Many lessons can be gleaned from history and, while no two periods are identically alike, there are often many similarities to learn from. The current period, for example, is often compared to the Great Depression in regards to unprecedented government action as well as with the 1970s in regards to trends in commodities and inflation. [Let's take a closer look.] Words: 1165

So says Chris Puplava (www.financialsense.com) in an article* which Lorimer Wilson, editor of www.munKNEE.com,  has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Puplava goes on to say: 

Over the years I have often drawn parallels to the 1970s given a similar pattern seen in the stock market and the S&P 500 [and below are two] charts that give you an idea how exceptionally similar the patterns are between then and now:

The S&P 500 – Then and Now

Given the unique nature of how the markets and the dollar played out in the 1970s, I thought it would be useful to see how the rest of the decade similarly performed. When looking at gold and the USD, it does appear we are following the 1970s script, but on a more accelerated pace. Most of this is well owed to the double rounds of money printing or QE a-la Helicopter Ben to save the economy, a program that didn’t exist back then.

The USD vs.Gold and S&P 500 – Then and Now

Shown below is the USD Index for the current period on the top panel and then the USD Index, gold, and the S&P 500 from 1972-1980. As you can see in the first two panels, the USD Index in the present time is tracing out a similar pattern to the later 1970s. In the 1970s the USD bottomed in 1973 and then again two years later in 1975. After the 1975 bounce the USD Index held up relatively well until it peaked in 1976 and began to slide. It had a brief bounce in 1977 before it began a waterfall decline in which it fell nearly 24% into the 1978 low.

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Once the support line for the USD Index connecting points A-B-C was broken in early 1978, gold went on to rally more than 300% into the 1980′s peak and the S&P 500 rallied nearly 37% into early 1980 and over 60% by late 1980. While the S&P 500 staged an impressive rally in nominal terms, in real terms (inflation-adjusted by the CPI Index) the S&P 500 fell more than 10% heading into 1980 and it gave a false sense of rising wealth creation and prosperity.

Source: Bloomberg

Looking at the figure above, it does appear that the pattern seen in the dollar is repeating the 1970s path and we may be entering the waterfall decline in the greenback that was seen in 1978. If that is the case, then cash is indeed trash and don’t be surprised to see the stock market rally in nominal terms and gold and commodities to jump significantly.

What is also interesting to note from that time is that the USD Index’s sharp sell-off ended in 1978 and gold had a mild pullback before vaulting much higher. After the USD’s initial sharp bounce it essentially traded sideways and gold continued higher unabated.

The USD vs. Interest Rates – Then and Now

While it may seem counterintuitive for gold to rally along with the dollar, there were other factors at work. Given the slide in the USD in 1978 import inflation was building and by the time the USD Index bottomed inflation accelerated and real interest rates turned negative. Some of the strongest returns in gold in the 1970s came when real interest rates were negative as monetary policy (interest rates) fell behind inflationary trends.

This is seen in the figure below which shows in the shaded red period that, while the USD was firming, real interest rates were on a straight path southwards and it wasn’t until both the USD and real interest rates headed higher together (shaded green region) that gold finally peaked and its secular bull market came to an end.

Source: Bloomberg

Fast forwarding to the present time, at 0.77%, real interest rates (10yr UST yield less CPI YOY % Chg) are heading south and not too far off from going negative. Real rates are likely to plunge through the rest of the year given the slide in the USD…

Given our transition from a manufacturing-based economy [back then] to a service-economy [these days] the trends in the USD and import prices [now] show a stronger correlation to inflation rates than to labor costs [as it did back then]… A weak USD makes foreign imports more expensive and the present slide in the USD is going to lead to a spike in import inflation ahead. The year-over-year (YOY) rate of change in the USD Index leads import price inflation by several months and argues for a spike in import inflation north of 4% in the coming months.

Source: Federal Reserve, BLS

The Chinese Renminbi Exchange Rate vs. US Import Inflation

One of the main culprits for rising US import prices is China, given our large trade deficit with them. Shown below is the USD and Chinese Renminbi exchange rate where you can see how periods in which the Renminbi strengthens relative to the USD (black line declines) leads to rising import prices from China. Consequently, the appreciation in the Renminbi since mid 2010 has led to a resurgence in US import inflation. It is the below development that should cause US Congress members to be careful what they wish for in terms of China revaluing their currency.

Source: Bloomberg

Conclusion

With the easy monetary policy and complete lack of recognition by Fed Chairman Bernanke in terms of what the USD is doing to commodities and import prices, we are likely to see the dollar continue to weaken ahead which has resulted in the major 3-year trend line support being broken as it was in the 1970s.

Back then, once support was broken we witnessed gold rally more than 300% and the S&P 500 rally in nominal terms but decline in real terms. The present slide in the USD will lead to higher inflation and thus lower real interest rates which will only be bullish for gold ahead…

Until Ben Bernanke restores the Fed’s credibility in terms of fighting inflation, and until the U.S. government gets serious about its long-term fiscal position, we are likely to see further records set in the USD and gold, in opposite directions.

*http://www.financialsense.com/node/5074

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.
• Sign up to receive every article posted via Twitter, Facebook, RSS Feed or our FREE Weekly Newsletter.

Gold

At present, the governors of the Fed are creating massive distortions in the financial markets with little hope of improving real economic growth or employment… Quantitative easing promises to have little effect except to provoke commodity [gold and silver] hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5- to 10-year total returns below 5% annually). [Let me explain.] Words: 3066

So says John P. Hussman, Ph.D. (www.hussmanfunds.com) in an article* which Lorimer Wilson, editor of www.munKNEE.com, has reformatted and edited [...] below for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Hussman goes on to say:

The Fed is not helping the economy, it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

The “Liquidity Trap” Explained

John Maynard Keynes said in his “The General Theory”, “There is the possibility … that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control.”  Keynes’ contemporary John Hicks explained this “liquidity trap” [as when the] monetary policy transmits its effect on the real economy by way of interest rates. In that view, the loss of monetary control occurs because, at some point, a further reduction of interest rates fails to stimulate additional demand for capital investment.

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Alternatively, monetary policy might transmit its effect on the real economy by directly altering the quantity of funds available to lend. In that view, a liquidity trap would be characterized by the failure of real investment and output to expand in response to increases in the monetary base (currency and reserves).

In either case, the hallmark of a liquidity trap is that holdings of money become “infinitely elastic.” As the monetary base is increased, banks, corporations, and individuals simply choose to hold onto those additional money balances, with no effect on the real economy. The typical Econ 101 chart of this is drawn [below] in terms of “liquidity preference,” that is, desired cash holdings plotted against interest rates. When interest rates are high, people choose to hold less cash because cash doesn’t earn interest. As interest rates decline toward zero (and especially if the Fed chooses to pay banks interest on cash reserves, which is presently the case), there is no effective difference between holding riskless debt securities (say, Treasury bills) and riskless cash balances, so additional cash balances are simply kept idle.

In 1978, MIT economist Nathaniel Mass developed a framework for the liquidity trap based on microeconomic theory – rational decisions made at the level of individual consumers and firms. The economic dynamics resulting from the model he suggested seem strikingly familiar in the context of the recent economic downturn. They offer a useful way to think about the current economic environment and appropriate policy responses that might be taken.

“The theory revolves around a set of forces that for a period of time promote cumulative expansion of capital formation, but eventually lead to overexpansion of capital production capacity and then into a situation where excess capacity strongly counteracts expansionary monetary policies.

“The capital boom followed by depression runs much longer than the usual short-term business cycle, and is powerfully driven by capital investment interactions. The weak impact of monetary stimulus on real activity arises because additional money has little force in stimulating additional capital investment during a period of general overcapacity.

Mass describes the resulting economic dynamics:

“Following the monetary intervention, relatively easy money provides a greater incentive to order capital… But now the overcapacity that characterizes the peak in the production of capital goods reaches an even higher level than without the stimulus. This overcapacity eventually makes further investment even less attractive and causes the decline in capital output to proceed from a higher peak and at a faster pace. Due to persistent excess capital which cannot be reduced as fast as labor can be cut back to alleviate excess production, unemployment actually remains higher on the average following the drop in production.”

In what reads today as a further warning against Bernanke-style quantitative easing, Mass observed:

“Even aggressive monetary intervention can do little to correct excess capital… Once excess capacity develops, the forces that previously led to aggressive expansion are almost played out. Efforts to prolong high investment can produce even more excess capital and lead to a more pronounced readjustment later.”

Mass concluded his 1978 paper with an observation from economist Robert Gordon:

“Why was the recovery of the 1930′s so slow and halting in the United States, and why did it stop so far short of full employment? We have seen that the trouble lay primarily in the lack of inducement to invest. Even with abnormally low interest rates, the economy was unable to generate a volume of investment high enough to raise aggregate demand to the full employment level.”

[What held true then certainly seems to hold true today!]

Effect of “Monetary Velocity” on GDP

A related way to think about a liquidity trap is in terms of monetary velocity i.e. nominal GDP divided by the monetary base. (The identity, which is true by definition, is M * V = P * Y – the monetary base times velocity is equal to the price level times real output).

Velocity is just the dollar value of GDP that the economy produces per dollar of monetary base. You can also think of velocity as the number of times that one dollar “turns over” each year to purchase goods and services in the economy. Rising velocity implies that money is “turning over” more rapidly, so that nominal GDP is increasing faster than the stock of money. If velocity rises, holding the quantity of money constant, you’ll observe either growth in real output or inflation. Falling velocity implies that a given stock of money is being hoarded, so that nominal GDP is growing slower than the stock of money. If velocity falls, holding the quantity of money constant, you’ll observe either a decline in real GDP or deflation.

The belief that an increase in the money supply will result in an increase in GDP relies on the assumption that velocity will not decline in proportion to the increase in money. Unfortunately for the proponents of “quantitative easing,” this assumption fails spectacularly in the data – both in the U.S. and internationally – particularly at a zero interest rate.

How to Spot a Liquidity Trap

The chart below plots the velocity of the U.S. monetary base against interest rates since 1947. Since high money holdings correspond to low velocity, the graph is simply the mirror image of the theoretical chart above.

Few theoretical relationships in economics hold quite this well. Recall that a Keynesian liquidity trap occurs at the point when interest rates become so low that cash balances are passively held regardless of their size. The relationship between interest rates and velocity therefore goes flat at low interest rates, since increases in the money stock simply produce a proportional decline in velocity, without requiring any further decline in yields. Notice the cluster of observations where the interest rate is zero. Those are the most recent data points.

Effect of QE on “Risk Premiums”

One might argue that while short-term interest rates are essentially zero, long-term interest rates are not, which might leave some room for a “Hicksian” effect from QE – that is, a boost to investment and economic activity in response to a further decline in long-term interest rates. The problem here is that longer-term interest rates, in an expectations sense, are already essentially at zero. The remaining yield on longer-term bonds is a [maturity] risk premium that is commensurate with U.S. interest-rate volatility (Japanese risk premiums are lower, but they also have nearly zero interest-rate variability). So QE at this point represents little but an effort to drive [maturity] risk premiums to levels that are inadequate to compensate investors for risk. This is unlikely to go well. Moreover, as noted below, the precise level of long-term interest rates is not the main constraint on borrowing here. The key issues are the rational desire to reduce debt loads, and the inadequacy of profitable investment opportunities in an economy flooded with excess capacity.

Effect of “Money Supply” on Economy

One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers).

Likewise, real economic growth has no observable correlation with growth in the monetary base (the correlation is actually slightly negative but insignificant). Rather, economic growth is the result of hundreds of millions of individual decision-makers, each acting in their best interests to shift their consumption plans, saving, and investment in response to desirable opportunities that they face. Their behavior cannot simply be induced by changes in the money supply or in interest rates, absent those desirable opportunities.

You can see why monetary-base manipulations have so little effect on GDP by examining U.S. data since 1947. Expand the quantity of base money, and it turns out that velocity falls in nearly direct proportion. The cluster of points at the bottom right reflect the most recent data.

(Geek’s Note: The slope of the relationship plotted above is approximately -1, while the Y intercept is just over 6%, which makes sense, and reflects the long-term growth of nominal GDP, virtually independent of variations in the monetary base. For example, 6% growth in nominal GDP is consistent with 0% M and 6% V, 5% M and 1% V, 10% M and -4% V, etc. There is somewhat more scatter in 3-year, 2-year and 1-year charts, but it is random scatter. If expansions in base money were correlated with predictably higher GDP growth, and contractions in base money were correlated with predictably lower GDP growth, the slope of the line would be flatter and the fit would still be reasonably good. We don’t observe this.)

Japanese Experience Shows QE Does Not Work

Just to drive the point home, the chart below presents the same historical relationship in Japanese data over the past two decades. One wonders why anyone expects quantitative easing in the U.S. to be any less futile than it was in Japan.

The Real Effect of “Quantitative Easing” on the Economy

Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short-term interest rates. Once short-term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity.

I should emphasize that the Federal Reserve does have an essential role in providing liquidity during periods of crisis, such as bank runs, when people are rapidly converting bank deposits into currency. Undoubtedly, we would have preferred the Fed to have provided that liquidity in recent years through open-market operations using Treasury securities, rather than outright purchases of the debt securities of insolvent financial institutions, which the public is now on the hook to make whole. The Fed should not be in the insolvency bailout game. Outside of open-market operations using Treasuries, Fed loans during a crisis should be exactly that, loans – and preferably following Bagehot’s Rule (“lend freely but at a high rate of interest”). Moreover, those loans must be senior to any obligation to bank bondholders – the public’s claim should precede private claims. In any event, when liquidity constraints are truly binding, the Fed has an essential function in the economy.

At present, however, the governors of the Fed are creating massive distortions in the financial markets with little hope of improving real economic growth or employment. There is no question that the Fed has the ability to affect the supply of base money, and can affect the level of long-term interest rates, given a sufficient volume of intervention. The real issue is that neither of these factors is currently imposing a binding constraint on economic growth, so there is no benefit in relaxing them further. The Fed is pushing on a string.

The Fed Does Not Appreciate That They Do Not Have Total Control of the Economy

Certain economic equations and regularities make it tempting to assume that there are simple cause-effect relationships that would allow a policy maker to directly manipulate prices and output. While the Fed can control the monetary base, the behavior of prices and output is based on a whole range of factors outside of the Fed’s control. Except at the shortest maturities, interest rates are also a function of factors well beyond monetary policy.

Analysts and even policy makers often ignore equilibrium, preferring to think only in terms of demand, or only in terms of supply. For example, it is widely believed that lower real interest rates will result in higher economic growth but, in fact, the historical correlation between real interest rates and GDP growth has been positive [and,] on balance, higher real interest rates are associated with higher economic growth over the following year. This is because higher rates reflect strong demand for loans and an abundance of desirable investment projects. Of course, nobody would propose a policy of raising real interest rates to stimulate economic activity, because they would recognize that higher real interest rates were an effect of strong loan demand, and could not be used to cause it. Yet despite the fact that loan demand is weak at present, due to the lack of desirable investment projects and the desire to reduce debt loads (which has in turn contributed to keeping interest rates low), the Fed seems to believe that it can eliminate these problems simply by depressing interest rates further. (Memo to Ben Bernanke: Loan demand is inelastic here, and for good reason. Whatever happened to thinking in terms of equilibrium?) Neither economic growth nor the demand for loans is a simple function of interest rates. If consumers wish to reduce their debt, and companies do not have a desirable menu of potential investments, there is little benefit in reducing interest rates by another percentage point, because the precise cost of borrowing is not the issue.

The current thinking by the FOMC seems to treat individual economic actors as little, unthinking toy blocks that can be moved into the desired positions at will. Instead, our policy makers should be carefully examining the constraints and interests that are important to people, and act in a way that responsibly addresses those constraints. A good example of this “toy block” thinking is the notion of forcing individuals to spend more and save less by increasing people’s expectations about inflation (which would drive real interest rates to negative levels).

Effect of Low Nominal Interest Rates on Price of Gold and Silver

If one examines economic history, one quickly discovers that just as lower nominal interest rates are associated with lower monetary velocity, negative real interest rates are associated with lower velocity of commodities (hoarding). Look at the price of gold since 1975. When real interest rates have been negative (even simply measured as the 3-month Treasury bill yield minus trailing annual CPI inflation), gold prices have appreciated at a 20.7% annual rate. In contrast, when real interest rates have been positive, gold has appreciated at just 2.1% annually. [Please refer to this article for further commentary on interest rates and the price of gold.] The tendency toward commodity hoarding is particularly strong when economic conditions are very weak and desirable options for real investment are not available. When real interest rates have been negative and the Purchasing Managers Index has been below 50, the XAU gold index has appreciated at an 85.7% annual rate, compared with a rate of just 0.1% when neither has been true. [See this article for a more detailed explanation of this analysis.] Despite these tendencies, investors should be aware that the volatility of gold stocks can often be intolerable, so finer methods of analysis are also essential.

Conclusion

Quantitative easing promises to have little effect except to provoke:

1. commodity hoarding,

2. a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and

3. an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5- to 10-year total returns below 5% annually).

The Fed is not helping the economy, it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

*http://news.goldseek.com/MillenniumWaveAdvisors/1289145600.php

A recent research paper* by the Bank for International Settlements, entitled “The Future of Public Debt: Prospects and Implications” paints a terrifying prospect for the inhabitants of most of the developed world with deficits spiralling out of control for every western industrialized country under study and inflation a foregone conclusion as a result. Words: 1128

In further edited excerpts from the original article** Cam Hui (www.humblestudentofthemarkets.blogspot.com/) goes on to say:

Deficits to Persist – Regardless
What is more depressing about this study is that, regardless of the level of budget cuts (with or without cuts to promises made about entitlement programs), debt to GDP continues to skyrocket for the major industrialized countries of Japan, UK and US and what is even MORE worrying is the fact that, as the report states:

“Most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery.”

Inflation is Coming – Regardless
The authors then conclude that all roads seem to lead to inflation and a tight monetary policy cannot prevent its resurgence, saying:

“When the public reaches its limit and is no longer willing to hold public debt, the government would have to resort to monetisation. The result, consistent with the quantity theory of money, is inflation and anticipation that this will happen may also lead to an increase in inflation today as investors reassess the risk from holding money and government bonds. In such an environment, fighting rising inflation by tightening monetary policy would not work, as an increase in interest rates would lead to higher interest payments on public debt, leading to higher debt, bringing the likely time of monetisation even closer. Thus, in the absence of fiscal tightening, monetary policy may ultimately become impotent to control inflation, regardless of the fighting credentials of the central bank.”

In other words, a Volcker-style approach of tight monetary policy in order to wring inflationary expectations out of the system may be futile. Inflation is ultimately a fiscal phenomenon. What’s more, bond market vigilantes won’t solve the problem in time as the report point out:

Simmering Fiscal Problems Coming to a Boiling Point – Regardless
“[B]ond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades. We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. In the face of rapidly aging populations, for many countries the path of pre-crisis future revenues was insufficient to finance promised expenditure.”

Unemployment and Debts/Deficits to Stay High – Regardless
The standard solution for believers of the free market is that organic growth, i.e. economic growth not from government stimulus, will eventually happen and, as such, we can grow our way out of trouble. The report believes that these structual deficits are so overwhelming that:

“We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future. As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained.”

Either USD to Collapse or Interest Rates to Go Much Higher – Regardless
Fiscal deficits do matter and interest on debt can overwhelm spending priorities. Long-time analyst Richard Russell, publisher of the Dow Theory Letters since 1958, wrote the following words about a year ago:

“The US national debt is now over $11 trillion dollars. The interest on our national debt is now $340 billion. This is about a 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let’s say that by some miracle the interest on the national debt in 10 years will still be 3.04%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof.”

Bill Gross of PIMCO also came to a similar conclusion about the trajectory of the US fiscal position:

“As the IMF… aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the U.S., in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.”

Is It Time to “Buy” Inflation?
The authors of the BIS working paper believes that all roads lead to inflation. I concur with that view and, as such, inflation hedge vehicles such as hard assets, commodities and shares of commodity producers have their place in every portfolio. However, I also believe that any commodity bull is likely to experience a high degree of volatility as gold’s surge from $35 in the early 1970s to $850 in January 1980 followed by a correction of 43% exemplified.

Here is the dilemma. The world faces a high degree of uncertainty about policy direction, which should result in gut-wrenching intermediate term market volatility. Global economies are currently mired in a fragile slow-growth environment, but inflation could break out at any time. Investment hedges that perform well in a runaway inflationary environment will do poorly in a recessionary period and vice versa. You can get the picture right and get hurt really badly in the interim.

*http://www.bis.org/publ/work300.pdf?noframes=1
**http://seekingalpha.com/article/198211-all-roads-lead-to-inflation-bank-for-international-settlements?source=email

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
- Sign up to receive every article posted via Twitter, Facebook, RSS feed or our Weekly Newsletter.
- Submit a comment. Share your views on the subject with all our readers.
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It is understandable why there is such a major divide between Republicans and Democrats in America when one examines their diametrically opposed, and seemingly irreconcilable, Keynesian and Austrian economic views.

Below are edited [ ] and reformatted excerpts from an article* by Sterling T. Terrell (www.mises.org) in which he explains the different approaches to fiscal policy and why he thinks one approach is better than the other based on research on the subject:

[Republican Party - Conservative - Austrian Economic Philosophy]
The government has no money of its own. It has only the power to tax and spend the money of others. There can only be a transfer that takes place, not a creation of wealth: jobs in X are gained, but jobs in Y are lost. However, this transfer is actually a loss. Taxing away a person’s ability to fulfill his own wants and then providing him with things he may not care about makes him worse off. This process condescendingly supposes that individuals cannot decide for themselves what they need.

[Democratic Party - Liberal - Keynesian Economic Philosophy]
If the economy is “too slow” then the government should lower interest rates and increase government spending. If the economy is “overheated,” the government should raise interest rates and decrease government spending. Increased government spending, [i.e. economic stimulus,] will act as a fiscal multiplier in that one dollar in government spending, once it filters through the economy, will make GDP increase by more than one dollar.

Research Findings
Research** done by Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh, covering data from 45 countries from 1960 to 2007, has determined that “it depends” on the size of the fiscal multiplier. Furthermore, the size of the fiscal multiplier critically depends on:

1. Key characteristics of the economy:
a) closed versus open,
b) predetermined versus flexible exchange rate regimes,
c) high versus low debt.

2. The type of aggregate being considered:
a) government consumption,
b) government investment.

As such, policymakers would be well -served by taking into account a given country’s characteristics in evaluating the benefits of any fiscal stimulus package.

Conclusion
The findings of Ilzetzki, Mendoza, and Vegh suggest that in a country such as the United States the fiscal multiplier is virtually zero and, therefore, in addition to fiscal policy taking away the freedom to choose, robbing X to hand it to Y, and penalizing the very people that improve our lives, it also fails empirically.

Fiscal policy, the attempt to use government outlays and revenue to better the economy, simply does not work either a priori or in practice – but the Austrians already knew that.

*http://mises.org/daily/3950
**http://econweb.umd.edu/~vegh/papers/multipliers.pdf

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
- Sign up to receive every article posted via Twitter, Facebook, RSS feed or our Weekly Newsletter.
- Submit a comment. Share your views on the subject with all our readers.
- Buy the book below from Amazon. It’s pertinent to this article and inexpensive too.

“Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” says Warren Buffett. Words: 982

In the following edited excerpts from the original article* Cam Hui (www.questfunds.com) puts forth the case for both inflation and deflation by the likes of Richard Russell, Warren Buffett and Van Hoisington:

The Case for Deflation

1. De-leveraging
There are many analysts making the case for a Japanese 1990s style prolonged period of deflation. One of the more prominent spokesmen of this view is Hoisington Investment Management. Simply put, Hoisington believes that we are in a de-leveraging cycle, and de-leveraging means deflation. Their case for deflation can be summarized in the following way:

- US debt to GDP has gone sky high, indicating that borrowing capacity is stretched. Much of that borrowing went to pump up asset prices. Even though asset prices have fallen, the debt remains. The endgame is obvious: we need time to pay off all of the excess debt and that process is highly deflationary.

- Credit creation is falling dramatically. The economy cannot recover unless banks are willing to lend to businesses and households. Otherwise, where does growth come from?

- Monetary policy is pushing on a string. Inflation is considered to be a monetary phenomenon. When Helicopter Ben prints too much money, theory suggests that too much money chasing too few goods and services ignites inflation. Hoisington argues that increasing the money supply will not result in inflation because banks aren’t lending. All of the newly printed dollars are winding up in bank reserves and doesn’t get pushed into the real economy. Therefore inflation will stay tame until banks begin to lend again and start a new credit cycle.

- Fiscal stimulus won’t work either. One of the major problems on the expenditure side is that the government sector is smaller than the private sector. Moreover, increasing government spending would mean either the government must either raise taxes or borrow funds in the financial markets that would have otherwise gone to the private sector, which is counterproductive.

- The American consumer’s balance sheet is extremely weak and over-levered. It will be a while before the consumer can resume his profligate ways, assuming a new frugality doesn’t take hold. If the consumer doesn’t spend, then where will growth come from?

To the above points, I would also add the following:
- US capacity utilization is falling and capacity utilization leads core CPI by about a year, according to Albert Edwards of SocGen.

- The Eurozone won’t be a source of global growth near-term. Europe is undergoing its own de-leveraging cycle as widespread defaults from Eastern European loans become a reality.

(See the Hoisington case at http://www.investorsinsight.com:80/blogs/john_mauldins_outside_the_box/archive/2009/01/19/thegreat-
experiment.aspx)

2. Too Much Debt
- Debt to GDP has gone sky high…Credit creation is falling dramatically…Consumer balance sheets are very weak, making them unlikely to spend. Capacity utilization is falling and capacity utilization leads CPI by about a year. Source: Societe Generale

The Case for Inflation

1. Massive Fiscal and Monetary Stimulus
In a New York Times op-ed (see http://www.nytimes.com/2009/08/19/opinion/19buffett.html _r=2&scp=2&sq=buffett&st=cse) Warren Buffett warned that:

- “enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.” Buffett was saying, in so many words, that all of the money being printed today is unlikely to ignite inflation because of the lack of lending. However, Americans will have to eventually pay the price for all this government spending and monetary stimulus.

- once we start to see signs of a recovery, “slowing [the stimulus] down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.”

- the price to be paid would likely be an uncontrolled decline in the US Dollar: “Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.”

2. Falling US Dollar
The United States is in the enviable position of being the issuer of a major reserve currency. For central bank reserve managers, the only other realistic reserve currencies are the euro and perhaps the Yen. All other currencies are too illiquid to be serious contenders for major reserve status.

Given the profound troubles that Europe faces with its banking system and the continuing problems in Japan, the US Dollar is unlikely to fall significantly against either the euro or the Yen. Pressures on the US Dollar would show up as rising commodity prices – which translates to inflation.

3. Higher Interest Rates
Long-time analyst Richard Russell, publisher of the Dow Theory Letters since 1958, put the dilemma more succinctly:

- The US national debt is now over $11 trillion dollars. The interest on our national debt is now $340 billion. This is about at 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let’s say that by some miracle the interest on the national debt in 10 years will still be 3.09%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof.

*http://www.qwestfunds.com/publications/newsletters_pdf/newsletter_november_2009.pdf (Qwest Investment Management Corp. is an investment firm which specializes in identifying, structuring and managing investment products focused in the natural resource sector.)

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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The crucial assumption of the book is that “the market” does have a central value and that the world of stock markets is a “mean reverting” world. As a consequence, the market can be over-valued or under-valued but will, over time, return to its central value. Words: 1317

In further edited excerpts from the original review* at www.SeekingAlpha.com, John Mason goes on to say:

Smithers states at the beginning of the book that it is based on two principles:

1. that assets can be objectively valued
2. that it is extremely important that central bankers should adjust their policies when asset prices get substantially out of line with their underlying values.

He concludes that it was the denial of these two principles that led to the errors by central bankers which are the fundamental cause of our current troubles.

The denial of these two principles came about because investors and policy makers have explicitly, or implicitly, assumed that the Efficient Market Hypothesis (EMH) as created and applied by academic economists, and its derivative assumption, the Random Walk Hypothesis (RWH), have dominated the investment community and central bank thinking. The condition that defines the EMH, according to Smithers, is that current market prices contain all the information that is available to investors and, therefore, assets are efficiently priced so that share prices must always be at fair value and there can be no difference between price and value. Since information comes to the market randomly, then price movements within the market must themselves be random so that the RWH is closely connected with the EMH.

Smithers proposes an alternative hypothesis which he calls the Imperfectly Efficient Market Hypothesis because markets are not totally efficient but are only moderately efficient. Crucial to this conclusion is that empirical tests of the EMH do not support the theory and, as a consequence, the theory must be rejected. The primary empirical test that leads to this view is that the underlying assumption about the RWH does not hold, that the variance of market prices does not remain constant through longer investor holding periods. It has been found that the variance of market prices declines as holding periods get longer and that this results in a negative serial correlation of returns. That is, this is evidence that markets “rotate around fair value.”

Two approaches to determine fair value are presented by Smithers and these, he argues, are consistent with the Imperfectly Efficient Market Hypothesis.

1. The first method was developed by James Tobin and is captured by the variable q. The value q is the ratio of the market value of the firm divided by the reproduction costs of the assets of a firm or market less the debt of the firm or market. If the value of q is equal to one, then the net value of the assets and the market value of the company are equal. If the market value of the company or market is above the net value of the assets the company or market then the company or market is over-valued and vice versa if the net value of the company is above the market value, then the company or market is under-valued. (Since profits have tended to be overstated historically, the average value of this ratio tends to be below 1, but the movements in the ratio still give the correct signals.) Over time, there is the distinct reversion to the mean that Smithers looks for.

2. The second method is the one develop by Robert Shiller and is called the cyclically adjusted price/earnings ratio (CAPE). The long-term average of the PE ratio is stable so that this variable represents more of an “equilibrium” value rather than a value just based upon the current level of earnings.

The research conducted and reported by Smithers supports the use of these two variables in analyzing whether or not the stock market is over- or under-valued. The remarkable thing is that the two variables move very closely together and this “reinforces the probability that the real return on equities is stable.”

Since the author concentrates on whether or not stock values are over- or under-valued, he also expresses concern about the over- or under-valuation of other assets such as the price of housing or the price of bonds. Within the book he develops methodologies for determining whether or not these assets might be over-priced or under-priced. In this he is very concerned about the existence of asset bubbles because he perceives that much of the turmoil that financial markets face results from the existence of, and subsequent collapse of, asset bubbles.

Developing his approach in this way allows him to focus on three different asset markets so as to develop information about bubbles that can reinforce a conclusion. In this way Smithers can review the historical record and show how the evidence from each market generally supported the over-all conclusion about the valuation of assets and whether or not they were out-of-line with fair value.

Here is where he introduces the rationale for the “inept” behavior of central bankers. Central bankers, Smithers argues, are strong advocates of the EMH and hence believe that market prices are always correct while at the same time following a random walk. Hence, asset bubbles cannot occur, and, since asset bubbles cannot occur, there is no way the Federal Reserve can either identify asset bubbles or introduce a policy that can combat asset bubbles. The assumption that market prices are always “correct” results in central bankers doing things that are not only not helpful but can result in them doing things that make situations worse.

The primary example here is the action of the Federal Reserve System over the past 15 years or so. Smithers argues that the monetary policy of the Fed created the stock market bubble of the 1990s. Around the year 2000 the United States stock market was more over-valued than at any time during its history and this judgment was supported by the “q” ratio and the CAPE variable. The stock market had to break and it did. The response of the Federal Reserve was to lower its policy interest rate to an extraordinarily low level and keep it there for an extremely long period of time. The result was the bubble in housing prices and the loss of liquidity in the bond markets. Thus, in the decade of the 2000s all three market indicators were flashing the “over-valued” sign but this did not deter the Fed. According to the author, a reaction had to come and we are now working through the results of the “inept” leadership at the Federal Reserve.

The author addresses how a central bank should approach the conduct of monetary policy and how it should react to the performance of financial markets and the economy. Smithers argues that the Fed should focus on several market variables in order to set policy: these are the price of stocks, housing prices, the price of financial market liquidity, and consumer prices. He further argues that the Fed needs a tool or policy instrument to apply to each target so that the manipulation of a short term interest rate is not sufficient for the conduct of monetary policy and the control of asset bubbles. One other policy tool he suggests is bank reserve requirements.

“Wall Street Revalued” is an important work to read. One can get lost in the detail and the side-trails that the author takes us through but it is worthwhile to work through the research results that Smithers presents and the history he relates it to. It is not that the book is difficult to read it is just that there is a lot to be covered in 198 pages of text.

*http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
- Sign up to receive every article posted via Twitter, Facebook, RSS feed or our Weekly Newsletter.
- Submit a comment. Share your views on the subject with all our readers.
- Buy the book below from Amazon.

My thesis is that risk-free bond speculation suppresses the rate of interest and destroys capital in the process. I have challenged neo-classical economists who still consider the open-market operations of the Fed to be a ‘refined tool to manage the national economy’. I want them, instead, to see in open-market operations the cancer of the economy responsible for the withering of the world’s prosperity. So far my challenge has fallen upon deaf ears. Words: 2854

In further edited excerpts from the original article* Antal E. Fekete (www.professorfekete.com) goes on to say:

I have maintained over the years that with such bond speculation the economy would go into a recession and then morph into a depression. As I see it the immediate cause of such a depression is the destruction of capital and the ultimate cause is the monetary policy of open market operations. The chain of causation is as follows:

1. Open market operations (in effect, net purchases of T-bills) by the Fed invite bond speculators to take risk-free profits offered by this fact of their predictability.

2. Bond speculators buy the long-dated Treasurys and sell the short-dated ones, to pocket the difference in yields. These straddles represent borrowing short and lending long. As such, they are inherently risky. However, quantitative easing takes the risk out by making the odds that the normal yield curve will invert negligible.

3. The bond speculator faces the problem of having to roll forward the fast-expiring short leg of his straddle by selling T-bills. The extraordinary funding and refunding requirements the Treasury is facing, and the extraordinary pressure on the Fed to increase the money supply combine to make it ultra-easy for the bond speculator to move both the short and the long leg of his straddles as he sees fit.

4. The upshot is that interest rates keep falling along the entire yield curve. Regardless how many long-dated issues the Treasury offers, bond speculators snap them up even before the ink is dry on them.

Here we have the solution to the Greenspan-conundrum: the sky is the limit to the bond speculators’ appetite for Treasury paper. They are all right as long as they can sell T-bills against them. As the sky is the limit to the Fed’s appetite for T-bills, both flanks of the speculators are secure.

This is a vicious spiral: the more currency the Fed creates, the more risk-free profits bond speculators will reap, contributing to a further fall of interest rates.

The Squeeze is on to Bankrupt the Entire Economy
This outcome is the exact opposite of the one predicted by monetarism which predicts that the new money created by the Fed will flow to the commodity market bidding up prices there, to nip depression in the bud. Bernanke & Co. fully expects this to happen. This is not what is happening, however. The new money refuses to flow uphill to the commodity market. It will flow downhill to the bond market where the fun is. Why take risks in the commodity market, the speculators ask, when you can gamble risk free in the bond market? So grab the money, buy more bonds and sell the bills. As a consequence of bullish bond speculation interest rates fall, prices fall, employment falls, firms fall. The squeeze is on, bankrupting the entire economy.

The Fed’s Fiat Currency Play is Nothing But a Ponzi Scheme
Some might object that the Fed could short-circuit the process and undercut the bond speculators’ lucrative business. All it has to do is to buy the short-dated paper directly from the Treasury. Inverting the yield curve will shake off the parasites but in my view there is no danger of this happening. The Treasury and the Fed know that bond-vigilantes watch what they are doing like a hawk. Any hanky-panky of direct sales of T-bills by the Treasury to the Fed would make them cry “foul play” as indeed it would be because direct sale of Treasury paper to the Fed would degrade the dollar from irredeemable currency to fiat currency. That is a subtle difference, realized only by a few.

Fiat currency is worse. Its arbitrary augmenting is decided behind closed doors. It does not need the endorsement of the open market. Fiat currencies have a short life-span as they readily succumb to the sudden-death syndrome. Irredeemable currencies are different from fiat in that they are created openly, using collateral purchased in the open market. They have a more respectable life-span. As long as the official check-kiting conspiracy between the Treasury and the Fed remains hidden from the general public, irredeemable currency may even prosper. Direct sale of T-bills by the Treasury to the Fed would tear down the curtain that hides the fact of check-kiting.

The mechanism of check-kiting is as follows: the Treasury issues debt which it has neither the intention nor the means ever to repay. This debt is used as “backing” for Federal Reserve notes and deposits, which the Fed has neither the intention nor the means ever to redeem. When the Treasury debt matures, it is paid in Federal Reserve credit issued on the collateral security of new Treasury debt. When Federal Reserve credit is presented for redemption, the Fed offers interest-bearing Treasury debt in exchange. This is a shell game and it exhausts the definition of check-kiting. Neither the Treasury debt, nor the Federal Reserve credit is issued in good faith. Neither is redeemable any more than Charles Ponzi’s tickets were. They are both issued in order to mesmerize a gullible public, much the same way as Ponzi did.

The Fed are Trying to Avoid a Crack-up Boom
Treasury and Fed officials know their history. They are familiar with the fate of the assignat, the mandat, the Reichsmark, not to mention the Continental. They know that no fiat money ever survived “the slings and arrows of an outrageous fortune”. Their only hope is that the fate of the irredeemable dollar, as predicted by Friedman, will be different. They will not embark upon an adventure in monetary policy involving direct sales of T-bills by the Treasury to the Fed because they know that if they did, surely this would be the end of their experiment. Foreigners as well as Americans would start dumping the dollar unceremoniously, and buy anything they can lay their hands on. This is variously known as flight into real goods, Flucht in die Sachwerte, crack-up boom, Katastrophenhausse. I purposely avoid using the term hyperinflation as it connotes with the Quantity Theory of Money, which is not really a theory. It is a linear model trying to explain non-linear phenomena.

Bond Speculators are “Scalping” the Fed
There is also a second method by means of which bond speculators are making risk-free profits. They “front-run” the Fed in the bill market. This means that, through inside information or otherwise, they divine when the Fed has to answer “nature’s call” and must make the next trip to the open market in order to buy the collateral without which it cannot issue more money. Bond speculators forestall the Fed by purchasing the bills beforehand, thus driving up the price. Then they turn around and dump the paper into the lap of the Fed at the enhanced price, making a risk-free profit. This process is called “scalping”, after the kindred activities of small-time speculators in tickets for the World Series and other popular sporting events.

The objection that the Fed knows how to throw bond speculators off scent by various stratagems ― for example, through falsecarding, say, by selling when speculators would expect it to buy ― can be safely dismissed. There is no question that every year the Fed is a big buyer of bills on a net basis. If it sells, it has to buy that much more later on. Fiddling means that the Fed may miss its target. Falsecarding may back-fire.

The speculators are a smart lot, thanks to “natural selection” culling the rank and file. They risk their own capital which they stand to lose if they place the wrong bet. Once their capital is gone they are out, and smarter guys will take over their place. Hired hands at the Fed are no match for them as far as brightness and adroitness is concerned. The latter work for salaries. If they make the wrong bet, losses will be replenished by dipping into the public purse.

Cheating in Las Vegas
My voice has remained a cry in the wilderness. Nobody pays attention to the mumblings of this armchair economist. Interestingly, however, a website called Jesse’s Café Américain (http://jessescrossroadscafe.blogspot.com), recently posted a story entitled “Front-Running the Fed in the Treasury Market” suggesting that someone has tapped into the Fed’s buying plans to monetize the public debt and is front-running those purchases, essentially ‘stealing’ money from the public. It’s what they call a ‘sure thing’. To try and figure out who might be doing it, I would look for some big player who is showing extraordinary returns on their trading, with consistent profit that is not statistically ‘normal’, but is consistently ‘too good’. The problem with cheaters is that they sometimes get greedy and call attention to themselves. In Las Vegas the bigger cheats at the casino were often taken to the desert for further questioning and final disposal. On Wall Street they are more arrogant and persistent, defying resolution with that ultimate defiance, “We’ll just have to figure out other ways to cheat, and come back again”. Time for a trip to the desert?

Congenital Disease of the Irredeemable Dollar
While the above may, indeed, be occuring cheating is not necessarily involved. What is happening may not be a purposeful, if veiled, Fed policy, nor is it necessarily someone at the Fed tipping off his brother-in-law at a brokerage house (however valuable the tip may be). Instead, what we may be facing here is a congenital disease of the irredeemable dollar.

There is no need to look for a conspiracy in the bond market. It is quite possible that a large number of smart speculators, acting spontaneously and independently of one another, have come to realize that there is a bonanza, perfectly legal, in ripping off the public purse. Of course, they have kept their own counsel.

If anybody is responsible for this colossal blunder of economics releasing the genie of risk-free speculation out of the bottle, the names that come to mind are those of Keynes and Friedman, respectively. They invented the ‘improved’ system of floating exchange rates assuming a goldless currency that has to be arbitrarily augmented from time-to-time through the monetization of government debt (that, incidentally, proliferated profusely after the politicians deliberately unbalanced the budget upon the explicit advice of Keynes). The rest, as they say, is history.

As long as budget deficits were ‘modest’, the activity of speculators making risk-free profits in the bond market escaped public attention. With the advent of ‘quantitative easing’ and mega-deficits, everybody sitting at a bond-trading desk can see it. The figures literally jump off the screen, as explained by Jesse’s blog.

The Fed’s has Encouraged Bond Speculation
To be fair to Jesse’s anonymous correspondent I must admit that his conjecture, that in risk-free bond speculation we may be looking at deliberate Fed policy, is plausible. It is not impossible that the rot in the U.S. monetary system has already spread so far that in a truly free and unrigged bond market no bidders would turn up. Time is long since past when Treasurys were eagerly sought after by the most conservative segment of the investing public, such as the guardians of widows and orphans, trust funds, eleemosynary institutions.

Typically, they held the bonds to maturity. Treasuries, second only to gold, were the most trusted instruments of wealth-preservation. Under the regime of the irredeemable dollar no investor in his right mind would buy a Treasury bond and hold it until maturity. Treasuries lose value as ice melts in the sunshine. They have become a plaything in the hands of speculators for their value in turning a fast buck. Under the gold standard there was no bond speculation, just as there was no foreign exchange speculation. Interest rates were stable and so were bond prices. Speculators would shun bonds. Of course, all this changed when president Nixon defaulted on the short-term gold obligation of the Treasury to foreigners in 1971, and gold was finally removed from the international monetary system at the behest of the U.S. government.

For a decade speculators were happy with the trading profits they could make in the bond market. As the monetary system kept deteriorating, however, they started abandoning bonds, transferring their activities to the commodity market. By 1981 demand for bonds practically evaporated. As this spelled the end of the regime of the irredeemable dollar, the Fed had to do something to prop up the bond market by enticing bond speculators back. As such, it is quite possible that a decision was made at the highest level to offer the enticement of risk-free profits to bond speculators. It certainly cannot be denied that bond speculators have been making obscene profits in the course of the 30-year bull market in bonds that is still ongoing. These profits are unprecedented in the history of speculation, both on account of their magnitude and their regularity. They were made at the expense of productive enterprise, the capital of which has been surreptitiously siphoned off by the falling interest-rate structure.

The Fed has Recruited a Corps of Shills
Another way of describing this scenario (assuming it is correct) is that in 1981 the Fed, unknown to the public, decided to recruit a corps of shills to prop up a moribund bond market. The shills hired by the casinos of Las Vegas bet big and win big at the gaming tables in full view of the gamblers who are unaware that they are being treated to a show. The sight of these big payoffs will then perk up the gambling spirit of a lethargic clientele.

The shills recruited by the Fed are the bond speculators, and their remuneration is in the form of risk-free profits they are allowed to make (and keep). The scheme was a roaring success. Not only did it save the bond market from extinction; it also saved the dollar from ignominy, and was instrumental in making possible a whole string of bubbles, each bigger than the previous one, during the past decade.

The Road to Hell Is Paved with Good Intentions
The problem is far more serious than it may at first appear. Risk-free speculation is like a computer-virus that has no antidote and threatens to wipe out the Internet. It short-circuits normal economic processes and gobbles up the world economy.

I would welcome a public debate of my thesis that risk-free bond speculation suppresses the rate of interest and destroys capital in the process. I have challenged neo-classical economists who still consider the open-market operations of the Fed as a ‘refined tool to manage the national economy’. I want them, instead, to see in open-market operations the cancer of the economy responsible for the withering of the world’s prosperity. So far my challenge has fallen upon deaf ears.

Here is the Problem
The prevailing orthodoxy is the unholy alliance between Keynesianism and monetarism inspired by Friedman (defying the pretence that these two are antagonistic theories). The idea that an artificial increase in the money supply must raise commodity prices dies hard but as my theory suggests, and as events have repeatedly shown (first during the Great Depression of the 1930’s, and again, during the present crisis), the presence of risk-free speculation renders the increase in the money supply counter-productive. It causes prices to fall rather than rise.

Giving them the toy of risk-free profits, speculators vacate the commodity market where risks are too high, and they congregate in the bond market where risks are non-existent. The speculator who in the absence of risk-free profits might resist falling prices in the commodity market, will decline the honor of helping the Keynesian agenda if given the choice of risk-free profits in bonds. This is basic human reaction that cannot be criticized, still less rectified, by official brow-beating. Keynesians should have thought about the consequences of their master-plan more thoroughly before they put open-market operations into effect.

The intentions of policy-makers at the Fed are praiseworthy. They want to prevent prices and employment from collapsing but they are prisoners of their orthodoxy, and their good intentions make them steer the economy on the road to hell.

A catastrophe is confronting the Titanic, but the captain, just confirmed in his position in spite of a most serious public challenge, will not change course. A head-on collision with the iceberg straight ahead, otherwise known as the debt-tower, now appears inevitable.

*http://www.professorfekete.com/articles%5CAEFFrontRunningTheFedInTheTreasuryMarket.pdf

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
- Sign up to receive every article posted via Twitter, Facebook, RSS feed or our Weekly Newsletter.
- Submit a comment. Share your views on the subject with all our readers.
- Buy the book below from Amazon. It’s pertinent to this article and inexpensive too.