Wednesday, August 25, 2010

Credibility Inflation

Here's a neat little concept that FOA introduced briefly in 1999. I think it explains a lot about the inflation, deflation, hyperinflation debate when it finally sinks in that this is where all the money went for the past 30 years: into inflating the credibility of the $IMFS far beyond the underlying reality. And yes, it has a direct impact on the Freegold revaluation as well. So here I will try to expound on this enlightening concept just a bit. The Setup Part of the reason the rest of the world did not abandon the dollar in 1971 was that the rate of economic expansion flowing from Middle Eastern oil cheaply priced in U.S. dollars was already exceeding the expansion rate of the money supply. So the switch from a semi-gold-(con)strained monetary system to a much more expandable "balance sheet money system" as I like to call it or another name I like is "purely symbolic monetary system" allowed for the non-deflationary addition of many new "quality of life" gadgets, widgets and shipping lanes that the world had never before imagined. For the next three or four decades we would be able to comfortably afford the new introduction of Betamax VCR's, microwave ovens in every home, personal computers, DynaTAC cell phones, camcorders, digital cameras, LaserDiscs, Compact Discs, DVD's, MP3's, and on and on. Eventually, all of these wonderful products would be built cheaper by someone else on the other side of the world and shipped to us cheaply using the oil purchased from the Middle East with easily available U.S. dollars.
Sony BetaMax

The reason I like the term "balance sheet money" is that whenever there is a need for more dollars they can be easily gotten from any bank's balance sheet. The dollars don't have to be there in the bank. You simply jot down the "need" for them on one side of the balance sheet and the dollars magically appear on the other side. Presto! Of course once that "need" (demand) is supplied, the balance sheet must then be serviced with interest. But the thing about easy money is that you can always borrow new to service the old. In the previous system (con)strained by its parity fixation to the U.S. Treasury's limited supply of gold all these wonderful lifeenhancing advances would have put a deflationary pressure on the dollar. What this means is that when all these new products came to market, the dollars we needed to purchase them would have become more and more precious with each new widget that came to market. The cost to borrow dollars to buy a new BMC-100P or DynaTAC-8000 would have been prohibitive. And even if you did borrow the money, the service of that debt would have grown more and more burdensome over the life of the loan as dollars became ever more precious.

This deflationary dynamic would have stifled the global economic growth rate and confined it to only reasonable risk-taking. Which is part of the reason the foreign central banks, represented by the BIS, did not lobby the U.S. to officially devalue the dollar against its Treasury gold in 1971. Rather than closing the gold window, the U.S. could have, for example, raised the price of gold to $200 and kept the system going for another 30 or 40 years. A move like this would have been the mathematical equivalent of increasing the Treasury's physical stockpile 5X to double what it was at the height of the Bretton Woods experiment. But while that would have satiated the monetary transgressions of the past, it would have done little for the future. It would not have substantially changed the system to one of easy money. It would only have extended the old system of hard money.
BMC-100P - The first camcorder

It was reasoned at that time that more than just the ridiculous price of gold being broken, the system itself was broken, and needed a global finance structural change. So the international consensus was to let the U.S. default outright on its gold obligations rather than lobbying for a revaluation of its gold at a new fixed rate. But then continue using the dollar anyway, as long as relatively cheap oil could be gotten for dollars. And with this decision, the stage was set for a renewed global (Western?) economic growth spurt, much like after the end of WWII. Only this time, the value lost through the non-delivery of U.S. Treasury gold would be more than replaced by the value oil brought to the new world economy, especially with first-of-akind products like Pong, released for the Christmas season in 1975.
Pong - The first video game

Even at the higher oil prices of the 1970's, the economic demand for oil proved to be a far superior "backing" to the dollar than the depleting Treasury gold had been. And in a certain (limited) sense, the world got its first small taste of Freegold in the 1970's. But as gold's price began freely rising in the global marketplace, the old alarm bells went off in the dollar's management office. The dollar, which had always been viewed at par with gold, was now seen to be falling as gold soared. So during the mid to late 70's the U.S. Treasury and the IMF held a series of gold auctions to flood the market and quell the perceived danger. But by 1979 the demand for gold was so overwhelming that the auctions had to be stopped. Through '78 and '79 the dollar plunged against foreign currencies, and in July of 1979 a desperate Jimmy Carter appointed the tough New York Fed President Paul Volker to head the "deeply divided, inexperienced, soft and indecisive" Federal Reserve Board. Then in early October of that year, while attending an IMF meeting in Belgrade, Yugoslavia, Volcker received "stern recommendations" from his European counterparts that something big had to be done immediately to stop the dollar's fall. The general fear at that meeting was that the global financial system was on the verge of collapse.
TRS80 (Pronounced "Trash Eighty")

Returning to the U.S. on October 6, Volcker called a secret emergency meeting in which he announced a major change in Fed monetary policy. The Fed would switch from controlling interest rates through the Fed Funds rate to directly controlling the money supply through bank reserves. One of the side effects of this sharp policy change was that interest rates would now be governed by the marketplace rather than the Fed. The Fed did still raise its discount rate from 11% to 12%, but then the market took the Prime Rate up to 20% within 6 months where it mostly stayed for the next year and a half. It was later observed that Volcker's 1979 policy change was the most significant change in Fed policy since 1932, when in the middle of the Great Depression the Fed abandoned its "real bills doctrine" and started massive open market purchases of government bonds. In early 1980, Volcker's new Fed policy began to bite. As interest rates rose, the Dollar first slowed its descent, then stopped falling, and then began to rise. Both the public and the investment community which had stampeded into Gold were lured back into paper by this huge rise in interest rates and by the prospect of a higher U.S. Dollar.
LaserDisc

Many facets went into this change in investment attitude, but one concrete change in the U.S. financial system was the most telling. Way back in March 1971, four months before Nixon closed the Gold window, the "permanent" U.S. debt ceiling had been frozen at $400 Billion. By late 1982, U.S. funded debt had tripled to about $1.25 TRILLION. But the "permanent" debt ceiling still stood at $400 Billion. All the debt ceiling rises since 1971 had been officially designated as "temporary!" In late 1982, realizing that this charade could not be continued, The U.S. Treasury eliminated the "difference" between the "temporary" and the "permanent" debt ceiling. The way was cleared for the subsequent explosion in U.S. debt. With the U.S. being the world's "reserve currency," the way was in fact cleared for a debt explosion right around the world. It was also cleared for five of the biggest bull markets in history. The global stock market boom of 1982-87 The Japanese stock market/real estate boom of 1988-90 The Dow (and then Nasdaq) led boom - late 1994 to March/April 2000 The great global real estate boom of 2002-06 The global stock market revival of 2006-07 [1]
DynaTAC-8000

And thus, in 1980, began the modern era of Credibility Inflation. Salting the Mine Most simply stated, credibility inflation is the expanding confidence in the fiat financial system to always deliver a higher payoff tomorrow than today. And through credibility inflation we ultimately destroy the currency structure by believing it can somehow deliver more than reality will allow. Credibility inflation is the exact antithesis of price inflations like the 1970's. It is why we saw low consumer price inflation for the last 30 years relative to the massive monetary and financial product inflation. It is partly why we saw gold stagnant or falling for 20 years. Yet it is just as much a product of monetary inflation as regular price inflation is (more on this in a moment). And it is much more catastrophic in the end. Periods of high credibility inflation are generally not followed by smooth cycles of credibility DEflation. Instead, they tend to SNAP BACK into sudden real price inflation when confidence abates. What happens in the most extreme cases is real price HYPERinflation. This is one of the main concepts deflationists and mainstream economists completely miss; the SNAPBACK of credibility inflation that can instantly take down their precious fiat currency. And it is their intentional avoidance of this obvious concept that delivers aid and comfort to masterprinters like Gideon Gono and Ben Bernanke. When people try to protect their assets against the effects of fiat money, what are they really fighting against? The first inclination is to say "rising prices." Yet it's much more than that! Most everyone agrees that the interest rate paid by the banks never covers the loss of buying power brought on by price inflation. Especially the "after tax" return. It's the same old story, played out decade after decade. We must "invest our savings" (or become a day trader?) because the money will erode in value! Even at 3%, price inflation can eat away at any cash equivalents. But, price inflation isn't the only story that impacts us. Rising prices come and go, but money inflation continues to affect us without fail. So why do people feel better when price increases slow or stop, even as money inflation runs ever upward? The good feelings usually evolve from the effects that money inflation

(increases in the money supply) has on financial instruments. These assets take on the very same characteristic that the rising prices of goods once exhibited. They run up in currency price. During these periods of "less goods inflation" another sinister form of mindset lurks in the shadows. Credibility inflation! Yes, it has been here many times before as every fiat currency alternates its effects upon the feelings of the populace. Fiat currencies must, by definition, always expand in quantity. Their continued usage and acceptance is always obtained with the bribe of "more wealth to come!" Without that bribe, humans would never fall for holding a debt to receive the same goods in the future if they could get the real thing today. Human nature has always dictated that we buy what we need now instead of holding someone's IOU to receive it later. That nature is only changed through the "greed to obtain more." Like this: "I'll hold my wealth in dollars as long as my assets are going up. Later those increased assets will buy me a better lifestyle as I purchase more goods and services than I could buy now." This is the hidden dynamic we see today. Just as destructive as "goods price increases," "credibility inflation" impacts our emotions to "hold on for the future, more is coming!" In every way, "credibility inflation" is just as much a product of an increase in the money stock as "regular price inflation" is. As cash money streams out to cover any and all financial failures, we begin to attach an ever higher credibility to the continued function of the fiat system. In effect, the more money that is printed, the higher we price the credibility factor. [2] Selling the Salted Mine Is this not where we are today? Interest rates and with them, bond valuations have run their 30 year course from 20% down to 0%. The credibility of paper assets has taken at least three severe beatings in the last decade. And now, to simply slow the acceleration of credibility DEflation, every manner of bailout and market rigging is being employed, practically in broad daylight. And this on the assumption that the global flock of sheep will only watch the numbers, not the men making them or the underlying economy from which they spring. GDP is one of the great deceivers in the fiat money world. During the last century (??) or so, some form of GDP has always been used to measure the great mass of human endeavors. Yet, throughout this time, some form of fiat currency has always been in effect. Even during the Gold standard, fractional reserve banking expanded "gold note money" more so than the "gold money" in existence. Prior to 1929 this effect, if not creating outright "price inflation" during a time of Gold standard policy, was creating "credibility inflation" in the minds of investors. Using the backdrop of a growing GDP, people bought into inflating financial assets and ignored these signals as evidence that the fractional currency system was failing. Even though the dollar contained a policy statement to supply gold, back then a gold loan was still only good until everyone asked for gold. The same thing is happening today. People destroy the currency structure by thinking it can deliver more than reality will allow. Instead of all debt failing slowly with each upward march of price inflation, prolonged "credibility inflation" snaps all at once as investors try to suddenly revert to a "buy now mentality." The inability of government authorities to contain the fiction of "good debt" is usually the feature behind the investor mood change. The "snap back" into a sudden "real price inflation situation" caused during this stage by a currency failure always breaks the whole structure. We approach this end today! The GDP has been the relative gauge to mark all other measurements against. Even so, its numbers reflect little more than the result of an "expanding fiat money supply." Yes, there have been recorded downturns in GDP, but these contractions would have been worse if measured in real (gold) money. In opposite fashion, expansions paint a much brighter picture as all financial liabilities seem less a threat if held against a rising GDP. I submit that the GDP figures offer little more than a way to entice investors to increase their "credibility image" of our monetary system. Fiat moneys are always on a long term upward expansion, and they can hardly do less than bloat the picture.

Someone I know once said; "your wealth is not what your money say it is!" A great historical example of credibility inflation with parallels to our present financial and monetary system was the system in France under the direction of the esteemed Scottish economist, John Law. In 1716 Law established the first French central bank, the Banque Gnrale, which was later nationalized and renamed the Banque Royale. Law used the Banque to introduce paper money in France. Simultaneously, Law aggregated the trading companies in the French colony of Louisiana into a singular monopoly under the name "Company of the Indies" and sold shares of this company back in France. Law exaggerated the prospects of the company so well that he was actually appointed Controller General of Finances (essentially the first French Central Banker) by Philippe d'Orlans and given the official job of pumping this stock. In a way, John Law was kind of like the "Jim Cramer meets Larry Summers" of his time. Wild speculation on the shares of the Company of the Indies led to the Banque Royale issuing more and more paper money to fund the monetary demands of the buying frenzy. And the "company profits" owed to the shareholders were also paid in fresh paper money. John Law's credibility was being entirely financed by his printing press. Then, in late 1720, opponents of John Law's paper money attempted en masse to exchange their paper notes for gold. This forced the Banque Royale to cease physical gold "delivery," declare the essence of "force majeure" (which incidentally is a French term from French law), and admit it had issued much more paper than it had in gold. Both the Company stock value and the paper money itself plunged, ultimately to worthlessness. The monetary system in France was revamped six years later, but by the end of 1720 John Law had been disgraced, relieved of his official job, and had to flee France a poor man. He died in poverty nine years later. Trading Salted Mines One observation we can make is that in the long-line cycles of monetary history, technical (momentum) trading emerges in the very late stages of cycles in its most frenetic fashion. This is when it draws the most people into the unproductive activity of trading for trading's sake. And this is when it draws in the greatest profits, right before it delivers a catastrophic total loss. In the early stages of these long-line cycles the greatest profits in society come from productive enterprises like building large companies from the ground up. But in the very late stages the greatest profits seem to come from paper churning and speculation in things that were previously traded mostly on fundamentals, based on actual, physical use. We can see this in the famous bubbles like the tulip bubble, the Mississippi bubble, the South Seas bubble, the dot com bubble and the housing bubble. But it also occurs at the end of currency cycles. History is full of stories of traders frantically trying to trade out of their positions at the end of long-line cycles, while the currency burns around them. Look at any list of historic hyperinflations to find examples. The modern version of this late-stage trading fad is most prevalent in the West, because that is where modern currency flows into financial assets at the highest rate relative to their real world, physical counterparts. For example, Western paper gold traders look to the seasonal preferences of Eastern physical gold users to plan their buys and sells. The Asian harvest season, after which farmers invest some of their years surplus income in gold is closely watched by Western traders. As is the Indian wedding season where every year Indian brides are adorned with physical gold. Western paper gold traders love front-running these Eastern gold-buying seasons. Recall ANOTHER's comment on this from my last post: Everyone knows that western minds don't like or want gold, but if they think you like it they will trade it up

in price for the sake of "sticking it to you." Enter the world of "paper gold." This paper trading mentality works really well right up until the moment it doesn't. And that's when it can deliver a total loss. I sometimes wonder if it should even be considered a profitable activity when a split second of fundamental phase transition can take away a decade of technical trading profits. Or the inverse, when the price of a fundamental misjudgment can be the opportunity cost of generations' worth of wealth. In a way, this is the hard question Freegold poses. Getting Out Before the Collapse Above I mentioned that the snap-back effect when a fiat currency loses its credibility (hyperinflation) is one of the obvious concepts intentionally ignored by deflationists and mainstream economists alike. Another obvious concept they remain oblivious to is that the two primary functions of money are in no way necessarily tied together. Those two functions being: "medium of exchange" and "store of value." Just because we have suffered their apparent fixation for centuries, they are most definitely not fixed by nature. As long as you have the freedom to spend your money the freedom to spend the fruits of your labor, which exists everywhere outside of outright whips-and-chains slavery you have the choice of how to save your money. If you can spend your money then you can save your wealth in something other than money. This is the essence of Freegold. A medium of exchange need only have value in its usage (trade clearing) function. It can quickly lose all value when it is no longer used. This long-forgotten principle can be easily comprehended in Antal E. Fekete's "A 'fairy' tale" which I used in The 100 Year Clearing: A fairy tale Let us look at another historical instance of clearing that was vitally important in the Middle Ages: the institution of city fairs. The most notable ones were the annual fairs of Lyon in France, and Seville in Spain. They lasted up to a month and attracted fair-goers from places as far as 500 miles away. People brought their merchandise to sell, and a shopping list of merchandise to buy. One thing they did not bring was gold coins. They hoped to pay for their purchases with the proceeds of their sales. This presented the problem that one had to sell before one could buy, but the amount of gold coins available at the fair was far smaller than the amount of merchandise to sell. Fairs would have been a total failure but for the institution of clearing. Buying one merchandise while, or even before, selling another could be consummated perfectly well without the physical mediation of the gold coin. Naturally, gold was needed to finalize the deals at the end of the fair, but only to the extent of the difference between the amount of purchases and sales. In the meantime, purchases and sales were made through the use of scrip money issued by the clearing house to fair-goers when they registered their merchandise upon arrival. Those who would call scrip money "credit created out of nothing" were utterly blind to the true nature of the transaction. Fairgoers did not need a loan. What they needed, and got, was an instrument of clearing: the scrip, representing self-liquidating credit. In this example the scrip money at the fair had value only through its use at the fair, not intrinsic in itself. After the fair, if you ended up with a trade surplus (extra scrip money), you turned in your medium of exchange for gold coins, the tradable store of value at the time. Can you imagine how this concept could work in a fair that's open for business 24/7/365? So how can we possibly have one thing as a medium of exchange and something else as the store of value in our modern world? Has this ever been tried before in recent times? Of course it has! We have been doing it all along!! But the problems that ultimately come arise from those stores of value that are denominated in, and tied to, the durability of the scrip money, the medium of exchange. Once upon a time, when the medium of exchange was physical gold coin, it was very durable. And stores

of value denominated in that durable medium of exchange, denominated in gold, were quite durable for a time. But through the gold standards of the past century that "paper denominated in gold" became the medium of exchange. And now gold will once again become the store of value. You see, these two monetary functions play off each other in a see-saw fashion. As "assets" (claims really) denominated in the medium of exchange fail and collapse, true physical "store of value" assets alternately rise to the occasion. It is only our ingrained misconception that both monetary functions must be somehow fixed at parity with each other that leads us to foolish ends. And understand also that the Giants of this world know better.
The Freegold Monetary Quadrangle Explained in Gold is Money - Part 3

Today all governments of the world hold only two assets in reserve, meaning "for a rainy day." They hold claims against counterparties denominated in the medium of exchange and they hold gold, the store of value. And some of the more forward-thinking governments are already floating their gold reserves on the books, for all to see. Now, the claims held in reserve have two vulnerabilities; the solvency of the counterparties and the durability of the scrip they are denominated in. Of course new scrip can be easily conjured on the national balance sheet to keep the counterparties technically solvent so most assuredly it will be the scrip itself that fails. The gold in reserve, on the other hand, has no counterparty and plenty of durability. So what monetary asset do you think will rise to fill the global monetary reserve void when the scrip finally fails? Palladium? Bear in mind too that these Giant balance sheets can move the price (value) of gold more in a split second than all of us could in a lifetime of buying. And with any such tectonic shift in the importance of gold on international balance sheets, you can say goodbye to the fractionally reserved commodity (paper) gold trading arena and anything remotely associated with it.

The Collapse of the Salted Mine Hyperinflation First of all I would like to clear up probably the most common misconception about hyperinflation. What most people believe is that massive printing of base money (new cash) leads to hyperinflation. No, it's the other way around. Hyperinflation leads to the massive printing of base money (new cash).

Hyperinflation, in most people minds, conjures images of trillion dollar Zimbabwe notes. But this image is simply the government's reflexive response to the onset of hyperinflation, which is actually the loss of confidence in the currency. First comes the loss of confidence (hyperinflation), then, and only then, comes the massive printing to keep the government and its obligations afloat. And what sets the stage for hyperinflation is a period of high credibility inflation followed by the loss of credibility. During our period of high credibility inflation the dollar was invisibly hyperinflated in a nearmonetary sense. This has already happened. We are already there. When I say the dollar has already hyperinflated in a near-monetary sense, I am talking about the number of dollars people, entities and even foreign nations think they have in reserve. Not in a shoebox, but in contractual promises of dollars to be delivered more or less on demand by somebody else. Claims denominated in dollars. This is how the vast majority of "dollars" are held; as promises to deliver more dollars. And this is why they are held this way. Because of the more in "more dollars." "Let me spend your dollars today and I will give you more dollars tomorrow!" The Credibility Waterfall I think it is fair to say that we have finished our 30-year run of high credibility inflation and we are now in the early stages of credibility deflation. The real question now is, can the credibility of the financial system deflate without tripping a breaker, without causing a credibility waterfall in the currency in which it is denominated? The difference between today and a few years ago is that a few years ago credibility inflation was being fed

by private credit (debt) expansion. Asset values, like homes, were being sustained and driven higher with the arrival of new marks. But today the Ponzi cycle of credibility inflation has peaked, there are no more new marks, and its decline is being managed centrally with the government expansion of new base money to conceal the failures one at a time. And as in any Ponzi scheme there comes a point when redemptions can no longer be financed by new marks. I think the tipping point of credibility must come once it is clear that Bernie Madoff, I mean Uncle Sam is writing redemption checks that can never be cashed. The point is, we are already past the tipping point. So timing isn't really a question anymore. The credibility waterfall has already happened. But somehow we still have early marks continuing to stockpile rubber checks as if they are worth something. Does this mean credibility still exists? I think not. I suppose this begs the question, is all that dollar debt out there in the world really worth anything anymore? If you answer yes simply because you cashed some of it in today for new underwear, then I say you didn't answer the question. The question is, is all that dollar debt out there in the world really worth anything anymore? The answer is no, it is not. Only at the margin, where you reside, can it still be cashed in for new underwear. But in aggregate, it is worthless, even today. And then the next logical question should be, what is gold really worth today? If you answered $1,240 per ounce simply because you bought a gold Eagle today for $1,240, then I say you didn't answer the question. The question is, what is gold REALLY worth today? And the answer is it is priceless, but probably could be had in extremely large volumes for somewhere between $10,000 and $50,000 per ounce. (How much physical gold could China realistically get today if it tried to cash in $2T in debt paper for gold? At today's price it could get more than 50,000 tonnes, but only if that's the real value of gold.) Only at the margin, where you reside, can physical gold still be had for $1,240 per ounce. But in aggregate, in the vaults of the world's central banks as the only reserve asset not tied to the medium of exchange, it is priceless, in the truest sense of the word. My advice: Get as much of this priceless reserve asset as you can while it's still going for $1,240 at the margin. Seems like a bargain to me. Sincerely, FOFOA
[1] Brown text from The Early Gold Wars by Bill Buckler, The Privateer [2] Blue text written by FOA in 1999