tag:blogger.com,1999:blog-82195792484853636252024-02-20T04:16:29.344-06:00Pensées Par ContreEconomic & Political CommentaryUnknownnoreply@blogger.comBlogger4125tag:blogger.com,1999:blog-8219579248485363625.post-9668128932442546752015-02-06T10:19:00.000-06:002015-02-15T11:12:21.097-06:00Grexit<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I’ve
been thinking a lot lately about the situation in Greece. The
question in my mind is whether this will become a trigger event that
leads into the next phase of the ongoing financial crisis. In my
mind, by the way, this crisis began at the turn of the century when
the credit cycle – two decades into its expansionary phase at that
point – finally rolled over. So anyway, here are my thoughts on how
the “Greek affair” might play out.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">Suppose
that Greece simply defaults on its debt. It declares a moratorium on
all principal and interest payments until such time as its economy
has recovered. Does that mean that Greece must exit the eurozone and
return to the drachma?</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I
would argue not! The Greeks have clearly rejected austerity, but does
that mean they want to resurrect the drachma? Do Greeks really want
to go the way of Zimbabwe or the Weimar Republic?</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">If
the drachma were resurrected, it would immediately become a banana
currency from which Greek citizens would be the first to flee. The
Greek central bank would find itself in a position similar to
Argentina or Venezuela, under constant assault by the markets and
struggling to stave off a currency collapse. Unless the Greek central
bank is willing to go the way of Zimbabwe, interest rates will be sky
high and could easily lead to circumstances even worse than what the
Greeks have already experienced.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">My
point is, for the foreseeable future the Greek government will not be
able to tap the credit markets, whether it remains under the tutelage
of the Troika or defaults. It has no choice but to live within its
means and run a balanced budget, and there is a strong possibility
that the Syriza government understands this situation. In other
words, austerity cannot be avoided no matter what path the government
takes.</span></span></span></div>
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">Given
that austerity is inevitable, why not give the Troika the middle
finger and then rally public support for the measures that need to be
taken? If Greek citizens see that the Syriza government has been true
to its word, the sense of crisis created by a default may facilitate
passage of needed reforms.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">The
first casualty of a Greek default would be its banking system. But
the Greeks have had plenty of advance warning. Surely by now everyone
with assets to protect has a bank account in Zurich or Frankfurt or
London or New York. Surely even the least sophisticated and least
wealthy of Greeks know to keep their cash under the mattress rather
than in a bank that could topple any day. Why does Greece need any
domestic banks? If there are profitable banking opportunities in
Greece, foreign banks will be eager to establish branches, and
investors may even start up new, fully-capitalized banks. </span></span></span>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I
suppose that it would be difficult for the Greek government to run
its affairs without any domestic banks. Having defaulted, the
government might have to deal with creditors trying to seize any
deposits held in offshore banks. But it’s hard to believe that
there wouldn’t be at least one bank willing to provide the
government with protected accounts, and I’m sure the Greek
government would make it worth that bank’s while. The crucial
question in all this, of course, is whether the Syriza government
will actually attack the corruption and cronyism that plagues the
country, and whether this government will provide an environment
conducive to economic growth.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">In
any case, let’s just assume that Greece has defaulted and, as I
just described, now refuses to leave the eurozone. What happens?</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">A
Greek default would force its creditors to write down their holdings,
and most of that debt is now held by official institutions. That
means the European Central Bank and other government entities, which
are not supposed to ever incur losses, would in fact incur losses.
And that would pose a serious political challenge to the entire
edifice of bailouts that has been erected to support the debt of the
Club Med countries. It might even call into question the rollout of
Quantitive Easing by the ECB this coming March. Eventually, the
markets might even start to price in the fact that most governments
are bankrupt, and that they are dependent on constant monetization of
their debt in order to avoid financial collapse.</span></span></span></div>
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">From
another perspective, if Greece is able to default on its debt and
weather the storm, that might inspire the other Club Med countries to
push for significant restructuring of their own debt. Spanish
elections are scheduled for late this year, and the Podemos party has
come from nowhere to lead in the polls. French elections are just
over two years away, and the National Front leads in the polls. Who
knows how long the current Italian government will last, and the Five
Star Movement is waiting in the wings. At a minimum, it’s hard to
imagine that these countries wouldn’t at least try to weasel out of
taking their share of the losses from a Greek default. German outrage
at being asked to shoulder even more losses would surely ratchet up
the political pressure.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">At
some point a schism will develop between the hard money (northern)
members of the eurozone, who refuse to finance any more bailouts, and
the Club Med (southern) members who refuse to continue down the path
of austerity. All of which will bring us to a climactic moment.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I
predict that there will eventually be an emergency weekend meeting of
the eurozone finance ministers, or perhaps even the prime ministers.
The markets will be on the brink, the politics of the zone will have
reached a stalemate, and it will be painfully obvious to all the
ministers present that the monetary union can no longer be sustained.
At that moment, I believe the southern members will ask the hard
money members to withdraw from a position of strength, rather than
forcing the Club Med members to withdraw from a position of weakness.
And faced with a political disaster of epic proportions, I believe
that request will be granted as a sop to appease somewhat the bitter
feelings that will surely endure for a long time to come.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">This
may very well be the strategy of the current Greek government, and if
so would be all the more reason for Greece not to exit the eurozone
after defaulting. Freed of the constraints imposed by Germany and its
monetary brethren, the ECB (whose HQ would presumably move to Paris)
could open the monetary spigots and provide financing to all the Club
Med countries, Greece included. There are nineteen members of the
eurozone, and I predict nine of them would remain after this schism
(Belgium, Cyprus, France, Greece, Italy, Malta, Portugal, Slovenia &
Spain). Together, they would wield enough economic heft to support a
currency regime on a par with any large Third World country.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">By
convincing Germany et al. to exit the eurozone, the Club Med
countries would be spared the necessity of re-introducing their
legacy currencies, re-denominating bank accounts and financial
instruments, and arbitrarily re-writing contracts to the advantage of
one party and the disadvantage of the other. Their markets could open
normally on Monday morning, and everything would function exactly as
it had the previous Friday, except of course that now the ECB has
their backs beyond any shadow of a doubt.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">But
what about Germany and the exiting countries? First of all, I do not
believe that they will form a new common currency regime. If they
exit the eurozone, there will be absolutely zero political appetite
for another monetary adventure. They will resurrect their legacy
currencies and carry on as before. There may very well be a currency
bloc where different countries peg their currencies to one another.
But when monetary pressures build, they will be addressed by simply
adjusting the peg, just as was done before the Maastricht treaty came
into effect.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">So,
the emergency weekend meeting concludes with a decision that ten
countries will exit the eurozone (Austria, Estonia, Finland, Germany,
Ireland, Latvia, Lithuania, Luxembourg, Netherlands & Slovakia ).
At this point, conventional thinking seems to be that the countries
pulling out will declare an emergency banking holiday for a day or
two while all the accounts in each country are converted into its
legacy currency. I do not agree, and here is my alternative scenario.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I
think that instead, Germany et al. will announce that in the next few
days, each country will bring back its own legacy currency. These
resurrected currencies will not replace the euro, but rather will
circulate alongside the common currency. There will be no automatic
re-denomination of accounts, and all contracts will be honored as
written. When the markets open on Monday, the euro will drop sharply
but everything throughout the entire eurozone will function normally,
just as it did on the previous Friday.</span></span></span></div>
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">Then,
when each exiting country has put in place the technical requirements
for resurrecting its legacy currency, its central bank will hold
auctions where it sells some of the newly created currency for gold
and foreign currencies that it wants to hold as reserves, thereby
injecting appropriate amounts of the legacy currency into the banking
system. In the early days these resurrected currencies may only exist
in electronic form, just like the euro when it was first introduced,
but notes and coins should start to circulate within a matter of
weeks. Simultaneously with its central bank injecting the resurrected
currency into the banking system, the government of each exiting
country will auction debt denominated in said legacy currency. *</span></span></span></div>
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">With
only the Club Med countries remaining in the eurozone, the common
currency will drop sharply against the legacy currencies coming back
into existence. While the government debt of the Club Med countries
may be money good, now that the ECB has their back, it’s money good
in a rapidly depreciating currency. That means euro interest rates
will quickly move back toward levels that reflect the risk of
inflation, probably north of 5%. The combination of higher interest
rates and a depreciating euro will allow the exiting countries to
retire their euro-denominated debt at a significant discount in terms
of their newly issued legacy currency.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">The
process I’ve just described will have a lot of market players
screaming in outrage. In particular, anyone holding German debt or
similar assets, with the expectation that they would be protected in
the event of a eurozone breakup, will be shocked to find they are not
shielded at all. And since there have been no defaults, since there
has been no breach of contract, plain vanilla credit default swaps
would not be triggered.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">A
lot of citizens from the exiting countries would also be quite
unhappy to see the value of their euro-denominated savings shrink
with the depreciating euro. To mollify their own citizens, each
exiting country would therefore issue tradable warrants giving
holders the right to convert euros into the legacy currency at the
same rate where the legacy currency was converted into euros back
when the common currency was launched. Each citizen and “qualified”
corporation would receive those warrants in amounts equal to two or
three years of income. In addition, banks headquartered in the
exiting country would probably receive warrants in the amount of
twice or thrice their capital. (As an aside, this could go a long way
toward recapitalizing those still questionable banks.)</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">So
there we are! Aside from Greece, the eurozone has broken apart
without any defaults, without any banking holidays and without any
credit default swaps being triggered. And even the Greek default was
quickly cured when the ECB began massively monetizing its debt. Of
course, none of the underlying economic problems that led to the
breakdown have been resolved. The structural imbalances and
impediments to economic growth still remain. And the division of
Europe into a northern and southern bloc could easily lay the
groundwork for the world’s next great conflict. **</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">As
long as I’m painting “what if” scenarios, consider how the
struggle in Ukraine might turn out. With Europe divided, the Club Med
countries remaining in the eurozone will surely seek to solidify and
expand their economic heft. It’s not hard to imagine the rump
eurozone pushing east. The ten northern European members that
withdrew could be replaced by ten new members from the Balkans. Once
the eurozone bumps up against Ukraine, it’s easy to imagine a deal
with Russia. In return for energy, trade and banking agreements, the
rump eurozone accepts the dismembering of Ukraine and gives official
recognition to the Republic of South Ukraine, a nation allied with
Russia and bordering Moldova. I think you can already see the
nightmare developing.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I
could go on and on with possible scenarios on how the breakup of the
eurozone might turn out for better or worse. Belgium could split up,
with Flanders joining the Netherlands and Wallonia joining France.
Northern Italy could secede, become independent and join the northern
bloc. Maybe Ukraine leads to WW III, or maybe Germany and Russia come
to agreement on carving up the country along ethnic lines. Who knows,
maybe Texas secedes and becomes the capitol of a new USA, the
northeastern states become the USSA and join the rump eurozone, and
Latin America becomes a colony of China. Stranger things have
happened.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">Addendum (15 February 2015)</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">The
more I watch negotiations between Greece and the eurozone authorities
drag out, the more convinced I become that the Greek objective is to
break up the eurozone. I think it’s universally agreed that a
return to the drachma would be a disaster. What Greece really wants
to do – I think – is remain in the eurozone and have its debt
monetized. And that’s exactly what France, Italy, Spain, Portugal
and numerous other countries want.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">The
problem: Germany and other hard-money countries are adamantly opposed
to debt monetization policies. The solution: convince Germany et al.
to pull out and leave the eurozone to its weak members. And a Greek
default is exactly what is needed to force the issue.</span></span></span></div>
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;">I
edited this post to correct some errors in the original version. For
any purists out there, here is how those paragraphs were originally
written; the errors should be obvious.</span></span></span></div>
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<span style="color: #1c1c1c;"><span style="font-family: Arial, sans-serif;"><span style="font-size: small;"><br /></span></span></span></div>
<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
*
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;">“<span style="font-family: Arial, sans-serif;"><span style="font-size: small;">Then,
when each exiting country has put in place the technical requirements
for resurrecting its legacy currency, its central bank will begin
auctioning off a portion of its euro reserves and thereby inject some
of the newly resurrected currency into the banking system. In the
early days these resurrected currencies may only exist in electronic
form, just like the euro when it was first introduced, but notes and
coins should start to circulate within a matter of weeks.
Simultaneously with its central bank injecting the resurrected
currency into the banking system by selling euro reserves, the
government of each exiting country will auction debt denominated in
said legacy currency.”</span></span></span></div>
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<br />
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<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
**</div>
<div style="font-style: normal; font-weight: normal; margin-bottom: 0in;">
<span style="color: #1c1c1c;">“<span style="font-family: Arial, sans-serif;"><span style="font-size: small;">So
there we are! The eurozone has broken apart without any defaults,
without any contracts being breached, and without any banking
holidays being declared. Of course, none of the underlying economic
problems that led to the breakdown have been resolved. The structural
imbalances and impediments to economic growth still remain. And the
division of Europe into a northern and southern bloc could easily lay
the groundwork for the world’s next great conflict.”</span></span></span></div>
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Unknownnoreply@blogger.com5tag:blogger.com,1999:blog-8219579248485363625.post-68304964163475939272013-05-19T01:11:00.000-05:002013-05-19T01:11:28.723-05:00Deflation or Inflation?<div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal; text-align: start;"><span style="font-family: Georgia, Times New Roman, serif;"><span style="vertical-align: baseline; white-space: pre-wrap;">It’s been four and a half years since I posted on this blog, and during that time I have watched the political and economic powers of this world push the envelope far beyond anything I could ever have imagined. There can be no doubt that our leaders worship at the Temple of Mammon, and that they truly believe if a great enough libation in the form of freshly printed money is offered to their god, then he will bestow his blessings of peace and prosperity upon all of us.</span></span></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal; text-align: start;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">But they worship a false god, and their misplaced faith will cost all of us dearly. Their refusal to countenance any possibility that their god is merely a totem fabricated by their inflated egos defines a new height of insanity, and their vanity will inevitably lead to the destruction of civilization and our way of life. I have given great thought to how the tide might be turned, and how our civilization might be restored to its former grace. But after the recent elections that returned all the same faces to power, it seems clear to me that we are living out a classic tragedy, where all the actors insist on playing out their assigned roles until the plot has reached its inexorable dénouement.</span></span></span></div>
<b id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal; text-align: start;"><span style="font-family: Georgia, Times New Roman, serif;">
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal; text-align: start;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">There is only one path that can lead to our salvation, and that is for some corner of this planet to revolt against the insanity, to declare its independence from the dementia of the Old Order, and to institute a New Order that is dedicated to the precepts of Classical Liberalism: individual liberty and personal responsibility, private property and free enterprise, limited government and the rule of law. In other words, a New Order that is dedicated to the reestablishment of freedom. I have put forth a <a href="http://sites.google.com/site/parcontre/" target="_blank">detailed proposal</a> on how such a New Order might be established, but in this essay I will explain why the Progressively Insane Monetary Policy (PIMP) that is currently being</span></span></span><span style="font-weight: normal; text-align: start;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;"> pursued by central banks cannot save us from</span></span></span><span style="font-weight: normal; text-align: start;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;"> the implosion of deflation, and if pursued to the perverse limits of its own logic will eventually create an explosion of hyper-inflation. </span></span></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal; text-align: start;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">In my <a href="http://parcontre.blogspot.com/2008_08_01_archive.html" target="_blank">first blog</a>, I discussed the Major Credit Cycle and three crucial interest rate levels: the Equilibrium Rate, the Boiling Point and the Tipping Point. Let me hasten to add that it’s impossible to identify exactly where these interest rate levels are at any point in time, except that in a truly free market that is unfettered by government intervention, the Equilibrium Rate will coincide with actual market rates. Let me also emphasize that these rates are not fixed, but rather fluctuate with shifts in the flow of savings and investment. As in all markets, prices ( in this case interest rates) act as a signal for suppliers to channel their resources toward those things that are rising in price while diverting resources away from those things that are sinking in price, whereas consumers spend their money on the best bargains that can be found. In this manner the invisible hand of self interest guides a society toward the most efficient uses of capital and labor, and consequently toward ever increasing levels of prosperity.</span></span></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal; text-align: start;"><span style="font-family: Georgia, Times New Roman, serif;"><span style="vertical-align: baseline; white-space: pre-wrap;">The chart below, courtesy of <a href="http://greenbackd.com/2009/11/18/chart-of-the-djia-priced-in-gold/" target="_blank">GreenBackd</a>, </span><span style="vertical-align: baseline; white-space: pre-wrap;">displays the history of the Dow Jones Industrial Average in terms of gold. I include a chart below of the same DJIA divided by the CPI, essentially the stock index in the “real” terms that most mainstream economists use, which shows a similar pattern except that is has yet to roll over (more on that later).</span></span></span></div>
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<b id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal;"><a href="http://research.stlouisfed.org/fredgraph.png?g=hVS" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=hVS" width="400" /></a></b></div>
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<b id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal;"><span style="font-family: Arial; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"></span></b><br />
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<b id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;"> These charts clearly illustrate the three bubbles that have been created since the establishment of the Federal Reserve, the central bank of the United States, in 1913. I have asserted, and continue to assert, that the expansionary phase of the bubble is nothing but a growing illusion of wealth, the result of excessive credit creation by the central bank. Except for a brief period under <a href="http://en.wikipedia.org/wiki/Paul_Volcker" target="_blank">Volcker</a>, the Fed has always carried out its chosen monetary policy by fixing the Fed funds rate, a key interest rate for overnight interbank lending. The Fed injects or drains whatever amount of reserves from the banking system is necessary to maintain that rate in the marketplace. </span></span></b><br />
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<b style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;">When (not if) the Fed errs on the side of easy money, i.e. rates too low, it sends a false signal to the markets that there is additional capital available for lending. There is in fact additional credit available, but that newly created credit does not correspond to an increase in actual capital; it was merely conjured up by the Fed out of thin air. As the first injection of counterfeit credit gives an artificial boost to investment, the economy displays an initial euphoria that leads Officialdom to congratulate itself for a job well done. Once the illusion begins to build and the euphoria grows, there is no one in a position of power, either at the central bank or in elected office, who is eager impose the pain that would be incurred should the illusion fade away, dissolved into nothingness by a harsh reality. Certainly the Fed might raise rates from time to time in an attempt to keep the process reasonably well-behaved, but never enough for the illusion to completely dissipate.</span></b></span><br />
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<b style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;">There seems to be a lot of confusion about gold, and whether or not it is money. In order for something to act as a money in every sense of that word, it must be (1) a medium of exchange, (2) a measure of value, and (3) a store of value. In the past, gold has acted as money and performed all three functions</span></b><b style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;"> simultaneously.</span></b><b style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;"> In today's world, very few places will accept payment in gold as a matter of course, and so gold fails to fulfill the first condition. On the other hand, while the dollar performs the first and second functions wonderfully, it has lost some 95% of its value since the Fed was established; it therefore fails to fulfill the third condition of being a money. So while it's fair to say that at present gold is not a complete money, neither is the dollar if we use the same criteria.</span></b></span><br />
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<b style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;">Imagine two investment options at the start of 1934, when FDR devalued the dollar to $35 per troy ounce of gold. Option #1 is to invest $35 in T-bills and roll it over each quarter, while option #2 is to bury an outlawed 1-ounce gold coin in the backyard. As the chart below illustrates, option #2 outperformed significantly over the hundred year period, but if T-bill rates had been 100 basis points higher over the entire period the two strategies would have been roughly equal (assuming no income tax, of course). So the choice is basically, invest in a depreciating asset that pays interest, or invest in an asset that maintains its value but pays no interest. I like to use gold as a measure of constant value, and while it may not be perfect for that role, it's better than any of the alternatives.</span></b></span><br />
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<b id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">We are all familiar with the financial economy, where everything is denominated in money. But beneath that financial veil is a real economy where goods and services are exchanged in countless transactions every day. As the illusion of wealth grows, a divergence between the financial and real economies also develops and grows. Eventually, after many years, the illusion of wealth reaches the limits of reality. The divergence between the financial and real economies becomes so great that there is almost no amount of counterfeit credit capable of growing the illusion. (Think of houses so expensive no one can afford to buy them.) And as investors realize that their financial assets are in fact only an illusion of wealth, there is a mad scramble to exchange illusory wealth for the real thing.</span></span></b></div>
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<b id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76" style="font-weight: normal;"><a href="http://research.stlouisfed.org/fredgraph.png?g=hPa" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=hPa" width="400" /></a></b></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">Let’s look back at history and how the dissipation of illusory wealth has played out in past cycles. A bubble peaked in 1929 and in 1934 the dollar was devalued from $20.67 to $35 per troy ounce of gold. A bubble peaked in 1966, the dollar’s link to gold was ended in 1971, and gold went from $35 to $850. A bubble peaked in 1999, and so far gold has climbed from $250 to over $1900. So in every case, the primary reaction of Officialdom to a bursting bubble is to inflate the money. And yet that inflation has not been enough to stave off a wave of banking failures, as you can see from the chart above. The data only goes back to 1934, so the early years of the Great Depression are not captured by this chart.</span></span></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">When the TARP was passed in 2008, Officialdom declared that the financial system was on the verge of total collapse. But the wave of banking failures crested at about 150 and hardly lasted for 5 years, whereas the previous wave crested at over 500 and lasted a dozen years. Granted, the number of banks has shrunk by about half. But still, if this was such a crisis it seems the wave of banking failures should have been a lot worse.</span></span></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><b id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="font-weight: normal; line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">I don’t believe the crisis is over. I think that when Officialdom got a glimpse of how ugly the return of reality would be, of how much wealth might simply dissipate into the thin air from whence it came, and what the impact of that event would be on pensions and retirement accounts, they panicked. The U.S. Treasury chief demanded that Congress write a blank check to bail out financial institutions that were insolvent, while the Fed slashed its key interest rate to zero and began a program of force feeding counterfeit credit to the financial markets (the Progressively Insane Monetary Policy), which continues to this day and apparently will continue until it has totally destroyed the global financial system. The chart below puts some numbers on the amount of illusory wealth that needs to be wiped out.</span></b></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><b id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="font-weight: normal; line-height: 1.5;"><a href="http://research.stlouisfed.org/fredgraph.png?g=hW7" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=hW7" width="400" /></a></b></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><b id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="font-weight: normal; line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Roughly speaking, total credit is at $55 trillion and the GDP at $16 trillion, for a ratio of about 350%, down from the recent peak of 375%. Assuming the economy remained constant (not likely), total credit would have to shrink by about $30 trillion (55%) to reach what looks like a stable level of 150% of GDP. At the height of the credit crisis, total credit actually shrank slightly for the first time in the history of this statistic. But the Fed quickly cranked up the PIMP and flooded the financial system with counterfeit credit. The chart below displays just how unprecedented, on a historical basis, the massive flood of "liquidity" that the Fed pumped into the financial system has been.</span></b></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span style="font-family: Georgia, Times New Roman, serif; line-height: 1.5; white-space: pre-wrap;">The forces of economic nature are at work trying to dissipate the illusion of wealth that has built over over the past three decades. And the more that the Fed and other central banks attempt to perpetuate the illusion, the greater become the economic forces that central banks are fighting against. Let's take a look at how the different measures of money have behaved since the implementation of the PIMP.</span></span><br />
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><a href="http://research.stlouisfed.org/fredgraph.png?g=i7H" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=i7H" width="400" /></a></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="line-height: 1.5;">
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; white-space: pre-wrap;">Monetary growth rates don't show anything out of the ordinary. There was a spike up as the crisis hit in 2008, and then another spike a couple of years later when the PIMP was ramped up. Growth for M1 peaked at levels higher than previous peaks, but on the other hand MZM (Money of Zero Maturity) peaked at lower rates. All in all, nothing in the above chart really merits our attention. So let's next take a look at the money multipliers.</span></span></span><br />
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="line-height: 1.5;"><a href="http://research.stlouisfed.org/fredgraph.png?g=i7J" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=i7J" width="400" /></a></span></span></div>
<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="line-height: 1.5;"><span style="font-family: Georgia;"><span style="white-space: pre-wrap;"><br /></span></span></span></span></div>
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="line-height: 1.5;">
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<span id="docs-internal-guid-4f6262ac-589f-07f8-eea7-c7735923fd76"><span id="docs-internal-guid-069d8fb6-675b-0f57-6ced-5c4d5238bb14" style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Now we're getting to the heart of the matter. Massive expansion of the monetary base has not flowed through to the monetary aggregates. Or to put it more colloquially, the Fed is pushing on a string. For the illusion of wealth to be sustained, the illusion must be perceived as reality by the populace. But the Fed is playing a confidence game with a populace that has already been fooled once too often. Everyone knows that, as soon as the PIMP goes away, reality will reimpose itself with a vengeance. There is simply not nearly enough real loan demand to absorb the counterfeit credit coming from the PIMP. So the counterfeit credit mostly goes into either speculation on financial assets or banks' excess reserves.</span></span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">It appears that the reign of the PIMP -- whose fifth anniversary is approaching -- has achieved what I predicted, in my first blog, might eventually happen: a constant stream of artificial credit creation has resulted in </span></span><span style="line-height: 1.5; white-space: pre-wrap;">the Boiling Point now being situated somewhere above the Tipping Point. The counterfeit credit from the PIMP is overwhelmingly flowing into speculation rather than productive investment, and that speculation is slowly but surely impoverishing our society. Meanwhile,</span><span style="line-height: 1.5; white-space: pre-wrap;"> leverage continues to grow as indebtedness increases throughout the economy, and with it the sensitivity of the economy to an increase in interest rates. At this point, the Equilibrium Rate is probably so far above the Tipping Point that as soon as the PIMP goes away, interest rates will skyrocket and a massive wave of bankruptcies will destroy the financial infrastructure of the world. </span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=i8z" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=i8z" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Let's take another look at the Major Credit Cycle. Above, we see that since the massive stock market bubble of the 1920s, the DJIA has traded in a band of five to twenty times the monetary base, with the timing of peaks and troughs corresponding to other measures of the cycle. But soon after the peak in 1999, the ratio reversed and moved sharply higher, only to collapse when the crisis hit and the PIMP was launched in 2008. That collapse does not indicate a fall in the DJIA, which is currently near record highs in nominal terms, but rather a massive increase in the monetary base. Let's zoom in and take a closer look at the same ratio using weekly data.</span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=imv" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=imv" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">It's important to keep in mind that, of the three Major Credit Cycles created by the Fed, the current one is the first where the Fed has not been constrained by a link to gold. So after the recent peak in 1999, it quickly began pumping massive amounts of counterfeit credit into the financial system, which caused the stock market to reverse course and move back to new (nominal) highs. But that counterfeit credit also led to a massive real estate bubble and other forms of speculative froth, and when that bubble finally popped the financial industry was plunged into an existential crisis. This time really is different, in that never before have we seen such a massive expansion of (counterfeit) credit by all the central banks of the world. And yet, while financial markets are once again showing signs of speculative froth, stock prices are merely rising in line with the increase of the monetary base and the underlying economy is treading water.</span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">What I'm trying to show with these various charts is that the illusion of wealth, built up during the past three decades, is dissipating and the central banks are powerless to stop it. The stock market is a proxy for the valuation of financial assets in general, and the various measures of money reflect how the expansion of counterfeit credit is flowing through the financial system. Let's take another look at both of these items, individually this time. As you can see below, from the trough in 1980 through the peak in 1999, the stock market got way ahead of the monetary base. The PIMP is effectively a rear guard strategy by central banks to validate, after the fact, the illusion of wealth that built up during the 1980-1999 period.</span></span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=imO" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=imO" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">We can also look at bank assets and see a similar picture. In the chart below, TRARR is total bank reserves and AMBSL is the monetary base, both of which are adjusted from billions to millions. </span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=in9" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=in9" width="400" /></a></div>
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<span style="font-family: Georgia, Times New Roman, serif; line-height: 1.5; white-space: pre-wrap;">Money is not wealth, it is a medium of exchange that facilitates the purchase and sale of wealth. The nature of the bubble, when the illusion of wealth builds up, is that financial assets are over-valued. If something is over-valued, then by logic something else must be under-valued, relatively speaking. When we look at the ratio of stocks to gold on a long-term chart, what we see is that stocks (financial assets) are over-valued at the peak of the credit cycle, and that gold (real asset) is over-valued at the trough. Over time, of course, all prices denominated in dollars tend to move higher as the currency loses value.</span></div>
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<span style="white-space: pre-wrap;">Most price indices, such as the Consumer Price Index (CPI), ignore financial assets and focus on the goods and services that people buy on a regular basis in their normal lives. In essence, the concept of inflation has become tainted by politics. When people's investments are being pumped up, everyone's happy and politicians call it a "strong economy"; but when the cost of living is being pumped up, it's "inflation" and a reason to vote out the incumbent. </span><span style="line-height: 1.5; white-space: pre-wrap;">As the illusion of wealth builds, the velocity of money (ratio of GDP to money supply) tends to slow; when the bubble bursts and real assets begin to outperform financial assets, the velocity of money accelerates. We see below how both the CPI and the velocity of MZM peaked at the trough of the last Major Credit Cycle.</span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=imZ" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=imZ" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Let's see how closely the performance of the CPI is related to money growth and velocity. Below is a model that estimates where the CPI index should be according to the monetary base and the velocity of MZM, and the actual CPI is displayed alongside.</span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=in1" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=in1" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">While the model occasionally calls for dips, notably at recessionary periods, that do not show up in the actual CPI</span></span><span style="font-family: Georgia, 'Times New Roman', serif; line-height: 1.5; white-space: pre-wrap;">, it seems to provide a reasonably good fit over a period of half a century. It may be that the prices measured by the CPI possess a certain amount of inertia that restrains sharp moves. In any case, </span><span style="font-family: Georgia, 'Times New Roman', serif; line-height: 1.5; white-space: pre-wrap;">let's extend it out a few years to take into account the past four years.</span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=in7" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=in7" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">As you can see, there has been a major divergence between the model and actual CPI. And this reflects the same phenomenon discussed above: the massive injection of counterfeit credit has simply not flowed through the financial system. The central bankers are pushing on a string. Or to put it more bluntly, reality is refusing to conform to the academic theories of the economists. </span></span><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">Like the monarch of old who ordered the tide to recede, the commands of the central bankers have been ignored by the economic forces of nature.</span></span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">At the very beginning of this blog I mentioned that, since the peak of the cycle in 1999, the CPI-adjusted DJIA had not fallen as sharply as the gold-adjusted DJIA. The chart below goes a long way toward explaining why not. In January 1913 the CPI was at 9.8 and the dollar was fixed at $20.67 per ounce of gold, so our "model gold" price is simply the CPI multiplied by 2.11 (20.67/9.8). The model and actual gold price are on the right axis, and the 7-year annualized change in the CPI is on the left axis.</span></span></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg41FhyKC-ILbV-ZL82qDZqR_H7VHocNXRsCOWxOKDQa-uE-7DLBxGyAH1M_pcdmIUqeoqwLSEbyAPbHV98hZP3e6mRwGmWD9VuuFs8K0M3XYOsd2R4f7GR7dBe7VLlmJH3CwA8_T43UWo/s1600/CPI-Gold.tiff" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="152" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg41FhyKC-ILbV-ZL82qDZqR_H7VHocNXRsCOWxOKDQa-uE-7DLBxGyAH1M_pcdmIUqeoqwLSEbyAPbHV98hZP3e6mRwGmWD9VuuFs8K0M3XYOsd2R4f7GR7dBe7VLlmJH3CwA8_T43UWo/s400/CPI-Gold.tiff" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Notice how CPI growth bottoms around the Major Credit Cycle peaks (1929, 1966, & 1999), and peaks around the troughs (+/- 1942 & 1980) -- except that CPI growth has not picked up since the last peak in 1999. Then check out how actual gold lagged behind the model in the 1960s, soared far above the model at the trough in 1980, and then fell back until it actually dropped below the model at the cycle peak of 1999.</span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">Since the cycle peak of 1999, gold has rocketed to a height far above the model, which suggests either of two possibilities, or some combination thereof: gold is way above its equilibrium, or the CPI is lagging and has some serious catching up to do. The previous chart suggested that CPI needs to increase about 60% to catch up with the expansion of money supply, so we can imagine a scenario over the next decade where our model gold price climbs to around $800, actual gold glides down to the $500-700 range, and the CPI climbs about 5% annually.</span></span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;"><br />But remember what happened at the last Major Credit Cycle trough in 1980 -- the Fed allowed interest rates to absolutely blow through the roof. The 90-day T-bill hit 17% and the 10-year T-note went over 15% before the markets finally settled down. The Fed is not about to allow that to happen; on the contrary, it is determined to follow the PIMP until the economic forces of nature cease their evil ways and obey the commands of Emperor Bernanke. And as the PIMP drives financial assets into a fresh speculative frenzy, it perversely acts as a drag on the CPI, and the seemingly docile CPI only intensifies the Fed's allegiance to the PIMP.</span></span></span></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Before leaving the subject of the CPI, let me remind you that my monetary model for the CPI takes into account the velocity of money (MZM). As you can see above, velocity and gold both peaked almost exactly at the trough of the last cycle. But while gold has come back to hit new highs, money velocity continues to plunge. At some point velocity will reverse, and that increasing velocity should feed through to growth of the CPI.</span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">Suppose that the Fed decided to terminate the PIMP; it's starting to get nervous about the increasing speculative froth in the financial markets and decides to bite the bullet. And as long as we're playing make-believe, let's pretend that Emperor Bernanke suddenly becomes a devout Austrian. So</span></span><span style="line-height: 1.5; white-space: pre-wrap;"> after the next FOMC meeting he announces that going forward the Fed will grow the monetary base at 5% and allow interest rates to find their equilibrium in the marketplace.</span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif;">The chart below shows federal debt and interest paid on that debt, both as a share of GDP. First notice that interest expense was much higher at the 1990 peak even though debt was much lower than its 1940s peak. Then notice that interest expense has remained near its post-war lows even as debt has climbed back above the 100% level. This reflects the extremely low interest rates that have prevailed recently and during the 1940s.</span></div>
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<span style="white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">Next I take the ratio of the two items above to get the implied rate of interest that was paid on the debt, and I throw the actual 90-day T-bill rate on the same chart for a comparison. Bear in mind that these are annual figures for GDP and yearly averages for the T-bill rate, and do not even begin to take into account the yield curve for different maturities of treasury issuances. Still, as you can see below, there is a reasonably good fit. </span></span></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">At the trough of the last Major Credit Cycle, interest rates on treasuries went north of 15%. This time around, there has been an unprecedented amount of pushback by central banks. Arguably, the PIMP began not with Bernanke, but with Greenspan when he took the fed funds rate to 1% in 2003</span></span> . So once again let me remind everyone how the laws of supply and demand work: a drop in price stimulates demand and discourages supply, an increase in demand pushes up the price, and a drop in supply pushes up the price. <span style="line-height: 1.5;">So artificially low interest rates discourage savings and encourage borrowing, and a decrease in saving coupled with an increase in borrowing pushes interest rates higher. If we are a decade into the reign of the PIMP, it's safe to say that the Equilibrium Rate is way, way up there. I will go so far as to predict that, when we finally hit the trough of the current Major Credit Cycle, interest rates <b><u>will take out the highs</u></b> from the last trough.</span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif; line-height: 1.5;">Since the total federal debt is now slightly higher than the national GDP, </span><span style="font-family: Georgia, 'Times New Roman', serif; line-height: 1.5;">the interest expense in terms of GDP will be slightly higher than the average rate of interest paid on the debt. </span><span style="font-family: Georgia, 'Times New Roman', serif; line-height: 1.5;">A 5% rate of interest means the amount of interest expense paid by the federal government is just above 5% of GDP, and so forth. As you can see above, federal spending in the post-war era has been around 20% of GDP. So if the average interest rate paid on federal debt surpasses 10% -- and I think it could go a lot higher -- interest expense alone will be in the neighborhood of half the federal budget. That will absolutely, positively blow up the budget! Given political and economic realities, it will be absolutely impossible to reduce spending and/or raise taxes enough to accomodate that amount of interest expense. And the increase in interest rates will almost certainly be accompanied by a severe recession, which will raise the political pressure for increased government spending and even greater deficits. As markets see the government borrowing more and more just to pay interest on the debt, the government will find itself trapped in a vicious cycle from hell, where higher interest rates lead to more borrowing and more borrowing leads to higher interest rates. Our republic will not survive in its current form (see my solution <a href="https://sites.google.com/site/parcontre/home" target="_blank">here</a>).</span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=itz" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=itz" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">Above we see the monthly price of crude oil. It hit a high point around the last trough of the Major Credit Cycle and a low point around the last peak. After that cycle peak in 1999 the price of crude shot higher, peaking around $135 (monthly average) and then plunging back to $40. The action of the last five years can actually be interpreted as a contracting triangle, which is usually a consolidation pattern, and if crude breaks out to the upside implies a target about $95 above current levels. I think we can all imagine what crude near $200 would mean for the economy. The question is, will it break out to the upside or to the downside?</span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">If the Fed maintains its allegiance to the PIMP, then I believe that eventually crude will break higher. But if the Fed ends the insanity and allows financial economy to finally converge with the real economy, then crude will head back toward the $40 level.</span></span></span></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">GDP stands for Gross Domestic Product, emphasis on gross. It doesn't take into account the normal depreciation of the nation's capital stock, the inevitable wear and tear that every day grinds away at our infrastructure. The slowly decaying bridge in Minnesota has no impact on measured GDP, and its eventual collapse due to a lack of maintenance has no measured impact, but the cost of its reconstruction does increase the measure of GDP. That reconstruction has not added to the total wealth of the nation, however, it has only restored at great cost an asset that could have been properly maintained at much lower cost. How much vital maintenance is being deferred in order to finance the profligacy of Big Brother and the Nanny State?</span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">We are eating our seed corn. We are consuming the capital that was built up by previous generations, and at an ever-increasing rate. </span></span><span style="line-height: 1.5; white-space: pre-wrap;">While the financial economy is flush with central bank liquidity, the real economy is starved for investment because the PIMP has destroyed incentives to save, and savings are the only source of real capital.</span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">Ben Bernanke has a tiger by the tail -- he dare not hang on but he dare not let go. My suspicion is that every day he prays for the current false equilibrium to endure until he can retire with dignity. It was the belief of Ivory Tower Economists that if enough counterfeit credit was pumped into the financial system, lending to businesses would increase and that increased lending would lead to an economic resurgence. The moral and idealogical bankruptcy of that belief is now obvious to all, but the ITEs and their acolytes refuse to countenance any alternative to our continued progress down the road to ruin.</span></span></span></span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline;"><span style="white-space: pre-wrap;">Eventually, the divergence between the financial economy and the real economy will be resolved. The more that central banks strive to maintain the divergence, the greater become the forces of economic nature pushing toward convergence.</span></span></span><span style="line-height: 1.5; white-space: pre-wrap;"> The Fed could still decide to allow the financial economy to move back toward the real economy, and effectively push over-indebted institutions into bankruptcy. That way lies economic collapse, a breakdown of governments and the rise of revolution. Not surprisingly, central banks continue to follow the PIMP.</span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline;"><span style="white-space: pre-wrap;">At some point, however, the dam will break and all the counterfeit credit that central banks have pumped into the banking system will flood into the real economy. But it will not flow into real investments because it is not real capital. It will instead stream into real assets that represent safe havens from the massive monetary dilution to which central banks have dedicated themselves. It will flow into gold, silver and commodities such as crude oil. The real economy will move toward the financial economy, prices will move higher across the board, central banks will struggle to accomodate the increased demand for money by increasing their injections of counterfeit credit, and finally paper currencies will collapse into the whirlwind of hyperinflation. </span></span></span><span style="line-height: 1.5; white-space: pre-wrap;">That way lies economic collapse, a breakdown of governments and the rise of revolution. </span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif; line-height: 1.5; white-space: pre-wrap;">Let me wind down this diatribe by going back to where I began. Below is a chart of the DJIA/Gold ratio using daily data. The recent peak was around 45 ounces of gold on August 25 of 1999, and the strenuous efforts of the Fed have created a local bottom at 5.8 ounces on August 22 of 2011, a span of almost exactly one dozen years. When we arrive at the trough of the current Major Credit Cycle, the DJIA should approach a level equal to one single troy ounce of gold. We have a long way to go.</span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=iwi" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=iwi" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline;"><span style="white-space: pre-wrap;"><br /></span></span></span><span style="line-height: 1.5;"><span style="vertical-align: baseline;"><span style="white-space: pre-wrap;">Below we take another look at stock prices (DJIA) and two real assets, crude oil and gold, with all three set equal to the number one (1.0) at the recent peak of the Major Credit Cycle on August 25 of 1999. This provides a nice perspective on the relative performance of these assets over the long term.</span></span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5; text-align: start;"><span style="vertical-align: baseline; white-space: pre-wrap;">Finally, let's take a closer look at interest rates and the Major Credit Cycle. Below we </span></span><span style="text-align: start;">see the ratio of bond prices to gold. (I used Moody's AAA because the data goes back to 1919, and used the PV function to get the price of a 100 par, 30-year, 5% annual coupon bond; the gold price is $20.67 until 1934 when it jumps to $35.00, and from 1968 onward I use the monthly average of the London PM fix.) What we see is a stair step pattern, where the bond price in terms of gold holds steady for a long period and then drops sharply. In the 1930s the drop was almost a straight line down, reflecting the official devaluation. In the 1960s a long slide began that only ended in 1980 at the trough of the credit cycle.</span></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsjhXXSEiu_l1e0N6z-MLA_7O8eSy2CFPGN3wgxOsPdVzKSzItuiIMyMy1ovQB5rLDZg2MTwdfu3_DHOCk6y1kuu8lDTjJzB-VFlD1k_TnbVKAP0F3TyO0kjPAo7HrkCfeEaGWUV_AJpc/s1600/Bond-Gold.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="196" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsjhXXSEiu_l1e0N6z-MLA_7O8eSy2CFPGN3wgxOsPdVzKSzItuiIMyMy1ovQB5rLDZg2MTwdfu3_DHOCk6y1kuu8lDTjJzB-VFlD1k_TnbVKAP0F3TyO0kjPAo7HrkCfeEaGWUV_AJpc/s400/Bond-Gold.png" width="400" /></a></div>
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<span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">Let's take a closer look at the previous chart; below is the same bond/gold ratio, but using daily data and T-note yields. Here we can clearly see the contrast between </span></span><span style="line-height: 1.5; white-space: pre-wrap;">the bear market in bonds, which came to an end </span><span style="line-height: 1.5; white-space: pre-wrap;">at the trough of the last cycle, and the bull market that continues to this day. Still, although the bull market continues, the bond/gold ratio topped out around the peak of the cycle in 1999.</span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=ixR" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=ixR" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="font-family: Georgia; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="line-height: 1.5;"><span style="font-family: Georgia, Times New Roman, serif; vertical-align: baseline; white-space: pre-wrap;">The bull market in bonds, more than three decades old, is getting rather long in the tooth. If the next bear market is anything like the last, bond investors would be well advised to buckle up and brace themselves for a series of stomach-churning air pockets. From the high of around four ounces of gold in the 1940s, the (futures equivalent) bond price fell to less than one tenth of an ounce at the low in 1980. That's a drop of 97% in real value!!!</span></span></div>
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<span style="font-family: Georgia, Times New Roman, serif;"><span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;"><br /></span></span><span style="white-space: pre-wrap;">Now of course investors were receiving coupons from their bonds, so the net loss was not quite that bad. But still, a portfolio of bonds whose income would have provided a solid middle class income before the beginning of WWII was probably not enough to even pay the rent and groceries by the end of the 1970s. But look at the bull market that followed! It looks more like a sideways market than a strong rally. Yes, the bond price went from one tenth to about four tenths of an ounce, but that doesn't even begin to claw back all the value that was lost in the previous bear market.</span></span></div>
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<span style="white-space: pre-wrap;"><span style="font-family: Georgia, Times New Roman, serif;">The bond/gold ratio is currently around one tenth of an ounce of gold, back near its low of 1980. I'm going to go out on a limb and make a prediction that I'm sure will make me a laughingstock for anyone who worships the god of paper money. My prediction: when we finally hit the trough of the current cycle, the price of <b><u>Treasury Note futures in terms of gold will hit zero.</u></b></span></span></div>
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<a href="http://research.stlouisfed.org/fredgraph.png?g=iyh" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fredgraph.png?g=iyh" width="400" /></a></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;"><span style="font-family: Georgia; font-size: 16px;"><br /></span><span style="font-family: Georgia, Times New Roman, serif;">Above we see the same values that made up the previous chart, but the individual components rather than their ratio, and the bond yield rather than the price. Notice once again how the price of gold and bond yields both peaked near the trough of the last cycle in 1980. But while gold, since the recent peak of the cycle in 1999, has rocketed to new highs, bond yields have continued to decline.</span></span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">I believe this reflects the "flight to quality" that has occurred since the recent peak of the cycle, and especially since the debacle of 2008. Financial theorists like to build their equations around the concept of the "risk-free rate of interest," and government bonds are typically used as proxies for this concept. But since the debacle of 2008, the universe of "risk-free" government bonds has shrunk, and this shrinkage has increased the relative value of those bonds that remain members of the "risk-free" club.</span></span></span></div>
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<span style="line-height: 1.5;"><span style="vertical-align: baseline; white-space: pre-wrap;">When a chain breaks, it's always the weakest link that snaps. And in the complex financial system that ties together the economies of the world, it is the weakest economy that collapses first, and then the second weakest, and then the third weakest, and so forth and so on. And the process continues until every insolvent institution has been forced into default.</span></span></span></div>
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<span style="white-space: pre-wrap;">Virtually every government in the world is ruled by politicians who entrench themselves in power by borrowing from the future in order to provide freebies to their constituents today. This model is guaranteed to eventually blow up as each government hits the limits of its borrowing capacity. And as I have explained above, it is my belief that governments have already begun hitting those limits. Eventually, even the United States will succumb to the inevitable. </span><span style="line-height: 1.5; white-space: pre-wrap;">But for now, in the world's laundry basket of soiled assets, U.S. treasuries continue to be the cleanest dirty shirt.</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">Well I woke up Sunday morning,</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">With no way to hold my head that didn't hurt.</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">And the beer I had for breakfast wasn't bad,</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">So I had one more for dessert.</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">Then I fumbled through my closet for my clothes,</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">And found my cleanest dirty shirt.</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">An' I shaved my face and combed my hair,</span></span></div>
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<span style="font-size: large;"><span style="font-family: Georgia; font-style: italic; vertical-align: baseline; white-space: pre-wrap;">An' stumbled down the stairs to meet the day.</span></span></div>
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<span style="line-height: 1.5;"><a href="http://www.youtube.com/watch?v=vbqGWTxwZEA" target="_blank">Kris Kristofferson</a></span></div>
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<span style="font-family: Georgia, Times New Roman, serif; font-weight: normal;"><span style="font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"></span></span><span style="font-weight: normal;"><span style="font-family: Arial; font-size: 16px; vertical-align: baseline; white-space: pre-wrap;"></span></span></span>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-8219579248485363625.post-13213724616921518982008-09-11T15:48:00.003-05:002008-09-11T16:03:45.611-05:00G.O.P. - R.I.P.<p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Once upon a time, this nation had a choice of political philosophies from which to choose. During his first campaign for the White House, in his acceptance speech at the Democratic convention, Franklin Delano Roosevelt promised a new direction for the country.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"></span></span></p><blockquote><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“What do the people of America want more than anything else? To my mind, they want two things: work, with all the moral and spiritual values that go with it; and with work, a reasonable measure of security--security for themselves and for their wives and children. Work and security--these are more than words. They are more than facts. They are the spiritual values, the true goal toward which our efforts of reconstruction should lead. These are the values that this program is intended to gain; these are the values we have failed to achieve by the leadership we now have.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“Our Republican leaders tell us economic laws--sacred, inviolable, unchangeable--cause panics which no one could prevent. But while they prate of economic laws, men and women are starving. We must lay hold of the fact that economic laws are not made by nature. They are made by human beings.. . .</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“I pledge you, I pledge myself, to a new dea l for the American people. Let us all here assembled constitute ourselves prophets of a new order of competence and of courage. This is more than a political campaign; it is a call to arms. Give me your help, not to win votes alone, but to win in this crusade to restore America to its own people.”</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"></p></blockquote><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The standard bearer for the Grand Old Party, incumbent Republican president Herbert Hoover, responded with an eloquent defense of classical liberal values.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"></span></span></p><blockquote><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“It is false liberalism that interprets itself into the Government operation of business. The bureaucratization of our country would poison the very roots of liberalism that is free speech, free assembly, free press, political equality and equality of opportunity. It is the road, not to more liberty, but to less liberty. Liberalism should be found not striving to spread bureaucracy, but striving to set bounds to it. True liberalism seeks freedom first in the confident belief that without freedom the pursuit of all other blessings and benefits is vain. That belief is the foundation of all American progress, political as well as economic.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“Liberalism is a force truly of the spirit, a force proceeding from the deep realization that economic freedom cannot be sacrificed if political freedom is to be preserved. Even if governmental conduct of business could give us more efficiency instead of giving us decreased efficiency, the fundamental objection to it would remain unaltered and unabated. It would destroy political equality. It would cramp and cripple mental and spiritual energies of our people. It would dry up the spirit of liberty and progress. It would extinguish equality of opportunity, and for these reasons fundamentally and primarily it must be resisted. For a hundred and fifty years liberalism has found its true spirit in the American system, not in the European systems.”</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"></p></blockquote><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">When the votes were counted, the American People had overwhelmingly chosen the vision laid out by FDR. In his first inaugural address, he elaborated:</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"></span></span></p><blockquote><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“If I read the temper of our people correctly, we now realize as we have never realized before our interdependence on each other; that we can not merely take but we must give as well; that if we are to go forward, we must move as a trained and loyal army willing to sacrifice for the good of a common discipline, because without such discipline no progress is made, no leadership becomes effective. We are, I know, ready and willing to submit our lives and property to such discipline, because it makes possible a leadership which aims at a larger good. This I propose to offer, pledging that the larger purposes will bind upon us all as a sacred obligation with a unity of duty hitherto evoked only in time of armed strife.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“With this pledge taken, I assume unhesitatingly the leadership of this great army of our people dedicated to a disciplined attack upon our common problems.”</span></span></p></blockquote><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">FDR was true to his word, and during his four terms in the White House, he laid the foundation for our modern welfare state. He confiscated Americans' gold, abrogated contracts written in terms of true value, and gave the people a paper money. He created Social Security, by which each generation would be responsible for providing a retirement income for the previous generation, not through saving and investment, but rather in the nature of a pyramid scheme. He created the Federal National Mortgage Association and the Federal Housing Administration to provide Americans with home loans. He created the Federal Deposit Insurance Corp to guarantee bank deposits.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In the decades since FDR launched the New Deal, through both Democrat and Republican administrations, government has continued to grow and social welfare programs have proliferated. Republicans have continued to profess their belief in limited government and free markets, and a significant portion of the citizenry remains wary of big government. But the fact of the matter is that the welfare state has become ensconced in our national conscience. The elderly want their Medicare and Social Security. Farmers want price supports and urban dwellers want subsidies for mass transit. The poor want welfare checks and businesses want protection from their competition. Home buyers want cheap mortgages so they can buy overpriced houses, students want subsidized loans so they can pay outrageous tuitions. Everyone wants something, and they expect the government to provide it to them, or at least a subsidy to offset its high price.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">But FDR was wrong about economic laws being man-made; the laws of supply and demand are as immutable as the laws of gravity. Economic resources are by their very nature scarce, and must be rationed in one manner or another. Supply and demand must always find equality in the marketplace; if not through the mechanism of price, then by waiting in line or with government-issued ration cards. If resources are underutilized or misallocated, then economic growth will be diminished. Businesses forced to pay above-market wages will eventually go bankrupt. Most important of all, money is not wealth, and printing more of it will not create lasting prosperity.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">By virtue of having led the free world to victory in WWII, as well as its military and economic might, America became the world's leading economy and its dollar the global currency. And because the dollar was the world's reserve currency, America was able to borrow almost without limit. But that temptation has proven too great to resist, and the country that was once the greatest economy and largest creditor to the world, has now become the biggest debtor and greatest spendthrift of all time. But even America does not have truly unlimited borrowing power.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">What we are witnessing today is the inevitable collapse of the New Deal, and the entire edifice of the welfare state which was built upon it. George Bush had an opportunity to face this challenge based upon the principles of the party on whose ticket he ran for office. George Bush could have said that we are a nation of laws, and that he is charged with executing those laws. Every security issued by Fannie and Freddie carries a disclaimer that it is NOT guaranteed by the US Treasury, and investors earned premium returns for investing in those securities because they were taking on risk. George Bush could have dealt with Fannie and Freddie's insolvency by simply placing them in conservatorship, and allowing losses to accrue to those who put their money at risk. But no! He did none of these things. When his Chinese debt masters snapped their fingers, George Bush jumped to do their bidding.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The bailout of Fannie and Freddie will, at best, prolong the inevitable. If George Bush is lucky, the financial debacle that awaits us will occur on his successor's watch. Observing the current administration is like watching a gambling addict at the roulette table. After each spin, he doubles down, convinced that the next number will redeem his fortune. First it was the bailout of Bear Stearns, now the bailout of Fannie and Freddie, next will be the bailout of Lehman Brothers and Merrill Lynch, to be followed by the bailout of the FDIC, the bailout of the PBGC, the bailout of Detroit automakers, and the bailout of state and local governments. But who will bail out our government when there's no one left to bail?</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">I'm sure the Republican Party will continue to be on ballots for many elections to come. And I'm sure that its candidates will continue to profess their devotion to conservative principles. But the Republican party has become like the village whore who puts on a white dress and walks down the aisle. While the church scene may display an aura of innocence and virtue, none will be fooled into believing her a virgin, and many will chuckle as they recall the moments of pleasure they once shared with her.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The Democrats promise to expand the welfare state, and I have no doubt that they will. They promise to raise taxes, and I have no doubt that they will. They promise to cut our national defense, and I have no doubt that they will. They promise to deliver equality for every race, creed and gender, and I have no doubt that their vision will lead us to a poverty shared equally by all.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">There is no promise a Republican can make to which I will any longer give credence. Their talk of conservative principles is a hollow shell in which I have completely lost faith. Their candidates are empty suits whose only goal is preservation of their political careers. I hope and pray that from somewhere, and soon, a political movement will arise that embodies the principles of liberty and freedom upon which this country was founded. But as for myself, a lifelong Republican like my parents before me, I swear to God that so long as I live, never again shall I cast my ballot for a candidate of the Grand Old Party.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><br /></p>Unknownnoreply@blogger.com7tag:blogger.com,1999:blog-8219579248485363625.post-39920354487346280422008-08-24T23:09:00.013-05:002008-08-24T23:41:16.403-05:00What is the problem?<div><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">It seems like every time I read the financial press, there is at least one article on the front page speculating about the Federal Reserve. What will it say at the next meeting, how long until the next rate move, and will the move be up or down?</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The question I never see asked, but which screams out for on answer, is why the government fixes the price of credit in the first place. Isn't our financial system supposed to be based on free markets, which allocate resources according to supply and demand through the mechanism of price? If the government can fix the price of credit, what's to prevent it from setting that price based on political considerations rather than supply and demand? What's to prevent it from setting the price of credit too low, thereby creating an excess of demand and a shortage of supply in the market for capital? And in fact, that is precisely what has happened.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The reason we have a financial crisis is because the Fed has held interest rates below their natural equilibrium for far too long, thus leading to a major divergence between the financial economy and the real economy.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">It's important to keep in mind that money is a medium of exchange, and has value only to the extent that it can be exchanged for real goods and services. Philosophically, money can be thought of as a claim on real assets. The act of saving consists of not exercising all of one's claims; instead, those claims are transferred through the financial system to businesses and entrepreneurs, who exercise the claims and and use the assets claimed to create new productive assets. Those new capital assets then generate more resources, from which businesses return to the saver his original claim, plus interest or dividends to compensate for his deferment of consumption. </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In the financial economy, interest rate equilibrium occurs where dollars borrowed equal dollars lent. Since the Fed has virtually unlimited lending powers, it has a powerful – but not unlimited – ability to set interest rates in the financial markets. In the real economy, however, interest rate equilibrium occurs where total saving equals total investment. When the Fed pushes interest rates below their natural equilibrium, it creates the illusion that saving has increased, which in turn leads to an increase in investment. But this increase in investment has occurred without any corresponding increase in saving, so total consumption plus total investment now exceeds the total available goods and services in the economy.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Put another way, when the Fed pushes interest rates below equilibrium it discourages saving and encourages investment, and so we get less saving and more investment. But a decrease in saving coupled with an increase in investment will push interest rates higher. Thus, the more the Fed pushes interest rates below their equilibrium, the greater become the natural forces pushing interest rates higher.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Now consider economic players' reactions to this disequilibrium between the financial and real economies. Real investment opportunities are always limited, so entrepreneurs facing a glut of capital begin to invest in less attractive endeavors, i.e. those with a higher risk to reward ratio. In addition, while the rate of saving declines, those who do save are tempted to shift into riskier assets in an attempt to maintain their cash flows or achieve greater capital gains. On either side of the ledger, both borrowers and lenders are taking on more risk.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">At some point, the Fed decides rates are too low and begins to raise them; economic players suddenly realize they are taking too much risk and a collective scramble for safety ensues. The economy begins to turn down. But the equilibrium interest rate will have moved higher, depending on how low and how long the Fed held down rates. If the Fed lets rates move all the way back up to the new equilibrium, then the divergence between the real and financial economies will have been eliminated, but at a cost. Essentially, the illusion created by the Fed must be undone, and that means marking down financial and other assets to their real worth. Usually, however, the pains of disillusionment prove too great to bear, and so the Fed begins once again to lower rates before achieving a new equilibrium or eliminating the divergences.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Monetary policy, as practiced by the Fed, is bounded by what I call the 'Boiling' and 'Tipping' points. If interest rates are pushed down to the Boiling Point, economic activity becomes driven by speculation and irrational exuberance. If rates are pushed up to the Tipping Point, economic activity falls off a cliff and the pain is so great that social turmoil results. The problem is that no one really knows where these levels are, and the levels themselves are constantly shifting.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Let's first consider the Boiling Point. This occurs because in the real economy, there are a limited number of investment opportunities. Entrepreneurs will always invest first in those opportunities which promise the most attractive returns. So any addition capital will be invested in less attractive opportunities, and eventually in the least attractive opportunities. Since the additional credit created by the Fed first flows through the financial markets, there tends to be a boom in financial assets. At the Boiling Point, it becomes more attractive to speculate on financial assets than to invest in actual wealth-producing enterprises. People purchase assets because they expect prices to go higher, regardless of intrinsic value or economic fundamentals.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Now one might argue that, on the contrary, the number of investment opportunities is infinite, and if only more capital were available then all these opportunities could be pursued. But that is precisely the point; there is a limited amount of capital available for investment, and in a free market capital is allocated to those opportunities which promise the highest return with the lowest risk. When the Fed pushes interest rates below their equilibrium and creates the illusion of additional capital available for investment, entrepreneurs will begin embarking on less attractive investments because they do not immediately realize that the additional capital is an illusion. The result is a competition between investors and consumers for scarce resources, and hence upward pressure on prices. When interest rates eventually move higher and losses are realized on investments, this represents a real economic loss, as many of those losing investments will be under utilized or even abandoned. Goods and services were squandered, real wealth was destroyed.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">If the Fed does not allow interest rates to rise up to the new equilibrium before it begins pushing them down again, then the still-existing imbalances from the previous rate cycle will be compounded by the creation of a new illusion. In the previous cycle, businesses invested more than they otherwise would have because of the illusion created by the Fed. In many cases, the result was over-capacity. So as the Fed lowers interest rates once again, businesses are less eager to invest and the Fed needs to be more aggressive with its rate cuts in order to get a similar level of stimulation. </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Over a number of cycles, if the Fed fails to restore equilibrium, businesses will become less and less eager to invest. But the credit injected into the financial system by the Fed has to go somewhere, and what is not channelled into productive endeavors will inevitably be channelled into non-productive endeavors, i.e. speculation.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">These two factors, lingering imbalances and reluctant entrepreneurs, suggest that from one cycle to the next, the Boiling Point is likely to rise. In other words, the Fed's ability to drive increases in real investment will weaken over time.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Now let's consider the Tipping Point. Remember that real saving can be thought of as a claim on assets that has not been exercised. That claim is transferred to businesses who exercise the claim, and invest the claimed resources in new wealth producing assets. The wealth generated by those newly-created assets is used to pay the saver his principal and interest.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">When the Fed pushes down interest rates, it does so by buying government bonds in the open market, thus becoming the marginal buyer at the intersection of supply and demand. Because it pays for the bonds by essentially writing a check on itself, the Fed is effectively injecting additional credit money into the debt markets. But that additional credit does not represent a claim on any resources, it is simply created out of thin air. Because there are no corresponding claims on real assets associated with the additional credit, there is no underlying foundation upon which to build new wealth-creating assets necessary for generating interest payments to the saver.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">If debt cannot be serviced by the income from newly created productive capacity, then it must be serviced by capital gains; there is no other alternative. When the Fed first pushes interest rates down to the Boiling Point, where speculation becomes the dominant investment theme, this is not a problem; the boom in financial and other assets is more than enough to service the illusion that the Fed has created. But the longer the Fed holds rates below their equilibrium, the greater becomes the illusion of wealth and the greater become the debt servicing requirements of this illusory capital.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The Tipping Point is a reflection of an economy's sensitivity to interest rates. When the ratio of debt to productive assets is low, the Tipping Point is very high; when the ratio of debt to productive assets is high, the Tipping Point is very low. So as we go from one credit cycle to the next, without the Fed allowing interest rates to move up to an equilibrium where divergences between the real and financial economies can be eliminated, it stands to reason that relative level of debt will rise. Also, as mentioned above, when the Fed pushes interest rates below their equilibrium, both borrowers and lenders tend to take on more risk. This implies an ever-increasing sensitivity to interest rates, and thus a decline in the Tipping Point from one credit cycle to the next.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In conclusion, we have three key interest rates: the Equilibrium Rate, the Boiling Point and the Tipping Point. We know that from one credit cycle to the next, as long as the Fed insists on holding interest rates below their equilibrium, the Equilibrium Rate will rise, the Boiling Point will rise and the Tipping Point will decline. If carried on for long enough, a scenario for disaster unfolds: the Equilibrium Rate moves above the Tipping Point, while the Boiling and Tipping Points converge on each other.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">If we look at recent economic history, we see that somewhere in the 1950s or 60s (perhaps earlier), the Fed began to push interest rates below their equilibrium. By the late 70s, the Equilibrium Rate had moved well above the Tipping Point; the situation was only resolved when the benchmark interest rate was allowed to rise to the previously unimaginable level of 20%. At the time, it appeared that a true interest rate equilibrium had been achieved, and that the divergence between the real and financial economies had been eliminated. Without a doubt, the Equilibrium Rate and Boiling Point fell dramatically, while the Tipping Point rose in equal measure.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Perhaps the excesses were never completely flushed from the system. Or perhaps the Fed is simply incapable of resisting the urge to give the economy a little boost with its monetary powers. In any case, not even three decades after the economy endured Volcker's harsh medicine, we're fighting the same fight once again.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Before we take a close look at some economic history to get a sense of these monetary cycles, let's consider just exactly what the nature of money is. An economist would say that money performs three functions: it is (1) a medium of exchange, (2) a measure of value, and (3) a store of value. Medium of exchange simply means that we pay money for what we buy, and in turn are paid in money for our labor, etc. Measure of value means that prices, salaries, etc. are quoted in monetary units. And store of value means that money set aside today can be spent at some later date.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">There's no doubt that the U.S. dollar performs the first two functions of money admirably. But with regard to the third function, the dollar's performance had been less than stellar. The St Louis Fed puts the Consumer Price Index at 19.0 for the start of 1921 and at 219.964 for July of 2008. That works out to an annualized rate of inflation of 2.84%, i.e. a doubling of prices every quarter century. So in any study of economic history, using the dollar as a benchmark of constant value will provide a skewed perspective. Gold, in terms of which the dollar was once defined, has by contrast increased in value from $20.67 to $800 during that same period, which represents an annualized rate of increase of 4.27%.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">It's important to understand, however, that gold often acts like a canary in the coal mine of financial markets. When confidence in the dollar is low, demand for gold is high; when confidence in the dollar is high, gold is scorned as an investment that pays no interest. In 2001 gold traded as low as $255, while in 2008 it has been as high as $1035. Based on those recent prices, gold's annual rate of increase would be 3.17% and 4.60%, respectively. The question remains, however, whether gold is a reasonable benchmark of constant value, or if it has an inherent tendency to appreciate in value.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Finally, we must consider the accuracy of the CPI itself. There have been serious allegations, notably by </span></span><a href="http://www.shadowstats.com/"><span style="text-decoration: underline ; color:#000080;"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">www.shadowstats.com</span></span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">, that the CPI substantially understates the rate of inflation. Given that Social Security and other government obligations are tied to the CPI, it is certainly in the government's financial interest to understate the CPI. But in the end, with regard to the study of economic history, one can choose either an inflation-adjusted dollar or gold as a benchmark for constant value. Some put their faith in government statistics; I trust the market.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"> Below is a chart of gold going back a century. The prices are Comex gold futures, and monthly averages from the London fix (courtesy of Kitco.com) from before the futures were traded. It's admittedly not the best, but hopefully sufficient for this essay. Notice the big spikes up in the 1970s and the 21</span></span><span style="vertical-align: 5.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:x-small;">st</span></span></span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"> century. At a minimum, I think we can all agree that these spikes represent periods of low confidence in the dollar.</span></span> </p><div><span class="Apple-style-span" style=" ;font-family:'Times New Roman';font-size:12px;"><br /></span></div></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixNBsj2GDq9i7bs1ePR3ItDiZKohyphenhyphenoiIddcf1KpYQejVgYAb_20FTh9vT3VA7_udnRhYzysG2mK2KlTvk2DmQZtq4ti2dBBXAxGH6vQOIulwnmhYngCAT01zldgoeFJMpO4Ohvp7VGxXI/s1600-h/Gold-mthly.jpg"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixNBsj2GDq9i7bs1ePR3ItDiZKohyphenhyphenoiIddcf1KpYQejVgYAb_20FTh9vT3VA7_udnRhYzysG2mK2KlTvk2DmQZtq4ti2dBBXAxGH6vQOIulwnmhYngCAT01zldgoeFJMpO4Ohvp7VGxXI/s200/Gold-mthly.jpg" border="0" alt="" id="BLOGGER_PHOTO_ID_5238306742195199602" /></a><br /><div><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman"><span class="Apple-style-span" style=" ;font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Next we have a chart of the Dow Jones Industrial Average, in nominal dollars, on a log scale. There were two bear markets of significance, which began in 1929 and somewhere in the 1960s. In the first bear market, the DJIA declined by 89% (386 to 40) while gold appreciated 69% ($20.67 to $35). In the second bear market, the DJIA went sideways while gold appreciated 1847% ($35 to $681). That's using end-of-month prices, at its peak gold was up 2400%. It remains to be seen how significant the bear market that began with the 21</span></span><span style="vertical-align: 5.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:x-small;">st</span></span></span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"> will turn out to be.</span></span><br /></p><div><span class="Apple-style-span" style=" ;font-family:'Times New Roman';font-size:12px;"><br /></span></div></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiYfNgaqm3i1WR2qElxd9zSSVx1vTfnXCsFGmAB7zwSxX8n_0QSxf0fMvQf0NGPKDZHZh0OwhDAns0oRwRcnwWGtcm04bjshv1phBJfhVM08UDkThhrUXGT_M_Py9_ewx-ZlB9uZpqo4-U/s1600-h/Dow-mthly.jpg"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiYfNgaqm3i1WR2qElxd9zSSVx1vTfnXCsFGmAB7zwSxX8n_0QSxf0fMvQf0NGPKDZHZh0OwhDAns0oRwRcnwWGtcm04bjshv1phBJfhVM08UDkThhrUXGT_M_Py9_ewx-ZlB9uZpqo4-U/s200/Dow-mthly.jpg" border="0" alt="" id="BLOGGER_PHOTO_ID_5238306213936089490" /></a><span class="Apple-style-span" style="font-size:small;"><br /></span><div><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"> </span></span></p><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Up to now I've been using the term 'cycle' rather loosely. A MAJOR credit cycle runs for a third of a century or so, and ends only when interest rates touch the Equilibrium Rate, resulting in the elimination of divergences between the real and financial economies. Within a major credit cycle are numerous MINOR credit cycles, which correspond to the traditional business cycle. But with each minor cycle, as the Fed pushes rates down and then fails to raise them back to the new, higher Equilibrium Rate, the Boiling Point rises and the Tipping Point declines.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">When a major credit cycle begins, the Boiling Point is very low and the Tipping Point is very high. So the Fed's policy of holding interest rates below their equilibrium is very supportive of stocks, as the low interest rates push financial assets above their natural levels. But beneath the surface, divergences between the financial and real economies are forming and gathering strength. When we finally hit the Boiling Point, the Fed is reaching the limits of its illusive monetary powers. The divergence between the financial and real economies has become so great that the natural forces pushing them back together can no longer be held in check.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In the illusive phase of the major credit cycle, some assets are driven to well above their intrinsic value. But if some assets are priced above their intrinsic value, logic dictates that other assets must be priced below their intrinsic value. Remember that money is a medium of exchange. Behind the veil of money is a real economy where every good and service can be measured in terms of any other good or service. For the value of anything to go up, something else must go down. Suppose that today an orange is worth two apples, and tomorrow an orange is worth three apples. That means the value of oranges in terms of apples has gone up, but it also means that the value of apples in terms of oranges has gone down. Every value is relative to some other value.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">One could imagine, of course, a situation where the government simply hands out money to everyone, and consequently all prices go up by exactly the same proportion. In that case, the value of the dollar would drop, but the value of all goods and services relative to each other would remain constant. That is not, however, what happens during a major credit cycle. The reason that this topic generates so much interest is precisely because distortions and disequilibriums do in fact occur, and generally wreak havoc on the economy. Additional money is not injected into the economy by the government handing it out to everyone in a fit of generosity, it is injected by the Fed purchasing financial assets and paying for those assets by writing a check on itself.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">To continue, during the illusive phase of the major credit cycle, assets are pushed away from their intrinsic values. Generally, financial assets become overvalued and real assets become undervalued. I use the word 'generally' because the definition of financial and real assets is not always clear. Recently, we have seen houses, generally thought of as a real asset, turned into financial assets through the magic of securitization. In the realistic phase of the cycle, assets move back toward their intrinsic values. And yes, the process typically overshoots to a significant degree.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">A stock traded on an exchange is the epitome of a financial asset. By general agreement, it is worth the present value of all its future cash flows, which to a large degree are a function of the economy's performance extending out into the foreseeable future and well beyond. The calculation of present value is highly dependent on the level of interest rates. And since each shareholder's ownership interest is such a small part of the whole, there is no practical way to cash out his holding other than selling his shares back into the market.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Gold is the epitome of a real asset. Its only value comes from the fact that is has always been valuable, in and of itself. It depends on no one's promise or endorsement There are almost no practical applications for it, and so virtually all the gold ever mined either sits in a vault or is worn as jewelry. It is extremely compact, and large values can easily be carried on one's person. It is virtually indestructible.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The two charts above displayed a century of history for both gold and stocks. But to really see the history of major credit cycles, one needs to combine the two. The chart below shows the DJIA in terms of gold, i.e. the end-of-month level of the DJIA divided by the end-of-month price of gold. The solid blue horizontal line at the bottom is one ounce of gold per DJIA, and the dotted blue line just above it is five ounces. The date of each peak is labeled in green, and of each trough in brown. Two vertical orange dotted lines indicate the dates when the American public was defrauded by their government, and each line is labeled with the name of the despot who carried out the crime. For the remainder of this essay, for the sake of brevity, each major credit cycle shall be referred to by the year in which it peaked, i.e. the cycle of 1929, 1966 or 1999.</span></span></p><div><span class="Apple-style-span" style=" ;font-family:'Times New Roman';font-size:12px;"><br /></span></div></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhdWa1au06yO8NG0rA_V6kV4xOsVz0lk-YnIzqVapJFKTP-FlNghoj3MHOCYgpJvc2IegefQZvhf98fpzAFYVogsy8DEk4wmiyUMaEKiaKnAAf8jrTzQlD7owd52Ap-a892XmhKTVIfrbI/s1600-h/Dow-Gold-mthly.jpg"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhdWa1au06yO8NG0rA_V6kV4xOsVz0lk-YnIzqVapJFKTP-FlNghoj3MHOCYgpJvc2IegefQZvhf98fpzAFYVogsy8DEk4wmiyUMaEKiaKnAAf8jrTzQlD7owd52Ap-a892XmhKTVIfrbI/s200/Dow-Gold-mthly.jpg" border="0" alt="" id="BLOGGER_PHOTO_ID_5238305573110452402" /></a><br /><div><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p><p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The Federal Reserve began operations in 1913, and since then there have been two complete major credit cycles; we are well into the third, and my back of envelope calculation estimates it will finish somewhere in the middle of the next decade. Below is a summary of key statistics for each major credit cycle; all prices are end of month.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <table cellspacing="0" cellpadding="0" style="text-align: center;border-collapse: collapse; "> <tbody> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">peak</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(8/1929)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">trough</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(6/1932)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">change</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">DJIA</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">386.10</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">40.56</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">-89.5%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Gold</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">20.67</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">35.00</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+69.3%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">DJIA / Gold</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">18.40</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">1.16</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">-93.7%</span></span></p> </td> </tr> </tbody> </table> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: -2.2px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <table cellspacing="0" cellpadding="0" style="text-align: center;border-collapse: collapse; "> <tbody> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">peak</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(1/1966)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">trough</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(1/1980)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">change</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">DJIA</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">983.51</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">875.85</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">-10.9%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Gold</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">35.00</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">681.50</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+1847.1%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">DJIA / Gold</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">28.10</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">1.29</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">-95.4%</span></span></p> </td> </tr> </tbody> </table> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: -2.2px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <table cellspacing="0" cellpadding="0" style="text-align: center;border-collapse: collapse; "> <tbody> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">peak</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(8/1999)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">July</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">2008</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">change</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">DJIA</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">10829.30</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">11378.00</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+5.1%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Gold</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">255.80</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">913.90</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+257.3%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">DJIA / Gold</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">42.33</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">12.45</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">-70.6%</span></span></p> </td> </tr> </tbody> </table> <p style="text-align: center;margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: -2.2px; font: normal normal normal 12px/normal 'Times New Roman'; min-height: 15px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">I should point out that my numbers for the cycle of 1929 are somewhat arbitrary. Until April of 1933, the dollar was legally defined in terms of gold at the rate of $20.67 per troy ounce of gold. At that time, FDR decided to confiscate Americans' gold, and then devalued the dollar to the rate of $35 per ounce. So the entire 89.5% plunge in the DJIA occurred while the dollar was still redeemable for a fixed amount of gold. The appreciation in the price of gold occurred the following year, and was the result of legal dictate rather than a free market. But the events are inextricably linked to each other, and I argue that without the devaluation of the dollar the DJIA would have bottomed at a lower level than it actually did, and probably much later.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">While it remained illegal for Americans to possess gold until 1975, under the terms of the Bretton Woods agreement foreign central banks could redeem their dollars at the official rate of $35 per ounce, and there was an active market for dollar-denominated gold in London. In the 1960s pressure began to mount on the dollar, and in August of 1971 Nixon surrendered to market forces with his declaration that the dollar would no longer be redeemable for gold, thereby breaking his country's promise to the world.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In all my charts and statistics, the price of gold was $20.67 until 1933, when it jumped to $35. There was effectively no free market for gold until 1971, although my price data does show that gold began to move in 1968. I would love to incorporate historic daily prices from the London gold fix into my figures, but to this date have been unsuccessful at finding such data. To conclude this brief history of gold, I am aware that my price assumptions are somewhat arbitrary, and that my price data is not of the highest quality. Given the history and circumstances, however, I believe that my assumptions are reasonable and that the quality of my data is adequate.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">As we examine the above chart of DJIA/gold, there are a few things that leap out at us. The cycles of 1966 and 1999 each peaked at levels about 50% higher than their predecessor, but the troughs of both completed cycles were just above one ounce. The amount of time between cycle peaks was 36 years and 5 months, and then 33 years and 7 months, which works out to an average of exactly 35 years. Since the cycle of 1999 has yet to reach its trough, we only have one measure of the time between troughs, and the trough of the cycle of 1929 occurred remarkably soon after the peak. Given the aforementioned history of gold and the length of the Great Depression, I am going to take an extraordinary leap of faith and make the relatively unsubstantiated argument that the 'true' trough for the cycle of 1929 occurred in April of 1942 (brown arrow on chart). That would make the time between troughs to be 37 years and 9 months, which when worked into the time between peaks comes to an average of 35 years and 11 months for the life of a major credit cycle.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">If we look at the time from peak to trough, we have 12 years and 8 months (using April 1942), and then 14 years, for an average of 13 years and 4 months. Given a peak in August of 1999, that would put the next trough in December of 2012. From the trough of the 1966 cycle (January 1980), if we go forward by the average length of a cycle (35 years, 11 months), we get the next trough in December of 2015. This suggests to me a reasonable likelihood that the trough of the present cycle will occur sometime between the end of 2012 and the end of 2015.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">At the trough, DJIA/gold approaches one ounce. Based on July's closing prices, we can throw around some ballpark figures. If the DJIA remains unchanged, then gold should rise to almost $11,378. If gold remains unchanged, then the DJIA should fall to almost 914. If both gold and the DJIA were to move by the same factor, that factor would be 3.5285; the DJIA would drop 71.6% to 3225 and gold would rise by 253% to reach the same level. If the cycle of 1999 is anything like the cycle of 1966, when the DJIA in nominal terms was down 11% at the trough, that would put gold's peak near $9,600.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">This essay began as a discussion about interest rates, and the inevitable consequences of holding them below their natural equilibrium. So let's look at a history of interest rates. Below is a chart of the long bond futures, traded at the CBOT. This contract is based upon a nominal U.S. Treasury bond with a 6% coupon and a maturity of at least 15 years. Originally, the contract was based on an 8% coupon, but changed in 1999 to the current 6%. I exported all my old data to a spreadsheet, made the same percentage change to all prices, and then imported it back into my charting software. For prices before 1977, when the futures started trading, I took historic interest rates for U.S. Treasuries and converted them into futures prices. So once again, I must confess that my data is not absolutely pristine; nevertheless, I think it is reasonably accurate, at least for the purpose of this discussion.</span></span></p><div><span class="Apple-style-span" style=" ;font-family:'Times New Roman';font-size:12px;"><br /></span></div></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_NE6-u7SI3rrIgZGvAQH9puGcQhFxoS13JtR9Po_-51ndrC194d5Kg8dwIkIugDumQfS18iW_hnc-D7k81rtR4Ur4nwoTpOOnIKS2v0ajvvkku5WZtTKpqTcPxg8c0TlkAJCX-IKzG4M/s1600-h/Bonds-mthly.jpg"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_NE6-u7SI3rrIgZGvAQH9puGcQhFxoS13JtR9Po_-51ndrC194d5Kg8dwIkIugDumQfS18iW_hnc-D7k81rtR4Ur4nwoTpOOnIKS2v0ajvvkku5WZtTKpqTcPxg8c0TlkAJCX-IKzG4M/s200/Bonds-mthly.jpg" border="0" alt="" id="BLOGGER_PHOTO_ID_5238304914670834914" /></a><br /><div><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman"><br /></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The first thing I notice from this chart of bond prices is that nothing suggests the existence of major credit cycles. Not, at least, in anything like the form for which I made the case above. It is worth noting that bonds made a major bottom in September of 1981, when yields were around 14%, which is 1 year and 8 months after the trough of the 1966 cycle. Also, bonds made a major high in June of 2003, with yields just over 4%, which is 3 years and 10 months after the peak of the 1999 cycle. These two items suggest that perhaps interest rates tend to hit their extreme some period of time after a cycle has turned. Intuitively, this makes sense. At the peak, the Fed continues to push rates down even after rate cuts have lost their potency. At the trough, rates keep pushing higher until the demons of divergence have been totally vanquished.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Another thing to consider is that well into the cycle of 1966, we were still on a gold standard. As long as the dollar was fixed to gold, inflation was not really a factor to consider when valuing a bond with virtually zero chance of default. But with a free-floating dollar, inflation risk becomes a constant concern. All in all, I think it's reasonable to argue that the nature of the bond market changed in 1971 when the link to gold was severed. But to get a better picture, let's look at bonds in terms of gold. The chart below is the same bond futures divided by the price of gold. You can think of it as the number of ounces of gold it costs to buy an annuity of $6 per year for the next 15 years, with an extra payment of $100 at the end of 15 years.</span></span></p><div><span class="Apple-style-span" style=" ;font-family:'Times New Roman';font-size:12px;"><br /></span></div></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaXi-4_xmMcswrKv3TRPhjmIvg_OaU7-KG_qsIFrx_zEm088vXd3zYLf2BtL-gKQs8XZAuQQOTT1GhovT264mKBmmfg8uRIqSnvD2LuBoUL7EWTlWG2pKU1gg6mFPOz9nBCrR18BOJHsw/s1600-h/Bonds-Gold-mthly.jpg"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgaXi-4_xmMcswrKv3TRPhjmIvg_OaU7-KG_qsIFrx_zEm088vXd3zYLf2BtL-gKQs8XZAuQQOTT1GhovT264mKBmmfg8uRIqSnvD2LuBoUL7EWTlWG2pKU1gg6mFPOz9nBCrR18BOJHsw/s200/Bonds-Gold-mthly.jpg" border="0" alt="" id="BLOGGER_PHOTO_ID_5238304215148123026" /></a><div><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman; min-height: 15.0px"><br /></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style=" ;font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The stair step pattern of this chart is certainly thought provoking. I have drawn blue dotted horizontal lines at 6.0, 4.0 and 0.4 to indicate approximate levels of stability. The amount of decline from one level of stability to the next is shown in red. If bond prices in terms of gold can be considered as a proxy for the real cost of capital, then this chart suggests that a long period of stability is followed by a sharp rise in the cost of capital (drop in bond/gold price). Why would that be?</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Once again I refer to the major credit cycle. By pushing interest rates below equilibrium, the Fed creates the ILLUSION of wealth. When we hit the Boiling Point and the peak of the major credit cycle, the dimensions of the illusion have become so great that it can no longer be sustained, so the inevitable return to reality begins. As the financial and real economies converge, those assets which were overvalued decline relative to those which were undervalued. The overvalued assets, precisely because they experienced so much price appreciation, were the most likely to be used as collateral for loans. </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Earlier in this essay, I pointed out that credit injected by the Fed does not represent a claim on any resources, it is simply created out of thin air; it has value only to the extent that it dilutes the value of all existing claims on resources. Because there are no corresponding claims on real assets associated with the additional credit, there is no underlying foundation upon which to build new wealth-creating assets necessary for generating interest payments to the saver. During the illusive phase of the credit cycle, when overvalued assets are becoming still more overvalued, there are enough capital gains to support interest payments on the illusory capital. But after the peak of the cycle, those capital gains disappear. Shrinking collateral, and no income stream to support the interest expense, sends loans into default and forces lenders to take losses.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In the cycle of 1929, there were actual runs on banks. Soon thereafter, the government established insurance for bank accounts, so we don't have runs on banks anymore. But that doesn't change the fact that at the peak of a major credit cycle, a huge amount of wealth in the economy is an illusion. It doesn't really exist, it was a mirage created by the Fed. Somebody has to accept a reduction in wealth, and that mere suggestion is enough to send all economic players fleeing for the exits. In the old days we had runs on banks, but the government has taken on that risk, so now we have runs on the government. More specifically, we have runs on the dollar. </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">During the illusive phase of the major credit cycle, economic players are trying to maximize their gains; after the peak of the cycle, in the realistic phase, everyone wants to minimize his losses. Every business wants to survive, but knows that many will fail. Every business knows that the assets on its balance sheet are overvalued, and suspects that many others are in even worse shape. Every business wants to sell depreciating assets before they decline still further, but no one wants to catch a falling knife. Losing some portion of one's wealth is infinitely preferable to losing all of one's wealth. In such an environment, it is no surprise that those still willing to lend demand an arm and a leg, which of course is reflected in a high cost of capital. All of which is simply another way of saying that the equilibrium rate of interest is very high.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In the cycle of 1929, the market was obviously blindsided by FDR's confiscation of gold and devaluation of the dollar. That first stair step was almost a straight line down, with a bottom in January of 1934 (see chart above). After that, there were about two decades of stability and then a decade of slow decline. It's clear the market anticipated the end of Bretton Woods, because around the peak of the cycle of 1966 the decline accelerated. The end of Bretton Woods triggered a sharp decline, there was a significant bounce in the mid-1970s, and then a slow decline to the bottom in September of 1980. The sharp drops in the bond/gold price shortly after the peak of the major credit cycle supports the general thesis of this discussion.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The current period of stability is approaching three decades, the length of the previous period, which suggests that we may be close to the next stair step down. The bottom in September of 1980 was 0.087; that was followed by a slow rise to 0.40 in March of 2001 and a decline to 0.12 in July of 2008. There has been a small bounce since then.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">There is no pattern, that I can discern, to suggest how far down the next stair step will be. The average of the past two stair steps down was 2.8 ounces, but that would put us well into negative territory; at the extreme, the value of bonds can only fall to zero. The average percentage drop was 61.5%, but any trend line with only two points is pretty weak, and this one strikes me as particularly so.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Earlier, I suggested that if the cycle of 1999 is anything like the cycle of 1966, when the DJIA in nominal terms was down 11% at the trough, and assuming that DJIA/gold approached one ounce, that would put gold's next peak near $9,600. If bond yields hit 15%, around where yields peaked at the trough of the last cycle, that would put the bond price at about $50. That gives us a bond/gold price of 0.005, which works out to a stair step down of almost 99% from the 0.4 level of stability. The peaks of major credit cycles, as measured by DJIA/gold, have been higher and higher, so it sort of makes sense that the stair steps down for bonds/gold should be greater and greater.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">These estimates of future increases in gold are an implicit prediction of sharply higher inflation. There is currently a great debate between those who foresee hyper-inflation in the near future, and those who see only deflation down the road. So once again I must emphasize that the key nature of the major credit cycle is the distortions caused by excessively low interest rates. Some assets become extremely overvalued, but by the laws of nature that means other assets become undervalued. The divergence between overvalued assets and undervalued assets, or as I have previously described it, between the financial and real economies, is the central element of the major credit cycle.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">When the divergence reaches its natural limit, the process reverses itself, and continues until overvalued assets have fallen below, and undervalued assets risen above, their respective intrinsic values. There is no fundamental requirement that this process be accompanied by a general rise in the price level. However, the decline in overvalued assets inflicts severe pain on all those who participated in the speculation, notably banks and other lending or investing institutions. This pain diffuses itself throughout the general economy, eventually resulting in a significant slowdown.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The only cure for this economic malaise is to allow nature to follow its course. In time, the divergences will unwind themselves; losses will be written off, resources will be redirected toward their optimal employment, savings will increase with higher interest rates, and the economy will reestablish itself on a much sounder footing.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">“I feel your pain, and when elected I will solve this issue.” That is what virtually every candidate for office says in this political season. I can probably count on the fingers of one hand those politicians who advocate the course I prescribed in the previous paragraph. It doesn't matter that there is nothing the government can do, every candidate promises to do something.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Actually, there is something the government can do to solve the problem, and that is to get out of the way. But that is not what will happen. Instead, the government will do everything it can to stop the divergence from unwinding. Rules will be implemented to avoid the recognition of losses, in the vain hope that by waiting long enough overvalued assets will return to their prior unsustainable highs. The government may even spend tax monies to purchase overvalued assets, thus guaranteeing deficits or higher taxes down the road, as the government joins the company of those speculator suffering losses. But most importantly, the Fed will try to push rates lower in still another vain attempt to stem the tide of reality that is sweeping the markets.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Economic players and market participants are not stupid, and will soon realize that the tide has turned. It will become obvious to anyone with half a brain that the trend has reversed, and that previously overvalued assets are declining while previously undervalued assets are rising. So as official fiscal and monetary policy pumps money into the financial system, hoping against hope to stem the tide, that money inevitably flows into appreciating assets, which officialdom would prefer to suppress, rather than the depreciating assets it wants to support. </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">As I've said before, during the illusive phase, financial assets tend to become overvalued while real assets tend to become undervalued. But price indices are generally made up of real assets, so during the illusive phase the official price indices tend to be subdued. In the realistic phase that ensues after the peak of the major credit cycle, that tendency reverses and price indices begin to rise. The degree to which they rise will depend on the Fed, and how aggressively it attempts to fight the process of unwinding divergences. The more the Fed attempts to support prices of inflated financial assets, the greater will be the rise in the price of real assets, and consequently the rise of price indices.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><br /></p></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiWTx82EU0hzDjJHHWRLLcYRzHxAEr1fxfH2uxNxOGe6npu-aqN-r2uKT7qRc03lk-Skx3UfNwm1oeHv9V-XLeiJYoIXy4Qkzc8MZ-KGekvL53G_yesZlrq1l1vjWpro4_phOiDYIMra34/s1600-h/CPI.jpg"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiWTx82EU0hzDjJHHWRLLcYRzHxAEr1fxfH2uxNxOGe6npu-aqN-r2uKT7qRc03lk-Skx3UfNwm1oeHv9V-XLeiJYoIXy4Qkzc8MZ-KGekvL53G_yesZlrq1l1vjWpro4_phOiDYIMra34/s200/CPI.jpg" border="0" alt="" id="BLOGGER_PHOTO_ID_5238303428090602466" /></a><br /><p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman"><span class="Apple-style-span" style=" ;font-family:georgia;">The above chart is an 80-year history of the Consumer Price Index, with the change from the previous year in blue and the change over seven years (annualized) in red. That 7-year change is essentially a medium term average that eliminates noise and smoothes out the trend, so let's compare it to the peaks and troughs of major credit cycles. The table below displays the key points.</span><br /></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"> </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></p> <table cellspacing="0" cellpadding="0" style="border-collapse: collapse"> <tbody> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Cycle Date</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">peak</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(8/1929)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">trough</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(4/1942)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">peak</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(1/1966)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">trough</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(1/1980)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">peak</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(8/1999)</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">CPI 7-year average</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">-5%</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+7.4%</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+1.2%</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+8.9%</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">+2.1%</span></span></p> </td> </tr> <tr> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">CPI Date</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">low</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(4/1933)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">high</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(1/1948)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">low</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(5/1965)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">high</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(6/1980)</span></span></p> </td> <td valign="middle" style="border-style: solid; border-width: 1.0px 1.0px 1.0px 1.0px; border- padding: 0.0px 5.0px 0.0px 5.0pxcolor:#bfbfbf #bfbfbf #bfbfbf #bfbfbf;"> <p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">low</span></span></p><p style="margin: 0.0px 0.0px 0.0px -2.2px; text-align: center; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(12/2003)</span></span></p> </td> </tr> </tbody> </table> <p style="margin: 0.0px 0.0px 0.0px -2.2px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The history of the CPI strongly supports the thesis of this essay. And we can confirm it by simply looking at what has been happening in the markets. Gold hit a low of $255 in February 2001; earlier this year it traded over $1000. Crude oil hit a low of $10.35 in December 1998; it recently traded over $145. Soy beans traded below $4.16 in January 2002; recently they were over $16, a historic high. Copper traded below 61 cents in November 2001; in 2006 and again this year, it briefly surpassed the $4 mark. Every market has its own dynamics, of course, and is subject to the vagaries of supply and demand which affect that particular asset. But the long term trend is fairly clear, and that is for real assets to rise relative to financial assets.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">When will it end? The process will reverse course when, like a pendulum swinging back and forth, the dominant trend's waning energy is overcome by the waxing energy of the counter trend. And like the pendulum, if left to its own devices, the economy will eventually come to rest at a point of equilibrium.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">But as long as the Fed is trying to prop up inflated values by holding interest rates below their equilibrium, the process will gain momentum. From a manic desire to own financial assets no matter how high the price, the process will, if driven long enough, eventually end in a panic to flee from financial assets no matter how great the loss. The Boiling Point will have crossed above the Tipping Point.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">As I study the economic history of the past century, I wonder whether the major credit cycle is a phenomenon that will endure forever, or is simply a phase leading to the next period of history. Once the current major cycle – the third since the creation of the Federal Reserve System – reaches its trough, will we then begin the fourth cycle? Or is this the third and final one?</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The reason for these thoughts is that our current economic system may not be able to survive the coming trauma implied by my predictions. Consider out federal government: the last time I looked its budget was about $3 trillion and its debt about $9 trillion. Just for the sake of some back of envelope calculations, let's say the debt is three times the budget. That means each one percent of interest expense is equal to about three percent of the budget. At the trough of the last major cycle, in 1980, long term Treasury bonds yielded around 14% and short term bills close to 20%. According to the chart of DJIA/gold, each major cycle is hitting new extremes, so it's certainly possible interest rates will hit new highs as we approach the next trough. If average interest expense for debt hits 10%, that's 30% of the budget; an interest expense of 15% would be 45% of the budget; an expense of 20% would be 60% of the budget. I think it's pretty obvious that somewhere in that scenario, there is a major crackup. </span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">If we look at economic history going back six thousand years, there has never been a fiat money that did not eventually achieve its intrinsic value of zero. Governments have a long history of stiffing their creditors, and that's exactly what both FDR and Nixon did when they devalued the dollar. At a time when foreigners hold more U.S. debt than ever, and aging baby boomers threaten entitlement programs with a tidal wave of red ink, the government wants to step squarely in front of the locomotive bearing down on it by underwriting the obligations of privately owned financial institutions. From my perspective, it's pretty obvious where this will end.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">That's not to say that America is headed for the trash heap of history. History shows that even great powers can take serious stumbles and still pick themselves up again, becoming even stronger and more powerful as a result of the trauma they survived. Perhaps we'll see another revolution, this time in the form of a Constitutional Convention called by the states. If so, and our financial system were to be rebuilt from scratch, what ought the future look like?</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">First of all, we have to recognize three underlying problems: a banking system based on fractional reserves, a Fed that exacerbates that problem, and a government unwilling to accept the workings of a free market. That last problem I will leave for another day, but let's examine the first two.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">A fractional reserve banking system is inherently unstable; no bank can pay back all its depositors, should they all want to withdraw their money at once. As long as depositors have confidence in their bank, they prefer to leave their money where it is safe; but the moment there is the slightest doubt, everyone wants to withdraw his money and the bank suffers a run.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Banks deal in a fungible commodity, credit, and a loan from one bank is just as good as a loan from any other bank. So borrowers shop around for the lowest rate, and competition forces banks to match the lowest rate. Because of fractional reserves, banks acting collectively expand the amount of money in the system. When times are good, banks are happy to lend and rates decline, until monetary expansion reaches its natural limit. Then the cycle turns, and tough times force banks to raise their rates and call in loans. This is the minor credit cycle, and the reason that the Federal Reserve System was established.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In theory, a central bank acting as lender of last resort can reduce risks to the financial system. But in practice, this means the central bank is called to lend, i.e. inject additional money into the system, at exactly the moment when there is already too much money in the system. Financial crisis occur when the expansion of money reaches its natural limit – that is when the good times turn into hard times. Imagine, if you will, driving on a crowded expressway. As traffic begins to move, everyone accelerates. Then red lights flash ahead, and everyone hits their brakes. Accidents don't happen when everyone is accelerating; they occur when everyone brakes, and someone is going too fast and following too close.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Now suppose a government bureaucrat is assigned to study the problem. He soon observes that accidents occur when drivers slam on their brakes. His imminently logical conclusion, therefore, is that government should pass a law outlawing brakes on cars. This is the type of thinking that brought us the Federal Reserve System. The free market solution, on the other hand, is simply to tell drivers to be careful and pay attention, because if you cause an accident then you are responsible for the damages.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">The creation of the Fed has resulted in minor credit cycles that are less painful, but only because the Fed prevents those processes from playing themselves out. We may have fewer accidents, but when we have one it's a massive pileup that shuts down the entire system.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">I hypothesize that, had the Fed not been created, the banking system would have evolved beyond a system based on fractional reserves. Commercial banks would provide services such as checking, money transfers, safe deposit boxes, payroll processing, etc. But customer deposits would be invested in money market funds and similar cash equivalents. Commercial banks could also offer trading accounts for customers who want to buy securities, similar to the way discount brokers now operate.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">Exchanges would provide trading platforms for bank default futures, standardized contracts that pay a fixed amount if that particular bank defaults before the contract's maturity, or nothing in the absence of default. (Notice that selling such a contract would be similar to buying a note issued by the bank.) A default would consist of the bank being unable to pay any depositor his funds as promised. Any commercial bank that defaulted would be immediately forced into bankruptcy and liquidated. Savvy investors would closely scrutinize banks for any sign of risk-taking, and buy default futures at the first such sign. Any rise in the default futures on a bank would be widely reported, and quickly trigger a run.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">In such a system there might be a lot of bank runs and subsequent defaults; but if it happened early in the process, before a bank made too many bad investments, depositors would be likely to recover most of their money. And for bankers, the knowledge that disaster is never more than a rumor away should be an excellent motivation.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">And investment banks? Well, they could invest. There are always plenty of businesses that, although too small to issue their own securities, can put capital to good use. Even larger businesses that can issue their own securities will still need the advice and counsel of finance professionals.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;">As for a central bank, I see absolutely no need. Milton Friedman once suggested that monetary policy be run by a computer program, and that strikes me as a reasonable compromise. Make it an open source model on which everyone can keep an eye, and let the free market work its magic. It made America great once, and it can do so again.</span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"><br /></span></span></p> <p style="margin: 0.0px 0.0px 0.0px 0.0px; font: 12.0px Times New Roman; min-height: 15.0px"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size:small;"> </span></span></p><div><span class="Apple-style-span" style=" ;font-family:'Times New Roman';font-size:12px;"><br /></span></div>Unknownnoreply@blogger.com8