Whilst we, as staunch Austrians, would prefer less liquidity provision and more allowance for markets to naturally self-correct and deleverage… we suspect that as markets try to self-correct, the authorities generally will be forced to print more and more [as] it is the easiest course for them to take and the typically all too human option…As such we look once more at how inflationary and deflationary outcomes might affect precious metal investors. Words: 1323

I’ve heard and seen my share of specious arguments, fantastical predictions, moronic conclusions, and positively farcical objectives — from all measures of wannabe (and practicing) politicians and economists [that we are in a deflationary environment]. This idea, however, that consumers aren’t spending because they are waiting for lower prices is just absurd. Furthermore, the ensuing leap of logic, that consumers are responsible for a so-called “deflationary” environment is positively imbecilic. [Let me explain.] Words: 1582

So said Paco Ahlgren of BottomViolation.com in an article* back in 2010 that warrants reposting as nothing has changed over the ensuing year. Lorimer Wilson, editor of munKNEE.com (It’s all about Money!), 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 reposting to avoid copyright infringement. Ahlgren had the following to say:

Understanding the Difference Between Inflationary and Deflationary Environments

If you ask the average person to define an inflationary environment, you get this response: “Rising prices.” Similarly, the same person would likely define a deflationary environment as” falling prices”. Both answers are incorrect, though. In fact, they’re gross misrepresentations of the words, and this simple, but popular misconception of the true meanings of inflationary and deflationary is the root of every single economic problem we face today.

Rising prices do not cause inflation, nor are they inflation. On the contrary, rising prices are the result of an increase in (or inflation of) the money supply – through printing currency, and/or the manipulation of interest rates by any entity controlling the money supply (like the Fed, The ECB, or whatever).

Simply put, inflation is always monetary. Likewise, pulling currency out of circulation constitutes the deflation of the money supply. Falling prices are not, in and of themselves, deflationary. Indeed, if prices are falling, but the government is printing more money, then the economic environment is properly described as inflationary.

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You may be unaware of the fact that the authorities controlling the status quo – namely Ben Bernanke, Barack Obama, and all their little elves – actually want you to use the words inflationary and deflationary incorrectly. You might also make the claim that I’m merely splitting semantic hairs – that these definitions are insignificant in the grand scheme of things. That’s not really a good argument, though, because if the majority of people believe we are in a deflationary period, despite the fact that the Fed is printing money at the fastest rate ever, well, then we’re not preparing for the inevitable. We are certainly not in a deflationary period – nor have we been for many, many decades and the “inevitable” to which I am referring is an incalculably rapid rise in prices across the globe.

If you think about it, it makes sense: more dollars in the economy mean less valuable dollars. Money is just like everything else — it has value, and the laws of supply and demand are every bit as applicable to currencies as they are to everything else: the larger the supply of money, the lower its value.

Deflationary Environment

In the midst of all this misapplied talk about a deflationary environment, one of the main arguments I keep hearing is that the main reason prices are dropping — on everything from real estate to electronics – is that consumers are waiting for bargains; as such, they won’t spend now. That consumers are responsible for a so-called “deflationary” environment is positively imbecilic for at least two reasons:

1. It’s a misapplication of the word deflationary — as I pointed out above.

2. While it is true that the average consumer isn’t (and won’t soon be) spending as much as he used to, it’s not because he’s waiting for bargains. No, it’s because he’s out of credit, he’s unemployed, his house, car, motorcycle, boat, and plasma television have all either been repossessed or foreclosed upon, and his wife just left him. He’s not exactly in the mood for shopping. He’s not waiting for bargains. He’s waiting for a miracle – and I don’t think they sell those at the mall.

You think consumers really stop spending in anticipation of lower prices later? Really? Ever heard of Moore’s Law? The one that says the price of technology will be halved every 18 months? Buy a computer today, it will be worth 50% of that value in a-year-and-a-half. So, in an industry like technology — where real prices consistently fall — do you really believe that most people put off buying products in anticipation of lower prices? I mean, it happens, but it’s not the exception, not the rule.

Consumers, for the most part, do not postpone purchases — even in an industry like technology. This is only borne out by the fact that the technology industry has been one of the fastest growing and profitable in our economy for decades. People will pay today – even in the face inevitable obsolescence.

So let the pundits talk about a deflationary environment all they want, but we know (or should know) the truth: the money supply is not shrinking. Even if the prices of most asset classes are still falling – which is arguable, at best, in real dollars — consumers do not postpone purchases in anticipation of lower prices. They are not causing “deflationary” environment.

Inflationary Environment

Say it with me: we are in an inflationary environment [not a deflationary one]. How do you think the government is going to pay for all of the trillions of dollars it has promised to spend over the next two (or more) years? I’ll tell you how: it’s printing dollars. Lots of them. The money supply has been increasing for decades — lately, at a faster clip than ever.

What did we just say about supply and demand? That’s right — the value of dollars is going down, not up. It may feel like we’re in a deflationary environment more than an inflationary environment, but I promise you we are not, and even if you don’t feel it now, you will. You can rest assured, the very nanosecond Ben Bernanke suspects that the effects of this rapidly increasing money supply are causing upward pressure on prices in our economy, he and his gang of calculator-toting dandruff eaters are going to start jacking up interest rates every way they know how. Then they’re going to huddle in the middle of the room and start praying it works. Which it won’t.

Still not convinced? Have you seen what precious metals, agriculture, and oil have been doing for the last twelve months? They’ve been going up and it isn’t because consumers are expecting prices to fall. Commodities are the best predictors of future prices. I don’t care what the Dow 30 are doing; look at commodities. That’s where the story is.

The Fed – by way of John Maynard Keynes — is the main instigator of this preposterous idea that we must fight falling prices with everything at our disposal. Lately, they’ve even attacked the long end of the yield curve by buying long-term Treasuries in the open market. Some of you may not understand the implications of this behavior, so I’ll give you a little help: if the Fed thinks it can maintain lower long-term rates by buying Treasuries, it’s going to have to use dollars, and those dollars will have to come from somewhere. Can you hear the printing presses groaning?

So this brings us to four final questions (as well as their answers, which I am thrilled to provide at no extra charge):

1. If the Fed is going to (attempt to) hold down long-term rates by using printed money to buy Treasuries, isn’t that going to cause downward pressure on the value of the currency? (Yes!)

2. As the dollar loses value, won’t U.S. creditors be reluctant to loan us more money – or even to hold existing American debt? (Yes!)

3. Won’t that necessarily mean rising interest rates? (Yes!)

4. So how, exactly, is that going to keep long-term Treasury rates lower? (It won’t!)

Look, if you ignore everything else I’ve said, try to remember this: the Fed is comprised of a decidedly small number of people, who make decisions that will affect you, your job, your family, and your life for years to come. They are not gods; they are human beings, and their perception of reality is just as subject to error as yours and mine.

Conclusion

Your currency is more vulnerable than at any other time in history, and you should be scared. Actually, you should be terrified. I know I am!

[Repeat after me:

• There is nothing deflationary about our environment – it is inflationary
• There is nothing deflationary about our environment  – it is inflationary
• There is nothing deflationary…

*http://www.bottomviolation.com/consumer-driven-deflation-not-even-close/

Related Articles:

1. These Indicators Say Inflation to Go to 4% Soon – and 6% by 2014 
2. Official and ShadowStats Monthly Inflation Rates: 1872 to Present 
3. Understanding Inflation: It’s Here – and It’s Going to Get Worse, Much Worse! 
4. What Inflation? Take a Look At All the Deflation Around You! 
5. Inflation Coming? Treasury Market Says Otherwise! 
6. Real-time Inflation Data is Now Available – Finally 

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.

 

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.

Editor’s Note: Don’t forget to sign up for our FREE weekly “Top 100 Stock Market, Asset Ratio & Economic Indicators in Review”.

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

The U.S. economy is in a downward spiral of debt deflation despite the bold actions of the federal government and of the U.S. Federal Reserve taken in response to the financial crisis that began in 2008 and the associated recession. Indeed, von Mises once said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later, as a final and total catastrophe of the currency involved” and just that is happening before our very eyes. Words: 2242

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com, provides below further reformatted and edited [..] excerpts from Ron Hera’s (http://www.heraresearch.com/newsletter.html) original article* 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 reposting to avoid copyright infringement.) Hera goes on to say:

Green Shoots Have Turned Brown
Despite the sighting of supposedly green shoots in the spring of this year the evidence is anything but encouraging:
- the unemployment rate has risen to 9.9%,
- paychecks in the private sector have shrunk to historic lows as a percentage of personal income,
- personal bankruptcies have risen yet again,
- roughly 14% of U.S. mortgages are delinquent or in foreclosure,
- credit card defaults are rising,
- consumer spending hit 7 month lows,
- consumers appear to be borrowing to service existing debt.

Outside of the federal government, which is borrowing at record levels and expanding as a percentage of GDP, and outside of the bailed out financial sector, debt deflation has continued unabated since 2008. [Following is evidence of such an event unfolding and some examples of the ultimate result:]

1. Money Supply is Contracting
A contraction of the broad money supply is taking place because the influx of money into the U.S. economy, i.e., lending to consumers and non-financial businesses, has fallen below the rate at which money is flowing out of general circulation as a function of debt service (interest and principle payments on existing debt). Thus, a net drain of money from the broad U.S. economy is taking place. As a result, additional borrowing, as consumer spending falls, appears to be servicing existing debt in a pattern that is clearly unsustainable and that signals a further rise in debt defaults in coming months.

The estimate of the broad money supply (the Federal Reserve’s M3 monetary aggregate) is crashing and the Federal Reserve’s M1 Money Multiplier, a measure of how much new money is created through lending activity, fell off of a cliff in 2008, and remains practically flat-lined.

2. Debt Servicing Remains Low
The contraction of the broad money supply points to a potential slowing of economic activity and indicates that consumers and non-financial businesses will be less able to service existing debt. Despite easing somewhat in March 2010, credit card losses are expected to remain near 10% over the next year and mortgage delinquencies, are currently at a record highs, and these dismal predictions implicitly assume a stable or growing money supply.

3. A Tsunami of Mortgage Defaults Expected
A tsunami of eventual mortgage defaults seems to be building and loan modifications have been a failure thus far. There have been only a small number of permanent loan modifications (295,348) under the Home Affordable Modification Program [HAMP] in 2009, out of 3.3 million eligible (60 days delinquent) loans and more than half of modified loans default.

4. Consumer Savings Are Being Liquidated
Although it has been reported that American consumers are saving at a rate of 3.4%, the contraction of the broad money supply suggests savings liquidation. Given a contracting money supply, ongoing debt defaults and declining consumer spending, the increase in non-mortgage consumer loans indicates that consumers are borrowing where possible to consolidate debts, cover debt service, or borrowing to continue operating financially as their total debt grows, thus as they approach insolvency.

5. There is a Reduced Ability To Borrow
The increase in non-mortgage consumer loans has not prevented an overall decline in total household debt attributed to ongoing deleveraging by consumers. While deleveraging (paying down debt) has been interpreted as caution on the part of consumers, or as low consumer confidence, the decline in outstanding credit reflects a reduced ability to borrow, i.e., to service additional debt. This suggests that the recovery of the U.S. economy may be illusory and that the economy is likely to contract further in coming months.

Commercial borrowing has declined more sharply than household debt suggesting that the nominal return to growth estimated at 3% has not been matched by debt financed expansion in the private sector.

6. Structurally High Unemployment to Remain
Unemployment and labor force data suggest that the U.S. labor market is in a structural decline, i.e., millions of jobs have been and are being permanently eliminated, perhaps as a long term consequence of offshoring, outsourcing to other countries and the ongoing deindustrialization of the United States. However, the immediate meaning of the term “structural” has to do with the fact that jobs created or sustained during the unprecedented expansion of debt leading to the financial crisis that began in 2008, e.g., a substantial portion of service sector jobs created in the past two decades, now appear not to be viable outside of a credit expansion.

The total number of unemployed or underemployed persons, including so-called “discouraged workers” (Bureau of Labor Statistics U-6), is at 17.1%. Using the same methods that the BLS had used prior to the Clinton administration, U-6 would be approximately 22%, rather than the official 17.1% statistic. With official U-6 unemployment of 17.1% and a workforce of 154.1 million there are roughly 26,197,000 people officially out of work. Using the pre-Clinton U-6 unemployment calculation of approximately 22%, there would be 33.9 million unemployed. If the average US household consists of 2.6 persons and if 33% of the unemployed are sole wage earners, then 55.5 million US citizens currently have no means of financial support (17.9% of the population).

While it has been reported that the labor force is shrinking, the characterization of workers permanently exiting the workforce by choice may be inaccurate. While a shrinking workforce could reflect demographic changes, the rate of change suggests that tens of millions of Americans are simply unemployed.

Setting aside the question of whether or not those “not in the workforce” are, in fact, permanently unemployed, the workforce– as a percentage of the total US population– is currently at 1970s levels. Since many more households today depend on two incomes to meet their obligations, compared to the 1970s, a marked drop in the percentage of the population in the workforce points to a decline in the labor market more significant than official unemployment statistics suggest.

7. Structural Government Deficits to Remain in Place
What is more important, however, is that structural unemployment suggests structural government deficits, e.g., unemployment benefits, welfare, food stamps, etc. Since more than 2/3 of US GDP (roughly 70%) consists of consumer spending, a sustainable recovery from recession seems improbable if unemployment is worsening or if the labor force is in a structural decline, since that would imply unsustainable government deficits, whether or not they are masked by nominal GDP gains thanks to economic stimulus measures.

8. GDP Growth May Stay Negative
The U.S. federal government is a growing portion of GDP, thus reported GDP growth is largely a byproduct of government deficit spending and stimulus measures, i.e., reported GDP growth is unsustainable. Total government spending at the local, state and federal levels accounts for as much as 45% of GDP, thus nominal gains would be expected when government deficit spending increases. According to some measures, reported gains in GDP are a byproduct of relatively new statistical methods and, using earlier methods of calculation, GDP remains negative.

9. Declining Dollar and High Inflation a Distinct Possibility
Government borrowing and spending may have offset declines in the private sector, but only to a degree and only temporarily. The resulting growth in U.S. public debt has an eventual mathematical limit: insolvency. Of course, the actual limit to U.S. borrowing remains unknown. The continuing solvency of the U.S. depends on the ability and willingness of governments, banks and investors around the world to lend to the U.S., which in turn depends on the tolerance of lenders for the U.S. government’s profligacy and money printing by the Federal Reserve, e.g., quantitative easing and exchanging new cash for worthless bank assets. U.S. Treasury bond auctions will fail if lenders conclude that a sufficiently large portion of their investment will be diluted into oblivion by proverbial money printing. In that event, the U.S. dollar will surely plummet, despite deflationary pressures within the domestic U.S. economy, and the cost of foreign goods, e.g., oil, will rise, causing high inflation or triggering hyperinflation.

According to the Bank for International Settlements (BIS), the federal budget deficit increased from 3.1% of GDP in 2007 to 9.2% in 2010. Rather than being the result of one-time expenses, such as temporary stimulus measures, much of the deficit represents permanent increases in government spending, e.g., due to the growing number of federal employees. If increased government spending is removed, GDP appears to be declining significantly. Of course, sustainability has more to do with total debt than with deficit spending because a deficit assumes that there is an underlying capacity to service additional debt.

10. Debt is Unsustainable
While asset prices have declined, e.g., real estate and equities, debt levels have remained high due to the federal government’s policy of preserving bank balance sheets, which had ballooned prior to the financial crisis to the point that overall debt in the U.S. economy reached unsustainable levels.

The absolute debt to GDP ratio of the U.S. economy peaked in 2007 when debt levels exceeded the ability of the economy to service debt from income based on production, even at low interest rates. Although U.S. GDP began to decline prior to the advent of the global financial crisis, debt coverage had been in decline approximately since the 1970s, coincidentally, around the time that the U.S. dollar was decoupled from gold.

Government deficit spending cannot correct the situation because, for every dollar of new borrowing, the gain in GDP is negligible and some have argued that the U.S. economy has passed the point of “debt saturation.”

In a growing economy, additional debt can result in a net gain in GDP because the money supply grows and economic activity is stimulated by transactions that flow through the economy as a result. The debt saturation hypothesis is that, as debt levels rise, additional debt has less impact on GDP until a point is reached where new debt causes GDP to decline, i.e., the capacity of the economy to service debt has been exceeded and, not only is it impossible for the economy to grow at a rate sufficient to service existing debt (since interest compounds), but economic activity actually declines further as a function of additional debt.

11. A Downward Spiral in Debt Deflation is to Continue
The process of debt deflation is straightforward. New lending at levels that would maintain or expand the broad money supply is impossible for two reasons:
1. asset values and incomes have fallen and millions remain unemployed and
2. debt levels remain excessive compared to GDP, i.e., real economic activity (outside of the government and financial services industry) cannot service additional debt.

The inability to lend, actually the result of prior excess lending, results in a net drain of money from the economy. The drain effect, in turn, leads to further defaults as cash strapped consumers and businesses fail to service existing debt, and as debt defaults impact bank balance sheets, putting a damper on new lending and completing the cycle of debt deflation.

Keynesian economic policies, i.e., government deficit spending, are irrelevant vis-à-vis excessive debt levels in the economy and bailing out banks is not a solution, since it cannot stop the deterioration of their balance sheets. The process is self-perpetuating and cannot be stopped by any government or monetary policy because it is not a matter of policy, but rather one of mathematics.

Since the presence of excess debt (beyond what can be supported by a stable GDP, or by sustainable GDP growth) impacts the broad money supply, efforts to preserve bank balance sheets, i.e., to keep otherwise bad loans on the books of banks at full value, will ultimately cause bank balance sheets to deteriorate more than they would have otherwise. The fact that U.S. banks issued trillions in bad loans cannot be corrected by changing accounting rules, nor can the consequences be avoided by government deficit spending or by unlimited bailouts, and the problem cannot be papered over by dropping freshly printed money from helicopters flying over Wall Street.

Conclusion
The major problems facing the U.S. economy today, namely
- a tsunami of debt defaults,
- structural unemployment,
- massive government budget deficits,
- a contraction of the broad money supply outside of the federal government and the financial system, and
- a lack of sustainable growth
cannot be addressed as long as excess debt levels are maintained. As von Mises clearly understood, sound economic conditions cannot be restored unless and until the excess debt, which resulted from a boom brought about by credit expansion, is purged from the system.

The current policy of the United States, is a downward spiral into a bottomless economic abyss.

*http://seekingalpha.com/instablog/496474-ron-hera/74344-into-the-abyss-the-cycle-of-debt-deflation

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.
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Austrian Economics teaches that a circulation-credit-fueled boom can only be sustained by ever-greater doses of credit and money expansion, provided at ever-lower interest rates. As soon as the growth rate of credit and the money supply slows down, the illusionary upswing collapses. Mal-investment is revealed, firms cut employment, and the economy goes into recession. [Sound familiar?] Words: 982

In further edited excerpts from the original article* Thorsten Polleit (www.mises.org) goes on to say:

The current upward dynamic of the debt-to-GDP ratio in the U.S. is economically unsustainable but something can be done to correct the situation. While we do not know how much debt relative to GDP an economy can shoulder the level of debt relative to income cannot rise without limit. This insight is important, given that there is strong reason to believe that the extraordinary rise in the debt-to-GDP ratio is a result of the government-controlled, fiat-money system in which the money supply is increased through bank lending.

The Correction Scenario
Let us assume, for the sake of argument, that the current debt-to-GDP ratio has exceeded its sustainable level. What are the chances that output could start expanding more strongly than debt, thereby lowering the ratio? This would be a rather favorable scenario, as the debt-to-GDP ratio would decline, while income and employment would increase. Unfortunately, however, it is a rather unlikely correction scenario.

Lenders can then be expected to demand higher interest rates and/or to stop extending loans as the outlook for the possibility of borrowers repaying their debt (in real terms) deteriorates. In other words, market forces start pressing for a change in the hitherto-observed path of the total-debt-to-GDP ratio.

If commercial banks make their debtors repay their loans, the money supply declines. A drop in the money supply, in turn, would represent deflation and the symptoms would be declining prices for goods and services of current production, and for existing assets such as, for instance, stocks and real estate.

Deflation would lead to credit losses as a growing number of borrowers would find their incomes greatly diminished and — most importantly — falling short of expectations. Many borrowers would default on their debt.

If credit-related losses exceed their equity base, banks go bankrupt. Savers and investors in bank debentures would have to accept losses, as banks could not meet their debt service. It doesn’t take much to see that such an outlook could trigger a “flight out of debt.”

Investors would try to dump their bonds, causing interest rates to go up. Borrowers in need of rolling over their debt would have to accept higher refinancing rates, which would leave a growing number of investment projects unprofitable. The mere expectation of rising credit costs would therefore make possible an anticorrection scenario.

The Anti-correction Scenario
In the anti-correction scenario, central banks — seeing an unraveling debt pyramid — would decide to prevent banks from defaulting on their debt by pushing short-term interest rates to record lows and providing additional base money for bank refinancing — by monetizing banks’ debentures and/or (troubled) assets.

Keeping a circulation-credit boom going requires ever-greater amounts of credit and money, provided at ever-lower interest rates. However, credit and money cannot be increased indefinitely by the central bank and commercial banks. In fact, it is money demand that would set a limit.

If inflation — that is, a rise in the money supply — does not exceed an unacceptable level, people may well continue to use money even if it loses its purchasing power. If, however, inflation exceeds an acceptable level, or if people start expecting inflation to continue to rise further, the money is doomed to fail.

As Ludwig von Mises noted in 1923, “once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.”

The private sector may be able to cope with deflation (and the ensuing redistribution of property rights). The institution of government, in its current size and scope, however, cannot. Inflation — the rise in the money supply — is an indispensable tool for financing government outlays for which the taxpayer would presumably not want to pay out of his current income.

Mises noted, “inflation becomes one of the most important psychological aids to an economic policy which tries to camouflage its effects. In this sense, it may be described as a tool of anti-democratic policy. By deceiving public opinion, it permits a system of government to continue which would have no hope of receiving the approval of the people if conditions were frankly explained to them”.

The effort to prevent government from defaulting on its debt is, therefore, the greatest danger for the value of money and this is why an unsustainable debt-expansion path poses such a great danger to the exchange value of money.

Central banking makes it possible for the government to expand the money supply by any amount, at any time deemed necessary and once (hyper)inflation is publicly seen as being the lesser evil of all options available for the government meeting its debt service, it cannot be dismissed out of hand that (hyper)inflation would be the consequence of an unsustainable debt-to-GDP ratio.

*http://mises.org/daily/3754

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The debate over deflation/inflation continues as some of our most astute economic observers take sides. Frankly, I think that both sides are missing part of the picture. The debate concentrates on the after shocks of inflation/deflation: prices instead of the money supply and the demand for it. Words: 621

In further edited excerpts from the original article* Paul Mladjenovic (mladjenovic.blogspot.com) goes on to say:

“Prices” are the visible barometer that both sides of the debate gauge. The inflationists see (or warn about) “rising prices”. The deflationists see (or warn about) “falling prices”. There are very convincing cases by both sides.

At the present time the deflationists seem to have the upper hand. They point out that we have a “deflationary economic environment” due a variety of factors that are contributing to falling prices (such as deleveraging and unemployment). Inflationists see the current stage being set for future rising prices due to factors such as expanding money supply and a weakening dollar. What is the real deal?

First, let’s set the record straight on the terms…

Inflation:
Is the condition where more money (such as a paper currency) is created by the issuing authority (the government’s central bank) and this growing supply of money is chasing a fixed basket of goods and services (and/or assets). Inflating the money supply (“monetary inflation”) is the problem and the symptom is usually rising prices (“price inflation”). Inflation is not the price of things going up…it is the price (or value) of money going down.

Deflation:
Generally the opposite… The money supply is stable or shrinking relative to the supply of stuff we
buy and subsequently there is less money chasing goods and services. In this case, the “value” of money usually increases.

Therefore, for prices to rise there needs to be more (and growing) money supplied to the market relative to what is being bought. Two things need to happen for prices to rise from an inflationary perspective:

1. More money needs to be created.
This money needs to “chase” what is being purchased (Think “circulation” or “velocity”). This is a crucial point. Prices won’t go up just because the money supply expands; the money has to be actively “chasing” those goods or services (or assets) for the prices to see upward movement.

2. For prices to go up (“price inflation”), you need monetary inflation (increasing the money supply) and velocity (the money is chasing goods, services and/or assets).

In recent years, the money supply has indeed expanded dramatically…but…relatively little “chasing” has been going on. If the Federal Reserve instantly created $10 trillion dollars and gave it to you, that is definitely monetary inflation but… if you merely put it in your sock drawer and hoard it, then it would not circulate (chase stuff) and therefore you wouldn’t see “price inflation”.

This is where part of the confusion and controversy is. Inflationists point out that money supply is growing dramatically and they are correct. Deflationists point to falling prices in many areas of the economy and they are also correct. Here is what we should be aware of…

The prices of goods, services and assets are most affected by 2 fundamental factors:
1. The money supply (primarily enacted by government)
2. Demand and supply (primarily enacted by the marketplace)

Understanding the money supply (its growth or shrinkage) coupled with understanding “demand and supply” will give you a better picture of the economy. This, in turn, will make you a better analyst, money manager or investor.

Regardless of what side of the debate is proven correct the bottom line is that precious metals should be considered in a balanced, diversified wealth-building strategy. Paper currencies can be produced at will but precious metals can not. Therefore, any investor or money manager interested in diversification and safety should consider precious metals.

*http://mladjenovic.blogspot.com/2009/10/part-i-deflation-or-inflation-here-is.html

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- 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.
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We are in for a inflationary depression and, as such, investors should put their money in those things that will benefit from both inflation and strong demand and supply and stay away from where there is a deflationary impact, such as real estate. Words: 825

So says Paul Mladjenovic (www.ProsperityNetwork.com) in edited excerpts from his original article*.

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and www.munKNEE.com (Your Key to Making Money!) has edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) the article below for the sake of clarity and brevity to ensure a fast and easy read. The report’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Mladjenovic goes on to say:

The prices of goods, services and assets are most affected by two fundamental factors, namely:

1. The money supply (primarily enacted by government)

2. demand and supply (primarily enacted by the marketplace)

Demand and supply are an important factor in this debate and I believe that this becomes a source of misunderstanding. Inflationists talk about the money supply exploding and that this massive increase will (sooner or later) mean higher prices and even to the point of hyperinflation. The deflationists tell us that we are (and will continue to be) in a powerful deflationary environment. What gives?

Demand and supply complete the observation. Look … if a trillion dollars is printed right now but this money is not flowing toward anything (“demand”) then you probably won’t see a price increase. Demand has decreased for some goods, some services and some assets in recent years. However, demand has increased (or has had continued strength) in other goods, services and assets.

In other words, BOTH of the inflationists and deflationists can be correct if you break down the picture. You can have inflation in one part of the economic picture but not another. You can have demand and supply bring prices down in one part of the economy and not another.

Real Estate
Demand, for example, has been dropping like a rock in real estate. The real estate bubble of 2000-2006 artificially stimulated supply which increased the national inventory of available property (both residential and commercial) to the highest level in history. Too much supply with falling demand obviously means falling real estate prices. No amount of created money supply was able to overcome this.

Labor Markets
The same is true for the labor markets. Labor is priced higher than the market could realistically pay for. We forget that the price of labor is more than just “the gross pay”; it also includes many other costs such as payroll taxes, workmen’s comp, etc. The high cost of labor dampened the demand for labor; especially when demand for products and services fell. Right now, the supply of labor is much higher relative to the demand for labor.

In turn, as there are more and more unemployed, that means that less money is then available for discretionary purposes such as vacations and new cars. You get the picture.

“Deflation” vs. “Deflationary”
Keep in mind that there is a big difference between “deflationary” and “deflation”. It is much like the difference between “fainting” and “dropping dead”. Lower demand does have a “deflationary” effect. If less people want something then of course the price will likely drop and this can happen even if the government’s central bank keeps expanding the money supply. What does all of this then mean for us as investors and traders?

What to do With Your Money
It is actually simple to figure out what to do with your money given this historic debate. Consider putting your money in those things that will benefit from the monetary situation and from the demand and supply equation, i.e. put your money (retirement or otherwise) into those things tied to “HUMAN NEED”. If you have your money in those things that will benefit from BOTH inflation AND where demand and supply are strong, then this merits your attention.

a) Stay away from where there is a deflationary impact (such as real estate…unless you really need to buy a home). Go where the money is migrating.

b) Given this, I like gold, silver, grains, energy and other commodities. Investors and traders should consider “human need” and view it as a mega-trend during the coming months and years. I believe that a commodities super-boom is a likely event (and is already unfolding). No matter how good or bad the economy will be, people will still need to eat, drink, heat their homes, etc. For these reasons (and other ones), I like commodities for the long haul.

For those deflationists that believe inflation is not possible when there are bad economic conditions, I say think again. Most hyperinflations in history happened during bad economic times. Germany (1920s), Yugoslavia (1989-1994) and Zimbabwe (2007-present) are good examples.

Yes…inflation and a depression can happen simultaneously. Plan accordingly…

*http://www.resourceinvestor.com/News/2009/10/Pages/Part-II-Deflation-or-inflation-Here-is-the-answer.aspx (Check out www.ProsperityNetwork.net for Paul’s latest educational program “How to Cash in on the Commodities Super Boom Seminar” and visit his blog at www.Mladjenovic.blogspot.com.)

“If you’re holding paper currency, you have to have some kind of trust that the country that issued it is not just going to print its way out of its problems. That’s a real concern right now. Gold, on the other hand, has real intrinsic value, unlike a paper currency which can be debased by its government.” – Sacha Tihanyi, currency strategist, Scotia Capital; Words: 2233

In further edited excerpts from the original article* Nick Barisheff (www.bmgbullion.com) goes on to say:

Currency versus Money
Most investors confuse money and currency, but they are not the same thing.

a) Money is defined as a medium of exchange, a unit of account and a store of value. For centuries, money referred to coins made of rare metals (gold and silver) with intrinsic value, and to notes backed by precious metals.

b) Currency, while it is a medium of exchange, is not a store of value. It only derives its value by arbitrary fiat government decree and hence the term “fiat currency”. Paper banknotes represent money but they are not money. They are simply promissory notes whose long-term “value” or purchasing power depends entirely on the fiscal and monetary discipline of the government that issued them.

Therein lies the problem. In an era of massive fiat currency expansion by profligate governments across the globe, today’s currencies are depreciating in value faster than yesterday’s news. Fortunately for precious metals investors, gold and precious metals have risen in value, and will continue to rise in value against all currencies because they have once again resumed their historical role as stores of value: money.

“When the price of gold moves, gold’s price isn’t moving; rather it is the value of the currencies in which it’s priced that is changing.” – John Tamny, economist, H.C. Wainwright Economics

The Decline of the World’s Currencies
Currency debasement isn’t a recent phenomenon. For decades, governments around the world, through their central banks, have been creating money out of thin air to cover their excessive spending and mounting debt. Investors have for the most part accepted this subtle form of taxation, because it seemed to have little personal impact. However, appearances are deceiving. Investors are discovering that the value of their dollar-denominated assets has actually declined a staggering 82 percent since 1971!

The Wrong Measuring Stick
Every day, the media (via currency traders) informs Canadian investors about the latest price of the Canadian dollar in US dollar terms, while US investors compare the US dollar to a basket of the world’s major currencies [the U.S. Dollar Index]. This information, however, gives investors surprisingly little insight into the true value of their portfolios. If we started measuring the world’s currencies against money (i.e., gold), investors would be horrified at the stark decline in the value of all currencies. Most investors’ portfolios are heavily weighted towards currency-denominated financial assets (stocks and bonds), but few realize that the true value or purchasing power of their portfolios is declining every single year because of currency depreciation.

The Rate of Currency Decline is Accelerating
Since 1913 (the year the US Federal Reserve was established), the US dollar has lost over 95 percent of its value of which 82 percent of its value has been just since since 1971 so the rate of currency decline is accelerating.

In the past ten years alone, the US dollar, the Canadian dollar, the UK pound and the euro have collectively fallen 70 percent in value if measured in real (currency-debased) terms. In other words, when they are priced in terms of gold.

The (Fiat Currency) Money Supply
Not too long ago, all the world’s major currencies were backed by gold because it was a universally recognized store of value. The gold standard imposed fiscal and monetary discipline, since each country had to hold enough gold to equal the amount of money in circulation however that is not the case any longer. Government spending around the world is exploding, and (fiat currency) money supply, along with government debt in the world’s major economies, is exploding along with it. Nowhere in the world has spending become more out of control than the US where the monetary response to last year’s financial crisis is creating yet another bubble, and this time it will be the bubble to end all bubbles.

Countries are Increasingly at Risk of Sovereign Debt Default
“In the process of saving a few ‘too big to fail’ corporations and their bond holders, policymakers are greatly increasing the risk of sovereign defaults.” – Puru Saxena, editor/publisher, Money Matters

The risk of massive and widespread sovereign debt default has never been higher. “Official” US government debt has soared to 90 percent of GDP, while multi-trillion-dollar budget deficits for the next several years will send that number soaring. Japan, the world’s second-largest economy, was recently put on credit watch. Its debt is twice total GDP, yet its newly elected government has announced much higher spending for 2010. The UK’s 2009 budget deficit will be over 14 percent of GDP, adding to a net debt that will reach 56 percent of GDP this year, 65 percent in 2010 and 78 percent by 2015.

Spain, Italy and Portugal are facing major fiscal deficits, as is Eastern Europe. Dubai is billions in debt and its prize jewel, Dubai World, is bankrupt. Greece’s credit rating has been slashed, and its debt is forecast to reach 130 percent of GDP. Then there is Iceland, whose debt had exploded to seven times GDP before the global meltdown. The country’s banking system has now collapsed, its currency is deeply devalued, its real estate market has imploded and the country is in a full-blown economic depression.

The Incredible Shrinking Dollar
As the world’s reserve currency, the US dollar is a proxy for the rest of the world’s currencies. The dollar’s decline is a direct reflection of America’s deepening financial troubles, exacerbated by a ravaged banking system that, by 2010, may see over one thousand banks insolvent. In 2009, the US incurred a budget deficit of $1.4 trillion, and its debt rose by $1.9 trillion due to off-budget expenditures. These off-budget expenditures alone were more than the 2008 budget deficit. At the end of 2009, America’s total debt was over 100 percent of GDP.

In their attempt to reflate the bubble-driven economy, President Barack Obama, Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner have decided to add to this financial house of cards. Instead of raising taxes or cutting expenditures, they have decided to borrow their way out of the problem and have the Fed create money out of thin air, which will almost certainly create another bubble. This bubble will make the others pale by comparison and will help destroy the US dollar. The dollar may be the world’s reserve currency, but China and other countries are not only questioning its status, but also actively campaigning for greater use of alternative currencies.

Gold Bullion Holding Strong
Where are most investors putting their cash? It should no longer be in stocks. Key stock indices like the Dow Jones Industrial Average have been flat to negative in nominal terms since the end of the last century but if the Dow is priced in gold (in other words, money) as opposed to depreciating dollars (in other words, fiat currency), its decline is far more dramatic. The Dow:Gold Ratio is not only in a downtrend, the downtrend is steepening which is a continuing indicator to move from equities to bullion.

Global creditors who currently hold trillions of dollars’ worth of dollar-denominated financial assets are dumping them to preserve their wealth. That is why gold bullion, along with its precious metals cousins, silver and platinum bullion, have been consistently keeping their value against financial assets.

Central Banks are Buying Gold Bullion
“We have a market-friendly Fed injecting a lot of liquidity in the system which will set us up for another bubble economy. Excessive monetary accommodation just takes us from bubble to bubble to bubble.” – Stephen Roach, chief economist, Morgan Stanley

India recently bought 200 metric tonnes of gold bullion from the International Monetary Fund for $6.7 billion. Russia has recently added 120 tonnes of bullion to its reserves, while China has steadily (and surreptitiously) increased its gold bullion reserves from 600 tonnes in 2003 to 1,054 tonnes today. China is even urging its people to put five percent of their savings into gold and silver because it is so worried about the dollar. Because trillions of dollars of its reserves remain in US dollar-denominated assets, China’s central bank will be diversifying into gold for many years to come.

The world’s central banks know that gold is primarily a monetary asset, not a commodity. That’s why a growing number of them are quietly diversifying out of US dollars and adding to their 29,000 tonnes of gold reserves.

In its 2010 Precious Metals Outlook, Scotiabank noted that “seeing the value of the dollar steadily erode must be a nightmare for large US creditors such as China, Japan, South Korea, Russia, the oil producing countries and Sovereign Wealth Funds (SWF)…

Major Investors are Diversifying into Gold
“Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that.” – Lou Jiwei, Chairman, China Investment Corporation

It is not just governments that are dumping dollars for bullion:
- A rapidly growing number of sovereign wealth funds (including China Investment Corporation) are participating, as are major institutional investors.
- Hedge fund manager John Paulson, who made $3 billion in 2008 by shorting subprime mortgages, recently took a multi-billion-dollar position in gold as a hedge against inflation.
- Northwestern Mutual Life Co.’s CEO Edward Zore said his company purchased $400 million in gold (the first time in its 152-year history) because “the downside risk is limited, but the upside is large. We have stocks in our portfolio that lost 95 percent. Gold is not going down to $90.”
- Hedge fund manager David Einhorn, through his Greenlight Capital fund, has sold gold ETFs in order to invest in longer-term and lower-risk gold bullion because of current US economic policy.
- Lone Pine Capital significantly increased its stake in gold this year.

Perhaps of even greater interest to the unwary investor is a survey of US hedge fund managers by London-based Moonraker Fund Management: 90 percent (20 of the 22) of the hedge fund managers surveyed admitted they had bought physical gold for personal investment. These sophisticated investors know something that the average investor doesn’t: that the global policy response to the financial crisis will not only devalue the world’s major currencies, it will decimate the US dollar.

Many Investors Still View Gold as a Commodity
Individual investors are not so farsighted – yet. Because most of them have only experienced one kind of market – a 25-year bull market in stocks – many still think gold is just a commodity like copper, zinc or pork bellies. Gold is far more than that, however. It has a 3,000 year history as money. For much of that time, it was the universal medium of exchange because of its divisibility, portability, rarity, beauty, malleability and indestructibility. Despite today’s negative sentiment, gold is not a speculation or a barbaric relic. Gold is money. Gold retains its purchasing power year after year.

Forty years ago it took 66 ounces of gold to buy a compact car. Today it takes only 14 ounces. If you had put your money in gold instead of dollars, the same car would actually be 79 percent cheaper, because gold keeps its value. Houses, stocks and virtually every other asset on earth would also be cheaper if bought with physical gold.

The more investors learn about bullion, the better for their portfolios If you are already a bullion investor, now is the time to add to your portfolio. If you are new to investing in bullion, now is the time to start dollar-cost-averaging into bullion. I encourage investors to learn as much as they can about bullion and about the markets in general. A good place to begin is the Learning Centre section of our website (www.bmgbullion.com). It offers a comprehensive look at the economy, money, markets and bullion investing, and provides a variety of thought-provoking articles written by experts in the field of gold and precious metals.

Gold is Money
Gold is money because it cannot be created out of thin air by government decree. Unlike bonds, gold does not represent someone else’s liability and, unlike stocks, gold does not rely on someone else’s promise of performance. Gold is money because, unlike currencies, impatient monetary policymakers cannot change its value. The rising gold prices we have experienced for the last eight years do not signal a bull market in precious metals, but rather a vote of decreasing confidence in the future value of paper currencies.

Currency-denominated financial assets are a disaster waiting to happen. The current economic rebound is a mirage, being entirely dependent on something artificial and unsustainable: massive government spending. A new crisis is building out of unprecedented fiscal and monetary mismanagement. Fortunately, smart investors can protect their wealth from the coming storm. The true level of risk has not been priced into the markets.

The time to shelter your wealth from the storm is now. There is no safer investment on earth than bullion, because bullion is and always will be money.

*http://www.bullionbullscanada.com/index.php?option=com_myblog&show=gold-is-money-unlike-the-world-s-currencies-gold-retains-its-value.html&Itemid=116

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.
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A soaring gold price is a vote of “no confidence” in the central bank and the dollar [and]… reflect a growing restlessness with the increasing money supply, our budgetary and trade deficits, our unfunded liabilities, and the inability of Congress and the administration to reign in runaway spending. Words: 1911

In further edited excerpts from the original speech* before the U.S. House of Representatives United States Congressman Dr. Ron Paul goes on to say:

Interest in gold has soared along with its price… Much can be learned by understanding what the rising dollar price of gold means.

Gold – Protection Against the Debasement of Fiat Currency
The rise in gold prices from $250 per ounce in 2001 to over $600 [in early 2007 and almost $1200 in early 2010] has drawn investors and speculators into the precious metals market. Though many already have made handsome profits, buying gold per se should not be touted as a good investment. After all, gold earns no interest and its quality never changes. It’s static, and does not grow as sound investments should.

It’s more accurate to say that one might invest in a gold or silver mining company, where management, labor costs, and the nature of new discoveries all play a vital role in determining the quality of the investment and the profits made.

Buying gold and holding it is somewhat analogous to converting one’s savings into one hundred dollar bills and hiding them under the mattress – yet not exactly the same. Both gold and dollars are considered money, and holding money does not qualify as an investment. There’s a big difference between the two however, since by holding paper money one loses purchasing power. The purchasing power of commodity money, i.e. gold, however, goes up if the government devalues the circulating fiat currency.

Holding gold is protection or insurance against government’s proclivity to debase its currency. The purchasing power of gold goes up not because it’s a so-called good investment; it goes up in value only because the paper currency goes down in value. In our current situation, that means the dollar.

Gold – A Store of Value
One of the characteristics of commodity money – one that originated naturally in the marketplace – is that it must serve as a store of value. Gold and silver meet that test – paper does not. Because of this profound difference, the incentive and wisdom of holding emergency funds in the form of gold becomes attractive when the official currency is being devalued. It’s more attractive than trying to save wealth in the form of a fiat currency, even when earning some nominal interest. The lack of earned interest on gold is not a problem once people realize the purchasing power of their currency is declining faster than the interest rates they might earn. The purchasing power of gold can rise even faster than increases in the cost of living.

Four Cents on the Dollar
The point is that most who buy gold do so to protect against a depreciating currency rather than as an investment in the classical sense. Americans understand this less than citizens of other countries; some nations have suffered from severe monetary inflation that literally led to the destruction of their national currency. Though our inflation – i.e. the depreciation of the U.S. dollar – has been insidious, average Americans are unaware of how this occurs. For instance, few Americans know, nor seem concerned, that the 1913 pre-Federal Reserve dollar is now worth only four cents.

Officially, our central bankers and our politicians express no fear that the course on which we are set is fraught with great danger to our economy and our political system. The belief that money created out of thin air can work economic miracles, if only properly “managed,” is pervasive in D.C.

Current Monetary System Unsound
In many ways we shouldn’t be surprised about this trust in such an unsound system. For at least four generations our government-run universities have systematically preached a monetary doctrine justifying the so-called wisdom of paper money over the “foolishness” of sound money. Not only that, paper money has worked surprisingly well in the past 35 years – the years the world has accepted pure paper money as currency. Alan Greenspan bragged that central bankers in these several decades have gained the knowledge necessary to make paper money respond as if it were gold. This removes the problem of obtaining gold to back currency, and hence frees politicians from the rigid discipline a gold standard imposes.

Many central bankers in the last 15 years became so confident they had achieved this milestone that they sold off large hoards of their gold reserves. At other times they tried to prove that paper works better than gold by artificially propping up the dollar by suppressing market gold prices. This recent deception failed just as it did in the 1960s, when our government tried to hold gold artificially low at $35 an ounce but, since they could not truly repeal the economic laws regarding money, just as many central bankers sold, others bought. It’s fascinating that the European central banks sold gold while Asian central banks bought it over the last several years.

Since gold has proven to be the real money of the ages, we see once again a shift in wealth from the West to the East, just as we saw a loss of our industrial base in the same direction. Though Treasury officials deny any U.S. sales or loans of our official gold holdings, no audits are permitted so no one can be certain.

Dollar is Depreciating vis-a-vis Gold NOT Vice Versa
The special nature of the dollar as the reserve currency of the world has allowed this game to last longer than it would have otherwise but the fact that gold has gone from $252 per ounce to over $600 [and now closer to $1200] means there is concern about the future of the dollar. The higher the price for gold, the greater the concern for the dollar.

Instead of dwelling on the dollar price of gold, we should be talking about the depreciation of the dollar. In 1934 a dollar was worth 1/20th of an ounce of gold; $20 bought an ounce of gold. Today [early 2007] a dollar is worth 1/600th [now almost 1/1200th] of an ounce of gold, meaning it takes $600 [now almost $1200] to buy one ounce of gold.

Blame it on the Money Supply
The number of dollars created by the Federal Reserve, and through the fractional reserve banking system, is crucial in determining how the market assesses the relationship of the dollar and gold. Though there’s a strong correlation, it’s not instantaneous or perfectly predictable. There are many variables to consider, but in the long term the dollar price of gold represents past inflation of the money supply. Equally important, it represents the anticipation of how much new money will be created in the future. This introduces the factor of trust and confidence in our monetary authorities and our politicians and these days the American people are casting a vote of “no confidence” in this regard, and for good reasons.

The incentive for central bankers to create new money out of thin air is twofold. One is to practice central economic planning through the manipulation of interest rates. The second is to monetize the escalating federal debt politicians create and thrive on.

Today no one in Washington believes for a minute that runaway deficits are going to be curtailed… Most knowledgeable people assume that inflation of the money supply is not only going to continue, but accelerate. This anticipation, plus the fact that many new dollars have been created over the past 15 years that have not yet been fully discounted, guarantees the further depreciation of the dollar in terms of gold.

[Excess money] will drive the dollar down, while driving interest rates and commodity prices up. Already we see this trend developing, which surely will accelerate in the not too distant future. Part of this reaction will be from those who seek a haven to protect their wealth – not invest – by treating gold and silver as universal and historic money. This means holding fewer dollars that are decreasing in value while holding gold as it increases in value.

Though everyone decries inflation, trade imbalances, economic downturns, and federal deficits, few attempt a closer study of our monetary system and how these events are interrelated. Even if it were recognized that a gold standard without monetary inflation would be advantageous, few in Washington would accept the political disadvantages of living with the discipline of gold – since it serves as a check on government size and power. This is a sad commentary on the politics of today.

Addicted to Deficit Spending
a) Government
The best analogy to our affinity for government spending, borrowing, and inflating is that of a drug addict who knows if he doesn’t quit he’ll die; yet he can’t quit because of the heavy price required to overcome the dependency. The right choice is very difficult, but remaining addicted to drugs guarantees the death of the patient, while our addiction to deficit spending, debt, and inflation guarantees the collapse of our economy.

b) Special Interest Groups
Special interest groups, who vigorously compete for federal dollars, want to perpetuate the system rather than admit to a dangerous addiction. Those who champion welfare for the poor, entitlements for the middle class, or war contracts for the military industrial corporations, all agree on the so-called benefits bestowed by the Fed’s power to counterfeit fiat money. Bankers, who benefit from our fractional reserve system, likewise never criticize the Fed, especially since it’s the lender of last resort that bails out financial institutions when crises arise.

While it’s true that special interests and bankers do benefit from the Fed, and may well get bailed out, what the Fed cannot do is guarantee the market will maintain trust in the worthiness of the dollar. Current policy guarantees that the integrity of the dollar will be undermined. Exactly when this will occur, and the extent of the resulting damage to financial system, cannot be known for sure – but it is coming. There are plenty of indications already on the horizon.

c) Foreign Policy
Foreign policy plays a significant role in the economy and the value of the dollar. A foreign policy of militarism and empire building cannot be supported through direct taxation. The American people would never tolerate the taxes required to pay immediately for overseas wars, under the discipline of a gold standard. Borrowing and creating new money is much more politically palatable. It hides and delays the real costs of war, and the people are lulled into complacency – especially since the wars we fight are couched in terms of patriotism, spreading the ideas of freedom, and stamping out terrorism. Unnecessary wars and fiat currencies go hand-in-hand, while a gold standard encourages a sensible foreign policy.

A fiat monetary system encourages speculation and unsound borrowing. As problems develop, scapegoats are sought and frequently found in foreign nations. This prompts many to demand altering exchange rates and protectionist measures. The sentiment for this type of solution is growing each day.

*http://www.dailyreckoning.com.au/gold-us-dollars/2007/01/19/ (Dr. Ron Paul is a Republican member of Congress from Texas and perhaps the only voice in Washington still advocating “limited” government in the Jeffersonian tradition.)

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.

In the popular framework of thinking, which originates in the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings. In the Keynesian framework, the key to prosperity is the ever-expanding monetary flow. Monetary expenditure drives economic growth. Words: 542

In further edited excerpts from the original article* Frank Shostak (www.mises.org) goes on to say:

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditures and raise their savings. If, for instance, for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending. Consequently, a vicious circle sets in. The decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more.

In order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.

Keynes suggested, however, that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they could not fall further. This, according to Keynes, could occur because people might adopt the view that interest rates have bottomed out and that rates will subsequently rise, leading to capital losses on bond holdings. As a result, peoples’ demand for money would become extremely high, implying that they would hoard money and refuse to spend it no matter how much the central bank tried to expand the money supply.

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending could be on all sorts of projects — what matters here is that a lot of money must be pumped in order to boost consumers’ confidence. With a higher level of confidence, consumers would lower their savings and raise their expenditures, thereby reestablishing the circular flow of money.

It is interesting to note that Keynesian economic ideas have been embraced and implemented by the governments and central banks of the major economies of the world [with the Obama Administration its greatest endorser].

*http://blog.mises.org/?p=010700

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.