Great article

Written by a fellow named Porter Stansberry at DailyWealth.com.

Strong and Weak Money

Vietnam recently decided to depreciate their currency, the dong, by 5%, raising concerns throughout Asia about the possibility of competitive currency depreciations. Vietnam has a strong export sector, which is facing heavy competition from other Asian producers, including China and Thailand. If labor costs cannot go lower, if productivity cannot be raised, why not make Vietnam’s exports cheaper by simply making the dong worth less, meaning a dollar or Euro goes further than it did before.
The contradiction of Asia is that every country wants their currency to be strong and weak at the same time. Strong currencies are viewed as stable, and attract investment. Yet weak currencies allow the country to export goods that seem cheap in other countries.


How will China respond to this move? They might like to depreciate the Yuan, which has strengthened 17% against the dollar since 2002. After all, that would make their exports more competitive with Vietnam’s exports. China has been marked by a very slow and consistent approach to foreign exchange. There do not seem to be any sudden changes when it comes to policy about the value of the Yuan. It’s been assumed by most observers that the strategy is simply to capture the American market with low prices (which they know we can’t resist).


China’s goal may be far more ambitious: to create a new global reserve currency. Could the Chinese Yuan be a contender for that illustrious role? Such a possibility seems unfathomable. The natural contender to the dollar is clearly the Euro, the currency of the world’s largest trading economy, the Eurozone. After the Euro perhaps is the Yen. But China’s growth is far more vigorous than that of the Eurozone or Japan. Investors of all kinds want to get in on China’s growing markets, exchanging Euros or dollars for Yuan, which steadily pushes up the value of the Yuan. Since the Yuan is stable (and in fact, standing behind it is the largest currency reserve the world has ever seen), investors have faith it will keep its value.
What does China do with it’s growing foreign exchange surplus? It’s much more than they need to stabilize the Yuan’s value. They buy assets of real value: gold, copper, rare earth elements, stocks, real estate, and of course, government bonds, many of them US Treasurys. As long as China’s growth continues to be vigorous, the Chinese economy will draw in more and more outside capital. The lion’s share of the world’s Foreign Direct Investment is in the Eurozone, but utilized FDI in China has increased 10% a year since 1999, on average.


It’s unclear whether China’s goal can succeed. But they seem to be pursuing it with some vigor, and if they cannot be the world’s reserve currency, they can at least be part of a few key currencies, finally accepted as a great industrialized power. It seems increasingly clear that the US dollar will lose its spot on that list, particularly with the recent decision to commit even more troops to Afghanistan, which will add billions to the US fiscal hole.

A Very Interesting Animation: Empires Decline

Look at this fascinating visualization of the decline of the great imperial powers of the 19th and 20th centuries. Who might be next, I wonder?

Visualizing empires decline from Pedro M Cruz on Vimeo.

Holiday Spending and the Fed

The veil of illusion that says the dollar has value is being torn away.


Last week’s “Saturday Night Live” had an actor playing President Obama giving a press conference with an actor playing China’s President Hu Jintao, who repeatedly reminded Obama that the US owes China a lot of money. At one point, Hu asks, “Do I look like Mrs. Obama?”, answering the question soon after with: “Then why you try to make sex with me like I was Mrs. Obama!”


Some things can be said in a joke that can’t be said with a straight face.

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Imagine telling someone back in 1989 that in twenty years China would be the world’s emerging power, and the US would be running to China to ask for more money to plug its enormous deficits, while reassuring China that its money is secure, and politely asking China to respect copyright rules and ensure free internet access (which China will politely ignore).


So where will we be in twenty years from now? The dollar will be discredited, a shell of its previous value, no longer a reserve asset. The world will want currencies backed with real assets, not fiat paper which can be printed at will with the touch of a keystroke.


In the US, anger is rising about the massive financial bailouts engineered by the Fed and the Treasury, which so far have not caused any reduction in unemployment or real economic stimulus. Perhaps this sentiment is why Rep. Ron Paul’s amendment to audit the Fed has passed a vote in committee and is gathering support in both houses of Congress. In a surprise move, Rep Barney Frank delayed a vote on the bill until after the Thanksgiving recess.


Why does the Fed oppose being audited so vociferously? Bernanke says he doesn’t want the Fed to be too influenced by short-term politics, but it’s hard to see how the current veil of secrecy prevents politics from entering into the Fed’s deliberations. The country ought to know what the Fed is doing (or was doing, as the bill calls for the release of information only with a 6 month lag).


Early reports on Black Friday, the largest single shopping day in the US, indicate a very small increase in spending over last year of 0.5%. Strangely enough, articles on Black Friday never seem to adjust sales figures for inflation. Given that the CPI rose 0.5% in the last two months, it’s more accurate to say that spending is flat or declining in real terms. We’ll have more details on the numbers in a few days, but the trend toward more frugal spending is still in force. Even if an increase is recorded, we have to keep in mind that retailers are offering massive discounts, which may pull sales to Black Friday at the expense of other days. We’d also do well to recall what products are being discounted: mostly electronics, which are rarely produced in the US. Increases in retail spending on imported goods puts the US economy in a deeper hole. We need to come to balance, and that won’t happen because of an unsustainable surge in retail spending, but rather will be due to growth in the productive sectors of the economy.

What Exactly Would a Stronger Yuan Do for the US Economy?

Obama’s trip to China was mostly photo-ops and talk about the importance of trade. The one topic on which Obama spoke sharply was the need for China to allow the Yuan (officially called the Renmimbi) to strengthen against the dollar. Many analysts are criticizing the Chinese government for ‘manipulating’ the Yuan, keeping it too low relative to other Asian currencies. Paul Krugman, perhaps the best-known economist in the US, calls it ‘outrageous’, and accuses China of making its export-oriented neighbors poorer through unfair currency manipulation. Leaving aside the obvious point that all currencies are manipulated—in a world of fiat currencies, no item of intrinsic value stands behind the dollar or the Yuan—let’s explore the question of how the US might benefit from an strengthening of the Yuan.


Back in 2005, the World Bank estimated the Yuan to be undervalued by 10%, based on purchasing power parity. Other economic analyses have concluded an undervaluation of 20 to 25%. Let’s take the upper end of the these estimates and assume the Yuan is undervalued by 25%, and that China, acting for the good of the world, allows the Yuan to appreciate 25% against the dollar. What would that do for the US economy?


The most obvious and immediate effect would be an increase in prices. Consumer price theory tells us that that increases in exogenous costs such as tariffs are not fully reflected in final prices, but the cost is shared by producer and consumer depending on the elasticity of demand. The increase in prices directly translates into increased prices for consumer goods, for apparel, electronic goods, raw materials, food items, etc. It’s hard to see how that rise in prices would benefit American households, who are feeling the effects of 10.2% unemployment and falling home prices. It’s more likely that increased consumer prices would bring significant hardship.


In theory, an appreciation of the Yuan should narrow the trade deficit between the US and China. But it’s likely that the trade deficit won’t fall much (if at all), because consumers driven by low prices are likely to select goods from other low cost producers (Thailand, South Korea, the Phillipines, or India, for example).


Would an appreciation of the Yuan cause an increase in American employment? It’s hard to see how. There aren’t many US industries that are in direct price competition with Chinese exporters. Overall, the US economy is in a process of shifting back toward productive activity (including manufacturing), but such a shift is the product of many structural economic forces, not simply the relative value of the Yuan and the dollar.


As Obama urged China to allow the Yuan appreciate, Zhou Xiaochuan, the head of China’s central bank, fired back that the US needs to get its fiscal deficits under control and raise interest rates. Zhou is clearly correct that currency manipulation (in whatever direction) cannot help the US economy out of its malaise. Only fundamental economic changes can do that. But cutting the deficit in this economy will require massive spending cuts, while raising interest rates will cut off the monetary stimulus, no doubt deepening the recession.

If only it were as easy as blaming China.

Cash-for-clunkers, Dollars-for-dishwashers, and Other Government Consumption Stimulus Ideas

The news of the week is rising auto sales in the US, stimulated by the Federal program called ‘cash-for-clunkers’ where you trade in fuel-inefficient car for a more efficient one, and get thousands of dollars from the government. The program has been such a ‘success’ that it has made lawmakers think of other possible ways to stimulate consumer spending, such as the dollars-for-dishwashers program, which gives $300 mil in federal rebates for new appliance purchases. Of course, a larger version of this same theme is the new-home purchase credit. All these efforts are attempts to stimulate consumer spending, and all go in exactly the wrong direction.

Why should we be trying to stimulate consumption? We ought to be attempting to stimulate saving and investment, for these are the keys to long-term prosperity. Perhaps the most pernicious economic fallacy is revealed in the oft-repeated phrase: ‘consumption spending is the driver of the economy’. Before one can consume, one must produce. The best way to stimulate production would be to allow market competition to determine interest rates, and to eschew the pro-cyclical tendencies and distortions of fractional reserve banking. During the Panic of 2008, money destruction took place even as the Fed cut interest rates, because banks restricted their lending faster than the Fed created liquidity.

Banks had good reason to restrict lending; they were over-exposed to bad loans, their balance sheets crammed with assets of dubious value. Bank reserves shot from $44 bil to $800 bil in a year, going from less than 1% of deposits to over 10%. At the same time, lending fell (although there was massive borrowing from the Fed by banks to increase their reserves).

All parties in the economy, from the government, to corporations, to households, must reduce their debt, or ‘de-leverage’. Consumers see the wisdom in this, recognizing the frailty of their situation when they live paycheck-to-paycheck, without any cushion of savings, while debts steadily mount. The government cannot reverse the process of de-leveraging. When it tries, it loses credibility. We still remember the spectacle of Fed chairman Alan Greenspan urging consumers to take on adjustable rate mortgages. The best that can be done is to allow de-leveraging to proceed swiftly. And let’s look on the bright side; while many businesses will fail, most will survive, and they will be stronger for it, because the market, given time, rewards prudence at the same time as it punishes foolish risks.

Gold Prices Continue to Climb

So far in 2009, the S&P 500 is up 21%, while gold is up nearly 25%. Gold and stocks have been moving in tandem for much of the year, an unusual situation, to say the least.

The rising stock market has been one of the few bright spots of the economy. While it’s difficult to say what causes short-term movements in stock prices, the year’s increases in the stock market is probably not connected to the performance of the economy, actual or perceived.

I say this because the rally has not been driven by outside events. At the low of the market, in March 9, 2009, the sentiment was bleak. Analysts who had previously been known as solid bulls began to say, “the sky is falling!” News since then has been solidly bad, with continuing job losses, rising unemployment, trade deficits, budget deficits, and a rising disillusionment with the Obama Administration. Now sentiment has reversed; everywhere the talk is of green shoots and growth; all experts agree: the recession is over. They point to the performance of the stock market and the recent rise in GDP (mostly driven by debt-funded government consumption).

It seems more likely that the rally is a correction of the long slide in stock prices that took the Dow down 7500 points over a period of about 17 months. The nature of markets is action and reaction, movement followed by countervailing movement. The stock rally of 2009 is simply a long counter-movement, where the market recoups a portion of its losses. The general rule to look for is a counter-movement of 50%, though it may be as large as 75%. The former has basically been achieved. That means extreme caution is warranted about future market moves. Indeed, it seems to me that the sentiment has become so uniformly bullish that the only possibility is a sharp downward movement, even an eventual violation of the lows of March 2009. This possibility is not driven by sentiment alone, but by the fundamentals of a weak economy coupled with the multiple threats to the dollar’s reserve currency status.

Right now it seems unthinkable to nearly all observers that the dollar could be displaced. That alone should give us pause. The last two years have been a time when most observers have been disastrously wrong. Most did not foresee the crash of October 2008. Most did not foresee the rapid downturn of February 2009, nor the rally that began in March. Early in 2009, when oil prices dove to below $40, most analysts predicted they would stay there; instead, they doubled within the year, in the face of worsening economic deterioration.

Yet India’s purchase of 200 tonnes of gold from the IMF at near-record prices shows that nations are increasingly distrustful of the dollar. Individual investors should take note.

Where are all the posts?

Well, my writing activity has really fallen off over the last few months. But I have been writing for the Borsen-Kourier, just not posting it on the blog. I know, very lazy... so what I'm going to do is go backwards, and post the articles I've written over the last couple of months on the day I wrote them. (I won't make any changes to make myself look more prescient!)

US GDP Swings to Growth

For the first time during this recession, US GDP is registering solid growth of 3.5% for Q3 of 2009.

Declining businesses inventories played a large role, but much of the growth was caused by increases in consumption spending: 40% of the increase in consumption was cars, driven by the cash-for-clunkers program, and another big slice was new home construction, driven by the $8,000 first time home buyer credit.

Those of us who were skeptical about these Federal programs to prop up consumption, may now be shown the rising GDP numbers as proof that these kind of government actions work. Well, yes, they work. But at what cost, and for how long? When the government borrows in order to give money to home buyers and car buyers, not only is that a dubious redistribution of resources, it causes a distortion in prices and in perceived demand. It causes sales from the future to happen in the present, inflating both automakers’ view of demand for cars and homebuilders’ view of demand for new homes.

It’s painfully obvious that the government cannot keep borrowing in order to funnel money toward consumption. When it ceases to do so, growth will fall, perhaps to negative territory.

Federal spending was up sharply, though state and local spending fell, due to declining revenues. States have a budget constraint that the Federal government doesn’t have.

Though the weakness in the dollar pushed up exports by 14.7%, imports increased by 16.4%, underscoring Americans’ addiction to low-priced foreign goods. The tendency to buy imports is true for cars as well as clothing and electronics: an often-overlooked feature of cash-for-clunkers was the fact that people often bought Hondas and Toyotas, which helps to stimulate Japan’s economy more than the US (with the exception of those Hondas and Toyotas produced in the US).

The Obama Administration claims the $160 billion that has been spent (of the $787 billion stimulus bill) has created or saved 640,329 jobs. Do the math: that’s $249,000 per job. That seems a bit expensive to me. For that price, we could’ve given 3.2 million Americans $50,000. Of course, the number of jobs ‘created or saved’ is already a bit dubious. Could it be that the government agencies who received stimulus funds had an incentive to say more jobs were ‘saved’ then actually was the case, to secure future stimulus funding? The Bureau of Labor Statistics doesn’t have a category for jobs saved, but it does have a category for net job creation, which has been massively negative for nearly 2 years, adding up to a total number of jobs lost of over 7.2 million. Given that the Bush administration also did a stimulus of $170 bil in Feb 2008, if $330 bil gives us only 640,329 jobs, how much would have to be spent to give us 7.2 million jobs? The answer is a staggering $3.6 trillion.

The reality is that the massive stimulus efforts have produced only small numbers of jobs, which have been swamped by the restructuring occurring throughout the economy. But such restructuring is necessary and unavoidable, and should be allowed to happen quickly rather than being dragged out through massive government consumption schemes.

Downsizing and Consolidation

The American household continues the path of downsizing and consolidation. Electricity usage, which hardly ever declines, has fallen 2.3% in the US since August 2008, reflecting mostly the decrease in industrial output.

Rents have been dropping, as vacancy rates rise. This is perhaps an odd finding: shouldn’t the tightening of credit mean fewer people can buy homes, channeling more demand into the rental market? Similarly, shouldn’t rising foreclosures push more people into the rental market? It seems that these forces were overwhelmed by the drop in household income caused by the recession, and the resultant tendency to live more frugally.

Some condo developers expected the baby boomer generation to consolidate and move to smaller spaces in urban centers as they retired, but because home prices fell, they haven’t really done so. They can’t sell their homes at the price they think the homes are worth. There hasn’t been a movement away from suburbs en masse (in fact, there isn’t much moving at all: moving rates are the lowest they’ve been since 1948, when the Census Bureau began tracking them) though the preference for smaller homes seems to be increasing over the last 2 years. But that is probably a counter-reaction to the excesses of enormous McMansions, with their costly heating and electricity bills.

One hot trend is the tiny home. Several home builders are bucking the trend and moving toward very small homes. Often modular or mounted on trailers, tiny homes are less than 300 sq ft. People are going small for financial reasons, but also because of concerns over the environment and the impact of consumption. Large homes seem to engender large collections of things.

How does all this saving and decreased consumption affect the economy?

Keynes called it ‘the paradox of thrift’. Though saving is good for individuals, it can be bad for society, because it moves society to an equilibrium of lower spending, which Keynes considered the driver of economic growth. Here is where I part ways with Mr Keynes. Investment is the driver of economic growth, not spending, and higher rates of savings allow us to achieve higher rates of investment. But that won’t happen until businesses clean up their balance sheets and eliminate debt. That process will require some inefficient and overleveraged firms to enter bankruptcy. The sooner they do so, the quicker they can emerge and the sooner the economy can recover.

Individuals are curtailing their spending because that seems the smart thing to do, given the circumstances. My guess is that we’ll find a silver lining in this, for even though consumption is likely to grow more slowly in the coming years, we may be taking a path that is more sustainable.

The 'Soft Budget Constraint' Hardens

The fate of the US empire depends on access to debt and the ability to service the existing debt burden at low rates. We could’ve chosen a different path. During the 2000 election, Al Gore spoke of paying down the entire public debt. Perhaps things may have gone a different way in the absence of the Bush/Cheney bloodless coup of 2000.

But now we seem to be committed to sky-high deficits, despite recent talk of health care being ‘deficit neutral’ and plans for reducing the deficit. Even the tough talk hints at the reality: we speak of reducing the deficit, not eliminating it, not running a surplus, not reducing the total debt outstanding. The only thing that qualifies as a plan is to increase the debt at a slightly slower rate than the economy expands, so that the debt burden becomes smaller in relative terms, while growing in absolute terms. The economist James K. Galbraith calls it a ‘soft budget constraint’. But how long can it remain soft?

The Fed has poured money into the US Treasury market, a practice called ‘monetizing debt’; this has made Treasury yields fall across the board. That makes the debt easier to service, but if taken too far, it makes US Treasurys unattractive relative to other investment-grade debt.

Fed chair Ben Bernanke criticizes China for having a ‘savings glut’. While they have been spending more, he warns them, don’t save too much! America, with the exception of government, is not following his advice. Americans have gone from being like the fabled grasshopper who fiddles all day long to the ant who works and saves. (If only finding steady work was that easy. There are now six job seekers for every available job.) A new culture of frugality is spreading to every corner of American society. Americans are planting vegetable gardens, learning to preserve food by home canning, even raising chickens. (Not that the average American is doing all this, but things spread from the leading edge to the center) Fashion designers are bringing out new looks inspired by the 1930s, as designers and artists embrace the new ‘rough luxe’ aesthetic, elevating old, vintage, weathered, used objects.

There is a lot of talk about recovery, but state unemployment figures for September indicate that payroll unemployment declined in 43 states. Pressure is beginning to mount on the Fed to raise rates. A recent Barron’s cover story argues that the Fed should raise the interbank lending rate from 0% to 2%. If the Fed does raise rates, we’ll see how strong the recovery truly is. If that rate increase takes place while states continue to trim spending, residential foreclosures continue to escalate, followed by increases in commercial foreclosures, that looks like the making of the return of the credit crunch of 2008, and the double-dip recession of 2010.

War and Peace

Obama’s surprise Nobel peace prize has caused a reality rift in the US; On the right, Peggy Noonan writes that the Nobel peace prize has always been “an award by liberals for liberals”. She can’t believe Reagan didn’t get one. Yeah, Reagan. The guy who called the Soviet Union “the evil empire” and pushed for the star wars program to militarize space. Bret Stephens wants to give one to Harry Truman. You know, the guy who killed 300,000 civilians by dropping the bomb on Hiroshima and Nagasaki. No serious historian puts forth the claim that this barbarous act was necessary to get Japan to surrender. On the left, Howard Zinn asks, how can you give a Nobel peace prize to a man who’s continued two disastrous wars?

Meanwhile, Australia’s central bank has reversed the course of slashing rates to raise their overnight loan rate by a quarter point. Glenn Stevens, Australia’s chief central banker, warns of the danger of being ‘too timid’ in raising rates. Australia, it seems, wants to avoid the pitfall of being the world’s carry trade sop. Could that award be coming the US? If so, the strategy of borrowing in dollars, then dumping them to buy stocks or bonds in other currencies will weigh on the dollar’s value. The dollar hit a 14-month low recently.

US Fed chief Bernanke and Treasury Secretary Geithner talk of wanting to maintain a ‘strong dollar’ but actions speak louder than words. It seems more plausible that what is wanted is a steadily weakening dollar, which will make the government’s large and escalating debt easier to pay.

The average worker is likely to see continued pain from such a strategy, as wages continue to fall. Colorado has decreased its minimum wage, as their standard is tied to the CPI, and deflation slightly reduced the CPI last year, mostly due to falling oil prices. However, the weaker dollar places pressure on import prices, such as the prices of goods at Wal-mart and other low-cost retailers relied upon by the lowest-paid workers in the US. During a recession, prices and wages tend to fall, but not necessarily by the same amount. However, certain prices are rising again. Oil is now at $75, and gold is over $1060. We could easily see the worst of both worlds, stagnating economy combined with inflation.

The Fed has injected trillions of dollars of money into the economy, in a bid to prevent deflation. But all that money has to go somewhere; so far it seems to have gone into the stock market, and commodities like copper, oil, and gold. It’s hard to believe that the Fed could reverse course anytime soon and start raising rates like Australia. Imagine what a rate increase would do to the still-weak economy. Without one, the dollar will continue to slide.

Maybe the Nobel peace prize should be given to the economy. As the dollar loses value, the US will find it difficult to finance the imperial adventures in Iraq and Afghanistan; at least, that is my hope, though it hasn’t happened yet.

Greed vs Fear

Treasuries and gold are fear investments. Investors have bid up the price of 10-year Treasury bonds, driving down the yield to 3.178%. Fear. Gold has just hit a new high, $1038. More fear. Stocks are a greed investment, and stocks are looking tired, moving sideways after a 7 month rally. As the rally has continued, volume has seen a mild but steady decline.

If Wall Street is torn between greed and fear, what about Main Street? Unemployment continues to rise, hitting 9.8% as of last month. The economy seems to be continuing to shed jobs, albeit at a slower pace. Incomes are falling, as is the average workweek. More are working part-time when they’d like to have full time jobs. The housing market continues to decline, offering a benefit for some Americans: falling rents. Thousands of condos that cannot be sold, and thousands of homes that were bought by speculators who don’t want to sell at current prices but need cash to pay the mortgage hit the rental market, have pushed rents steadily downward. In addition, people are consolidating, doing with less.

People are even borrowing less. Total consumer credit has declined by 3.6% during this recession. Comparable declines haven’t been seen since 1991. Even with those declines, the consumer remains heavily mired in debt, so it seems reasonable to expect it will take consumers some time to lower their debt levels, as seems to be their preference. Many consumers are saying now that they wouldn’t return to their ‘spend now, pay later’ ways.

Corporations are facing the shock of billions of dollars of worthless assets clogging their balance sheets, or, even worse, these toxic assets are not on the balance sheet, because they are not being valued honestly. New accounting rules have allowed corporations more flexibility in their amortization of gains and losses, i.e., less transparency for investors, meaning more risk. Corporations have been hollowed out by two decades of mergers, acquisitions, restructurings, layoffs, and re-brandings. The CEO and upper management—facing little opposition from the Board of Directors, shareholders, workers, or other stakeholders—have looted the corporation. New models of leadership will be needed for corporations to move forward. I expect the wild executive compensation of the boom years will swiftly fade away.

Meanwhile the various levels of government struggle with massive revenue shortfalls and budget deficits. Most states are cutting spending and raising taxes. The former is good during a recession, the latter, disastrous. Many are following California’s example, turning toward debt to put off their budget problems. In the face of all this, the Federal government considers a health plan that will fine people who don’t have health insurance, and we debate over whether to call this a new tax or not.

In the battle between greed and fear, there is no contest. Indeed, I’ll believe in the recovery when I see some genuine signs that greed has returned.

Price Levels

Everyone’s attention seems to be focused on whether we’ll see deflation or inflation in the US economy (and in the global economy) as we move forward.

On the deflation side, we have the moribund housing market, falling or stagnant consumer spending, along with falling incomes and rising unemployment, and on the inflation side we have truly massive money creation led by the Fed, followed by the Treasury, and finally by the Federal government in the form of federal stimulus packages, all on borrowed money.

Which of these two forces will prove to be more powerful?

I live in San Francisco, one of the more expensive urban centers in the country. In my neighborhood, I see flyers posted that say “One Hour Massage, $40”. It caught my attention because I think that price is half to a third the price you would have paid two years ago. Basic economics: if goods and services won’t sell at a given price, then the price will fall.

The bond market may provide us with a clue, as bond investors are highly concerned about inflation. The yield on the bellwether 10-yr US Treasury bond has been dropping rapidly. Since mid August, the yield has fallen from 3.8% to close below 3.2%. This may mean that bond investors are taking a stand on deflation, but it may also mean that investors see the rally in the stock market ending soon, and they’re getting back into Treasuries for a safe haven. The surge in gold prices to close above $1,000 for six days seems to lend support to the safe haven thesis, but it also could support the inflation thesis.

Oil and copper are also important signals to the strength of the global economy. Both seem indecisive after strong gains this year. The same can be said for the CRB commodities index, which is up 25% from its low this year, recorded back in March.

Given all this indecision, we may see a bifurcation, with certain commodities and services rising while others fall. We await, with bated breath, the next round of economic developments. The latest labor market data indicate that the US economy shed 263,000 jobs last month, for a total of about 7.2 million jobs lost so far during this recession. That is a truly stunning number, made all the more serious when one considers that the economy must create 150,000 jobs or so each month in order to simply keep pace with population growth.

Ambivalence on Health Care

My wife and I had to take our baby girl to the emergency room because she had a high fever, some diarrhea, and we worried she’d get dehydrated. We were there a few hours, during which time she was checked on several times by very conscientious doctors, who spent a total of maybe 30 minutes of total person-hours on her care. The bill? Over $10,000. We have health insurance through my job, but we continue to get seemingly-random requests for co-payment. Every few months it seems they want another $50.

In places like Japan, Canada, and much of Europe, it is thought to be rather curious that Americans have such resistance to universal health insurance coverage. This incident provides a clue as to why it is so. For those lucky enough to have health insurance, the outcome we observe seems pointlessly mediocre. This is the land of customer service. Yet most experiences with health care delivery tend to involve long lines, ample doses of frustration, Byzantine rules and regulations, and a complete lack of alternatives. I thought markets were about free choices and clear prices. Asking how much a medical procedure costs is itself an exercise in futility. It depends on your coverage, because different deals have been made with different parties. Health insurance seems to have wrought a system that is complex and delivers rather poor overall results. There are over 100,000 deaths in American hospitals per year due to infections contracted in those hospitals; experts estimate two-thirds of those deaths could be wiped out by instituting simple procedures involving hygiene, such as hand-washing.

Unbelievable. Can you imagine any other business that is not affected by thousands of needless deaths? If one restaurant has an outbreak of E coli, it gets shut down. But not for hospitals.

I’m not an expert in health care. But it seems to me that the health insurance system effectively shields the industry from the competition in price and quality that every other business faces, to the detriment of consumers, and indeed, to all of us, because the care we get is overpriced and of poor quality. While many helpful people work in health care, people who genuinely care about helping people, the overall experience tends to be poor. When we were in the emergency room, were taken to an uncomfortable, poorly heated, poorly lit facility with little privacy. Nearby are several drug addicts in various stages of overdose. We would much prefer to see a doctor, as our situation is hardly a complex medical issue, just a simple matter that could be handled by a general practitioner, even a nurse, and an IV. But it’s pretty hard to see a doctor on the weekend, so one is left with the ER.

Where this all leaves me personally is with the same ambivalent attitude toward health insurance that I think is shared by many other Americans. I’m very thankful that the system is there for me if I were to have a truly catastrophic accident. But in almost every interaction I’ve had with it, I’ve been left with the feeling that there’s got to be a better way. While I don’t know exactly what that way is, it seems clear that the insurance system that we have isn’t working very well, even for those that have good insurance plans. So while I support Obama’s plan, and indeed it seems to be the outcome of a thoughtful analysis by a person who cares deeply about the country, I doubt that it will give us high-quality health care at an affordable price.

Stimulus Blues

I recently had the opportunity to take an unoffical poll of my economist colleagues a the City College of San Francisco, where I teach. One of the areas of very strong agreement was that the US dollar is the most serious risk to the US economy (there was one dissenter out of six economists). The other area of agreement was that the US needs another stimulus, on the order of $500 billion. Here, I was the lone dissenter. (Several of my colleagues didn’t feel another stimulus was politically feasible; I don’t think another stimulus is desirable economically.)

My colleagues are in good company; Paul Krugman, the 2008 Nobel prize-winner in economics has called for a second stimulus, as has Robert Reich and many others. A majority of economists were in favor of the first stimulus, though there were also some prominent dissenters. I think the views of economists tend to mesh with the conventional wisdom that the government has to do something.

The problem is that doing something is rarely a good substitute for doing the right thing.

Economics has largely scrapped the distinction between necessary and surplus value; necessary value is the portion of value that reproduces the capital and labor that went into producing a good or service, while surplus value is the additional value of the product above the cost of production. Without this key distinction, it becomes impossible to distinguish between economic activities which are productive (directly produce surplus value) and unproductive (those that do not); we’re left with only GDP numbers, without a notion of where the value flows came from.

To try to increase GDP without considering whether we’re increasing productive or unproductive economic activity is dangerous in an economy like the US, where unproductive activity has been steadily rising over the last 60 years. This rise has been financed by growing debt and capital inflows to the US economy, but as these flows slow, unproductive activity becomes less and less viable. To put it simply, the future of the US economy is in agriculture and manufacturing, not in finance, retail, or advertising. While there will always be a place for finance and other unproductive activities in the economy, it must be recalled that government is also an unproductive activity. As government spending increases, it absorbs a greater portion of the economy’s total surplus, at the very moment when that surplus is most needed to restructure, innovate, and re-invest. That is a recipe for a lingering malaise, such as what Japan experienced in the 1990s.

This is the time for government to cut back, do less and spend less, to balance the budget, and to trim taxes. In short, the government should take the advice given to a man in a small pond, thrashing about in an effort to make the muddy water clear:

Be still; it will happen best on its own.

The IMF Unravels the Global Monetary Order

On August 28^th, the International Monetary Fund quietly made history.

The IMF was a product of the Bretton Woods summit of economists that created the post-war global monetary order of the same name. The IMF was envisioned as a global central bank, that would act as a lender of last resort to countries facing balance-of-payments crises. The IMF has traditionally lent by raising funds among the wealthy nations, but in 1969 it created a special kind of currency, called the Special Drawing Right. SDRs aren’t used as a means of payment anywhere in the world; SDRs are used as an accounting device between countries for international settlements. Perhaps SDRs were created in the hope that one day the IMF may be able to issue its own fiat currency, a step toward a global ‘super-currency’. If so, that day has arrived.

The IMF announced on August 28^th that it would create $283 bil worth of SDRs, and distribute them to member countries. I know of no other instance of fiat currency being issued by a non-governmental organization that has no economy behind it. Countries can exchange their SDRs for one of the four hard currencies that underlie the SDR’s value (the US dollar, the pound sterling, the euro, and the yen). The US will receive one-sixth of the new SDRs, worth about $47 bil. Small change next to the magnitude of the deficits, but every billion helps.

What’s the game here? The US desperately needs to fill the hole caused by continuing trade and budget deficits and is increasingly sensitive to the criticism (made by many world leaders and central bankers) that it plans to do so by printing dollars. Could this be a sneaky move where the US receives the benefit of free money but sticks the IMF with the bill? It won’t work, of course, as global markets will simply respond by increasing prices. Increasing the money supply without increasing the supply of goods will always create inflation.

The global recession was caused by reckless money creation, which inflated the value of assets from stocks to commodities to real estate, while encouraging astounding degrees of leverage. The financial house of cards was simply not built to last, and pumping more fake money into the deflating credit bubble won’t work. Debt leverage isn’t available like it was in the past, and even if it were, a more important illusion has been punctured, namely that all this risk was essentially free. Risk always comes with a price tag, and the sooner that price is accurate, the better for the global economy.

Important Article on the Global Monetary Order

Take a minute and read this important article by Paul Nathan on the changing role of the IMF's fake currency, the SDR, or special drawing rights.

I'll have more to say on this article shortly.

Is Inflation Coming Soon?

Most economists will tell you that there’s a tradeoff between inflation and unemployment (called the Phillips Curve), making it unlikely that a high unemployment economy generates unemployment. Well, expect to see the unlikely happen soon.

Here’s a chart of monthly inflation, as measured by the Consumer Price Index, since 2007:

The Federal Reserve is waging war against deflation, funnelling trillions of new dollars into the financial system in an attempt to defeat deflation.

The Fed will win; in fact, they’re already winning. Inflation has simply been channeled into the stock market. Oil has doubled in price. Gold has recovered from its low of the fall of 2008, when it dipped below $700, and is currently pushing $950. These are early signs of inflation.

An interesting feature of the CPI is that it’s not designed to measure changes in the cost of living. It’s designed to provide a measure of how much money it takes to maintain a constant level of satisfaction. That means the Bureau of Labor Statistics must do a very difficult thing: instead of merely measuring prices, they must measure our satisfaction. They do this by imputing value to technological changes, and by using sophisticated averaging techniques which attempt to measure how consumers make substitutions between products in response to price changes. The outcome of this fancy guessing-game is the most widely-quoted measure of inflation in the US, but CPI has little to do with what most think the CPI measures.

My guess is that we’re already seeing the kind of inflation that the Fed so fears: consumer price inflation. Prices ought to fall during a recession, and some have. But I think prices have not fallen as much as they should, given the extreme weakness in consumer demand. If the effect of money creation is the prevention of falling prices, that’s inflation, it just doesn’t look like it when we look at the CPI.

It’s clear that the Federal government would prefer inflation to deflation. With the ten-year deficit now officially projected to add $9 tril to the public debt (which would bring it above $20 tril), some inflation sure makes the interest easier to pay in depreciated dollars. I wonder if the American consumer will go along for this ride. Sure, inflation will probably kill your real wages, but it can also zap the value of your debts. Perhaps the average American won’t complain too much if inflation begins to roar. Much depends of what happens to the unemployment numbers as we move forward.

Unemployment in the US

I’ve got a friend who has been unemployed for a year. She has a PhD in archaeology, and experience in both non-profit and for-profit organizations. A graduate degree tends to insulate one against unemployment; for many years the rate of unemployment for those with master’s degrees and higher was less than a third that of the rate for those with only a high school education. But this recession doesn’t spare the educated. Though the disparity between unemployment rates by educational attainment is still large, the recession has narrowed it.

California’s unemployment rate is pushing 12%. Michigan’s is 15%. (They were 7.3% and 8.3% a year ago). Unemployment rates have skyrocketed in the last year, and though this month’s national rate shows a slight improvement (9.5% to 9.4%), these numbers are still eye-popping.

An interesting feature of the numbers is that the labor force participation rates are also declining for all levels of education, as those who cannot find work become discouraged, or move to another activity, such as school, caregiving, or work in the informal economy. The Bureau of Labor Statistics’ U-6 unemployment rate attempts to capture the effect of people moving out of the labor force (or moving to part-time employment when they’d prefer full-time); the U-6 stands at 16.8%.

And these numbers have been getting steadily worse (or holding more or less steady) since the beginning of 2009. Even the BLS’s narrowest measure, called U-1, those unemployed 15 weeks or longer, is at a frightening 5.1%. That’s truly unreal. Over 5% of the labor force has been unemployed 3¹/₂ months or more. In the face of this, the stock market has rallied 45%.

Why should unemployment be so high? It’s a grave sign that the economy has become sclerosed, and cannot quickly adjust the forces of supply and demand. This is the Great Contraction: you lose your job, you must cut expenses, more people per square foot of real estate, fewer hours spent on leisure. This is still the richest country in the world, with 90% of Americans still working. For the labor market to clear, wage rates would have to fall, and with them, so would the housing market, (both prices and rents would be relentlessly beaten down until they reached a proper proportion to household incomes). Many other prices would also fall. All those overpriced services will cost an awful lot less: think of haircuts, dog walkers, personal shoppers, personal assistants. These services and more will be driven down in price by falling demand and price competition on the supply side, as those remaining in these fields attempt to keep a portion of their sales.

What I’m saying has become anathema to the field of economics, yet it’s a simple truth: falling prices can be healthy for the economy. Yet we’re spending trillions to try to keep inflated prices high. If we simply stay out of the way, markets will clear and prices will find their natural level. Then a truly robust recovery can and will begin.

Economic Medicine and Poison, part 1

The most helpful thing we could possibly do for the economic corpus is to create a sound currency that is linked to a stable banking system.

Right now we have neither, and so we have risks to the economy that are simply unknown. A risk that you don't know is always worse than one you can understand. Will your bank be around tomorrow? This is no longer an idle question.

Creating a stable currency would not be hard. It's a simple matter of pricing, and there is nothing that markets do better than pricing, when they are allowed to function without interference. Take an item of real value, one that cannot be produced by the printing press. Let's say, I don't know, how about the gold standard of money?

Gold has been used as money for 5000 years or more. Let's say we go back to using gold as money. You want to sell something. OK, how many grams of gold would you accept to part with it? You want to buy something. How many grams would you give up to obtain it?

The thing is, we're used to using dollars as our standard. We think, "how many dollars is that worth?", not "how many grams?" Like visitors in another country, we'll be running the numbers through our heads, converting to dollars. At least for a while. Pretty soon we'll get the hang of it.

If we get rid of the risky fractional reserve system (perhaps following this great plan by Kotlikoff and Leamer), then we have the absolute best basis for economic prosperity. Systematic inflation becomes impossible. And deflation has no power to wreak economic havoc. Deflation becomes your friend, because deflation is simply falling prices. We only associate deflation with the end of the world because deflation has typically occurred only at the end of a credit bubble, as the harbinger of deep recession, bringing with it financial panic and high unemployment.

The problem is how the stable currency would interact with the dollar. The dollar decays like a radioactive isotope. A stable currency operating in parallel with the dollar would instantly reveal what a poor currency the dollar really is. Fewer assets would be held in dollars, and fewer transactions would be made in dollars. Both would cause a reduction in the demand for dollars, and a depreciation in the value of the dollar. Perhaps that would be viewed as an "attack" on the dollar. It's not an attack to remove lipstick from a pig. (My apologies to Mrs. Palin.)

The dollar is worth about what the paper it's printed on is worth, and to put it next to a commodity with real value simply reveals that truth.

What Will It Take to Pay Off the Federal Debt of the US?

The US is awash in debt on every level: Federal, state, local, as well as households and businesses. But for the private part of the economy, there is a different consequence for bankruptcy than for the public side. If a private individual or business goes under and fails to pay their bills, the creditors lose money, of course. But when a government goes under, it tends to go under in a way that inevitably affects everyone, for it devalues the currency.

Of course no government destroys its own currency with malice aforethought, but the pressures that come to bear on governments are such that destroying the currency seems at the time to be the right thing to do, given other options. Circumstances are already headed in that direction now, and pressure on the dollar continues to build in the face of rapidly expanding Federal debt.

The current Federal debt is $11,659 bil, and with the stimulus and other unfunded expansions in Federal spending, it’s widely believed to expand by at least another $1,800 bil in the next year alone, and to nearly double in ten years. It’s an open question as to how the Federal government expects to get the funding for that level of debt, as our foreign creditors are already reducing their purchases and seeking to ‘diversify’ their assets. China is inking trade agreements with Brazil and Argentina to conduct trade in the Renmimbi rather than in dollars. China is also channeling more of its massive currency hoard into durable commodities like copper, gold, and oil. Every day it seems, the discussion of the status of the dollar becomes a bit more open, a bit more honest, as countries seem to feel increasingly free to point out that the dollar’s days as the reserve currency of the world are numbered. Dollar-denominated Treasury debt is like a game of musical chairs: in the end, not everyone will get a seat.

In the past, the US has relied on economic growth to reduce its debt. Is that possible now? Total Federal government revenue was $2,554 bil in 2008. Let’s say that average rates of US growth resume immediately (3% per year) and continue indefinitely. Say that Federal revenue increases at the same pace. Say we immediately run surpluses, so that we can pay the interest on the debt plus an additional 1% of Federal revenue to pay the principle. (In 2008, that combination would cost $451 bil in interest plus $25 bil in principle, instead of the $458 bil deficit that actually occurred). Even with these rosy assumptions, it would take about 90 years to pay back the debt. Ninety years of solid economic growth and perfectly balanced budgets (plus the 1% surplus). No government on earth has such a record. (This analysis doesn’t include all the unseen obligations the US government has, such as Social security and Medicare, which add up to trillions more).

It seems likely that at some point, the United States’ largest creditors will demand repayment in some other form than dollars. Perhaps they would demand payment in their own currency, but that seems unlikely. The traditional asset for international settlements is gold, so gold is the most likely candidate, especially given that our two largest creditors, China and Japan, have relatively low gold reserves, while the US has the largest gold hoard in the world.

Let’s consider what would happen if the debt would have to be paid off in gold. According to the US Treasury (www.fms.treas.gov), the US government is in possession of 261,498,899 Troy ounces (8,133 tonnes) of gold, which at a gold price of $964, is worth $252 bil. The US gold stock is unaudited, and since it is also routinely leased to other parties, how much of it is owned free and clear by the government is unclear. The way that gold is leased is through a kind of repurchase agreement called a gold swap, which gives the US Treasury cash in exchange for a firm commitment to buy back the gold at a specified point in the future. For example, Goldman Sachs may give the US Treasury $1 bil today, using the gold as collateral, to receive $1.05 bil in one year, whereupon the gold reverts to the Treasury’s possession, though the gold has never left the vault. While 5% isn’t a great return, I’d say that Goldman can use the contract as an asset, since it’s backed by gold and the full faith of the US Treasury, which allows Goldman to obtain a risk-free return on the $1 bil, and still put the money to work in other ways to obtain returns.

The Gold Anti-Trust Action Committee (GATA) has estimated that the total amount of gold that is leased through gold swaps is between 12,000 and 15,000 tonnes, about half the total of all gold held by central banks. Individual nations don’t publish the extent of their gold swaps, but let’s say that half of the US Treasury’s gold has been leased, meaning that the gold is no longer an asset, but rather an obligation. If the Treasury really owns just half the gold in its possession, then it has about 131 mil Troy ounces of gold, worth $126 bil.

Now let’s imagine that a few of the large holders of US Treasury debt were to demand that the debt be repaid in gold rather than in dollars. The US Treasury holds its gold at a book value of $42.222 per Troy ounce, rather far below market prices. (If only one could buy a few ounces at that price!) Say that China and Japan (which own $1,477 bil) demand repayment in gold. Of course, these countries wouldn’t be so unreasonable as to ask for all the money all at once; let’s say they simply stop buying new debt, and ask for the interest on the debt outstanding to be paid in gold. If any large buyers were to stop or even slow their buying, yields would rise. Let’s say the yield rises only to the historical mean of about 6.5% (an event like this would probably push the yield far higher). At that yield, the interest would come to $96 bil a year, which would quickly drain the US Treasury’s entire gold stock. In fact, it would be gone in less than 18 months. If China and Japan started asking for gold, other countries would no doubt follow, as would large domestic holders, both institutional and individual. If the entire interest bill had to be paid in gold, it would come to $63 bil per month, and the Treasury would be out of gold in two months.

Now if there are no new buyers for Treasury debt, either the Federal government must immediately balance the budget, which seems unlikely, to put it mildly. More likely the Fed will step in and buy the debt directly, with money it conjures out of thin air. This leads to further depreciation of the dollar against gold, and would probably lead to a lot more demands for payment in gold, as creditors realize that their dollars will get less gold than before.

So we can’t grow our way out, and we can’t fall back on gold. The only other possible avenue is to depreciate the dollar. But how much depreciation would it take to reach the equilibrium that markets demand? If the situation arises where gold is sought for repayment rather than dollars, the question is, at what price? The US government will have give up the accounting fiction that the gold is worth $42.22 an ounce, and set an exchange rate between the dollar and gold. The rate chosen will not be below the market price, it will be well above the market price. How high is anyone’s guess—I’ll say $10,000 an ounce just to get the guessing started. This option allows the US to service its debt without the humiliation of an outright default, though it will still probably result in chaos, just as it did when the US last tried it, in 1933. It also creates a de facto gold standard. With gold at $10,000, the Treasury’s gold is worth $1,310 bil, and can now be used to pay the interest on the debt!

Where things go next is hard to foresee. But it’s clear that the debt is far too large to pay off, and that the United States’ creditors will demand payment in an asset that the US government can’t depreciate at will. The signal to investors is pretty clear: get out of Treasury debt and into gold. One way or another, the US will repudiate its debt. The other lesson is equally clear: the inevitable depreciation of the dollar simply follows the logic of the market, and cannot be denied by either money creation or fiscal stimulus.

The Rally Continues!

Well, I went on vacation and that market made a fool out of me while my back was turned!

Far from the rally running out of steam, as I predicted (here and here) the rally merely paused, then continued steeply upward, revitalizing the talk of recovery and green shoots.

Gold has gone back to tracking the market, and has also done well, as has oil. This makes me wonder if the surging stock market isn't really an early sign of inflation. This is what can happen in financial markets - they act as a canary in a coal mine, sending off inflationary signals well before consumer prices are affected. But these signals are hard to read. We generally think a rising market is good, and it carries us along in a bullish daze. Even my phrase "done well" to indicate "rising price" is a sign of the positive spin we put on it.

But I wonder what the market is up to. All that money the Fed created has to go somewhere. A lot of money is still on the sidelines, waiting to get back in. Barron's asked recently, should you get in or get out? Could this be the time that the Dow chooses to get back above 10k, even claim 11k?

I do not believe that the worst is over. The economic restructuring that is inevitable has barely begun. But a rising market has a way of making us all feel better. The sooner we face the need to restore the balance between productive and unproductive labor, the better. We need to shake out the debt, and we need a sound currency under the dollar, which is sadly and hideously overvalued.

This Ain't Your Grandma's Statistics!

An interesting article in the NY Times about career opportunities in statistics. Getting a doctorate in stats can bag you a starting job pulling down $125k. Statisticians are the new rock stars at Google and Yahoo.

Getting to the Source of Systemic Risk

Recent articles on the US and world economic crisis have often been focused on the concept of ‘systemic risk’. For example, Robert Pozen, author of Too Big to Save?, argues in The Wall Street Journal (7/9/09) that the Federal Reserve ought to be given the job of monitoring systemic risk. What this refers to is certain kinds of financial ‘products’ and practices that have often graced the headlines of late: credit default swaps, collateralized debt obligations, and other kinds of credit derivatives.

The idea that the financial crisis has been caused by exotic new financial instruments—from credit derivatives to adjustable rate mortgages—has become part of the conventional wisdom. But is it true?

No doubt there is always a tendency to find fault in new practices that seem to be responsible for disasters, such as humbling the titans of finance with billions of dollars of losses, charmingly called ‘write-downs’. But how does that lead to systemic risk? If a large corporation (financial or otherwise) loses billions or even hundreds of billions, how does that threaten the system as a whole? Well, corporations often owe money to other corporations, and perhaps if a large lender goes under, other firms are placed at risk. That does indeed sound bad. But how is it different from the usual course of events? Companies rise and fall. Taking risks can lead to success or failure. When an idea leads to a failure, that strategy tends to be repeated less than those that are successful. A failure, even a large one, poses no threat to the system. Failures are an integral part of the system. Even the largest corporations are subject to market forces. And thank goodness for that. Big corporations must be exquisitely sensitive to quality and reputation, or else they are at risk of losing market share and potential takeover.

In the same way that nature rewards certain kinds of risks and penalizes others—successful strategies lead to greater propagation of a species—an evolutionary market-based process is the best enforcer of risk. The Fed or any regulator will always be 10 steps behind. Even if the government regulator happens to be on time, what should the penalty be? Will such penalties be subject to political forces—such as those that determined that Lehman should fail while Bear Stearns or AIG is rescued?

The nature of markets is the equalization of risk and return. Risky activities ought to have high returns, while less risky activities yield lower returns. Financial markets are filled with risky products that are hundreds of years old. Short-selling (the practice of borrowing shares in order to buy them back later, hopefully at a lower price) exposes the seller to potentially unlimited risk. Out of-the-money options that are close to expiration are also extremely risky. But these options are priced accordingly, not by government regulators, but by the market.

Yet even when markets are functioning well, it’s true there is a systemic risk lurking. At any moment, banks could collapse, for their reserves are only a tiny fraction of their deposits. Any threat to the banking sector sets off a damaging spiral: bank failure leads to bank runs, leading to loss of faith in banks, leading to further contraction in lending and paralyzing the conduit that runs from savings to investment.

This is why economists Kotlikoff and Leamer argue for a new financial architecture, one that does away with this source of systemic risk once and for all, while channelling society’s savings into investment, and providing prices for financial assets that correctly equalize risk and return. (See “A Banking System We Can Trust”, Forbes, 4/23/09). Their brilliant proposal would essentially to do away with the fractional reserve system. Unfortunately, this proposal has received little attention or discussion in the US. I get the sense we’re sick of the topic here. We’d rather believe in the green shoots that are supposedly sprouting. They say ‘less bad’ is the new ‘good’. My guess is that as the rally fades and new risks to the system are revealed, there will be an surge of interest in reforming the fractional reserve banking system, the source of systemic risk to the economy.

Gold Correction

Gold is one of the few assets in the world which is in a primary bull market, meaning that the asset is rising overall, despite periods of downward movement. We're in one such period now, which is going to act as a brake on all gold-related assets, including mining stocks like Seabridge Gold SA which I've recommended.

I still think the stock is a long term win, but I must say that it's likely it will go into correction mode (in fact, it already has fallen $6 or so from its recent peak, a 20% decline). Those with a short-term frame may think about selling, even at a loss, in order to get back at a lower price.

Since I expect the overall market to begin another period of decline, I like a stock that will move inversely to the market, like DXD. (Remember, DXD is for short-term trading only; it has mathematical characteristics that make it a poor long-term investment.)

I suppose I now have to break my 10 grand bit into two groups: long term and short term. Long term, stay with Seabridge, even though you're down right now. It'll come back. Short term, take the loss and move into DXD while you wait for SA to bottom out.

Cheap Gas

Detroit!

Stop tempting us with your cool new muscle cars, like the new Camaro, which gets 22 mpg (on a completely flat road, driving the speed limit, which I'm sure I will be with a 304 horsepower engine).

What with the fall in gas prices and all, the Camaro is destroying the Honda Insight in the sales department.

I guess the thinking behind the muscle car resurgence is, wouldn't it be nice to go back to a simpler time, when all that mattered was how many horses you had under the hood?

It just doesn't seem like the best move, to stake the fate of the American car industry on denial.

Deflation

The Bureau of Labor Statistics released the Consumer Price Index yesterday, which shows a very small monthly increase since April (0.1%), but the story that's grabbing the headlines is the 12-month drop in prices, or deflation, to the tune of negative 1.3%.

It's a bait and switch story. What number do we emphasize? The scary number, about the deflationary monster? Or perhaps the core inflation number, which excludes food and energy, and shows a 12-month increase of 1.8%? Only two categories in the CPI fell: transportation and energy. Both are tied to the fall in oil and gas prices. Every other category increased.

What does this tell us?

Expect inflation, not deflation to prevail in the coming months.

Ah, Krugman!

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

The above is a quote from the marvelous Paul Krugman. I love him; and yet, he's so wrong right now.

Let's be clear: aggressive monetary and fiscal policy have not averted any danger to the economy. The danger is not inflation, nor is it deflation. The danger is economic distortions. That is, massive investment in unproductive economic activity (retail, advertising, finance, etc.). This kind of economic activity does not produce anything, and hence it is the major threat to the economy.

Why are there economic distortions? Why should it be the case that the market, which often gets things right, ought to be disastrously wrong? What causes the distortions is the massive inflation of the money supply. That may lead to inflation or it may even lead to stable prices, even deflation for a time. It all depends on how the extra dollars are used. If they are saved, no inflation in consumer prices. If dollars are spent elsewhere in the world, no inflation (at least in the US). If those extra dollars are spent in the US, expect to see some inflation.

Rising or falling prices is not the danger. The danger is that there is a prolonged period of confusion: what are my assets worth? Is my business viable? Should I start this business? What is the market saying?

If the answers to these questions are unusually obscure for a long period of time, the result will be stagnation, low growth, and unemployment. This is the danger. And it's in full bloom now. More aggressive monetary and fiscal policy will worsen the situation, not make it better.

Stocks Fall

The Dow has, as of this moment, taken a big hit. It feels like the rally is over.

I expect that there may be an upward movement tomorrow, but I think the rally is basically out of steam.

Seabridge took a big hit today, falling to $25. I expect it will go up to $29, but then follow the market down. I think gold may have a big day tomorrow, as a new wave of fear washes investors out of stocks and into the safety of gold.

I'm going to try to sell SA at or around $29, and get into DXD at or around $45.

Arthur Laffer on Inflation

Arthur Laffer created the Laffer Curve, a rather dubious piece of economic theory that entered the economic canon without ever passing through the peer-review cycle.

He has a rather good piece on inflation and monetary expansion in the Opinion section of the Wall Street Journal.

His argument is that the monetary base has increased dramatically, and that this should result in inflation. Since I've been saying the same for some time, I like the argument.

As Gold Continues to Slide, Treasuries Crater, World Openly Debates the Fate of the Dollar

{I wrote this on 6/8, but didn't get around to publishing it until 6/11, which was after the WSJ wrote a cover story on the rising 10-year Treasury!]

The yield on the 10-year US Treasury note is up to 3.88%, [now it's gone up to 3.93%, then slid back to 3.86% today] as prices for the note continue to crater. (Recall that as bond prices fall, yields rise) The battle continues. Since this yield is tied to so many other interest rates, the hazard is that the rising yield will soon become higher interest rates for mortgages, car loans, credit cards, etc. The bigger problem perhaps is, are there borrowers?

It's an economic distortion that interest rates should fall when the economy moves into recession and credit tightens after being loose for so long. What's being revealed is that the risk of default is much, much higher than was previously thought. Naturally, interest rates should rise to compensate for the increased risk. But instead, the Fed tries to go against the market and lower interest rates.

The Keynesian logic is straightforward: because credit is tending to tighten, money destruction ensues through the action of the fractional reserve banking system. However, that destruction of money results in far less aggregate demand. The solution: create money through the central bank (the Fed) equal or greater to the money destruction, lowering interest rates, encouraging firms and consumers to borrow, and stimulating the economy when it most needs it.

Unfortunately, what this Keynesian story overlooks is that the economy has a hangover. The best cure isn't a couple of (trillion) shots of booze, it's a reorganization, a re-thinking of priorities and activities.

The economy has binged on unproductive economic activity: a frenzy of finance, retail, advertising, lawyering and lawmaking. Corporations have turned their attention away from productive investment (the kind that is designed to produce better things) and toward unproductive investment, designed to capture an ever-larger piece of the economic surplus. But since efforts to capture a bigger piece of pie don't actually grow the pie, only so much of US capitalism can be engaged in such endeavors.

Meanwhile, the International Monetary Fund, seeking to retain some kind of relevance, jumps in to say that the world could potentially use a different reserve currency than the US dollar. Of course, their solution is the bogus Standard Drawing Right, administered by an impartial, international central banking organization. I wonder who that would be. Of course, they call for "liquidity", a silly central banking code word which means "fake money". It's obvious that the IMF does not have in mind the creation of a currency backed by an item of real tangible value, such as gold. After all, Keynes called gold a "barbarous relic".

Of course the IMF thinks we're years away from such a "revolutionary" move. Only slowly can we change the global monetary order.

Right.

The world has a way of changing faster than you think. The dollar is already dead. Each country in the world is simply trying to figure out how to edge away from the dollar's corpse before every other country in the world does so. Gold has tripled in price since the year 2000. The technology of producing gold hasn't changed much.

The world faces a choice: either we descend into a morass of distrust, reversing the tide of globalization, retreating behind border walls and tariffs, or we create a new global monetary order that no country, no individual, no corporation can game. That order simply must be based on an item of real value, that no government can manipulate, that holds its value over time, that cannot be destroyed through the printing press. We need the gold standard of money. What could that be?

I'll Be Off For the Rest of the Week

Treasuries are up today, pushing the yield back down to 3.55%. Still too high. With the ten year US Treasury note at that yield, a lot of other interest rates are going to be higher. Still a lot of volatility in this market; today's swing was 2.55%. A lot of movement for any market in one day.

How can the Fed possibly re-inflate this impossibly flaccid credit bubble with high rates?

Commodities took a pause; gold is back under $970, oil retrenched to $66, copper's down to $2.22. A bit of backfilling is in order. I wonder when the next big move up will happen. Next week?

Meanwhile, banks are doing their best to resist honesty and transparency. Here's a piece about their off-balance sheet assets. Isn't it a bit absurd that a corporation would have off-balance sheet assets? What possible rationale could there be for keeping an asset off the books besides lying about its true value?

I'll be traveling for the rest of the week. Have a great weekend!

Ferguson vs Krugman

Historian Niall Ferguson takes Paul Krugman to task in a recent Financial Times piece.

Ferguson is right of course, that the debt load of the US is onerous and that our creditors are starting to wonder if we'll ever pay it back.

While Ferguson is correct that we have not entered a repeat of the Great Depression yet, I think he lays a bit too much emphasis on that fact. Yes, we're not there. Yet. The big difference, of course, is the status of the dollar as the world's reserve currency. That will change, and as it does, a series of painful adjustments will take place in the US.

GM Bankruptcy...

(The picture is of Alfred P. Sloan, the man who created GM as a consolidation of several smaller automakers)

I feel I have to say something about the GM bankruptcy, simply because the story is dominating the news: WSJ, NY Times, USA Today.

Frankly, the story bores me. It's full of wailing and gnashing of teeth, sound and fury, signifying nothing.

Why should I care that GM is going bankrupt? Is it simply because it's a venerable corporation? That doesn't do it for me. A corporation (or any institution) doesn't deserve to continue just because its been around for a while.

In an earlier era, the economist Joseph Schumpeter called capitalism "creative destruction". Like living organisms, corporations are born, they flourish, they fail, they die. When they fail or die, the corporate body (redundant, I know, because both words mean the same thing) becomes food for other economic agents: other corporations, individuals, institutions.

It is only our tendency to cling to the past that makes us think it is somehow wrong that a big corporation should go bankrupt. It's not wrong, merely part of the artificial garden of capitalism. People say, what about the workers? What about the jobs that will be lost?

It's better to clear out an institution that is not functioning, so that new jobs can be created. Americans will still buy cars. So other producers will buy GM's plants and equipment, hiring some of the workers, while others will find new jobs doing other things.

Change is hard. Some people may have to leave the communities they know to find work elsewhere, or they may need to start new businesses, or accumulate new skills. But this change is the cornerstone of the economy. To resist it, to go against it, to prop up these companies and others like GM that made disastrous errors during the boom years, is wasteful, inefficient, and rewards incompetence instead of productivity.

Treasuries Crumple... Again!

Crash... recover... crash.

The price of the bellwether 10-year US Treasury note cratered Thursday, recovered Friday, and now has crumpled again, sending the yield skyrocketing to close at 3.715%.

This is exciting stuff. It's like a pitched battle is being waged over Treasury notes. The yield is like the front line. Meanwhile, the kings of the commodities (oil, copper, gold, silver) are all up sharply. Oil is above $68, gold is above $975, silver is above $15.60 and copper has shot up to $2.30. (Check out NYMEX for a good source on all these commodity prices.)

Remember, this may be a harbinger of higher interest rates, signaling a loss of confidence in the dollar, which would mean the Fed would have a very hard time using monetary policy to stimulate the economy.

What will happen is that interest rates will rise as investors edge away from the dollar and US treasury debt. That will deepen the recession. (Why do I say recession instead of depression? Habit, I guess. There is no technical distinction in economics. There is a joke (sort of): a recession is when your neighbor loses his job. A depression is when you lose yours.) The best strategy for dollar depreciation is investing in hard assets with no debt or leverage whatsoever.