When an unemployed individual could get a zero down mortgage for over $500,000 on an already highly speculative property, alarm bells should have been ringing.  Such a person is unlikely to even be able to service the minimum monthly payments on their own, much less repay the mortgage.

Lenders being aware of this, often approved 125% cash back mortgages(based on optimistic estimates of the homes future value).  This way the borrower could use the extra funds to service the minimum mortgage payments for a couple of years and then either “flip” the home for a profit, or just walk away in some cases without recourse.  The banks bet on property values rising indefinitely and saw little risk involved in the transactions.

Of course we know how the story ends, but at the time it appeared everyone was a winner and U.S. GDP numbers reflected this.  For instance:

• The person selling the home pockets a hefty profit
• The realtor and mortgage brokers involved make a fat commission
• Wall street underwriters buy the mortgage along with hundreds of thousands of others like it, then repackage them into tradable asset backed securities
•  The ratings agencies make their cut by stamping these securities with a AAA rating
• Wall street brokers make fat commissions selling the repackaged debt to the market
• Banks purchase these AAA securities and receive fat dividends each quarter from holding these “risk free” assets
• The home buyer gets to live in their dream home with a hefty bank account balance from the “cash back” they received
• Retailers see their sales grow as this “new” money seeps from buyers bank accounts and floods into their cash registers
• Retail jobs are created as stores hire additional staff to keep up with consumer demand
• Developers rake in windfall profits and can’t build malls and retail outlets fast enough to keep up with demand
• Stock markets soar as homeowners “invest” their new wealth seeking greater returns

Of course this is an over simplified example, but it illustrates the typical cycle we saw during the real estate boom.  This cycle continued for several years as borrowers and lenders took on ever increasing amounts of debt, all the while reporting significant increases in their wealth(on paper anyway).  But it only tells half of the story.  A silent partner working behind the scenes made all of this possible.

The Silent Partner

The Federal Reserve was created in 1913 with the enactment of the Federal Reserve Act, largely in response to address a series of financial panics.  It’s evolved into its present day role which is to conduct the nation’s monetary policy, supervise and regulate banking institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government, and foreign official institutions.*Courtesy of Wikipedia

Perhaps the least understood role of central bankers is their indirect influence on the free market economy and its economic cycles.  Based on theories developed in the early 1900‘s by John Maynard Keynes, modern day Keynesians believe that the free market can’t function efficiently on its own.

They prescribe regular doses of government intervention, administered by a small panel of “experts” looking down from an ivory tower.  With methods about as reliable as consulting tea leaves, they decide when an economy is expanding too rapidly or contracting too severely and adjust monetary policy accordingly.

Keynes was a free thinking and somewhat eccentric intellectual, with overall rather fragmented logic.  He became famous for his fresh ideas on the stale subject of economics.  Armed with an above average intellect, he often publicly humiliated those who dared challenge his ideas.  He was a force to be reckoned with, garnering the respect of the most powerful influencers of his time.  He soon became an authority on economic policy.

Arguably one of the most influential economists of our time, he pioneered the field of macroeconomics.  But while many of his ideas appeared brilliant in theory, they often proved to be quite flawed in practice.  Keynes regularly contradicted himself throughout his career, even publicly refuting his own theories at times.

Despite the flaws in his theories, many of Keynes ideas are still practiced in modern economic policy.  The idea of a panacea for all financial woes continues to prove irresistible to policy makers and politicians.

The Federal Reserve and government policies created a moral hazard in an otherwise efficient free market economy.  By lowering and holding interest rates too far and for too long, they fueled speculation in leveraged investments.  In addition, policy supporting home ownership distorted an otherwise reliable risk/reward system of checks and balances in the financial sector.  We are living through the consequences of this self imposed economic crisis.  Some say we’ve averted a depression, but I fear we’ve simply postponed it.

It’s interesting to listen to “experts” from both the inflation and deflation camps explain what we need to do in order to fix the global economy.  Of particular interest (for entertainment value alone) is Nobel prize winning neo-Keynesian Paul Krugman.  He contributes regularly to his blog on the NY Times and doesn’t hold back when sharing his delusions views.

Of course he’s firmly in the deflation camp and believes that the US is stuck in a classic liquidity trap and that the recovery hasn’t gained traction because Bernanke and the Fed haven’t acted aggressively enough.  He states that if he were in charge, he’d have thrown far more stimulus at the system.  In fact, on one of his posts he goes on to say that the best thing that could happen to the economy would be to start a fictitious war against imaginary aliens.  ”Super” Krugman claims he’d  save the economy by creating American jobs building weapons and defences in preparation for a war that would of course never happen.  This “stimulus” would give the economy the much needed traction it needs and the private sector would step in as the program wound down.  He must love the positive effect hurricanes and earthquakes have on the economy!  Think of all of the construction jobs the clean up and re-building creates.

The logic is tragically flawed.  It’s typical Keynesian dogma that believes in creating productivity out of thin air.  The reality is, you just can’t.  Sure, you create jobs and in turn the dollars earned in those new jobs work their way into the local economy.  But in order to “create” jobs, the resources must first be taken away from somewhere else.  Winston Churchill summed this up rather nicely.

We contend that for a nation to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.

We must always remember that whatever the government gives, it must first take away.  If they are “creating” jobs, the money to pay those wages must come from somewhere.  It has a neutral effect at best.  In the US, it’s worse because the money is borrowed and accumulates interest.

The markets lately sure seem to reflect deflation though don’t they?  In the US, lending remains stagnant, housing prices continue to fall, the markets are falling, gold and silver have fallen significantly and interest rates are reman at all time lows.  People and corporations are hoarding cash and sitting on the side lines so the economy remains stalled.  Seems like the the deflationists are winning right?  Where’s all of the massive inflation and soaring interest rates that some predicted?

The answer lies in the solutions laid forth thus far.  Take housing for example.  The astronomical rise in home prices was instigated by the federal reserve lowering interest rates and holding them at record lows for far too long.  As people realized they could borrow money cheaply, many used the leverage offered to them to speculate in real estate.  As this “new” money entered the system, it created inflation in the housing sector.  In order to work off the effects of this bubble, the free market needs adjust prices back to affordable levels for regular Americans.  The government has repeatedly tried unsuccessfully to revive this bubble to spur economic growth.  Homebuyer tax credits and record low interest rates aren’t enough to encourage Americans to buy.  They’ve been burned too badly, plus many don’t have the credit worthiness to allow them to borrow or refinance.

Gold has risen significantly over the last year.  In fact, it has risen every year over the last decade.  But to say it has risen is actually misguided.  In reality, gold IS money.  Its value remains constant.  No government can set its price.  All they can do is manipulate their fiat currency.  So if it used to cost $400 US dollars to buy an ounce of gold and it now takes $1,600, the dollar has in fact lost $1,200 in purchasing power.  Sure, other prices haven’t risen that much in the local economy, yet.  That’s because prices and wages tend to be sticky and take a while to adjust to the true effects of inflation.  But once inflation really takes off, prices will rise significantly.

The official reported inflation numbers are very misleading.  For starters, they exclude food and energy.  They also use formulas based on hedonic regression to offset the true rise in the price of goods.  For example, they would state that if a business has a recent computer that’s 5 times more powerful than one bought 3 years ago, then those using that computer are by proxy, 5 times more productive.  Ridiculous I know, but it’s what they do.  For a more accurate measure of inflation statistics, Shadow Stats offer figures based on non manipulated numbers.

So is the theory of a liquidity trap really something we need to worry about?  After all, deflation seems to be a major worry as people won’t spend money if they think they can get the same goods and services for less at a later date, right?  Reality tells us a resounding NO!  Do people hold off on buying the latest TV, iPhone, or computer because they know it’ll cost way less for the same item later?  Do people put off filling their tank with gas or eating if they suspect prices will drop in the future?  You know the answer.  And what’s wrong with people saving money anyway?  After all, we don’t have a demand problem at all.  The market always has enough demand for viable resources and services.  I’m sure demand fell for horses and carriages when Henry Ford invented the Model T.  But that’s what progress does.  Society moves on.  If they implemented modern economic policy back in Ford’s day, they might have bailed out the horse breeders to “stimulate” growth in that sector.

Reality is much simpler than fiction.  It’s also true that common sense isn’t so common.  We all seem to suffer from a major case of analysis paralysis.  What we should do is shrink the size of government and get them out of the economy.  We need real progress and real job creation, not life support for obsolete professions.  We need infrastructure, modern transportation methods and cleaner energy.  But not if we have to foot our grand children with the bill.  I’m sure I’d be much more efficient if I had a private jet instead of a car to get around.  But you know what?  I can’t afford a jet, so I make do with what I have.  Citizens, governments and businesses around the world need to learn this lesson.  It’s not those with the most resources that win.  It’s those who are most resourceful and resilient that thrive.

Finally, I’d like to end by to putting a final nail in the coffin on the tired theory of deflation.   Falling prices are not the real threat at all.  Governments all use fiat currency nowadays and have access to a printing press.  They can print as much money as they like.  They can create as much inflation as they would like.  In fact, all central banks CAN do effectively is create inflation.  So no threat of deflation could ever not be countered by the far more powerful inflation creating tools they already hold.

I anticipate the G20 nations to continue to stimulate and prop up defunct industries and countries.  But in the end, the free market is far more powerful and will ultimately rule.  Simply buying time and in turn, making the problems worse by nationalizing debts is far from a solution.  The bubble we’re experiencing right now is the government.  It too will pop and it’ll be ugly.  Socialism is already dead.  It has never and will never work over the long run.  The world is learning this right now. You can’t spend more than you take in long term .  It just doesn’t work.  The sooner we embrace this, the sooner the real economy can recover.  God speed!

I hear from people who already own gold wondering if they should sell.  Many people think it’s too late to buy or worry that there’s too much downside risk at this point. Aren’t we close to the top now?  I say we’re not even close.

Sure, we’ve had a decade long bull market in gold and on the surface it appears to be a bubble ready to pop.  Yet bull market bubbles typically end at the height of extreme speculation, characterized by three to five days of a decline in price with higher volume than the preceding session, occurring within a relatively short period of time.  This is followed by a mass entrance by retail investors, who as always are late to the party and soon get wiped out. Think dot com mania.  So far, we have seen neither of these events.

While gold is trading significantly over its 150-day moving average, the fundamentals contributing to gold’s rise remain unchanged. With the latest speech from Bernanke today, I have even more confidence that it will continue to rise.

But it’s not just my opinion.  South Korea’s central bank recently purchased gold for the first time since the Asian financial crisis in 1997.  The gold portion of South Korea’s official foreign reserves surged to $1.32 billion at the end of July, up from just $80 million at the end of June.

I expect prices to continue to climb so long as central bankers around the world are underinvested gold and are still looking to increase their holdings:

• Mexico recently upped  its gold reserves by almost 100 tons, up from just 6 tons holdings prior!
• Russia purchased 26 tons during the second quarter, taking its total gold holdings to around 837 tons, equivalent to almost 8% of the country’s reserve assets.
• Thailand’s gold reserves rose by 15.5% in the two months and rose to about 4.07 million ounces in June, from about 3.523 million ounces in May.

So if central banks around the world are topping up their gold reserves and have quadrupled their total purchases from the market in the last quarter alone, should we feel safe holding gold as well?

Central banks were net sellers of gold for nearly two decades up until 2009 when the became net buyers of gold.

Venezuelan President Hugo Chavez said that he plans to nationalize the gold sector, including extraction and processing and use the production to boost the country’s international reserves:

“I have here the laws allowing the state to exploit gold and all related activities. That is to say, we’re going to nationalize the gold and we’re going to convert it, among other things, into international reserves because gold continues to increase in value” – Hugo Chavez

He’s also ordered the repatriation of 90 percent of Venezuela’s gold reserves held abroad, returning the country’s gold reserves back to Caracas:

“We’ve managed to increase the international reserves. We have close to 12 or 13 billion of dollars in gold reserves. We can’t allow it to continue to be taken away” – Hugo Chavez

With the current policies of central banks around the world, the fundamentals for gold price appreciation (which is really fiat currency depreciation) remain sound.  Unless we see some major shifts in global economic policies, we’re still far away from a ceiling in the price of gold.

“More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at the time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.”

“Since then we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.”

“The outlook on the long-term rating is negative. We could lower the long-term rating to AA within two years if we see that less reduction in spending than agreed to, higher interest rates or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

Stop! Havenstein! – Hyper Inflation could be around the corner

In the 1930’s, the US dollar money supply (measured by M3) dropped by about 30%.  This was the steepest deflationary drop in the quantity of money in history.  The purchasing power of the dollar rose dramatically because less money was in circulation compared to the amount of goods/services available in commerce.

Since 2006, the US Fed no longer reports M3, making historical comparisons difficult.  The Fed does still report M1 and M2 which have they’ve grown 7.1% and 1.7% respectively over the last year.  By these two measures, the dollar is inflating (qty. of dollars is expanding) relative to the quantity of goods and services currently being produced in the current depressed economy.

Inflation is clearly visible in market prices.  Crude oil prices, while volatile, have more than doubled since the post-Lehman crash lows.   On a broader scale, the price index of 19 individual commodities compiled by the Commodity Research Bureau is up 46% during this same period.  More recently, Walmart has increased many of it’s prices, some by as much as 60% due to rising costs of exports from China (due to higher wage inflation over there).

Many people point to the dramatic collapse of real estate prices (estimated at around $17 Trillion in losses since their peak).  This massive destruction of wealth certainly looks a lot like deflation but it’s actually just a distraction from the dollar approaching hyperinflation.  These prices were artificially inflated to unrealistic levels and are simply correcting back to a realistic price model.

Crude oil prices have doubled and commodity prices have risen significantly since  September 2008 as M1 and M2 during this period have increased only marginally.  So the prices of goods and services are rising more rapidly than the increase in the quantity of dollars in circulation.  This resulting “shortage of money” is being widely misinterpreted as deflation, which is exactly what happened in Weimar Germany shortly before the Reichsmark turned into wall paper as it became swept up in a hyperinflationary whirlwind.

‘STOP!  Havenstein!’.  It’s Havenstein time for the dollar.  While inspired by MC hammer, the name comes from the ill-fated president of the Reichsbank who presided over the destructive hyperinflation that devastated Weimar Germany.

It’s the Havenstein dilema all over again for the United States and there are only two alternatives at this point.  Government either tightens its own belt and stops printing new money, so inflationary expectations will eventually be reversed and prices will fall once more (relieving the money shortage by lowering prices). Or government follows its own inherent inclination to counterfeit and appeases the populous by printing more money to allow the public cash balances to ‘catch up’ to prices.  Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices ‘run away’…[i.e., hyperinflate]”  Weimar Germany took the second alternative.

Will policymakers tighten the federal government’s belt?  Or like Herr Havenstein, will Mr. Bernanke continue to ‘print’?

Unfortunately, the Federal Reserve will choose to ‘print’, for one reason.  Despite the noble goals assigned to it in textbooks and offered in Congressional hearings, the Federal Reserve exists for only one reason – to make sure the federal government gets all the dollars it wants to spend.  This reality puts the dollar on a hyper-inflationary course.

Following the same path as the Weimar government, spending by the US federal government is out of control, causing it to borrow record amounts.  The money to fund this growing mountain of debt must come from savings or ‘printing’, and there isn’t enough accumulated savings in the world to satisfy the spending aspirations of Washington’s politicians.  So beyond what it can collect from taxpayers and extract from the world’s savings pool, the dollars the federal government is spending can only come from one place – the ‘printing press’, which in today’s monetary system means bookkeeping entries by the Federal Reserve to create dollars that it deposits into the federal government’s checking account.

The deflation of the 1930’s is not possible for another reason.  Like the Reichsmark, the US dollar is no longer defined as or redeemable into a weight of gold or silver.  When it was on a metal standard, dollars could only be created if there was precious metal in the vault to back the newly issued currency. Today there is no restriction – no external control mechanism – on how many dollars can be created, so expect a flood of them from the Federal Reserve.

As Liaquat Ahamed explains in “Lords of Finance”, Herr Havenstein faced a dilemma.  “Were he to refuse to print the money necessary to finance the [government’s] deficit, he risked causing a sharp rise in interest rates as the government scrambled to borrow from every source.  The mass unemployment that would ensue, he believed, would bring on a domestic economic and political crisis…”  Mr. Bernanke faces the same dilemma, and like Herr Havenstein, he thinks he can save the economy by creating more currency.  Instead, the outcome will be hyperinflation, which not only destroys the currency but also the very economy he set out to save.

The remedy to prepare for this impending destruction of the dollar is simple.  Avoid the dollar as much as practical and own physical gold and physical silver instead.

But are they really this close to financial armageddon?  Or is this a dangerous game of political scare tactics to raise the debt ceiling and kick the can a little further down the road?  I believe it’s the latter, although the methods and language they’re using puts them much closer to a default than they need be.

First off, Obama has come on the air and publicly stated to the world that unless the United States borrow more money, they will default on their obligations (interest payments) to bond holders.  They just publicly confirmed that they’d rather shaft their lenders than attempt to cut spending.  Sorry, China and the rest of you who hold Trillions of dollars of our debt.  You’re our lowest priority and will be the first to suck wind when things go South!

Are U.S. officials really that stupid?  I don’t think so.  If they were seriously concerned about the possibility of defaulting on August 2nd, they’d instead be telling the world not to worry.  They’d assure their lenders that they’ll do whatever is required make their minimum interest payments and avoid a default.

The fact is that U.S. can easily meet their minimum obligations without raising the debt ceiling.  They take in approximately $2 Trillion a year in tax revenues.  The interest obligations they are required to pay out amount to around $300 Billion a year.  They could quickly find cuts without forcing seniors to eat cat food (ie. cutting Social Security benefits) by immediately slashing defence spending.  What we’re seeing is nothing more than an ongoing game of political hardball.

To put things in perspective, the U.S. currently spend about $800 Billion per year on defence and just under $300 Billion on Social Security.  Major military spending cuts along with closure of other non-essential Government services would easily allow them to meet their debt obligations for the year.

Make no mistake though, the U.S. will eventually default through a currency collapse if they continue on their present course.  The fact that they’re even talking about it right now, rather than glossing over the harsh facts makes that pretty clear.  Their biggest blunder to date however was  publicly  admitting that they’d throw their creditors under the bus in a heart beat if push came to shove.  The real threat isn’t hitting a self imposed debt ceiling, it’s foreign investors refusing to continue to lend them money(by buying up their treasury notes).  Obama’s basically admitted that their finances are just a big ponzi scheme and unless they can continue to pump in new borrowed money, everything will come crashing down and those last in will be hurt the most.

With no buyers of debt, sellers would have nobody to offload their holdings to which would send interest rates soaring and freeze markets.  This would essentially in turn shut down many of the world’s financial markets and cause massive financial carnage from the top banks right down to Main Street.

Emergency measures would likely be instated and the U.S. would print untold amounts of money in a last ditch attempt to save the system.  But at this point, it will do no good as their dollar would continue to collapse and eventually become worthless.  Investors will place the majority of their assets in Gold, silver and other physical precious metals, which I believe will become the default and only viable world reserve currency when the dollar implodes.

So do I think that the U.S. will default on August 2nd?  Frankly, no.  They will stall until the last minute, there’s a very good chance that their credit rating will be cut prior to the deadline as a result of the gridlock, but they will come through.  They have to.  If they don’t meet their minimum debt repayments, the consequences will be nothing short of catastrophic.