Who's Been Sleeping in Our Beds?

The Daily Reckoning PRESENTS: Wall Street and the financial media have hijacked the children’s story of Goldilocks and the Three Bears to use as a metaphor to explain the current economic environment. Dan Amoss points out that if we take this metaphor to its logical conclusion, we see that it has big, positive implications for precious metals investors…


A recently popularized concept dubbed the “Goldilocks economy” sounds nice in theory, but sorely lacks historical precedent. But Wall Street and the financial media have hijacked the children’s bedtime story of “Goldilocks and the Three Bears,” using it as a metaphor to explain the current economic environment. If we take this metaphor to its logical conclusion, we see that it has big, positive implications for precious metals investors.

Here’s how the story goes: Fed Chairman Ben Bernanke, having broken into the three bears’ house, is faced with a choice of three bowls of porridge: one “too hot,” one “just right,” and one “too cold.” His academic background gave him the knowledge to choose this “just right” bowl – a bowl characterized by low inflation and 2-3% economic growth.

Had Bernanke chosen Papa Bear’s “too hot” bowl, maintaining an easy monetary policy too long, inflation would now be out of control and the economy would be growing 5-7%. Had he chosen Mama Bear’s “too cold” bowl, he would have tightened monetary policy too much, inflation would now be turning negative, and the economy would be heading into recession.

So what is the moral of Wall Street’s story, now that we are in the midst of a “just right” economy? We should all invest in index funds and watch our savings yield real returns above 10% per year all the way to retirement.

But it’s interesting how the nonmetaphorical version of this bedtime story actually ends. Wikipedia provides a synopsis:

“Goldilocks is still asleep in the baby’s bed when the bears return home. They wake her up, and depending on the brutality of the storyteller, either kill her or scare her away. The moral of the story can differ as well; a general theme is that the privacy of others should be respected.”

Taking this metaphor to a more plausible conclusion – the Federal Reserve has broken into the house, sat in the chairs, ate the porridge, and slept in the beds of every individual saver of U.S. dollars. This institution constantly injects new floods of cash into the banking system by “monetizing” government liabilities (mostly Treasury bills). With each new dollar created, the value of each existing dollar held by savers declines in value.

Will the Fed ultimately reach the same fate as Goldilocks, running away from the wrath of savers in a panic? Probably, but it will take a monetary crisis to wake savers up from their hibernation and recognize that the Fed is the primary enabler of inflation, not the “inflation fighter” that so many have come to believe. The ultimate moral of Wall Street’s version of this bedtime story is to buy and hold a position in gold to guard your savings from inflation.

This Goldilocks concept rests on the erroneous assumption that inflation will begin to boil over once economic growth climbs above some arbitrary threshold. But this concept exists only in the minds of academics and in economics textbooks. Real economic growth – the kind that produces “wealth” in the true sense of the word – actually exerts downward pressure on the CPI, provided that the Fed-enabled money supply remains stable.

It’s only logical to assume that a growing supply of manufactured goods and services will be forced to compete for a relatively fixed quantity of customer dollars. The business model of Dell comes to mind. This company provides a great example of capitalism’s “creative destruction,” raising every computer buyers’ standard of living by passing on the incredible productivity gains of electronic component manufacturers.

Those charged with maintaining the value of paper money will follow scripted responses to each bubble’s pop or hiss: cheapen money yet again. The future environment for gold mining equities remains as bright as ever, so stay tuned for more recommendations in this sector.

In the case of computer manufacturing, productivity gains are measured by how fast prices fall each year. Wealthy elites were the first to enjoy the benefits of personal computers back in the 1970s and 1980s. But as new competition surmounted the low barriers to entering this business, PC supply accelerated, while prices and profits fell. Today, the lowest-cost producers dominate this market.

This example runs counter to the “Goldilocks” concept. By visualizing the Dell business model, you can appreciate how complex factors of production and competition can combine to produce improving products at lower prices, while yielding profits to reward the most innovative and efficient companies along the chain of production. Why does an economy of increasing goods and services productivity require an ever-increasing money supply? The general price level would nearly always fall in a free market economy without such an out-of-control fiat currency backdrop.

But Fed officials do not see it this way. They believe they can set the temperature of the economy as if they were preheating an oven. History shows time and again that the Fed allows the formation of credit bubbles by lowering the price of credit to artificially cheap levels. At the first sign of a credit bubble imploding under its own weight, this highly regarded institution actually compounds its original mistake, creating another bubble by lowering the price of credit yet again!

As complex adaptive systems, economies will react differently to each bubble’s aftermath. Nevertheless, it’s pretty apparent that the global economy has passed the “point of no return” in terms of writing off its bad debts, rebalancing its imbalances, and beginning afresh. So at the top of the Fed’s playbook is a plan to rescue the housing and stock markets with a heaping dose of stimulus at the first sign of real distress.


Dan Amoss, CFA
for The Daily Reckoning
February 7, 2007

P.S. This is the backdrop I have in mind when issuing investment recommendations for Strategic Investment. Ever since the discipline of the gold standard has been dismissed as unnecessarily restrictive for our sophisticated, perfectible modern times, the real creators of wealth in the economy have been tossed about by waves of successive credit and asset bubbles. Those charged with maintaining the value of paper money will follow scripted responses to each bubble’s pop or hiss: cheapen money yet again.

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

What, me worry? This is an Alfred E. Neuman market.

Remember him? The adorable scamp from MAD magazine?

Yesterday, the markets froze up. History stopped. Time stood still.

The Dow barely moved. Nor did the dollar bestir itself. Bonds…gold…commodities – everything lay motionless and quiet, like a wide, frozen river.

You’d think investors had nothing to worry about – or no imagination.

Bush’s dollar-busting budget…the army pinned down in the Mideast…record trade deficits…China’s bubble stock market…rising oil prices…war with Iran…a sudden increase in the yen…rising inflation…bear market in housing. If investors wanted to worry, they’d have plenty to worry about. But near the peak of a bull market in liquidity, worry is the last thing they are wont to do…

“Another general trait that may play a large role in bubbles is ‘disaster myopia,'” writes John Calverley in “Bubbles and How to Survive Them.” Disaster Myopia is the “tendency to ignore major negative events that have a low probability. If we started to think of all the terrible things that could happen, to ourselves or to our investments, we probably could not get out of bed in the morning, let alone buy risky stocks or take on a large mortgage to buy a new house. So the things that happen very rarely we tend to ignore altogether.”

This trait, he goes on, is “linked to a tendency to extrapolate from the recent past, rather than to take a longer view of the history of risk probabilities.”

Mr. Calverley is the chief economist at American Express Bank. We met him a couple of years ago. Then, we both marveled at how worry-free investors seemed to be. But that was in 2005. Little did we realize how utterly sans soucis they could remain two year later.

That is evident from prices. The Dow is at an all-time high. So are other stock markets all over the world, with Chinese stocks at not only a record…but a giddy absurdity – up 200% in the last 18 months. Everything else is up too….

One thing that is down, on the other hand, is the cost of protecting against the disasters that investors don’t see coming. When the sky is clear, the price of umbrellas goes down. So, speculators are able to insure their bets at low cost – giving them the gall, the wherewithal and the encouragement to make even grander bets.

The Bank of Japan lends at less than 1% interest. What’s more, the yen itself has been steadily deteriorating – now, it is at a 15-year low against the European currencies, for example. Seeing no danger, speculators borrow yen…exchange it for dollars…and put their money to work at higher yields. This gamble has been such a steady performer for such a long time that many are the hedge funds and financial firms ready to guarantee – for a low fee – that it never will go wrong. Since the speculator now has not only a marvelous money machine at his disposal…but also a mechanic standing at-the-ready to make sure it never breaks down, he doubles up his bets – which puts even more money at play.

The whole thing is so breathtaking that yesterday we began working on a unified theory for why this credit bubble has been allowed to bubble on for so long…and how so many sensible people in person can act like such dumbbells in public.

We know you are on the edge of your seat, dear reader, waiting for this Darwinian insight. And we promise to reveal the whole thing…later…but for today, we merely marvel at one aspect of this phenomenon:

The surer the profits, the surer the disaster.

Do you see why, dear reader? The more comfortable the speculators become…the riskier the bets they take.

Yesterday, came news that the BOJ is frozen in time too. No, it said; it would not bend to pressure to raise rates. The bets look surer than ever. And the cost of insurance – puts, swaps, hedges, straddles – is lower than ever. How could anything go wrong? Double up. Raise the stakes. Eventually, there is so much hot money on the table it sets the house on fire.

So far, nothing has gone wrong. And until something goes wrong, nothing will go wrong. Then, when something does go wrong, things are likely to go wrong in a big way.

Right now, the clouds are gathering…and it’s not hard to see what could easily come our way in the next five years: a falling dollar, geopolitical strife, a crumbling housing market – and one of these events could send us into a bonafide financial disaster. We always say that the best way to be prepared for the future is to learn about the past…and the History of Financial Disasters does just that.

More news…


Byron King, reporting from Pittsburgh:

“…I am going to tell you more than you might want to know. But I am doing this because, deep down, it is still for you. That is, it is all for you if you care to join in the spirit in which I am offering what I am about to say…”

For the rest of this story, see today’s issue of Whiskey & Gunpowder


And more thoughts…

*** Poor Zimbabwe. “The big problem about Zimbabwe,” said a political analyst who asked not to be identified for fear of reprisals, “is that the one thing you can’t rig is the economy. When it fails, it fails. And you can have unpredictable effects.”

What could happen in Harare is a revolution or a military coup. People are getting sick of inflation rates over 1,000%. Last month, inflation hit a new high, at over 1,200%. People complain that bus fares take up their entire salaries. Food is becoming scarce (farmers get fuel at a preferentially low price…then sell it on the black market for 10 times as much). Teachers, and even doctors and nurses are on strike. And the police are threatening to riot.

But leave it to the politicians and economists to come up with a solution. The Central Bank of Zimbabwe announced this week that henceforth inflation would be illegal. Anyone who raises prices will be arrested.

Just who do they think they are, the Nixon Administration? Nixon’s bunch also tried to make inflation illegal. But our Harare source is right. “You can’t rig the economy.” Nixon gave up…inflation rose. It only stopped rising when big Paul Volcker stepped into the Fed and hammered it down….not without pain. The U.S. economy went into its worst slump since the Great Depression…and stocks – adjusted for inflation – went down 80% below their 1960s highs.

Which makes us wonder about the future of the U.S. economy. Consumer price inflation has yet to strike the 50 states, but there is plenty of inflation in the money supply and in the prices of capital assets.

We notice also that bond yields have begun to rise… since December, in fact. Could the bond market be getting a little skittish – looking at all that inflation of the dollar? Maybe…

*** Meanwhile, there are 2.1 million empty houses in the U.S., according to a recent report. The homeless are in luck…plenty to choose from.

In Tucson, for example, sales of single family houses fell 33% last year. Currently, the Tucson paper tells us that there is a 9.5 month supply of houses on the market. But this is after many houses have been withdrawn. Last year, 3,700 houses stayed on the market for so long the listing agreements ran out. Another 3,000 were simply taken off the market after owners gave up trying to sell them. Many of these houses are now empty…earning no income while the sun fades the paint and the property taxes rise.

Still, Tucson may be a better bet than Michigan. A news item yesterday tells us that nearly a third of Michigan residents are planning on clearing out. This comes on the same day as news that – for the first time ever — the majority of new cars sold this year are expected to be imported. Neither bit of news is a good omen for prices of Michigan houses.

And from the Boston Globe, we get this bit of news: Mortgage lenders submitted a record 19,487 foreclosure filings in Massachusetts last year, leaving more homeowners in danger of losing their homes than at any time since the real estate recession of the 1990s.

Kevin Cuff, executive director of the Massachusetts Mortgage Bankers Association, said yesterday in a statement that homeownership has increased, due to the greater availability of mortgages. “2003 through 2005 were historic years for [mortgage] production in Massachusetts,” his statement said, “and it would correlate to the increased foreclosure results for 2006.”

*** Of course, it is impossible to understand world politics without reference to empire. The Bush budget includes $750 billion for defense – an outrageous amount of money for a country that has no real military rivals worthy of the name. That amount is not for defense at all. An empire is in the business of maintaining order all over the world. It does this by sending its garrisons to far-flung frontiers…Vietnam, Bosnia, Grenada, Sudan, Iraq, Afghanistan. Then it meddles in them. And gets into one scrape after another.

But that’s the path empires follow – the path of all public spectacles: humbug…then farce…and finally, disaster. The humbug is always the same – that the imperial power has a culture or a system so superior it must be imposed on others. The farce begins when absurd things are done to justify the humbug – such as announcing ‘mission accomplished,’ when all that was accomplished was that billions more dollars and more than a hundred thousand troops were now pinned down by a few fanatics with towels on their heads.

It is always difficult and dangerous to speculate about the future. Rome dragged on for 300 years after it reached its peak under Trajan. But America’s enemies are almost comically weak and it is possible that the empire could find the resources to drag on too, for many decades to come. On the other hand, you can’t rig an economy…in Harare or DC. After the current credit boom deflates, where will the resources come from?

The Daily Reckoning