Friday, July 30, 2004 12:00:51 PM
Cash in a safety deposit box anyone...?
After reading these first two articles, maybe holding cash in a safety deposit box makes sense... A potential problem with cash in banks and brokerage accounts is your money is simply electronic debits and credits... Maybe cash in your safety deposit box makes as much sense as holding gold and silver in your box... Maybe Bob Prechter is right... YIKES!!
But be sure to read final article below, Paul Van Eeden's view seems more realistic to me...
While defaults and asset sales are deflationary, and hence increase the value of the dollar inside the US, I find it hard to believe that foreign investors are going to fall over themselves to snap up more US stocks and bonds. Imagine: falling asset prices, rising interest rates and a contracting economy. Under those circumstances why would foreign investors want to invest in the US? If the US loses its appeal to foreign investors the demand for dollars on foreign exchange markets will decline, and the dollar will weaken against other currencies.
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Richard Russell
July 28, 2004
As you know, the debt situation in the US is of massive proportions. I don't believe that the US debt "mountain" could hold up against a new down-leg in the bear market. I said a few months ago that I thought the tower of debt that has been built in the US constitutes a synthetic short position against the dollar.
What I mean is that it takes tens of billions of dollars to carry the current $32 trillion dollars of US debt (debt in all areas from housing to corporate debt to consumer credit card debt). With the stock market breaking down, there's got to be pressure on debt. Debtors need dollars to keep solvent. If they don't have the dollars, they've got to find them somewhere. They're in the position of being SHORT of dollars. That may be the beginning of what we're seeing now as the dollars climbs higher and higher.
At the same time, the currencies are breaking down. The Swissie, often the leader, plunged below its 50-day moving average three days ago. Today the Swiss franc dropped below its 200-day MA. As I said, the Swissie often leads the other currencies.
The euro today broke below both its 50-day and 200-day MAs.
The yen today broke below its 50-day MA -- it already has broken below its 200-day MA.
What this all means is that we could be facing the ultimate in the unexpected -- the beginning of a panic for cash, liquidity, dollars.
I don't know how many of my subscribers have read the book that I recommended, "Balance Sheet Recession" by the brilliant Richard Koo. If you did read the book you know that the problem is NOT ENOUGH SPENDING, and DEFICITS THAT ARE NOT BIG ENOUGH.
And yes, that concept is totally counter-intuitive. You'll hear the people at the conventions shouting that we've got to cut the deficits. But to keep this economy going, the government has to spend more! It has to run up even bigger deficits.
And you I'll tell you something -- the US government may spend more but it won't be enough to keep the economy going. So the ultimate irony is materializing -- not enough spending to keep this bear market at arm's length.
Right now, aside from lousy stock market action, I believe that the currencies and the strong dollar is telling the story. In the US, everyone is going to need dollars to ward off the "big squeeze." And when I say big squeeze, I'm talking about the "big squeeze" that has been brought on by the need for cash to carry the debt.
Unfortunately, the rush for dollars is putting pressure on gold. Gold's time has not yet come. But it will. There's no easy way to time the move in gold. It will come suddenly, and violently, as faith in paper collapses. Gold is the insurance we have to have, and I honestly don't attempt to time it. I just want to own a certain portion of gold, and that's it. This whole economic situation is far bigger than just walking away with some stock market profits.
By the way, I also believe that housing is very vulnerable. Generational low interest rates have moved two-thirds of American families into their own homes. It's a bubble waiting to burst. People don't realize that when they buy a house it's going to cost them 10 percent a year to carry that house.
I see people here in Southern California buying one million, two million and three million dollar homes. These people don't realize that it's going to cost them in the hundreds of thousands of dollars to carry these million-dollar homes. In the end, many of these "good-time buyers" will lose their homes. The housing bubble will burst, and the homes that people stood in line to buy -- will be a drug on the market.
www.dowtheoryletters.com
_________________________
http://worldmarket.blogspot.com/2004/07/which-flation.html
Thursday, July 29, 2004
which flation?
during his recent testimony on the hill, Alan Greenspan , when questioned by Ron Paul about the Fed's money printing, averred that today's fiat systems 'do a very good job of replicating a gold standard, and are not inherently inflationary as i had previously thought'. as proof of this assertion Greenspan mentioned Japan's experience of the 90's, which showed that deflation is possible in a fiat system - something which he thought was impossible previously.
well, this is a sort of 'yes and no' proposition. on the one hand, the assertion that 'fiat systems are good at replicating a gold standard' can be disproven without much ado. the Federal Reserve has been an engine of inflation from the moment it was founded. as Greenspan himself admitted in another q&a, in spite of a few ups and downs during the 19th century (for instance, the civil war inflation, which was followed by a period of mild deflation), prices in the US remained by and large STABLE from the beginning of the 19th century until 1913, the year the Fed as well as the income tax came to life.
contrary to that experience, it now takes 1,900 dollars to buy what 100 dollars bought in 1913. thus, the fiat system has done a very poor job indeed of 'replicating a gold standard' with regards to the most inportant feature of same, stable prices over a very long period of time.
long term US CPI: http://www.northerntrust.com/library/econ_research/weekly/us/images/030801_01.gif
on the other hand, Greenspan does have a point about Japan. Japan's experience has not been deflationary in the classical sense, insofar as Japan's aggregate money supply has risen every single year during the 90's. however, prices have certainly declined (in some instances sharply) during this time, and outstanding bank credit at one point had contracted for 58 months in a row.
so what had happened? the BoJ after all did everything it could to instigate inflation. it dropped rates to zero, and pushed money into the system with abandon, most recently with its 'quantitative easing' policy that entails even the (allegedly temporary) monetization of stocks.
it stands to reason that Japan's experience holds vital clues as to the possibility of deflation in a fiat dispensation.
but first let's look at some recent commentary on the issue. a curious little news item crossed my desk not too long ago:
"According to a monthly survey conducted by Merrill Lynch, a net 78% of fund managers expect global core inflation to be higher a year from now. "
as we all know, such a broad consensus usually turns out to be wrong. indeed, if one looks at positioning data in debt futures instruments, one notices that this consensus is extremely widespread. speculative net short positions in US bonds and notes futures have reached several consecutive record highs this year, and the Rydex bond ratio (the ratio of assets deployed between the Rydex short and long bond funds) at one point reached an incredible 120 points, which amounts to a bearish consensus of well over 99% (it has since retreated to a less conspicuous 27, but that's still 27 dollars invested short for every dollar invested long). the contrarian conclusion from all this is that in spite of the CRB index scaling mutli-year highs, the inflationists (i.e., the by now relatively large contingent of market participants expecting a replay of the 70's stagflation) are probably wrong.
two of the most eloquent proponents of the inflationists have in recent weeks presented their views on the issue; they are Steven Saville (who btw. frequently points out that he does NOT expect a replay of the 70's, but nevertheless expects inflation to accelerate appreciably in coming years) and Ed Bugos. both are adherents of the Austrian School, which is probably why they are so determined on the inflation issue - most Austrians are of the opinion that the Fed can inflate at will (see also Gary North and Sean Corrigan), and this is true in principle. but you can probably guess that i have some objections.
Saville: http://news.goldseek.com/SpeculativeInvestor/1084893010.php
Bugos (criticizing Richard Russell for daring to even contemplate deflation): http://news.goldseek.com/GoldenBar/1088099734.php
Saville quotes Corrigan in support of the thesis that deflation is highly unlikely (to his credit, he doesn't rule out the possibility completely) - as evidence, the Fed's willingness to flood the system with credit at every opportunity (in both real and imagined crises) is cited. the evidence is indeed damning - the Fed DOES open the spigot at every available opportunity, and as Doug Noland of prudentbear has chronicled, is usually helped in these endeavors by the GSEs via expansion of their balance sheets.
however, this does not address the major argument in favor of an eventual deflationary outcome: namely the fact that these past goosings of credit have added up to what is now a grand total of approximately 360% of GDP in total credit market debt, leaving the previous historic record of 1929 (260% of GDP) in the dust. the point here is that the debt has become so large, that the authorities, and of course the debtors, would like nothing better than inflating it away - but as Bill Bonner has so sagely remarked, people sometimes don't get what they want, but what they deserve. in order to 'inflate debt away' in the current fiat money system, the new money has to be 'borrowed into existence'. in other words, the inflation depends on expanding this astonishing debt mountain even further. the central bank's modus operandi dictates how this is done - in the US via the short term interest rates the Fed controls, the monetization of government debt (and to a smaller extent, since 2000 also GSE debt) and tinkering with free reserves in the banking system.
Bugos has a very good point when he alleges, as he frequently does, that the Fed wants everybody to believe that there is no inflation in order to be able to inflate all the more. after all, if the market became convinced that the Fed is indeed successfully inflating, it would drive up interest rates to levels that would act as a very effective counterweight to the inflation attempt. the Fed's scheme to inflate works only as long as most market participants believe the rate of inflation is tame.
but it seems from Japan's experience, that it is NOT as Bugos likewise says , the central bank alone that determines the degree of inflation. in a widespread credit collapse such as that of the 1930's US or 1990's Japan, the central banks traditional methods of goosing inflation tend to fail (it could alternatively adopt a modus operandi that is explicitly designed to destroy the currency it issues). neither the 30's Fed, nor the 90's BoJ were shy about boosting free bank reserves or monetizing government debt. but the banks, for lack of trustworthy debtors, turned around and re-invested the reserves freed up by selling government bonds to the central bank into more government bonds, or occasionally, as was observed in Japan, the money market would simply be awash in liquidity that nobody wanted.
thus, while Japan's money supply still rose (due to the the government's debt issuance spree counter-acting the plunge in private sector bank credit) , the velocity of money declined sharply.
Bugos is correct that the term 'overinvestment' is misguided, and the appropriate term is 'malinvestment' - economic activities that are per se, not wealth-generating, and would never spring up in a truly free market to the extent that they do in a fiat money regime (this is not to say that no entrepreneurial errors occur in a truly free market, only that there are far fewer of them, and those that do occur are corrected more quickly).
such malinvestments are on the artificial life support of money created out of thin air - when the expansion of credit slows down, or reverses, these activities collapse.
usually, a tightening of credit (often on the belated realization that a credit boom has gotten out of hand) by the central bank becomes the proximate cause, although i suspect that a credit boom can eventually become exhausted even in the absence of such a tightening.
on this point, the Austrian scholar Frank Schostak writes:
"As long as the pool of real funding is expanding and banks are eager to expand credit (credit out of "thin air") various nonproductive activities continue to prosper. Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real funding is set in motion. Consequently, the performance of various activities starts to deteriorate and banks' bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock. "
and further:
"How is it possible that lenders can generate credit out "of thin air" which in turn can lead to the disappearance of money? Now, when loaned money is fully backed up by savings, on the day of the loan's maturity it is returned to the original lender. Thus, Bob—the borrower of $100—will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe, the lender, his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.
In contrast, when credit is created out of "thin air" and returned on the maturity day to the bank this amounts to a withdrawal of money from the economy, i.e, to a decline in the money stock. The reason for this is because there wasn't any original saver/lender, since this credit was created out of "thin air." "
Shostak's article ("Does a falling money stock cause economic depression?" - an excellent article with many charts depicting the 30's depression's macroecnomic and monetary data - which prove, beyond a shadow of doubt, that the Fed was priming the pump madly at the time, contrary to popular mainstream economic misconceptions. but it didn't work - a deflation of both the money stock and bank credit, as well as a vicious price deflation ensued. note that prices at one point registered an aggregate annual decline of over 10%). as an added bonus, there's a chart detailing the change in the BoJ's holdings of government securities during the 1990's - which contradicts Saville's contention that Japan relied 'mostly on fiscal deficit spending' as opposed to monetary pumping. it relied in fact on both.
http://www.mises.org/fullstory.aspx?control=1211
so there you have it. deflation as a side effect of the liquidation of malinvestments when an artificial credit induced boom in a fiat regime falters - with the proviso that the pool of real funding is in decline, since as long as the pool of real funding still expands, the central bank's 'reflation' measures will APPEAR to re-ignite the boom.
what about the pool of real funding in the US? how can we ascertain whether it is or isn't in trouble? one of the yardsticks used by Shostak to illustrate the likelihood of trouble looming is the personal income-to-outlays ratio, which as he notes, has declined more steeply during the last 24 years of Fed accommodation than it ever did during the 1920's and 1930's.
furthermore, one of the strongest hints we have is how the stock market behaved after the year 2000 Nasdaq bubble peak - for the first time since the 1930s, the stock market has failed to regain the level it inhabited at the time the Fed began its rate cutting campaign. since the stock market is a mirror of perceptions about economic reality, this failure must be counted as a sign that the pool of real funding is in trouble. note in this context that in Japan likewise, the stock market has given this very same signal after the 80's bubble peak there.
what else do we know? we know that the Fed's 'reflation' strategy has had both intended and unintended consequences, all of which are symptomatic of the very basic conditions that eventually lead to a decline in the pool of real funding.
Shostak:
"Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real funding is set in motion."
the evidence that this has taken place is overwhelming - of note in this context is the real estate bubble (an 'intended consequence' if we take Greenspan at his word, since he has hailed the ability of consumers to 'extract housing wealth' as a salutory event for the economy), which is the ultimate in 'consumption without preceding production' or 'exchanges of nothing for something'.
it should be obvious that when the price of a house rises on account of a massive credit expansion, its value does not. it is still the same house.
another ('unintended') consequence is the relentless rise in commodity prices. this is taken as proof by the inflationists that more broad based inflation is looming ('cost push'), but as Bugos notes, an important component, namely rising wages, is at this stage conspicuously absent (this is one the major differences in terms of macro-economic data compared to the 1970's stagflation period, and while Bugos thinks rising wages are inevitable, the evidence argues otherwise. labor has no pricing power, since it is abundant in China and India, and i would argue that in spite of the rose-colored statistics published by the US BLS, it is abundant in the US as well).
the rise in commodity prices is partly a symptom of the reflation effort, which has inter alia spurred a credit boom in China, but it is also a symptom of decades of malinvestment, i.e. investment directed in the wrong direction.
the reflation attempt, by encouraging even more malinvestment , leads to demands on resources exceeding the supply of same - hence the price rises.
but are rising commodity prices really heralding broad based price inflation? this seems unlikely in view of the lack of pricing power on the part of both corporations and labor (except of course commodity producers, who are enjoying a rare bout of pricing power, but represent such a small slice of overall economic output that they can't dent the aggregate picture).
rather, the additional funds that have to be expended on raw materials are sapping both consumer's and corporations ability to shell out money on other things, such as consumer goods, capital goods and debt service.
the following article by the Hoisington Group illuminates what they refer to as the 'deflationary gap' in the US economy, by looking closely at qu. 2 2004 economic data in a longer term context. among the few bond market bulls in the current investment landscape, they argue that the Fed is not 'behind the curve' as one often hears these days, but actually 'ahead of the curve'. i fully agree with their view that the current baby step interest rate increases campaign will eventually be reversed in its entirety.
of interest from an Austrian point of view is here the continuing high level of the capital spending to GDP ratio (while factory use remains mired a full 6 percentage point BELOW the post 1949 average). it is a sign that the necessary realignment of the economy has been arrested by the combination of the Fed's monetary pumping and the government's Keynesian fiscal stimulus in the wake of the post bubble experience. the bust should have redirected resources away from capital goods to consumer goods production, but this has failed to transpire.
also of note, the expectation that money velocity will continue to decline in coming years - imo an essential symptom of a deflationary bust in a fiat regime.
Hoysington report: http://www.hoisingtonmgt.com/HIM2004Q2NP.pdf
lastly, an article by Gary North (who's ironically firmly in the inflation camp), which ponders the possibility that the 'lender of last resort' may one of these days be confronted with a crisis too big to bail - a good argument for deflation as it were. he mentions the 'interbank settlement' issue first chronicled by Warren Pollock, as well as Greenspan's famous 'cascading cross-defaults' saying on occasion of the LTCM intervention post mortem. i take his warning at the end of the article very seriously, and urge everybody to take it to heart.
Gary North ("the limits to central banking"): http://www.lewrockwell.com/north/north282.html
PS: i have several times referred to the central bank's 'modus operandi' above. this is an important point that requires to be expanded upon. one of the major arguments in favor of stagflation is that the Fed (and presumably other central banks as well) will do 'whatever it takes' to avert deflation.
famously, Ben Bernanke , saint of the printing press, has referred to the option of 'helicopter money'. he didn't mean it literally, but a literal enactment is exactly what it would take. if they DID drop money from helicopters, all the outstanding debt could be instantly monetized. the debt deflation cycle could in theory be arrested, since the urge to pay down debt, or alternatively the need to default on it, as well as the corresponding urge to save (all inherently deflationary in the fiat system) would be obviated.
however, i believe this expectation (i.e. 'they will do whatever it takes') is misplaced. granted, they would probably resort to 'unusual' measures, such as buying up government debt across the yield curve, or even monetizing stocks as the BoJ has done, or expanding the monetization of land (i.e., GSE debt) beyond temporary injections. but they would shy away from the literal helicopter for a simple reason: it would utterly destroy the currency they issue, and very likely a number of local free market monies would arise in its stead. that would mean relinquishing the very power they now wield (the power to redistribute wealth via inflation 'creep') , and i doubt that that is an option they'd consider.
a final comment: deflation is not 'bad'. what's bad about goods and services getting cheaper? in fact, mild deflation is the NATURAL order of things in a true free market economy. it is only considered 'bad' because of the fiat debt mountain that has been built up. but think about this for a moment: let us say the economy lapses back into recession - worse than before. what should those that will lose their jobs wish for? that their savings buy LESS goods and services than before, or more? true, their assets will deflate as well - but whatever they have in cash or cash like instruments can either buy less (stagflation) or more (deflation). the choice seems clear.
posted by pater tenebrarum at 8:55 PM
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Debt: a synthetic short position in the dollar
July 23, 2004
A short position is when you have sold something you don’t own. Take a stock as an example. If you borrow the stock and sell it you are short the stock. At some point you have to buy the stock in order to give back that which you borrowed. Because you will eventually have to buy the stock that you sold short, the fact that you are short means there is latent demand for the stock.
It has been said that the tremendous amount of US debt can be likened to a synthetic short position in the dollar because the debt must be repaid at some point, and repaying the debt will require dollars. This demand for dollars will then, supposedly, increase the price of dollars and strengthen the dollar on foreign exchange markets. A stronger dollar implies a lower gold price, which is why the synthetic short position in the dollar has a few gold investors worried.
Maturing debt is normally repaid by issuing new debt with no net demand for dollars and, hence, no increase in the value of the dollar. However, if the credit quality of the issuer is cast into doubt, investors may not be willing to buy the new debt -- at least not at the same price as the existing debt. Several things could then happen.
The borrower could default on the maturing debt and not repay it at all. In this case the invested money is lost causing a contraction in the money supply. Less money increases the value of the remaining money and so defaults increase the value of cash (dollars).
If the borrower sells assets to raise cash and pay off the debt the result is the same. An increase in asset sales will depress the value of assets and increase the relative value of dollars.
If the US economy was a closed system one could therefore make the case that debt represents a synthetic short in the dollar since, at some point, dollars will be needed to repay the debt when new debt cannot be issued.
But the US is part of a world economy and we have to consider not only the value of the dollar relative to US assets and labor, but also against other currencies.
The US government’s budget deficit is rapidly increasing the supply of US debt, thereby increasing interest rates. As a result of higher interest rates the US economy is likely to slow down and a slower economy in conjunction with higher interest rates can cause an increase in defaults and asset sales.
While defaults and asset sales are deflationary, and hence increase the value of the dollar inside the US, I find it hard to believe that foreign investors are going to fall over themselves to snap up more US stocks and bonds. Imagine: falling asset prices, rising interest rates and a contracting economy. Under those circumstances why would foreign investors want to invest in the US?
If the US loses its appeal to foreign investors the demand for dollars on foreign exchange markets will decline, and the dollar will weaken against other currencies.
In summary then, the dollar could appreciate within the US against assets and labor but simultaneously fall against other currencies -- leading to higher gold prices.
Most currency traders do not share my views and still see higher interest rates as positive for the dollar. The dollar strengthened this week because Alan Greenspan gave an upbeat assessment of the economy and his comments were interpreted to mean that interest rates would continue to rise gradually while any sign of inflation would be dealt with harshly.
Because the dollar strengthened the gold price declined. Until we see evidence that higher interest rates are hurting the economy the dollar will continue to strengthen as rates edge upwards. And unless the dollar weakens in the face of higher interest rates the gold price is unlikely to sustain a rally.
Paul van Eeden
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After reading these first two articles, maybe holding cash in a safety deposit box makes sense... A potential problem with cash in banks and brokerage accounts is your money is simply electronic debits and credits... Maybe cash in your safety deposit box makes as much sense as holding gold and silver in your box... Maybe Bob Prechter is right... YIKES!!
But be sure to read final article below, Paul Van Eeden's view seems more realistic to me...
While defaults and asset sales are deflationary, and hence increase the value of the dollar inside the US, I find it hard to believe that foreign investors are going to fall over themselves to snap up more US stocks and bonds. Imagine: falling asset prices, rising interest rates and a contracting economy. Under those circumstances why would foreign investors want to invest in the US? If the US loses its appeal to foreign investors the demand for dollars on foreign exchange markets will decline, and the dollar will weaken against other currencies.
______________________________
Richard Russell
July 28, 2004
As you know, the debt situation in the US is of massive proportions. I don't believe that the US debt "mountain" could hold up against a new down-leg in the bear market. I said a few months ago that I thought the tower of debt that has been built in the US constitutes a synthetic short position against the dollar.
What I mean is that it takes tens of billions of dollars to carry the current $32 trillion dollars of US debt (debt in all areas from housing to corporate debt to consumer credit card debt). With the stock market breaking down, there's got to be pressure on debt. Debtors need dollars to keep solvent. If they don't have the dollars, they've got to find them somewhere. They're in the position of being SHORT of dollars. That may be the beginning of what we're seeing now as the dollars climbs higher and higher.
At the same time, the currencies are breaking down. The Swissie, often the leader, plunged below its 50-day moving average three days ago. Today the Swiss franc dropped below its 200-day MA. As I said, the Swissie often leads the other currencies.
The euro today broke below both its 50-day and 200-day MAs.
The yen today broke below its 50-day MA -- it already has broken below its 200-day MA.
What this all means is that we could be facing the ultimate in the unexpected -- the beginning of a panic for cash, liquidity, dollars.
I don't know how many of my subscribers have read the book that I recommended, "Balance Sheet Recession" by the brilliant Richard Koo. If you did read the book you know that the problem is NOT ENOUGH SPENDING, and DEFICITS THAT ARE NOT BIG ENOUGH.
And yes, that concept is totally counter-intuitive. You'll hear the people at the conventions shouting that we've got to cut the deficits. But to keep this economy going, the government has to spend more! It has to run up even bigger deficits.
And you I'll tell you something -- the US government may spend more but it won't be enough to keep the economy going. So the ultimate irony is materializing -- not enough spending to keep this bear market at arm's length.
Right now, aside from lousy stock market action, I believe that the currencies and the strong dollar is telling the story. In the US, everyone is going to need dollars to ward off the "big squeeze." And when I say big squeeze, I'm talking about the "big squeeze" that has been brought on by the need for cash to carry the debt.
Unfortunately, the rush for dollars is putting pressure on gold. Gold's time has not yet come. But it will. There's no easy way to time the move in gold. It will come suddenly, and violently, as faith in paper collapses. Gold is the insurance we have to have, and I honestly don't attempt to time it. I just want to own a certain portion of gold, and that's it. This whole economic situation is far bigger than just walking away with some stock market profits.
By the way, I also believe that housing is very vulnerable. Generational low interest rates have moved two-thirds of American families into their own homes. It's a bubble waiting to burst. People don't realize that when they buy a house it's going to cost them 10 percent a year to carry that house.
I see people here in Southern California buying one million, two million and three million dollar homes. These people don't realize that it's going to cost them in the hundreds of thousands of dollars to carry these million-dollar homes. In the end, many of these "good-time buyers" will lose their homes. The housing bubble will burst, and the homes that people stood in line to buy -- will be a drug on the market.
www.dowtheoryletters.com
_________________________
http://worldmarket.blogspot.com/2004/07/which-flation.html
Thursday, July 29, 2004
which flation?
during his recent testimony on the hill, Alan Greenspan , when questioned by Ron Paul about the Fed's money printing, averred that today's fiat systems 'do a very good job of replicating a gold standard, and are not inherently inflationary as i had previously thought'. as proof of this assertion Greenspan mentioned Japan's experience of the 90's, which showed that deflation is possible in a fiat system - something which he thought was impossible previously.
well, this is a sort of 'yes and no' proposition. on the one hand, the assertion that 'fiat systems are good at replicating a gold standard' can be disproven without much ado. the Federal Reserve has been an engine of inflation from the moment it was founded. as Greenspan himself admitted in another q&a, in spite of a few ups and downs during the 19th century (for instance, the civil war inflation, which was followed by a period of mild deflation), prices in the US remained by and large STABLE from the beginning of the 19th century until 1913, the year the Fed as well as the income tax came to life.
contrary to that experience, it now takes 1,900 dollars to buy what 100 dollars bought in 1913. thus, the fiat system has done a very poor job indeed of 'replicating a gold standard' with regards to the most inportant feature of same, stable prices over a very long period of time.
long term US CPI: http://www.northerntrust.com/library/econ_research/weekly/us/images/030801_01.gif
on the other hand, Greenspan does have a point about Japan. Japan's experience has not been deflationary in the classical sense, insofar as Japan's aggregate money supply has risen every single year during the 90's. however, prices have certainly declined (in some instances sharply) during this time, and outstanding bank credit at one point had contracted for 58 months in a row.
so what had happened? the BoJ after all did everything it could to instigate inflation. it dropped rates to zero, and pushed money into the system with abandon, most recently with its 'quantitative easing' policy that entails even the (allegedly temporary) monetization of stocks.
it stands to reason that Japan's experience holds vital clues as to the possibility of deflation in a fiat dispensation.
but first let's look at some recent commentary on the issue. a curious little news item crossed my desk not too long ago:
"According to a monthly survey conducted by Merrill Lynch, a net 78% of fund managers expect global core inflation to be higher a year from now. "
as we all know, such a broad consensus usually turns out to be wrong. indeed, if one looks at positioning data in debt futures instruments, one notices that this consensus is extremely widespread. speculative net short positions in US bonds and notes futures have reached several consecutive record highs this year, and the Rydex bond ratio (the ratio of assets deployed between the Rydex short and long bond funds) at one point reached an incredible 120 points, which amounts to a bearish consensus of well over 99% (it has since retreated to a less conspicuous 27, but that's still 27 dollars invested short for every dollar invested long). the contrarian conclusion from all this is that in spite of the CRB index scaling mutli-year highs, the inflationists (i.e., the by now relatively large contingent of market participants expecting a replay of the 70's stagflation) are probably wrong.
two of the most eloquent proponents of the inflationists have in recent weeks presented their views on the issue; they are Steven Saville (who btw. frequently points out that he does NOT expect a replay of the 70's, but nevertheless expects inflation to accelerate appreciably in coming years) and Ed Bugos. both are adherents of the Austrian School, which is probably why they are so determined on the inflation issue - most Austrians are of the opinion that the Fed can inflate at will (see also Gary North and Sean Corrigan), and this is true in principle. but you can probably guess that i have some objections.
Saville: http://news.goldseek.com/SpeculativeInvestor/1084893010.php
Bugos (criticizing Richard Russell for daring to even contemplate deflation): http://news.goldseek.com/GoldenBar/1088099734.php
Saville quotes Corrigan in support of the thesis that deflation is highly unlikely (to his credit, he doesn't rule out the possibility completely) - as evidence, the Fed's willingness to flood the system with credit at every opportunity (in both real and imagined crises) is cited. the evidence is indeed damning - the Fed DOES open the spigot at every available opportunity, and as Doug Noland of prudentbear has chronicled, is usually helped in these endeavors by the GSEs via expansion of their balance sheets.
however, this does not address the major argument in favor of an eventual deflationary outcome: namely the fact that these past goosings of credit have added up to what is now a grand total of approximately 360% of GDP in total credit market debt, leaving the previous historic record of 1929 (260% of GDP) in the dust. the point here is that the debt has become so large, that the authorities, and of course the debtors, would like nothing better than inflating it away - but as Bill Bonner has so sagely remarked, people sometimes don't get what they want, but what they deserve. in order to 'inflate debt away' in the current fiat money system, the new money has to be 'borrowed into existence'. in other words, the inflation depends on expanding this astonishing debt mountain even further. the central bank's modus operandi dictates how this is done - in the US via the short term interest rates the Fed controls, the monetization of government debt (and to a smaller extent, since 2000 also GSE debt) and tinkering with free reserves in the banking system.
Bugos has a very good point when he alleges, as he frequently does, that the Fed wants everybody to believe that there is no inflation in order to be able to inflate all the more. after all, if the market became convinced that the Fed is indeed successfully inflating, it would drive up interest rates to levels that would act as a very effective counterweight to the inflation attempt. the Fed's scheme to inflate works only as long as most market participants believe the rate of inflation is tame.
but it seems from Japan's experience, that it is NOT as Bugos likewise says , the central bank alone that determines the degree of inflation. in a widespread credit collapse such as that of the 1930's US or 1990's Japan, the central banks traditional methods of goosing inflation tend to fail (it could alternatively adopt a modus operandi that is explicitly designed to destroy the currency it issues). neither the 30's Fed, nor the 90's BoJ were shy about boosting free bank reserves or monetizing government debt. but the banks, for lack of trustworthy debtors, turned around and re-invested the reserves freed up by selling government bonds to the central bank into more government bonds, or occasionally, as was observed in Japan, the money market would simply be awash in liquidity that nobody wanted.
thus, while Japan's money supply still rose (due to the the government's debt issuance spree counter-acting the plunge in private sector bank credit) , the velocity of money declined sharply.
Bugos is correct that the term 'overinvestment' is misguided, and the appropriate term is 'malinvestment' - economic activities that are per se, not wealth-generating, and would never spring up in a truly free market to the extent that they do in a fiat money regime (this is not to say that no entrepreneurial errors occur in a truly free market, only that there are far fewer of them, and those that do occur are corrected more quickly).
such malinvestments are on the artificial life support of money created out of thin air - when the expansion of credit slows down, or reverses, these activities collapse.
usually, a tightening of credit (often on the belated realization that a credit boom has gotten out of hand) by the central bank becomes the proximate cause, although i suspect that a credit boom can eventually become exhausted even in the absence of such a tightening.
on this point, the Austrian scholar Frank Schostak writes:
"As long as the pool of real funding is expanding and banks are eager to expand credit (credit out of "thin air") various nonproductive activities continue to prosper. Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real funding is set in motion. Consequently, the performance of various activities starts to deteriorate and banks' bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock. "
and further:
"How is it possible that lenders can generate credit out "of thin air" which in turn can lead to the disappearance of money? Now, when loaned money is fully backed up by savings, on the day of the loan's maturity it is returned to the original lender. Thus, Bob—the borrower of $100—will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe, the lender, his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.
In contrast, when credit is created out of "thin air" and returned on the maturity day to the bank this amounts to a withdrawal of money from the economy, i.e, to a decline in the money stock. The reason for this is because there wasn't any original saver/lender, since this credit was created out of "thin air." "
Shostak's article ("Does a falling money stock cause economic depression?" - an excellent article with many charts depicting the 30's depression's macroecnomic and monetary data - which prove, beyond a shadow of doubt, that the Fed was priming the pump madly at the time, contrary to popular mainstream economic misconceptions. but it didn't work - a deflation of both the money stock and bank credit, as well as a vicious price deflation ensued. note that prices at one point registered an aggregate annual decline of over 10%). as an added bonus, there's a chart detailing the change in the BoJ's holdings of government securities during the 1990's - which contradicts Saville's contention that Japan relied 'mostly on fiscal deficit spending' as opposed to monetary pumping. it relied in fact on both.
http://www.mises.org/fullstory.aspx?control=1211
so there you have it. deflation as a side effect of the liquidation of malinvestments when an artificial credit induced boom in a fiat regime falters - with the proviso that the pool of real funding is in decline, since as long as the pool of real funding still expands, the central bank's 'reflation' measures will APPEAR to re-ignite the boom.
what about the pool of real funding in the US? how can we ascertain whether it is or isn't in trouble? one of the yardsticks used by Shostak to illustrate the likelihood of trouble looming is the personal income-to-outlays ratio, which as he notes, has declined more steeply during the last 24 years of Fed accommodation than it ever did during the 1920's and 1930's.
furthermore, one of the strongest hints we have is how the stock market behaved after the year 2000 Nasdaq bubble peak - for the first time since the 1930s, the stock market has failed to regain the level it inhabited at the time the Fed began its rate cutting campaign. since the stock market is a mirror of perceptions about economic reality, this failure must be counted as a sign that the pool of real funding is in trouble. note in this context that in Japan likewise, the stock market has given this very same signal after the 80's bubble peak there.
what else do we know? we know that the Fed's 'reflation' strategy has had both intended and unintended consequences, all of which are symptomatic of the very basic conditions that eventually lead to a decline in the pool of real funding.
Shostak:
"Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real funding is set in motion."
the evidence that this has taken place is overwhelming - of note in this context is the real estate bubble (an 'intended consequence' if we take Greenspan at his word, since he has hailed the ability of consumers to 'extract housing wealth' as a salutory event for the economy), which is the ultimate in 'consumption without preceding production' or 'exchanges of nothing for something'.
it should be obvious that when the price of a house rises on account of a massive credit expansion, its value does not. it is still the same house.
another ('unintended') consequence is the relentless rise in commodity prices. this is taken as proof by the inflationists that more broad based inflation is looming ('cost push'), but as Bugos notes, an important component, namely rising wages, is at this stage conspicuously absent (this is one the major differences in terms of macro-economic data compared to the 1970's stagflation period, and while Bugos thinks rising wages are inevitable, the evidence argues otherwise. labor has no pricing power, since it is abundant in China and India, and i would argue that in spite of the rose-colored statistics published by the US BLS, it is abundant in the US as well).
the rise in commodity prices is partly a symptom of the reflation effort, which has inter alia spurred a credit boom in China, but it is also a symptom of decades of malinvestment, i.e. investment directed in the wrong direction.
the reflation attempt, by encouraging even more malinvestment , leads to demands on resources exceeding the supply of same - hence the price rises.
but are rising commodity prices really heralding broad based price inflation? this seems unlikely in view of the lack of pricing power on the part of both corporations and labor (except of course commodity producers, who are enjoying a rare bout of pricing power, but represent such a small slice of overall economic output that they can't dent the aggregate picture).
rather, the additional funds that have to be expended on raw materials are sapping both consumer's and corporations ability to shell out money on other things, such as consumer goods, capital goods and debt service.
the following article by the Hoisington Group illuminates what they refer to as the 'deflationary gap' in the US economy, by looking closely at qu. 2 2004 economic data in a longer term context. among the few bond market bulls in the current investment landscape, they argue that the Fed is not 'behind the curve' as one often hears these days, but actually 'ahead of the curve'. i fully agree with their view that the current baby step interest rate increases campaign will eventually be reversed in its entirety.
of interest from an Austrian point of view is here the continuing high level of the capital spending to GDP ratio (while factory use remains mired a full 6 percentage point BELOW the post 1949 average). it is a sign that the necessary realignment of the economy has been arrested by the combination of the Fed's monetary pumping and the government's Keynesian fiscal stimulus in the wake of the post bubble experience. the bust should have redirected resources away from capital goods to consumer goods production, but this has failed to transpire.
also of note, the expectation that money velocity will continue to decline in coming years - imo an essential symptom of a deflationary bust in a fiat regime.
Hoysington report: http://www.hoisingtonmgt.com/HIM2004Q2NP.pdf
lastly, an article by Gary North (who's ironically firmly in the inflation camp), which ponders the possibility that the 'lender of last resort' may one of these days be confronted with a crisis too big to bail - a good argument for deflation as it were. he mentions the 'interbank settlement' issue first chronicled by Warren Pollock, as well as Greenspan's famous 'cascading cross-defaults' saying on occasion of the LTCM intervention post mortem. i take his warning at the end of the article very seriously, and urge everybody to take it to heart.
Gary North ("the limits to central banking"): http://www.lewrockwell.com/north/north282.html
PS: i have several times referred to the central bank's 'modus operandi' above. this is an important point that requires to be expanded upon. one of the major arguments in favor of stagflation is that the Fed (and presumably other central banks as well) will do 'whatever it takes' to avert deflation.
famously, Ben Bernanke , saint of the printing press, has referred to the option of 'helicopter money'. he didn't mean it literally, but a literal enactment is exactly what it would take. if they DID drop money from helicopters, all the outstanding debt could be instantly monetized. the debt deflation cycle could in theory be arrested, since the urge to pay down debt, or alternatively the need to default on it, as well as the corresponding urge to save (all inherently deflationary in the fiat system) would be obviated.
however, i believe this expectation (i.e. 'they will do whatever it takes') is misplaced. granted, they would probably resort to 'unusual' measures, such as buying up government debt across the yield curve, or even monetizing stocks as the BoJ has done, or expanding the monetization of land (i.e., GSE debt) beyond temporary injections. but they would shy away from the literal helicopter for a simple reason: it would utterly destroy the currency they issue, and very likely a number of local free market monies would arise in its stead. that would mean relinquishing the very power they now wield (the power to redistribute wealth via inflation 'creep') , and i doubt that that is an option they'd consider.
a final comment: deflation is not 'bad'. what's bad about goods and services getting cheaper? in fact, mild deflation is the NATURAL order of things in a true free market economy. it is only considered 'bad' because of the fiat debt mountain that has been built up. but think about this for a moment: let us say the economy lapses back into recession - worse than before. what should those that will lose their jobs wish for? that their savings buy LESS goods and services than before, or more? true, their assets will deflate as well - but whatever they have in cash or cash like instruments can either buy less (stagflation) or more (deflation). the choice seems clear.
posted by pater tenebrarum at 8:55 PM
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Debt: a synthetic short position in the dollar
July 23, 2004
A short position is when you have sold something you don’t own. Take a stock as an example. If you borrow the stock and sell it you are short the stock. At some point you have to buy the stock in order to give back that which you borrowed. Because you will eventually have to buy the stock that you sold short, the fact that you are short means there is latent demand for the stock.
It has been said that the tremendous amount of US debt can be likened to a synthetic short position in the dollar because the debt must be repaid at some point, and repaying the debt will require dollars. This demand for dollars will then, supposedly, increase the price of dollars and strengthen the dollar on foreign exchange markets. A stronger dollar implies a lower gold price, which is why the synthetic short position in the dollar has a few gold investors worried.
Maturing debt is normally repaid by issuing new debt with no net demand for dollars and, hence, no increase in the value of the dollar. However, if the credit quality of the issuer is cast into doubt, investors may not be willing to buy the new debt -- at least not at the same price as the existing debt. Several things could then happen.
The borrower could default on the maturing debt and not repay it at all. In this case the invested money is lost causing a contraction in the money supply. Less money increases the value of the remaining money and so defaults increase the value of cash (dollars).
If the borrower sells assets to raise cash and pay off the debt the result is the same. An increase in asset sales will depress the value of assets and increase the relative value of dollars.
If the US economy was a closed system one could therefore make the case that debt represents a synthetic short in the dollar since, at some point, dollars will be needed to repay the debt when new debt cannot be issued.
But the US is part of a world economy and we have to consider not only the value of the dollar relative to US assets and labor, but also against other currencies.
The US government’s budget deficit is rapidly increasing the supply of US debt, thereby increasing interest rates. As a result of higher interest rates the US economy is likely to slow down and a slower economy in conjunction with higher interest rates can cause an increase in defaults and asset sales.
While defaults and asset sales are deflationary, and hence increase the value of the dollar inside the US, I find it hard to believe that foreign investors are going to fall over themselves to snap up more US stocks and bonds. Imagine: falling asset prices, rising interest rates and a contracting economy. Under those circumstances why would foreign investors want to invest in the US?
If the US loses its appeal to foreign investors the demand for dollars on foreign exchange markets will decline, and the dollar will weaken against other currencies.
In summary then, the dollar could appreciate within the US against assets and labor but simultaneously fall against other currencies -- leading to higher gold prices.
Most currency traders do not share my views and still see higher interest rates as positive for the dollar. The dollar strengthened this week because Alan Greenspan gave an upbeat assessment of the economy and his comments were interpreted to mean that interest rates would continue to rise gradually while any sign of inflation would be dealt with harshly.
Because the dollar strengthened the gold price declined. Until we see evidence that higher interest rates are hurting the economy the dollar will continue to strengthen as rates edge upwards. And unless the dollar weakens in the face of higher interest rates the gold price is unlikely to sustain a rally.
Paul van Eeden
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