August 19, 2011

I am for a transition from a fiat standard to a gold standard over time.  In my book, The New Gold Standard, I make the case for this transition to be accomplished within the Federal Reserve System, not through its outright elimination.  A gold standard will only return with fiscal responsibility, not before. The Fed can be an important part of this transition.

The tolerance for the Federal Reserve, a fiat system, and the power of the government to control money and interest rates is waning across the board as we appear to be moving toward a de facto gold standard. Individuals, institutions, and governments, are moving to acquire gold for financial protection, as an alternative reserve asset, and a means of preserving wealth.  There is growing suspicion about the Fed's power to create money.

Milton Friedman himself, an advocate of a fiat standard, was for the abolition of the Board of Governors at the Fed. He stated many times that he would have no problem replacing the FRB with a computer. The key is to move away from men controlling the money supply and interest rates, to a system where the market controls these things.

There is a lot of anti-Fed talk, speculation, and articles being written about the Fed's "real motives.” Along with growing suspicion is a growing movement to abolish the Fed. Is the Fed actually a conspiracy of bankers who plan to inflate away debt, or artificially stimulate the economy in an attempt to create the illusion of prosperity? Are they only interested in power and control, as we are increasingly hearing?

What would be their motive? Board members make less money than they can in the private sector, so f they want riches they are in the wrong profession. They are overseen by Congress and have very little power as individuals except to try to create stability. If they do not achieve this stability, they are crucified by the populace. Fed Chairmen are ridiculed and abused by politicians and pundits alike, in fact I can’t think of one who hasn’t been. So, power is not their motive. An easy life is not their motive. And getting rich is not their motive. Why then would they want to create anything less than what their job dictates—stability? Who needs the abuse that would come with anything less?

 

It is true that Fed Chairmen and Governors make mistakes, and perhaps this is the best argument to end the Fed. But as it stands the mistakes made are at their own peril; just look at what is going on around the world with literal riots in the streets over inflation. Even the Communist Party of China fears the populace response to progressive inflation.

 

The Federal Reserve Board responsible for making monetary decisions is made up of both democrats and republicans. It is not an ideological board; it is a diverse one that dissents within at times. The board is instead goal driven, charged with preserving the value of money and within the constraints of congressional mandates. Violate those mandates and Congress, the public, or both, will come down hard on the FRB. So I ask again, what is the upside for these individuals to inflate?

Most criticism directed at the Fed, its Chairmen, or the Board of Governors, is misplaced. If anything, it is Fed policy that needs to be criticized, not those who in good faith, serve their country in a tough capacity. And considering the difficult task they are given, isn’t it natural that they would make some mistakes? Verbally pistol-whipping the Fed will do nothing to bring monetary stability to our nation or the world.

Regardless, it is time to change the mandate of the Fed to one of simply controlling inflation, and as Friedman said, we don't need a FRB for that. It is time to debate and resolve whether we as a nation want a Fed that controls the money supply and acts as a bank of last resort—or not. Our decision will determine the future of the Federal Reserve and perhaps the future of the financial system and economy we live in. Should money continue to be controlled by politicians and their appointees? Or is it simply too important to be left in government hands? Only after answering these tough questions will we truly determine what kind of future monetary system we will have in America.

 

 


Market Update:

 

I mentioned last week that one of the indicators I was looking at was M2. M2 is mostly a combination of checking and savings accounts. It represents money ready and able to be spent. For years the money injected by the Fed has been laying dormant as reserves on bank balance sheets. The money, which is in the trillions, has never come out of hiding. In the last few months this has begun to change.

 

This is not a Fed induced change. It is a market one. People are beginning to spend. And banks are beginning to lend. For the first time since the financial crisis money is beginning to be mobilized. Economists call this phenomenon, "velocity." There are two very important ramifications of this increase of velocity.

 

First, if it continues and grows it will stimulate, temporarily. It will show up in stock prices, increased sales, increased profits, and eventually increased employment. Second, such a rise in M2 is inflationary. As more money chases goods, it tends to bid up prices, across the board. This is very different from what we have witnessed in the last few years with manic/depressive prices.  If this increase in money supply and velocity continues, it should take hold next year. It takes about 6 to 9 months for the new money to enter and circulate in society.  This should be temporary if the Fed does its job.

 

It's too soon to call an end to the recessionary/disinflationary bias that hit this country last spring, but it is not too soon to call the possible beginning of the end. For sure, there will be a pause in both spending and lending due to the scare the country and the world has just been through. If the stock markets get their legs under them again, and the financial threats from Europe get off the front pages, we may re-established a more normal economic pattern.

The sharp increase in money supply is not due to new Fed injections of money, but past increases, and new demand for money; which to this point lay dormant and unwanted by the marketplace. This has come at a very awkward time. It may force the Fed to dust off its "exit plan" sooner than expected and abandon their two year interest rate freeze early. All of this requires a close watch since the potential consequences for the markets is enormous.

This week was the battle of the machines as high frequency trading whip-sawed the markets back and forth four and five hundred points a day.  The driving forces behind market sentiment have been driven by fears of a banking crisis in Europe and a possible world wide recession.  One reason I widened my trading range for the DOW a thousand points either side of 11,200, is because of the black boxes that now run the markets ragged.

During the week, I did nothing.  There's a time to trade and a time to sit on your hands.  This week was a good time to be a spectator.  All stocks bought in June are in the green, some substantially.

 

No change in the portfolio.