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Showing posts with label Investment. Show all posts
Showing posts with label Investment. Show all posts

Monday, October 8, 2012

Determining the value of gold













Author:

When considering whether gold is a value investment, one needs to first recognise that gold does not have a balance sheet, management team, price-earnings ratio or any of the other things one needs to analyse before making an investment. Also, gold does not generate any cash flow, so it does not pay a dividend. We can therefore conclude from these observations that gold is not an investment. Indeed, it is something different, which means that normal investment analytical techniques cannot be used to determine gold’s value.

Value of course arises from an item’s usefulness, and gold is useful because it is money. Though only used as currency these days in a few places like Turkey and Vietnam, gold is still useful in economic calculation, or in other words, measuring the price of goods and services.

For example, when the Maastricht Treaty was signed in February 1992, one barrel of crude oil cost $19.00, €15.95 (Dm 31.30) or 1.67 goldgrams. Now it costs $91.79, €71.27 or 1.61 goldgrams, which makes clear that not only is gold useful in communicating prices, it preserves purchasing power. Gold has been useful in these ways for over 5,000 years, so it is logical to assume that gold will remain useful for the foreseeable future.

Sunday, October 7, 2012

The three Big Central Banks, the Japanese, the European and the Americans are all in the game and printing

Jim Rogers : "The central bank in Europe is getting in the party — everybody is in the party. The Chinese are not quite so much in the party as they were before but the three big central banks, the Japanese, the European and the Americans are all in the game and printing."
"Either the world economy is going to get better and commodities are going to go up because of shortages, or they are going to print more money, and throughout history when they printed a lot of money, you protect yourself by owning real assets."

- in NewsMax TV

Click Here to watch the full interview>>>>>

Jim Rogers started trading the stock market with $600 in 1968.In 1973 he formed the Quantum Fund with the legendary investor George Soros before retiring, a multi millionaire at the age of 37. Rogers and Soros helped steer the fund to a miraculous 4,200% return over the 10 year span of the fund while the S&P 500 returned just 47%.

The Fed and the ECB: Two Paths, One Goal

by Philipp Bagus
 Both the Federal Reserve (Fed) and the European Central Bank (ECB) are owners of the printing press. They produce base money. On top of the base-money production, the fractional-reserve-banking system can produce money out of thin air. Both central banks produce money in order to finance their respective governments. As a result of their money production, prices will be higher than they would have been otherwise. All money users indirectly pay for the government deficits through a reduction in purchasing power and the reduced quality of their money.Download PDF
While the ECB's and Fed's functions (to provide liquidity to the banking system in times of crisis and to finance the government together with the banking system) are the same, there exist small differences between them. In the so-called open-market operations (another term for active manipulation of the money supply) the central banks produce or destroy base money.
There are two ways central banks produce base money. By tradition, the Fed uses the produce-money-and-purchase approach (PMP). Normally, the Fed produces money in their computers and uses it to buy US Treasuries from the banking system. In exchange for the US Treasuries, the Fed creates money on the account that the selling bank holds at the Fed.
The ECB, in contrast, uses the produce-money-and-lend (PML) approach. It produces money and lends it to the banking system for one week or three months. The preferred collateral for these loans to banks is government bonds.[1] As a result of PMP and PML, banks receive new base money. They hold more reserves at their account at the central bank. The additional reserves mean that they can now expand credit and create even more money.
For governments, the mechanism works out pretty well. They usually spend more than they receive in taxes, i.e., they run a deficit. No one likes taxes. Yet, most voters like to receive gifts from their governments. The solution for politicians is simple. They promise gifts to voters and finance them by deficits rather than with taxes. To pay for the deficit, governments issue paper tickets called government bonds such as US Treasuries.
An huge portion of the Treasuries are bought by the banking system, not only because the US government is conceived as a solvent debtor, thanks to its capacity to use violence to appropriate resources, but also because the Fed buys Treasuries in its open-market operations. The Fed, thereby, monetizes the deficit in a way that does not hurt politicians.
But what about the interest paid on the Treasuries? The US government has to pay interest on the bonds to their new owner, the Fed. The Fed receives the interest, which increases the Fed's profit. Who receives the Fed's profit? The bulk of the Fed's profit is remitted back to the US government at the end of the year.
But what about the principal on the bonds? What happens when the bond must be paid back? At the end of the term of the bonds, the government would have to pay its holders. The trick here is just to issue a new bond to pay for the maturing one. Thus, the debts must never be paid but keep getting monetized. Figure 1 shows how the Fed finances the US deficit:
Figure 1
Figure 1: How the Fed finances the US government
The ECB finances deficits in a more subtle way. Only in the sovereign-debt crisis did it start to buy government bonds outright. Normally, the ECB lends to banks against collateral. Banks buy government bonds because they know it is preferred collateral at the ECB. By pledging the bonds as collateral at the ECB, banks receive new reserves and can expand credit. As the government bonds are still owned by banks, governments have to pay interest to banks. Banks, in turn, pay interest on the loans they receive from the ECB, which remits its profits back to governments.
Thus, the system is similar to the Fed, with the difference that normally some of the interest payments leak out to the banking system that pays lower interest rates on its loans than it receives on the bonds. Another important difference is that there may be a redistribution between governments if eurozone governments run deficits of different sizes. In my book The Tragedy of the Euro I explain that the Eurosystem resembles a tragedy of the commons. Several independent governments can use one central-banking system to finance their deficits and externalize the costs in the form of a loss of purchasing power of the Euro onto all users of the currency. The incentive is to have higher deficits than other eurozone governments in order to profit from the monetary redistribution. The flow of the new money is shown in figure 2.
Figure 2
Figure 2: How the ECB finances Euro area governments
Is the difference between the Fed's and the ECB's manipulation of the money supply essential? The Fed buys government bonds outright, while the ECB accepts them as collateral for new loans to the banking system. Economically, the effects are identical. The money supply increases when the Fed buys government bonds. When the ECB grants a loan with government bonds pledged as collateral, the money supply increases as well. In the case of the Fed, the money supply increases until the Fed sells the bond. In the case of the ECB, the money supply increases until the ECB fails to roll over (renew) its loan to the banking system.
There exists a legal difference. The Fed integrates the government bonds on its balance sheet. The ECB does not do so as bonds remain legally the ownership of the banks. Because the ECB does not publish the collateral provided for its loans, we do not know how many Greek government bonds, for example, are provided as collateral for ECB loans. The Fed is more transparent in this respect.
In both cases, government deficits are effectively monetized. That means that the ECB was bailing out Greece even before May 2010. It did not have to buy the Greek bonds outright; it only had to accept them as collateral. If the ECB had not accepted Greek bonds, Greek debts could not have mounted to such an extent. The Greek government would have had to default much earlier.
Aside from this more direct monetization, there is also a monetization going on that is often neglected. Market participants know that central banks buy government bonds and accept them as the preferred collateral. Banks buy the bonds due to their privileged treatment ensuring a liquid market and pushing down yields.
Knowing that there is a very liquid market in government bonds and a high demand by banks, investment funds, pension funds, insurers, and private investors buy government bonds. Government bonds become very liquid and almost as good as base money. In many cases, they serve to create additional base money. In other cases they stand as a reserve to be converted into base money if necessary. As a consequence, new money created through credit expansion often ends up buying liquid government bonds, indirectly monetizing the debt. (Another main holder of government debts is other foreign central banks.)
Imagine that the government has a deficit and issues government bonds. Part is bought by the banking system and used to get additional reserves from the central bank, which buys the bonds or grants new loans, accepting them as collateral. The banking system uses the new reserves to expand credit and grant loans to, for example, the construction industry. With the new loans, the construction industry buys factors of production and pays its workers. The workers use part of the new money to invest in funds. The investment funds then use the new money to acquire government bonds. Thus, there is an indirect monetization. Part of the money created by the fractional-reserve-banking system ends up buying government bonds because of their preferential treatment by the central bank, i.e., its direct monetization.
The process is shown in figure 3:
Figure 3

While it is an intricate system at the first sight, one that many common citizens fail to understand, the system boils down to the following: The government spends more than it receives in taxes. The difference is financed by its friends from the financial system, accommodated by central banks. Money production sponsors politicians' dreams, thereby destroying our currencies. The population pays in the form of a lower purchasing power of money.
For governments it is the perfect scheme. The costs of their deficits are externalized to the users of the currency. The debt is never paid through unpopular taxes but simply by issuing paper that says, "government bond."

Notes
[1]  Traditionally central banks have used both ways to finance government debt. America's Federal Reserve System places emphasis on the purchase of government bonds in its open-market operations. It also accepts government bonds as collateral in repurchase agreements. Repurchase agreements and other loans in which government bonds were accepted as collateral rose in importance during the financial crisis of 2008. The European Central Bank, on the contrary, has put more emphasis on accepting government bonds in collateralized loans in its lending operations to the banking system. Only during the sovereign-debt crisis of 2010 did the ECB started buying government bonds outright. On these central-bank policies in the wake of the financial crisis, see Bagus and Howden (2009)Download PDF and Bagus and Schiml (2010).Download PDF

The Fed Plays All Its Cards


There never really could be much doubt that the current experiment in competitive global currency debasement would end in anything less than a total war. There was always a chance that one or more of the principal players would snap out of it, change course and save their citizenry from a never ending cycle of devaluation. But developments since September 13, when the U.S. Federal Reserve finally laid all its cards on the table and went "all in" on permanent quantitative easing, indicate that the brainwashing is widely established and will be difficult to break. The vast majority of the world's leading central bankers seem content to walk in lock step down the path of money creation as a means to economic salvation. Never mind that the path will prevent real growth and may ultimately lead off a cliff. The herd is moving. And if it can't be turned, the only thing that one can do is attempt to get out of its way.

The details of the Fed's new plan (which I christened Operation Screw in last week's commentary) are not nearly as important as the philosophy it reveals. The Federal Reserve has already unleashed two huge waves of quantitative easing (purchases of either government securities or mortgage-backed securities) in order to stimulate consumer spending and ignite business activity. But the economy has not responded as hoped. GDP growth has languished below trend, the unemployment rate has stayed north of 8%, and the labor participation rate has fallen to all-time lows. In the meantime, America's fiscal position has grown significantly worse with government debt climbing to unimaginable territory. Despite the lack of results, the conclusion at the Federal Reserve is that the programs were too small and too incremental to be effective. They have determined that something larger, and potentially permanent, would be more likely to do the trick.

However, in making its new plan public, the Fed made a startling admission. At his press conference, Ben Bernanke backed away from previous assertions that printed money would be effective in directly pushing up business activity. Instead he explained how the new stimulus would be focused directly at the housing market through purchases of mortgage backed securities. He made clear that this strategy is intended to spark a surge in home prices that will in turn pull up the broader economy. Such a belief requires a dangerous amnesia to the events of the last decade. Despite x²the calamity that followed the bursting of our last housing bubble, economists feel this to be a wise strategy, proving that a poor memory is a prerequisite for the profession.

But now that the Fed is thus committed, the focus has shifted to foreign capitals. Not surprisingly, the dollar came under immediate pressure as soon as the plan was announced. In the 24 hours following the announcement, the Greenback was down 2.2% against the euro, 1.6% against the Australian Dollar, and 1.1% against the Canadian Dollar. A week after the Fed's move, the Mexican Peso had appreciated 2.7% against the US dollar. Many currency watchers noted that more dollar declines would be likely if foreign central banks failed to match the Fed in their commitments to print money. On cue, the foreign bankers responded.

It is seen as gospel in our current "through the looking glass" economic world that a weak currency is something to be desired and a strong currency is something to be disdained. Weak currencies are supposed to offer advantages to exporters and are seen as an easy way to boost GDP. In reality, weak currencies simply create the illusion of growth while eroding real purchasing power. Strong currencies confer greater wealth and potency to an economy. But in today's world,no central banker is prepared to stand idly by while their currency appreciates. As a result, foreign central banks are rolling out their own heavy artillery to combat the Fed.

Perhaps anticipating the Fed's actions, on September 6th the European Central Bank announced its own plan of unlimited buying of debt of troubled EU nations (however, the plan did come with important concessions to the German point of view - see John Browne's commentary). On September 17th, the Brazilian central bank auctioned $2.17 billion of reverse swap contracts to help push down the Brazilian Real. The next day, Peru and Turkey cut rates more than expected. On September 19th, the Bank of Japan increased its asset purchase program from 70 trillion yen to 80 trillion and extended the program by six months. It's clear we are seeing a central banking domino effect that is not likely to end in the foreseeable future.

Although the Fed is directing its fire towards the housing market, the needle they are actually hoping to move is not home prices, but the unemployment rate. Until that rate falls to the desired levels (some at the Fed have suggested 5.5%), then we can be fairly certain that these injections will continue. This will place permanent pressure on banks around the world to follow suit.

All of this simultaneous money creation will likely be a boon for nominal stock and real estate prices. But in real terms such gains will likely not keep pace with dollar depreciation. Inflation pushes up prices for just about everything, so stocks and real estate are not likely to prove to be exceptions. Even bond prices can rise in the short term, but their real values are the most vulnerable to decline. In fact, even nominal bond prices will ultimately fall, as inflation eventually sends interest rates climbing. But prices for hard assets, precious metals, commodities, and even those few remaining relatively hard currencies should be on the leading edge of the upward trend in prices.

While I believe the Fed's plan will be a disaster for the economy, the silver lining is that it provides investors with a road map. As the policy of the Fed is to debase the currency, those holding dollar based assets may seek alternatives in hard assets and in the currencies of the few remaining countries whose bankers have not drunken so freely from the Keynesian Kool-Aid. We believe that such opportunities do exist. Some broad ideas are outlined in the latest edition of my Global Investor Newsletter, which became available for download this week. I encourage those looking for ways to distance their wealth from the policies of Ben Bernanke to start their search today.

Peter Schiff is CEO of Euro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices.

Damages

  • The U.S. has federal debt/GDP less than 100%, Aaa/AA+ credit ratings, and the benefit of being the world’s reserve currency.
  • Studies by the CBO, IMF and BIS (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years. 
  • Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow, and the dollar would inevitably decline.
I have an amnesia of sorts. I remember almost nothing of my distant past – a condition which at the brink of my 69th year is neither fatal nor debilitating, but which leaves me anchorless without a direction home. Actually, I do recall some things, but they are hazy almost fairytale fantasies, filled with a lack of detail and usually bereft of emotional connections. I recall nothing specific of what parents, teachers or mentors said; no piece of advice; no life’s lessons. I’m sure there must have been some – I just can’t remember them. My life, therefore, reads like a storybook filled with innumerable déjà vu chapters, but ones which I can’t recall having read.

I had a family reunion of sorts a few weeks ago when my sister and I traveled to Sacramento to visit my failing brother – merely 18 months my senior. After his health issues had been discussed we drifted onto memory lane – talking about old times. Hadn’t I known that Dad had never been home, that he had spent months at a time overseas on business in Africa and South America? “Sort of, but not really,” I answered – a strange retort for a near adolescent child who should have remembered missing an absent father. Didn’t I know that our parents were drinkers; that Mom’s “gin-fizzes” usually began in the early afternoon and ended as our high school homework was being put to bed? “I guess not,” I replied, “but perhaps after the Depression and WWII, they had a reason to have a highball or two, or three.”

My lack of personal memory, I’ve decided, may reflect minor damage, much like a series of concussions suffered by a football athlete to his brain. Somewhere inside of my still intact protective helmet or skull, a physical or emotional collision may have occurred rendering a scar which prohibited proper healing. Too bad. And yet we all suffer damage in one way or another, do we not? How could it be otherwise in an imperfect world filled with parents, siblings and friends with concerns of their own for a majority of the day’s 24 hours? Sometimes the damage manifests itself in memory “loss” or repression, sometimes in self-flagellation or destructive behavior towards others. Sometimes it can be constructive as when those with damaged goods try to help others even more damaged. Whatever the reason, there are seven billion damaged human beings walking this earth.

For me, though, instead of losing my mind, I’ve simply lost my long-term memory. It’s a damnable state of affairs for sure – losing a chance to write your autobiography and any semblance of recalling what seems to have been a rather productive life. But I must tell you – it has its benefits. Each and every day starts with a relatively clean page, a “magic slate” of sorts where you can just lift the cellophane cover and completely erase minor transgressions, slights or perceived sins of others upon a somewhat fragile humanity. I get over most things and move on rather quickly. The French writer Jules Renard once speculated that “perhaps people with a detailed memory cannot have general ideas.” If so, I may be fortunate. So there are pluses and minuses to this memory thing, and like most of us, I add them up and move on. If that be the only disadvantage on my life’s scorecard – and there cannot be many – I am a lucky man indeed.

The ring of fire
In last month’s Investment Outlook I promised to write about damage of a financial kind – the potential debt peril – the long-term fiscal cliff that waits in the shadows of a New Normal U.S. economy which many claim is not doing that badly. After all, despite approaching the edge of 2012’s fiscal cliff with our 8% of GDP deficit, the U.S. is still considered the world’s “cleanest dirty shirt.” It has federal debt/GDP less than 100%, Aaa/AA+ credit ratings, and the benefit of being the world’s reserve currency – which means that most global financial transactions are denominated in dollars and that our interest rates are structurally lower than other Aaa countries because of it. We have world-class universities, a still relatively mobile labor force and apparently remain the beacon of technology – just witness the never-ending saga of Microsoft, Google and now Apple. Obviously there are concerns, especially during election years, but are we still not sitting in the global economy’s catbird seat? How could the U.S. still not be the first destination of global capital in search of safe (although historically low) prospective returns?

Well, Armageddon is not around the corner. I don’t believe in the imminent demise of the U.S. economy and its financial markets. But I’m afraid for them. Apparently so are many others, among them the IMF (International Monetary Fund), the CBO (Congressional Budget Office) and the BIS (Bank of International Settlements). I hold on my lap as I write this September afternoon the recently published annual reports for each of these authoritative and mainly non-political organizations which describe the financial balance sheets and prospective budgets of a plethora of developed and developing nations. The CBO of course is perhaps closest to our domestic ground in heralding the possibility of a fiscal train wreck over the next decade, but the IMF and BIS are no amateur oracles – they lend money and monitor financial transactions in the trillions. When all of them speak, we should listen and in the latest year they’re all speaking in unison. What they’re saying is that when it comes to debt and to the prospects for future debt, the U.S. is no “clean dirty shirt.” The U.S., in fact, is a serial offender, an addict whose habit extends beyond weed or cocaine and who frequently pleasures itself with budgetary crystal meth. Uncle Sam’s habit, say these respected agencies, will be a hard (and dangerous) one to break.

What standards or guidelines do their reports use and how best to explain them? Well, the three of them all try to compute what is called a “fiscal gap,” a deficit that must be closed either with spending cuts, tax hikes or a combination of both which keeps a country’s debt/GDP ratio under control. The fiscal gap differs from the “deficit” in that it includes future estimated entitlements such as Social Security, Medicare and Medicaid which may not show up in current expenditures. Each of the three reports target different debt/GDP ratios over varying periods of time and each has different assumptions as to a country’s real growth rate and real interest rate in future years. A reader can get confused trying to conflate the three of them into a homogeneous “fiscal gap” number. The important thing, though, from the standpoint of assessing the fiscal “damage” and a country’s relative addiction, is to view the U.S. in comparison to other countries, to view its apparently clean dirty shirt in the absence of its reserve currency status and its current financial advantages, and to point to a more distant future 10-20 years down the road at which time its debt addiction may be life, or certainly debt, threatening.

I’ve compiled all three studies into a picture chart perhaps familiar to many Investment Outlook readers. Several years ago I compared and contrasted countries from the standpoint of PIMCO’s “Ring of Fire.” It was a well-received Outlook if only because of the red flames and a reference to an old Johnny Cash song – “I fell into a burning ring of fire –I went down, down, down and the flames went higher.” Melodramatic, of course, but instructive nonetheless – perhaps prophetic. What the updated IMF, CBO and BIS “Ring” concludes is that the U.S. balance sheet, its deficit (y-axis) and its “fiscal gap” (x-axis), is in flames and that its fire department is apparently asleep at the station house.

To keep our debt/GDP ratio below the metaphorical combustion point of 212 degrees Fahrenheit, these studies (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years. An 11% “fiscal gap” in terms of today’s economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year! To put that into perspective, CBO has calculated that the expiration of the Bush tax cuts and other provisions would only reduce the deficit by a little more than $200 billion. As well, the failed attempt at a budget compromise by Congress and the President – the so-called Super Committee “Grand Bargain”– was a $4 trillion battle plan over 10 years worth $400 billion a year. These studies, and the updated chart “Ring of Fire – Part 2!” suggests close to four times that amount in order to douse the inferno.

And to draw, dear reader, what I think are critical relative comparisons, look at who’s in that ring of fire alongside the U.S. There’s Japan, Greece, the U.K., Spain and France, sort of a rogues’ gallery of debtors. Look as well at which countries have their budgets and fiscal gaps under relative control – Canada, Italy, Brazil, Mexico, China and a host of other developing (many not shown) as opposed to developed countries. As a rule of thumb, developing countries have less debt and more underdeveloped financial systems. The U.S. and its fellow serial abusers have been inhaling debt’s methamphetamine crystals for some time now, and kicking the habit looks incredibly difficult.


As one of the “Ring” leaders, America’s abusive tendencies can be described in more ways than an 11% fiscal gap and a $1.6 trillion current dollar hole which needs to be filled. It’s well publicized that the U.S. has $16 trillion of outstanding debt, but its future liabilities in terms of Social Security, Medicare, and Medicaid are less tangible and therefore more difficult to comprehend. Suppose, though, that when paying payroll or income taxes for any of the above benefits, American citizens were issued a bond that they could cash in when required to pay those future bills. The bond would be worth more than the taxes paid because the benefits are increasing faster than inflation. The fact is that those bonds today would total nearly $60 trillion, a disparity that is four times our publicized number of outstanding debt. We owe, in other words, not only $16 trillion in outstanding, Treasury bonds and bills, but $60 trillion more. In my example, it just so happens that the $60 trillion comes not in the form of promises to pay bonds or bills at maturity, but the present value of future Social Security benefits, Medicaid expenses and expected costs for Medicare. Altogether, that’s a whopping total of 500% of GDP, dear reader, and I’m not making it up. Kindly consult the IMF and the CBO for verification. Kindly wonder, as well, how we’re going to get out of this mess.

Investment conclusions
So I posed the question earlier: How can the U.S. not be considered the first destination of global capital in search of safe (although historically low) returns? Easy answer: It will not be if we continue down the current road and don’t address our “fiscal gap.” IF we continue to close our eyes to existing 8% of GDP deficits, which when including Social Security, Medicaid and Medicare liabilities compose an average estimated 11% annual “fiscal gap,” then we will begin to resemble Greece before the turn of the next decade. Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline. Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the “Ring of Fire.”

If that be the case, the U.S. would no longer be in the catbird’s seat of global finance and there would be damage aplenty, not just to the U.S. but to the global financial system itself, a system which for 40 years has depended on the U.S. economy as the world’s consummate consumer and the dollar as the global medium of exchange. If the fiscal gap isn’t closed even ever so gradually over the next few years, then rating services, dollar reserve holding nations and bond managers embarrassed into being reborn as vigilantes may together force a resolution that ends in tears. It would be a scenario for the storybooks, that’s for sure, but one which in this instance, investors would want to forget. The damage would likely be beyond repair.

William H. Gross
Managing Director 

Hyperinflation Watch - Cyclical or Structural?

by James Turk - Goldmoney

The US federal government spent $369 billion in August, but only received $179 billion in revenue. The resulting $190 billion deficit was a record for any August and the third highest monthly deficit in the current fiscal year, which ends on September 30th.

Looking at this deficit another way, the federal government borrowed 51.6% of the dollars it spent in August. Consequently, the growth of the national debt continues to accelerate, as illustrated by the green bars in the following chart.



This chart also illustrates that the deficit – the gap between expenditures (red line) and revenue (blue line) – is not narrowing to any significant extent, which is a critically important observation. A persistent gap that is barely shrinking has never happened before.

Normally economic activity revives after a recession, which in turn leads to increased revenue for the federal government, like it did from 2004-2008 when the more rapid growth in revenue almost eliminated the deficit. But not this time. Revenue is increasing, but so are expenditures at almost the same rate.

Consequently, the deficit is not shrinking, which confirms a point I have made repeatedly for two years. The US is confronting a structural problem. It is not a cyclical one that will go away with improved economic activity. Importantly, the failure to address this problem will eventually lead to hyperinflation and the destruction of the dollar.

Mr. Bernanke sees it differently. Here is what he said in his well-publicized Jackson Hole speech on August 31st.

“In light of the policy actions the FOMC has taken to date, as well as the economy's natural recovery mechanisms, we might have hoped for greater progress by now in returning to maximum employment. Some have taken the lack of progress as evidence that the financial crisis caused structural damage to the economy, rendering the current levels of unemployment impervious to additional monetary accommodation. The literature on this issue is extensive, and I cannot fully review it today. However, following every previous U.S. recession since World War II, the unemployment rate has returned close to its pre-recession level, and, although the recent recession was unusually deep, I see little evidence of substantial structural change in recent years.” [emphasis added]

Note how Mr. Bernanke relies on precedent to defend his point of view. He believes that economic activity will grow just like it has after “every previous U.S. recession since World War II” because unemployment will fall as it always has, even though unemployment remains stubbornly high. Not only does he thereby imply that so-called black-swans – which are rare events – exist, he clearly refuses to believe that we may already be in one. To see the “evidence of substantial structural change” he says is missing, all Mr. Bernanke needs to do is look at the deficit gap so clearly illustrated in the above chart.

It is not the first time Mr. Bernanke has relied on ‘what is supposed to happen’ instead of what is actually happening. The following is from a CNBC interview on July 1, 2005.

“INTERVIEWER: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.” [emphasis added]

Just a few months before, Doubleday published The Collapse of the Dollar and How to Profit From It, the book I co-authored with John Rubino. Here is what we said on page 164 after providing our analysis of the housing market: “To put it bluntly, by virtually every measure, today’s housing market is a classic financial bubble.” The housing bubble was apparent not only to John and me, but also the dozens of others who understand the fundamental economic principles of the Austrian School. Apparently, that does not include Mr. Bernanke.

In conclusion, don’t put your faith on the pronouncements of any central planner. Rely instead on your own common sense, which hopefully has been well grounded by insights from parents or grandparents who lived through the collapse of the German Reichsmark, Serbian dinar, Argentine austral or any of dozens of other currency collapses. If you did not have that opportunity to learn from relatives who experienced a currency collapse firsthand, then I recommend that you read Mises, Rothbard and the other Austrian School scholars published at Mises.org.

Once you do, then decide for yourself whether the problem facing the US is cyclical or structural. Common sense and experience are telling me that it is structural.

Sadly, policymakers are doing little if anything about it. So we need to prepare for the consequences. The best way to do that of course is to own physical gold and silver.


Gold is Good Money - Dr. Ron Paul, U.S. Congressman

goldseek.com

Last year the Chairman of the Federal Reserve told me that gold is not money, a position which central banks, governments, and mainstream economists have claimed is the consensus for decades. But lately there have been some high-profile defections from that consensus. As Forbes recently reported, the president of the Bundesbank (Germany's central bank) and two highly-respected analysts at Deutsche Bank have praised gold as good money.

Why is gold good money? Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce - making it a stable store of value. It is all things the market needs good money to be and has been recognized as such throughout history. Gold rose to nearly $1800 an ounce after the Fed's most recent round of quantitative easing because the people know that gold is money when fiat money fails.

Central bankers recognize this too, even if they officially deny it. Some analysts have speculated that the International Monetary Fund's real clout is due to its large holdings of gold. And central banks around the world have increased their gold holdings over the last year, especially in emerging market economies trying to protect themselves from the collapse of Western fiat currencies.

Fiat money is not good money because it can be issued without limit and therefore cannot act as a stable store of value. A fiat monetary system gives complete discretion to those who run the printing press, allowing governments to spend money without having to suffer the political consequences of raising taxes. Fiat money benefits those who create it and receive it first, enriching government and its cronies. And the negative effects of fiat money are disguised so that people do not realize that money the Fed creates today is the reason for the busts, rising prices and unemployment, and diminished standard of living tomorrow.

This is why it is so important to allow people the freedom to choose stable money. Earlier this Congress I introduced the Free Competition in Currency Act (H.R. 1098) to permit people to use gold as money again. By eliminating taxes on gold and other precious metals and repealing legal tender laws, people are given the option between using good money or fiat money. If the government persists in debasing the dollar – as money monopolists have always done – then the people would be able to protect themselves by using alternatives such as gold that are both sound and stable.

As the fiat money pyramid crumbles, gold retains its luster. Rather than being the barbarous relic Keynesians have tried to lead us to believe it is, gold is, as the Bundesbank president put it, "a timeless classic." The defamation of gold wrought by central banks and governments is because gold exposes the devaluation of fiat currencies and the flawed policies of government. Governments hate gold because the people cannot be fooled by it.

Big Changes Are Coming, But The World Will Not End

by Robert Fitzwilson


40 year veteran, Robert Fitzwilson, wrote the following piece exclusively for King World News. Fitzwilson, who is founder of The Portola Group, warned, “Changes are coming, but it doesn’t mean the world will come to an end. But financial regime changes do result in a massive transfer of wealth from those who own paper assets, to those that own real assets.”
“Reflecting upon the news and the current state of affairs, it is striking how events are playing out according to script, as history and strategists have predicted. In the beginning of our journey, it was focused on discovery, historical context and understanding as to what had changed about markets, governments and people. The answer is almost everything if one looks just at our lifetimes.
On the other hand, nothing has really changed if one takes a longer view. One of our favorite sayings is, “The only thing new is the history you have not read”....
“We can vouch for that. After a review of much of the last 2,600 years, we have concluded that we are not the historic anomaly that we surmised at the beginning of the journey. In fact, we are simply repeating the same cycles and mistakes that all of our ancestors have made before us. Every culture throughout history has done exactly what we are doing now. The only difference is that this time it involves the entire planet.
As we read history, paper money was not designed to be an asset. It was an intermediary between sellers of goods and services. A seller might not have an immediate purchase in mind, so receiving a paper receipt that could be redeemed at a later time, and even at another location, was both efficient and much safer than receiving payment in gold or silver. The return trip from Rome to London was perilous under normal circumstances, let alone if one was returning with precious metals.
In our era, these receipts have taken many forms. Even the cash in our pockets is a derivative. In technical terms, it is a zero-coupon, perpetual obligation of the issuing government. In essence, the writing on the paper currency is promising “somebody owes you something, someday”.
The post-WWII monetary system began at Bretton Woods, New Hampshire. It began to unravel in the middle of the 1960s, but the mortal blow was struck by President Nixon with the suspension of dollar/gold convertibility. It has certainly been a long “suspension”.
Almost every ugly chart relating to the growth of debt and money can trace it’s roots to 1971. The evidence is incontrovertible. The value of the ancient form of receipts has been sliding ever since. The slide has not been linear over that 40-year period, but it certainly went into free-fall 12 years or so ago.
In the past, rulers created money out of something considered to hold value, often gold and silver. Seignorage was the right of kings to make a profit on that money. Unlimited seignorage was impossible as supplies of gold and silver came and went, and it was expensive to mint the coins.
With the use of paper and now electrons to create money, we now have unlimited seignorage. Money is created out of nothing, and you can see how it has been abused in the post-1971 charts. The abuse is accelerating on a massive, global scale. Cash and other derivatives have replaced our markets. Profits were to be made on creating and trading derivatives, not providing real goods and services. The real aspects of our economies continue to function, but the derivatives dwarf the size of the real global economy.
Much has been written about the historic confluence of our population growth coming together with the exponential endpoint of our resources. The same can be said for our money. Our resources are finite. The ability of our planet to sustain a population is finite.
We are now witnessing the exhaustion of our savings and real assets and our ability to sustain an exponential growth in money and derivatives. Unlimited derivates are hitting the proverbial brick wall, and their collapse will destroy everything based upon them, it is just history. This cycle has been repeated time and time again.
We also believe that we are approaching the end of a wonderful 200-year period in human history, driven by the industrial and technological revolutions. The exponential usage of resources and our population growth began almost precisely 200 years ago. If we combine this resource endgame with various groups which are desperate to maintain power or inflict it on others, it is a very toxic historical “soup”.
As to the resolution of what comes next, it is impossible to say. There are too many moving parts, or ‘Black Swans’ as people say. All we can do is to pay careful attention to events as they unfold, looking for clues as to how this mess will play out.
For our portfolios, the message is clear. Get out of paper assets that can be destroyed by the unlimited seignorage, and convert them into real assets. The end of the fiat money system will come swiftly, and perhaps overnight. It cannot be too far off at this point.
Changes are coming, but it doesn’t mean the world will come to an end. But financial regime changes do result in a massive transfer of wealth from those who own paper assets, to those that own real assets. Historically, gold and silver are traditional safe havens.
Despite what we read, the physical supply of these metals is becoming diminished for a variety of reasons. Waiting too long to purchase them could result in the inability to do so or certainly being forced to buy at much higher prices.”

Friday, September 28, 2012

Gold Could Easily Double From These Levels

By Caesar Bryan from kingworldnews.com

 “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 kingworldnews.com  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.”
 

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 www.goldmoney.com

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

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 : www.businessinsider.com

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 :  www.321gold.com

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.

Conclusion

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.

Source www.thefreemanonline.org