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July 31, 2008

Of Misnomers, Fallacies, and Lies
by Brady Willett

While Elton John made us think of Norma Jean as a candle in the wind, the financial markets in 2008 bring to mind a stick of lit dynamite in a hurricane. Does an explosion loom before the unpredictable gusts finally dissipate? If so, gold may be the only answer...

The Misnomer

The top misnomer being perpetuated by personalities like Jim Cramer and policy makers like Henry Paulson today is that financial problems are lingering because there is a 'crisis of confidence' in the marketplace. This misnomer continues that confidence can only be restored via radical bailout actions by policy makers. To note: we are not being told that Bear Stearns, the GSEs, and others necessarily deserve to exist, only that they must be bailed out because there existence is essential to the system (how confident are you in the 'system' after hearing this?)

To begin with, the contention that unprecedented bailout efforts are required to restore investor confidence is patently wrong. If a company is reliant upon the credit markets for its day-to-day survival and/or can not function if its reckless trading book no longer fetches top dollar, investors were wrong to have confidence in this enterprise in the first place. In this regard confidence restoration in the U.S. is akin to trying to bring back the grainy luster of a table made press board.

Next, if 'confidence' in the marketplace can only be generated by making the populace share the financial burden of bad financial choices it would be socialism, not capitalism, which engenders the greatest confidence in financial markets. How many bailout efforts does it take before the supposed confidence generating payoff from socialistic activities no longer outweighs the growing burden on the U.S. government and its citizens? Current trends suggest that we will eventually find out.

In short, the real story is not of investors being more or less 'confident', but of investors no longer behaving stupidly.

The Fallacy

The top fallacy making the rounds today is that inflation is the serious threat. What few seem willing to acknowledge is that the rising inflationary trend in 2008 has not been hurting the U.S. on a relative basis. Rather, and after ending a multiyear stretch of sever underperformance in 2007 (compared to other world markets), U.S. markets are holding up exceptionally well in 2008. Moreover, spiking inflation rates have helped take the once ominous threat of emerging market dominance off the radar.

Another positive (?) inflation story is seen in the debasing of the U.S. dollar (or the primary cause of today's 'inflation'). With trillions in U.S. assets being destroyed, bank stocks crashing, and policy makers reacting frantically to this deflation, dollar debasement is not only generating inflation but also helping smooth an otherwise rocky path for the financial markets. Given that this statement may seem controversial, consider the following: take away the debasing of the dollar and the bailouts still to come do not get enacted, future stimulus checks do not get printed, and wars do not get funded. In other words, it is a massive contradiction to extol the benefits of a strong dollar to combat inflation in one breath while calling for more unprecedented bailout efforts with the next.

To make a potentially long story short, a weakening dollar has and can be in the best interests of America if this weakness does not spark a 'crisis of confidence' in the dollar, or (remembering the above misnomer) so long as investors continue to behave stupidly.

The Lie

The biggest lie is that the Fed can always save the day. The reality is that post-Volcker the Fed has done everything possible to avert periods of creative destruction in the marketplace while at the same time doing little to promote the longer-term health of the U.S. financial markets through regulatory prudence. At the risk of sounding like a broken record, this deadly dynamic is largely the result of Alan Greenspan, a man who eulogized the supposed benefits of self-regulation at every opportunity. Today's crisis is suggesting that the self-regulated beast requires larger and larger bailouts in order to survive and a super-regulator to tame it - thanks for nothing Sir Alan!

As the Fed slashes interest rates, accepts junk for treasuries, and applies for the job of regulatory ringmaster, the recurring gravity of the situation should be obvious: the Fed can only save the day by postponing necessary periods of adjustment (i.e. today's 'deleveraging' is moving at a snails pace largely because of Fed meddling!) It goes without saying that when the adjustment obstacles become too large for even the Fed to handle the U.S. dollar and financial system crumbles. Perhaps only then will the 'lie' in question be fully exposed.

MF&Ls Unite!

If the deflationary monsters can remain veiled behind advantageous amounts of inflation, perhaps the U.S. bailouts can be effective over the short-term. Perhaps also if the world feels that it has no choice but to continue along the USD-hegemony-trail a little while longer, the system can avoid Armageddon. Nevertheless, few trends tell us that longer-term a crisis of confidence in the U.S. dollar can be avoided, and this suggests that one of the few safe options for the investor remains gold.

But before arguing that gold is about to return to its safe haven throne, remember that global policy makers, regulators, and money managers desperately want to avoid this outcome. As for the average investor, so long as he or she remains hooked on the misnomers, fallacies, and lies, they will continue running down a paper dream while walking right by gold. To wit, amidst today's financial blow-ups, foreclosures, and bank runs how many investors have been hoarding gold because they fear holding fiat money? Not many.

In short, while gold is the answer if the explosion occurs, there is reason to be optimistic that the paper chase can continue. Confidence in paper money may indeed be shrinking as the inflation rate increases and the Fed tries to throw its soothing cocoon over the financial world, but this confidence - unlike the trillions in OTC derivatives and off-balance sheet schemes - is nonetheless still observable.

Brady Willett
FallStreet.com

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