Denial of Crisis

7/31/2019 Denial of Crisis

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In Denial of Crisis :

An Economy Undermined by Failures of the Monetary System, the Concentrated Media, and Political Will

June 2005 David Jensen is the Principal of Jensen Strategic (www.jensenstrategic.com) aVancouver-based strategic planning and business advisory services company. The followincommentary is not investment advice.

With economic growth estimates for 2005 of 2.5% and 3.4% respectively, Canaand the US look forward to steady if not stellar growth of their economies in thcoming year. The Bank of Canada notes for 2005 that the prospects for continurobust growth are quite favorable1 .

Yet all is not as promising as it seems. Central Banks (Canadas and the U.Sincluded),on false grounding in economics and using a monetary system based-upan endless cycle of debt creation, have for decades maintained that the economcould be controlled by central planning and manipulating the amount of money ainterest rates in the economy. This has allowed over-spending for massi

government programs, unsupportable promises of future benefits to retirees, and costly military adventures incredibly coupled with seemingly endless growth in consumers net worth and consumption.

In a repeat of errors committed in the 1920s, failure of central bank monetary policy led to the1990s dot.costock market bubble and correction in 2000 which now reveals a distorted economy saturated with unsustainaband increasing levels of debt just to continue the economy. The post-bubble response of the US FedeReserve Bank in lowering interest rates to 1% now leads to rampant and destabilizing financial speculatibubbles in the economy including the North America-wide real estate bubble.

We have a concentrated media in both Canada and the U.S, which has provided little critical analysis economic policy choices, and a political ruling class most interested in short-term crises and solutions, whihand-off chronic but acute problems to the next elected official. The result is in that we have not had aaccountability and correction of highly visible economic policy failures by our government and monetaauthorities that have been visible for years. We are now on the brink of a strong economic correction like

impacting our populations for generations.

Immediate and bold remedial action by government is required to mitigate the impact of the coming correction.

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Under the placid surface [of the economy], there are disturbing trends: hugeimbalances, disequilibria, risks -- call them what you will.

Altogether the circumstances seem to me as dangerous and intractableas any I can remember, and I can remember quite a lot.

Paul Volcker, Former US Federal Reserve Bank Chairman 2

April 10, 2005.

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If the American people ever allow private banks to control the issue of currency, first by inflation, then bydeflation, the banks and corporations that will grow up around them will deprive the people of all property unti

their children will wake up homeless on the continent their fathers conquered

Thomas JeffersonThe Debate Over the Recharter of the Bank Bill, 1809

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The above two statements were made almost 200 years apart, however, they have a common concern theconsequent damage from the manipulation of the money stock (i.e. the money that exists in society) foreconomic gain.

Economists and politicians have long known that increasing the money stock has the beneficial consequence ostimulating the economy. The initial short-term effect is that it increases the money available to be spent andinvested which for a period increases economic activity. However, manipulation of the money supply hasnegative consequences which have damaged countries (including Canada and the U.S.) who travel down this

road, including:

1. Inflation. In simple terms, with a fixed amount of goods in an economy, increasing the stock oramount of money (called the money stock by economists) results in more dollars being availabfor a basket of goods, causing inflation (or a rise) in the price of goods. Damaging because itimpoverishes those holding savings and those on fixed incomes, price inflation of goods in theeconomy has a further negative impact in that, once it starts to climb, hoarding behavior byconsumers and businesses to forward purchase goods creates artificial shortages driving priceseven higher in a damaging spiral. Once the inflation spiral is started, it can only be shaken fromthe economy through an economic slowdown usually induced by sharply higher interest rates.

2. Investment bubbles and mania. Examples include:! 1920s stock market mania leading to the 1929 Crash followed by the 1930s Depression! the 1989 Nikkei stock market and real estate bubble in Japan followed by a 15 year

malaise in Japan; and! the 1990s dot.com stock market bubble followed by its correction in 2000; a market

bubble and crash which created by and has now been so mal-addressed by the USCentral Bank (the Federal Reserve or Fed) that we face our impending economiccorrection

3. Inevitable internal economic distortion resulting in growing imbalances which ultimately correctwith economic busts, deep recessions and depressions.

It is the last item which politicians, central bankers, and economists popular in the political realm have denied isa consequence of their centrally-planned monetary control.

Readers in Canada or the U.S. will likely not have a concern regarding the current economy however, asChairman Volcker notes, large distortions exist beneath the surface which will manifest themselves. Thesedistortions and coming correction are visible to our political leaders, but while Volcker notes that urgent action isneeded, he also notes governments tend to react after the fact which in this case will impart great damage tothe both the U.S. and Canada.

The coming economic fall-out now militates that the damaging, anachronistic centrally-planned attempts bycentral banks and politicians to steer the economy using the monetary system must be curtailed.

Jeffersons Insight

If we read Jeffersons comments with todays definition of inflation and deflation, it makes little apparent sense.However, the meaning of the words inflation and deflation have changed over time so that they now mean,respectively, an increase or decrease in consumer goods prices. In their more classic economic sense, inflatiorefers to an in increase in the money stock (cash and debt) outstanding in the society. Deflation refers to adecrease in the money stock.

Jeffersons warning now becomes a little clearer. History is riddled with monetary inflation accompanied byuneconomic activity, speculative booms, and investment mania, all resulting from the excess inflation of themoney stock, followed by crashes. There is nothing surprising or even unreasonable about market speculationso long as one realizes the dynamic causing the speculation and limits exposure be it real estate, equities,bonds, interest rate derivatives, and other financial instruments. However, few retail investors do understand


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when a bubble is underway and the top usually occurs after the flow of new credit or increases in the moneystock starts to slow a visible signal within the financial system but not to the average investor.

Extraordinary Popular Delusions and the Madness of Crowds3 was initially published in 1841 and documentedexcess credit and money creation inducing trading bubbles and collapses such as the Dutch Tulip Mania(Holland - 1630s), John Laws Mississippi Scheme (France 1720 : a stock market bubble engulfing Franceinduced by massive inflation (or debasement) of Frances money stock), The South Sea Bubble (England 1720 : investment mania where even Sir Isaac Newton lost his family fortune), etc.

In a more recent work

4

, Edward Chancellor documents more than a dozen historical and contemporary monetaand credit booms that drove speculative mania including the 1920s stock boom, the late 1980s Nikkei stockmarket and real estate boom in Japan, and the 1990s dot.com stock market bubble in the US.

The excess which can be attained during an investment bubble are well illustrated by the following words froman investment prospectus to raise money during the South-Sea Bubble of 1720: A company for carrying on anundertaking of great advantage, but nobody to know what it is. 5

Creation of investment bubbles and their subsequent crashes are directly and obviously negative as they simplresult in the transfer of wealth from the public to those promoting investments (such as through Initial PublicOfferings (IPOs) of a stock ) during an investment bubble. Thus, the phenomenon of speculative boom and buacts as a wealth ratchet. The financial industry, speculators, stock industry promoters and traders makeenormous profits on the ascent stage and, if savvy, can roll-out of investments with gains into cash or otherstable asset positions before a correction, then buy assets at prices of pennies to the dollar in the subsequentbust when investors must liquidate assets to settle losses.

Key bankers, politicians, and Wall Street traders wanted the creation of the U.S.s central bank in 1913 andworked through a White House insider Edward Mandell Colonel House to see the Federal Reserve Actdeveloped and passed. ( Colonel House was a wealthy Texas patrician who had never served in the militaryand whose family fortune was acquired by his father in the South during the American Civil War. ) Althoughcalled the Glass-Owen Bill (after Congressman Carter Glass and Senator Robert Owen), the Federal Reserve

Act was the creation of President Wilsons point-man on banking matters, Colonel House.

The immediate effect of the creation of the new central bank (The U.S. Federal Reserve Bank) to control themoney supply was the price inflation of 1914 to 1920, then the 1920s stock market mania and crash of 1929which revealed that average citizens who were skeptical of the wisdom of creating a central bank were correct.That the Fed caused the stock market bubble resulting in the crash of 1929 and the Great Depression is notargued by todays supporters of the Fed. In 2002, at the 90th birthday party for famed economist and monetarisMilton Friedman, then Fed Governor Ben Bernanke commented You were right, we did it. But thanks to you wwont do it again. 6 Whether the Fed and other central banks can prevent another financial rupture is a questioon which the jury is still very much out.

Our Stable Economy Stable or a Redux to Another Apparently Stable Time?

So what is former Chairman Volckers concern today? The economy is healthy: inflation is apparently low, thestock market has corrected to lower stock price to company earnings (p/e) ratios, the housing market isbooming, we are looking forward to further growth: whats the problem?

First, The US (and in fact the Worlds) economy is still very much in recovery from the dot.com stock marketcrash of March 2000. As we will see, Mr. Greenspans declared victory when stating we were very much correin our decision to address the after-effects of the bubble rather than the bubble itself may have been a littlepremature.

The stock market bubble of the late 1990s was a textbook recreation of the 1929 bubble and the late 1980sJapanese Nikkei stock market and real estate bubble. They all relied upon the creation of excess credit in turnbrought about by excessive monetary policy of central banks (note that money enters the economy as loansfrom banks to borrowers. Increasing the money stock therefore means increasing the debt level in theeconomy).


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The origin of the 1920s stock market bubble, notes Economist Murray Rothbard was that, in order to assistBritain in artificially maintaining the strength of its currency while it was in economic decline, America increasedits money stock by an average of 7.7% annually over an 8 year period from 1921 to 1929. In his words, it was very sizable degree of (monetary) inflation 7 and the entire monetary expansion took place in money substitutewhich are products of credit creation The prime factor in generating the (monetary) inflation of the 1920s wasthe increase in the total bank reserves. 8.

Yet, like today, while the 1920s economy roared ahead, consumer price inflation was apparently tame while thstock market appeared reasonably priced. Rothbard notes The fact that general prices were more or less

stable during the 1920s told most economists that there was no inflationary threat, and therefore the events ofthe great depression caught them completely unaware.9 Economists who support manipulation of the economby varying the money stock and interest rates are dubbed monetarists. The father of modern monetarism andthe Quantity Theory of Money, which is the basis of central bankers expansion of the money supply, is IrvingFisher, who was himself so enthused about future prospects that in October 1929, one week before the marketcrashed, he made his famous (mis)statement:

Stock prices have reached what looks like a permanently high plateau. I do not feel that there will sooif ever, be a fifty or sixty point break below present levels as Mr. Babson has predicted. I expect to seethe stock market a good deal higher than it is today within a few months10

Irving Fisher

The DOW would decline 89% from its 1929 peak value of 381 bottoming 3 years later in 1932 at 40. Fisher whhad a net personal wealth of $10 million from designing and patenting the Rolodex, lost his entire fortune in thecrash and ultimately died penniless. But his Quantity Theory of Money still built favor with economists,politicians and central bankers of the future.

What Fisher missed, and one of the reasons there are so few billionaire economists, was their fundamentalmisunderstanding of the economy and the distortions engendered by their monetarist economic theory. Liketoday, after administering the wrong thing (excess money (debt) creation), they were measuring the wrong thin(goods inflation) and had a crucial misunderstanding regarding the apparently limitless suspension of the 1920economy distorted by more than a decade of excess monetary and credit expansion.

To this day, monetarist economists suggest that there was nothing wrong with the stock market in 1929. TheNational Bureau of Economic Research (NBER) issued a working paper in December 2001 titled The StockMarket Crash of 1929 Irving Fisher was Right (McGrattan and Prescott) in which they stated We find that thstock market in 1929 did not crash because the market was overvalued. In fact, the evidence strongly suggestthat stocks were undervalued, even at their peak. The Federal Reserve agrees. In March 1999, the FederalReserve Bank of San Francisco issued an Economic Letter that stated that with stock prices at 30 timesdividend yields, the market was not overvalued 11. (For a clear-eyed comparison of todays and the 1920seconomy, see the article How Could Irving Fisher Have Been So Wrong? by Doug Noland - available on theinternet 12 )

The standard response by economists of todays Milton Friedman / Irving Fisher monetarist school is that thedepression of the 1930s was caused by Fed incompetence in not increasingthe money stock adequately inresponse to the crash starting in 1929. In fact between January 1930 and December 1933, the Fed didintervene by increasing their purchases of bonds from Banks by 98% per annum thereby injecting dollars into thbanking system13. This added $2 Billion to bank reserves which should have resulted in further loans and anattendant increase in economic activity. However, bank credit contracted 30% during this period as the initialcontraction had revealed the non-productive nature of many enterprises and speculative investments and theirdependence upon repeated rounds of financing used to sustain the boom.

The excess credit financing of speculative and unproductive activities dried-up as did consumer stomach for de a form of credit revulsion took hold and the economy slowed (ultimately declining almost 50% by the mid1930s) shaking-out the unproductive enterprises that had grown in the economy after a decade of loose credit.

That economists like Milton Friedman and Fed Chairman Greenspan could today advocate that a stock marketbubble and crash caused by excess credit accompanied by resultant economic distortions could and should beaddressed by even more excess credit, raises serious questions. And yet, that has been Chairman Greenspan


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and the Feds response to the correction of the 1990s dot.com stock market bubble the Fed and TreasurySecretary Robert Rubin started in 1995 with their strong dollar policy (we will see it was anything but).

The U.S. and Canada now find themselves in an economic corner. There is a need to continue raising interestrates to combat rising inflation yet we are surrounded by investment bubbles and a housing bubble which willstrongly correct if the required action is taken by our central banks.

Origins of the dot.com Bubble and Post-Bubble Federal Reserve Action

In 1993 and 1994, the Fed increased the broad money stock (called M3) by roughly $80 Billion each year. In1995 the Fed suddenly reversed policy and started growing the money stock in the U.S. by larger amounts eacyear thereafter ( up $267 Billion in 1995 and rising until it was increased $597 Billion in 1998) the stockmarkets immediately responded with the Dow Industrials Index growing 34% in 1995 vs. an historical annualaverage of 10%. In December 1996 when the Dow was at 6,500 (up 71% from it level of 3,861 in January 19952 years earlier ) Greenspan warned of irrational exuberance. Instead of cutting the annual growth of the monstock, The Fed accelerated its growth and all US stock markets grew tremendously until the bubble pop in Marc2000. From 1998 on, Greenspan lost his concern about irrational exuberance lauding the new economy andtechnologically driven productivity as justifying the elevated stock market levels. The Dow closed 1999 at10,970 having increased more than 7,000 points (gaining more than 200%) in just 5 years and the NASDAQgained more than 500% from a starting value of 752 points in January 1995 to an ultimate peak of over 5,000.

U.S. Stock Markets vs. Annual Money Stock (M3) Growth

$577 B.

$507 B.

$597 B.

$479 B.

$347 B.

$268 B.

$83 B.$80 B.

0

100

200

300

400

500

600

1993 1994 1995 1996 1997 1998 1999 2000

Year End

U.S.Stock

Markets

.

(1993

=100)

-$50

$50

$150

$250

$350

$450

$550

$650

AnnualM3

Growth

.

($Billions)

Dow Jones Year End (1993 = 100)NASDAQ Year End (1993 = 100)M3 Money Stock Growth ($ Billions)

Source: U.S. Federal Reserve (Money Stock Data)

The creation and crash of the dot.com stock market bubble represented a complete failure of the FederalReserve central bank yet no accountability or consequences have stemmed from this failure either at the Fedin the financial industry or in the media which all cheered on and justified the wildly inflated market as it grew 14

Unchastened, Greenspan went on in 2001 to encourage the massive Bush administration tax cuts despite thefact that the Congressional Budget Office warned that capital gains and other taxes received by the Governmenwould drop along with the declining stock market craze and corporate profits were projected to grow modestlyuntil 2010 15.


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Given the Feds money (debt) creation combined with further government deficits, the U.S. economy is nowmore financially indebted than at any other time in history exceeding even the debt vs. GDP levels of 1934which were only attained after the U.S. economy GDP declined almost 50% during the great depression.

Source: Clapboard Hill Investment Partners; Barrons Magazine

In the aftermath of the crash in 2000 of the dot.com stock market bubble, the Fed and U.S. Treasury Departme(now under the auspices of President Bushs Treasury Secretary Paul ONeill) stood ready to make sure thateveryone could continue to access credit to rescue the economy and the markets. In January 2001 interestrates were first lowered from an initial 6.5 % Fed Funds Rate to an ultimate 1% (the Fed Funds determines shoterm interest rates in the credit system).

Before the Feds low interest rate response to the dot.com market crash, there were clear warnings made to thFed about an already developing real estate bubble. The Fed insisted that a real estate bubble was not possibas the U.S. real estate market was composed of many small markets. The Fed now says it has heaanecdotal evidence that some real estate markets may be somewhat frothy. Single family homes in the entstate of California, representing 20% of the U.S. real estate stock, have increased 35% in price in the lastyears where single family dwellings are currently 290% of their 1997 price level. The California market has nohit the silly stage where home purchases are financed with risky financing methods such as increasing principloans where the borrower does not pay the full monthly interest on a mortgage (and hopes the house increasein value at a faster rate than the increase in the loan principal). Home prices in North America increased double digit rates in 2004.


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Source: www.prudentbear.com

With low interest rates and sharply rising real estate values, consumers were quick to spend their new foundwealth through cash-out home mortgage refinancing and home equity loans. However, this only represents aincrease in indebtedness relying on artificially inflated assets as collateral, not a creation of new or sustainablewealth in the U.S. economy (Noland).

The low cost of borrowed money fed speculative finance activity not only in real estate, but also in bonds,derivatives, and the stock markets. Although the stock markets have corrected from historically high valuationsthey continue to be over-valued on historical terms.

US stock market performance has tracked the Nikkei post 1989 crash profile while, with the lowering of interestrates, yet speculation has returned to the stock markets along with increasing overvaluation of stocks. Excesshas returned the market value of the internet stock Google is now over $76 billion with a p/e ratio of 109.


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In aggregate, stocks are still over-valued compared to historical norms:

Source: Century Management Inc.

A Distorted Economy

Item: The U.S. has a total debt (Government, Corporate, and Household combined) of $38 Trillion. Inaddition, in 2002 Treasury Secretary Paul ONeill commissioned a report identifying that the U.S. hadfuture unfunded entitlement liabilities (Medicare, Medicaid, and Social Security) with a present value of$43 Trillion16 which in 2002 would have required an immediate and perpetual income tax of 69% if theywere to be met. The U.S.s net annual economic production (Gross Domestic Product or GDP) is $11.7Trillion with a current budget deficit of $500 Billion per year (includes Iraq War costs). It is clear fromthese numbers that, even if the economy was healthy, these debts and liabilities cannot be paid.

Item: According to the Fed, In 2004 U.S. debt (government, corporate and household combined)increased by $2.72 Trillion dollars17 (23% of GDP) yet this debt spending in the U.S. Economy can onlyproduce economic growth this year of 3.4% of GDP. Thus $6.50 of debt increase is producing $1 of

growth in the economy.

Item: The U.S. requires an injection of $2 Billion in foreign investment each day to sustain its economyabsorbing more than 80% of the Worlds annual savings.

Something is amiss.

After decades of monetary and debt injections to provide a fix for the economy, the U.S. economy now standssaturated and severely distorted by its credit excess. From a vitally productive and inventive society to onewhere financial speculation reigns supreme, the US economy has been transformed to a financial betting parloWhere, historically, manufacturing had accounted for 45% of business profits and financial services accountedfor 15%, this relationship has been turned on its ear in the new economy with less than 15% of profits now

generated by the manufacturing sector and 45% of profits generated by shuffling paper in the financial sector(stocks, bonds, derivatives, mortgage financing, etc.) . According to the U.S. Bureau of Labor Statistics, theFinancial Services Industry accounts for 6% of current U.S. employment giving a sense of outsize profits beinggenerated by the Financial Services sector.


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Source : Bridgewater Associates; The Money Shufflers Vig

Globalization was one of the critical component of the Greenspan / Rubin strong dollar policy talk which wasinitiated in 1995 it was actually a gross, inflationary dilution of the US dollar (the strong dollar policy positionis today amusingly repeated by the Bush Administration Treasury Secretary John Snow despite U.S. FederalReserve policy, deficit spending and trade policy which is flooding the world with US dollar debt and money).

The service industry jobs which were supposed to be generated by globalization have been muted. Instead, thinternet driven global arbitrage in labor, as identified by Morgan Stanleys Chief Economist Stephen Roach, hled to a transfer of high skills job out of the U.S. service industry. Operations in China and India using highlyeducated and skilled workers can provide overnight legal, accounting, engineering and business services overthe internet at a fraction of the price of North American service providers.

Instead of gradually transitioning to a free trade environment, the U.S. markets door has been swung wide-open. While this has gutted the production base of the U.S., the pressure of Chinese worker salaries of $0.50per hour and lax Chinese environmental laws on the U.S. factory worker wages until recently kept consumergoods price inflation at bay. Cheap imports have effectively served as a substitute for prudent stewardship ofthe money stock by obscuring central bank monetary inflation.

This allowed the Fed and Treasury under the Bush Administration to lower interest rates to 1% resulting in afurther injection of debt into the economy thereby delaying the consequences of the popping of the dot.comstock market bubble. The correction we face with a housing bubble added to the fray will now be much worse.

The depressing impact of cheap imported goods in the manufacturing industry, in combination with the distortineconomic impact of the Feds decades of credit creation on the U.S. economy, have resulted in the economicrecovery since the 2001 post-bubble recession posting no net private sector job growth despite claims theeconomy is healthy. According to Morgan Stanley, the U.S. now has 10 million fewer jobs post the dot.comeconomic decline than it would in an average previous recovery18.


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Source: www.jobwatch.org May 4, 2005 Bulletin.

While the official unemployment rate has declined from 6.3% in 2003 to 5.2% in 2005, the actual percentage ofthe workforce that is employed has declined from over 67% of the population in 2000 to 65.5% of the populatioin 2005 this despite an increase in the number of elderly forced back into the workforce after the 2000 stockmarket correction19. These contradictory figures arise because the U.S. and Canada both define thoseunemployed only in terms of individuals actually looking for work. If jobs are not available and an unemployedperson is discouraged and in recent weeks has not actively searched for a job, they are no longer counted asunemployed and the government can ignore them in the unemployment survey.

The Chinese economic miracle with unheard of 15+ % per year economic growth is itself the product not onlyof the U.S. export market but also of central bank monetary distortion within the Chinese economy. In theheadlong rush to develop Chinese infrastructure and import technology in the shortest term possible, rather thagrow at a measured pace that can be maintained over the long-term, loose Chinese central bank policy hasresulted in Chinese banks now sitting on $US 800 billion of bad (or in banking parlance non-performing) loansequating to 50% of GDP. Also like the U.S., China maintains interest rates below the inflation rate. Chinesegoods are thus subsidized by their own expandable elastic money system and with prices that do not reflect thetrue cost of production within China.

With a declining U.S. economy and rising inflation, it will be increasingly difficult for foreign investors to continueto finance the U.S. deficits at 4% interest on a 10-year bond and sustain the real estate and speculativeinvestment booms in the U.S. Not covered well in the media, is that in September 2004 and November 2004,

the Japanese and Chinese, who had been the major purchasers of U.S. Treasury debt, veritably stopped theirpurchases. How long Caribbean Banking Centers 20, who initially filled the gap as foreign purchasers of U.S.bonds, can sustain the U.S.s debt addiction is open to question. All the while, both Canadian and US househodebt is increasing each year by more than 10% per annum.

This path is unsustainable, yet U.S. and Canadian leaders have chosen the path of cheerleading the economyalong with an obeisant media. And each day consumers are led on by rising and unsustainable housing markeprices and a sense that the economy is healthy, to walk deeper and deeper into the quicksand of debt.


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The Central Bankers Delusion : The Root of Our Economic Malaise

In his book Debt and Delusion: Central Bank Follies that Threaten Economic Disaster 21, Peter Warburtonidentifies that deregulation of the worlds financial markets since the 1970s allowed central banks to embark ona trajectory of inflating the money stock thereby also inflating by multiples the worlds stock, bond and real estamarkets - this all while apparently containing price inflation (for an good summary of Warburtons book, see thepaper Debt and Delusion commentary by Robert Blumen at www.mises.org/fullstory.aspx?control=1579&id=71).

The containment of inflation depends upon ones definition of inflation. With the monetary injection into theeconomies of the West, investment values in almost all financial asset classes have ballooned with the stimulusof the money injected.

The worlds equity (stock) markets are now valued at more than $26 Trillion; the bond market has grown from

less than $1 trillion in 1970, to $23 trillion in 1997, and $43 trillion in 200222

. Real estate is in a bubble. And thderivativesi markets have grown to total invested values of $9.1 Trillion and using financial leverage to multiplythe opportunity for gain (but also loss), the levered exposure value of these derivatives (what the Bank ofInternational Settlement optimistically calls notional value) has grown from $47 Trillion in 1995 to nowexceeding more than $200 Trillion more than 500% of the worlds entire annual economic output23.

Inflation, while very much around us, has until recently been constrained to financial investments while centralbankers have claimed that their inflation of the money supply has not produced classic consumer goods priceinflation.

iDerivatives are financial instruments reflecting a bet upon some underlying market characteristic such asinterest rates or the price of commodities. Derivatives include instruments such as futures, puts, calls, swaps

etc.


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Interest rate related derivative instruments (70% of outstanding derivatives), in particular, are sensitive to sharpinterest rate moves. ii Fed intervention to buffer investment losses are a previous pattern of ChairmanGreenspan as the Fed has invariably turned to liquidity injections and bail-outs of destabilized marketparticipants in times of crisis ( 1987 stock market crash, 1997 Asian currency crisis, 1998 LTCM bail-out, etc.).Lulled by past Fed Intervention and soothing words during Greenspans tenure, spiking interest rates aresomething the bond and derivatives speculators are betting wont happen.

The financial system risk which derivatives represent have long been known (derivatives have been labeledweapons of mass destruction), yet Greenspan has for years argued against regulation of the derivativesmarket. If there is a sufficient interest rate acceleration, this market can quickly lock-up as the levered nature oderivatives which multiplies losses means that, without regulated derivatives exchanges, large amounts ofmoney can quickly be lost and derivatives holders on the wrong side of a trend can be quickly financiallybankrupted. Given the level of unstable and levered risk in this market which exceed greatly exceed the assetsof all financial trading institutions combined and entering a period where inflation has started to rise, the financisystem is particularly vulnerable.

Past Fed monetary policy and intervention has combined to form this lethal mixture: excess liquidity and lowinterest rates combined with the creation of moral hazard as market speculators believe that any crisis broughton by speculative excess will be buffered by a Federal Reserve bailout. In this vein, Warburton notes the dangin central banks serving as the interventional saviors or lenders of last resort (LLRs) to bail-out with publicmoney not just banks but private sector entities which are designated as too big to fail. In Warburtons wordsCentral banks unquestioned roles as LLRs to the commercial banks and guardians of the financial systemmaintain an ambiguity over the ultimate responsibility for catastrophic loss, however and wherever it occurs.This ambiguity has promoted excessive risk-taking in the private sector and has fostered the very circumstancein which financial disasters have occurred before. 24

Until recently, consumer goods inflation were restrained in their price rises because (1) Globalization providincheap imports have until now capped consumer goods prices, (2) our governments have defined inflationmeasures in a way that understates true price rises (see discussion below), and (3) financial investment vehiclehave absorbed the lions share of the profligate money creation bloating all investment classes during thisperiod.

iiMuch has been written about the unregulated derivatives market and the threat of systemic instability that it poses to themonetary system (for a derivatives primer, see: http://www.financialpolicy.org/dscprimers.htm; for a discussion regarding tdangers posed by derivatives, see: http://www.ex.ac.uk/~RDavies/arian/scandals/derivatives.html &http://www.financialpolicy.org/fpfspr8.pdf)


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This is the failure of the Fed and the all the worlds central banks: they have viewed inflation in terms of prices goods in society as opposed to an increase in the money stock and have increased money and debt in societybelieving they were free to do so without understanding distortion this engenders in the operating structure of theconomy.

While the inflationary monetary liquidity is locked in the financial markets, our notion is that consumer priceinflation remains apparently stable however, if speculation in commodities and then goods inflation occurs or investors seek stability by investing in commodities and traditional safe havens such as precious metals, theneven a relatively small portion leaking from the multi-trillion dollar financial investment silos can drive

commodities prices skyward thereby resulting in an explosive appearance of consumer price inflation, forcing uinterest rates to contain the inflation. The kimono so cleverly hiding central bank fiat monetary inflation fordecades will suddenly be dropped.

In a perverse replay of the 1970s, we may potentially see loose monetary policy followed by weak economicgrowth and rising commodity prices (or stagflation) except in this version we will have twice the debt-to-GDPratio and investment bubbles as the inflation starts to manifest itself.

Speculation in commodities has already started. Driven both by international demand as well as a hedgingagainst currency declines, the past 4 years have seen a 65% increase in the price of commodities shown in theCRB Commodities Index chart below. Inflation has now also reared its head in the U.S. consumer price indexwhich is rising at an annualized 6.2% in the first quarter of 2005 and 3.5% in the 12 months through the firstquarter. And these price rises are in spite of cheap import compressing price rises in the economy.

The manifestation of strong goods price inflation can result in one of two responses by the Fed and the Worldscentral banks :

With an aim to maintaining foreign investor confidence, defend the dollar and ultimately other fia

currencies by strongly raising interest rates. This would eventually control inflation but pop the debtdependent investment and asset bubbles (including the real estate bubble) with severe economic faout. This would leave heavily indebted consumers in a form of indebted servitude unable to pay-down debt incurred in a low interest rate, real estate bubble environment.

Abandon defense of the dollar injecting massive amounts of liquidity (money) into the bankingsystem resulting in a hyper inflationary spiral and ultimate collapse of existing paper currencies.

There is third scenario which is unlikely. However, the loss of personal privacy and freedoms in the US andCanada since the 9/11 War on Terror was initiated makes what would have seemed absolutely impossible adecade ago now at least a considered, although remote, possibility. That would be to declare the free markettoo dangerous and the imposition of tighter government control over the economy and individuals (a scenario


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suggested by Jim Sinclair Mr. Gold ofwww.jsmineset.com ). It would be an irony indeed that an economicemergency caused by the failed paradigm of central planning in turn applied by central banks to a mal-designedmonetary system should be deemed a failure of the free market.

The game now remains one of confident statements by central bankers and politicians worldwide to continue thdebt, investment and speculation cycle in financial markets. Inflation is contained; commodities price surgesare temporary; the world foresees steady growth. It is essential that the silos of investment capital, that havetemporarily enabled their policies, be maintained and constrain capital from flowing into commodities andprecious metals.

Former Federal Reserve Governor Ben Bernankes 2002 statement that the Fed stood ready to drop moneyfrom helicopters if deflation becomes a threat, perhaps becomes clearer. What sounded like an irresponsibleboast made some look the wrong way (away from speculation in commodities) by giving the impression the Fedwas fighting deflation, an environment where commodities lose value, not the explosive inflation that lies in thewings. The irony in Bernankes statement is that the Fed and central banks have been figuratively droppingmoney from helicopters for decades.

A U.S. national savings rate being below 1% of GDP ( a record low vs. an historical norm of approximately 6%of GDP) has been driven by the Fed interest rate being lowered to its low of 1% (and at 3% today, still below thrate of inflation). This has made the U.S. dependent upon foreign sources for financing of budget deficits andtrade deficit requiring the daily injection of $ 2 billion of foreign capital. With the Japanese and Chinese pause US Treasuries purchases, a sustainable source of foreign financing for the US has not yet appeared.

Foreign investors already hold more than $5 Trillion in U.S. Treasuries, currency and stocks alone. A decline inforeign appetite for U.S. investments can send investment paper washing back to the U.S. Just a slowdown ofUS debt purchase by foreigners, not a full stoppage or dumping of U.S. dollars, is all that is required to cause afurther fall in the US dollar and interest rates to rise steeply disrupting markets and precipitating a further declinof US investments held by foreigners.

Compounding the tenuous nature of the current situation is that 60% of the outstanding $4.5 trillion U.S.Treasury bonds (net $2.7 Trillion) in the hands of the foreign and domestic public will mature within the next 3years. Thus in addition to the $500 billion in treasuries that need to be floated each year to finance the budgetdeficit and the Iraq war, another $900 billion on average must be rolled-over into new bonds to continue the U.Sdebt at the current low interest rates 25. In total, $1.4 trillion of U.S. Treasuries need to be purchased each yeaby foreign and domestic investors unless the Fed wishes to print more money and purchase the bonds itself.This is perfectly possible but will be attended by much higher interest rates as even the lethargic bondvigilantes recognize the aggressive dollar dilution this signals.

How did we ever get to this point?

That the money stock can today be manipulated at will by central banks is a consequence of our currentunbacked (or fiat ) monetary system.

In years past, the worlds industrial economies were limited in their ability to manipulate the money stock as mocurrencies were on a strict gold standard. Gold backed a countrys money at a fixed ratio and currency wasfreely redeemable for gold from a countrys treasury and banks at that fixed ratio.

Because the gold standard monetary system prevents limitless creation of money, it has been noted:

Gold is an unimaginative taskmaster. It demands that men, banks, and government be honest. Itdemands that they create no debt without seeing clearly how these debts can be paid But when acountry creates debt light-heartedly, then gold grow nervous. There comes a flight of capital (gold)out of the country. 26

Benjamin M. Anderson

Much to the bane of politicians and central banks, currency backed at a fixed gold ratio and freely redeemablefor gold coin from a countrys banks and Treasury allows that currencys citizen holders to convert that currencyto gold coin and to either hold it in hand or safety deposit boxes within a country. Foreign holders could also


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remove the gold from a country that exercises economic policy that cannot be supported by reasonable taxatioand fiscal policy. By removing the backing mechanism (gold) from banks and the Treasury, such actionessentially removes money from circulation within that country forcing-up interest rates and forcing a change inpolicy by the offending government (Fekete).

This disciplinary problem was addressed gradually over the 20th Century by governments transition to todaysmonetary system where no currency redeemable in gold thus allowing central banks to control the money suppby central bank edict or fiat - a privilege that all have abused.

With the elastic, fiat monetary system where the money stock is freely expandable, Governments are able togenerate large debts by issuing government bonds then dissipating the debt at a later date by printingiii currencto consume that debt by inflationary dilution and devaluation.

Creation of money to stimulate an economy is nothing new. The Romans secretly diluted their silver coins andthe Chinese (the first to use paper money) experienced monetary inflations in the 1300s.

During the 20th Century the world witnessed Weimar Germany undergoing hyperinflation (defined as more than50% per month) in 1922 1923 which consumed its WW I reparations debt. Serbia issued 500 billion dinarnotes as recently as 1993 with daily rates of inflation of 100%. Hyperinflationary periods result in currencycrashes so the helicopter money scenario discussed by Ben Bernanke is not an attractive scenario.

In the U.S., the United States Revolutionary War in 1775 was financed by the Continental Congress issuingnotes (Continentals) which were unbacked by gold or silver and were predictably printed and inflated toworthlessness leading to the saying not worth a Continental and George Washington to comment Awagonload of currency will hardly purchase a wagonload of provisions. 27 This as well as other bank currencyschemes in the 1800s left a deep and abiding distrust for irredeemable paper currency in the American people

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How is money created and the money stock controlled?

This is a staggering thought. We are completely dependent on the commercial banks. Someone has tborrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money weare prosperous; if not, we starve. We are absolutely without a permanent money system

Robert H. Hamphill, Formerly of the Atlanta Federal Reserve Bank

Three concepts are key to understanding the creation of money,.

1. When we think of money, we tend to think of cash both bills and coin. However, less than 5% of monexists in this form - the majority of money in existence exists as bank deposits. They are merelyaccounting totals.

2. All money in existence has come into existence as a loan and reflects a current loan in the financialsystem. The constant increase in the money stock reflects a continual increase in debt in the fiat monebanking system. Conversely, if loans are paid-down, the money stock contracts.

3. Money is created by Banks , not the government or the central bank, with loans injecting money into themonetary system and economy. Banks simply credit accounts by making loans in response to twomechanisms:

Money is lent from the central bank to chartered banks which in turn lend out multiples (typically10 times the amount received ) thus creating money in the economy. This is referred to as fractionalreserve banking. If interest rates are held constant and central banks lend money beyond demand inthe banking system, banks lower credit quality requirements for borrowers to stimulate demand anddeploy their assets.

iii Note: the term printing money is used loosely to denote an increase in the money stock as today the majority of money in society a

number entries indicating holdings in bank accounts.


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Central banks lower interest rates thus stimulating demand for loans which are then offered bybanks, again as multiples of their cash deposits, to create money by simply crediting accounts.

Contrary to popular belief, a loan does not necessarily come from someone elses savings. It is merelycreated as an account entry as a response to the issuance of a loan.

The flip side of this consideration is that if all loans were paid-off, the money stock disappears - thus MrHamphills comment that our system exists without a permanent money stock and the need for increasidebt levels.

By the broad monetary measure called M3, all the money in existence (Canada roughly $930 billion andin the U.S. $ 9.6 Trillion) reflects institutional loans that require the payment of interest.

Our central banks, the US Federal Reserve and Canadas Bank of Canada are relatively new creations they are not the inevitable result of using currency whether or not that currency is backed by gold

There is an alternative to this monetary system and that is one where the Treasury of Canada or the U.Swould issue money which is permanent (whether backed or unbacked by gold is another discussion). Insuch a system, the Treasury would issue money, typically through government spending, without moneybeing created through bank loans.

Such money would be permanent and exist without being originated as a loan however this wouldremove a major profit generating mechanism from our financial institutions as it would greatly slow thegrowth of debt.

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The Fiat Cat Keeps Coming Back

In America, the failed Continentals were followed in 1861 by another attempt at issuing a central currencybecause, as noted by the Federal Reserve itself, once again the need to finance a war provided the impetus foa change to the monetary system. 28 That war was the Civil War.

Thus, in 1861 Congress authorized Demand Notes (called greenbacks due to their green ink) which wereunbacked by gold and then in 1862 also began issuing United States Notes which, during the Civil War anduntil 1879, were also made irredeemable in gold and silver coin.

Both the Norths Notes and the Souths Confederate Notes were printed (and counterfeited) en masse during thCivil War deepening the mistrust of U.S. citizens (North and South) for irredeemable paper currency. (It shouldbe noted that the Federal Reserve on its website states the fact that paper currency U.S. Notes issued by theNorth starting 1861 (Confederate notes were in the end worthless) are still redeemable for modern monetary


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notes at face value is important for the record or currency stability which this represents 29. That this currencyonly has a fraction of its original buying power seems to escape the Fed.)

The US Federal Reserve Bank was created in 1913 when the American people were reticent to have a centralbank a sentiment arising both because of numerous upheavals from previous failed currency manipulationiv inthe U.S. and in other countries. The reticence also existed because of a fear of concentration of power whichmany believed would be abused by Money Trusts in the Eastern financial banking centers.

To address the concern of American citizens about a Central Banking System, the Federal Reserve Act of 1913

created a system of 12 regional banks now overseen by 7 governors appointed by the President. In theory, thiwas a system of regional banks. In reality, these reserve banks formed the U.S.s Central Bank overseen by thBoard of Governors and its principal policy making body, the Federal Open Market Committee (FOMC).

The creation of the Federal Reserve was on the eve of World War I which began in 1914 and the FederalReserve Act was passed on December 22, 1913 by the U.S. Senate by a vote of 43 to 25, at a time when 28Senators were away for Christmas vacation, and signed by President Wilson on December 23. With the creatioof the Fed, money was backed by gold but could be created in greater quantities than held in gold by Treasury.

After running on an election platform promising to retain the gold standard, President Franklin D. Roosevelt(FDR) reneged in 1933, confiscated gold held by U.S. citizens in their Bank deposit boxes and suspended theright of citizens to own gold or redeem U.S. notes and Federal Reserve notes for gold (although foreign holdercould). Finally in 1971, after having run an exceptionally loose monetary policy and creating money at multipleof the official gold reserves of the US to finance the Vietnam War, after France (initially) then other countriesredeemed massive amounts of U.S. currency for gold. To prevent such further delivery of national assets foroutstanding debt, ending all pretenses, President Nixon officially defaulted and made all U.S. currency and debinstruments held by foreigners also irredeemable for gold. The U.S. public was once again able to own gold bylaw.

The dollar has lost 92% of its buying power since the Feds initiation of operation in 1914 while during the1800s, despite bouts of currency manipulation, the buying power of the gold-backed dollar was ultimately steadwhen the interventionist schemes subsided.

Central Banks and Their Elastic Currency

The founding fathers, being aware of the withering effect of monetary inflation which had occurred with theunbacked Continentals during the revolution forbade the use of a currency that was not gold or silver backed.Specifically Article 1, Section 10 of the Constitution stipulates : No State shall coin Money, emit Bills ofCredit; make any Thing but gold and silver Coin a Tender in Payment of Debts; . Despite clear and expressopposition of those who wrote the Constitution to un-redeemable fiat money as Legal Tender, through a series hand-wringing decisions, U.S. courts in 1878 finally ruled paper money constitutional allowing the future removof gold and silver from any disciplinary role in the issuance of US currency 30

There are many who have voiced concerns about the creation of the Federal Reserve and the elastic money itcreated including Warren Buffetts father31 (Congressman 1943-49, 1951-53) as well as Alan Greenspan himsein a previous manifestation 32.

From 1914 and on in the U.S. and in Canada we have the current age of central bank fiat currency, where thecentral bank in each country modulated the amount (stock) of money and its cost (the interest rate) in an effort control the economy. Freed by the suspension of the fixed convertibility of money into gold, Canada and theU.S. were able to finance their war activities with an elastic (expandable) money stock.

iv Central Bank and currency manipulation preceded the Depression of 1819 caused by currency inflation by the Second Bank of theU.S.; Slump of 1836-37 again caused by inflationary distortion of Second Bank of the U.S. enough that President Andrew Jackson

prevented its re-charter; 1873 post Civil War downturn following the excesses of Civil War greenback money creation (ref.

Lawrence W. Reed; Great Myths of the Great Depression, Mackinac Center for Public Policy)


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Since the creation of the Federal Reserve, the U.S. has had three major price inflations corresponding with anincrease in the money supply: 1914 to 1920, 1939 to 1948, and 1967 to 1980 33 coincidentally correspondingto WW I, WW II and the Vietnam War, respectively.

The Federal Reserve Bank, while permitted to operate U.S. monetary policy by the U.S. government, are notFederal at all and they have no hard reserve backing the Federal Reserve notes. Instead, the Feds shares arefully owned by a combination of national banks (who must own shares in the Fed) and state banks (who mayown shares in the Fed). Thus the U.S. monetary system (interest rates, money stock growth, etc.) is controlledby an institution (the Federal Reserve), that, while approved to operate by the Federal Government, is a private

institution owned by banks operating in the U.S.

In conjunction with the Fed, the U.S. Treasury prints Federal Reserve Notes (todays paper dollar currency) atthe directive of the Federal Reserve. The Secretary of the Treasury is the principle economic advisor to thePresident and thus works with the Fed although he does not have authority over the US money stock only thFed Board of Governors and the Feds FOMC has that control and operates independently.

The interest rate setting FOMC is composed of the 7 Fed Governors plus the president of the New York Fed pl4 other presidents selected from the remaining 11 Fed Regional Banks.

The Fed has grown in its powers over time. Initially limited to controlling the money supply under the directive othe Secretary of the Treasury, the Feds powers have been increased both by Congressional action and by theFeds own edict. As an example of the latter, the Fed states that in order to maintain its independence the Feof its own volition in 1962 began to intervene in foreign currency markets 34 that had been the strict purview ofthe U.S. Treasury. This raises the question how an independent, non-government body can expand its ownpowers giving it the ability to act in contravention to the Department of the Treasury which is overseen by thePresident and the executive branch of government.

In Canada, monetary policy is set by the Bank of Canada. Established in 1934 as a privately held bank, theBank of Canada was nationalized in 193835. Since Confederation, Canadas dollar had been redeemable at afixed quantity for gold. Due initially to World War I, from 1914 to 1926, and forward from 1931 (de facto) andofficially (by Cabinet Order) in 1933, Canadas currency was removed from the fixed gold standard.

The Age of Monetarism Already Looking for a Place to Happen

In 1911, the famed economist, Irving Fisher published his quantity of money theory in his work The PurchasinPower of Money where he postulated that the level of economic activity was somehow related to the amount omoney in an economy.

What Fisher did not show with his theory was causality that the government could effect greater sustained anreal economic activity by increasing the money stock. This was not an issue as the central banks in 1914 did nrely on Fishers economic theory as justification for their massive increases in the money stock. A war was onand money needed to be created and spent in relation to the war effort they now had the elastic money stockneeded.

That there was immediately a price inflation in 1914 in both the U.S. and Canada followed by the stock marketmania and crash of the 1920s tells us the machine was not quite perfected.

A tangible sigh of relief must have swept through central bank and government circles with the publishing ofJohn Maynard Keynes General Theory in 1936 which put forth that during economic slow-downs, falling pricewere evidence of insufficient money in the economy and not only could the money stock affect the level ofeconomic activity, the government and central banks shouldintervene with government spending and centralbank injections to the money supply to counter this insufficiency made evident by falling price levels thistheory is accepted even today by government and central bank economists. Keynes theory relied on humansacting neatly and predictably as aggregates who, no matter what the money stock levels, could and should besteered by government and central bank intervention using their mathematical models.

Not all embraced Keynes. As noted by economist Henry Hazlitt:


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I have been unable to find in [Keynes General Theory] a single important doctrine that is both true andoriginal. What is original in the book is not true; and what is true is not original. In fact, even much that isfallacious in the book is not original, but can be found in a score of previous writers. 36

However, the ball was already rolling and Governments and central banks now had the ammunition backing themonetary and government expansionist policy they had already been using creating money to allow activitybeyond their means.

In the long run we are all dead. - Keynes

Keynes trite argument for not waiting and rather intervening to spur on the economy should give us pause for ocurrent monetary intervention in the economy.

Before monetarism and Keynes belated theory to justify central bank expansion of the money stock andgovernment spending to boost the economy, there was what is now referred to as the Austrian School. Startingin the late 1800s the name Austrian was applied as a derisory term by German economists to attempt toportray this group as not being part of the mainstream Prussian-German body of economists.

In the Austrian school started by Carl Menger in the 1870s and extended most famously by Ludwig von Mises(1881 1973) in the 20 th century, the central tenet of this school was that analysis of economic phenomena andthen attempted explanation by various mathematical models was not possible humans are complex andcannot be predicted by aggregating their average behavior according to neat mathematicians curves.

The nub of von Mises theory was as follows: the complexity of human behavior required that you could onlydevelop a rational and objective economic theory based upon fundamental logical principles (deduction) ofhuman action as opposed to the monetarists and Keynesians selected observation followed by attemptedmathematical modeling (induction). (The latter method being the source of endless frustration of those who relon economists predictions as mathematical forecasting models have shown their failure. To wit: PresidentLyndon Johnsons exclamation Will someone get me a one-armed economist! after tiring of hearing On one-hand. Yet on the other hand. from his economists with their insufficient models and need to hedge theirpredictions.). von Mises correctly identified that all individuals are independent actors and the effect of additionof money to the money supply would see individuals using it in different ways that could not be predicted onlyobserved after the fact.

von Mises identified that the pool of funding (loan availability from savings) in a gold standard economy is set borganic growth of the economy through productive enterprise and consequent savings. As a medium ofexchange, the money stock in the economy and the associated bank interest rate of money transfers criticalinformation about the state of the economy, self-adjusted economic activity and were thus not to be manipulate

The Austrian / von Mises model works as follows: in a system with a given money stock, the availability of monethrough savings in bank accounts sets interest rates according to the laws of market supply and demand. Withhigh consumer spending, bank accounts would be drawn-down and interest rates set by market forces wouldincrease to attract savings so that banks could still provide loans. These higher interest rates would focusindustry on activities which would give short-term financial return on the loans by satisfying current consumerand industry demand. As consumer/industry needs were met, demand for goods would slow somewhat andsavings would increase thereby lowering interest rates as more money was available for lending. Less costlyloans at lower interest rates allow industry to undertake longer-term project which give a return over a longerperiod.

When a central bank expands the money stock, it does not enlarge the (real) pool of funds. It gives risto the consumption of goods, which is not preceded by production (and savings). It leads to less meansof sustenance. As long as the pool of funding continues to expand, loose monetary policies give theimpression that economic activity is being boosted. That this is not the case becomes apparent as soonas the pool of funding begins to stagnate or shrink. Once this happens, the economy begins itsdownwards plunge. The most aggressive loosening of money will not reverse the plunge37

Frank Shostak


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Under a gold standard monetary system, the availability and cost of money, as the signaling mechanism for seladjustment of the economy, is continually adjusted by economic activity as a consequence of the decisions ofconsumers. Because there is no central bank intervention into interest rates and the money supply, thecontinual self-adjustment of the interest rate and industry and consumer response to these movements results interest rates tending to be stable and varying little over time. As a result of this continual market drivenadjustment of interest rates, economic growth and recessions also tends to be more steady under the goldstandard. From 1850 to 1910, the U.S. average economic growth of 1.3% per worker38 per annum which speato the relative strength of the economy during this period of industrialization and social upheaval. Compared tothe contraction of GDP by nearly 50% during the Great Depression, the gold standard performed in a far

superior manner compared to the Federal Reserves elastic money era which quite literally started with a bang(and will likely end thus).

As a result of this stability, under the gold standard there is little variability between various bond maturities bethey 1-year, 2-year, 5-year, or 10-year bonds; because interest rates vary little, bond market speculation overinterest rates would be stopped and they would simply hold value for their intrinsic interest rate return of thebond. What economists today call the yield curve which graphs variations in bond yields based upon theirmaturity, simply reflects anticipation of central bank error and correction of interest rates. This guessing gameand speculation over what the central bank will do with interest rates disappears under the gold standard39 asdoes the opportunity for outsize trading profit, which depends upon changing sentiments as to where interestrates are headed. This would free up some of the greatest talents in our society to pursue truly productiveactivity minds which today are locked-into the financial markets trying to find opportunities to make profit byclever trading of financial assets.

The effect of central planning intervention by central banks in manually enlarging the money pool and manuallysetting the interest rate, forces interest rates down to levels far below the natural market set-point, thus mal-structuring the economy and the demand for goods and services by distorting the market pricing mechanism ofmoney. In addition, with excess money and credit available in the economy, growth of ineffective commercialenterprises, investment wagering, bubbles and crashes occur that otherwise would be limited when theavailability of money meets the natural productive needs of society.

Artificially inflating the money supply (savings pool) to drive demand is no replacement for preceding organicgrowth and savings in the economy.

von Mises saw the folly of central planning of the economy and the distortions and overshoot created byinterfering with the natural market pricing mechanism of money by central banks interfering with the moneysupply and the natural market rate of interest. The resulting distortions in the economy caused by excess credcreation ultimately reveal themselves when the credit and interest rate policy of the central banks are normalizeas they always must (if not, crippling inflation explodes within the economy as the excess money creation startsto manifest itself in higher commodity and goods prices driving the price level higher). von Mises also identifiedthat in prolonging the expansion of credit, in addition to mal-structuring the economy, by definition dictates thatcontinually lower credit quality borrowers must be brought into the credit pool which further destabilizes thefinancial system.

When these distortions and uneconomic activities are revealed and shaken-out by rising interest rates, a sharprecession follows while restructuring the economy for future productive. If the credit and money supplydistortions continue for a long-enough period, then this correction is strong and prolonged as was the 1930sDepression von Mises indelicately named such a collapse and general depression a crack-up boom.

von Mises noted that when rationally arguing the monetarist/Keynesian model be abandoned because of theinevitable unsustainability, economic distortion and busts it produces, he found:

It could not influence demagogues who care for nothing but success in the impending electioncampaign and are not in the least troubled about what will happen the day after tomorrow. But it is

precisely such people who have become supreme in the political life of this age of wars and revolutionsNearly all governments are now committed to reckless spending and finance their deficits by issuingadditional quantities of unredeemable paper money and by boundless credit expansion.40


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On Keynes new economics he noted:

The policies he advocated were precisely those which almost all governments, including the British, haalready adopted many years before his General Theory was published. Keynes was not an innovatorand champion of new methods of managing economic affairs. His contribution consisted rather in

providing an apparent justification for the policies which were popular with those in power in spite of thefact that economists viewed them as disastrous. His achievement was a rationalization of the policiesalready practiced. He was not a revolutionary, as some of his adepts called him. The Keynesianrevolution took place long before Keynes approved of it and fabricated a pseudo-scientific justification f

it. What he really did was right an apology for the prevailing policies of governments. This explains thequick success of his book. It was greeted enthusiastically by the governments and the ruling politicalparties. Especially enraptured were a new type of intellectual, the government economists. 41

( One of Keynes great advantages was that his theory necessitated legions of economists analyzing data andcreating mathematical equations in an attempt to model the results and thus it was quickly embraced andpromoted by economists in both government and academia. It is telling that today there is no unifying andcomplete theory of monetarism and Keynesian intervention. Economics textbooks invariably state that the realworld can be explained by macro-economic theory which is a patchwork of monetarism, a bit of Keynesianism,several other concepts and a pinch of moon dust. Almost nowhere in University macro- economics texts canwe find analysis of the Austrian school. This writer in completing his MBA heard months of monetarism andKeynesian theory. On the last day of lectures, the professor mentioned that there was another school of macroeconomic thought and that they were called fiscalists - that was it. Fiscalists, indeed. They are also called th

Austrian School. )

In discussion of the Keynesian philosophy of active monetary and government intervention with economists, ontypically gets the response that monetary intervention is correct youve just got to know when to stop. Thatgovernment spending intervention, central bank monetary intervention and suppression of interest rates distortsthe market pricing mechanism structuring the economy with unproductive enterprise and attendant speculationand that the consumption of savings today at the cost of tomorrows economic growth, is beyond their ken.

A final note on Keynes. Keynes well understood the damaging effect of a system of inflating elastic money. In1919, in his book The Economic Consequences of the Peace, he made the observation about inflation:

..By a continuing process of inflation, governments can confiscate, secretly and unobserved, animportant part of the wealth of their citizens..

von Mises theory did not win him many friends because they worked against the perceived interest of thepolitical class, economists and academics, bankers and the investment industry. The tragedy of von Misesremains that, as a Jewish intellectual living in Switzerland during WW II, upon the publishing of his major workNationalokonomie in 1940 which was written in German but went against the prevailing socialist winds of theNational Socialist (Nazi) party in Germany (the book was later published as Human Action in 1949 by the YaleUniversity Press),von Mises was pressured to leave Switzerland narrowly escaping through France to theUnited States. While almost all other socialist and communist economists who emigrated to the U.S. could findemploy and despite von Mises keen and productive mind and extensive publishing of economic thought, hecould find no paid economic tenure in the U.S.42

The real testament to von Mises strength of character is he never capitulated. He steadily supported aneconomic approach that he knew was superior despite the fact that easy personal reward, which his peers soeasily accessed, lay in promoting monetarist economics.

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Creative Numbers

von Mises saw the occasional and shallower slow-downs in the economy under the gold standard as ahealthy restructuring of the economy for future growth where ineffective and unproductive enterprise areweeded-out. During periods where there is higher measured unemployment, those with jobs tend tospend less until the economy strengthens. Keynes called this phenomenon the Paradox of Thrift43.


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According to Keynes theorem, citizens response to an economic slowdown makes slowdowns worsethan need be. During these periods, Keynesians and many political leaders feel that more money needto be injected into the economy and government spending enacted to overcome this natural economiccharacteristic.

In the 1970s during a period of economic turmoil and high inflation, we saw the introduction of theunemployment rate that only included individuals actively looking for work; the unemployed who werediscouraged were not counted as unemployed. In this way, citizens were presented with a better pictureto prolong their spending (but deepening imbalances) and politicians, who liked to pretend they create

jobs during good time yet not wanting responsibility for slow-downs and job losses, were offered an out

As noted above, today we hear from Washington that inflation is subdued, the economy is strong, andunemployment is declining. If we look at the employment participation rate which is the percent of thepopulation actually employed, we find that there has been a steady decline from 67% of the U.S.population employed in 2000 to 65.5% of the population employed in 2005. This while the Bureau ofLabor Statistics states the Unemployment rate has dropped from 6.3% in 2003 to 5.2% in 2005.

In addition to inflations human toll which aggravates voters, governments are averse to acknowledginginflation because it triggers the hoarding response which creates artificial shortages worsening the priceinflation condition. Price inflation also increases the cost of entitlement costs (old age pension / socialsecurity payments, welfare payments, etc.) limiting the amount of new government initiatives that can beundertaken. Yet inflation is a feature of the fiat money system.

Weve also had the introduction of the core consumer price index (CPI) that excluded volatile itemssuch as food and energy. If a government understates inflation, pension and employment wageincreases which are indexed to the Core CPI are diminished Social Security payments aloneconstitute a $480 Billion per year expense for the U.S. government. Containing benefit increases thatcompound annually in the social security budget is not a trivial matter.

In addition, the Consumer Price index is now calculated using a tool called hedonics. The term isderived from the Latin word pleasure. For example, if a product such as a computer were to feature a50% greater speed for, say, the same price year-to-year, the product would be deemed to be 33%cheaper ( 100% / 150% ).

More than 35% of the U.S. basket of goods in the CPI is hedonically adjusted including clothing. For asummary of how government statistics are massaged to make the consumer and business leader feelbetter while having less money left over see links below for papers by Gillespie Research v.

In Canada, the CPI shelter component in Canada is now broken down into two components: RentedAccommodation and Owned Accommodation that together constitute 26.8% of the total CPI basket. ThRented Accommodation component accounts for roughly 1/3 of the Shelter Component while Owned

Accommodation accounts for 2/3 of the Shelter Component.

The art in the Canadian CPI calculation is interesting. The Rent Paid portion accounts for approximatel6.0% of the total CPI basket while the Owned Accommodation cost is calculated using an imputed usecost or what rent for which a homeowner could rent the accommodation back to themselves. Incalculating the imputed user cost, the mortgage interest composes 5.4% of the total CPI basket, buildingdepreciation costs (excluding property value) are calculated at 2% per annum of the building value (3.3%of the total CPI basket) and property taxes (3.2% of the total basket) are utilized - it is assumed that the

vFor an analysis of government massaging of numbers see the following series of articles by John Williams of Gillespie Research: (

http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=35446;http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=35770;http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=36238 )


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property is not amortized (i.e. the mortgage is never paid-off). Adding the above, the total direct OwnedAccommodation housing costs (excluding insurance, hydro, water, maintenance, etc. ) accounts for 18%of the CPI. When all shelter costs are included, shelter composes 26.8% of the CPI.

According to the Royal Banks Housing Affordability Index, rent accounts for 40 to 70% of renters pre-tamedian income while home ownership costs (including amortization of the home loan but excludingmaintenance) accounts for 20 to 30% of home owners pre-tax median income in Canada. In total, theRoyal Bank finds that shelter costs for all households in Canada (overall rental and ownership costscombined) total 25 to 40% of Canadians pre-tax household income. This compares to a total CPI shelt

component of 26.8% of the consumer goods basket which would reflect post-tax costs and assume noamortization of mortgages.

New housing purchasers in Vancouver and Victoria will be heartened by the following March 2005 CPIstatistic: without adjusting for inflation, owned accommodation dollar costs in Vancouver are 95.3% oftheir 1992 costs and in Victoria they are 96.9% of their 1992 adjusting for the Bank of Canada estimatof 26.6% inflation since 1992, owned accommodation costs today are 75.3% of the 1992 cost forVancouver and 76.5% of the 1992 cost for Victoria. (for reference: The Real Estate Board or GreaterVancouver gives a current detached house average selling price of $555,000 vs. $300,000 in 1992 (and$400,000 at the beginning of 2003) for an increase of 85% and a similar 81% increase in condo housingprices over the 1992 to 2005 period) as amortization is ignored in the index.

In July of 2004 with interest rates at their bottom, it was determined that the mortgage interest cost at8.4% of the Consumer Price Index basket was excessive and this component was reduced to 5.4% of thbasket total (a 33% decrease). The total shelter component of the CPI was also decreased by 8% fromits previous weighting this at a time when real estate costs were climbing steeply across Canada andinterest rates would start to climb.

What the CPI reflects is not clear, however, it should not be used to inflation adjust pensioner income acost of living increases in labor agreements.

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Back to the Gold Standard

A major benefit of the gold standard was the fact that it was unencumbered by nationality and thereforecould not be operated in a capricious irresponsible manner; Americas policy on the dollar policy clearlyis We have long discussed Americas growing financial imbalances and its consequent vulnerabilityto third world-style debt trap dynamics.44

Marshall Auerback, 2001.

It is clear from the past 8 decades of expanding central bank power and their expansion of the money-stock, thantiquated central-planning approach of central banks forcing interest rates and the artificial manipulation of themoney stock can not nearly replicate the delicate self-adjustment, stability, and balancing of the gold standardmonetary system. A central banking committee cannot ever hope to read the tea leaves of the economy andreplicate the continual balancing of interest rates and economic activity effected by trillions of consumerdecisions each day. There will be many criticisms of a return to a gold standard currency and statements that will be absolutely impossible to reinstitute this currency system by parties who have an interest in todays volatimarkets and interest rates (Greenspan suggested in 1981 that such a transition back to the gold standard waspossible and even desirable 45 ). The volatility begets opportunity for trading gains in stocks, bonds and interesrate sensitive instruments such as derivatives, ultimately spawning bubbles. However, the volatility, bouts ofinflation and ultimate busts are not in interest of a stable or just society.

Investors have today been lulled into a sense of security regarding perpetual low-interest rate while the potentiafor an inflation shock to the economy as a result past central bank monetary inflation begins leaking intocommodities speculation / safe haven hedging or a shock from foreign investors slowing their purchases of theUS debt is very real. The consequent rise in interest rates and the attendant investment and economicslowdown can rapidly deplete the inflated paper value of stocks, bonds, real estate and derivative investments


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and lead to a massive wealth transfer; those who are liquid and without debt will be presented an opportunity toacquire assets at significant discounts as investors scramble to stop losses and debt by disposing of losing assclasses which then overshoot to the downside.

Given the U.S.s investment and real estate bubble, its dependence on foreign f inanciers, the unprecedentedlevel of indebtedness, and Canadas almost complete dependence upon the U.S. economy through trade sincethe implementation of the Free Trade Agreement in 1989, both countries face the risk of economic disruption ifinterest rates are forced-up by the onset of inflation or outside economic shock.

Government action to restructure and stabilize the monetary system and to mitigate the economic consequencwhich approach is needed.

Gold : An Unwelcome Barometer of Fiat Currency Health

Gold ( and silvervi ) are viewed unfavorably by central bankers exercising monetarist expansion of their moneystock. Keynes referred to gold as a barbarous relic and pop economists such as Paul Krugman have appliedother epithets to describe it. Why the hard feelings against a metal that has been used as money for 5,000years?

Gold is an unwelcome barometer of the health of any paper currency but especially the US dollar that has hadthe privilege of being the Worlds central bank reserve currency (60% of central bank reserves have to date beein US dollar instruments). That status has allowed the U.S. to create and pay all its debt in its currency whichother central banks were usually happy to hold. When a money stock is inflated, the price of gold in thatcurrency compensates by rising thereby giving a signal of that dilution this poses a problem for Keynesiansand monetarists when they wish to increase the amount of currency to, in their minds, further spur or continuethe economy. Given golds signal of inflation, investors and citizens can roll-out of currencies that are beingdiluted (inflated) and into gold to maintain the buying-power of their savings and also indirectly influencing thebond market to demanding higher interest rates for bond and other debt instruments (please note: while centrabanks control the short term interest rates, longer term rates, while tempered by market intervention by the Fedand Treasury, are set by the bond market). Larry Summers who was Deputy Treasury Secretary until Rubinsretirement in July 1999 and then himself Treasury Secretary until December 2000, noted in his co-written papeGibsons Paradox Revisited46.

(The Paradox was so-named by Keynes as he notes the gold price moved inversely to the real interest ratewhich is defined as interest rates minus inflation. Keynes noted if interest rates in debt markets give insufficienreturn while inflation rises, then the price of gold will shoot up. Interest rates would thus respond not to thepublished rate of inflation but instead to the absolute price level of gold as the indicator of inflation. This makessense as gold has a long history as money. However it was an obstacle to Keynes as it limited application of htheory. Thus, in addition to the Paradox of Thrift, he also called this natural phenomenon a paradox. )

The U.S. has established the U.S. Treasurys Exchange Stabilization Fund for exchange market interventionpolicy and is utilized as a stabilization fund to effect an orderly system of exchange rates. Accordingly, theTreasury Secretary may deal in gold, foreign exchange, and other instruments of credit and securities 47Chairman Greenspan says that the Fed and Treasury do not trade in gold48 James Turk, a noted expert inthe gold markets notes evidence to the contrary 49. Given Greenspans word parsing and obfuscation over thepast 18 years, it will be interesting to see exactly what Greenspans words on trading in gold mean a criticalquestion would be whether the Fed and Treasury, or their designees, trade in gold derivatives (a paper financiainstrument rather than gold itself) which can steer the price of physical gold by holding dollar instruments ratherthan gold itself (see further discussion below).

In the 1960s during the U.S.s monetizing effort to support its war in Vietnam, the United States, U.K. and otheEuropean Powers central banks openly coordinated gold sales in what was called the London Gold Pool tooversupply the market with gold bullion in an effort to keep its price from appreciating in U.S. dollars from the$35/oz. official peg. Again, in 1968 France realizing there would be no end to the printing of U.S. currency,

vi Since 1945, 6 billion ounces of U.S. silver bullion stocks have been dishoarded onto the world silver market depressing the price ofsilver. The U.S. mint is now a buyer of silver for silver eagle bullion mintage. World silver bullion stocks stand at 200 million oz. ($1

billion at $7/oz. ) and there is an annual mine production deficit of approximately 100 million oz.


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asked for conversion of US dollar denominated debt and currency to US government gold as these instrumentspermitted at the time leading to the end of the visible central bank manipulation of the gold price.

The visible London Gold Pool coordinated central bank intervention to contain the price of gold was extremelycostly to the gold reserve of participating central banks as shrewd investors (not just the French government)could see U.S. monetary policy, and knowing that the price of gold could not be contained forever, simplybacked their trucks up to the London Gold Pool and waited for the gold of participating nations to be unloaded aobviously discounted prices. In the final days of the London Gold Pool, purchasers were taking delivery of up to225 tons of goldper day50.

Ultimately 55% or 10,000 thousands tons of the U.S.s gold stock which started at 18,000 tons in 1957 wasconsumed before Nixon decoupled the dollar from the gold standard and let its currency float.

When gold is suppressed for a period to prevent its signaling of monetary dilution (inflation), it tends to explodein value when correcting to its true value. When President Nixon made the US dollar irredeemable to all foreigholders of U.S. currency and debt, the price of gold rose dramatically from its fixed price of $US 35/oz. to over$US 850/oz by 1980 ($2,100 in 2005 dollars) before settling lower to average $400/oz. during the 1980s. Asfrequently quoted statement by Warren Buffett is intervention always fails. And sometimes spectacularly.

From 1995 to 1999 with the implementation of the Feds dollar printing spree, the dollargained18% againstother currencies and gold declined 38% during the same period in US dollars from roughly $400 in 1995bottoming out at $250 in 1999. How can this be when the markets when the M3 money stock was itselfincreased (the dollar diluted) during this period by 45% according to the M3 broad money measure? Instead ogold strengthening by 45%, gold weakened by 38%. A number of factors contributed to the decline of goldduring this period.

Investors were keen to hold U.S. investments gold was not seen by some as a necessary storeof value when U.S. dollar denominated assets were appreciating in the U.S.s new economy homeof the d

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Denial of Crisis

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