How The Best of Intentions Destroyed Liquidity

By Jared Dillian

I just got done grading the final exams for my class (took me 12 hours). It’s 100 short answer questions and two essays. One of the essay questions is about the Volcker Rule. “Paul Volcker, former Federal Reserve chairman, as part of the rulemaking process for Dodd-Frank, included a provision prohibiting proprietary trading by banks, known as the Volcker Rule. Do you agree or not agree with the Volcker Rule? Explain.”

The funny thing about asking someone what they think of a law is, if you leave the question open ended and you don’t really describe what the law does, the response is generally favorable. Out of a class of 20 students, only two or three opposed the Volcker Rule. Most of them were in favor of it, as they were in favor of Glass-Steagall when I asked them to write a paper on that.

Seems pretty straightforward. If you have these banks that you call “systemically important,” such that they could go out of business and get rescued by taxpayers, then you don’t really want them taking risks with their own capital, right?

I mean, look how this worked out in the past.

Milton Friedman once said that laws should be judged by their results rather than their intentions. Liquidity has disappeared, and it is directly attributable to the Volcker Rule. If you hear someone try to make an argument that it’s not, that person is probably a journalist or a professor with no first hand knowledge of the situation.

I remember when the Volcker Rule first passed, years ago, someone senior in the equity derivatives market asked me, “Do you really think they will have regulators going through your trades, one by one, line by line, asking you if it was your intent to make money?”

“That seems very unlikely,” I told him.....But that is what we got.

In addition to confiscating cell phones and monitoring phone conversations, chats, and emails, the vast army of compliance officers at investment banks really will go through a trader’s blotter line by line and determine if each trade was a bona fide hedging transaction or if he was trading for his own account. In single stocks, this is pretty straightforward—either you were buying GE for a client or you were buying it for yourself. But in derivatives, it’s not. If you get hit on the GE Jan 30 calls, you’re not going to be able to turn around and sell them—you have to sell something else.

For example, if you’re long too much vega, you may want to sell some short-dated stuff against it, putting on a term structure trade. Is that a hedge, or prop trading? It’s impossible to make that distinction. But the compliance guys try. The interpretation varies. In equity derivatives, traders generally get the benefit of the doubt. In credit, they don’t. You can’t sell bond B to hedge bond A. You literally have to sit there and try to sell bond A. This is why the bond market is such a mess, which we have talked about in this space before.

Of course, none of this gets us any closer to preventing an investment bank from blowing up, because the guy trading 500 call options on GE was never going to blow up the bank in the first place. On the other hand, the Volcker Rule never would have prevented Jon Corzine from blowing up MF Global with European sovereign bonds. If a CEO really wants to do something like that, is some compliance dork really going to stop him? To say that this regulation is a catastrophic failure would be an understatement. Liquidity has disappeared, with no discernible benefit. I’m a middlebrow market commentator, and I’m not supposed to say things like “This is dumb,” but this is really dumb. It doesn’t take an Austrian economist to figure out the unintended consequences.

In the old days (10 years ago), banks were the big liquidity providers. Let’s look at this a different way: do we want banks to continue to be liquidity providers, yes/no? Banks were not always liquidity providers. In the ‘90s, in equity options, it was the physical trading floors where all the risk was handled. Stocks, too. But the bond market has always been an upstairs phenomenon.

If banks aren’t going to be liquidity providers, then we need non bank entities to provide liquidity, and we need to encourage it. Some large hedge funds and some second tier (i.e., not systemically important) broker dealers are starting to do this. But it’s not enough.

The goal was to take a bank and turn it from a risk taking institution to a toll taking institution, where everything is traded on an agency basis, with a commission applied. The FX markets, which were once all risk, are starting to look like this. In equities, traders don’t do much aside from maintain relationships and plunk orders into auto trader, where they are preyed upon by the algorithms.

This is unsustainable, because how can you hire all these smart people from fancy schools and pay them all this money just to push a button—while all their communications are monitored? Nobody is happy with the current state of affairs. 10 years ago, you could sell 250,000 shares on the wire. Or $25 million of bonds.

I have two radical solutions. Here they are:

1. Repeal the Volcker Rule
2. End decimalization

When I came into the business, stocks still traded in fractions. On the options floor, I had to learn to add and subtract fractions in my head. Seriously—I ran drills on this, testing myself for speed. When I got to Lehman, to the program trading desk, I noticed something remarkable—we could send our orders to “wholesalers” like Spear, Leeds & Kellogg or Knight Trading. They would auto execute the orders up to 2,000 shares on the bid or the offer—for free.

Then decimalization happened. The preferential treatment lasted about another month, then they started charging us a penny a share. Market making went from being a profitable business to an unprofitable one.
Guess what—if market making is profitable, a lot of people will want to do it, and you will have a lot of liquidity. If market making sucks, nobody will want to do it, and you will have no liquidity.

Did the retail investor benefit? Maybe. Now he could go into his E-Trade account and execute something for a penny instead of 1/16. But if he was a shareholder in a mutual fund, the mutual fund portfolio manager now had to drop 250,000 shares into auto trader, getting preyed upon by the aforementioned algorithms, instead of getting it done for 1/8.

Then SEC Chairman Arthur Levitt led the charge for decimalization. More unintended consequences.
It’s not likely we’ll go back. Levitt was having conniptions about the length of time it was taking for the options market to decimalize, even though the computing power didn’t even exist.

Ask any portfolio manager today: Liquidity is the number one concern. That’s bullcrap. It’s like buying a house and having plumbing be your number one concern. It should just take care of itself.

Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. 

The article The 10th Man: How The Best of Intentions Destroyed Liquidity was originally published at mauldineconomics.com.

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Why Stocks Could Fall 50% if the Fed Makes the Wrong Move

By Justin Spittler

One of the most brilliant investors in the world just made a stunning call…..


Ray Dalio is the founder of Bridgewater Associates, the world’s largest hedge fund. Dalio manages nearly $170 billion in assets. He has one of the best investing track records in the business. When he speaks, we listen. Dalio has been saying for a long time that governments and businesses around the world have borrowed far too much money. He thinks their high levels of debt have created an extremely fragile and dangerous situation.

The stats back up Dalio’s view. In the United States, government debt as a percentage of gross domestic product (GDP) is 102%...its highest level since World War II.

Countries around the world are in a similar position. Japan’s debt-to-GDP ratio is at 226% and climbing. In Italy, government debt/GDP jumped from 100% in 2007 to 132% in 2014. Dalio explained how these extreme debt levels are one reason for the recent market volatility we’ve been telling you about…

These long term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars.

•  In an article published yesterday, Dalio said the Fed should start another round of quantitative easing...…

Quantitative easing (QE) is when a central bank buys bonds or other assets to lower interest rates and boost asset prices. It’s mostly just another name for money printing. The Fed started QE in a desperate attempt to stave off disaster during the 2007-2008 financial crisis. It launched the first round in November 2008…a second round in November 2010…and a third round in September 2012. It stopped its last round of QE last October.

The first three rounds of QE fueled a big bull market in US stocks. The S&P 500 has gained 113% since the Fed started QE in 2008. Dalio thinks the Fed should bring QE back. It’s a bold call, and one that most economists disagree with. Most economists expect the Fed to raise rates soon. Raising rates would tighten monetary conditions…essentially the opposite of QE.

•  Dalio is worried the Fed won’t get it right..…

Dalio thinks the Fed will raise rates, even if it’s just to “save face.” He pointed out that the Fed has threatened to raise rates so many times that not raising rates would hurt its credibility. Dalio’s big concern is that the world is too indebted to handle a rate hike. He thinks it could cause a financial disaster like a stock market crash, or worse.

In a letter to clients earlier this year, Dalio made a comparison to 1937, when the world was in a similar situation of having way too much debt. He explained that the Fed made a huge mistake by raising rates, and it caused the stock market to plummet 50%.

The danger is that something similar could happen if the Fed raises rates today.

•  We asked Dan Steinhart, executive editor of Casey Research, for his take..…

Here’s his response…...

I don’t know what the Fed’s going to do. That’s a guessing game. What’s important is Dalio’s point that we’re in an extremely fragile situation. The world has too much debt, and the Fed’s margin for error is tiny. If it takes a wrong step and stocks plummet 50%, it could cause a bigger financial crisis than in 2008.

So the real question is, do you trust the US government and the Fed to manage this dangerous situation?

I don’t. This is the same Fed that blew two huge bubbles in the last twenty years. First the 1999 tech bubble…then the even bigger housing bubble, which almost took down the whole financial system when it popped in 2007.

And keep in mind – this is all a gigantic experiment. The Fed is using tools, like QE, that it had never used before the financial crisis. No one in the Fed, the US government, or anywhere else knows how this is going to work out.

Who knows…maybe the Fed will surprise us and successfully guide the economy through this dangerous period. But that’s not an outcome I’d bet my savings on. Dan went on to explain two things you can do to prepare for another financial crisis. One, own physical gold. Unlike stocks, bonds, or cash, it’s the only financial asset that has value no matter what happens to the financial system.

Two, put some of your wealth outside the “blast radius” of a financial crisis. We wrote a new book with all of our best advice on how to do this. And we’ll send it to you today for practically nothing…we just ask you to pay $4.95 to cover our processing costs. Click here to claim your copy.

The article Why Stocks Could Fall 50% if the Fed Makes the Wrong Move was originally published at caseyresearch.com.

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How Global Interest Rates Deceive Markets

By John Mauldin

 “You keep on using that word. I do not think it means what you think it means.”

– Inigo Montoya, The Princess Bride

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”

All right class, it’s time for an open book test. I’m going to give you a list of yields on various 10 year bonds, and I want to you to tell me what it means.

United States: 1.80%

Germany: 0.36%

France: 0.54%

Italy: 1.56%

UK: 1.48%

Canada: 1.365%

Australia: 2.63%

Japan: 0.22%

I see that hand up in the back. Yes, the list does appear to tell us what interest rates the market is willing to take in order to hold money in a particular country’s currency for 10 years. It may or may not tell us about the creditworthiness of the country, but it does tell us something about the expectations that investors have about potential returns on other possible investments. The more astute among you will notice that French bonds have dropped from 2.38% exactly one year ago to today’s rather astonishing low of 0.54%.

Likewise, Germany has seen its 10-year Bund rates drop from 1.66% to a shockingly low 0.36%. What does it mean that European interest rates simply fell out of bed this week? Has the opportunity set in Europe diminished? Are the French really that much better a credit risk than the United States is? If not, what is that number, 0.54%, telling us? What in the wide, wide world of fixed-income investing is going on?

Quick segue – but hopefully a little fun. One of the pleasures of having children is that you get to watch the classic movie The Princess Bride over and over. (If you haven’t appreciated it, go borrow a few kids for the weekend and watch it.) There is a classic line in the movie that is indelibly imprinted on my mind.
In the middle of the film, a villainous but supposedly genius Sicilian named Vizzini keeps using the word “inconceivable” to describe certain events. A mysterious ship is following the group at sea? “Inconceivable!”

The ship’s captain starts climbing the bad guys’ rope up the Cliffs of Insanity and even starts to gain on them? “Inconceivable!” The villain doesn’t fall from said cliff after Vizzini cuts the rope that all of them were climbing? “Inconceivable!” Finally, master swordsman – and my favorite character in the movie – Inigo, famous for this and other awesome catchphrases, comments on Vizzini’s use of this word inconceivable:

“You keep on using that word. I do not think it means what you think it means.”

(You can see all the uses of Vizzini’s use of the word inconceivable and hear Inigo’s classic retort here.)
When it comes to interpreting what current interest rates are telling us about the markets in various countries, I have to say that I do not think they mean what the market seems to think they mean. In fact, buried in that list of bond yields is “false information” – information so distorted and yet so readily misunderstood that it leads to wrong conclusions and decisions – and to bad investments. In today’s letter we are going to look at what interest rates actually mean in the modern-day context of currency wars and interest-rate manipulation by central banks. I think you will come to agree with me that an interest rate may not mean what the market thinks it means.

Let me begin by briefly summarizing what I want to demonstrate in this letter. First, I think Japanese interest rates not only contain no information but also that markets are misreading this non-information as meaningful because they are interpreting the data as if it were normal market information in a familiar market environment, when the truth is that we sailed beyond the boundaries of the known economic world some time ago. The old maps are no longer reliable. Secondly, Europe is making the decision to go down the same path as the Japanese have done; and contrary to the expectations of European central bankers, the potential to end up with the same results as Japan is rather high.

The false information paradox is highlighted by the recent Swiss National Bank decision. Couple that with the surprise decisions by Canada and Denmark to cut rates, the complete retracement of the euro against the yen over the past few weeks, and Bank of Japan Governor Kuroda’s telling the World Economic Forum in Davos that he is prepared to do more (shades of “whatever it takes”) to create inflation, and you have the opening salvos of the next skirmish in the ongoing currency wars I predicted a few years ago in Code Red. All of this means that capital is going to be misallocated and that the current efforts to create jobs and growth and inflation are insufficient. Indeed, I think those efforts might very well produce a net negative effect.

But before we go any farther, a quick note. We will start taking registrations for the 12^th annual Strategic Investment Conference next week. There will be an early bird rate for those of you who go ahead to register quickly. The conference will run from April 29 through May 2 at the Manchester Grand Hyatt in San Diego.

For those of you familiar with the conference, there will be the “usual” lineup of brilliant speakers and thought leaders trying to help us understand investing in a world of divergence. For those not familiar, this conference is unlike the vast majority of other investment conferences, in that speakers representing various sponsors do not pay to address the audience. Instead, we bring in only “A list” speakers from around the world, people you really want to meet and talk with. This year we’re going to have a particularly large and diverse group of presenters, and we structure the conference so that attendees can mingle with the speakers and with each other.

I am often told by attendees that this is the best economic and investment conference they attend in any given year. I think it is a measure of the quality of the conference that many of the speakers seek us out. Not only do they want to speak, they want to attend the conference to hear and interact with the other speakers and conference guests. This conference is full of speakers that other speakers (especially including myself) want to hear. And you will, too. Save the date and look for registration and other information shortly in your mail.
Now let’s consider what today’s interest rates do and do not mean as we navigate uncharted waters.

Are We All Turning Japanese?

Japan is an interesting case study. It’s a highly developed nation with a very sophisticated culture, increasingly productive in dollar terms (although in yen terms nominal GDP has not moved all that much), and carrying an unbelievable 250% debt to GDP burden, but with a 10 year bond rate of 0.22%, which in theory could eventually mean that the total interest expenses of Japan would be less than those of the US on 5 - 6 times the amount of debt. Japan has an aging population and a savings rate that has plunged in recent years.

The country has been saddled with either low inflation or deflation for most of the past 25 years. At the same time, it is an export power, with some of the world’s most competitive companies in automobiles, electronics, robotics, automation, machine tools, etc. The Japanese have a large national balance sheet from decades of running trade surpluses. If nothing else, they have given the world sushi, for which I will always hold them in high regard.

We talk about Japan’s “lost decades” during which growth has been muted at best. They are just coming out of a triple dip recession after a disastrous downturn during the Great Recession. And through it all, for decades, there is been a widening government deficit. The chart below shows the yawning gap between Japanese government expenditures and revenues.



This next chart, from a Societe Generale report, seems to show that the Japanese are financing 40% of their budget. I say “seems” because there is a quirk in the way the Japanese do their fiscal accounting. Pay attention, class. This is important to understand. If you do not grasp this, you will not understand Japanese budgets and how they deal with their debt.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: How Global Interest Rates Deceive Markets was originally published at mauldineconomics.com

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Paper Gold and Its Effect on the Gold Price

By Bud Conrad, Chief Economist

Gold dropped to new lows of $1,130 per ounce last week. This is surprising because it doesn’t square with the fundamentals. China and India continue to exert strong demand on gold, and interest in bullion coins remains high.

I explained in my October article in The Casey Report that the Comex futures market structure allows a few big banks to supply gold to keep its price contained. I call the gold futures market the “paper gold” market because very little gold actually changes hands. $360 billion of paper gold is traded per month, but only $279 million of physical gold is delivered. That’s a 1,000-to-1 ratio:

Market Statistics for the 100-oz Gold Futures Contract on Comex
	Value ($M)
Monthly volume (Paper Trade)	$360,000
Open Interest All Contracts	$45,600
Warehouse-Registered Gold (oz)	$1,140
Physical Delivery per Month	$279
House Account Net Delivery, monthly	$41

We know that huge orders for paper gold can move the price by $20 in a second. These orders often exceed the CME stated limit of 6,000 contracts. Here’s a close view from October 31, when the sale of 2,365 contracts caused the gold price to plummet and forced the exchange to close for 20 seconds:

Many argue that the net long term effect of such orders is neutral, because every position taken must be removed before expiration. But that’s actually not true. The big players can hold hundreds of contracts into expiration and deliver the gold instead of unwinding the trade. Net, big banks can drive down the price by delivering relatively small amounts of gold.

A few large banks dominate the delivery process. I grouped the seven biggest players below to show that all the other sources are very small. Those seven banks have the opportunity to manage the gold price:

After gold’s big drop in October, I analyzed the October delivery numbers. The concentration was even more severe than I expected:

This chart shows that an amazing 98.5% of the gold delivered to the Comex in October came from just three banks: Barclays; Bank of Nova Scotia; and HSBC. They delivered this gold from their in house trading accounts.

The concentration was even worse on the other side of the trade—the side taking delivery. Barclays took 98% of all deliveries for customers. It could be all one customer, but it’s more likely that several customers used Barclays to clear their trades. Either way, notice that Barclays delivered 455 of those contracts from its house account to its own customers.

The opportunity for distorting the price of gold in an environment with so few players is obvious. Barclays knows 98% of the buyers and is supplying 35% of the gold. That’s highly concentrated, to say the least. And the amounts of gold we’re talking about are small—a bank could tip the supply by 10% by adding just 100 contracts. That amounts to only 10,000 ounces, which is worth a little over $11 million—a rounding error to any of these banks. These numbers are trivial.

Note that the big banks were delivering gold from their house accounts, meaning they were selling their own gold outright. In other words, they were not acting neutrally. These banks accounted for all but 19 of the contracts sold. That’s a position of complete dominance. Actually, it’s beyond dominance. These banks are the market.

My point is that this market is much too easily rigged , and that the warnings about manipulation are valid. At some point, too many customers will demand physical delivery and there will be a big crash. Long contracts will be liquidated with cash payouts because there won’t be enough gold to deliver. I saw a few squeezes in my 20 years trading futures, including gold. In my opinion, the futures market is not safe.

The tougher question is: for how long will big banks’ dominance continue to pressure gold down?

Unfortunately, I don’t know the answer. Vigilant regulators would help, but “futures market regulators” is almost an oxymoron. The actions of the CFTC and the Comex, not to mention how MF Global was handled, suggest that there has been little pressure on regulators to fix this obvious problem.

This quote from a recent Financial Times article does give some reason for optimism, however:

UBS is expected to strike a settlement over alleged trader misbehaviour at its precious metals desks with at least one authority as part of a group deal over forex with multiple regulators this week, two people close to the situation said. … The head of UBS’s gold desk in Zurich, André Flotron, has been on leave since January for reasons unspecified by the lender…..

The FCA fined Barclays £26m in May after an options trader was found to have manipulated the London gold fix.

Germany’s financial regulator BaFin has launched a formal investigation into the gold market and is probing Deutsche Bank, one of the former members of a tarnished gold fix panel that will soon be replaced by an electronic fixing.

The latter two banks are involved with the Comex.

Eventually, the physical gold market could overwhelm the smaller but more closely watched U.S. futures delivery market. Traders are already moving to other markets like Shanghai, which could accelerate that process. You might recall that I wrote about JP Morgan (JPM) exiting the commodities business, which I thought might help bring some normalcy back to the gold futures markets. Unfortunately, other banks moved right in to pick up JPM’s slack.

Banks can’t suppress gold forever. They need physical gold bullion to continue the scheme, and there’s just not as much gold around as there used to be. Some big sources, like the Fed’s stash and the London Bullion Market, are not available. The GLD inventory is declining.

If a big player like a central bank started to use the Comex to expand its gold holdings, it could overwhelm the Comex’s relatively small inventories. Warehouse stocks registered for delivery on the Comex exchange have declined to only 870,000 ounces (8,700 contracts). Almost that much can be demanded in one month: 6,281 contracts were delivered in August.

The big banks aren’t stupid. They will see these problems coming and can probably induce some holders to add to the supplies, so I’m not predicting a crisis from too many speculators taking delivery. But a short squeeze could definitely lead to huge price spikes. It could even lead to a collapse in the confidence in the futures system, which would drive gold much higher.

Signs of high physical demand from China, India, and small investors buying coins from the mint indicate that gold prices should be rising. The GOFO rate (London Gold Forward Offered rate) went negative, indicating tightness in the gold market. Concerns about China’s central bank wanting to de-dollarize its holdings should be adding to the interest in gold.

In other words, it doesn’t add up. I fully expect currency debasement to drive gold higher, and I continue to own gold. I’m very confident that the fundamentals will drive gold much higher in the long term. But for now, I don’t know when big banks will lose their ability to manage the futures market.

Oddities in the gold market have been alleged by many for quite some time, but few know where to start looking, and even fewer have the patience to dig out the meaningful bits from the mountain of market data available. Casey Research Chief Economist Bud Conrad is one of those few—and he turns his keen eye to every sector in order to find the smart way to play it.

This is the kind of analysis that’s especially important in this period of uncertainty and volatility… and you can put Bud’s expertise—along with the other skilled analysts’ talents—to work for you by taking a risk-free test-drive of The Casey Report right now.

The article Paper Gold and Its Effect on the Gold Price was originally published at casey research

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A Nation of Shopkeepers

By John Mauldin

“To found a great empire for the sole purpose of raising up a people of customers may at first sight appear a project fit only for a nation of shopkeepers. It is, however, a project altogether unfit for a nation of shopkeepers; but extremely fit for a nation whose government is influenced by shopkeepers.”

– Adam Smith, The Wealth of Nations

One of the great pleasures of writing this letter is the fascinating correspondence and the relationships that develop along the way. The internet has allowed me to meet a wide range of people all over the world – something that never happened to me pre-1999. Not only do I get to meet a wide variety of people, I also come into contact with an even wider range of knowledge and ideas, much of which comes my way from readers who send me work they think I’ll have an interest in. I have a bountiful, never ending source of thoughtful material, thanks to you.

This week’s letter emanates from a rather provocative email I received from David Brin. Science-fiction aficionados will immediately recognize him as the many-time winner of every major sci-fi writing award and an inductee into the Science Fiction Hall of Fame. Non-SF junkies might remember the movie The Postman (with Kevin Costner). Brin’s 2002 book Kiln People is one of my favorites, and I think it’s one of the more important books for trying to understand the impact of technology in our future. Will the science he describes be available? Probably not. But different technological variations on it will be, I think. And the book has a great plot. (David is also something of an expert on the role of and loss of privacy, which is a central theme of the book.)

David is something of a polymath. His degrees are in astrophysics and space science (Caltech and UCSD), but like many science fiction writers he is interested in almost everything. He frequently takes me to task, always constructively, sometimes publicly, about my writing. He is also a bit of an Adam Smith junkie.

I am going to use his latest complaint as a launching point for today’s letter. He was responding to last week’s Outside the Box, about the future of robotics and automation, which I introduced with a shot off the bow at the reigning Keynesian paradigm. He objects.

Today’s letter will be more philosophical in nature than most – we won’t be looking for technical signals; but it’s August – half the trading world is on vacation (except for the unsleeping computers run by high-frequency traders, which create the bulk of the volume these days), and so any technical signal we picked out this week would be suspect. Yes, August is a great time to think philosophical thoughts about the political economy. So, without further ado, let’s see what has my close friend Dr. Brin so upset.

Supply-Side (Voodoo) Economics?

John, excellent missive on automation.  I share your overall optimism.

Still... although Keynesianism deserves lots of criticism for the 30% of the time that it has proved wrong... and Hayek had a lot of good and important things to say... it remains disappointing that you do not use your influence to help hammer nails into the coffin of the Rentier Caste's catechism... Supply Side (Voodoo) Economics (SSVE), which is not just 30% wrong. It has proved to be almost 100% diametrically opposite to right, with every forecast that SSVE ever made having proved to be calamitously wrong.

Adam Smith might have had some problems with Keynes... and some with Hayek. But Smith warned us incessantly about the horrific economic effects of favoring monopolistic-collusive rent-seeking oligarchs, who destroyed freedom and markets in 99% of human cultures. When the Olde Enemie – who wrecked freedom and markets across 6000 years... the enemy Smith warned against and the US Founders rebelled against... comes roaring back... aren't you behooved to help raise the hue and cry?

Some Thoughts on Adam Smith

David,
You will perhaps forgive me if I use you as a straw man to draw out a few principles for my readers. And I’m sure you’ll have an eloquent answer posted within a few hours. (Interested readers will be able to find that at http://davidbrin.blogspot.com/ along with fascinating commentary on all matters technological and philosophical. David relishes his role as self-appointed uber-contrarian.)

Your comments on Keynesianism and supply-side economics are so wrong that I think I will hold my tongue and save my criticisms of them for next week. You are expressing a common meme that totally buys into the reigning economic nonsense that passes for thinking about economic theory – a sin you’re usually not guilty of. But I’m not about to respond to you (not anymore!) with an off-the-top-of-my-head analysis, so I will spend the bulk of my week thinking about secular stagnation and the causes of growth, and then respond.

Neither is what follows totally off the top of my head; there was some work involved. What I would like to take up is Adam Smith views on the rentier class, which, for me at least, is a far more intellectually interesting topic than Keynesianism versus… SSVE. You keep quoting Adam Smith at me as if somehow Adam Smith’s is a gospel that must be adhered to. And I admit to being a serious Adam Smith enthusiast. Smith demonstrates an amazing amount of intellectual prowess. I stand in awe. His insight seems even more profound when you put the man in the context of his times.

And Smith was totally a man of his times. He was making observations about the changing nature of the economy and wealth in mid-18^th-century Scotland and England, and his thoughts were disturbing to many of his associates at the top – the 1%, in modern parlance. He described a political economy in such stunning detail that it has influenced minds for almost 250 years. Yet, he was an early explorer in a land (that of the political economic landscape) that was not yet much trodden. He did however come along at a time when people were trying hard to understand the changes erupting around them. England especially and Scotland to some extent were transforming from a feudal agrarian society (which Smith clearly did not like) to one that was more commercial, as the Industrial Revolution took root and began to send forth green shoots.

Smith welcomed change, but with some reservations that are not often talked about. We’ll look at some of them today. As we will see, Smith was a complicated person. But he is best understood if we put him back into his times and recognize that he is not penning his observations on the “wealth of nations” to deal with our situation today, though many of his insights are timeless.

Over the last 200 years, the ways scholars have looked at Adam Smith have changed. There have been Adam Smith fads. While the fact is not much discussed in modern-day polite society, Smith was a clear influence on Hegel, who of course informed Marx. As hard as it is to understand today, there were those along the way who thought Smith was foundational to Marxism. In the 19^th century, socialists and neoliberals of all stripes approvingly cited Smith’s Wealth of Nations.

Smith was not held in much favor by classical economists, though that has changed. Who can forget Margaret Thatcher moaning that she could not win the hearts and minds of Scotland, “‘home of the very same Scottish Enlightenment which produced Adam Smith, the greatest exponent of free enterprise economics till Hayek and Friedman.” Yet only a few years later Gordon Brown (a Scot and English Prime Minister) offered up a speech in which he claimed that Adam Smith (who lived in the region Brown represented in Parliament) would in fact be center-left, were he on the scene today.

You, David, are seemingly part of a coterie described by Neil Davidson in “The Battle for Adam Smith” in the Scottish Review of Books. (Note: Davidson makes some points I categorically disagree with, but I think he has an excellent handle on the history.)

Finally, there have been attempts, perhaps surprisingly from the radical left, to discern in Smith’s work a model of a ‘real free market’ which has been violated by ‘the global corporate system’. As John McMurty writes, ‘every one of Smith’s classical principles of the free market has been turned into its effective opposite’. This is an attractively counter-intuitive idea, which challenges the neoliberals on their own terms. Other writers, like the late Giovanni Arrighi have gone further and argued, not only that the market system envisaged by Smith can be distinguished from capitalism, but that ‘market-based growth’ distinct from ‘capitalist growth’ is now embedded in Chinese or perhaps East Asian development more generally.

[Sidebar: American readers may be puzzled to learn that neoliberalism is a label for “economic liberalism which advocates under classical economic theory support for economic liberalization, privatization, free-trade trauma, open markets, deregulation, and reductions in government spending in order to enhance the role of the private sector of the economy.” Who knew that the large fraction of my readers who consider themselves conservative thinkers are actually neoliberals? Sadly, the word is now generally used pejoratively by the left. Personally, I think it is more fun to think of oneself as a neoliberal than as an Austrian.]

On the other hand, conservative British Parliament members of the Whig Party were castigated by one observer for superstitiously worshipping Smith. And certainly, (conservative) neoliberal thinkers have quoted Smith appreciatively.

Thus, it turns out that Smith can be read in many different ways. “A man hears what he wants to hear and disregards the rest.” Let’s take a look at some context.

In Book 1 of The Wealth of Nations, Smith noted that the division of labor was changing the character of commercial society. In his classic analysis of the manufacturing of pins (probably from French sources), he wrote about the amazing productivity possible when different aspects of the manufactory process were divided among artisans (laborers). (He decided there were 18 different processes involved, although current scholarship would suggest there were as few as nine, but his point is still made.) He saw the same dynamic at work in a variety of industries, and he approved. He really did not like the feudal system and “overlords” (rentiers) who benefited from association with the king and other authorities, living on “rents” for which they performed no useful work. He valued productive activity far more than anything else, apparently.

I think it will be useful here to pull a few paragraphs from Book 1 of Wealth of Nations. (Interested readers can find the whole book for free at The Library of Economics and Liberty.)

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. 

One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving, the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. 

I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. 

There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. 

But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

In every other art and manufacture, the effects of the division of labour are similar to what they are in this very trifling one; though, in many of them, the labour can neither be so much subdivided, nor reduced to so great a simplicity of operation. The division of labour, however, so far as it can be introduced, occasions, in every art, a proportionable increase of the productive powers of labour. 

The separation of different trades and employments from one another seems to have taken place in consequence of this advantage.

But that classic observation and explanation of productivity gains from the division of labor and free markets is a long way from the laissez-faire capitalism of Hayek and Friedman.

Let’s return to Neil Davidson:

Anachronistic misconceptions concerning his work could of course be corrected by the radical expedient of actually reading The Wealth of Nations and The Theory of Moral Sentiments, preferably after situating them in their historical context, namely Scotland’s emergence from feudalism. When Smith attacked unproductive labour, he was not making some timeless critique of state employees, but thinking quite specifically about Highland clan retainers. When he opposed monopolies, he was not issuing a prophetic warning against the nationalisation of industries in the twentieth century, but criticising those companies which relied for their market position on the possession of exclusive royal charters in the eighteenth. Above all, unlike his modern epigones, he did not see the market as a quasi–mystical institution that should be made to penetrate every aspect of social life; but rather as a limited mechanism for liberating humanity’s economic potential from feudal and absolutist stagnation.

We have to remember that Adam Smith was writing The Wealth of Nations in 1776 – prior to Watt and the steam engine. The Industrial Revolution was in its infancy. The pin manufacturing process described in Smith’s Book 1 produced about 5000 pens a day for each laborer’s work. By 1820 there were 11 pin factories in Gloucester alone, yet 119 years later (in 1939) there were only 12 in all of England.

By the late 1970s there were only two. But the productivity of the manufacturing process had grown to 800,000 pins per day per person! That is an increase of 160 times. Of course that is using automated and computer-driven machines. Not that I would suggest it, but if you start searching for information on pin manufacturing today, you quickly get bogged down in the intricacies of manufacturing procedures for hundreds of different types of pins, all of which are ridiculously cheap. My guess is that productivity has leapt significantly further in the last few decades.



Smith was troubled by some of the implications that he saw in early manufacturing jobs. Remember when you read the excerpt from Wealth of Nations below that this is from one of the leading lights of what was called the Scottish Enlightenment. If someone were to say those things today, we would question his enlightenment. Just saying. Back to Davidson (emphasis mine):

Even so, the advocacy of Smith and his colleagues for what they called ‘commercial society’ was very conditional indeed. He intuited, long before capitalist industrialisation began in earnest, that it would lead to massive deterioration in the condition of labourers and their reduction to mere ‘hands’. Understood in the context of the Scottish Enlightenment conception of human potential, the description of pin manufacture at the beginning of The Wealth of Nations, reproduced from 2007 on £20 banknotes, not only celebrates the efficiency of the division of labour, but also shows the soul-destroying repetition that awaited the new class of wage labourers. In Book V, in contrast to the more frequently cited Book I, Smith explicitly considered the way in which the division of labour, while increasing the productivity of the labourers, did so by narrowing their intellectual horizons:

The man whose whole life is spent in performing a few simple operations, of which the effects, too, are perhaps always the same, or very nearly the same, has no occasion to assert his understanding, or to exercise his invention, in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become. The torpor of his mind renders him not only incapable of relishing or bearing a part in any rational conversation, but of conceiving any generous, noble, or tender sentiment, and consequently of forming any just judgment concerning many even of the ordinary duties of private life. Of the great and extensive interests of his country he is altogether incapable of judging; and unless very particular pains have been taken to render him otherwise, he is equally incapable of defending his country in war.… His dexterity at his own particular trade seems, in this manner, to be acquired at the expense of his intellectual, social, and martial virtues.

Smith contrasts this unhappy state of affairs with that existing under earlier modes of subsistence – modes which, remember, he was committed to transcending:

It is otherwise in the barbarous societies, as they are commonly called, of hunters, of shepherds, and even of husbandmen in that rude state of husbandry that precedes the improvement of manufactures, and the extension of foreign commerce. In such societies, the varied occupations of every man oblige every man to exert his capacity, and to invent expedients for removing difficulties which are continually occurring. Invention is kept alive, and the mind is not suffered to fall into that drowsy stupidity, which, in a civilized society, seems to benumb the understanding of the people.... Every man, too, is in some measure a statesman, and can form judgments concerning the interest of the society, and the conduct of those who govern it.

I have a fantasy about bringing Adam Smith into the world of 2014. I think he would be overwhelmed, totally fascinated, and at times horrified to see what his intellectual children have done in the last 238 years. But what he would also see is the massive improvement in the standard of living for even those we consider to be poor, at least in the developed world. Overall, he would have to be pleased.

Yet, to show him pictures of the factories that have developed over the centuries or to take him to some of the manufacturing companies in Asia, where thousands of workers sit on benches doing the same thing day after day after day, would disturb him. And yet, there are lines of workers waiting to take those jobs.

[As an aside, David, one of my great hopes for robotics and automation (which I think was apparent in last week’s Outside the Box) is that they will help relieve humanity of mind-numbingly repetitive work and allow us to explore more interesting, life-fulfilling options. Granted, that means we have to figure out how to allow people to make a living in the process. But the transformation of technology in any particular field has always been a rather messy business in regards to labor. Going from an agrarian society to where, in the US, only 1% work in agriculture today (yet feed much of the world) was tumultuous and at times violent. Change is not easy.

It appears that the new generation of robots is allowing companies in the US (and the rest of the developed world) to be far more competitive and is actually increasing the number of jobs in the US as manufacturing is brought back here. While that trend is good for our workers, it means workers somewhere else are being squeezed. But back to our original theme.]

Adam Smith, Revolutionary

I agree with Milton Friedman in the essay he presented at the Adam Smith Institute on its bicentennial in St. Andrews:

Adam Smith was a radical and revolutionary in his time – just as those of us who today preach laissez faire are in our time. He was no apologist for merchants and manufacturers, or more generally other special interests, but regarded them as the great obstacles to laissez faire – just as we do today.

Friedman went on to note that contemporary free-marketers would have to extend their categories of special interests, broadening “the tribes of monopolists to include not only enterprises protected from competition but also trade unions, school teachers, welfare recipients, and so on and on.”

Let’s move on to your point about the depredations of crony capitalism and the use of government to create special opportunities for profit not available to ordinary citizens as one of the main sources of headwinds to growth (Will get back to your critique of supply-side economics. What you called the Olde Enemie.) I think one of the primary roles of government should be to create a level playing field. I think we can agree on this. And we can find further agreement in examining the original thinking of Adam Smith in its historical context, rather than in trying to apply it to the current structure of capitalism.

Sadly, politics as it operates today is the art of employing highly paid lobbyists and other insiders to get governments to enact laws that you favor. We can’t entirely get away from that system (as some of my libertarian anarchist friends would like to do), as we do need a government that will provide and enforce rules and regulations so that the playing field can remain level. But special benefits are not part of a level playing field.

You focus on what I like to call crony capitalism. That is just one aspect of your critique, but let’s deal with it first.

One simplistic way to subvert cronyism would be to lower the corporate tax rate to something like 15%, making the US as competitive as any nation in the world, but at the same time eliminate all of the 3000-odd tax benefits doled out to various corporations. When you and I personally pay more in income taxes than General Electric, something is seriously wrong. Start the corporate tax at $100,000. The form is a postcard. How much your corporation makes minus $100,000 times 15% is your tax. Income generated outside of the United States is taxed at 10%. End of story.  I understand that 15% might seem low to most people, but it would dramatically increase the amount of taxes that we actually collect.

Whoever is the next president should direct (in concert with Congress) the various federal departments to take another look at rules that favor one company or group over another and figure out how to eliminate them. That is not just corporations. I agree with Friedman: include trade unions and other associations. Get rid of the barriers of entry to industries and jobs. Credentials are all well and fine, but not barriers to entry.
(I would also restructure the personal income tax code in such a way as to eliminate almost all deductions, but that is an argument for another letter.)

Next week I’ll deal with your confusion about the roles of supply-side economics and Keynesianism in steering the economy. This is actually a very important topic, as it relates to the current economic discussion about secular stagnation (to which a passing reference in the robotics letter probably caught your attention). You are confusing correlation with causation.

What to do about economic growth is perhaps the single most important question of our time, as the demographics of the developed world are shifting in such a way is that we will simply not have enough money for us all to be able to retire in the style to which we have been accustomed by our governments. An extra 1-2% of growth per year, however, can cover a multitude of structural secular sins. Just as true stagnation would transform even minor sins into those worthy of capital punishment.
As Dr. Woody Brock frequently notes, growth is a choice. And most of the choices that drive growth or hobble it have nothing to do with monetary policy. Monetary policy is just one part of the equation. The banter today about structural secular stagnation is more about making excuses for the failure of theoretical positions than it is about how to actually apply the mechanisms that would allow the “invisible hand” of Adam Smith to produce growth.

And, in this, Adam Smith is 100% relevant: “To found a great empire for the sole purpose of raising up a people of customers may at first sight appear a project fit only for a nation of shopkeepers. It is, however, a project altogether unfit for a nation of shopkeepers; but extremely fit for a nation whose government is influenced by shopkeepers.”

By “raising up a people of customers” Smith means that focusing on overall economic growth and specifically on the growth of the income of individuals should be at the forefront of the social project. A government that does not allow for increases in productivity and thus an improvement in lifestyles will not be one in which the citizens are happy.

We’ll close with that thought for now, but let me offer a precursor to next week, from a recent essay by Woody:

1. Northern Europe Pre- and Post-Industrial Revolution circa 1700-1850: The growth in productivity is estimated to have been zero, on average, in the period 1000 BC to 1700 AD. Productivity growth did not increase, nor did living standards, nor did life expectancy. This continued to be the case worldwide after 1700, except in Northwestern Europe where the Dutch Republic and England (after its Glorious Revolution of 1688) adopted new policies including patent protection, the rule of law, respect of property rights, and so forth. Nations that did not follow suit stagnated.

2. China Pre- and Post-1979: Growth during the Cultural Revolution was negative. It then exploded to over 10% for twenty years. Why this reversal? It was largely because entrepreneurial behavior was de‐criminalized. Recall Premier Deng’s legendary mandate, “It is now glorious to go get rich.” Additionally, the government adopted a massive infrastructure plan that represented productive investment spending in contrast to the unproductive spending that occurred during 2008-2012 (“see-through cities”).

San Antonio, Washington DC, NYC(?), and Training Day

I have been enjoying my time at home these last few weeks. Right now I am scheduled to be nowhere else until I head to San Antonio for the Casey Research Summit September 19-21. My next trip after that falls at the end of the month, when I head to Washington DC for a private conference and a few meetings. That is all that is on my schedule for the next 60 days, and then it gets a little busy. I can’t recall having this much time at home for a decade or two, at least.

Bill Dunkelberg, the chief economist for the National Federation of Independent Business, came to see me last week, and we spent the day trying to decide whether to write a book about the future of work. It is a complicated project, but it is part and parcel of the theme we discussed today, which is economic growth and the division of labor. If the work landscape shifts under the feet of an increasingly large number of people as their jobs are automated, then that means we have to help people transition. And better yet, train them in disciplines that have very little chance of being automated in the next 30 or 40 years.

From the perspective of the Long View, our education system is completely broken. We are not training our children to deal with the future, and we are not helping people transition into sustainable independence. Our welfare and disability rolls are growing faster than new jobs are being generated. Dunk and I are trying to come up with an outline and research topics over the next few weeks, just to see if we even think we have the capability to write on the topic. I’ll let you know.

One of the benefits of being home is the opportunity to get to the gym on a regular schedule. I can feel and see the results. Plus, it is easier to adhere to a stricter diet plan (basically shunning all extraneous carbs), and that is helping, too. It seems strange to me, but I will be turning 65 in another month (on October 4). My goal is to be able to do 65 push ups and to be close to my target ideal weight by then. I am getting into the gym nearly every day and trying to schedule a trainer for six days out of seven each week. Some part of my body is sore pretty much all the time; the trainer just makes sure it’s a different part every day. Getting out of shape was just not a good idea.

I was having lunch today with some of my kids and was surprised to learn the Labor Day is next weekend. Where has the summer gone? And speaking of summer vacation, I note that Senator Rand Paul spent some time in Guatemala performing eye surgeries. I read that he also visited with some patients he treated there 15 years ago. Journalists and political commentators are always talking about optics. Sen. Paul is doing something about optics in a tangible way. His patients will be able to line up a putt with their own eyes. Optics indeed.

I smile at the small irony that I will be writing about growth and labor productivity next week, on Labor Day weekend. I didn’t plan it that way, but it does make it more fun. Have a great week.
Your trying to increase his personal productivity analyst,

John Mauldin

The article Thoughts from the Frontline: A Nation of Shopkeepers was originally published at Mauldin Economics

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Are the Arsonists Running the Fire Brigade?

By John Mauldin

The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake.

– Alan Greenspan

If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.

– John Maynard Keynes

And He spoke a parable to them: "Can the blind lead the blind? Will they not both fall into the ditch?"

– Luke 6:39-40

Six years ago I hosted my first Thanksgiving in a Dallas high rise, and my then 90 year old mother came to celebrate, along with about 25 other family members and friends. We were ensconced in the 21^st floor penthouse, carousing merrily, when the fire alarms went off and fire trucks began to descend on the building. There was indeed a fire, and we had to carry my poor mother down 21 flights of stairs through smoke and chaos as the firemen rushed to put out the fire. So much for the advanced fire sprinkler system, which failed to work correctly.

I wrote one of my better letters that week, called "The Financial Fire Trucks Are Gathering." You can read all about it here, if you like. I led off by forming an analogy to my Thanksgiving Day experience:

I rather think the stock market is acting like we did at dinner. When the alarms go off, we note that we have heard them several times over the past few months, and there has never been a real fire. Sure, we had a credit crisis in August, but the Fed came to the rescue. Yes, the subprime market is nonexistent. And the housing market is in free-fall. But the economy is weathering the various crises quite well. Wasn't GDP at an almost inexplicably high 4.9% last quarter, when we were in the middle of the credit crisis? And Abu Dhabi injects $7.5 billion in capital into Citigroup, setting the market's mind at ease. All is well. So party on like it's 1999.

However, I think when we look out the window from the lofty market heights, we see a few fire trucks starting to gather, and those sirens are telling us that more are on the way. There is smoke coming from the building. Attention must be paid.

I was wrong when I took the (decidedly contrarian) position that we were in for a mild recession. It turned out to be much worse than even I thought it would be, though I had the direction right. Sadly, it usually turns out that I have been overly optimistic.

This year we again brought my now-96-year-old mother to my new, not-quite-finished high-rise apartment to share Thanksgiving with 60 people; only this time we had to contract with a private ambulance, as she is, sadly, bedridden, although mentally still with us. And I couldn't help pondering, do we now have an economy and a market that must be totally taken care of by an ever-watchful central bank, which can no longer move on its own?

I am becoming increasingly exercised that the new direction of the US Federal Reserve, which is shaping up as "extended forward rate guidance" of a zero-interest-rate policy (ZIRP) through 2017, is going to have significant unintended consequences. My London partner, Niels Jensen, reminded me in his November client letter that,

In his masterpiece The General Theory of Employment, Interest and Money, John Maynard Keynes referred to what he called the "euthanasia of the rentier". Keynes argued that interest rates should be lowered to the point where it secures full employment (through an increase in investments). At the same time he recognized that such a policy would probably destroy the livelihoods of those who lived off of their investment income, hence the expression. Published in 1936, little did he know that his book referred to the implications of a policy which, three quarters of a century later, would be on everybody's lips. Welcome to QE.

It is this neo-Keynesian fetish that low interest rates can somehow spur consumer spending and increase employment and should thus be promoted even at the expense of savers and retirees that is at the heart of today's central banking policies. The counterproductive fact that savers and retirees have less to spend and therefore less propensity to consume seems to be lost in the equation. It is financial repression of the most serious variety, done in the name of the greater good; and it is hurting those who played by the rules, working and saving all their lives, only to see the goal posts moved as the game nears its end.

Central banks around the world have engineered multiple bubbles over the last few decades, only to protest innocence and ask for further regulatory authority and more freedom to perform untested operations on our economic body without benefit of anesthesia. Their justifications are theoretical in nature, derived from limited variable models that are supposed to somehow predict the behavior of a massively variable economy. The fact that their models have been stunningly wrong for decades seems to not diminish the vigor with which central bankers attempt to micromanage the economy.

The destruction of future returns of pension funds is evident and will require massive restructuring by both beneficiaries and taxpayers. People who have made retirement plans based on past return assumptions will not be happy. Does anyone truly understand the implications of making the world's reserve currency a carry-trade currency for an extended period of time? I can see how this is good for bankers and the financial industry, and any intelligent investor will try to take advantage of it; but dear gods, the distortions in the economic landscape are mind-boggling. We can only hope there will be a net benefit, but we have no true way of knowing, and the track records of those in the driver's seats are decidedly discouraging.

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A Monetary Master Explains Inflation

By Terry Coxon, Senior Economist

One of the best things about being a partner in a research firm employing about 40 analysts is that I have unfettered access to really smart people. While we have a great team with expertise across the spectrum, when it comes to monetary matters, my go to guy is Terry Coxon, a senior editor for our flagship publication, The Casey Report.


Terry cut his teeth working side by side for years with the late Harry Browne, the economist and prolific author of a number of groundbreaking books, including the 1970 classic, How You Can Profit from the Coming Devaluation. The timing of Harry's book should catch your eye, because his analysis that the dollar was headed for a big fall was spot on. Anyone paying attention made a lot of money.

As coeditors of Harry Browne's Special Reports, Terry and Harry made a formidable team for over 23 years. During this period, the two deeply researched the operating levers of the global economy, with a focus on the nature of money and impact of monetary policy. They also looked for ways to apply what they learned about macroeconomics into practical investment strategies, coauthoring Inflation-Proofing Your Investments. On his own, Terry wrote Keep What You Earn and Using Warrants.

Putting his expertise into action, Terry founded, and for 22 years served as the president of, the Permanent Portfolio Fund, one of the top performing funds in history.

Having Terry on the Casey Research team as a senior economist has been a huge personal boon. By the time you finish reading my brief interview with him, I suspect you'll understand why.......David Galland

David: Let's start by defining terms. What exactly is inflation? Most people view inflation as a noticeable increase in the prices of everyday things. How do you define inflation?

Terry: The original use of the term in financial matters referred to money, not to prices. It meant an increase in the total amount of money held by the public. Such a monetary inflation can be engineered by government printing or, under a gold standard, by increasing the official price of gold, as in 1933.

Monetary inflation can also be engineered by inventing a new category of legal tender, as in the case of the silver dollars minted in the 19^th century. And inflation of the money supply can happen without government tinkering, such as through the discovery and development of new gold deposits (as in the cases of the California and Klondike gold rushes), or through decisions by commercial banks to operate with thinner cash reserves in order to issue more deposits.

Today "inflation" usually refers to price inflation, which is a rise in the general level of consumer prices. That second use grew out of the public's experience of episodes of monetary inflation being followed by periods of rising prices.

Notice that with either use of the word, there is a little mushiness. During some periods, depending on what you include as "money," you may find either an increase or a decrease in the supply of the stuff. Suppose that the supply of hand-to-hand currency goes up while the quantity of bank deposits goes down by a larger amount. Is that monetary inflation or monetary deflation? And what exactly does an increase in the "general level of consumer prices" mean? There's more than one way to define an index of prices, and there are many ways to tinker with it.

David: In your view, have the US government and the Fed been following an inflationary policy?

Terry: Yes. Since the Lehman swoon in 2008, the M1 money supply (hand to hand currency plus checkable bank deposits) has increased by 72%, so the policy is clearly one of monetary inflation. And the Fed is avowedly committed to avoiding price deflation at all costs. They'll do whatever it takes to prevent price deflation, up to and including sacrificing virgins. That deflation phobia is necessarily a commitment to price inflation, and Mr. Bernanke has indicated that consumer prices rising at a rate of 2% per year would be ideal. So either way you define inflation, the Fed is all for it.

David: Based upon your studies, just how extreme or extraordinary has inflation been since the beginning of this financial crisis?

Terry: A 72% growth in the money supply over a period of five-plus years is a gigantic increase. Take a look at the chart. It shows the annual growth rate in M1 over all five year periods from 1959 to the present (dates on the chart indicate the end of a five-year period). As you can see, the only episode of monetary inflation that comes close to what is happening now is the money printing spree of the high price inflation 1970s and early 1980s.

David: How certain are you that the monetary inflation here in the US is going to ultimately manifest as price inflation?

Terry: You're asking for a lot when you say "certain", certainly more than you're going to get from me. But here's why price inflation seems inevitable. The Federal Reserve can easily create more money. There's no limit to that power, as they've already demonstrated. At any hint of deflation, they will produce more cash. They can never know how much new cash would be enough, but because they see deflation as a vastly more serious problem than price inflation, they always will err on the side of too much new money. That attitude is a guarantee of price inflation.

David: When price inflation begins, how significant do you think it will be? A little inflation? A lot? Hyperinflation?

Terry: Mr. Bernanke will get to visit his ideal world of 2% price inflation, but it will only be a whistle stop. The price inflation that lies ahead will be at least as bad as what happened in the 1970s episode, when the annual inflation rate approached 15%. The money that's already been printed so far may be enough to produce such a 1970s size problem. And more new dollars are coming, because the Fed won't stop printing until price inflation becomes obvious.

Making matters worse is that the devices for paring down the amount of cash that you need for the sake of convenience, such as credit cards, ATMs, and online banks, are now far more widely available and cheaper to use than they were in the 1970s. When price inflation becomes noticeable, people will turn more and more to those devices to reduce their holdings of value leaking cash. That drop in the demand for money will reinforce the price inflation that originated in the Federal Reserve's increase in the supply of money.

David: I know it can only be a wild guess, but based on your observations, how long do you think it will take for price inflation to become obvious?

Terry: Within twelve months after you hear that the economy has at last fully recovered from the recession.

David: What is the biggest flaw with the deflation argument?

Terry: Whatever process someone might have in mind as a driver of price deflation, no matter how powerful that process might be, the Federal Reserve has the power and the will to carpet bomb it with more new money. What the deflationists overlook is that if deflation ever seems to be winning, the Fed will simply extend the game for as many innings as it takes for inflation to win. In a fiat-money system, inflation always gets another chance.

David: What would make you change your view that price inflation is inevitable?

Terry: Brain surgery.

A time tested way of protecting wealth is to move it out of one's native currency and into a location that's more economically sound. But is that even possible for US citizens these days? If so, what are the best places to explore for moving wealth offshore, and how is that best accomplished? Should you and your family follow your money and expatriate your home country?

All these questions, and many more, are answered in a new, free report by legendary speculator Doug Casey. Titled Getting Out of Dodge, it offers specific, actionable advice for moving your wealth and your life safely offshore. Get started while you still can: governments around the world are beginning to tighten their nooses.


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Bloomberg: Crude Oil Rises as Reports Show Improved U.S. Economic Outlook

Crude oil climbed in New York after reports showed improvement in the U.S. economy, raising investor expectation fuel demand will increase. Futures retraced some of yesterday’s 2.4 percent decline as Asian equity markets gained following data showing jobless claims fell in the world’s largest economy. The New York based Conference Board’s index of leading economic indicators climbed 0.3 percent, matching the forecast of economists surveyed by Bloomberg News.

“For the short term, the positive economic indicators should support the prices,” said Tetsu Emori, a commodity fund manager at Astmax Ltd. in Tokyo. “Fundamentals aren’t what people are looking at for the market but currencies and financial market conditions.” The December contract added as much as 60 cents, or 0.7 percent, to $81.16 a barrel in electronic trading on the New York Mercantile Exchange, and was at $81.05 at 11:55 a.m. Singapore time. Yesterday it lost $1.98 to $80.56. The contract has fallen 1 percent this week.

Oil also rose as Labor Department figures yesterday showed U.S. initial jobless claims dropped by 23,000 to 452,000 in the week ended Oct. 15. Chinese crude production gained 9 percent in September, the National Bureau of Statistics said Oct. 21. Oil refining reached 8.5 million barrels a day last month, China Mainland Marketing Research Co. said......Read the entire article.



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Crude Oil Falls the Most in a Week as Equities Decline, Dollar Strengthens

Crude Oil fell the most in more than a week as global equities declined and the dollar advanced on skepticism European governments will approve the Greek bailout plan quickly enough to help the country avoid default. Oil lost 1.4 percent after Greece’s largest union said it will stage a strike for a day next month and Germany’s Chancellor Angela Merkel said yesterday that Greece “must do its homework” to reduce its deficit. A stronger dollar reduces the appeal of commodities as an alternative investment.

“Oil is lower because global equities are weaker and the dollar’s stronger,” said Addison Armstrong, director of market research at Tradition Energy, a Stamford, Connecticut-based procurement adviser. Crude oil for June delivery dropped 78 cents, or 0.9 percent, to $83.42 a barrel at 10:13 a.m. on the New York Mercantile Exchange. Earlier, it touched $83.06 a barrel. Prices have risen 66 percent in the past year.
The U.S. dollar rose to $1.3306 per euro from $1.3383 in New York yesterday. The Standard & Poor’s 500 Index dropped 0.4 percent to 1,207.60.

Oil and equities pared their losses after the Conference Board reported confidence among U.S. consumers increased in April to the highest level since September 2008 as Americans became more upbeat about the labor market. The Conference Board’s confidence index rose more than forecast to 57.9 from 52.3 in March, according to the New York- based private research group. The median forecast of economists surveyed by Bloomberg News projected an increase to 53.5.....Read the entire article.

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Crude Oil Falls After U.S. Payrolls Unexpectedly Decline

Crude oil fell after U.S. payrolls unexpectedly declined last month, spurring concern that the economy and fuel demand will be slow to recover. Oil slipped as much as 1 percent after the Labor Department reported that the world’s biggest energy-consuming country lost 85,000 jobs in December. Futures climbed to a 14-month high this week as temperatures dropped in the Northern Hemisphere, U.S. crude-oil supplies rose and the dollar weakened, bolstering the appeal of commodities to investors. “These numbers increase skepticism about the recovery,” said Michael Fitzpatrick, vice president of energy with MF Global in New York. “There’s no rational reason for prices to be at these levels. We’ll probably soon see a good-sized setback in prices.”

Crude oil for February delivery fell 50 cents, or 0.6 percent, to $82.16 a barrel at 9:44 a.m. on the New York Mercantile Exchange. Futures are up 3.5 percent this week after touching $83.52 on Jan. 6, the highest level since Oct. 14, 2008. Payrolls were forecast to be unchanged, according to the median estimate of 76 economists surveyed by Bloomberg News. “Today’s unemployment number underscores that any recovery in payrolls will be slow,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts. “The recent rally was, in part, built on a much rosier outlook for the economy than these numbers paint. This will probably cool things off”.....Read the entire article.

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