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Friday, September 28, 2012

Gold Could Easily Double From These Levels

By Caesar Bryan from

 “The balance sheets of the major central banks, over the last several years, have gone from just over $2 trillion, to almost $10 trillion.  We’re talking here about the Fed, ECB, BoE, and the BOJ.”

“Most of that increase has been in the last few years, since the financial crisis.  We are clearly not at the end of this, and you could argue that the rate of increase is actually accelerating.  I don’t believe that has been properly reflected in the gold market yet.

The gold market breached $1,000 in the beginning of 2008, fell toward the $700 level after the Lehman crisis, and then went back over $1,000 in 2009.  Since that time we have had a dramatic increase, a more than doubling of the balance sheets of just those four central banks....

“The underlying price of gold hasn’t even kept up with the increase in the balance sheets of the central banks.  So there is no question that gold is undervalued today.   As these central banks continue to expand their balance sheets, the upside for gold is very significant.

It’s not as if investors are overweight in gold.  On the contrary, central banks and private investors have a very tiny exposure to gold.  So should there be a discussion about changes to the financial architecture, with a role for gold being part of that new architecture, then gold would go much higher.  Gold could easily double from here.

Gold has had a decent move over the past couple of months, but you have to remember that gold already traded near $2,000 in the summer of 2011.  Meanwhile, money printing at central banks continues unabated.  The Fed has already said they are going to do this mortgage-backed asset purchase scheme, but if the economy does not respond, they are prepared to do more. 

The European situation is different, but the result seems to be very similar.  We have unsustainably high interest rates in the periphery of Europe, and the ECB is going to purchase those peripheral bond markets until rates come down and those countries can finance themselves.

The political will in Europe to maintain the euro is very strong.  To maintain the euro necessitates these dramatic moves.  So it is crystal clear that in an environment of subdued economic growth, central banks are going to remain very active, and this will act as an accelerant for gold going forward.”

 “The gold equities continue to be inexpensive, and unloved, despite their recent performance.  There is excellent potential, in a high gold price environment, for gold equities to put in a very powerful performance.  The bottom line is they are still incredibly cheap at these levels.”

A Faltering Global Economy, Neo-Keynesians & $15,000 Gold

by  Jean-Marie Eveillard

Today legendary value investor Jean-Marie Eveillard told King World News, “There are people who have figured out that in view of the enormous amount of money printing, which has taken place over the past three or four years, a price of $15,000 an ounce for gold would not be absurd.”

Eveillard, who oversees $60 billion, also said, “I’m not sure they are right, because I have not studied how they came to that conclusion, but I think what is true is there has been gigantic money printing, which will of course help the price of gold.”

Here is what Eveillard had to say: “The global economy seems to be weakening. It’s weakening in the US, Europe, China, in Asia, and this is in spite of the stimulus. Asia is suffering because Japan continues to do poorly. Again, this weakness is apparent despite the fact that Neo-Keynesian policies are in place. There is enormous fiscal stimulus associated with gigantic budget deficits.”
“There is considerable monetary stimulus associated with the Fed and now the ECB, with the ECB deciding in an ‘unlimited way’ they would print money.  So this weakness is a puzzle for policymakers.  It’s a sign that the economies in the developed world are not responding to the Neo-Keynesian remedies.

First, the Keynesian policies are somewhat dubious, but number two, after a major financial crisis, it’s always very difficult for the economies to recover....
“In view of the fact that the Neo-Keynesian policies continue to be in place almost everywhere, and as long as there is no change in those policies, I think gold still has considerable upside.

There are people who have figured out that in view of the enormous amount of money printing which has taken place over the past three or four years, a price of $15,000 an ounce for gold would not be absurd. 

I’m not sure they are right, because I have not studied how they came to that conclusion, but I think what is true is there has been gigantic money printing, which will of course help the price of gold.

I would also add that I think the mining shares, of course it was impossible to determine the timing, but they had been lagging the price of bullion for so long, and in such a major way, that we knew at some point they had to outperform.  It’s quite possible that a week and a half ago we got to that point.

The move in the mining shares surprised some market observers because they thought they could pick the bottom.  Going forward, I think investors should own a proper balance of undervalued equities, gold, and cash.  Gold is appropriate today for the obvious reason we have discussed, but they should also own undervalued equities because to some extent they are also real assets.”

Interest Rates Are Prices

by Ron Paul - Daily Paul

One of the most enduring myths in the United States is that this country has a free market, when in reality, the market is merely the structural shell of formerly free institutions. Government pulls the strings behind the scenes. No better illustration of this can be found than in the Federal Reserve's manipulation of interest rates.

The Fed has interfered with the proper function of interest rates for decades, but perhaps never as boldly as it has in the past few years through its policies of quantitative easing. In Chairman Bernanke's most recent press conference he stated that the Fed wishes not only to drive down rates on Treasury debt, but also rates on mortgages, corporate bonds, and other important interest rates. Markets greeted this statement enthusiastically, as this means trillions more newly-created dollars flowing directly to Wall Street.

Because the interest rate is the price of money, manipulation of interest rates has the same effect in the market for loanable funds as price controls have in markets for goods and services. Since demand for funds has increased, but the supply is not being increased, the only way to match the shortfall is to continue to create new credit. But this process cannot continue indefinitely. At some point the capital projects funded by the new credit are completed. Houses must be sold, mines must begin to produce ore, factories must begin to operate and produce consumer goods.

But because consumption patterns have either remained unchanged or have become more present-oriented, by the time these new capital projects are finished and begin to produce, the producers find no market for their goods. Because the coordination between savings and consumption was severed through the artificial lowering of the interest rate, both savers and borrowers have been signaled into unsustainable patterns of economic activity. Resources that would have been used in productive endeavors under a regime of market-determined interest rates are instead shuttled into endeavors that only after the fact are determined to be unprofitable. In order to return to a functioning economy, those resources which have been malinvested need to be liquidated and shifted into sectors in which they can be put to productive use.

Another effect of the injections of credit into the system is that prices rise. More money chasing the same amount of goods results in a rise in prices. Wall Street and the banking system gain the use of the new credit before prices rise. Main Street, however, sees the prices rise before they are able to take advantage of the newly-created credit. The purchasing power of the dollar is eroded and the standard of living of the American people drops.

We live today not in a free market economic system but in a "mixed economy", marked by an uneasy mixture of corporatism; vestiges of free market capitalism; and outright central planning in some sectors. Each infusion of credit by the Fed distorts the structure of the economy, damages the important role that interest rates play in the market, and erodes the purchasing power of the dollar. Fed policymakers view themselves as wise gurus managing the economy, yet every action they take results in economic distortion and devastation.

Unless Congress gets serious about reining in the Federal Reserve and putting an end to its manipulation, the economic distortions the Fed has caused will not be liquidated; they will become more entrenched, keeping true economic recovery out of our grasp and sowing the seeds for future crisis.
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Animal spirits

The BBC is running a three-part series on notable economists, starting with Keynes. There were a number of errors made, but I shall ignore those and address two Keynesian fallacies. The first was that Keynes correctly anticipated the economic and political consequences of the Versailles Treaty, which inflicted punitive reparations on Germany: this was true. It was bizarrely extrapolated to the current situation, concluding that Germany must reduce its prosperity and economic power to a level closer to that of the other Eurozone countries in the interests of economic balance.

The second point was that Keynes described unexpected changes in economic behaviour as "animal spirits". Mervyn King, Governor of the Bank of England no less, said on the programme that it was the best explanation for the Banking crisis five years ago. To describe such an event in those terms is not an explanation and exposes a yawning gap in King’s knowledge.

"Animal spirits" amount to the failure of Keynesians to explain a basic phenomenon of human action. The origin of the phrase, if the programme is to be believed, comes from Keynes’s unsuccessful attempts to predict stock market prices. We have all been there: we invent a fool-proof trading system only to see it fail in practice. "Animal spirits" is a substitute for understanding that it is impossible to predict tomorrow’s prices with certainty, whether they be of financial assets or of goods.

Prices change for one of two reasons. Either there is a change in the value of the goods being exchanged for money, or there is a change in the value of the money used. The Banking crisis to which King referred was about a sudden change in the value of money.

Before the crisis, banks were willing to lend, and consumers were willing to borrow to buy. The prerequisite was continually expanding credit, a process that was bound to end sometime. And when it did, the consequence of a change in the availability of money was an increase in its value to the consumer, and the result was a fall in prices. "Animal spirits" is an attempt to summarise this effect without understanding it.

Left alone, prices would have adjusted to new lower levels. Government action was focused on stopping this happening, by introducing schemes such as car scrappage, or cash-for-clunkers, to encourage demand. At the same time central banks flooded the banking system with money to stop its value rising. Prices were therefore prevented from adjusting to the bursting of the credit bubble. This Keynesian solution has another fallacy at its heart, clearly stated by the experts, including King, on the programme. They believe that production has to be subsidised in order to keep unemployment down. If people remain employed, they will spend, and that gets the economy back on track. This analysis is incorrect: as we have seen, the problem is prices, not production.

The order of events does not start with production, it starts with consumption. If prices are too high, because of a change in the value of money, then they must fall if consumers are to be tempted. The fall in prices exposes over-valued productive capacity. It is an adjustment that must occur, and no amount of subsidy and money-printing to address "animal spirits" can change that. And the sooner it happens, the sooner an economy gets back on track.

Originally published on

The Fed is Trapped, Gold is the Exit

47% of US investors dependent on the Fed believe they are victimized by government, who believe they are entitled to enough liquidity to profit when risk is laid-off onto others, to society, to you-name-it… On September 13th, the Fed announced QE3, a policy of open-ended bond purchases which would add $1 trillion annually to the Fed’s balance sheet. The Fed’s decision to provide liquidity ad infinitum, i.e. QE etc, was framed in reasonable and carefully chosen language: …These actions, which together will increase the Committee's holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…

The measured wording gave the Fed sufficient cover to mask its increasingly desperate condition, i.e. how to keep its fatally-wounded credit and debt ponzi-scheme functioning while searching for a solution that doesn’t exist.
In capitalist economies, capital, i.e. money, is introduced by central banks into the economy in the form of loans; and because interest constantly compounds, economies must constantly expand in order to pay down and/or service those loans. This is why economists in capitalist systems are obsessed with growth. Capitalism is, in actuality, a smoke and mirrors shell game where credit and debt have been substituted for money; and, as long as capitalism expands no one is the wiser because the fraud is so subtle. Capitalism, however, is no longer expanding. It is contracting. Capitalism reached its peak in 2008 when Greenspan’s historic credit bubble burst. What investors believed was a finely-tuned balancing act between credit and debt orchestrated by Fed Chairman Alan Greenspan turned out instead to be a speculative bubble fed by Easy Al’s easy credit from the Fed’s 24/7 discount window. While Greenspan presided over the greatest credit expansion in the history of capitalism, Greenspan also presided over two of its largest speculative bubbles—the 1996-2000 bubble and 2002-2007 US real estate bubble. Greenspan would later refer to evidence of these bubbles as ‘froth’; to those who lost homes and fortunes, it was blood.
read more here :

Fed Easing Only Helped Stocks, Not Economy

Macro Analytics - FEDEREAL RESERVE - Flawed Premise - Mistaken Role

The Federal Reserve and its Monetary Malpractice is at the core of the American Dream becoming a myth for the vast majority of Americans. Jobs, disposable income and financial security are all under pressure, as the Federal Reserve continues its historic monetary gamble on unproven policies of Quantitative Easing and ZIRP.

Charles Hugh Smith and Gordon T Long discuss how a flawed premise and the mistaken role for this private-public institution is leading to moral hazard, unintended consequences and dysfunctional financial markets. They argue that there is sufficient proof to now call into question the historic role of the Federal Reserve .

This two part series also examines who is winning, who is losing and where it is likely to lead. The facts laid out in this series should be a concern to all Americans who care for their country and the future for their children.

Thursday, September 27, 2012

Fed Virtually Funding the Entire US Deficit: Lindsey

The latest round of extraordinary Federal Reserve stimulus is risky and leaves little room to maneuver should another crisis hit, economist Lawrence Lindsey told CNBC’s “Squawk Box” on Wednesday.

Lindsey said that with the Fed purchasing at least $40 billion a month in mortgage debt through QE3, “they are buying the entire deficit.” (Read more: Fed Pulls Trigger, to Buy Mortgages in Effort to Lower Rates.)

“I have no problem doing extraordinary things in extraordinary times,” said Lindsey, a former White House economic advisor under former president George W. Bush who now runs his own consulting firm.

Lindsay said he agreed with the Fed’s first two rounds of quantitative easing. Now, with the economy now growing closer to its trend rate, “doing something that’s really out of the ordinary is risking things.”

He added, “If this becomes the new ordinary, it’s hard to imagine the Fed’s maneuvering room” should another crisis hit. (Read More: Why Fed Policy Just Like the NFL Refs: El-Erian.)

The central bank's recently announced bid to stimulate the economy has also taken the pressure off politicians to deal with the U.S. fiscal cliff, Lindsay argued, which could result in destabilizing tax hikes and spending cuts automatically taking effect early next year.

“The Fed, maybe because it can't do otherwise, has told the Congress: 'We're going to buy your bonds no matter what,'” Lindsey said. “I think that's keeping the pressure off the president, off the Congress.”

The effective of QE3 on interest rates may also keep Congress from reining in borrowing.

“If the (Fed) chairman’s estimates of the effectiveness of QE3 on interest rates come true, we’re going to be down to an average cost of borrowing for the government of 0.6 of a percentage point,” Lindsey said. “Why would any Congress not borrow and spend if they could borrow at 60 basis points?” 
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Spain is turning into the new Greece, and Mariano Rajoy has himself to blame

When the economic situation is bad (the country’s GDP estimates fell again on Wednesday) there’s nothing like a dose of political mismanagement to give things a good hard shove towards the same abyss that Athens disappeared into sometime in the middle of last year.

It’s only September but the scenes from Madrid in recent days prompted me to revisit the annual predictions in which we indulge every January. At the start of the year, as we looked forward to another 12 months of experimental eurozone economics, not to mention politics, with renewed austerity measures and another euro treaty, this column said: “None of this has been tested at the ballot box and I predict a year of popular political protest across the eurozone, some of which will turn violent, prompting shocking scenes as governments use force to regain order.”

You can’t let a gun off slowly, but Spanish prime minister Mariano Rajoy has been openly flirting with the idea of seeking a bail-out from the European Central Bank in recent days but only if capital market investors forced Spain into it by sending yields on Spanish government debt higher.

In the land of bull fighting, he has waved the proverbial red rag. Lo and behold, Spanish bond yields duly shot up again on Wednesday to 6pc, pricing Spain out of the markets and forcing him closer to going cap in hand to Frankfurt, assuming the ECB bail-out is actually real as opposed to an empty promise. This, in turn, will undermine his political credibility at home which the riots in Madrid and secession fever in Catalonia reveal is already suffering.

It reminds me of John Major’s government in 1992 and a determined Norman Lamont giving George Soros any excuse to bet against the pound and test just how determined the Treasury really was about defending sterling.

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The Fed is the Great Enabler

We've speculated in TSI commentaries that unwavering devotion to bad economic theory (a type of stupidity) is the most likely reason for the Fed's introduction of a new inflation program at this time. There are other plausible explanations, but in general terms it boils down to this: the Fed is either stupid, or evil, or stupid and evil. There is no fourth possibility that makes any sense. It is either evil enough to inflate the currency in an effort to help banks (or the re-election chances of Obama*) even though it knows that doing so will harm the overall economy; or it is stupid enough to believe that the economy can be helped by creating money out of nothing and distorting the price signals upon which an efficient market relies; or it is evil enough and stupid enough to believe that it can transfer wealth to the banks and simultaneously create a net benefit for the overall economy. We'll go with evil and stupid. The timing of the new policy was probably determined by the deteriorating employment situation, but the Fed may well be trying to kill multiple birds with a single stone. In any case, regardless of the reasoning behind the Fed's latest policy move, the Fed exists primarily to enable growth in the government and secondarily to enable growth in the banking industry. Growth in government is enabled because a government with a captive central bank will never run short of money, irrespective of how big its deficits become and how far into debt it goes. Growth in the banking industry is enabled because the central bank's unlimited power to create new bank reserves means that banks need never run short of reserves, irrespective of how reckless they are in their lending and borrowing.

It is clear from the following chart that the Fed has succeeded in its primary objective. The chart shows spending by the US federal government as a percentage of GDP from 1880 through to 2012. In 1880 the federal government spent about 3% of GDP. In 1913, the year the Federal Reserve came into existence, the federal government also spent about 3% of GDP. In other words, as a percentage of GDP there was no growth in the US federal government during the 33 years prior to the inauguration of the Federal Reserve. An ultra-long-term upward trend then began. Ignoring the war-related spikes during the late-1910s and the first half of the 1940s, there has been steady growth in the US federal government from 1913 through to the present. Currently, US federal government spending equates to about 24% of GDP. This means that since the birth of the Federal Reserve the cumulative increase in the size of the US federal government is about 700% greater than the cumulative increase in US GDP.

Would a Republican victory in this year's US Presidential election reverse the upward trend in the size of the federal government? If history is a guide, the answer is no. In fact, over the past thirty years the size of the US federal government, as indicated by federal government spending as a percentage of GDP, increased by more during Republican administrations than during Democratic administrations. The Republicans often talk a good game (they pay lip service to smaller government), but in practice they are usually just as bad as or worse than their Democratic counterparts. One of the main reasons is that the Republicans are generally in favour of boosting the amount of money spent on the military. An increase in military spending is always politically easy to accomplish because most Americans are proud of their armed forces, but of the main areas of US government spending the most unproductive is the military. We are certainly not in favour of government spending on public works programs in an effort to create jobs, but it would be much better for the government to spend money building a bridge in the US than blowing up a bridge in the Middle East.

So, a Romney-Ryan victory in November would probably change the composition of the federal budget, but believing that it would result in a smaller government is an example of the triumph of hope over experience. Regardless of who wins in November, it's a good bet that the US federal government will be a bigger part of the economy four years from now than it is today. And as always, the government growth will be enabled by the Federal Reserve.

The extent of the Fed's success in achieving its secondary objective (enabling growth in the banking industry) is less easy to establish. This is because the big banks periodically go way too far and blow themselves up. The Fed then bails them out, either immediately and directly via the injection of new money or gradually and indirectly by manipulating the yield curve and altering regulations, but the periodic blow-ups mean that there hasn't been a consistent ultra-long-term upward trend in the banking industry relative to the overall economy. The US financial sector's performance has been lumpy, although it has still managed to grow from about 3.5% of GDP at the introduction of the Fed to about 8% of GDP today.

The bottom line is that we can speculate about why the Fed introduced a new inflation program at this particular time, but in the grand scheme of things it doesn't matter. A specific policy move by the Fed will generally be a reaction to recent economic data and short-term considerations, but the Fed doesn't exist for the purpose of fine-tuning the economy (although the current Fed chairman and governors may well be politically naive enough and economically illiterate enough to believe that it does). It is a tool that facilitates the growth of the government and the banking industry.

*In last week's Interim Update we outlined our reasons for thinking that the Fed did not act with the aim of boosting Obama's re-election chances. We also said that in the unlikely event that it did act for this reason, the move could backfire. An informal Facebook survey conducted by the Federal Reserve Bank of San Francisco underlines the possibility that the Fed's move could hinder rather than help the Obama campaign. As noted in a WSJ blog entry on 17th September, the Facebook survey indicated an overwhelmingly negative public response to QE3.

Steve Saville

Pierre Lassonde - Gold & Central Banks Fearful Of A Depression

Lassonde is arguably the greatest company builder in the history of the mining sector. He is past President of Newmont Mining, past Chairman of the World Gold Council and current Chairman of Franco Nevada. Lassonde is one of the wealthiest, most respected individuals in the resource world, so we take his warning very seriously.

But first, Lassonde had a great deal to say about the gold market: “I was very surprised in the summer that gold didn’t break the $1,500 level. I say that because Europe is really going into a recession, and I felt the lows were going to be breaking the $1,500 (level). But you know what saved the gold market? The central banks.”

“The central banks came in and bought almost 150 tons of gold in June and July, and the gold market never looked back. It was very stable, and it built from there. From here on in it’s very simple, when you look at the Federal Reserve, with QE3, when you look at the ECB with their OMT, it should be OMG, for ‘Oh My Gold,’ because they are essentially going to be monetizing Spanish and Italian debts.

When you look at the Japanese Central Bank, they just announced their own QE3 program. It’s essentially all of the central banks around the world printing money. So what do you think gold is going to do?....

“It’s going to keep on going up.

Don’t be surprised to see $2,000 gold in the next six months. I would not be surprised at all. Ultimately, my view is that we are looking at a 15 to 20-year bull market in hard assets. Mostly (in) gold, if we want to be specific. We are in year 12, so we still have quite a few years to go.

I do believe that every one of those bull markets has had a mid-cycle recession. I think that when you look at the metals index, not when you look at gold, but when you look at the metals index, we have entered that mid-cycle recession.

Iron ore-prices are down from $180 to $85. You look at just about every metal and the whole index is down. The only metals and commodities that have held up better than expected are copper and oil. That being said, I think we are in a mid-cycle recession. So we are going to have to be a bit more patient in terms of what do we expect over the next year or two from a level of around $2,000 (for gold).

So I think for the next 12 months one will have to be patient. The gold price is well supported. The central banks are there. They are buying. When you talk about the worldwide slowdown, the central banks are worried about a depression, and that’s why they are printing all of that money.

The long-run, we all know it, it’s going to come back to bite them. The way it will come back to bite them is through inflation. When you start to see inflation starting to get imbedded in food prices, wage increases, that will be the start of the final bull run in gold.”
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BofA Sees Fed Assets Surpassing $5 Trillion By End Of 2014... Leading To $3350 Gold And $190 Crude

Yesterday, when we first presented our calculation of what the Fed's balance sheet would look like through the end of 2013, some were confused why we assumed that the Fed would continue monetizing the long-end beyond the end of 2012. Simple: in its statement, the FOMC said that "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability." Therefore, the only question is by what point the labor market would have improved sufficiently to satisfy the Fed with its "improvement" (all else equal, which however - and here's looking at you inflation - will not be). Conservatively, we assumed that it would take at the lest until December 2014 for unemployment to cross the Fed's "all clear threshold." As it turns out we were optimistic. Bank of America's Priya Misra has just released an analysis which is identical to ours in all other respects, except for when the latest QE version would end. BofA's take: "We do not believe there will be “substantial” improvement in the labor market for the next 1.5-2 years and foresee the Fed buying Treasuries after the end of Operation Twist." What does this mean for total Fed purchases? Again, simple. Add $1 trillion to the Zero Hedge total of $4TRN. In other words, Bank of America just predicted at least 2 years and change of constant monetization, which would send the Fed's balance sheet to grand total of just over $5,000,000,000,000 as the Fed adds another $2.2 trillion MBS and Treasury notional to the current total of $2.8 trillion.

In other words, for once we actually were shockingly optimistic on the US economy. Assuming BofA is correct, and it probably is, this is how the Fed's balance sheet will look like for the next 2 years:

Or, in terms of US GDP, the Fed's balance sheet will have "LBOed" just shy of 30% of all US goods and services.

It gets worse:

Since the Fed is effectively becoming the marginal player in both the MBS and Treasury markets, a very relevant question is how much private market debt is left to sell. Short answer: not much. According to BofA's calculation, the Fed will own more than 33% of the entire mortgage market by 2014.

That's half the story.

On the Treasury side, in just over 2 years, "Fed ownership across the 6y-30y portion Treasury curve is likely to reach about 50% by end of 2013 and an average of 65% by end of 2014." You read that right: in just over 2 years, the Federal Reserve will hold two thirds of the entire bond market with a maturity over 5 years (which by then will be part of the Fed's ZIRP commitment, yield 0% and essentially be equivalent to cash).

No wonder that David Rosenberg is worried that the Fed will soon run out of securities to buy (well, there are always equities of course, but the Fed will not monetize those until some time in 2015 when hyperinflation is raging).

And speaking of hyperinflation (and our earlier note that nothing "else is equal") the real question is if indeed the Fed will own $5 trillion in "assets" in 27.5 months, what does that mean for gold and crude? The answer is plotted below:

In case it is unclear, the answer is:
$3350 gold
$190 oil.

Luckily the Fed has already factored all these soaring input costs (and "alternative money" prices) in its models, and there is nothing to worry about. Lest we forget, the Fed can crush inflation cold in 15 minutes cold... somehow. Even when unwinding its balance sheet would mean sacrificing 30% of US GDP and, let's be honest about it, civil war.

* * *

That's it in a nutshell. Those who are interested in the nuances of the BofA analysis, which is a replica of our own, can read on below:

The Fed Bazooka

Given our growth forecast, we expect the Fed to follow up the expiration of Operation Twist with an open-ended outright Treasury purchase plan at the December meeting. We expect the pace could be between $45 billion (which would be equal to the current size of Twist) and $60 billion/month for two years [in 10 year equivalents]. We expect a long program given the slow improvement in the labor market as well as the Fed’s focus on a “substantial and sustained improvement” in the employment situation.

Table 2 compares different asset purchase programs by the Fed in terms of the net notional and duration take-out. Were the Fed to engage in renewed Treasury purchases post the end of Twist (in the same maturity distribution), this could easily become one of the largest programs in terms on monthly 10y equivalent demand from the Fed. Note that even MBS buying takes duration out of private hands, which would put downward pressure on rates

Mortgages: Fed buys most of monthly issuance

We estimate that Fed purchases will take out about 60% of monthly MBS production. However, our mortgage strategists note that historically the Fed has concentrated its buying in 30y conventionals. For example, in August the Fed bought $23bn of conventional 30s, $2.5bn of conventional 15s and $3bn of GNs. This compares with gross issuance at $122bn, which is split into $88bn in conventionals ($66bn in 30s, $22bn in 15s) and $34bn in GNs. In other words, the Fed has concentrated 80% of its purchases among conventional 30y. A similar pattern would suggest that the Fed would buy an additional $30bn in this sector, which could end up being almost 90% of all issuance in conventional 30y. This explains the significant tightening in the mortgage basis, and would argue for the Fed to buy some other sectors as well.

In terms of outstandings, we expect the Fed to end up owning more than 33% of the total market by the end of 2014, which is also significant since many mortgage investors tend to reinvest paydowns. These investors would need to be persuaded to sell MBS to the Fed, which would require tighter spreads.

Treasuries: Fed will own a 45-50% in the long end in a year

Given our growth forecast, we expect the Fed to follow up the expiration of Operation Twist with an open-ended outright Treasury purchase plan at the December meeting. We estimate further what the potential ownership of the Fed could look like in the Treasury market over the course of the next two years. We assume that: 1) Purchase sizes are in the same distribution as Twist, sans the sales; 2) Treasury coupon auction sizes remain constant; and, 3) The Fed does not change the 70% per issue maximum SOMA limit.

Table 3 and Table 4 simulate the Treasury universe during the course of 2013 and 2014. Fed ownership across the 6y-30y portion Treasury curve is likely to reach about 50% by end of 2013 and an average of 65% by end of 2014. Given the current issuance schedule, we believe it is very likely that the Fed changes its purchase buckets through the next round of Treasury purchases. In particular, the Fed will begin to run out of issues in the 8y-10y bucket and will be forced to buy newly issued 10y notes should they choose to maintain the same distribution. We believe this is unlikely, and that the Fed is likely to redistribute its purchases and possibly include the 5y portion of the curve to provide some room.

Five Years Since The Great Financial Crisis: "No Growth, No Deleveraging"

One of the populist buzzwords of the past 5 years, particularly in Europe, has been "austerity", which as we have said for the roughly the same past 5 years, is simply a synonym for "deleveraging" but one which carries just the right amount of negative connotations, and is used by crafty politicians to shift blame from their own failure to enact proper policy (which over the past 30 years has merely meant to borrow growth from future political cycles, aka, issue debt) onto a "technical" word conceived by Ph.D.-clad economists, who too, are looking for a passive victim on which to project their failure of enacting a voodoo economic theory. There is one problem with all of the above. As we have also been saying for the past five years, the austerity deleveraging myth is one big lie. We are setting the record straight below with facts and figures. We would be delighted if some politician, somewhere, could disprove these facts, which essentially imply that the world is now in a global recession, having experienced no growth as the recent 100% contractionary PMI print of all major economies confirms, yet without any country actually having implemented austerity, pardon deleveraging to have at least a modest justification for this failure of growth.

Finally, this article proves that the European chorus screaming for "growth" when everyone knows it demands merely more of the same drug - debt - is 100% wrong, and that while the underlying causes of "growth" are there, the only thing missing are the symptoms. DB's Jim Reid provides the charts and facts:

Figure 37 shows the combined Debt to GDP of the EU-12 (excluding Luxembourg), the US, UK, Japan and Australia. This debt includes Governments, Financials, Corporates and Households. Ireland’s small economy and large financial system (domestic and foreign), ensures an outsized reading which we cut off in the chart.

Figure 38 then shows; 1) how this ratio has changed from the end of 2007 to the end of 2011; 2) what the trend was in the 1-year to the end of 2011 to see momentum; and 3) where the ratio is from the peak point. The data is represented in percentage point moves.

As can be seen, only the US and Australia have seen their overall economy Debt to GDP fall since the end of 2007 and for both these the fall is negligible. The US has gone from around 348% to 345% on this measure. From the peak the US has fallen from the 366% seen in 2009 and the 353% seen in 2010 but few other countries are seeing their debt/gdp ratio move in the right direction. Many are currently at their peak overall economy wide leverage number and as already discussed when looked at from the start of the crisis all but the US and Australia have seen this ratio rise. Interestingly as we’ll see below Australia and the US have still seen debt rise but Nominal GDP has risen by a higher amount, thus helping them see leverage ratios decline slightly. It shows how important growth and inflation are if you want to delever.

Deleveraging problems from both the debt and growth side

The deleveraging problem comes from both sides. As we saw in Figure 36 in the previous section, growth has struggled to eclipse its peak levels across a number of countries with only inflation allowing many to surpass their peak activity levels. In terms of debt, Figure 39 shows the growth of an index of economy wide liabilities from our DW sample rebased at 100 at the end of 2007. We have gone back as far as the full data starts for each country.

Figure 40 then shows a simple un-weighted average and median of this basket and shows that debt is still increasing in the developed world.

Figure 41 then looks at the numbers for each country again from the end of 2007 to Q1 2012, since the end of 2010 and also from the peak. Debt hasn't started to turn down anywhere in the Developed World since the end of 2007. As already discussed, those that have seen their debt/GDP ratios stabilise (e.g. US and Australia) have required some nominal GDP growth.

So debt is still climbing in most countries. Clearly the splits are changing with more emphasis on public over private debt but there's little evidence that the DM deleveraging trend has started yet.

Given such an unparalleled run up in debt over the last few years and decades, will we be able to de-lever naturally and without defaults? If we can find a higher pace of growth and inflation than debt accumulation then we can. But can every country succeed? The reality is that we would make a strong argument suggesting that the high debt burdens are actually holding growth back thus ensuring a problem of circularity. As a minimum it likely ensures that these economies remain fragile and vulnerable to shocks for many years to come.

So in aggregate the DM post-GFC world can be characterised by a “No Growth, No Deleveraging” mantra and one where we are still in a similar situation to where we were five years ago.

BofA Makes The Case For $3,000 Gold

Everyone loves gold these days. Deutsche Bank sees $2000 gold soon. And Citi says it could go to $2500 in six months.
BofA, too: the firm recently initiated a $2,400 target price for the shiny yellow metal since the Fed's announcement of open-ended bond buying.
However, BofA analyst Stephen Suttmeier thinks there's a case to be made that gold goes even higher than the bank's official call.
In a note to clients today, Suttmeier writes:
The secular bull case for Gold $3000
We remain secular bulls on gold. Key chart and uptrend supports between $1600 and $1400 have held and we have viewed $1550-1500 as a good area to buy gold. The breakout above the year-long downtrend line completes the correction within the longer-term uptrend and targets resistances at $1800 and $1925. But, the secular bull market for gold points to a stronger rally to $2050-2300 and up to $3000 longer-term. The top of the rising channel from mid 2005 is near $2375 and reaches the $3000 area by early 2014. Key channel supports are in the $1600 and $1400 areas and rise ~$25/month. The chart below shows the secular bull market for gold.
Here is the chart Suttmeier is looking at:

Gold futures – monthly semi-log chart

BofA Merrill Lynch

source :

Government Default: Yes or No?

 It is not often that readers get a clear-cut choice between two forecasts. Most forecasts have wiggle room. Not the following.

1. The United States government will default.
2. The United States government will not default.

I hold the first position. John T. Harvey holds the second. He wrote a piece for Forbes defending his position: "It Is Impossible For The US To Default".

I regard this as the most fundamental economic issue facing the U.S. government. I regard it as the most fundamental economic issue facing Americans under age 60.

Mr. Harvey begins.

With so many economic, political, and social problems facing us today, there is little point in focusing attention on something that is not one. The false fear of which I speak is the chance of US debt default. There is no need to speculate on what that likelihood is, I can give you the exact number: there is 0% chance that the US will be forced to default on the debt.

That is the kind of forthrightness that I appreciate. Here is my response. With so many economic, political, and social problems facing us today, it is crucial that we focus attention on something that is both catastrophic and inescapable. The fear of which I speak is the chance of U.S. debt default. There is no need to speculate on what that likelihood is, I can give you the exact number: there is 100% chance that the U.S. will be forced to default on the debt.


Why do I believe this? Because I believe in the analysis supplied by Professor Lawrence Kotlikoff of Boston University. Each year, he analyzes the statistics produced by the Congressional Budget Office on the present value – not future value – of the unfunded liabilities of the U.S. government. The latest figures are up by $11 trillion over the last year. The figure today is $222 trillion.

This means that the government needs $222 trillion to invest in private capital markets that will pay about 5% per year for the next 75 years.

Problem: the world's capital markets are just about $222 trillion. Then there are the unfunded liabilities of all other Western nations. These total at least what the U.S. does, and probably far more, since the welfare state's promises are more comprehensive outside the USA.

Conclusion: they will all default.

Mr. Harvey thinks that the U.S. government could choose to default, but it won't.

We could choose to do so, just as a person trapped in a warehouse full of food could choose to starve, but we could never be forced to. This is not a theory or conjecture, it is cold, hard fact. The reason the US could never be forced to default is that every single bit of the debt is owed in the currency that we and only we can issue: dollars. Unlike Greece, we don't have to try to earn foreign exchange via exports or beg for better terms. There is simply no level of debt we could not repay with a keystroke.

There are a lot of people inside the camp of the gold bugs who also believe this. They are probably wrong. They are wrong for the same reason why Mr. Harvey is wrong. They do not understand Ludwig von Mises.


Mises was a senior advisor to the equivalent of the Austrian Chamber of Commerce after World War I. He understood monetary theory. His book on money, The Theory of Money and Credit, had been published in 1912, two years before the war broke out.

In the post-War edition of his book, he wrote of the process of the hyperinflationary breakdown of a currency. He made it clear that such a currency is short-lived. People shift to rival currencies.

The emancipation of commerce from a money which is proving more and more useless in this way begins with the expulsion of the money from hoards. People begin at first to hoard other money instead so as to have marketable goods at their disposal for unforeseen future needs - perhaps precious-metal money and foreign notes, and sometimes also domestic notes of other kinds which have a higher value because they cannot be increased by the State '(e.g.the Romanoff rouble in Russia or the 'blue' money of communist Hungary); then ingots, precious stones, and pearls; even pictures, other objects of art, and postage stamps. A further step is the adoption of foreign currency or metallic money (i.e. for all practical purposes, gold) in credit transactions. Finally, when the domestic currency ceases to be used in retail trade, wages as well have to be paid in some other way than in pieces of paper which are then no longer good for anything.

The collapse of an inflation policy carried to its extreme - as in the United States in 1781 and in France in 1796 does not destroy the monetary system, but only the credit money or fiat money of the State that has overestimated the effectiveness of its own policy. The collapse emancipates commerce from etatism and establishes metallic money again (pp. 229-30).

In 1949, his book Human Action appeared. In it, he discussed hyperinflation. He called this phase of the business cycle the crack-up boom.

The characteristic mark of the phenomenon is that the increase in the quantity of money causes a fall in the demand for money. The tendency toward a fall in purchasing power as generated by the increased supply of money is intensified by the general propensity to restrict cash holdings which it brings about. Eventually a point is reached where the prices at which people would be prepared to part with "real" goods discount to such an extent the expected progress in the fall of purchasing power that nobody has a sufficient amount of cash at hand to pay them. The monetary system breaks down; all transactions in the money concerned cease; a panic makes its purchasing power vanish altogether. People return either to barter or to the use of another kind of money (p. 424).

Later in the book, Mises discussed the policy of devaluation: the expansion of the domestic money supply in a fruitless attempt to reduce the international value of the currency unit.

If the government does not care how far foreign exchange rates may rise, it can for some time continue to cling to credit expansion. But one day the crack-up boom will annihilate its monetary system. On the other hand, if the authority wants to avoid the necessity of devaluing again and again at an accelerated pace, it must arrange its domestic credit policy in such a way as not to outrun in credit expansion the other countries against which it wants to keep its domestic currency at par (p. 791).Mt. Harvey has described just such a policy. He concluded that the United States government can never go bankrupt. It can print its way out of every obligation.

No, it can't.


The expansion of the monetary base can go on until such time as commercial banks monetize all of the reserves on their books. Prices then rise to such levels that transactions no longer take place in the official currency unit. The division of labor contracts. The output of capital and labor falls. At some point, people adopt other currency units. They no longer cooperate with each other by means of the hyperinflated currency.

Professor Steve Hanke has co-authored an article on the worst 56 hypernflations. He discovered that most of these in industrial nations were over in a couple of years. The crack-up boom ended them.

No nation can long pursue a policy of hyperinflation. It destroys the currency and destroys the division of labor. The result is starvation. The policy of hyperinflation ends before this phase. Members of society shift to other forms of money.

This is why the policy of hyperinflation is useless in dealing with the 75-year obligations of the federal government to support old people through Social Security, Medicare, Medicaid, and federal pensions. These obligations are inter-generational. Hyperinflation lasts for months, not decades. When the government ends its policy of hyperinflation, it finds that it is still saddled with these obligations.

If the Federal Reserve resorts to hyperinflation, its retirement portfolio will reach zero value unless it shifts to foreign currencies, gold, or other hyperinflation hedges. It will publicly announce that the U.S. dollar is a failed currency, as manipulated by the FED.

If it refuses, then it will oversee Great Depression 2, monetary deflation, and the contraction of the division of labor. The U.S. government will go bankrupt.

If Congress nationalizes the FED, then it will pursue hyperinflation. The crack-up boom will end the experiment.

At that point, all of the obligations to retirees will still remain. But the government will not have the money to pay them. The $222 trillion of present valued unfunded liabilities will still remain unfunded.

The government's obligations are inter-generational. Hyperinflation is not. The latter in no fundamental way reduces the former.

This means that the government will default. This is 100% guaranteed.


Mr. Harvey cites the experts. "Don't take my word for it. Here are just a few folks from across the political spectrum and in different walks of life saying the same thing." Then he gives a series of quotations from these men: Alan Greenspan, Peter Zeihan, Erwan Mahe, Mike Norman, Monty Agarwal, L. Randall Wray. Other than Mr. Greenspan, I had heard of none of them. He concludes:

Mind you, that doesn't mean there might not be other economic or political consequences. Inflation and currency depreciation, for example, are possibilities.

Yes, they surely are, since they are the same thing. But they do not solve the problem of the inevitable default. They merely add to the misery before the default.

Indeed, we have seen neither hide nor hair of inflation or high interest rates during the current run up of the debt. It is critical to bear in mind, too, that these deficits are not a result of the government trying to buy something it cannot otherwise afford (as would be the case for you or me). Rather, they are setting out to generate sufficient demand for goods and services to employ all those willing to work (that said, not every kind of government spending does this effectively, but that's a different question). As there is no limit to how much debt we can successfully carry, we should be aggressively pursuing the latter goal rather than talking about being "fiscally responsible." There is nothing responsible about leaving over 12 million Americans out of work.

We have plenty of problems in the world. No point in making one up.


This appeared in Forbes. The article cited a list of supposed experts, with Alan Greenspan at the head of the list. Somehow, the author expects us to take his argument seriously. We are also supposed to take his cited experts seriously, beginning with Alan Greenspan. We are supposed to imagine that debts are forever, that they need not be repaid, that credit is eternal, that the Baby boomers are not retiring by the millions, that digits can overcome economic theory, that Medicare is solvent, that Social Security is solvent, and that hyperinflation is always available as a way for the government not to default.

The nation is run by people who share his views. So is every Western nation.

This is a very good reason to prepare for a catastrophe, if we are lucky, or possibly several: (1) mass inflation, stabilization, deflation, depression, and government default, or (2) hyperinflation followed by a default. Take your pick.
source :

Bernanke Put: Beware of Easy Money

By Axel Merk

Central bankers around the world may be providing a backstop to the financial markets in much the same way Greenspan did during the “Goldilocks” years, but when the short-term euphoria wears off, will the negative repercussions be even more severe? Bernanke’s Federal Reserve (Fed) appears to specifically target equity market appreciation as part of its offensive in bringing down the unemployment rate; expectations are high: every time the market sells off, the Fed might simply print more money. We fear central bankers have overstepped their reach, and the implications of their actions may be much worse than the anticipated benefits.

To an extent, the effects of today’s monetary policies resemble the “Greenspan Put” (named after former Fed Chair Alan Greenspan) in the years leading up to the crisis. Today’s central bankers have been quite straight forward in communicating their stance: they appear willing to step in with evermore liquidity should the global economy show any signs of further weakness. Bernanke’s Fed has gone even further: the Fed has stated it’s accommodative policies will “remain appropriate for a considerable time after the economic recovery strengthens”. In other words, financial markets will be awash with liquidity for an extended period, even if we see signs of a sustainable economic recovery.

At first glance, this may appear a positive development for investors holding stocks and other risky assets. After all, Bernanke appears willing to underwrite your investments over the foreseeable future. Indeed, Bernanke appears to specifically target equity market appreciation, on many occasions noting one of the key benefits of quantitative easing (QE) has been to increase stock prices. Notably, while he believes the Fed’s QE policies have had a positive impact on stock prices, he considers it has not caused increases to inflation expectations or commodity prices. We disagree, which we elaborate below. Ultimately, the Fed may have reached too far, bringing risks to economic stability and elevated levels of volatility; the full implications of its actions may be somewhat dire down the road.

From the Bank of Japan and the People’s Bank of China to the European Central Bank (ECB), the Bank of England (BoE) and the Fed, central bankers are either putting their money where their mouth is (quite literally) or strongly insinuating that continued, ongoing easing policies are needed to prevent another significant downturn in global economic activity. While all the excess printed money may or may not have the desired effect of stimulating the global economy, the money does find its way somewhere; unfortunately, most central bankers appear to fail to realize that they simply cannot control where that money ends up.

Fed Chair Bernanke’s Achilles’ heel since the onset of the financial crisis has been the housing sector. It’s no surprise why the Fed bought over a trillion dollars worth of mortgage backed securities (MBS) since 2009: to re-inflate home prices and in so doing, bail out all those underwater with their mortgages. The problem was, it didn’t work – house prices continued to weaken across the nation, and have stagnated to this day. Now, the Fed has announced another MBS purchase program, this time open-ended, under the auspices of “QE3”. Do they believe the time is now ripe for MBS purchases to positively impact the housing market and thus the economy? Unfortunately, the first MBS purchase program failed to have its desired effect; we do not foresee how QE3 will be any better at stimulating house price appreciation.

One of the things we believe such actions do stimulate are inflation expectations. Indeed, the jump in market-implied future inflationary expectations in reaction to the Fed’s QE3 decision was quite remarkable:

(Click on image to enlarge)

In contrast to Bernanke’s views that QE does not cause commodity price appreciation, in our assessment, much of the freshly printed money only serves to inflate the value of assets that exhibit the greatest level of monetary sensitivity: commodities and natural resources. These are essential in the manufacture and production of goods and services purchased by U.S. consumers on a daily basis. As such, inflated commodity and resources prices ultimately pressure consumer price inflation, as the consumer’s “everyday basket of goods” becomes evermore expensive. The ongoing weakness in the U.S. dollar only serves to compound these inflationary pressures. A weak dollar, we believe, is part of Bernanke’s strategy to stimulate the U.S. economy through stimulating exports. While we fundamentally disagree that this is sound monetary policy for the U.S. to pursue, the inflationary ramifications are clear: the U.S. imports a great deal from abroad; every time the dollar depreciates against a currency of a country from which the U.S. imports, the price of those imports rises.

Not only have the Fed’s actions heightened inflationary risks, but we also believe it implicitly heightens the risk that the Fed gets monetary policy wrong. For instance, Fed Chair Bernanke believes that the Fed’s non-standard policies since 2008 may have helped lower 10-year Treasury yields by over 1.5%1. In so doing, the Fed has taken away a key metric used to gauge the economy and thus set appropriate monetary policy: free market interest rates. The Fed has historically relied on long-term yields, such as the 10-year and 30-year Treasury yield, as part of its assessment of the overall health of the economy. In manipulating those same yields, the Fed can no longer rely upon them to provide valuable information on the health and trajectory of the economy. In other words, the more the Fed meddles in the market through non-standard measures, the more the Fed is in the dark regarding the appropriateness of monetary policy. Such a situation inherently creates an additional level of uncertainty over the U.S. economy, U.S. monetary policy, and may continue to underpin weakness in the U.S. dollar.

The vast amounts of liquidity provided via the Fed’s quantitative easing programs will, at some point, have to be reined in. Whether due to inflationary pressures or a sustainable recovery, only time will tell, but the need to rein in liquidity may create massive headaches down the road. Given the ongoing high level of leverage employed in the economy, such monetary tightening runs the risk of undermining any economic recovery and potentially causing it to crash back down, as the likelihood of it negatively affecting consumer spending is high. With a still-leveraged consumer, rising rates may be overly painful, dramatically slowing consumer spending and, in turn, the economy. Such dynamics may have an outsized impact on the U.S. economy, given consumer spending makes up approximately 70% of U.S. GDP.

All of which underpins our view that there is a significant risk that the Fed has gotten monetary policy wrong. We consider the Fed’s actions have not only heightened inflationary risks, but have also inherently created risks to appropriate monetary policy going forward. Both of which will likely contribute to ongoing high levels of market volatility over the foreseeable future.

With so many dynamics yet to be played out globally, and with central bankers becoming evermore active in meddling with economic dynamics around the world, investors may want to consider preparing for the potential ramifications of such policies. While we may disagree with the policies being pursued, central bankers appear to be at least predictable in their decisions. We believe the currency market provides the most effective way to position oneself to protect and profit from the implications of such monetary policies.

In the current environment, the general equity market seems to be moving on the back of the next anticipated move of policy makers, and less so on fundamentals, but company-specific risks remain. With the outlook for the economy still on tenterhooks, many companies have been missing earnings forecasts. Currencies don’t have this additional layer of risk. As a result, currencies may be the “cleanest” way of positioning oneself for the next policy move. Historically, currencies have also exhibited much lower levels of volatility relative to equities, when no leverage is employed. As such, investors may want to consider adding a professionally managed basket of currencies to their existing portfolios.

1 Source: Bernanke’s 2012 Jackson Hole speech, “Monetary Policy since the Onset of the Crisis”, dated August 31, 2012.

Axel Merk

source :

Interest Rates and the Business Cycle

by Glen Tenney 

The cause of the business cycle has long been debated by professional economists. Recurring successions of boom and bust have also mystified the lay person. Many questions persist. Are recessions caused by underconsumption as the Keynesians would have us believe? If so, what causes masses of people to quit spending all at the same time? Or are recessions caused by too little money in the economy, as the monetarists teach? And how do we know how much money is too much or too little? Perhaps more importantly, are periodic recessions an inevitable consequence of a capitalist economy? Must we accept the horrors associated with recessions and depressions as a necessary part of living in a highly industrialized society?

Concerns about aggregate money supply levels and aggregate spending might make for interesting conversation, and a discussion of these matters might even reveal certain threads of truth, but they are inadequate in arriving at the cause of the boom and bust cycle that seems to pervade the economy in modern times. Economists in the Austrian school of thought have provided an explanation that bases economic fluctuations on microeconomic theory that is firmly grounded in principles of human action. These economists have pointed out that macroeconomic fluctuations, or what have come to be known as business cycles, are caused by extraneous manipulations of interest rates in the economy.1 This manipulation of interest rates might entail conscious actions by governmental authorities or merely the result of governmental actions taken with other goals in mind.

Interest Rates Reflect Time Preferences

The rate of interest in an economy is an important reflection of the time preferences of individuals. People are willing to forgo some amount of current consumption in order to invest in production processes which promise finished goods that are valued higher than the sum of the inputs to the production process. The spread between the amounts paid to the owners of the productive inputs and amounts obtained from the sale of the completed product is interest income to the businessman who advances money incomes to the resource owners in terms of wages and rents. The capitalist/ businessman then provides current buying power to workers and owners of other productive inputs in exchange for an amount we call interest. And looking from the opposite perspective, workers and other resource owners are willing to take a discounted amount in payment for their productive inputs in order to have current incomes rather than waiting for the completion of the product.

Of course in the market for loans, the interest rate also contains an entrepreneurial component which accounts for certain areas of uncertainty which are always present in borrowing and lending money. An inflation premium is included if the dollars to be repaid on the loan are expected to have less purchasing-power than the dollars that are lent. And a default-risk premium is included based upon the ability and/or willingness of the borrower to repay the loan as agreed. Thus the interest rate that is agreed upon in the loan market includes these entrepreneurial factors in addition to an amount sufficient to induce people to forgo current consumption in favor of consumption in the future.

The interest rate serves a coordinating function in the economy by providing useful information about the availability of credit and the profitability of investments to both lenders and borrowers, if, for example, people’s rates of time preference increase, this change is reflected as higher interest rates, which encourages more saving and discourages borrowing at the margin. This means that individuals in general are requiring more of an incentive to forgo current consumption than they did previously. There are two ways in which this coordinating function is hindered by governmental action in the economy.

New Money Gives a False Signal

Money is primarily a medium of exchange in the economy; and as such, its quantity does not have anything to do with the real quantity of employment and output in the economy. Of course, with more money in the economy, the prices of goods, services, and wages, will be higher; but the real quantities of the goods and services, and the real value of the wages will not necessarily change with an increase of money in the overall economy. But it is a mistake to think that a sudden increase in the supply of money would have no effect at all on economic activity. As Nobel Laureate Friedrich A. Hayek explained:

Everything depends on the point where the additional money is injected into circulation (or where the money is withdrawn from circulation), and the effects may be quite opposite according as the additional money comes first into the hands of traders and manufacturers or directly into the hands of salaried people employed by the state.

Because the new money enters the market in a manner which is less than exactly proportional to existing money holdings and consumption/savings ratios, a monetary expansion in the economy does not affect all sectors of the economy at the same time or to the same degree. If the new money enters the market through the banking system or through the credit markets, interest rates will decline below the level that coordinates with the savings of individuals in the economy. Businessmen, who use the interest rate in determining the profitability of various investments, will anxiously take advantage of the lower interest rate by increasing investments in projects that were perceived as unprofitable using higher rates of interest.

The great Austrian economist Ludwig von Mises describes the increase in business activity as follows:

The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulation of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated.

The word “profitable” was undoubtedly put in quotes by Mises because it is a mistake to think that government actions can actually increase overall profitability in the economy in such a manner. The folly of this situation is apparent when we realize that the lower interest rate was not the result of increased savings in the economy. The lower interest rate was a false signal. The consumption/ saving ratios of individuals and families in the economy have not necessarily changed, and so the total mount of total savings available for investment purposes has not necessarily increased, although it appears to businessmen that they have. Because the lower interest rate is a false indicator of more available capital, investments will be made in projects that are doomed to failure as the new money works its way through the economy.

Eventually, prices in general will rise in response to the new money. Firms that made investments in capital projects by relying on the bad information provided by the artificially low interest rate will find that they cannot complete their projects because of a lack of capital. As Murray Rothbard states:

The banks’ credit expansion had tampered with that indispensable “signal”-the interest rate—that tells businessmen how much savings are available and what length of projects will be profitable . . . . The situation is analogous to that of a contractor misled into believing that he has more building material than he really has and then awakening to find that he has used up all his material on a capacious foundation, with no material left to complete the house. Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.

Capital-intensive industries are hurt the most under such a scenario, because small changes in interest rates make a big difference in profitability calculations due to the extended time element involved.

It is important to note that it is neither the amount of money in the economy, nor the general price level in the economy, that causes the problem. Professor Richard Ebeling describes the real problem as follows:

Now in fact, the relevant decisions market participants must make pertain not to changes in the “price level” but, instead, relate to the various relative prices that enter into production and consumption choices. But monetary increases have their peculiar effects precisely because they do not affect all prices simultaneously and proportionally.

The fact that it takes time for the increase in the money supply to affect the various sectors of the economy causes the malinvestments which result in what is known as the business cycle.

Government Externalizes Uncertainty

Professor Roger Garrison has noted another way that government policy causes distortions in the economy by falsifying the interest rate. In a situation where excessive government spending creates budget deficits, uncertainty in the economy is increased due to the fact that it is impossible for market participants to know how the budget shortfall will be financed. The government can either issue more debt, create more money by monetizing the debt, or raise taxes in some manner. Each of these approaches will redistribute wealth in society in different ways, but there is no way to know in advance which of these methods will be chosen.

One would think that this kind of increase in uncertainty in the market would increase the risk premium built into loan rates. But these additional risks, in the form of either price inflation or increased taxation are borne by all members of society rather than by just the holders of government securities. Because both the government’s ability to monetize the debt and its ability to tax generate burdens to all market participants in general rather than government bond holders alone, the yields on government securities do not accurately reflect these additional risks. These risks are effectively passed on or externalized to those who are not a part of the borrowing/lending transactions in which the government deals. The FDIC, which guarantees deposit accounts at taxpayer expense, further exacerbates the situation by leading savers to believe their savings are risk-free.

For our purposes here, the key concept to realize is the important function of interest rates in this whole scenario. Interest rates serve as a regulator in the economy in the sense that the height of the rates helps businessmen determine the proper level of investment to undertake. Anything in the economy that tends to lower the interest rate artificially will promote investments in projects that are not really profitable based upon the amount of capital being provided by savers who are the ones that forgo consumption because they deem it in their best interest to do so. This wedge that is driven between the natural rate of interest and the market rate of interest as reflected in loan rates can be the result of increases in the supply of fiat money or increases in uncertainty in the market which is not accurately reflected in loan rates. The manipulation of the interest rate is significant in both cases, and an artificial boom and subsequent bust is inevitably the result.


Changes in the supply of money in the economy do have an effect on real economic activity. This effect works through the medium of interest rates in causing fluctuations in business activity. When fiat money is provided to the market in the form of credit expansion through the banking system, business firms erroneously view this as an increase in the supply of capital. Due to the decreased interest rate in the loan market brought about by the fictitious “increase” in capital, businesses increase their investments in long-range projects that appear profitable. In addition, other factors as well can cause a discrepancy between the natural rate of interest and the rate which is paid in the loan market. Government policies with regard to debt creation, monetization, bank deposit guarantees, and taxation, can effectively externalize the risk associated with running budget deficits, thus artificially lowering loan rates in the market. Either of these two influences on interest rates, or a combination of the two, can and do influence economic activity by inducing businesses to make investments that would otherwise not be made. Since real savings in the economy, however, do not increase due to these interventionist measures, the production structure is weakened and the business boom must ultimately give way to a bust.