Endless Credit-Creation

The Daily Reckoning PRESENTS: The Fed decided to hold rates steady today, pausing for the third consecutive meeting so they can determine the direction of the U.S. economy. But will inflation behave without the Fed heads stepping in? Puru Saxena explores…


The “tight” liquidity conditions prevalent today are being held responsible for the recent sharp declines in commodities and the emerging-markets. The current sentiment seems to be leaning more towards deflation, which is a major shift away from the runaway-inflationary fears present not so long ago.

In my view, not much has really changed, and we are still living in a highly inflationary environment. Although I concede that the rate of inflation (money-supply growth) in the United States has been in decline since 2002; bank credit continues to grow at a record-pace – $4.4 trillion annualized in 2006 compared to $3.3 trillion last year. So, there is no scarcity of money and credit today.

In the past, whenever the central banks were serious about monetary tightening, credit contracted in a meaningful way compared to the previous year. After all, monetary tightening has one prime objective: to curtail the excesses in the economy and capital markets. On this account, the central banks have done a poor job of tightening as credit growth (not captured in the money-supply figures) is still in the stratosphere.

In summary, money-supply growth has contracted somewhat due to rising short-term interest-rates, but this has been largely offset by a surge in bank credit, thereby making the monetary tightening ineffective.

It is critical to understand that monetary inflation is now a global phenomenon and over the long-term, the purchasing power of your savings will be confiscated regardless of the “paper” currency you select. Take a look at the latest money-supply growth-rates around the world:

Australia           + 10.4%

Britain               + 13.7%

Canada             + 6.5%

Denmark           + 7.4%

US                    + 4.9%

Euro zone          + 7.4%

So you can see that despite the supposed monetary “tightening,” over the past year, the supply of money has continued to grow rapidly.

It is interesting to note that the rate of inflation or money-supply growth in the United States peaked in 2002; however, the U.S. public only started to get worried about this problem earlier this year, when inflation was significantly lower than the previous four years. On the other hand, in 2002, when the inflation-rate was extremely high, most people were concerned about deflation! This may seem totally absurd, but it begins to make sense when you realize that most people equate rising prices to inflation and falling prices to deflation.

The majority fail to understand that rising prices are an effect of inflation (money-supply growth) and falling prices are an effect of deflation (money-supply contraction). So, when asset-prices collapsed in 2002 following the NASDAQ-bust, a “deflation scare” emerged, thus giving the Federal Reserve the perfect excuse to inflate as the U.S. inflation rose to a shocking 22%! Back then, as the supply of money (or inflation) soared, its effects (rising asset and commodity prices) only started becoming more visible to the public four years later. This is due to the fact that there is a time lag between inflation (the cause) and rising prices (the effect).

Today, the rate of inflation (money-supply growth) in the United States is relatively subdued, commodity prices have taken a beating, real-estate is cooling-off and a “deflation scare” is emerging yet again. If history is any guide, you can be sure that the response of the central banks will be to accelerate the supply of money and credit to unprecedented levels. I suspect that the next bout of inflation is not far away and when it occurs, the current trough in asset-prices will end, setting the stage for the next advance in asset-prices.

Since the early 1970’s, when gold was removed from the monetary system, we have seen constant inflation around the world. It is interesting to note that the total non-gold international reserves worldwide have grown to US$4.6 trillion today; a shocking 46-fold increase from the 1974 level of US$100 billion!

In the 1970’s, this liquidity found a home in tangible assets (commodities) and in the 1980’s and 1990’s; it rushed into financial assets, pushing stocks and bonds in the developed world to record-highs. Since the start of the millennium, capital has been flowing out of financial assets and rushing (yet again) towards tangibles. Over the coming decade or so, I expect this trend to accelerate, which will cause the prices of precious metals and commodities to rise immensely.


Puru Saxena
for The Daily Reckoning
October 25, 2006

P.S. As investors living amidst an endless supply of paper “money,” we must not underestimate the inflationary powers of the central banks. Back in March 2000, when the tech-bubble burst, I bet against the U.S. stock market, which after 2003 was a painful experience as asset-prices rebounded sharply due to monetary inflation.

So, in the current inflationary environment, I would not advise you to try and profit from falling asset-prices. A better strategy is to utilize the current weakness in asset-prices and take positions in precious metals and commodities where a sound case can be made for a sustainable boom.

Editor’s Note: Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise “Email Updates,” which are sent out when an important development in the capital markets warrants immediate attention.

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Yesterday, at the Puerto del Sol, a group of demonstrators chanted; but none took up weapons. The whole day went by without a single political murder…by left or right.

What’s happened to the Spaniards? Have they forgotten what happened in the thirties? With memories of the turbulent, bloody 20th century still fresh in their minds, how can they act so Zen-like…so cocksure of themselves?

But it’s not just Spain. Everywhere, there is an unnatural calm.

Stock market volatility, which measures market jitters, is near all-time lows. Stocks themselves, as measured by the Dow, are at an all-time high. The U.S. government, the biggest debtor in world history, is still able to borrow money for more than ten years at less than 5% interest, even though consumer price inflation is currently near 3 percent. And foreigners still take U.S. paper dollars at par – China now has one trillion of them in reserve – even though the country runs a banana-republic-sized trade deficit – equal to 7% of GDP.

What’s happened to the world?

Indeed, the Dow rose again yesterday. Gold is still in its correcting mode – at $587. Oil seems to be wondering what to do next. We looked at the charts; the Dow is clearly in an uptrend, which, of course, could end at any moment. Oil and gold look as though they could do anything for a while longer.

It takes some time for a major trend to reveal itself. There is always a lot of back and forth, hemming and hawing, to-ing and fro-ing, giving and taking. The media is full of explanations as to why a trend is one way or another; but you never really know until long after. Then you look back, and it looks so obvious.

Along with setbacks, come second thoughts. You can’t help but wonder if your theory is correct. You’re tempted to chuck the whole thing and just go with the flow.

So let’s review: Our theory was that the Dow began a major bear phase in January of 2000. ‘Sell stocks, buy gold,’ we said. But here we are, six years later, and the Dow is higher than it was, at least in nominal terms. Were we wrong?

Well, yes…and maybe not.

The Dow is higher; but the dollar is worth less, and gold is worth a lot more. In order to keep up with the dollar index, the Dow would have to be at 15,000 to be even with January 2000. In order to keep up with gold, the Dow would have to trade at 23,000.

What’s more, a couple of analysts at the Fed just looked at inflation in a new way, which they consider to be a better reflection of actual price trends. What they found is that consumer price inflation is under-estimated by about 30%. Instead of 2% inflation, they say, the real level is about 3 percent. If so, it makes the Dow an even bigger loser in real terms.

What these figures are telling us is that the Dow is still in a downtrend, and that our theory may be correct after all. Yes, there is a flood of dollars in the world economy. And yes, many of those dollars are getting recycled back into U.S. stocks. But the fundamentals still don’t look good for stocks…or the dollar, for that matter.

America’s record trade deficits continue to be taken up by foreign central banks. For the moment, foreigners are still content to convert these trading profits into dollar-based assets. When they will get tired of doing so, we don’t know. In the meantime, the greenback may be going up, but it is still a dangerous thing to hold.

This is true of stocks too. They may even continue to rise; but in our opinion, an investor buys them at his own peril.

For the moment, investors act as if the fundamentals don’t count. No one seems concerned with the trade deficit; no one frets about the mountain of dollars in foreign hands; nor is anyone particularly worried about the downturn in housing; it’s supposed to come in for a landing so soft there won’t even be a ripple in the wine glasses of the first class compartment.

This may be so. Maybe it will turn out that investors are right to be so tranquil…so complacent…and so positive. But if we were you, dear reader, we’d buckle our seat belt, just in case.

More news, from our friends at Whiskey & Gunpowder:


Byron King, reporting from Pittsburgh…

“…It is no mere coincidence in time that a revolution in Persia started to gain traction in June 1905, just a month after Tsushima as the Persian people revolted against a leader who they perceived to be a puppet…”

For the rest of this story, and for more market insights, see today’s issue of Whiskey & Gunpowder


And more thoughts…

*** Here we are in Spain, where for three years in the late ’30s people tried to kill each other for no apparent reason. The situation was murderous all around. Left wing groups controlled some towns, while right wing thugs controlled others. In places where the leftists ruled, priests were dragged out of their churches and gunned down…nuns too. Landowners, factory owners, conservatives, the rich – anyone who wore a hat or a tie, according to some accounts – would be rounded up, and often executed.

In other areas, groups of vigilantes, fascist organizations, or the army itself knocked on doors and dragged out trade union members, communists, anarchists, or even liberal republicans. As towns changed hands, both groups tried to exterminate as many of their ‘enemies’ as they could. The fascists killed the communists because if they didn’t, the communists would kill them. But why did either wish to kill each other?

The death toll rose to the hundreds of thousands. Even today, mass graves are still being discovered and excavated so historians can do their grisly death counts.

What made the Spanish – an agreeable, civilized people under normal circumstances – turn to such butchery? When we walked down the streets of Madrid yesterday, we didn’t see a single Spaniard murder anyone. We checked the papers this morning; no, there were no instances of mass murder recorded last night.

What happened? Why did they want to annihilate each other in the ’30s…but now they don’t? Many are the reasons given…but they are all just hypotheses.

Social, economic, and political conditions in China were very different at the time – but the Chinese did much the same thing! Germany and Russia turned to barbarism at the same time too – with death tolls that far outdid anything the Spanish were able to achieve.

Naturally, while people were busy cutting each other’s throats, the outlook for stocks was dim. After the ’29 peak, stocks sank…rallied…and sank again. They hit a new low directly following the crash, then another low at the beginning of WWII. People hardly believed they would ever rise again! Spirits sank…and the Dow collapsed.

“Well,” began our mother, when we asked her to reminisce, “I remember that there were a lot of people who thought we wouldn’t win that war…it seemed like a close thing at the time.”

Ultimately, the war was won; but animal spirits hardly revived. Instead, people thought the end of the war would bring the recession back. They believed that the war was what had put people back to work, and they anticipated deep cuts in the labor force when the demands for war materiel were over.

And so, the Dow sank again. But it turned out to be a buying opportunity. The long period of rising bonds and falling stocks was over. With the Korean War – and then the Vietnam War – came a new boom. This one lasted from the early ’50s to the late ’60s.

*** But enough market history…we will only add that the boom of the second half of the 20th century was accompanied by inflation, aided and abetted by the feds. In the ’70s, inflation seemed out of control…and again, the market sank. By the early ’80s, you could take a single ounce of gold and buy every one of the Dow stocks.

And again, people were so gloomy they thought the stock market was finished.

‘The End of Equities,’ announced Business Week.

Of course, it was not the end of equities. It was just the beginning of another bull phase.

And here we come to our point, dear, long-suffering reader. The Dow is now rising. But what kind of rise is this? Is this another great bull-market phase? Is this another buying opportunity…such as the one in 1949 or 1982? Or is it an opportunity to lose money by buying stocks near the very top?

When stocks headed down in January of 2000, we guessed that the top was in. Now, we seem to have a new top to look at. But is it new? Our guess is that it is the same top – stretched out, pulled along, and propped up by the feds.

And buying stocks at a top is never a good idea, no matter how long the top has stayed in place.

*** Politicians are spending a record $2.6 billion on this year’s elections. Meanwhile, France’s leading Socialist candidate, Segolene Royal, proposed the creation of a “popular jury,” chosen by lottery, to review the government’s performance. If you can choose such groups by lottery, asked commentators, why not just choose the legislators themselves by lottery?

A good idea, in our opinion – let fortune pick our lawmakers, rather than fraud.

The Daily Reckoning