Part 1 of 2 fine article addative to everyones knowldege base;
*** Memo to Richard Russell ***
Memo to Richard Russell - On the Margin Baby
By: Ed Bugos, GoldenBar.com
June 24, 2003
"There's nothing I like less than bad arguments for a view that I hold dear" (Daniel Dennett).
That sums it up on most days that I read the arguments of supposed gold bulls and libertarian writers. It's no surprise that when the going gets tough they abandon ship - because their theories usually don't stand up to the light of day in the first place.
What was one to do, for instance, if buying gold in 2001 solely on the basis of growing Japanese demand due to a collapsing yen when soon afterwards the yen turned up? Had they turned bearish on gold then it would have been at exactly the wrong time.
Just like some buyers of gold may have failed to realize the true significance of the budding bull market then, many of today's gold bulls - who may think that gold has been benefiting from the drop in nominal interest rates - are remiss in their concern that when interest rates turn up, the dollar wont' be far behind, and that gold is going to collapse, as if the only reason the dollar fell was because interest rates did.
It doesn't work quite so neatly. Indeed, the simple correlation coefficients going back to 1972 are as follows: between gold and interest rates (10 year Tnote yield) it is -3.7%; and between the USd index and interest rates it is +28.0%.
The veracity inherent in the inference that the currency's value is affected by changes in interest rates is limited to relative movements in real interest rates and the steepness of the yield curve. Indeed, one of the strongest correlations I know of is that between money supply and the yield curve; using M3 the coefficient is -45.4% back to 1972.
This would suggest that as money supply grows there is about a 45% chance that the yield curve is flattening, or that as the yield curve steepens there is a 45% chance that money supply is contracting. In reality, there's a lag time for the relationship in yields to affect money supply - both in fact and theory - so the correlation would be more direct and significant were that taken into account. And at the moment the yield curve is still as steep as it has ever been in the past thirty years, which is what's inflationary - not merely the actual level of rates.
In any case, there are a myriad of sources of demand for the dollar today that have nothing to do with anticipating or exploiting changes in yields between currencies, or the sudden inclination for a borrowing dependent society to pay down its debts and increase its collective balances of Federal Reserve Notes relative to other assets and goods.
In fact, although we hope to disprove it in this column, Richard Russell's interpretation assumes that higher interest rates would lead to a decline in the growth of money supply on account that borrowing demand will falter. But this for instance would only hold good if by higher interest rates we meant that the Fed would shut down its open market manipulations and let the market decide the true (unopposed) level of interest; or if a Volcker type were put in charge to do practically the same thing.
Be that as it may, Russell, the highly accredited author of the Dow Theory Letters, has begun to waver on the bull market case for gold as near as I can tell.
He's been arguing, apparently, that since everyone is so bearish on the dollar, it's due for a bounce; and it seems that in order to rationalize that conclusion he has pulled together a mish-mash of incoherent premises cloaked in a deflationist dogma.
To be fair, other writers previously in the gold camp have made similar observations lately... that there are too many dollar bears. But this isn't our main contention.
Thus, before we elaborate further on the dollar, and Mr. Russell's deflation fallacies, let me emphasize that there is no malice or defamation intended here. While I don't personally subscribe to his letter, I have enjoyed the occasional snippets encountered throughout my career and life. His courageous contrarian knack deserves respect if only because it's been correct often enough. And of course it was nice to have him on board the gold bull for a while, even though it's bucked him now.
The objective here is not to change his mind (although that would be nice) or to tell you that the renowned Dow Theorist doesn't know the first thing about inflation; it is to illuminate some of the common fallacies about the subject of money and gold.
Russell's views undoubtedly reflect those of a large segment of the investing population, and so in criticizing his widely read arguments I only hope that you may reflect on some of the common misconceptions in the case for gold.
USD Not Oversold, Don't Take Your Eye Off the Trade Ball
The US dollar has fallen about 30 percent in a little over two years against a basket of trade-weighted currencies, which is about as fast as it has ever fallen. However, there are at least two facts that suggest it is not oversold (on foreign exchange markets):
1) the trade deficit keeps widening (recall, a trade deficit arises when prices rise faster in the domestic economy, or fall faster abroad - in other words, because the dollar is falling slower on the currency markets than it is in exchange for domestic goods and services); and
2) if it weren't for the massive interventions last year by the Bank of Japan and China the US dollar would have fallen even faster than it did (and the trade deficit might then have narrowed).
Indeed, our explanation for the reason the trade deficit has continued to grow is that the Fed's inflation is causing the value of the medium to fall relentlessly faster in the US economy than on the market against other currencies - which is due to the artificial policy induced intervention-related demand by central banks abroad.
But the bottom line now is that this Asian demand appears to be going away along with all the other reasons to buy dollars (like rising stocks and bonds) leaving only one probable resolution: ultimately a correction in the trade deficit on a sharply lower dollar. I emphasize probable because there are other possible resolutions - such as the Fed pushing up ahead of the curve to target money supply growth itself - which isn't likely.
Indeed, the argument that a collapse in asset values will result in a deflationary bust where consumers cash in their goods in exchange for dollars to pay down their massive debts with does not hold good in an environment where the central bank stands ready to lend below market, as you shall see today.
It is probably true that there are more dollar bears than there used to be; but I would stop short of saying there are too many. If there were "too many" gold would have done better than put in a move that paled in comparison with the 1985-87 bear market rally, bond yields would have long ago exploded upward, and as already suggested, the trade deficit would probably have narrowed.
Besides, anecdotally I personally can't find all that many dollar bears today. My bearish dollar outlook is often challenged - investors seem widely diversified in their outlooks for the dollar. The only dollar bears left, besides the remaining gold bulls, are those primarily that believe the weak dollar is deliberate policy - and hence to whom the Dennett quote aptly fits also. Even many devout long term dollar bears (gold bulls) have resigned to a more stable prognosis at least until after the election in November.
But Russell has embraced the deflation outlook to argue for a dollar rally; which would be bullish for the dollar if it were possible - and it is not, yet. Hence he's gone to the other side. His argument is basically that the forces of deflation are indeed hard at work, but that the central bank will keep them at bay until the consumer is "tapped out," since it is the consumer presumably that drives the credit cycle from the demand point of view.
Understandably, Mr. Russell seems confused over whether the central bank is a hero or villain. We'll try and clear that up for him today too.
I had refuted the premise that money supply changes were determined solely by the market - or by the demand for credit as if the credit system were elastic - in my last issue to subscribers by referring to Ludwig von Mises' theory on money and banking written almost 100 years ago (just before the Fed was born) discrediting just that very concept, but which still dominates most contemporary financial literature alongside the multitude of other misguided dogmas long ago disproved.
Mises' theories are typically not contested; they're merely ignored.
Central banks would like to have you believe in the elasticity of credit because then you don't need a gold standard. We shouldn't need to refer to Mises to refute it; the arrival of Ben Bernankiasm should have been plenty proof that it is the central bank in control of money supply. But now, since interest rates are going to rise, there's confusion about the whole thing again.
I've been writing on the subject of inflation for years but as quickly as I can elaborate on one fallacy another takes root. Notwithstanding that, our outlook has been mostly confirmed and our conviction vindicated. There are a lot of difficult things to predict in this world - but the general direction of money supply (as long as the dollar is a Federal Reserve Note) is one of the surest things on this planet besides death and taxes. In fact, once you understand inflation you'll certainly conclude it is only another tax.
Richard Russell figures the whole thing is still up in the air. And he misses the point that the central bank is in the business of sustaining inflation. This is what it does.
IT DOES NOT EXIST TO FIGHT DEFLATION!!
That's just voodoo. As I've frequently quipped, however, I can guarantee you that at least some of the Fed's governors find genuine comfort in that very popular contention.
It's true that the central bank can abandon its inflation policy at any time and embark on a deflationary policy, or in the extreme, dissolve itself and put the country on a gold standard. But nobody is going to accept a deliberate deflation "policy," clearly, and how much deflation a gold standard would cause is debatable - it merely comes down to what gold price would work. I think this is all fairly obvious.
But what isn't obvious is that there are no other deflationary forces at play but this possibility. We've argued in prior articles that falling prices aren't deflation unless they are caused by a contraction in money. Prices move up and down for many real reasons unrelated to monetary policy; inflation is a monetary phenomenon. The Internet and Wal-Mart are not deflationary forces; Japan is not experiencing deflation. The former are productive market forces, and the latter is a currency issue. There is nothing wrong with falling prices if they are not influenced by changes in money; it is the achievement of capitalism that it produces a greater amount of desired goods at increasingly affordable prices. This doesn't mean that money is becoming scarcer as Russell implies in his definition of inflation/deflation (discussed further below).
I have a few objections to Richard Russell's reasoning but I'll just comment on the two that stand out most. First, underlying his contention is the presumption that consumers drive the credit cycle; that money growth is a manifestation of the demand for credit driven by various things such as incomes, and consequently constrained by the consumer's debt service ratio (the proportion of disposable income that goes to paying the interest on debts), or rationings of wealth.
It is one of the most significant underlying currents to the entire deflation side of the debate. The (debt) cycle supposedly ends when the economy busts (i.e. asset values decline) and/or when the debt service ratio reaches some arbitrary level beyond which consumers can no longer service their debts; so they liquidate their assets in exchange for increasingly scarce dollars to pay their debts off with, and even begin to save.
As Russell puts it:
The problem is that somebody's got to USE the paper, and if American consumers are "tapped out," so to speak, they'll be cutting back on their spending and (God help us) possibly beginning to save - Russell on Gold, 12 June 2004
What he's saying essentially is that because the Fed is ardently fighting deflation they are printing so much money/credit that they'll saturate the credit markets, demand will fall off, and people, instead of borrowing, will now save.
There are three main problems with this line of thinking:
1) The printing presses aren't determined by the demand for credit. Or, at least, that the demand for credit isn't a force au naturale. On the contrary, the institution that controls the price of credit exerts an incredible influence on both the supply and demand for it.
2) Wages can rise, as well as other developments may occur to alter the numerator or denominator in the debt service ratio enabling the cycle to continue ad infinitum.
3) Dollars aren't scarce to begin with. For the dollar short thesis to work the aura of scarcity would need to exist beforehand - people would have to naively believe that the Fed couldn't come up with new ways to inflate.
The Inflationary Effects of Pricing Credit Below Market
The price of credit is, you guessed it, the interest rate.
In the section on Banking Policy (the Elasticity of Credit Circulation) in the Theory of Money & Credit Ludwig von Mises uprooted the fallacy that money supply changes are determined by the demand for credit, by showing that the issuing banks or the issuing authority influenced this demand by manipulating interest rates:
"The issuers of the fiduciary media are able to induce an extension of the demand for them by reducing the interest demanded to a rate below the natural rate of interest, that is below that rate of interest that would be established by the supply and demand if the real capital were lent in natura without the mediation of money (central banks), whereas on the other hand the demand for fiduciary media would be bound to cease entirely as soon as the rate asked by the bank was raised above the natural rate" - pp. 340, Chapter 17 TM&C
The underlined is mine. This is the key; it's what the deflation camp don't get.
What people don't seem to grasp is that interest rates are determined by the market but heavily influenced by the largest central planning body on the face of the earth - rates are almost completely controlled at the short end. And their influence has only grown.
Even if interest rates go up, so long as the Fed keeps them lagging behind where the market would otherwise have them it creates an advantage to transacting credit that didn't exist before. The yield curve is usually important to the incentive for the issuers of credit and credit derivatives; but if interest rates on the curve are artificially kept below market it will stimulate demand for credit, period... like a good that's priced below market except that credit is virtually unlimited because there is a central bank.
If interest rates happen to go up it is usually for one sole reason - inflation. Changes in interest rates do not reflect changes in the nation's profitability.
If that were true then rates wouldn't have fallen after 1980 because supposedly the US was from then on producing the most profits! Right? A credit transaction involves the exchange of a future good (money) for a present good (money). Thus the most significant factors determining the level of interest are monetary.
The interest rate is essentially the product of negotiation in the market between the relative value that the borrower places on the consumption of a good now rather than in the future (his time preference rate), and the value lenders place on the choice of whether to save or spend (same). But central banking and the arrival of fiduciary media has brought the costs of issuing credit down to the bare essentials - to the technical logistics of granting credit and issuing money out of virtually nothing.
So lenders aren't really having to face the choice of forgoing one good for another, or the opportunity cost of lending rather than consuming. Hence there is a surplus of available credit, which helps drive interest rates down, down, and down - normally.
The lower they go, artificially, the more they induce the consumption of goods today rather than tomorrow, or rather than to save - in fact, the Austrians fittingly refer to this process as a type of "forced savings." But it is technically inflation and it affects a debasement - though not in a straight line. When the debasement picks up speed at some point the level of interest begins to increasingly reflect expectations about further devaluations in the future value of money. Again, the main reason for large swings in the determinants of interest rates today are inflation and inflation expectations.
The key point though is that theoretically, higher rates do not slow the issuance of credit and money (fiduciary media today) unless they are higher than the natural rate - that is, that rate which reflects the truest possible inflation reality and time preference rate (it's always changing; there's no fixed equilibrium - it would defeat the purpose).
Nevertheless, if when interest rates rise they don't affect a contraction in the money supply the determinants of the commodity bull will remain; the only effect they will have on prices is in asset prices whose values are dependent on a future stream of income (money) discounted at record low interest rates and inflation.
To sum up, the demand for credit is influenced by the Federal Reserve System, by its interest rate policy, while the issue of credit is unlimited.
Hmmm. Yeah, the forces of deflation these are. The central bank does not exist to fight deflation, it exists to sustain inflation. As you'll see, the policy has a specific aim.
Breaking Down the Credit Cycle; Laws of Physics Need Not Apply
In theory a debt (or credit) cycle can continue indefinitely so long as:
the debtors are willing and able
the creditors are willing and able
Let's briefly recount how theory applies. Starting with the creditors; there is no question of their ability to issue credit (or stimulate the demand for it), and since it is virtually unlimited the question of whether they are willing depends solely on the price - or interest rate - that they might receive. Debtors too are willing to borrow so long as there is an advantage in forgoing future consumption; so long as rates are kept below market it is made artificially cheaper to consume now than to put it off. Another related incentive to borrowing lies in terms of the ultimate effects of the inflation - debasement.
If rates are at a level that underestimates the future erosion of the value of the currency being transacted the advantage to borrow materializes.
A decline in rates relative to the natural rate, everything equal, might induce individuals to place a higher value on current consumption while an increase relative to the natural rate would encourage more savings. However, this 'natural' rate is a moving target, and because the Fed's easy credit policy produces increasing inflation, how easy it may be to catch up to it are up to circumstances beyond the Fed's reach. In many countries where similar policies reigned and subsequently broke down interest rates have been known to soar to the hundreds of percent range without helping the currency find support or preventing the central bank from expanding its quantity.
I realize that in most of these cases the market system is far less developed - hence less able to adjust. But historically even quasi market economies have been known to fall victim to such chaos, amounting to demonetization.
Now, it is conceivable that if the Fed today were to target money supply in order to close the gap between current rates and the market rate it could inspire the outcome that Richard Russell and Rick Ackerman propose in their "dollar short" hypothesis - and thus essentially abandon the boom, or credit cycle.
But it's a reality that is far from likely for what I hope are obvious reasons. Besides, it is not what they are talking about.
Their reasoning is that borrowing demand will peter out and people will turn into savers when the cost of servicing their debts has reached a constricting threshold. In other words, they are focusing on the borrowers "ability" to borrow as per the above equation.
Ever Heard of a Wage-Price Spiral?
What if the denominator in the debt service ratio could rise along with or more than the numerator? In other words, what if incomes or wages could participate in the inflation? No way you say; the economy is too productive and the labor market is weak.
It was weak in the seventies also, and yet wages soared. The price of labor, like any other good, is also influenced by inflation and its consequences... to the extent those consequences are perceived. The fact that unions were more powerful in the seventies might well be related to the massive devaluation in the dollar that occurred that decade.
If the interest rate is a price - especially one that is supposed to reflect inflation - then let's look at it in the context of what else is going on when rates are rising: other prices are too; inflation awareness is rising; hence, why wouldn't wages start to rise faster? Wages tend to lag inflationary trends normally, especially those that are fixed.
Wage earners are the losers in this particular system (see below on the redistribution of wealth through inflation) in other words until they start budding in line like gold bulls hope to. It is true that it is not entirely predictable when this will be but it is safe to say that once a commodity cycle has begun it isn't far behind - because a commodity cycle basically reveals the inflation that the central bank has tried to hide for decades. This is the point at which the prior downtrend in interest rates reverses; since the inflation is more visible it is more acutely priced into financial assets.
How much longer will people believe that the increase in oil and gas prices is temporary for example? How about Lumber, Cocoa, and the other metals? How about Platinum which keeps making new all time highs?
These things make up a small proportion of total production costs, and so haven't completely returned pricing power at the retail end; but who can argue that these price increases aren't beginning to be noticed by the little guy today?
Soon enough even the layest of laymen must interpret this as a decline in the value of the currency that he is getting for his labor. As this ball gets underway, production costs are going to rise, followed by retail prices, and so on. The bottleneck to the onset of a wage price spiral has so far been the unwillingness of the labor market to participate for whatever reason - whether insecurity or ignorance.
But at the point when the wage earner starts to barter up his wages the process takes off - the Fed wants to prevent this with all its might. Yet it is this point of recognition that gold bulls are waiting for, that we believe will ignite the bull market. Moreover, it is also this point that could raise the denominator in the calculation of debt service ratios.
Or forget about theory and just look at the facts. The credit expansion has continued to grow essentially uninterrupted since the gold standard was abandoned in 1933.
The dollar short / deflation prognosis has never materialized since. The only deflation we've seen since 1933 were its symptoms (falling prices), occassionally, and they're explained by the work of capitalism or other ad hoc developments in the currency market before deflation in the technical sense of the term (definition below).
A theory is only as good as it fits the facts.
What's Too Much Money Then?
Russell puts it like this:
Another area of confusion -- one that I've been writing about. In the background we have the global forces for deflation, which stem from world over-production and its accompanying pressure on pricing power. Add the deflationary forces of giant Wal-Mart plus the Internet, and it's enough to give Alan Greenspan the "heebie-jeebies." Against these deflationary forces we have our heroes, the central banks of the world -- led by the Greenspan Fed. These guys (I believe they all talk to each other) are printing the paper that is calculated to hold deflation at bay. Remember, the classic monetary definition of deflation is too many goods lined up against too little money - Richard Russell on Gold, 12 June 2004
First off, there's no such thing as "world overproduction." There's only the problem of whether we're producing the right stuff - whether we're overproducing the wrong stuff and under producing the right stuff. Otherwise, as already pointed out, capitalism is supposed to provide us with generally more stuff.
But besides that Russell's "classic" definition misses on several other fronts. What's too little or too much money? In other words, is there a proper ratio between the stock of goods and the stock of money? If so, the assumption is that prices are supposed to be stable. And if the volume of goods increases does that increase the demand for money?
Obviously there is a relationship between money and other goods. But it would never exist without a human. So it is subjective. Money allows us to acquire goods more easily because it's something everyone else recognizes for holding that precise property - it allows for transactions that would not occur otherwise; it facilitates free exchange.
It is worth only what can be gotten with it. It has no value as a consumption or capital good (even though the good that represents money may). It's value is affected by changes in the way humans value other goods, and also by the factors that affect the demand and supply of money - independently of those that affect the value of goods. Improvements in the clearing system affect a decline in the demand for money balances, broadly, for instance, while the increasing reliance on money substitutes decreases the demand for money balances in the narrow sense. But it doesn't affect changes in the way we value other goods; just changes in price that has nothing to do with the real factors directing the nation's productive resources.
When people talk about money as the root of all evil because "others" would do anything for it they're confusing it with wealth, or capital, or even power. What people seek is wealth. They don't want to carry change around. Money is only a proportion of wealth that is meant to cover the uncertainties that might give rise to daily transactions that can only made with cash. If people wanted money they'd cash in their assets to get it. They want to be able to acquire more goods, not money balances.
Now that we got that out of the way...
The key point is that because money doesn't produce anything and its sole utility is in its ability to facilitate exchange it almost doesn't matter how much there is. It is the opposite with the nation's stock of goods or capital. The more capital there is the better. But more money doesn't do a darn thing to increase the amount of real wealth. The exact quantity of money that is appropriate is determined by the market when it makes a particular good the object of money, or a common medium, in the first place.
Beyond that, there is no real need for additional money, the Austrians proved. The only effect is on prices; there is no change to "total" real wealth and there is no incentive to producing real wealth that can be derived from increasing money, or liquidity as the Fed would have it. If one were to imagine, for instance, two identical economies perhaps on different planets or in different dimensions (?), and one were endowed with twice the money the other was - assuming everything else was exactly identical we're arguing the only difference would be that in one economy prices will be roughly twice the other. There would be no difference in the quantity of goods one could buy with their money.
Hence, the relationship between goods and money Russell depicts is not relevant in the manner implied. The exact ratio between the stock of goods and money that could be declared optimum is nebulous at best. What I'm saying is that if we could vary the ratio between money and goods in a series of controlled experiments that almost any ratio would work as well as the other.
We can only define what is too little or too much money once this is understood because it is the specific impact of changes in the money stock on prices that do the real evil; it is not the impact arising from changes in the ratio between the quantity of money and the stock of goods on the real side that matters; and it is not the absolute price level that matters. It's the changes in the supply of money relative to the demand for it (not relative to the stock of goods outstanding) that determine inflation or deflation, and subsequent variations in the value of money - the impact on prices from the monetary side - which matters. And these are wholly unnecessary.
But more importantly, it's in the way that these changes do affect prices that affect real wealth and its redistribution that is. If the true hero, Richard Russell, saw this he wouldn't consider the central bank as hero... I'm confident. |
