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September 13, 2008

Backed by Bananas
by David Petch

The following article was posted for the benefit of subscribers on September 6th, 2008.

Imagine if you will the US government finally after nearly 50 years opened the vaults of Fort Knox for an inventory of gold by an "External Auditor". There have been claims by the folks of the US Government of audits as recent as one year ago...there are a number of thoughts regarding IF there is in fact any gold present in Fort Knox. This article is not intended to debate the above thought, but to metaphorically "think" what they truly would find within the vaults of Fort Knox. My thoughts are that opening the vault of Fort Knox as above would result in seeing it filled with bananas...quite a contrast to the expected yellow objects "thought" to be contained behind tonnes of steel.

Implications of having a currency "Backed by Bananas" imply that the US is on the road to becoming a banana republic. The US has a relatively short but rich history that many books have been written about, it is important to focus on the time frame from 1913 to present, which coincides with inception of the US Fed. The US along with many other countries throughout the history of the globe have at one time or another had a gold standard. Of course, one could get an alternate version of what did not make it into the history books.

Gold standards imply that a country must hold a certain amount of gold for the amount of fiat currency within circulation. Under a true gold standard, currencies were denominated in value based upon the metal composition, namely gold, silver and copper. There is an excellent book titled Kristeva, Psychoanalysis and Culture. This thread allows one to read pages 9 through 12, which describes the essential path any Empire faces when it spreads itself thin. Empires initially start out small and can easily provide the required quantities of gold, silver copper etc. required for circulation of "true" currency. When Empires begin to expand to fast and consume the local resources, it becomes difficult in order to meet currency objectives...so they begin down the fiat road to perdition. Initially, other metals such as zinc, tin etc. are substituted to allow enough money to be in circulation with minimal amounts of gold silver or copper required. Later, this shifts to paper fiat, which in today's world of high tech thievery, governments must change circulating notes on a frequent basis (<3-5 years) to prevent other crooks from getting a piece of their action.

Whenever a nation has been in a war, gold standards traditionally have been dropped and embraced a fiat regime whereby their coffers were not restricted by the amount of gold bullion held in their reserves (the US has been at war with some country since the attach at Pearl Harbor...long inflationary cycle). This sort of action eventually leads to high rates of inflation and people on the Dole (pun intended with respect to the title of the article).

The US was on a gold backed currency at the turn of the 20th century but a banking panic in 1907 led to the eventual creation of an entity called the Federal Reserve System. The last thread takes a few minutes to read but several red flags can be noted such as:

prevention of bubbles (the US Fed has created a policy of creating new bubbles to replace popped bubbles)
board members appointed by the President of the United States (appointed to fulfill objectives of the current party in the White House?)
Low levels of cash in the FDIC available for bailing out failed banks (A method of injecting cash into banks, keeping enough funds to cover as losses.
Interbank lending to make up for shortfalls in other banks that are short on cash.
Open market operations for selling treasuries to other banks to get paid cash
Controlling interest rates by setting a targeted short term interest rate and expanding or contracting the money supply though open market operations (Note: the actual market determines longer-term rates)
Implementation of the "Term Auction Facility" to auction a set amount of funds to depository institutions against a wide range of collateral (collateral likely to become worthless shares of financial institutions).
Discontinuation of the FED tracking M3.
CPI and PPI hedonically altered by government since the early 1990's
Actual working capital of the FED around 40.5 billion dollars as of May 15, 2008
Principles run counter to those of Austrian Economics such as von Mises (this is a worthy read unto its own).

In 1929, the US was on a gold-backed fiat currency so when the prices of real estate plummeted, alongside stocks and wages etc., true deflation set in place. In 1933, ownership of gold and silver bullion was made illegal in the US, which was really a ploy for the government to have some leeway for increasing their monetary reserves. Gold was fixed at $35/ounce from 1933 until 1971...there was a slow inflationary creep, which by the year 1971 had caused many miners to go out of business due to the inability to make money.

Due to internal pressures in 1971, President Nixon took the US off the gold standard, thereby severing the financial link between government policy and the general populous. The US government as well as other governments get most of their finances from taxation as well as the hidden creep in the supply of money (thereby causing inflation).

Back in 1970-1980, the US was still a manufacturing giant and had a young demographic profile that encourages consumption. This scenario allowed for cost-push inflation to occur through powerful unions being successful at delivering large wage increases. A combination of classical monetary inflation and price inflation occurred, causing interest rates to spiral out of control. It took the appointment of Paul Volcker to raise interest rates above the true level of inflation and constrict the available supply of money to end the inflationary cycle.

Subsequently, from 1980-2000, the globe experienced a period of disinflation (declining interest rates), but examination of inflation rates from this period continued to rise. Inflation was persistent due in part to the fractional reserve banking system where every dollar invested creates $10 available for lending. Around the early to mid 1990's, governments around the globe began to hedonically adjust inflation rates, particularly nations with a declining manufacturing base and aging populations (pig in the python scenario...lower cited inflation rates lowers the amount governments are on the hook for pension payments, disability payments etc). Before this, wages in general kept up to rates of inflation, but post 1995 began to mark a disconnect between stagnant wages and rising inflation, namely inflation causing prices of most commodities to rise. Note: increases in production of manufactured goods often involve new technologies that tend to lower the sale price as it becomes more and more available to the masses.

Large injections of liquidity by the FED throughout the 1990s accumulated along with expansion of credit through the use of margin at brokerage houses. The stock market bubble of 1998-2000 resulted in the masses taking out huge loans, which according to von Mises is a component of monetary expansion. From 2000 until the end of March 2003, the stock market fell, thereby resulting in the loss of trillions of dollars. In order to prevent a deflationary collapse, Allan Greenspan lowered short-term interest rates to 1%, thereby allowing the masses to borrow cheap money to prevent defaults on accumulated debt. Note that this action was to bail out the consumer and keep the market model of "consumerism" alive.

The general populous in 2001 embraced cheap credit and it was the first time in US history that people continued to go further into debt rather than increase personal saving rates...this marked one of those moments in history where the cliché "This time its different" was applicable. The "Super-Size Me" psychology began to run rampant as people scaled up their homes and unlocked new found credit for purchasing new cars, toys and vacations. Of course as we all know, this developed into another full-fledged mania, which peeked in 2005 and has the housing real estate market has been cratering since, with no sign of a bottom.

The US economy is based on consumerism, which accounts for 72-74% of it. Easy credit from 2001-2005 fed the economy, but now the personal ATM machines have all been removed. The next wave of consumer debt failure will originate from credit cards and auto loans.

When a small percentage of consumers can not pay bank loans, their items are repossessed to cover losses and the individual is screwed. As the number of consumers failing to pay debt payments or declare bankruptcy continues to dramatically rise, banks will be screwed and they approach the Fed with their hats out (this is already happening). When people run out of money, it is their problem...when a bank runs out of money it becomes a major issue since they facilitate the grease required to keep the economy expanding i.e. liquidity.

Obviously, the consumer is tapped out and there are deflationary forces at work, some points which have been eloquently addressed by Michael "Mish" Shedlock . As I noted earlier, going off the gold standard separated the linkage of government and consumer actions that traditionally exist when economies enter recessions. Before I go further into this article an example is required in order to animate the thought an "Ace trumps all other cards". Global warming has been linked to increased C02 levels linked to human activity and removal of carbon sinks around the globe. A new business of exchanging carbon credits (Is it any surprise that Al Gore happens to own and run such a company?) has evolved, but it may prove to be unwarranted. Recently, it has been noted that sunspot activity has not followed its regular rhythm, even though a couple of scientists nearly one decade ago predicted this would happen, based upon subtle shifts in the UV spectrum output. The last time this event occurred, a period of significant global cooling occurred (last year, the mean global temperature declined by 0.7oC). Obviously solar output trumps the global level of CO2 for importance of temperatures on Earth, since it is the origin/source of energy required to sustain life on Earth i.e. An Ace is an Ace and trumps all other cards.

Back to inflation, monetary inflation is defined as an increase in the total available supply of money (fiat and credit). Since the link between government and the general populous was broken societies at such junctures generally go From Freedom to Fascism i.e. the actions of government increasingly "trump" the actions of the general populous. Back in 1930, the US currency was tied to gold and caused deflation due to the restricted ability of government intervention at increasing the money supply. At present, there is a contraction in the M3+credit, which is sending signals that deflation is about to take root. This represents a small part of the equation that is about to be "trumped" by the action of government policy i.e. the US government controls the printing press and can increase the supply of money at will. Anyone who wished to understand human psychology, I suggest reading a book by Bernd Widdig . It is a little dry, by provides striking parallels to the breakdown in social structure of Weimar Germany to modern day North America. The bottom line of the book is that monetary policy govern the general values and thought patterns of the general populous (Imagine the lawsuits to fly if any lawyer gets wind of this).

Some may wonder how inflation can persist or even increase if consumer or companies can not borrow money, thereby destroying the economic model made possible with fractional reserve banking. Persistence of inflation globally is rather complicated, involving the US government and global liquidity. As a country passes into the realm of socialism, monetization of failed banks and businesses etc. prevent destruction of circulating money. Increasing the size of government in an economy result in a gradual reduction in businesses, thereby resulting in a reduction of a taxation base. More often than not, governments resort to printing money to cover their bills. Depending upon the size of a country's economy and its relevance in the global economy, expansion of a given currency might not result in an immediate debasement of the currency. Rather, a Tipping Point is reached, where rapid currency devaluation occurs.

A sharp decline in a given currency raises the cost of imported goods, which provides internal feedback within, requiring government set minimum wages set to rise accordingly so people can live (food, shelter, clothing). As the wages of people rise, the government must print more money, which is the cause of further currency debasement. This is a close looped system, which eventually destroys itself thereby giving birth to a new currency.

The US currently imports more than 70% of its energy requirements and more than 90% of all manufactured items. Any currency devaluation in the USD would result in a rise in all of the above. Many foreign governments control vast amounts of US currency denominated in cash and US treasuries, so it is important for the US government to "manage" the psychology surrounding the US greenback. Any change in sentiment could prevent any country from showing up at Treasury auctions or even worse "dump treasuries". Either event would cut off US government monetary expansion abilities, thereby forcing them to turn on the printing press.

The first "Tipping Point" will be noted when currencies pegged to the USD are decoupled and allowed to rise on the open market in order to allow an increase in purchasing power, thereby causing a reduction on imported items. At present the USD is having a bear market correction, that should end around July 2009. The present rise in the USD has been triggered by banks hoarding cash, people saving dollars, debt payment etc. As the US government continues to increase liquidity into the system through monetization of failed businesses, banks, TAF etc. etc. the role of government for causing inflation will "trump" the deflationary environment seen amongst the consumer.

In the not too distant future with increased monetary expansion, the USD will truly be Backed by Bananas and the monkeys running the system.

A major portion of the work I do is technically oriented, but I write 2-3 editorials per week often intertwined within the analysis. For further viewing of prior work, simply click on the Archive section of this site. Weekly, I update the AMEX Gold BUGS Index, AMEX Oil Index, US Dollar Index, 10-Year US Treasury Index, S&P 500 Index as well as commentary on market-related issues and new technical analysis findings. We follow some 60 stocks, with a focus on core positions and stocks that actually make up our personal portfolio. As well, the keeper of the site, Captain Hook writes 2-3 articles per week discussing macro issues, ratio analysis of various markets and an in-depth study of put/call ratios and shorting candidates.

If you have any questions, comments, or criticisms regarding the above, please feel free to drop us a line.

David Petch
TreasureChests.info

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