Blog 2 Columns

Economics isn’t about money. Money is important because it facilitates the division of labour, but good economic theory applies with or without money. Economics is about how humans allocate scarce resources. This implies that trade-offs are critical to the good economist, because he/she understands that allocating scarce resources to satisfy one need in the present means that these resources will not be available to satisfy another need in the present or the future*. Right now, the entire world is dealing with a trade-off that has far-reaching consequences.

The trade-off is associated with the COVID-19 threat and has been portrayed as being between lives and money, but the correct way to view the trade-off is between lives today and lives in the future. Unfortunately, the people making the decisions regarding what should be done have neither the data nor the knowledge to properly analyse the trade-off.

For one thing, when decisions were made to implement widespread lock-downs these people clearly had no inkling of the short-term cost, in terms of illness and lives, of NOT locking down the economy. We know this because as recently as six weeks ago there were projections of millions of deaths in the US alone**, but the actual rates of death and serious illness have been vastly lower than projected. The experts who made these wildly inaccurate forecasts claim that the vastly lower death rates are due mainly to the lock-downs, but we know this isn’t true based on what happened in countries that didn’t implement draconian social distancing measures. For example, although Sweden, which was not forced into lock-down mode, has experienced a slightly higher rate of infection than its Scandinavian neighbours, its rate of COVID-19 infection is about the same as that of Germany, which is considered to have done a good job of containing the virus via strict social-distancing measures, and much lower than those of Spain, Italy, France and the US.

Even more importantly, the decision-makers are clueless about the long-term costs, in terms of lost lives and lowered living standards, that likely will result from the lock-downs. How could they not be clueless, because in order to make a reasonable assessment you must have a thorough understanding of history and good economic theory. As far as I can tell, not one of the health/medical officials or political leaders at the forefront of the COVID-19 decision-making process has this understanding.

Regarding the cost to human life stemming from locking down large sections of the economy, there is a lot of evidence that people who are poor and out of work are more likely to die than people who are financially comfortable. This is not only because the poorer people have access to lower-quality healthcare and food, but also because they are more prone to stress-related diseases and/or more likely to be subject to physical violence. In addition, a more immediate negative consequence of the lock-downs is that some people have been denied elective surgeries and others have decided not to seek immediate medical treatment for minor issues. This will lead to many deaths over the coming 12 months that would have been avoided with earlier medical intervention.

Note that I refer to GOOD economic theory above, because only a good economist is capable of comprehending the indirect, long-term and unintended consequences of a policy. A bad economist may well believe that shutting down the entire economy for 2+ months is akin to a very long weekend, and that everything will go back to normal soon after the shut-down ends — just like it does every Monday following the 2-day weekend shut-down. Larry Summers is a case in point.

The upshot is that people with power/authority are making decisions regarding a major trade-off between lives today and lives in the future while being in possession of insufficient information about one side and almost no information/knowledge about the other side of the trade-off.

*This is related to Frederic Bastiat’s Broken Window parable, in that what is immediately obvious is the benefit achieved by allocating the resource to satisfy one current need but what isn’t immediately obvious are the benefits that would have accrued if the resources had been allocated differently.

**The experts at Imperial College predicted 2.2M deaths in the US and 510K deaths in the UK.

[This blog post is an excerpt from a recent TSI commentary]

Last week, a highly paid (we assume) JP Morgan analyst opined:

“When it comes to market developments, we believe that the Fed’s action last Thursday represents a pivotal moment in this crisis. Powell’s statement included that “we will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery” and probably the most important, historic statement, “We should make them whole. They did not cause this.” This crisis is different from any other in recent history in that it was not caused in any way by businesses or investors. Unhindered by moral hazard, the response of fiscal and monetary authorities is and will continue to be unprecedented, with the goal of essentially making everyone ‘whole.’ We believe the significance of this development is underestimated by markets, and this reinforces our view of a full asset price recovery, and equity markets reaching all-time highs next year, likely by H1. Investors with focus on negative upcoming earnings and economic developments are effectively ‘fighting the Fed,’ which was historically a losing proposition.”

Well, if moral hazard was the only thing that prevented the Fed from acting in the past to eliminate everyone’s losses, then why has the Fed never bothered to eliminate poverty? After all, not every poor person is in that situation due to having done something wrong. In particular, none of the children living in poverty are to blame for their predicament.

Taking a broader view, if it is possible for the central bank to make everyone “whole”, then why are some countries poor? These countries have central banks that are capable of doing what the Fed is now promising to do.

The problem, of course, is that the central bank cannot add real wealth to the economy. It cannot produce anything of real value. All it can do is conjure money and credit out of nothing, thus setting in motion countless exchanges of nothing for something and distorting the price signals upon which markets rely. This is a recipe for more poverty and generally lower living standards in the long term.

At some point during the second half of this year, the release of pent-up demand as restrictions are removed and people go back to work, combined with the flood of new money generated by the Fed, could make it seem as if there has been a ‘V’ bottom in the economy and that the entire recession lasted only about four months. This could enable the SPX to return to within 10% of its February-2020 all-time high before year-end. However, the price distortions that have been and will be caused by the effort to make everyone “whole” will prevent a sustainable recovery.

The deluge of new money will boost asset prices and the prices of life’s necessities, but many businesses that closed their doors during March of 2020 will never re-open and many people who lost their jobs will remain unemployed (and thus dependent upon government handouts). Also, many of the people who do end up with jobs will find that their real incomes have fallen, because there will be an excess supply of labour and the currency’s loss of purchasing power will be reflected to the greatest extent in the prices of things that are in relatively short supply. For the majority of people, therefore, the post-shutdown economy will never be as good as the pre-shutdown economy, not despite the Fed’s efforts but largely because of them.

In a blog post three weeks ago, I mentioned that in TSI commentaries over the past year I had been tracking the current performance of the gold mining sector (as represented by the HUI) with its performance during the mid-1980s (as represented by the Barrons Gold Mining Index – BGMI). The 1980s comparison predicted the big moves that have occurred since May of last year, including the Q1-2020 crash. I concluded the earlier post with the comment: “History informs us that after a crash comes a rebound and after a rebound there is usually a test of the crash low.”

Here is an update of the weekly chart that I have been showing at TSI for almost a year. The latest price shown for the HUI is last week’s close. The chart suggests that the obligatory post-crash rebound is almost complete and that the next move of consequence will be a decline to test the March low.

If a test of the March low occurs, it should be successful (it’s highly probable that the gold mining indices and ETFs made their bottoms for the year last month). However, with regard to future outcomes there is always more than one realistic possibility. For example, although the historical record suggests that a test of the March low will happen within the next two months, a more bullish short-term outcome is possible.

Parameters that could be used to indicate that a different short-term scenario was playing out have been mentioned at TSI, but at this stage I think the odds favour a test of the crash low for pretty much everything that has crashed, including the gold sector. Looking beyond the short-term, I expect that the major fundamental differences between the late-1980s and the present will assert themselves during the second half of this year and cause the current market for gold mining stocks to diverge (in a bullish way) from the 1980s path.

[This blog post is an excerpt from a recent commentary published at TSI]

Modern Monetary Theory (MMT), which isn’t modern and isn’t a theory (in the true meaning of the word), is now being put into practice in many countries, including the US. What’s happening isn’t being called MMT, but that’s what it is.

Under cover of the “coronacrisis”, we are now witnessing the introduction of MMT. Specifically, in an effort to alleviate the short-term pain associated with the economy-wide shut-downs that they are enforcing as part of history’s biggest ever over-reaction, governments are now promising to spend money as if they had access to an unlimited supply of the stuff. They can do this because with the help of the central bank they do have access to an unlimited supply of the stuff.

The US government and the Fed are leading the way and in doing so all lines that are supposed to separate these two organisations are being blurred or eliminated. To put it another way, the pretence that the Fed is independent of the government has been dropped.

First, there’s the $2 trillion “stimulus” package that was just signed into effect by President Trump. How could a government that supposedly had to limit the pace of its deficit spending suddenly decide to instantly triple its deficit? Where is the money coming from to do this? After all, nobody is talking about increasing taxes. On the contrary, there is talk of delaying and reducing taxes. Clearly, the plan is for the money to be created out of nothing by the Fed.

Even more tellingly, there are the programs introduced by the Fed over the past two weeks. These are:

a) The Commercial Paper Funding Facility (CPFF), via which the Fed will buy commercial paper from issuers.

b) The Money Market Mutual Fund Liquidity Facility (MMLF), via which the Fed will lend to financial institutions secured by assets purchased by the financial institution from money market mutual funds.

c) The Main Street Business Lending Program (MSBLP), via which the Fed will lend directly to small and medium-size businesses.

d) The Primary Market Corporate Credit Facility (PMCCF), via which the Fed will buy corporate bonds from issuers.

e) The Secondary Market Corporate Credit Facility (SMCCF), via which the Fed will buy corporate bonds and bond ETFs in the secondary market.

f) The Term Asset-Backed Securities Loan Facility (TALF), via which the Fed will support the issuance of asset-backed securities.

Now, the Fed isn’t supposed to do any of the above, but it is getting around the existing regulations by creating Special Purpose Vehicles (SPVs) that will do the actual buying and lending. The US government will fund these SPVs with initial capital that the Fed will leverage 10:1. That is, for every dollar injected by the government into one of these SPVs, the Fed will create 10 new dollars via the traditional methods of fractional reserve banking.

The truly crazy thing is that the dollars that the government will inject into the Fed’s SPVs were previously created out of nothing when the Fed monetised Treasury securities. So, the Fed creates money out of nothing. This money then goes to the government. The government then deposits some of this money into the Fed’s new SPVs, and based on this injection of ‘capital’ the Fed creates a lot more money out of nothing.

The indirect costs, in terms of reduced productivity, higher unemployment and reduced living standards, of this money creation will be huge and long-lasting, but we’ll leave the discussion of these longer-term issues until after the immediate crisis has abated.

Our main point today is that the method of government funding appears to have changed in a permanent way. No longer will governments feel constrained by their abilities to tax the population and borrow from bond investors. From now on they will act like they have unrestricted access to a bottomless pool of money.

Inflation expectations have crashed along with the stock market and the oil price. This is evidenced by the following chart of the 10-Year Breakeven Inflation Rate, which indicates the average CPI that the market expects the government to report over the years ahead. Since the advent of the TIPS (Treasury Inflation Protected Securities) market in 2003, the Expected CPI was only below last Friday’s level of 0.50% during November-December of 2008 and January of 2009, that is, during the concluding months of the Global Financial Crisis.

The collapse in inflation expectations over the past several weeks does not indicate that “inflation” will be much lower in the future. On the contrary, beyond the short-term it greatly increases the risk of higher “inflation”.

Over the next few months the CPI will be lower than would have been the case in the absence of the coronavirus-related restrictions to economic activity and the plunge in the oil price, but by this time next year the CPI probably will be much higher due to the following:

1) Aggressive central bank reactions to the economic slowdown and the stock market plunge. These reactions will distort prices and hamper the economy, but to a man with nothing except a hammer every problem looks like a nail. To a central banker, every economic problem other than obvious “price inflation” looks like a reason to create more money and credit out of nothing. Also, to the central bankers of the world the recent rapid decline in inflation expectations is like a giant cattle prod pushing them in the direction of pro-inflation monetary policy.

2) In addition to aggressive monetary stimulus there will be aggressive fiscal stimulus. This would be the case anyway under such circumstances, but in the US the short-term stimulus from increased government spending will be more aggressive than usual due to this being an election year.

3) Once the coronavirus threat dissipates, there will be the natural release of pent-up demand.

4) The widespread shutting down of mines, production facilities and trade-related transportation will damage supply chains, in some cases permanently due to parts of ‘chain’ going bust, and ensure that it will take more time than usual for producers to respond to increased demand and rising prices.

Adding the natural force of pent-up demand release to the unnatural forces of monetary/fiscal stimulus and supply disruptions resulting from forced shut-downs should mean that “inflation” will be materially higher a year from now than would have been the case in the absence of the Q1-2020 calamity. My prediction: During the first half of 2021 the official US CPI, which routinely understates the increase in the cost of living, will print above 4%.

In TSI commentaries since May-June last year I have been tracking the current performance of the gold mining sector with its performance during the mid-1980s. More specifically, I have been comparing the current HUI with the mid-1980s Barrons Gold Mining Index (BGMI). The chart that illustrates this model is displayed below.

The model predicted the rapid rise in the HUI during June-August of last year, the steep correction from a peak by early-September to an October-November low, the rise to a new multi-year high by January-2020 and the crash to a low in March-2020. The big predictions associated with this model are now in the past, which is why I can take the liberty of including it in a free blog post.

The main point I want to make with this post is that even though the present often looks very different from any previous time, the bulk of what happens in the financial markets has happened before. It’s often just a matter of finding the right historical comparison, which is always easier said than done. Also, valid comparisons with previous times always have limited lifespans. It’s possible, for example, that my comparison with the mid-1980s has almost reached the end of its useful life.

Knowledge of how markets have performed in the past, including the distant past (not just the preceding 10-20 years), is useful even if it doesn’t lead to a specific history-based model. For example, anyone with knowledge of market history knows that when the gold mining sector is stretched to the upside near the start of a general stock market crash, it always crashes with the broad market. As far as I know, there have been no exceptions.

History informs us that after a crash comes a rebound and after a rebound there is usually a test of the crash low.

[This blog post is a modified excerpt (with an updated chart) from a TSI commentary published one month ago]

Last July the gold/silver ratio came within 10% of its 50-year high, which was reached in 1991, and within 15% of its multi-century high, which was reached in the early 1940s. The following monthly chart from goldchartsrus.com shows that on a monthly closing basis the ratio has just made a new multi-decade high and is now within 10% of a 300-year high, meaning that silver has almost never been cheaper relative to gold than it is today.

One way to interpret the gold/silver ratio chart is that silver has huge upside potential relative to gold. I think this interpretation is correct, but there is a realistic chance that the ratio will make a new multi-century high (in effect, a new all-time high) before silver embarks on a major upward trend relative to gold.

This is not my preferred scenario, but a new all-time high in the gold/silver ratio could occur within the next 12 months due to a major deflation scare.

My current expectation is that over the bulk of this year there will be US dollar weakness and signs of increasing “inflation”, which is a financial/economic landscape that would favour silver over gold and pave the way for some mean reversion in the gold/silver ratio. However, if the stock market bubble were to burst, economic confidence probably would tank and there would be a panic towards ‘liquidity’. For the general public that would involve building-up cash, but for many large investors it would involve buying Treasury bonds and gold. Silver eventually would benefit from the strength in the gold market, but the silver market is not big enough and liquid enough to accommodate investors who are in a hurry to find a safe home for billions of dollars of wealth. Initially, therefore, the gold/silver ratio could rise sharply under such a scenario.

The scenario described above would lead to panic at the Fed, eventually resulting in the introduction of the most aggressive asset monetisation scheme to date. That’s the point when silver probably would commence a major catch-up move.

A 23rd February blog post by Sven Henrich hits a couple of nails on the head. Here’s an excerpt:

“…the virus…clearly has a short term effect, but rather the broader risk is the excess created by ultra-loose monetary policies that has pushed investors recklessly into asset prices at high valuations while leaving central bankers short of ammunition to deal with a real crisis. There was no real crisis last year, a slowdown yes, but central bankers weren’t even willing to risk that, instead they went all in on the slowdown. It is this lack of backbone and co-dependency on markets that has left the world with less stimulus options for when they may be really needed. Reckless.”

Yes, central banks present a vastly greater threat to the economy than the coronavirus. Unfortunately, however, there never will be a vaccine that could immunise the economy from the effects of interest rate manipulation. Also, Sven is wrong when he writes that central bankers are short of ammunition and when he implies that stimulus options of the central planning kind will be needed at some point in the future. These options are always counter-productive and therefore never needed.

Central banks are a long way from being short of ammunition, because there effectively is no limit to the amount of money they can create. They can monetise (purchase with money created out of nothing) pretty much anything. At the moment they generally have restricted themselves to the monetisation of their own government’s debt, but they could expand their bond-buying to encompass investment-grade corporate debt and, if that wasn’t deemed sufficient, high-yield (junk) debt. They also could monetise equities, perhaps beginning with ETFs and working their way down to individual stocks. If they wanted, with a change of some arbitrary rules they could even monetise commercial and residential real estate.

It could be argued that “inflation” (in the popular sense the word: an increase in the so-called general price level) limits the amount of new money that central banks can create, in that after “inflation” starts being perceived as a major threat the central bank will come under irresistible political pressure to tighten the monetary reins. This is one of the tenets of the idiocy known as Modern Monetary Theory, or MMT for short. According to MMT, the government should be able to create out of thin air whatever money it needs, with the “inflation” rate being the only limitation. However, in some developed countries, including the US, many people already are having trouble making ends meet due to the rising cost of living, and yet the central bank claims that the “inflation” rate is too low and senior politicians agree.

As well as distorting price signals and thus getting in the way of economic progress, when the central bank makes long-term additions to its balance sheet it is, in effect, surreptitiously nationalising part of the economy. For example, the Bank of Japan (BOJ) already has nationalised Japan’s government bond market and is well on its way towards nationalising the market for ETFs (the BOJ owns about 80% of all ETF shares listed in Japan).

The creeping nationalisation of markets is something that is rarely, if ever, mentioned during discussions of current and potential monetary stimulus, but it’s a big problem that looks set to get even bigger.