M3 Hysteria and a Look M2, MZM, GDP and PPI

Ambrose Evans-Pritchard has a bold headline US Money Supply Plunges at 1930s Pace that is sure to provide much referential action for the UK Telegraph.

I like to read AEP, but have to admit that he is given to sensational headlines on rare occasion. That is because it sells papers, and also draws blog clicks, as posters on the web are sometimes wont to emulate. Fear sells. The financial sectors also thrives on rumours and panic selling. It clears the decks for new Ponzi rallies. And it seems as though fear has become an inseparable partner and helpmate to central governments these days.

But there were some mildly disappointing elements to this particular piece in addition to its somewhat overstated headline. The US stopped publishing M3 several years ago. At the time I was not happy about this, and complained quite a bit.

Several enterprising fellows, including my friend Bart over at Now and Futures, as well as John Williams at Shadowstats, have been attempting to extrapolate the M3 figures, and doing a fine job given what they have to work with. In an added footnote, AEP says he is using John Williams' service. He also incorrectly states that the still Fed publishes all the components. They do not disclose eurodollars. The basis for discontinuing M3 was to eliminate the 'inordinate expense.' Obviously if they still published all the components, that could not be a credible case. This is not just being picky. Eurodollars are a remarkably volatile component these days, and also a method of buying Treasuries via London if one were so inclined to monetize US sovereign debt that way. Could the BoE and the Fed be scratching each other's backs as they say? The BoJ has already paid for one false US recovery, so they deserve a break.

Here is a quick review of the components of the Monetary Supply figures including M3 for your review. You may also wish to refresh your knowledge here: Money Supply a Primer.

The chief component that is 'missing' these days which must be estimated is "eurodollars," which as you may recall are US dollars being held overseas. You know, those dollars that Bernanke has been sending over to Europe en masse lately through the swaplines.

The fellows can estimate this, but the reporting of eurodollars lags by a quarter or more, the only reliable source of information being the forex commercial banking reports from BIS.

I would very much like to have M3 back, but in particular I would like the Fed to be releasing a more accurate and contemporary measure of Eurodollars, the dollar overhang overseas, particularly in light of the huge swings in the DX index, and its almost undeniable relationship to the recent dollar short squeezes on the European banks. The Dollar Rally and the Deflationary Imbalances in the US Dollar Holdings of Overseas Banks.

But alas, we do not have this, so we can only estimate M3, particularly the eurodollar component. But the good news is that we still have both M2 and MZM.

Here are the most recent figures for MZM and M2 from the St. Louis Fed, expressed as a percent of change YoY, not adjusted for seasonality. For good measure I have added GDP and PPI Finished Consumer Goods in the mix.



It might also be wise also to keep in mind that after a period of sharp growth in response to a developing recession that flattens out afterward, the year over year percentage growth can fall precipitously and look quite impressive on a growth chart without necessarily providing a meaningful decline in the nominal values. This can be seen in the M2 chart below.

And it is also true that during a period of slack growth in GDP the demand for money is lessened such that normal or even flat money supply growth would seem to the Fed monetarists to be 'inflationary.' This does not mean that they have forgotten where the 'ON' button to printing press is located. Of all the things that might concern us about the Bernanke Fed, the least of them is that they will be too stringent in supplying liquidity when and where it might be needed, in substantial volumes, at least to the banking system.



MZM is the broadest measure of liquidity, and is very much a creature of the Adjusted Monetary Base. As one can see from the chart, the Fed, using their various policy tools, jams the short term money supply higher in response to a lagging economy, and the broader measures like M2 tend to follow with a lag.

The Fed then backs off, and waits to see the effect of their actions, as well as any accompanying fiscal programs, on the real economy as measured by GDP, with an eye on inflation. In this case I am using PPI, but I greatly prefer John Williams' unadulterated CPI measure. Unfortunately I do not have it in the proper format for this study. But PPI finished goods will do.

Now, looking at this chart, it appears that the Fed is following their usual gameplan. The excess reserves that the banks are holding, at least indirectly in response to the balance sheet expansion and interest rate payments on their own deposits by the Fed, are enormous and unprecedented. If the Fed were to start pulling some levers to motivate those reserves into the real economy through loans, the impact could be dramatic. The Fed will do this if their fear of inflation begins to be overcome by their fear of deflation.

For the moment, the great bulk of liquidity is being used by the banks to bolster their reserves, and their unresolved bad debt, as if the bad debt itself was the cause of the problem. The problem is that a credit bubble left consumers with the inability to pay their debts, and while nothing is done for the median wage, and the bad debt is not written off, the problem continues. This was the story of the zombie economy of Japan's lost decade, because their kereitsu corporate combines would not take the 'hit' for their land bubble.

Right now it appears to me that they are overly preoccupied with the status of the biggest of the banks and their asset quality problems an under stimulating the real economy. I think this will be regarded as a policy error as were the actions of the Federal Reserve in 1932 wherein the Fed overreacted to a spike in CPI and tightened prematurely. The Fed may be engaged now in a policy error of a different sort.



I am not saying what MUST or WILL happen. I am not arguing from theory. I am just attempting to demonstrate what is happening now based on the data. And right now Ben is indeed printing money, and figuratively dropping it from helicopters. The problem is that the helicopters are hovering over Wall and Broad Streets, and not Main Street. And so we obtain asset bubbles in paper favored by the denizens of the Street.

If you want to know the theory, in a perfectly fiat system (no external standard constraint) deflation and inflation are always the outcome of policy decisions amongst a number of variables and competing interests. Period. That is how it is, and that is why central banks prefer it to the discipline of an external standard like gold.

Once the US relaxed its adherence to the gold standard and devalued the dollar, deflation became a moot point. What was not handled well was the continuing lack of organic aggregate demand, and velocity of money, because of the resistance of the Republican minority in Congress to jobs creation, and the overturning the New Deal minimum wage initiatives and labor reforms by the US Supreme Court. Consumers cannot generate healthy demand when they are unemployed, or being paid near starvation wages. But if you are in a well-to-do minority, things couldn't seem better, unless of course you were living in Germany, Italy, or perhaps even Japan.





I am not saying what the 'right thing' to do is. But what I am attempting to get across is that one way or the other, excess financial sector debt is going to be liquidated, either through default, or through inflation, or through a mixture of higher taxes and sluggish growth with a disparity of income that increasingly resembles 19th century serfdom and political instabilty, the rise of demagogues, and some vicious ghosts from the past.

At some point this dynamic is going to become less 'economic' and more political and the equilibrium will be reached. A good leading example of this is found in Iceland.

See also The Case for Deflation, Stagflation, and Implosion

For those relying on the Output Gap and slack Aggregate Demand please see Price, Demand, and Money Supply as They Relate to Inflation and Deflation

People tend to become very emotional over this sort of topic. There are many who are afraid that what they have will be taken, and there is even a vocal minority of the self-identified elite who wishes to obtain greater power and riches by leveling the middle class and the poor to improve their own supreme vistas. The funny thing is that to the genuinely powerful these 'elites' are about as significant as a bug on the wall, and their turn will come if that is the way it goes.

The most touching example of delusion that I have witnessed recently was an unwavering prediction about what will happen in the future because 'the majority of the people on the this chatboard have agreed on it.' Well, perhaps history gives a hoot. But I suspect that we are in His hands now more than ever. And you might do well to prepare yourself accordingly.

By the way, and this is just a stab at my own theory, a strawman as opposed to an examination of the data, I think the US is hammering the ECB to devalue the Euro, because they wish to further devalue the US dollar. If the major fiat currencies can be devalued in a relatively uniform manner, and some other statistics and prices controlled, the people can be subtly relieved of their savings and wealth, and be none the wiser. But those stubborn Germans had to be brought to heel first. And so it is.

Here is something from an old trading acquaintance of ours. Stage Set For Another Bernanke Adventure - Brady Willett of FallStreet

Performance of Several Key Currencies Since January 2007

This chart shows the comparative performance of several currencies in their dollar crosses since January 2007, or shortly before the most recent financial crisis took hold. For the US dollar itself we are using the DX index.



Gold did sell off hard in the market plunge in October of 2008 reaching an intraday low of $680, a buying opportunity of the first order. Many who said they were waiting to buy a dip never bought, because like most speculators they keep waiting for 'THE' bottom, and keep lowering their target buy price, and never really take a position. Then watch it run away from them, and wait for a pullback, but again never buy back in. Oh they will point to certain stocks that performed fabulously off the bottom, but they did not buy and hold them either, except in their fantasies and trash talk.

This is a flip side to those bulls who were long the tech bubble, and kept waiting for a higher price to sell their positions, just a few dollars more, and ended up taking a ride on a death spiral.

If you did not buy in then, what makes you think you can muster the conviction to buy on any other dip in a new major selloff? What makes you think the market will give you a second chance?

Gold never broke in the Crash of 1987, and offered quite a safe haven until Greenspan and the central banks started selling into it in 1988 to discourage the competition. Think they can do that again? With what?



And as for the theory about debt destruction making a currency more valuable, it could work, but don't hold your breath for the euro to strengthen as the sovereign debt of the PIGS starts swirling the bowl. And where they go, so will the UK and then the US go as well.

And before you complacently snicker at the problems in the eurozone, keep in mind that as a percent of GDP, the US debt is fast approaching the same level as Portugal, and climbing.

Massive Deflation Sighting in the US As Noted in the Asia Times

David Goldman says in the Asia Times that "It’s Still the Worst Deflation in US History." He shows a chart (below) of US commercial lending to prove his point.

Asia Times
It’s Still the Worst Deflation in US History
November 18th, 2009
By David Goldman

This morning’s news that housing starts “unexpectedly” dropped by 11 percent month on month is consistent with my grim view of the American economy. The crystal-meth monetary policy at the Fed makes everyone feel better, until they don’t.

The nonstop rise in the price of dollar hedges tells us that it can’t last forever. Large balance sheets attached to the Fed’s money pump can show profits, and the price of spread assets (as PIMCO’s Bill Gross keeps emphasizing) is stupid rich. But at the capillary level, through, the economy is dying and gangrene is setting in.

Here’s year on year growth in commercial and industrial loans from weekly reporting banks in the US:



A 20% decline year on year does not look like a recovery. In fact, it looks like nothing we have seen since the Great Depression. C&I loan growth lags the end of recessions, to be sure, but this extreme level of credit reduction suggests profound trouble....

Yes commercial lending is slack and gone negative. And yes, it does signal severe economic distress in the productive economy. But is that deflation?

No, it is a sign of a very slow GDP growth and deleveraging in the aftermath of a credit bubble, with a GDP that I think is still negative in real terms. The US economy is still very bad, and David is probably less gloomy about that than Le Proprietaire.

One could assume that by 'deflation' David means 'a recession/depression' or 'a lousy economy.' But that is not deflation, as the economists learned in the economic stagflation of the 1970's. Words count, and this is an important distinction, because one reacts to situations as diverse as inflation or deflation, hyperinflation or stagflation, differently.

Is this a deflation which we see now in the US, even if it is not the 'worst in history?' Is there a steadily strengthening US dollar ,and low money supply growth relative to demand, or GDP relative to money suppy as indicated by an abnormally high velocity of money?

Only in the mind and imagination of someone who already believes in a deflationary outcome with all their mind and heart.

Can deflation happen? Yes. That is inherent in a fiat currency.

If the Fed raised the overnight interest rates to 20% tomorrow, we would have a deflation 'lickity split' because that would be an extreme policy action which relative to the underlying demand for money and economic conditions, is purposeful and dramatic towards a specific end. And this is the Fed's 'hole card,' the means by which they think they can control inflation in the future once the US economy has recovered (if it does sustainably I would add, and not just another asset bubble).

Inherent in David's conclusion is that money supply can only grow through bank lending. This is economic illiteracy. The Weimar inflation, for example, was not caused by excessive lending by German commercial banks in a vibrant economy. It was caused by the monetization of existing debts, the war reparations debt, without a corresponding growth in productive GDP.



So, absent a conscious policy decision by the Fed to strangle the US economy premature to recovery, deflation becomes a likely outcome if the Federal Reserve runs out of debt obligations, both public and private, which it is willing and able to monetize. That is the only 'hard stop' in the game on that side of the equation, and good luck with that.



Deflation would hurt those who owe debts in dollars, and be a boon to those who are the creditors. The American people are the debtors, and they control the growth of their money supply, at least for now.



The obvious pivot point, one key vector, in all this is one simple question: "Can the US economy become self-sustaining again, productive in its own right without having to export inflation by printing currency and living on credit?"

A second, but important question is can China and the rest of the mercantilist world adjust gracefully to a rebalancing in the distribution of demand, while maintaining sustainable growth of their own, despite their fears of a rising middle class?

We say yes, but only with a serious effort at fiscal and economic rebalancing. Cutting spending alone is not enough. That is the route to self-destruction, economic anorexia, if nothing else changes. Liquidationism alone is inherent in the neo-Calvinist roots in the US that emphasize the justice of non-redemptive suffering. They have sinned, so they must suffer, and the more the better.

There are three things the US must do: reform, reform, reform. Everything else is a palliative, to buy time at best while you seek to make the necessary systemic changes.

What does it matter, the details of the outcome, as long as the economy is in a slump?

If you want to suffer, go into a serious and protracted stagflation in the US holding dollars as the bulk of your wealth, and that will give you a taste of hell.

What is the most likely outcome? Would you care to buy a vowel? I would suggest that you buy an "I" and then see if there is an "S."

Deflation and straight inflation are relatively easy to hedge. Stagflation is the most difficult outcome to manage from an investment perspective. We'll talk more about this later if that appears to be the case.

Stagflation will be the unintended consequence that will catch the most people unprepared. This is the outcome most feared by the Fed, because it renders their monetary policies ineffective. The Fed can create money until the dollar goes to zero, but it cannot manage fiscal and industrial policy, and confer productive vitality which is essential to a sustainable recovery.

You cannot say that Bernanke did not warn you about what he will do. Deflation: Making Sure "It" Doesn't Happen Here

But we cannot stress enough that the outcomes are not predetermined, except in the minds of true believers. Therefore flexibility and clear-headed watchfulness are important now, more than ever.

So Why Is the Stock Market Going HIgher?

Q: But Jesse, if things are so bad, why is the stock market going up?

A: There is no doubt that equity markets, when judged in nominal terms, can do amazing things when the Fed spikes the punch bowl with grain liquor. Especially when market regulation has been weakened by decades of mistaken ideology and corruption.

The German stock market during the Weimar Crack Up Boom showed some remarkable gains, and was actually a lifesaver for many investors, for a time.

Bull markets are generally corrosive of the average intellect. That is why statists with something to hide love them so much. No matter what era, people willingly surrender their common sense to the bubble, if only for pragmatic reasons.

Those actively playing the deflation trade, short stocks and commodities, are getting killed for now. They are obviously early. The real deflation in paper asset prices will eventually come as the bust follows boom, but more selectively than most imagine, except temporarily if there is a genuine crash and not a long slow decline. Some assets will soar even higher as the dollar devaluation gains momementum and not retrace significantly as the dollar collapses in slow motion.

As Ludwig von Mises noted:

"This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to their altered money relation

There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.

These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy...

But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against 'real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last."

Until then, be aware that the paper chase is on, backed by the full faith and credit, and desperate lies, of some very frightened, but still very powerful and increasingly ruthless, men. There is a good case to be made that the financial sector, led by Wall Street, hijacked the US productive economy and bought off the politicians and has been managing it for their own benefit most notabley since. This is not the first time, and it will most likely not be the last.

Try to stay out of their way as they thrash about, looking for something to fill the hollowness of their being, more fuel for the bonfires of the profane.

China May Lead Coalition of Nations to Topple the US Petrodollar

It does make sense that this would happen, and many including ourselves have been forecasting this outcome as a viable trigger for a significant, but orderly, dollar devaluation.

The US has violated the premise under which the Dollar served as the world's reserve currency. As Alan Greenspan himself said, the US Dollar regime worked because it was managed as though it was still under an external monetary standard, mimicking the rigor of a hard currency while maintaining a flexibility for monetary policy adjustment. We questioned the veracity of that claim when he made it, but it was the appearance, if not the reality, of responsibility and discipline that made things work for the monetary wizards.

Ironically enough, the closet goldbug Mr. Greenspan shattered that discipline with a gearing up of financial engineering in response to economic and trading crises starting with 1987 and reaching higher notes with LTCM and the Asian currency crisis.

China devalued the yuan against the dollar, and was able to promote an aggressive program of industrialization through multinationals like Walmart who desired cheap labor. The Chinese were able to persuade Bill Clinton and then George Bush to grant them favored nation trading status, without the condition of a freely traded currency. This allowed China to import manufacturing jobs, and made the US politicians and financiers happy with their personal donations and profits.

The dogs of war were loosed by the Fed in 2002 with a remarkably reckless expansion of debt through over easy interest rates, with an explosion of fraudulently rated US dollar financial assets from an Anglo-American banking system grown utterly corrupt and in full bloom of a credit bubble.

Bernanke has taken the dollar into its endgame, while insiders grab fistfuls of dollars and quietly sell their financial assets behind the scenes during this recent market rally. Obama and his team are either corrupt or incompetent. The same can be said of his two predecessors, at least.

"The capitalists will sell us the rope with which we will hang them."
Vladimir Ilyich Lenin

However this plays out over the next nine years, it will be history in the making, and interesting to say the least. It will be neither straightforward, nor easy, nor transparent to the public. But it seems inevitable that the days of Empire based on dollars backed by oil and global military reach are over and gone-- until the next time.

The Independent UK
The demise of the dollar
By Robert Fisk
Tuesday, 6 October 2009

In a graphic illustration of the new world order, Arab states have launched secret moves with China, Russia and France to stop using the US currency for oil trading

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years.

The Americans, who are aware the meetings have taken place – although they have not discovered the details – are sure to fight this international cabal which will include hitherto loyal allies Japan and the Gulf Arabs. Against the background to these currency meetings, Sun Bigan, China's former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East. "Bilateral quarrels and clashes are unavoidable," he told the Asia and Africa Review. "We cannot lower vigilance against hostility in the Middle East over energy interests and security."

This sounds like a dangerous prediction of a future economic war between the US and China over Middle East oil – yet again turning the region's conflicts into a battle for great power supremacy. China uses more oil incrementally than the US because its growth is less energy efficient. The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold. An indication of the huge amounts involved can be gained from the wealth of Abu Dhabi, Saudi Arabia, Kuwait and Qatar who together hold an estimated $2.1 trillion in dollar reserves.

The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. "One of the legacies of this crisis may be a recognition of changed economic power relations," he said in Istanbul ahead of meetings this week of the IMF and World Bank. But it is China's extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America's power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states.

Brazil has shown interest in collaborating in non-dollar oil payments, along with India. Indeed, China appears to be the most enthusiastic of all the financial powers involved, not least because of its enormous trade with the Middle East.

China imports 60 per cent of its oil, much of it from the Middle East and Russia. The Chinese have oil production concessions in Iraq – blocked by the US until this year – and since 2008 have held an $8bn agreement with Iran to develop refining capacity and gas resources. China has oil deals in Sudan (where it has substituted for US interests) and has been negotiating for oil concessions with Libya, where all such contracts are joint ventures.

Furthermore, Chinese exports to the region now account for no fewer than 10 per cent of the imports of every country in the Middle East, including a huge range of products from cars to weapon systems, food, clothes, even dolls. In a clear sign of China's growing financial muscle, the president of the European Central Bank, Jean-Claude Trichet, yesterday pleaded with Beijing to let the yuan appreciate against a sliding dollar and, by extension, loosen China's reliance on US monetary policy, to help rebalance the world economy and ease upward pressure on the euro.

Ever since the Bretton Woods agreements – the accords after the Second World War which bequeathed the architecture for the modern international financial system – America's trading partners have been left to cope with the impact of Washington's control and, in more recent years, the hegemony of the dollar as the dominant global reserve currency.

The Chinese believe, for example, that the Americans persuaded Britain to stay out of the euro in order to prevent an earlier move away from the dollar. But Chinese banking sources say their discussions have gone too far to be blocked now. "The Russians will eventually bring in the rouble to the basket of currencies," a prominent Hong Kong broker told The Independent. "The Brits are stuck in the middle and will come into the euro. They have no choice because they won't be able to use the US dollar." (Look for the NWO to start making a stronger play to control the EU - Jesse)

Chinese financial sources believe President Barack Obama is too busy fixing the US economy to concentrate on the extraordinary implications of the transition from the dollar in nine years' time. The current deadline for the currency transition is 2018.

The US discussed the trend briefly at the G20 summit in Pittsburgh; the Chinese Central Bank governor and other officials have been worrying aloud about the dollar for years. Their problem is that much of their national wealth is tied up in dollar assets.

"These plans will change the face of international financial transactions," one Chinese banker said. "America and Britain must be very worried. You will know how worried by the thunder of denials this news will generate."

Iran announced late last month that its foreign currency reserves would henceforth be held in euros rather than dollars. Bankers remember, of course, what happened to the last Middle East oil producer to sell its oil in euros rather than dollars. A few months after Saddam Hussein trumpeted his decision, the Americans and British invaded Iraq.

The Utility of Gold and Silver Over the Past 200 Years

A bit of an oversimplification as one might expect for a short video, but rather effective in making its several of its points. Some interesting data as well.

Warren Buffett has asked "What utility does gold have?"

Since his views are respected and he is unusually successful, it is important to consider this question.

The utility of gold is that it resists the manipulation of the statists, which is why they hate it. It provides a store of wealth that is difficult for the state to confiscate through debasement. Gold and silver have represented the instruments of freedom and safety, a secure store of wealth, for individuals faced with adversity and uncertainty over thousands of years.

For quite some time the various pieces of evidence with regard to the Central Banks and gold have been becoming public. It seems to this reader, based on a careful search and consideration of the facts, that the attempt to control the price of gold and to a lesser extent silver by some of the Banks, led by the Brits and the Yanks, is almost certain as an adjunct in their efforts at financial engineering.

But the Banks are failing. They are failing in particular since the market break of 2000 when the first of the post Asian financial crisis bubbles collapsed. They are being broken, once again, by the physical buying coming in particular from Asia and Europe, where currency risk is a familiar concept. Most American go through their lives never having handled another currency except the dollar, and their education in finance, and even their own history, is sadly lacking. For them, the US dollar is the monetary alpha and the omega, and its decline is incomprehensible.

We are now in the midst of a new financial bubble in world equity markets, and it too will collapse.

This is not to say the future will be straightforward and simple. It will not.

People sometmes worry about government confiscation. Since gold no longer has any official status in the US except as private property, this is a bit of a red herring. True, government can try to seize any of your private property not just gold. It can try to force you to wear a number, or imbed a chip in your head, to buy and sell, it can even try to pack you on a freight train for resettlement in New Mexico. The question is not what the state can try to do, but rather, what you will let them do and how you will respond to it.

At the moment the US dollar remains the linchpin of the Anglo-American financial oligarchy. That is it failing is probably one of the great issues facing world stability today.

Right now the Dollar is the subject of an aggressive carry trade, with traders selling it short to buy other assets. This obviously sets up the potential for another short term dollar squeeze such as we saw last year when the Eurobanks were devastated by the failure of the toxic dollar assets on their balance sheets which had to be paid in full in dollars to their depositors.

A reversal in the dollar and the collapse of carry trade would shake world equity markets to their core as the gamblers are forced to unwind positions. The vampire squid and associates would probably benefit, but many would suffer. In today's environment, that makes the possibility of this happening even more likely in our book.

But then again, sometimes things do go down into a long spiral, and finally are priced at 30 on a Friday, and open up on Monday at 2, or 'no bids.' It happens. But usually it happens in slow motion at first with national currencies. It is much easier to boil a batch of frogs slowly than to wade in and start chopping heads.

Likelihood is a dollar rally at some point if stocks start unwinding. And then things get interesting, and ugly. Not with a bounce, but a 'splat,' with interest rates running to levels that would make your jaw drop.

For a longer view and a warning likely to fall on deaf ears, the more the oligarchs and elitists take the world's people through these cycles, the greater they need to pay attention to one lesson that ripples throughout history: the trick is not only how to make a great fortune through theft and trickery, but how to hold on to it, and very likely your life, when the tide turns and the people have finally had enough.



Gold and Silver Video

Confessions of a 'Flationary Agnostic

I have no particular allegiance to either the hyperinflation or the deflationary camps. Both outcomes are possible, but not yet probable. Rather than being a benefit, occupying the middle ground too often just puts one in the middle, being able to see the merits in both arguments and possibilities, and being unwilling to ignore the flaws in each argument. But this is where reason takes me.

In a purely fiat regime, where a monetary authority has the ability and the willingness to monetize debt, there is NO mandated, no predetermined outcome for hyperinflation or deflation in the event of a credit crisis, unless that money is pegged to an external standard, which is ruled out by definition in a purely fiat regime.

In a credit crisis there is often a 'credit crunch' which is what was seen in the financial system when short term credit transactions seized up out of fear. This is not the same as a true monetary deflation which is a real contraction in the money supply, at the least. So far we have not seen this. And we may never.

Also, I would have to agree that the eventual fate of all fiat currency is failure and reissuance of a 'new' currency, due to the sustained erosion of a seemingly incessant, if gradual, inflation. This does not HAVE to be, but it is, as an outcome of human nature. Men will always and everywhere eventually succumb to the temptation of currency debasement, a free lunch, and so they cannot be trusted to manage a nation's affairs with the unrestrained keys to the Treasury.

And at the end of a currency's lifespan, there is quite often a bout of serious inflation that precipitates the reissuance and restructuring. How long this period of time can be no one can say.
That is the simple fact of it. The only limitation on the Fed's ability to inflate is the value of the dollar and the bonds; that is, their acceptability to 'creditors' who are willing to exchange goods and services with real value for paper.

And it should be perfectly clear that to choose a monetary deflation as a fiat policy decision for a country that is a net debtor would be bizarre to say the least.

Everything else is noise and generally ad hominem attacks. And the louder the noise, the less likely the person speaking knows anything about monetary systems.

I read that the Fed has taken on (a euphemism for 'monetized') roughly half of the Treasury debt issued in the second quarter of 2009. And it is quite likely that this is only a part of it, that a good portion of the rest of the debt was arranged for with other central banks, including those who are engaged in large scale currency manipulation of their own which is a de facto monetization on the road to default as China will be finding out most likely some day.

There is quite a bit of misunderstanding on the issue of deflation. As we have discussed before, deflation driven by slack demand is not uniform across product and service classes as it would be during a true monetary deflation. That is because goods and services vary in the elasticity of their demand.

Yes some prices will decrease, as one would expect, especially in those assets whose value has been inflated during a preceding bubble and discretionary items with a significant elasticity of demand.

But other items will remain stable or even increase in price, particularly essential items, and those provided from a sector with an oligopolistic framework.

Why? Because those who control access to essentials will seek to increase prices and 'rents' even during severe recessions to make up for lost revenue streams and profits in other areas of their business. Barring government intervention, every crisis has its profiteers.

So we have the phenomenon of banks being bailed out by the government, with public funds, not lending as they had promised, and greatly increasing fees and cutting services whenever and wherever they can on certain instruments such as credit cards, for example. Or other financial firms taking advantage systemic flaws and leverage and loopholes to game the markets, extracting what amounts to increased rents, a tax, on the nation's transactions, further dragging down the real economy.

Credit is not money. Debt is not money per se. These are things that are instrumental to the process of money creation and destruction.

If I 'owe you' ten dollars, are you ten dollars richer? Not unless you hold some sort of legally enforceable piece of paper to back it up, and even then there is a discount on the value of that paper which is repayment risk, the possibility that I might default on that arrangement.

Money is the sanction of the monetary authority on a particular debt arrangement. It is limited to only that which has been sanctioned, that which passes through the hands of the creditor "into" the money system. This may occur at the point of origin, the central bank, or one of its officially designated representatives, sanctioned by executive order or under the law created by the Congress.

One does not count a private debt obligation held by the creditor as money, in addition to the actual currency that was delivered to the debtor. That would be double counting, a misunderstanding of the accounting system. The debt held by the creditor is an asset, of varying liquidity and risk.

If you have an unused credit card with a $1000 credit limit, do you have $1000 dollars? Does that $1000 dollars exist anywhere? No, clearly not. You may act differently in having it, it may influence your behaviour, but it is not money.

Once you use that card, and 'borrow' $1000 on that credit line, then it does exist as money, and a corresponding liability of $1000 is created and is held by the bank as an asset.

Is that $1000 debt obligation being held by the bank the same as the $1000 in money that was created when you borrowed it and spent it, putting it into motion within the real economy? No. If anything we might have learned from this credit crisis should sink in, the value of collateralized debt obligations, a collection of assets on a variety of instruments, is deeply affected by risk.

This is why a private debt obligation cannot be money, because it is not significantly riskless and is more an asset. Anything that bears a significant risk of default that is not tied to the full faith and credit of the central monetary authority is not money. It is a product, some proxy for money.

Is the savings deposit in excess of FDIC at my local bank 'money?' Yes, but not of the same quality as cash in my pocket. That is why there are a variety of money supply figures.

Is the reduction of debt directly correlated to the levels of money in the nation's monetary supply? It depends on how it is accounted. The debt can be written off, and no 'money' is destroyed per se but the bank will take a writedown on assets. We are seeing this in action today, as vast amounts of CDS and MBS are devalued on the books of the banks.

We make a distinction obviously between the existence of the money itself, and the means or ability to create money through a particular process, which can itself be impaired, without a reduction in the aggregate supply of 'money' depending on how you account for it.

Here is an interesting chart. It clearly shows the precipitous dropoff in commercial lending, and the actions of the monetary authority and the government to step in and support lending, primarily in the programs of the Fed.



This lack of productive economic vigor is impairing the ability of the Fed to maintain an organic growth in the money supply. But it does not stop it. They have some limitation or impairment in their ability to manage the money supply, because of the slack demand in the economy and the loss of the aid of the 'money multiplier' and the moribund velocity of money. The money that is created by the Fed without a corresponding increase in economic activity is 'hot money' that is particularly dangerous from an inflationary perspective.

Here is an interesting paradox. At a time of slower growth rate of money supply, many might think that this is 'good' for the dollar, because less dollars means more value for each dollar, right? In essence, this is one of the major tenets of those called 'deflationists.'

First, there are not less dollars. The growth rate of dollars is slowing but as one can see, this is a relative thing historically.









But here is the key point.

The growth rate of dollars is slowing at the same time that the 'demand' for dollars, the velocity of money and the creation of new commercial credit, is slowing. GDP is negative, and the growth rate of money supply is still positive, and rather healthy. This is not a monetary deflation, but rather the signs of an emerging stagflation fueled by slow real economic activity and monetization, or hot money, from the Fed. The monetary authority is trying to lead the economic recovery through unusual monetary growth. All they are doing is creating more malinvestment, risk addiction, and asset bubbles.

Money supply and the rate of money supply growth is a confusing topic, primarily because lots of commentators twist it and split hairs about it to make points, without really caring to explain what is actually happening to those who are not specialists. 'Experts' hide behind terminology to obfuscate the situation to support particular policy initiatives under a cloud of fear, uncertainty and doubt. Despicable.

We have not written it out and worked the details yet, and the lags and expectations are always a significant issue, but generally the growth in the broad money supply should bear a positive relationship to the growth rate of real economic activity, with the appropriate lags. It ought not to lead it or lag it artificially except in extreme circumstances. Using money as a 'tool' to stimulate or retard economic activity is a dangerous game indeed, fraught with unintended consequences and unexpected bubbles and imbalances, with a spiral of increasingly destabilizing crises and busts. The Obama Administration bears a heavy responsibility for this because of their failure to reform the system and restore balance to the economy in any meaningful way. Whether it is cowardice, ignorance, or corruption is difficult to judge, but it is a failure without regard to motives.

What makes matters worse is that given the cumulative years of government 'tinkering' some of the key economic measures are hopelessly spoiled. The Consumer Price Index is probably the best example as is shown at Shadowstats. Consumer inflation is a key problem because it is used, as the chain deflator, in calculating real GDP, the basic measure of economic activity in a nation.

And so after the cumulative years of financial engineering by the government and the Federal Reserve, here we are today, caught in an ugly cycle of boom and bust, with an outsized financial sector, a government controlled by the money interests, and a productive economy in a systemic decline.

And this is why we say:

The banks must be restrained, and the financial system reformed, and the economy brought back into a balance between the productive and administrative sectors, before there can be any sustained recovery.

Peter Schiff on the Surge in Gold; Jesse Weighs in on Inflation and Deflation

Peter Schiff has not always been correct, most notably on the decoupling theory of foreign markets with the US, and the desirability of their equity markets, at least so far.

It is the case, of course, that the US lagged emergence from the Great Depression as compared to a number of overseas economies, for a variety of reasons on which we have speculated in the past.

Will this happen again? Perhaps, we cannot know. But the US is 'ground zero' for the Wall Street debt fraud and bubble economy based on the dollar reserves, and seems utterly incapable of taking action except to print more money and give it to Wall Street.

The decline in the value of the dollar does seem like a very high probability, as well as the rather severe stagflation which this may eventually produce. On this point Mr. Schiff seems most insightful, especially compared to the commentators on financial television.

The discussion which Peter has towards the end is particularly interesting about inflation and deflation. We tend to diverge again a bit from his analysis there however. He references monetary inflation. But this is not the only cause of price change.

There are definite and easily observable deflationary forces at work in the economy today in the form of slack demand, unemployment, and net credit contraction. This is putting severe downward pressure on prices as one would expect.

This will become worse as people realize that our current 'recovery' is a public relations event, and it may even result in a 'credit crunch' once again as it did last year. This is the 'dollar short' phenomenon that we have described, which particularly impacted European banks holding dollar assets.

At the same time, Bernanke has the printing presses running from the Adjusted Monetary Base up, and is pushing on the monetary inflation button, monetizing bad debts of non-traditional sorts, and weakening the dollar.

Foreign holders of US debt are starting to make their first moves in this game of prisoner's dilemma. At some point if confidence breaks, things might start moving much more quickly. Until then it will be a slow grind, an erosion of value and wealth.

The general American public is, in a sense, caught in the middle, with a lack of jobs and income for the working classes, but higher prices in imports and essentials. This is the stagflation outcome which we had feared. One bright spot is that it might be good for exports, if the Asian countries can generate domestic consumption and decide to free up access to their markets.

See Price Demand and Money Supply As They Relate to Inflation and Deflation You might also take a look at Some Common Fallacies About Inflation and Deflation.

Inflation and Deflation are not linear, that is, not straightforward and simple economic functions with a few variables, except at the tails of probability where the power of the extreme crushes the equation into simplicity by overwhelming other factors into insignificance. You print enough dollars, and consumer demand matters much less as an input to inflation.

Approaching the future with one dimensional game plans can be quite risky. But for some reason gold, and to a less extent silver, always appear to work to some degree in the solution mix, hence their continuing rally despite the best efforts of the powers that be to talk them down. As Bernard Baruch famously observed, "Gold has 'worked' down from Alexander's time... When something holds good for two thousand years I do not believe it can be so because of prejudice or mistaken theory."

The lack of coherent financial reform from the Obama Administration, and their ludicrous proposal to create a 'super-regulator' in the privately owned Federal Reserve, after a landslide victory in an election based on change and reform, is an outcome almost too bizarre to be believable. Unless, that is, you accept that Obama and those around him are either incredibly naive or corrupt. We suspect that as in all things it is some of both.

By the way, in case you missed it, Charlie Rangel, in charge of Ways and Means and the major proponent of a new military draft, is being investigated as another tax cheat among the Democratic leadership.

Do these people take us for imbeciles? Do they think that the world does not see their corruption, their greedy, devious nature when it is not masked by a captive media, and is not repelled by it?

In 2005 we forecast this very outcome, that Wall Street and their cronies would push their schemes beyond all reason, like drunk drivers or addicts who cannot quit, until they create a cathartic, catastrophic event which will cause someone to finally take away their keys at the last.

That time is approaching. No one can predict exactly when, but it is there. Make sure you are wearing your seat belts.

"There is precious treasure and oil in the house of the wise, but a fool consumes all that he has and saves none." Proverbs 21:20

(hat tip to Denver Dave for the link)

Hedge Funds Betting on a Deflationary Market Collapse

The observations herein regarding the nature of this stock market rally are quite in parallel with our own.

Buying the dollar to play the debt deflation trade may also be a good one in the short run, especially if leveraged foreign punters have to quickly raise cash to cover bad bets made in the US markets.

However we would have to add that this scenario assumes no black swans with regards to the heavy overhang of US dollars being held by overseas central banks.

If we were in such a position, we would be selling the rallies, given the huge amount dollars on the books.

Bloomberg
Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say
By Cristina Alesci

Sept. 1 (Bloomberg) -- Paul Tudor Jones, the billionaire hedge-fund manager who outperformed peers last year, is wagering that Goldman Sachs Group Inc. and Morgan Stanley got it wrong in declaring the start of an economic recovery.

Jones’s Tudor Investment Corp., Clarium Capital Management LLC and Horseman Capital Management Ltd. are taking a bearish stand as U.S. stock and bond prices rise, saying that record government spending may be forestalling another slowdown and market selloff. The firms oversee a combined $15 billion in so- called macro funds, which seek to profit from economic trends by trading stocks, bonds, currencies and commodities.

“If we have a recovery at all, it isn’t sustainable,” Kevin Harrington, managing director at Clarium, said in an interview at the firm’s New York offices. “This is more likely a ski-jump recession, with short-term stimulus creating a bump that will ultimately lead to a more precipitous decline later.”

Equity and credit markets have rallied on hopes that government intervention is pulling the U.S. out of the deepest economic slump since the Great Depression. The Standard & Poor’s 500 Index jumped 51 percent from its 12-year low in March through yesterday.

The economy will expand at an annualized rate of 2 percent or more in four straight quarters through June 2010, the first such streak in more than four years, according to the median estimate of at least 53 forecasters in a Bloomberg survey.

Tudor, the Greenwich, Connecticut-based firm started by Jones in the early 1980s, told clients in an Aug. 3 letter that the stock market’s climb was a “bear-market rally.” Weak growth in household income was among the reasons to be dubious about the rebound’s chances of survival, Tudor said.... (aka the growth in the median wage that we have been harping about - Jesse)


A focus on misleading indicators is driving markets, macro managers say. (Are there any other kind coming out of Washigton or Wall Street these days? - Jesse)

Clarium watches the unemployment rate that accounts for discouraged job applicants and those working part-time because they can’t find full-time positions, Harrington said. July joblessness with those adjustments was 16 percent, according to the Department of Labor, rather than the more widely reported 9.4 percent.

The housing data isn’t as rosy as some see it, Harrington said. As existing U.S. home sales rose 7.2 percent in July from the previous month, distressed deals including foreclosures accounted for 31 percent of transactions, according to the National Association of Realtors, a Chicago-based trade group.

A report by the Mortgage Bankers Association, based in Washington, showed the share of home loans with one or more payments overdue rose to a seasonally adjusted 9.24 percent in the second quarter, an all-time high.

Clarium, which oversees about $2 billion, is positioned for an equity bear market through investments in the U.S. dollar, Harrington said. Falling stock prices will strengthen the currency by forcing leveraged investors to sell equities to pay down the dollar-denominated debt they used to finance those trades, he said.... (That's one way to play it, conventionally, if the swans stay white - Jesse)

The Financial Accounting Standards Board voted in April to relax fair-value accounting rules. The change to mark-to-market accounting allowed companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities that plunged with the housing market.

Banks are reporting better earnings because they haven’t been forced to account for their losses yet, Clarium’s Harrington said.

“We haven’t fixed the problem,” he said. “We’ve just slowed down the official recognition of it...”

“Despite every effort by government in North America and Europe to avoid deflation,” Horseman wrote, “the current numbers suggest they are losing the battle.”

The Particularity of Japan from an Economic and Demographic Perspective

Since Japan is so often, and as we think incorrectly, cited as a likely deflationary pattern for the US in monetary outcomes, and since so few who discuss this subject have an understanding of Japanese culture and social structures, I thought it would be timely to point out a basic fact that should be reasonably well known but is so often overlooked.

Japanese population growth is flat, and the percent of the population that is no longer economically productive is growing rather quickly.

So would we be so suprised that Japan's GDP is flat, and that their money supply growth is sluggish? One should not be, unless they are not bothering to look at the data.

America also has an aging population as do many countries, but Japan is unique because of its extraordinarily low rates of immmigration due to the very homogenous nature of Japanese society.



Japanese population is now estimated at about 127.7 million people with a very nominal immigration rate of about 20,000 people per year and a negative birth-death rate.



When one mixes a negative native birth-death rate and very low immigration due to a rigid approach to race and citizenship, it should be no suprise that Japan has an unusually high level of elderly citizens.



The charts seem to suggest that countries with significantly aging populations with low population growth will experience a natural slow growth in GDP.

As you know we tend to like to view money supply growth and GDP in relation with each other and to per capita variables.

When one adds to this demographic mix the Japanese cultural bias to low domestic consumption and a high savings rate, and a bureacratic bias to a mercantilist industrial policy, the reasons for Japan's economic status become rather obvious.



I am not suggesting that Japan must change. I have spent many happy moments in Japan, and spent a great deal of time to learn the language and understand the culture, albeit with results inadequate to my hopes.

I have had many Japanese friends, and find great enjoyment in their art and music and social personality. I regret that I have not been to visit there in some years, and have forgotten so much and miss so many old acquantances. And I am particularly at a loss for their wonderful cuisine which I find fascinating, uniquely refreshing and delightful.

It is important to understand a country in its context, and with some attention to detail and its particulars, if one is going to perform an economic analyis and then perform broad comparisons and construct models.

Demographically speaking, Japan is an outlier with some unique characteristics. If one does not consider this, it can be a source of false conclusions.

A Final Word on Inflation and Deflation

A serious bout of inflation is rarely caused by normal business activity, such as commercial bank lending and private debt.

In almost every case that I have studied, a very serious monetary inflation is triggered by excessive government debt obligations, and not private debt, that can no longer be adequately serviced by a productive real economy and domestic taxation.

That unserviceable debt becomes 'monetized' and a serious inflation results. It is a form of debt default.

Devaluation of a currency is a form of inflation which specifically addresses external debt obligations, as well as default on bonds which is a form of selective national bankruptcy.

The reason that the output gap is no sure barrier to this type of inflation is that it ironically serves to feed it in the presence of profligate government spending, since it dampens tax revenues and domestic GDP.

Private debt bubbles, asset bubbles, stock bubbles all seem to be the symptoms, the side effects, of an over easy monetary policy from a central monetary authority. In some instances they have been caused by exogenous events, even in the face of a hard monetary standard, by events such as a precipitous decline of the population from disease, or a sudden influx of a new wealth from discovery, such as the influx of silver and gold to Spain from the New World.

But the notion that banks must always lend to create inflation, or employment must be at robust levels, absolutely flies in the face of all historical experience.

And it does raise the issue, despite his protestations of innocence, impotence, and confusion, that Fed chairman Greenspan and the Federal Reserve itself, owns a unique culpability in the creation of several bubbles, from tech to housing, and the eventual outcome.

A Postscript on the Question of Inflation and Deflation

First, thanks to the many readers who mailed in a link to the book by Adam Fergusson at the Mises Institute. It is a good read, and free is much more attractive a price than $1,000 which is the price for a hard copy in good condition on Amazon. I purchased my own copy some years ago at a bookstall in Brighton. The online version is available here.

As to the discussion on inflation and deflation, I feel the need to make it clear that that inflation / deflation is a "policy decision" in a fiat currency regime with nothing preordained. In other words, either outcome is possible within a wide range of gradation. Most outcomes in the real world follow a similar pattern, not black and white but many shades of gray.

But not all things are equally possible. "Life is a school of probability."

If the Fed came out tomorrow and raised short term rates to 22% we would see a stronger dollar and the beginnings of a monetary deflation.

This arbitrariness of a fiat currency is intellectually difficult for most people because their domestic money has a natural patina of 'confidence' and objective value to it.

It is an assumption, one of those shorthand beliefs that help us through day to day life without having to intellectualize and analyze every aspect of every decision. It comes from using that currency as a store of wealth and medium of exchange, almost every day of our life (presumably even an American can take a day off shopping occasionally) and assuming that it will hold its value in the short term.

So we tend to invent 'rules' for the creation of money that preclude 'arbitrariness' and help us maintain our assumption set against 'black swan' thinking. When an assumption begins to conflict with the underlying reality it can become a 'prejudice.'

It is this very arbitrariness that is the goal of the central bank and statists whose preference is aggressive financial engineering. The limitation on the Treasury/Fed in a fiat regime is ultimately the value of the dollar and the sovereign debt. While people accept it, they can print it. This is a soft limitation with much more latitude than a hard external standard.

Having added the important caveat of possibility, given that the US is an enormous net debtor, it would be suicidal for the monetary authority to choose deflation as the Japanese did for their own particular reasons. We may experience a brief period of deflation as did the US in the early 1930's in which the money supply actually contracts, but this is much less likely now because the Fed has no external standards with which to contend.

There is a technically possible, rather conspiratorial line of thought that suggests that the wealthy elite who control the central government would opt for deflation in order to enhance their personal cash assets, driving the rest of the US into a form of debt serfdom. The probable response from the public would be in the tradition of the storming of the Bastille or the Winter Palace.

Almost all money issuing entities will choose inflation if they have the option. Sometimes they lose control of the process, the confidence game, and fall into a more serious and pernicious inflation and even hyperinflation. But this is not 'the norm.'

Our own Fed is rather arrogant these days, fully confident they know how to stop inflation given the Volcker experience. This may cause them to fall into a serious policy error on the inflationary side. In many ways our fate is no longer in their hands, but in those of our creditors, such as the Chinese and the Saudis.

Paul Volcker gave the odds of inflation in the current crisis as 99% for, allowing only for a serious policy blunder against it.

I wanted to highlight the Weimar experience to debunk the 'output gap' and the 'bank lending' restraints on the inflationary outcome. Much of what we hear on the financial channels smacks of propaganda, the 'confidence game.'

Yes the Fed faces the headwinds of slack demand and a very low velocity of money, which the Austrians will assert doesn't DO anything, but is rather of the nature of a economic speedometer. Speedometers don't' DO anything either, but their output is certain to be of some interest to the driver and their passengers.

This is less of an issue than one might think, keeping in mind that monetary inflation is the creation of money supply in EXCESS OF DEMAND. As the velocity decreases, so does demand for money, similarly the expansion of credit. So any monetization of existing debt, or government obligations by the Fed, becomes more potent so to speak.

As for the need to create more debt, let us just say that the Fed and Treasury would have yeoman's work to monetize the debt obligations the US already has, which recent estimates put at north of 40 trillions. Even with inflation at their backs, the government will be pressing the default button, selectively but surely, in the coming years.

The most probable outcome is stagflation, perhaps quite serious IF the economy and financial system is not reformed. This could have the vestiges of a monetary deflation were we not a net importer and net debtor.

This is an important distinction between the US experience and that of Japan whose industrial policy is well known to be in the bureaucratic clutches of MITI and the various kereitsu.

Japan sought to stimulate the economy and avoid deflation while aggressively exporting the fruits of their domestic productivity and consumption to support their long standing industrial policy. One cannot have their natto and eat it too. These were conflicting objectives and resulted in a decades long stagnation. This was a policy blunder of the first order.

So, deflation is possible, but not probable. If people understand that, I will feel that I have done a good job in raising the level of understanding about monetary economics.

But isn't all this debate and too often name-calling amongst the bloggers a distraction from the real problem facing the average person, in the same sense as Paris Hilton, Survivor, big time wrestling, the McLaughlin Group and American Idol?

The banks must be restrained, and the economy brought back into balance, before there can be any sustained recovery.

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.

Finacial Crisis Racks Up $50 Trillion in Worldwide Losses in 2008

This is the price we pay for chronic malinvestment, unsustainable imbalances, a bubble in the world's reserve currency, and a blind eye to protracted fraud and misrepresentation of the economic reality by the financiers and their partners in government.

Staggering losses to be sure, and more to come. But what is most discouraging is that so far we have made little or no progress towards systemic reform and a return balanced global trade with organic growth, savings, and an efficient world financial flow of goods, services, and wealth.


Economic Times (India)
$50 trillion wiped off world financial assets: ADB
9 Mar 2009, 1022 hrs IST,
ET Bureau

MANILA: The global crisis wiped a staggering $50 trillion off the value of financial assets last year including $9.6 trillion of losses in developing Asia alone, the Asian Development Bank said Monday.

``This is by far the most serious crisis to hit the world economy since the Great Depression,'' said ADB President Haruhiko Kuroda. But he predicted Asia would be ``one of the first regions to emerge from it.''

In a study commissioned by the Manila-based lender on the impact of the financial crisis on emerging economies, it estimated the value of financial assets worldwide, currency, equity and bond markets, to have dropped by $50 trillion in 2008.

It said developing Asia was hit harder, losing the equivalent of just over one year's worth of gross domestic product, than other emerging economies because the region has expanded much more rapidly.

In Latin America, losses were estimated at $2.1 trillion. According to the study, the figures provide clear proof of the close connections between markets and economies around the world, leaving few, if any, countries immune to financial or economic fallout. A recovery can only now be envisaged for late 2009 or early 2010, it said.

A sprawling region, developing Asia includes 44 economies from the central Asian republics to China to the Pacific islands. The bank had earlier projected the region's growth to slow to 5.8 percent this year from an estimated 6.9 percent last year.

The worldwide downturn has hit export-driven economies particularly hard. From South Korea to Taiwan to Singapore, exports have plunged by double digits in recent months as American and European consumers spent less on cars and gadgets....

Inflation v. Deflation and the Yield Curve: Jesse's Lifetime Trading Plan

More on the inflation v. deflation debate. There is a divergence among the pros as you can see from this article in Bloomberg which is worth reading.

Our 'model' is deflation now, at least in prices, with a nasty inflation of probably double digits at least to follow.

There is little advantage in trying to anticipate the progression of these events unless you are looking at the slow accumulation of precious metals and key investments with very long time horizons. Timing will be difficult until things become obvious, which leaves sufficient time to move among relatively liquid assets.

The Fed will be slow to drain, and it is not unlikely that we could see short term rates spike up to 15 to 20 percent with much of the longer yield curve at 12+%. The Fed will feel the need to crush a burgeoning inflationary cycle, especially if there are any exogenous shocks in key commodities.

That will set up a once-more-in-our-lifetime buying opportunity in zero coupons and annuitiies, and very high quality dividend paying utilities with DRIPS. We made that play in the early 1980's and it was a long term winner.

You now have our investment gameplan for what is likely to be the rest of Jesse's life. Let's see how it plays out and allow the market to inform us of the timing, and surprise twists. We see little advantage in anticipating these markets and the preservation of capital is paramount.


Bloomberg
Treasury Real Yield at 16-Month High on Inflation Bet
By Dakin Campbell

Feb. 2 (Bloomberg) -- For the first time since 2007, Treasury investors are betting that inflation will accelerate.

The yield on 10-year notes exceeds the consumer price index by 2.72 percentage points, the most since December 2006. The gap between two- and 10-year rates widened at the fastest pace in a year last month as traders demanded more compensation for longer-term debt. Treasury Inflation Protected Securities that signaled falling prices as recently as Nov. 20 show they will increase in the U.S. this year.

Deflation was the growing concern for investors in 2008 as government bond yields fell to historic lows in December, the Reuters/Jefferies CRB Index of commodities tumbled 53 percent since July and home prices plunged 18 percent amid a deepening recession. Now, the bond market is saying Federal Reserve interest rates at zero percent, President Barack Obama’s $819 billion planned stimulus package and $8.5 trillion of U.S. initiatives to revive credit markets will reignite inflation.

“When the Fed gets finished here they will have an inflation nightmare on their hands,” said Mark MacQueen, who helps oversee $7 billion as co-founder of Sage Advisor Services Ltd. in Austin, Texas. “There is a lot of downside in conservative government bonds.”

MacQueen is selling 30-year Treasuries, which are more sensitive to inflation expectations than shorter-maturity debt.

Rising Yields

The yield on 30-year Treasury bonds climbed 29 basis points, or 0.29 percentage point, to 3.61 percent last week, according to BGCantor Market Data. The price of the 4.5 percent security due in May 2038 declined 5 29/32, or $59.06 per $1,000 face amount, to 116 2/32. For the month, the yield rose 93 basis points, the most since climbing 100 basis points in April 1981.

The yield fell three basis points to 3.57 percent at 8:08 a.m. in New York.

Yields are rising so fast they are already higher than where economists just three weeks ago expected they’d be at year-end. The median estimate of 44 economists, investors and strategists surveyed by Bloomberg News from Jan. 5 to Jan. 12 was for 3.45 percent by 2010.

Investors in 30-year bonds lost 14.6 percent last month, according to Merrill Lynch & Co. index data. January was the worst month for government securities since Merrill Lynch began tracking returns on the securities in 1988. (That was a drop from a record spike high however - Jesse)

Yields on 10-year notes fell to the lowest on record in December as the cost of living dropped 0.7 percent, trimming the annual advance to 0.1 percent, the smallest rise in half a century, according to the Labor Department in Washington.

Crude Oil

Consumer prices fell as crude oil dropped 78 percent to $32.40 a barrel on Dec. 19 after rising to a record $147.27 in July. House prices in 20 cities plunged by more than 18 percent in November from a year earlier, according to the S&P/Case- Shiller index.

At the current sales rate, it would take a record 12.9 months to absorb all the unsold homes on the market. That’s more than twice as much as the five to six months that the National Association of Realtors in Washington says is consistent with a stable market.

“We are in the midst of a deflationary freefall,” said John Brynjolfsson, the chief investment officer at hedge fund Armored Wolf LLC in Aliso Viejo, California. “I don’t anticipate there is anything the Fed can do to prevent that from continuing for the next six to 12 months.”

So-called real yields that measure the difference between Treasuries and the inflation rate turned negative in November 2007 and stayed there until October, dropping as low as negative 1.79 percent in August.

Real Yields

Except for one month in 2005, the last time real yields were negative was 1980, when the Fed raised interest rates to 20 percent to fight inflation that exceeded 14 percent. During that time, real yields were below zero for 23 of 24 months ending December 1980. (The Fed will do this at some point AFTER inflation has become apparent. There will be a significant opportunity to lock in high yields on annuitites, utilities with DRIPS, and the purchase of zero coupons. But that is some years away. It sticks in my mind because I made my parents retirement very comfortable using this strategy in 1980. Timing wil be important.- Jesse)

Policy makers led by Chairman Ben S. Bernanke cut the target rate for overnight loans between banks to a range of zero to 0.25 percent in December to revive lending and stem deflation. Obama’s stimulus plan passed the U.S. House Jan. 28 and went to the Senate for approval.

The current real yield is in line with the average 2.71 percentage points in the past 20 years, showing investors see an increasing threat in inflation. By the fourth quarter, consumer prices will accelerate at a 1.75 percent annual rate, according to the median estimate of 56 economists surveyed by Bloomberg.

Yield Curve

The difference in rates on two- and 10-year notes, known as the yield curve, has steepened from a six-month low of 125 basis points on Dec. 26 to 189 basis points on Jan. 30. That’s more than double the average of 91 basis points over the last two decades. Investors usually demand more compensation on longer- maturity debt when inflation is accelerating, causing the curve to steepen.

“We see the Fed and all the policy action gaining traction and reflating the economy,” said Mihir Worah, who oversees $65 billion in inflation-linked securities for Newport Beach, California-based Pacific Investment Management Co., the manager of the world’s biggest bond fund.

Treasury Inflation Protected Securities, or TIPS, due in 10 years yield 1 percentage point less than notes that aren’t linked to consumer prices. The so-called break-even rate, which reflects traders’ outlook for consumer prices, is up from negative 0.08 percent on Nov. 20.

TIPS pay interest on a principal amount that rises with the Labor Department’s consumer price index. TIPS ended last week at 103 13/32 to yield 1.75 percent.

Inflation concerns are also rising outside the U.S. Charteris Portfolio Managers bought inflation-protected bonds for the first time for its top-performing U.K. gilt fund.

Fed Assets

The City Financial Strategic Gilt Fund started investing in index-linked bonds in November and now holds 65 percent of its assets in the securities, Ian Williams, chief executive officer of Charteris, said in an interview last week in London.

“Government attempts to reflate the economy, especially in the U.S., will ultimately work,” Williams said. “It’s too pessimistic a view to see all this money being pumped into the system and still assume it’s all going to fail.”

The Fed’s assets have grown by $1 trillion over the past year under credit programs ranging from $416 billion in term loans to banks to purchases of $350 billion in commercial paper issued by U.S. corporations. Cash that banks can lend to consumers and business, known as excess reserves, rose to almost $844 billion in the week ended Jan. 14, central bank data shows.

Debt Sales

“We are already seeing a huge expansion of the Fed balance sheet and the multipliers that are implicit there are extraordinary,” said Brynjolfsson at Armored Wolf. “Double- digit inflation is not out of the question in the following decade.”

The corporate bond market offers one sign that the efforts by the Fed to unfreeze credit markets may be working. Companies sold $138 billion of debt last month in the U.S., the most since May, according to data compiled by Bloomberg.

Fed officials suggested that prices are increasing too slowly at last week’s meeting of the Federal Open Market Committee. “The committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term,” the FOMC said in a Jan. 28 statement.

“The Fed and Treasury will do whatever they can to get the economy going and that is ultimately what will stop deflation,” said Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York. “It’s clear they will keep their foot on the accelerator until you get real growth.”