Gold and the Tragedy of the Commons
This report was originally prepared for Strategic Energy Research and Capital, LLC.
"The business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play" - Rothbard
The Greek crisis is but a symptom of the general problem afflicting the world economy. It is still the canary in the coal mine, but EU officials replaced it with a dead parrot when the market wasn't looking.
A week ago today, prompted by fears over a possible default on Greek government debt and stomach churning swings in debt, currency and stock markets all over the world, European officials rolled out a monster 750 billion euro version of TARP, brokered by the IMF which will contribute 1/3.
The world's major central banks chipped in by reopening their (dollar) liquidity swap facilities with the Fed, and the ECB said it would buy corporate and government bonds. However, the ECB also said that it would sterilize these purchases by draining liquidity from elsewhere, and by paying commercial banks to make deposits with it.
The deal stirred a lot of controversy because not only did the German government defy its constituents by hastening the bailout plan through parliament, but also, they did it just before crucial elections. The risky move cost Merkel's government a significant amount of seats in a strategic jurisdiction last week.
This tells us they were motivated by fear.
Fear of what? Fear that the whole thing could snowball into a global nightmare. Fear that the German banks who own the paper would keel over and die. Fear that the European Union could unravel.
Greece won't default; we knew that wouldn't be allowed. That fear is dead, for now.
The other fears live on.
Justifying the move the German government lashed out against speculators calling them "treacherous" parasites who brought on the crisis, and are now biting the very hand that feeds them. Socialist leader Angela Merkel believes the evil market is at war with her government, and needs to be put in its place.
"First the banks failed, forcing states to carry out rescue operations. They plunged the global economy over the precipice and we had to initiate recovery packages. Because of these packages, we have become indebted and now, they are speculating against these debts; that is really very treacherous... To some degree this is a battle between the politicians and the markets. But I am firmly resolved -- and I think all of my colleagues are too -- to win this battle; Governments must regain their supremacy over the markets, which they no longer have, and for that we need much stricter global rules" - German Chancellor Merkel on Greek crisis.
There you have it: banks did it. Now they are unfairly making it difficult for her government to paper over the whole mess. Is this true? Do markets wage war? Are the banks at fault? Do we just need more regulation to make the bad guys go away? Can the State stimulate growth, or create wealth?
Will the bailout work? How will all this affect the markets?
Why the Central Banks Won't Sterilize its Bond Purchases (Drain Liquidity)
We already know central banks can drain liquidity if they wanted. The question is, will they have the foresight and resolve? The Federal Reserve has been talking about it for over a year, but hasn't started yet. The reluctance to let markets believe they are throwing caution to the wind and ramping up the printing presses is healthy, but, we suspect, not steadfast. The reality of the current monetary set up is that wherever the ECB tries to drain liquidity it will probably cause trouble in those markets.
That is because the structure of the economy and the inflationary booms we get have grown up around, and become dependent upon, the borrow-spend-inflate paradigm. Under this paradigm, the withdrawal of inflation is what brings on the crisis. Of course, the Greek riots are a good example of where this paradigm ultimately leads, and other countries should take heed: it is not sustainable.
But that lesson is out of fashion. The more fashionable lesson is that the faster governments react to a crisis - by adding even more debt and inflation - the quicker the economy recovers. But this thinking is not only erroneous; it is part of the cause of the tragedy, and it is not confined to Greece.
What brings about depression is not the mere liquidation of bad investments at all; it is the forestalling of this market clearing process through rigid interventions and inflation, which effectively prevent the market from making the adjustments necessary to put the economy on a sustainable growth path, one that does not need the support of government. This interference, writes Murray Rothbard in America's Great Depression, is what lengthens the period of depression as it did in the 1930's. Furthermore, it continues to subsidize the very activities that led to the crisis, to where the government wants to shift the blame. The inflation policy destroys capital. Actual growth is fueled by real saving, which is also discouraged by this policy. Indeed, despite the outward appearance of an inflationary boom, this is the phase of the cycle where the damage is being done to the processes that truly create wealth.
It is the part where capital and other scarce resources are diverted to the creation of CDO's, too many banks, too many brokers, too many bureaucrats, too many ponzi schemes, and so on, the voices in the wilderness keep telling us. The bust is simply the market returning to dynamic equilibrium
But breaking the cycle of inflation, debt, crisis and more inflation requires thinking about the long term and requires more resolve than elected politicians can spare these days. Neither central bankers nor governments are willing to tolerate the dreaded deflation, which is, unfortunately, the only way to encourage savings and return the economy to free-market proportions - i.e. the desired consumption-savings pattern that allows sustainable growth without the support of government. This is not to say that markets are inherently unstable and constantly in need of liquidation just to get back on track.
Au contraire. We're with Rothbard, that the instability is caused by reckless government policies -too much spending, intervention, and too much inflation. It is after all the elephant in the china shop.
This is why the bailout won't really work. It will alleviate the immediate problem of a default. It might even engender another boom. However, it cannot result in growth anymore than the 2001-03 easing.
Monetary circumstances being what they are today, any slow down in the growth rates of liquidity are thus dangerous to the liquidity dependent economic structure; and as long as the resulting liquidation is viewed as punishment, rather than a necessary adjustment, the cycle of stupidity is self-reinforcing.
The intervention (bailout) postpones the inevitable adjustments and each subsequent crisis gets larger as more malinvestment is piled on; ultimately, interest rates will end up having to go much higher.
So it is one thing to say we're going to sterilize when markets are going up; it's another to do it when they aren't. The rally in stock and bond prices that the stimulus news engendered last week is starting to wilt again, so we'll see soon enough how much resolve there is in this idea about draining liquidity.
We don't believe it. Neither does gold.
Markets Don't Make War, They Make Love
If the government is at war with the markets this is not new... it has always been. It is the nature of the state because the state is institutionalized force. It holds a monopoly on this. But markets don't wage war. They deal with risk and uncertainty; but more relevant, they are a voluntary order.
Ludwig von Mises is lucid in his description of a market,
"The market is precisely the freedom of people to produce, to consume, to determine what has to be produced, in whatever quantity, in whatever quality, and to whomever these products are to go. Such a free system without a market is impossible; such a free system is the market. We have the idea that the institutions of men are either (1) the market, exchange between individuals, or (2) the government, an institution that, in the minds of many people, is something superior to the market and could exist in the absence of the market...."
Number two sounds familiar (see Merkel's comments above).
Here's the rest of Mises's quote,
"The truth is that the government - that is the recourse to violence, necessarily the recourse to violence - cannot produce anything. Everything that is produced is produced by the activities of individuals and is used on the market in order to receive something in exchange for it. It is important to remember that everything that is done, everything that man has done, everything that society does, is the result of such voluntary cooperation and agreements. Social cooperation among men - and this means the market - is what brings about civilization and it is what has brought about all the improvements in human conditions we are enjoying today."
"Such a process cannot be adopted by a government, for it is not an artificial construct. Capital accumulation, exchange and investment are all naturally occurring. Although these actions are oftentimes grouped under the title of "capitalism," it is important to note that capitalism is nothing but the mechanisms of a voluntary society and a web of individual human actions. So, far from being something a government can adopt, it is a concept the government must respect. It is something innate in all societies, and so governments can only become burdens upon this web of naturally occurring human actions" - Ludwig von Mises
If this is true, and it is, what good is it going to do anyone when governments regain "supremacy"?
There is no need to go into the value of speculators in the stabilization of markets via the provision of liquidity. We assume our audience is familiar with the basic principles of economics. But we need to expose the fallacy in this anticapitalist slander once and for all. For Merkel is not alone in her assault on the voluntary order. Members of the Senate are familiar with this tactic themselves, having used it in their own crusade against Goldman Sachs, and the investment banking business more broadly.
Thus it is appropriate that in this unabashed assault on the voluntary order of exchange I am reminded of an old quote by Marcus Tullius Cicero (106-43 BC) cited in St. Augustine's City of God,
"There was truth as well as neatness in what the captured pirate said to Alexander the Great when Alexander asked him what business he had to infest the sea, and he defiantly replied: "The same as you have to infest the world. Because I do it with one small ship, I am called a terrorist. You do it with a whole fleet and are called an emperor"" - Augustine quoting Cicero
There is no bigger pirate than the State.
How the State Persuades the Public that it Can Create Wealth
What Merkel and her ilk fail to understand is that their beloved State could never exist in the absence of a market. The State is the parasite almost by definition. It is not the creator (or originator) of wealth and capital. It can only expropriate, transfer and redistribute it through taxes and inflation. And it is not accountable to consumers like a business has to be (nor is it accountable to voters it would seem).
The ONLY way to increase wealth (to make the pie bigger) is to invest and accumulate capital.
The tragedy is rooted in an old lie that has regained its footing over the past two decades; ironically it began as the world abandoned communism. The leaders of Venezuela, Cuba and North Korea may be the last of the orthodox communists left standing today, but the world is chock full of socialists and other shades of statists who believe that markets are inherently unstable, and a necessary evil whose animal spirits just need to be regulated, controlled, tamed, poked, prodded and otherwise managed.
These are the views of Germany's government, and every government on the planet today.
But how do governments pull off this grand deception?
Again, Mises comes in handy since he busted it wide open almost 100 years ago,
"The various brands of socialism and interventionism could not retain their popularity if people were to discover that the measures whose adoption is hailed as social progress curtail production and tend to bring about capital decumulation. To conceal these facts from the public is one of the services inflation renders to the so-called progressive policies. Inflation is the true opium of the people administered to them by anti-capitalist governments and parties."
That is one of our long time favorite quotes. You can see it working today. Governments use inflation (monetary expansion) to buy votes and confidence in their policies. The debts pile up, requiring ever more inflation, and when it unravels governments can blame the Goldmans and the Michael Milken's.
The fact that people do not understand inflation allows government to expropriate funds (real savings) and redistribute incomes, without ever having to resort to direct taxation, towards ends they believe the market doesn't appreciate, or cannot perform as well. This is a great convenience to politicians.
Will the True Cause of the Crisis Please Stand...
As Rothbard remarked of the Fed years ago, the culprit is the one pointing his collective finger,
"The culprit solely responsible for inflation, the Federal Reserve, is continually engaged in raising a hue-and-cry about "inflation," for which virtually everyone else in society seems to be responsible. What we are seeing is the old ploy by the robber who starts shouting "Stop, thief!" and runs down the street pointing ahead at others." - Rothbard, case against the fed
The great statesman Alan Greenspan once wrote an essay for Ayn Rand in which he argued that the welfare statists are the greatest antagonists of the gold standard because it checks their expenditures.
Needless to say, they did away with the gold standard long ago.
Thus is the legacy we are living through.
It is easy to forget about Iceland or the Dubai scare, but they too were part of the same unwind that started with the collapse of Bear Stearns and the bailout of JP Morgan in 2007 and spread to the annihilation of Lehman Brothers, as well as the nationalization of AIG and both GSE's - Freddie & Fannie - in the US, and of Northern Rock in the UK, etc, etc. The subprime crisis came apart two years after house prices peaked in the US. The soundness of the market then was predicated on a premise of continuously rising home prices, which were the product of the central bank's previous inflationary policy. This phenomenon occurred around the world. Governments everywhere rolled out their own brand of the community reinvestment act and inflation to fund their contribution to the war on terror, and to deal with the economic bust back in 2001-02, itself the consequence of the inflationary policy that produced the tech bubble, which in its turn was crafted in response to the Asian currency crisis of 1997 and the LTCM debacle -the product of too much money sloshing around again.
That is how this works. It's a vicious cycle: the process produces a vicious cycle of interventions that beget larger interventions, and the world is at an uncomfortable slope in this curve.
A fractional reserve banking cartel supported and regulated by a central bank with a legal tender monopoly is not a free market set up -the Fed is an extra market institution accountable to the State.
The Fed's inflation policy can create a boom but it can only be sustained as long as the bank doesn't have to withdraw the policy, which is why it is ephemeral. Thus, when central banks started pushing rates up some time after 2004, the impetus to the subprime premise (rising home prices) evaporated.
But the policy doesn't only encourage reckless behavior on Wall Street. It encourages recklessness in government programs and expenditures, because it offers them another way to fund their progressive programs. This is why many countries are in the fiscal predicament they are in today. That is what happened to Iceland, Dubai, Greece; and as long as the solution in each case is more debt and more inflation (and regulation), these problems will continue to mount. Indeed that is why the bailout, which should surprise no one at this point, has gold bulls particularly fired up. The events thus confirm our general thesis for the precious metals and commodities (hard assets) markets and the inflation trade.
It is vitally important, however, because it is easy to forget, that it is the central bank's monetary policy that sustains the unproductive activities that invariably have to be liquidated. That is, this activity is encouraged and incentivized not by the free market, but by government policy.
What Happens Now?
Whatever else can be said of them, the events of recent days are fundamentally bullish for the gold price, particularly the response by government officials announced last week.
While they may have surprised stock and bond traders, gold traders had anticipated the crisis, having pushed up gold prices steadily from their February low. Specifically, we expected that the crisis would worsen, and that Greece ultimately would not be allowed to default -that a bailout would happen, and that it would be inflationary. Not only that but we have been harping for some time on the theme that gold would rise even as the dollar rose - precisely because we felt the euro and pound would continue to crumble under the weight of their own quantitative easing programs. We further argued that the euro would lose fanfare as a viable reserve currency alternative to the US dollar as the market started to realize that it is also an inherently inflationary currency; at least as much if not more than the dollar.
The ECB inflated M1 and M2 by 128% and 98%, respectively, over the past ten years; the Federal Reserve has increased these quantities by 53% and 81% respectively (although "true money supply" is up by 131% in this period we don't have an equivalent statistic for the ECB - call us for more color).
The scope of the current bailout and coming tide of regulation is destined to produce consequences beyond our imagination today, but none that can possibly be good.
The only part we can predict with any degree of certainty is that there will be more regulation, more inflation, more suffering, more taxes, more civil strife and possibly even more war in our future.
Unless the UK and the US can bring their own finances under control it is just a matter of years before they face magnitudes of debt that will also become unmanageable. Already they are so large that the pressure to monetize and debase their currencies cannot be resisted without superhuman effort.
The somewhat good news (bad news for gold) is that there is some political will in the UK to bring the runaway deficit under control. While its debt to GDP ratio is nowhere near that of Greece or Italy, or even the US, its annual deficit, at 12% of GDP, will bring the debt/gdp ratio up to >100% in 3-4 years, if not checked. We'll continue to monitor the situation, but the UK alone cannot roll back this tide.
Glitch or no glitch on the NYSE, this kind of volatility has got to bear on the evaluation of equities as a long term investment for the average person, especially since stocks have been such poor performers over the last ten years. Ten years ago, a conservative portfolio would have predominantly comprised some mix of the following: government bonds, income trusts, good quality mortgage backed securities, REIT's, even bank stocks and perhaps a few investment properties scattered around the country.
Even Greek government bonds would have been preferred........to gold. A conservative portfolio then did not include gold. It was a four letter word... considered much riskier than many assets.
The euro too was supposed to be the anti-gold establishment's answer to the worry that there was no alternative reserve currency. The currencies competing for this position (vis-à-vis the USD) were backed by comparatively smaller governments, most of which typically ran unsound monetary policies.
The few that were considered to be sound - the Swiss, German, French and British currencies - were either not really, or simply had too small a float to achieve the worldwide circulation the dollar had.
Agitation by inflationists and economists (on both sides of the ocean) for a move towards the creation of large currency blocs during the 1990's was based on the idea that size, rather than sound monetary policy, would promote the circulation of a given currency, enabling it to compete with the dollar, and bestowing upon it and the lucky nation all sorts of privileges that apparently only the US enjoys today.
But importantly, the Euro was hailed as the next reserve currency.
We never believed it, but we are at the point now where the rest of the market doesn't either.
So, given this, how would one construct a conservative income portfolio today?
Today, with the safest securities yielding hardly enough interest to cover inflation and taxes, where can the average person invest prudently? Where would you tell your grandmother to put her retirement nest egg? Even stocks as an asset class were considered a relatively safe long term investment ten years ago... a must in fact for the baby boomer. In the two decades previous, after all, they'd gone up in most years with but few hiccups. Mutual fund salesmen never had it so good.
Gold has scored a lot of points in its performance over the last decade. It has not always been the best place to be in the short term but it has proven to be the best place to be over the decade -note that the stock market is down in this period, and that Berkshire's total return is less than 80 percent.
We think this will continue as the lesson drawn from previous crises continues to be the same: i.e. the government or the central bank did not act fast enough to preempt it. The politics of abandoning the boom time policy are littered with pot holes that could cost elections. Indeed, the principle of unsound money, as we call it, is a feature of the democratic state, and not free market capitalism -inflation is to a [progressive] democracy what the gold standard was to laissez faire liberalism in the 19th century.
In a recent conference call well known hedge fund manager [John] Paulson said he was bullish on stocks and the housing market, "The market correction is a buying opportunity in the U.S. and European equity markets, in the face of the recovery we're likely to experience." He said we should buy homes too. For the record we have to agree, more or less, since the value of capital should hold up better than the value of currency in this environment of competitive currency devaluation.
Certainly, we expect the golds to correct as the safehaven trade unwinds and everyone rushes back into stocks (spending those new euros before they're even printed), and out of bonds and currency.
While gold stocks are not as expensive as they were at the top of the 2006-08 cycle, in relation to the gold price, many could be overbought in the short term. Nevertheless, we continue to expect to see our $1400 target (for 2010) in coming months, and expect gold shares to generally outperform.
And if by then we don't have new governments talking about austerity packages and abandoning the printing press, we should expect the precious metals to really catch fire.