott: This 0% interest rate policy, 20 years from now, will be looked at as one of the biggest financial jokes of all time. Of course, the primary beneficiaries are the banks and the government. Banks can borrow for nothing and the government can borrow for next to nothing, but the true interest rate should be much higher. I mean, what’s the point of saving? You’re asking somebody to save to fund the deficit and then you pay them nothing to save. What’s the point? You get nothing for your savings. Why would people save?

HRN: With a second round of quantitative easing, QE2, do you think there could be a loss of confidence in US government debt or in the US dollar?

Eric Sprott: We have a dilemma staring us in the face and I don’t see an easy way out of it. People will start questioning sovereign risk. It started with Ireland; it went to Iceland; it went to Greece; it’s maybe now with Portugal or Spain and it might be washing up on the shores of North America. As you know, the dollar has been quite weak recently and I think, as more and more people assess the problem, they’ll find that there aren’t many safe sovereign places to go. There just aren’t many. They’re very, very rare. Either there will be no QE2 and interest rates will go higher, or, if there is a QE2, interest rates can stay low, but ultimately, if we then go on to QE3 or QE4, the gig will be up because everyone will realize we’re just printing money and we’re not getting out of this problem. If we’re just printing and printing and printing, people will want to convert their bank deposits to something real because they’ll realize that fiat money is not going to hold its value.

HRN: What do you see as a solution here? What’s the path forward for the world?

Eric Sprott: I don’t think there’s a solution. People always say to me, “When would you not be bearish?” I say, “Well, I won’t be bearish when I see people in the central banking community and in the sovereign area start to take responsibility.” One might argue that maybe we’ve seen the first signs of that over in Europe and the UK and Greece with austerity. What’s interesting is that most of these programs start a year later. They don’t start today. It will be interesting to see when we get there, how powerful those programs will be.

HRN: Are the European austerity measures indirect bailouts, preserving sovereign debt?

Eric Sprott: That’s why they announce them. We saw QE with the ECB when they put a trillion dollars in for the Greek bailout. If they hadn’t announced austerity programs what would we all be thinking? You can’t get the bailout and not at least say you’re going to try to stop spending money. It was almost mandatory for people to say at the time. They all had to chime in because the Euro and the European banking system were under immense pressure. Deposits were leaving those countries, so they had to do something.

HRN: How do you foresee the sovereign debt situation unwinding?

Eric Sprott: I think we’re too far gone. There’s way too much debt. Just the federal debt is something like $40,000 for every American, so a family of four has got $160,000 in debt they’ve got to lug around; and that’s forgetting the states. I don’t think we can work our way out of it. We’ve gone for 60 years by expanding debt and, all of a sudden, that era ends and you have a contraction and the contraction will be rather elongated.

HRN: Thank you for sharing your views with us.

Eric Sprott: Thanks a lot.

After Words

Eric Sprott’s track record as a Portfolio Manager and as an entrepreneur in the natural resource sector speaks for itself. Whether one agrees with Eric Sprott’s skepticism regarding the fiscal responsibility of governments, the soundness of fiat currencies, or the stability of debt-laden companies and sovereigns, his contrarian analysis has enabled him to capitalize on the trade of the decade: gold. Between the anemic US economy, the Federal Reserve’s low interest rates and purchases of financial assets, as well as the US federal government’s deficits, and a second round of quantitative easing (QE2), the US dollar will certainly weaken further, fueling demand for gold.

Interview: Dr. Marc Faber on the Federal Reserve and Hyperinflation

Ron Hera — Fri, 24 Sep 2010 00:07:00 GMT

The Hera Research Newsletter (HRN) is delighted to present the following powerful interview with noted speaker and best selling author Dr. Marc Faber, whose newsletter, The Gloom Boom & Doom Report, highlights unusual investment opportunities. Dr. Faber is a popular speaker at investment seminars and conferences around the world and is best known for his contrarian investment approach.

Born in Zurich, Switzerland, Dr. Faber went to school in Geneva and Zurich and finished high school with the Matura. He studied Economics at the University of Zurich and, at the age of 24, obtained a PhD in Economics magna cum laude.

Between 1970 and 1978, Dr. Faber worked for White Weld & Company Limited in New York, Zurich and Hong Kong and, since 1973, has lived in Hong Kong. From 1978 to February 1990, he was the Managing Director of Drexel Burnham Lambert (HK) Ltd.

Dr. Faber’s best selling book Tomorrow’s Gold – Asia's Age of Discovery has been translated into Japanese, Chinese, Korean, Thai and German. Dr. Faber is a regular contributor to several leading financial publications around the world.

Dr. Faber, who is an investment adviser and fund manager associated with a variety of funds, is a member of the Board of Directors of numerous companies around the world.

Hera Research Newsletter (HRN): Thank you for joining us today. You’ve commented that the Federal Reserve’s policies have been linked to past boom and bust cycles in the US economy. Why do you believe that?

Dr. Marc Faber: Booms and busts happen also under the gold standard like we had in the 19th century various railroad and canal booms, and we also had real estate booms, first on the east coast in Chicago, then, at end of the century, in California. What the Federal Reserve has really done is create a lot of economic volatility. If you look back at the various crisis starting with the S&L crisis in 1990, then the Tequila crisis [the Mexican Peso crisis] in 1994, then Long Term Capital Management (LTCM), the NASDAQ bubble and at the current crisis, each crisis actually became worse and worse and the bubbles became bigger and bigger. The Federal Reserve did not pay any attention to excessive credit growth. The reason I am so negative about the Federal Reserve’s policies is that they only target core inflation and argue that they can’t identify bubbles, but when each bubble bursts they flood the system with liquidity that bring about unintended consequences.

HRN: What would be an example of that?

Dr. Marc Faber: Commodity prices peaked in May 2006 and after May 2006, especially in 2007, where there was actually a slowdown in the global economy and so there was no reason for commodity prices to go ballistic, but the Federal Reserve slashed interest rates after September 2007. In a global economy that was going into recession, the price of oil went from $78 to $147 and that burdened the US consumer with additional “tax” of five hundred billion dollars. I am not saying that is the only reason but it helped push the US consumer into recession. The fact is that without the Federal Reserve’s expansionary monetary policy after 2001, we wouldn't have had a housing bubble to the same extent. The Federal Reserve’s policies basically encouraged sub prime lending; it’s not the case that they discouraged it.

HRN: Is there a relationship between monetary expansion and the fact that the US economy depends so heavily on consumption?

Dr. Marc Faber: Basically, if you look at consumption as a percent of the economy and at housing activity, the excessive debt growth began essentially after LTCM and, I have to say, it was a huge mistake of the Treasury and Fed to bailout LTCM because it gave Market participants in the financial sector a signal that there is a Greenspan put, and later on a Bernanke put, with an even higher strike price and this resulted in excess leverage. So, if you have problems, the Federal Reserve will bail you out or the system will bail you out. That’s where I think the Federal Reserve acted irresponsibly—irresponsibly—that has to be said very clearly. They didn't pay attention to credit growth. Every central banker in the world pays attention to credit growth, but not in the US.

HRN: What would you recommend that the Federal Reserve do differently?

Dr. Marc Faber: The first action Mr. Bernanke should take is to resign. If I had messed up the system so badly, as he has done, I would have to resign. He has talked constantly about the Great Depression and what caused the depression but the problem is that he really doesn't understand what caused the depression, which was also excessive leverage at that time. I have to stress that in 1929 the debt to GDP ratio was of course minuscule in comparison what it is today. It was 186% of GDP but you didn't have Social security, Medicare and Medicaid and unfunded liabilities for Social Security and so forth. So, debt today, as a percent of GDP, is 379% and if you add the unfunded liabilities we are at over 800%. The Federal Reserve should pay attention to that.

HRN: With debt levels and liabilities so high, what solution is there for the United States?

Dr. Marc Faber: The solution is, basically, for the government to move out and not intervene in the economy. There are economists who will dispute that the Federal Reserve is partially responsible for the crisis and there are economists that will still tell you that debt doesn’t matter, that deficits don't matter and they want to continue to intervene in the free market constantly. To these economists I respond: What about Fanny Mae and Freddy Mac? It was an intervention by the government into the housing market and into the mortgage market and the biggest bankruptcies—bigger than Citigroup and all the banks—are Fanny Mae and Freddy Mac—government-sponsored enterprises. The same economists will tell you that the government has to intervene and to these economists I say: Well, you have made so many mistakes already with interventions do you think that in the future your interventions will improve anything? Einstein defined insanity as doing the same thing over and over and expecting different results, but these economists and the Federal Reserve think that by more interventions with fiscal measures and more money printing they will improve things. No, they won’t. They will make things worse.

HRN: It seems the US is moving towards more government intervention into the free market rather than less.

Dr. Marc Faber: Yes. That’s why I’m very negative about economic growth in the US. It just won’t happen. Can the US economy grow at 2% per annum or, in the best case scenario, at 3% per annum with current policies? Yes, but it will create a lot of distortions. The best case for an economy that goes into a boom phase, in other words over consumption, is to bring it back into the trend line as quickly as possible. So when you have an excursion into a boom, what you need is a cleansing of the system and that may take a few years to happen in the US because the excesses were built up not just in the last 7 years between 2000 and 2007 but, over the last 25 years. So, to really bring the US back into sanity—into a healthy mode where the economy can grow—might take 5 to 10 years, but it won’t happen under the Obama administration.

HRN: Given the poor prospects for US economic growth, do you foresee a flight of capital from the United States?

Dr. Marc Faber: You would be out of your mind, with health care reforms and with the government interventions and the uncertainty about future taxes in the US, to even consider expanding in the US and this is a problem. I mean people say that loan demand is down because banks are not lending, but maybe nobody wants to borrow any money in the US and nobody wants to expand in the US but they are expanding in China, India, Vietnam, Bangladesh, Africa and Brazil. The business world is an international place today, and if you run a corporation, whether you employee 50 people or 10,000, you can choose where you invest your money in terms of capital spending. Where do you want to expand factories? If I employed people in the US, I would rather think of reducing the 50 employees maybe to only 20.

HRN: Where should American investors put their money?

Dr. Marc Faber: Different people have different investment objectives but I made a presentation recently where I showed, that in terms of goods markets, the emerging world is now larger than the developed world and so I think people should have at least 50% of their money in emerging economies. With interest rates at zero and with the prospect that they will stay at zero, or below zero in real terms for a long time, I think cash is not particularly attractive. I think US government bonds are unattractive in the long run, although they may be attractive for the next three months. I would recommend to people to accumulate precious metals and invest in a basket of shares in emerging economies.

HRN: Are you saying you would consider buying gold even at today’s prices?

Dr. Marc Faber: Yes, I keep accumulating gold although in the next three months it may go down and not up, but maybe it won’t go down. To me, it doesn’t really matter if it goes down by 10% or 20% or whether it stays where it is. I think if in case gold came down 20% it would be because tightening of global liquidity and, in that scenario, equities wouldn’t do particularly well either.

HRN: You mentioned that cash is not attractive. What are the prospects for the US dollar?

Dr. Marc Faber: The dollar has been relatively weak in the last few years. It’s just that the other currencies are not much better. There has been a tendency for the dollar to weaken and certainly it has weakened against the price of oil, against the price of precious metals and raw materials and it's lost its purchasing power. There is no question about the fact that, today, if you have $100,000 you can buy less than 10 years ago or 20 years ago. Just look at the housing market. It has come down somewhat but a house is much more expensive than in 1980.

HRN: Can you comment on inflation versus deflation?

Dr. Marc Faber: In this whole inflation and deflation debate investors have to realize that in a system—say you have a room like this and then the money is dropped from helicopters into this room, it can flow into real estate; it can flow into equities; it can flow into precious metals; it can flow into the art market or it can flow out into other currencies or into commodities that the Federal Reserve doesn’t control. They only control essentially how much money they will drop from the helicopters.

HRN: Is this an example of why central planning of the economy by the Federal Reserve isn’t effective?

Dr. Marc Faber: Yes. Exactly.

HRN: Do you think hyperinflation in the US is possible?

Dr. Marc Faber: The Federal Reserve doesn’t want to create a hyperinflation. I mean Mr. Bernanke may be incompetent, but he’s not an evil person per se. He just doesn’t have sufficient knowledge to be a central banker, in my opinion, and has misguided economic theories, but he’s not evil in the sense that he would not wish to debase the currency entirely. Clearly, if the US economy moves into a double dip recession and you have deflationary pressures reappearing, in the housing market, for example, and if the S&P drops from roughly 1,100 down to say 900, then I think further monetization will happen. I believe that because of the unfunded liabilities and the deficits of the US government, which will stay high for a long time; sooner or later there will be more monetization anyway.

It’s more a question of when it will happen rather than if it will happen. For sure it will happen but will it happen right away, say in September, or maybe only in two years time? Eventually, before everything collapses we’ll have an inflationary bout which may not be so strongly felt in consumer prices, as in stocks or housing or precious metals prices or in commodities like oil; or inflation could occur mostly in foreign currencies, in other words, in Asia where the currencies could appreciate.

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

Dr. Marc Faber: Thank you.

After Words

Dr. Marc Faber is not only one of the world’s most outspoken critics of the Federal Reserve and of its monetary policy, but is quite possibly the Federal Reserve’s most credible critic. Dr. Faber’s detailed, evidence-based arguments, linking Federal Reserve policy decisions, such as interest rate changes, to economic developments like the US housing bubble and oil price changes are supported by thorough research. Dr. Faber’s research raises serious questions about the results of central economic planning in the form of central bank monetary policy and about the wisdom of intervention into the economy by governments. The evidence suggests that centralized manipulation of money and credit has a destabilizing influence on the economy overall—it increases economic volatility—and has unintended consequences totally outside the control of so-called monetary authorities. History shows that well-intentioned lawmakers and their economic advisers cannot predict the outcomes and unintended consequences of economic interventions. Neither central bankers nor governments have been successful in substituting centrally planned economic agendas for the decentralized decisions of millions of entrepreneurs and owners of private capital, but they persist nonetheless with ever more centralized control and ever larger interventions. Dr. Faber confidently predicts that greater government control over the economy will hamper economic growth rather than stimulate it, and that interventions into the free market, no matter how large or well meaning, will continue to fail as they consistently have in the past.

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.

Evaluating US Treasury Auction Distress

Ron Hera — Thu, 08 Apr 2010 19:26:00 GMT

Investors often seek safety from financial market turbulence in US government bonds since they offer virtually no risk of default and, unlike cash or gold, provide a yield. At the same time, sovereign debt default concerns outside the US, e.g., Iceland, Dubai, and Greece, have been linked to short-term rallies in the US dollar and have diverted attention from the fiscal challenges facing the US. However, since seven US states are in worse financial condition than Greece, Ireland, Portugal or Spain, shelter may prove hard to find. With a $3.83 trillion budget, a $12.3 trillion federal government debt, a $1.35 trillion 2010 budget deficit and $63 trillion in unfunded liabilities, the fiscal condition of the US has come into question and foreign interest in US Treasuries has declined. In late March, it was reported that the 10-year US Treasury Note yield had risen 30 basis points and that foreign holders of 10-year Notes were selling in record numbers.

Chart courtesy of StockCharts.com

Reports of US Treasury auction distress first appeared in December of 2009 when an article by Eric Sprott and David Franklin entitled "Is it All Just a Ponzi Scheme?" questioned the "Other Investors" reported by the US Federal Reserve. The unidentified investors held $359.1 billion worth of US Treasuries in the forth quarter of 2008 but $880.5 billion by the end of the third quarter 2009, an increase of $521.4 billion. Based on the Federal Reserve Flow of Funds Report, Messrs. Sprott and Franklin found the increase attributable to the "Household Sector", which is defined in the Federal Reserve's Flow of Funds Guide as "...amounts held or owed by the other sectors ... subtracted from known totals ... [such that] the remainders are assumed to be the amounts held or owed by the household sector." Thus, the "Household Sector" is strictly an artifact of accounting practices, and, as a result, there has been some speculation regarding the parties responsible for $521.4 billion in 2009 US Treasury purchases.

A recent analysis of 4-week Treasury auction results by OmniSans Investment Research suggested that US Treasury auctions are more distressed than has been generally recognized, and a similar analysis appeared on the popular Zero Hedge website.

Chart courtesy of Zero Hedge

The OmniSans and Zero Hedge articles focus on the percent of Treasury auction purchases made by the Federal Reserve's own primary dealers, as compared with other bidders, and on the percentage of indirect (foreign) bids accepted. In particular, the acceptance of 100% of foreign bids suggests extremely weak foreign demand. While the evidence is accurate, the conclusion is less clear since the changing pattern of US Treasury auction results is more complex.

Federal Reserve measures designed to increase financial market liquidity and to recapitalize the banking system, such as the Term Asset-Backed Securities Loan Facility (TALF), represent monetary inflation (or re-inflation), and some of this currency has certainly found its way into the coffers of the US Treasury, i.e., a rise in primary dealer purchases. A rise in primary dealer purchases could also be a result of the low cost of borrowing from the Federal Reserve. In theory, primary dealers can generate profits simply by borrowing from the Federal Reserve at near zero percent interest rates and buying Treasuries with higher yields. Of course, primary dealer purchases funded by borrowing from the Federal Reserve would be tantamount to debt monetization.

An increase in primary dealer purchases, or in purchases by direct bidders, could compensate for a decline in foreign purchases of US Treasuries but would not explain it. To be significant, a decline in foreign purchases would have to be evident in more than one type of Treasury, i.e., outside of the reported 1.0 bid to cover ratio for indirect bidders in recent 4-week Treasury Bill auctions.

What may be an emerging pattern of falling foreign demand and rising primary dealer purchases, both of which have been moderated by an increase in purchases made by direct bidders (financial institutions that place bids directly with the US Treasury, such as domestic depository institutions and mutual funds) is evident in 4-week Treasury Bill auction results.

Direct Federal Reserve purchases of US Treasuries (monetization) have been distributed over Treasuries of different types and maturities and have been generally implemented as a consistent, low-level of buying for particular Bills, Notes or Bonds. Overall, the Federal Reserve increased its holdings of US Treasuries by $286 billion in 2009, an increase of more than 60% as of September 2009 compared to 2008, and, as of March 2010, the Federal Reserve's holdings of US Treasuries had increased another $14 billion to roughly $777 billion.

What is important is that monetization has been most significant in 4-week Treasury Bills, reaching 38.59% of total 4-week Treasury Bill sales on January 26, 2010, but similar spikes in Federal Reserve purchases do not appear in auction results for other types of Treasuries. Thus, it should come as no surprise that 4-week Treasury Bills have fallen out of favor with foreign investors.

Of course, the amount of currency created by monetization in a particular auction, regardless of the percent of Treasuries purchased by the Federal Reserve, represents only a small fraction of the monetary base. Nonetheless, there is not only a psychological dimension but also aggregate effects on the balance sheet of the Federal Reserve, on the US dollar and, ultimately, on the viability of US Treasury auctions.

A general pattern of decreased indirect bidder participation offset by rising direct bidder participation, setting aside any increase in primary dealer purchases, is evident outside of 4-week Treasury Bill auctions.

Foreign demand for 30-year Treasury Bonds has fallen over the past year, suggesting that foreign purchases may have shifted towards the short end of the maturity continuum. The more significant fact, however, is the marked increase in direct bidder purchasing, which has more than compensated for slack foreign demand at the extreme long end of the spectrum leaving primary dealer purchases flat.

Given the increase in direct bidder purchases, and reflecting on the questions raised by Messrs. Sprott and Franklin, it seems likely that the $521.4 billion worth of US Treasuries in 2009 reflects otherwise unclassified direct bidders, i.e., direct bidders other than recognized domestic investment funds and depository institutions. Unfortunately, the identities of the bidders remain unknown in any case.

The most dramatic example of primary dealer purchases replacing indirect (foreign) bidders is in Cash Management Bills, but these represent a rolling debt of perhaps $100 billion analogous to the corporate bond market and are not representative of other types of Treasuries.

While there are apparent signs of Treasury auction distress, based on a survey of Treasury auction data from January 2009 to March 2010, there is no indication of an imminent auction failure so long as the primary dealers and direct bidders continue to step into the breach. Further, the same patterns either do not appear or are much less pronounced in longer-term Treasury Note sales.

Zhu Min, Deputy Governor,

People's Bank of China

It seems unlikely that direct bidders within the US can compensate indefinitely, or to an unlimited extent, for falling foreign demand. Commenting on the ambitious spending plans of the US federal government, Zhu Min, Deputy Governor of the People's Bank of China said in December 2009 that "the world does not have so much money to buy more US Treasuries."

It would certainly be unreasonable for the US federal government and Federal Reserve to assume that ambitious deficit spending and ongoing quantitative easing (QE) would have no cumulative impact on US Treasury auctions. If there is a limit to foreign appetite for US debt, to foreign capacity to lend to the US, or to international tolerance for US dollar devaluation, the US government and Federal Reserve seem determined to find it.

Chart courtesy of Zero Hedge

China's foreign exchange reserves, valued at $2,399.2 billion at the end of December 2009 (not including gold), include only $894.8 billion in US Treasury bonds. In contrast, the US must issue or roll over $702 billion in debt in 2010 and a total of $2.55 trillion in Treasuries to be issued this year, while $3.7 trillion in US Treasuries are held abroad.

Yi Gang, Deputy Governor,

People's Bank of China

While US GDP was at $14.46 trillion in 2009 (with debt levels set to rise to 90% of GDP by 2020), China's GDP is currently estimated as $8.791 trillion. Although there are signs of recovery in Chinese exports, the entire value of China's reserves, assuming that its current Treasury holdings could be liquidated, is insufficient to finance US federal government debt in 2010.

Since China recently liquidated $34 billion in US Treasuries, the statement of China's Director of the State Administration of Foreign Exchange, Yi Gang, "[China is] a responsible investor and in the process of these investments we can definitely achieve a mutually beneficial result" seems obligatory. In reality, the US is currently the largest debtor nation in the history of the world, while China is the US' largest creditor, and neither China nor any other country is in a position to bail out the US should US Treasury auctions run aground. Nonetheless, an overt Treasury auction failure seems impossible with the Federal Reserve as the lender of last resort to domestic depository institutions and to its own primary dealers. Unfortunately, direct monetary inflation is not without consequences. Specifically, increased debt monetization would impact the value of the US dollar and could spark high inflation, i.e., rising US dollar prices for imported goods and energy, or an eventual hyperinflationary collapse of the US dollar.

Without a robust economic recovery in the US, it seems unlikely that the apparent distress of US Treasury auctions will abate. Among other things, the gap between increasing US federal government spending and falling federal tax receipts is currently growing. A continuation of current US federal government and Federal Reserve policies under deteriorating economic conditions suggests levels of debt that could not be absorbed by US creditors, and a so-called double-dip recession would put extreme pressure on the US dollar. Indicators of Treasury auction distress include:

Rising Treasury yields, regardless of interest rates, signaling inadequate demand.
A continued decline in foreign bids, thus a higher percentage of accepted bids, particularly in additional types of Treasuries, outside of 4-week Treasury Bills.
Direct bids failing to rise at a rate sufficient to offset falling indirect bidder demand, thus causing either primary dealer purchases or monetization to rise.
A marked and sustained increase in primary dealer purchases versus direct or indirect bidders.
Additional spikes in Federal Reserve purchases (monetization) in any type of Treasury, or a sustained increase in Federal Reserve Treasury purchases generally.
An expansion of the incipient shift away from the long end of the maturity continuum towards shorter-term Treasuries.

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.

The Ultimate Bubble and the Mother of All Carry Trades

Ron Hera — Sun, 31 Jan 2010 15:14:00 GMT

Among the many opinions expressed by billionaire investor George Soros over the course of the 2010 World Economic Forum in Davos, Switzerland was his statement on January 28 in an interview with Maria Bartiromo, host of CNBC's Closing Bell, that "When interest rates are low we have conditions for asset bubbles to develop, and they are developing at the moment. The ultimate asset bubble is gold." New York spot gold closed at $1085.40 down $1.80, but the price of gold is not as much about gold as it is about the value of currencies, particularly the US dollar.

Since new currency is created through lending activity, very low or 0% US interest rates and government deficit spending are fueling a US dollar carry trade and monetary inflation in the US dollar resulting in rising asset prices and global speculation. According to Zhu Min, deputy governor of the People’s Bank of China, “[The US dollar carry trade] is a massive issue; estimates are that it is $1.5 trillion, which is much bigger than Japan’s carry trade.” The close relationship of global commodity prices, particularly the gold price, to the value of the US dollar can be seen by comparing the changing value of the US Dollar Index to an inverted US dollar spot gold price chart.

^{Chart courtesy of}^{StockCharts.com}

The inverted gold price chart follows the USDX closely and while the fluctuations are not strictly proportional the overall trends as well as the peaks and troughs generally correspond, thus the asset price bubbles noted by Mr. Soros are reflections in asset prices of both the US dollar carry trade (the effective value of the US dollar) and, ultimately, of the long-term devaluation of the US dollar, thus the value of the US dollar in real terms.

^{Chart courtesy of}^{StockCharts.com}

An “ultimate bubble” in gold could be an offspring of the mother of all carry trades, but its magnitude would depend not only on the effective value and rate of change in value of the US dollar while the carry trade is booming, but also on the actual, eventual value of the US dollar (in real terms) after the carry trade has come to an end. Although the value of the US dollar will certainly recover to some degree when the carry trade ends, it will remain significantly lower in value for other reasons.

US Dollar Devaluation

In the above mentioned interview, Mr. Soros went on to say that "Some countries, like the US and European countries have plenty of room to increase their deficits; [although] the political resistance to doing so increases the chances of a double dip [recession] in the [global] economy in 2011 and after that." Since further monetary inflation as a consequence of government deficit spending may be necessary to maintain economic stimulus measures and financial system life support, Mr. Soros anticipates further devaluation of the US dollar. Devaluation of the US dollar will have both beneficial and harmful effects on the US economy.

Devaluation of the US dollar will reduce the value of debts in real terms, reducing the overall debt to GDP ratio of the US economy, and stimulate nominal GDP growth as domestic prices and wages (at different rates) adjust to the altered value of the US dollar, while at the same time helping to create conditions where US banks can resume lending to consumers and small businesses. Unfortunately, currency devaluation also has deleterious effects, such as higher prices, a loss in the value of savings and a reduction in the real value of wages. There is also a risk of uncontrolled domestic price inflation (although prices can be held in check without raising interest rates by curtailing the flow of money and credit to consumers and small businesses).

^{Chart courtesy of}^{Karl Denninger}

In addition to reducing the US debt to GDP ratio, devaluation of the US dollar will lessen the risk of higher interest rates resulting in greater deficit spending by the US government as a consequence of increased debt service ($145.4 billion in fiscal 2009) since it will allow the US federal government’s tax receipts to grow faster than the increase in debt service resulting from higher interest rates.

Currently projected US federal government borrowing (or, alternatively, quantitative easing) will maintain downward pressure on the value of the US dollar through the year 2019. According to the US Office of Management and Budget’s (OMB) baseline projection of current policy, federal deficits will total between $7 and $9 trillion for fiscal 2010 through fiscal 2019 and the US public debt will grow from $12.3 trillion to more than $16 trillion in 2019. Other estimates indicate that US federal government debt will exceed $18 trillion in 2019, setting aside the net present value of unfunded federal liabilities based on Generally Accepted Accounting Principles (GAAP). According to David M. Walker, former Comptroller General of the United States from 1998 to 2008 and current President and CEO of the Peter G. Peterson Foundation, current federal liabilities and unfunded obligations total approximately $63 trillion. As a result, further devaluation of the US dollar is inevitable.

Disparate US Dollar Values

Curiously, the US dollar has two different and diverging values, one within the US financial system and another in the broad US economy. As a result of the US financial system rescue, which included purchases of various assets from banks at book value by the US Treasury and Federal Reserve, the US monetary base has expanded roughly 150% since the beginning of the global financial crisis in 2008, but the newly created currency has not filtered into the broad US economy where, in contrast, deflationary pressures persist.

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

Although it is not apparent in the broad US economy, the value of the US dollar has been dramatically altered and its devaluation cannot be isolated indefinitely within the financial system independent of the broad US economy. The counterbalancing, but much smaller, contraction of the broad US money supply, as measured by the M3 monetary aggregate, also cannot continue indefinitely.

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

At some point, the two disparate values of the US dollar (that found within the financial system versus that found in the broad US economy) will be reconciled and, unless current policies are reversed, the outcome will be a substantially less valuable US dollar. The consequences of the eventual reconciliation will certainly include price inflation in the US, higher US dollar prices for commodities that are subject to global demand, such as oil and gold, as well as higher nominal values for US dollar denominated assets. However, the potential unintended consequences of a falling US dollar include high domestic price inflation, a further reduction in international demand for US debt or a collapse in demand, a disruptive decline in trade, i.e., US imports, or in the worst case, rejection of the US dollar as the world reserve currency or a hyperinflationary collapse of the US dollar.

Is Gold in an Asset Price Bubble?

Diversification for the purposes of risk mitigation and wealth preservation is a rational response to unstable market conditions and is not comparable to a market mania, like the dot-com bubble. Similarly, a long-term shift in asset allocation favoring one general category of assets over another based on fundamentals, while it may result in rising prices, does not by itself describe an asset price bubble.

An asset price bubble, such as the Dutch tulip mania of the 1630s, is an irrational and economically unsustainable investment trend that holds sway over investors only temporarily and that inevitably collapses violently. Asset price bubbles end when a tipping point is reached where the awareness of and tolerance for escalating risk exceed irrational exuberance producing a panic. So long as the great majority of market participants discount risk, individual participants may rely on the irrational exuberance of others. In contrast, rational confidence does not depend on a majority of market participants behaving irrationally and is based instead on sound fundamentals.

The view that rising global commodity prices, fundamentally, are asset price bubbles in various stages of formation unreasonably discounts the risks associated with financial institutions, governments and currencies. If we are to learn anything from Iceland, the Baltic states, Dubai, and Greece it is that if irrational exuberance exists in the financial markets today it is exactly confidence that is not based on sound fundamentals in financial institutions, governments and currencies.

In the 1980 asset price bubble, gold rose from an inflation adjusted low using constant 2009 dollars of $392.57 per Troy ounce on August 31, 1976 ($104 1976 dollars) to its January 21, 1980 peak of what would have been $2,358.04 in 2009 dollars ($850 1980 dollars), a gain using constant 2009 dollars of more than 500% in 4 years. The 1980 asset price bubble in gold violently collapsed in same year, returning to 1979 levels by 1982.

^{Chart courtesy of}^{Bianco Research, L.L.C.}

On April 4, 2001, the gold price would have been $315.78 in constant 2009 dollars, the lowest value since 1970 adjusted for inflation. From that point, the gold price rose from a nominal low of $255.95 on April 4, 2001 to a nominal high of $1,212.50 on December 2, 2009 (London PM fix), a gain of roughly 375% over approximately 10 years (284% using constant 2009 dollars).

^{Chart courtesy of}^{Kitco Metals Inc.}

Over the past decade, the US dollar has declined from its 2002 high by roughly 33% compared to other major currencies and approximately 40% from is 2000 high compared to the Euro. At the same time, most of the currencies in the major indices have been debased alongside the US dollar since 2008 for the same reasons, thus the value of the US dollar in real terms is not apparent from the index alone.

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

The alternate US Dollar Indices published by Shadow Government Statistics (SGS) suggest that the Federal Reserve’s trade weighted exchange index of major currencies, which includes the Euro zone, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden, may be an optimistic formulation.

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

The decline of a national currency, particularly that of a nation with a large trade deficit, is first apparent in international trade while domestic prices do not at first fully reflect the devaluation of the currency. As a result, the prices of commodities that are subject to global demand tend to rise before the general increase in domestic prices that results from currency devaluation, thus the prices of commodities such as gold would be expected to rise faster than domestic measures such as the US Consumer Price Index (CPI).

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

The alternate CPI measure provided by SGS may represent a more accurate method of estimating the US dollar prices of commodities that are subject to global demand. The SGS alternate data show accelerating price inflation over the past decade leading up to the global financial crisis in 2008.

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

If the SGS alternate CPI data are applied to the gold price it is apparent why Shadow Government Statistics’ John Williams stated in an interview with Bloomberg reporter Pham-Duy Nguyen that if the same methodology of measuring inflation were used today as in 1980, the 1980 gold price would be equivalent to $7,150.

^{Chart courtesy of}^FGMR

While gold certainly has enjoyed tremendous gains over the past decade, including the effect on the gold price of central bank gold demand, the current gold price, following on the heels of an unprecedented global financial crisis, has little in common with the 1980 asset price bubble. The current gold price reflects a rational diversification into hard assets for the purposes of risk mitigation and wealth preservation and can be explained in terms of monetary inflation and associated loss in the value of the US dollar independent of the US dollar carry trade. The continuing devaluation of the US dollar will result in a further rise in the prices of commodities that are subject to global demand, thus the gold price will continue to rise also.

Mr. Soros is certainly correct in that low interest rates contribute to the formation of asset price bubbles, but neither the value of the US dollar or the price of gold depend only on interest rates or on the US dollar carry trade. The view that a gold price over $1000 per Troy ounce represents the “ultimate bubble” ignores the ongoing devaluation of the US dollar, discounts risks associated with the stability of financial institutions, governments and currencies, and does not reflect confidence consistent with sound fundamentals.