A Discourse on the Method . . .

. . . of Rightly Conducting the Reason and Seeking Truth in Contemporary Economies & Markets, with sincerest apologies to the memory of Rene Descartes.



Seventeenth century medicine, Moliere observed, was a field where most men died of their remedies and not of their diseases. So too, twenty-first century interventionist monetary policy seems to kill more wealth than if recessions were left alone to run their course. Instead of bloodletting, our “physicians” pump us full of liquidity until we explode, and then pump more into us as we lay gushing.

In the US our chief surgeon, the Fed, has been able to operate unilaterally, virtually unencumbered by Congressional restrictions or mandates, so that Wall Street banks (its literal owners and first constituency) don’t die. And the Fed needn’t worry about claims of malpractice because, as we now see, when push comes to shove its insurance carrier is the US Treasury, which is another way of saying the same taxpayers that lay bleeding.

Transitive properties still hold: if A equals B and B equals C, then A must equal C. Applied here: if US taxpayers (A) fund the US Treasury (B), and Treasury backs the Fed (C), and the Fed backs Wall Street banks (D), then US taxpayers (A) back the ongoing profitability of Wall Street banks (D). Perhaps this explains why all those crisp new electronic dollars created from thin air last fall went directly to creditor banks rather than to debtor homeowners?

Saving the system was generally perceived then to be saving the US economy or saving the commercial paper market or saving depositors from losses. In fact these systems were never at risk given the Fed’s willingness to print money and cover all bets. Whether carefully designed or the result of impulsive reactions, there was a decision made at the highest levels of government. The only conclusion to draw was that the “system” saved was the system of government intermediation into the private sector economy and it was accomplished by saving the government’s ports of entry — Wall Street’s largest and most influential banks.

John Crudele of the New York Post used the Freedom of Information Act to gather information recently on Treasury Secretary Henry Paulson’s phone records one day last fall. It seems that beginning early in the morning of September 18, 2008 and continuing throughout the day – a day after the Dow Industrials dropped 449 points – Secretary Paulson spoke repeatedly with Lloyd Blankfein from Goldman Sachs and other Wall Street leaders. As Mr. Crudele points out, the Dow closed up 410 points that day. We don’t know whether these conversations affected market pricing and our interest here is not to prove whether there is a “Plunge Protection Team” aspect to the President’s Working Group on Financial Markets. We further presume any intervention would have been prompted by Mr. Paulson’s good intentions to restore order to the markets in a broader attempt to sustain confidence in the broader economy (perhaps, as Crudele implies by coordinating the funding of stock purchases to raise the indexes?). And, we are not going to complain that preferred banks and investors (i.e. BlackRock) knew information via direct contact with Treasury that the rest of us did not.

We don’t feel the need to prove conspiracy theories because our eyes and ears provide us reasonable conclusions, or to demand market fairness because we’ve known for a very long time that such an ideal does not practically exist. Along these lines it seems indisputable that there is now widespread acceptance of government intervention into the economy, banking system and the markets, whether through explicit fiscal and monetary policies such as Cash for Clunkers, Quantitative Easing, Debt Monetization, etc. or through the implicit, and perhaps surreptitious, sponsorship (price fixing) of financial markets. We think this widespread acceptance is a big deal and provides a fundamental guideline for investors as we discount future asset values: money and credit will be expanded at whatever pace and in whatever amounts are necessary to avoid a severe or prolonged economic contraction. Currencies will take the fall.


Against this backdrop we ask three questions: 1) Just when exactly did the Fed Put become a taxpayer Put; 2) if US taxpayers bail out the banks, the Fed and the Treasury, should we expect the banks, the Fed and the Treasury to bail out US taxpayers, and; 3) how should independent, politically agnostic investors play this?

We think the answer to the first question is that the Fed’s moral hazard has been with us since 1971 but becomes more obvious when currency bubbles burst and bank balance sheets implode. The second question was rhetorical. We can’t bail out each other when the economy’s total claims far exceed its manifest capital. We can only transfer paper back and forth, which in effect answers the third question for us. In this report we will consider the current method of economic distribution and how it doesn’t square with the majority of perceptions towards markets or with the national conversation surrounding economics and investing.

Opening the Kimono
Whether it is broadly recognized or not, the US has a bank-centric economic system in which the largest banks may behave as monopolistic utilities that inflate the Fed’s reserves by creating and distributing credit to the private sector. As such, the private sector banking system freely creates its own assets in the form of debt obligations, and is then able to charge interest on the assets it creates. These assets become government obligations when there is a system-wide disruption – not when an individual or business goes pear-shaped at a time when few others do. (It is safe to say that the US’s largest banks — not its Senators — comprise the country’s most exclusive club.)

Thanks to the US’s fractional reserve banking system — promoted and implicitly insured by Washington and the Fed — there is an almost unlimited amount of credit issued to the US private sector and implicitly collateralized by the production of the people and businesses to which the US banking system issues that credit. The obvious problem, however, is that the only way that public and private sector debtors can satisfy claims against them is with currency that doesn’t organically exist. So, the US banking system, with the endorsement of the US government (itself, the largest debtor), continually manufacturers more credit to pay off claims, which in turn further increases the amount of claims outstanding. This self-fulfilling monetary inflation promotes circularity reminiscent of an open-ended Ponzi scheme. (If Bernie Madoff could have printed currency in this manner then he wouldn’t have had a problem.)

This system ensures that the private sector must eventually become overwhelmed by debt that can only be repaid through government socialization. As a result of the necessary transfer of claims from debtor to creditor under this system, the US government (through the Fed) and the US banking system must ultimately (and now, presently do) control the means of production. Such is the US system of resource and wealth allocation.

If we were to attach a label to this system it would not be “free-market capitalism” characterized by private sector winners and losers operating under a system of natural incentives, and governed by the protection of fundamental property rights and contract law. The most honest description would be “bank-centric socialism” in which the real value of a nation’s resources and capital production takes a back seat (and is ultimately effectively confiscated) by the state and by the nation’s financial network.

This economic system must be managed constantly by an intervening government or else natural economic incentives would destroy excessive credit and capacity. Due in large part to the reserve currency status of the dollar, this model has also been adopted by other major economies. So, to perpetuate control it is reasonable to conclude that global governments create and foment economic inefficiencies in the form of excessive money and debt creation. We presume they do this to counteract natural short term economic corrections, which are politically sub-optimal.

The observations above should not be Cartesian insights to anyone who thinks about them for a minute and a half. Nevertheless, we feel we must pause to interject the disclaimer that we are not formally judging the merits of this economic system in its entirety because it may have evolved from what was once considered wise public policy within a broader social, economic and political context. We simply don’t know what may have prompted policy makers to perpetuate an unsustainable global economic system that promotes manic booms and busts – corruption, laziness, political expediency, or, we suppose, farsightedness or because it simply beat the alternatives? In this report we will not focus on intention but rather on making sense of the current state of US and global economies in an effort to better understand current, and anticipate future, asset valuations by better understanding true economic incentives.


If your child were to ask you what “being economical” meant, you might respond “finding ways to save money”. This simple notion is at the heart of the social interaction that is theoretically supposed to drive broad economies. If you are a builder and I am a cook, I will feed you for a year while you build my house. If other cooks offer to feed you for less, you would build their houses before mine. I might then reduce the price of my food to you depending on how badly I want a house. The point is that the natural dynamic of a diverse economy is to drive prices down as specialization and efficiencies prevail.

In large, mature societies where there might be overcapacity for builders and cooks, the natural tendency would be declining prices for goods and services, which in turn would suggest builders and cooks would be paid less. Some might decide to migrate into other fields where they might have more pricing power, which would serve to equilibrate prices at levels where supply and demand find parity. In an idealized real economy, lower wages and costs would engender the same affordability (and more leisure time). We would simply have smaller balance sheets.

There would also be room for lenders and leverage in a real economy. The cook might decide that instead of trading food for a house he would borrow from a bank, or even the builder, who would front the money needed to buy the materials and labor to build the house. In a real money system, it would be perceived that the value (purchasing power) of money tomorrow would matter as much as it does today, and so the loan would be collateralized, in full or to a great extent, by the home based on an accurate and sustainable price. As such, the cost of credit extended would be economically driven and the loan would facilitate the creation of capital for both the lender and the borrower.

The “economies” we have today are not economical or even capital producing because governments (or central banks, or both working in concert?) intervene to manage the overall price structure of goods, services and assets by controlling the money stock in general and certain prices in particular. The political dimension perpetrated by governments today provide a highly inflationary bias because money and credit are continually created, which in turn controls and distorts the pricing, allocation and distribution of collateral resources.

One of our dearly-departed grandfather’s-in-law paid $190 for his first car in the 1920s and another grandfather paid $680 for a car in 1938. Ask yourself this: Was the demand per capita for cars back then higher or lower than the demand per capita today, when cars cost $30,000? The difference is not shifting supply or demand, which in fact would argue for lower car prices today. The difference is the nominal amount of money and credit in the system.

For some reason government and market regulators have consistently ignored the consequences of excessive money and credit creation, which has further encouraged economic participants, wanting merely to maintain their lifestyles, to become increasingly indebted. Irresponsible private sector consumerism and borrowing should not be blamed for economic booms and busts. Consider that economic participants such as homeowners seeking merely to maintain the same purchasing power as their neighbors must borrow as much as their neighbors so that they will generate the same levered gain upon the sale of their home, providing them with adequate future purchasing power. The problem goes back to excessive money printing that politicians and policy makers control, and with which consumers must abide. In fact, those “irrational consumers” are behaving quite rationally by jettisoning their dollars.

We have noticed most commentators trying to deconstruct the current crisis are getting it wrong because they are beginning at the wrong place, as though its derivation was irrational lending and the consequent sub-prime blow-up, in turn leading to a crisis of confidence throughout all credit markets. This is like saying Christianity started with Ste. Francis of Assisi or that the common cold starts with a sneeze. The nexus of the problem was government turning a convenient blind eye to the banking system’s unabated, self-serving credit distribution, and the shortsightedness of credit buyers, caring only about short term relative performance, stuffing their portfolios with high current yields. There had to be dubious paper created; this time it just happened to take the form of sub-prime mortgages.

Consider that M3, the broadest monetary aggregate that included overnight and short term repurchase agreements between the Fed and the largest Wall Street banks, grew consistently at an average annual rate of about 10% between 1996 and 2006. (The Fed stopped publishing M3 in March 2006.) We believe this was where the rubber met the road in terms of levering up the economy. Banks, borrowers and consumers, flush with all this Fed/bank credit, shared the same wayward economic incentives — to take the overnight funding effectively provided by the Fed to structure, sell and assume debt, and to push out debt repayment so they could produce short-term satisfaction (consumers), fees (intermediaries) or positive carry (investors).

At some point economic fundamentals would inevitably demand reconciliation, and, sure enough, vagrants with mortgages eventually began defaulting. Most economic and market observers using models constructed for a real economy didn’t see it coming. They saw money and assets as “capital” and they never netted out the debt. They never realized (and many still don’t) that only unencumbered money is true capital, and that the crisis was not a credit crisis per se but a currency crisis – too many claims for money in the future that couldn’t possibly be satisfied without increasingly exorbitant rates of monetary inflation. There was a relatively inadequate amount of currency outstanding being discounted by inadequately low interest rates.

Ultimately, the growing cost of indebtedness would have to overwhelm the economics of capital production to the point at which it wouldn’t pay for businesses to produce goods and services. Servicing debt and sustaining lifestyles would have to become increasingly difficult for the masses. Unemployment would have to rise. Either the explicit price of money — interest rates — would have to be much higher or the amount of actual money (not credit) outstanding would have to increase by many multiples.

And so here we are. We currently see the unsustainability of finance-based economies in government balance sheets, which can no longer be funded with revenues. In the US, sixty-two percent of the government’s budget is pre-committed to entitlements and interest on Treasury debt (and that’s after a couple years of very low Treasury yields). The defense budget consumes half of what remains, leaving less than $500 billion for everything else. (Kind of puts all those new trillions in scary perspective, eh?)

Governments can’t get blood from rocks. They can’t tax their deeply indebted masses enough to produce revenues with which they can pay down their own debts. Though the US government has been able to patch things temporarily through even more borrowing, which brought the national debt to over 40% of GDP in 2008, it appears unlikely this trend can continue much longer. The Congressional Budget Office projects US debt to GDP will rise to almost 70% by 2019. But we may not make it that long.

In the second quarter, the Fed purchased just less than 50% of all Treasury auctions, more than the combined historical bulwark of auction demand comprised of foreigners, households and primary dealers. Worse, the Fed’s capacity for Quantitative Easing should extinguish itself in early October leaving hundreds of billions in Treasury securities to be priced by the whim (and theoretically better sense) of the markets. Would policy makers allow interest rates to rise when both public and private sectors are so deeply indebted? Or, should we expect further price controls on interest rates, like an extension of QE?

Clearly, the US economy, as we’ve known it for a generation, is in its evanescence. US policy makers, as the managers, promoters and now price setters of the US and global economies, are running out of bullets. Reasonable, objective analysts should agree that a new economic order is likely to assert itself in the coming months and years.

The current credit crisis is making it more obvious to the general public that the US’s wealth is being channeled away from individuals and businesses lacking sufficient wherewithal to meet their short term debt obligations towards individuals and businesses that hold excess currency or claims on those resources. The government itself will always be able to meet its obligations because its central bank can print and lend it money. Large US banks, effectively backed by government and the Fed, will survive too because they will be able to continue to create unlimited claims from thin air, call them “assets” and then charge interest to borrowers.

Conceptually and practically, bank-centric socialism ensures the nation’s currency and debt must eventually become one, and indeed even casual observers can now see that the US has arrived at that point. To have money in the US today is to generally owe money to banks, to the shadow banking system, to the government and to each other. Only a small minority of individuals would have positive net-worths were they to liquidate their assets and extinguish their liabilities coincidentally. Given the US’s aging demographic profile and baby boomers’ growing intentions to monetize home equity, we presume aggregate real net-worths will only decline further and by a substantial amount.


Where can taxpayers and investors (who aren’t money center banks) hedge themselves against this open-ended monetary inflation (assuming they don’t work for those banks and choose not to own shares in them because banks tend to pay their employees before they pay their shareholders)? Would the best hedge for the rest of us be buying puts on ourselves?

You bet. That would involve shorting our real wages and financial assets as they are increasingly inflated away. Global stores of value that reach beyond the sovereignty and apparent omnipotence of discrete governments naturally come to mind – precious metals, capital resources, relatively scarce commodities and businesses with sustainable margins. Yet there seems to be confusion surrounding these investment options, perhaps born from generally accepted lapses in logic. Certain economic and investment relationships should be clarified before discussing investment expressions.

Gold, for example, is not a hedge against rising prices, as most people think. It simply recognizes the pressure on banking systems to de-lever and the subsequent response of all major central banks to prop up their economies through money printing. (Properly, it is a hedge against monetary inflation, not a rising CPI.)

In the real money systems of the past, gold was scarce and served as the reserves of banking systems. In the fiat money systems of today gold has become even scarcer, as its supply remains relatively constant while the quantity of paper bank reserves soars. There is no natural economic law in a fiat monetary system suggesting that declining goods and service prices can’t occur coincident with rising gold prices. In fact, this relationship should be expected.

As we’ve discussed at length in the past and have seen occur recently, when credit deflates and output shrinks, monetary authorities, unconstrained by the forced discipline of scarcity, print more money to replace the evaporating credit. In fact, thanks to a recent doubling of the monetary base, total US credit has not declined despite the substantial private sector credit crisis. The supply of paper money and credit grows far faster than the relatively scarce supply of gold allowing the price of gold to rise in US dollar terms even as employment and real output stagnates or falls. So, the prices of scarce stores of value like gold may be independent of changing goods and service prices generally reflected in broad price baskets, and therefore unreflective of an expansion or contraction of an output gap.

We also think the output gap itself is misunderstood. Under a fiat currency system, there are three determinants of pricing: 1) supply, 2) demand and, 3) the stock and velocity of money. Clearly, with wages stagnating and/or contracting and employment declining there is less demand for goods and services. Yet few economists seem to formally acknowledge that the same conditions that cause demand to contract also cause supply to contract. Fewer workers working fewer hours means less goods, services (and assets) being produced as well as being demanded.

An extreme example makes this point clear. Zimbabwe, determined to pay down nominal foreign debts and maintain nominal output growth, has been printing trillions of Zimbabwean dollars. Demand for goods and services in Zimbabwe is approaching infinity (due to mistrust in the currency as a store of value), as productive supply craters towards zero (again, due to mistrust in the currency in which wages are paid). The point is that the ultimate determinant of supply and demand (the variables determining an output gap) is the confidence in the means of exchange from transactions. A debasing currency reduces transactions, which reduces supply as well as demand.

We Are a Social Species, For Better or Worse
In his book, Descartes’ Bones, which provided the inspiration for the sweep of this narrative, Russell Shorto described the wall of traditional thinking faced by Rene Descartes, the father of dualism. Descartes asked and answered questions related to reconciling nature, previously explained awkwardly by centuries-old Aristotelian theory, with more scientific logic that an independent mind was capable of producing:

“Layers of tradition had built up for understanding reality. Centuries of robed scholars and scribes had bent in tallow-tapered light over parchment sheets and leather bound manuscripts, mouthing words, quill-scratching, rubricating, memorizing, parsing and analyzing and adding levels to the hoary infrastructure that had these categories as elements and that was applied as an increasingly unwieldy tool to explain natural phenomena, human behavior, history, the universe. But on what ground did they stand, these classifications? How could one trust them? How do we know they aren’t nonsense? As Descartes put it, devastatingly, ‘The best way of providing the falsity of Aristotle’s principles is to point out that they have not enabled any progress to be made in all the many centuries in which they have been followed.’”

We feel the same way Descartes must have about contemporary economics. To be clear, we’re no Descartes and John Maynard Keynes was no Aristotle. Thanks to the wisdom of others (who also tend to toil in relative obscurity), we know economic silliness when we see it and Keynesianism is it. The widely accepted false premise of Keynesian economics, (effectively that rational supply and demand incentives can occur naturally over time within a baseless monetary regime managed by government intervention), implies that policy makers will continue to misunderstand or underestimate (or purposely ignore) far more fundamental economic relationships.

From a purely economic point of view, pricing, production, employment, consumption and investment incentives are best understood when viewed through the prism of money, as the Austrian School suggests. If the money stock were to be kept constant (at whatever level), rational economic participants would make rational decisions. As policy makers and politicians lever up the economy; however, money itself overwhelms the capital it can produce. The more leveraged the system becomes, the more frequently people and businesses handling money need to exchange it for goods, services and assets. This constant state of monetary inflation and increasing velocity diminishes money’s value in relation to production, goods, services and assets. That’s why nominal prices must rise, and historically do.

A Keynesian based economy must therefore run on confidence – confidence in a baseless money keeping or increasing its purchasing power; confidence that policy makers will not become corrupted by politics; confidence that output can contract, interest rates can rise, or that an unforeseen national crisis can occur without jeopardizing the basic functioning of goods and service transactions. It is a loosey, goosey proposition that encourages centralization of power around elders at the top of society’s pyramid. Incentives naturally collide. Individual and collective wealth and property are ultimately shifted through the process of inflation based upon the whims of a few men and women.

Political ideology becomes secondary because all major political parties in all major economies agree that government should remain in control. Lost is the basic notion that natural incentives of the people that comprise an economy must inevitably force the political dimension past the point of being able to sustain popular confidence. This basic truth is misunderstood (or purposely ignored) by the vast majority of economic and market participants, and by observers practicing or accepting Keynesian economics (which is to say most all economists and investors today).

We again feel the need here to remind that we are not necessarily judging the societal and political virtue or vice of having a government and/or a central bank dominate a nation’s economy by having the effective ability to increase and diminish the value of private property and control the value of its productive resources. As Americans, we acknowledge that: a) our democratic society openly accepts being taxed in return for government services and protections and, b) most Americans are implicitly judging that their quality of life – in present, nominally material terms – is more important than controlling their own destinies. Our only formal assertion is that policy makers in the US today are greatly distorting natural economic law and promoting mal-investment. (They are also being disingenuous with their constituents, making it far more difficult for trusting investors to understand where true value lays.)

We are not alone on this branch. Independent voices arriving at similar conclusions seem to be seeping into the the public discussion more frequently. The link below will take you to a recent CNBC excerpt in which analyst Jim Rickards voices his take on the motivations and behavior of the Fed and how policy makers are trying to delay the dollar’s demise: http://www.cnbc.com/id/15840232?video=1275517570&play=1. Arthur Laffer’s recent opinion piece in the Wall Street Journal (http://online.wsj.com/article/SB10001424052970203440104574402822202944230.html) also reminds how the Great Depression was produced by excess money and credit creation, and then compounded by a devaluation of the dollar versus gold. There are many more independent voices. We are all speculating, to be sure, (just as Keynesians are), but the coalescing of conclusions that independent observers seem to be reaching implies more than a passing notion: Central banks are eventually corrupted by politics and, if given a baseless currency, will work to destroy it in return for short term benefits at the expense of broader, more severe economic consequences.

So why isn’t the fallacy of Keynesian economics (that it is mere political engineering rather than true economic theory) better know today? In a recent Huffington Post article, Priceless: How the Federal Reserve Bought the Economics Profession, (www.huffingtonpost.com/2009/09/07priceless-how-the-federal_n_278805.html), Ryan Grim concludes after a long and compelling investigation that; “the Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession. This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed’s thrall, the economists missed it, too.”

It would seem reasonable that experts throughout government, Wall Street and academia (including the esteemed institutions at which we worked and from which we matriculated) have been susceptible to adopting and, since the Great Depression, internalizing, a convenient philosophy (certainly convenient for government and Wall Street). Such a widespread abandonment of natural economic law would invite a narrow faction to dominate public policy debates.

Too conspiracy-minded for you? Are we really supposed to believe that the entire US economy has been corrupted by a system prioritized towards mutually-shared convenience for power bases in Washington and on Wall Street? Is the banking system, which prints and holds the people’s money and, as creditor, enjoys first claim on the people’s assets; positioned to inevitably take ownership control over substantial amounts of economies’ wealth? We are not concerned at the charge of looking for witches that don’t exist. We (like you) doubt two people in Washington can keep a secret, let alone hundreds over a long period of time. But that doesn’t mean that a system wasn’t set up originally that would ensure that as long as people behaved rationally, certain outcomes would be perpetuated.

For example, take a look at this memo from Fed Chairman Arthur Burns to President Ford in June 1975 (http://www.zerohedge.com/sites/default/files/Fed%20Arthur%20Burns%20on%20Gold%206%203%201975.pdf) in which Chairman Burns lobbies the President to side with the Fed against the Treasury to limit global central banks’ and governments’ ability to buy and sell gold at market prices. It would make sense that the Fed, as the banker for the banking system that effectively creates the nation’s currency (that had just become the world’s reserve currency), would not want a competing global currency with scarcity, like gold. Are we to think that the Fed’s position has changed since then?

As John Maynard Keynes himself declared: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…The process engages all hidden forces of economic law on the side of destruction, and does so in a manner which not one man in a million is able to diagnose.” Even himself Keynes understood the process he espoused.

We recognize our views above to be both contrarian and unyielding to the point where they may be off-putting to economists and investors used to passively playing the economic hand they’ve been dealt because they trust the good intentions of the dealer. And on that score we are sure policy makers are all fine ladies and gentleman looking to make things better for the vast majority of Americans. However, we also recognize that they are making it worse (a “fallacy of composition” if you will?). From an investor’s perspective, the dealer’s deck is limitless; it ensures all players will be nominal winners and that most all players will be losers in real terms because the chips they leave the table with will lose value as they play.


Our position would not be credible without a legitimate voice to dispute it. Marshall Auerback, a professional investor, friend and die-hard Keynesian with whom we discuss economies and markets regularly, offered cogent thoughts on the current situation from a different perspective:

““Money is not a commodity or a thing. It is an institution, perhaps the most important institution of the capitalist economy. The money of account is social, the unit in which social obligations are denominated. As Karl Polanyi argued, markets never sprang from the minds of higglers and hagglers, but rather were created by government.

The monetary system, itself, was invented to mobilize resources to serve what government perceived to be the public purpose. Of course, it is only in a democracy that the public’s purpose and the government’s purpose have much chance of alignment. In any case, the point is that it is a separation of the economic from the political — and any attempt to separate money from politics is, itself, political. Adopting a gold standard, or a foreign currency standard (“dollarization”), or a Friedmanian money growth rule, or an inflation target is a political act that serves the interests of some privileged group. There is no “natural” separation of a government from its money. The gold standard was legislated, just as the Federal Reserve Act of 1913 legislated the separation of Treasury and Central Bank functions, and the Balanced Budget Act of 1987 legislated the ex ante matching of federal government spending and revenue over a period determined by the celestial movement of a heavenly object. Ditto the myth of the supposed independence of the modern central bank — this is but a smokescreen to protect policy-makers should they choose to operate monetary policy for the benefit of Wall Street rather than in the public interest (a charge often made and now with good reason). So, money was created to give government command over socially created resources. As Randy Wray says:

Conventional wisdom holds that money is a private invention of some clever Robinson Crusoe who tired of the inconveniencies of bartering fish with a short shelf-life for desired coconuts hoarded by Friday. Self-seeking globules of desire continually reduced transactions costs, guided by an invisible hand that selected the commodity with the best characteristics to function as the most efficient medium of exchange. Self-regulating markets maintained a perpetually maximum state of bliss, producing an equilibrium vector of relative prices for all tradables, including the money commodity that serves as a veiling numeraire.

All was fine and dandy until the evil government interfered, first by reaping seigniorage from monopolized coinage, next by printing too much money to chase the too few goods extant, and finally by efficiency-killing regulation of private financial institutions. Especially in the US, misguided laws and regulations simultaneously led to far too many financial intermediaries but far too little financial intermediation. Chairman Volcker delivered the first blow to restore efficiency by throwing the entire Savings and Loan sector into insolvency, and then freeing thrifts to do anything they damn well pleased. Deregulation, which actually dates to the Nixon years and even before, morphed into a self-regulation movement in the 1990s on the unassailable logic that rational self-interest would restrain financial institutions from doing anything foolish. This was all codified in the Basle II agreement that spread Anglo-Saxon anything goes financial practices around the globe. The final nail in the government’s coffin would be to preserve the value of money by tying monetary policy-maker’s hands to inflation targeting, and fiscal policy-maker’s hands to balanced budgets. All of this would lead to the era of the “great moderation”, with financial stability and rising wealth to create the “ownership society” in which all worthy individuals could share in the bounty of self-regulated, small government, capitalism.

We know how that story turned out. In all important respects we managed to recreate the exact same conditions of 1929 and history repeated itself with the exact same results. Take John Kenneth Galbraith’s The Great Crash, change the dates and some of the names of the guilty and you’ve got the post mortem for our current calamity.

I will grant you this: Generally, free marketeers want to “free” the private financial institutions to licentious behavior, but advocate reigning-in government on the argument that excessive issuance of money is inflationary. Yet we have effectively given banks the power to issue government money (in the form of government insured deposits), and if we do not constrain what they purchase they will fuel speculative bubbles. So I can see the attraction of your argument for 100% reserve backed banking system. I’m sure the banksters would find a way to game that, but it’s a coherent and sensible position.””

Clearly, Auerback’s and Wray’s views are indisputable in that money, in any form including gold, is a commodity that provides no intrinsic value to sustain or improve life , and that any form of government can’t completely ignore money (if only to pay its military). But we would argue on behalf of free marketeers that all market participants – not just private financial institutions – would prefer to engage in truly free markets with sound money underpinning them. Anything less requires substantial government intervention in the form of shifting, reactive monetary policies and market regulations.

Either markets are free and fair for all participants or they are rigged games, managed by governments that allocate the spoils and burdens of tail risk. Government’s hard-wired alliance with its protected money distributors ensures they will always be protected through moral hazard and regulatory amnesty. Certain participants will always have an edge, and public awareness of this suggests there will be fewer sophisticated participants betting against the establishment. (Perhaps that is why policy makers do not try to hide some of their massive interventions, though they would likely prefer that people like us just wouldn’t try to define them.)

We are not zealots. Life’s too short, truth is truth, relative value is relative value and, fine people or not, we think policy makers behaving predictably and the legions of incurious investors following them present substantial opportunities. We recognize that the population’s willingness to accept compromise and proportional inequity in return for immediate access to easy credit, Wii and gasoline will allow economies and markets to continue to be government-managed. The only sensible bet then is to bet with government and to expect major inflation.

Exploiting Predictability
We think American policy makers will inflate away the relative burden of US debts by destroying the dollar and that most Americans will cheer them on. Policy makers are one stock market swoon away from inflating away the burden of US private sector debt. We could envision them saving the day through something resembling a “cash for clunker homes” program — sending newly created money to mortgage holders in the form of checks made out to their servicers. This would effectively cram down bank and shadow bank assets while not producing nominal bank losses.

It would also be economically stimulative (unlike sending money to creditor banks, as they did last year). Repaired homeowner balance sheets would raise nominal consumer spending power and confidence, the nominal value of homes and businesses, employment and even nominal wages, all while reducing the principal amount of debts and the ongoing burden of debt service. This, or something similar, might be the shape Mr. Bernanke’s famous “helicopter drop” would take.

Of course such a program would only shift the debt burden to the public sector, forcing the government to press the reset button on the currency soon afterward. But very few would care because American’s assets and liabilities are dollar denominated and very few have meaningful net savings. Retirees should be concerned, as should the ultimate creditors of dollar-denominated bonds (not to be confused with most fiduciary bond funds, presently unconcerned with real returns because they compete for nominal annual fee income).

Foreign holders of dollars should also care, but not as much as is generally perceived. Their central banks are also inflating their home currencies more or less in-kind with the Fed. US dollars are only marginally inferior (or superior) stores of value than Yen, Euros, Sterling, etc. (Despite FX fluctuations, no major fiat currency today should be expected to hold their purchasing power value over time, with the possible exception of economies with heavy natural resource output.)

Though we can’t prove it, we are of the view that powerful people inside and outside government have been negotiating terms of trade and currency reconciliation for a while now, and that we are likely in the late innings of these negotiations. Why else would gold have appreciated consistently over the last eight years as most public discussion has surrounded “deflation” and during a period when many major central banks publicly flaunted their gold sales? Why else would the US State Department accompany Tim Geithner’s Treasury to an economic summit this year with Chinese counterparts? Why else would Fed Governor Kevin Warsh publicly threaten to raise interest rates on the same day as a G-20 summit, if not to let foreign central banks know that the Fed intends to try to retard the dollar’s decline (followed the next week by Fed-lifer Donald Kohn’s retraction)? Why else would Chinese and Russian leaders periodically discuss a new global currency regime publicly, if not to threaten US policy makers with either dollar sales or outright gold purchases? Why else would crude oil spike to $145 a barrel in 2008 if not to give American politicians a taste of the future if they don’t come to the table? Why else would China’s government begin converting their dollars to natural resources and begin keeping most of the gold mined in their country?


One of the biggest headaches for central bankers is that while they can print unlimited monetary reserves and promote boundless credit, they cannot consistently direct where that money and credit flow. It would be irrational to expect dollar holders to find saving an attractive option, especially when low prevailing interest rates lock-in negative funding spreads. But that doesn’t necessarily promote consumption, as policy makers might hope. More likely it would promote paying down debts. Obviously, saving and paying down debt is not stimulative in the Keynesian realm of immediate satisfaction and would not reverse the inertia of rising unemployment.

It would also be a problem for central bankers if the private sector rationally decides to use the new money and credit to consume and/or store goods and services related to basic, relatively inelastic, commodity-oriented goods and services. Buying hard assets and resources would drive input costs higher, which in turn would raise the nominal prices of goods and services regardless of contemporaneous organic demand. So, if central bankers want to promote nominal output growth through money printing without substantial goods and service inflation, they must get an assist from other policy makers that may direct consumer incentives.

Should we expect new US legislative proposals to give new tax breaks to purchasers of new cars and computers, existing homes and commercial real estate; or to raise the capital gains tax on profits derived from “speculative” investing in commodities or commodity-related derivatives such as futures and ETFs? Should we expect the prime brokerage divisions of banks to cut back on funding hedge funds buying such products (again)?

But — and this is the big but for investors – redirecting investment would not affect the real loss of the dollar’s purchasing power and it would not impact the underlying appreciating value of certain property during a big inflation. It would not give incentive to commodity producers to take a loss on every good they sell, which means that miners, drillers and farmers would reduce their supplies while still demanding (and receiving) a disproportionate amount of that new money and credit. Relative scarcity of commodities needed for cars, homes, computers, etc. would lead to commensurately higher prices. Regardless of how clever policy makers and politicians try to be, inconvenient economic fundamentals will continue to get in the way.

The writing is on the Wall. Global monetary policy makers are gravitating towards a “solution” that calls for the IMF to issue Special Drawing Rights (SDRs) — a super-sovereign currency that would be convertible at some exchange rate into all the world’s existing currencies. It would be a fiat currency itself, a derivative on a derivative, backed by paper that is backed by nothing.

We suppose the IMF will have to print boatloads of SDRs initially to create enough liquidity and critical mass so that they could be used This would mean that much more of the constituent currencies that would ostensibly back the SDRs would have to be printed. The obvious consequence (intended or otherwise) would be a massive, one-time, coordinated inflation. When the press starts to prep us about SDRs as the means to lessen the pressures on US policy makers of maintaining the dollar as the world’s reserve currency, maybe we should quietly, among ourselves, think of the new currency as “Surplus Dollar Receptacles?”

Turning Theory into Practice
As the Fed and other central banks have been inflating their respective monetary bases rather dramatically over the last year, it is logical that gold has appreciated in dollar terms. (It is also logical that stock markets have risen. In monetary base terms, the S&P 500 would have to rise to 1300 just to match the real March ’08 lows!)

Global wealth holders (not to be confused with investors necessarily) have demanded gold over the last eight years in increasing amounts coincident with declining paper money purchasing power. It follows that these wealth holders will be greatly rewarded once more tactical investors, used to investing in financial assets, begin piling into “inflation hedges”. Though we have no idea whether the next short-term trend in precious metals will be up or down, we expect demand for them to go parabolic at some point once it becomes more “socially acceptable”.

At some point fiduciaries and investment committees will no doubt begin to fear a rising CPI. The trillions in allocable money should overwhelm the relatively tiny precious metal markets, and so we think bullion prices will rise many times in paper money terms. (In actuality, the value of bullion would remain the same while the value of paper money relative to it would drop. We see gold as a liquid money form that keeps its purchasing power regardless of how much paper central banks manufacture.)

We shouldn’t be anchored by nominal prices for precious metals in paper money terms. (Who would have thought $35 gold in 1971 would top out at over $850 nine years later?) Price ratios are the essence of relative value. (How many Dow Jones units may one buy with; a) a beach home in East Hampton; b) a trillion Zimbabwean dollars; C) an ounce of gold?) We expect precious metals prices to rise far more than the DJIA because we think investing one’s available resources today in enterprises that produce nothing but depreciating paper will provide negative real returns. Bond investments should fare even worse.

Rising precious metals prices merely signal the onset of rising prices in the stuff that really matters – money (like bullion) that holds its value, and assets, commodities and businesses that have inelastic demand properties (i.e. staples). Ultimately we expect to scale out of such plays at much higher prices in favor of plays with improving relative value, such as distressed (formerly over-leveraged) financial assets and certain fixed income products priced at much higher interest rates. Ratios will signal to us when it is time to act.

Lee & Paul

Paul Brodsky Lee Quaintance
pbrodsky@qbamco.com lquaint@qbamco.com

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