The People's Wisdom: A New Gold Standard

In a most insightful commentary published in the Financial Times of last Wednesday, Martin Taylor, himself a former banker, quipped:

"All business people know that you can carry on for a while if you make no profits, but that if you run out of cash you are toast. Bankers, as providers of cash to others, understand this well. They just do not believe it applies to their own business."

The reason bankers have trouble judging their own cash flow, he writes, is that "[i]n general, banks have no measures of cash flow that work for banking." He describes (with a great sense of humor) how bankers got us into this Great Recession by paying out "colossal accounting profits" in cash that were "largely imaginary.... Not only has the industry--and by extension societies that depend on it--been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place. Worse, it seems to want to do it all again." (He's referring to the banking bonuses, which are at a new high.)

He ends the piece perfectly:

"How depressing the shame and folly of it all is, when one considers that the system was brought down not because risk management was deficient (though it was), nor because greed was rampant (though it was), but because bankers could not count. Merry Christmas."

This really states it all in one newspaper column.


[Thanks to Britannica.com for the image.]

It also causes one to think: Do we really want the world's money supply punch bowl to depend upon government-employed academicians and government-fed bankers, through a government/bank monetary power hierarchy?

For that is what we have today. With the too-big-to-fail policy, we now have fewer and bigger banks than we did before the crisis, and a government that is too worried about its own survival to care what happens to us, the Forgotten Men and Women. The Fed has been pumping billions of dollars into the banks and into certain markets, like the mortgage market. By doing so, the Fed is trying to juggle the general price level, the mortgage rates, and unemployment--to wit, the whole economy.

Taylor's astute observation about bankers' inability to judge their own cash flow is key here. The observation also seems to apply just as well to Federal Reserve bankers. As long as the Fed offers the opportunity to turn short-term credit into cash, bankers apparently will take advantage of it. This is Taylor's point. No one knows how full the punch bowl really is, nor do they care.

The Fed believes that it can judge the proper amount of created cash through observation of the CPI. But bankers' pay, no matter how outrageous, will never raise the general price level. So the upside potential for this game is limitless.

As long as the Fed's generosity only extends to the small community on Wall Street, they can continue to inflate the bonus bubble at will, along with the speculative and unfair redistributive profits their actions engender. No matter what they do to the dollar, to our savings, or to our purchasing power, they can say they were "just doing their job."

How can we protect ourselves?

In another very good Financial Times article entitled "On the flip side," written by Javier Blas, these lines jumped off the page at me:

"For the first time in decades, investors are allocating a fraction of their portfolios to gold on a long-term basis. That marks a return to normality, some argue. For centuries, gold has been central to savers. 'The aberration had been the last 20-30 years in which gold moved out of most investors' portfolios,' says Mr. [Jonathan] Spall [a director at Barclays Capital in London and author of Investing in Gold: The essential safe haven investment for every portfolio.]."

Once again, we the people are smarter than the politicians or the bankers. We have taken up a kind of individual gold standard, to take the place of the one the politicians and bankers destroyed when it got in their way starting in 1933 and ending in 1971.

Gold may be only a speculative commodity to some, but to many it is still an ideal store of value and the only weapon at our disposal to combat (1) political expediency, (2) the legalized embezzlement that is monetary inflation (with or without price increases--see this post and this post for more on this detail), and (3) bankers' inability to count.

I don't believe gold has hit its high yet. Push must still come to shove if and when the general price level does start to rise. At that point, to prove their goodwill and their capacity to control prices, the Fed would have to make a show of starting to increase rates and stopping "printing money;" but at the same time, they will have their other eye on unemployment.

If unemployment doesn't start to decrease, they will see their choices as between doing nothing, thereby allowing some inflation (general price increases as measured by the CPI), or raising rates thereby stopping the employment "stimulus." My bet is they will choose some inflation, in the wild hope that unemployment figures will improve soon.

Their inaction will signal to the marketplace that they will tolerate a further devaluation of the dollar, and gold will rise up again. How far this game will go is anyone's guess.

If the CPI remains low, they can continue to "stimulate" as long as the bond market will absorb it. This is also good for gold, and for the bankers, if somewhat less so for the Chinese, Japanese, Arabs, and the others who hold US bonds.

Remember:

You can take gold out of the standard, but you can't take the standard out of gold.

The Inflation Boat Is Leaving the Dock

Last night we learned that the Federal Reserve is going to put into practice its announced plan to buy US government debt. Today's Financial Times article by Krishna Guha gives the gory details.

Everyone knows that this action by the Fed increases money supply, and most are aware that it increases the probability that at some point in the future the amount of money created will be excessive with regard to the actual needs of the marketplace, which in turn will tend to lead us towards a state of price inflation, or bubble inflation. Another article by Javier Blas on the early signs of this in the commodities markets is a fun read on the subject.

As the Fed sees the problem, then, they must feed us with money supply while the banks are frozen in a state of rigor vivus, and then in future, just at the right moment, they will take steps to prevent the normal outcome of price or bubble inflation by reversing the process.


[Thanks to 1stchoicecufflinks.com for the nice photo.]

This sounds logical. As an obscure economist named Edward C. Harwood wrote during our last episode of purposefully inflationary Federal Reserve intervention ("the ill-fated Operation Twist in the 1960s"), during a time when we were still trying to adhere to a modified form of the global gold standard:

"Once inflationary purchasing media have been placed in circulation, there are two ways in which sound money-credit relationships may be restored: (1) by means of devaluation, that is, reducing the gold weight of the monetary unit so much that the increase in the number of (smaller) gold dollars equals or exceeds what had been the inflationary portion of total purchasing media; or (2) by means of deflation, that is by removing inflationary purchasing media from circulation." [See this article from the American Institute for Economic Research website [AIER.]

Let's take these in order. In the 1960s during the last years of the gold standard era, the word "devaluation" had by definition a specific political action attached to it. We could say it was an official public confession to a previously committed inflationary crime, the central bank's admission of guilt and acceptance of their incapacity to rectify the situation. To devalue a currency was ripe with ominous significance, and central banks were supposed to take pains to avoid the embarrassment by not inflating the currency in the first place.

Today, however, the devaluation of our currency takes place painlessly for most of us (except for importers), and effectively the Fed gets away with it on a regular basis. In fact, without a gold or any kind of standard, the inflationary purchases of debt instruments that the Fed has already made, plus those it intends now to make, are already devaluing the dollar as I write. We don't have to wait for an official recognition and adjustment of any standard; it just happens on a day-to-day basis.

Under these circumstances, an official announcement of devaluation, therefore, will have no corrective effect. Quite the contrary, inflation will take place simultaneously with the devaluation of the dollar--a double whammy, if you will.

But we don't want prices to skyrocket, so the inflation will still need correction. Let's turn to the other option, deflation. Paradoxically, the Fed is taking its present inflationary action to fight fear of deflation. They are afraid that a banking panic and a lack of credit could cause the system to collapse in what is called a "deflationary spiral." So it will be a while before they feel comfortable with using the deflationary tactic.

Nevertheless, the Fed scientists and governors do believe that it will be possible for them, at some appropriate moment in the future, to begin a controlled deflation of money supply that will not upset the apple cart.

Harwood does write this about the possibility of a controlled deflation:

"That a period of gradually declining prices can be a period also of great economic growth has been amply demonstrated in the past. For example, between 1875 and 1895 while prices decreased substantially, the Nation's productive capacity and output of goods and services increased at a very rapid rate. The often heard assertion that an economy cannot grow unless prices are rising has no basis in fact....

"With gradual deflation, a longer time would be required to eliminate all inflationary purchasing media and reach an equilibrium between the remaining (noninflationary) purchasing media and prices and wages, but the traumatic events that are a feature of rapid deflation would not occur. The Nation would 'outgrow' the inflationary condition as part of the savings of individuals, businesses, and perhaps of the Government were used to pay off inflationary bank loans and thereby cancel both the loans and the checking deposits that the loans had created. Although gradual deflation would be accompanied by decreasing prices, wages almost certainly would decline less or might even be sustained by greater productivity due to technological and other developments."

(For more on why deflation is not always bad thing, read this research by David Beckworth at Cato.)

So it would seem that a gradual well-timed deflation is what Bernanke and his cohorts are counting on. But... there are a few minefields here. One is that we are no longer on a gold standard. We have no point of reference as to where the dollar should end up. I won't go into the reasons why this makes Bernanke's task more difficult, but it does.

Second, how will we know when prices begin to inflate or when bubbles start to form? Alan Greenspan is famous for having remarked that it is impossible to detect when a bubble is appearing. It's true that we all knew the real estate mania was a bubble (or at least I did; didn't you?), but our financial wonks at the Fed either preferred not to recognize it or couldn't prove it to their own satisfaction, at least not to a point where it would have forced them to take action. (I'd add that they may have had incentives not to want to find reasons to take that action, but that would be unfair speculation, so I won't.)

And what if prices remain the same? Does this necessarily mean that we don't have an inflationary maladjustment in the money supply that maintains prices at an artificially stable but too high level? What if the stimulus package spending turns out to be wasteful to some significant degree? Isn't that like blowing bubbles? Example: Bailout-funded Wall Street bonuses.

Third, and here's the real rub, we have not practiced what Harwood calls "sound money-credit principles" since the Fed was created. These principles mandate a specific equilibrium in the commercial banking system between true reserves, deposits, savings, and short-term commercial paper on the one hand; and loans and investments that are speculative and/or based only on some form of collateral, on the other, where these more risky activities would be allowed only outside the strict commercial banking system. (For more on sound commercial banking, find a copy of Harwood's book "Cause and Control of the Business Cycle," 1974 edition, at your local library, or in the AIER catalog. I will delve into the idea of sound money-credit banking in a future blog.)

Fourth, the Fed cannot reverse its current trajectory and start to take deflationary action until the time is right and the worst of the credit crisis is past. Will nothing unexpected disturb their plans? They are relying on deflationary scenario computer models where "all else is equal," meaning when outside factors remain stable. What if the market does something surprising that will make a controlled deflation either inadvisable or even impossible, at the very moment when it must happen? For example, US treasury bonds could become radically less popular among our foreign buyers as a result of the dollar devaluation the inflation will cause; and as nations all over the world scramble to inflate their own currencies, we may find that we have a lot of competition in the bond market.

Personally, I'm betting (and I disclose that I have put a little money where my mouth is by investing in gold-related products) that the Fed will be hard-put to time and measure the controlled deflation.

Why gold? Because, as I've said many times: You can take gold out of the standard, but you can't take the standard out of gold.