Gulf petro-powers to launch currency in latest threat to dollar hegemony

Mandate #1 – Price Stability

When the private Federal Reserve was chartered in 1913 by the unconstitutional Act of the same name, it stated two specific mandates: maximum employment and price stability. Those were to be the Fed’s areas of activity. However, with virtually no accountability to the American people (except vis a vis the President who appoints the Chairman and the Congress who invariably rubber-stamps such appointments), the Fed was turned loose on the undefended US Dollar.

For years, the American public has been duped into thinking that inflation is necessary for economic growth. This outright lie will likely compete for the title of biggest financial fraud in history. Aided by this unawareness, we have seen a fairly standard 5% rate of annual inflation institutionalized into our economic system. For quite a while, this inflation went virtually undetected as it feasted mainly on the prosperity America had achieved, particularly after the Great Depression. As a nation, we began to spend away our surpluses and attach claims on future economic activity through the great society programs of the 1960’s and the perpetuation of New Deal programs such as Social Security.

By the 1970s, however, we’d run short of real money and dealt the global financial system the shock of accepting paper dollars in settlement of our out of control deficit spending. This resulted in a period of increased instability in the 1970s and twin severe recessions. By this time, the devalued Dollar had destroyed enough of our purchasing power that it became necessary in many cases for a second breadwinner to work to maintain the standard of living. In the 1980s and 1990s, Americans began to rely increasingly on consumer credit to bridge the gap left by the waning dollar, and for much of the first decade of this new century, the house became the ATM as another gap filler.

It is no wonder that the recent contraction in consumer credit isn’t touched by the mainstream press; it is that critical to economic growth. This contraction is one of the biggest reasons the federal government has stepped in with record deficit spending. To keep the economic charade going, it has had to.

The above bevy of charts and data should make it perfectly clear that the Fed has failed in spectacular fashion in terms of price stability. The only thing it has been successful in is ensuring that the devaluation of the Dollar occurred gradually, over time, so as not to alarm Main Street.

Mandate #2 – Maximum Employment

The second part of the dual mandate was maximum employment. In this regard, the central bank has done only a slightly better job. America in general has ranked fairly high globally in terms of low unemployment. However, one thing that must be noted is the Fed’s role in assisting with the exportation of American industry and the high paying manufacturing jobs that went with it. How did the Fed do this? Conventional wisdom would assert that it was solely government trade policies and agreements such as GATT and NAFTA that ruined our manufacturing base. That is certainly true, but these government policies had plenty of help.

A consistently weaker dollar means export advantages. However, there was (and still is, albeit a smaller one) a significant gap between labor costs in foreign countries like much of Asia and the US. So US-based companies could export their manufacturing activities abroad to take advantage of the cheap labor while having export advantages over their foreign competitors because of the weak dollar.
While the bottom line was certainly money and power, it is debatable whether the de-industrialization was done to flood America with cheap imported goods to mask the loss of the Dollar’s purchasing power or if it was done merely to consolidate global power by knocking down the standard of living of the first world. I realize this is going to be a difficult point to argue when one can walk into a store almost anywhere in the country and purchase a myriad of items at ‘Rollback’ prices. However, if you take a look around you and imagine what would be there if it weren’t for the debt load, I think you’ll get a pretty good picture of what is going on here.

What is undeniable is the transition from a goods-producing economy to a service-oriented one. The biggest problem with a country full of employees performing services is that many of these services cannot be exported to pay for the goods we now must import. Despite the technological developments of the past 10 years, a haircut still cannot be exported to China. To be honest, the Fed’s direct impact on the job market has traditionally been much less than its impact on price stability. However, the fact that there has been a covert move to de-industrialize the first world cannot be denied. The fact that much of the impetus for this move came from the policies of the IMF and World Bank with assistance from regional central banks is equally real. A good take home message from this is that central planning almost always works against personal liberty and human rights.

Ramifications

Unfortunately, what has taken place over the years is that the Fed has used these two broad mandates to create for itself a battalion of illicit activities, to the point where mere disclosure of what these activities are would cause an instant depression if you listen to Ben Bernanke, Frederic Mishkin, and others. Attempts to shine the light of day on the Fed’s activities are painted as being ‘dangerous’. I’m sure they are dangerous – to the status quo. Even more disturbing is the Fed’s ability to buy out the entire country while Congress worries about state dinner party crashers and how many subpoenas should be issued. Few commentators have bothered to mention that when the Fed buys $852 Billion in mortgage bonds, it is buying the mortgages of American homes. Maybe your mortgage is now held by an offshore banking cartel even though your mortgage contract was with Countrywide, BAC or any of a thousand originators. Does that bother you? It should.

No, this is not a problem of a single rogue Fed Chairman. It is a problem of a rogue institution, which has stretched way beyond its original charter – and an unconstitutional charter at that. Recent moves to audit the Fed, while noble, will only go so far. I had the opportunity to chat with G. Edward Griffin about this very topic and share his concern that the audit movement will act as a lightning rod for public outrage while allowing the institution itself to continue in a business as usual manner. Congress has the power to yank the Federal Reserve’s ticket; it is about time they used it to give the Fed a 100th birthday present – a pink slip.

Addendum It should come as little surprise to anyone that a truly out of nowhere jobs report comes out just as Bernanke is ‘under fire’ on Capitol Hill. It would be nearly impossible to count all the times this has happened over the past year or so when either the stock market or some political figure has needed a boost. What must be noted is that goods-producing jobs continue to disappear, and that much of the ‘good news’ in the jobs report comes from the fact that temp agencies signed on 52,000 workers in November. Much ballyhooed about this trend is the fact that temp agencies have been adding staff for the last 4 months now. What should be of concern is that there appears to be almost no conversion of those temp jobs into permanent positions at this point in time.

For the past 9 years now, students of history and common sense have been literally shouting from the rooftops that Gold was the place to be as the monetary tradewinds shifted back in 2000 and the fiat inflationary cycle began to go parabolic. While the multi-trillion dollar deficits might be a surprise to many, for those who understand how these things work, it is just a mundane repetition of history and yet another confirmation that man cannot alter the laws of economics or his own intrinsic predilection to ignore events past.

From 2000 up until recently, there was a constant battle going on. Central banks and the IMF would sell off their physical Gold to suppress the price. Between 1999 and 2002, Gordon Brown, then England’s Chancellor of the Exchequer made the extremely wise decision to sell a good chunk of Mother England’s Gold (395 tonnes) in the $275-$300/oz area. The people were so enthralled by this obvious economic genius that they made him the Prime Minister. All sarcasm aside, this was only one prong of the tactic to suppress Gold prices.

The second prong consisted of large New York and London banks mercilessly shorting Gold in the paper futures markets. For most of the last nine years, the bulk of these futures contracts were rolled over or settled in cash; taking delivery wasn’t really en vogue. There have been many people such as Jim Sinclair working hard in the trenches to educate people on the merits of taking delivery and fighting the cartel by taking their playing chips off the table. Gold in your possession cannot be leased out by a central bank to various third parties, nor can it have futures contracts written against it.

Despite even these herculean suppression efforts, the price of Gold made the journey from $275 to $940 in fairly short order. Surely, there were many gut checks in there; days when the metal lost 5% and the pundits would scream the bubble had burst and it was all over, now please buy some mortgage backed securities. There were some epic struggles like the Battle for $700 shown below.

Through the past nine years the game was played under the rules of central banks and the IMF. In the past two months, countries, large players, and even Gold producers have turned the game on its head. Suddenly everyone wants physical metal, not paper promises. And don’t give us the 90% bars either; we want the good stuff. Suddenly, there are instant buyers for IMF sales that were previously guaranteed to suppress prices. Suddenly an IMF sale sparks a rally to a new all-time high. China tells NY and London banks to take a long stroll off a short pier by issuing a directive to its state banks to walk away from commodity derivatives contracts. And, even more telling, central bank selling has been dropping steadily over the past few years and has been nearly nonexistent in 2009.

And finally, Barrick is closing its infamous hedge book. What was once a 20 million ounce boat anchor on the price of Gold has become a multibillion dollar boat anchor around Barrick’s neck and they’ve finally had enough. The book, now around 3 million ounces will be closed by next year according to Barrick boss Aaron Regent.

Oddly enough, it is not the collapsing US Dollar that is driving this decision, but rather a realization that Gold production likely peaked in 2001 and that even a tripling in exploration budgets across the mining sector has yielded precious little in the way of new discoveries. During this entire time period, demand for Gold has been rising consistently, thanks in no small part to the continual abuse of paper currencies by governments around the globe. The existence of serious supply-demand dislocations immediately rules out the prospect of a speculative bubble. Granted, there are plenty of smaller players who are dabbling in Gold without the slightest bit of understanding as to why they’re doing it. The next correction will undoubtedly send many of them running back to mainstream newsletter writers demanding a refund. After all, they were supposed to be living on the beach in 6 months; the advertisement said so!

The shattering of the old paradigm as it relates to Gold is very similar to a paradigm that was shattered with regard to stock investing nearly a decade ago. In that case, the conventional logic was that the market always went up in the long run. And for 18 years, that had absolutely been the case. Even the crash of 1987 hadn’t done much to derail the bull market. However, when we crossed into the new century, the paper paradigm changed with the major indices going NOWHERE in the past 9 years and change. Yet many conventional financial professionals are still investing as if it were 1995 then blaming the markets for client losses when they should be blaming their own inability to see that our world has changed dramatically.

Unfortunately, another of the very negative sides of the attack on Gold have been the ad hominim attacks on proponents of Gold-backed currencies and those who promote the reality that Gold is in fact real money. The attackers use the term ‘Gold Bug’ to paint a picture of little men sitting in fallout shelters wearing tinfoil hats with stashes of food, water, and enough weapons to make the debate about Iran seem pretty foolish. That just isn’t the way it is. Simply put, a Gold bug is someone who understands Gold’s historical role as money and seeks to educate others in this regard while protecting their own assets from the abuses heaped on paper currencies by their custodians.

So today I, an admitted Gold bug, ask: Now… do we finally have your attention?

]]> http://www.sutton-associates.net/blog/2009/11/12/gold-do-we-finally-have-your-attention/feed/ 0 http://www.sutton-associates.net/blog/2009/11/11/barrick-world-gold-supply-runs-out/ http://www.sutton-associates.net/blog/2009/11/11/barrick-world-gold-supply-runs-out/#comments Thu, 12 Nov 2009 03:24:57 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=321 This is something I’ve been talking about for a while now (along with many others). The mainstream has continuously ignored the supply-demand dynamics of the Gold market instead choosing to focus solely on the inflation hedge. If you thought there was an upside before, this will increase it by several orders of magnitude.

http://www.telegraph.co.uk/finance/newsbysector/industry/mining/6546579/Barrick-shuts-hedge-book-as-world-gold-supply-runs-out.html

Cost vs. Price

It would probably be rather hard to find a single American that didn’t know the price tag of the stimulus bill. $787 billion has been included in nearly every news piece regarding the topic. What most people are not aware of, however, is that $787 billion only represents that amount of money actually put into the economy by the feds. It comes nowhere near addressing the actual cost of the program. A good recent example of this miracle of government accounting is the Medicare part D prescription benefit program. The price tag was $394 billion, but the cost is much higher – around $8.7 trillion and counting depending on which numbers you want to use. Granted this represents the net present value of the cost of these ongoing benefits over a 75-year period, but you get the idea.

Fortunately for taxpayers, the stimulus package is not an ongoing expenditure (yet), and as such consists of predefined outlays. Despite this, the total cost of the bill as compiled by the Congressional Budget Office is approximately $3.27 trillion. Amazing in this is the fact that we’ll pay nearly as much for debt service on the stimulus bill ($744 billion) as the measure was supposed to provide to the economy! Talk about sticker shock. The gory details are here.

The question now becomes one of return on investment. What exactly are we going to get for our $3.27 trillion? It had better be good too, because nearly all of it is borrowed from someone – either foreigners or the Fed. Unfortunately, such is not the case. Using the $3.27 trillion projected cost, the ROI for the stimulus bill stands at a whopping -415%. In the private sector, such a revelation would result in a project being killed instantly in the concept phase. Not so in the hallowed halls of Congress where the laws of economics and common sense do not apply.

A Good Deal for Taxpayers?

We have been assured in almost doublespeak fashion that the stimulus bill was necessary, and was in fact, a good deal for the American taxpayer and would create or save millions of jobs.

The ballyhooed cash for clunkers program deemed such a success ended up costing taxpayers around $24,000 for every car sold under the program. This when the actual benefit to the buyer was only $4,500. Some other examples, courtesy of AP, include:

- A company working with the Federal Communications Commission reported that stimulus money paid for 4,231 jobs, when about 1,000 were produced.

- A Georgia community college reported creating 280 jobs with recovery money, but none was created from stimulus spending.

- A Florida childcare center said its stimulus money saved 129 jobs but used the money on raises for existing employees.

One disconcerting admission in the past week came from Christine Romer, the head of the Council of Economic Advisors. She stated that the largest impact from the stimulus had already been felt and that moving forward, the stimulus would only serve to prevent the economy from slipping further rather than contributing to any growth. Sounds like a recovery eh? It would sound as if Ms. Romer is already laying the groundwork for the next brainchild of economic ignorance: Stimulus – The Sequel. Here are her quotes:

“By mid-2010,” she said, “fiscal stimulus will likely be contributing little to further growth.”

“While job losses will likely end early next year, robust job gains may still be several quarters away,”

“This is not a normal recovery, Coming out of this, we’ve got lots of things working against us.”

Like the laws of economics for starters?

What also must be noted is that the federal deficit alone for FY 2009, which doesn’t included net present value of unfunded liabilities, was $1.4 trillion. The fact that such a large sum of money had to be spent to prevent an all-out collapse of the US economy should be alarming to anyone with a pulse. The fact that current projections are for $1 trillion plus deficits annually for the next ten years should curl your eyebrows.

Let’s assume for a minute that Ms. Romer is correct and that we’ve seen all the bounce we’re going to get from the stimulus. According to AP, the number of jobs created directly by stimulus spending was around 25,000. Sure, there are probably some others that slipped through the cracks and it is very likely that some firms held off on layoffs because of the temporary burst of cash. But lets look at the cost of those jobs JUST in terms of the debt service created by the stimulus bill. Each of the 25,000 jobs created cost the taxpayer $29,600,000 in debt service alone.

Keep in mind that unemployment has been going up constantly during the time when we were getting the maximum ‘benefits’ from the stimulus. As soon as the money wears off, firms will fall back on their original plans, which include cutting back on staff. Another stimulus package will be needed – and soon – to stave off the infamous double dip that many economists and commentators have long been forecasting. The proverb that a house built on a rock will weather any storm, but one built on sand will certainly collapse rings very true in our current state of affairs.

The real question that needs to be posed to anyone supporting additional foolish stimulus needs to focus on an exit strategy. How will additional stimulus create a foundation for fundamental, healthy economic growth? The short answer is that it won’t, but lets make them answer anyway.

Nearly three months have passed since then and almost every piece of data that has come across this desk has validated the claims made back in February.

Just aside of the factors we mentioned in the February article, which were the CRB Index, Gold, and West Texas Intermediate Crude, there is another major indicator of this phenomenon and that is the stock market. From the 3/6/2009 bottom through today, the Dow Jones Wilshire 5000 Index raced from 6935 to 9342; an increase of 34.71%. More importantly though, lets look at it in terms of dollars. The value of the Wilshire 5000, which is one of the broadest measures of US market capitalization increased by $2.407 Trillion during that relatively short period of time.

It is utterly preposterous to assume that Mr. and Mrs. America dug in the couch and found that kind of money and decided to invest it. It is even more preposterous considering the environment that the real economy is dealing with at this time. Job losses have been staggering and persistent, it is demonstrably difficult for the unemployed to find work, and house prices are still falling like an elephant dropped from the Empire State Building. How else do we know this increase didn’t come from the real economy? Let’s look at past behavior. When the government handed out $168 billion in stimulus checks – essentially ‘free money’ – did the public invest it in the stock market? No. The public paid bills, or saved it – much to the consternation of the government.

So where did this dramatic bear market rally come from? In my opinion, it came from large institutional investors – many of the same people who had their coffers stuffed with TARP money over the past 6 months and the same folks who were essentially given a free pass a while back when the rules for mark to market accounting were relaxed. So what we have here is largely an inflationary rally. Certainly, this is not the first such rally, and it will most assuredly not be the last.

But it isn’t just the stock market. It is the commodities markets as well, and this is where it gets bad for consumers. We are about to witness a wave of inflation, a magnitude of which has never before been seen in America. Dr. Marc Faber had this to say about the subject:

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate. He also added, “The global economy won’t return to the “prosperity” of 2006 and 2007 even as it rebounds from a recession”.

Let’s revisit our charts and positions from February and see how much things have changed in just three months:

Reuters/Jefferies CRB Index

The 15% increase in just the past 3 months will not immediately be seen on store shelves, but it is already being seen at the gas pump and in the prices of many consumer items. It must be noted that the US economy contracted at a rate of 5.7% (annualized) in the first quarter of 2009, which is on the heels of a 6.1% decrease in the fourth quarter of 2008, yet consumer prices, commodities, and other inflation assets are rising. If this doesn’t strike down the notion that demand (economic growth) alone determines prices, then nothing will.

West Texas Intermediate Crude Oil (WTIC)

This one says it all – a 45% increase in the price of oil just since the middle of February. Keep in mind this increase in price has occurred during a period of a contracting US economy. It is high time that the mainstream press and every one of us stop being US centric when it comes to oil – and everything else for that matter. World demand has remained robust, but at the same time has not exploded over the past six months for sure. The problem is there are untold trillions of dollars parked around the globe. Remember last fall that it wasn’t just the US Fed who was printing like crazy. The Europeans were following suit, much to the dismay of any country that possesses a scarce resource.

Gold – Contract Price

Despite a major rally in equities and assertions from media and government alike that the economy has bottomed and will begin to heal soon, Gold has not taken the bait. After once again breaking through the $1000/oz level for a brief period in late February, Gold was pushed down to the $860 area, but has rallied nearly $100/oz in relentless fashion and is looking for its fourth straight week of gains. It is very obvious that the powers that be would prefer if Gold remained below the psychologically critical $1000/oz mark. A serious breakout to the upside would once again light the 1970’s-esque fire of inflationary expectations.

The US Dollar – Heads they win, tails we lose

The story for the US Dollar over the past year has been a fairly simple one: if there is a major crisis and stock markets are falling 700 points in a day, then people want dollars. Otherwise, forget it. So the only way holders of dollars get a break is if the wheels are falling off everything else. During periods of relative calm, such as what we are seeing now, the Dollar has retaken its outcast position as the whipping boy among currencies. The damage done by numerous bailouts and stimulus packages is common sense. The future damage of persistent trillion dollar annual deficits and tens of trillions in unfunded liabilities from Social Security and Medicare still remains.

The 11% move in the Dollar from 2/20/09 to the present will result in higher prices paid for imports, and in part has been one of the reasons for oil’s recent surge. However, oil’s move has been far in excess of what would have been necessary to merely keep pace with the dollar’s decay. Look for a return to higher trade deficits unless demand drops concomitantly, which is entirely possible.

The return of the Bond Vigilantes

Perhaps worst of all has been the Fed’s inability to keep bond yields under control. Despite open monetization to the tune of $300 Billion, and the 2009 purchases of upwards of $1.25 Trillion in mortgage bonds in an effort to keep rates low, bond rates have shot up dramatically. Perhaps even worse, mortgage bond yields are now starting to move up as well. The most alarming trend is the 10-2 spread for 10-year and 2-year Treasury notes. It cannot be ignored that with each recession, the spread grows. That is because each time the fears of inflation as well as actual inflation itself increase dramatically. It cannot be ignored that with each spike we have seen a large bolus of inflation enter the system resulting in a period of ‘prosperity’.

Anyone care to stretch their thinking a bit and notice how those periods of ‘prosperity’ are getting shorter and shorter despite greater infusions of fiat cash?

It should now be apparent to all that a massive inflationary wave has been unleashed. Policymakers are aware of this and are already preparing the public by discussing deficits in the trillions rather than billions as the government will make a futile attempt to keep pace. What is most alarming in all of this is the precarious position of the consumer. Nearly wiped out in 2008 by job losses, falling home prices (which had previously been regarded as income), stagnant wages, and dramatic losses in retirement and other investments, the consumer is not in the position to deal with the inflationary blow that is now in progress.

The green shoots theory was a nice try, but those shoots are about to be buried under an avalanche of another type of green – the green of increasingly worthless fiat paper money.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. On June 3rd, we welcome Professor Laurence Kotlikoff to discuss generational accounting and our mounting unfunded liabilities. To listen to this or other shows, visit www.my2centsonline.com/radioshow.php

]]> http://www.sutton-associates.net/blog/2009/05/29/confirmations-and-conclusions/feed/ 5 http://www.sutton-associates.net/blog/2009/04/03/commitments-and-confusion/ http://www.sutton-associates.net/blog/2009/04/03/commitments-and-confusion/#comments Fri, 03 Apr 2009 19:25:11 +0000 TwoCentsEditor http://www.my2centsonline.com/blog/?p=194 Talk about mixed signals. Confusion reigns supreme. On Thursday the economy was recovering because factory orders went up for February, breaking a multi-month downtrend. However, today, there is no end in sight as the employment report was released and another 663,000 Americans have lost their jobs. There is another storyline there, but we’ll save that for a different time. It would seem that commentators, economists, and policymakers alike are in a race to call the bottom. Fundamentals and economic analysis have all but disappeared under what is a seemingly never-ending wave of distortion caused by monetary creation. $1 Trillion to the IMF and World Bank. $787 Billion to ‘stimulus’, and a whopping total of $12.8 Trillion committed by the US alone with more to come. Let us take a sobering look at the commitments that have been created thus far (in Billions of Dollars) and eliminate some confusion:

Source: Bloomberg

Keep in mind that the above numbers do not represent the total cost of these programs. Just for example the second stimulus (HR1), which is counted as $787 Billion on the Treasury’s tab will actually cost $3.27 Trillion. This total is arrived at by considering the extension of current provisions, total impact of the legislation, and $744 Billion in debt service (interest) that will need to be paid on the borrowed funds. If that level of understatement is present in even a small portion of the programs listed above, it will result in a ballooning of the overall totals.

Just for illustrative purposes, we can get a very rough estimate of the total impact of these commitments by making a couple of rather weighty assumptions:

1) We’ll start making payment in 2020 since there is no possibility of a budget surplus until then. Unless of course the plan is to essentially take out a VISA to pay off a MasterCard, which is rather likely.

2) The interest rate paid on this debt will be an average of 3.70% (today’s 30-year bond yield). Granted, this is not an exact number, but it will allow us to ballpark the total.

3) We are assuming that 100% of the committed funds will be used to engineer the various rescues.

Given these rather basic assumptions, the value of the current commitments will have grown to around $18.5 Trillion by 2020 when we’ll make our first payment if everything goes well. Add on the 2020 value of our current national debt for a grand total of $34.5 Trillion. This is just for the current financial rescue and what we owe from past fiscal indiscretions. This accounts for none of the coming generational mess resulting from Social Security and Medicare. This accounts for none of whatever additional stopgap measures might be necessary to further ‘stimulate’ consumption. This assumes that we stop accumulating more debt today. In other words, the $34.5 Trillion estimate should be viewed as an absolute best-case scenario.

Perhaps even more telling in the numbers above is the portion that has been dedicated to helping the real economy as opposed to the financial system. While some of these programs indirectly help Main Street, they were clearly created to benefit Wall Street. By our count, approximately 4% of the funds above were created with the explicit intent of benefitting Main Street. So for every dollar committed, 4 cents were given to Main Street. We get 4 cents, but have to pay back the full amount – at interest. Sounds like a great deal doesn’t it? I’ll be the first to admit that the 4 cents figure is easily disputed and debated, but the spirit of the recent rescues is crystal clear.

Housing: Underpinning or Pinned Under?

All of the above notwithstanding, many ‘experts’ in the mainstream media have forecasted the recession to end by the end of 2009. How can this be so? It must be understood how many of these people view a recession. They are under the completely mistaken impression that the printing press is the solution to all economic maladies. Their biggest gripe with the Fed is that it didn’t print enough money fast enough. The concepts of savings, genuine capital formation, and the resultant investments elude them. They don’t understand that genuine capital comes from the foregoing of consumption, not the Greenspan/Bernanke printing press. It is also clear that these same people equate the housing and share markets with the overall economy.

Ben Bernanke, true to his promise, has managed to lower mortgage rates by around a full percent since the Fed started buying mortgage bonds in late 2008. This has touched off a wave of refinancing, which will put a few bucks back in consumers’ pockets. Apparently that is enough to call an end to the recession. Never mind that job losses continue unabated and forget about the annoying fact that real estate prices are still falling. According to NAR, real estate prices have now fallen 28% from their highs back in 2006. That is quite a bit of equity that can no longer be borrowed against. Their own flawed model is broken and they still won’t admit it. However, the equating of housing with the overall economy doesn’t stop at the pages of your local newspaper. Cleveland Fed Governor Sandra Pianalto said recently that lower mortgage rates offer ‘encouraging signs’ for the economy. It is pretty obvious that policymakers are of the opinion that if the housing bubble can just be reinflated that we could rewind to 2005 and forget about this meddlesome little crisis we now find ourselves in.

The stock market does NOT equal the economy

This is an obvious point, but given the public reaction to the recent rally off multi-year lows, it is one that needs to be reinforced. Think about how many times you have heard lately that the stock market is doing well therefore the economy must be getting better? These comments are not just limited to parties either, but have become regular fare on the evening news, newspapers, and even dedicated financial publications. At the severe risk of being repetitive, I am going to trot out a chart of the Dow Jones Industrials Average from 1929 through 1933. We all know the backdrop and how the economy contracted throughout this entire period. What is more telling is what happened to the DOW along the way.

After the crash of 1929, the DOW rallied significantly, getting back nearly 40% of what had been lost from the top. While traders made some serious money on the moves over the next 3 years, long-term investors were decimated, losing nearly 90% of their wealth when all was said and done. The important thing to note is that the real damage was done after the crash. Here is an even less comforting thought. In real terms, investors NEVER got that wealth back. The value of their dollars eroded faster than any subsequent gains in the stock markets. That situation has played out to this very day. This reality has manifested itself over the past 30 years in particular as the family has come to rely first on extra work hours, and finally, on credit to maintain pace.

The take-home message is that there are very clear examples in history that prove that sharemarkets do not equal the economy.

A more recent example is the 2007 DOW. In the fourth quarter of 2007, while America was entering a recession (which would not be admitted until nearly a year later), the DOW was peaking at an all-time high of over 14,000. Clearly, the economy had been slowing for a period of time prior, yet the DOW surged ahead. It is imperative to separate the two.

Perhaps the following definition will provide some guidance and eliminate a bit of the confusion that seems unfettered these days. The word ‘economy’ comes from the Greek words ‘oikos’ and ‘nomos’, which mean ‘house’ and ‘law’ respectively. Not much of a definition? Sure it is. I will take some linguistic license and say that it implies the order of one’s house. This applies whether you’re talking about individuals, businesses, states, or national governments. While we use fancy abbreviations, acronyms and statistics to describe the state of economic homeostasis, in the end what we’re really doing is assessing the extent to which we’ve kept our house in order. $34.5 Trillion in debt and commitments? Borrowing more than 100% of the world’s savings to finance it? Bailouts? The average person carrying over $16,000 in consumer debt – not including mortgages?

Let’s get our house in order – then we can talk recovery.

Take advantage of our complimentary report “The 7 Mistakes Investors make..and how to avoid them”. Get your copy today by going to our website www.sutton-associates.net and clicking the banner.

Gresham’s Law

Gresham’s Law deals with a situation when there are two (or more) competing currencies and one is ‘pegged’ against the other. More specifically, the law deals with bimetallic currency systems where both Gold and Silver are used in an economy and the ratio of the two is fixed. A good historical reference would be the post Bank of North America United States in the early 1800s. The US Constitution in Article 1, Section 8 gave Congress the power to coin money and determine the value thereof. A Constitutional Dollar was determined to be a coin containing 371.25 grains of pure silver. In order to encourage the use of gold as well as Silver, the ratio was set at 15:1 – therefore a Constitutional Dollar could also be a Gold coin containing 24.75 grains of pure Gold. For anyone who knows Gold, 24.75 grains is not a very large coin so coins that contained 247.5 grains of Gold were used and were valued at 10 Dollars. So far, so good, right?

The only problem here is that the exchange ratio of any two goods will vary over time. When the 15:1 value was set, that was the going market rate. Alexander Hamilton, who was a big proponent of the bimetallic system, gets an “A” for effort, but failed to recognize and/or provide for the constant fluctuation. In the case of the Gold-Silver ratio, the supply of Silver grew disproportionately to that of Gold due in large part to mining in the Caribbean. The silver made it to our shores thanks to a vibrant trading relationship between America and that region of the world. This is where Gresham’s Law comes into play. The law states that anytime one money is compulsorily undervalued while another is overvalued, the undervalued money will be driven out of the economy or hoarded while the overvalued money will explode into circulation. In following Gresham’s Law, Gold all but disappeared from circulation in early 19th century America. With the obvious consequences of Gresham’s Law, it is easy to ask why any government would forcibly attempt to impose a bimetallic standard on an economy? Hint: It must be remembered that in absence of paper money, the supply of money in the economy was determined by the quantity of specie (Gold and/or Silver).

The monetary ‘authorities’ at the time were attempting to make sure that the economy had enough money to function properly, which was certainly a good intention. Where they went wrong in their approach is that the economy could have easily functioned on silver alone since it was in good supply. Market prices for other goods would have adjusted themselves through the laws of marginal utility and supply/demand according to the supply of both specie and the other goods.

Gresham’s Law is easily observed today in our own currency system with a slight variation. While the Dollar and Gold are allowed to adjust to a certain extent in terms of each other, it is easy to see how the undervalued money (Gold) has gone into hiding while the overvalued ‘money’ (Federal Reserve Notes) have flooded into circulation.

Early American Attempts at Fiat Paper Money

Perhaps ironically, America’s first attempts at fiat money began before Lexington and Concord. Before the French and Indian War. And even before the 18th century had seen the light of day. The first government issue of paper money came in 1690 in the colony of Massachusetts. It had become a custom there to embark on plundering missions into Quebec and then use the proceeds of the missions to pay off the soldiers upon return to the colony. In 1690, however, one such mission was unsuccessful so there were no spoils to distribute. In order to placate the soldiers, the colonial government attempted to borrow the required money from local merchants. However, these merchants had a rather dim view of the creditworthiness of the government and refused. In an ill-fated decision, the government of the Massachusetts colony then decided to issue paper notes with the promise of both redeemability and that the issuance was a one-time affair. They ended up being wrong on both counts.

These endeavors continued almost constantly up to and through the American Revolution with two predictable results: the notes issued always depreciated versus the competing specie money and the amount of paper notes issued got larger with each subsequent attempt. These comparisons are important to make when connecting early monetary ventures to what is going on today.

The “Continental”

Early in the American Revolution, the Continental Congress ran into the serious issue of funding and opted to look towards fiat money for the solution to the problem. Unlike some of the previous redeemable fiat ventures, the ‘Continental’ as it became known was not to be redeemable at all, but would rather be dismantled after the war ended by using taxes paid by the colonies. While this was a temporary solution, it carried the double whammy of inflation and taxation for the colonies. Certainly, sacrifices had to be made, but what is most interesting is what happened next. From 1775 through 1779, the supply of Continentals exploded by over 1800%. Predictably, the value of the Continental in specie (silver) had fallen to 42:1 from a beginning value of 1-1.25:1. By 1781, with the war still raging, the value of the Continental had fallen to a negligible 168:1. Comparatively speaking, today’s fiat dollar which traded with specie (gold) before the Great Depression at a rate of 20:1 now trades around 950:1 – a similar hyperinflation although over a much longer period of time.

The next step taken by the colonial government was to impose price controls and attempt to dictate the market value of the failing currency. These efforts flouted several of the laws of economics, the first of which is that you cannot run an effective paper money system without confidence. The second is that price controls create shortages by artificially setting the market price below that of the equilibrium price as is illustrated in the chart below:

With the impending failure of the Continental in 1779, the Congress resigned itself to allow the Continental to depreciate unredeemed into worthlessness. However, and tragically, the Congress then resorted to issuing loan certificates for the purchase of goods and services from Colonial merchants and refusing to pay anything in else. Soon enough the certificates became used as a currency and, much like their brother the Continental, began to depreciate. Here’s the important part though. Instead of allowing the certificates to be redeemed at a depreciated value, they were carried into perpetuity and the permanent Federal debt was born. This unpaid bill is better known today as the National Debt.

The Bank of North America and Robert Morris

In 1781, Robert Morris introduced a bill that created both the first commercial bank and the first central bank. The resulting catastrophe, headed by Morris himself, opened in 1782 and quickly ran into problems. The first of these problems was our old friend confidence. Americans, already weary of paper notes due to decades of failures, inflation, and broken promises just couldn’t shake the perception that the new bank’s notes were being inflated compared to the still-existing specie. The bank, in an extraordinary move at the time actually went as far as to hire people to promote the new bank and its notes and to insist on redemption for specie. Obviously the idea here was to gain the confidence of the public by demonstrating that the notes were in fact worth something. Paradoxically, today’s Fed doesn’t even try to maintain an illusion of backing or intrinsic worth.

The First Bank of the US – 1791 (above)

This first experiment into central banking lasted barely a year as in early 1783 Morris moved to end the institution’s authority as a central bank and shifted its focus to commercial activities with a Pennsylvania charter. Although short, it was one of many important steps in the establishment of a central banking authority. Perhaps most importantly, the population grew more accustomed to using paper money. By the 20th century, specie was removed from circulation in totality while the ability to redeem still existed. Eventually, redeemability was suspended as well, leaving us with a paper currency with only implicit worth. In 1971, in a final blow to sound money, settlement of foreign debt in specie was suspended as well. What has transpired since has been a slower, but eerily similar version of the demise of the Continental.

In conclusion, there is absolutely nothing wrong with paper money in and of itself. It can actually serve a valuable purpose in that it is more portable, easily divisible, and in the case of the grain banks thousands of years ago, was much easier than moving bushels of wheat. However, the predilection of those charged with running these types of operations has been to coerce and conspire to rob the people of wealth through stealth. Whereas it would have been exceedingly problematic to confiscate a farmer’s grain without incurring his wrath, it was magnificently simple to inflate his wealth away through the over issuance of grain receipts. The parallels between these early experiments and what goes on today are astounding. We as a people still haven’t gotten our heads around the idea of inflation – the over issuance of fiat paper money – and the confiscation of wealth it represents. What could never be done through direct taxation has been done under another name, right under our very noses, and in plain sight.

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Sources:

“Man, Economy, and State” Rothbard, Murray N. Mises Institute.

“A History of Money and Banking in the United States” Rothbard, Murray N. Mises Institute.

Disclosures: Long GDX

In the 1990s globalization was presented to the nations of the world. Terms like competitive and comparative advantage became part of business lore. Americans, already punch drunk from a 25-year assault on the purchasing power of their currency, were sold on the promise of inexpensive imported goods. These goods would be made elsewhere and moved on barges powered by oil that would be cheap forever. While the former was certainly true, the costs of such shortsighted thinking were largely ignored by those in Washington. We are now witnessing the effects of those costs firsthand.

“We cannot afford a trade war”

This week, Senator John McCain proposed an amendment to the pork-laden ‘stimulus’ package that would have effectively wiped out the ‘Buy American’ clause in the package. Essentially this clause stated that any government or public building projects had to use steel that was produced in the United States. Having already lived through the obliteration of this iconic industry once, the ‘Buy American’ clause was very encouraging. However, it appears that in this regard, it will be business as usual, maybe not because we want to, but now because we have to.

To put it simply, America can no longer live on its own production. This is no surprise and has been the case for quite some time. However, we are in a position now where a little leverage might come in handy. Our economy is bleeding jobs and we need to be able to maintain and promote American manufacturing. And contrary to the tenets of globalization, there is absolutely nothing wrong with producing our own goods and services and we should be doing exactly that.

While the argument will be made that our trade partners cannot afford not to trade with us, it is much more likely that they can remain solvent far in excess of our ability to sustain ourselves. This is particularly true in the case of energy, the ultimate staple good. Despite the claims of many that we have enough oil right here in the US to last us umpteen years, even if that were true, you don’t just flip a switch and have oil flowing. History should have taught us that much. It takes years in many cases to raise these products, build a transport and distribution network and get them into the economy. Again, we have no leverage.

And in reality, why do these countries need to trade with us anyway? Much of what they get in return is nothing more than IOU’s on fancy paper.

The chart below illustrates our trade gap in terms of actual goods – goods we either aren’t able to or currently do not produce ourselves.

US Trade Statistics (Goods only – in Billions of Dollars)

*2008 Final Data Available on 2/11/2009

In typical lukewarm fashion, the US Senate shot down McCain’s amendment in it’s version of what is likely to become a $3 trillion pork-barrel spending package in the coming weeks. For those who are counting, that is $3,000,000,000,000. However, what was most telling is that the balance of the Senate has no respect for American jobs or industry either. This was evidenced by the addition of a proviso that no existing trade agreements be violated by the bill.

This is what happens when you’re behind the eight ball. You have no leverage and little flexibility. In the case of trade, it is doubtful that we can even talk tough let alone back it up with substantial action.

‘Free Trade’ agreements and the Lowest Common Denominator

Another spin off of free trade agreements such as NAFTA is that in addition to driving our jobs overseas, they created a lowest common denominator situation where wages in developed nations came under downward pressure. The causal relationship is simple to illustrate. If a company can make something in Taiwan for example where GDP per capita is about 1/3 that of the US (Economist World in Figures 2007), then import the goods back into the US, the consumer will benefit from the cheaper good. Unfortunately, for every benefit, there is an equal and opposite detriment, and in this case, the jobs in the US which used to produce that good no longer exist. This is what has happened over the past 25 years or so. We chose instead to focus on a service economy where we basically shuffled papers and intangible goods amongst ourselves and called it an economy. All the while, we racked up massive external debts to buy the real goods we needed to survive.

I will allow that obviously this transformation has not been total. There are still some thriving industries in the US, but rather, I am referring to the net effect of the past 2 and one half decades. Much of the wage gap has been filled with various types of consumer credit whether it is credit cards or, more recently mortgage equity withdrawals. Obviously, as we have seen in dramatic fashion, these levels of debt accumulation proved to be as unsustainable as the dynamics that necessitated the accumulation in the first place.

The Solution?

While we have been showered with announcements that our trade deficit is improving, it must be noted that this is almost entirely due to the liquidation of 2008 (which crashed commodity prices) and the US-led global recession. Were growth to return to normal levels, we would immediately observe the trade deficit returning to its prior trajectory. By way of extension, the same situation exists in the case of the US Dollar. Fundamentally, nothing has changed. Media outlets and pundits alike are reading false signals created by the distortions of a debt-laden, fiat monetary system. It is something along the lines of going to an 80s movie where 3D glasses were necessary to make sense of anything. Only the guy at the door forgot to give them a pair.

For quite some time now this commentary has been a soapbox for the idea that we need to rekindle our productive economy. Never has that been truer than right now. We tried the globalization experiment, and in my opinion, it has been a dismal failure. Sure we got some cheap goods, but as a country, we’ve become dependent on others for our very sustenance. This is not an enviable position for anyone to be in, especially not for a country that wants to call itself an economic superpower.

That said the upcoming stimulus package could be used help return America to her pre-1980s position of industrial superiority. During the late 1800s and early 1900s, we ran large trade deficits and put them to work building an industrial base that was second to none. We have a chance to use the debt that will be incurred regardless for something productive. Simply handing people checks so they can go buy television sets (thereby sending the money to Asia) is not going to help anything. Rewarding zombie banks for past financial transgressions will not help anything. Taking the ‘stimulus’ and building industrial capacity, creating real jobs, and producing high quality products, however, would be a nice start.

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Disclosures: None