There’s nothing like a bit of Middle East and North African violence to get the markets gurgling.

For the past six months the US market has straight-lined from 1,050 to 1,350 almost without taking breath.  That’s a 30% rise:

(Click to enlarge) Source: Google Finance

Central bank money-printing will do that to the stock market.

Since August, the US Federal Reserve has spent USD$431.3 billion buying US government bonds.  All of it done using freshly created electronic cash.

Why would that push stock prices higher?

A few reasons.  One is as bond holders sell bonds to the Federal Reserve some of the fresh cash is moved into the stock market where yields and capital growth are potentially higher.

Another reason is that traders and speculators are trying to pre-empt a future movement from bonds into equities.  As more money is created, traders foresee that this will filter into the economy – to improve company earnings – and will cause asset prices to rise.

Simple.

But the past week shows you that even central bank money-printing can’t stop the market from falling when investors panic.

If you look at the S&P500 volatility index (VIX) you can see investors have started to panic:

Source: Yahoo! Finance

Last night the VIX jumped 26%!

If you’re not familiar with it, to put it simply the VIX measures expected volatility in the US market.  It’s based on the price of call and put options.

You see, volatility is one of the price determinants of a call and put option.  If traders expect volatility to be higher sellers of an option will demand a bigger premium.  And if volatility is expected to be high, buyers of an option will expect to pay more because they see a greater chance of prices moving by a bigger margin.

In other words, if an options buyer believes a stock could move from $20 to $25 within the next month then they’ll pay a bigger premium for an options contract.

Whereas previously if the options buyer believed a stock would only move from $20 to $22 within the next month then they’d only be prepared to pay a lower premium – and the same goes for falling share prices.

The boffins at the Chicago Board of Options Exchange take this data, feed it into their super-computer and hey presto, out pops the VIX index.

If you don’t understand it, don’t worry.  All you need to know is the higher the index level the greater the expected market volatility.

A longer term view of the index will show you what I’m talking about.  As you can see on the chart below, the VIX index spiked above 80 in late 2008 as markets crashed:

Source: Yahoo! Finance

Today it is above 20, following the 26% move last night.

Now, it doesn’t necessarily mean the market will fall. It just means investors believe the market will be more volatile over the next thirty days.

And they’ve every reason to believe that.  Recently I wrote to you about the spread between West Texas Intermediate crude oil (the North American benchmark oil price) and the Brent crude oil price (the European benchmark oil price).

Historically WTI trades at a premium to Brent because WTI is the preferred oil for refiners.  But since the action started to kick-off in the Middle East and North Africa, Brent has taken off.

So that today Brent is trading at a USD$12 premium to WTI.  And that’s even with an 8.5% rally in the WTI contract last night!

Interestingly, crude has outperformed all other commodities.

Trading days like last night show you just what’s in the mind of investors.

In recent weeks, punters have loaded up on risky assets – small-cap stocks, base metals, and soft commodities.

They’ve mostly backed those assets because of the inflation trade – the central bank money-printing I’ve mentioned previously.

But when punters get scared… they get out.

Soft commodities, which have rallied hard, took a bath last night.  The Chicago Board of Trade (CBOT) wheat futures contract dropped 7% as it went limit-down.  Many futures contracts have a price breaker.  It means the price can’t move up (limit-up) or down (limit-down) by more than a certain amount.

In this case the wheat contract dropped by as much as the exchange would allow and therefore trading stopped.

The soybean contract took a beating too, falling over 5%, while corn was down 4%, cotton down 3.6% and rice down 3.3%.

This tells you punters have dropped off the broad inflation trade in favour of the oil supply risk trade.

And don’t forget, even though Libya only exports about 1.4 million barrels of oil per day, if this supply is cut or reduced, it will have an impact on oil prices – that’s why futures prices have jumped.

Normally, the difference between supply and demand is tiny.  Where supply is no more than a few hundred thousand barrels per day more than demand.

But take a look at the charts below to see what’s happened through 2010.

First the supply chart from the International Energy Agency (IEA):

Source: IEA

I’ve highlighted the most recent quarter and the 2010 average with a green box.

You’ll note the world supply for the last quarter was 88.2 million barrels per day.  And the average for 2010 was 87.3 million barrels per day.

Now look at the demand chart.  Again I’ve highlighted the most recent quarter and the 2010 average:

Source: IEA

The last quarter average demand was 88.9 million barrels per day and the average demand for 2010 was 87.7 million barrels per day.

If you do your sums you’ll figure out that demand exceeded supply for the first time since 2007.  In the last quarter by a whopping 700,000 barrels per day.

In other words, based on these averages, the market had to dip into reserves to keep up with demand.

And the last time demand exceeded supply we saw crude oil prices jump to nearly USD$150 a barrel.  Could we see a repeat?

Who knows, but if supply doesn’t pick up then there sure is a chance that the price could spike further, regardless of whether things hot up in North Africa and the Middle East.

And it’s the high commodity prices that create a problem for the Federal Reserve.  The more money it prints, the higher commodity prices will go.  But the higher commodity prices also increases costs for businesses and individuals.

That makes it harder for them to save.  And it makes it harder for businesses to take on more staff.  Plus it also means a greater proportion of income going towards energy costs rather than other items.

The upshot is the Federal Reserve needs to print even more money to try and prop up the economy, which… as you can guess means even higher commodity prices.

That’s how inflation harms the individual.  Because the individual is always the last to receive the inflated dollars – governments, bankers and vested interests get the cash first.  By the time individuals get their hands on the new cash, prices have already risen.

It’s why the so-called economic recovery is a sham.  Remove the monetary stimulus and the economy will fall in a heap.  Yet keeping the stimulus won’t help.

It only results in increasing further the living costs of individuals.  And increasing the costs for businesses.

Within the next few months the global economy will reach another potential turning point.  If the Fed believes its own spin about the recovery and stops printing money, the descent into a recession will soon follow.

Yet if the Fed continues to print money asset bubbles could blow out further, resulting in an even bigger recession (or even depression).

The fact is, it’s a lose-lose situation for the Fed whatever it does.

Regards,

Kris Sayce
for Money Morning Australia

“It finds that the IMF provided few clear warnings about the risks and vulnerabilities associated with the impending crisis before its outbreak.  The banner message was one of continued optimism after more than a decade of benign economic conditions and low macroeconomic volatility.  The IMF, in its bilateral surveillance of the United States and the United Kingdom, largely endorsed policies and financial practices that were seen as fostering rapid innovation and growth.  The belief that financial markets were fundamentally sound and that large financial institutions could weather any likely problem lessened the sense of urgency to address risks or to worry about possible severe adverse outcomes.  Surveillance also paid insufficient attention to risks of contagion or spillovers from a crisis in advanced economies.”

Those words come from the Independent Evaluation Office of the International Monetary Fund (IMF).

It’s contained in a report released a month ago titled, “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07”.

The report also states:

“The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink… a general mindset that a major financial crisis in large advanced economies was unlikely… Weak internal governance, lack of incentives to work across units and raise contrarian views… also played an important role, while political constraints may have also had some impact.”

Well that’s hardly surprising.  We could have told them that without writing a fifty-nine page report.

But despite the IMF’s failure to foresee the economic problems, in April 2009 the G20 agreed to give it even more money… to not see the next problem.

As the British Broadcasting Corporation (BBC) reported at the time:

“To help countries with troubled economies, the resources available to the International Monetary Fund (IMF) will be tripled to $750bn.”

So there’s the punishment for failing to alert the markets to the collapse of the global economy.  Have another $750 billion.  And keep up the good work… by not saying anything next time either.

Let’s be honest.  That’s what the IMF cash git is.  A payoff… hush money.

The last thing politicians and central bankers want is for an organisation they fund with taxpayers’ money, to point out flaws in the economy and banking system.

Because if it did, it would make it harder to justify their inflationary policies.

And it would also reveal the real solution.  The solution they don’t want anyone to know about – free banking.  Because with a free banking system, there’s no government interference, there are no central banks, and there’s no backstop or bailout for private retail banks.

Bankers would shudder at the thought.

Now, by free banking I don’t mean free bank accounts for everyone.  And I most certainly don’t mean a government operated “People’s Bank”.

That type of policy can only make the problem worse than it is.

No.  What’s needed is a competitive banking system.

A system that’s free from political and central bank manipulation.

A banking system that does little more than act as a warehouse for your savings.

One that provides financing to businesses and individuals without the need to fraudulently create money from thin air.

The only way this could happen is with less government intervention, not more.  So the chances of it happening without a major economic revolution are pretty slim.

The negative impact of government involvement in banking and the money supply is highlighted in Murray N. Rothbard’s excellent “A History of Money and Banking in the United States: The Colonial Era to World War II”.

You can buy the hardback copy on Amazon (as your editor did), or if you’ve got more sense you can click here and download it to an e-reader for nothing!

If only your editor had more sense!  But the hardback version is nice.

Anyhoo, we’ve only just started to tuck into it.  But already we’ve read a few treats that highlight the problems caused by government manipulation of the money supply.

Take this for starters.  It’s a perfect example of why even a government mandated national currency isn’t required.  As long as you’re using a currency that has real value:

“It is important to realize that gold and silver are international commodities, and that therefore, when not prohibited by government decree, foreign coins are perfectly capable of serving as standard moneys.  There is no need to have a national government monopolize the coinage, and indeed foreign gold and silver coins constituted much of the coinage in the United States until Congress outlawed the use of foreign coins in 1857.”

Article 1, Section 8 of the US Constitution even recognises foreign coins had an important part to play in the fledgling republic.  Although the framers of the Constitution undoubtedly made the mistake of giving the new Congress powers:

“To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures.”

But even more important is the historical proof that politicians and bankers always meddle with the value of money.  And they’ll always think they can get away with it.

It’s proof that today’s politicians and central bankers are doing nothing different to the wigged and powdered gentlemen of two centuries ago.  Read the following and see if it rings any bells – apologies in advance for the long extract:

“Massachusetts was accustomed to launching plunder expeditions against the prosperous French colony of Quebec.  Generally the expeditions were successful, and would return to Boston, sell their booty, and pay off the soldiers with the proceeds.  This time, however, the expedition was beaten back decisively, and the soldiers returned to Boston in ill humor, grumbling for their pay.  Discontented soldiers are ripe for mutiny, so the Massachusetts government looked around in concern for a way to pay the soldiers.  It tried to borrow £3,000-£4,000 from Boston merchants, but evidently the Massachusetts credit rating was not the best.  Finally, Massachusetts decided in December 1690 to print £7,000 in paper notes and to use them to pay the soldiers.  Suspecting that the public would not accept irredeemable paper, the government made a twofold pledge when it issued the notes: that it would redeem them in gold or silver out of tax revenue in a few years and that absolutely no further paper notes would be issued… The issue limit disappeared in a few months, and all the bills continued unredeemed for nearly 40 years.  As early as February 1691, the Massachusetts government proclaimed that its issue had fallen ‘far short’ and so it proceeded to emit £40,000 of new money to repay all of its outstanding debt, again pledging falsely that this would be the absolute final note issue.”

There you have it.  Hopefully you’ll agree it was worth it.

The upshot is that prices soared and the paper money became almost worthless.

But, as is always the case with inflation, not everyone loses out.  Those left holding the worthless bits of paper did poorly.  But, as Rothbard notes:

“[S]ince the paper was issued to finance government expenditures and pay public debts, the government, not the public, benefited from the fiat issue.”

In other words, the government was paying its bills with paper money it was deliberately devaluing.  The government was clearing the slate with creditors, but doing so with devalued paper money.

Reading through the long quote above, you should be able to draw plenty of parallels to US Federal Reserve chairman Ben Bernanke and his money-printing programme.

The promise to redeem the paper notes is broadly the same as the Fed’s current bond buying programme.  Investors who buy bonds from the US government have the safety net of knowing the Fed is standing ready to buy $600 billion worth of bonds with freshly printed money.

The trouble is, between buying the bonds from the government and getting paper money back from the Fed – redeeming the bonds, the value of those invested dollars has diminished… thanks to the creation of new dollars.

Once governments and central bankers get into a hole of issuing more debt and more new money to pay off old debt liabilities, it’s hard to get out.

That’s why they don’t bother trying.  Instead they dig deeper, hoping if they push the problem out further into the future someone else will deal with the it.

But, as Rothbard says, the decline into an inflationary blackhole doesn’t have to take long.  In a different attempt at a fiat currency, the US Congress began issuing paper money:

“The issue of this fiat ‘Continental’ paper rapidly escalated over the next few years.  Congress issued $6 million in 1775, $19 million in 1776, $13 million in 1777, $64 million in 1778, and $125 million in 1779.”

He goes on:

“The result was, as could be expected, a rapid price inflation in terms of the paper notes… By the spring of 1781, the Continentals were virtually worthless, exchanging on the market at 168 paper dollars to one dollar in specie.  This collapse of the Continental currency gave rise to the phrase, ‘not worth a Continental.’”

So, at the beginning of the US Revolution, the money supply was just $12 million.  Six years later it was over $225 million – about 90% of it backed by nothing more than a government promise that the paper money would retain its value.

As usual, the government broke its promise.  You would have needed 168 paper Continental dollars to get one silver dollar in return.  Yet just five years before the exchange rate was one-for-one.

If you’d held on to silver dollars during that time you would have been fine.

That’s how inflationary monetary policies change the value of the dollar in your pocket.  And it’s been going on in Australia and elsewhere for at least the last forty years.

And sadly the devaluation continues today.  Perhaps at a much faster pace than before thanks to US and European money-printing.

But that’s not all, unfunded government liabilities, especially in the US – but here too – will ensure governments and central bankers need to increase the money supply by many times over the next twenty years.

Not that they’ll blatantly admit it.  They’ll do it under the disguise of supporting economic growth and financial stability.  In reality it’s all about pushing the problem out to the future while at the same time destroying your wealth.

And of course, lining the pockets of the politicians and bankers who get their hands on the newly printed money first.

But not only that, the destruction of personal wealth has the feedback effect of making individuals even more reliant on government support.  Support that no government can afford.

The moral of the story is that protection of your assets and wealth is just as important as accumulating new assets and wealth.

Because every day central bankers and governments – despite their cozy exterior, [Ed note: cue tears Julia and Tony] – are working against you to destroy your wealth while lining their own pockets…

You’ve been warned, so do something about it and protect your wealth.
Regards,

Kris Sayce
for Money Morning Australia

Is the bond market finally catching on to the “forced risk” trade…?

AS NIALL FERGUSON never tires of reminding us, bond markets rarely react early to bad news, no matter how plain it looks to everyone else.

“In the years leading up to the First World War,” as the Harvard historian explained in 2006, for instance, “the London bond market – then the biggest in the world – appears to have become markedly less sensitive to international crises than it had been in the nineteenth century.” So despite much gnashing of teeth over the Russian/German/Yellow/Turkish threat to empire in the ever-xenophobic British press, the catastrophe of August 1914 still caught bond holders napping (holidaying in fact), oblivious to their imminent risk and the decades of negative real returns that lay ahead.

Similarly, in the 1970s, real yields – after accounting for inflation – consistently paid less than nothing, yet the bond-market sell-off only really began after nearly a decade of sub-zero returns. Bond holders again needed a lot of telling, in short. Which makes this month’s new Investment Outlook from Bill Gross – head of the world’s largest bond-fund manager, Pimco – signal.

“Central bankers have lowered the cost of money for 30 years now,” writes Gross, finally catching up with what us nutty gold bugs have long pointed out, “legitimately following global disinflationary forces downward, but also validating increased leverage [in the financial sector] via lower real interest rates.”

Today’s Fed promise of “low or negative real interest rate for an ‘extended period of time’ is the most devilish of all policy tools,” Gross goes on. Because “to rebalance debt loads and re-equitize financial institutions that should have known better, central banks and policymakers are taking money from one class of asset holders [savers and retirees] and giving it to another [bank bosses and the other finance croupiers].”

Negative real interest rates are nothing new, of course. As our chart shows, British cash savers have long suffered periodic bouts of sub-inflationary yields.

Absent the apparent noise of the first 125 years above, however – when real rates, denominated and paid in gold bullion of course, in fact averaged 3.8% per year – the last 140-odd years first rewarded cash savers, then whipped them wildly as the First World War  struck, and then denied them a balancing positive return to make up for their previous losses, right up until the start of the 1980s.

Paying the strongest real rates since the Great Depression, but without any hope of gold bullion to back its currency, the Bank of England – like the US Fed and German Bundesbank – finally got the inflation Gremlin back in the blender. Peace, general prosperity, and the “long boom” of ever-rising equity and bond prices ensued. Right up until those slowly declining real rates brought about a global financial bubble which demanded (or so policymakers believe) sub-zero real rates to fix its collapse.

What comes next? Bill Gross advises bond buyers to seek out positive real returns outside major-economy government bonds, basically recommending the “forced risk” trade which Japanese savers have long had to embrace. Other observers, fearing emerging-market volatility or default, might also want to consider hard assets. Because – and lacking all hard-money backing for currency – the common denominator between the last 10 years of rising gold prices and the inflationary 1970s remains miserable returns from other asset classes, most notably the negative real rate of interest paid to bank savings.

Here in the UK, for example, last month’s VAT tax increase, together with the zero returns still being offered to cash savers, have most likely taken the real return on bank deposits to new 30-year lows. The last time cash savings were losing value at this pace – worse than 4 pence in the Pound annualised – inflation stood at record peace-time levels, threatening to crush the economy. But the net effect today is just the same for retained wealth. With money under constant attack thanks to growth-at-any-cost policy, gold and silver are becoming increasingly attractive alternatives.

And for all the chatter about raising interest rates, seven of the nine policy-makers at January’s Bank of England meeting voted against hiking the base rate by even just 0.25%. Chief “hawk” Andrew Sentance will leave the committee in May, and with annual interest costs on the government’s debt set to double to £63 billion between 2010 and 2014 – and with a further £154bn of outstanding debt due for repayment by then as well – the political imperative for rates to stay low is clear, present and overwhelming. At the start of the ’80s, gross national debt was a fraction of today’s burden.

Bank depositors, in short, look set to continue paying for both the banking bail-out and the gently declining real rates of the last 3 decades which required it. Little wonder a growing number are opting out of official currency and national debt entirely, choosing industrial commodities and precious metals instead.

Adrian Ash

For Money Morning Australia
Adrian Ash is head of research at www.BullionVault.com

Hyperinflation is not simply inflation times 10. It’s most likely to strike – in fact – amidst a real deflation…

SO the FEDERAL RESERVE’s second-round of quantitative easing, announced on November 3rd, was a shoo-in – a fait accompli – already decided when the policy team first sat down the previous day.

How come? As the minutes released this week show, Brian Sack – manager of the New York Fed’s System Open Market Account (SOMA) – opened the meeting. And asked to judge the matter, he told the 64 other policy-wonks gathered in the Eccles Building that his team “could purchase additional longer-term Treasury securities at a pace of about $75 billion per month while avoiding disruptions in market functioning.”

Moreover, “implementing a sizable increase in the System’s holdings of Treasury securities most effectively likely would entail a temporary relaxation of the

35% per-issue limit on SOMA holdings under which the Desk had been operating.”

Hey presto! The following day, and after apparently intensive debate, a monthly target of $75 billion in Treasury bond purchases – plus a relaxation of the 35% limit on Fed holdings of any particular bond issue – was announced.

Does that make the Fed meeting a sham? No matter. “It’s not as if the Fed is doing anything radical,” says Princeton professor Paul Krugman. It’s simply looking “to boost the flow of economy-wide spending by changing the mix of privately-held assets,” agrees Berkeley professor Brad DeLong.

“It buys government bonds that pay interest in exchange for cash that does not. That is totally standard.”

But totally standard where, exactly?

Sure, buying and selling government debt in the open-market is how central banks control short-term interest rates. That’s why the Fed Funds rate is a target, and the actual outcome in the marketplace is instead known as the Effective Fed Funds. Bidding short-term bills higher (or lower) in price, the New York Fed thus pushes down (or up) the interest rate paid on those bills. But stuffing the market with money, in contrast, is a very different aim. Not least when you do it by buying longer-term bonds. And by only buying, rather than fine-tuning purchases with sales. And by doing it amid the heaviest net issuance of government debt in history. And by doing it so hard that, despite that record issuance, you still need to break your own limit on the proportion of any individual maturity-date you’re allowed to own.

So again, we ask here at BullionVault: Where in the world is such money creation “totally standard”…?

“I think using quantitative easing is a perfectly legitimate thing to do. And for heaven’s sakes, it’s not as if we’re in any danger of inflation any time soon.”

– White House advisor and former director of the Congressional Budget Office, Alice Rivlin, speaking to CNBC on 15 November 2010

“We have no ‘dangerous flood of paper’…On the contrary, our paper [money] circulation, though it shows a terrifying array of billions, is really not excessively high…”

– Vossische Zietung newspaper, 16 August 1922

“Several [Fed policy] participants saw a risk that a further increase in the size of the…monetary base could cause an undesirably large increase in inflation. However, it was noted that the Committee had in place tools that would enable it to remove policy accommodation quickly if necessary.”

– Federal Reserve minutes from 3 November 2010

“Even if the quantity of money were three times its present size, it would constitute no real obstacle to stabilization…”

– Berliner Börsener newspaper, 18 August 1922

Okay, so pasting a couple of quotes next to each other doesn’t mean the United States is headed straight for wheel-barrows and stormtroopers. Like everyone agrees, 1,000,000% inflation looks a long way off right now. But no central bank ever began a hyper-inflationary policy because it feared inflation. Such disasters always come because of vanished credit and economic depression. And whether in Germany nine decades ago, or in Argentina twenty years back, or in Robert Mugabe’s Zimbabwe around the turn of this century, stuff actually gets cheaper – not more expensive – in real terms during hyperinflation. It’s just that the local currency falls in value faster still, turning the “money illusion” we’re all prey to into a livid nightmare.

Hence the daily flood of French citizens across the border at Strasbourg each day during the early stages of the Weimar madness, emptying the stores with their highly-prized Francs. Hence the real-estate bargains snapped up by wily speculators during Argentina’s last-but-one collapse. Hence the zero-change in inflation – net net – for US Dollar earners during the early phase of Zimbabwe’s hyperinflation, followed by massive a deflation, in US Dollar terms, even as prices in the local currency soared.

On the ground, amidst these crises, it was monetary contraction – not soaring prices – that most worried policy-makers. “The lack of money [now] has a worse effect than the devaluation itself,” said one Berlin newspaper in summer 1922, as the Weimar Republic began to run the presses 24/7. “The government printed notes to satisfy everyone,” writes Adam Fergusson in his history of the disaster, When Money Dies, “telling itself that as the granting of credit…had so greatly decreased, the actual currency in circulation had to be so much greater.”

But let’s not get perverse. The latest flat-lining in America’s official Consumer Price Index does not mean that hyperinflation is in fact underway. The critical factors to watch out for remain a collapse in tax revenues, plus demands for immediate payment from foreign creditors. It bears repeating nevertheless, however, that – contrary to the worldview presented by academic economists and professional wonks – demand-push inflation is not how hyperinflation begins. Real values in fact fall as a genuine currency crisis takes hold.

And the fact that the Federal Reserve is so dead-set on its “emergency” response that it scarcely needs to meet to agree it, doesn’t mean the Fed actually knows what it’s doing.

Adrian Ash

For Money Morning Australia
Adrian Ash is head of research at www.BullionVault.com

It’s 9.03am as your editor begins writing today’s Money Morning.

The US market closed down nearly 2%. While major European indices closed down over 2%.

In China the CSI 300 index dropped 4.21%.

And the futures prices have the Aussie market opening lower by around 70 points. If it does, that would take the index back towards the 4,600 point level.

If you watch the hapless analysts and commentators on CNBC or Sky Business Channel today, they’re likely to talk about a bloodbath on the markets, or that the falling stock market is bad… if only it would always go up.

The reality – as you might expect – is much different.

You know how fond we are of illustrating things using fancy computer software, so we’ll do the same again today. Take a look at the following chart:

Source: Google Finance

It’s a forty-year chart of the Dow Jones Industrial Average. I’ve used the Dow simply because it’s the most recognisable of the major US indices. However, the shape of the broader S&P500 index is almost identical.

Now that you’ve seen the chart as a whole, we can break it down into sections. First, let’s look at the immediate aftermath of the Bretton Woods era:

Source: Google Finance

We’ll say this runs from the early 1970s to the early 1980s. You can see the market moves during this period more clearly in this close-up version below:

Source: Google Finance

During this period the Dow Jones index moved from around 800 points to as low as 600, before finishing this period above 1,000 points.

In other words, during the period of what has become known as stagflation, in the post-Bretton Woods era, stock markets gained about 20% over eleven years.

I mentioned stagflation recently. The general definition of stagflation, according to our pals at Wikipedia is:

“The situation when both the inflation rate and the unemployment rate are high. It is a difficult economic condition for a country, because then inflation and economic stagnation are occurring simultaneously…”

One of the causes of stagflation – so it’s claimed – was the oil shock, where high prices of oil caused prices to rise but also caused the economy to falter because businesses were unable to adjust to a sudden and unexpected increase in costs.

This caused companies to increase their prices, but at the same time made them reluctant to increase employment.

It’s not unrealistic to suggest that a similar thing is happening in the United States at the moment. While consumer prices haven’t gone through the roof, the increase in the money supply has caused prices to remain higher than they otherwise would be.

You only have to look at the price of commodities in US dollar terms to see how much commodities such as cotton and sugar have risen.

But back to the Seventies. Thanks to the end of Bretton Woods, the constraints on the money supply were lifted. Central banks could create more money, no longer having the requirement to hold gold in reserve.

And the retail banks could create more money as they only had to hold unbacked paper money in reserve. And considering the banks could effectively create their own reserves by lending more money, hey presto! More leverage, more money in the economy and therefore higher prices.

But while today’s problems all started in the Seventies, the inflation of asset prices didn’t really take hold in global economies until the 1980s. As you’ll see now in the following chart

Source: Google Finance

We’ll call this the period of Great Inflation. Here’s the close-up:

Source: Google Finance

During this period the Dow Jones increased more than ten-fold, from around 1,000 points to the dot-com high of around 12,000 points.

This was the golden age for Wall Street bankers. The increase in the money supply, the lack of discipline of a gold standard and the consequent innovations of financial engineers saw stock prices take off.

It was the biggest bull run in financial history.

And all that new money and leverage helped hoodwink Western consumers into believing that it was an age of new prosperity. Of course, it wasn’t though was it?

The new wealth, the bigger houses, the fancy cars and consumer goods were all bought on credit. Credit which some day would have to be repaid.

And here’s the thing. Early on the repayment of credit seems easy. As inflation takes hold incomes and asset prices go up, and therefore debt liabilities go down as inflation erodes the value of the debt.

Everyone seems to be a winner. To the extent that inflation becomes the consumers’ best friend, “Yeah, I’m not worried about debt, because after five years inflation will take care of it and I’ll be fine.”

The outcome is that this becomes a new form of personal financial management. Not only is debt good for you – the story goes – but the more the better. Hence the creation of asset price bubbles as we’ve seen in the recently popped Australian housing market.

We’ve warned you time and again not to fall for the ruse that inflation is good for you. That inflation will pay off your debts and you’ll be better off.

I’ve advised you to look no further than the experiences of people in Zimbabwe. They had hyperinflation. If normal inflation is a good way of paying off your debts then surely that means hyperinflation is even better, right?

Wrong.

How many Zimbabweans did you see jumping for joy that they’ve experienced hyperinflation? None… apart from Mugabe of course. How many Zimbabweans are now proud owners of houses that they’ve paid off thanks to hyperinflation?

None.

No, the reality is, if you’re leveraged to the hilt, when the crunch comes, the rate of interest and the cost of living will far exceed any supposed benefits (there are none) that you’ll get from inflation.

But, getting back to the Great Inflation, by the time the markets reached the year 2000, asset prices had peaked. Markets fell for the next three years as realisation set in that much of the new wealth was nothing more than, well, nothing.

That brings us to the next phase:

Source: Google Finance

We’ll call it the Great Reflation. Here’s the close-up:

Source: Google Finance

Rather than accepting that asset prices had been pushed unrealistically high, the mainstream was intent on finding the next excuse to reflate the market.

It didn’t take them long to find it – China.

From 2003 until late 2007 investors the world over came to the conclusion that demand from China would help take the market back where it belonged, to the heights of the dot-com boom.

Do you see a pattern emerging?

That’s right, it’s the craving for an asset bubble. Governments and central bankers and vested interest groups are in search of the perpetual boom.

They want stock markets and house prices to rise forever. In their world, “normal” is where the stock market was in 2000 and again in 2007. They want, at any cost, to do everything in their power to push markets back up there.

Whether they realise it or not, that ain’t normal.

Absent the meddling and interference from governments and central bankers, “normal” in stock market terms would see the Dow Jones closer to 2,000 points rather than 10,000.

But chaps like Ben S. Bernanke and his Keynesian pals don’t see it that way. They believe that the last thirty years has produced untold prosperity for the West.

And maybe it has – for some. But it’s all been achieved by borrowing from the future.

Prosperity in the 1980s and 1990s has been achieved by denying prosperity from those that will live through the 2010s and 2020s. Look no further than budget deficits and household debt for evidence of that.

What else can explain the shocking results from a survey by Rabo Bank, that according to The Age:

“One in 20 said they’d be forced to sell, with baby boomers under the most stress – 15 per cent of borrowers aged 50 to 65 years say they’d have to sell.”

Aren’t the baby boomers supposed to be the ones that have benefited the most from rising asset prices? How can 15% of them be in so much financial stress that they’ll have to sell their home if interest rates rise by another 1%?

They’re in this bother because they’ve fallen for the inflation trick hook, line and sinker. They’ve cashed in the on the increase in house prices, but thinking that they’re geniuses rather than lucky, they’ve leveraged up and bought an even bigger home and gone further into debt.

Just when they should be debt free, they’re lumbered with a whacking big mortgage going into retirement.

The Great Reflation is where we are right now. The US Federal Reserve wants markets to rise. It wants asset bubbles because asset bubbles make people feel rich, and if you feel rich you’re more likely to take on more debt.

And if you take on more debt, it prevents the banks from collapsing under the weight of dodgy and un-repayable loans. Furthermore, it postpones for a while longer the inevitable crash that will herald the next Great Depression.

Make no mistake. Governments and central bankers are doing everything they can right now to entice you into taking on more debt to help create the next asset bubble.

If you join in on their disastrous game then good luck to, just be aware that it won’t last. The last ten years have shown you how the attempts to inflate a bubble and keep it inflated have failed.

There is absolutely no reason whatsoever to believe that they will be successful in keeping current bubbles inflated.

Perhaps markets can go higher from here – although we’re not entirely convinced, hence why we’ve only got three stocks in the Australian Small-Cap Investigator portfolio – but like all asset inflation attempts previously, this one will succumb to the weight of excessive leverage and bad investments too.

The fact is, in order to pay back the excessive inflationary induced gains of the 1980s and 1990s, stock markets and other asset prices need to fall. And they need to be allowed to fall, rather than being propped up by government and central bank intervention.

Only when bad investments and bad money is purged from the global economy can markets and economies return to any kind of normal and sustainable growth.

Until that happens you’ll continue to see periods of asset price bubbles followed by even more rapid asset price pops.

Eventually those in control of pulling the levers will understand that it’s their actions which are causing all the problems. Perhaps then they’ll learn to leave things well alone and let the free market determine the price of money and the price of assets.

Understand that this is a very high risk market. Don’t fall for the mainstream view that economies will get through it in good shape, because they won’t.

Cheers.

Kris Sayce
For Money Morning Australia

PS. It’s 10.50am as we type those last few words and the Aussie market is down 66 points at 4,634.

“There is too little money in the economy.”
– Bank of England governor Mervyn King, 19 October 2010

SO the FEDERAL RESERVE is dead-set on creating inflation, and it’s plain to see why.

Household debt in the US now stands so large, paying it down to 2001 levels – as a proportion of income – would require a drop in consumer spending of $2.7 trillion, some 18% of this year’s gross domestic product. Deleveraging to 1990 levels of gearing (again, a then-record at the time) would cost US households $3.5 trillion, well over a quarter of their 2010 incomes.

It ain’t gonna happen, in other words. Not this side of Paul Krugman joining John Maynard Keynes in that eternal “long run” in the sky. So what’s needed, or so the theory runs, is inflation in prices. It would make deleveraging very much easier, as happened during the last retrenchment, back in the early 1980s. Consumers got to pay down debt without…well, without paying it down! And that gave households enough confidence (and rope) to start expanding their debts again.

Y’know, like the corporate sector is already doing today…

“We do have to wonder just what sort of ‘liquidity trap’ we are in – a state of paralysis where only cash will do, remember – when US (indeed, global) high-yield [debt] issuance hits its highest on record, as it did this past quarter,” writes Sean Corrigan of Diapason Commodities at the Cobden Centre.

“We also wonder just what sort of ‘liquidity trap’ we are in when equity IPOs increase 55% in value and 215% in number from the same period in 2009.

“We further wonder just what sort of ‘liquidity trap’ we are in when US-based [mergers and acquisition] rises 22% year-on-year, with private-equity involvement up 117% to a two-and-a-half-year high and, as such, [is] responsible for more than 10% of all deals.

“We wonder, too, just what sort of ‘liquidity trap’ we are in when the number of ETFs grows 22%, their assets rise 14%, and trading volumes jump 15% in the first nine months of the year.”

But while all the money spat out since late 2008 by the Federal Reserve and its friends in London, Tokyo, Frankfurt and Zurich has indeed found a home – and a home where it’s got busy with multiplication, too – it hasn’t yet reached the “economy”. Not the “economy” that you, me and Mervyn King at the Bank of England think of when we use the word – meaning our neighbors’ pockets.

Because although central banks can raise asset prices, as well as the cost of living, by nakedly slashing the value of cash…and even though they can do it with greater success than the Japanese beta-test of 2001-2006 – when the Nikkei-225 just about got back to break-even, rather than adding two-thirds as the S&P 500 has done since early 2009…they have yet to reverse unemployment or raise household incomes. So even with debt falling in real terms, households lack the inflated incomes they need to take advantage.

Yes, Washington’s official Consumer Price Index may indeed be a joke, just like today’s near-zero reading of inflation. Yes, the US Bureau of Labor Statistics itself admits that, if international standards are applied, CPI rose 1.9% in the year-to-Sept., rather than the 1.1% headline reported. And yes, John Williams’ Shadowstats puts the true rate of US inflation some four times higher again, way up at 8% per year, simply by applying the methodology used by Washington back in 1980.

But inflation in prices is only making things worse for consumers, not better, because inflation in wages is entirely absent. That’s unlikely to change with unemployment running at either 10% (official), 17% (the old U-6 measure) or perhaps 22% (Shadowstats, again). The top of the debt cycle – now three years since – therefore remains structural, because households cannot and will not raise their borrowing.

The recent past – and likely future – of the US economy, therefore, really is another country. Japan, in fact, as this chart from PragCap so neatly shows…

Looking ahead, Step #1, we guess from here, is that the Fed keeps pumping money into the banks – and thus commodities and financial markets – until inflation on the official CPI finally shows up. Or hyperinflation. Or a hot war with China. Or a sweeping Democrat victory in Utah. Whichever happens first. Let’s call it the “Krugman Trap” – the belief that, when an idiotic policy fails, it must be applied again, but raised to the power of, say, the number of idiotic things you can say in one column for the New York Times.

Step #2 – once that fails to work, again – will see the Fed stop buying Treasury bonds, and try instead to jivvy up corporate spending and bank lending by buying commercial debt, equity funds, or even real-estate investment trusts direct. Never mind that debt issuance and equity prices have had all the help they might need; it’s what Japan is about to try, 20 years after its bubble blew. Why not steal a march on Tokyo, and apply its latest ideas right now?

“With growth in private final demand having so far proved relatively modest, overall economic growth has been proceeding at a pace that is less vigorous than we would like,” said the Fed chairman in his recent speech, Monetary Policy in a Low-Inflation Environment. “In particular, consumer spending has been inhibited by the painfully slow recovery in the labor market, which has restrained growth in wage income.”

If only inflation in prices would spark inflation in wages – or consumers just did what they should and got back to borrowing and spending – then the recovery would be upon us! Even though, as noted above, the household sector in aggregate has lost all appetite for extending its debts without retrenching first. So finally, and unless sanity breaks out at the next Jackson Hole summit of central bankers…and barring the intervention of hyperinflation, a hot war with China, or the Democrats winning Utah…we move to Step #3 – outright gifts of cash to US households, personally delivered by the Fed chairman in a Santa outfit, if not buried in disused coalmines.

Because that’s what it will take to get US households spending more than they earn again any time soon. And it’s a trick the Bank of Japan has yet to try…so hey! It might just work!

“In reality,” writes Nomura economist Richard Koo in his 2008 book, The Holy Grail of Macroeconomics, “borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession. If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something. But when there are no borrowers the bank is powerless.”

You can lead a horse to water, and drown the bloody thing if you want. But you can’t make people borrow when they’ve barely begun to pay down the greatest credit bubble in history. The problem for retained wealth, therefore, is trying to second-guess what Dr.Ben’s patented deflation cure – the one he urged on Japan’s central bankers around a decade ago – will do to your money.

Adrian Ash
BullionVault

Why this really isn’t the early ’80s recession replayed…

WHATEVER the problem is, a lack of money it ain’t. Just so we’re clear. Quite how more money might help, therefore, we can’t say.

Still, that won’t stop the world’s No.1 central bank from creating yet more of the stuff. Not according to Ben Bernanke last week, nor to anyone listening or watching the Federal Reserve since America came round from his first stab at money-creation.

Instead of punching adrenaline through the chest wall again, Dr.Ben’s more likely this time to put up a drip (so analysts think), flushing $100 billion or so into the system each month, and reviewing America’s vital signs before changing the bag every quarter. Either way, the problem for retained wealth – meaning your savings and pension…if not (just yet) the money you hold from pay-day to month’s end – is trying to second-guess what Dr.Ben’s patented deflation cure will do when there’s no money-deflation to cure.

Sure, the Fed can create money. But it can’t create credit (from the Latin credere, “to trust, have faith”). And it sure as hell can’t let America’s outstanding debts – both private and public – simply get written off now, neither at home nor abroad. Not after all that crashing and banging in ER from 2007-09.

So never mind the record-large cash pile sitting at non-financial corporates. Never mind that their problem is too much debt, not the $1.8 trillion in cash they’ve already got. Never mind the 50-fold growth since 2007 to $1 trillion in US banks’ cash holdings either. Again, debt is their problem – not a lack of money – but it doesn’t matter. New money is the only fix Dr.Ben now has to hand (he’s all out of interest-rate cuts). So those foreign reserves, US corporates and domestic banks already drowning in money will get flooded with more.

This, if it weren’t for America’s debts, would surely mean runaway inflation in prices. But as there is all that debt, gnawing away on every spending decision. Hell, even US households have been re-building their cash savings…tucking away a total of $6.3 trillion by end-June, over a quarter more than they held in deposit and checking in 2005. But even after paying down debt at a record pace (2.2% annually during the April-June quarter), that still leaves a near-record volume of household debt outstanding ($13.5 trillion) with consumer leverage also squatting near historical highs – only just shy of the pre-crisis peak.

To date, the retrenchment in gearing-to-income also lags the pace of retrenchment during the early ’80s, although it is approaching a similar proportion…

Still, a lot continues to separate today’s retrenchment in household leverage from the retrenchment of 30 years ago…

• US households now carry twice as much debt – compared to income – as they did in the early ’80s. Maybe that kind of gearing is perfectly manageable…but maybe the peak of 2006 and 2007 marked an impossibility instead. Either way, today’s leverage remains much nearer the top than the pre-credit-boom levels of a decade ago;
• That bellwether of hope and growth, the stock market, sank to true fire-sale prices in the early ’80s…whereas the S&P index now trades above 20 times earning, rather than the middling single digits;
• Interest rates, on the other hand, are now are record lows (as in zip – or ZIRP, depending on whether or not you’re an economics professor)…whereas then, at the start of the ’80s, they were at record highs;
• Domestic devaluation of the Dollar – a.k.a. inflation – stands just to the right of zero. Three decades ago, consumer-price inflation was coming off peace-time records.

That last point is the clincher, of course. Because where America’s outstanding household debt has actually fallen this time around ($13.45 trillion from $13.84trn), it continued to grow at the start of the ’80s ($1.576trn from $1.276trn), even as leverage fell between 1979 and 1982. Inflation in both prices and income did the heavy lifting back then. It’s buckled, in contrast, since 2007.

Over the three years to end-1982, inflation ate nearly quarter of the debt which US households already owed at the start of that period. It would need to average more than 8% per year to achieve the same feat in three years today. But instead, the official Consumer Price Index rose by little more than 1.3% last month from Sept. ’09.

Even if inflation had been stronger, US households would still have needed stronger wage growth to get any benefit. From 1979-1982, personal incomes rose by 34% in nominal dollars, resulting in a real pay rise of 5.6%. Added to the impact of inflation on the burden of outstanding debt, that enabled consumers to expand their nominal borrowings by nearly one third while still cutting their gearing-to-income from 62% to 57%. Today, in contrast, US personal incomes (handily annualized by the BEA’s latest quarterly stats) have risen just 4.7% since 2007 – a mere 0.7% ahead of inflation (again, on the official CPI measure, and yes, still with three months of the year to run). So the current delevering has had to come almost entirely from paying down debt.

This, in short, is not the early ’80s recession replayed (y’know, the one when gold, oil, stocks and bonds all sank together), much less the 1990-92 recession or 2001 slowdown. (Consumer leverage leapt as the Tech Stock Bubble collapsed; what kind of “recession” was that?) The slump of the last three years (and counting) benefits from neither inflation or wage growth. Debts must either be paid down from static incomes, or be written off by forgiving lenders. Devaluation isn’t coming to help. Not yet at least.

But hey, that’s why they invented the Fed, right?

Part II to follow…

Adrian Ash
For Money Morning Australia

Adrian Ash is head of research at www.BullionVault.com

A few things are swirling about in our brain this morning, so let’s see what gushes out as we tip our head to the side…

We’ve been writing to you for some time about the impending threat of mass inflation. Inflation that could push you to the brink of poverty – unless you’re prepared for it.

Already you’re seeing inflationary pressures and increased risk taking push many commodities to all-time or multi-year highs.

For instance, in the September issue of Diggers & Drillers, Dr. Alex Cowie wrote:

“Since looking at the tin market last month, the speed of tin’s price rise has surprised me. In that time it has soared around 20% from $19,845, to recently hit $23,591. It has already been the best performing commodity for most of this year.”

The Stock Doc went on to say:

“The most extreme forecast had the tin price averaging around $25,000 during 2011. However, at the current rate we should hit $25,000 by next month!”

The Doc was wrong.

Tin hit $25,000 during the same month, and today it’s trading at an amazing $26,395! As you can see on the chart below from the London Metals Exchange:

But as I say, tin isn’t the only commodity to do nicely. Silver has soared to above USD$22 an ounce. And is trading at levels not seen since the Hunt brothers tried to corner the silver market thirty years ago:

Can it achieve the USD$50 level it hit back in 1980? Perhaps.

But what really got us thinking is what if the big inflation that we fear has already happened?

You may have seen the chart below before:

In a nutshell it shows you the increase in the money supply since around 1960. It has increased from – we’ll say – USD$250 billion, to a touch under USD$10 trillion today.

Most of the increase you’ll note, has occurred since the 1980s.

The point is, with the curve as steep as it is now, in order for the US Federal Reserve to try and engineer the kind of economic growth rates it wants, it will have to continue steepening that curve.

That would mean, over the next year or so, the US Fed would need to double the money supply. Is that likely?

Well, it’s not impossible. Look at the chart again. Between 2001 and 2008 the Money Stock doubled. Why shouldn’t that happen again?

And if you look at the next chart, you may be able to figure out why the central banks are so keen to get banks’ lending again:

There’s a remarkable similarity between the increase in the supply of money and the amount of credit made available by commercial banks.

The more the central bank prints the more the banks create through credit.

Here’s the increase in consumer credit over the same period:

And finally, to see how the boom in credit has fed through to the US economy, here’s the GDP numbers:

You could take each one of those charts, overlay them on the same chart and you’d barely be able to spot the difference between them.

It should be all the evidence you need to prove that the boom years from the 1970s onwards have been just that – boom years. Boom years supported by ever-increasing amounts of money creation and credit. The trouble is, it’s a boom that will ultimately lead to a bust.

And it’s that period we’ve got to look forward to next.

But before that happens, there’s the present. There’s the final inflationary boost to prices that should naturally follow the inflationary boost in money. It’s already been going on for some time, but it could be about to reach a frenzy.

As investors anticipate more money printing by central banks the demand for real hard assets is growing. Growing to the extent that gold, silver and even copper and tin are all approaching multi-period highs.

Right now, as we see it, there are two outcomes to this sorry mess…

First is that the money printers will get their way. They’ll cause a massive blow-out in the money supply leading to massive inflation. And crucially for you, the exportation of that inflation from the US to other economies – including Australia.

That would see the charts above receive another boost as more money is flushed into the market.

Commodity prices would soar even higher. And stocks would reach new highs too. For a time the boom would seem to be delivering untold wealth. But then…

Thump! Now, the next phase will happen regardless of whether there is another monetary stimulus from the central bankers or not.

It’s the inevitable conclusion. The timing of it just depends on whether the bankers try and stretch things out a little longer.

Let me explain. One of the things that’s been pushing the yield on bonds to such low levels is the expectation by the market that the Fed will keep buying bonds.

It’s resulted in nothing more than an attempt at manufacturing a risk-free arbitrage trade.

To fill you in on what that means, in the truest sense arbitrage is where you trade the same instrument on two different markets and are able to profit from a price discrepancy in one market versus the other.

For example BHP Billiton could be trading at $40 on the Australian market and USD$44 on the US market. If you can simultaneously buy at $40 here and sell at the equivalent of $44 in the US, providing you can deliver your stock to the US market, and minus all transaction costs, you could lock in a risk-free profit.

Such a trade is 99.9% risk free. All the trader has to do is ensure they can settle the trades across the two markets and it’s money in the bag. That’s not usually a problem for the big institutions that do this sort of thing all the time.

However, the arbitrage term has been bastardised somewhat to mean other trades which aren’t really risk free. The term is now generally used to describe a trade that’s risk free in the current conditions of the day. In other words, providing this continues to happen then the profits are assured.

The problem arises when “this” no longer happens. Because it’s not a genuine risk free arbitrage then losses can be huge as the trade breaks down. Especially if the investor has leveraged their position to maximise potential gains.

Right now traders are convinced the Federal Reserve is going to continue buying up US treasuries on the market. And so far they’ve been proved right.

Check out the Federal Reserve Bank of New York (FRBNY) website for yourself. You can see the list of transactions made by the FRBNY as it buys government securities on the market:

And that’s just three of the transactions – totalling over USD$9 billion worth of securities.

According to the website, the FRBNY has made thirteen such “operations” alone since the start of September for over USD$34 billion.

You can see from the numbers above that in the case of Operation 1, the Bank bought USD$2 billion worth of securities out of USD$25 billion submitted by traders.

For now traders still seem happy to bid up the price of treasuries (lowering the yield) in order to take a punt on the odds that the Fed will continue to keep buying them at a higher price.

And why would the Fed stop? Its actions have been the single biggest help in getting interest rates down. The more the Fed buys the lower the interest rate the US Treasury can offer on new issues of debt.

But there’s the problem. Markets are all about trying to figure out what’s going to happen in the future.

When you buy shares you buy them on the chance that the company will make a bigger profit next year than it did last year. The person selling the shares to you usually has the opposite viewpoint.

So, when more investors believe profits will be higher in the future, that’s when share prices go up. When more investors believe profits will be lower in the future then share prices will fall.

At the moment, investors are taking a punt that the Fed will keep buying US treasuries. They’re punting on the chance that even if they buy new treasuries issued by the government at a crazily high price (and low yield) that’s OK, because the Fed will always be a buyer because it wants to help push interest rates even lower.

It’s the greater fool theory again. That there will always be someone prepared to buy from you at a higher price than you paid. The bonus here is that the buyer is known to everyone – and so is its motive.

However, as we know, an exponential increase in anything can’t continue forever. At some point it breaks down as it becomes impossible to maintain the growth rate required.

It’s true for the stock market, for house prices, for population growth, and it’s certainly true for bond prices and money printing.

The only remaining unknown to this is how long the central banks can keep it going until investors stop playing. Unfortunately, that’s anyone’s guess right now. And to be honest, your editor certainly doesn’t have the answer.

But for the time being, as a way of hedging against inflationary money expansion, and profiting from the current commodities price boom, we find ourself agreeing with the Stock Doc who wrote this about tin in his latest newsletter:

“This forecast expects the shortage in the [tin] market to get rapidly worse, sending prices up by around 75% to as high as $40,000 by 2012. Considering we are so far ahead already, we may even see these prices as soon as next year.”

It takes a brave investor to jump onboard an already surging market, but if you know the risks then the rewards can be immense.

Remember, the exponential growth in commodity prices won’t last forever either – whether it’s tin, copper or gold – but as long as central banks are printing money, the demand for hard assets will continue, and prices will rise.

But as a word of warning – Just make sure you’ve got an exit plan, because one thing is for sure, eventually the boom will turn towards a bust.

Cheers.
Kris Sayce
For Money Morning Australia

Oh dear, it looks as though The Age has uncovered more problems for the crooks at the Reserve Bank of Australia’s money-printing firm, Securency.

You know we give the mainstream press a hard time of it on most days, but sometimes they do pay their way.

That’s in contrast to today’s Australian Financial Review for instance. Reading it was three minutes of your editor’s life that we’ll never get back. It was a yawn from start to, well, page twenty-six… that’s when we gave up and threw it to Diggers & Drillers editor, Dr. Alex Cowie.

Quick as a flash, like a Kobe Bryant clone, the Stock Doc deposited the woeful “newspaper” off the backboard (the wall) and into the basket (recycling box).

On the other hand, the article in the online version of The Age – “Global raids target Reserve Bank firm” – was worth every penny we didn’t pay for it.

According to the article:

“The Reserve Bank is reeling after federal police and overseas agencies launched global raids last night to uncover evidence of corruption and bribery involving Securency, the RBA subsidiary that makes banknotes.”

Oops! But that’s not all, the article goes on:

“The Reserve Bank, which has appointed half of the Securency board to oversee the firm since 1996, has been accused by former Securency employees and business experts of ignoring warning signs that the firm may be engaged in corruption.”

Double oops!

We mentioned this story in Monday’s Money Morning. Incidentally, here’s a note to the mainstream press. Do you see how easy it is to reference an article using the new-fangled interweb?

You find something, you read it, you decide it’s useful, and so therefore when you report on it you give proper and due credit to those that initially reported it. It’s called referencing. And it’s not difficult.

Yeah, you’re right, we do still have an issue with the fact that your editor picked up on the dodgy numbers in the Commonwealth Bank of Australia property presentation yet none of the mainstream reporters who picked up on our scoop had the manners or the integrity to reference Money Morning.

Instead they used patronising terminology such as, “there’s been a buzz in the blogosphere…” No wonder the traditional press is on its last legs.

Anyway, enough of the self-indulgence. Back to the point…

It still amuses us that the mainstream can’t see the fact that all paper money is effectively counterfeit.

There’s nothing backing it. It just rolls off the press on demand.

And because of that you get inflation. Or, to put it another way, your money is devalued. I’ve already covered some of this ground this week, but I thought visualising the effects of inflation might be useful to you. Take a look at the chart below:

The chart shows you the impact of inflation on the value of $100 over one hundred years.

You’ll be aware that part of the RBAs recently reaffirmed mandate is:

“Keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle.”

The chart above shows you the effect of a 2%-3% inflation rate. The inverse of inflation is the devaluation of the currency.

The red line reflects a 2% devaluation of the currency, while the blue line reflects a 3% devaluation.

In other words, $100 in your pocket today will only be worth the equivalent of $68 or $56 respectively in twenty years. In fifty years it will be worth just $37 or $22.

It doesn’t make sense does it? It doesn’t make sense that a mandated goal of an organisation whose other objective is to maintain “price stability” should pursue policies that are, erm, the exact opposite to stable pricing.

Funnily enough, you won’t see too many inflation-lovers reproduce the chart that I’ve shown you above. We wonder why? Probably because graphically illustrating how inflation and central banks destroy wealth is the last thing they’d want to admit to – even though they know it’s true.

Their preference is to show you the other side of the coin. The side of the coin that makes you think you’re growing wealthier. The chart below shows you what I mean:

Pretty dramatic isn’t it?

The green line shows that a $100 asset held today would be “worth” over $700 in a hundred years if it increased in line with a constant 2% inflation.

Yet, as you can see from the red line, the purchasing power of that $700 is now only worth the same as the $100 at the beginning. The $700 would only buy you the same as what $13 would have bought you one hundred years before.

It’s the wealth illusion.

You can perhaps see the point clearer if we use a logarithmic chart:

No wealth increase at all, despite the asset price increasing by 600%! Simply because the purchasing power of the increased asset value is worth 87% less.

Your assets have increased but the money they are priced in has decreased.

It’s no wonder Australia’s old timers are finding themselves going into debt in their autumn years.

Money Morning reader Tarquin (I’ve changed the name to preserve his anonymity) sent us details of a government programme called the Pension Loan Scheme.

Apparently, it seems, it has been around for years. We’d never heard of it though.

According to the blurb:

“The Pension Loans Scheme (PLS) is a voluntary arrangement which provides support in the form of a loan for a short time or an indefinite period. It is available through Centrelink and allows people of Age Pension age… with capital tied up in real estate to convert the real estate into fortnightly payments by claiming a top-up of their current pension entitlement as a loan.”

It is, we gather, a government version of the reverse mortgages offered by banks and finance companies.

But if nothing else, it gives the government another reason to try and keep the housing market propped up.

Considering it not only gives away free money to youngsters by encouraging them to go into debt to keep house prices pumped up, the government also has a direct equity interest in making sure house prices don’t fall by encouraging the oldsters to go into debt too.

It’s a government stitch up at both ends of the scale.

I mean, is there anything else the government wants to get its dirty fingers involved in? Cheeseburgers perhaps – cue another gratuitous photo of your editor eating a cheeseburger, this time in Maryland:

You would have thought the old timers would be better off selling up and buying something smaller.

But that’s a problem too. Downgrading to a smaller place in the same area you’ve lived all your life doesn’t necessarily result in much of a saving.

And the alternative of moving into rental accommodation isn’t always the ideal move for someone used to living in their own home for forty or fifty years.

Instead, thanks to the effects of inflation, and the fact that many retirees haven’t been able to build up savings, means the oldies are going back into debt probably not long after they’ve finally paid off the mortgage.

But even if you look at the example given in the Centrelink brochure, you have to wonder whether even relying on the so-called home equity will be much help anyway.

Here’s the example:

“Tim has a property valued at $510,000 which he offers as security for his loan. As he wants to be sure that he has the flexibility to move into a retirement village when the need arises, he nominates a guaranteed amount of $285,000 for that purpose. His eligibility for payments under the PLS is based on $225,000, the value of his property less the guaranteed amount.”

Which seems fine. But then you do the maths. In order for the old timer not to exceed $225,000 the annual income can’t exceed around $4,200. Which, over the thirty years would add up to $126,000…

Because don’t forget, there’s interest to be added at the rate of 5.25%. That means total interest payments over thirty years would be around $102,000. And, not forgetting that as the old timer gets older, unlike with a conventional mortgage, the more he or she receives through the PLS, the greater the interest bill.

So by the thirtieth year of retirement – all else being equal – the old timer is getting an annual income of $4,200 from the home but is paying $6,615 in interest!

Unless of course house prices continue to rise and the oldie can increase the withdrawal and also increase their interest repayments – just to keep up with inflation!

What a con job. This is supposedly how governments look after you in retirement. They tax you your whole life so you can’t afford to save, yet when you’re due to collect on the money the government has supposedly been saving for you, you end up with a pittance plus being in hock to the government with a whacking big interest bearing debt.

It used to be that you’d save for a rainy day. That you’d tuck money aside for the future, when you might need it.

That’s no longer the case. These days, thanks to inflation and government meddling, you now have to prepare yourself to go into debt for a rainy day. You’ve got to make sure that credit history is clean all the way through to and into retirement.

As you know, we always encourage you never to trust the government. Quite frankly, that’s never been truer than when it comes to saving for retirement. Because if you think the government will support you, it will, but only if you’re prepared to put yourself into hock.

Cheers.
Kris Sayce
For Money Morning Australia

It was interest rate bingo yesterday. But the only person shouting “House” was our new pal, Comsec’s Craig James.

You’ll remember that Mr. James made the argument that higher interest rates were already working to slow down the economy. That any further rate increase was unnecessary.

Well, at 2.30pm yesterday Mr. James stood up with a complete card as the Reserve Bank of Australia (RBA) left the interest rate exactly where it was. Sherries and blue-rinses all round.

Frankly, the whole RBA interest rate circus is a joke. There’s even some chitter-chatter going around suggesting the RBA deliberately misinformed News Ltd’s Terry McCrann just so it could stuff up Mr. McCrann’s perfect prediction record.

I mean, seriously, what are these clowns playing at? A bunch of pinstriped numpties sat in an office in Martin Place, manipulating interest rates and currency markets and playing little games with the media at their whim.

But really, what the RBA does is just a sideshow. Because what everyone wants to see is going on in the Big Top.

That’s where the mother of all freak shows is taking place. It’s so hideous and disturbing that it’s impossible not to watch it.

But before I explain exactly what’s happened and why you’re potentially living through a momentous occasion, I’ll ask you one question – Have you bought any gold yet?

If you have, well done. Your insurance policy against the madness of central bankers is nicely in place.

If you answered no, then you need to answer this one – why the heck not?

If you’ve got life insurance, home insurance and car insurance, then there’s absolutely no reason why you shouldn’t have monetary insurance in the form of gold or silver.

Because believe me, if the inflationary Armageddon plays out as I believe it will, you’ll need all the gold you can get.

But look, it’s not just gold that’s taking off. Take a look at any hard or soft asset and you’ll see a similar picture. Here’s a few examples:

[Reader's voice: no more puns please!]

In fact, the only hard asset that doesn’t seem to be going up is Australian house prices:

So much for housing being a hedge against inflation!

Of course, one reason that housing isn’t a suitable hedge against inflation is because even though the price of housing may rise, the cost of servicing the house also rises.

It’s for that very same reason that you won’t see too many millionaire farmers as a result of rising grain prices. Sure, the price of sugar and live cattle is higher, but the cost of producing the sugar and live cattle is also higher.

That’s why gold – and silver – make the grade as pretty good hedges against inflation and political meddling whereas other hard and soft assets don’t.

Yes, production costs can increase for gold, but as a holder of physical gold that’s not your concern. And unlike the holder of physical grains, gold isn’t perishable. And unlike the owner of a house, gold doesn’t cost much – if anything – to maintain it.

It just sits there like a great big fat lump. Although saying that, a big fat lump needs feeding, whereas gold doesn’t.

Anyway, I’m going to move away from gold here, because I’ll have more to say on the subject this afternoon. That’s right, this afternoon you’ll receive a special message that I want you to pay close attention to – especially if you live in the Sydney area.

But even if you don’t live in Sydney, keep an eye on your inbox for an important update…

Until then, back to the meddling by central bankers.

Last night US markets took off. The Dow Jones Industrial Average was up 1.8%, the S&P 500 gained 2.09%, and the Nasdaq added 2.36%.

Why? Do you really need to ask?

Central bank meddling of course.

As Bloomberg News reports:

“BOJ May Have Fired First Shot in New Round of Global Action”

It has fired a shot alright. A shot right to the heart of individuals everywhere. Unless we’re mistaken – which of course we could be – the great inflation is in full flight.

According to the press release from the Bank of Japan (BOJ), titled “Comprehensive Monetary Easing”:

“The Bank will maintain the virtually zero interest rate policy until it judges… that price stability is in sight…”

It also states – and this is where it gets really good:

“The Bank will examine establishing, as a temporary measure, a program on its balance sheet to purchase various financial assets, such as government securities, commercial paper (CP), corporate bonds, exchange traded funds (ETF), and Japan real estate investment trusts (J-REITs)…”

To us it looks like the BOJ is intent on buying up everything. We’re surprised they haven’t added cheeseburgers to the list – cue gratuitous photo of your editor eating a cheeseburger at a bar in Massachusetts:

The steps which central bankers are taking to destroy the wealth of individuals is extraordinary. So extraordinary that in your editor’s opinion it has crossed the line into being a crime against humanity.

We’re not joking either. These fools are intent on pushing individuals into poverty just to save the bacon of their buddies in government and in the banks.

And the amazing thing is, the BOJ, like the other central banks makes no secret about what it’s trying to do. The BOJ press release states:

“[T]he Bank will encourage the decline in longer-term interest rates and various risk premiums to further enhance monetary easing.”

In other words it’s implementing the same policies as the US Federal Reserve. Reducing interest rates across the yield curve in order to force investors to take bigger risks and to encourage people to spend rather than save.

It’s economic piracy no less. Plundering the wealth of those that have earned it in order to give it to those that will waste it – governments.

Because make no mistake, don’t fall for the idea that the central bankers don’t know what they’re doing. Because they know exactly what they’re doing.

You see, inflation is great for governments, central bankers and retail bankers, because typically they’re the ones who get their hands on the newly created money first.

They get it before the increased money supply has worked its way through the economy. The key for them is to spend it as quickly as possible. The quicker it’s spent, the bigger the bang they’ll get for their buck – or yen.

And for the banks it means writing as many new loans as possible every year. Because the longer a loan lasts the less valuable it becomes as inflation eats away at it. That’s why banks get so nervous when lending drops.

It’s important they keep stuffing new loans into the hopper in order to keep the Ponzi scheme going.

But for you as the average Jo Citizen, you don’t get the privilege of early access to the newly created money. The average punter on the street is usually the last to get hold of this new money.

By the time you get it, it’s already found its way through the economy and forced prices higher than they otherwise would have been. By the time you get the money it’s already worth less than the face value.

And even worse, thanks to the increased supply of new money, even your old money in savings is now worth less. It’s not a difficult concept the grasp, the more that’s created of something the less valuable it becomes.

If Ferrari started mass producing vehicles to compete with Holden or Ford do you still reckon a Ferrari would cost $400,000? Of course it wouldn’t. The price would fall.

The same goes for the money in your pocket.

And that’s exactly the goal for central bankers in Japan, the US, Europe, and ultimately in Australia.

The more the central bankers can devalue your money the more you’ll need it. And the more money you need, the more you’ll need to rely on banks to provide it through credit.

And so the Ponzi and inflationary fraud continues. Until it ultimately collapses.

Don’t forget to check out the special update I’ll send you this afternoon…

Cheers.
Kris Sayce
For Money Morning Australia