The U.S. Labor Department reported that around 467,000 Americans lost their jobs in June. This was unwelcome news. The data had been getting less bad every month since January. Then the June numbers rocked up, fell out, and took stocks down with them. This is causing everyone with a pulse (and most with a brain) to have second thoughts about just how good things are-or how much worse they might get.

The S&P and the Dow both fell nearly three percent. Oil and gold were down too. About the only things up were Treasury bonds and notes. Speaking of which, the U.S. will auction another $73 billion of those this week. Wednesday’s auction is for $19 billion in ten-year notes while $11 billion in 30-year bonds go on sale Thursday.

“You may have green shoots, whatever you want to call them, you may have temporary relief, but you are still in a world that’s breaking,” Black Swan author Nassim Taleb told CNBC’s Squawk Box. “Anything that’s fragile like the financial system will eventually crash, he said…We’re in the middle of a crash…So if I’m going to forecast something, it is that it’s going to get worse, not better.”

Taleb’s point is not a popular one. But it is a realistic one. The fiat money, leveraged finance Western financial system went global in the last twenty years, providing an epic rise in asset prices (and the debt used to purchase them). There’s no doubt that real goods and services have traded hands with world growth. But now we wonder how much of that is sustainable when you take the credit away.

Did we use phony money to build a world with completely unrealistic levels of growth? Were trillions of dollars of capital allocated based on final demand that was artificially pumped up by credit, currency manipulation (low U.S. interest rates and global dollar pegging), and government stimulation?

Yes we did!

Mind you, the crash of the financial system is not the end of the world. It is a massive calamity to be sure, wiping out the value of retirement assets many people were counting on to make it through their golden years. But as many readers have reminded us in the last few months, there is more to life than money.

Fair enough. But there is more to wealth than money too! Peace of mind, having your assets in forms that can’t be inflated away or won’t suffer from debt deflation…we would count these as “wealth” at a time like this.

That brings us back to the problem growing at the back of our mind yesterday. Can a massive deflating credit bubble nullify the liquidity measures by central bankers, which are puny in comparison to the nominal value of the assets at risk? “Yes you can!” comes the answer from some of the friends we put the question to.

“I’m tempted to disagree that expansion in government credit won’t reach the economy and therefore won’t be inflationary,” replied Money Morning editor Kris Sayce. “I’m not mistaken, the Fed is buying up these ‘assets’ in order to take them off the banks and also to help price them. If the Fed didn’t do this then the banks wouldn’t be able to lend extra money to customers as they would breach their lending limits.”

“It’s not so much that the Fed is directly feeding the banks money which flows through to the economy, it’s more that the Fed is feeding the banks money which allows them to expand lending which they otherwise wouldn’t be able to do. Thus at the very least is preventing prices from falling, or from falling as much as they ordinarily would without the intervention. In effect there is more money flowing in than there otherwise would be. There already IS inflation.”

Another colleague in the States replied that, “I am leaning more and more to the idea that the credit-based stuff will deflate (real estate, stock prices) but the cash-based stuff could rise (like foodstuffs, energy). In a way, it’s not a debate about inflation or deflation, but which assets inflate and which deflate. There might be a strong dichotomy within the economy between the two.”

To the extent that you cannot eat a mortgage-backed security, we see the wisdom in this view. The world has a lot of people. They have a lot of real needs. Regardless of the value of derivatives and opaque financial assets, a certain level of economic activity for a certain kind of tangible good will still be there. The challenge for investors is to determine if you can profit from this in traditional ways (stocks and bonds) or if you have to venture into less traditional asset classes and forms of ownership (land, real commodities, precious metals).

And of course, the thesis could be incorrect. If credit is not money-or if the large lending and government guarantee programs don’t reignite a lending boom in the real economy-then you may simply see a lot of wealth disappear down the memory hole.

Finally, a mystery Aussie commentator who wishes to remain anonymous but whom you may hear from in the future in this space sent a philosophical yet practical reply.

“What is money? Currently, that’s what the Federal Reserve (and other central banks) put in the reserve accounts of their member banks. The banks then use this as a base to create their own money, or ‘like money’. I guess this is also known as credit. So yes, credit is not money.

“And this bank credit is now contracting as the natural force of the market tries to drive prices lower and correct the boom. The Fed is offsetting this process by swapping ‘money’ (fed funds) for the impaired assets. But the banks are sitting on the cash, and obviously do not have the risk appetite (or the demand) to lend it out.”

“So at this point additional base money is not being lent out as inflationary ‘like money’. I’m not sure the Fed has the mechanism to make out and out purchases of assets other than through lending facilities, unless they are Treasury or Agency purchases. As far as I’m aware, the Fed can only distribute its newly created money through the banking system, and no other way. The banks have always been the source of inflation, and they need to lend to create this. They will probably use their excess reserves to buy Treasury’s in the coming years, and then the Fed can but the Treasury’s back off them in time. This will be inflationary.”

“Where does gold come into it? Well, gold is real money….chosen independently by the people. As trust in the US dollar continues to evaporate, demand for gold will increase. At some point gold will again be referred to as money. Because the amount of credit (debt) in the world dwarfs the amount of gold, and because gold will be a legitimate extinguisher of the debt, gold will likely rise massively to have the capacity to extinguish the debt. This is a process unfolding over years though.

“A rising gold price is actually deflationary in that it represents a rise in the purchasing power of money. So I think deflation is the ultimate force that cures this massive credit bubble…outright deflation if long-term faith in the US dollar remains, or gold price induced deflation should the bottom fall out of US dollar trust. The quantity of US dollars may be rising at the moment but the real turning point will be when the perceived quality of the dollar declines.”

Hmm. Gold rising indicates the rising value of cash…because gold is money. But if money is not wealth…and gold is money…does this mean gold is not wealth? Now there is something to think about.

Regards,
Dan Denning
Daily Reckoning Australia

July 7, 2009

This article was originally featured on Whiskey and Gunpowder

Money Isn’t Wealth

And speaking of colossally stupid government programs, you may have seen the news that the U.S. House of Representatives passed a climate change bill on Saturday by a narrow vote of 219-212. The cap-and-trade bill, otherwise known as Waxman-Markey (for the nominal writers of the bill), mandates that U.S. manufacturers and utilities reduce carbon emissions 17% from 2005 levels by 2020 and 83% by 2050.

Under the sausage making process that is the American Congress, the bill was filled with compromises. Congressmen from coal-producing states or states with lots of manufacturing jobs had to be bribed into supporting it through various means. It must now go the Senate, which must pass its own version of the bill.

If the Senate bill is different from the House bill (and it almost always is, given the different agendas in both bodies and the need for more bribes), the two bills go to “reconciliation.” That’s where a committee made of members from both houses settles on a final compromise version of the two bills and sends them back to their respective bodies to be voted on. Then it gets sent to the President to become the law of the land.

By the way you may have missed an amendment to the bill that’s stirred a bit of controversy. It was inserted the night before among the bill’s 1,200 pages, which you can be sure none of America’s elected officials actually read. The amendment placates Congressmen from Rust Belt states who worry about losing even more manufacturing jobs to the developing world (China). It requires the U.S. President to make a “border adjustment” on goods from countries that do not cap or reduce carbon emissions by 2020. It’s a tariff.

Already President Obama has backed off that particular amendment. He says, “At a time when the economy worldwide is still deep in recession and we’ve seen a significant drop in global trade, I think we have to be very careful about sending any protectionist signals out there.” Very careful, sure. But you already did send the signal didn’t you?

For what it’s worth, we think this was all an exercise in political window dressing to get some version of a bill passed. If the Senate and the House actually agree on a climate change bill that puts a high tax on carbon, then the apotheosis of Obama will be complete.

We will take The One at his word, though. Besides, as everyone knows, the real purpose of the bill is not to start a trade war (although it may do so). The purpose is to make conventional energy more expensive AND—in an era of declining government tax receipts and rising liabilities—to create a huge new source of government revenues by taxing carbon. It’s a revenue and power grab by an institution (the Nation state) that finds itself increasingly off-balance.

It’s also a massive project in socioeconomic engineering that ignores the reality (and physics) of energy generation in an industrial society. It’s true the world could benefit from cleaner and cheaper energy. But cleaner and more expensive energy is a recipe for economic suicide. It’s something Western nations seem particularly keen on committing, although we can’t really figure out why. It could be that the global Left simply finds modern life aesthetically ugly and consumerism (with all that pesky individual choice) a vulgarity that should be destroyed via legislation.

But speaking strictly in economic terms, unless a region or a country has ample hydroelectric or geothermal resources, it’s impossible to meet base load electricity needs reliably with renewable energy. Advocates envision a world full of ultra-long life batteries, windmills, and solar farms. But it’s just a fantasy. If the climate bills become law in Australia and America, it will accelerate the deindustrialising of Western economies and mean the transfer of even more manufacturing jobs to the developing world.

Of course maybe that’s just what the architects of these laws want. Who knows? We know they want to tax productive enterprise and make the bulk of the population dependent on government handouts. That makes people compliant and easily controllable. That is big government Utopia. Advancing the fears of climate change is the easiest way to get more control.

We’d expect to see the construction of a lot more natural gas fired power plants in the coming years in the West (although they are more expensive than coal-fired plants). All those re-chargeable plug-in hybrids have to get their electrons from somewhere. If it’s not going to be coal (which will be taxed out of existence), it’s probably going to be cleaner-burning natural gas power plants, powered by both conventional and unconventional gas.

Right now, global LNG capacity is rising and stockpiles are fairly high. But if you keep your eye on the big picture and we see a transition of the world’s power plant fleet from coal to natural gas, it obviously favours gas producers and explorers. Australia is moving ahead by leaps and bounds in this area with conventional offshore production in the North West Shelf and Timor Sea and more unconventional production (hopefully) from coal-seam-gas in Queensland.

Regards,
Dan Denning

July 1, 2009

This article was originally featured on Whiskey and Gunpowder

Climate Change, Cap, Trade, and the End of the Industrial West

The World Bank now says the global economy will contract by 2.9% this year instead of 1.7%. That could be right. But that’s not the reason stocks are falling. The rally that began in March has now run out of steam. It’s also run out of news events to send it higher. So what now?

Well, the primary trend—and by that we mean what we think the dominant trend is for the next few years—is the systematic reduction of debt in the household and business sectors. That ought to lead to write downs in asset prices and a general contraction in credit. Perhaps that is why—despite the mondo auction of $104 billion in new debt—even U.S. government bonds followed stocks and commodities down.

Let’s take a quick look at what the Federal Open Market Committee said yesterday in regard to U.S. interest rates. We’d planned to watch for language that tipped the Fed’s intentions regarding the bond market. It all begins with the bond vigilantes these days. So what did the Fed say?

It made clear low rates-at least the Fed’s target rate-are here to stay. “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Whether the Fed can talk down or manipulate long-term rates into staying dormant is another matter. But it had more to say on the subject. “As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.”

The important part here is “as previously announced.” This sounds a bit like, “I really mean it. I’ll do it. I’m dead serious. Don’t make me buy those mortgage bonds. I’ll do it if I have to. Don’t push me.”

In other words, the Fed is merely repeating what it said it would do earlier. It did not announce a new policy or its intention to expand quantitative easing to keep bond yields down. We imagine it would not want to advertise its willingness to keep buying bonds. That might induce a lot of selling and have the perverse effect of pushing U.S. yields up and investors into other assets.

But just for good measure the Fed repeated itself one more time. “In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

So it’s a waiting game now. The Fed hopes the economy recovers this year and that it can withdraw its massive liquidity measures before they leak through into the economy to cause inflation. So far, its credit facilities have not translated into an expansion in the money supply. That’s what the bond market fears (which is also why ten-year Treasury yields were up on the day).

We reckon investors and insiders will wait to wade back into the stock market until this correction (if that’s what it is) runs its course. After all, the insiders have not been buying the rally. They’ve been selling into it.

According to research service TrimTabs insiders of S&P 500 listed companies have unloaded $2.6bn in shares in June, compared with $120m in purchases. “The smartest players in the US stock market - the top insiders who run public companies - are not betting their own money on an economic recovery,” says TrimTabs CEO Charles Biderman.

So the American insiders are bearish. They’ve been net sellers for fourteen straight weeks, according to Ben Silverman at InsiderScore. If the inside money is getting out, we reckon shares are going to do some bottom searching over the next few weeks. The World Bank announcement, then, merely confirmed what the action in the market has been telling us for the last few weeks.

Insider selling is a particularly charged bit of investment intelligence. But in our experience it is a piece of information that confirms what is already apparent through an analysis of other technical and fundamental variables. It doesn’t necessarily tell you anything you can’t figure out by other means.

It’s true that the insiders may be selling because they have access to information not known by the general public (although trading on this information would, of course, not be legal…but there you go). And insider sales—at least on large stocks with lots of liquidity—are easier to conceal in the general course of trading. But the money flow and volume still tell the tale, especially with smaller stocks.

If you step away from the technical guts of the market for a moment, the larger question is whether this last financial year will trigger any shifts in the investment habits or psyche of the Australian public. Judging by the number of people who stayed in balanced or growth funds over the last year, the Australian public is brain dead (zombies!). But then, let’s be fair. Maybe they ARE keeping their eye on the bigger picture. They just see the picture slightly differently than other living, thinking people.

The bigger picture can be seen below, courtesy of Super Ratings, in the value of a balanced Aussie super fund versus cash since 2003. Cash is slow and plodding and lazy and conservative. Very turtelish. The balances super funds, on the other hands, had three ripper years up to 2007, and two disastrous ones since. Even after an epic charge in commodities, balances super has barely beaten cash. Hmmn.

The Tortoise Cash and the Balanced Hare

You can see that after reaching parity earlier this year (at the markets slow) balanced funds have since rebounded. But you have to wonder how balanced they really are. Balance-according to our Super expert Kris Sayce-is supposed to be a kind of middle ground between aggressive growth and conservative cash. It also sounds sensible. Who is against balance? It’s prudent, right?

But if we read the latest report right from Super Ratings, the median balanced fund has 60%-76% of its investment portfolio allocated to growth assets, the riskiest type! That sounds distinctly unbalanced. It sounds, in fact, really stupid, considering this is a bear market in stocks.

Balanced zombie minds will point out that on rolling five, seven, and ten-year periods, balanced funds are all still up (4.75%, 4.99%, and 5.07%, respectively). But we would humbly suggest that there’s never been a better time to question the basic assumptions about investing in balanced funds-or any funds for that matter.

That is, a passive approach that assumes markets always go up and time is on your side is probably going to get you slaughtered in the coming years. If inflation doesn’t kill you, a few bad years could. And if your rolling period coincides with some of the frequent 17-year periods in which stock markets do not go up at all-well then the whole idea of using the stock market as a retirement machine is as dead as a zombie.

Regards,
Dan Denning
Daily Reckoning Australia

June 26, 2009

This article was originally featured on Whiskey and Gunpowder

The Fed and Zombie Investors

By the way, last year at the Agora Wealth Symposium in Vancouver, one of our colleagues took the stage to point out that your editor was complete moron. In this particular case, it was for being bullish on gold

He said that gold hadn’t done much adjusted for inflation since 1980. What’s more, he said that it’s worth less—adjusted for inflation—than it was twenty years ago. How, he speculated, could anyone take the advice to buy gold seriously when it had performed so abysmally?

Well here are the facts. The gold price bottomed in October of 2000 at $263.80. At that time, the S&P 500 traded at 1,379. Since then, the S&P 500 has fallen by 31% (closing yesterday at 942.43) while the gold price is up 262% to $956.

We’ve asked Kris Sayce to bring this small fact to the attention of our colleague when he attends this year’s Vancouver show next month. The theme of this year’s show is “Ten Years of Reckoning,” Symposium Promo celebrating the tenth anniversary of the Daily Reckoning. Kris will be spearheading the Australian delegation. More details on that later this month.

In any event, it seems pretty obvious, that for the last ten years anyway, selling stocks and buying gold would have been a good trade/strategy. Stocks ended an 18-year bull market in 2000 and gold ended a 20-year bear market. One asset class was at a cyclical low. The other was at a cyclical high. In fact, you might even say that one was at a generational low and the other was at a generational high.

Gold is no longer as low as it once was. But it’s still not as high as we expect it to go before it starts to look foolish. Meanwhile, today’s government bond market looks an awful lot like the stock market circa 2000. You’re seeing a generational high in bonds. It’s another version of the “high-low” strategy.

This time around, though, we would add energy stocks to the mix, along with gold. Crude oil climbed to an eight-month high over $70 on Tuesday. Bloomberg says the weakness in the U.S. dollar is, “bolstering the appeal of energy as an alternative investment.” Sell bonds, buy energy. Pretty simple.

There is probably some truth to the fact that oil’s latest move is driven by investment demand more than, say, demand growth in the real economy. But investors ARE looking for ways to profit from U.S. dollar weakness. Oil is liquid and popular. In the long-run, it’s the smaller-than-expected oil supply growth that will drive the market.

One thing Kris will probably be making clear to U.S. dollar-based investors is just how relatively attractive Australia’s position is in the developed world. “Even as Australia’s challenges increase, it will still be the envy of the developed world,” writes William Pesek at Bloomberg. “Even in its worst moments… Australia is among the least unsightly economies anywhere,” he adds rather optimistically. We’ll see about that.

Finally, we meant to write a bit about other possibilities in China today. That is, we were going to explore collapse scenarios (financial, political, and societal). But we did not realize it would be ambitious to try that in a few hundred words. So look for something more considered later this week in the essay spot.

Regards,
Dan Denning
Daily Reckoning Australia

June 11, 2009

This article was originally featured on Whiskey and Gunpowder

Last Decade: Buy Gold. This Decade: Buy Energy.

If we were using numbers instead of metaphors, we’d say the CRB Reuters/Jeffries Index had its biggest monthly rally in 34 years. It was up 14% on the month. That was the best performance since July of 1974.

A monthly performance like that can only mean one thing. We’re just not sure what one thing it is. It could mean commodities have rebounded from being oversold, as they were in late 2008. It could mean that markets are less pessimistic about the global economy than your editor at the Old Hat Factory (though we doubt that).

It could also mean that investors increasingly prefer tangible assets as a long-term growth strategy over financial assets. Even after $1.465 trillion in realized losses by global banks and financial institutions, there are trillions more to come. Commercial real estate…the option-ARM recast period in the U.S. housing market…European banks…any or all of these things could conspire to lead to more losses and more capital raisings in the financial sector.

Perhaps that is what explains crude oil’s biggest monthly gain in a decade. July crude futures traded at $66.52 in Friday’s New York action. The U.S. dollar price of gold powered to $981.20, before sliding back a bit $975.

The Aussie gold price is fighting its way up despite the fact that the Aussie dollar keeps gaining on the greenback. While the Aussie gold price is up just $1.71 in the last 30 days (0.14%), the U.S. gold price is up nearly nine percent. We reckon the Aussie gold price will begin moving up closer to $1,500 again on a combination of events (weakness against the greenback for one.)

There are also two data releases this week that will affect the Aussie dollar. The RBA meets today to decide the price of money in Australia (set interest rates). And then Wednesday, the March quarter GDP figures come out. This will tell us how bad the recession is, although not how bad it may become.

It’s no use predicting these things, but for what it’s worth, our view is that we’re in a bit of a plateau between down moves. The “down moves” will come again in financial stocks, although they may not be as “down” as before, and employment. Mostly, the indices are going to have to price in very slow GDP growth for the remainder of the year and more job losses.

The wildcard for Australia is trade. Its proximity to Asia means that a rebound in that part of the world provides some cushion to resource companies. But then, we thought the resource stocks would be pretty well insulated from the first round of deleveraging too, and we were wrong about that. And the second time around?

Well, even if the long-term underlying demand for Aussie resources is real and growing, it still takes real money to make new projects happen. The financing of resource projects will continue to be a key issue in your stock selection. The other issue, obviously, is the direction of commodity prices.

Take LNG, for example. Last year the Australian Petroleum Production and Exploration Association said it wanted to triple Australia’s LNG output to sixty million tons per year. Meeting this weekend in Darwin, the group says 50 million is a more realistic target, given both the slump in energy prices and tight credit markets.

If LNG prices track oil prices-as they did in the big run up to $150 per barrel for crude-the economics of big Aussie projects get a lot better. Our view is that energy prices are going structurally higher anyway. Global recession aside, the big plunge in energy capital spending virtually guarantees a supply shortage in the coming years anyway.

Besides, you have to wonder why big international energy firms would be investing in conventional and unconventional Australian LNG projects if they weren’t convinced that a) oil prices were going higher, or b) more carbon-friendly fuels like gas would gain as coal gets politically demonized and punished with cap-and-trade or emissions-trading-schemes.

Obviously, if global trade continues to contract and a second round of losses in the global banking industry triggers another financial crisis, demand for energy is going to fall. And while we’re at it, stocks would probably test the 2003 lows too. We enter a new stage of grimness.

In the meantime, energy and precious metals stocks are riding higher commodity prices. And there’s a distinctly 2007 mind-set in the air. It’s vogue to be long-commodities and indifferent to risks in the financial system. It’s enough to make an investor with a short memory nervous.

Regards,
Dan Denning
Daily Reckoning Australia

June 2, 2009

This article was originally featured on Whiskey and Gunpowder

What Are Commodities Saying About the Financial Crisis?

So when you hear anyone say that the level of taxation in a country should be based on the “ability to pay”, be very afraid. These people are not only coming for your money. They’re coming for your economic liberty too. Ultimately, that means they’re after your political liberty as well.

Progressive taxation is the idea the larger your disposable income, the larger percentage of that income you ’should’ pay in taxes. Proponents of it—and these days nearly everyone one is—claim it is more ‘fair.” But let’s be honest and call things by their right names and say what progressive taxation is really about.

Even John Stuart Mill, who favoured it, called progressive taxation “a mild form of robbery.” That’s because progressive taxation is about using the tax code to redistribute wealth. It’s base on the class-warfare idea that the rich get rich illicitly and conspire to keep the riches of society for themselves. It uses the law (coercion) to correct what some people see as the social and economic injustice meted out by the marketplace.

But how people treat private property (and wealth IS private property) determines the character of society. A society that promotes the idea of wealth accumulation and that everyone can get rich is one in which standards of living will rise over time. It doesn’t mean getting wealthy is the only or even the most important ambition in life. That’s a matter of personal choice and values. But it just means that if you want to raise standards of living over time, you should guard economic liberty and not use taxation to punish personal incentives.

The only fair argument for progressive taxation is that indirect taxes (consumption taxes) hit the poor harder than they hit the rich. This is certainly true for taxes on consumption goods. But it is not true for income taxes, most of which the poor do not pay anyway. A tax on Gucci handbags is less onerous than a tax on a slab of beer. But that doesn’t justify the argument that just because you can pay more taxes, you should.

When is it ever right for a man to come in to your home and take what’s yours simply because he’d decided that someone else needs it more? And how is the government arbitrarily deciding to raise income tax rates on only certain citizens, based on their ability to pay, any different? Yet that’s the argument for progressive taxation in the modern world. And most people seem to think it’s fair and just.

Mind you, that doesn’t mean that free people can’t use legislatures to levy taxes in order to pay for projects they believe should be provided by the State, like roads, bridges and other infrastructure. But there is a difference between that kind of public spending and public spending financed by wealth redistribution to achieve particular social and economic outcomes.

How did we get to the point in civil society where a democratic majority that does not pay taxes can, through its elected representatives, legally confiscate the wealth of a minority? Friederich Hayek gives the history in, The Constitution of Liberty.

“As is true of many similar measures, progressive taxation has assumed its present importance as a result of having been smuggled in under false pretences. When at the time of the French Revolution and again during the socialist agitation preceding the revolutions of 1848 it was frankly advocated as a means of redistributing incomes, it was decisively rejected. “One ought to execute the author and not the project,” was the liberal Turgot’s indignant response to some early proposals of this sort.

“When in the 1830’s they came to be more widely advocated, J.R. McCulloch expressed the chief objection in the often quoted statement: ‘The moment you abandon the cardinal principle of exacting from all individuals the same proportion of their income or of their property, you are at sea without a rudder or compass, and there is no amount of injustice and folly you may not commit.’”

“In 1848,” Hayek continues, “Karl Marx and Freidrich Engels frankly proposed ‘a heavy progressive or graduated income tax’ as one of the measures by which, after the first stage of the revolution, ‘the proletariat will use its political supremacy to wrest, by degrees, all capital from the bourgeois, to centralise all instruments of production in the hands of the state.’

And these measures they described as ‘means of despotic inroads on the right of property, and on the condition of bourgeois production…measures…which appear economically insufficient and untenable but which, in the course of the movement out strip themselves, necessitate further inroads upon the old social order and are unavoidable as a means of entirely revolutionising the mode of production.’”

If Marx and Engels are to be taken at their word, progressive taxation was never about fairness. It was about putting production “in the hands of the State” and “revolutitionising the mode of production.” In the world of State-run capitalism, this is what we seem like we’re headed towards.

Now, we can take a step back and ask whether a State-run, union owned Chrysler makes a better car than the shareholder owned management-run Chrysler. It’s a fair enough question. We’d argue that government-built and designed cars are going to be about as appealing as a leather boot for breakfast. But that is not really the point.

The point is that the politicians are lying to you about the goal of progressive taxation. The goal is not to produce more “fairness” or “social justice.” It’s to place the State at the centre of economic production, so it can regulate and tax with impunity.

There is both a psychological and crassly economic motive to this movement to displace the free market with the State as the organiser of economic life. The smarty pants elitists in both political parties, with their ties to union and corporate money, really believe the world would be better off it was run be benevolent bureaucratic despots. Or maybe using coercive taxation to steal from the rich is simply envy-based class politics, a kind of populist theft conducted with the consent of a hi-jacked system for passing laws.

Once you go down this road of socking it to the rich instead of reducing spending, you get higher and higher rates of taxation that eventually shrink the economy. Britain adopted the income tax in 1910 and the U.S in 1913. At the time, the top tax rates on income were 8.25% and 7% respectively. Yet within 30 years, thanks to the Great Depression and the World Wars, those rates had risen to 97.5% and 91% respectively.

“Thus in the space of a single generation,” Hayek writes, “what nearly all the supporters of progressive taxation had for half a century asserted could not happen came to pass…All attempts to justify these rates on the basis of capacity to pay was, in consequence, soon abandoned and supporters reverted to the original, but long avoided, justification of the progression as means of brining about a more just distribution of income.”

How much a man should reasonably a pay to the State was no longer an economic question about his ‘ability to pay.’ It was revealed as the purely political decision it always was. Or as Hayek says, it’s “an attempt to impose on society a pattern of distribution determined by majority decision.”

That’s what we meant by the character of society. Do you want to live in a country where over 50% of a man’s income can be taken from him simply because the majority votes for it? In that kind of country you want to live in, where you have no real property rights and you don’t have equality before the law.

Upward income mobility is undermined in this kind of society. People don’t try to get rich because there’s no point in it if your gains are going to be confiscated. The net result of decades of progressive taxation is lower capital formulation, more consumption, less production, and ultimately a lower standard of living for everyone.

In that society, your only means of social and economic advancement is based on your personal connections and political patronage. Not surprisingly, in that society, politicians exercise enormous power. And decisions are not made by businesses that aim to offer consumers better products and services at lower prices; they are made by politicians who aim to cement their electoral position by favouring certain constituencies.

Progressive taxation has nothing to do with fairness, justice, or equality. It is unfair, unjust, an unequal. But hey, if that’s the kind of country you want to live in, or if you’re someone who’s getting the check instead of writing it, that might not seem like such a bad deal.

We’d just advise you to prepare for a lifetime of dependency on busybody politicians who become increasingly grasping, moralistic, and intrusive. If you’re a free man, you’d better pack your bags and look for some other luckier country.

This is not to glorify getting rich as the most important thing in this world (or any other world.) It isn’t. And there are much more important things in life. Whether you choose to pursue material gain is up to you.

And just as a government should not use the tax code to punish the rich, it ought to quit tinkering with it and providing so many deductions and rebates that allow anyone with a good accountant to avoid paying large income taxes. A much simpler taxation system based on consumption would be fairer for everyone and it would force the government to finally live within its means.

Of course that probably won’t happen. Ever. But it would be nice to think so. In the meantime, a society that discourages wealth creation and capital formation through so-called progressive taxation is eventually going to make itself a lot poorer and a lot less free.

Regards,
Dan Denning
Australian Daily Reckoning

May 15, 2009

This article was originally featured on Whiskey and Gunpowder

Progressive Taxation, an Assault on Liberty

Mind you, this is if you want to be in the equity market at all. There is a very good case to be made for NOT being in the equity market this year, or only being in those asset classes and single stocks you think will appreciate (or grow earnings) faster than the rate of inflation.

But let’s be more direct and say that this is still a bear market. The bear market began in 2000 with the popping of the tech bubble. The Fed fought back in 2003, setting a low-interest rate policy the rest of the dollar-pegged world followed. This kicked of leveraged booms in residential housing, credit derivatives, and stocks, bonds and commodities.

All those bubbles are popping. You do not wipe out twenty-five years of credit and leverage excess in a mere eighteen months. We are barely halfway through the liquidation/loss realisation phase. The essential question is which assets are going to perform the best as governments inflate and create a new bubble in government debt? And by the way, it’s going to be very large bubble.

Forget the $1.8 trillion deficit the Obama White House admitted to. The true scope of government borrowing is breathtaking, and rather sickening. More importantly, you have to wonder where the money is going to come from, and what will happen when it’s not forthcoming from private investors.

Consider the chart below, courtesy of Niels Jensen, writing in John Mauldin’s “Outside the Box” e-letter. Niels shows that according to IMF estimates, twelve governments around the world (the ‘Dirty Dozen’) will have to issue $10.2 trillion in bonds to cover future banking losses and funding requirements in the credit markets as a result of the ongoing financial crisis.

The ‘Dirty Dozen’ and $10.2 Trillion in New Bonds

Ten trillion is a huge number. But there’s every chance the number is, in fact, a conservative estimate of government borrowing requirements. It is based on smaller than expected losses in the banking sector (the bogus scenarios modeled in the U.S. Treasury’s ’stress tests’) and a lower-than-average increase in public borrowing to deal with a financial crisis.

The IMF estimate is that public sector borrowing will grow to an average of 27% of GDP in Western or industrialised countries. But according to a study by economists Carmen Reinhart and Kenneth Rogoff published last year, governments almost always underestimate the amount of public borrowing that takes place in the wake of a banking crisis.

They do because—as the government here in Australia has done—they underestimate the blow to tax takings that comes from lower bank lending and lower economic growth. Tax takings fall while spending generally increases, especially borrowing to subsidise lending in key sectors like say, high-risk mortgage lending and property development. Think of the AOFM’s role in buying securitised residential mortgage backed securities and Ruddbank.

So how big could government bond borrowing needs get? Under the ‘best case’ scenario (lower loan losses, quicker economic recovery) Rogoff and Reinhart say public sector debt would grow to an average of 40% of GDP, leading to global borrowing needs of $15 trillion-50% higher than the IMF’s estimate. But that’s just the best case scenario.

Using the chart below, Reinhart and Rogoff suggest that in previous banking crises, government borrowing as a percentage of GDP has risen to an average of 86%. Under that scenario, now you’re talking $33 trillion in global government bond issuance in the coming five years to deal with the rest of the losses in the banking system.

The Mother of All Bubbles in Government Debt

You can see why we think all this talk of recovery and rally is a bunch of hokum. Maybe it won’t be quite 86%. Or maybe it will be more. But we know for a fact that global governments are going to flood with world with bonds in the coming years. But will investors buy them? If they don’t, you can expect much higher bond yields and much more money printing. That means inflation.

What does an investor do? Well it’s worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It’s a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the endgame of this explosion in government debt and would much rather buy equity. That alone means the “weight of money” argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you’re going to stay in the equity markets.

What does an investor do? Well it’s worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It’s a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the endgame of this explosion in government debt and would much rather buy equity. That alone means the “weight of money” argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you’re going to stay in the equity markets.

But let’s say you don’t want to buy-and-hold blue chip stocks. And let’s say you want to be in the market and not just in gold, vodka [or bourbon—Ed.], bullets, and canned goods. If you’re a “financial survivalist” what else can you do?

Try uranium and lithium (as investments, not meals). We reckon the government WILL decide that because energy is an industry that’s going to survive the credit crisis. China is building twenty one-gigawatt nuclear reactors at the moment. China will not be able to supply its own uranium needs. Australia, with over 30% of the worlds proven uranium reserves, is in position to capitalise, should it so choose.

According to Scotia Capital Inc. China strategist Na Liu, China’s nuclear industry will consume 15,700 tonnes of uranium per year by 2020. “At this rate,” she writes, “China’s currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment.”

So you see, for the resource speculator, an inflationary boom can be the best of times. It is a high-risk exercise. But junior resource stocks are one of the asset classes that CAN go up faster than the rate of inflation. And if, as we believe, the explosion in government bond issuance is going to lead to an inflationary rally in stocks, then dabbling the junior resource stocks and small caps is like hitching a front seat on a rocket.

Remember, this is pure speculation. You only hope your rocket is like Richard Branson’s new Virgin Galactic space plane, and not the nuclear missile Slim Pickens rides in Dr. Strangelove.

And what about red wine? The bottle shop across the street from the Old Hat Factory is closed for renovations. In its clearance sale, we were able to pick up a few bargain bottles of Penfolds Bin 389 Cabernet Shiraz. That is wealth you can either drink or store. We’ve done a little of both.

But you can also sell it! There appears to be a roaring trade in Penfolds wines on e-Bay. There are certainly worse things you could spend depreciating paper money on. We’re also hearing that the 2004 vintage of the Penfolds Grange is the best ever. Can’t wait to find out.

Regards,
Dan Denning
Australian Daily Reckoning

May 13, 2009

This article was originally featured on Whiskey and Gunpowder

Very Large Bubble of Government Debt

In the markets, all the really interesting action is happening behind the scenes. On the surface, things appeared to get better on Friday. In the U.S., Ford told investors that it lost $1.4 billion in the first quarter. Apparently this was less than analysts expected. The Dow closed up 1.48% and climbed back over 8,000.

What a battler that Dow is. It’s got nothing on the S&P 500 though. The S&P is up 28% in the last thirty-three trading days. It hasn’t done anything like that since the 1930s. However the index did close down for the week. That broke a six-week run of gains.

One more note about that. Four-week winning streaks of ten percent are more are generally followed by much smaller gains or losses over the next four weeks, according to the analysts at Bespoke Investment Group. Their research shows that in the four weeks following a four-week rally of 10% or more on the S&P, the index followed up with average gains of 1.87%.

How about one more note about that. There were two four-week rallies of more than twenty percent, according to the same research. The S&P 500 surged 54.2% in just four weeks by early August of 1932. Over the next four weeks in went up another 30%. Then, in April of 1933, the index provided an encore to one four-week surge of 33.8% with another surge of 19.2%.

So there you go. What we do we make of all that? Well, it shows you that even in the middle of the Great Depression, the market was capable of staging mammoth rallies that would tempt investors back in. No doubt those were extremely tradable rallies. But they were followed by lower lows once the forces of economic and earnings reality reasserted themselves on the collective mind of the market.

This time will be different because it’s always different. But if you’re wondering if the stock market is flashing a recovery sign for the economy, you might want to take a look at insider selling. The insiders are selling this rally, according to Data by Maryland-based Washington Service. That outfit says the during the S&P’s 28% climb from twelve-year lows on March 9th, CEOs, directors, and senior officers of U.S. corporations sold 8.3 times more stock than they bought.

The insiders are probably not paying attention to the first quarter earnings reports that are responsible for the current rally. They’re looking at the rest of 2009 and probably planning for more layoffs. If they think the rally is over, it probably is. Not that there won’t be others. But behind the scenes, other things are happening which are going to drag on stocks.

One of those things is that many of the world’s sovereign governments are in the process of going broke. Spain, Ireland, Greece, and Portugal have all had their sovereign credit ratings downgraded by the ratings agencies. These countries face different challenges like burst property bubbles, declining government tax revenues, and banking sectors hobbled by massive bad loans. But what they have in common is that their respective governments have responded to the crisis by ramping up borrowing to credit-rating ruinous levels.

The scale of global borrowing plans is pretty breathtaking. And what you begin to wonder is a simple question: where is all the money going to come from? Or, to quote David Gray in Night Blindness, “What we gonna do when the money runs out?”

For example, the UK’s Debt Management office, which issues bonds on behalf of the British government, says that British bond sales between now and 2013 will exceed £696 billion. The Guardian reports that it will be more like £815 billion, according to figures from Deutsche Bank.

Do you think private investors are super excited to loan the British government money when the British economy is expected to contract by 3.5% this year? Under the budget revealed last week by Chancellor of the Exchequer Alistair Darling, the UK will borrow A$356 billion (£175 billion) this year alone, or about 12.5% of British GDP. Over the next five years, public sector debt would rise to 76% of British GDP from its current level of 46%.

Gee. That is a lot of borrowing. Britain is country drowning in debt. Adding more millstones around its neck would not seem to improve its chances of paying that debt down. You could pay it down by, say, generating national income from exports. This is what Australia is hoping to do.

S&P’s ratings agency keeps track of the sovereign debt to income ratio. If a country exports a lot of finished goods or raw materials, the government benefits from tax and royalty revenues. These monies are used to service the sovereign debt.

But if you’re not generating large export revenues, then you find a big gaping hole in your budget where royalty and tax revenue should be. Maybe that’s one-reason Britain’s new budget raises tax rates on high-income earnings from 40-50%. What you gonna do when the money runs out?

If Britain’s government thinks it can make up for disastrous public finances by raising taxes, it’s probably making another in a long-line of stupid mistakes. The high-income earners who would face the big tax increase are exactly the same people getting fired from their jobs in the City. This shows, once again, that building an entire national economy around high finance puts you in all sorts of trouble.

But wait. Maybe the high-saving nations of the world will bridge the gap between British expectations and financial reality. We wouldn’t count on it though. Remember the big hoopla from the G20 meeting in London when it was announced that the International Monetary Fund’s funding would be tripled to $750 billion?

That funding is desperately needed. The IMF itself reckons it will have to dole out some $187 billion in new loans to national governments just to ride the current phase of the global financial crisis. But a key piece of information was left missing in London. How would the IMF be funded?

The G20 finance ministers met in Washington to sort that out. And the early indications are that the IMF will be funded by issuing bonds sold to high-saving nations. If this is true, it’s a victory for the developing world and a defeat for the U.S. and Europe. The U.S. and Europe were both pushing for a direct cash injection funding method. In other words, they wanted China, Russia, Brazil, and India to use their foreign currency reserves to fund the IMF.

But the BRICs batted that proposal away. So now the IMF plans to sell around $500 billion in bonds. They will be denominated in the quasi-currency the fund uses internally (the special drawing rights, or SDRS that both Russia and China have floated as a possible new global reserve currency).

How the bonds actually work still has to be sorted out. But the internal logic of the whole arrangement is now clear: creditors hold the whip hand. Debtors are going to get whipped. The balance of power in the global economy is clearly shifting from the borrowers and spenders towards the savers and producers. Advantage BRICs.

Disadvantage Gordon Brown and Barack Obama and probably Kevin Rudd too. With the existing debt-to-GDP ratios in Britain and the U.K., we reckon it is going to be impossible to fund further expansions of financial bailout programs and welfare state programs without much higher interest rates (borrowing costs).

You can avoid the borrowing problem for a while by soaking the rich with higher taxes. You might also use climate change hysteria to tax carbon (really an indirect tax on consumers). If both happen this year and the result will be even more rapid economic contraction. They will be this Depression’s equivalent of Smoot-Hawley: exactly the wrong thing to do, done at the worst possible time.

Of course the easy out, we feel obliged to point out, is not to borrow the money at all or tax it from your citizens. You could just print it instead. But this tends to unleash hyperinflationary pressures which also tend to destabilize civil society. It’s better to avoid this if you can.

Either way, there is no avoiding the reckoning. Right now, you could make a compelling argument that the value of credit-backed assets is falling so fast that government steps to prop them up simply won’t (or can’t) work. Credit deflation rules the day. The formidable fiscal and monetary stimulus measures are disappearing in the maw of asset deflation while the world goes broke trying to prevent it.

If this is right, and it’s something investors take the time to notice, stocks are going to make lower lows again. A lot lower.

Regards,
Dan Denning
www.dailyreckoning.com.au

April 27, 2009

This article was originally featured on Whiskey and Gunpowder

S&P Ends Its Rally and Government Debt Still a Problem

The upside of a severe and painful depression is that the much needed adjust in the economy would finally happen. The flow of credit to productive enterprise and real risk-taking (value creating) activities could resume. Or, if you like, new “production possibility frontiers” would open (like terraforming the great red centre of Australia so that its climate is habitable, or reengineering the national energy grid to be less centralized and more resilient).

But history suggests policy makers will not allow the supply of money and credit to contract, or for the mistakes of the last bubble to be liquidated. That would mean someone has to take the losses. And if that happened right now, you’d have a lot of insolvent banks and foreclosed homeowners (especially in America, but perhaps later this year and next in Australia).

In fact, history shows that policy makers will do the exact opposite, pouring good money after bad into a market sorely in need of a return to the mean. Case in point is the way Congress treated the U.S. mortgage market in 2007 and 2008. It has led to the nationalization of the U.S. mortgage market, where the government now originates nine out of every ten new mortgage loans.

In 2007, the Congress passed the Federal Housing Authority Act. The Act loosened underwriting standards for Federal housing agencies in the U.S. It also allowed them to cut down payments in half (from 3% of a loans value to 1.5%) and loosened regulatory capital requirements. What’s more it raised the maximum value of loans the FHA could insure up to $417,000.

This was important. This was the size limit on loans that Fannie Mae and Freddie Mac could buy in the secondary mortgage market. But in market with inflated home values, with many home owners in desperate need of financing, the GSEs would be unable to step and provide what the private sector would not without a change in the conforming loan values.

The primary goal was to kick-start lending the U.S. mortgage market. It had to be kick-started because the non-bank lenders that sent prices soaring from 2004-2007 were out of the market. Private investors-seeing the bubble for what it was-were no longer funding the market. But that was just the beginning.

Next up was the Economic Stimulus Act of 2008, signed by President Bush on February 13th of that year. One little-discussed feature of that act raised the conforming loan limit for the GSEs from $417,000 to a maximum of $729,000 in some markets. This enabled the GSEs to buy or insure mortgages up to $720,000. This was designed to prevent mortgage activity in places like California, Nevada, and Florida from all but grinding to a halt.

The measure was pushed by folks in Congress who argued that median home values in some parts of the States were much higher than the national median. They argued that if the GSEs were to achieve their new mission of being the primary source of mortgage funds in the U.S., the size of the loans they could buy or insure would have to be raised. So it was, even though the original mission of the GSEs was to make housing more accessible to low-income and marginal buyers and NOT to prop up house prices in the most over-inflated markets.

The result, despite the subtle change of mission, was still pretty impressive. According to Inside Mortgage Finance, the GSE’s originated 73% of all mortgages in the U.S. in 2008. At the height of the mortgage bubble, non-bank lenders were stealing market share from the GSEs.

But as those lenders failed, the GSEs (Fannie and Freddie) once again find themselves as the only pillar holding up mortgage financing in the U.S. In the fourth quarter alone, if you include the FHA and the Department of Veterans Affairs, the government accounted for 92% of mortgage originations.

Did the GSEs massive expansion into the mortgage market keep U.S. house prices from falling even further? And let’s not forget the Fed, which is now buying GSE bonds in a further effort to prop up mortgage activity in the U.S. You can see the massive amount of new resources and capital that have been poured into keeping the market afloat, and by extension, preventing further deterioration on bank balance sheets that are chock-a-block filled with residential and commercial housing.

The bad news for the U.S market is that the provision to expand the conforming loan limit expired in December of 2008. Fortunately, for those interested in perpetuating the misery of the U.S. housing collapse, the American Recovery and Reinvestment Act signed by President Obama in February again raises conforming loan limits for the FHA and the GSEs to $729,750.

It’s enough to make you sick at your stomach. The U.S government is actively preventing an adjustment in U.S. house prices that would bring about a market-clearing price and lead the way to a recovery. House prices are falling anyway. So all the government has really achieved is the nationalization of the mortgage market, putting millions of Americans in mortgage purgatory.

What’s worse, you could credibly argue that the U.S. housing market is worse off today than it was two years ago-even after a 20% fall in national median home prices. More people have been sucked back into mortgages at values that are not sustainable. Look for higher default and foreclosure rates. And for the banks? You don’t even want to know…

As for Congress and Bush and Obama: nice work, fellas. Hope you’re proud of yourselves. If you wanted to put a whole generation into massive debt-above and beyond the Federal budget-you couldn’t have come up with a more devious series of laws to do it.

Here in Australia, the government is being coy about how long the First Home Buyers grant will be available to prop up home prices. However, the big story was consumer prices not house prices. And there were conflicting signs from the Australian Bureau of Statistics and the Reserve Bank about the real rate of consumer price inflation in Australia.

The ABS showed consumer price inflation increasing 0.1% month-over-month and 2.5% from the same time last year. But the RBA’s trimmed mean measure of inflation showed inflation up 4.4% year-over-year. That exceeds the RBA’s goal of between 2-3% inflation per year.

In any event, this should put to rest the “deflation” bogeyman for a while. And by the way, what is so bad about falling retail prices anyway? Nothing, as far as we can tell. If you’re a consumer, it means your dollar is stretching further and further.

It’s odd that people consider high prices and high wages a sign of a healthy economy. And besides, it’s not the number that matters. It’s what real wages actually are. Real wages are wages adjusted for inflation. If consumer prices are falling and real wages staying the same, consumers benefit with enhanced purchasing power.

The trouble for policy makes is that not all prices move in the same direction. If financial asset prices fall, this is “bad” because the value of shares and property are falling. That’s why we hear the deflation argument in consumer prices used as scare tactic to lower interest rates and prop up financial asset prices (good inflation).

But it does raise an interesting point: some prices can rise while others fall, even during a period where the general price level is rising. For example, the ABS reported that pharmaceuticals were up 13% in the March quarter. Secondary education fees were up 7.6%. Vegetables were up 6% and electricity was up 3.6%.

But some of those everyday higher prices were offset by the 14.1% fall for “deposit and loan facilities” and the 8.1% fall in prices for automotive fuel. Prices for domestic and holiday travel fell by 5.1% and overseas and holiday travel prices fell 4%.

That paints a picture of an economy in which prices for every day real expenses (food and medicine and rent) are rising, while prices for discretionary items (loan and vacations) are falling. So what?

Well, it means that in a hyperinflationary period, you could have plummeting stock and bond prices (in real terms) AND rising food, energy, and other prices (in real terms). So don’t go buy that house just because you think inflation is going to boost house prices. In real terms, a hyperinflation destroys value. It doesn’t add it.

Here’s the thing to remember: all the physical capital stock that gets built in an inflationary boom doesn’t go away. The factories are still there. The houses are still there. The capital goods are still there. And the cars are still there. But the value of that capital stock has to fall once the inflationary boom goes bust.

Mind you, not all of the capital stock will be productive in the future. How bad the bust is depends on how much capital was sunk into boom-time investments that don’t produce any return-ever. There are some people, for example, who argue that housing is a wasting asset, a sunk cost, or even the largest generational misallocation of capital ever [like Whiskey contributor James Howard Kunstler—ed.].

Whether it is or it is not is beside the final point in our notes. What we’re watching for now is whether it’s really possible to sustain the inflationary boom in financial assets and the consumer economy with an even greater amount of credit and debt. We suspect it is not. And that’s what’s scary.

Ever since the early part of this century, governments have been managing the contracting phase of the business cycle with the introduction of more credit. The ripple effects of the monetary expansion have steadily widened over the years, drawing more of the globe into the game. It culminated in the 200-2007 worldwide boom in all asset classes across the planet-the blow off top of 90 years of rising fiat money, if you will.

Once a global inflationary boom has been expanded to include every market everywhere, how do you keep expanding it? Is this what an IMF-backed global currency is about? The ultimate expansion of fiat money worldwide for a global policy of inflation? Is that the final frontier of fiat money? We’ll explore that space next week.

Regards,
Dan Denning
www.dailyreckoning.com.au

April 24, 2009

This article was originally featured on Whiskey and Gunpowder

Vagaries of Price Movement Amid Inlation and Deflation

“Maestro…you hardly look yourself. It looks like twenty years have dropped from your face. It must be liberating not to have to worry about inflation anymore.”

“What’s inflation?”

“Ah yes. About that. Why haven’t we seen it yet? You’ve seen massive fiscal stimulus plans the world over, a huge increase in the monetary base, and lower interest rates. But no inflation. Bond traders don’t seem especially worried either. They are not demanding higher interest rates because they fear future inflation. And gold? Well, it’s plodding along. But shouldn’t it be going much higher as the supply of fiat money explodes?”

“You’re thinking is so old fashioned. It’s true. Or at least it used to be true. In the days when we had a gold standard, it was a great defense against government monetary fraud (that’s what I used to call inflation, before I became a central banker).”

“Oh. What do you mean?”

“If each unit of paper currency in your hand is redeemable for gold, then each holder of paper units has the power to hold the government accountable for its fiscal and monetary policy. If the government prints too much money to pay for its spending programs, unit holders can redeem their paper for gold. This draws down the governments stores of real gold, forcing it to either reduce the supply of paper money, or lose all its gold.”

“Why would it worry about that if it could just print more paper?”

“Because paper is not money. And your trading partners will not accept your paper if it is not backed by either real money or the ability to collect taxes from your people.”

“I’m not sure I follow. Back up a bit for me.”

“Okay. Back when everyone was on a gold standard, before the Great Depression, international accounts were settled in gold. It wasn’t just citizens who could demand gold for their units. Nation states could do it to. Governments who ran up fiscal imbalances would see international holders of their currency redeem those paper units for real gold. This encouraged a kind of competition among nation states, or at least a kind of accountability. If you ran up deficits and borrowed a lot of money, gold flowed out to pay your creditors and to pay for your exports. Your inflationary monetary policy cost you your national inventory of gold and silver.”

“So what happened?”

“My you ask a lot of questions.”

“Hurry up. I think I have to wake up soon.”

“Well, under a gold standard, governments are forced to manage their monetary system for the benefit of their people. You get a stable price level because the value of the money is not fluctuating constantly with changes in the money supply. Governments want to avoid causing a run on their gold supply that would result from fiscal and monetary mismanagement.”
“Why did the world go off the gold standard if it was so good? What changed?”

“Lots of things. For example, with a gold standard, governments and people must live within their means. This is deeply unpopular with politicians, who must bribe populations with bright new shiny things to get elected. Gold makes it harder to bribe your people and win an election.”

“Okay. What else?”

“For whatever reason, perhaps because it is in their nature, governments like to take their people to war. It keeps them distracted from other problems, usually caused by the government. But war is expensive. To pay for a war you must increase taxes or borrow money. If you increase taxes (directly or indirectly) you risk alienating your population and causing a tax revolt (and sending a lot of economic activity underground, out of the view of the tax collectors). So you have to borrow. It’s the only way to greatly expand spending without raising taxes to punitive or socially disruptive levels.”

“Ah. I see. Under a gold standard, you couldn’t borrow excessively without causing a run on your nation’s gold. So…a gold standard was a natural constraint on a nation’s ability to make war.”

“Yes. That doesn’t mean nations didn’t go to war before there was a gold standard. It just means that if you had to pay for your war with real money, it made it an expensive proposition. And if it undermined the value of the currency your citizens held, they were unlikely to support you. In a monarchy or dictatorship, that doesn’t matter so much. But in a democracy, it matters a lot.”

“If what you’re saying is correct, Maestro, then there’d be a clear connection between the creation of fiat money which is not backed by gold at all, and war between nation states.”

“There might be. But you’re still thinking too small.”

“What do you mean?”

“It’s true that most nations suspended the gold standard upon entering World War I. This allowed them to run up ruinous debts to private bankers. They tried reinstating it, but then the Great Depression hit. And more than ever, governments needed the ability to print money to pay for domestic ‘wars’ on poverty and unemployment.”

“Right. And then World War Two-which was partly a consequence of the ruinous debt and reparations Germany could not repay-came along and you saw a huge explosion in government debt, this time mostly through bonds.”

“That’s right. Which brings us back to inflation today. When the government finances exploding debts through the issuance of new bonds, investors typically demand higher interest rates to compensate for the inflation that results from the increase in the money supply. But today, in a kind of conundrum, bond investors are not demanding higher interest rates.”

“Why not?”

“Who knows? For one, they don’t see inflation. They see falling prices that come with a collapse in global demand. But it could be that they fear the worldwide recession more than they fear inflation. The contraction in global trade and national GDPs has investors fleeing for the safety of bonds. This allows governments to print money and expand the monetary base with apparent impunity.”

“Apparent?”

“Yes. Why, there in Australia where you’re sleeping, the government is going to announce a budget in May which may include a $50 billion deficit. This is a country that had a surplus just a short time before.”

“That’s not as bad as my home country. In the U.S., the government is going to run a trillion dollar deficit this year. And it’s told everyone that number will double. But it doesn’t seem to have dented demand for U.S. bonds yet.”

“No, it hasn’t. And that’s because without a gold standard, governments don’t have to compete for capital as fiercely as they used to. They can all sell bonds to investors to finance deficits, provided the deficits aren’t too jaw-dropping and provided they can continue to collect taxes to pay interest on the debt. Plus, they’re colluding with one another to eliminate tax competition among countries, which gives them an even stronger grip on your wealth.”

“I’m with you Maestro. But I don’t see where this is going.”

“Let me show you. Governments can only raise direct taxes (income taxes) so much before it negatively affects the economy (and social cohesion), which in turns lead to falling tax revenues as real economic activity slows. So a sure sign of governments that are getting desperate for revenue is an increase in indirect taxes.”

“You mean like the alcopops tax here in Australia?”

“I’ve never heard of that. But if it’s a tax that the supplier of a good or service passes on to the consumer then yes, that’s exactly what I mean. It’s an efficient way for the government to raise revenue without looking like it’s being grubby, desperate, or just plain greedy. It can also claim the taxes are being raised to discourage socially undesirable behavior, but this is generally just a lie to disguise the need to raise revenues.”

“Ah. I see. You know the alcopops tax is illegal anyway, by the way. The government collected revenue on a tax using a law that hadn’t been properly been passed by the Parliament. How is that possible? What about the Rule of Law?”

“What about it?”

“Never mind. You need to finish your lecture before I wake up. When will inflation result from the large increase in the monetary base?”

“I have no idea, my boy. You see at its core, fiat money greatly accelerates the rate at which scarce resources are depleted. Land, labour, capital, and raw commodities are allocated based on a demand that isn’t sustainable. If you do that long enough-let’s say for the last seventy years or so-you get an entire global economy (and population) that exists because of the increase in credit. That’s the world we live in. And it’s all falling apart with the credit depression you’ve been writing about.”

“Wait a second Maestro. Are you saying that the scope and scale of this economic contraction is a lot greater than anyone expects because the fiat money system itself is failing?”

“You said it. Not me. But it does make sense to say that the last twenty years or so of building national economies around the growth of residential real estate and the finance sector has greatly hastened us to a day of reckoning, as your friend Bill Bonner might say. We will find out if all that investment made by banks is merely ‘temporarily impaired,’ or if it represents an enormous misallocation of our collective resources and has made us poorer for years to come.”

“So what should we do?”

“This is your dream. You decide.”

Regards,
Dan Denning

April 16, 2009

This article was originally featured on Whiskey and Gunpowder

Dreams of the Maestro, Gold and Inflation