When Do You Skip Gold?

QE or Not QE. Is That the Question?

Scene: Princeton University economics class taught by Ben Bernanke. After a late night of studying, a student falls asleep in class. This sent Bernanke into a tizzy and he came over and pounded on the desk, demanding an answer to a question he had just posed. The student, shaken but now awake says "I'm sorry Professor, I missed the question -- but the answer is increase the money supply..."

Despite all the models, the white papers, the academic credentials, and the sophisticated talk, all the Federal Reserve really does is print money.  That is the sum total of "quantitative easing", or QE.  Lots of people think that alone can create economic wealth, but I think that defies logic and common sense.  Didn't the Soviet Union prove that economic top-down control by a handful of elites doesn't work?  We do like our illusions.

As economic figures recently have been coming in generally weaker than expected, the calls from Wall Street for more manna from heaven have been heating up.  But does money printing work?  Can it be our economic salvation?  John Hussman writes one of the most worthwhile reads in his weekly missive, and a couple weeks ago he had this to say about QE:

Regardless of the fact that QE has had no durable economic benefits (more on that below), and does little but to repeatedly lay fresh wallpaper over the rotting edifice that is the global banking system, the main effect of QE has been to provide temporary support for the most speculative corners of the financial market after they have been pummeled…

Meanwhile, it is unwise to believe that additional rounds of QE will do much to help the economy in any event, as its primary effect is merely to drive investors into speculative investments by starving them of safer yields.

…The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances [with the exception fo a few select investments, SkipGold is there now!].

Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will "feel" wealthier and keep consuming - regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such "wealth effect" in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying "do something!" But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice…

Finally, the reason for doing QE through the Fed (rather than simply changing the maturity profile of the new Treasury debt) is that Wall Street - at least - believes that the Emperor is actually wearing clothes. Despite the fact that the main effect of QE is to boost speculation and release brief bursts of pent-up demand, both which immediately soften when the policies are suspended, this recurring pattern is still unclear to many investors and analysts. As long as that delusion persists, we can expect the Fed to periodically exploit it.

Ignore that the side-effect of this delusion is the misallocation of capital toward speculative assets in the belief that the Fed has set a "put option" under the markets. Forget that savings are discouraged, bad lending decisions are rescued, incentives and economic signals are distorted, and the accumulation of productive capital is disabled. We have the most creative, entrepreneurial nation on the planet, but our policy makers are intent on preventing debt restructuring and misallocating scarce capital. As a result, they continue to compromise long-term growth in favor of temporary bouts of short-term speculation.

That same speculation that has been driving the financial markets higher is also influencing the commodities market, including driving oil prices higher.  But don't expect any Presidential news conferences decrying stock speculators.

Name that Bubble

"Experience should teach us to be most on guard to protect liberty when the goverments' purposes are beneficent. Men born to freedom are naturally alert to repel invasion of their liberty by evil-minded rulers. The greatest dangers to liberty lurk in insidious encroachments by men of zeal, well meaning but without understanding."  --Justice Louis Brandeis

Despite their incompetence, our government and the Federal Reserve have been great at one thing -- promoting asset and credit bubbles.  These could not come to pass without massive deficit spending (false, unsustainable demand) and easy money policies (encouraging debt).  So we've had the Nasdaq bubble (still down over 40% from the peak 12 years ago) followed by the more painful housing bust.  And now we are on to yet another.  This one won't be as widely damaging as the housing bubble, but there will be about as many victims.

The answer?  Student loans.

The figure will almost certainly hit $1 trillion this year. After adjusting for inflation, students are borrowing twice what they did a decade ago.  Total outstanding debt has doubled in the past five years.  What explains this insatiable demand for this kind of debt?  Well, it's cheap, it's easily accessible, and it is fungible - a student can take out a loan, yet use part or all of the balance for tangential purchases like an iPad.  Unfortunately, student loans are the only debts that cannot be discharged in bankruptcy, so we are creating an entire generation of debt slaves.

To further the point, here is a great video by Peter Schiff (head of Euro Pacific Capital and former Senatorial candidate in Connecticut) discussing the good intentions of student loans gone awry:

The "Real" World

"From a time long ago when we sold our vote to no man, we have abdicated our responsibilities. The People who, once upon a time, handed out military command, high civil office, legions — everything, now sits in craven silence, and anxiously hopes for just two things: bread and circuses."

Juvenal, Satire X

Or in today's parlance, reality TV and smart phones.

One convenience for our policy-makers is that most American's do not differentiate between nominal and real returns and income.  Real is what matters.  Nominal is the focus Washington and Wall Street want you to have.  Like skilled magicians diverting your attention from the reality that their (Fed and Congress) massive monetary policies have wrought on your real world, they compel you not to look what the other hand is doing under the table. That way Dow 13,000 means a lot, when in fact in real, inflation-adjusted terms, stocks are down 20%+ over the past decade.  And you are maybe making more money, but real incomes have been stagnant for a few decades now while the cost of living (energy, gasoline, education, food, healthcare, etc.) is up materially over that same time period.  Dow 13,000 today is nothing like it would have been a decade ago, yet here we are celebrating it nonetheless.

To see what I mean of how this monetary expansion (i.e. inflation) can impact stock prices, here's a look at the Dow in terms of a currency that cannot be printed at will by those interested first and foremost in expediency.  This chart ought to calm down (though it will not) the nominal euphoria as Dow 13,000 screams across the screens. Since May 2008, the Dow is unchanged in price and down 50% in 'real' gold terms.

 

That's just something to keep in mind as the financial talking heads get euphoric.  I want to be clear that this is not necessarily an endorsement for gold in your portfolio, but saw this comment from John Mauldin, and I thought it summed up my thoughts well, too:

"I buy a little physical gold every month [SG: I don't monthly, but I do every so often]. I don't even look at the price [SG: I do]. The check is written the same day each month, for the same amount. I take delivery. I hope the price of gold goes down so I can get more gold per dollar. I also hope it ends up being worthless, as that will mean everything else has worked out just fine. But my gold is there just in case my crazy gold bug friends are right and we can't actually trust the government to find a reasonable solution to our dilemma. And maybe because deep down I really don't trust the (insert your favorite expletive). Just a little insurance, you understand."

I do, John, but unfortunately most are trusting in the powers that be to do the right thing.  Good luck to them.

We're Going the Wrong Way

Neal: He says we're going the wrong way... 
Del: Oh, he's drunk. How would he know where we're going?

-Planes, Trains, & Automobiles

Exploding deficits per capita with stagnant economic output per capita.  I would say this is scary to quite scary.  Ironically, our debt to GDP is expected to hit 100% on...Halloween.  Boo!

The "Big" Problem

Fascism should more appropriately be called Corporatism, because it is a merger of state and corporate power.  -Benito Mussolini

Fascism is capitalism in decay.  -Vladimir Lenin

I've noted numerous times on SG about the dangers of power in the hands of too few, most notably the Federal Reserve and our corporatist economy.  When viewing these charts, think about the ramifications of lobbying influence, the shaping of rules and regulation, the ability to limit competition by erecting barriers to entry, the power of political donations, the pricing power given limited consumer choice, etc.  While the charts below just highlight the banking and railroad sectors, the same can be said for healthcare, food (just four producers control more than 90% of the chicken and pork markets), autos, etc.  Too much power in too few hands is a danger to the freedom and liberties of the individual.

Banking:

Railroads:

The Big Bank Bailout Bluff

“Banks have done more injury to the religion, morality, tranquility, prosperity, and even wealth of the nation than they can have done or ever will do good.”

-John Adams

Because I think it is reasonably likely in the intermediate future, this needs to remembered when the time comes for potentially more bank bailouts -- any talk of the necessity of using taxpayer funds to "rescue" the big banks is a complete, fabricated lie.  It was true in 2008 during TARP, and it remains true to this day.  Any attempt at causing economic hysteria is meant solely to threaten economic armageddon in order to keep the status quo when the expiration date on that is long past due.

In this week's commentary John Hussman gives a little more detail:

Over the past three years, Wall Street and the banking system have enjoyed enormous fiscal and monetary concessions on the self-serving assertion that the global financial system will "implode" if anyone who made a bad loan might actually experience a loss. Because reversing this mantra is so difficult, policy makers are likely to continue fitful efforts to "rescue" this debt for the sake of bondholders, through mechanisms that are increasingly distasteful to the broader population. The justification for those policies will therefore have to be coupled with rhetoric that institutions holding these securities are too "systemically important" to suffer losses.

On this note, it is critical to remember that nearly all financial institutions have enough capital and obligations to their own bondholders to completely absorb restructuring losses without customers or counterparties bearing any loss at all. So keep in mind that the debate here is not about protecting customers or counterparties - it is really about whether the stockholders and bondholders of banks and other financial institutions should bear a loss. The "failure" of a bank only means that existing stockholders and bondholders are disenfranchised - the company simply takes on a new life under new ownership. Existing stockholders lose everything, unsecured bondholders typically lose something, and senior bondholders get any residual obtained as a result of the sale or transfer of the company. If the global economy is fortunate, the financial system two or three years from now will look much the same as it does today, but the ownership and capital structure will have changed almost entirely. A major restructuring of debt is the clearest path to long-term economic recovery, and the accompanying losses to those who recklessly made bad loans would be the highest realization of Schumpeter's idea of "creative destruction."

From that perspective, Warren Buffett's $5 billion investment in Bank of America preferred stock last week was essentially a defense of the old guard. Buffet observed, "It's a vote of confidence, not only in Bank of America, but also in the country."

Yes - to be specific, it's a vote of confidence that the country will bail out Bank of America in any future crisis. We should all hope that Buffett's investment is successful - provided there is no future crisis - and we should equally hope that Buffett loses the entire investment otherwise.

We'll see what happens.  I suspect Uncle Warren's investment in BofA will be tested in the next 18 months.

The "Success" of Bernanke's Quantitative Easing

"When God desires to destroy a thing, he entrusts its destruction to the thing itself.  Every bad institution of this world ends by suicide."  -Victor Hugo

I don't know about you, but I am fired up about the Fed's next round of money-printing, also known as "Quantitative Easing", or QE-3 for short.  Investors are already anticipating it:

U.S. Index Futures Climb on Speculation Bernanke to Signal Third QE Round

Aug. 22 (Bloomberg) -- U.S. stock futures rose, signaling the Standard & Poor’s 500 Index will rebound from its biggest four-week drop since 2009, amid speculation the Federal Reserve will unveil further measures to support the economy…

“The market is expecting another round of asset purchases and it will come,” said Matthias Jasper, head of equities at WGZ Bank AG in Dusseldorf.

But I jest.  We are coming up on the one year anniversary of "QE-2".  Ben Bernanke is scheduled to speak Friday at the annual Jackson Hole event, and mention of another round of quantitative easing is being hoped for by the Fed's Wall Street allies.  For those promoting QE-3 -- you must assume that interest rates being too high are the key impediment to economic growth?  That's the story you are going with?  That interest rates are too high?  Okee-dokee.  The 10-year Treasury is very close to 2.0% and mortgage rates are dropping to fresh all-time lows.  And the Fed's answer is to implement a policy designed to further lower interest rates?  That's quite the theory.

John Hussman did a nice job last week of summarizing just how "successful" QE-2 has been, and maybe provide a glimpse of what's to come with the next round (and the next, and the next...):

Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That's a nice sentiment, but it does overlook one minor detail. QE2 didn't work.

Actually, that's not quite fair.

-The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out.

-The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP - a level that requires short-term interest rates to remain below about 3 basis points in order to maintain price stability ( see Charles Plosser and the 50% Contraction in the Fed's Balance Sheet ).

-The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor - particularly in developing countries.

-The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar.

-The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield.

-The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system.

-The Fed was successful at boosting the trading profits of the banks that serve as primary dealers, by announcing precisely which securities it would be buying prior to Treasury auctions, and buying them on the open market a few days later from the dealers that acquired them. -

-The Fed was successful in creating a portfolio of low yielding securities that will be almost impossible to disgorge without capital losses unless the Fed holds them to maturity.

On proper reflection, the list of the Fed's successes from QE2 is nothing short of stunning.

It is beyond comprehension why anyone would wish for more of this recklessness.

Since the Fed enacted QE-2, GDP growth has been less than 1.5% annually, and the official unemployment rate has risen.  Quantitative easing is economically baseless, but in reading the bullet points above one can see why Wall Street and their media allies are such big fans.  It also exposes the rank hypocrisy of many of those who espouse "free markets" and "capitalism".  Many of them are nothing but welfare queens themselves.

 

It's a Little Late...

Wild swings in the market cause the average investor to make ill-timed decisions.  Better to stay conservative and diversified, and then sell-offs can be greeted opportunistically rather than fearfully.  When it comes to investing, think Pete Rose and Rod Carew, not Babe Ruth.  Striking out in investing means you may not get another at-bat.

When Noah started building the arc, it was sunny.  Preparing for a flood after 3 weeks of rain is an exercise in futility.

Commentary on the U.S. Downgrade

The markets worldwide got slaughtered today (actually, it's been a few weeks now).  Nearly everyone pointed to the downgrade by S&P of U.S. debt as the reason.  I think that's just a smokescreen for a much bigger fire.  And ask yourself, if the downgrade is so negative for Treasuries, why did they rally so hard today??

What ails us is far bigger than historic downgrades.

Worthwhile commentary from John Hussman today hit on more important topics, most notably this tidbit:

"Coupled with the slowdown in year-over-year GDP growth, the composite of economic and financial evidence we presently observe has always and only been associated with ongoing or immediately impending recessions. This is not an opinion or a viewpoint, but a fact of the data."

Very interesting considering everyone on Wall Street has been suggesting a second-half recovery.  We shall see.

And he also touched on the real #1 issue facing the U.S. (and global) economy: 

If there is one crucial point that should not be missed, it is this: the fundamental source of our economic challenges, from joblessness, to unresolved housing strains, to sovereign debt crises, is that our policy makers have repeatedly opted for fiscal band-aids and monetary distortions instead of addressing the core problem head-on. That core problem is simple: the careless encouragement of asset bubbles, and the refusal to restructure bad debt.

Encouraged by inappropriately easy monetary policy and lax regulatory oversight, the U.S. went on a debt-financed binge of consumption and unproductive investment that lasted nearly a decade. When that binge collapsed, policy makers ignored the fundamental need to restructure bad debt, and instead fought tooth and nail to defend bondholders and lenders who had extended credit carelessly. We are now left with a global financial system where the debtors are incapable of making good on those debts, and governments around the world are frantically trying to prop up bad debt with public funds and monetary policies aimed at distorting the financial markets even further.

…

The way that our policy makers address the recent weakness in the markets will tell a great deal about the prospects for a durable recovery. If the policy initiatives focus on subsidizing bad debt on the fiscal side, and distorting the financial markets on the monetary side, it would be best to use whatever short-term enthusiasm those proposals provoke as an opportunity to further reduce risk. The best policy responses are those that relieve some constraint on the economy that is binding. Another round of policies geared to creating an even larger sea of zero-interest liquidity, re-igniting asset bubbles, or further lowering already depressed Treasury yields, would be a signal of panic and incompetence from the Fed. If policy makers instead push to facilitate debt restructuring, coupled with pro-growth fiscal responses (e.g. R&D investment incentives, full funding of the National Institutes of Health, productive infrastructure investment, etc), yet another drawn-out cycle of distortion and crash might be avoided.

The Fed, the European Central Bank, the IMF -- these are the agents of the status quo and of large financial interests.  Their policies are ruinous.  I fear that instead of doing the right thing, policymakers will do the same thing they've been doing, only more of it.  The big picture is that we have wasted 4 years and untold trillions trying to hide the fact that nothing has really changed.  I could be convinced to go along with intelligent deficit spending (Hussman gives some ideas in his commentary) if it buys us time to restructure the underlying imbalances in the system.  But we've done nothing of the sort.  We've gone outside and put ice cubes on the thermometer and claimed we fixed global warming.

Despite that, it must be noted that I did put money to work today near the close.  That works for me, my risk tolerance, and current allocation.  Unlike most investors, I feel my eyes are wide open to the risks we face.  Careful out there.

The Debt, Deficit, & Default Disconnect

"The liberties of our country, the freedom of our civil Constitution, are worth defending at all hazards... We have received them as a fair inheritance from our worthy ancestors: they purchased them for us with toil and danger and expense of treasure and blood. It will bring an everlasting mark of infamy on the present generation... if we should suffer them to be wrested from us by violence without a struggle, or to be cheated out of them by the artifices of false and designing men."  -Sam Adams

I think the best thing about the debt ceiling debate was that it opened people's eyes to the realities of our fiscal problems and the limits of gov't.  More people are (finally!) engaged.  For example, how many people knew before that the federal gov't sends out 100 million checks per month to federal employees, entitlement recipients, and vendors?  Or that despite our own debt and deficit problems, we are kind enough to guarantee some of the debt of Israel and Egypt?

And more people are waking up to the reality that the argument over whether we cut $1.8 trillion or $4 trillion over the next 10 years is downright silly.  Both are meaningless and are but a small downpayment of what is to come.

This great graphic from Businessweek highlights just how deep the rabbit hole goes.  Over $200 trillion, in fact.  This massive disconnect between expected spending (and entitlement receiving!) and lack of revenues will be addressed eventually, and likely the hard way.