February 11, 2011

The following article was written in May of 2009 in response to the introduction of quantitative easing by the Fed.  Remarkably we are in the same place economically and monetarily as we were then. Two years later we are still debating the same questions. A re-read of this article may provide a little perspective regarding where we are and what confronts us today. 

In fact it may be difficult when reading this article to remember that it wasn't written for today. In 2009 we were told that the Fed was leading us down the road to inflation.  That claim has been proven wrong--the rate of inflation has declined since 2009.  Today, those same claims are being recycled. I believe they will be proven wrong again. As Yogi Berra once quipped, "It's like deja vu all over again."





Most hard money advocates understand that artificially increasing money and credit is inflationary.  So when Ben Bernanke increased the money supply by over a trillion dollars, and the government increased the budget deficit from a half trillion to over four times that figure in one year, most fiscal conservatives and fed watchers yelled "inflation." I was one of them.


Last week in testimony before Congress, Bernanke was questioned on this very point by Congressman Ron Paul.  The exchange was instructive.  Ron Paul cited these massive increases of spending and money and credit creation. He questioned if interest rates went up substantially, whether the fed would have the will to contract the money supply and allow the economy to fall into recession. 


In effect Bernanke's response was that if it came to a choice between defending the currency and preventing a recession, the currency was their number one priority.  He delineated the tools the fed had at their disposal to accomplish this.  And he reiterated that the moves the Fed took were both necessary to prevent structural damage to the nations monetary system and temporary.


I do not believe that Bernanke is an evil man.  Nor do I believe he is stupid.  I think he knows everything we know about the threat of inflation and agrees with the very real potential threat Ron Paul was pointing out.  I also believe he has thought through how he intends to combat progressive inflation.  He believes his strategy will re-inflate enough to preserve the monetary system and prevent deflation from taking hold, but not so much as to cause an institutionalized inflationary problem.


There is a difference between inflation and progressive inflation.  Inflation, which is the artificial increase of money and credit, dilutes all other dollar claims outstanding.  It is a tax.  It applies whether prices are rising or falling.  A deflation combated by an aggressive Fed may see prices fall, but by less than they otherwise would absent Fed intervention.  This is also a tax.  Any major initial increase of money affects prices, interest rates, production, and investment decisions--throughout the economy--and distorts the market process along the way.


However, once the new money has worked its way through the economy the market adjusts to the new set of conditions and the effects stop there.  Yes a tax has been levied and distortions occurred; but as long as this is a one time only injection the economy tends to adjust and return to normal. Prices become stable again.


Progressive increases in the supply of money and credit are a very different story.  Progressive increases mean going from say rates of 2% to 5% to 7%, ad infinitum. These increases create vast distortions which lead to malinvestment, over-consumption, and the misallocation of resources.  Allowed to go on unchecked this leads to progressive increases in prices and interest rates.  At the end of this process the monetary system explodes as it becomes impossible for the market to adjust.


 If we take him at his word, Ben Bernanke will choose to allow interest rates to rise, if and when the economy recovers.  He will opt to fight inflation when the time comes. This means allowing the economy to turn down if and when necessary.   If I read him right, he will take whatever actions necessary to prevent systemic damage but that does not include preventing recession, nor does it include progressive inflation by the Fed.  His focus is on the health of the financial system.  If and when the system stabilizes, he will allow the chips to fall where they may.


Two problems arise with this strategy: 


First, will the administration allow this?  The agenda of Barak Obama is not the agenda of Ben Bernanke.  The Obama Administrations 3.6 trillion dollar budget is intended to stimulate the economy, reduce unemployment, and change social priorities.  The trillion dollars supplied by the fed is an attempt to replace the money lost to the banks.  It is an attempt to prevent deflation and an implosion of the entire banking system.  Bernanke cannot control Obama's fiscal policy, but he doesn't have to finance it.  Will Bernanke be allowed to "take away the punch bowl" as he said he would in testimony to Ron Paul?


Second, if prices rise will the fed attempt to withdraw the money it injected into the economy and return the inflation rate to lower levels as Ron Paul and many hard money advocates want?   Bernanke has said as much in testimony.  I believe this could be a huge mistake.  There is a historical example of this that provides a valuable lesson.


During the first world war England was on the gold standard.  It suspended gold convertibility and pursued inflationary policies to finance the war.  After the war it tried to return to the gold standard by reducing the money supply and force the price level of the country back down to pre-war levels.  To do this England tried to fix the pound in terms of gold, but at the previous price. The experiment failed miserably.  The gold standard itself was blamed as the nation went into depression.  This mistake was responsible for England abandoning the gold standard it had adhered to more or less since the 14th century.  In many things monetary, you cannot go back.  I believe this is the case now.


The price of gold shot up 60 dollars on the day Bernanke announced the fed would monetize the debt by buying long term bonds. But then gold re-evaluated the inflationary threat.  Since that day gold has leveled off again and the dollar has traded in a narrow range.  Interest rates have risen in the face of the Feds announcement. (Remember, this was May of 2009.  We have been through this before.)


The gold market has re-evaluated the inflationary threat, I think so should we. Most hard money advocates are convinced that progressive inflation, if not hyper-inflation, is inevitable.  I think this fear may be overstated.  If Bernanke makes this a temporary injection of new money and credit, and if he eventually allows interest rates to rise, then I think we can avoid a nasty bout of inflation.  If Bernanke does not contract the money supply, but reduces the rate of increase to normal levels, and allows the markets to adjust to it, I think we can avoid a more severe recession.


The best course of action, and perhaps the only rational one we have, is to pay the penalties we must and allow the economy to adjust.  Pay the inflation tax which might only be a one time 3 to 4% penalty. Pay the interest rate penalty which may mean having to endure 5 to 7% long-term interest rates for awhile.  Pay the higher tax bill which is coming on the local, state, and eventually the federal level. Pay the penalty of further economic slowdown if necessary.  And most importantly, endeavor to resume reasonable monetary growth as soon as possible. If we "pay the price" in these ways, we should eventually return to a stable price level.  Economic activity will remain sub-normal, but that is just another penalty for our multi-trillion dollar expenditure.


In the months ahead we will test the will and wisdom of Mr. Bernanke to fight inflation and we will also test the political fortitude of President Obama to tolerate this fight in the face of rising interest rates.  It should be interesting.




Post Script:  Nothing has changed in the two years since this article was written.  Inflation has not gone up progressively as was predicted, the dollar has not crashed as we have constantly been told it would, and the economy is still puttering along.  The test of Mr. Bernanke I referred to above is still in the future--but unavoidable.


For those of you saying that we have a huge commodity inflation and that this is the result of the Fed and QE2, I suggest  you pull up a chart of the CRB, which is an index of fifteen commodities, weighted heavily in oil.  You will find that in June of 2009, the CRB stood at 440.  Today it is 338.  Commodities are substantially lower than they were a couple of years ago.  You would never know it from the great howls of criticism leveled against the Fed and fears of inflation.  And the CPI has fallen from 2.5% increases to .08% increases since the Fed injected the new huge amounts of money into the banking system.


To Bernanke's credit, he did not make the mistake of post-war England and reduce the money supply which would have thrown us into a major deflation.  He abandoned his "exit policy" plans in favor of resumed increases in money supply. He has announced that those increases will end this June. Once again I think this is a mistake, and I hope he will reconsider as he did last time. 


What he should have announced is that the Fed will return to normal open market operations, increasing the money supply at a steady and low rate of increase.  He need reduce the money supply only to the degree that present dormant money becomes active and begins chasing goods.  That would be a temporary stabilizing process.


What the Fed decides is crucial to future investment decisions.  A contraction of the money supply will have profound effects on commodities as well as economic growth if done in response to theory rather than what is actually happening in the economy.


Interest rates are moving up.  Soon, after a brief spurt of growth, I believe economic growth will slow.  I also believe we will see unemployment begin to rise again, and the bite of increased inflation and increased interest rates will not be welcomed by the populace at large.  It is then that the Fed will need to move in spite of public and political opinion. They will need to provide a stable and predictable monetary policy and allow the economy to re-adjust.  Such a policy will mean a mild economic contraction, but as I pointed out in 2009, this is a penalty we must pay.


Meanwhile, Barak Obama will be looking at re-election.  Will he let the Fed, be the Fed?  Will Congress let the Fed be the Fed?  Many think not. There are already schemes by both the Administration and Congress to usurp the Fed's power.  As I write this it has been announced that Kevin Warsh, the last Hawk on inflation, has announced his departure from the Fed.  This leaves only Obama appointees on the Board Of Governors.  Which leads to a final question: will the Fed let Bernanke be Bernanke?


Once again...it should be interesting.



Market Update:


For the first time in about four years we are seeing a return to normalcy in the credit markets. First signs of an increase in credit being extended through car loans, home loans, credit to small business, and consumer credit card use, are being seen in the US marketplace.  For years, credit has been frozen.  What this credit increase means is a return of the normal velocity of money.


M1 and M2 have been increasing together with velocity for the first time in about four years.  Prior to this, the Fed would increase the money supply, the money would lay dormant, and not chase goods.  It would not be lent out, and not be invested.


What we are beginning to see are the first signs of overall economic health returning.  Investing has picked up as the stock market has risen and the bond market has fallen.  As growth and inflation picks up, bond investors are slowly transferring out of their bond positions into companies that are earning record high profits and increasing their dividends.  What we are witnessing is a "melt up" as the stock market makes weekly new recent highs.


As the market goes higher, the wealth effect increases.  There is an estimated 6 trillion dollars of "scared money" still on the side lines, that could potentially be employed to either invest or spend.  What this money does will determine in large part where markets go, and where the economy goes.  Add to this the transfer of investment dollars away from emerging markets to the US, and you can see why we are moving continuously higher and higher in the stock market.


Just as there has been an international "walk" on gold, there is an international walk on US stocks taking hold.  Since the recession ended, we have now seen a year and a half of continuous growth, with 80% of companies reporting upside surprises in earnings.  Among the leaders of these stocks are the commodity and materials companies.


Last summer I covered my short position in the market and went  "all in" resource stocks.  I made a subtle change though, by switching away from gold stocks toward silver stocks.  In the fall of last year I continued to broaden out the portfolio by further diversifying into copper.  And just recently I added potash and uranium as part as my trading and investment universe.


Less than 1% of institutions and mutual funds own gold stocks.  Pension Funds own only about 2.6% of commodities.  The norm of both is 3-5%.  This indicates that we are a long way from the investment community being fully invested in precious metals.  This week Goldman Sachs announced it would for the first time, take gold as collateral, which further legitimizes gold use as a currency and as reserves. 


We remain in the infancy of a return to a gold standard, with some taking the first baby steps toward it's resurrection, whether they know it or not.  But the road to recovery will be bumpy. I  believe we will hit a soft spot after the first quarter of the year as interest rates and inflation begin to become problematic.


I think the first quarter will be the strongest quarter and I am looking to take profits soon.  Right now it's shaping up to be in March, but one never knows how long this run will last in the short term.


Portfolio by weight:


Coeur d'Alene Mines


Silver Wheaton

Copper Fox Metals

Rubicon Minerals

Lexam VG Gold

US Silver Corp


Denison Mines


Rochester Resources LTD