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Jim Cook



Every once in a while I switch the TV channel from Fox to CNBC to see what the liberals are saying.  After listening awhile I get a deep sense of hopelessness and foreboding for our country.  The most important thing for the left is giving money to people.  They are happy to see the growth of food stamps, disability payments, housing subsidies, free healthcare and all the other welfare benefits.  They utterly fail to see the damage it is doing to the recipients.  Whole cities that once flourished have deteriorated into rotting eyesores populated with shambling hulks of chemically dependent drones.  These people are no longer employable.  They have become incompetent and helpless and the liberals can’t see that it’s their doing.

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The Best of Jim Cook Archive

Best of Martin Hutchinson
September 4, 2012
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Into the Monetary Vortex

Last week’s revelation in the Fed minutes for its August 1 meeting that another “QEIII” government bond purchase is almost inevitable has intensified the recent upward trend in markets. With fiscal and monetary policies more extreme than any in history, now entering their fifth year, and equally unprecedented advances in communication and computing enabling ever-faster trading, it’s not surprising that market behavior is anomalous. Only the almost total absence of inflation is strange. Soon however that anomaly will be explained, as the immense supply of negative-cost money causes the global economy to spiral into a vortex of hyperinflationary collapse. The Mayan calendar, in which the fourth world ends on December 21, leading us to a Fifth World of greater enlightenment, may be only too accurate, economically speaking – but that enlightenment will have been purchased at a fearful cost.

Probably the central puzzle of monetary policy in the last two decades is that of velocity. Money supply, however measured, has increased consistently more rapidly than nominal GDP, so we are told that monetary velocity has declined. The non-appearance of the expected inflation in the last several years of negative real interest rates is explained by monetary velocity having declined even further. This variable, which had increased consistently in every decade since the Industrial Revolution or even before, has now mysteriously turned tail and is heading steadily downwards. Yet nobody can explain why.

Ludwig von Mises was scathing about the velocity concept; he called it “a vicious mode of approaching the problem of prices and purchasing power.” When you examine the concept more closely, you can see what he meant. Since the invention of the Internet, our ability to transfer money through means such as PayPal, both within single economies and around the world, has increased geometrically and our need for physical cash has declined. Credit cards also allow us to spend money in advance of receiving it, thus further increasing its velocity.

Above all, there is the phenomenon of “fast trading.” More than two thirds of the volume on the world’s stock exchanges results from computers flicking buy and sell orders at each other, trying to make a tiny profit through insider knowledge, for a millisecond or so, or these days even less, of the other guy’s trades. Every week or so one of these systems malfunctions, losing its owner several hundred million dollars, causing the year’s largest IPO to go up in flames, or maybe one day causing a planet-wide catastrophe – who knows? – certainly not the owners of these computer systems and their laughably misnamed “risk managers.” There’s monetary velocity for you!

Yet for two decades reported monetary velocity has declined. The concept is self-contradictory.

The explanation lies in the rise in the last two decades of immense stagnant balances, earning near zero interest rates, which are never spent but simply build up idly. The largest of these is international central bank reserves, increasing at 17% annually since 1998 and now at a level of some $10 trillion. The chairman of the Bank of Thailand said this week that Thailand’s $176 billion of official reserves “should be spent on boosting the economy rather than on doing nothing useful” and was vilified by orthodox economists, but really he has a point. (Unlike the Argentine government, which has persistently found endless unproductive ways to waste their currency reserves, the current Thai government might spend the money on useful infrastructure.)

A second vast pool of useless liquidity is that of the U.S. banking system’s free reserves at the Fed, currently some $1.6 trillion. The Fed pays interest on these, so since there are no other uses for the money that don’t involve risk, it’s not surprising that the banking system keeps them high. It is however surprising that, four years after the crisis, the system has not found a way of deploying this pool of money more efficiently.
A third pool of useless money is the “Target 2” balances of the European payments system. This pool is somewhat different, even chimerical. Even though the head of the Bundesbank may go to sleep each night happy that he has $850 billion of short-term central bank obligations sitting in his vaults, in reality these obligations are derived from such as the Bank of Greece, and not worth the paper that, being virtualized, they are not written on.

Then there is the $2 trillion of cash sitting on the balance sheet of U.S. non-financial corporations. This can best be explained by thinking of all the prudent corporate Treasurers, seeing interest rates at record low levels, who have borrowed next year’s capital spending plan in the long-term markets in order to avoid tapping them at next year’s higher rates. Of course, since this has gone on for several years, there are many corporate Treasurers who are now working on the capital spending plan for 2043. Still at least this avoids actually returning some of that cash to shareholders – perish the thought! After all, at some time in the next couple of decades there may come an opportunity for a truly value-destroying acquisition on which the cash can be spent.

The result currently is a situation in which a small part of the world’s money supply is rushing around like a blue-arsed fly, carrying out transactions at a rate of several terabits a second, while most of it sits idly polishing its fingernails and earning its owners a measly 0.0005%. Needless to say, this is not a stable situation.

It’s difficult to specify precisely what will be the outcome of all this, since neither theory nor past experience offer much guidance – indeed we are in the area of wild, unsubstantiated guesses. Mine, for what it’s worth, is that the small portion of the money supply that is doing all the work is now redoubling its efforts, given additional verve by “quantitative” easing by the Fed next month and a further massive bond purchase program by the European Central Bank. Asset prices are once again headed to the skies and the glorious, celestial gold bull market for which gold bugs have yearned for the last decade is at last in progress. From July 1978 to January 1980, the gold price soared from $175 per ounce to $850; we may well see such a rise again, from a base almost ten times as high.

This will not last, of course; indeed its most obvious terminus is already in sight, in the form of November’s election. Whichever candidate wins, time horizons in the market will shift in early November, from the next six months to January 2017. On that time horizon, the market picture is clouded. Another $5 trillion on U.S. Federal debt, which will be incurred in the next four years, puts it at an Italian or Greek level (though still short of the lofty heights reached in Japan). What’s more 2017 is the year that the Social Security system, which since 2009 has been running an unexpected deficit instead of the anticipated surplus, tips over finally and starts running sizeable deficits, with the cash outflow increasing until the Baby Boomers start dying off in large numbers in the 2030s.

This could lead to two possible outcomes (again, remember, we’re guessing here, but anyone who says they are not is a liar!). One would be a bond panic, in which U.S. real interest rates rise because risk premiums soar, much as has happened in Spain and Italy, where 10-year rates are in the 6% range. European monetary policy, as here attempts to be ultra-sloppy, but in Spain and Italy it can’t be, because anyone wanting to borrow in those economies must pay a premium over the local governments, i.e., a substantial real interest rate. Such a rise in real interest rates, which might happen quite suddenly, would cause a crash in stock markets and gold prices, and a substantial recession. Since the recession would worsen the budget deficit, the Fed would be powerless to alleviate it, and “stimulus” would be out of the question. This would be very unpleasant, and is rather the outcome our political class deserves. On the other hand – look on the bright side – we would probably avoid major inflation.

The other possible outcome would be a further surge in optimism about the economy, without a bond panic. In that case, stock markets would continue to rise, gold would soar to the moon, and all the idle cash balances in the U.S. banking system, corporations, central banks, etc. would be put to work. Since at this point we would have active money supply far larger than before, and today’s elevated level of tech-induced velocity, the result would be burst of inflation, not 4-5% as in the 1970s, but Weimar-style, reaching 20-25% very quickly and soaring thereafter. The good news: we would not necessarily experience another major recession, at least not immediately, and the federal debt problem would become much less onerous. This is the outcome that Ben Bernanke deserves, and would provide a useful lesson to future Fed chairmen not to get drawn down his path.

Both outcomes are possible with either party winning in November, but if you asked me to guess, I’d say the first outcome is more likely with an Obama victory and the second outcome more likely with a Romney victory. Either way, the denouement will not be pleasant, and we will emerge from the Mayan apocalypse wiser about economic cause and effect.

Meanwhile, until November, we are caught up in the vortex. Enjoy the ride!