Archive for the ‘Monetary Inflation’ Category

Inflation Versus Deflation: Part Two

December 17, 2008

In my previous blog entry, I explained that:

  • The current economic crisis could result in either deflation or inflation;
  • Deflation and inflation have very different effects on savings and investment vehicles, so understanding the probability of one or the other can help you make better decisions with your money;
  • Whether we end up with deflation or inflation depends on whether or not the Federal Reserve can succeed at getting money to move through the economy again.

Our task now is to assess the likelihood of the Federal Reserve achieving its goal.

The Zero-Bound Problem

Ordinarily, the Federal Reserve controls the rate at which money flows through the economy (its “velocity”) by changing the interest rate that it charges member banks for overnight loans (the “Fed funds rate”). Through the mechanics of the commercial banking system, lower short term rates cause a reduction in the rates that banks charge for long term lending, such as car loans and mortgages. Lower long term rates, in turn, stimulate economic activity.

Despite the Fed’s aggressive program of lowering the funds rate in the past year, commercial banks have remained reluctant to lend, and long term interest rates have not declined. Just yesterday, with falling consumer prices raising further fears of deflation, the Fed lowered its funds rate to a record low of 0.25%.

The Fed has arrived at the “zero-bound” problem: it cannot lower interest rates below zero. The Fed has reached the end of the rate reduction paradigm for controlling the velocity of money.

The zero-bound problem explains why, in addition to announcing the rate cut, the Fed announced its readiness to “move to a new phase of monetary policy in which it prints vast amounts of money.” To prevent a deflationary spiral, the Fed must employ other means to get money to move through the system to return the economy to an inflationary track.

Unconventional Measures

In 2002, before he became Chairman Of the Federal Reserve, Ben Bernanke addressed precisely this issue in a speech that earned him the epithet “helicopter Ben.” In his talk, Bernanke reminded his audience of Milton Friedman’s description of a central banker dropping money onto the populace from a helicopter. Also known as the “printing press speech,” Bernanke’s address included the following formulation:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

In my last blog entry I explained that inflation is a monetary phenomenon: very simply, an increase in the supply of money relative to the goods and services produced by the economy causes prices to rise. A steady increase in the nominal prices of goods and services discourages savings because, unless interest rates keep pace, unspent money rapidly loses its value. Thus, the plan to “reduce the value of a dollar” serves as a mechanism to fight deflation. Dollar devaluation, we shall see, lies at the core of the Fed’s deflation fighting strategy.

The Fed has done a lot of creative thinking about the uses to which it can put the printing press in order to revive spending. In 2005, Robert Blumen published an article in which he analyzes a number of papers and speeches on this topic by Bernanke and other Fed officials.   Few people have the interest or patience to wade through this kind of material. But understanding the Fed’s thinking about deflation fighting gives a good deal of insight into current events, such as yesterday’s announcement. Blumen has done a great public service with his analysis. With his help, I shall now enumerate some of the Fed’s tactics.

  • Long-Term Interest Rate Intervention: The Fed can influence long-term interest rates by buying long-term bonds on the open-market.  The Fed has already implemented this strategy in order to lower mortgage rates by purchasing mortgage backed securities. Yesterday’s statement makes it clear that the Fed will continue purchasing mortgage securities as well as long-term US Treasury bonds.
  • Lending: A 1999 paper, Monetary Policy and Price Stability, explains that “A central bank can also attempt to spur private aggregate demand by extending loans to depositories, other financial intermediaries, or firms and households.” The Fed has already engaged in a record level of lending through its discount window and has been buying commercial paper. Yesterday’s announcement says the Fed now intends to implement a “Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.”
  • Currency Devaluation: In a paper entitled Monetary Policy When the Nominal Short-Term Interest Rate is Zero, Fed officials describe the concept of a “money rain” whereby it would “give money away either through directly disbursing currency to the public or by disbursing it through the banking system.” As I observed above, devaluation forces people to spend their dollars to avoid losing their savings. Devaluation, by the way, can also be achieved through what these papers refer to as “exchange rate intervention.” The central banks of other countries might, for example, agree to sell enough of their dollar reserves into the open market so as to effect a deliberate fall in the dollar.
  • Imposition of Negative Interest Rate: In the paper Monetary Policy in a Zero-Interest-Rate Economy, a Fed official observes that the Fed could induce people to spend by a mechanism to “make money pay a negative nominal interest rate, by imposing some type of ‘carry tax’ on currency and deposits.” In other words, people saving money in dollars would have to pay for the privilege of doing so.
  • Direct Purchase of Goods and Services: By exchanging federal government debt for freshly printed money, the Fed could indirectly “conduct an open market purchase of real goods and services.”  This idea, also presented in Monetary Policy in a Zero-Interest-Rate Economy, may sound far-fetched. But it might be what yesterday’s Fed statement hints at by saying it will “continue to consider ways of using its balance sheet to further support credit markets and economic activity.”

This inventory of ideas gives a pretty good idea of just how far the Fed will go to reflate the economy. As a  student of the Great Depresion, Ben Bernanke believes it necesary to fight deflation with these types of tools to avoid long-term economic suffering. As one can see from the developments of the past several months and from yesterday’s Fed statement, we must take these ideas at face value. We must understand them not as theoretical possibilities, but as an armamentarium of tactics that it fully intends to deploy now that it has reached the zero-bound. Very simply, the Fed will stop at nothing to prevent deflation.

With this understanding of the Fed’s strategies as background, I am confident that the deflationary trend of the past months will not last long. It could continue for a number of months into 2009, or perhaps even into 2010. But I have little doubt that, by dint of its creative application of monetary authority, the Federal Reserve will prevail.

What Will Happen To All That Money?

Mainstream economists view inflation of around 3% or so as benign. A bank CD paying interest of 5%, or a long-term bond paying 8%, would compensate for inflation and leave the investor with a reasonable return. The mainstream investment and economic community assumes that, one way or another, the Fed will target a reasonable level of inflation once the crisis has subsided.

And, indeed, the Fed has mechanisms for “mopping up” the excess money it creates in order to prevent excessive inflation. The Treasury can deposit the proceeds of bond sales with the Fed, taking those dollars out of circulation and reducing their inflationary effect. The Fed can also increase the reserve requirements for banks. For example, by increasing the deposit to loan ratio from 10% to 15%, less money would circulate through the economy. And of course the Fed can raise interest rates.

But one has to wonder whether the Fed, or the government, would have the discipline to throw cold water on an economy recovering from a severe recession. A monetarily responsible Fed under Alan Greenspan should have raised interest rates when the economy showed signs of recovery from the bust. Its failure to do so led to the housing bubble that caused the current recession. Our economy’s  addiction to credit as a vehicle of economic “growth” will make the Fed reluctant to slow down credit expansion as the economy recovers.

More importantly, in the coming decades our government will be forced to adopt a deliberate policy of inflation to cope with the national debt. Our national debt has reached over $10 trillion. Adding future entitlements such as Social Security and Medicare to the mix brings the total in coming years to a mind-boggling $70 trillion. And, of course, all of the bad corporate debt that the Fed continues to buy in order to rescue the banks adds to this burden.

Inflation can serve as a release valve for any government facing this level of debt obligation. You’ll recall from my discussion of the mortgage as a hedge against inflation that inflation transfers wealth from creditors to debtors because the nominal value of the loan decreases as the nominal value of the underlying asset inflates. In a similar way, the government’s obligation to entitlement beneficiaries (most notably retirees) becomes a smaller burden when inflation persistently and steadily devalues the nominal value of the fixed payment. It has the same effect on the government’s debt to international creditors, such as China, who hold large dollar reserves in treasury debt.

Bear in mind, too, that since the government controls inflation statistics, it can control whether and to what extent entitlement payments keep pace with true inflation. Please review John Williams’ work on inflation for more about the true rate of inflation.

Ultimately, an economy that depends on an indefinite expansion of credit to sustain its growth cannot go on forever. Eventually, debts must be paid. In the current crisis the Fed is introducing the world to the printing-press approach that will later serve to cope with the country’s debt.

But eventually this strategy must fail. Relentless devaluation of currency renders it worthless.  The dollar must die eventually.

How To Save And Invest

I do not believe that a currency collapse is imminent. The more likely scenario is a slow burn lasting for decades in which a series of booms and busts will obfuscate the underlying trend towards hyperinflation.

In the short term (for the next year or so), the prices of stocks and consumer goods may continue to fall due to the the effects of defaulting credit and gloomy economic reports. In any economic climate, a prudent savings and investment strategy would keep enough emergency funds in cash (short-term bonds and bank CDs) in case of protracted unemployment or other exigencies. Just bear in mind that the cash you would need in the short term for emergencies will lose its value over the long term as the Federal Reserve pursues its policy of relentless and deliberate devaluation of the dollar.

A long-term portfolio should include some percentage of investments that hold their value independently of the monetary system, such as commodities, precious metals, and businesses that produce food and energy.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser


Inflation Versus Deflation: Part One

December 14, 2008

Benjamin Roth’s Depression Diary chronicles the impressions of an Ohio lawyer during the Great Depression. He paints a poignant picture of things that happened to investors in that era. “For over a year now,” he writes in 1931, “people have been buying stocks at what they think are bargain prices.” But, he adds later in 1936, “these early buyers were badly mistaken and many of them were wiped out.”

The process that took stock values down by 90% from 1929 to 1932, and depressed the prices of virtually everything else, is known as “deflation.” The story makes plain the danger of investing in any financial asset during a deflationary spiral: if that asset’s market has not truly bottomed, you risk great losses. Today one frequently hears in the financial news what a bargain good companies are selling for on the stock market. Roth’s journal entries provide a scary backdrop to this advice.

Last week I alluded to a debate that his been raging for several years within the contrarian financial community between the inflationaistas and the deflationistas. Both sides have always agreed that excess consumer and government debt would lead to an economic crisis.  They continue to disagree about the outcome, even as the outcome unfolds before our eyes.

Roth’s diary should clue us in to the fact that either outcome, deflation or inflation,  bears more than academic curiosity. Either one can change the results of any particular savings and investment strategy. It matters even — or rather, especially — if all you ever do is save money in a passbook savings account or Certificate of Deposit. Deflation would magnify the purchasing power of your savings , whereas inflation would diminish it. Generally, the strategies for dealing with inflation and deflation have little overlap. In making up your mind about how to proceed, you’ll want to have some idea about the probability of one outcome over the other.

My discussion will be lengthy and will occupy this week’s and next week’s blog entries. It will challenge your attention span and your willingness to follow technical detail.  So please bear with me. I promise to reward your attention with a greater understanding of current economic events.

Credit: Bubbles And Contraction

To understand how a deflationary spiral works, you have to understand the inflationary bubble that precedes it. The bubble begins with the availability of cheap credit. First the central bank lowers the interest rate on short term loans.  Then, through the mechanics of fractional reserve lending, the member commercial banks offer lower interest rates on long term loans to their customers. As more money enters the system, nominal asset prices rise. But eventually prices get so high that buyers stop buying and the bubble reverses itself. The weakness in such bubbles lies in the understatement of risk by lenders.

Let’s look closer at this phenomenon through the lens of the subprime mortgage meltdown.  Subprime mortgage lenders (and apparently rating agencies) assumed that the economy would remain strong enough for borrowers to sustain their mortgage payments. They also assumed that the values of homes would remain high enough to cover the mortgages in the case of default.

Of course, the inevitable happened.  Home prices got so high that, even at low interest rates, buyers stopped buying, and prices began to fall. And when initially low “teaser rates” on mortgages re-adjusted to their higher long-term rates, borrowers became unable to make their mortgage payments. An increase in defaults put more homes on the market in distressed circumstances, reducing the value of homes to below the amount of the mortgages that financed them.

Such loan defaults end up as losses on the balance sheets of the banks, causing some of them to go out of business. If those banks owe money, their creditors also suffer losses. As loan defaults cascade through the banking system, banks hoard their cash to maintain the integrity of their balance sheets and become reluctant to lend.  When they lend, they do so at prohibitively high interest rates.

The contraction of credit wreaks havoc on other financial assets.  In our day, hedge funds had attempted to magnify their earnings by borrowing heavily against their assets. As credit tightened due to subprime mortgage losses, the hedge funds’ creditors  raised borrowing rates and demanded additional collateral even for relatively safe investments. To raise cash, the hedge funds had to sell off holdings in stocks and commodities, resulting in price declines.

Credit contraction also slows down economic activity. For example, the banks’ unwillingness to extend letters of credit has seriously affected international trade. Many businesses depend on short-term loans known as commercial paper in order to function on a day-to-day basis. Commercial paper, too, has suffered from the credit contraction.

As businesses fail or contract from the paucity of credit, they lay people off. Fewer people have money to spend or are afraid to spend it for fear of losing their jobs, slowing the economy even further.

If it continues unchecked, credit contraction leads to the general price decline known as deflation.

Inflation And Deflation Are Monetary Phenomena

Almost everyone has heard of the law of supply and demand. Very simply, the more scarce a product or service, the higher its price. The requirement that plastic surgeons go through many years and hundreds of thousands of dollars in medical training makes them relatively scarce. But almost anyone can, with enough motivation, clean a house. Thus you pay a plastic surgeon thousands of dollars for the few hours of time it takes her to fix your nose,  whereas the house cleaner earns $10 per hour.

The price effects of inflation and deflation differ quite a bit from supply-demand dynamics. For many economists,  and for the purpose of our discussion, changes in the money supply cause inflation and deflation. The great economist Milton Friedman is famous for saying that “Inflation is always and everywhere a monetary phenom­enon.”  That is, inflation results from an increase in the supply of money relative to the goods and services in the economy; deflation results from a decrease of money supply.

With this point in mind, remember that, in our system, all money is debt. All money flowing through the system began as the transfer of money from a creditor to a debtor. If everyone in the world paid off their loans at once, all money would disappear from the economy. Availability of credit increases the money supply and thus creates “economic growth,” while the unavailability of credit results in economic contraction. Please watch Paul Grigon’s documentary, Money As Debt, for a really good explanation of this concept.

So, credit contraction plays the lead role in the drama of a deflationary spiral.

For the moment, although the price of oil and other commodities has dropped, true deflation has not yet taken hold of the economy. The prices of food, housing, and health care remain relatively stable. But if the contraction of credit continues, the supply of money to the economy will eventually decrease and all prices will fall.

How To Save Or Invest For Deflation

In investing and saving, inflation and deflation have different consequences. In deflation, the dollar-denominated value of everything drops. Relative to goods and services, then, the purchasing power of cash increases. But since less of it flows through the economy, cash is hard to come by.

Although I do not believe that true deflation has taken hold at this point, the desire for cash in a credit contraction might explain the behavior of investors in US bonds. The demand for short-term US bonds has pushed their yield almost to zero. When transaction fees are figured in, investors are paying a premium over par value for these securities because of their perceived safety.

In inflation, on the other hand, cash becomes less valuable because prices expressed in the currency become higher. In such an environment, it becomes advantageous to buy stocks, commodities, and real estate because their prices will rise in nominal value, thus preserving the original value of the investment.

I should add that deflationista extraordinaire Mish Shedlock believes gold to be a good investment for both deflation and inflation because of its true role as money.  Robert Prechter, on the other hand, insists that even precious metals will decline in nominal value under deflation.

What Can Be Done?

Though complicated by the many intracacies of modern economics and finance, the argument between the deflationistas and the inflationistas boils down to one fundamental question: will the monetary authorities succeed in reflating the economy?

Once deflation sets in, stopping it becomes very difficult. The deflationistas assume that the monetary authorities are ultimately powerless against the economic forces driving deflation. They foresee a sustained period of monetary contraction resulting in a global depression with chronic and high unemployment. The inflationistas argue that the monetary authorities will succeed in getting money to move through the economy again and thus put the economy back on the inflationary track to “growth.”

To make up your own mind about this question, you will need to understand  how the Federal Reserve seeks to accomplish this goal. I shall examine the Fed’s strategy in my next blog entry.

© 2008 Philip Glaser

Debt As An Inflation Hedge

December 4, 2008

I highly recommend Axel Merk’s latest discussion of the Fed’s fight against deflation. He addresses many of the currency and debt dynamics I have touched upon here in the past weeks, but with greater technical depth and detail. One element of Merk’s discussion deserves particular focus:

Banks are in the business of borrowing short and lending long: typically, banks would have deposits (short-term loans from depositors, callable at any time) and lend to finance long-term projects. This may well be the greatest carry trade of all times, except that it has neither credit, nor currency risk; it does have interest risk, i.e. if long-term interest rates go up because the market prices in the risk of inflation, then banks could lose money.

A bank pays a lower rate of interest to its depositors than it charges for the long-term loans it lends. If it gives its depositors 2%, but charges its debtors 6% for a mortgage, it profits from the 4% spread.

The risk to the bank from rising interest rates deserves our attention because, as Merk explains in his article, it now drives a number of the Fed’s current actions. I have already alluded to the possibility that China may grow increasingly reluctant to purchase US debt obligations. The drop in oil prices now makes it less likely that oil producing countries will want to purchase US debt, as well. By the simple law of supply and demand, a decrease in demand for US Treasury Bonds would force interest rates to go up.

Now imagine a scenario in which rising interest rates force the banks to pay its depositors 4%. The higher payment to the depositors squeezes its spread on the mortgage loan down to 2%. Many banks mitigate this kind of risk by selling mortgages to third parties. But of course that just transfers the problem to bigger banks.

As the bank of all banks, the Fed must do everything to protect the interests of the banking industry. Thus, as Merk observes, on November 25 the Fed announced that it would purchase $600 billion of mortgage-backed securities. This announcement signaled to the market an increase in demand for these securities and consequently sent their yields lower. The Fed publically justifies these actions as a means of unfreezing the credit markets. But they also have the effect of protecting the banks’ profits. The Fed has many other tricks up its sleeves to accomplish these goals, all euphemistically defined as Quantitative Easing.

The debate rages between the deflationistas, such as Mish Shedlock and Robert Precther, and inflationistas such as James Turk and Peter Schiff. The question boils down to one’s belief in the the Fed’s ability to accomplish its goal of getting money to move through the economy to prevent a deflationary spiral (a state of high unemployment and consequent decrease in prices as the country suffered in the Great Depression). If it succeeds, but fails to remove the excess money it created from the system, inlation will result.

As a believer in both the Fed’s ingenuity and the inevitability of inflation, I have suggested investing a limited but steady stream of savings in precious metals, for reasons that I have outlined in this blog. But, in the interest of diversification, I am now scrutinizing another tool for coping with inflation: a fixed rate mortgage.

If you have the nerve to tolerate the gory details of how badly our government manipulates inflation statistics, I recommend having a look at John Williams’ Shaddow Stats. Using the same inflation calculation methodology that the government used in the 1970s (when it counted food and energy in its inflation formula), Willams estimates current inflation to be at around 11%. But because the government’s official inflation numbers understate inflation by about 7%, salaries have not kept pace. The 1970’s differed insofar as the government did not lie about inflation so that salaries did increase with inflation.

Daniel Amerman makes an important observation about all this: people who held fixed rate mortgages from the 1960s paid those mortgages off in inflated dollars throughout the 1970s and got their homes virtually for free. The fixed interest rate guaranteed that the payment in nominal dollar terms stayed the same, while salaries, again in nominal dollar terms, increased. This dynamic made the mortgage payments an increasingly smaller expense of household budgets. In effect, inflation transferred wealth from creditors to debtors.

Now it should be even more clear why, as I discussed above, the Fed will do anything in its power to prevent interest rates from rising.

No one can know for sure whether or not the Fed will succeed in preventing a deflationary spiral, or whether inflation will become undeniable enough that salaries have to rise. But Amerman would argue that even people who can afford to own their homes outright can benefit from mortgaging some percentage of their home as a hedge against inflation.

In order for this strategy to work, a number of conditions must be met:

  • The homeowner must have emergency cash available for making the mortgage payments for any foreseeable period of unemployment;
  • The homeowner must also have diversified their portfolio into assets that would do well if inflation does not turn out as predicted;
  • The mortgage’s interest rate must be fixed; an adjustable rate mortgage in a period of inflation is disadvantageous to the mortgage consumer.

To be honest, I am not sure whether I believe this strategy to be practical or ethical. But it intrigues me. If nothing else, this discussion will have given you a better understanding of how the banking system works and how it could even work to your advantage.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser

How Do We Pay For The Bailouts?

November 21, 2008

The Federal Reserve and Treasury are making a desperate attempt to prevent the kind of deflationary spiral that led to the Great Depression.  In such a spiral, creditors, coping with defaults on existing credit, refuse to lend or lend only at prohibitive interest rates . As less money flows through the system, people lose jobs and cannot spend. Others fear losing their jobs and become conservative in their spending. This reduction in spending further reduces the flow of money, resulting in further job losses.  It’s an ugly scenario.

A major focus of the prevention effort lies in purchasing the bad mortgage and credit card debt held by major banks. By exchanging bad debt for cash, the Treasury enables the banks to remain viable because their balance sheets will demonstrate cash in place of bad debt. When they are viable, the banks will resume lending. Lending will increase the flow of money through the economy, which in turn will cause a resumption of what mainstream economists refer to as “economic growth.”

It would be a good thing if these actions in fact prevent a prolonged recession or depression. But I want to briefly explain some rather disturbing consequences of what the government is doing. I’m afraid the discussion will be rather technical, but I believe that it is important for folks to understand some of the mechanics of money creation, debt, and currency valuations. So please bear with me.

Revenues from taxes do not provide the funds with which to purchase the bad debt from the banks. So the government has to borrow the money. To do so, the Treasury issues bonds. In 2009 the US government will have to find buyers for upwards of two trillion dollars in new debt.

China has been a major buyer of US Treasury securities. It had a surplus of American dollars because of its exports to the US. By exchanging the dollars it received from its exports for Treasury debt, China helped finance the US debt and, in a self-reinforcing cycle, enabled the US to continue importing China’s products.

But the reduced spending and imports by US consumers has diminished the amount of cash with which China can purchase securities. (This may explain recent slowdown in the growth of dollar- denominated debt instruments held by foreign countries.)  And now, China plans to spend over $500 billion on its own domestic  stimulus package. To finance this package, it may sell some of its dollar reserves. China may be poised to shift from being a net buyer to a net seller of US securities.

The supply-demand dynamics of the credit markets could counteract the Federal Reserve’s effort to increase money flow by lowering interest rates. When the level of debt to be sold exceeds the number of willing buyers, the buyers must be rewarded with higher interest rates. Very simply, the “investment” must be made to appear more attractive. But the Fed must avoid raising interest rates: high interest rates constrict the flow of money and impede economic growth.

The Treasury and The Fed can take a couple of different routes to financing the debt without increasing interest rates. the Federal Reserve can create money out of thin air. When no other buyer can be found, the Fed can “monetize” the treasury debt by exchanging it for money that comes into existence at the flick of a switch. When China purchased US Treasuries, it exchanged cash already in the system for those debts. The effect was to exchange existing money for the promise of future money. It did not increase the amount of money in the system. But monetization increases the amount of money in circulation. Thus the Fed’s inevitable purchase of billions of dollars in treasury debt will increase inflation significantly. Some observers believe that monetization has already begun. Indeed, by its own numbers, the aggregate base of money has increased in recent months by almost 800%.

A deliberate and coordinated devaluation of the dollar could also help with the debt problem. A dollar devaluation would enable foreigners to buy US debt at a discount due to the relative strength of their currencies, without raising interest rates. It’s not clear to me exactly how such a devaluation could be controlled, though unleashing the Plunge Protection Team on the currency markets might do the trick.

Both monetization and devaluation would hurt anyone who saves their money in the traditional “safe haven” assets: certificates of deposit and US Treasury securities. I have already said a good deal about how to protect one’s assets against this type of scenario in this blog. You might to review past articles to get a feel for these options.

© 2008 Philip Glaser

How Our Monetary System Harms The Environment

November 6, 2008

I can’t imagine a more exciting time to be an American. After eight years of deterioration in our foreign relations, civil rights, and economic policy, Barak Obama will bring meaningful change to our country. My parents had the privilege to witness the rise of Martin Luther King as our country’s greatest civil rights leader. I am priviledged to witness the election of America’s first Afro-American president.

Facing the worst economic crisis since the Great Depression, Obama is wasting no time in putting together an economic security team. His consideration of Paul Volker for the post of Treasury Secretary has great significance. For several years now Volker has been observing with increasing alarm the economic imbalances that lead to the current crisis. As Fed Chairman under Jimmy Carter in the 1970s, Volker restored confidence in the dollar by raising interest rates. Doing so took a great deal of vision and courage because high interest rates impede economic growth. But he succeeded in putting the economy on solid footing for the longer term. Considering Volker for the post of Treasury Secretary demonstrates that Obama understands the type of economic leadership our country needs.

But the current crisis is merely a symptom of the deep structural problems in our world’s financial system, problems that also lie at the root of our environmental crisis.

Catherine Austin Fitts’ audio seminars on The Falling Dollar introduced me to fiat currency and the likelihood of a monetary collapse sometime in the next decade or so.  In her interview with James Turk she pointed out that some environmentalists do not like precious metals. However, though improper mining practices do have a negative environmental impact, she argued that the long term effects of fiat currency and the fractional reserve banking system have done far worse. James Turk added that in the 1960’s Paul Einzig predicted the detrimental environmental outcome of our world’s monetary practices.

I have been planning to research Enzig’s writings to develop my understanding of this problem. Then, today, Providence dropped this wonderful video presentation, Money As Debt, into my lap.

Aside from explaining with great clarity why our monetary system must eventually crumble under its own weight,  Paul Grignon’s fourty-seven minute presentation demonstrates the incompatibility of our fractional reserve banking system with ecological sustainabilty.

In our economic system, the consumption of natural resources must keep pace with the growth of money-debt supply to avoid hyperinflation (hyperinflation can only be avoided when the material output of the eoncomy keeps pace with the growth in money supply). The system makes plundering the earth’s resources not only profitable, but continuously necessary.

Anyone interested in sustainable living must understand and embrace this understanding of our monetary practices. To save the planet, we must develop an alternative system, one that does not require exponential growth in both the money supply and the consumption of natural resources.

And if you choose to protect your personal assets by purchasing precious metals, know that doing so constitutes an act of economic and political protest. By withdrawing value from the monetary system and storing it in a way that does not require interest payments from any counter party, you undermine the money-debt mechanism that our banking system feeds on.

Please watch Grignon’s presentation and think about these ideas. He gets to the sustainability problem at the end of the video, but please watch all of it: very few people have presented the history and practices of fractional reserve banking with this level of clarity and insight. And then bring your questions and comments back here for discussion. I’m really excited about the level of clarity that Grignon brings to these issues.

Note: I recommend that you mute the sound on the video and let it run all the way to the end without watching it, and then rewind it to the beginning and unmute. This way you will buffer the entire video and avoid the annoying interruptions that occur when streaming video content over the web.

Have a great day!

© 2008 Philip Glaser

Price Volatility of Precious Metals

October 6, 2008

Something rather strange happened to me just after publishing last week’s article. You’ll recall that that article dealt with purchasing precious metals. After the dramatic 700 point drop in the Dow, a neighbor stopped me outside my house and said: “You were sure right about the market!” Something similar happened a few years ago: the stock market dropped sharply, shortly after I had sent out an email to my circle of friends and neighbors about monetary inflation. A different neighbor at that time said the same thing: Oh, you were right about the markets!

I have the sinking feeling that my recent advice gave the impression that precious metals mitigate the risk of stock market investments. Yikes!  I’d  be happier if my neighbor had complained to me about the drop of silver prices from their high of over $20 per ounce in March to under $11.00 on September 11th of this year. A Maalox-moment if ever there was one!

The decline of silver and gold prices in the past several months illuminates some important points about the volatility risk of investing in precious metals. To begin with, let’s reiterate the risks that precious metals do mitigate: loss of principal value due to inflation, monetary collapse, and counterparty default.


Inflation results from an increase in the “velocity” of money. That is, when the supply of money in the economy increases, spending also goes up. The increased demand then drives prices up. Money supply grows primarily through expansion of credit. For example, the housing bubble now in the process of collapsing came about because the Federal Reserve dramatically lowered interest rates in 2000 and 2001 to deal with the recession of those years. Low interest rates make credit less expensive and thereby increase the velocity of money. The dramatic rise in the price of energy and food in the past few years result from the increased money supply. (The supply-demand problem of petroleum and natural gas is a whole other problem that I shall take up at some point in the  future.)

Precious metals protect purchasing power against inflation because its price rises with everything else. Thus the rise of silver from around $5.30 per ounce in January 2000 to its highs of this past spring. Gold prices tell the same story. Holding silver and gold since the year 2000 would have compensated for the 40% drop in the value of the dollar during the same period.

Monetary Collapse

The dollars in which we transact business have no backing by precious metals or any other real commodity. Our legal tender laws force us to accept dollars as payment for business transactions. History shows that  “fiat” currencies like ours follow a particular pattern of decline in which the government overproduces money in order to cover its debts: the examples include Wemar Germany following World War I and Argentina in the late 1990s. The increased money supply causes hyperinfaltion, a situation in which the highest face-value bill has more value as toilet paper than as a medium of exchange. At that point, the populace turns to other media of exchange. Precious metals provide a reliable store of value when the currency reaches the hyperinflationary state.

Counterparty Risk

I mentioned last week that, in our fractional reserve banking system, a savings bank can lend out 90% of its deposits. By definition, a bank cannot satisfy a demand for all of its deposits at one time. It relies on most people leaving most their deposits in the bank most of the time. The borrowers to whom the bank has lent the depositors’  money indirectly owe that money to the depositors. The bank’s borrowers, not the bank itself, holds most of the despitors’ assets. If these counterparties default on their loans in great numbers, the depositors’ money disappears. When large numbers of people and businesses default on their loans, as in a severe economic downturn, depositors loose confidence in the balance sheet of the bank. In a “run on the bank” a large number of depositors demand their deposits at the same time and the bank has to close its doors. FDIC insurance protects depositors against this kind of scenario. But a massive banking meltdown could easily overwhelm and bankrupt FDIC itself.

When you physically hold precious metals, you avoid counterparty risk entirely.

So What’s The Catch?

Like any asset class, precious metals do not perform well in all economic situations, the worst situation being deflation. In the typical deflation scenario, a credit bubble reverses itself into a credit contraction. Interest rates rise and banks become reluctant to lend money even to each other. The decrease in money supply reduces the velocity of money, causing the reverse effect of inflation: the price of everything drops. The drop in the prices of stocks, energy, agricultural commodities, and precious metals in the past few weeks exemplies the kind of deflationary pressure that occurs when credit tightens. Deflation may be the only situation in which cash and short-term bonds have an advantage over other asset classes: as the price of everything drops, the relative purchasing power of cash increases. The deflationary crisis of the Great Depression presented great buying opportunities to anyone who had cash to spend: real estate, for example, could be purchased at bargain basement prices.

Other factors affect the price of precious metals. Many hedge funds hold precious metals in the form of paper-based obligations. That is, they do not hold physical precious metals, but hold various kinds of financial instruments that represent precious metals. As shareholders in these funds demand redemption of their shares, the hedge funds dump their precious metal holdings (along with other commodities) to raise cash.

Intervention in the markets by central banks to undermine gold as the primary competitor to fiat currency also plays a role. The Gold Anti-Trust Action Committee has for years chronicled interventions of this sort.

If any of this seems counter-intuitive, take note of the the fact that precious metals dealers today have difficulty fulfilling orders — gold and silver bullion are flying off the shelves faster than the refineries can produce it, and it can take several months for the backorders to be filled. Based on physical demand the price of precious metals should be much higher right now. The disparity between the market price and physical demand suggests either deliberate market manipulation or the short-term effect of hedge funds dumping their paper proxy holdings of precious metals.

My belief in the long-term outlook for inflation remains firm. The recent spate of bailouts have increased the Federal Reserve’s balance sheet dramatically. And as the default credit swap crisis enlarges the circle of credit problems from the mortgage sector to the economy as a whole, more bailouts will come.

But that’s not all. In the next few years, the retirement of the baby-boomer generation will put tremendous pressure on government entitlement programs such as medicare and social security. The government will have no way to meet these obligations other than borrowing more money. Through the machinations of the Treasury department and the Federal Reserve, the government debt will further increase the money supply and inflation will run rampant.

Precious metals will do well in the long term as our monetary system unravels. But, as we see today, the volatility of precious metal prices make them a poor choice for money that you need to access in the short-term.  Holdings for more immediate use are better held in the short-term bonds of foreign countries that follow more conservative monetary policies. One mutal fund to consider, the Prudent Bear Global Income Fund (ticker symbol PSAFX), holds a diversified portfolio of short-term bonds in a number of such countries. You will need to figure out the right mix of physically held precious metals and something like PSAFX for your own personal asset protection plan.

A Slightly More Useful Disclaimer

This is the point in my post where I have been saying “I am not a professional financial planner and have no credentials in this area. You should always review your long-term financial plan with a qualified financial planner.” That of course is true. But this time I would like to offer you the view of Chris Ciovacco, who is a professional financial planner and does have excellent credentials in this area. In his recent article Investing Now: The Big Picture, Chris observes:

While there is no question gold still has very positive long-term prospects for a variety of reasons, risks remain in an environment where there is open trader talk of possible U.S. dollar intervention by global central bankers. . . . Gold’s lower lows and failure to make a new high during a very serious financial crisis, tells me the following:

  • For the moment, the markets are more concerned about economic weakness rather than inflation (the focus will change in the months and years ahead).
  • Dollar strength is curbing the demand for all commodities, including gold.
  • Central bankers and policy makers do not want to see high gold prices. High gold prices put a spotlight on excessive money creation and government intervention into the free markets (all related to debt and currency debasement). Central bankers and policy makers still carry a heavy hand in the financial markets. They can crush the little guy in the short run. They can alter markets in the short-run. Gold’s 28% drop between July 15, 2008 and September 11, 2008 is a painful illustration of this concern.

In the interest of brevity I have left out the parts of this section of the article in which Chris advocates for reducing one’s exposure to gold (and by extension we would say silver as well) during this period of uncertainty in asset values. That would not be my personal approach because I have more of a buy-and-hold orientation. But please take a look at his article for further and more technically detailed insight into another view of how one might proceed in this market environment.

© 2008 Philip Glaser

The Psychology of Buying Precious Metals

September 29, 2008

I’ve been advising my friends, family, and neighbors to buy precious metals to protect their assets against inflation for several months now. A number of questions have come up.

  • How do I know that the coins I buy aren’t forgeries?
  • I looked at Franklin Sanders’ website and he seems a bit idiosyncratic; is he ok?
  • Once I buy silver coins, where do I store them?

These are good questions. But before answering them, I want to discuss the psychological factors behind the choice to buy precious metals. Buying gold and silver bullion as a safe haven presupposes letting go of certain beliefs about the way our monetary system functions and how that system is likely to fail in the coming years. Let’s take a look at them.

Belief # 1: Dollars and Banks Make Your Assets Secure

We all grew up believing that keeping dollars in a passbook bank account preserves our savings in the most conservative way. The bank protects the money from theft and even pays us a fee called “interest” in return for the right to lend our money to other people.

Most folks who buy precious metals challenge this assumption  for a number of reasons:

  • The Federal Reserve’s monetary policies have seriously eroded the purchasing power of the dollar;
  • Inflation makes the going interest rate effectively negative; and
  • Fractional reserve banking (the mechanism that allows a bank to lend 90% of its deposits) poses this risk: if the loans that its depositors financed default in large numbers, the depositors can’t get their money back (and yes, FDIC could easily go belly up if enough banks fail simultaneously).

The catastrophic collapse of the banking system during the Great Depression happened so long ago that few of us grew up thinking in these terms. And you wouldn’t be likely to ask why the U.S. Constitution explicitly mandates gold and silver as the national medium of exchange unless you knew about the numerous hyperinflationary disasters that befell many of the Colonies. Without studying some history and understanding some rather arcane concepts about our monetary system, questioning the safety of a good old fashioned bank sounds like lunacy.  You may as well try to convince a five-year old child that Santa Claus does not exist: either he won’t believe you, or he will be emotionally devastated.

Belief # 2: The Next Fifty Years Will Look The Same As The Last Fifty Years

The past fifty years of America brought a level of material wealth to more people than could ever have been possible at any other time in human history. It is natural to assume that things will continue as they have. The alternative view embraces the realization that this unprecedented level of wealth results from:

  • Unsustainable consumption of natural resources;
  • The availability of cheap petroleum;  and
  • The willingness of foreigners to finance our national debt.

There are good reasons to question the long-term viability of these conditions. The emerging industrial countries (most notably China and India) are competing with us for natural resources. And they are discovering investments more secure and lucrative than the US Treasury Bonds that finance our national debt.

The signs of decline are all around us: the rising cost of food and medical care; the growing doubt about America’s ability to ever repay its national debt; the rapidly rising price of gasoline, home heating fuel, and electricity.  The frantic pace of our lives makes it hard to notice the signs of deterioration and to understand what they mean for our economic future. Good old fashioned denial also plays a role.

The Hesitation To Dive In

A dispassionate examination of the facts and a lucid understanding of a few economic concepts easily expose the fragility of our monetary and banking system. The same goes for the material changes that will affect our standard of living in the coming years. This knowledge has motivated some of my friends and neighbors to explore purchasing precious metals.

But my informational answers to the very reasonable questions people are asking me don’t always satisfy them. A few days ago my wife and I answered the same question about Franklin Sanders three times in one day from the same person. So I think there’s more to these questions than the quest for information. There’s also a good deal of anxiety.

So let’s be clear. It takes a major shift in consciousness to make this chioce. One has to let go of some deeply held assumptions about the solidity of the monetary world in which we earn and spend. Psychological shifts of this magnitude always raise fear and anxiety.

So as I answer the specific questions about buying precious metals, pay attention not only to the information itself, but also to your reaction to what you are doing. You are giving concrete form to your preparations for an uncertain future. By doing so, you are demonstrating to yourself an acceptance of the great uncertainties that the future does indeed hold. Investing even a tiny portion of your total savings in silver bullion coins gives form and reality to your beliefs. Psychologically, that’s a big deal.

A Few Answers

With that, I’ll just say a few things now to address the specific questions that folks have asked me recently.

  • How do I know that the coins I buy aren’t forgeries?

The pre-1965, 90% silver U.S. coins that I recommend are miniscule in silver content (0.715 of their face value, to be exact). It just cannot be worth anyone’s while to counterfeit them. Forging 10, 100, or 1000 ounce bullion bars would be much more lucrative. Today’s relatively low price of silver (around $13 per ounce) makes the proposition even more unlikely. Moreover, if you put one of these coins side-by-side with a newer coin the difference will hit you over the head: the silver ones are bright and shiny while the newer ones look dull and grey.

To set your mind at ease, put in a minimum $100 MAP order with Franklin Sanders and then have the coins checked out at a coin shop. While you’re there, inquire about the coin dealer’s commission on the same coins. The answer will help you understand the value of the MAP.

  • I looked at Franklin Sanders’ website and he seems a bit idiosyncratic; is he ok?

Franklin makes no bones about discussing his political and religious beliefs on his website. I have found this to be the case for quite a few precious metals dealers (check out Don Stott’s website for comparison). No question about it, the precious metals community marches to its own counter-cultural drum.

More to the point, I don’t do business with Franklin Sanders because I agree with everything he has to say (though with an open mind I have learned a thing or two from him about the nature of our monetary system). I find Franklin Sanders to be an honest and ethical businessman. He created the monthly acquisition program to make the purchase of precious metals as affordable as possible: he believes that everyone has a right to protect their assets against the foolish and reckless monetary practices of the government. He also has a great sense of humor (don’t be surprised if he asks you for your “gulag number” when he’s getting your zip code).
I have no affiliation with or other reason to promote The Money Changer. Buy from someone else if you wish. Just understand that the Monthly Acquisition Program makes the purchase of gold and silver bullion coins as inexpensive as it can possibly be.

  • Once I buy them, where do I store them?

Some folks hide their precious-metals at home. Others prefer a safe deposit box. Storing them at home poses the risk of theft or of forgetting where you buried them (this can and has happened). On the other hand, if your bank fails, you may not have access to your safe deposit box during precisely the period of time that you need to get to it. And if, as happened in 1933, the government confiscates gold, it can supervise the opening of your safe deposit box to seize your assets.

The thought of storing my financial safety net at home makes me nervous and I’d rather not do so. The best bet, I think, is to use a safe deposit box until you start to see signs of potential bank failure or some similar disaster. At that point, the relative security of keeping your silver bullion coins at home would outweigh the risk of the safe deposit box. You must always keep a close watch on economic events as they unfold.

Finally, please remember that I do not recommend putting all or even any significant portion of your assets into any one asset class, precious metals included. All I recommend is buying some amount of precious metals on a monthly basis or as often as possible.

The Usual Disclaimer

I am not a professional financial planner and have no credentials in this area. You should always review your long-term financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil. My only purpose is to educate you about ways to protect your financial well-being in the face of the dark period of economic and social collapse that looms ahead of us in the next decade.

© 2008 Philip Glaser

The Big Bailouts: The Cure Could Kill The Patient

September 21, 2008

The unprecedented government intervention to save AIG rankles those of us who would prefer that the government refrain from intervention in the financial markets. Especially a government led by Republicans, who supposedly believe in free markets. But there is a good reason for the intervention: the size of AIG’s credit derivatives market is sixty-two trillion dollars, which exceeds the size of the entire world economy. Its failure would cause a domino effect of failures that would bring the world financial system to its knees. The infusion of $85 billion seems like a small price to pay to avert disaster.

And now Henry Paulson and Ben Bernanke want the government to shell out $700 billion to rescue the failing mortgage securities. Holy smoke!

Let’s assume for a moment that these interventions and others that may follow in the near future succeed in preventing a market collapse. The sight of the financial markets humming along with normal ups and downs would present a welcome relief to the precipitous drop that they took last week.

But should we all then breathe a sigh of relief? I’d say not. Even if the plan succeeds, the effects of the bailout on the monetary system will eventually come back to bite us in a serious way.

Consider this:

  • The multi-billioin dollar bailouts transfer ownership of the financial industry’s bad loans to the US taxpayer;
  • Since the government does not have the capital to finance this bailout, the Treasury Department will fund the transfer of private debt by issuing treasury bonds (in other words, taking on more debt);
  • The Federal Reserve will convert these obligations to dollars either by selling them to foreigners or through ‘monetization’ — i.e., by inventing the dollars out of thin air;
  • The net effect of this operation will be to erode the value of the dollar and effectively tax the US citizenry through inflation, or bring about a precipitous monetary collapse.

The net effect of these monetary machinations amounts to inflation. Governments that just print money willy-nilly to meet their debts (as happened to Weimar Germany in the 1920’s or, more recently, to Argentina in 1999) create hyperinflation. In the worst and most ludicrous scenarios, it takes wheel-barrows full of currency to buy a loaf of bread. In the end, the currency ends up having little more value than toilet paper as a medium of exchange. And as the example of Weimar Germany illustrates, the social and political effects of this kind of collapse can be horrific: it was this economic collapse that led to the rise of the Nazi party.

The value of the dollar has already fallen forty percent since the year 2000 when the Federal Reserve aggressively lowered interest rates to stimulate the economy in the wake of the tech bust and the economic effects of 9/11. Even without the mortgage bailout, the unending promises by politicians to reward voters with entitlements and pork barrel goodies ensure that the government will take on more debt and further erode the dollar. The current bailout only accelerates this process. When the dollar crisis strikes, it will make the value of dollar-denominated investments — especially passbook savings accounts and CDs — worthless. It might happen precipitously in a panic or it may happen over a period of time as it has been for the past eight years. It is the inevitable result of the government’s current course of profligate spending.

If the bailout plan does not succeed, and the financial system does collapse, it is theoretically possible a deflationary depression might happen. In that case, currencies or short-term bonds would be the best place to keep money because the value of everything (including the commodity hedges against inflation that I discuss below) would fall. Remember though that the only tool the government has to deal with financial crises is the monetary system. I believe with total confidence that all out market collapse would spur the government to print even more money than it proposes to print now.

Many of the authors whose articles you will find referenced below recommend buying commodities such as precious metals, land, oil, natural gas, and agricultural stocks. Such items maintain their value independent of the currency. When hyperinflation strikes, the price of these assets in dollars will rise, so that you to retain the purchasing value of your money. It is also possible that their relative value will increase as a result of their popularity when your next-door neighbor and brother-in-law understand what’s happening and start rushing to buy them. If you begin to accumulate these kinds of assets at a low cost (as you can now), you will even make a profit after inflation.

The complexity of navigating commodity investments can easily overwhelm the novice investor. They are not available in most 401k and state retirement programs. And their price volatility can give you quite a roller-coaster ride. In the past year, crude oil shot up to over $150 a barrel and then plummeted to under $100. A good deal of psychological preparation and technical understanding makes sense before plunging into this area.

I intend to elaborate on these topics in future articles. For now, I want to draw your attention to an easy and, in my view, sensible way to get into commodities: the purchase of silver coins. The cost of silver is denominated in the ‘spot price‘ per ounce. All forms of precious metals (specially minted one ounce coins or bullion bars) carry some premium over the spot-price. The least expensive silver coin is the pre-1965 US coins. Prior to 1965, dimes, quarters, half-dollars and dollar coins were made of 90% silver. When originally minted, a $1000 face-value bag of such coins contained 725 ounces of silver. Accounting for normal wear, such a bag today contains 715 ounces of silver. To know the silver content of such coins, you multiply their face value by 0.715. So three pre-1965 US quarters contain 0.53265 ounces of silver. At today’s spot price of silver, these three coins are worth $6.76. An advantage of these coins over the larger one-ounce silver coins or bullion bars is that when the currency collapses they can be used as a medium of exchange for small purchases.

You hear a lot about gold in the news, but silver represents a better value. Historically, when precious metals prices are high (like at the end of a bull market), the ratio of gold to silver is 1:16. That is, it takes 16 ounces of silver to purchase one ounce of gold. When the prices of precious metals are depressed, the ratio is more like 1:60. The price of silver, in other words, rises significantly faster than that of gold in a precious metals bull-market. Another way of looking at it is that silver relative to gold is much cheaper. And when the market is at its height, you can exchange your silver for gold and purchase significantly more gold than you could now.

There are many dealers of gold and silver The one with whom I am most familiar and trust is the The Money Changer. In times of ordinary uncertainty (times when a slow-burn on the value of the dollar is more likely than a precipitous collapse), I recommend that people start with small purchases of pre-1965 90% US silver coins in small quantities through the Money Changer’s monthly acquisition program. The advantage of this program is that you buy small amounts (as little as $100/mo.) at a commission level (about 3%) that would ordinarily require a purchase of thousands of dollars worth of silver. Think of it as a precious metals buying cooperative. If you can’t afford the minimum $100 a month, split the purchase two, three, or four ways with a group of people.

Since this is a time of extraordinary uncertainty (a collapse of the banking system or of the value of the dollar could happen rather immediately and precipitously), I recommend that you call Franklin Sanders immediately and purchase some amount of these coins. The amount you buy will depend on your means and on your level of concern about the current situation. You can then begin the process of regular purchases through the monthly acquisition program.

Some of you may have noticed that the price of gold, silver, and oil has recently undergone a dramatic drop in price. That’s ok because monetary inflation and shortages of energy supplies are part of a long term trend. By purchasing on a monthly basis, you apply the method of “dollar-cost-averaging” wherein the steady purchase of the item smoothes out the highs and lows of the market over time.

Finally, a few disclaimers. I am not a professional financial planner and have no credentials in this area. You should always review your long-term financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil. Also, I have no affiliation with or other reason to promote The Money Changer. Buy from someone else if you wish. My only purpose is to educate you about ways to protect your financial well-being in the face of the dark period of economic and social collapse that looms ahead of us in the next decade.

Suggested Reading:

AIG’s Dangerous Collapse: A Credit Derivatives Risk Primer, by Daniel R. Amerman
The Subprime Crisis Just Starting, by Daniel R. Amerman
A Day That Shall Live in Infamy, by Chris Martenson

© 2008 Philip Glaser