Nothing Solved! – An outlook

Want to know what is the biggest threat to your prosperity? Look no further than the policy statement released last night by the U.S. Federal Open Market Committee (FOMC)- America’s monetary politburo, the nation’s committee for financial central planning staffed with a select group of highly educated bureaucrats and guided by a former economics professor, and continuously engaged in administratively setting interest rates, manipulating asset prices and determining the extent of lending in what is really the pseudo-capitalist economy of the U.S. of A.

I don’t mean the specific wording of the statement that gets the economists on Wall Street so excited – what phrase did they change? Is this more hawkish or more dovish than last month’s statement? –Who cares? What matters is the sheer and utter economic idiocy underlying the Federal Reserve’s ‘mandate’ and being at the core of practically every fiat money central bank. What you see in this statement – black on white – is the conceptual lunacy at the heart of our global paper money system, the reason we are in a massive crisis and about to get deeper into it.

The core belief enshrined in this document, and indeed in every Fed policy statement, is this: the central bank can and should, via discretionary changes in the supply of state paper money, affect interest rates in such a way that the economy reaches full employment and enjoys stable prices. What frivolous hubris! In a proper market economy, interest rates would, of course, be set by the market and result from the free interplay of voluntary saving and voluntary investment decisions by independent agents. Alas, not so in our semi-socialist system of state-controlled fiat money with a central planning bank. The committee knows better what interest rates and asset prices the economy needs to reach its full potential. After all, the committee is staffed with really clever people. Such things cannot be left to the public or – the market.

Think about the puerile assumption behind this: Good, lasting and competitive jobs, one assumes, not as a result of saving, capital formation and entrepreneurial risk taking but as a result of clever monetary manipulation by the FOMC. And as the committee has ascertained that, presently, the US public is not reaching its full economic potential, Americans need to be cajoled into doing better with continuing super low interest rates that encourage them to go more into debt, and with delicately manipulated bond prices via the Fed’s debt monetisation program. This is such unspeakable rubbish, and such a shameless declaration of administrative arrogance, I can’t believe that many people outside the common-sense-free ivory tower of the MIT economics department and the privileged paper money aristocracy takes this seriously. My sense is fewer and fewer people in the real world do.

Not Paul Volcker! (Photo by U.S. Federal Reserve)

This idiotic assumption is the reason the entire world has, over the past forty years, converted from commodity money, or, paper money at least tentatively linked to commodities, to complete fiat money systems in which the supply of money is not only fully elastic and unrestricted by any ‘barbaric’ raw materials -shudder! -but under the full control of the enlightened and well-meaning state bureaucracy. By injecting new money into the economy, full employment can be generated. Fantastic! No really, it is fantastic. I mean fantastic as in imaginary, fanciful, implausible, incredible, insane, ludicrous, mad, irrational, nonsensical, outlandish and preposterous. That type of fantastic.

Make no mistake. This system is not only suboptimal, it is unsustainable. And we have already reached the endgame.

Of course, by printing new money, expanding the central bank balance sheet and artificially lowering interest rates, – something that has been done on a vast scale for decades on end! – extra economic activity can be generated for a period. Lower interest rates fool the public into believing that more savings are available, that the consumer is okay with more resources being diverted from meeting present consumption needs and towards meeting needs in the more remote future. Low interest rates mean that the factor of time is less of an issue when planning resource allocation. That would be okay if low interest rates reflected society’s true time preference and propensity to save – if low interest rates were the result of saving and not money-printing. But in our world of fully elastic state money, interest rates are simply another policy tool. Easy monetary policy thus leads to asset prices and economic structures that are not in line with the true preferences of the consumer. Whenever the supply of new money slows, this becomes evident, the credit-structure begins to unravel and a recession sets in. However, the central bank then quickly lowers rates again, and sets off another artificial boom.

This has been going on, pretty much uninterrupted, for forty years. It is, as I said, the very essence of modern central banking and the paper money economy. All around us, the distortions that a system of fully flexible paper money must generate are increasingly palpable: an inflated and increasingly unstable financial sector, overstretched fractional-reserve banks, asset price bubbles, serial bailouts, excessive debt levels, persistent distortions in income and wealth distribution.

This is not capitalism. In fact, this system gives capitalism a bad name.

Real Money (photo by Swiss Banker - no joke!)

This morning, the Wall Street Journal headlines that the Fed signalled the end of bond buying with last night’s statement. As if this meant policy tightening! A pause – and it will only be a pause – in debt monetisation was already expected. Otherwise, the statement and press conference were timid. I think the reaction in the gold and fx market is telling: gold pushed through to another all-time nominal high, trading above 1,530 paper dollars an ounce as I write this. The dollar gets trashed again versus the other major toilet paper monies.

The market knows that the Fed is boxed in. Proper policy tightening is out of the question. The dislocations are way too big. The system is only propped up by ever more money from the Fed, ridiculously low interest rates and ever more public deficit spending.

The financial system is less stable today than at the time of the Lehman collapse. Lehman gave everybody a glimpse of the abyss, a notion of just how overstretched, distorted and shaky the global paper money system has become. And we have discovered another thing: a market-guided correction of the credit edifice cannot or will not be tolerated by the paper money bureaucracy. ‘Too big too fail’ is now the number one policy objective. Another Lehman has to be avoided at all cost. Market forces – which would necessarily point towards debt deflation and default and thus a proper, if painful, cleansing of the economic body- will be kept at bay with ever more extreme policy intervention. Nothing has been solved. The underlying problems are very much with us.

The big banks know this and play the system like a fiddle. As monetary policy cannot be tightened meaningfully, the state increasingly resorts to heavy-handed regulation to sort out the banks but this is countered quickly with blatant threats to cut back on lending if regulation gets too onerous. Of course, I am opposed to regulation and would rather have free capitalist banking with full risk of bankruptcy, which is only possible in a system of apolitical commodity money, entirely outside of state control. In our system, however, the state needs the banks and the banks – qua inherently insolvent and illiquid fractional-reserve banks – need the state. The public pays the price in the form of market distortions and a dwindling purchasing power of state paper money.

By the way, the unholy alliance between states and banks is evident in every advanced paper money economy. The bankrupt Portuguese government is now placing 90 percent of its bill issuance with its own banks. Like two drowning sailors hanging onto one another in order to postpone the inevitable, overstretched banks thus accumulate the debt of insolvent governments to keep the façade of solvency up and to stay in business themselves, a strategy by which the world’s most highly indebted country, Japan, has managed to project the mirage of sustainability for more than a decade.

But time is running out. Even if the Fed had announced an impending move to higher rates, the gold market would have, in my view, looked right through it. Nobody in Washington or on Wall Street has the cojones to undergo Volcker-style root-canal treatment. Proper monetary tightening – tightening that deserves the name and that cleanses the system of the accumulated distortions – is out of the question.

The economy will remain subdued and the financial sphere will remain painfully fragile. Easy money has a quickly diminishing return in respect of its impact on short-term growth. The trade-off between artificial growth and  persistent inflation gets progressively worse. Yet, Bernanke has no plan B. I am thus convinced that we have not seen the last of central bank asset buying. QE2 may end in June but QE3 will come. My hunch is that by Christmas the Fed’s balance sheet will be bigger, not smaller than today.

In the meantime, signs of rising inflation are everywhere. A gold price of $1,500, a silver price of $48 and an oil price of $113 are not harbinger of deflation. The demise of paper money continues.

Be that as it may, none of us can change it. So the question is how to survive it. In my view there is no alternative to gold (and maybe silver, although it is less clear-cut as a monetary asset). Whenever paper money systems disintegrate, gold – the eternal monetary asset -comes back. A 1980s-style correction in gold appears unlikely. Bernanke is no Volcker, and 2011 is not 1979. The system is vastly more overstretched today.

If gold were at $2,300 it would only be back at its 1980 high in inflation-adjusted terms. I think it will go much higher.

Furthermore, I think one should minimize economic exposure to the state (government bonds, dependency on any form of state transfer payment), banks (bank bonds, deposits) and paper money. Equities may continue to do well for a while on the back of easy money but they are ultimately a poor hedge in a paper money crisis. So is real estate (with the probable exception of arable land in certain locations). My forecast is this: gold will outperform inflation which will outperform stocks which will outperform the economy which will outperform fixed income which is the short of the century, in particular government bonds.

The First Great Depression

Of course, Bernanke & Co believe that what they are doing is preventing another Great Depression. They are just keeping ‘aggregate demand’ up, buying the economy some time to heal. Soon the economy will be back to self-sustaining growth, and all sins of the past will be forgiven.

Yeah, and pigs will fly.

In fact, present policy is the disease, not the medicine. It is obstructing the economy’s process of healing and recovery, keeping it instead addicted to cheap credit forever – and to ever bigger doses of the drug.

The Great Depression was not the result of tight money in the 1930s but of easy money in the 1920s. Once money-induced distortions are substantial, a correction is inevitable. I strongly feel that dislocations are potentially even bigger today than in 1929, and that they are getting worse by present ‘stimulus’ policies.

The road to economic ruin is paved with state paper money. Prepare for some very nasty times!