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Today's Daily Reckoning: Hangover Nation London, England Tuesday, January 27, 2009 --------------------- *** The real action is happening in the gold market...the woe in this global meltdown is most acute on the periphery... *** Everybody’s got an opinion...you don’t need bankers or capitalists to allocate capital... *** Gold is up 15% in the last two weeks...Bernie Madoff bears a striking resemblance to a Founding Father...and more! --- Special Offer --- A Behind-the-Scenes “Guest Pass” to Profit in the World’s Most Secretive “Millionaire’s Market” Once you are inside the financial community’s best-kept secret, you’ll begin to legally “withdraw” $810 or more per week – and you’ll be able to deposit the money directly into your retirement account! Read on here... --------------------- Yesterday, the Dow fell 38 points. But the real action is in the gold market – the price rose to $908 per ounce. Even the gold miners are finally going up. What does it mean? Is inflation closer than we thought? Copper is up. Yields are up. Silver is up. The dollar is down to $1.31 per euro. Why? We don’t know. But everyone seems to have a cure for what ails the world economy. All the treatments are dangerous. But only one is effective; unfortunately, it also – most likely -- fatal. The only sure protection? You guessed it, gold. For nearly 10 years, we kept a lonely vigil. We watched...we waited...we guffawed... What were we waiting for? The bubble economy of 2002-2007 had all the appearance of a happy, healthy financial system. Trouble was, it was having far too much fun. People can’t party that hard without getting sick. We waited for them to start throwing up. Now, there are so many sick people around you have to watch where you step... Today brings news of more illness. “More woe as 72,500 jobs axed in one day,” is the lead line in the Financial Times . As expected, the New Year is brought the collywobbles. The financial crisis of 2008 is becoming the economic crisis of 2009. The euro area is in its deepest slump ever in its 10-year history... The economy of Europe is expected to decline 1.9% this year. The woe is most acute on the periphery. Spain, Ireland, Portugal, Greece – the countries that most benefited from low euro-land interest rates are those that suffer most from tightening credit. At the center, France and Germany are still in relatively good shape. But the periphery states are finding it harder to finance their deficits...and, with the limits on deficit spending imposed by the Maastricht Treaty, they have no way to spend their way out of recession (assuming that would actually work). And out in the North Atlantic, problems caused by the financial crisis have become so severe that mobs are forming in the streets...inducing the president of the country, Geir Haarde, to resign. Back in the USA, the government is still at work, but the working stiffs are rapidly running out of work to do. Caterpillar said it was cutting 20,000 jobs. Pfizer said it could do without 19,000. Sprint Nextel lopped off 8,000 people from its payroll. And Home Depot said sales were so slow it sent 7,000 of its employees home. And this headline from the Wall Street Journal : “IBM payroll cuts may be deeper than anticipated.” Bloomberg reports that last year saw the biggest drop in house prices in the United States since they began keeping records...and probably since the Great Depression. The typical house lost 15% of its value in 2008. Oh woe...oh woe... But, fear not... every sentient meddler on the planet is offering advice...and solutions. More below... *** Over in the Financial Times , the editorial staff tells the Obama Administration what it should do: “stop fretting over currency and press China to spend more.” On the facing page, a pair of economists insist that government must recapitalize the banks, but must do it in a smarter way: “The most politically robust solution is for the government to acquire not voting stock, but warrants – the option to buy such stock. These warrants would convert to commons stock when sold, and a Resolution Trust Corporation-type structure could manage the disposal of these controlling stakes into the hands of private equity investors.” Even commentators who are usually sensible have given in to the urge to public service. Can you blame them? They see a problem...they want to fix it. Many of the leading fixers, of course, are either on the Obama payroll already...or angling for a job. Other improvers are taking the mountain air at Davos... Maybe the altitude will help them think more clearly...and help them come up with solutions to the problem they clearly don’t understand. Aside from a couple of economists – Roubini and Shiller – who are trying to explain to the group how market cycles work, none of the movers and shakers now jiggling the Alps or helping Team Obama saw the problem coming. None has any idea how an economy actually functions. None has a clue how to make it work better. In fact, almost all of them played some role – great or small – in CAUSING the crisis...either by omission or commission. Some were regulators who misled the public into thinking there were cops on the beat. Others worked on Wall Street. (Only recently, when they heard the police sirens, did they take the stockings off their faces and dump their pistols in the trash bins.) Jonathan Weil: “Almost half the people on Obama’s economic advisory board have held fiduciary positions at companies that, to one degree or another, either fried their financial statements, helped send the world into an economic tailspin, or both.” But that doesn’t stop them from wanting to put things right. And the only fix they can imagine just happens to be a fix which, by pure coincidence of course, gives more power and money to the fixers. Yes, dear, dear reader... ...now, people are retching all over the place. We’re no longer waiting for them to get sick. We’re not on Bubble Watch any more. Now, we’re on Quack Watch...waiting to see how the quacks put them out of their misery. At every level, the politicians are getting out their black bags and taking command of the situation. In California, for example, two cities aren’t waiting for the Obama ambulance to arrive on the scene. They’re giving mouth-to-mouth themselves. The WSJ reports: “Victorville, a desert town on the main highway between Las Vegas and Los Angeles, recently approved a $200,000 loan to Victorville Motors, a 40-year-old family-owned dealer in the town’s auto park.” So you see, dear reader, you don’t need bankers or capitalists to allocate capital. Any city councilman can do it. Yes, of course, the hacks will err...they will allocate capital stupidly and counterproductively. But not necessarily worse than the bankers have done recently... What they won’t be able to do is to take a year off the calendar. We will never party like it was 2006, again. At least, not in our lifetimes... Included in the Wall Street Journal this morning is an editorial, commenting on the Obama resuscitation plan. The emergency plan includes hundreds of billions for various projects designed to get the economy’s heart beating again. Trouble is, most of these projects don’t begin until after 2010. Infrastructure spending, for example, takes time. You don’t begin building a bridge tomorrow. First, you have to draw up plans...have engineering studies...and so forth. In other words, the patient is going to be a dried up corpse before the medicine takes effect. The British newspaper, The Guardian , is also catching on to why the quacks won’t be able to cure what ails the world economy: “In the 1960s and 1970s, total debt [in the US] was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments. “This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion). “The resulting debt was only sustainable so long as economic conditions remained extremely favourable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows... “From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio. “In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer. “ We have suggested another way to look at this, several times. The WSJ further explains: “...the money from this spending boom has to come from somewhere, which means it is removed from the private sector as higher taxes or borrowing. For every $1 the government ‘injects,’ it must take $1 away from someone else – either in taxes or by issuing a bond.” The Journal , not to be left out of the orgy of civic spirit, favors a different kind of medicine: tax cuts. Permanent cuts in marginal rates, it says, are the best solution. We never met a tax cut we didn’t like. But we don’t see how it solves the essential problem: whether the feds spend the dollar, or the taxpayers...it’s still just a dollar. But everybody’s got some patent medicine he wants to try. The most potent elixir is the one from the central bank of the US, the Fed. In fact, it’s the only one that works. The Fed has cut rates to the lowest level in 95 years... “What will the Fed do next?” asks CNBC. “Since it can’t lower rates any more,” answers the WSJ, “it has begun effectively to print money in an attempt to bolster the economy.” This is where it gets interesting. We’re not on Bubble Watch now...we’re on Quack Watch...looking to see how much damage the fixers do. We bring the binoculars up to our eyes...and look at the printing presses. And what do we see? Gold. *** Have you noticed? Bernie Madoff bears a striking resemblance to George Washington. And so goes the nation...from the man who couldn’t tell a lie, to the man who couldn’t tell the truth. *** Gold is moving again. It’s up 15% in the last 2 weeks and 34% from its October low. What’s going on? While almost every analyst expects a deflationary slump...gold is acting as if inflation were in the headlines. What has bothered us is that so many people expect inflation...and a rising gold price. Where’s the surprise, we wondered. We could only think of two. One – that deflation goes deeper and remains longer than expected...pushing the gold price down and discouraging the gold speculators. Two – that inflation arrives quickly...and violently – before investors have a chance to unload their government bonds, or buy gold. Which will it be? Until tomorrow, Bill Bonner The Daily Reckoning P.S. To be on the safe side, we encourage our dear readers to check out all the opportunities available to pad your portfolio with gold – and other hot commodities. For a limited time, you can gain access to a secret ‘Millionaire’s Market’. Get your free pass here . --- Special Offer --- Penny Pinching Pays Off BIG In tough times, every penny counts. Especially when that penny can be turned into something a little more valuable... Click here to learn how to turn those little pieces of copper into solid gold. Guest Essay: The Daily Reckoning PRESENTS: Fed Chairman Bernanke and Treasury Secretary Paulson are clever, but they have been playing with fire and their little project may soon explode – taking the economy with it. Although more and more analysts are growing uncomfortable with the growth in the monetary base in recent months, in the article below, Robert Murphy will show just how precarious the situation really is. Read on... BERNANKE PAINTS HIMSELF INTO A CORNER by Robert P. Murphy Unfortunately, Bernanke has gotten himself into a position where the only way to prevent massive price inflation is to cut-off the financial sector’s life support and to jack up interest rates. First, we should define some terms. The monetary base consists of currency in circulation, plus bank reserves held on deposit with the Fed itself. The base is the narrowest definition of money, and is directly controlled by the Fed. This is why economists often look at the monetary base to gauge whether the Fed is loosening or tightening. If we broaden the scope of our definition of money, we have M1, which consists of currency in circulation, demand deposits (i.e. checking account balances), traveler’s checks, and a few other extremely liquid assets. For our purposes in this article, the essential differences between the monetary base versus M1, is that the base includes bank reserves with the Fed (while M1 doesn’t), and M1 includes checking deposits (while the base doesn’t). We’ll see in a minute why these differences are important to understanding the danger of the current situation. At the risk of triggering nauseating flashbacks to mandatory college lectures, let’s review how the Fed creates money which in turn leads to price increases. Normally, when the Fed wants to engage in “loose” monetary policy, it engages in open-market operations by buying assets from the public. For example, the Fed might buy $10 million worth of government securities from private-sector holders. In the transaction, the Fed acquires the $10 million worth of Treasury debt, and writes a check on itself for $10 million. This is the precise spot where money is created “out of thin air.” When the Fed writes a check on itself, the recipient deposits it at his bank, and the bank in turn deposits it with the Fed. So the Fed bumps up that particular bank’s account balance by $10 million; in other words, that bank’s reserves with the Fed have gone up by $10 million. Yet there is no counterbalancing debit anywhere else in the system. When Joe Smith writes a check for $10,000 to Bill Jones, total deposits haven’t changed; Jones’ checking account goes up by $10,000, while Smith’s goes down by $10,000. Yet when the Fed writes a check for $10 million, some bank’s reserves go up by that amount, while no other bank’s reserves fall. The additional $10 million in reserves was created by changing the 0s and 1s in the Fed’s computer system. As readers may recall, the process does not stop there. Because of the fractional reserve nature of our banking system, an injection of new reserves can lead to a multiple increase in the overall money stock. For example, if the reserve requirement is 10%, then the bank depositing the $10 million is able to make new loans of up to $9 million. Businesspeople may come in and win approval for loans, and receive new checking accounts with a total of $9 million in their balances. They can go out into the community and start writing checks on these balances, pushing up prices. At the same time, the original person who sold Treasurys to the Fed, still thinks he has $10 million more in his checking account too. Thus, while the monetary base has increased by $10 million (i.e. that’s how much total bank reserves have increased), M1 has increased by $19 million. And the process continues. The merchants who receive payments from those taking out new loans will in turn deposit the checks with their own banks, and some of the “excess reserves” (i.e. the $9 million that the original bank held over and above the legal minimum needed to back up the first person’s deposit) are transferred to other banks. They in turn can now make new loans, because the 10% reserve rule applies to their new reserves as well. In the end, if we assume a 10% reserve requirement, and that all of the banks are fully “loaned up,” then the original purchase of $10 million in Treasurys will yield an increase of $100 million in total checkbook balances in the community. Prices for goods and services will be higher than they otherwise would have been, because there is now an extra $100 million in household “cash” chasing them. The process works in reverse, too. If the Fed grows concerned about price inflation, it can slam on the brakes by engaging in open-market operations to sell off assets from its balance sheet. When the public buys an asset from the Fed, the transaction ultimately reduces the reserves that member banks hold with the Fed, meaning that they will need to contract the total outstanding checking balances of their customers. (We are assuming the banks had originally been fully loaned up, i.e. that they held no excess reserves.) Assuming a 10% reserve ratio, if the Fed sold $10 million of securities that it had been holding, that could lead to a reduction of $100 million in the quantity of money held by the public. Now back to the current situation. The chart below shows the banking system’s total excess reserves, meaning how much banks are holding that could be used as the base on which to pyramid loans to customers. The above chart is startling. Notice that the timeline goes back to 1929; nothing even remotely close to our current situation has occurred, even during the depths of the Great Depression. What is happening is that the Fed has allowed its balance sheet to explode during the last year, from $920 billion in December 2007 to $2.3 trillion in December 2008. (See this excellent summary article.) Yet because of general fear, as well as various gimmicks (such as paying interest on reserves held with the Fed), the banks are sitting on these huge injections of reserves, rather than granting new loans to their customers. This is why prices have been falling, even amidst this unprecedented expansion in the monetary base. Another way to see the discrepancy is to contrast the growth in the monetary base with the growth in M1. Remember that the Fed directly controls the base, whereas it is M1 (a measure that includes checking deposits) that most accurately captures how much money the public has available for immediate spending. Look at how much more the base has grown, compared to M1: Sometimes when economists focus too much on the supply of money, it leads to a neglect of the demand for money. As the second chart above illustrates, M1 has indeed grown remarkably in the last year, even while prices have been fairly stable. This is because the recession and general panic has led the public to demand greater cash balances. In other words, people want to concentrate much more purchasing power in extremely liquid assets (including Treasury debt as well as currency and FDIC-insured checking accounts). Thus, even though the total stock of money has risen considerably, prices haven’t followed suit. The general price level is the flip-side of the dollar’s strength, and so if the demand to hold dollars goes up, then its “price” goes up too, meaning its exchange value versus real goods and services goes up. In the summer, one U.S. dollar traded for a quarter-gallon of gas. Now that the dollar has considerably strengthened against gasoline, one dollar fetches (say) three-quarters of a gallon. The “gas-price” of a dollar has risen, meaning that the dollar-price of gasoline has fallen. The same is true – to a lesser extent – with other goods and services. Even though increases in the demand for U.S. dollars can offset increases in its supply – so that its market value doesn’t plummet – this observation is no cause for comfort. Using back-of-the-envelope calculations, the year/year growth in demand deposits (i.e. checking account balances) was about 38% in December. In contrast, the year/year growth in reserves was more than 1,400%. If the banks became optimistic about the future of the economy and began loaning out their excess reserves, right now there is enough slack in the system for the public’s money supply to increase by a factor of 14. There is nothing conspiratorial about the points I have made above. (Indeed, I have run these thoughts by other economists who are experts on the banking system and they generally endorse the analysis.) Analysts simply assume that once the recovery begins, Bernanke will wisely suck the excess reserves back out of the system, in time to tame price inflation. But is that really going to be politically feasible? The federal government is currently borrowing money at amazing rates: if we include not just the on-budget (cash flow) deficit, but also the government’s overall long-term financial liabilities, then the total federal debt increased by more than $1 trillion in 2008 alone. When we consider that Bernanke and Paulson have extended more than $5 trillion in new taxpayer exposure with all of their bailouts, the pressure on Uncle Sam in the coming years could be enormous. Why is the federal debt relevant to our discussion? Well, recall that in order to soak up excess reserves from the banking system, the Fed will need to sell off its assets. If it uses its vast holdings of Treasury debt to do so, then the massive dumping will raise U.S. interest rates, just as surely as if the Chinese government decided it no longer thought the U.S. government were creditworthy and dumped all of its Treasurys. Bernanke will therefore be reluctant to go that route. But his other options won’t be pretty either. The Fed has acquired all sorts of dubious assets in the last year, in an effort to provide “liquidity” to the financial sector. Is Bernanke really going to paralyze the big banks by throwing billions of mortgage-backed securities onto the market, just as the economy limps out of recession and into recovery? The Federal Reserve under Ben Bernanke’s leadership has painted itself into a very tight corner. He has cleverly managed to stave off utter disaster so far, but he is running out of options. Ironically, the effects of his incredible injections of new reserves have been masked simply because the financial sector is still paralyzed. If and when the economy begins to improve, Bernanke will have to decide whether to allow double-digit price inflation or instead contain prices by strangling the incipient recovery. Regards, Robert P. Murphy for The Daily Reckoning Editor’s Note: Robert P. Murphy has a PhD in economics from NYU and is author of The Politically Incorrect Guide to Capitalism (Regnery 2007).  He runs the blog Free Advice .