Adults Wanted

Paul Brodsky & Lee Quaintance run QB Partners, a private macro-oriented investment fund based in New York.

This month we identify the nexus of the current economic problems and propose a solution to fix them. We discuss why we think our proposal would work, why some policy makers probably already know it, why it will ultimately be adopted in spite of their intentions not to (whether or not they know it yet), and why we think we will profit from it.

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Leading up to the great bust in 2007, homeowners, consumers and investors owned highly encumbered assets. Balance sheets were terribly mismatched; most assets including real estate and stock portfolios were market-priced and subject to potentially volatile price swings while liabilities like mortgage and auto loans were mostly longer-term and had fixed obligations. It has recently become apparent to all that homeowners, consumers and investors generally mistook their expanded balance sheets for wealth.

As the liabilities on their balance sheets overwhelmed the available dollars needed to repay them, it was inevitable that: a) the Fed would ultimately have to manufacture those dollars and/or b) the asset prices at which their liabilities were valued would have to decline. Both dynamics have been playing out over the last two years and they currently seem to be accelerating. Our years-long (Fed-sponsored) hedonistic foray has passed and we are left now with a terrible burning sensation that just won’t go away.

The creation of trillions in new money and credit currently underway is being done to pay down these nagging obligations. It will work; indeed it has to work because there is no legal limit to how much money and credit the Fed may create from thin air and because the Fed has openly expressed its intention to pursue this path. It seems unanimous – everyone wants the pain to stop quickly and doesn’t care what must be done to accomplish this goal. We care deeply, but we are not letting our idealism get in the way of pursuing profits.

You may have noticed a disconnection in our writings over the last two years. We anticipated the Fed would inflate beyond all precedent in an attempt to stabilize nominal asset prices and make creditors “whole,” yet we have been unable to hide our outrage as this policy has now begun to accelerate. Our view is this: we intend to knock it out of the park owning investments highly correlated to monetary inflation and we intend to keep expressing this strategy’s cynical rationale loudly and publicly to anyone who will listen in an attempt to expose the fraudulent, unsustainable monetary system from which we intend to profit.

Not only do we feel current US monetary policy is dangerous to the long-term common good – even when considered within the context of current events and broader public policy – we believe it is the most telling indicator of future asset prices. The full power of US fiscal, monetary, trade and foreign policies – if somehow efficiently coordinated and streamlined – is not soon likely to re-create previous levels of grass roots credit growth and investor ebullience necessary to re-inflate the global economy to levels remotely approaching their previous high-water marks. This polestar frees us to begin applying incentives to policy makers and investors with greater confidence.

Inflate or Die

Policy makers have always had the tool at their disposal to fix our current economic problems (in nominal terms) by effectively covering all bets – reducing the burden of all debts by driving up nominal revenues and wages in relation to those debt burdens. They do this by printing money. So far they have taken an incremental approach to monetary inflation – $700 billion here in an optic attempt to re-liquefy banks, a commitment to $200 billion there for a global insurer with long tentacles, a trillion pledged for other public/private guarantees, etc. As large as these numbers are they pale next to the estimated $55 trillion in fixed obligations coming due as the economy slows.

We continue to believe without equivocation that policy makers will begin running the printing press and distributing money in previously unimaginable amounts once it becomes obvious to all that there is only one way out of the current jam. Ben Bernanke’s massive and indiscrete helicopter drop has not yet begun.

What are they waiting for? Policy makers are most comfortable playing along with a familiar narrative. We think they will soon learn that their bi-partisan, post-World War II Keynesian stimulation isn’t working and won’t work because the current global landscape cannot provide the vast majority of economic actors with adequate incentives to reverse course. We make this assertion in light of the already devastated health of bank balance sheets; the substantial amount of new debt that policy makers feel must be issued to save the banks and stimulate the economy; the accelerating loss of US consumer confidence; the onset of a shifting US and European demographic profile to older, less productive populations; the already low absolute level of global sovereign bond yields and the lapse of the Fed and other central banks into Zero Interest Rate Policies (ZIRPs) and quantitative easing (QE).

That does not mean they will not try. We recognize that most policy makers are bright people with good intentions (just like the financial engineers and their managerial overseers that democratized credit for all to abuse?). But this establishment doesn’t seem to understand that their high SAT scores and ambitious tendencies are being applied inappropriately. Their solutions rely on extrapolating cause and effect from the wrong era, just as derivative modelers extrapolated too-narrow time-series’ forward.

There is a solution to the accelerating economic problems that would save the system far quicker and with far less pain across the socioeconomic spectrum, and would be far more sustainable than the current incremental, ad hoc, confusing and ineffective path policy makers seem to be cobbling together. Maybe it takes a couple of unshackled bond traders – the same guys policy makers used to want to impress – to recognize the error of their ways?

The Real Fix – Declare Sound Money

In recent write-ups – “A Not-So Modest Proposal” (October 2008) and “The Shadow Gold Price” (November 2008) – we put forth an idea for a new monetary regime that would return the US to a sound money system. Implicit in this idea would be a US and global banking system that would survive and prosper.

Policy makers believe that to save the US and global economies they must first save Wall Street. (Though we would dispute this premise vehemently, we will accept it as a political imperative.) So be it. To save Wall Street and Main Street you must save – or show how you will save in the future – the real value of the currency for which Wall Street acts as intermediary. Otherwise there is no purpose in trying to preserve Wall Street (the Fed’s wholesale credit distribution center). We, the markets, intuit this. We, the people that policy makers hope will begin to consume, do too.

The Fed has unitary authority to devalue the US dollar (the world’s reserve currency) without suffering the same dismal fate as other fiat currencies that have done this in the past. It should use this power; de-value the US dollar – not to other paper currencies with infinite potential supply – but to gold, a currency with relatively scarce supply.

In our papers last year we established that an equilibrium price of gold (our “Shadow Gold Price”) would be something north of $9000/oz today. We used simple, Bretton Woods-model math (Federal Reserve Bank liabilities divided by US official gold holdings). To save the US and European banking systems and stabilize western economies we believe the US dollar peg to gold should be implemented at a much lower conversion price than its equilibrium price. The following actions should be taken:

1)The Fed announces a public tender for any/all outstanding private gold holdings at $3,000/oz.

2)The Fed prints Federal Reserve Notes (aka US dollars) to fund these purchases

3)As once privately-held gold flows into the Fed, the Fed’s balance sheet de-levers in gold terms

4)The Fed would soon own enough gold to credibly support the newly-designated peg

5)The Fed would also purchase the “people’s gold” currently held by the Treasury Department at the $3,000/oz clearing auction price (Treasury is carrying gold on its books at $42.22/oz.)

Bang – the soundness of the dollar suddenly becomes unquestioned because it has scarcity value. Its hegemony is protected and its status as global reserve currency is solidified.

A three-fold increase in the gold price should be enough to guarantee that the “free market” would drive asset prices up to the point that all toxic and opaquely-marked paper is once more reserved by banks at ratios greater than one. The loss that JP Morgan et al would suffer in their gold/silver short positions (yes we know about those) should be more than offset by the move to Par in all their respective paper assets. In fact, given the current interest rate structure of sovereign yield curves, we would argue that most dubiously-priced paper held by banks would be valued well in excess of Par, as credit spreads would collapse to reflect sharply higher asset collateral coverage ratios.

On an ongoing basis, the Fed would hold public auctions (as a buyer/seller) to maintain the $3,000/oz. peg. The gold market would become the new outlet for the Fed’s open market operations. Other economies would have to follow suit and devalue their currencies to preserve trade relationships (particularly net exporters to the US). This would be a huge transfer of wealth to the US, particularly from China and Japan. No doubt the US would have to negotiate terms with these exporters.

It may surprise many that the Euro and Pound Sterling would benefit from this devaluation, given the aggregated gold holdings of Europe’s legacy central banks and the BOE. The US and European Union could proceed in concert and essentially make the USD and EUR fungible in gold terms. The next step would be to develop an Asian bloc currency (and indeed this has already begun). In time, this Asian bloc currency would be able to raise its gold reserves as it continued to be a net exporter, and thus run an ongoing current account surplus. This surplus would be funded in newly gold-backed currencies such as the US dollar.

We believe the US economy would stabilize quickly and return to a sustainable growth path. Nominal price inflation would be “baked into the cake” and financial and real estate assets, in US dollar terms, would likely stabilize and begin to appreciate meaningfully. The US balance sheet – including the banking system – would be solvent.

It comes down to a choice – either let the natural forces compelling the economy to migrate back to sound money occur, or let the broad economy continue to slide deeper into the abyss. Wall Street and Main Street are going down (and will stay down) in real (inflation-adjusted) terms regardless (indeed, because of) of how much money central banks print to fix the nominal problems. We will all lose if policy makers continue on their current path.

Messrs. Summers, Bernanke, Geithner, Frank, Rockefeller, Rubin and Dimon – its time to Man Up: Keep your fractional reserve banking system if you must so that you can live to inflate another day. Once the smoke clears and the economy and markets settle, you or your successors can push the reset button and begin to debauch the dollar for another 25 years on the backs of the rest of the world. No other currency could compete.

Perspective – Our Current Flawed Policy

Understanding where the supply and demand for credit come from allows us to better judge the current economic situation. From 1982 to 2007 the Fed regularly supplied extraordinary amounts of dollar-based credit to the public markets through the banking system that in turn created an extraordinary amount of dollar-based assets and liabilities. At first, the Fed, the banks and the securities markets began promoting credit to consumers, borrowers and investors who weren’t terribly encumbered by debt. As time went on financial asset prices and real estate values appreciated, which mathematically justified further debt assumption.

From 1996 to 2006, the Fed accelerated its credit promotion, encouraging extraordinary amounts of private sector credit consumption. This new credit was publicly distributed through lenders and the securitization process to global pension funds, insurance companies, foundations and endowments. A mawing gap began to separate the record increase in the collective size of US homeowner and government balance sheets and the growth rate of US revenue and income needed to maintain those balance sheets. Despite historically low interest rates and credit spreads, that unsustainable bubble began to burst in 2007. It is still bursting, as we all are painfully aware.

We can only guess why so much credit was so consistently supplied and promoted by global central banks. We don’t know whether it was commonly thought that globalization and the opening of China, India and Russian-bloc economies suggested to already established economies that they could not afford recessions, or whether Alan Greenspan and his foreign colleagues simply wanted to be loved. The net effect is the same: policy makers built an economic house of cards on the back of public and private sector credit issuance and debt assumption.

They did not act alone. The vast majority of institutional debt buyers (creditors) were judged by their constituents on a relative basis (i.e. compared to one another and to various bond indexes). As fiduciaries then, they “behaved prudently” by buying the same credit everyone else bought, more or less. They were not mandated to consider absolute returns, risk-adjusted returns or inflation-adjusted returns. To this day, nowhere in the vast majority of institutional investors’ investment objectives will one see the goal of maintaining or enhancing their constituents’ future purchasing power. (Some college endowments, like Brown University’s, do have such stated missions.)

So then the supply and demand of substantial amounts of credit are embedded into the architecture of commerce and finance in established economies. This economic model ensures great financial (and thus economic) booms and busts. In such an environment a rational person would not save her money (the US has a 0% savings rate) and indeed would borrow all she could (the US household debt to income level rose more from 2001 to 2008 – to 139% – than it had in the previous 39 years). Unless one has the extremely lucky timing to spend like a sailor during the boom and then check out before the bust (Oh, Dick Cheney you were so close!), this monetary regime serves no societal benefit.

Indeed it is terribly flawed. A fiat currency system characterized by a potentially infinite amount of paper money subjectively printed by a unitary policy maker ensures that very few economic participants will retain real wealth. It will either be taken away as the debtors must eventually sell their assets to pay off their debts or it will be inflated away by the natural government compulsion to save nominal asset prices through money printing. (To paraphrase Jerry Seinfeld; “not that there’s anything wrong with that” – it’s just not capitalism.)

Our Wall Street-Centric Economy…

The world seems to have it wrong presently. Policy makers intent on “putting the fire out” by saving Wall Street before they can begin saving Main Street (by leveraging everyone up again!) seem terribly misguided. They should be drawing a firewall around the Wall Street banks that were foolish enough to eat their own bad cooking. These are the “bad banks” that should, if necessary, die.

The economic pain would be limited to the employees and bond-holders of those banks. Existing and new banks with cleaner balance sheets would step into the void, assuming and re-creating the business functions of the quarantined banks so that the economy could continue to function at capacity. Who knows? Maybe some of the employees at the bad Wall Street banks would be hired by – or even open – new or better ones?

The alternative currently being pursued – effectively making US taxpayers the bad bank – is unnecessary, un-economic and unfair. The “unintended consequences” of this policy will surely be that the largest banks will forever be perceived as too big to fail (and rightly so). They will almost certainly attract deposits from depositors at the expense of smaller, less politically-connected and thus more prudential regional and local banks that are perceived to be less of a systemic threat should they fail.

…Allows US Policy Makers to Control the Currency…

Why then are policy makers so determined to save Wall Street? Because our “economic” crisis is actually a more easily recognizable manifestation of a global currency crisis. We are astounded that virtually all policy makers,

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influential government think tanks and the media still behave as though the bubble that burst was a housing bubble, or a derivative bubble, or a bank bubble, or even a credit bubble. It was none of the above. These were merely second-order impacts of too much implied currency extended by the Fed to banks and by banks to the capital markets – (a dollar in credit created today is a claim on a dollar that doesn’t exist yet but that must be produced).

The Fed ultimately provided credit to the banking system and the “shadow banking system” – lenders, securitizers and even the purchasers of that credit. Regulators and legislators of all political persuasions were also complicit in blowing this currency bubble through negligent oversight and profligate spending. In short, the Fed and Wall Street is the narrow spigot through which politicians control the US’s (and the global reserve) currency, US tax receipts and government appropriations. This is our public/private monetary and fiscal relationship. This is why Washington is forcing taxpayers to bail-out Wall Street.

…So the US Can Better Control Broader Public Policy.

US policy makers do not want sound money (i.e. a currency that is a store of wealth as well as a unit of account and means of exchange). When Bob Rubin invoked the US’s “strong dollar policy” during the Clinton administration, he meant that it was in the best interest of the US economy to keep the dollar’s purchasing power strong versus other fiat currencies. Indeed this policy was symbiotically in the best interests of most other major economies, and coordinated central bank monetary policies have been able to perpetuate it.

The US dollar is the world’s reserve currency; it is used for all US trade and in over 60% of all global transactions. This means that exporting economies including Japan, China, India, Russia and Brazil greatly prefer their currencies to be weak versus the dollar so that their domestic cost of production is less than the value of the monetary proceeds they receive for their exported goods and services.

It is easy to imagine how controlling the value of the US dollar relative to other currencies became a foreign policy lever through which the US could negotiate matters far beyond mere terms of trade. The price paid by US consumers in local terms for a Toyota or a barrel of oil from Saudi Arabia or a plastic toy from China would have meaningful and direct impacts on the viability of domestic affairs of state in these exporting nations.

Source: Bloomberg

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The graph on the previous page shows the DXY index – the US dollar’s value in relation to other major currencies. The vertical line towards the left of the graph is September 11, 2001. Shortly after that tragedy, the US dollar began a secular decline.

The graph is merely an observation. It is not meant to imply that we know or suspect the motives, cause or effect of global policy makers or heads of state. We are unwilling to imply that there was some geopolitical, realpolitik deal struck in which exporters to the US benefited and the American people were spared further attacks. In fact, a credible case may be made that the dollar may have started its long descent in 2001 because Alan Greenspan had been priming the pump since 1996 and had more recently stepped it up following the NASDAQ crash in 2000 and the terrorist attacks in 2001.

We are willing to assert, though, that a weak dollar did benefit oil exporters and we would also think that happy exporters are more likely to crack down on the angry souls among them that could get in the way of their profits. Our point is not to judge whether saddling Americans with extraordinary amounts of debt was the de facto cost of protection from terrorism; our point is to raise the possibility that US domestic monetary policy may be influenced by factors far-a-field from the stated domestic mission of “sustainable growth with acceptable inflation” or whatever policy makers want us to swallow. We see monetary, fiscal, trade and foreign policies as inter-related tools our policy makers use in an attempt to improve the greater good (at least we hope so).

The Risks Began to Outweigh the Benefits

Despite the general decline in the relative value of the US dollar from 2001 to 2008, the US officially clung to its “strong dollar policy”. During this 7-year suspension of disbelief, US policy makers had to ensure that US and European consumers would continue buying imported goods and services from emerging exporting economies. To sustain demand, central banks of importing economies stood ready to promote enough systemic credit issuance (and consumer debt assumption) through which domestic consumer demand would remain relatively inelastic. In short, it seems to have become tacit public policy in the US and much of Europe to suspend economic slowdowns, which in turn created a synthetic global price structure.

This was a slippery slope. Consumers in importing economies were given incentive to pay “too much” for imported goods and services (too much when one backs out the debt they assumed to buy those goods and services). It is also true that workers in exporting economies were paid too little for their labor, though this is not as obvious. The Chinese worker that helped manufacture Poly Pocket dolls received US dollars in return. Though it may appear difficult at first to argue that US consumers got the better end of the deal, (Poly Pockets, are you kidding me?!), we would point out that the US sent China green paper that, if not spent, would soon depreciate from shear overabundance (much like a ticking time bomb). Paper currency gives its holders utility only in the short term.

We suspect a modern central banker’s defense against perpetuating this synthetic price structure would center on relative exchange values. In other words, the Poly Pocket worker takes his dollar, converts it to Yuan and buys dinner. If the doll cost the American dad what he would have spent on dinner, then it was a fair and equitable trade.

Or was it? This discrete transaction doesn’t account for the affected economic actors the transaction leaves out. Let’s say there are a bunch of potential workers in Detroit that could make Poly Pocket dolls in return for US dollars but choose not to because doing so wouldn’t pay them enough. Instead, they make 20 times the daily pay of the Chinese worker by working for a US auto manufacturer. They take their higher annual compensation and borrow five times that for a home, a car and their children’s education. As we are seeing presently, when this US laborer is ultimately forced to “settle” his balance sheet he finds that he is no better off than the Chinese laborer (and maybe worse off than living paycheck to paycheck like the Chinese worker because, being the higher-cost global producer, he is more likely to find himself out of a job longer).

The point is this: the synthetic suspension of the natural pricing of resources, goods, services and assets promotes harmful mal-investment and systemic economic delusion that, as we are now seeing, leads to an abysmal outcome. Would it have been better if Detroit workers made 20 times less and couldn’t afford to buy dinner AND Poly Pocket dolls? No, but the fullness of time shows how they would not have been worse-off either.

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Nothing Has Changed

The US is in the business of exporting notional Monopoly money in return for the fruits of others’ labor. To do this a good many of us spent the last twenty-five years trading this monopoly money amongst ourselves. Have you noticed that up until a couple of years ago there weren’t any losers? Everyone got “richer” by consuming relatively more and more than they were producing. How could this be?

Perception is indeed reality (at least in the short term). We’ve been conditioned to think that the wrong stuff is reality. Go to your window and look outside. Do you see the same buildings as yesterday? What about the supermarket – same groceries? And the gas station – same gas?

How about your co-workers? Though fewer of them come into the office than before, the same amount of potential workers are out there. The same assets and resources are there – the only thing changing is the nominal and relative “pricing” of them. Has “the stock” of wealth really changed or, alternatively, has the perceived value of “claims on wealth” changed? We would argue for the latter.

The global economy is attempting to naturally shrink notional prices so that it may again function more normally, according to a valuation metric that better reflects the supply and demand for resources. Financial assets and real estate to which this notional currency formerly flowed have begun depreciating in value, vaporizing the trillions in paper money claims that the banking system created. More workers are being laid off, which is in direct response to their real sustainable utility at their former pricing.

Why is this such a terrible thing? If all prices – food, energy, housing – depreciated to reflect real supply/demand equilibria, then couldn’t the Detroit worker or bank president make twenty times less and have the same quality of life? Price is meaningless. It is exchange ratios that matter in the real economy. But, therein lies the rub.

The current problem isn’t only that assets are losing “value”; debt is gaining “value” relative to them. Is this making anyone worse off? Yes, all the people and businesses that collateralized their debt with their assets. Is anyone better off? Yes, anyone that lent money to all the people and businesses that collateralized their debt with their declining assets. So who lent the money? The banks and bondholders lent the money and these loans are their assets.

Thus, there has been no net change in the collective value of US assets; however, there has been a significant shift in relative pricing – a shift that hurts most of us and helps a very concentrated few. This is NOT the destruction of wealth but a TRANSFER of wealth. Those who hold paper claims today for the production of real wealth tomorrow are the losers. Those with the power today and tomorrow to issue those claims are the winners. Watch and see.

Wall Street is a Necessary Conduit…

You may have noticed that there has been no indication that remaining Wall Street banks are in jeopardy of going out of business. Sure, their stocks have gotten killed, but it seems pretty obvious that all remaining entities have been chosen to survive – like cockroaches in nuclear winter.

Why is current public policy to keep banks at the center of recovery efforts and to keep Americans at all socioeconomic levels indebted? If the government is intent on writing checks, why isn’t it sending them directly to homeowners for $x or for x% of their mortgages made payable to their mortgage servicer? Wouldn’t this strategy serve two purposes: stabilize home prices and build consumer confidence? Why do policy makers insist on going through Wall Street? (We think we answered these questions above.)

The irony – that policy makers are relying on Wall Street to again distribute more monopoly money to “save us” from the debt with which they already saddled us – is almost too rich to bear. It is so rich – and so fantastically absurd, in fact – that we think it is, at the end of the day, far-fetched. Are we really supposed to believe that the public and its naïve representatives are taking taxpayer money to maintain these bad banks so they can help re-lever up the system again, which in turn would stimulate the economy by keeping workers deeply in debt so they can then consume? (We wish our keyboard would let us write in circles.)

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The same trillions the Fed is currently printing and applying to Wall Street balance sheets could instead be deposited into FDIC coffers. Washington could let the profligate banks fail and say to us ordinary American bank depositors, “Okay, your deposits are fully insured”. The Fed, as the bank regulator, could also send money to thousands of banks with clean balance sheets and transfer lines of credit to them. Doing this would be the equivalent of carving out the cancer so the patient could begin to recover. Or put another way, it would make better banks “good banks” and the bad banks, well, “bad banks”; not the bad banks, the good banks and the US taxpayer the bad bank.

Wall Street knows it is necessary to Washington interests. We imagine that when the economy experiences “a credit crisis”, Wall Street banks tell policy makers (or better yet, tell their former colleagues with influential positions in Washington) that unless they’re bailed out the banking system will fail. In their eyes – and the eyes of the legislators they can influence – it becomes a public imperative to save the banking system because it is presumed that either the economy would spin into a 30s-style economic depression or the public would lose confidence and start a run on their banks.

This is not true and such fears are fallacious. A 1930s style depression is not likely to occur today because of the Fed’s fall back plan; print as much money as is necessary to allow legislators to send it wherever it’s needed. As we discussed, policy makers can inflate away the burden of all public and private sector debt (debase the currency), which would raise nominal wages, revenues, tax receipts and asset prices while keeping principal debt amounts constant. They can do this anytime they wish. No economy in the world is on the gold standard and so all currencies are ephemeral. Printing paper to clean the slate is an easy thing to do.

And as for banks, they have three functions: 1) they warehouse our money, 2) they intermediate the interests of private borrowers and lenders and, 3) they help distribute the US’s currency. No one disputes banks are necessary to safe-keep our money and to provide a fluid means of settling transactions. If this were the only issue surrounding the Wall Street bailout, Washington would no doubt let deserving Wall Street banks die and allow healthier ones to continue on.

It seems obvious then that the wayward path policy makers find themselves skipping down ultimately derives from Wall Street wanting to protect its market share on the money (credit) distribution side. Wall Street competes with the “shadow banking system” – the securitization process that allows regional and local banks and lending intermediaries to share in the fees from distributed credit.

…For Power to Remain Centralized…

Something is rotten in the state of Denmark. No group of people – even short-sighted politicians – is dense enough to miss the irony of fixing a credit problem by issuing more credit. And so we don’t think they are. We think Washington needs Wall Street intact to distribute the debt that it uses to fund its priorities. Policy makers are not behaving to save their constituents; they are acting to keep control (and this is bi-partisanship at its finest).

We think Washington wants to make sure the current fiat monetary system stays in place to keep discretionary control over money and credit. Congress gave the Fed the power in 1913 to have ultimate primacy over all dollar-based credit issuance and to be ultimately obligated to absorb a systemic breakdown of creditworthiness. With this power US the government controls the people’s money and credit terms; it may effectively force Americans into debt and bring them out of debt collectively.

The key for individuals (who want to keep their social standing and sanity) is to get “rich” and go bankrupt with everyone else; otherwise the Fed won’t save them. People that choose not to borrow so they can purchase bigger homes, cars and assets at debt-inflated prices are unable to lead lifestyles commensurate with people that do.

The current monetary system is inconsistent with the supposed ideals of Democrats and Republicans. If the goal of a progressive approach to government, as is Congress’ current preference, is to democratize opportunity for the greatest number of people, then it is easy to equate democratizing debt with democratizing opportunity. Fair enough. But standing by Wall Street is no longer required to keep open the ability of a working class family to assume debt in the same way a more prominent family might – especially as it would place a far higher debt burden on that working family (either outright or through inflation).

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A Democratically controlled Congress should be trying to disassemble the narrow Wall Street spigot and to contain the losses within the Wall Street banks. We don’t think generally more Libertarian Republicans that believe the US should be a meritocracy where individual hard work and frugality should lead to improving one’s quality of life would have any problem with this either. Yet this is clearly not the case; everyone wants to help Wall Street.

We think the record shows clearly that Wall Street is the means to fund far-reaching domestic and foreign policies, which requires the ability to manipulate incentives that control the masses. Any wealth gained by aggressive Wall Streeters posing as capitalists is merely the price of executing these policies. Hamilton was as brilliant as they say.

…so the following Economic Model is perpetuated.

The US is not practicing capitalism. Capitalist, free-market economies promote productive efficiencies over time. Among the sources of efficiency are labor force specialization, technological progress and the free-flow of goods and services. Over time, therefore, organic forces for aggregate price deflation prevail and the fruits of labor can be shared by all. In general, living standards rise as wealth is created. Lower prices are a boon for workers, clearly enhance their pool of savings and promote further growth in that pool of savings. This pool of savings, in turn, primes the pump for further investment in productive capital. It’s a virtuous cycle when left alone.

(In an alternative monetary regime with a sound money system, in which currency would also be a store of wealth, deficits would be constrained by multiples of what they are presently and government would shrink. Aggregate wealth would be higher and the distribution of the pool of wealth would be much broader. For example, investment bankers wouldn’t make 25 times what doctors make.)

As difficult as it may be to write or read, the US is practicing bank-centric socialism. The banking system is a parasite on capital formation and central banks are their enablers. If the inflationary scheme on which a central bank relies is perfectly orchestrated (big “if” as we see today), the result would be “stable to modest price inflation” (other buzzwords such as “optimal ranges” and the like come to mind as well). In effect, the organic price deflation which would accrue to the consumer and frugal saver is stolen from them by the financial system.

Government empowers the financial system to play this game by legitimizing the Fed and by allowing the banks to be “fractionally reserved”. In turn, Government gets its share of the pie through the gigantic pool of deficit spending it can apportion. The intellectual justification for this monetary system is Keynesian economics.

Keynesian economics is a deluded form of academics that relies on the promise of administering economic policy in a manner that promotes more efficiency and “fairness”. The great irony is that it does the exact opposite. The Maestro himself – Alan Greenspan – identified this publicly in a 1966 broadly-published essay delivered before Congress (before he went to work for the Fed). Keynesianism is a big juicy rationalization to centralize control in Washington. (To paraphrase Jerry Seinfeld again; “not that there’s anything wrong with that” – it’s just not capitalism.)

This is it, plain and simple. Recognition of this economic model is essential to one’s understanding of what is happening today and why highly inflationary policies are being pursued by policy makers and by those who most directly influence them.

We’re Paid to Make Money, Not Policy

As investors we couldn’t be more pleased with current events. In times like these, creating real wealth requires anticipating substantial changes in the future not obvious to the masses of professional analysts that came of age extrapolating their (inapplicable) experiences forward. Expert advice that finds its value from decades of a tacit carry-trade mentality is worthless to us. They are measuring the ripples in the bath as the dam outside is bursting.

As we demonstrated above, we’ve been willing and eager to approach investing under the presumption that capital markets do not operate freely and discretely; that financial assets are highly influenced at all times by public policy, more so than most market participants tend to acknowledge or consider. A good case in point is our constant (incessant?) discussion of US and global monetary policies (print money when times are good and print more of it when that policy blows up the economy), and of the impact this public policy must have on financial asset prices. Our investment rationales have hinged on logic that seemed perfectly sound to us but unconventional and extreme according to market orthodoxy.

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Though we would selfishly prefer to see a seminal event that suddenly re-prices all our assets to levels we think they’ll ultimately reach (like our $3,000 USD/gold devaluation above), the powerful trends we envisioned seem to be gaining traction regardless. Gold remains in its eight year secular uptrend and the US dollar has begun rising vis-à-vis other fiat currencies. We think their coincident strength implies both current anxiety about the global monetary system and, we think, the future demise of all fiat currencies.

The reason for our optimism (yes, optimism) is because we think the endgame is upon us. We see the current entropic environment as the result of many years of intense monetary intervention combined with laissez faire market regulation meeting quickly failing efforts to reverse the destructive consequences of that combination. Indeed we see little that can be done to save the current monetary system and this fact seems to be just starting to be absorbed by Wall Street and Washington.

If we are to apply personalities as markers, we would imagine Larry Summers – the current sentry of the failing print, distribute and kick the can down the road monetary system – frantically chiding siloed, bureaucratic policy wonks to step up their efforts. We would guess Summers has ascended to his current perch by joining and now overseeing a team, a philosophy, a Keynesian brand of “economic pragmatism” that transcends political parties. To us this means he is blind to an organic change that can’t be managed and vulnerable to sudden failure.

Like most branded academics, policy makers and investors, we think it is highly likely Summers and his team have lost their abilities to reverse course as changing situations demand. He was hired to execute strategy according to his know-how and he would lose credibility among his peers and his boss if he were to reverse course.

Therefore, we think he is likely to use the current crisis to promote an acceleration of monetary inflation without limit, placing the full weight of the White House on Bernanke’s Fed. We think the Fed will happily comply, either by continuing to print and distribute reams of new money and credit willingly, as Bernanke so forcefully lectured at Princeton; or, if Bernanke has a sudden bout of consciousness, through Summers himself taking his job. (We can’t shake the vision of Mortimer in Trading Places yelling “turn those machines back on!”)

***

We don’t see public/private intervention stopping there. Secretary of State Hilary Clinton has taken it upon herself to put US-Sino relations front-and-center. Her first trip abroad was to Asia (not Europe as is customary), including a trip to China where she engaged in multifaceted talks including trade. This is a big deal. The nexus of US/China trade relations is giving China access to the US consumer base in return for China continuing to fund US deficit spending (public and private). But what happens when US consumers don’t want to play? What happens to US leverage in trade talks when its government can’t make its consumer-wedge comply?

Clinton and Summers are old friends that, from what we can gather, share the same political and economic philosophies. In fact it is well-known that Summers (and Bob Rubin before him) greatly shaped the Clintons’ economic platforms. What do you think Summers told Clinton to say to Wen Jiabao about trade? We have a guess.

Clinton: “Jiabao, Larry told me to express to you our country’s immense gratitude for continuing to participate in our Treasury auctions and to tell you that we are working very hard to get US consumers spending again on Chinese exports as soon as possible.”

Wen: “That is very nice, but we are concerned that the way you are going to get your consumers to spend will be to extend them more credit, which of course will devalue our 2 trillion of US dollar reserves.”

Clinton: “We understand your concern, Jiabao, but we just passed a stimulus package that should get the US consumer back to Wal-Mart.”

Wen: “Yes, that was certainly great news, Hillary and I’m confident it will work. I’m sure you won’t mind then if we set a timetable for withdrawing our dollar reserves. We are at great risk.”

10

Clinton: “Oh now Jiabao! Now you know a timetable often leads to great stress among friends! Our brand of democracy can’t react as quickly as yours! Incentives take time to filter though to the people”

Wen: “Yes I know this. That is our worry.”

(Long Pause)

Clinton: “Jiabao…what if the IMF were to sell a bunch of gold? You could buy it before, well, you know…”

Wen: “How much and when?”

Clinton: “I’ll talk to Larry.”

Wen: “Very well. I’m sure we will be pleased by what you will have to tell us. Perhaps you can let me know by the next quarterly Treasury re-funding?

Clinton (irritated): “I wouldn’t want you to set a date that might place greater stress on your economy than ours.”

Wen: “I don’t see how that’s possible.”

Clinton: “I think you do. I understand the people in the provinces are growing angry.”

(Long Pause)

Wen: “Tell me Hillary, if we took another $500 billion of your dollars and bought Treasuries, would that make our contribution to global peace and stability that much more valuable than, say, Taiwan’s?”

Clinton: “Now I don’t see how one thing has to do with the other.”

Clinton: (Whispers and shrugs) “One-trillion, long term Treasuries and we’ll ship you the gold…”

Are we out of our minds – amateur hacks dangerously imagining a series of outcomes that lifers at State and Treasury would consider highly naïve? That’s a definite probability. But it doesn’t matter for our purposes. Our middle-school age children would be sophisticated enough to see growing social, economic and political tensions threatening the status quo. They would be sophisticated enough to believe that leaders of all countries behave in their own best interests. (They might not be sophisticated enough, however, to envision their own country’s leaders greatly compromising stated ideals and objectives to paper-over near term adversity.)

We think the best bet in the markets now is to stay with the trend. Policy makers are destroying the currency and are unlikely to do anything about it (except maybe suddenly fix it by officially devaluing it to gold). We continue to bet the US government will continue to do whatever it takes to solve short-term domestic economic problems regardless of whatever consequences may arise later. And in this, there is only one way out – print. They’ll inflate our nominal problems away.

Why Gold?

Deflation is essentially money demand exceeding money supply. Demand for money goes up when, among other things, pressures to pay down debt escalate. Supply for money goes up when the Fed monetizes assets. It’s a tug of war. Timing is always uncertain but to bet against the Fed is illogical. The Fed IS the monetary base.

One can envision the Fed as a small balloon inside a larger one. The small balloon is the monetary base and the larger one is, for argument’s sake, M3 (which includes the monetary base plus credit). The small one is inflating rapidly while the large one is deflating rapidly. At some point, the small one and large one converge upon one another.

11

The Fed has an infinite air supply. We think the Fed will continue to inflate until the large balloon is expanded, via growth in the smaller balloon, to the point at which the Fed is comfortable. This target is reflected in an aggregate level for nominal asset prices. The supply of monetary base that the Fed can provide is costless. Therefore monetary inflation is theoretically infinite. The same can be said for all other central banks globally.

We foresee the final (and huge) leg of the gold bull market will be a near direct transfer of wealth from government bond holders. Why, if so many people “need” dollars, would they lend them so aggressively to the US Treasury?

At the end of the day (or the day after), the gold price should be most highly correlated with the size of the monetary base (which, in the past was gold and, after repeated failures of fiat currency systems, has always reverted back to gold). Leveraged assets (e.g. stock markets, real estate, credit spreads) should be most correlated with the broad measure of money and credit (think M3).

The markets are bearing this out today. A lower CPI does not call for lower gold prices. It merely is a measurement of lower consumer prices, which are a function of debt deflation (or, put alternatively, an increase in the marginal propensity to save). The Fed is going hard right while the consumer is going hard left. Gold follows the Fed, not the consumer. In the end, we think stocks should rise but greatly under-perform precious metals and precious metal shares.

Best,

Lee & Paul

Lee Quaintance Paul Brodsky

lquaint@qbamco.com pbrodsky@qbamco.com

“The problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money.”

– Adam Smith

“At the end fiat money returns to its inner value—zero.”

– Voltaire

“If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered.”

– Thomas Jefferson

“The money power preys upon the nation in times of peace and conspires against it in times of adversity. It is more despotic than monarchy, more insolent than autocracy, more selfish than bureaucracy.”

– Abraham Lincoln

“Give me control of a nation’s money and I care not who makes the laws.”

– Amschel Rothschild

“I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. No longer a government by free opinion, no longer a government by conviction and vote of majority, but a government by the opinion and duress of a small group of dominant men.”

– President Woodrow Wilson (regretting signing into law the Federal Reserve Act)

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before morning.”

– Henry Ford

“By this means (fractional reserve banking) government may secretly and unobserved, confiscate the wealth of the people, and not one man in a million will detect the theft.”

– John Maynard Keynes, The Economic Consequences of the Peace (1920)

“The modern banking process manufactures currency out of nothing. The process is perhaps the most astounding piece of slight hand that was ever invented…If you want to be slaves of the bankers, and pay the cost of your own slavery, then let the banks create currency”.

– Lord Josiah Stemp, Former Director of the Bank of England (1937)

“If the governments devalue the currency in order to betray all creditors, you politely call this procedure “inflation.”

– George Bernard Shaw

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation […] Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.”

– Alan Greenspan, Gold and Economic Freedom (1968)

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