Britannia Radio

Wednesday, March 25, 2009 A day that will go down in history: the Fed starts buying U.S. Treasuries... The feds are sowing the wind with their quantitative easing... Plagued by 'what ifs'...what investors should do as the dollar depreciates... Robert Murphy shows us the parallels between the era of stagflation and the current economic state...and more! Fed Begins Buying U.S. Treasuries by Bill Bonner London, England Write in your diary...save today's newspapers...remember what you did today. Most historians won't even notice, but today is a big, big day. Today is the day the Fed begins buying U.S. Treasuries. Britain is doing it already. So is Japan. Why shouldn't we? What's a few trillion extra...just between friends? The scope of the project is immense. Do you remember how it works, dear reader? When you buy a U.S. Treasury bond, you pay for it with real money - or, at least as real as dollars get. Money changes hands. No net increase in the money supply. But when the Fed buys a Treasury bond it creates the money to buy it...and thus the money supply increases. It's called "monetizing the debt" - or converting debt into currency. Given the size of upcoming Treasury purchases, the total size of the U.S. monetary base is expected to increase 500% in the months ahead. Is there any doubt what this will mean to the dollar? To the price of gold? Yes, there is... Alas, the more we learn, the less we know. The more we find out; the more we find out what we haven't found out yet. But we'll come back to that in a moment. Let's first look at what happened on Wall Street yesterday. Stocks went down - 115 points on the Dow. End of the rally? We keep wondering. Whatever can be said about it, it's not the best rally we've ever seen. It seems to peter out every time it gets going. But we'll wait a few days before pronouncing judgment. Meanwhile, oil seems sluggish at $54. The euro, too, at $1.34. But gold at least showed some action - down $28 to $923. What happened in the gold market? Didn't investors notice that the Fed has begun almost literally "printing money?" Why didn't the price go to $1,000? But remember how we've worried that inflation was too obvious? You can see it coming a mile away. Which is why we say the United States can pay off its debts in a currency whose value it alone controls... But what if it weren't true? What if the feds couldn't control the value of the dollar? What if inflation didn't happen - at least, not the way we all expect? Let us begin with something that is true: that which must happen will happen. When you increase the money supply, ceteris paribus, the price of money must go down. That is why the price of gold is over $900 rather than, say, $750. Investors see the trillions going into the world's money supply. They weren't born yesterday. They know what happens next. It is just a matter of time before the price of gold doubles...and doubles again. Read the full report here. But just because you add to the money supply doesn't mean prices MUST rise. Instead, it means only that that MAY rise...under certain conditions. Ah...there's the rub...there's the crack in our little bell...there's the little grain of sand in our shoe. The Japanese have been monetizing their debt for a long time, writes our friend James Ferguson in MoneyWeek. "First, the authorities ran a steady double-digit growth in the money supply for over a decade, while the Japanese banks were initially in denial, and then the government injected nearly 10% of GDP directly into the banks' capital bases. Yet even after money as a proportion of GDP had doubled, Japan's banks were still shrinking lending. "The Bank of Japan, believing it had perhaps just lacked imagination, doubled M1 money supply again, this time over the much shorter period of two to three years from 2001." This is roughly equivalent to the Fed spending not $1 trillion to buy up Treasury paper, but $10 trillion. "Yet the impact on Japanese bank lending was...nothing," James continues. "Bank lending continued to fall by 5%-6% a year, as it had done for the prior three years." James lived in Japan for many years. He reports that when the Japanese economy finally began to pick up in 2006, the government became very concerned that all that money it had put into circulation would suddenly turn into consumer price inflation. But it didn't happen. Instead, the little flower of growth was crushed in the downturn of '07-'08...and now Japanese prices seem to be headed down again. How come? Are the Japanese particularly incompetent? Or is it harder to weaken your currency than we thought? We don't know...so we will turn to Ian for further news while we think about it... "The housing swan dive continues today," writes Ian Mathias in today's issue of The 5 Min. Forecast. "U.S. home prices have been reduced to levels unseen since 2003, says the latest rendition of the S&P/Case Shiller Home Price Index. Yesterday's printing capped off 2008 with another record decline. "December data showed a 19.2% yearly fall for their 10 city composite and a 18.5% slump for the 20 city - both records. This index has now fallen every month for two straight years. "'The broad downturn in the residential real estate market continues,' says David M. Blitzer of S&P. 'There are very few, if any, pockets of turnaround that one can see in the data. Most of the nation appears to remain on a downward path...' "We suspect this home price trend will continue in Case Shiller's January and February reports," continues Ian. "According the National Association of Realtors today, the median new home price fell to $200,900 in February. That's a record 18% fall from the same time a year ago and the lowest level since 2003. Consider yesterday's record fall in existing home prices, and it seems this trend is still alive and kicking." Each day, Ian and Addison bring readers the The 5 Min Forecast, is an executive series e-letter that provides a quick and dirty analysis of daily economic and financial developments - in five minutes or less. It's a free service available only to subscribers of Agora Financial's paid publications, such as Easy Money Options. This service acknowledges the fact that many investors are wary of working with options, and shows you how you can move in and out of options much more efficiently and with much less risk than most options traders...while still turning a tidy profit. Learn more here. And back to Bill, reporting from London... It would be much simpler for us if the world were set up in a more orderly and predictable way. But then, it wouldn't be nearly as much fun. Even the feds could control a simpleton's world. What a dreary place that would be! Still, ships' compasses don't intentionally lead us onto the rocks. More money = more inflation; that's the rule. Besides, it's not just a matter of money. The feds are clearly sowing the wind with their quantitative easing. They deserve to reap the whirlwind. But wait...it's inflation they WANT. Nature, in her wisdom, rarely gives a rascal what he wants. Instead, she gives him what he deserves. What then, do the feds deserve? We know their crime...what will be their punishment? Ah ha! Maybe they deserve the doldrums...locked in irons, with no wind at all! They want to lower the debt burden by instigating inflation. They want to increase the velocity of money - by lightening it up a little so people are eager to get rid of it. They want to get lenders lending, and consumers consuming - all eager to turn over their dollars as fast as possible. They want to shift the burden of losses from the people who made them to the people who didn't. Well, what if the dollar doesn't cooperate? What if it grows heavier? What if it seems more solid? And what if dollar-denominated debts sticks like tar to the people who incurred it? Seems impossible, doesn't it? And yet, that is what happened in the Land of Rising Sun. Our hypothesis seemed so sure...so airtight. The feds have no alternative but to try to inflate the currency. Because it will reduce the debt load on consumers...and, not coincidentally, on the government too. It will also induce people to spend money, rather than save it. This will increase the velocity of money, which will have a further inspiring effect on animal spirits. If at first they don't succeed, the feds will try, try again. And sooner or later, they'll get the inflation they desire - first in moderation, then in exaggeration. But what if it doesn't happen that way? What if the feds - and the entire debtor class - were tortured before they were finally killed? And what if we - those who think we know what is going on...and who are stacking up gold coins in our home safes in anticipation - are driven mad by deep corrections in the gold market? What if gold sinks to $600...and stays there for years? What if the markets stay irrational for longer than any of us can stay solvent...first wiping out the bulls in a major new break in the stock market...then wiping out the bears with a major new break in the gold market? And then, when we have all given up hope...and sold all our stocks...and all our gold...and are curled up in a corner, whimpering, clutching a handful of crumpled dollar bills, maybe then Mr. Market will feel sorry for us. Maybe he'll finally come over and put us out of our misery...delivering the coup de grace of blow out inflation...a la Weimar or Harare? Anything is possible. But there are major differences between Japan and the United States - and reasons to think that the U.S. feds might succeed where the Japanese feds failed. For the moment...we'll keep our Dollar Crash Alert flag flying...and wait until tomorrow for further insights. "It comes as no great surprise," comments colleague Chris Mayer, "that the value of our money has done nothing but depreciate over the years." "So what are investors to do? "First off, buy things. In a world in which paper depreciates, tangible assets will hold their value better. Unlike with paper, we can't create oil reserves or clear land or find water by pressing a few buttons at the Fed. Tangible assets take time and labor to create. "Secondly," Chris advises, "buy gold and gold stocks. Gold is a commodity, but it is unique in its monetary heritage. It was money - in the sense that you could buy groceries with it - not that long ago, in the grand scheme of things. People are again flocking back to gold as the dollar's prospects turn uglier. This move has a long way to go. "Gold stocks are a more leveraged and riskier way to play the rise in gold. This year, in particular, sets up as a good one for gold, thanks to lower energy prices and currency effects. "And finally, buy the stronger currencies or assets in stronger currencies. All paper currencies are on the long road to zero. But some are on a faster road than others." Those are just a few of Chris' ideas. Many of the companies in the Mayer's Special Situations portfolio fall into these three 'buckets' that he outlines above - and have been performing well. To learn more about Mayer's Special Situations, and to see what other interesting ideas Chris plans on adding to his portfolio, click here. The current actions by the feds have the Chinese worried...but their worry is that the feds may succeed in debasing the dollar. Here, they're proposing a new monetary system...based on Special Drawing Rights (on gold) administered by the IMF. The country's central bank governor Zhou Xiaochuan said as much in an essay, published earlier this week: "The outbreak of the current crisis and its spillover in the world confronted us with the long existing but still unanswered question i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF? There were various institutional arrangements in an attempt to find a solution, including the Silver Standard, the Gold Standard, the Gold Exchange Standard and the Bretton Woods system. The above issue, however, as the ongoing financial crisis demonstrates, is far from being solved, and has become even more severe due to the inherent weaknesses of the current international monetary system. "Theoretically, an international reserve currency should first be anchored to a stable benchmark and issued according to a clear set of rules, therefore to ensure orderly supply; second, its supply should be flexible enough to allow timely adjustment according to the changing demand; third, such adjustments should be disconnected from economic conditions and sovereign interests of any single country. The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history. The crisis called again for creative reform of the existing international monetary system towards an international reserve currency with a stable value, rule-based issuance and manageable supply, so as to achieve the objective of safeguarding global economic and financial stability..." Finally, so many sideshows... Madoff, AIG bonuses, Geithner...and tax havens. Here at The Daily Reckoning, we've never met a tax cut we didn't like...or a tax haven where we didn't want to have money. But the world's governments are cracking down. They don't like it when people get away...so they're raising the walls and electrifying the windows. Tax havens are for tax cheats, they say. Tax havens are being abused, they go on. In a better world, of course, there would be no need for open doors. People would be happy where they were. They would stay put...and turn over however much of their money to the government as its functionaries requested. But occasionally, something goes wrong. Occasionally, people are unhappy - and with very good reason. So it was that German trade unionists and Jews turned to Swiss banks in the 1930s - to protect themselves from getting robbed by the Nazi regime. The Germans asked the Swiss to divulge the names of its account holders. The Swiss said they would not. Bank secrecy was introduced in Switzerland in 1934 so that Swiss bank managers would have to reply in the negative, and the law prohibited them from revealing their clients names. Now, of course, everything is different. All the world's governments are good. And they are all working for the benefit of their citizens...except AIG bosses, of course. Now that the rapture has arrived, we have no further need of open doors or secret bank accounts. Until tomorrow, Bill Bonner The Daily Reckoning The Daily Reckoning PRESENTS: Today, the Federal Reserve takes drastic steps to monetize the U.S. debt. While many free market economists predict that they measures by the Fed will 'fix' the economy, Robert Murphy is not convinced. In fact, by looking back at the 1970's days of stagflation, he believes the current economic state in the United States will get much worse before it can get better. Read on... The Threat of Hyper-Depression by Robert P. Murphy Nashville, Tennessee In the Keynesian heydays of the 1950s and 1960s, most economists and policy makers believed in the "Phillips Curve," which was the (alleged) tradeoff between unemployment and price inflation. The idea was that the Federal Reserve could cure a recession by printing money, or that the Fed could cure runaway inflation by jacking up interest rates. Each of these moves had its downside, of course, but the point was that the Fed could choose one poison or the other. This Keynesian orthodoxy was shattered in the 1970s when the United States suffered through "stagflation," which was high unemployment and high inflation. This outcome was not supposed to be possible, according to the popular macroeconomics models, and it left policy makers with no clear choice. If the Fed raised rates to stem the inflation, it would hurt the economy even more, but if the Fed cut rates (through printing more money) the inflation problem would worsen. The vacuum created by this crisis in both theory and policy was filled by the Reagan Revolution and supply-side economics. At this stage nothing is certain, but the country is currently headed straight into a period of very rapid price hikes and a very bad recession. It would not surprise me at all if the national unemployment rate and the annualized rate of consumer price inflation both broke through into double digits by the end of 2009. Moreover, regardless of when it actually starts, I predict that things will get much worse before they get better, and that the United States will be mired in a malfunctioning economy for at least a decade, with price inflation in the double-digits (possibly higher) the entire time. We can call this condition "hyper-depression." As with stagflation during the 1970s, hyper-depression will blow up the prevailing "cutting edge" models of the macroeconomy. Back when he was an academic, Fed Chair Ben Bernanke was actually an expert on the Great Depression. Bernanke adheres to the (alleged) lesson taught by Milton Friedman and Anna Schwartz in their classic A Monetary History of the United States. F&S argued that Fed officials bore a large share of the blame for the Great Depression, because they did not pump in enough liquidity. The quantity of money actually declined by about a third from 1929-1933, as panicked customers withdrew cash from the banks. (In a fractional reserve banking system, when people withdraw deposits, the banks have to shrink their outstanding checking balances because of reserve requirements.) As the following chart illustrates, Bernanke has taken Friedman's warning to heart: The Fed has more than doubled its balance sheet since the financial crisis began, leading to an unprecedented jump in the monetary base: Thus far, this enormous injection of new reserves into the banking system hasn't caused the CPI to explode, but that is because (a) the banks are mostly sitting on the new reserves because they are all terrified, and (b) the public's demand for cash balances has risen sharply. But using very back-of-the-envelope calculations, there is now enough slack in the system so that if banks calmed down and lent out the maximum amount of reserves, the public's total money stock could increase by a factor of 10. There is no way that the public will simply add that new money to its checking accounts or home safes without increasing their spending. Eventually, prices quoted in U.S. dollars will start shooting upward. "The 1970s proved that the Fed cannot fix structural problems with the economy by showering it with new money. Hyper-depression is simply stagflation squared." All of the financial analysts are aware of this threat, but they foolishly reassure us, "Bernanke will unwind the Fed's holdings once the economy improves." But this commits the same mistake as the Keynesians during the 1970s: What happens when the CPI begins rising several percentage points per month, and unemployment is still in the double digits? What would Bernanke do at that point? Expecting the Fed chief to relinquish his new role of buying hundreds of billions in assets at whim, in the midst of a severe recession, would be akin to hoping that a dictator would end his declaration of "emergency" martial law in the middle of a civil war. There are even many free market economists who are predicting that the Fed's massive money-pumping will "fix" the economy, at least for a while, but at the cost of high price inflation. Yet these analysts don't realize that they are buying into - what we all thought was - the discredited Phillips Curve. The 1970s proved that the Fed cannot fix structural problems with the economy by showering it with new money. Hyper-depression is simply stagflation squared. People need to stop wondering, "When will the market find its bottom? This month? Next?" The federal government has already done an incalculable amount of damage to the American financial sector, and the insults keep growing. Think of it: Besides the unpredictable "sometimes we seize you, sometimes we take billions of bad assets off your books, sometimes we let you fail" strategy with respect to major financial institutions, the government has also done childish things such as ban short-selling of financial stocks. No one knows what the rules will be next week in these markets. Only a fool would expose new capital to the American financial sector at this point - and the politicians have the gall to wonder, "Why are the laissez-faire credit markets frozen?" Market interest rates are prices and as such they communicate important information about real, underlying scarcity. When the central banks of the world decided to drive interest rates down to practically zero, they crippled the ability of the world economy to heal itself after the overconsumption of the housing boom. People all over the world need to be saving right now, and yet governments are doing everything they can to squander what's left of the capital stock. I had resisted predicting that we are now living through the early period of the Great Depression II. After all, the conventional statistics today are nowhere near as bad as they were in the 1930s. However, the recent tussle over AIG bonus payments convinced me that we are in this one for the long haul. In particular, Senator Charles Schumer's comments - and the proposed legislation to back them up - show that we no longer have property rights in this country: "My colleagues and I are sending a letter to [AIG CEO] Mr. Liddy informing him that he can go right ahead and tell these employees that are scheduled to get bonuses that they should voluntarily return them, because if they don't, we plan to virtually tax all of it. He should tell these employees if they don't give the money back, we'll put in place a new law, that will allow us to [tax] these bonuses at a very high rate, so that it's returned to its rightful owners, the taxpayers. So for those of you who are getting these bonuses, be forewarned: You will not be getting to keep them." This is an extremely dangerous precedent. It's true - as many outraged callers to the AM talk shows explain - AIG received billions in government handouts, and so there is a plausible case to be made that those contractual arrangements with its executives should have been amended. But if that's the case, then the government should have made that a condition of the original "loan," or at the very least the government should now exercise its power as the de facto owner of AIG. Liddy was handpicked by the government to run the company, so if the politicians don't like his decisions, they should fire him. In contrast, look what Schumer & Co. have done. They are establishing the precedent that if a particular group of rich people does something that angers the government, and if this group happens to be wildly unpopular with the general public, then it is noble for the government to implement ex post facto changes to the tax code, singling this people out and basically robbing them. Schumer's speech against AIG executives is not much different from him declaring, "So I say to Rush Limbaugh and other talk show hosts: Go ahead and continue preaching your hatred and pessimism about the U.S. economy; this is a free country and you have the right to do that. But be forewarned that we are crafting new legislation that will tax 90 percent of your ad revenues from doing so." What people need to realize is that the government is going to keep making this worse. In other words, it is not enough to step back and say, "Well, the feds have already partially nationalized the entire banking system, and brought politics into all major business decisions - including how executives choose to travel to business meetings. What are the effects?" On the contrary, we need to realize that as things continue to deteriorate - and they will - the Obama Administration will keep upping the ante. "What? The first stimulus didn't work? OK let's borrow and spend another $1 trillion; maybe that will 'take.'" The American people need to prepare themselves for hyper-depression. The future is still uncertain, and if the folks in Washington suddenly found free market religion, that terrible outcome could be avoided. But I'm not holding my breath. Regards, Robert Murphy for The Daily Reckoning Editor's Note: Robert P. Murphy has a PhD in economics from NYU and is author of the forthcoming The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery 2009). He runs the blog Free Advice.