Blog 2 Columns

[This post is a slightly-modified excerpt from a recent TSI commentary.]

Last October I wrote a piece that explained why gold mining had been such a crappy business since around 1970 and why it was destined to remain so as long as the current monetary system was in place. The explanation revolved around a boom-bust cycle and the associated mal-investment linked to the monetary machinations of central banks.

The crux of the matter is that when the financial/banking system appears to be in trouble or it is widely feared that central banks are playing fast and loose with the official money, the stock and bond markets are perceived to be less attractive and gold-related investments are perceived to be more attractive. However, gold to the stock and bond markets is like an ant to an elephant, so the aforementioned shift in investment demand results in far more money making its way towards the gold-mining industry than can be used efficiently. Geology exacerbates the difficulty of putting the money to work efficiently, in that gold mines typically aren’t as scalable as, for example, base-metal mines or oil-sands operations.

In the same way that the mal-investment fostered by the Fed’s monetary inflation has caused the US economy to effectively stagnate over the past 15 years, the bad investment decisions fostered by the periodic floods of money towards gold mining have made the industry inefficient. That is, just as the busts that follow the central-bank-caused economic booms tend to wipe out all the gains made during the booms, the gold-mining industry experiences a boom-bust cycle of its own with even worse results. The difference is that the booms in gold mining roughly coincide with the busts in the broad economy.

In a nutshell, the relatively poor performance of the gold-mining industry over the past several decades is an illustration of what the Fed and other central banks have done, and are continuing to do, to entire economies.

Obviously, gold itself is not made less valuable by the monetary-inflation-caused inefficiencies and widespread wastage that periodically beset the gold-mining industry. That’s why gold bullion has been making higher highs and higher lows relative to the average gold-mining stock since the late-1960s, and why the following weekly chart shows that the BGMI/gold ratio (the Barrons Gold Mining Index relative to gold bullion) is now at its lowest level since the 1920s.

When the next bust gets underway in the broad economy, the surging demand for gold will temporarily generate huge real gains for gold-stock investors. At the same time it will lead to yet another round of massive mal-investment in the gold-mining industry that ensures the eventual elimination of these gains

In a recent article, John Mauldin dealt with the question: is economic growth driven by consumption or production? Unfortunately, he made a dog’s breakfast out of an attempt to explain why the correct answer is “production”. I’ll try to do better.

That there is even a much-debated question here is evidence of the great depths to which the science of economics has sunk. It would be like a debate between two groups of mathematicians, with one group arguing that 2 + 2 = 4 and the other group arguing that 2 + 2 = 17. Incredibly, in the world of economics the equivalent of the 2 + 2 = 17 group has gained the ascendancy. And within this leading group, the Keynesians dominate.

One of the fundamental tenets of Keynesian economics is that consumption drives economic growth, with an increase in consumption (a.k.a. aggregate demand) causing the economy to grow and a decrease in consumption causing the opposite. According to Mr. Mauldin, on the other side of the fence we have “Austrian” economist Friedrich Hayek, who “asserted that it is actually production that stimulates the economy and drives consumption.”

On a side note, “stimulates the economy” is a Keynesian phrase that an economist from the Austrian school would not normally use (economies aren’t “stimulated”), so I doubt that Hayek ever spoke/wrote in those terms. More importantly, the knowledge that production drives consumption and therefore economic growth predates Hayek by about 150 years. It is called Say’s Law and was part of the 1803 publication titled “A Treatise on Political Economy”. Say’s Law can be expressed as “production funds consumption” and “people produce in order to consume”. Because Say’s Law is demonstrably true, the “Austrians” adopted it.

The easiest and clearest way to see that an increase in production must come before an increase in consumption in order for the resulting growth to be sustainable is to consider a barter economy. An economy that uses money will tend to be more complex than one based on barter, because money facilitates specialisation (the division of labour) and intermediate stages of production, but the same basic principles apply.

When a barter economy is considered it becomes obvious that in order for someone to consume more he must first produce more, because what someone spends is what he produces. To put it another way, someone can’t spend what he or someone else hasn’t already produced. For example, a potato farmer spends potatoes, a cobbler spends shoes, and a baker spends bread. Consequently, if a baker who produces X loaves of bread per day wants to consume more on a permanent basis, he must first increase his production to X+Y loaves per day.

But how could our hypothetical baker spend more bread if there didn’t already exist demand for more bread?

The simple answer is that he couldn’t. There would have to be more demand for bread at some price. Perhaps by investing in a new oven or finding some other way to produce bread more efficiently the baker would be able to increase his production by, say, 30% and simultaneously reduce the price per loaf by 10%, enabling his customers to afford to buy more bread and increasing his own ability to consume.

Of course, if the bread market were saturated then it would not be possible for our baker to increase his production and therefore his consumption, but within the economy at any given time there will always be many things that people want more of. It’s a matter of targeting the things for which there is demand, and this is where prices come in. Prices transmit information, which is why it is so important that they not be distorted by “monetary stimulus” and other interventions. Prices tell people what to produce more of, and in cases where there is temporarily much greater demand than supply they ration the available supply. For some entrepreneurs, it can also be a matter of targeting the things for which there is currently no demand but for which there could be huge demand in the future. For example, there was no demand for the iPhone before Apple made the first one, but then, suddenly, millions of people around the world wanted an iPhone.

The bottom line is that in the real world there must be an increase in production before there can be a sustainable increase in consumption, because it’s the increase in production that funds the increase in consumption. This is as axiomatic as 2 + 2 = 4.

The market action is getting more interesting. Here are three examples:

1) Although the S&P500 Index and most other important US stock indices ended Monday’s session with gains, the Dow Transportation Average (TRAN) lost ground and has marginally breached support at 8600. It is now at its lowest level since last October — a significant bearish divergence.

Due to Monday’s marginal breach of support, the stage is set for some informative price action over the days ahead. TRAN is going to either follow through to the downside and confirm its breakout or quickly reverse upward and indicate that the downside breakout was false. Each of these possible outcomes contains clues about what the future holds in store.

2) Due to the much-worse-than-expected US employment report that was published when the financial markets were closed last Friday, it was very likely that there would be a decent bounce in the gold price when trading resumed on Monday. The gold price quickly rose to the $1220s on Monday and in doing so traded above its late-March spike high, but it subsequently gave back about half of its gains and ended the day at its 50-day MA. This price action is not bullish, but the set-up is still in place for additional near-term gains.

Critical support is at $1178.

3) I continue to think that the Dollar Index made a multi-month top in March, but the market is stubbornly refusing to either validate or invalidate this view. A daily close below 94 would remove all doubt that a multi-month top is in place, while a daily close below support near 96 would be a preliminary signal. Given the recent economic data, the Dollar Index has done remarkably well to remain above 96 until now. Even last Friday’s lousy employment report wasn’t a sufficient catalyst for a breakdown.

There’s a school of thought to the effect that if the market price of a stock you own has fallen below the price at which you bought, you haven’t really suffered a loss unless you sell. If you don’t sell, all you have is a “paper loss”. While technically correct, this is an amateurish and dangerous way to look at things. If you view a paper loss as materially different from and of lesser consequence than a realised loss, then you are essentially deluding yourself. Incredibly, some newsletter writers encourage this form of self delusion.

There will usually be a chance that a stock in your account that is currently ‘under water’ will recover and move into profit. The probability of this happening could, in fact, by very high, but it is important to acknowledge the reality that it is now showing a loss and that a recovery is not guaranteed. The simplest way to do this is to regularly — say, at the end of every week — mark your portfolio to market. In doing so, a “paper loss” is accounted for in the same way as a realised loss and a “paper gain” is accounted for in the same way as a realised gain.

By taking the simple step of regularly marking your portfolio to market you will be facing up to reality and avoiding the counter-productive behaviour, when things are going badly, of ‘sticking your head in the sand’. Accordingly, you will be putting yourself in a position where decisions can be based to a greater extent on facts and to a lesser extent on hope — a position where you will be less likely to kid yourself.

Of course, almost all good practice in the world of investing/speculating is easier said than done.

This post is a slightly-modified excerpt from a recent TSI commentary.

The monetary data published by the ECB last week showed that the rate of euro-zone TMS (True Money Supply) growth continued to accelerate in February — to a year-over-year rate of 11.8%, from 11.4% in January and ‘only’ 6.4% last October. Here’s a chart that puts the current monetary inflation rate into perspective.

The ECB didn’t begin its new QE program until March, so the above chart doesn’t include any of the effects of this new program. In fact, the effects of the new program probably won’t start becoming apparent until the April monetary data are published in late-May.

In one way, the current situation in Europe is similar to the situation in the US during the final few months of 2012. Back then, the Fed embarked on an aggressive new money-pumping program despite the year-over-year rate of US TMS growth already being in double digits and despite the prices of US stocks and bonds being near multi-year or all-time highs. Now we have the ECB embarking on an aggressive new money-pumping program despite the year-over-year rate of euro-zone TMS growth already being in double digits and despite the prices of European stocks and bonds being near multi-year or all-time highs.

The QE program introduced by the Fed in late-2012 did not help the US economy, but it did inflate a new stock market bubble. It also encouraged stock buybacks at the expense of capital investment, incentivised the continued accumulation of debt at a time when both the private and public sectors were already over-indebted, and fostered an investment boom in the shale-oil industry that’s now in the process of collapsing.

Apart from the specific example of the oil-investment boom, it’s possible that the QE program recently introduced by the ECB will end up having similar effects.

Yesterday I published a short piece dealing with the logical fallacies and self-contradictions in one of Ben Bernanke’s early blogging efforts. David Stockman has since published a more in-depth demolition of the same Bernanke post, titled “Central Banking Refuted In One Blog — Thanks Ben!“.

Stockman starts with Bernanke’s absurd assertion that because the Fed’s actions determine the money supply and the short-term interest rate, the Fed has no choice other than to set the short-term interest rate somewhere. He points out that as originally designed/envisaged, the Fed “had no target for the Federal funds rate; no remit to engage in open market buying and selling of securities; and, indeed, no authority to own or discount government bonds and bills at all.” Instead, “[the] entire purpose of the original Fed’s rediscounting tool was to augment liquidity in the banking system at market determined rates of interest. This modus operandi was the opposite of today’s monetary central planning model. Back then, the rediscount window at each of the twelve Reserve Banks had no remit except the humble business of examining collateral.”

According to Stockman: “…in 1913 there was no conceit that a relative handful of policy makers at the White House, or serving on Congressional fiscal committees or at a central bank could improve upon the work of millions of producers, consumers, workers, savers, investors, entrepreneurs and even speculators. Society’s economic output, living standards and permanent wealth were a function of what the efforts of its people added up to after the fact — not what the state exogenously and proactively targeted and pretended to deliver.”

Stockman’s point, in a nutshell, is that the machinations of today’s Fed represent one of the most egregious examples of mission creep in world history.

For anyone interested in economics and economic history there’s a lot of useful information in the Stockman post. For example, Stockman notes that during the 40 years prior to the 1913 birth of the Fed, “the US economy had grown at a 4% compound rate — the highest four-decade long growth rate before or since — without any net change in the price level; and despite the lack of a central bank and the presence of periodic but short-lived financial panics largely caused by the civil war-era national banking act.”

In fact, Bernanke’s short post and Stockman’s lengthy rebuttal make an interesting contrast. The former is gibberish, whereas the latter displays a good understanding of economic theory and history.

Former Fed chief Ben Bernanke now has a blog. This is mostly good news, because he will certainly do less damage as a blogger than he did as a monetary central planner. However, it means that he is still promoting bad ideas.

I doubt that I’ll be a regular reader of Bernanke’s blog, because his thinking on economics is riddled with logical fallacies. Some of these fallacies were on display in his second post, which was titled “Why are interest rates so low?“. Some examples are discussed below.

In the fourth paragraph Bernanke states: “The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth — not by the Fed.” However, earlier in the same paragraph he states that the real interest rate is the nominal interest rate minus the inflation rate, that the Fed sets the benchmark nominal short-term interest rate, that the Fed’s policies are the primary determinant of inflation and inflation expectations over the longer term, and that inflation trends affect interest rates. Also, the Fed clearly attempts to influence the prospects for economic growth. So, by Bernanke’s own admission the Fed exerts considerable control over the “real” interest rate. In other words, he contradicts himself.

A bit further down the page he states: “…[the Fed's] task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or — more realistically — its best estimate of the equilibrium rate, which is not directly observable.” And: “[the Fed] must try to push market rates toward levels consistent with the underlying equilibrium rate.”

So, having said in the fourth paragraph that the Fed has minimal control over the real interest rate and then contradicting himself by saying that the Fed controls or influences pretty much everything that goes into determining the real interest rate, he subsequently says that the Fed’s task is to push the market interest rate towards the “equilibrium rate”, which, by the way, is unobservable. Now, the so-called “equilibrium rate” is the REAL interest rate consistent with optimum usage of resources. In other words, he’s now saying that the Fed’s task is to push the REAL market interest rate as close as possible to an unobservable/unknowable “equilibrium rate”, having started out by claiming that the Fed doesn’t determine the real interest rate. I wish he would at least keep his story straight!

As an aside, the equilibrium rate is the rate that would bring the supply of and demand for money, capital and other resources into balance, which is the real rate that would be sought by the market in the absence of the Fed. In other words, if the Fed did its job to perfection, which is not possible, then it would be constantly adjusting its monetary levers to ensure that the market interest rate was where it would be if the Fed didn’t exist.

Bernanke goes on to say that today’s US interest rates aren’t artificially low, they are naturally low. Apparently, the Fed’s ultra-low interest rate setting is a reflection of a naturally-low interest-rate environment, not the other way around. This prompts the question: Why, then, can’t the Fed just get out of the way? To put it another way, if default-free nominal interest rates would be near zero and real interest rates would be negative in the absence of the Fed’s gigantic boot, then why can’t the Fed allow interest rates to be controlled by market forces?

It seems that Bernanke cleverly anticipated this line of thinking, because in a beautiful example of circular logic he says “The Fed’s actions determine the money supply and thus short-term interest rates; it [therefore] has no choice but to set the short-term interest rate somewhere.” That is, the Fed can’t leave the short-term interest rate alone, because if the Fed exists it will inevitably act in a way that alters the short-term interest rate. Clearly, Ben Bernanke can’t even imagine a world in which there is no central bank.

Ben Bernanke ends his post by putting aside all the talk in paragraphs 5 through 9 about the Fed’s efforts to control the real market interest rate and by reiterating his comment (from paragraph 4) that the Fed doesn’t determine the real interest rate. As a final piece of evidence he notes that interest rates are low throughout the world, not just in the US, but forgets to mention that central banks throughout the world are behaving the same way as the Fed.

If the free market can’t be trusted to set the most important price in the economy (the price of credit) and if government intervention can help the economy work better, then total government control of the economy must be the optimum situation. Therefore, if Keynesians were consistent they’d advocate for either Communism or Fascism.

In practical terms, Keynesian economics, which is the type of economics that dominates policy-making throughout the world today, involves using monetary and fiscal policy to ‘manage’ the economy. The overarching idea is that a free market is inherently unstable and that by modulating interest rates and something called “aggregate demand” the government can keep the economy on a smooth upward path. The fact that the results of putting this idea into practice have typically been the opposite of what was predicted doesn’t, according the Keynesians, indicate a major flaw in the underlying concept; it just means that the right people weren’t in charge.

Anyhow, the purpose of this post isn’t to argue against Keynesian economic theories, it’s to make the point that completely logical proponents of these theories would recommend a Communist or a Fascist political system. The reason is that these are the political systems that are most consistent with Keynesian economic theory.

As an aside, I’m applying the word “theory” very loosely to what the Keynesians believe, because what they believe is not encompassed by a coherent set of principles. It is more like an endless stream of anecdotes than a theory. Actually, it is a bit like Elliot Wave (EW) analysis. In the same way that EW analysis can always explain what happened in the past but is not useful when it comes to explaining the present or making predictions, Keynesians are always able to come up with an anecdote that explains why historical performance, while seemingly being totally at odds with their theories, fits perfectly into their theoretical construct after the special set of circumstances associated with the time period in question is taken into account. Since there are special circumstances associated with every period, Keynesians will always be able to come up with anecdotal explanations for why things didn’t pan out as expected. There is never any perceived need to question the underlying ideas.

Getting back to my point, consider the control of interest rates by a central planning agency called the Central Bank. All Keynesians (and pretty much everyone apart from the “Austrians”) believe this price-setting power to be not only legitimate and appropriate, but also necessary to facilitate the smooth running of the economy. OK, but given that the price of credit is influenced by a greater number of variables than any other price and would therefore be the most difficult price for a central planner to get right, if central planners can do a better job of setting interest rates than a free market then it stands to reason that central planners could do a better job than the free market of setting all prices. Therefore, anyone who claims that it is right that a central bank controls interest rates would, if they were being consistent, also claim that similar agencies should be established to control all other prices.

Now consider the Keynesian notion that the government should modulate “aggregate demand” to create a more stable economy. The thinking here is that 1) a free-market-economy periodically gets ahead of itself and then plunges into an abyss, 2) dramatic economic oscillations are caused by largely unfathomable changes in “aggregate demand”, with the devastating downswing the result of a mysterious collapse in “aggregate demand”, and 3) by adding and removing demand via its own spending, the government can smooth the transition from one boom to the next. In effect, the economy is treated as if it were a swimming pool that sometimes, for no well-defined reason, loses a lot of water, while the government is treated as if it were an institution capable of replenishing the water, even though in the real world the government has no water of its own.

If the economy really were like an amorphous mass of liquid that could be manipulated, via changes in government spending, in whatever direction was needed at the time to create the optimum outcome, then total government control of the economy would definitely work.

The upshot is that if uber-Keynesian Paul Krugman went on television and argued in favour of a Soviet-style system, he would be taking his economic principles to their natural political conclusions. In doing so he would be totally logical. He would be totally consistent. And he would be totally discredited.