Monty Pelerin's World

Economics, Finance and Politics Through The Prism of Classical Liberalism

Monty Pelerin's World

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Many of Us Will Never See “Happy Days Are Here Again” Again

The spiral into insolvency continues, despite government’s efforts to make you believe that there is a recovery. At this point, this country is too far gone. It is mathematically impossible to service the debt. Furthermore, the debt burden makes it impossible to regenerate reasonable economic growth. The end has been determined, only the timing remains to be known.

For politicians (and it does not matter which party), the only remaining strategy is to use bailing wire to hold matters together from one election to the next. Unfortunately, the supply of bailing wire is now scarce. Will we last until November 2012 before a financial collapse or some other event uncovers the fraud? That is hard to tell, but the postponement of reality is all that drives the political approach to economic policy.

The employment report this past week showed a substantial rise in new hires, although it was not enough to reflect a true recovery. The mainstream media, desperate for some good news in order to support their candidate Barack Obama, trumpeted the results as an inflection point in the economic “recovery.” There is no economic recovery! Nor will there be one until an economic collapse of historical magnitude occurs.

The increased hiring is welcome, but do not believe it is indicative of a turnaround. The drop in the unemployment rate has been highlighted “the lowest in three years.” Few choose to point out the games played in the measurement of this rate or bother to cite the incongruity of how another 1.2 million workers left the workforce last month. (Here is Rick Santelli’s take.)

The stock market, no longer an investment vehicle but a large roulette wheel, took off roaring in anticipation of “happy times are here again.” Do not be fooled by this burst of euphoria. Nothing has changed other than the pulse beats of the gamblers.

Lets try to put matters into a bit more perspective. Here are three excerpts from

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How Currencies Die and Gold Prospers — Part I

The Dollar is doomed. So too are most other fiat currencies. It is the nature of fiat currencies and the nature of governments throughout history.

All countries have abused their citizenry and investors via the printing press. Since the formation of the Federal Reserve in 1913, the dollar has lost 96% of its value. Most of that loss has occurred since 1970. It was 1971 when the U.S. officially defaulted on its promise to redeem dollars for gold. That marked the point where, for the first time in modern history, gold was completely removed from any role in the world monetary system. Then, there was no hard constraint to prevent any country from inflating its currency. All did!

With the dollar as the reserve currency of the world, the U.S. has had (and used) advantages not available to, but coveted by other countries. At times, our monetary policy has forced (at least in the opinion of foreign policy makers) inflation onto other countries. Behind the scenes there has been resentment building toward U.S. dollar hegemony for decades. Part of this resentment results from US abuses, part results from other countries wanting a similar ability to plunder. The current financial crisis, arguably begun in the U.S., has exacerbated both of these sentiments.

We were at an impasse with Europe over proper monetary and fiscal policy. In The Keynesian Dead End the conflict was described:

Now the political and fiscal bills are coming due even as the U.S. and European economies are merely muddling along. The Europeans have had enough and want to swear off the sauce, while the Obama Administration wants to keep running a bar tab.

Even the progenitor of Keynesian economics, England, was abandoning the model by implementing spending cuts and tax increases, despite the major recession. The U.S.was and still is unwilling to bite this bullet, despite signs that other governments have lost faith in the U.S. and its dollar reserve system. The US continues to stimulate, primarily via the creation of credit.

Recently, as the economic crisis worsened in Europe, politicians backed away from their “austerity” moves. Their central bank began creating money to flood the ailing banking system so as to avoid individual or multiple banking system failure. When the Greek panic struck, the dollar benefited. However, it benefited primarily relative to the Euro. Did the dollar strengthen or did the Euro merely weaken? Certainly the dollar strengthened relative to the Euro, but both deteriorated against gold, now near all-time highs in both currencies. In other words, both currencies weakened, but the Euro did so faster than the dollar.

Were there any alternative to the dollar, the U.S. would already have lose its monetary hegemony. That does not mean that other countries are not feverishly working behind the scenes to create one. Several meetings have taken place, without the U.S., to develop a substitute. Only the vagaries of history enable the dollar to continue, at least for a time, as the world currency. This important perquisite may be near its demise.

Financial Sense Online provides evidence of declining faith in the dollar:

In another ominous sign for the dollar, the Financial Times reported Wednesday that after two decades as net sellers of gold, foreign central banks have now become net buyers. What’s more, more than half of central bank officials surveyed by UBS didn’t think the dollar would be the world’s reserve in 2035. Among the predicted replacements were Asian currencies and the euro, but – by far – the favorite was gold. This is supported by Monday’s revelation by the Saudi central bank that it had covertly doubled its gold reserves, just about a year after China made a similar admission. There is no reason to assume these are isolated incidents, or that the covert trade of dollars for gold doesn’t continue. To the contrary, this is compelling evidence that foreign governments are outwardly supporting the status quo while quietly preparing for the dollar’s almost-inevitable devaluation.

Sophisticated investors are moving money into gold. That and rising gold prices are signs that something is happening. The value of all fiat currencies is moving toward Voltaire’s definition of their “intrinsic value” — zero.

Matters approach a critical state around the world. Most of the advanced economies, including the U.S., are insolvent (see here and here). It is mathematically impossible for these countries to avoid defaults on financial and social obligations. Spending cuts and tax hikes are also inevitable. The tipping point for such actions was passed years ago.

Europe’s situation is unique because one central bank serves different countries. Their announced austerity programs are too little too late. As the politicians experience the social unrest and potential risk of civil war(s), these efforts will be abandoned. They, like the US, will avoid the hard decisions to cut back programs and spending and turn to more monetary stimulus and bailouts. Instead of fixing the problems, politicians will sacrifice their currencies. So is the way of politics — never impose pain. Instead the game will be kept going via inflationary expansion of money and credit until fiat currencies collapse.

If the U.S. continues to stimulate, the devaluation of the dollar will harm “responsible” countries, as they will become less competitive in terms of exchange rates. Whether intended or not, this strategy is identical to the “beggar thy neighbor” policy that was employed during the 1930s. History shows that such behavior leads to competitive devaluations or even war. No country can gain at the expense of another under this policy, except for a short period. The policy is nothing more than a race to the bottom. All countries end up conforming to the policies of the least responsible one. All currencies are destroyed in such a competition.

It is not practicable to forecast the process or rate at which world currency debasement plays out. There are too many market and political variables. It will continue, because it is the only political alternative to default on real and promised obligations. Currency purchasing power is headed down. All currencies will not all head down in relative terms,(measured against one another in terms of exchange rates); that is mathematically impossible. But they all will head down in terms of purchasing power or when measured against gold and other scarce commodities. Against gold all currencies have been in consistent decline for more than a decade. Although an imperfect measure of loss of purchasing power, it took $250 to purchase an ounce of gold a decade ago. Today, it takes over $1700!

Got Gold?

(Part II will follow later this week) 

Russell on Markets

The sage Richard Russell said recently (my emboldening):

As the world deleveraging process continues, commodity prices turn soft. Deleveraging means that people will be tightening their belts and using less of everything.

However, I don’t get the feeling that Americans believe that hard or harder times lie ahead. All one has to do is survey the car-filled freeways or check out the crowded restaurants to realize that Americans, for the most part, are still sipping from the punch bowl.

As for the timing of trouble, we should have our eyes glued to the stock market. If or when the Dow breaks below 12,000, that would be my first danger signal. Below 11,000 on the Dow would be my second danger signal. And below Dow 10,000 would be my signal for “all out trouble.” In the meantime, we wait and watch and avoid doing anything stupid like loading up on stocks. 

Inflation or Deflation Before The Unavoidable Depression?

The argument persists as to whether our current economic crisis will end with massive inflation or in a deflationary spiral. Ultimately, either one results in a Depression.

For investors, this argument is more than an academic one. It is the single most important variable for near and intermediate term investing success. It is also important in regard to taking actions which can prepare and protect you and your family.

Respected analysts are on both sides of the inflation-deflation debate. Each side makes a strong case for their position. Which group should one believe? In my opinion, the primary difference between the two camps is how narrowly or broadly they view the field of economics. For purposes here, it is useful to view conceptions of economics in the context of an imperfect taxonomy described as “narrow” and “broad.” These are neither technical terms nor normal classifications, although this dichotomyis useful for explanatory reasons.

The Narrow Perspective of Economics

The narrow perspective utilizes current or historical data as he input to mathematical models. Doing so produces a very strong case for massive deflation based on increased saving, lowered consumption and debt defaults. The amount of debt is the overwhelming problem. Government at all levels – federal, state and municipal — are hopelessly insolvent, especially when the ticking time bomb of pensions is considered. Debt in the private sector is also massive, primarily in the mortgage, student loan and consumer finance areas. The banking system is also insolvent and faces another crisis bigger than the previous one.

Bankruptcies and other debt defaults are inevitable. Debt contraction leads to money supply contraction which is the very definition of deflation. Thus the deflationary scenario is quite plausible and would produce a deflationary collapse, otherwise known as a Depression.

A form of “deterministic physics” is the basis for virtually all macroeconomic models. None of these models saw the current crisis coming. It is mechanistic and oriented to past relationships. Economics is a social science dealing with acting and reacting individuals who are constantly shifting their behavior in order to protect and improve themselves. People are not dumb molecules bouncing off walls of laboratory beakers. The rate at which molecules collide with walls can be determined using past behavior (or explanatory theory) because molecules do not change behavior. When human beings bump into walls, it is unpleasant so they purposefully adjust their behavior to reduce the probabilities of it recurring.

A Broader Perspective of Economics

The broad perspective of economics recognizes economics as a science of human behavior. As thinking beings, men act purposefully in order to achieve ends. As such it cannot be modeled like physics which depends on past actions repeating. That does not mean economics does not have fundamental laws which allow knowledge of what a rational response would be toward a particular end. The difficult problem is discerning ends or the intentions of the human being. That piece of knowledge is subjective and problematic, limiting the value of economics as a predictive science.

Future actions are sometimes reasonably predictable. While it is nearly impossible to predict the actions of millions and millions of individuals because of their differing goals, it is possible to reasonably predict the actions of the federal government, at least in the near term. To understand why, one needs to understand the behavior and motivation of politicians.

No politician anywhere in the world wants to have a Depression on his watch. No politician wants to even experience an economic slowdown. Hence, we can be nearly certain that government will take whatever actions it believes will avoid the bad experience. Ironically, prior attempts to avoid economic corrections make a Depression inevitable. As expressed by Bob Chapman:

[The] crisis has been with us for more than 50 years and this portion of that crisis could become a very dynamic closer as massive monetization and inflation is let loose. We are at the stage now that risk is growing exponentially, as central banks and governments aggressively intervene into markets causing major distortions. These actions set the stage for heretofore-unexpected events, now called “black swan” events.

Politicians have tools to defer some crises, but only by making future crises bigger. But future crises are of no concern to politicians who live in the moment, dominated by the Keynesian creed that “in the long run we are all dead.” All political decisions are designed to produce short-term fixes. Most only achieve cosmetic outcomes from which temporary political advantage can be gained. “Kick the can down the road” is used almost exclusively to describe such political actions.

Politicians must not allow a deflation, which equates to a Depression under current circumstances. So long as they control the printing presses, they will flood the system with liquidity in hopes that one final bounce can be elicited from the economy. Two crises are foremost in their minds.

  1. The insolvent banking system which will need to be bailed out again. Banks are carrying toxic assets on their books (made attractive by government changing FASB rules of accounting) which are grossly overvalued. If banks recognized these, the entire system would contract, plunging the economy into a Depression. Government knows this and encourages the fraud to continue. What cannot be ignored is a collapse of the banking system in Europe which will trigger a similar result here. The Fed is already surreptitiously involved in an effort to assist in the bailout of European banks.
  2. The federal government has no money and will soon be unable to pay its bills from revenues obtained from taxes and bond sales. Politicians will do anything rather than stopping payments on things like social security, medicare, military pay and the like. The government will sell bonds to the Federal Reserve (quatitative easing or printing money, if you prefer), to avoid this. The Fed has become little more than the “buyer of last resort.” Cutting spending back to the levels that can be funded by tax revenues and market bond sales is unacceptable to the political class. That will not happen during a recession, nor with a political class that has conditioned themselves and their constituents to the idea that the government has unlimited resources. A complete and total economic debacle will be necessary before this mindset is altered.

Politicians will not allow deflation. Of course, there is the risk of political miscalculation in the pursuit of this goal, but virtually no risk in determining what they will attempt to accomplish.

We are headed for high inflation which the Fed will undoubtedly rationalize as necessary in order to save the economy. There are two reasons for that:

  1. The level of inflation is dependent on the supply of money but also the demand for money. Arguably the Fed may be able to control the former. They are unable to control the latter which is determined by the millions of people who handle money. As inflation increases, people spend their money faster in order to beat expected price increases. This increases the “velocity” of money which changes the relationship between the quantity of money and economic activity. Ludwig von Mises termed this end stage as “the crack-up boom” which is accelerated spending that results in hyperinflation. The purchasing power of money is declining so rapidly that people do not want to hold it. Think Weimar Germany or Zimbabwe.
  2. The Fed cannot stop increasing the supply of money unless government limits its spending to what they bring in.

Unfortunately there is no way the Fed can calibrate the level of inflation. It is impossible, for example, to say that we will have an 8% level of inflation with any reasonable hope of achieving it. Neither politicians nor the Federal Reserve are capable of “managing” inflation in the sense that they can dial in some acceptable level and maintain it. Furthermore, inflation will not help the economy but can kill it. Once money reaches the “crack up boom” phase, it ceases being acceptable as currency. People resort to barter which is necessarily inefficient and costly. The economy shrinks and the economy plunges into a Depression. This result can occur in a highly inflationary environment (a hyperinflationary Depression) or it could devolve into a deflationary Depression. The decision as to which occurs is in the hands of the government and the Federal Reserve. If they continue printing, there will be a hyperinflationary Depression.

Whether the government chooses to pursue inflation or allow deflation to play out, economically the end is the same — a Depression. From a political standpoint, it is beneficial to continue to kick the can down the road. The bottom line is that a Depression is unavoidable. I am betting on the inflation choice based on politicians doing what is in their best interest rather than that of the country. There are decades of political greed and cowardice upon which my position rests. That is not going to change, regardless of who is elected in 2012.

If one believes that politicians will behave as I suspect, the only way to believe that deflation is our next step is that printing money is not inflationary. Even with a complete collapse in debt levels, there is no speed that the printing presses cannot match.

Russell on Markets

Richard Russell

It is nice to see that Richard Russell, famed octogenarian investment newsletter author, has apparently recovered fully from his recent setback. This quote is an example of his outlook on markets (emboldening added):

Subscribers who are buying or holding stocks on the on the basis of the better employment news should remember that deteriorating internals in the face of improving newspaper headlines give us the worst of all markets. I cannot warn subscribers strongly enough that they face hard times in both the market and the economy during the months ahead. The operative words now are “extreme caution.” Please be out of all common stocks with the exception of the mining shares. According to my studies this year it’s going to be a long, cold fall and winter.

It is difficult to argue with his outlook, although mining stocks likely have not done well in down markets, at least during the primary downward moves. Longer term they should be fine. I currently own them although not in aggressive quantities. 

The Year That Was

A worthwhile recap of the year:

2011 Year in Review: Signs of an American Spring and a Fourth Turning

Friday, December 30, 2011, 11:54 pm, by Adam

[Every year, friend-of-the-site David Collum writes a detailed "Year in Review" synopsis full of keen perspective and plenty of wit. This year's is no exception. Moreover, he's graciously selected CM.com as the site where it will be published in full. It's quite longer than our usual posts, but by any measure 2011 offered an over-abundance of 'business as unusual' developments to summarize. We hope you enjoy David's colorful observations and insights - which are very much his own. -- cheers,

 

 

To encourage your read, here is one excerpt from this long piece:

Here's my biggest gripe in a nutshell. The Fed, whether it's a wholly owned subsidiary of the banking cartel or not, is charged with protecting the banking system. Period/full stop. The banking system is global. Period/full stop. Ergo, one does not even know if the Fed's actions are in the best interest of the United States. Period/full stop. What is to prevent them from sending trillions to Europe, Asia, or any faraway place because bankers got themselves in trouble? Absolutely nothing; they do it relentlessly. (They even sent the missing pallets of $100 dollar bills to Iraq for Christ's sakes!) Bloomberg's FOIA suit showed how far off the reservation they had strayed, pumping in at least $7.7 trillion. Bernie Sanders claims the audit shows $16 trillion. The Levy Economics Institute claims numbers approaching $30 trillion. We keep hearing that we made money on the bailouts, including from General Motors! That's an OMG/LOL/WTF all rolled into one. The $700 billion TARP was put on display for public consumption. It wasdesigned to be paid back in the light of day. The rest of the money entered the system covertly. They saved GM during the crisis by pooling their ample toxic assets, named it Ally Bank, and bailed it. GM cost us a fortune. Bankruptcy lawyers saw alternative strategies and better outcomes as described in an Econtalk interview [18]. They are selling off assets and declaring profits (like junkies selling blood), but have a balance sheet filled with dregs. Bank of America recently dumped its enormous derivatives book into its banking subsidiary to assist the Fed with another profitable bailout in the near future. Hussman outlined in vivid detail the illegality of a number of Fed’s asset purchases [19]. (Stephen Roach had done so years earlier, but neither Stephen nor I could locate the link.)

Read the full piece here.

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