Voices of Reason Still in the Wilderness

The fingers of blame are pointing every which way during the U.S. financial crisis…but in Ed Bugos’ opinion on a few are pointing in the right direction: toward the Federal Reserve System.

"Karl Marx (1818-1883) originated the idea that recurrent crises are inherent in the unhampered (free) market economy. Mises has shown that ‘the trade cycle is… on the contrary, the inevitable effect of manipulation of the money market’"
– Percy L. Greaves Jr., Mises Made Easier

Occasionally I hear the odd guest on CNBC or Bloomberg Radio who lays blame for the crisis in exactly the right place – the Federal Reserve System in the U.S….or central banking more broadly.

These extremely influential institutions ostensibly exist to regulate prices, employment and interest rates by way of control over the money supply. They do this by inflating bank reserve credit, on which the banks can pyramid, thus essentially abrogating the role of interest rate determination by the market.

That is, the central bank tries to determine interest rates as far as it can. The rationale for this policy is to attain full employment and price stability, and to otherwise manage economic affairs.

Any economist whose lenses aren’t blurred by the fatal errors of the neo-classical doctrines is immediately capable of spotting the problem with that policy foundation. Unemployment could scarcely exist on a free market, where the government did not interfere with the price of labor. Just like shortages of goods cannot really exist in a market where their price is free to adjust to the reality of existing conditions, there can be no excess labor unless the government intervenes to artificially boost its price. It’s the same principle. It is a simple economic fact – free of political considerations. Labor is an economic good primarily because it is scarce.

Moreover, whether we are talking about labor legislation or the central bank trying to manage growth, prices and interest rates, it amounts to economic management, even planning.

The apparent effect of the policy is to bring about a boom in investment and consumption… the building up of bubble companies and uneconomic enterprises relying on the continued increases in the selling prices of the goods they deal in – be it widgets, homes or securities.

These price increases are afforded by regular money debasement, which is one of the economic consequences of an increase in the supply of money in particular. So it is illusory.

In reality, as Rothbard points out, the boom "is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit’s tampering with the free market".

So this policy, and the booms it engenders, crowds out real savings (by pushing rates below market), and investment comes to rely on the continued "stimulus" of money creation or from borrowing overseas.

Ultimately, it further lays the seeds of its own demise because the process invariably arrives at a point at which the central bank must desist if it does not want to prompt a run of confidence in its notes, leading to hyperinflation.

This is why we say the policy is "unsustainable."

Thus it tries to withdraw the stimulus or "tighten" money and credit – explaining that the overheated economy might produce inflation. The error in its thinking is that it is managing a delicate balance between price stability and growth…that it checks market failures, and can know the unknowable (the future).

In fact, almost all economists would agree, it cannot produce growth. It’s like the analogy of pushing on a string.

The Fed’s policy can only increase employment by decreasing the relative cost of labor through inflation (the expansion of money supply relative to demand). And as one of the largest of interventions conducted by government policy, it only produces more instability – i.e. the boom-bust cycle as well as interest rate and foreign exchange volatility eventually.

Technically, tampering with the rate of interest produces disequilibrium as a mismatch between consumer preferences and producers’ investment plans – during the boom phases. Effectively, it taxes long run growth, and is but a massive redistribution of wealth from savers to borrowers and speculators.

The bust, which often begins with the onset of a financial crisis, brings much pain, and threatens job losses on a wide-scale. But this is because the artificially low rate of interest produced by the previous policy, which could not be sustained, produced waste, a "cluster of error" as Rothbard called it. This "malinvestment" or uneconomic activity is essentially exposed as the subsidy is withdrawn.

In his book, America’s Great Depression, Rothbard posits the error in Marx’s reasoning,

"In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time."

What you see then is basically the widespread failure of parasitic enterprises that could not survive on their own – without the handouts and support of the central bank. This is the empirical evidence that should indict any inflation policy. But, the bust still merely represents a return to natural market ratios.

"The ‘depression’ is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments" (Rothbard)

It follows then, that "Attempts to interfere with free and flexible prices, wage and interest rates prevent recovery and prolong the depression period" (Mises Made Easier)

Efforts to stabilize the bust with even more inflation effectively prevent the liquidation of uneconomic enterprises necessary to return the economy to equilibrium, where markets reflect actual conditions.

Now, I’m not a policy maker. I don’t want to suggest the best way to fix the world or argue why these theories are true. My chief concern is the future. And the evidence that most people would side with Marx on this (over Mises et al) is all I need to predict more inflation, war and higher gold prices.

Joe Public can’t for the life of him figure out why it matters if interest rates are 1.5% or 1%.

He cannot connect the escalating price at the pump to the process of money creation required to bring about such a modest change in the interest rate. The tech bust was the fault of irrational speculators, and greedy investment bankers. The housing bust is blamed on Wall Street’s larceny, his mortgage and real estate brokers, or the thrust toward deregulation. The painful increase in commodity prices is caused by too much growth. The growing trade deficit is caused by new competition from foreign countries. And so on.

For, Joe takes his cue not from Mises, but from the media and political classes under heavy influence by the progressive institutions.

Political leaders in Europe, meanwhile, are taking full advantage of Joe to wage a new war on capitalism from the left on grounds that American style capitalism is in dire need of more regulation.

This is the great evil of the inflation policy.

It is insidious. The great economists have all recognized this truth. It only produces the opposite of what it claims to accomplish. It also funds the growth of government and anti-capitalist sentiment, and other confused ideas that may lead, ultimately, to the general disintegration in the division of labor, the fabric of society. It promotes moral degradation and corruption, conflict, and finances wars. It is 80% of what’s wrong with the world.

But for the most part, the voices of reason that point to this cause are trampled over by the rhetoric of the larger political class, which fear mongers people into clamoring for more money and credit.

This truth is evident in the Fed’s actions. It has abandoned any remnants of conservatism, as have the other central banks worldwide. The helicopter blades are in full swing. So any enthusiasm about the world having reached this place where it is ready to turn a new leaf must be tempered by this fact.

The voices of reason, though on the beltway, are still only voices in the wilderness.

This alone suggests we are going to continue to see more inflation, taxes and government. The scary part is that this process is accelerating.

The next bubble may well be in gold.

Good trading,

Ed Bugos
for The Daily Reckoning
November 19, 2008

Before starting up Gold & Options Trader, Ed comes straight from the North American heart of the gold market – Vancouver’s Howe Street. During the nasty commodity bear market in the ’90s, Ed still guided his clients to gold profits in Argentina Gold and Arequipa, both of which became buyout bait for Barrick. He also founded the "Bugos Gold Stock Index" which included no more than 10 stocks at any time.

Yes, dear reader, we are going where no man ever went before …into the wild.

All around us is virgin territory. No one has ever been here before. But watch out, these virgins are vicious amazons. In this wild place, you can forget living it up. Don’t even think about getting rich. Riches? If you’ve got ’em…hide ’em. Luxury? Who needs it anyway? The best you’ll be able to do is survive. And then, maybe, years from now, we can put our financial lives back together again…and get on with things…

Never before have seen so much wealth disappear in such a short time. The latest report from MSCI shows the planet’s losses from the sell-off of equities has now reached more than $30 trillion – or more than twice the GDP of the U.S.A.!

And this is just stocks. Reported write-downs, write-offs and credit losses have reached almost a trillion. And losses of housing prices in the United States alone – the only country for which we have reliable figures – has reached about $5 trillion.

Nor have we ever seen such a rapid reaction. In the space of a few months, people have gone from believing that nothing could go wrong to thinking that there’s nothing that won’t go wrong. Where once they thought that free-market capitalism would make them rich…they now believe that the government can save them from getting poor. And where only a year ago they thought the world’s globalized economy would always give them everything they needed "just in time," they now believe they better keep a few sheckels on hand "just in case."

And just look at the bonds! A few months ago, investors stretched for yields. Now, it’s safety they reach for. They dump corporate bonds for fear they may be "toxic," and grab U.S. Treasury debt with both hands. Investors now seem to have an unqualified trust in the full faith and credit of the world’s largest debtor. Yields on 91-day T-bills have fallen to 0.11% – scarcely a tenth of one percent!

Yes, dear reader, the "Great Unwind"…the "Big Bust"…the "Great De-leveraging" – call it what you want; we’ve never seen anything like it.

The Dow rose 151 points yesterday – a limp and pathetic little attempt buck the downward trend. Gold lost $6.80…leaving it at $735.

China’s stock market had managed an 18% rebound…following the announcement of its half-trillion dollar bailout plan. But yesterday, Chinese stocks were collapsing again.

The latest news from America tells us that housing prices are still going down in 4 out of 5 cities. Homebuilders’ wives are hiding the shotguns and pouring out the whiskey; their husbands’ confidence has never been lower, according to this morning’s news report.

Big towns…little towns…in the sophisticated cities and out in bumpkin country, the story is the same. The Wall Street Journal tells us that the "fall in crop prices" is putting an end to the boom in the boonies.

U.S. producer prices fell 2.8% in October – the most they’ve ever fallen. And the Big Three automakers say that if they don’t get some help soon, the results will be "catastrophic."

Meanwhile, over on the sunny California coast, the whole state is going up in smoke…it’s not only going broke, it’s burning up.

"I have to dust the ash off my car every morning," reports daughter Maria, recently arrived in LA and hoping to make it big in the motion pictures. "It’s eerie…there’s always a little smoke and soot in the air…"

Not only is the bust unlike anything we’ve ever seen before…so is the planet-wide effort to stop it. All over the globe, the feds are going ‘into the wild’ with extraordinary measures. They’re mobilizing troops to fight the crisis in the boardrooms. They’ll fight it in the stock markets. They’ll fight it at home – with house-to-house combat to stop foreclosures and defaults. They’ll fight it abroad – the U.S. government is even loaning money to foreign governments! They’ll fight it with loans and giveaways. They’ll fight it with fiscal policy. They’ll fight it with monetary policy. They’ll fight it with every weapon available to them – including the printing press.

And they will lose.

*** To give you an idea of the wild measures undertaken by the feds, we look at what is happening at the world’s leading bank – the U.S. Federal Reserve.

The short form of how the Fed operates is this: it holds a certain amount of securities in its vault; this is the cornerstone capital – or monetary base – of the whole banking structure. How does it get this capital? It buys it, creating the money to pay for it as necessary. Naturally, the Fed doesn’t want to create too much money or the inflation rate would get out of control and economists would point their fingers accusingly. But now, people fear dandruff more than inflation. So, the Fed has gone wild.

From the day of its founding in 1913 to September 24, 2008 the Fed’s assets – the aforementioned cornerstone capital for the US financial system – grew to $1 trillion. By November 14, 2008 the amount had grown to over $2 trillion. And in a speech in Texas, the head of the Dallas branch of the Fed said he expected the total to reach $3 trillion by year-end.

For the moment, this explosion of monetary inflation is hardly noticed. Asset deflation has the headlines. People worry about having too few dollars, not about having too many.

Comes the news this morning that U.S. business chiefs are asking the up-coming Obama administration for another $500 billion ‘stimulus’ program. They’ll get it. And much more. Trillions worth.

Trying to stimulate the economy with easier credit in the early 2000s, Alan Greenspan overdid it. He gave the world the credit it wanted, and created the biggest bubble in human history.

Now that bubble is collapsing and his successor – Ben Bernanke – is confronted with a new problem. Now it is cash that people want – income to pay their debts! Bernanke will give them what they want. And, most likely, he will overdo it too.

*** At a recent hearing on Treasury Department use of government assistance funds, Ron Paul, who is well-known for often calling out the Federal Reserve chairman on their liberal use of the printing press, took on Big Ben. Here is the transcript of their interaction, in case you missed the C-SPAN coverage:

Ron Paul: The Austrian free market economists had predicted all these problems would come, and they were certainly correct in everything that they said. Of course they’re not very satisfied including myself with the so-called solutions, because it looks like we’re spending a lot of energy and a lot of money trying to patch a system together that is unworkable.

So we have Congress spending a lot of money, we have Treasury very much involved in trying to pick and choose which worthless asset that we’re going to buy, and of course the Federal Reserve is involved in injecting trillions of dollars that nobody seems to be keeping track of.

But what we’re failing to do I think is to recognize that the system no longer works, but I can understand why we do this because if Congress couldn’t do this and if the Fed couldn’t do this and Treasury couldn’t do this, it would make us all irrelevant. And instead of looking at the causes of this, and then finding the solutions aren’t going to be found here, we have to make ourselves feel pretty important.

But I think there’s another reason we think we’re pretty important, it’s because in a way our interference in the market corrections that tried to come about since 1971 seem to work. I mean, the failure was established in 1971 with a system that had no way of automatically correcting the balance of payment and the current account deficits.

And that’s where the problems have been, and economists – whether they were left or right or middle – over the last several decades have always said, this current account deficit is a big problem. And now it’s totally out of hand. So here we are struggling with all these rules and shifting back and forth and really getting nowhere.

My question is directed toward, when we come to the full realization that the system is unworkable, what are we going to do, what have you thought about doing, and already we see talk in the newspapers. We see articles about a new international world reserve currency, and to me that’s pretty important, because the fiat dollar reserve system is not going to work anymore, and that’s the information that we have to accept and decide what we’re going to do in the future.

Also, this is not new in history. Currencies have failed, financial systems have failed, and generally, to restore the confidence that everybody is talking about, they usually have to go back to a currency with integrity to it, rather than just fiat money.

And, you know, the stages is there. It’s not impossible, already the central banks of the world still own 15% of all the gold that was ever mined in all of history. So they hold on to this gold for some reason, and therefore something has to give, or are we going to keep trying to waste more money and time patching this system together.

Just last week there was a report that Iran purchased 75 billion dollars worth of gold, took their reserves out of Europe, bought gold and put it in Asia. So is that a sign of the times, is that moving on?

My question is, in your meetings, and you had a meeting just recently with other central bankers, does this thought come up about a new international world reserve currency, and if so, does the subject of gold ever come up?

How do you restore the confidence? Have you recently had conversations with any central banker, and is there a move on to replace the dollar system, because the dollar system is essentially declared dead, because it’s not working, but this indeed was predictable because of these tremendous imbalances that were never allowed to be corrected, and they were always patched up. We always came in. We’d spend, we’d inflate, we would run up deficits, and since ’71 we’ve been able to correct these problems.

Could you tell me what kind of conversations you’ve had regarding a new reserve currency?

Ben Bernanke: Yes, Congressman. I don’t think the dollar system is dead. I think the dollar remains the premier international currency. We’ve seen a good deal of appreciation in the dollar recently during the crisis precisely because there’s been a lot of interest in the safe haven and the liquidity of dollar markets.

And the Federal Reserve has been engaged in swap agreements to make sure there’s enough dollar liquidity in other countries because the need for dollars is so strong. So I think the dollar system remains quite strong.

I do agree with you very much on one point, which is about the current accounts. The current account imbalances have proved to a very serious problem. It was in fact the large capital inflows in those current accounts which created a lot of the financial imbalances we saw and have led to some of the problems we are seeing, and one of the silver linings in this huge grey cloud is that we’re seeing some improvement and greater balance in our current account deficits.

Ron Paul: But does the subject of a new regime ever come up?

Ben Bernanke: No, it doesn’t.

Ron Paul: And does the subject of gold ever come up in any of your conversations?

Ben Bernanke: Only in terms of the sales that the central banks are planning.

The I.O.U.S.A. team interviewed the Congressman for the documentary. If you didn’t have a chance to see the film when it was in theaters, now’s your chance. We are offering an exclusive package to long time DR sufferers: you can get the DVD (before it is released to the general public), the companion book and your own personal bailout package.

*** GWB – you can’t say we didn’t warn you. A top British judge has just announced that he considers the Bush administration’s attack on Iraq as a violation of international law. Years from now, George W. Bush is likely to be charged with war crimes and human rights violations. Normally, this would pose no problem. A former U.S. president could expect the protection of the U.S. government. But as Americans sink into depression they are not likely to feel kindly towards their ex-president. They will blame him for the decline of their incomes…and for the fall of their empire. They are likely to want to cooperate with the world’s new institutions…and throw over their own former commander-in-chief.

Advice to GWB: Go back to Texas. Don’t ever leave home again.

*** Colleague Patrick Cox, at Breakthrough Technology Alert offers some rare optimism into this otherwise downright gloomy market:

"Yes, we have been swindled by politicians who pushed the U.S. banking system into the shape it’s in today. The people who tried to stop the meltdown have utterly failed to explain the root of the problem to the American people. We’ve officially entered recession now and policymakers will do little to address the real problems.

"Though the hit the economy has suffered recently pales in comparison with the drain on world resources associated with that war, our situation is similar. We are at a point of incredible opportunities.

"The reason is, in a word, science. The accelerating pace of breakthrough discoveries will deliver economic benefits that few fathom today. While the entire world will gain from these discoveries, investors who understand what we are going through now will profit most and earliest. Even better, the return on these stocks will be so great that even relatively modest investments will produce fortunes.

"Let me give you a few hints about the shape of things to come. Just in the last few weeks, two groups of scientists announced the discovery of microorganisms that produce biodiesel naturally. Professor Gary Strobel from Montana State University discovered a fungus deep in the Patagonian rain forests of Argentina. This organism naturally produces the long chain hydrocarbons needed to create fuels.

"Even bigger news is coming on the medical front. I predict that real stem cell therapies will be offered offshore within the year. Currently, there is a billion-dollar industry offering stem cell snake oil, but real lifesaving and life-extending therapies are already available in the laboratory. These therapies are relatively inexpensive to produce and will revolutionize medicine. Even the FDA will come around when wealthy early adopters begin reporting true rejuvenation results. By the end of Obama’s first term, we will see SC and other therapies that will radically cut the cost of treating horrendously expensive illnesses."

Patrick has been alerting us to a breakthrough that could change the way we view modern medicine. And when news breaks – which is rumored to happen tonight – those who have gotten in on this revolutionary idea stand to make some pretty major gains.

*** We got a letter from Her Majesty’s government.

"Winter Fuel Payments…don’t miss out!"

Yes, dear reader, this is how societies collapse. People invent problems. Then, they find solutions to the problems. Then, the solutions cause more problems. And finally the cost of all the solutions brings the whole system falling down.

A news report out today tells us that the weekend will be cold. An "arctic blast" is said to be on its way.

Of course, some parts of the city already feel as though they were in a nuclear winter. London’s main industry is finance. And finance has iced up. A headline in yesterday’s paper told us that London is expected to lose 370,000 jobs over the next two years.

But thank God for the world improvers:

"Our records show that you may become eligible for a payment this winter," begins the letter.

Why? Because your editor is enrolled in the Britain’s national health service (a requirement for employment). NHS records must have revealed to the authorities that your editor turned 60 in September. Accordingly, he is eligible for 125 pounds to help him with his heating costs this winter.

Imagine the miserable bureaucrats administering this program. They have computers to program…letters to write…records to keep…internal procedures to devise, administer and respect. They have to hire people…and then support them for the rest of their lives, paying for pensions and holiday, just like any other business. Then, they have to work out internal disputes…make sure the coffee maker is working properly…and organize an annual Christmas party. It probably costs more than 125 pounds to send out each check!

And why should someone over 60 get money and not someone under 30? The older person has had 30 more years to stuff newspaper in the cracks, firewood in his garage and money in his bank account. If he’s cold this winter…it’s his own damn fault.

But if you’re going to give him money to help him keep warm, why not some extra money to help him with his eating needs? He has to eat, doesn’t he? And why doesn’t HM Government just send him a bottle of Chateau Margaux? Maybe 1985. To help him with his drinking needs.

Until tomorrow,

Bill Bonner
The Daily Reckoning