A Letter to Governor Dodge - Part 2
P.O. Box xxxxx Sasamat
Vancouver, B.C. V6R 4P2
December 21, 2007
David A. Dodge, Governor
Bank of Canada
234 Wellington Street
Ottawa, Ontario K1A 0G9
Dear Governor Dodge,
Thank you for your letter of October 29, 2007.
I would like to follow-up to my previous letter with a few thoughts that I think are pertinent on the role and distortion of gold as a monetary indicator, the importance of the broad money stock measure, the distortion of the CPI inflation measure, and the condition of our economy following a secular inflation of the money stock in the U.S., Canada, Western Europe, China, Japan, and Russia.
First, with regard to Gibson's Paradox and the relationship between gold and real interest rates, a typical quick response from economists regarding this critical indicator of monetary inflation is that it is an historic relationship that is no longer applicable. The relationship between gold and real interest rates has been sporadic for more than 50 years.
What this view ignores are two activities aimed specifically at distorting the relationship between gold and real interest rates for prolonged periods during this time: The Bretton Woods Accord and, more recently, off- balance-sheet leasing of gold by central banks.
Under the Bretton Woods Accord, to preserve the dollar gold peg price relationship thereby masking the ongoing currency debasement, the United States had the choice of constraining the growth of its money stock and limiting its ability to finance overseas spending or, with the assistance of Bretton Woods signatory countries' coordinated selling of gold through the London Gold Pool (LGP), dishoarding gold into the world market to contain the price of gold in dollar terms while a loose monetary policy was continued. The former approach was a permanent solution and the latter approach a temporary approach to distort gold's signal to the market of monetary inflation. The latter approach could only be maintained until available central bank gold ran out.
The choice was the latter. However, the dishoarding of gold through the LGP failed in the late 1960s when the equivalent of 5% of the U.S.'s central bank gold reserves (400 tonnes) was required to be sold in one day to prevent gold from rising above the target $35/oz. peg. This visible approach of dumping gold failed to contain the gold price permanently as it was an obvious fire-sale of a monetary asset that would in the end fail due to unabated dollar debasement; the smart money simply backed up their trucks and bought all they could get for $35 per oz.
The US Treasury characterizes its gold holdings as "a hedge against calamity". That central banks would divest this critical insurance instrument or economic lifeboat, a patrimony of their citizens, into the world markets while stimulating asset bubbles would seem to be beyond comprehension.
Second, the discussion of inflation being a monetary phenomenon leading to inflation of many asset classes including stocks, real estate and eventually consumer goods prices, needs the money stock to be defined. Greenspan himself noted in 2006 that when we talk about liquidity, we must include securities in our determination of total liquidity. While this may seem to be an obscure statement in terms of conventional monetary views, it is not so especially in the current environment where we are living through a terminally increasing debt bubble.
This graph from Barron's Magazine shows that to 2004, at 304% of GDP, the U.S. had a ratio of credit market debt to GDP greater than during the depths of the great depression when the U.S. GDP had already declined by 50%. Today, the US credit market debt to GDP ratio is more than 340%.
Source: Clapboard Hill/Barron's Magazine
The attempt to grow the economy with credit is not just a phenomenon of the U.S. economy. The below graph illustrates that consumer credit in Canada is now growing at greater than 12% per year having grown at 10% since 2004.
This period of continued and increasing credit/debt levels has resulted in accumulated debt not being liquidated and, especially during the final period of the increasing debt phenomenon which can only continue until the entire dynamic and the debt markets themselves fail, debt instruments such as treasuries themselves become monetary instruments as "near-money" media of exchange. These near-money instruments have a second order and time lagged, but very real, impact on the financial markets, asset prices, and the price level of goods (consumer goods inflation) in the economy.
The impact of the broad monetary stock such as M3, or in Canada's case M2++, on inflation is documented in this paper from Commerzbank's May 23, 2006 edition of ECB Watch https://www.commerzbank.co.in/.... The report is also included in an attached .pdf file.
While an increase of the narrower monetary aggregates has a more direct impact on price inflation, the broader aggregates (M2, M3, etc.) cannot be discounted in their importance. For this reason, we cannot ignore the decade-long plus increase in M3 in the U.S. market and the fallout on their (and our) economy.
The relationship between the broad money stock and price inflation is further shown below in this long term graph from www.nowandfutures.com. The purple curve shows the impact of the Boskin / Greenspan effort to "define down" the Consumer Price Index (CPI) calculation which reduced the published CPI.
The deferred impact of consumer price inflation of the broad money stock, as identified in the Commerzbank study, is clearly visible as the black line calculating the CPI using the U.S. Bureau of Labor Statistic's (BLS) own constant methodology from 1980 and calculated by John Williams of www.shadowstats.com.
The fallacy of the Boskin / Greenspan CPI revisions such as hedonic "adjustments", which mask inflation's existence by suppressing the inflation measure, can be logically illustrated by the fact that progress has always existed. Advances in technology are not something new that started in the 1980s or 1990s, nor are substitution effects (whereby individuals are assumed to buy ground beef when they can no longer afford steak thereby not increasing food prices) or owner imputed rent substituted for home ownership costs realistic devices in calculating CPI inflation.
CPI adjustments including hedonics to reduce the responsiveness of goods price inflation measures would not have made a difference in the 1970s' inflationary blow-off following the decade long money stock inflation of our central banks and they serve no purpose other than masking reality, increasing monetary policy error with what will be a greater final impact today.
It can be argued that Canada's inflation calculations are no more accurate than those of the U.S. According to Statistics Canada our CPI for October 2007 is 2.4% on an annualized basis. The construction of Canada's CPI (http://www.statcan.ca/english/sdds/document/2301_D37_T9_V1_B.pdf), is such that housing mortgage costs represent 5.16% of the CPI monthly basket, while property taxes make up 3.27%, telephone costs are 2.35%, child care is .63%, and paper supplies are .45% of the CPI basket – and the principle on owned homes is not paid. It seems rather wishful that the average person's mortgage interest costs are twice their phone bill and that childcare costs are only half again as much as their monthly cost for buying paper supplies.
The consequence of the focus on consumer goods price inflation (accompanied by a distorted CPI measure) to the exclusion of asset prices, silent leasing of central bank gold, and ignoring M3 as a monetary measure have contributed to a record overextension of credit and monetary expansion in our societies.
The continual extension of credit and debt and the accompanying increase in the money stock has also contributed to a secular inflation of the world's capital markets over the past 40 years.
The following graph composed with information from McKinsey & Company's McKinsey Quarterly publication (the 1969 data point is from State Street ) shows that the world's total financial stock, composed of equities, bonds and bank deposits and excluding derivatives, have grown from $2 Trillion in 1969 to $136 trillion in 2004. From 1980 to 2004, the world's financial stock has grown from 109% of world GDP to 334% of world GDP.
As yields in financial assets during the latter period of financial market growth were superior, capital pursued returns in the financial markets and not real assets. This financial asset inflation has until recently sequestered the visibility of monetary expansion away from consumer goods prices. The combination of the U.S. BLS and Statistics Canada's muting of the CPI measures and apparent leasing of central bank gold to suppress the gold inflation signal has also contributed to the masking of the consequences of inflation of the money stock with its attendant record total debt levels in our economies.
We are now living through the terminal phase of a debt and credit cycle where greater amounts are required to be borrowed to pay interest on the existing debt to finance an economy already distorted by excessive credit creation and riddled with associated uneconomic enterprise, misallocation of resources, and speculative activity.
To illustrate the point, the annual credit market borrowing has increased to the extent that, in 2006, the U.S. economy required total credit market borrowing of $3.8 Trillion in a combined Federal, State, corporate and consumer measure. This $3.8 trillion in borrowing occurred in an economy with a GDP of $13.2 Trillion in 2006. Borrowing an additional 29% of GDP led to economic growth optimistically estimated at approximately 3% in 2006 using the current CPI measures.
The "Austrian School" of economics has long warned of the results of fueling apparent growth by an expansion of the money stock and credit. Their argument is that real growth cannot be created by increasing the medium of exchange. Money is simply that - an intermediary - and, as such, to increase it to "fuel" economic growth has always led to stagflation or inflationary recessions where monetarily induced economic distortions and excess credit and debt are shed from the economy and the prior monetary increase manifests itself in higher goods prices. If the monetary/credit expansion is prolonged as in the 1920s, the end result is a crash and an economic depression.
As noted by Ludwig von Mises in his book Human Action,
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
These repeated warnings by the Austrian School are not, as some claim, an endorsement of economic crashes. They simply warn that such crashes are the unavoidable result of attempting to fuel growth with credit and monetary expansion and that no increase in the cause of the economic distortion, credit and monetary expansion, can prevent the unwind when the falsity of the prior economic "growth" becomes apparent.
In his book, The Great Depression, economist Murray Rothbard notes that the 1920s stock bubble arose as a consequence of America increasing its money stock at an average rate of 7.7% per year from 1921 to 1929. He states that "this was a very sizable degree of (monetary) inflation" and that "the entire monetary expansion took place in money substitutes which are the products of credit expansion... ... the prime factor in generating the (monetary) inflation of the 1920s was the increase in the total bank reserves."
Further, Rothbard notes that the asset inflation of the 1920s, like that which was initiated in the 1990s, occurred during a period where consumer goods inflation appeared tame and the stock market appeared "reasonably" priced. Rothbard warns "The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat and therefore the events of the great depression caught them completely unaware." During economic crashes such as occurred in 1929, credit contracts as unsustainable loans are cleared from the system. Additional available credit cannot address the inevitable reset of a distorted economy after such periods.
After a prolonged period of credit and monetary expansion coupled with the associated distortion that permeates the entire economy, this distortion and unsustainability makes itself apparent rapidly and then cannot be arrested through further monetary easing. One can only destroy the currency with such attempts.
Economies, like many complex natural systems, are modeled according to "criticality theory". This theory predicts that such complex systems can be severely distorted and enter a meta-stable state where the distortion and associated instability is very difficult to measure and the final failure, once it is initiated, will be complete. A simple analogy is a mountain snow field burdened with increasing amounts of snow or a pile of sand where grains of sand are continually added on top of an apparently stable pile while the angle of the base continually increases until it reaches the angle of criticality. In this meta-stable state, the simple addition of a small amount of additional snow, or a human's shout, or a few grains of sand added to the sand pile can result in catastrophic failure. An avalanche of snow or the collapse of the sand pile results.
Economist Frank Shostak describes the economic wind-down that we are seeing in the U.S. and beginning to see in Canada, with an inference to criticality theory:
"When a central bank expands the money stock, it does not enlarge the (real) pool of funds. It gives rise to the consumption of goods, which is not preceded by production (and savings). It leads to less means of sustenance. As long as the pool of funding continues to expand, loose monetary policies give the impression that economic activity is being boosted.
That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downwards plunge. The most aggressive loosening of money will not reverse the plunge."
What is occurring now in the CDO, Asset-Backed Commercial Paper (ABCP), auto loan, and mortgage markets is the precipitous failure of these markets. Other markets are following in their decline. The Austrian School warns that additional monetary easing will not stop the plunge of these markets or of the greater economy as it is the leveraged (and wrong) bets on unsustainable U.S. and Canadian real estate bubbles and distorted economies, built on credit excess, that are showing themselves to be wrong. The economic wind-down underway cannot be combated with monetary easing which will accelerate the destruction of our currencies.
The greatest danger we face today is the onset of hyper-inflation as the markets reallocate capital to real assets to protect wealth and price controls will not address the reason for this reallocation to protect wealth and maintain market function.
With world capital markets now inflated to more than $150 trillion in value, relatively small reallocations of this capital at the margins to assets undervalued in real terms such as commodities, energy, and precious metals can quickly explode the price of such critical assets in a bout of rapid-onset hyperinflation.
When the markets increasingly realize that bonds, currencies, and equities have been inflated over a prolonged period by monetary policy and have little value, this asset reallocation itself will likely follow the criticality theory model.
During periods of hyperinflation, currencies become worthless and this loss of trust in currency results in economies ceasing their normal function. Federal Reserve Chairman Bernanke and other central bank chairmen advocate making unlimited credit available to solve "liquidity" issues when it is the value of financial instruments and economic unsustainability that is at issue. Again, these injections of liquidity will destroy their currencies in addition to not addressing the underlying economic issues.
Governor Dodge, it is essential that a focus be placed on preserving faith in our currencies through immediate currency reform to avert a calamity beyond the very difficult economic contraction that is approaching. Our politicians will not respond until it is too late. Your efforts would be of tremendous value in this regard as we have entered a period where economic disruption will accelerate and, if not addressed properly, I think it not an overstatement to say that we face economic catastrophe with consequences difficult to imagine.