In a blog post a couple of weeks ago I noted that it’s normal for large and fast price declines in the major financial markets to be accompanied by unusually-high trading volumes, meaning that it’s normal for large and fast price declines in the major financial markets to be accompanied by increased BUYING. I then wondered aloud as to why it is held up as evidence that something nefarious or strange is happening whenever an increase in gold buying accompanies a sharp decline in the gold price. Right on cue, ZeroHedge.com (ZH) has just published an article marveling — as if it were an inexplicable development — at how the recent sharp decline in the gold price was accompanied by an increase in buying.

As is often the case in the realm of gold-market analysis, the ZH article incorrectly conflates volume and demand. The demand for physical gold must always equal the supply of physical gold, with the price rising or falling by the amount needed to maintain the balance. If sellers are more motivated than buyers, then price will have to fall to restore the balance. The key point to understand here is that for every buyer there must be seller, and vice versa, so the purchase/sale of gold does not indicate a change in overall demand — it only indicates a fall in demand on the part of the seller and an exactly offsetting increase in demand on the part of the buyer. It is also worth noting — even though it should be obvious — that demand for physical gold cannot be satisfied by paper gold.

Trading in paper gold (gold futures, to be specific) clearly does have an effect on the price at which physical gold changes hands. The paper and physical markets are inextricably linked, but this link does not make it possible for the demand for physical gold to rise relative to the supply of physical gold in parallel with a falling price for physical gold.

What happens in the real world is that when the futures market leads the physical market higher or lower it changes the spread between the spot price and the price for future delivery. For example, when the gold price is being driven downward by speculative selling in the futures market, the price of gold for future delivery will fall relative to the spot price. In a period when risk-free short-term interest rates are being pegged at or near zero by central banks, this can result in the spot price becoming higher than the price of gold for delivery in a few months’ time. This creates a financial incentive for other operators in the gold market to buy gold futures and sell physical gold. For another example, when the gold price is being driven upward by speculative buying in the futures market, the price of gold for future delivery will rise relative to the spot price. This creates a financial incentive for other operators in the gold market to sell gold futures and buy physical gold.

The bullion banks are the “other operators”. They tend to focus on trading the spreads between the physical and futures markets. In doing so they position themselves to make a small percentage profit regardless of the price trend and therefore tend to be agnostic with regard to the price trend.

After harping on about the dislocation between the physical and paper gold markets, a dislocation that doesn’t actually exist but makes for good copy in some quarters, the above-mentioned ZH article moves on to the level of the CME (often still referred to as the COMEX) gold inventory. To the sound of an imaginary drumroll, the author of the article breathlessly points out that the amount of “registered” gold at the COMEX has dropped to a 10-year low and that the amount of “open interest” in gold futures is now at a 10-year high relative to the amount of “registered” gold.

The information is correct, but isn’t relevant other than as a sentiment indicator. It’s a reflection of what has happened to the price over the past few weeks and the increase in negativity that occurred in reaction to this price move. It is not evidence of physical-gold scarcity.

I currently don’t have the time to get into any more detail on the COMEX inventory situation. However, if you are interested in delving a little deeper you could start by reading the July-2013 article posted HERE. I get the impression that this article was written in response to the scare-mongering that ZH was doing on the same issue two years ago.

Thanks largely to the unprecedented measures taken by the senior central banks over the past few years, there have been many strange happenings in the financial world. However, the increased buying of physical gold in parallel with a sharply declining gold price and the reduction in COMEX “registered” gold cannot be counted among them.

The answer to the first question is ‘sort of’. The answer to the second question is no. The effects of having an institution with the power to manipulate interest rates and the money supply at whim are equally pernicious whether the institution is privately or publicly owned. However, if you strongly believe that the government can not only be trusted to ‘manage’ money and interest rates but is capable of doing so to the benefit of the economy, then please contact me immediately because I can do you a terrific deal on the purchase of the Eiffel Tower.

The fact is that the Federal Reserve would be a really bad idea regardless of whether it were privately owned or owned by the US government. The question of ownership is therefore secondary and the people who stridently complain about the Fed being privately owned are missing the critical point. In any case and as I explained in an article way back in 2007, the Fed is not privately owned in the true meaning of the word “owned”. For all intents and purposes, it is an agency of the US Federal Government.

In addition to the work of G. Edward Griffin referenced in my above-linked 2007 article, useful information about the Fed’s ownership can be found in a 2010 article posted at the Mises.org web site. This article approaches the Fed’s ownership and control from an accounting perspective, that is, by applying Generally Accepted Accounting Principles (GAAP), and concludes that:

“…the Fed, when tested against GAAP as the Fed itself uses it in the Fed’s assessments of those it regulates, is a Special Purpose Entity of the federal government (or, according to the latest definition, is a Variable Interest Entity of the federal government). The rules of consolidation therefore apply, and the Fed must be seen as controlled by federal government, making it indivisibly part of the federal government. The pretence of independence is no more than that, a pretence.

There is, however, no denying that the banks have tremendous vested interest in influencing the policies of the Fed, nor that the power being so narrowly vested in the president makes him a special target for influence. Still, the power to control the Fed is not in the hands of its “owners” but firmly in the hands of the federal government and the president of the United States.”

It is clear that the Fed was established by the government at the behest of bankers with the unstated aim of facilitating the expansions of the government and the most influential banks. It is effectively a government agency, but due to the influence that the large banks have on the government it will, if deemed necessary by the Fed Chairman, act for the benefit of these banks at the expense of the broad economy. The happenings of the past eight years should have left no doubt about this.

In numerous TSI commentaries over the years I’ve written about the confusion in the minds of many analysts regarding what constitutes gold supply and the relationship between supply, demand and price in the gold market. I’ve also covered the issue several times at the TSI Blog, most recently on 24th June in the post titled “More confusion about gold demand“. I’m not going to delve into this subject matter again today other than to use the example of last Monday’s trading in GDX (Gold Miners ETF) shares to further explain a point made in the past.

On Monday 20th July the GDX price fell by about 10% on record volume of 170M shares. Since every transaction involves both a purchase and a sale, more GDX shares were bought last Monday than on any other single day in this ETF’s history. And yet, this massive increase in buying occurred in parallel with a large price decline. How could this be?

Obviously, the large price decline CAUSED the massive increase in buying. Many holders of GDX shares were eager to get out and the price had to fall as far as it did to attract sufficient new buying to restore the supply-demand balance.

It’s normal for large and fast price declines in the major financial markets to be accompanied by unusually-high trading volumes, meaning that it’s normal for large and fast price declines in the major financial markets to be accompanied by increased BUYING. Most people understand this. So why is it held up as evidence that something nefarious is happening whenever an increase in gold buying accompanies a large decline in the gold price?

I can only come up with two plausible explanations. One is that many analysts and commentators switch off their brains before pontificating about gold. The other is that the relationship between gold supply, demand and price is deliberately presented in a misleading way to promote an agenda. I suspect that the former explanation applies in most cases, meaning that in most cases there’s probably more ignorance than malice involved.

Here are links to the two best articles I’ve read about the Iran nuclear treaty. The first is by David Stockman, an author, a blogger, a Wall Street veteran, and the Director of the Office of Management and Budget under President Ronald Reagan. The second is by Uri Avnery, a writer, the founder of the Gush Shalom peace movement, and a former member of Israel’s parliament. Although they tackle the issue from different perspectives, both articles are rich in historical information and insightful analysis. One thing Stockman and Avnery — and, as far as I can tell, everyone who is objective and well-informed on the subject — agree on is that Iran did not have a nuclear weapons program and probably had no intention of starting such a program.

http://davidstockmanscontracorner.com/all-praise-to-barrack-obama-hes-giving-peace-a-chance/

http://jewishbusinessnews.com/2015/07/17/uri-avnery-the-treaty/

Every attempt to come up with a single number (a price index) that reflects the change in the purchasing power (PP) of money is bound to fail. The main reason is that disparate items cannot be added together and/or averaged to arrive at a sensible result. However, some price indices are less realistic than others. In particular, some well-meaning private-sector efforts to come up with a consumer price index (CPI) that does a better job than the official CPI have generated some of the least-plausible numbers.

One of the most popular alternatives to the official US CPI is the CPI calculated by Shadowstats.com. As I noted in a previous post, it always seemed to me that the Shadowstats number was derived by adding an approximately constant fudge-factor to the official (bogus) CPI to essentially arrive at another bogus number that, regardless of the message being sent by real-world experience, was always much larger than the official number. As I also noted at that time, economist Ed Dolan did some detective work to determine the cause of the strangely-large and fairly-constant difference between the Shadowstats number and the official number. It turned out that Shadowstats had made a basic calculation error that caused its version of the CPI to consistently be at least 4.5%/year too high even assuming the correctness of its own methodology.

Another alternative CPI is called the Chapwood Index. The components of this index were selected based on a survey of what Ed Butowsky’s friends and associates spend their money on (Ed Butowsky is the index’s creator). The prices of the 500 most commonly purchased items were then added together to generate the index. Not surprisingly, considering the methodology, the result is not a realistic measure of the change in the dollar’s PP or the cost of living. As evidence I point out that if the roughly 10%/year average increase in the general price level estimated by the Chapwood Index during 2011-2014 is correct, then the US economy’s real GDP must have been about 25% smaller at the end of 2014 than it was at the end of 2010*. In other words, if the Chapwood Index is an accurate reflection of PP loss then the US economy now produces about 25% less goods/services than it did four years ago. This is not remotely close to the truth.

When assessing the validity of economic statistics it’s important to use commonsense. A statistic isn’t valid just because it happens to be consistent with a narrative that you wholeheartedly believe.

*I arrive at this figure by approximately adjusting nominal GDP by the Chapwood Index, that is, by using the Chapwood Index as the GDP deflator.

A popular view these days is that the euro is a failed experiment because economically and/or politically disparate countries cannot share a currency without eventually bringing on a major crisis. Another way of expressing this conventional wisdom is: a monetary union (a common currency) cannot work without a fiscal union (a common government). This is unadulterated hogwash. Many different countries in completely different parts of the world were able to successfully share the same money for centuries. The money was called gold.

The fact that a bunch of totally disparate countries in Europe have a common currency is not the problem. The problem is the central planning agency known as the European Central Bank (ECB), which tries to impose a common interest rate across these diverse countries/economies. This leads to even more distortions than arise when such agencies operate within a single country (the Fed in the US, for example), which is really saying something considering the distortions caused by the Fed and other single-country central banks.

I’m reticent to pick on John Hussman, because his analysis is usually on the mark. However, his recent comments on the Greek crisis and its supposed relationship to a common currency make for an excellent example of the popular view that I’m taking issue with in this post. Here is the relevant excerpt from the Hussman commentary, with my retorts interspersed in brackets and bold text:

“The prerequisite for a common currency is that countries share a wide range of common economic features. [No, it isn't! Money isn't supposed to be a tool that is used to manipulate the economy, it is supposed to be a medium of exchange.] A single currency doesn’t just remove exchange rate flexibility. It also removes the ability to finance deficits through money creation, independent of other countries. [Removing the ability to finance deficits through money creation is a benefit, not a drawback.] Moreover, because capital flows often respond more to short-term interest rate differences (“carry trade” spreads) than to long-term credit conditions, the common currency of the euro has removed a great deal of interest rate variation between countries. [No, the ECB has done that. In the absence of the ECB, interest rates in the euro-zone would have correctly reflected economic reality all along.] It may seem like a good thing that countries like Greece, Spain, Italy, Portugal, and others have been able to borrow at interest rates close to those of Germany for nearly two decades. But that has also enabled them to run far larger and more persistent fiscal deficits than would have been possible if they had individually floating currencies. [This is completely true, but it is the consequence of a common central bank, not a common currency.]

The euro is essentially a monetary arrangement that encourages and enables wide differences in economic fundamentals between countries to be glossed over and kicked down the road through increasing indebtedness of the weaker countries in the union to the stronger members. [The ECB, not the common currency, encourages this.] This produces recurring crises when the debt burdens become so intolerable that even short-run refinancing can’t be achieved without bailouts.

Greece isn’t uniquely to blame. It’s unfortunately just the first country to arrive at that particular finish line. Greece is simply demonstrating that a common currency between economically disparate countries can’t be sustained without continuing subsidies from the more prosperous countries in the system to less prosperous ones. [If this is true, how did economically disparate countries around the world use gold as a common currency for so long without the more prosperous ones having to subsidise the less prosperous ones?]“

Money is supposed to be neutral — a medium of exchange and a yardstick. It is inherently no more problematic for totally disparate countries to use a common currency than it is for totally disparate countries to use common measures of length or weight. On the contrary, there are advantages to the use of a common currency in that trading and investing are made more efficient.

In conclusion, the problem is the central planning of money and interest rates, not the fact that different countries use the same money. It’s a problem that exists everywhere; it’s just that it is presently more obvious in the euro-zone.

A lot of nonsensical commentary gets written about the Commitments of Traders (COT) data for gold (and silver). The information in the COT reports can be used as an indicator of gold-market sentiment. Nothing more, nothing less. It cannot validly be used to support the theory that “commercial” traders (primarily bullion banks) have been conducting a long-term price-suppression scheme.

One of the most important points to understand with regard to the positioning of traders in the gold futures market is that the group known as speculators drives the short-term price trends. This is made apparent by the following chart, which was created by Saxo Bank and linked at the article posted HERE. The chart clearly shows that, with only a few minor discrepancies, over the past three years the net position of speculators in the COMEX futures market (the black line) has moved with the gold price (the red line). More specifically, it shows that speculators start adding to their collective net-long position at price lows and continue to add until the price makes a short-term top, at which point they become net sellers and their collective net-long position begins to decline. The process is self-reinforcing, in that a rising price prompts buying and a falling price prompts selling by the trend-followers within the speculating community. Note that a chart stretching back well beyond 2012 would show the same relationship.

As is the case in any market, the speculators in gold tend to be most bullish/optimistic just prior to significant price tops and most bearish (or least optimistic) just prior to significant price bottoms. That’s why the COT information can be used as a sentiment indicator. And as with most sentiment indicators, the COT’s weakness is that there are no absolute benchmarks. For example, while we can be confident that a short-term price bottom for gold will coincide with a relatively low level for the speculative net-long position in COMEX gold futures, there’s no way of knowing that level in advance.

If we lump large speculators and small (non-reporting) traders together under the “speculators” label, then the “commercial” position is simply the inverse of the speculative position. In order for speculators to become net-long by X contracts, commercials must become net-short by X contracts. This is a function of mathematics, since the futures market is a zero-sum game. Furthermore and as discussed above, we know that it’s the group known as “speculators” that’s driving the process since the price has a strong positive correlation with this group’s net-long position.

Therefore, getting angry with commercials for shorting gold futures — as some gold bulls do — is equivalent to getting angry with speculators for buying gold futures, since speculators, as a group, cannot possibly increase their long exposure in gold futures unless commercials, as a group, increase their short exposure.

With the return to a currency that can be devalued at will by its own government being spoken of in some quarters as part of the solution to Greece’s economic malaise, this is an opportune time to reprint a piece about currency devaluation that was originally included in a TSI commentary in July of last year. The gist of the piece is that currency devaluation cannot possibly help, but it can certainly hurt. Here it is, beginning with a quotation from a surprising source.

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth*. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.”

The above quotation is perfect. It does such a good job of succinctly describing why currency devaluation is a destructive policy, both economically and socially, that it could have been written by Mises. Strangely, therefore, it was written by Keynes**.

It seems that Keynes understood the problems wrought by policies designed to debauch (devalue) the currency, but such understanding is nowhere to be seen among his modern-day followers. Instead, the modicum of sense contained in the writings of Keynes has been discarded by the Keynesians of today in favour of a total focus on “aggregate demand”. If you wrongly believe the economy to be an amorphous blob driven by changes in “aggregate demand”, then you are looking at the economy through a lens that creates such a distorted view of the world that what you perceive is the opposite of reality. When looking through such a lens, currency-devaluation policy can appear to be justifiable.

One of the most common ‘justifications’ for currency devaluation is that it makes local exporters more competitive. The problem, as explained in previous TSI commentaries, is that it can only benefit exporters at the EXPENSE of consumers and importers. There can be no net benefit to the economy. Moreover, the beneficiaries only benefit temporarily. The reason is that a sustained reduction in a currency’s value on the foreign exchange market requires relatively high monetary inflation, which leads to rises in domestic prices that not only counteract any benefit to exporters from the exchange-rate decline, but also distort relative prices in a way that makes the overall economy less efficient.

Related to the “we need to devalue our currency to make our exports more competitive” idiocy is the handwringing that happens in reaction to trade deficits. According to neo-Keynesian orthodoxy, every dollar that flows out of the US due to a trade deficit is a dollar less of spending within the domestic economy, which, in turn, leads to a weaker domestic economy and higher unemployment. In reality, however, every dollar that flows out due to a trade deficit eventually returns as some form of investment. That’s why the $500B+ annual US trade deficit has not reduced the US money supply. As Joseph Salerno (a good economist) explains in a 17th July article, trade-deficit dollars get invested by foreigners in US stocks, bonds, real estate such as buildings and golf courses, and financial intermediaries like banks and mutual funds, with many of the dollars ultimately being lent to or invested in US businesses. These businesses then spend the dollars on paying wages and buying real capital goods like raw materials, plants and equipment, and software. The point is that the flow of spending in the US economy is not diminished by a negative trade balance, but merely re-routed. There will be a redirection of labor and capital out of export industries into industries producing consumer and capital goods for domestic use, with no net loss of jobs. A net loss of jobs will, however, come about due to policies put in place to ‘fix’ a perceived trade-deficit problem.

Another common ‘justification’ for currency devaluation is that it lowers real wages and thus gets around the problem that the nominal price of labour tends to be ‘sticky’. The idea is that nominal wage rates are excessively slow to fall in response to reduced demand for workers, and that currency devaluation helps by surreptitiously reducing the real price of labour. The first point to note here is that the ‘stickiness’ of wages was never a problem in the US prior to the 1930s, when the Hoover and Roosevelt Administrations took steps to prevent wages from falling in response to a severe economic downturn. A second and related point is that government payments to the unemployed can reduce the incentive for able-bodied people to accept lower wages to re-enter the workforce. In other words, if nominal wages are problematically ‘sticky’ it is because of government intervention, not the free market. Third, the knowledge that modern money relentlessly loses purchasing power over time would tend to make nominal wages ‘stickier’ than they would otherwise be. In other words, the policy designed to address the perceived problem of ‘sticky’ wages actually contributes to the problem. In any case, these points are not critically relevant. Regardless of whether wages really are ‘sticky’ and regardless of the cause of the supposed problem, ‘sticky’ wages could never logically justify a policy that must ultimately weaken the economy.

The primary problem with currency devaluation is that it leads to non-uniform changes in prices throughout the economy. In effect, the implementers of devaluation policy send false price signals into the economy, which leads to more investing mistakes than would otherwise happen. As a result of the greater number of investing mistakes, there ends up being less wealth. Furthermore, the smaller pool of wealth will be redistributed by the devaluation policy, often in a way that is so obviously unfair that it provokes calls for new interventions and punitive taxes. It therefore puts the economy on the proverbial “slippery slope”.

In summary, Keynes wasn’t right about much, but early in his career he was absolutely right about currency devaluation. It is a process that engages all the hidden forces of economic law on the side of destruction, and it does so in a manner that not one man in a million will be able to diagnose.

    *The undeserved wealth distribution caused by currency devaluation policy is the root cause of today’s fixation on “inequality”. Unfortunately, none of the most popular writers on this topic understand the cause of the perceived problem.

    **The quotation is from Chapter 6 of Keynes’ 1919 book titled “The Economic Consequences of the Peace”.

It’s not an overstatement to say that over the 6-year period beginning in September-2008, the US Federal Reserve went berserk with its Quantitative Easing (QE). The following chart shows that the US Monetary Base, an indicator of the net quantity of dollars directly created by the Fed*, had a gentle upward slope until around August of 2008, at which point it took off like a rocket. More specifically, the Monetary Base gained about 30% during the 6-year period leading up to September of 2008 and then quintupled (gained 400%) over the next 6 years. Is it therefore fair to say that the Fed has now ‘shot its load’ and will be unable to do much in reaction to the next financial crisis and/or recession?

Unfortunately, the answer is no. The sad truth is that the Fed is not only capable of doing a lot more, it will almost certainly pump a lot more money into the economy the next time its senior management decides that the financial or economic wheels are falling off.

The Fed is capable of doing a lot more because it is not yet remotely close to running out of things to monetise. For example, the US Federal debt is presently about $18.1T and will probably top $20T within the next two years. This means that there is plenty of scope for the Fed to add to its current $2.5T stash of Treasury securities. Also, the Fed is not strictly limited in what it can monetise. Up until now it has been monetising Mortgage-Backed and Agency securities in addition to Treasury securities, but it could branch out into other asset-backed securities (those backed by auto loans or student debt, for instance), municipal bonds, investment-grade corporate bonds, and equity ETFs. If the situation were perceived to be sufficiently dire it could even change the rules to allow itself to monetise commercial and residential real-estate.

And the Fed almost certainly will do a lot more on the money-pumping front in the face of future economic and/or stock market weakness, because it has not only failed to learn the right lessons from the events of the past 15 years, it has learned exactly the wrong lessons. Rather than learning that injecting more money into the economy in an effort to mitigate the fallout from a busted bubble leads to a bigger bubble, a bigger bust, greater hardship and structural economic weakness, its senior management is convinced that the QE and interest-rate-suppression programs provided a substantial net benefit to the overall economy. Given this conviction in the righteousness of its previous actions, why wouldn’t the Fed do more of the same if the perceived need were to arise in the future? The answer, of course, is that it would. And it will.

In conclusion, those who think that the Fed is incapable of further monetary expansion do not have a good understanding of the situation, and those who believe that the Fed could do more, but will choose not to as the result of newfound financial prudence or concern for the well-being of savers, are naive.

*The Monetary Base is made up of currency (physical notes and coins) in circulation outside the banking system plus bank reserves. Bank reserves aren’t counted in the True Money Supply, but for every dollar of reserves created by the Fed as part of its QE the Fed also adds a dollar of money to the economy via a deposit into the demand account of a Primary Dealer. That is, QE results in the one-for-one creation of money and reserves. For a more detailed explanation, refer to my 16th February 2015 post.

The answer to the above question is no, meaning that “Austrian Economics” makes no prediction about whether the future will be inflationary or deflationary. That’s why some adherents to “Austrian” economic theory predict inflation while others predict deflation. A good economic theory can give you insights into the likely short-term, long-term, direct and indirect effects of policy choices, but it doesn’t tell you what will happen regardless of future choices and events. I’ll try to explain using two well-known quotes from Ludwig von Mises, the most important economist of the “Austrian” school.

Here’s the first quote:

“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 voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The first sentence of this quote is sometimes taken out of context as part of an argument in favour of deflation. It could be construed, if considered in isolation, as a statement that a period of deflation MUST follow a credit-fueled boom. However, no good economist, let alone the greatest economist of the past century, would ever claim that price deflation was inevitable regardless of what was happening to the money supply. To do so would be to claim that the law of supply and demand did not apply to money. In the real world there will always be a link between money supply and money purchasing power. The link is complex, but it will always be possible to reduce the purchasing power of money by increasing its supply.

The second sentence provides the necessary clarification. In essence, it says that a boom fueled by a great credit expansion can collapse in one of two ways. The first is by voluntarily ending the credit expansion. This would generally involve doing nothing or very little while a corrective process ran its course. The other is by relentlessly persisting with credit expansion in an effort to avoid a crisis. This would lead to a total catastrophe of the currency system, meaning it would lead to the currency becoming completely worthless.

The first of the two alternatives is the deflation path. The second is the inflation path (endless rapid monetary inflation leading to hyperinflation and, eventually, to the currency becoming so devalued it no longer functions as money). Note that money can only collapse due to inflation. Deflation makes money more valuable.

The Fed is presently heading down the inflation path, but it doesn’t have to stay on this path. A change of direction is still possible.

Now for the other Mises quote mentioned in the opening paragraph:

“This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”

The gist is that if the inflation policy continues for long enough then a psychological tipping point will eventually be reached. At this tipping point the value of money will collapse as people rush to exchange whatever money they have for ‘real’ goods. Mises refers to this monetary collapse as the “crack-up boom”. Prior to this point being reached it will not be too late to abandon the inflation policy.

Today, the US is still immersed in the first stage of the inflationary process. If it continues along its current path then a “crack-up boom” will eventually occur, but there is no way of knowing — and “Austrian” economic theory makes no attempt to predict — when such an event will occur. If the current policy course is maintained then the breakdown could occur within 2-5 years (it almost certainly won’t happen within the next 2 years), but it could also be decades away. Importantly, there is still hope that policy-makers will wake up and change course before the masses wake up and trash the currency.

In conclusion, “Austrian” economic theory helps us understand the damage that is caused by monetary inflation and where the relentless implementation of inflation policy will eventually lead. That is, it helps us understand the direct and indirect effects of monetary-policy choices. It doesn’t, however, make specific predictions about whether the next few years will be characterised by inflation or deflation, because whether there is more inflation or a shift into deflation will depend on the future actions of governments and central banks. It will also depend on the performances of financial markets, because, for example, a large stock-market decline could prompt a sufficient increase in the demand for cash to temporarily offset the effects of a higher money supply on the purchasing power of money.

The upshot is that regardless of how the terms are defined, at this stage neither inflation nor deflation is inevitable.

In reaction to the ECB cutting off financial support to Greece’s banks and the resulting closure of all banks in Greece, the Global X Greece ETF (GREK) plunged 19% on Monday 29th June to a new bear-market low.

However, apart from the assets most directly affected by the goings-on in Greece there are currently no real signs of fear in the financial markets. For example:

The Dollar Index initially rallied on Monday and broke above short-term resistance at 95.5-96.5. This was a predictable response to the burgeoning crisis in the euro-zone, but the gains were quickly given back and the Dollar Index ended the day with a loss. This price action reflects a general lack of concern.

The S&P500 Index (SPX) finally broke below the bottom of its recent narrow trading range, but while this is a preliminary sign of weakness it is far from a sign of panic.

The EURO STOXX 50 Index (STOX5E), the European equivalent of the Dow Industrials Index, fell 4% on Monday. This is a sizable decline for a single day, but it wasn’t even enough to push the index to a new multi-week low.

TLT, an ETF proxy for long-dated US Treasuries, bounced on Monday, but the bounce came from a 6-month low and wasn’t even sufficient to take the price to the declining 50-day MA.

The HYG/IEF ratio, a credit-spread indicator that rises when credit spreads contract and falls when credit spreads widen, has been working its way higher since mid-January. This upward trend implies increasing complacency and/or rising economic concidence. It pulled back on Monday in reaction to the Greek news, but the size of Monday’s move was not out of the ordinary.

I would have expected a bigger financial-market reaction to the ramping-up of the “Grexit” risk. However, with none of the other major financial markets showing much fear on Monday, I’m not surprised that there was only a small move in the gold price.

There could be a much bigger reaction over the days ahead as the situation in Greece continues to evolve, but right now the financial world is taking the Greece news in stride. The thinking seems to be: this is a major problem for Greece, but a minor issue elsewhere.

I was recently sent an article containing the claim that during the next financial crisis and/or stock-market crash there will be a panic ‘into’ the US dollar, but that unlike previous crises, when panicking investors obtained their US$ exposure via the purchase of T-Bonds, the next time around they will buy dollars directly. This is wrong, because large investors cannot simply buy dollars. As I’ll now explain, they must buy something denominated in dollars.

If you have $50K of investments in corporate bonds and stocks, then you can sell these investments and deposit the proceeds in a bank account. You can also withdraw the $50K in physical notes and put the money in a home safe. In the first case you are effectively lending the money to a bank and therefore taking-on credit risk, but the deposit will be fully insured so the credit risk will be close to zero. In the second case you have no credit risk, but there will be the risk of theft. The point is that it is feasible for an investor with US$50K to go directly into US$ cash.

This is not true, however, for an investor with hundreds of millions or billions of dollars.

If you have $1B of investments and you want to ‘go to cash’ you can, of course, sell your investments and deposit the proceeds in a bank account. The bank will certainly be glad to receive the money, but less than 1% of the deposit will be covered by insurance. This means that more than 99% of the deposit will be subject to credit risk (the risk that the bank will fail), which can be uncomfortably high during a financial crisis. In effect, depositing the money at a bank will be risking a loss of almost 100%. Not exactly the safety you were looking for when you shifted to cash!

Also, if you have a huge sum of money then removing the money from the banking system will not be an option. First, you probably won’t be permitted to convert such a sum to physical notes, but even in the unlikely event that you are permitted you will have the cost of transporting, storing, insuring and securing the cash. This cost will be large enough to preclude the exercise. Furthermore, accumulating a physical cash position of that magnitude will have the undesirable side effect of drawing greater government scrutiny to your business dealings.

Therefore, if it’s US$ exposure that you want and you are looking for a place to safely park a large quantity of dollars for a short period, you really have no choice other than to lend the money to the US government via the purchase of Treasury notes or bonds. That’s why a panic ‘into’ the US dollar will always be associated with a panic ‘into’ the Treasury market.

Keith Weiner often posts thought-provoking stuff at his Monetary Metals blog. A recent post entitled “Interest – Inflation = #REF” is certainly thought-provoking, although it is also mostly wrong. It is mostly wrong because it is based on a fundamental misunderstanding about saving.

Before I get to the main point, I’ll take issue with the following paragraph from Keith’s post:

“Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.”

Who says you shouldn’t have to spend your savings? One of the main reasons to save today is so that you can spend more in the future. Also, interest isn’t a modern development, it has been inherent in economic activity since the dawn of economic activity.

Now, the main point: When people save money, it’s not actually money that they want to save. Money is just a medium of exchange. What they want to save is purchasing power (PP). For example, if I have a million dollars of savings to live on over the next 20 years, what matters to me is what the money buys now and what it will probably buy in the future. If a million dollars is currently enough to buy a mansion in the best part of town and if a dollar is likely to maintain its PP over the next 20 years, then I’ll probably be able to live quite comfortably on my savings. However, if a million dollars only buys me a loaf of bread, then I have a problem.

A consequence is that, contrary to the assertion in Keith’s post, the real interest rate is very important to the average retiree. The easiest way to further explain why is via a hypothetical example.

Fred, our hypothetical retiree, has $1M of savings at Year 0. At the dollar’s current purchasing power his cost of living is $20K per year. Also, the interest rate that he receives on his savings is ZERO, but the dollar is gaining PP at the rate of 5% per year.

At Year 1, Fred’s monetary savings will have declined to $980K, because he spent $20K and received no interest. However, $980K now has the same PP that $1029K had a year earlier. That is, over the course of the year Fred’s PP increased by 29K Year 0 dollars. Furthermore, his annual living expense will have declined to $19K.

At Year 2, Fred’s monetary savings will have declined to $961K, because he spent $19K and received no interest. However, $961K now has the same PP that $1059K had at Year 0.

That is, after 2 years of receiving no nominal interest on his savings, our hypothetical retiree is in a significantly stronger financial position. Thanks to the receipt of a positive real interest rate he now has more purchasing power than he started with. The fact that he has less currency units is irrelevant.

I could provide a second hypothetical example of a retiree who, despite earning a superficially-healthy positive nominal interest rate and ending each year with the same or more currency units, has a worsening financial position over time thanks to a negative real interest rate. I could, but I won’t.

The upshot is that the real interest rate is not only important, for savers and investors it is of greater importance than the nominal interest rate. The problem, today, is not only that central banks have pushed the nominal short-term interest rate down to near zero, it’s also that they have done this while reducing the PP of money. The great sucking sound is wealth being siphoned from savers via negative real interest rates.

“Nonsensical Gold Commentary” was the title of a recent Mineweb article in which the author, Lawrence Williams, laments that a significant amount of commentary published on gold can be uninformed and misleading. This is ironic, since the bulk of Lawrence Williams’ writings about the gold market (and the silver market) are uninformed and misleading.

When it comes to his gold-market commentary, Mr. William’s most frequent mistake is to focus on the amount of gold ‘flowing’ into China as if this were one of the most important drivers, if not the most important driver, of the gold price. To be fair, in this regard he has a lot of company and much of what he writes on the topic is copied from the wrongheaded analyses put forward by reputed experts on gold.

I’ve dealt with the China gold fallacy in several previous posts*. It is related to the more general fallacy that useful information about gold demand and the gold price can be obtained by monitoring the amount of gold being transferred from one part of the market to another or from one geographical region to another.

Since every gold transaction involves an increase in gold demand on the part of the buyer and an exactly offsetting decrease in gold demand on the part of the seller, it should be obvious that overall demand cannot possibly change as a result of any purchase/sale. And it should be obvious that regardless of whether gold’s price is in a bullish or a bearish trend, some parts of the market and some geographical regions will be net buyers and others will be net sellers. And it should also be obvious that an increase in volume — which requires an increase in both buying and selling — can accompany a price decline or a price advance, meaning that there is nothing strange about a fall in price going hand-in-hand with increased buying or a rise in price going hand-in-hand with increased selling.

Unfortunately, none of these facts are apparent to the gold analysts who attempt to obtain clues about gold’s price performance and prospects by tracking the amount of gold being transferred from sellers to buyers.

I’m reticent to pick on Lawrence Williams, because I suspect that he means well and, as mentioned above, he has a lot of company. However, his commentary is difficult for me to ignore, the reason being that I closely monitor the Mineweb site and therefore can’t avoid seeing the headlines of the articles he writes. For example, when scanning through the Mineweb headlines a few days ago I was enticed to click on an article titled “SGE gold withdrawals surge again“, which turned out to be another Williams piece about China’s gold demand. Although this article regurgitated some of the usual misleading information, the last paragraph was interesting.

The last paragraph was interesting because it contained a blatant contradiction. Here’s the relevant excerpt:

“…the overall level of SGE [Shanghai Gold Exchange] withdrawals has to be a consistent indicator of Chinese demand trends and from them it looks as though the trend is rising so far this year whether they are a definitive measure of Chinese wholesale gold consumption or not. They are most certainly a measure of China’s internal gold flows.”

The last sentence is correct. The SGE withdrawals are a measure of internal gold flows, that is, a measure of the amount of gold transferred from some people in China to other people in China. As a consequence, they provide NO information about overall Chinese demand trends. The last sentence therefore contradicts the preceding sentence and shines a light on the confusion in the minds of those who attempt to gather useful information about the gold price by fixating on trading volumes.

*For example: HERE, HERE, HERE and HERE.

Junior uranium producer Uranium Energy Corporation (UEC) has been in the news (in a bad way) over the past few days due to ‘revelations’ contained in an article posted HERE. I put inverted commas around the word revelations in the preceding sentence because there is nothing in the article that should have surprised anyone who has been following the company. I don’t follow the company closely, but I was well aware of the information that seemingly shocked the stock market late last week.

It seems that many holders of the stock were surprised to find out that UEC had essentially stopped producing uranium. They shouldn’t have been, because the company has made no secret of its scaled-back mode of operation. For example, for the past several quarters the company has reported no sales and only small increases in its uranium inventory*, indicating production on a small scale. Also, the CEO of the company sent shareholders a letter in January of this year reminding them that “Palangana [the only in-production project at this time] is operating on a small scale pending ramp-up when the price of uranium is in a viable range.”

In other words, with regard to its operational performance UEC doesn’t appear to have tried to hide anything, although the company and many of the people who recommend owning the shares have not been completely forthright (to put it politely). The reason is that if production costs were as low as claimed, UEC’s Palangana project would be solidly profitable at the current spot uranium price and very profitable at the current contract uranium price. Nobody puts a genuinely-profitable mining operation on what is, in effect, “care and maintenance” for an indefinite period pending a rise in commodity prices. Therefore, it’s a good bet that UEC’s total production cost is above $35/pound and that the $20/pound “cash cost” quoted by the company is a misleading figure.

In any case, the problem I have always had with UEC — and the main reason I have never been interested in buying the stock — is its valuation. The company’s market cap has always been disproportionately high relative to the underlying business’s size and assets.

Even now, with the stock price having tumbled from its recent high, the company has a market cap of US$165M at last Friday’s closing price of US$1.80/share. For this market cap you get a company with a book value (BV) of only US$26M. It’s worse than that, however, because the BV itself is suspect. The BV comprises “Property, Plant and Equipment” of only $7M, working capital of only $2M, long-term debt of $20M, and $39M of “Mineral Rights and Properties”. That is, more than 100% of the company’s BV is in the “Mineral Rights and Properties” asset category.

By way of comparison, the current US$93M (pre-Uranerz-takeover) market cap of Energy Fuels (EFR.TO, UUUU), another US-based junior uranium producer, is slightly lower than a book value that is, in turn, more than 100% accounted for by the company’s working capital and “Property, Plant and Equipment”.

In other words, UEC is presently being priced by the market at 6-times a suspect book value while EFR, a comparable company, is presently being priced by the market at around 1-times a solid book value.

Unrelenting promotion of the stock is the most plausible explanation for UEC’s ability to maintain a disproportionately-high market cap for so long. The promotion periodically goes into overdrive and the stock price goes vertical (see chart below). It then gives back the bulk of its gains, but it is never allowed to reach a level at which there is real value before the next promotion gets underway.

I have ‘no axe to grind’ with UEC and no financial incentive to add to the recent downward pressure on the stock price. I’m just surprised that an article that did nothing other than point out a couple of obvious facts about the company had such a dramatic effect.

*Finished goods (U3O8) inventory rose from 70K pounds at 31st July 2014 to 78K pounds at 31st October 2014 to 81K pounds at 31st January 2015 to 84K pounds at 30th April 2015.

The following charts are sending conflicting signals about gold-related investments. Which one is right? We could find out over the next 2 trading days.

Some commentary relating to these charts will be sent to TSI subscribers within the next couple of hours.

BULLISH:

NEUTRAL:

BEARISH:

VERY BEARISH:

Late last month Sprott Asset Management made an offer to acquire all of the units of the Central Gold Trust (GTU), a gold bullion investment fund, in exchange for units of Sprott’s own gold bullion investment fund (PHYS) on a net asset value (NAV) for NAV basis. This implied — and still implies — a small premium for GTU unitholders, the reason being that GTU units were — and still are — trading at a discount of several percent to their NAV. GTU’s Board of Trustees subsequently recommended that its Unitholders reject the Sprott Offer for reasons that were outlined in a Trustees’ Circular, which was followed by dueling press releases. What’s the average retail GTU unitholder to do?

To answer the above question it is necessary to consider the benefits, if any, of exchanging GTU units for PHYS units. As far as I can tell and despite the numerous reasons given by Sprott for voting in favour of the proposed unit exchange, there is just one benefit: PHYS, the Sprott bullion fund, offers a physical redemption facility that — although it can only be used by large investors — prevents the units from trading at a sizable discount to NAV.

The thing is, the historical record indicates that GTU units only ever make significant and sustained moves into discount territory during multi-year bearish trends in the gold price. In other words, the historical record indicates that Sprott’s benefit only applies during gold bear markets.

Of course, there’s no guarantee that past is prologue in this case and that GTU’s discount will disappear in the early part of a new multi-year upward trend in the gold price, but recent performance suggests that nothing has changed. As evidence I point to the following chart comparing the US$ gold price and GTU’s premium to NAV (a negative premium is a discount). Notice that the bounce in the gold price from last November’s low of around $1140 to January’s high of around $1300 caused GTU’s discount to shrink from 12% to 4%. It’s not hard to imagine that if the gold price had extended its rally to $1350-$1400, GTU’s discount would have been eliminated.

Also of potential interest is the next chart showing a comparison between the gold price and the GTU/PHYS ratio. This chart shows that GTU has generally performed better than PHYS in strong gold markets and worse than PHYS in weak gold markets. Again, we can’t be sure that the past is an accurate predictor of the future, but there is no evidence at this stage that anything has changed.

Returning to the question “What’s a retail GTU unitholder to do?”, I think the right answer depends on the unitholder’s timeframe. Someone planning to hold GTU during the remainder of the gold bear market and well into the next gold bull market should reject the Sprott offer by taking no action, whereas someone planning to exit within the next few months should accept the Sprott offer.

The types of bet a person can make can be categorised as follows:

1. A bet where a rational bettor hopes to win and has a reasonable expectation* of winning. For example, someone who buys a stock following careful analysis of potential risk versus reward hopes to obtain a profit and believes that they have put themselves in a position where the expected outcome is a profit. This type of bet is called a speculation or an investment.

2. A bet where a rational bettor hopes to win but knows that the expected outcome is a loss. For example, someone who bets on roulette at a Las Vegas casino should realise that the expected outcome is a loss, but people who bet on roulette are generally hoping to beat the odds. This type of bet is a gamble. Note that many of the people who claim to be speculating/investing are actually gambling, because they haven’t done sufficiently thorough analysis of risk versus reward for their bet to be categorised as a speculation or an investment.

3. A bet where a rational bettor hopes and expects to lose. This type of bet is called an insurance payment.

When you buy insurance you can be very confident that the expected outcome is a loss because anyone prepared to offer you insurance on any other terms will not stay in business for long. Furthermore, a rational and honest person who takes out insurance will be hoping that they will never actually need to cash-in their insurance policy; that is, they will be hoping to lose the money paid for the insurance. For example, someone who buys fire insurance for their home is, in effect, betting that their home will burn down, but this is a bet they will generally be hoping to lose.

Due to the expected outcome being a loss, you should never pay someone to take-on an insurance risk you can afford to take-on yourself. It will, however, make sense to pay for insurance in certain cases. This is because even though the expected outcome is a loss, the consequences of not having the insurance could be devastating. Many people, for instance, would be financially devastated if their home burnt down, so it would probably make sense for them to pay for fire insurance. But it probably wouldn’t make sense for Warren Buffett to have his modest Omaha residence insured against fire because the financial value of his home is miniscule compared to his net worth.

Managing risk in the financial markets is often equivalent to buying insurance. That is, it often involves making a bet you hope and expect to lose, but a bet that makes sense nonetheless because it will prevent you from experiencing severe financial pain if things don’t go according to your best-laid plans.

*When I say “a reasonable expectation of winning” I mean that the expected outcome is a win, which is different from saying that the probability of winning is greater than 50%. For example, a bet that has a 70% probability of yielding a 10% profit and a 30% probability of yielding a 50% loss has an expected outcome of minus 8% [0.7*10 + 0.3*(-50)]. In this case there’s a 70% probability of winning the bet, but a rational person will not make such a bet.

In many real-world situations the probabilities needed to calculate “expected outcome” will not be known, meaning that speculators/investors will be forced to use educated guesses (guesses made after carefully weighing the known facts). These educated guesses will sometimes be wrong, which is why risk management is crucial.

(This post is an excerpt from a recent TSI commentary.)

The stock market is not a machine that assigns prices based on a calm and objective assessment of value. In fact, when it comes to value the stock market is totally clueless.

This reality is contrary to the way that many analysts portray the market. They talk about the stock market as if it were an all-seeing, all-knowing oracle, but if that were true then dramatic price adjustments would never occur. That such price adjustments occur quite often reflects the reality that the stock market is a manic-depressive mob that spends a lot of its time being either far too optimistic or far too pessimistic.

The stock market can aptly be viewed as an emotion pendulum — the further it swings in one direction the closer it comes to swinging back in the other direction. Unfortunately, there are no rigid benchmarks and we can never be sure in real time that the pendulum has swung as far in one direction as it is going to go. There’s always the possibility that it will swing a bit further.

Also, the swings in the pendulum are greatly amplified by the actions of the central bank. Due to the central bank’s manipulation of the money supply and interest rates, valuations are able to go much higher during the up-swings than would otherwise be possible. Since the size of the bust is usually proportional to the size of the preceding boom, this sets the stage for larger down-swings than would otherwise be possible.

The following monthly chart of the Dow/Gold ratio (from Sharelynx.com) clearly shows the increasing magnitude of the swings since the 1913 birth of the US Federal Reserve.

In the real world there is money supply and there is money demand. There is no such thing as money velocity. “Money velocity” only exists in academia and is not a useful concept in economics or financial-market speculation.

As is the case with the price of anything, the price of money is determined by supply and demand. Supply and demand are always equal, with the price adjusting to maintain the balance. A greater supply will often lead to a lower price, but it doesn’t have to. Whether it does or not depends on demand. For example, if supply is rising and demand is attempting to rise even faster, then in order to maintain the supply-demand balance the price will rise despite the increase in supply.

When it comes to price, the main difference between money and everything else is that money doesn’t have a single price. Due to the fact that money is on one side of almost every economic transaction, there will be many (perhaps millions of) prices for money at any given time. In one transaction the price of a unit of money could be one potato, whereas in another transaction happening at the same time the price of a unit of money could be 1/30,000th of a car. This, by the way, is why all attempts to come up with a single number — such as a CPI or PPI — to represent the price of money are misguided at best.

If money “velocity” doesn’t exist in the real world, why do so many economists and commentators on the economy harp on about it?

The answer is that the velocity of money is part of the very popular equation of exchange, which can be expressed as M*V = P*Q where M is the money supply, V is the velocity of money, Q is the total quantity of transactions in the economy and P is the average price per transaction. The equation is a tautology, in that it says nothing other than the total monetary value of all transactions in the economy equals the total monetary value of all transactions in the economy. In this ultra-simplistic tautological equation, V is whatever it needs to be to make the left hand side equal to the right hand side. In other words, ‘V’ is a fudge factor that makes one side of a practically useless equation equal to the other side.

Another way to express the equation of exchange is M*V = nominal GDP, or V = GDP/M. Whenever you see a chart of V, all you are seeing is a chart of nominal GDP divided by some measure of money supply. That’s why a large increase in the money supply will usually go hand-in-hand with a large decline in V. For example, the following chart titled “Velocity of M2 Money Stock” shows GDP divided by M2 money supply. Given that there was an unusually-rapid increase in the supply of US dollars over the past 17 years, this chart predictably shows a 17-year downward trend in “money velocity”.

Note that over the 17-year period of downward-trending “V” there were multiple economic booms and busts, not one of which was predicted by or reliably indicated by “money velocity”. However, every boom and every bust was led by a change in the rate of growth of True Money Supply (TMS).

Chart source: https://research.stlouisfed.org/

In conclusion, “money velocity” doesn’t exist outside of a mathematical equation that, due to its simplistic and tautological nature, cannot adequately explain real-world phenomena.