It was also clear that Bernanke and Paulson are fundamentally stumbling around in the dark, being purely reactive, and focusing on making things "go back to the way they were." Even though the "way things were" was suboptimal.
A moment now to talk about money supply and inflation.
Suppose an economy has a money supply of X. Suppose it also has a supply of real goods and services, Y.
If X increases by 10%, and Y increases by 10%, there should be no change in aggregate price indices since you have (proportionally) the same amount of money, chasing the same amount of goods and services. Note that anyone saving money in X has been diluted by this 10% increase in X. I used to think that a perfect, globally balanced basket of currencies would be perfectly hedged against inflation but I was wrong -- it does not protect you from dilution.
Alternatively, suppose X increases by 20%, and the supply of real goods and services increases by only 10%. Here you have dilution as before, and you will also have rising prices show up in the CPI, and thus be termed "inflation" by economists and the press.
The fall in real estate prices and other asset classes has shrunk X. The supply of real goods and services has contracted also, but not as much. So, X has decreased more than Y has decreased. This is why we are in deflation and the economy is also shrinking.
The Government is printing a huge amount of money and giving it to financial institutions. They may also start giving it to automakers. Since both industries are a net destroyer of value, this means that the increase in X will not be met by a concomitant increase in Y. If they "stimulate" too much, then X > Y and we'll get inflation. Maybe a lot. If they "stimulate" too little, then money supply will continue to fall, and we will stay deflationary. If they "stimulate" just right, then any increase in X will be met by an increase in Y, and we won't see a change in prices, but the supply of goods and services will increase.
Please note that all of these scenarios will result in "dilution" and punish anyone holding dollar bills. The Press and economists seem to think that China's current account surplus with the US means that China is in a better position than the US, but they've been exporting real, useful good and services in exchange for paper. I know which I would rather have.
Also, please note that the majority of Government actions to date have focused on supporting particular industries, which guarantees that in the increase in money supply will exceed the increase in real good and services. State owned enterprises that continually hemorrhage money (AIG, Fannie, Freddie, GM, Ford, Chrysler, Citi, Goldman, JP Morgan, AMEX etc.) are inflationary in that the money they get from the Government goes into general circulation, increasing supply, while the goods and services they produce are not commensurate to that increase in supply. This will be dilutive and inflationary (X increases, and the increase in X is greater than the increase in Y).
The next Great Recession is in the making. The money supply trends say so. And it is looking more and more like this next Greater Recession is going to be one for the ages…
The money supply, as measured by THE CONTRARIAN TAKE‘s broad (and preferred) TMS2 metric (TMS for True “Austrian” Money Supply), posted a 14.6% year-over-year increase in February, making this the 39th consecutive month of double digit year-over-year rates of monetary inflation. All told, TMS2 is up a huge 50% over those 39 months. Even more interesting is what those TMS2 metrics were leading up to the housing boom turn credit bust turn Great Recession – 37 consecutive months for a cumulative increase of 50%.
Here’s a look at the monetary record through a TMS lens beginning year 2000…
Although, it is hard to assess the exact time the next collapse will come, I don’t think it will be like 2-3 years into the future. Crystal ball reading is always difficult. But the fundamental economic reasons behind an economic collapse is seldom in doubt. In this most excellent article by Egon von Greyerz of Matterhorn Asset Management, he does a lucid job in explaining what I see also. We are in agreement over global monetary collapse driven by the USD collapse, economic collapse and the price of gold will rocket!
The autumn of 2009 will be full of shocking surprises in the banking sector, in financial markets and in the world economy. The events that we outlined in our previous newsletter, “The Dark Years Are Here” are going to start unfolding. There will also be shocking falls in stockmarkets, in the dollar and in bond markets. But these falls will create major opportunities for investors which we will also discuss.
The syndrome of hope and false expectations
Some readers might feel that we are prophets of doom and that there is only gloomy news coming out of Matterhorn Asset Management. For people who want only good news we suggest that you listen to politicians or read the newspapers or your average stockbroker’s forecast. This is where you find the good news. But if you do listen to these people, remember that virtually nobody warned you about the events in the last couple of years, and that today most of these people are saying that the worst is over. And this is also what stockmarkets are telling us, isn’t it? These “optimists” whether they are politicians, bankers or from the media all make their living based on good news and this is why they will continually tell you lies and never warn you about the risks.
Investments are all about managing risk and our responsibility is to understand risk and warn investors when risk is unacceptably high. We have done this for many years and we will continue to do it. Sadly most investors base their investment decisions on hope. When government, private and corporate debt explodes the risk to the economy becomes very high. And when bank credit is growing exponentially and bank leverage is 50 times or more, this is very high risk. When derivatives reach $ 1 quadrillion with virtually no reserves against this astronomical exposure then investors should run for cover.
… In the next few years the leverage will hit back with a vengeance and the deleveraging of asset bubbles and credit bubbles will have a devastating effect on the world economy. This is will lead to a massive deflation of assets and credit. Governments will continue to print money at an accelerating rate. Eventually the money printing will lead to a collapsing currency creating hyperinflation in many countries and especially the US and the UK. But even with hyperinflation many assets such as real estate and stocks will decline in real terms.
Governments living in cloud cuckoo land
Never before have governments in the world expanded deficits and credit to the extent that we are seeing now. In 2009-10 government budget deficits will be at least $5.5 trillion. This amount needs to be raised by all the countries running deficits. The US, of course, has the biggest black hole and will need at least $3 trillion during this period. But these sums, which are unlikely to be sufficient, are just budget deficits and do not take into account the likely rescues of banks, other financial institutions, corporate failures, pension funds, insurance companies, cities, states, local government etc.
The US has lent or committed $13 trillion to prop up its collapsing financial system and economy. Virtually none of these funds have been written off yet and there will be a lot more to come in the next couple of years. It is still our view that the total cost to the US alone of the current crisis will be at least $25-30 trillion.
And where is the money coming from? …. Governments believe that they have found an unlimited source to prosperity. … Especially the US and UK governments, being the biggest culprits, believe that they can manufacture endless amounts of money and that this will create eternal wealth for their economies.
How do they do it? Governments use fancy terms like Quantitative Easing in order to confuse the people. In simple terms it means borrowing money that doesn’t exist or just printing money. To borrow money that doesn’t exist must be fraudulent and both against the law and the constitution. Yes of course the government is breaking the law and the constitution. But not only that , they are actually stealing money from the people, money that the people doesn’t have, but that they will have to work for generations to pay off.
But governments are not just creating money out of thin air. They are also looking after their affairs better than any other group in the economy. The only net increase in jobs in the last few years has been in the government sector, both in the US and the UK. Whilst the rest of the economy is suffering and cutting down, government is adding hundreds of thousands of jobs. Also pay and pensions in government jobs are superior to the private sector. So the main growth sector in the economy in the last few years has been the government sector that produces nothing but consumes 50% of GDP. No wonder we are all in trouble.
Government spending has gone from 10% of GDP in 1932 to almost 50% in 2008
Even more intriguing is of course that the financial institutions that caused the crisis, mainly through greed, are the ones that benefited from the bubbles they helped to create. They are also the beneficiaries of the trillions of dollars that governments have printed to rescue the system. This is like giving somebody who has robbed a bank the reward money.
This is Robin Hood in reverse, with governments robbing from the poor in order to reward the rich for their misdeeds. The poor, who are likely to get much poorer in the next few years, are unlikely to accept their fate without a fight. With the next stage in the downturn, due to start in the autumn, social unrest will grow and it could easily get out of hand in the next 2-3 years.
US Dollar UK Pound (and many other currencies) will have major falls
Both the US and UK governments have for years printed their currencies. From 2007 when the current crisis started the printing of dollars and pounds have accelerated. In the case of the US dollar we are looking at trillions of new dollars. So when money is created which has only air behind it and no assets or substance, is this money not worthless? Yes of course it is but because governments and financial institutions worldwide have benefited from a strongish dollar, no one has said that the emperor is naked although everyone know he is.
Supporting the dollar has also benefited the Chinese who have built up their own industrial base by financing the US deficits and excesses. But the Chinese with over $ 2 trillion in reserves of which as much as 2/3 could be in US dollars have now said in their veiled but very clear language: “The Emperor has no clothes”. The Chinese have now told the US to clean up their act but the Chinese know and the Americans know that their is no chance whatsoever that the US can reduce their deficits and dollar printing.
Therefore the dollar is living on borrowed time and as we outlined in last month’s newsletter “The Dark Years Are Here”, the autumn of 2009 will see a precipitous fall of the dollar. It will be relentless and greater than anyone can imagine. There is always a day of reckoning when the law of supply and demand is out of kilter and that day is now here. The move will be unexpected by many and this will mean that everyone will run for the exit and dump their dollars thus exacerbating the fall.
The situation for the pound is not much better due to the dire straits of the UK economy. The pound may not fall as much as the dollar and probably not at exactly the same time. Normally a currency is attacked one at a time so we might first see the dollar moving and then the pound. But the pound has started to move down against the Euro and Swiss Francs in August and it is also possible that it will fall with the dollar against other currencies.
Gold (and silver) – a spectacular rise
Investors who understand markets, know that if something has a major fall, something else will have a major rise. All you need to do is to turn the chart upside down. The major beneficiary of the dollar fall will be gold (and silver). Gold has all the advantages that the dollar has not:
- Gold can’t be printed
- Gold has no debt attached to it
- Gold has represented real money for 5,000 years whilst no paper currency has ever survived in tact throughout history
- Gold has limited supply – Gold production is declining and demand increasing
- Total annual mine production of gold is only $75 billion per annum which is 0.05% of world financial assets
- Total increase in debt in 2009 in the US alone will probably be in excess of $5 trillion against an increase in gold of $75 billion – a 66 to 1 ratio
- Central banks which have been net sellers are becoming net buyers of gold
- China and Russia are major buyers of gold and only declare increases in holdings with long delays
- Retail demand of gold in China and India is very high – These are nations who understand the virtue of gold as savings
With world debt probably increasing by as much as $7.5 trillion in 2009, there will be at least 100 times more paper money created than new gold produced. It can’t be difficult to forecast which money is likely to appreciate the most in the next few years – paper money with an unlimited supply or real money, GOLD, with very limited supply.
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In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits (depositors' easily accessed assets on the books of financial institutions).
Money supply data are recorded and published, usually by the government or the central bank of the country. Public and private sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.
That relation between money and prices is historically associated with the quantity theory of money. There is strong empirical evidence of a direct relation between long-term price inflation and money-supply growth, at least for rapid increases in the amount of money in the economy. That is, a country such as Zimbabwe which saw rapid increases in its money supply also saw rapid increases in prices (hyperinflation). This is one reason for the reliance on monetary policy as a means of controlling inflation.
This nature of this causal chain is the subject of contention. Some heterodox economists argue that the money supply is endogenous (determined by the workings of the economy, not by the central bank) and that the sources of inflation must be found in the distributional structure of the economy.
In addition, those economists seeing the central bank's control over the money supply as feeble say that there are two weak links between the growth of the money supply and the inflation rate. First, an increase in the money supply, unless trapped in the financial system as excess reserves, can cause a sustained increase in real production instead of inflation in the aftermath of a recession, when many resources are underutilized.
Second, if the velocity of money, i.e., the ratio between nominal GDP and money supply, changes, an increase in the money supply could have either no effect, an exaggerated effect, or an unpredictable effect on the growth of nominal GDP.
The U.S. federal government cannot allow high inflation. With 10% unemployment (really it is more like 17% right now, because they calculate it wrongly to make unemployment seem lower than it really is), workers have no ability to negotiate higher wages to keep up with inflation. Allowing high inflation will cause even fixed rate mortgage holders to default, and will ultimately lead to food riots and worse.
The U.S. money supply has been expanding at an absolutely unprecedented rate. So why are we not experiencing rampant inflation? Why is the U.S. dollar not falling through the floor? Well, the truth is that all of this new money has gotten into the U.S. financial system but it is not getting into the hands of U.S. businesses and consumers. In fact, even though the money supply is exploding, U.S. banks have dramatically decreased lending. This has brought us to a very bizarre financial situation as a nation.
What we have seen is the U.S. government shovel massive amounts of cash into the U.S. financial system and then watch as the big banks sit on that cash and refuse to lend it. The biggest banks in the U.S. reduced their collective small business lending balance by another 1 billion dollars in November 2009. That drop was the seventh monthly decline in a row. In fact, in 2009 as a whole U.S. banks posted their sharpest decline in lending since 1942.
So all of this money that the U.S. government pumped into the financial system has been doing American businesses and consumers very little good. That is why we can have a vastly increased money supply (as you can see from the chart below) and very little inflation.
1. Switching Reserves away from the Dollar.
The US is currently the world's reserve currency. Central banks currently hold upto 90% of their foreign reserves in the dollar. However, as the US economy and finance sector looks very weak, it makes sense for countries to diversify out of the dollar. If countries were to switch from holding reserves in dollars to holding reserves in Yen, Euros or others, it could spark a free fall in the dollar.
There is also the danger of OPEC oil exporting countries shifting out of the dollar or at least not using their oil surpluses to buy US securities. (By the way, markets think this is more likely if Obama wins election)
2. US Debt increasing.
US debt currently stand at $9 tn or 65% of GDP. However, it is forecast to increase substantially Some argue National debt could soon pass 100%. This is because
- Financial bailout for subprime debt. If house prices continue to fall, if mortgage defaults continue to rise; the legacy of toxic debt could leave the US treasury facing unprecedented losses as it tries to bale out the system.
- Long term spending commitments on health care and pension will increase spending. Although, this has gained less publicity, in the long term, it could be more expensive than the current financial bailout. The Ageing population will increase the debt burden.
To finance the growing national debt, the government may also just increase the money supply because they can't sell any more bonds. This would increase the money supply and inflation and also cause a depreciation in the value of the dollar.
3. Credit Crisis - Worst still To Come
The credit crisis and banking losses put downward pressure on the dollar because:
- They are forcing the US government to borrow more.
- Lack of Confidence in US financial markets which affects confidence in the dollar.
For several years, the US has been running a large current account deficit. This peaked at around 6.5% of GDP in 2006 (It has since fallen to 5% on the back of a weaker dollar.) Upto now the current account deficit has been financed by capital flows from abroad (mainly Asia and OPEC countries). If these capital flows were to dry up, as Asian countries no longer wanted to hold dollar securities, the dollar would fall.
5. Economic Recession and Low Interest Rates.
US interest rates are already low - 2%. However, if the economy was pushed into a very deep recession (e.g. growth of -2%) then there may be pressure for further cuts in interest rates. This would make the US even less attractive as a place to save money. Therefore demand for dollar would fall.
Reasons Why Dollar Will not Collapse1. Fall against Whom?
The US economy is facing difficulties. But, so is the Eurozone economy, and Japan. It is not clear that any other country could cope with having a strong currency. US debt is high, but so is European debt. Japanese National debt stands at 195% of GDP, it makes the US look positively, frugal. The point is that although the dollar looks weak, so do most other major currencies.
2. Dollar is already weak.
Using purchasing power parity, the dollar is already undervalued against the Euro and Yen. Europe is already struggling with a high value of the Euro. If the Euro was to keep rising, it would cause further problems as the Euro economy slips into recession. This is why Gold looks such a good investment at the moment.
3. The Chinese don't want to lose All their Dollar Investments.
Because China have so many dollar assets, they have a vested interest in preventing a depreciation in the dollar becoming a rout. Also, China is aware that their economy relies heavily on exports to America. They wouldn't want that source of demand to completely dry up. Therefore China would like to avoid a collapse in the dollar - not out of altruism but self interest.
The American dollar isn't a good investment. The dollar has depreciated by 40% in the last 6 years; and with the ongoing credit crunch affecting America the most, I would anticipate this steady decline to continue into 2009 and 2010.
At the moment, I can't see the dollar collapsing, if only because the US is not the only economy facing real weaknesses. However, there is a real danger US government debt could get out of control and they respond by increasing the money supply, which would devalue the dollar.