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It is open season for wild monetary
prognostications. More premature obituaries on the dollar have been posted on
the Internet. For example, see Jim Willie’s The US Dollar Paper
Tiger (Gold-Eagle, January 11) with epitaphs like "the U.S. dollar
rising to the cemetery", or "dollar death dance". Or see
another article, Jeff Nielsen’s entitled Maximum Fraud in U.S. Treasurys (Gold-Eagle, January 3). It betrays maximum
misunderstanding about keeping the dollar on a life-support system. It
assumes that the Fed and the U.S. Treasury are fighting tooth and nail to
keep the value of government debt high lest it collapse in want of support
from Japan, China, and other countries.
These views hang the picture upside down. In
actual fact, the Fed and the U.S. Treasury desperately want to beat down the
value of the dollar. The greatest obstacle frustrating their effort is the
stubbornly high and still increasing value of U.S. Treasurys.
Captains of the world’s monetary system are yanking levers and twisting
throttles which are no longer connected to anything. The captains are no
longer in control. Yet they continue to wave their batons feverishly and
pretend that the orchestra is paying attention. They want Jim Willie, Jeff
Nielsen and everyone else to believe that the falling interest-rate structure
is the outcome of their deliberate monetary policy. In fact, the Fed and the
U.S. Treasury are trying to stop the rate of interest from falling further.
They instinctively realize the threat of falling interest rates brings
deflation and depression in its train. The dollar is much too strong,
contrary to the wishes of policy-makers. It is not so easy to beat down
the value of the dollar as suggested by Keynesian textbooks, even if you have
the key to print shop where the presses are running. The dollar’s
strength prevails in spite of the withdrawal of Chinese and Japanese support
of the U.S. bond market, and in spite of the destructive monetary policies of
the American guardians of the dollar.
This observation reveals the prevailing
profound misunderstanding about the nature of this financial crisis. To set
the matter right, in this article I shall recapitulate the argument that I
have been presenting on the Internet for the past ten years.
Where Keynes went wrong
At the heart of my theory is speculation, the
main driving force of the huge oscillating money flows between the commodity
market and the bond market. It can, and often does, overrule official
monetary policy.
It is well-known that Keynes had a poor
understanding of speculation. His occasional excursions to the pits resulted
in significant financial losses for him. No more successful was he as a
theorist. For example, he introduced the concept of normal backwardation as
the main underlying feature of the futures market. He insisted that in buying
futures contracts speculators demand ─ and receive ─ compensation
for their services as ‘insurers’ in return for carrying the price
risk that owners of physical commodities and first order financial assets are
unable or unwilling to carry. First order financial assets such as stocks,
bonds, foreign exchange, mortgages must be carefully distinguished from
higher-order financial assets such as futures and options on first order
financial assets, options on futures, options on options on futures, and so
on and so forth ad libitum. Keynes did not live to see the rise of
higher order financial assets. He called the insurance premium speculators
pocket when their contracts mature ‘normal backwardation’.
Backwardation is the name for the market
condition under which futures are offered at a discount relative to
physicals. Keynes is putting things upside down. The futures market, far from
being an insurance-operation, is in fact a market for warehousing services.
The warehouseman buys the physicals and sells the futures as a matter of
arbitrage. But he can do that only if the future price is at a premium over
the cash price. This condition is known as contango,
which is the exact opposite of backwardation. For example, at harvest time
cash wheat is plentiful and contango is robust. The
elevator operator, our warehouseman, is buying cash wheat against selling
wheat futures. In doing so he performs a useful service to society: that of
warehousing and rationing the wheat supply until the next crop comes around a
year later. The premium, the difference between the futures price and the
cash price is his fee for the service. To create this arbitrage opportunity
was the main justification for starting futures trading in wheat and in other
agricultural commodities in the 19th century, when the monetary unit was a
positive rather than a negative value. Notice that nature is responsible for
the fluctuation in the price of agricultural commodities: weather, unforeseen
natural disasters, climes and other things over which man has no control.
All this has changed when, at the behest of
Keynes, governments exiled gold from the monetary system and embraced a
negative value, debt, as the monetary unit. As an immediate consequence a lot
of new futures markets sprang up, chief among them the futures market for
foreign exchange and the bond market. In these the cause of fluctuation was
no longer nature. Instead of nature-created risks, here futures trading
addressed artificial risks created by man. Keynes blithely assumed that
futures trading would have the same stabilizing effect on the price of these
financial assets as it did in on the price of agricultural commodities. This
was his worst blunder. When man or a committee of men rather than nature
calls the shots, speculation becomes destabilizing. The nature of
speculation has changed beyond recognition. In the first scenario when nature
alone calls the odds all speculators start with equal chances. No combination
of bets is capable of changing the odds. This is no longer the case when
risks are man-made. In this case speculation assumes the character of
gambling. Here speculators (gamblers) are matching their wits against that of
the house. Here, given a bottomless purse, a combination of bets can indeed
change the odds. The gamblers can even beat the house. We have seen it happen
time and again: speculators in foreign exchange or bonds won and the
government or the banks had to take huge losses.
It would be more reasonable to talk about normal
contango than about normal backwardation,
the obsession of Keynes. Backwardation in many ways is an anomaly. If
and when it occurs, it indicates scarcity. In case of scarcity there is no
need for warehousing. Keynes got it all wrong.
The problem of warehousing applies to gold par
excellence, which owes its status as the monetary commodity
(independently of the wishes of governments and banks) to the size of stocks
which are large relative to flows which are meager. The
stocks-to-flows ratio of gold is a high multiple, in contrast with that of
copper, for example, which is a small fraction for reasons of its fast
declining marginal utility.
If gold is forcibly divorced from money by
order of the government, or to say it differently, if a negative value such
as debt is foisted upon society as the new monetary unit, then the price of
gold will fluctuate inviting speculation and gold
futures trading. The gold futures market, if it is to function at all, must
be a contango market. Otherwise it would give an
opportunity to speculators to make risk free profits (they would buy cash
gold at a discount and sell futures at a profit). That would immediately
eliminate the discount on gold futures (making a mockery of Keynes’ normal
backwardation.) However, in the case when gold is scarce as a result of
flight from paper currencies, permanent backwardation of gold puts in
an appearance. This sounds the death knell of the regime of irredeemable
currencies.
Not only did Keynes misunderstand speculation,
but he also completely misconstrued the God-ordained role of gold in society.
He did not see that variable foreign exchange rates would ultimately
undermine paper currencies and bond values due to gold hoarding. Moreover,
vanishing confidence in foreign exchange rates and bond values could be
directly measured in terms of vanishing contango.
Ultimately, all monetary gold would be driven into hiding. The biblical
writing on the wall "Mene tekel upharsin" (you
have been put on the scale and found wanting) would become reality in a
literal sense.
Ever since gold futures markets started
trading in the early 1970’s, they were subject to the Law of Vanishing Contango. It was never properly understood by the
so-called experts or by anyone else. While nobody could predict when contango would go into permanent backwardation, it is
certain that when this ominous event happens, the music stops and the game of
musical chairs is up. Mainstream economists ignore
the problem of permanent backwardation in gold. They do it at their
own peril.Keynesian/Friedmanite economics is going to be shipwrecked on the
reef of permanent backwardation. Irredeemable paper currencies which they
have spawned will be ignominiously wiped off the face of the earth.
Economic resonance
When at the behest of Keynes foreign exchange
rates were deliberately destabilized, a couple of other ominous things
happened. Most importantly, interest rates were also destabilized that made
an old phenomenon, the Kondratiev long-wave cycle
self-boosting, leading to runaway-vibration. As may be recalled, this rather
rare physical phenomenon caused the Tacoma suspension bridge in Washington
state plunge into the river in 1940. Parcels of energy bombarding the bridge
in gusting winds resonated with one of the characteristic harmonic
frequencies of the bridge. As a result total energy, rather than dissipating
harmlessly, kept piling up. It ultimately overwhelmed the statics of the
bridge. Engineers have forgotten to take runaway resonance into account when
the bridge still existed only as a blueprint. Likewise, designers of the
regime of irredeemable currency have failed to consider economic resonance.
Runaway vibration exists in economics whether recognized or not. It can
destroy currency and bond values just as it can destroy bridges.
I describe the present economic crisis in
terms of economic resonance. The economy experiences oscillating money-flows
between the commodity market and the bond market. When money flows from the
bond market to the commodity market, we witness the inflationary phase of the
cycle. Inevitably, rising interest rates accompany this phase. At the top of
the cycle the money-flow will reverse itself and will go from the commodity
market to the bond market. This is the deflationary phase of the long-wave
cycle that, no less inevitably, is accompanied by falling interest rates.
These huge money-flows are driven by speculation. There is a linkage between
the price level and that of interest rates compelling them to move in the
same direction (always subject to leads and lags). Furthermore, the two
resonate. It is altogether too naïve to suggest that the government is
equipped to control the phenomenon of economic resonance. As the story of
King Canute shows, tides of the sea cannot be turned back by royal
proclamation.
For centuries the Kondratiev
cycle has been kept on a leash. Resonance was always damped so that vibration
could never reach runaway levels. Neither prices nor interest rates were
allowed to grow indefinitely. At one point the policeman would stop their
march and turn them back. The policeman was none other than the gold
standard.
The regime of irredeemable currency fired the
policeman and resonance has become self-boosting. Runaway vibration is in the
making. When the energy level of the self-boosting system overwhelms
centripetal forces, the system snaps like a broken chain, releasing the
surplus energy most destructively. This is the substance of every crack-up
boom. Like Mises, I also object to the use of the
word hyperinflation, albeit for a different reason. It suggests that the
phenomenon is linear and follows the laws of the Quantity Theory of
Money. The more money is printed, the higher do prices go. However, we are
here facing highly non-linear phenomena. Our economy is torn to pieces
by runaway vibration. We are victimized by the self-destruction of the
monetary system subjected to oscillating money-flows boosted by the resonance
of fluctuating interest rates resonating with fluctuating prices.
The vampire of risk free bond speculation
Another ominous thing happened when, at the
behest of Keynes, foreign exchange rates were deliberately destabilized.
Monetary policy has become counter-productive. When the central bank
intervenes in the market to control the rise of interest rates, it
inadvertently makes prices fall; and when it intervenes to stop prices from
falling, it inadvertently makes interest rates rise. The upshot is that the
central bank intervention, rather than tempering movements, aggravates them.
Once more, the source of the trouble is
Keynes’ poor understanding of the dynamics of speculation. Whether
combatting inflation or whether combatting deflation, the central bank has
only one policy tool, namely, printing more money. Keynesian economics
pretends that the central bank operates in vacuo.
It can assume away any and all side effects. But there is one side effect it
certainly cannot wish away, and that is bond speculation that follows the
central bank like the shadow follows the thief. The bond market is huge,
exceeding the equity market in size more than ten-fold. Equally huge is its
speculative following.
When the central bank wants to control rising
interest rates, then it goes into the open market to be a net buyer of
Treasury bonds. Inevitably, speculators want to preempt the central bank.
They strive to buy the bonds first, dumping them into the lap of the central
bank at a higher price afterwards. Speculators are making risk free profits.
The central bank is helpless. It has to pay the speculators’ price.
Likewise, when the central bank wants to
control falling prices, it goes into the open market to be a net buyer of
Treasury bonds. Speculators will gratefully take the new money so created. Of
course, the central bank wants them to buy commodities to prevent prices from
falling. However, speculators have a better idea. They go to the bond market
where the fun is. Commodities are too risky for their taste, especially when
they can make risk free profits in bonds. The risk free profits speculators
make are made possible by Keynesian monetary policy.
This is the fundamental flaw of Keynesian
economics. At the present junction the Fed is buying bonds to combat
deflation. Bond speculators know this, will buy the
bonds first driving down interest rates in the process. The result is more
deflation, not less. The Keynes-inspired central bank action is
counter-productive. Policy-makers are blind and don’t see this. They
stick to their self-defeating monetary policy. They actually become the
quartermaster general of the depression they are trying to avoid. As if
cursed by a particular kind of madness, policy makers saddle society with the
vampire of risk-free speculation. They turn the constructive energy of
stabilizing speculation into a most destructive kind of energy: destabilizing
speculation. The problem cannot be cured because bond speculation cannot be
eliminated. It should be clear that as long as the world does not succumb to
a military conflagration such as a world war destroying supplies of goods and
production facilities, the danger is not inflation as predicted by the
Quantity Theory of Money. The danger is deflation due to risk free-profits
with which Keynesian economics inadvertently tickles speculators.
It is suggested that the world is facing an
imminent inflationary collapse of the dollar for reasons of over-issue. But
what the world is getting is a deflationary collapse of the economy, as a
result of the obtuseness of academic economists and policy-makers sold on
Keynesian economics. They fail to see in the collapse of the rate of interest
the inherent destruction of capital. Businessmen are lethargic. They know
that making new investments while interest rates keep falling is suicidal. No
matter how low interest rates may go, their competitors who invest later will
have the advantage of investing at lower rates still.
Destruction of the wage fund
The German economist Heinrich Rittershausen (1898-1984) predicted the horrendous unemployment
that was to hit the world economy in the 1930’s in terms of the
destruction of the wage fund. He pointed to the failure after World
War I to rehabilitate the real bill market. The victors in their
conceitedness ignored the fact that the wage fund, out of which workers could
be paid up to 91 days in advance of the sale of merchandise they are
producing, was part of the volume of circulating real bills. When the
bill market was destroyed in consequence of the deliberate decision not to
allow real bill circulation to return after hostilities ended, the wage fund
was destroyed along with it. There was no one to advance the funds out of
which wages could be paid for labor whose product has not been and may not be
sold for up to 91 days. But workers could not wait 91 days to buy food,
clothes and shelter for themselves and for their offspring. In the absence of
a wage fund employers had no choice but to lay off their employees.
Rittershausen was ignored by economists in the Anglo-Saxon
countries. His message is still being ignored in the world today. But make no
mistake about it, unless gold bill trading is rehabilitated soon, the world
will face a new wave of unemployment far worse than that of the 1930’s.
This also confirms the deflationary diagnosis for the present crisis.
The majority of hard-money analysts call for a
hyperinflationary collapse of the dollar. Their analysis is faulty. Like a
cornered rat, the dollar is capable of putting up a vicious fight for
survival. In the words of Mark Twain, all the obituaries on the dollar are
premature. The dollar is not a push-over. A yen-yuan
coalition (or any other combination of existing or yet to-be-invented fiat
currencies) cannot send it into oblivion.
To say that the dollar is strong is not the
same as saying that is also healthy. In fact the irredeemable dollar is
terminally ill. The reason for this is its departure from constitutional
money. The Constitution mandates a metallic monetary system for the United
States. Nothing shows the bad conscience of our monetary leadership more
clearly than the fact that they could never muster up enough moral courage to
propose a Constitutional amendment giving the federal government the power to
establish a monetary unit based on negative values such as debt. Cheerleaders
for fiat money in academic circles, in the media, and in financial journalism
will not be able to live down the shame that will be their lot when the world
economy collapses. The excruciating economic pain that people will suffer as
a consequence will be their responsibility. The break-down in law and order
will be their fault. As history and logic conclusively prove, fiat money is
not a viable monetary system. It is prone to succumb to the sudden death
syndrome. Whether caused by inflation or whether caused by deflation, sudden
death is assured.
It should not be beyond the wit of human
intelligence to see this coming and fend off the disaster by making a timely
return to sound money, based on a monetary unit of a positive value as
mandated by the American Constitution.
January 13, 2012.
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ANNOUNCEMENT
New Austrian School of Economics
Course
Four Munich, Germany
from March 24 - April 2, 2012
Title of the course:
The Austrian Theory of Money, Credit, and
Banking
This is the fourth in a four-course series on
Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including
beginners, who are interested in the theory of money, credit, and banking,
with special emphasis on the current financial and economic crisis. The
complete program consists of four courses (10 days, 20 lectures each).
Completion of each course will earn one credit. Participants who have
accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 and courses Two
and Three that were given in 2011 are not a prerequisite. All three are available on DVD for purchase.
For further information or in order to register
for the course you can get in contact with the organizers Ludwig Karl and
Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de
) or phone ( +49 – 170 – 380 39 48 , before calling please
consider a possible time lag).
http://www.professorfekete.com/
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