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If a lawless gang
of madmen, gamblers and alcoholics seized control of a large company, how
would you expect the business to perform? How would you expect the
story to end? What if, instead of a company, they seized control of the
world’s largest economy, thus, to some extent, the world financial
system?
Unsound monetary
policy, reckless risk taking, and out-of-control spending are what
characterize the US
economy today. The proverbial madmen are central bankers, i.e., the US
Federal Reserve, whose polices, inspired by Johannes Gutenberg, threaten to
destroy the US dollar in the name of saving US banks from their own
irresponsibility and greed. The compulsive gamblers are Wall Street
investment banks, along with the largest US banks, which have gone so far as to speculate with government bailout money, having learned
little from the near collapse of the world financial system in 2008. If
money were liquor, the US
federal government would be a band of raging alcoholics in charge of a liquor
store. These are the tragic characters upon whom Americans depend for
their jobs, for their college and retirement funds, for the financing of
their educations, homes and business ventures, for the stability of prices
and US financial markets, and for the value of their hard earned savings.
The triangle of
dysfunction has not gone without notice. Foreign purchases of US Treasury bonds are being made, essentially, under
duress while demand for Treasuries remains tepid and quantitative easing by the Federal
Reserve continues. The US dollar has fallen from new low to new low and
the skyrocketing price of gold is sounding the
alarm, but between Washington
DC and Wall Street nary an ear
can hear.
The
Madmen
The incurable
incapacity of a central autocracy to accurately match interest rates and the
money supply to the requirements of the diverse, complex markets that make up
the US economy is a
fundamental flaw in US
monetary policy. While the ideology may be different, central economic
planning under the name of central banking produces no better result than
central economic planning under the name of communism. A series of ever
larger economic bubbles coupled with an ever weaker currency is ultimately
little better than the economic stagnation of the former Soviet system.
Low interest rates may stimulate economic activity, for example, but they may
also result in high inflation, unsustainable levels of debt, and asset price
bubbles.
For every
intervention in the free market, whether by government edict or monetary
policy, there are unintended consequences. Government intervention in
the US
housing market, for example, intended to increase opportunities for home
ownership among less successful members of society, played a key role in
undermining lending standards. Combined with the Federal
Reserve’s policy of low interest rates, which fueled speculation in
real estate and mortgage backed securities, government intervention
ultimately proved disastrous.
Markets have
existed since the dawn of human civilization without the blessings either of
government subsidies and guarantees or of central banking. An economy
is best described as an organic system rather than a machine.
Interventions purporting to be the processes required to
‘operate’ the economy are at best futile if not inevitably
disruptive and destructive. Like a living organism, the economy is
largely self organizing and self regulating. When governments collapse,
for example, currencies may fail but trade marches on. The behavior of
an economy is an infinitely complex aggregate of individual human actions
driven by self-interest and, while it may be characterized at different times
either by rationality or by irrationality, it is self correcting (unlike
interventions, which know no bounds). As a result, it is not possible
for a small group of experts, no matter how intelligent or well intentioned,
who have an imperfect understanding and incomplete, inevitably out-of-date
information to successfully control the economy without unintended,
unexpected and usually destructive consequences.
The notion that a
central authority, even one equipped with sophisticated computer models, can
successfully substitute a mathematically-based view from on high for the
individual judgments of millions of businesses, entrepreneurs, and consumers
across countless regions and industries is not merely the height of hubris
but quite simply mad. Fundamentally, it is entrepreneurs deploying
private capital, not bankers or economists that create the products,
services, business, and jobs that make up the economy. Whether for the
sake of social welfare or for the purposes of monetary policy, intervention
in the free market invariably distorts the distribution of wealth, causes a
net reduction of wealth for society as a whole, and misdirects entrepreneurs
into activities eventually revealed as uneconomic. Perhaps the best
argument for the futility of central bank monetary policy is that of Federal
Reserve Chairman Ben Shalom Bernanke, Ph.D., who said to graduates of the Boston College School of Law on May 22,
2009:
“As
an economist and policymaker, I have plenty of experience in trying to
foretell the future, because policy decisions inevitably involve projections
of how alternative policy choices will influence the future course of the
economy. The Federal Reserve, therefore, devotes substantial resources
to economic forecasting. Likewise, individual investors and businesses
have strong financial incentives to try to anticipate how the economy will
evolve. With so much at stake, you will not be surprised to know that,
over the years, many very smart people have applied the most sophisticated
statistical and modeling tools available to try to better divine the economic
future. But the results, unfortunately, have more often than not been
underwhelming. Like weather forecasters, economic forecasters must deal
with a system that is extraordinarily complex, that is subject to random
shocks, and about which our data and understanding will always be
imperfect. In some ways, predicting the economy is even more difficult
than forecasting the weather, because an economy is not made up of molecules
whose behavior is subject to the laws of physics, but rather of human beings
who are themselves thinking about the future and whose behavior may be
influenced by the forecasts that they or others make.”
Mr.
Bernanke’s comments are not remarkable only for their clarity and
candor, or because they are a stark admission of the failure of central bank
monetary policy, but because they echo the founding principles of the
Austrian school of economics. In fact, Mr. Bernanke provides excellent
reasons for the repeal of the US Federal Reserve Act. Despite common
misconceptions of economics as a branch of mathematics or as a hard science,
economics is in fact a social science, similar to psychology. For
example, when we speak of economic incentives we are referring to the
manipulation of human behavior through artificial means to achieve policy
objectives such as increasing consumer spending, just as pairing the sound of
a bell with the introduction of dog food will produce dogs that salivate at
the sound of a bell when no food is present (of course the salivation
response can eventually be extinguished if no food is provided for an
extended period of time).
Psychology, it
turns out, has a great deal to say about economics, investment banking, and
public finance. Indeed, key psychological themes are common to all
three areas of endeavor.
The
Illusion of Control
There may be a
simple explanation, rooted in human nature, for the ever larger disasters
brought about by government interventions in the economy and by the
institution of central banking. The illusion of control is persistence
in the belief that a given outcome can be controlled when no demonstrable
influence exists or where, as Mr. Bernanke stated, outcomes cannot be
accurately predicted. Whether intervention is the result of central
bank monetary policy or of government legislation, taxation or regulation, it
is the inherent unpredictability of the outcomes of intervention that belies
the philosophy of interventionism itself. Former Federal Reserve
Chairman Alan Greenspan, Ph.D., grappled with this fact in the wake of the
financial crisis when, in testimony before the US Congress on October 24, 2008, he
said:
“…
an ideology is [...] a conceptual framework with the way people deal with
reality. Everyone has one. You have to -- to exist, you need an
ideology. The question is whether it is accurate or not. And what
I'm saying to you is, yes, I found a flaw. I don't know how significant or
permanent it is, but I've been very distressed by that fact. [That
there is a] flaw in the model that I perceived is the critical functioning
structure that defines how the world works, so to speak. … I was
shocked, because I had been going for 40 years or more with very considerable
evidence that it was working exceptionally well.”
Mr. Greenspan
accurately refers to the dominant economic theory, not as a science, but as
an ideology that ultimately does not conform to reality. In
psychological terms, an irrational belief that cannot be modified by reason
or evidence is precisely the definition of the term “delusion.”
Despite his having been confused for 40 years, Mr. Greenspan clearly
recognized and acknowledged a limitation of his economic ideology. In
retrospect, perhaps Mr. Greenspan regrets having departed from his original views.
Sadly, the same cannot be said for the majority of economists, central
bankers and US government officials who do not recognize, as Albert Einstein
pointed out, that ”the definition of insanity is doing the same thing
over and over again and expecting different results.”
The
Gamblers
Gambling
addiction and belief in the paranormal, e.g.,
psychokinesis, are examples of the illusion of control. When rolling
dice in the casino game craps, for example, people tend to throw harder for
high numbers and softer for low numbers when there is no connection between
the force with which the dice are thrown and the result. Experimental
subjects can even be made to believe that they can affect the outcome of a
coin toss through their level of concentration. The illusion of control
is a key factor in gambling addiction because it is reinforced by occasional
successes and, as has been long established by behavioral psychologists,
behaviors conditioned by intermittent reinforcement are the most difficult to
extinguish.
Warning signs of
gambling addiction include defensiveness, secrecy, and desperation: precisely
the attitudes exhibited by Wall Street bankers seeking bailouts from the US
government in 2008. Like US banks transferring private losses to
taxpayers, gambling addicts may hold others responsible for their financial
problems and they may adamantly insist that they be trusted. Gambling
addicts tend to be secretive about finances, while at the same time
irrationally insisting on having control over money, just as Federal Reserve
Chairman Ben Bernanke has insisted that Congressional review of the Federal Reserve’s books.
i.e., to find out what financial institutions received taxpayer dollars, would compromise its vaunted independence and harm the US economy.
The more gambling addicts are in debt, the more they feel the need to defend
gambling and they often defend a specific theory or model that
“guarantees” winning (if only they can get more money to continue
gambling).
A gambling
addict’s savings and assets may mysteriously dwindle, perhaps like
crumbling bank balance sheets laden with sub-prime mortgages or bank losses
associated with risky financial derivatives, and there may be unexplained
loans or cash advances, perhaps like the Federal Reserve’s Term
Asset-Backed Loan Facility (TALF) program. Like banks jacking up credit card interest rates,
gambling addicts become increasingly desperate for money to fund further
gambling. The debts of gambling addicts may increase sharply,
reflecting a “bet more, win more” mentality that inevitably leads
to the gambler going bust. Gambling addicts seek money with increasing
desperation, perhaps like former US Treasury Secretary (and former Chairman
and Chief Executive Officer of Goldman Sachs) Henry M. Paulson’s dire warnings of financial Armageddon in
2008. Items easily sold or pawned for money may
mysteriously disappear, perhaps like the US government’s Fort Knox
gold, which is surrounded by rumors and speculation that a long sought (e.g.,
by the Gold Anti-Trust
Action Committee) independent audit could easily dispel.
The
Alcoholics
The original Twelve
Steps published by Alcoholics Anonymous include
admitting that one’s life, or in this case the US economy has become
unmanageable and that a power beyond one’s self (i.e., beyond current
economic theories and government policies) is necessary to restore
sanity. Contrary to the views of current Goldman Sachs CEO Lloyd Blankfein, the Higher Power cannot be one’s self.
The self regulating dynamics of a free market, for example would certainly
adjust US housing prices to sustainable levels and promote sound lending
standards, but this has been prevented by the interventions of the Federal
Reserve and US government. Not coincidentally, it was the Federal
Reserve and the US government, respectively, that originally caused the
inflation of housing prices and undermined lending standards.
Breaking the grip
of alcohol addiction requires a searching and fearless moral inventory, admitting
the exact nature of one’s wrongs, and an unreserved willingness to
change and to make amends with those who have been harmed. Sadly,
neither Federal Reserve, nor Wall Street bankers, nor the US Congress, which
is committed to borrowing its way out of debt, seem likely to repent.
The destructive
behavior of alcoholics is often enabled by dysfunctional, co-dependent relationships.
A dysfunctional relationship is one that
creates more emotional turmoil than satisfaction, or in the case of the US
economy, more destruction of wealth than creation. Warning signs of a
dysfunctional relationship include, for example, addictive or obsessive
attitudes, an imbalance of power, or a superiority complex on the part of one
person. Co-dependency is a pattern of detrimental behavioral
interactions within a dysfunctional relationship, most commonly a
relationship with an alcohol or drug abuser, but equally possible in a
relationship with a gambling addict. The co-dependent is a person who
perpetuates the addiction or pathological condition of someone close to them
in a way that impedes recovery.
The US government
appears trapped, together with the Federal Reserve and Wall Street banks, in
a destructive web of dysfunctional, co-dependent relationships. The US
government is addicted to the easy money created by the Federal Reserve at
the expense of taxpayers who eventually suffer a loss of purchasing
power. According to Mr. Greenspan’s 1966 article Gold and
Economic Freedom, “deficit spending is simply a
scheme for the confiscation of wealth.” Wall Street bankers
depend on US government bailouts and guarantees, as well as on the Federal
Reserve’s lax monetary policy, and the Federal Reserve depends directly
on the US government for the legalization of its unaccountable monopoly and
indirectly on the continuation of the largest US banks. While a
dysfunctional triangle of co-dependency is merely descriptive, the
interdependence of the Federal Reserve, the largest US banks and the US
government and is a fact in reality.
Unfortunately, it
is no more possible to spend one’s way to prosperity or to borrow
one’s way out of debt than it is to drink one’s self sober.
Nonetheless, thanks to the Federal Reserve’s 7 day per week, 24 hour
per day money printing service, the US government plans to do precisely this.
If creating wealth were as simple as printing money, the dominant school of
economics would be led by Robert Mugabe, President of Zimbabwe, and
Gideon Gono, governor of Zimbabwe's Reserve Bank (and winner of the 2009 Ig Nobel
Prize in Mathematics), who share with Mr. Bernanke a love for
the feel of crisp paper and for the smell of fresh ink.
As Milton Friedman once said “The real
problem with government is not the deficit. The real problem with
government is the amount of our money that it spends.”
The wealth
destroyed by the collapse of the US real estate bubble and the stock market
crash of 2008 has not been and cannot be brought back by bailouts, stimulus
spending or outright money printing. While averting a deflationary
spiral is necessary, propping up asset prices by dropping money from a helicopter
redistributes wealth and interferes with the price mechanism of the free
market. Devaluing the US dollar may help to hold up asset prices but it
also prevents housing prices from falling to sustainable levels while at the
same time adding the risk of eventually far higher prices, or, in the worst
case, hyperinflation. There is no historical example of a successfully
re-inflated economic bubble. What is more important, however, is that
the unintended consequences of currency debasement, i.e., the result of an
inflationary monetary policy marked by near 0% interest rates, are likely to
outweigh the goals of the policy even if they are achieved.
Reducing the
value of debts in real terms through currency debasement requires a
commensurate loss of purchasing power, thus while housing prices may be
prevented from falling further, savings will be destroyed and wages will lag
behind prices once they inevitably begin to rise. Although consumer
prices in the US currently lag behind the downtrend of the US Dollar Index
(USDX), an inflation tax will eventually be levied. Under the name
“economic stimulus”, wealth is being dissipated by the US
government at an alarming rate with no sustainable benefit. US
government programs like Cash for Clunkers only impact short-term economic
data while, in reality, destroying wealth, increasing debt and diverting
consumer spending into already bankrupt industries. At the same time,
the US government is eager to increase tax revenues to offset deficit
spending and it has all manner of businesses, as well as wealthy individuals
in its crosshairs. German-born Presbyterian clergyman William Boetcker
(1873-1962) wrote:
“You
cannot bring about prosperity by discouraging thrift. You cannot help
small men by tearing down big men. You cannot strengthen the weak by
weakening the strong. You cannot lift the wage-earner by pulling down
the wage-payer. You cannot help the poor man by destroying the
rich. You cannot keep out of trouble by spending more than your
income...”
Boetcker’s
words are profound. It is not possible to repair the US economy through
stimulus spending or to increase the wealth of consumers by inflating asset
values via currency debasement. Supporting asset prices, thus bank
balance sheets, via currency debasement, in the best case, can spread debt
defaults over time, perhaps delaying the collapse of bankrupt financial
institutions. However, currency debasement promises to move Americans
closer to the financial status of Zimbabweans due to the destruction of the
purchasing power of the US dollar. A less valuable US dollar will
reduce consumer spending in real terms, and reduced consumer spending will
impact businesses and, therefore, jobs.
The US
Dollar and Gold
The price of gold
indicates a lack of confidence in the US dollar and in the US economy and it
reflects poorly on the credibility of the Federal Reserve and of the US
government. The changing composition of central bank reserves,
i.e., increasing gold holdings, is a direct effect of the currently weak US
economy and US dollar, which has lost considerable value in recent
months. In contrast, gold is the only financial asset, in fact a
currency that has no counterparty risk. This simple, but often
overlooked fact goes a long way to explain current investment
demand for gold.
Chart courtesy of
StockCharts.com
All other things
being equal, strong economies offer investors superior returns and lower risk
compared to weak economies, thus the currencies of stronger economies are
always preferred over those of weaker ones and have a higher relative value
as a function of supply and demand. Of course, monetary inflation and
monetary deflation also influence the value of a currency in terms of supply.
In a world
financial system composed entirely of fiat currencies, where no currency is
redeemable in terms of hard assets, money is an abstract claim on production
and the value of one national currency relative to another can only,
ultimately be a reflection of the performance of the underlying economy that
the currency represents (performance being inclusive of the consequences of
its monetary policy), i.e., a claim on its production. Thus, if an
economy is in decline, i.e., its production is falling, its currency, over
time, must also decline. Conversely, there can be no doubt that if the
US economy were exhibiting credible and significant growth, i.e., if
production were increasing, the US dollar would certainly gain value, but
that is not the case.
Chart courtesy of
StockCharts.com
The fact that
central banks are reducing US dollar holdings and increasing holdings of
other currencies, as well as gold, is simply a matter of preserving the value
of their reserves in the face of developments influencing the value of the US dollar, such as the
burgeoning US dollar carry trade. Having
gone “all in” to save the largest banks, the Federal Reserve and
US government continue to assume that the crisis can be managed, despite the
fact that their policies are making the situation worse in terms of
sustainable housing prices, public debt and the value of the US
dollar. In the mean time, Wall Street bankers have gone back to the
casino, nonchalantly cashing in their bailout chips and pocketing the gains.
The rationale of
buying time for US banks and of supporting US real estate prices seems
reasonable on its face but this probably doomed policy is proving
counterproductive. Despite the patina of economic recovery sprinkled
over the news media like fairy dust, small business and commercial real estate failures, as well as
ongoing residential mortgage and credit card defaults, are rippling
through the weak US economy, while unemployment continues to rise undermining consumer spending thus,
ultimately, bank balance sheets.
Setting aside the understandable reluctance of US banks to make new loans, no
amount of tenuous
good news, no matter how exaggerated, has been able to rekindle the
frenzy of consumer borrowing that formerly
characterized the US economy.
The illusion of
control is a temporary state of affairs. The triangle of dysfunction
and co-dependency formed by the Federal Reserve, Wall Street banks, and the
US government is like a story about a madman, a gambler and an alcoholic,
where each traps the others in their respective downward spirals. The
illusion of control, common to all three, is gradually bringing about a
situation that will inevitably be entirely out of control, but, as with gambling
addicts and alcoholics, the point where control is lost can only become
apparent after the fact, just as the financial crisis of 2008 caught the vast
majority of experts by surprise.
Investors,
governments and central banks around the world are seeking safety outside the
US dollar, particularly in gold, as well as outside of the US stock market,
e.g., in emerging economies. The more
borrowed money the US government spends, the more money the Federal Reserve
prints and the longer zombie banks are kept on life support, the
worse the eventual condition of the US economy, the weaker the US dollar and
the higher the price of everything in US dollars will ultimately be,
particularly gold.
Ron Hera
Hera Research
Visit his website
Send him mail
Also
by Ron Hera
Ron Hera is the
founder of Hera Research, LLC, and the principal
author of the Hera Research Monthly newsletter. Hera Research provides deeply
researched analysis to help investors profit from changing economic and
market conditions
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About Hera
Research
Hera Research,
LLC, provides deeply researched analysis to help investors profit from
changing economic and market conditions. Hera Research focuses on
relationships between macroeconomics, government, banking, and financial
markets in order to identify and analyze investment opportunities with extraordinary
upside potential. Hera Research is currently researching mining and metals
including precious metals, oil and energy including green energy,
agriculture, and other natural resources. The Hera
Research Monthly newsletter covers
key economic data, trends and analysis including reviews of companies with
extraordinary value and upside potential.
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