Paul Volker Swings at Ben Bernanke on Inflationism

Writing at the New York Times former Federal Reserve Chairman Paul A. Volcker takes a swing at Ben Bernanke over the latter’s inflationist policies (bold emphasis mine)

IN all the commentary about Ben S. Bernanke’s recent speech in Jackson Hole, Wyo., little attention has been paid to six crucial words: “in a context of price stability.” Those words concluded a discussion by Mr. Bernanke, the Federal Reserve chairman, of what tools the central bank could consider appropriate to promote a stronger economic recovery.

Ordinarily, a central banker’s affirming the importance of price stability is not headline news. But consider the setting. There is great and understandable disappointment about high unemployment and the absence of a robust economy, and even concern about the possibility of a renewed downturn. There is also a sense of desperation that both monetary and fiscal policy have almost exhausted their potential, given the size of the fiscal deficits and the already extremely low level of interest rates.

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

Mr. Paul Volker appears to live up by his “inflation fighting” reputation

And with special emphasis, Mr. Volker criticism highlights Mr. Bernanke’s excessive reliance on models.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way.

Mr. Volker’s stinging rebuke reminds me that inflation is not a policy that will last.

From the great Ludwig von Mises,

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.

Global Equity Markets: Sell in May and Go Away?

Some experts have been talking about selling in May and going away.

The premise of this precept is fundamentally seasonal.

Chart from Equityclock.com

One expert even cited the Tobin Q which implied for high valuations, as one of the 'fundamental' reasons to do so.

Chart from Greg Mankiw

As I have been saying since 2008, it has been politics that has essentially driven financial markets more than corporate valuations or economics. And that’s why many experts, relying on the former metrics as guidance, have got it all so wrong.

Anything can happen in the markets. Most especially that today’s financial markets have been heavily distorted by various government interventions.

And as I have repeatedly been pointing out, the stock market have been a target for government policies where the US government has even less been coy about this, which they claim represents “success” in policymaking.

This means politics will continue to determine market outcomes or its directions (via the boom bust cycle).

Say for instance, if the US Federal Reserve decides to “covertly” bolster the US Democratic Party to negotiate for the vote on the debt ceiling, all the Fed has to do is to allow 'some' market volatility to pervade by withholding QE or by selling some market securities held by the Fed.

And the ensuing market volatility, as the politicians will point out, will be imputed to the uncertainty from the unwillingness to increase the debt ceiling by the opposing Republican Party.

But the truth is the US Fed has been instrumental in shaping the conditions of the equity markets. It’s been part of Ben Bernanke’s ‘crash course to central bankers’ dogma.

Market volatility, thus, adds to the leverage of politicians in negotiating vital policies.

Also the war on commodities may have ripple effects on global financial markets not limited to equities, as I pointed out in my latest observation on the possible ramifications of global price manipulations on the commodity markets to the Philippine Mining index.

So there are many complex interrelated and intertwined factors that may influence global stock markets more than seasonal factors.

I’d rather use the actions taking shape in major commodity markets, global equity markets, yield curves of major economies and of Asia, and the unfolding geopolitical events as guidance.

Why Bernanke’s Inflationary Policies Will Hurt Americans

The short answer...because Americans have taken over the financing of her own liabilities!

New York Times’ Floyd Norris writes,

NEARLY a decade ago, when budget deficits ballooned in the United States, it was widely said that Washington — like Blanche DuBois in “A Streetcar Named Desire” — “depended on the kindness of strangers.” In Washington’s case, foreigners — mostly foreign governments — stepped in to buy most of the new Treasury securities being issued.

Budget deficits have ballooned again, but the story is different this time. Americans are buying most of the new Treasuries being issued. Foreign governments, whose purchases were once critical, were net sellers of Treasury securities in the first half of 2010, according to figures released this week.

Well, the US government’s policy to inflate simply means robbing her citizens of her purchasing power.

In a choice of policy actions, it’s almost always short term or goals of immediacy over the long term consequences that matters for policymakers. Who cares about tomorrow? In the long run we’re all dead as their favorite icon used to say.

Yet once the bond bubble implodes, this is going to hurt Americans badly.

F. A. Hayek On Keynes: I Think He Would Have Been Fighting The Inflationary Policy

Here is a short video interview of F.A. Hayek in discussion of wage rates and the deflation during the British Depression of the 20s and 30s.(Hat tip Greg Ransom)

Some important quotes,

“While I’d spent a year analyzing in great detail his earlier book the Treatise on Money and then only to hear him by the time the second part of my criticism was published “oh I no longer believe in all that”, I didn’t want to invest more effort in criticising the general theory who’s success is still a puzzle to me, because it reverted to a very primitive idea which had been clearly refuted in the nineteenth century that there is a single relation between the demand-aggregate demand for final products and employment. So much so that Leslie Steven in the 1880s had pointed out “The test of a good economist is that he does not make that particular mistake. Well Keynes revived it and gave a plausible explanation and, I should add that he did not succeed while he lived. But when he died he was suddenly raised to sainthood.”

“The very last time I saw him about six weeks before his death...and talked to him after dinner and asked him whether he wasn’t alarmed by what his pupils naming two....were agitating for more expansion. when in fact, the danger was clearly inflation. He completely agreed with me and assured me my theory was frighteningly important in the 1930s when the question was of combating deflation. If inflation ever becomes a danger, I am going to turn around public opinion like this and six weeks later he was dead and couldn’t do it. I think he would have been fighting the inflationary policy.”

The Lost Decade: US Edition Part 2

As we earlier pointed in The Lost Decade: US Edition, stock market returns had been dismal, a decade since the new millennium.

Well, America's blemished decade hasn't just been confined to the performance of its stock markets, but likewise reflected on major economic indicators as magnificently shown in the chart below from the Washington Post.
According to the Washington Post, (bold emphasis mine)

``The U.S. economy has expanded at a healthy clip for most of the last 70 years, but by a wide range of measures, it stagnated in the first decade of the new millennium. Job growth was essentially zero, as modest job creation from 2003 to 2007 wasn't enough to make up for two recessions in the decade. Rises in the nation's economic output, as measured by gross domestic product, was weak. And household net worth, when adjusted for inflation, fell as stock prices stagnated, home prices declined in the second half of the decade and consumer debt skyrocketed."

The obvious lesson is that policies that promote short term prosperity through inflating asset bubbles negates the ephemeral yet unsustainable policy driven gains.

As Ludwig von Mises presciently warned in his magnum opus, ``The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment."

In short, bubble blowing policies simply don't work.

To add, the impact of the fast ballooning Federal regulations as seen in the Federal Register journal [as earlier discussed in Has Lack Of Regulation Caused This Crisis? Evidence Says No] should likewise be considered in the decomposition of the prevailing conditions of the US economy.

As previously quoted,``According to the Washington, DC-based Competitive Enterprise Institute’s 2009 edition of “Ten Thousand Commandments” by Clyde Crews, the cost of abiding federal regulations is estimated at $1.172 trillion in 2008 – 8% of the year’s GDP. This “regulation without representation,” says Crews, enables the funding of new federal initiatives through the compliance costs of expanded regulations, rather than hiking taxes or expanding the deficit."

In other words, numerous opportunity costs from the costs of compliance, costs of an expanded bureaucracy and the attendant corruption, the cost of the crowding out of private investments, the misdirection and wastage from inefficient use of resources and other forms 'unseen' distortions from the said regulations should also be reckoned with in appraising the economy.

To argue that America's decade have been emblematic of the frailties free markets is to engage in Ipse Dixitism or plain falsehood.

That's because it's easy to use the strawman to blame others, yet the worst is to admit one's mistakes. And passing the buck won't solve anything but agitate for more restriction of individual liberties and possibly provoke unnecessary conflicts.

Why Dubai’s Debt Crisis Isn’t Likely THE Next Lehman

``In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better.” Murray N. Rothbard Economic Depressions: Their Cause and Cure

The unraveling of the Dubai debt crisis during the US Thanksgivng holiday may have contributed to the sharp gyrations in the marketplace. The dearth of information speedily led to emotions based speculations. Since there was a paucity of information from the details surrounding the Dubai Debt Crisis, perhaps some investors made decisions or projections anchored on a leash or a chain effect where countries sensitive to leveraged balance sheets will likewise suffer from debt woes.

And perhaps that’s the reason why some selloffs had been broad based (except in parts of Latin America) and not limited to the banking system or to some crisis affected countries.

We even read some even citing the Dubai Crisis as evolving to “Icelandic proportions”.

Figure 3: Bespoke Invest/Bloomberg: Dubai CDS

It’s a folly to trade based on emotions but as we wrote in Dubai Blues As Seen In CDS, It's All About Perception!, we have to look at the bigger picture than react intuitively like our ancestors during the hunter gatherer era in the face of wild predators. Technology has given us the privilege of accessing global information at the touch of our fingertips.

So we basically agree with Bespoke Invest that the recent market carnage seems as a vastly exaggerated reaction, as per Bespoke, ``As shown in the Bloomberg snapshot of Dubai's historical sovereign debt credit default swap price, the recent spike up to 600 bps or so isn't even near the level of 1,000 bps seen earlier this year. Had Dubai's default risk spike earlier this year been an isolated event like it is this time around, it would have made news back then. At the time, however, default risk was spiking for the majority of developed nations as well, so Dubai was the least of our problems. Now that global markets have stabilized and exited crisis mode, an isolated event in Dubai where default risk doesn't even spike to its 2009 highs has caused a global market selloff." (bold highlights mine)

In a rush to drum up a contagion effect, some have even mistakenly, in my view, placed the entire United Arab Emirates at risk!

The United Arab Emirates is a federation of seven emirates, particularly Abu Dhabi, Dubai, Sharjah, Ajman, Umm al-Quwain, Ras al-Khaimah and Fujairah.

Dubai is only the second largest emirate, while the Abu Dhabi serves as the seat of the national government. Abu Dhabi according to Wikipedia.org, ``is also the country's center of political, industrial, and cultural activities.”

Dubai’s meteoric rise via profligate projects produced many of the world’s landmark projects (boondoggles), such as the only seven star hotel, the Burj Al Arab, the world’s tallest skyscraper, Burj Dubai (uncompleted), biggest indoor ski slope, Ski Dubai, largest shopping mall (in terms of total area and not gross leasable space), the Dubai Mall, the world’s biggest theme park, the Dubailand and the Palm Islands, the Palm Jumeirah, has virtually challenged Abu Dhabi’s role.

Figure 4: McKinsey Quarterly: The New Power Brokers

To consider that Abu Dhabi has still the world’s largest sovereign wealth fund estimated at $470-740 billion as shown in Figure 4, despite suffering an estimated $125 billion of losses last year due to the contagion effect from the US mortgage crisis (Bloomberg).

Meanwhile the debt burden accrued by Dubai World, Dubai’s investment arm, is estimated by UBS AG to be in the range of $80-90 billion, which includes its property arm unit, the Nakheel PJSC, which has some $3.52 billion of Islamic bonds due Dec. 14. (Bloomberg)

This means that Abu Dhabi could easily extend a bailout if it so desires, without necessarily roiling the markets. But it didn’t. Although we understand that some Abu Dhabi banks already have loan exposures estimated at $5 billion to Dubai prior to the Dubai Crisis (Reuters).

The point is, this may not necessarily be confined to an economic “debt problem” spectrum but to one with a political face. Perhaps Abu Dhabi desires to impose some sort of discipline or temper Dubai’s spendthrift ways or politically revert Dubai to her role as supporting cast.

So a contagion risk is not necessarily in place.

Second, it would be another mistake to argue that the Dubai Debt Crisis is outside the jurisdiction of the major central banks.

The fact that the biggest underwriter of loans to Dubai World is the Royal Bank of Scotland Group, which according to Bloomberg, ``RBS, the largest U.K. government-controlled bank, arranged $2.3 billion, or 17 percent, of Dubai World loans since January 2007, JPMorgan said in a report today, citing Dealogic data. HSBC, Europe’s biggest bank, has the “largest absolute exposure” in the U.A.E. with $17 billion of loans in 2008, JPMorgan said, citing the Emirates Banks Association”, means that major central banks have direct and indirect influence on Dubai’s credit predicament.

As Bob Eisenbeis of Cumberland Advisors rightly explains, ``US financial institutions are not exposed to Dubai to the significant extent that European institutions are. Furthermore, discount-window and other borrowing facilities are already in place, should liquidity be needed.” (bold emphasis mine)

This means that existing currency swap arrangements can also be used, aside from extending the Quantitative Easing programs to cover problematic assets or loans held by HSBC or RBS or other banks exposed to Dubai.

Moreover, even if we incorporate all estimated Western banking system’s loan books of UAE they appear to be manageable.

Figure 5: Danske Bank: Western Banks Exposure to UAE as of 2008

To quote Danske Bank, ``Although some UK banks have exposure to UAE (Dubai is only one of seven emirates) it is not material in our view…As can be seen the exposure to the region is fairly limited. Furthermore, it should be stressed that so far we are only talking about one (big) company. Still, it is a factor to watch out for in case the problems are more widespread than they appear. Remember, back in 2007 virtually everybody agreed that subprime mortgage loans were a manageable and limited problem. So some caution is warranted.”

Indeed.

Bottom line: The Dubai Debt Crisis doesn’t necessarily imply a contagion risk. That’s because the crisis appears to have a national political twist, since Abu Dhabi alone could have reticently mounted a rescue considering its immense forex holdings in its SWF-the largest in the world.

Besides, global central banks have the means to deploy their “inflationary” tools to “rescue” anew national banks exposed to potential bad loans in Dubai. European and Abu Dhabi banks have the most risk exposure to Dubai.

And this is exactly why inflation is a future risk because of mainstream central banker’s fundamental fear of a deflation triggered global banking meltdown. Hence, we should expect some Dubai related globally coordinated policy actions in the coming days or weeks.

Furthermore, the western banking system has relatively minute exposure to the UAE which isn’t likely to further dent on their beleaguered balance sheets.

What needs to be seen is if other nations suffering from similar debt pressures may surface and do a Dubai.

Otherwise, the Dubai tempest will likely signify as a short term bump or a bear raid amidst an inflationary recess.

The Lost Decade: US Edition

Mr. Floyd Norris of the New York Times gives us a good account of how US stocks have fared in a relative sense compared to emerging markets and commodities over the past decade or so...


According to Mr. Norris, (all bold highlight mine) ``THE American stock market has soared 64 percent since it hit bottom eight months ago.

``And that leaves it just where it was more than 11 years ago.

``The United States stock market was the world leader in the great bull market of the late 1990s, but more recently it has been a laggard, in large part because of the weakness of the dollar. As the accompanying charts show, a stock investor looking for a part of the world to invest in back in 1998 — and to hold onto until now — could not have done worse than to choose the United States.

``The charts show the movement of the Standard &Poor’s 500 and the S.& P. International 700 in the period since the American index first reached 1,100 on March 24, 1998. The International 700, which encompasses the non-American stocks in the S.& P. Global 1,200, rose much faster in the middle of this decade, then fell faster in the global recession. But since prices bottomed, it has leaped more than 80 percent.

``For the entire period, an investor was better off in emerging markets than in the developed world. The segments of the global index representing Latin America, Australia and emerging Asian countries have soared. The Canadian index also more than doubled, thanks largely to natural resources stocks.

``But prices, as measured in local currencies, are lower now than in 1998 for both the S.& P. Europe 350 and the S.& P./Topix 150, covering Japan. Measured in American dollars, as shown in the charts, those markets posted gains of 20 percent and 7 percent, respectively, because of currency movements.

``On a sector basis, the best place to be over that period, both in the United States and globally, was in energy stocks. Oil prices fell to just above $10 a barrel in late 1998, and few investors saw value in the area. More recently, oil company profits set records as crude soared well above $100 a barrel, and even after the global downturn the price is more than $70.

``Financial stocks have suffered more in the United States than in the rest of the world, but the credit crisis brought down many banks in other regions as well.

``The charts also show 15 well-known companies from around the globe whose share prices are at least 300 percent higher than they were in 1998, and 15 such companies whose prices are less than half what they were then."

Additional comments:

-the return of the S & P 500 to the 1,100 level established 11 years ago implies that the US stocks have been in a bear market. It resembles Japan's lost decade-the American Edition.

This means that investors have largely lost than profited from stock investment.

-losses in the US markets do not account for real or inflation adjusted returns. According to the inflation calculator of the Bls.gov the US dollar has lost 25% of its purchasing power since 1998.This implies that US stocks have yet to recoup the real inflation adjusted levels in spite of the S&P reclaiming the 1,100.

-commodities and emerging markets have been clear outstanding winners.


-the Dow Jones have essentially reflected on the inflation of the US dollar, which have lost 75% in relative terms against gold.

This essentially debunks objections that gold is a lousy investment because it has no income. Chart courtesy of Reuters

-the US dollar isn't the primary source of the 'stagnation' of US stocks but instead reflects on bubble policies imposed by the US government. The US dollar serves only as a market outlet or a manifestation of such imprudent policies.

-This also shows that bubble policies have temporary benefits and don't work or prolongs investor agony over the long run, yet government officials are addicted to them.

-In addition, this also implies that the current policy directives to devalue the US dollar aimed at propping up the banking system and to reduce real liabilities means a wealth transfer and further outperformance of commodities and emerging markets relative to the US.

Rediscovering Gold’s Monetary Appeal

``Gold is a speculation. But it is a speculation on a certainty: the debasement of the currency.”-James Grant

For some rising gold prices has been gladly cheered upon. For the gold is “barbaric metal” camp, rising gold prices account for as an intense denial to the vulnerability of their interventionist doctrines.

For us, rising gold prices epitomizes a build up of monetary systemic stresses arising from an overdose of politicization of the US dollar- the world’s de facto substitute to the gold standard. This warrants more concern than either acclamation or denial.

The world has been operating on a monetary system that has been anchored on paper money since 1971 or 38 years ago, yet for the thousands of years of human civilization, paper money has unsuccessfully thrived as the sustained standard of global medium of exchange. This has been due to the cyclical or inherent self serving nature of the political leadership to profit from inflation or by taxing society in order to uphold, expand or preserve their political powers.

Even commodity money had not been spared from the inflation taxation. This has been evident even during the Roman Empire, as Joseph Peden wrote ``In Diocletian's time, in the year 301, he fixed the price at 50,000 denarii for one pound of gold. Ten years later it had risen to 120,000. In 324, 23 years after it was 50,000, it was now 300,000. In 337, the year of Constantine's death, a pound of gold brought 20,000,000 denarii.”

And the same dynamics holds true today.

Essentially, the politicized nature of money eventually leads to its demise.

Inflation Is Dead. Long Live Inflation!

Gold have been rising for many valid cited reasons such as an inflation hedge (see Figure 4), supply demand imbalances, the shifting nature of gold ownership (as investment instead of jewelry), or central bank buying or reduced sales [see Four Reasons Why ‘Fear’ In Gold Prices Is A Fallacy]

Figure 4: US Global Funds: India-IMF Deal: Tipping Point for Gold

Gold’s record price surge appears to have resurrected its innate monetary appeal.

Over the years, gold had earlier been reckoned as headed for oblivion, as the political authorities along with their banking agents, whom are their chief associates, as well as their academic disciples imbibed on the fantasy that “inflation as an elixir” have allowed them to finally “domesticate” and “tame” inflation with modern and sophisticated mathematical tools.

In essence, the supposed conquest of inflation became a mainstream credo which operated under the principle of the philosopher’s stone- or the alchemy of turning base metals into gold! Prosperity can, thus, simply be achieved by Free Lunch policies! And supporting such beliefs were literatures that sprouted to claim the death of inflation!

Unfortunately today, reality has begun to sink in. To add, such bubble psychology has also commenced to unravel over the imbalances built beneath the surface by overweening overconfidence. Hence, the ramifications from the previous sins have started to emerge and become manifest in the marketplace. All these are being reflected in terms of changes in price levels.

The Role Of Scarcity In The US Dollar’s Diminishing Luster

So why gold’s role as money being revived?

Because the very important fundamental attribute of money is in the process of being perverted.

The basic and most important attribute of money according to Mr. Ludwig von Mises is scarcity, ``Media of exchange are economic goods. They are scarce; there is a demand for them. There are on the market people who desire to acquire them and are ready to exchange goods and services against them. Media of exchange have value in exchange. People make sacrifices for their acquisition; they pay "prices" for them. The peculiarity of these prices lies merely in the fact that they cannot be expressed in terms of money. In reference to the vendible goods and services we speak of prices or of money prices. In reference to money we speak of its purchasing power with regard to various vendible goods.”

When money fails to dispense of its role, then the public begins to question its existence and look into alternatives. The ruckus to replace the US dollar by key emerging market central banks reflect on these symptoms.

So it is of no doubt to us that commodities (particularly precious metals) will likely benefit from the uncertainty interregnum as the world continues to deal with the burgeoning tensions from the US dollar system.

Figure 5: stockcharts.com: Commodities versus the US dollar Index

Said differently, for as long as society hasn’t resolved on the dilemma of, or found a substitute for, the prevailing money (US dollar) system, these commodities will exhibit their innate roles as potential candidates as money, for the basic reasons of scarcity and their historical role as money.

As Professor Gary North wrote, ``Individuals in the past voluntarily adopted gold and silver coins as the preferred commodities to facilitate economic exchange. They did not accept these two metals as the preferred monetary units because of their commitment to economic theory. They chose those metals because there are advantages offered by these metals that competing commodities do not possess to the same degree. The main advantage is continuity of value (price) over time. Gold and silver became currencies throughout the world because they possess certain physical characteristics that facilitate their adoption as money. The most important aspect of both gold and silver is that they must be mined. It is expensive to dig these metals out of the ground. Silver is primarily a byproduct of the mining of other metals: lead, copper, and zinc. Mining firms must bear the costs of extracting these metals from the earth. This limits the production of these metals. They are comparatively scarce minerals, and it is expensive to dig them out of the ground.” (bold highlights mine)

Ergo, the pricing levels will exhibit on the relationship of precious metals’ role as money.

Does India’s Recent Gold Buy Herald A Watershed Moment?

In addition, India’s recent surprise acquisition of 50% of IMF’s inventory of gold for sale establishes two important points:

One, emerging markets appear to be intrepidly exhibiting a snowballing desire to accumulate less US dollars reserves and also less US denominated securities and channel most of their spare reserves into hard assets. It’s basically a vote against the US dollar.

This reinforces our “commodity-as-insurance” view and the potential role of commodity as part of the future money. According to Professor Michael S. Rozeff, ``There are only two kinds of solutions: inflationary and non-inflationary. A British pound as good as gold is long gone. A U.S. dollar as good as gold is long gone, but the dollar has hung on for 37 years now. A yuan as good as gold does not exist. A basket of currencies as good as gold does not exist. The inflatable dollar and inflatable currencies are ruling the roost at present. India’s action and some of China’s actions signal that they are inching – really groping – their way back to hard assets and a non-inflationary solution.”

Second, India’s gold purchases could be indicative of a monumental redistribution process or of a convergence of wealth between developed economies and emerging economies.

This quote from the Financial Times echoes such sentiment, ``Pranab Mukherjee, India’s finance minister, said the acquisition reflected the power of an economy that laid claim to the fifth-largest global foreign reserves: “We have money to buy gold. We have enough foreign exchange reserves.”

``He contrasted India’s strength with weakness elsewhere: “Europe collapsed and North America collapsed.” (bold emphasis mine)

Hence, India’s purchase of IMF’s gold could be interpreted as a watershed moment or a tipping point as this could mark the decline or the twilight zone of the US dollar as the international currency reserve.

Also, we’ve been asked if Gold at present levels is a buy today. While we have been serendipitous enough to have accurately called for a gold breakout last August [see Gold As Our Seasonal Barometer], market timing isn’t our forte.

Seen from seasonality patterns, gold usually peaks on February and will be on a downhill until August.

But it isn’t clear if such pattern will hold.

This would likely depend on how global central banks and global investors will react to recent fresh unprecedented developments.

As we have said, markets have been acting significantly less to exhibit the conventional mode. Instead, markets have demonstrated its unorthodoxy due to its Frankenstein state-being highly dependent on government steroids.

Figure 6: US Global Funds: India-IMF Deal: Tipping Point for Gold

And as figure 6 suggests, any bandwagon effect from India’s purchases could inflame a stampede for Gold!

With emerging markets holding the bulk of global currency reserves, ``IMF data shows emerging and developing economies hold USD 4.2 trillion of the USD 6.8 trillion in total reserves. China has over USD 2 trillion, followed by Russia with more than USD 400 billion and Brazil and India with above USD 200 billion each” (moneycontrol.com), and aside from central banks of emerging markets being vastly underrepresented in gold reserves relative to the US or Europe, a mad dash for gold can’t be discounted.

And we are not speaking of central bank alone, Adrian Ash of BullionVault.com recently estimated the gold market, ``Estimated at 165,000 tonnes, the total stock of gold-above-ground is now worth some $5.8 trillion. Research by BullionVault puts that sum at no more than 6% of global investable wealth, down from well over 10% throughout the 1980s and peaking nearing 30% at the points of extreme investor stress in the late 1970s and early '30s.”

Conclusion and Recommendation

To close, gold’s recent record run appears to have dramatically signaled a seismic change in the perspective of the marketplace and of governments in terms of gold’s role as money.

As strains or pressures on the US dollar standard remains unsettled, such uncertainty is likely to underpin the dynamics behind gold’s rise.

Rising gold prices represents global monetary stress than simple localized “inflation”. Moreover, because monetary stress is a structural issue, then it won’t just be central banks underpinning gold’s ascent but likewise the investing public, which accounts for a bigger share of ammunition, in the context of wealth preservation.

Moreover, the accumulation of gold by emerging markets signal wealth convergence aside from the watershed decline of the US dollar as the world’s reserve currency.

Since gold’s dynamics has been evolving from jewelry to investment and or central bank reserve demand, it would be futile to short term timing markets. The best is to buy on dips and await gold’s full transition of its bullmarket trend into the mainstream.

On the interim, the politicization of the monetary and fiscal policies will likely exacerbate the US dollar predicament. And as political faux pas compounds, gold’s functional role of money will likely expand.

Nevertheless, the end of the gold bullmarket will entail the resolution of the US dollar’s foreign currency reserve predicament, which is unlikely to happen soon. That’s because domestic politics and geopolitical issues serve as principal hurdles.

Central Bank Policies: Action Speaks Louder Than Words, The Fallacies of US Dollar Carry Bubble

``The cause of waves of unemployment is not “capitalism” but governments denying enterprises the right to produce good money”-Friedrich August von Hayek

In last week’s outlook [5 Reasons Why The Recent Market Slump Is Not What Mainstream Expects], we proposed that the recent market volatility had most likely been a government mounted attempt to put a rein on “animal spirits” having gone berserk. We also posited that markets, having been overstretched, may have likely reached a snap back point or analogous to the breakage of the crosslinks elasticity as seen in the dynamics of a Rubber band.

In short, we argued that the recent downside volatility could have embodied a “bear trap”- a bearish signal that turns out to be false or a trap.

Market performance, this week, appears to have validated us anew. While short term direction is less of a concern to us as markets can go or gyrate bi-directionally, what matters most is the strategic context of the risk-reward or market analytical framework fused with a tactical approach in portfolio management.

And strategical analysis should consist of objective interpretations of all available facts, underpinned by appropriate definitions and realistically functional theories, and not the selective collection of facts (data mining) that are designed to fit (usually ideological) biases and stamped as “analysis”.

And from this standpoint, we argued that government’s present pronouncements, which recently spooked markets, will eventually be unmasked in the face of grinding realities from the cumulative and prospective political actions and from the prevailing economic and financial conditions.

As we previously said, ``So the Fed’s communiqué and the real risks appear to be antithetical. One will be proven wrong very soon.”

It would seem that this vindication partly happened so soon.

Policy Statements And Actions Diverge

The Fed declared last October 29^th, the end of its Treasury purchase program, ``The Federal Reserve completed its $300 billion Treasury purchase program today amid signs the seven-month buying spree helped stabilize the housing market and limited increases in borrowing costs” (Bloomberg).

I don’t know what the Federal Reserve’s definition of today is, but to my understanding the self-imposed limits of $300 billion and October 2009 has been met yet the Treasury purchase program seems ongoing (see Figure 1).

Figure 1: Federal Reserve of Cleveland: Credit Easing Policy Tools

The Federal Reserve bought nearly $2.8 billion of US treasuries by November 4^th!

So if there is any short term validation, it is that the political actions of the US government have been to continually undertake quantitative easing or further inflationary activities regardless of its official pronouncements.

This only validates our postulation that the US banking system represents as the first order of priority among the many issues of concern by the incumbent US political and non-political leadership. Hence, the massive redistribution of wealth from the real economy to the financial sector and the corollary of accruing of structural imbalances in the pursuit of immediate resolution from short term oriented policies.

The same goes with the Bank of England, which recently declared a continuation of its own version of quantitative easing but at a “slower” pace (Telegraph).

Moreover one shouldn’t forget that equities have also been qualified as an eligible collateral as part of the TARP program.

To quote Mr. Practical of Minyanville (bold highlights mine), ``Under TARP, the fine print allows dealers to REPO stocks to the Fed as collateral (holy cow is right).

``What if there were an arrangement where large dealers buy stocks and stock futures through the day and REPO them to the Fed at the high closing prices? The dealer would book the profits derived from the difference at no risk.

``If you look at the trading patterns of the largest dealers, one in particular lost money trading in only one day last quarter. Statistically that's like finding a needle at the bottom of the ocean.”

What this implies is that the TARP program could be one of the many instruments used to prop up the equity markets.

As we have long been argued, markets today don’t act on the norm or as “traditional” forward indicators, which has essentially flummoxed the mainstream, but as policy instruments engineered primarily to keep the banking system afloat and secondarily to manage the “animal spirits” in order to jumpstart the economy.

As we noted last week, ``The underlying fundamental malaise is that the ‘bank as trader model’ has been a product of the collusion between the banking system and the US government to inflate the economy to the benefit of the elite bankers!”

So if market response this week appears favorable, that’s basically because money isn’t neutral- or money from these governments actions have filtered into equity and commodity assets-regardless of what has been happening in the real economy.

The Fallacies Of The US dollar As The Mother Of All Bubbles

This similarly shows that the allegations that the US dollar carry trade is now the “mother of bubble” isn’t generally true.

That’s because it hasn’t been the carry trade, but direct government liability accumulation via the quantitative easing aside from other government programs designed to reinforce the banking system that has kept the global financial markets at hyper-animated conditions.

Moreover, we take on the cudgels for investment guru Jim Rogers, in his debate with celebrity guru Mr. Roubini over the latter’s thesis that the US dollar signifies as the “Mother of ALL Bubbles” [see Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble].

We argue that the fundamental premise behind the falling US dollar hasn’t been the arbitrage leverage amassing within the private sector financial system especially in the US, which continues to reel from the lackadaisical credit growth amidst signs of surging reserves, but from global governments’ balance sheets.

Mr. Roubini oversimplistically attaches every asset class to the currency leverage, which he extrapolates as having an inverse direct causal relationship: a prospective bust in global assets as a result of delevaraging which should propel for massive rebound in the US dollar. This view has been anchored on (anchoring bias) virtually the same dynamics which made his celebrity “rock and roll star” status during the 2008 meltdown-(letting go of a success identity seems so hard to do!)

Moreover, the surge in commodity prices hasn’t just been a private sector dynamic, instead emerging market governments have played a pivotal role in the elevated state of commodity prices.

India’s recent surprise $6.7 billion purchase of half IMF’s gold’s reserves for sale serve as a major proof.

Figure 2: US Global Investors: China’s Impact On Metals

As one can observe in Figure 2, Chinese imports of metals and steel have exploded!

In addition, in 2009 China’s predominantly state owned enterprises has acquired $21.9 billion of privately owned resourced based companies (80% of which have been oil or energy while 20% have been in metals). Three more acquisitions are still in the process- Nigeria (offshore oil fields), Russia (stake at UC Rusal) and Norway’s Statoil (20 of the 451 drilling leases) [World Bank].

Emerging markets governments’ acquisition of commodities hasn’t entirely been for economic and monetary interests, but likewise has geopolitical dimensions into it. In short, the incentives that drives governments are likely political more than economical.

So it would be plain naïve to lump private sector speculation with government purchases and make a generalized conclusion based on unfounded one size fits all hypothesis.

I would like to further add that the degree of state buying advances our view that markets have been severely distorted by government interventions.

Moreover, unless one views the world as falling into an abyss from globalized deflation (which seems as a near impossibility given the fundamental nature of the paper money standard from today’s central banking and the diversified capital structure of each nation), today’s risk takers including that of governments/ government enterprises seem widely apprised of the risks from high inflation and the accompanying high interest rate regime, which could destabilize or cause heightened volatility in such arbitrages.

These have been evident from

-the numerous and growing clamor (including the United Nations) to replace the US dollar as reserve currency possibly with the Special Drawing Rights-SDR (a controversial rumor was recently publicized by the Independent which alleged that several key emerging markets and developed economies could have been attempting to a form coalition to conduct trade in oil in a basket of currencies outside the US dollar),

-increasing arrangements to conduct bilateral trade away from the US dollar (Argentina-Brazil, Russia-China, a Latin American Bloc),

-expanded currency swap arrangements in Asia, and

-importantly the proposed expanded use of the Chinese remimbi or the Yuan as the ASEAN’s currency standard [see The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency].

Ergo, the accumulation of commodities by emerging markets could function as an insurance against currency volatility, in view of a heightened inflationary environment, as consequence to spendthrift and reckless US national policies that could incite systemic global instability. Effectively, this demolishes the core premise of the “US dollar carry trade mother of all bubble”.

True, there are maybe some parts of the marketplace that has engaged in the carry trade but the overall climate departs from the 2008 environment depicted upon by Mr. Roubini.

``A fiat-money inflation can be carried on only as long as the masses do not become aware of the fact that the government is committed to such a policy. Once the common man finds out that the quantity of circulating money will be increased more and more, and that consequently its purchasing power will continually drop and prices will rise to ever higher peaks, he begins to realize that the money in his pocket is melting away. Then he adopts the conduct previously practiced only by those smeared as profiteers; he "flees into real values." He buys commodities, not for the sake of enjoying them, but in order to avoid the losses involved in holding cash. The knell of the inflated monetary system sounds” admonished Ludwig von Mises. (bold underscore mine)

Put differently, as the public loses trust of the functionality of the prevailing money standard they either look for substitute/s (in the past-resort to barter or a foreign currency-but in this case a new currency standard) or a return to basics…commodities.

Fancy But Unrealistic Models

Of course, one can’t help but point out on the foibles of the highly mechanical traits of analyzing markets from presumptive models utilized by the mainstream that frequently leads to severe misdiagnosis and the subsequent maligned therapeutical prescriptions or perversely flawed actions in managing a portfolio.

Figure 3: Wall Street Journal: U.S. Factories Are ‘Grossly Underutilized’

Low capacity utilization is one of the most frequently used justifications by the mainstream to argue for “low” inflation which is blamed on the deficiency in demand as responsible for “idle” resources. The fundamentally flawed premise of mainstream’s concept of inflation is due to its definition-inflation is seen as rising prices instead of as emanating from money supply growth. Secondly, capacity is viewed in the context where capital is homogeneous.

In the Wall Street Journal article we note of such differences (bold highlights mine),

``Looking beyond the headline number points to another sobering reality: Some industries were hit much harder than others — and therefore have further to go to get back to more normal utilization. Capacity utilization in primary metals plunged from 86% in December 2007 to 55% currently, mainly because of collapsing demand for some types of steel, while the utilization rate in the computer and peripherals industry fell to 58%, down from 83% in December 2007.

``Each industry got hammered by its own mix of headwinds. Computer sales suffered as businesses postponed information technology upgrades and laid off white-collar workers, while makers of big ticket items such as furniture and cars suffered because consumer financing dried up even for those still eager to buy.

``Only a few industries avoided going off the cliff. Capacity usage in the petroleum refining and coal industries fell only 1 percentage point over the last 21 months, while in the food industry, usage declined only 2 percentage points.”

The performances of capacity utilization vary across industries. This extrapolates that the current monetary policies will likely influence relative “overinvestment/s” on specificity basis on a relative circumstances or that over investments will happen in some areas more than the others.

For instance, the implosion of the dot.com bubble in 2000 didn’t put a check on the 2003-2007 US housing bubble cycle from inflating. Moreover, in the recent case of Iceland, both rising unemployment and falling output didn’t forestall inflation, which had been a consequence of the currency’s or the krona’s devaluation [see Iceland's Devaluation Toll: McDonald's].

As Brookesnew’s Gerard Jackson explains, ``Sufficient monetary growth reduces excess capacity by raising the value of the product relative to production costs. (It should be noted that this does not always mean a general increase in prices). However, where inflation is already a force and there is a great deal misallocated capital then a loose monetary policy can bring about accelerating inflation before full operating capacity has been reached and full employment restored.”

Not to mention that the massive interventions put forth by the US Federal Reserve on the banking system combined with fiscal policies aimed at propping up select industries at the expense of the rest of society or as Mr. Jackson avers, ``inflation is already a force and there is a great deal misallocated capital then a loose monetary policy can bring about accelerating inflation”, ergo, the seeds of inflation has been planted, hence inflation is what we will be harvesting.

It’s just the “degree” of inflation that will likely be debated.

In short, mainstream can’t fathom the prospects of a stagflationary environment (at the very least) because of the continued reliance on popular but fallacious models.

Overall, for as long as global political and bureaucratic authorities continue to mount a massive campaign to fillip their respective economies with reflation steroids, we should expect the “Frankenstein” market to respond accordingly. So far the favorable responses will arise from Asia and emerging markets, until the systemic leverage renders them unsustainable.