Some Common Fallacies About Inflation and Deflation: the Weimar Nightmare in Review

There are several fallacies making the rounds of the economic community, often put forward by pundits on the infomercials for corporate America, and also on the internet among well-meaning but badly informed bloggers.

The first of these monetary fallacies is that 'the output gap will prevent inflation.' The second is that a lack of net bank lending or other 'debt destruction' will require a deflationary outcome. Let's deal with the output gap theory first.

Output gap is the economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity.

The theory is that when GDP underperforms its potential, with unemployment remaining high, there can be no inflation because demand is weak and median wages will be presumably stagnant. This idea comes from neoliberal monetarist economics, and a misunderstanding of the inflationary experience of the 1970s.

The thought is that sustained inflation is due to a 'wage-price' spiral. Higher wages amongst workers cause prices to rise, prompting workers to demand higher wages, thereby fueling inflation. If workers do not have the ability to demand higher wages there can be no inflation.

While this is in part true, it tends to confuse cause and effect.

The cause of a monetary inflation, which is a broadly based inflation across most products and services relatively independent of demand, is often based in a monetary expansion of the currency resulting in a debasement and devaluation.

A monetary expansion is relatively difficult to achieve under an external standard since it must be overt and often deliberative. A gradual inflation is an almost natural outcome under a fiat currency regime because policy-makers can almost never resist the temptation of cheap growth and the personal enrichment that comes with it.

There can be short term non-monetary inflation-deflation cycles that tend to be more product specific in a market that is not under government price controls. But this is not the same as a broad monetary inflation or deflation.

The key difference is the value of the dollar which has little or nothing to do with a business cycle or product demand/supply induced inflation/deflation.

In the modern era the Federal Reserve can increase the money supply independent of demand by the monetization of debt, with the only restrictions on their ability to increase supply being the value of the dollar and the acceptability of US sovereign debt. This requires the acquiescence of the Treasury and the cooperation of at least one major money center bank.

People tend to invent 'rules' about how the money supply is able to increase, and confuse financial wagers and credit with money. This is in part because the average mind rebels at the reality behind modern currency and the ease at which it can be created. Further, people often invent facts to support theories that they embrace in an a priori manner.

In a pure fiat currency regime, the swings between inflation and deflation are almost always the result of policy decisions, with the occasional exogenous shock. A government decides to inflate or strengthen their money supply relative to productivity as a policy decision regarding spending, central bank credit expansions, banking requirements and regulations, among other things.

As a prime example of a rapid inflation despite a severe economic slump, what one might call uber-stagflation, is the Weimar experience.

Since pictures are worth 1000 words, let me be brief by showing you a few important charts.

The basic ingredients of the Weimar experience are...

A high level of official debt issuance relative to economic growth

High unemployment with a slumping real GDP



Wage Stagnation



I should stop here and note that although the statistics at hand involve union workers, in fact unemployment was widespread in the Weimar economy. The saving grace of being in the union was that one was more often able to retain their jobs and some level of nominal wage increases.

Anyone who has read the history of the times knows that unemployment, underemployment and slack demand was rampant, and that hoarding was commonplace as people refused to trade real goods for a rapidly devaluing currency.

Rapidly Rising Prices Despite Slack Demand and High Unemployment



So much for the wage price spiral and the output gap.

A Booming Stock Market, at Least in Nominal Terms



Booming Price of Precious Metals as a Safe Haven Even While Basic Material Prices Slumped

Notice the plunge in the price of copper as the economy collapsed and gold and silver soared.

If one can obtain a copy, as it is out of print, one of the best descriptions of the German inflation experience is When Money Dies: the Nightmare of the Weimar Collapse by Adam Fergusson. There is a copy of the book available online for free here.

From my own readings in this area, the people who tended to survive the Weimar stagflation the best were those who:
1. Owned independent supplies of essentials including food and shelter and were reasonably self-sufficient.
2. Had savings in foreign currencies that were backed by gold such as the US dollar and the Swiss Franc
3. Possessed precious metals
4. Belonged to a trade union and/or had essential skills or government position which guaranteed a wage
5. Were invested in foreign equity markets, and even in the domestic German stock market for a time

People will argue now that the Fed understands that inflation is caused by perceptions, and that by managing those perceptions inflation can be avoided because even those prices are rising and the currency is being devalued, if they ignore it the inflation cannot reach harmful levels.

This is what I call the "psychosis school" of behavioral economics.

Granted, perception is important, and managing perception may delay outcomes for a period of time. But unless the underlying cause of the problem is remedied during what is at best is an extended interlude, the resulting break in perception will ignite a firestorm of cognitive dissonance, loss of confidence, and social unrest.

In summary, in a purely fiat currency regime a sustained monetary inflation or deflation is an outcome of policy decisions regarding fiscal policy, monetary policy, and economic balance and output.

As long as the government is able to generate debt, deflation is a highly unlikely outcome. And when the government reaches the practical limits of debt creation, the underpinnings of the currency give way and the economy tends to collapse in a stagflationary slump.

There are no predetermined outcomes in a fiat monetary regime. Deflation, stagflation and hyperinflation are not 'normal' but are certainly possible if the central authority is permitted to abuse the real economy and the money supply for protracted periods of time.

What about Japan? Japan is the perfect example of a policy decision made by a fiat currency regime in what was decidedly NOT a free market, but under the de facto control of a highly entrenched bureaucracy, a single political party, and large corporate giants in pursuit of an industrial policy that favored exports and domestic deflation.

The difference between the Japan of the 1980s and the US of today could not be more stark. Choosing a deflationary policy and high interest rates as a debtor nation is economic and political suicide. It would be interesting to see what happens if the US elites try to take that path.

We will know if there is a true monetary deflation in the US because the value of the dollar will start increasing dramatically with regard to other hard assets, other currencies, goods and services, and precious metals and commodities. Prices will decline especially for imports as the dollar gains in purchasing power.

Remember that a true monetary inflation and deflation would only show up over time. Even in the Great Depression in the US, as demand slumped and prices fell, the stage was set for a significant devaluation of the US dollar and a rise in consumer prices well in advance of the eventual recovery of the economy that caused the Fed to tighten prematurely. As I recall the actual contraction in money supply lasted two years. This again highlights was an amazing piece of bad policy that Japan represents in its 'lost decade.'

People embrace beliefs for many motivations. So often I find they are not 'rational' and based on a scientific study of the facts, even on the most cursory level. Fear and greed and prejudice are often motivations that are surprisingly resilient, even in the face of overwhelming evidence against them. Leadership understands this well.

There are often appeals to private judgement. I do not care what you say, this is what I believe, what I think, what I feel. This is appropriate in the supra-natural realm, but in the natural realm there may be private judgement but the facts are public, and the outcomes are well beyond the complete control of the most fully-managed perceptual campaigns, at least so far in human experience.

"The lie can be maintained only for such time as the State can shield the people from the political, economic and or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State." Joseph Goebbels, of the perception modification school of economic thought

What is truth? It is difficult to estimate but not completely out of reach.

Our own view is that a serious stagflation with further devaluation of the US dollar as it is replaced as the world's reserve currency is very likely, after a period of slackening demand and high unemployment. A military conflict is also a probable outcome as countries often go to war when they fail at peace.

Weimar was not an anomaly although the level of inflation was indeed legendary. Argentina, post Soviet Russia, and most recently Zimbabwe are all similar examples. Serious Instances of Monetary Inflation Since World War II

There are many, many variables in play here, and policy decisions yet to be made. It is highly discouraging to see Obama's Administration fail so miserably to do the right things, but there is always room for hope, less so today than six months ago however.

Argue and shout grave oaths and wave our hands though we might, we are in God's hands now.

Let's see what happens.

A very special thanks to our friend Bart at Now and Futures who makes these charts, among other things, available on his highly informative web site for public review. If you are not familiar with his work you might do well to view it. We do not always agree, but he demands attention because of the rigor which he applies to his work for which we are grateful, always.

NAVs of Several Precious Metals Funds and ETFs

Goldman Sachs Set for Record Profits, Largest Bonuses Ever

As they say in the States, "in your face."

Or just some 'getting out of town money' ahead of a financial collapse?

The outsized financial sector, with its exorbitant fees, represents a serious tax and a growing threat to the real economy.

We may have, at best, the illusion of a recovery based on the increasing monetary inflation and monetization of debt as shown in the money supply figures, as compared to real GDP growth. Price, Demand and Money Supply

It will be a selective recovery at best, and damaging to the political fabric of the United States. It is a drain on the world economy while the US dollar is the reserve currency.

It is seigniorage on a grand scale, unprecedented tax on productivity not seen since the decline of colonialism, perhaps even feudalism.

Until the financial system is reformed there can be no sustainable recovery.

The Guardian
Goldman to make record bonus payout
Surviving banks accused of undermining stability

Phillip Inman
The Observer
Sunday 21 June 2009

Staff at Goldman Sachs staff can look forward to the biggest bonus payouts in the firm's 140-year history after a spectacular first half of the year, sparking concern that the big investment banks which survived the credit crunch will derail financial regulation reforms.

A lack of competition and a surge in revenues from trading foreign currency, bonds and fixed-income products has sent profits at Goldman Sachs soaring, according to insiders at the firm.

Staff in London were briefed last week on the banking and securities company's prospects and told they could look forward to bumper bonuses if, as predicted, it completed its most profitable year ever. Figures next month detailing the firm's second-quarter earnings are expected to show a further jump in profits. Warren Buffett, who bought $5bn of the company's shares in January, has already made a $1bn gain on his investment.

Goldman is expected to be the biggest winner in the race for revenues that, in 2006, reached £186bn across the entire industry. While this figure is expected to fall to £160bn in 2009, it will be split among a smaller number of firms.

Barclays Capital, Credit Suisse and Deutsche Bank are among the European firms expected to register bumper profits, along with US banks JP Morgan and Morgan Stanley following the near collapse and government rescue of major trading houses including Citigroup, Merrill Lynch, UBS and Royal Bank of Scotland.

In April, Goldman said it would set aside half of its £1.2bn first-quarter profit to reward staff, much of it in bonuses. It is believed to have paid 973 bankers $1m or more last year, while this year's payouts are on track to be the highest for most of the bank's 28,000 staff, including about 5,400 in London.

Critics of the bonus culture in the City said the dominance of a few risk-taking investment banks is undermining the efforts of regulators to stabilise the financial system.

Vince Cable, the Liberal Democrat treasury spokesman, said: "The investment banks more than any other institutions created the culture of excessive leverage, excessive risk and excessive bonuses that led to the downfall of the financial system. Now they are cashing in and the same bonus culture has returned. The result must be that we are being pushed to the edge of another crash."

Goldman Sachs said it reviewed its bonus scheme last year and switched from a system of guaranteed rewards that were paid over three years to variable payments that tied staff to the firm. It told employees last year that profit-related bonuses would be delayed by 12 months.

Until the release of its first quarter profits in April, it seemed inconceivable that a firm owing the US government $10bn would be looking to break all-time records in 2009.

David Williams, an investment banking analyst at Fox Pitt Kelton, said: "This year is shaping up to be the best year ever for investment banks, or at least those that have emerged relatively unscathed from the credit crisis.

"These banks are intermediaries in the bond markets where governments and companies are raising billions of pounds of new money. There is also a lack of competition that means they can charge huge sums for doing business."

Last week, the firm predicted that President Barack Obama's government could issue $3.25tn of debt before September, almost four times last year's sum. Goldman, a prime broker of US government bonds, is expected to make hundreds of millions of dollars in profits from selling and dealing in the bonds.

The Alternatives to Uncle Buck Being Considered

China Stakes
BRIC, SCO Discuss "Super-Sovereignty" Currency, USD Alternatives
By Scott Zhou
June 16,2009
Shanghai

China continued to consider a “super-sovereignty” currency among the countries of Shanghai Cooperation Organization (SCO), an intergovernmental mutual-security organization that met today in the Russian city of Yekaterinburg, in the Urals at the division of Asia and Europe. Members include China, Kazakhstan, Kyrgyzstan, Russia, Tajikistan, and Uzbekistan, with India as one of its four observers.

Right after the SCO meeting, the BRIC country (Brazil, Russia, India and China) leaders met formally for the first time. It is not merely coincident that three of them have expressed a desire to adjust their foreign exchange reserve portfolios by reducing the share or volume of US dollar assets.

China has just halted the increase its holding of US Treasury debt. By the end of April, China held $763.5 billion of it, a fall of $4.4 billion, month on month, the first time China has reduced its Treasury holdings. Since May, 2008, China has increased its holding by $260 billion.

Inside China, USD is a hate-more-than-love story. Analysts have long argued that China should be very cautious on buying US government bonds since dollar is bound to weaken. Others hold that US treasury debts are still the best and first choice for China's near $2 trillion foreign exchange reserve.

In March, Madam Hu Xiaolian, the chief of China's State Administration of Foreign Exchange and a deputy governor of the People's Bank of China, China's central bank, said that investing in US national debt is an essential part of China's reserve management. But while continuing to buy US national debt, China is concerned about the risk of the fluctuation in value of its assets.

China has announced that it would buy up to $50 billion in bonds issued by the International Monetary Fund (IMF). Meanwhile, Russia and Brazil have said they are planning to buy up to $10 billion in IMF bonds, which would mean selling Treasury bonds. India has expressed the same interest. In April, China, Russia, and Brazil all reduced their holdings of US treasury debt.

China now believes that a long-term dollar decline is inevitable, and the risk to the value of its $2 trillion foreign exchange reserve has become realistic, if not imminent.

China has been a huge beneficiary of the order of the world economy and a monetary system with the US dollar as the reserve currency. China's economy has been anchored by a stable dollar exchange pegged by China's currency, RMB.

But the financial crisis has given China a wake up call that the present monetary system is not sustainable, and neither is China's foreign exchange regime and mode of economic growth, which has been largely based on relentless exporting.

What, then, is the role RMB can play in the future? Russia has been urging China for years to settle their bi-lateral trade in their respective currencies. Brazil intends to trade with China by RMB and the real. Recently Russia suggested making RMB convertible to become an international reserve currency.

China can not challenge US directly. The BRIC summit is a convenient platform for China and the other BRIC powers, set to become the 4 of the 6 largest economic entities by 2050, to put a bit of pressure on the US. Held before the first China-US Strategic and Economic Dialogue in late July in Washington DC, the BRIC summit may give China some leverage in dealing with the US.

Russia is ready to use its exchange reserve to buy securities issued by BRIC countries. In return, Russia hopes the others will be willing to buy financial instruments issued by Russia. The leaders discussed increasing of the share of settlement currencies for trade among them. They also discussed adjusting their reserve assets portfolio in a coordinated way.

At the SCO meeting held just before the BRIC summit and attended by China, Russia and India, China proposed to research the feasibility of using a super-sovereignty currency among SCO member countries.

Kazakhstan president Nursultan Nazarbayev proposed that trade among SCO countries be settled by currencies of member countries. He also suggested that a super-sovereignty currency used inside the SCO eventually become a SCO reserve currency. Russian President Dmitry Medvedev also supported the idea.

SP Futures Hourly Chart

This is a quad witch option expiry week. The futures front month is rolling over but we have not yet made the change to September futures.

Volumes remain remarkably light even for June.

Support is obvious.

Keep a close eye on the VIX volatility.

And the Winner Is.... the SDR?

This is a significant development.

It appears clear now that the preferred alternative to the US dollar reserve currency regime for international transactions is going to be the Special Drawing Rights (SDR) units from the International Monetary Fund. We have seen indications that this was going to be the alternative, as compared to the euro, but it was not so confident a probability as it seems today.

Now it seems to be. And those SDR units will be an adjusted basket of commodities and currencies that will be more reflective of the current global economic picture. This may be phased in over time if the US and its political supporters have their way.

This is important because it is feasible, a realistic alternative, much more practical than the complete replacement of the US dollar by something else like the euro for example. We may also see more bilateral agreements based on local currencies.

Achieving the concurrence of the Saudis and other US client states will be important, because the dollar reserve strength has been largely based on its political connection to oil and military power. Most commentators and analysts miss this, but it is essentially at the heart of the matter. History may look back on this as a period of neo-colonialism since it has been so pervasive and uneven in its geopolitical relationships, especially since the 1970's: a Pax Americana.

This is not to say that the IMF's SDRs will be THE solution. They may very well falter. But if one is looking for a politically and financially palatable alternative to break the Big Dollar cartel, this looks likely to us. If it falters, it will be replaced with something else, most likely after some 'tinkering' with the basket composition first.

Let's keep an eye on this. But it is our judgement that the US dollar will continue to decline in signficance, in a relatively orderly fashion for the forseeable future, looking out perhaps over the next ten years, barring a major exogenous event, most likely of a geopolitical or military nature.


Russia calls for revision of SDR currency basket
By Gleb Bryanski
Tue Jun 16, 2009 3:58pm IST

YEKATERINBURG, Russia (Reuters) - The International Monetary Fund (IMF) should expand the basket of Special Drawing Rights to include the Chinese yuan, commodity currencies and gold, a senior Kremlin official said on Tuesday.

The SDR is an international reserve asset allocated to member countries with its exchange rate determined by a basket of currencies, at the moment including dollar, euro, yen and sterling. A review of the basket is due in November 2010.

"The rouble, yuan deserve to be included in the SDR basket," Kremlin economy aide Arkady Dvorkovich told a news conference ahead of the first summit of Brazil, Russia, India and China, known as BRIC, in the Russian city of Yekaterinburg.

"It is important that the composition of the basket also reflects the role of commodities in the global economy," Dvorkovich said, naming Australian and Canadian dollars as possible candidates.

"We also think that gold has a potential as a possible participant. The price of gold has a negative correlation to the dollar. Therefore it is beneficial to tie these two instruments into one so that investors feel safer," he said.

Dvorkovich said he doubted Russia would complete its transition to an inflation-targeting regime which implies a freely floating exchange rate for the rouble next year when the IMF basket's review takes place, as announced by the central bank.

Dvorkovich said BRIC leaders will discuss new reserve currencies at the summit but called for caution in the currency debate, saying it was in no-one's interest to ruin the dollar.

Russia rattled financial markets last week when a central bank official said Moscow will cut the share of U.S. Treasuries in its forex reserves in favour of IMF bonds and bank deposits.

Finance Minister Alexei Kudrin played down this statement over the weekend saying the dollar's status as the world's main reserve currency would unlikely change in the near term. Dvorkovich said new reserve currencies were inevitable.

"The world economy will grow... In the future we are sure growth will resume. This growing pie should be divided in a fairer way. We are not talking about excluding the dollar but the share of other currencies should increase," he said.

He said BRIC leaders will discuss investing their reserves, which are among the seven largest in the world, in each other's currencies, settling bilateral trade in domestic currencies and striking currency swap agreements.

"It would make sense for us if our partners agreed to place some of their reserves in Russian roubles," Dvorkovich said.

He said BRIC countries had a common position regarding the reform of the International Monetary Fund while a decision by China, Brazil and Russia to purchase SDR-denominated bonds issued by the IMF would boost the role of SDRs.

"Any expansion of the IMF's resource base implies ... strengthening of SDRs' role in the international currency system," Dvorkovich said.

Ennui

Although the Cafe is open, the proprietor is temporarily overcome by a state of ennui regarding the financial markets.

From the volume today it appears to be a more widespread condition than those managing this distribution rally would have preferred.

No positions taken into the close except of course those very long term ones so firm as to be not worth discussing.

"Notre ennui, nos mœurs fades sont le résultat du système politique." Balzac La Femme de Trente Ans 1832

(Our boredom, our insipid customs, are the result of the political system.)

Wall Street's Toxic Message Carried in the Winds of Change

Joe Stiglitz writes an important essay, and it is suggested that you take the time to read it. It helps to explain many of the things we have been saying, including the forecast that 'a new school of economics will rise from the ashes of this crisis, as Keynesianism rose from the Great Depression.'

These are changes of an historic nature, and as such they will progress slowly, and be largely unnoticed by those going about their daily business.

But the tides of change have been loosed, and what we have known, and relied upon, and expected will be shaken to its foundations.


Wall Street's Toxic Message by Joseph Stiglitz - Vanity Fair (pdf)

US Dollar Long Term Chart

Price, Demand, and Money Supply as They Relate to Inflation and Deflation

There are three basic inputs to the market price of something:

1. Level of Aggregate Supply
2. Level of Aggregate Demand
3. Relative Value (purchasing power) of the Medium of Exchange

Let's consider supply and demand first, since they are the most intuitively obvious.

The market presents an overall demand, and within that demand for individual products in particular.



Supply is the second key component to price. We are not going to go into more detail on it since what we are facing now is a decrease in Aggregate Demand.


It can seem a little confusing perhaps. Just keep in mind that if the aggregate demand decreases for goods and services for whatever reasons, such as severe unemployment, and supply remains available then prices will drop overall, with some variance across products because of their differing elasticity to price changes.

This is known as the Law of Supply and Demand.

How we do know when aggregate Demand is decreasing?

Gross Domestic Product = Consumption + Investment + Government spending + (exports − imports),
or the famous economic equation GDP = C + I + G + (X − M).

Consumption, or Aggregate Demand, is a measurable and key component of our GDP figures.

Given the huge slump in GDP, it should be obvious that we are in a demand driven price deflation on many goods and services. People are saving more and consuming less.

Now, that covers supply and demand as components of price, but what about money?

Money

Notice in the above examples we talk about Price as a value without a label.

Money is a medium of exchange. It is the label which we apply to give a meaning to our economic transactions.

If you are in England, or France, or Argentina, or China, the value label you apply to Price is going to be different according to local laws and customs.

Money is the predominant medium of exchange that a group of people have agreed to use when engaging in economic transactions that are not based on pure trading of goods, known as barter.

The source and store of wealth are the 'credits' within the system which one uses to exchange for products. The money is the medium of exchange.

If you work for a living, you are exchanging your time and your talent, which is your source of wealth, for products. The way in which this is labeled and facilitated in the United States is through the US dollar. I n Russia and China is it something else completely.

The Value of Money

How do we know what some unit of money is worth? Try not to think about your domestic currency. Since we use it so often every day, we tend to think of it with a set of assumptions and biases. Most Americans have little practical exposure to foreign exchange, and tend to think of themselves as living in a dollar-centric world.

Let's use the Chinese yuan. What is the yuan worth? What if I offered you a roll of yuan in exchange for a day's work? How would you know if it was a 'fair trade?"

Since there is no fixed standard for money in our world, you would most likely inquire in the markets what you could obtain for those yuan I offered to you in an accessible market.

But what sets the rate at which yuan are exchanged for a given product?

In a free market system, it is a very dynamic system of barter. When you offer something for money, I know how much of my source or store of wealth I must exchange for the yuan to provide for the product offered.

Money is just a placeholder. We hold it because we expect to be able to trade it for something else which we really desire. You don't eat or wear money; you exchange it for things which you wish to eat or wear.

If the value of money changes, the price of all the things to which you have been applying that label changes. This is why it is important to distinguish between price changes because of changes in demand, and changes because of money supply. They are different, and require very different responses.

Money supply

In a very real sense, there is a relationship between how many goods and services are available, and how much money exists.

Let's say we are in China. I give you 100 yuan. Tomorrow the Chinese government triples the amount of yuan in the economy by giving each of its citizens ten thousand yuan for essentially doing nothing, for not producing anything more or less.

Do you think the 100 yuan will be worth as much as they were the day before? No, obviously not.

In real economies these changes tend to happen with a time lag, or gradually, between the action and the reaction. This is necessary because people can only adjust their daily habits, their economic transactions, gradually. Otherwise it becomes too stressful, since our daily routines and decisions are based so heavily on habits and assumptions of value and consequences.

But in general, if the supply of money is increasing faster than real per capita GDP over a longer term average the money supply is inflating, that is, losing real purchasing power.

Seems simple? Well its a bit more complicated than that unfortunately since these things relate to free markets, and if there is any other thing you need to remember, we do not have free markets, only free to varying degrees.

The logical question at this point is to ask, "What is the money supply?" That is, what is money and what is not?

We dealt with this at some length, and suggest you look at this Money Supply: A Primer in order to gain more knowledge of what is money and money supply.

We would like to note here though, that there is a difference between money supply and credit, between real money and potential money.

If I have 100 Yuan in my pocket, there is a real difference between that money, and my ability to work at some job tomorrow and be paid 100 yuan, or have you repay 100 yuan to me which I gave to you yesterday, or my hopes that I can borrow 100 yuan from some third party.

If you do not understand this, you will not understand money. It is one of the great charades of our time that risk has been so badly distorted out of our calculations. We cannot help but think that some future generation will look at us as though we had all gone barking mad.

The subject becomes even more complicated these days because we are in what is called a fiat regime. Fiat means 'let it be done' as we will it, and we are if anything in a very relativistic age in which we think we can will just about anything.

The major nations of the world get together and attempt to manage the value of their currencies relative to one another, primarily through their finance ministries and central banks.

Countries will interfere in the markets, much more than they will admit, to attempt to maintain certain relationships among currencies of importance to them. Sometimes they are overt about it, as when nations 'peg' one currency to another, and at other times they are more subtle and merely influence other currencies through mass purchases of debt and other forms of persuasion and the molding of perception.

I hope this helps. I don't intend to answer loads of questions on this, particularly from those who immediately start inventing complex examples to try and disprove this. Most of the time the examples betray a bias that person has that defies patience and a stubborn belief that everything is relative. In the longer term it is most assuredly not.

Each will learn at their own pace what is real and what is not. But they will not be able to say that they have not been warned that sometimes appearance is different than reality.

Here are some examples of money supply growth in the US. If you read our Primer you will know that MZM is by far the most important now that M3 is no longer reliably available.



Is money supply growing faster than real per capita GDP? Yes, decidedly so. And unless this trend changes significantly we will face a whopping monetary inflation.





Here is a chart that shows the buying of US debt that other countries have been doing through the NY Fed Custodial Accounts for a variety of motivations. Without this absorption of US money supply the value of the dollar would be greatly diminished relative to several other currencies. This is probably not a sustainable relationship but it has had a good long run because it is supported by the US as the world's superpower.

Other countries are essentially exchanging their productivity, their per capita GDP, for our excess money supply. This is why a US monetary inflation has remained manageable. Other countries are providing an artificial Demand for US debt at non-market prices.



One of the great errors of our generation has been the gradual and erroneous mispricing of risk through a variety of bad assumptions and convenient fallacies. Without the appropriate allowance for risk, there is no ability to discover valid pricing and allocation of capital.

The consequences of this abuse of reason are going to be enormous.

I do not see this improving quickly because the manipulation of risk for the benefit of the few, and the transfer of that risk to the public and the rest of the world, has tremendous value to the powerful status quo.

But the day of reckoning and settlement of accounts is coming, and as it approaches it will accelerate and come with a vengeance. For after all,

"Life is a school of probability." Walter Bagehot

School is almost out.

SP Futures Hourly Chart at 2:30 PM

The volumes remain thin, and the market appears to be in the control of the big trading desks, flush with TARP money, and the demimonde of hedge funds and daytraders.

Be in this market for the short term only, or not at all. The manipulation of certain funds, options and indices makes this a 'professionals only' market.

Let's see if any serious support breaks, ahead of the second quarter earnings. The mainstream media is preoccupied with bread and circuses, and the financial news media is an extended informercial, if not propaganda machine.

There is no economic recovery, only a paper chase. The Obama Administration is failing to take the next steps of creating an industrial policy that places the US labor force and economy on an equal footing with the rest of the world, and reforming the financial system which is unbalanced to the point of deformity and inefficient to say the least.

Is the USO Oil Fund "Like a Pyramid Scheme?"

Some very hard words being said about the USO Oil Fund ETF, sparked by comments from the Schork Report.

Certainly the USO oil fund has not been tracking the performance of the commodity it attempts to represent, and has severely lagged the recent rally in West Texas Intermediate Crude.

This is in contrast to ETFs which target a percentage of the continuous commodity contract such as GLD or SLV. However, one should never mistake the commodity for what is essentially a derivative position, with little or no underlying guarantee of taking delivery of the commodity, as opposed to the futures markets.

This is different from the issue with levered ETFs which we reported on back in December, which reset their basis every day. But we think they also are contributing to volatility particularly in the last hour of trade.

Here is the information on USO. We do not believe in holding the ETFs for long periods of time, which in our lexicon is more than a couple of weeks. We understand that the CFTC is setting revised rules for "commodity pool operators."

"So how is this like a pyramid scheme? A pyramid scheme is funded by a constant flow of dollars into the venture by new investors. The second investor knowingly and willingly pays the first investor on the assumption he will get paid by the third investor… and so on. It’s similar to a Ponzi/Madoff scheme, with the key difference, investors don’t know (or don’t want to know as long as those alleged returns keep rolling in) they are being scammed.

The USO is being funded by a proliferation of new retail investors looking to diversify into “alternative investments” (which as far as we have been able to ascertain, alternative investment is a euphemism for Las Vegas style bets on commodities by retail investors tired of watching their 401Ks drop). More importantly, these investors are obviously out of their league, i.e. taking buy-and-hold positions in a contango which raises their cost basis every month they roll into the higher priced deferred contract.

We assume they are buying the USO because they are bullish. But in a peculiar way, their actions could be helping to prevent the market from rallying. These new investors are not funding a pyramid per se, but they are helping to fund storage. That is to say, with global demand in the doldrums, the contango will persist. And, as long as it lasts, traders will continue to front-run the rolls, which in turn will exacerbate the contango, which will then incentivize storage builds further, which will then ultimately weigh..."

USO: A Self-Propelled Pyramid? - Financial Times

USO Oil Fund or Just a Pyramid Scheme? Stockmaster.com

USO Oil Fund: All of the Drop and Some of the Gain - Phil's Stock World

Special thanks to Ilene over at Phil's Stock World for the comparison chart. We also enjoyed this quote from their article.

"In fact, it’s very possible that if you did an proper investigation (perhaps a Congressional one) you would find that MOST of the oil traded on the NYMEX has nothing to do with real demand at all but is pure speculation that is sold to retail investors as "commodity investing" or "inflation hedging" but what kind of inflation hedging loses 33% a year PLUS TRANSACTION FEES before a profit can be made? Oh and a funny note - who handles USOs cash and places trades on the ICE and NYMEX for them? Aw, you guessed it - Goldman Sachs!

So here you are giving your money to an ETF that gives its money to the biggest shark in the ocean, who chews off your legs in transaction fees and contango spreads BEFORE they even bother to circle around for the kill by gaming the market. NOT ONLY THAT, but the idiotic rules of the fund lead them to PUBLISH THE DAYS THEY ARE ROLLING IN ADVANCE so every little shark in the sea knows exactly when and where to feast on your bloody, bobbing carcas this month - and the next and the next and the next. Don’t worry though, once you are chewed up and digested, there will be a fresh round of suckers herded back into commodities and the commodity pushing stocks and ETFs every time GS, MS or Cramer need another payday. "

Should a bank guaranteed by public funds and the FDIC be active operators in speculative markets? Or should they be confined to the more conservative realms of commercial banks as they were under the Glass - Steagall regime?

We think the answer is obvious, especially given the fact that a great deal of the problems we face today are a direct result of the repeal of Glass-Steagall and the mixing of public funds with private greed in a coopted political and regulatory regime.

SP Weekly Chart

Natural Gas and Crude Oil: An Interesting Spread to Watch

The spread between Natural Gas and Crude Oil is now at an 18 year record low.

Nat gas has fallen from $13 to $3 while Crude Oil soared to $70.

Either crude is incredibly frothy, or natural gas represents an outstanding bargain.

A few years or so ago I published a fairly comprehensive study of the seasonality of natural gas, and some relative relationships with demand and supply. I will look for it, and see if I can update it. Since I no longer trade the futures I have not looked at this in some time. But I do remember the spreads and saw this one grown shockingly wide.

My first thought is that oil has been driven higher by monetary inflation and speculation, which are in some ways the same thing. Hot money craves beta and drives the prices of real assets to extremes.

Keep in mind that if enough people get in on this trade, the market makers who can see your aggregate holdings will use it to skin the speculators, without regard to fundamentals in the short term.

It's never easy.

SP Hourly Futures Chart at 2:30 PM

The SP futures are climbing the trellis of a reflationary ramp on thin volumes.

Although we would not suggest stepping in front of it, and certainly not seriously shorting it until the trend is broken, nevertheless the move has all the feel of artificiality and will meet its test when earnings start coming out for Q2.

From what we have seen on the fundamentals of earnings, stocks seems very fully valued here, and would not be looking for a great deal of upside, particularly when the banks finish their price manipulation to support their equity offerings to pay back their TARP funds.

"There is something wonderful in seeing a wrong-headed majority assailed by truth." John Kenneth Galbraith

Non-Farm Payrolls Trend Mismatch

Here is our usual chart comparing the seasonally adjusted and actual payroll numbers from the Bureau of Labor Statistics.

Two things are worth noting.

The first is that the recent uptrend in the seasonally adjusted 'headline' number is conspicuously at odds with the actual numbers, which are still in the same downtrend.

The second is the usual observation we make, and that is to remind people that the adjustments that are made to the actual numbers for seasonality are enormous, and subject to significant revisions after the fact.



About 220,000 of those jobs in the actual number are due to the birth death model 'plug' which is a real howler when you look at the specifics that the BLS attributes growth in the new / small business segement of the economy.



We will get a little more optimistic when the longer term trend turns higher. Granted, it will miss the bottom by a few months, but it is an important signal to confirm any uptrend in the economy that seems to be highly reliable.



The level of unemployment is still a major impediment to the economy despite hopes for a bottom to the economic contraction. Economists will say that this is a lagging indicator, and we will say yes, but we would say that it is the standard by which a bottom will be judged.

Our take on these numbers is that they are at best a short term uptick in response to historically unprecedented monetary stimulus and at worst a false recovery fueled by dangerous levels of monetization and some disappointing short term statistical razzle dazzle.

Can the Non-Farm Payrolls Report Show the Market Some Green Shoots on Friday'?

Ben and Timmy will be providing the Ho - Ho - Ho...

The Stock Market in Context with the Great Crash of 1929 - 1932

The US Stock Market Crash of 2007 - 2010 expressed in percent decline from the market top in October 2007.



A trading day by trading day comparison of the Great Crash of 1929 - 1932 with the current market decline from its October 2007 top.



The classic profile of a collapsing bubble.



The economic policy of the early post-Crash period was heavily influenced by what was later called Liquidationism epitomized by prevailing views of the Hoover Administration. The idea was that allowing companies and banks to fail as quickly as possible, in a relatively uncontrolled manner, was the appropriate response. This view is still held by the Austrian School of economics.

The flaw in this theory would seem to be that the decline of a crash is not like a natural decline in a business cycle or a severe demand contraction, but the result of a precipitous collapse from a Ponzi-like monetary and credit expansion.

One can argue this point, endlessly if they wish to ignore history and economic reality, but again we need to remember that the outcome in several other nations embracing this theory was the rise of militant, fascist political regimes in response to societal dislocations.

Obviously the best cure is prevention, in not allowing monetary bubbles in the first place. Duh. But one has to play with the cards in one's hand, and not the hand they wish to have.

But there is a lesson in this for our current 'cure' in that blowing yet another asset bubble from a monetary expansion, and little else, will not work. We ought to have learned this from the Fed's policy responses in 2003-2006 which led to the US housing bubble.

Systemic reform and rebalancing is absolutely essential to a sustained economy recovery, and needs to be measured by an increasing median wage and a reversion to manageable income - debt ratios.

The headwinds against this remedy from an outsized financial sector that in many cases has coopted the political process makes a sustained economic recovery less probable without a significant shock to the political and economic structures of the US at least.



Bernanke's wager

Being a student of economic history, Ben Bernanke believes that he can inflate the currency subtly without a formal devaluation, and avoid a second leg down to a deeper bottom.

The Fed is now confident, with the Volcker era inflation experience under their belts, that they do not need to replicate the NY Fed policy error of the 1931 by increasing nominal interest rates prematurely out of inflationary concerns.

Things ARE somewhat different today, in that there is no gold standard, and the world has relatively free flows of fiat capital under a US dollar reserve currency schema.

It should be noted, with no mistake, that the limiting factor on the Fed is the valuation of the US dollar and its sovereign. In 1931 the limiting factor was the gold standard which severely limited the Fed's options, and eventually caused a significant formal devaluation of the US dollar in a step-wise function.

In a fiat regime the devaluation can be done gradually without fanfare.



It is also easy to forget that in 1931 the business community and the leading economists were convinced that the worst was over and that a recovery was underway. Their concerns shifted to inflation, and dealing with the then unprecedented expansion of narrow money in the adjusted monetary base to ease short term credit problems.



The 'risk' is obviously that the analog with the Fed's experiment with subduing inflation in the 1970's under Volcker are not completely consistent to the environmental context today.

The levels of US debt to be absorbed by the rest of the World are without known precedent. And the degrees of freedom in the Fed's calculation are significantly impacted by the policy actions of countries that may be sympathetic but not completely consistent with their own national self-interest or inclinations.

From our own viewpoint, without signficant structural reforms to the US economy and political process, which at this time seem unlikely to overcome the resistance of the status quo, the Fed's actions will most likely result in another type of bubble, less obvious than the last two perhaps, and a stagflationary economic recovery of a sort combing some of the nastier aspects of the Japanese experience, but with a nasty dose of the post-Soviet / Argentinian slumps.

A deflationary envionrment with a stronger US dollar appears to be a fantasy in our opinion, although we have always held it to be possible. Of course it is possible. If the Fed raised short term rates to 22 percent tomorrow, we would see a serious deflation and a stronger dollar.

We would also see riots and civil insurrection in response. This is another limiting factor on the policy decisions of the Fed and the Administration, which people tend to underappreciate, again ignoring many of the social and political events of the 1930's.

The US dollar will continue to decline until there is a precipitating currency crisis that clears the market for US debt. Things will not be able to continue on this way forever. We estimate that the next bubble, if the Fed is able to get the rest of the world behind it, will be decisive.

However, we continue to degrade the probability of this happening as the weeks go by, and the rest of the world appears to be asserting its financial sovereignty from the Anglo-American banking cartel.

ADP: Department of Records Revision

"April’s reading was revised to show a reduction of 545,000 workers, up from a previous estimate of 491,000."

Is an 11% month over month change in an employment number a revision or a rewrite?

The ADP report is supposed to be based on actual reports from private industry.

This pervasive pattern of 'good numbers' that result in stock market rallies and the massaging of public opinion, only to be replaced by downward revisions thirty days later, with little notice or quote, is cynical manipulation of the media at best, and a dangerous slide into social engineering by an increasing distortion of 'reality' at worst.

If you have not read the novel or seen the movie lately, 1984 is worth a look.


Bloomberg
ADP Estimates U.S. Companies Cut Payrolls by 532,000
By Courtney Schlisserman

June 3 (Bloomberg) -- Companies in the U.S. cut an estimated 532,000 workers from payrolls in May as the labor market showed little sign of improving even as the recession abated, a private report showed today.

The drop in the ADP Employer Services gauge was bigger than economists forecast. April’s reading was revised to show a reduction of 545,000 workers, up from a previous estimate of 491,000.

Companies from General Motors Corp. and Chrysler LLC to American Express Co. continue to cut jobs to control costs even as the economy shows signs of stabilizing. Mounting unemployment will restrain consumer spending, muting any recovery.

“Still losing over half a million jobs a month is hard to get excited about,” Derek Holt, an economist at Scotia Capital Inc. in Toronto, said in a note to clients. “Steep job losses still signal a deeply troubled economy.”

...Economists forecast the ADP report would show a decline of 525,000 jobs, according to the median of 28 estimates in a Bloomberg News survey. Projections ranged from decreases of 425,000 to 580,000.

Economists’ Forecasts

A government report on June 5 may show payrolls at companies and government agencies shrank by 520,000 in May and unemployment rose to a 25-year high of 9.2 percent, according to a Bloomberg survey of economists.

Job-cut announcements last month showed the smallest increase in more than a year, Chicago-based placement firm Challenger, Gray & Christmas Inc. also said today. Planned firings rose to 111,182, up 7.4 percent from May 2008. The rise was the smallest since firings last dropped in February 2008.

Today’s ADP report showed a reduction of 267,000 workers in goods-producing industries including manufacturers and construction companies. Employment in manufacturing dropped by 149,000. Service providers cut 265,000 workers.

Companies employing more than 499 workers shrank their workforces by 100,000 jobs. Medium-sized businesses, with 50 to 499 employees, cut 223,000 jobs and small companies decreased payrolls by 209,000.

German Chancellor Strenuously Objects to Central Bank Monetization

This is important in its own right, but even moreso because it suggests that some rumours that have been going around the trading desks over the past two weeks might be true.

We will keep you informed as things progress.


Financial Times
Merkel mauls central banks
By Bertrand Benoit in Berlin and Ralph Atkins in Frankfurt
June 2 2009 17:25

Unconventional monetary policies being pursued by the world’s main central banks could aggravate rather than ease the economic crisis, Angela Merkel, Germany’s chancellor, suggested on Tuesday.

Her surprisingly strong attack on the US Federal Reserve, the Bank of England and the European Central Bank was remarkable coming from a leader who had so far scrupulously adhered to her country’s tradition of never commenting on monetary policy.

“What other central banks have been doing must be reversed. I am very sceptical about the extent of the Fed’s actions and the way the Bank of England has carved its own little line in Europe,” she told a conference in Berlin.

“Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds.”

She added: “We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years’ time.”

Ms Merkel’s decision to ignore one of the cardinal rules of German politics – an unwritten ban on commenting on monetary policy out of respect for central bank independence – suggested Berlin is far more concerned about the ECB’s approach than has so far been apparent.

Meanwhile, Berlin is anxious that central banks will struggle to re-absorb the vast amount of liquidity they are pouring into the markets and fears the long-term inflationary potential of hyper-loose monetary policies.

The ECB’s efforts have been focused on pumping unlimited liquidity into the eurozone banking system for increasingly long periods. But last month, it followed the US Federal Reserve and Bank of England in announcing an an asset purchase programme to help a return to more normal market conditions.

The ECB announced it had agreed in principle to buy €60bn in “covered bonds”, which are issued by banks and backed by public-sector loans or mortgages. The purchases were only agreed after extensive discussions within the 22-strong ECB governing council. According to one version of May’s meeting, the council had discussed a €125bn asset purchase programme that would also have included other private sector assets, but only the purchase of covered bonds was agreed....