Yaser Anwar January 2010


This paper pertains to two key issues, Gold and Keynesian policies, with an aim to familiarize the reader about both by deconstructing the misperceptions, presenting their track record and addressing the flaws, as well as the implications of the two issues; being cognizant of the central bankers framework, which in this case has been Keynesian, allows one to position their portfolio, and wealth in general for the average individual, accordingly. We start by looking at the key characteristics of gold, origins of the yellow metal and U.S. dollar as reserve currency, and the misperceptions around gold purported by prominent economists who fail to realize why investors would buy a negative-carry asset that has a lack of industrial usage. Next, the paper refutes Paul Krugman's, a prominent Keynesian economist, assertion that under a Gold Standard we would have witnessed deflation by discussing policy errors in the early 20th century (i.e. over and under valuation by Britain and France, respectively) that would have lead to such a belief. Whether we should be under the gold standard or not is beyond the scope of this paper. I then discuss key characteristics of the Keynesian policy, and delve into how policy makers following Keynes' framework of deficit spending and full-employment have, since its first applications in the 1960s to present time, produced huge inflation spikes, asset bubbles and busts, and most importantly record deficits. We discuss the Federal Reserve’s point of view pertaining to asset bubbles and why their thought process is wrong, as well as pros and cons of inflation from the government and consumer’s perspective, respectively. I conclude by pointing out the common link between our two key issues and the role of gold in a world run under a policy framework advocated by Keynes. The appendix includes some short notes on anticipating inflation; expected inflation and gold; lessons from Japan's Great Recession; a look at U.S. unemployment over the decades; the U.S., U.K. and Euro regions central bank balance sheets; Asian central bank’s gold relative to foreign exchange reserves; and real GDP growth in the first two-three years of deleveraging.

Yaser Anwar


“If you want to know when a society is set to vanish, watch the money. Whenever destroyers appear among men, they start by destroying money, for money is men’s protection and the base of moral existence. Destroyers seize gold and leave to its owner a counterfeit pile of papers. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values. Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims. Watch for the day when it bounces, marked: account withdrawn." - Francisco D'Anconia (fictional character in Ayn Rand’s Atlas Shrugged)

"One risk-related consideration should be paramount above all others: the ability to sleep well at night, confident that your financial position is secure whatever the future may bring.” - Seth Klarman

"The current crisis is not only the bust that follows the housing boom, it's basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency. Now the rest of the world is increasingly unwilling to accumulate dollars." - George Soros “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and governmentcreated bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” - Alan Greenspan "Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." – John Maynard Keynes “The world will never work itself, and keep itself, out of an inflationary era until it returns to a full gold standard. The classical gold standard provided a practically automatic check on excessive internal credit expansion. That is why the bureaucrats abandoned it.” – Henry Hazlitt “The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust. You brought the economy to the brink of a Great Depression.” John Taylor “Bubbles are best identified by credit excesses not valuation excesses.” - Jim Chanos Yaser Anwar


“The U.S. would be mistaken to take for granted the U.S. dollar’s place as the world’s predominant reserve currency.” – Robert Zoellick (President, World Bank) "I can calculate the motions of the heavenly bodies, but not the madness of crowds" – Sir Isaac Newton (remarks following his loss of 20K pounds when the South Sea Company, British trading company, bubble burst) "We borrowed too much, we screwed up, and so we're going to fix it by borrowing more." - Kenneth Rogoff "The current, rather mild U.S. recovery has been driven by asset appreciation/consumption and not employment or CAPEX growth. Future growth is dependent on additional asset appreciation in real estate and stocks if Asia continues to absorb much of our investment and many of our jobs." - Bill Gross "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." - James Carville (former Bill Clinton Political Advisor) "Keynesian economics is just an excuse for easy money, overspending and overconsumption." - Richard Dennis "I think of fiat currency as being paper money with no intrinsic value which has been simply declared to be legal tender. Up to this point, it has been widely accepted that currency or money is worth the goods and services for which it is routinely exchanged. I hope this remains the case, but think that the odds are against it. In the past, I have stated my belief that there is not enough money in the world to soak up the tens of trillions of dollars of deleveraging that must occur over the next few years." - J. Kyle Bass "With the benefit of hindsight, future historians might conclude that the major blunder of last year’s (2008) bailout was the failure to reduce or even address the economy’s debt burden." - Hugh Hendry "In the years leading up to the current crisis, it was “as plain as the nose on your face” that prospective returns were low and risk was high. In simple terms, there was too much money looking for a home, and too little risk aversion." - Howard Marks "Many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them." - William White (former Chief Economist, Bank of International Settlements) “You either crowd out other borrowers or you print money.” – Niall Ferguson "The second vice is lying; the first is running in debt" - Benjamin Franklin

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Gold, “The Barbarous Relic”
Gold is the only true hard-asset with an objective value that provides an individual the means of preserving one's wealth and one's future. Contrary to popular opinion amongst prominent economists1, it is not a barbarous relic but a hardasset that: i) has been a preserver of wealth for over six centuries, allowing investors to maintain the purchasing power relative to the U.S. dollar; ii) the Founding Fathers mandated in the constitution of the United States of America in 1789; iii) has an inelastic supply; and iv) investors have bought to avoid bouts of inflation and continued debasement of currency by excessive spending of the governments under a fiat-system (i.e. any money declared by the government as legal tender and backed by their word), which leads to the marginal productivity of each dollar of new debt created by expansionary fiscal and monetary policies diminishing over time as per the law of diminishing returns. According to Antal Fekete, Professor of Memorial University in Newfoundland, in the 1950s when the U.S. dollar was still redeemable in gold, the marginal productivity of debt was approximately 3 (i.e. each dollar of new debt increased GDP by three). By 1970, when President Nixon defaulted on the gold obligations (more on this below), the marginal productivity had dropped below one2 (i.e. total debt is rising faster than GDP).

Origins of the Gold Standard & U.S. Dollar as the Reserve Currency
The aforementioned characteristics are what prompted countries to adopt the Gold Standard throughout the 20th century. Under the Gold Standard central banks were allowed to convert paper currencies into gold at a pre-established rate. The Gold Standard was designed to maintain the value of the currency over time and protect consumers from inflation. Let’s look at an example of the U.S. under the Gold Standard. When the U.S. inflates its money supply its prices rise. The increase in prices prompts domestic consumers to import from abroad since the stronger U.S. dollar makes foreign goods cheaper relative to domestic goods. At the same time, the higher prices in the domestic market discourages exports abroad; the result is a deficit in U.S.’ balance of payments, which must be paid for by the foreign countries cashing in dollars for gold. The gold outflow means that the U.S. must eventually contract its inflated currency in order to prevent a loss of all of its gold; this outflow is what caused the U.S. to go off the Bretton Woods agreement in 1971 (more on this below). Once the inflated supply of paper is reduced via a contractionary monetary policy stance, the prices in the domestic market are lowered, thus reversing the earlier effect as gold now flows in due to an export surplus until the price levels are equalized between the trading partners. In the 1920s, Britain made the error of getting back on
1 2

Krugman, Paul. The Gold Bug Variations. Slate, 1996 and Roubini, Nouriel. The Gold Bubble and the Gold Bugs. Project Syndicate, 2009 Fekete, Antal. The Marginal Productivity of Debt. Safe Haven, 2009

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the Gold Standard, after World War I, on a level that overvalued the pound (more on this below), which lead to increasing unemployment and lack of economic prosperity that was being witnessed by the world3. In 1930, the Great Depression hit the U.S. and economic growth stagnated, so the country abandoned the Gold Standard because devaluing their currency and generating inflation seemed to be a way to maintain aggregate demand. Gold prices rose by approximately 70% from 1933 to 1934 as a result of monetary expansion to limit the downward spiral. The origins of the U.S. dollar as a world reserve currency date back to the Bretton Woods system, where it replaced the British pound as the world reserve currency because the British economy, and subsequently the pound, lost its luster as the world reserve currency due to economic weakness after the Second World War. Furthermore, given the U.S.’ strength on a military and political basis, the world accepted the U.S. dollar, which was “as good as gold”, as the global reserve currency. The Bretton Woods system was setup as a fixed exchange rate system whereby countries would peg their currencies to the U.S. dollar, which itself was pegged to gold at a rate of US$ 35 per ounce of gold, and buy/sell USDs to keep market exchange rates within the established band. Given the economic malaise globally, the world was comfortable accepting those dollars for more than 25 years with little question. That changed in the late 1960s when France, Switzerland and West Germany demanded, as it was their right to do so, that the U.S. make good on their pledge to pay one ounce of gold for each $35 they delivered to the U.S. Treasury. This resulted in a colossal gold drain, which lead to closing of the gold window by the then-U.S. President Richard Nixon, as the U.S. refused to payout the remaining gold and announced on August 15th, 1971, that they would be unilaterally stepping out of the Bretton Woods agreement, which maintained the convertibility of the dollar into gold, thus bringing end to a poorly devised gold standard. After the U.S. went off the peg, gold rallied throughout most of the decade and reversed, for a short-period, once the Federal Reserve under Paul Volcker adopted an aggressive contractionary stance towards monetary policy (i.e. increasing interest rates) in the early 1980s. Astonishingly, a new system was devised which allowed the U.S. to print money on behalf of the world as the world’s reserve currency (i.e. used as pricing currency in global markets) with no restraints placed on it. This was worse than the pseudo-gold standard, which at least had a pretense of gold convertibility; this new system had none.

As we will discuss going forward, this in essence is why the gold prices have increased exponentially; market participants’ belief that government spending can not be restrained because the government is inherently inflationary, thus the value of fiat currency will keep depreciating as time goes on. The failure to understand the importance and key implications for the rise in gold’s price is primarily because prominent economists such as Nobel prize winning Paul Krugman and Nouriel Roubini have perpetuated the belief that because of lack of Gold’s utility on a day-to-day basis and lackluster economic performance of the gold, under a flawed, standard during the early 20th century, to own gold would be an exercise in futility. This couldn’t be further from the truth. The underlying premise of the arguments purported by the aforementioned economists is flawed. Let’s take a look at why under a Gold Standard, we would not have the

Rothbard, Murray. What Has Government Done to Our Money? And The Case for a 100 Percent Gold Dollar. Auburn, Alabama: Ludwig Von Mises Institute, 2005

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deflation Paul Krugman alludes to, and what the policy mistakes were during the early 20th century that made it inevitable to go off the Gold Standard.

Paul Krugman’s Deflation Argument & Policy Errors Under the Gold Standard
“The United States abandoned its policy of stabilizing gold prices back in 1971. Since then the price of gold has increased roughly tenfold, while consumer prices have increased about 250 percent. If we had tried to keep the price of gold from rising, this would have required a massive decline in the prices of practically everything else--deflation on a scale not seen since the Depression. This doesn't sound like a particularly good idea4." - Paul Krugman, Nobel Laureate This quote by Mr. Krugman shows that he does not understand why gold prices have outpaced the consumer price inflation index in the first place. Gold inherently is a negative-carry asset that has little industrial use, relative to Silver (Gold’s industrial usage is 11%5 and Silver’s industrial usage is 50%6), so for a hard-asset like gold it would be irrational to increase 4x as much as consumer prices (markets are irrational in the short-term, but over the period Mr. Krugman alludes to, a period that would be characterized as long-term, markets tend to be rational). So, why then has gold outpaced consumer prices (from 1972 to December 2009, CPI index appreciated 473% vs. gold’s 2872%)? Gold has outpaced consumer prices because of market participants’ belief that the continually increasing monetary base of the fiat-currency governments under a Keynesian monetary policy focus, primarily the world’s reserve currency, their purchasing power would diminish (the amount of gold above ground growing at roughly the same rate as global real income per capita, gold has tended to maintain its value relative to other goods in the economy). As evident by the M2 (see appendix), the rise in money supply has been astounding. Furthermore, lawmakers in the U.S. have raised the national debt ceiling 90 times in the past 69, according to data from the Office of Management and Budget7, to allow the government to continue to spend exorbitant amounts to meet its excessive spending needs that have taken its total debt to GDP to stratospheric levels (see appendix). So, why you may ask is someone like Paul Krugman alluding to gold being deflationary? His view is based on the early 20th century when governments were, on and off, tied to the gold standard. What he fails to mention is that it's not the gold standard that caused deflation, it is the policy mistakes of the Federal Reserve and interference by governments to artificially over and undervalue their currencies that were the real culprit. Robert Mundell, Nobel Laureate, said it best,

4 5 6 7

Krugman, Paul. The Gold Bug Variations. Slate, 1996 World Gold Council Silver Institute Sahadi, Jeanne. U.S. about to hit debt ceiling - again. CNN Money, 2009

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“It is a mistake, though a common one, to blame the gold standard for the deflation and the great depression. The gold standard, however, is just a mechanism that worked well when it was managed well and worked badly when it was mismanaged8.” So, it was not the gold standard that broke down, rather deliberately abandoned after being mismanaged. As Henry Hazlitt points out in, The Inflation Crisis & How to Resolve it, “that governments do not want their domestic economy and prices to be tied into the world economy and world prices. They want to be free to manipulate their own domestic price level, so that they can pursue purely nationalistic policies at the expense or imagined expense of other countries.” Federal Reserve errors: The policy under gold standard rules was to reduce the discount rate so that money and credit would expand as gold flowed in, especially in 1927 and 1929. Instead, the Federal Reserve pursued deflationary policy by not letting gold inflows raise prices. According to Allan Meltzer in, “the Federal Reserve's policy tried to achieve two incompatible objectives: a stable price level and stable exchange rates. It failed on both counts 9. An example of overvaluation: In the 1920s, Britain made the error of getting back on the Gold standard, after World War I, on a level that overvalued the pound because price levels relative to their competitors had risen to such a point that deflation was desirable, which lead to increasing unemployment and lack of economic prosperity witnessed by the world. As Murry Rothbard described in his book, What Has Government Done to Our Money? And The Case for a 100 Percent Gold Dollar, “The British pound, for example, had been traditionally defined as a weight which made it equal to $4.86. But by the end of World War I, the inflation in Britain had brought the pound down to approximately $3.50 on the free foreign exchange market. The sensible policy would have been for Britain to return to gold at approximately $3.5. Instead, the British made the fateful decision to return to gold at the old par of $4.86. It did so for reasons of British national “prestige” and in a vain attempt to reestablish London as the “hard money” financial center of the world. To succeed at this piece of heroic folly, Britain would have had to deflate severely its money supply and its price levels, for a $4.86 pound British export prices were far too high to be competitive in the world markets. But deflation was now politically out of the question, for the growth of trade unions, buttressed by a nationwide system of unemployment insurance had made wages rigid downward; in order to deflation, the British government would have had to reverse the growth of its welfare state. In fact, the British wished to continue to inflate money and prices. As a result of combining inflation with a return to an overvalued par, British exports were depressed all during the 1920s and unemployment was severe all during the period when most of the world was experiencing economic boom.”

An example of undervaluation: France returned to the gold standard back on the gold standard in 1927 at an

8 9

Mundell, Robert. The Future of the Exchange Rate System. Economic Notes of the Banca Monte dei Paschi di Sienna 24, 1995 (pgs 453-478) Meltzer, Allan. A History of the Federal Reserve, Volume 1, 1913-1951. Illinois, Chicago: University Of Chicago Press, 2004

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undervalued exchange rate and drew gold from other gold standard countries, Britain and Germany in particular10. This policy imposed deflation on the rest of the world. It sterilized much of the gold inflow by substituting gold for foreign exchange in its reserves. The policy produced mild deflation in France, instead of the inflation called for under gold standard rules. Furthermore, Krugman fails to mention that due to instability of gold distribution on the world market, the long-term stability of the Gold standard was overcome by the short-term downfalls. As Leland Crabbe points out in, The International Gold Standard and U.S. monetary policy from World War I to the New Deal, “the Gold Standard Act of 1900 interfered with the Federal Reserve System established in 1914 due to the fact that the Federal Reserve was charged with crafting a stable domestic monetary policy, while the Gold Standard was suited to international stabilization. This conflict, coupled with the Great Depression would eventually lead to more dependence on domestic monetary policy over that of the Gold Standard in 1934.”

Gold is a homogeneous, liquid asset that as we have discussed is a hedge against continuous debasement of fiat currencies given the large increases in monetary base and burgeoning deficits, is going to see a structural shift in its demand, primarily coming from surplus nations like China, Brazil and India, whose gold weightings relative to their foreign exchange reserves are minuscule (see appendix), as they seek to diversify away from their U.S. treasury holdings, especially China which alongside Japan is responsible for approximately 35% of U.S. treasury demand. The most important reason investors will, and have been shifting, shift towards gold over time is because unlike fiat currencies, gold cannot be produced en masse by the authorities who, inspired by Keynes' full-employment (i.e. the 1960s through 1970s) and deficit spending policies (post-2000), can, and have, print money. The Gold Standard was a system under which central banks converted paper currencies into gold at a pre-established rate. The system, which had its shortcomings but nonetheless better than a complete fiat system, was designed to maintain the value of a country’s currency over time and protect consumers from inflation, just as the Alan Greenspan quote highlights on the main first page that,” in the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case gold.”


Moure, Kenneth. The Gold Standard Illusion: France, the Bank of France, and the International Gold Standard, 1914-1939. Oxford, UK: Oxford University Press, 2002

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The Keynesian Elixir: The Low Interest Rates & Deficit Spending Approach
"It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on" - Amos Tversky (Cognitive Science Pioneer) In the early 20th century, John Maynard Keynes, a Cambridge University economics professor and investor, championed that interest rates should be kept low so businesses can borrow funds to increase their investments, and the low interest rates would give consumers less incentive to save, thus increasing their spending, leading to full-employment and pushing up the aggregate demand. According to Keynes, we should avoid high interest rates, as we would avoid hell-fire11. Not only that, Keynes believed that a remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the boom to last. He states that, “The right remedy for the trade cycle is not to be found in abolishing booms and thus keep us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom12.” According to Keynes, in the 19th century the politics, literature and religion joined a grand conspiracy for the promotion of saving, as such the duty of saving became nine-tenths of virtue and the growth of the cake the object of religion13. When people choose to save instead of spend, the money does not simply disappear nor remain idle; it is utilized for investment purposes by companies who borrow from institutions people choose to save with, only in this case they buy different goods (i.e. producer goods as opposed to consumer goods). And what if investors withhold their funds from the loan market (i.e. do not accept low interest rates)? Then, Keynes believed the government can bring down the interest rates by increasing the quantity of lendable funds14 (i.e. printing money). This is ironic because Keynes, as quoted on the first page, talks about how there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The main culprit of this debauching of the currency that Keynes alludes to occurs because governments print money, causing inflation. In a perfect world the Keynesian elixir would work well. A world where market participants believe that close to zero interest rates purported by Keynes will not raise inflation (expected and otherwise) and keep the economy close to full- employment; where the central bankers will inject just the right amounts of money supply to keep aggregate demand in check and the governments will balance their books almost perfectly by keeping their spending and borrowing in check, to keep us in a quasi-boom forever. Such discipline and objectivity sounds good in theory. However, the fact is the governments use the Keynesian

11 12 13 14

Lewis, Hunter. Where Keynes Went Wrong. New York, NY: Wiley, 2009 (pg 21) Lewis, Hunter. Where Keynes Went Wrong. New York, NY: Wiley, 2009 (pg 21) Lewis, Hunter. Where Keynes Went Wrong. New York, NY: Wiley, 2009 (pg 29) Lewis, Hunter. Where Keynes Went Wrong. New York, NY: Wiley, 2009 (pg 19)

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elixir to borrow their way to prosperity; such borrowed prosperity has lead to the demise of a great many civilizations 15 and there's no reason why this time it’s different because, and ironically, as Alan Greenspan quote on the first page highlights that, “the financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” Let’s look at the key components – deficit spending, low interest rates, consumer spending and business investment to increase aggregate demand and reach full-employment - of what Keynesian policy aims to achieve and the results of following such a policy.

The Phillips Curve & Keynesians
“We’re all Keynesians now” – Richard Nixon, 1971

The Keynesian policies were first put to full test during the 1960s when economists utilized the Phillips Curve, which is the trade-off between inflation and unemployment (i.e. lower rate of unemployment can be achieved at the expense of higher inflation), to achieve what Keynesians refer to as "full-employment". At the recommendation of Walter Heller, the then-U.S. president John Kennedy adopted this economic framework to stimulate the economy, thus raising GDP and lowering the unemployment rate at the cost of a higher inflation rate. Robert Samuelson highlights in his book, "The Great Inflation and Its Aftermath", that it worked for a time as the economy flourished and inflation inched up only marginally. However, over time as the administrations changed - first, Lyndon Johnson, followed by, Richard Nixon, Gerald Ford and Jimmy Carter - the growth rate dropped and inflation saw a considerable uptick as each administration wanted to trade a little more inflation to lower unemployment and sustain the GDP, which in retrospect was not any more possible than a drug addict using a bit more heroin to sustain the high. Initially, economists were right that it was possible to exploit a stable trade-off between inflation and unemployment because if you accept a slightly higher rate of inflation, it allows the economy to have a permanently (so they thought) lower rate of joblessness. However, applying George Soros' reflexivity theory, the positive feedback loop this trade-off leads to (i.e. temporarily lower unemployment and higher GDP as inflation is still low) resulted in very optimistic economist expectations of how further down unemployment could be pushed to. As a result of these overly optimistic expectations of economists, and policy makers they advised, they forgot that a higher rate of inflation does not yield a permanently lower rate of unemployment

The first great inflation occurred in third century AD Rome. The territorial limits of empire had been reached several decades earlier and the huge army, which in former times had financed itself (through the conquest of new, plunderable and taxable lands), was now needed to protect the border from barbarian invaders. Just like the baby boomers of today’s developed world, that cohort of Roman society which had once been its engine of growth became its unsustainable financial burden, straining imperial finances so thoroughly that the government could only fund itself by debasing the coinage. The silver content of a denarius, which had been 75% in 180AD, was a mere 0.02% by 270AD. Fiscal pressure had caused the first inflation and the Empire would never regain its former greatness. And since this early Roman experience the theme has repeated itself again and again. Medieval Europe, Sung China, revolutionary France, America during its civil war, Weimar Germany and arguably even post WW2 Britain and America, all saw inflations in which money was the vehicle, but the root cause was a government unable to pay its way. Grice, Dylan. Inflation is Always and Everywhere a Fiscal Phenomena. Societe Generale Research, 2009

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because the natural rate (i.e. when inflation is not rising or falling) is higher than their expectations. This resulted in excessive expansionary policy that drove up inflation as policy, according to Robert Hetzel's, "The Monetary Policy of the Federal Reserve: A History," erred on the side of expansion. Inflation is exactly what happened. Samuelson highlights that from 1960 to 1979, inflation rose from 1% to nearly 14% and that it was the greatest inflationary spike in the US’ history, which had enormous repercussions for consumers. The repercussions he alludes to included a wage price spiral that Samuelson calls, "the greatest domestic policy blunder since WWII," and that, "these failed policies of printing money (this is because to achieve the same economic payoff required ever more stimulus), new taxes, spending programs and regulations led to Ronald Reagan’s election to the presidency in 1980.” The policy makers failed to realize that as they continued to print money and aim for "full-employment", workers demanded raises to compensate for the higher prices, which meant firms had to raise prices, pushing up interest rates, as Paul Volcker did in the early 1980s (i.e. Volcker brought inflation down from an average of 14% in 1979 to 4% by the summer of 1987), causing a recession during 1981-1981, and what Samuelson alludes to as, "the stagnation in living standards16, and a growing belief–both in America and abroad–that the great-power status of the United States was ending.”

The Low Interest Rates Phenomena
Between 2002 and 2007 debt-financed spending by U.S. consumers (i.e. Keynesian inspired low interest rates to encourage house speculation, which were used as ATMs thanks to mortgage equity withdrawal) provided the catalyst for export-driven growth of China and Asia. The Federal Reserve under Alan Greenspan could afford to keep rates low, and as a result of this was one of the primary reasons it caused the credit crisis17, because the inflationary risks were subdued due to falling production costs in countries such as China, primarily Asia18 whose growth was fueled by exports provided to the U.S. consumers, who were spending more than they were earning; so as their expenditures and incomes grew at the same rates, they had to raise their debts, cut their assets or get dramatic debt relief through lower interest rates. Furthermore, as the Chinese exported goods to the US, this meant competition for domestic firms, which kept a lid on wages and even pulled them lower. Households had saved too little and borrowed too much. The end of the housing bubble left many people insolvent; Unemployment, on a U6 scale is 17% and the official U3 scale is 10%, with

Toward the end of Jimmy Carter’s first and only term in office, the economy resembled a train wreck. Inflation, unemployment, and interest rates hovered in the stratosphere, the economy was stagnant, and the stock market was gasping for breath. The housing market was all but dead, with mortgage rates running 16 or 17 percent; the automobile market was moribund, with the prime rate, which determines other borrowing costs, well above 20 percent; and jobs were scar ce when they could be found at all. Various pundits cited something they called the pain index—the sum of the rates of unemployment and inflation—and discovered it was the highest in decades. In an attempt to fix this mess in 1979, Carter got rid of the hapless Fed chairman he had appointed only a year earlier, G. William Miller, and replaced him with the hard-money Democrat Paul Volcker, who was respected on Wall Street and in international financial markets. Tuccille, Jerome. Alan Shrugged: Alan Greenspan, the World's Most Powerful Banker. New York, NY: Wiley, 2002 (pages 161-162) 17 “The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust. You brought the economy to the brink of a Great Depression.” - John Taylor 18 Prices for imported goods from the newly industrialized countries (NICs) of Asia—a group that includes Hong Kong, Singapore, South Korea, and Taiwan— fell 2.4 percent per year from 1993 to 2006, compared with a 0.3 percent rise in price for total non-oil imports into the United States. Amiti, Mary and Stiroh, Kevin. Is the United States Losing Its Productivity Advantage? Federal Reserve Bank of New York Volume 13, Number 8, 2007

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labor participation rate and average duration of unemployment both increasing (see appendix). This results in weaker domestic demand which the US must offset by stronger net exports (and fiscal spending as the Japanese government did to keep nominal GDP in positive territory as consumers and corporate sector deleveraged to the tune of 20% of GDP 19). It also requires interest rates in the U.S. to remain low to allow imbalances created by excessive debt burdens to be worked out as consumers pay off their debts. Richard Koo posits that during a balance sheet recession (i.e. caused by a drastic increase in asset prices which need to deflate) monetary policy is useless. So, the challenge for the next stage relies primarily with fiscal authorities as global growth rebalances. This would require U.S. production to growth faster than domestic spending and surplus nations like China to increase domestic spending greater than production. So far the pattern of global growth, which relied on US consumption, is no longer feasible, and as a result we have seen, amongst other Asian and surplus nations, China spend close to 30% of GDP and expansionary credit policies to boost domestic demand to insulate itself from a debt-ridden U.S. economy. According to Ken Rogoff, "the growing role of the government, and the shrinking role of the private sector, almost surely portends slower growth later this decade20. The reason we are never going to get rid of Keynesian economics is because it provides an excellent excuse to rationalize a politician's overspending and a central banker's excuse to print money. The Keynesian elixir serves as an excellent shortterm remedy to match the short-term nature of a politician's tenure allowing the government to mitigate the problems to a future generation by encouraging overspending and printing money via the central bank in hopes that more money would be the answer to problems which were caused by overspending financed by easy credit. To pay for its excessive spending, government, as Keynes suggests, should levy taxes. The progressive taxation Keynes argued for, especially taxing the rich disincentivises businesses to spend. This is countered by lowering interest rates so low on the Keynesian belief that "any investment, even misdirected one, is better than no investment”. What Keynes did not realize that the most disruptive form of this taxation is on corporate earnings, which reduces their income thus leading to higher unemployment and lower production, or when the firms raise their prices to counter the taxes, increasing the inflation level (as we discussed in the aforementioned period of 1960s to 1970), followed by the interest rate, which leads to lower income and unemployment during the recession (i.e. Paul Volcker had to lower inflation by conducting an aggressive contractionary monetary policy, which led to the recession during the period of 1981-1982).


Japanese GDP grew throughout the 1990s despite a collapse in asset values amounting to 1500 trillion Yen. That collapse equates to three years worth of Japanese GDP. At the depths of the Great Depression, the US had by then lost the equivalent of one year's worth of GDP. The Japanese collapse equated to, in Koo’s words, the largest peacetime loss of wealth in human history. But in the Great Depression, US GDP fell by 46% and the unemployment rate reached 25%. During Japan’s “lost decade”, its unemployment rate never rose higher than 5.5%. How did they escape? The Japanese government issued bonds and spent the excess savings of the private sector in order to sustain GDP (see appendix). Koo, Richard. The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. Singapore, Asia: Wiley, 2009 (page 33) 20 Rogoff, Kenneth. The “New Normal” for Growth. Project Syndicate, 2009

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Asset Bubbles, What Asset Bubbles? It’s called a Quasi-Boom
By adopting a Keynesian based monetary policy21 approach, where interest rates are kept low to keep the economy in a quasi-boom, central bankers ignore the asset price bubbles that lead to sizeable debt build-ups on a consumer, firm and even a government level lead to weaker balance sheets and financial imbalances (e.g. the Japanese balance sheet recession through 1989 to 2005 and the ongoing U.S. one). Ignoring asset price bubbles promotes instability in the financial system and, as a result, on the economy. Ben Bernanke argues that a central bank should not respond to asset prices insofar as they signal changes in expected inflation22 but he does not realize that - as Michael Bordo, Dueker and David Wheelock pointed out23 - excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Let’s consider this example in the context of the housing market, which was the epicenter of the boom and as a result key variable in the credit crisis. As we discussed above, the Federal Reserve could afford to keep rates low because of relatively cheaper Asian imports, thus putting pressure on domestic producers to be more cost-efficient. These low interest rates fuelled a housing bubble (see image below), which allowed consumers to spend even more by utilizing the equity built up in their houses. So, while CPI remained within the Federal Reserve’s range - as Michael Bordo, Michael Dueker and David Wheelock argued - excess demand pressures showed up first in asset prices (i.e. housing prices) rather than goods & services. Hence monitoring asset prices would have alerted the Federal Reserve of the upcoming pricing instability and dangers of deflation such an astronomical increase in asset prices would have caused. Keynesians believe that deflation must be kept at bay; this is one reason we’ve seen the central banks balance sheet balloon. But do they not realize what causes deflation in the first place? It’s when asset prices turn into bubbles, which eventually burst, thus causing households and businesses to pay of the bad debts accumulated during the euphoria phase of the bubble. This is what happened in Japan, and it is evident from the Federal Reserve’s rhetoric that they did not learn anything from Japan’s Great Recession. The central bankers have a reactive approach, when in fact they should be proactive in preventing bubbles by nipping them in the bud because these asset price booms and busts occur as the Federal Reserve itself increasingly works to create the environment in which such bubbles flourish in the first place. The central bankers should pay more attention to asset prices since such movements influence and help to predict general price inflation, and point out imbalances early on. However, the Federal Reserve's Vice Chairman Donald Kohn recently dismissed this notion, claiming that monetary policy is not the appropriate tool for dealing with asset bubbles. This sentiment is also echoed by the current Federal Reserve Chairman Ben Bernanke, according to whom, "It is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment24." Au contraire says Joseph Stiglitz, a Nobel Laureate and professor of economics at Columbia, who, alongside another
21 22 23

"We use our interest-rate tool to try to meet our dual mandate which is full employment and price stability." - Ben Bernanke Ben Bernanke. On Bubble Prevention. WSJ, 2009

Bordo, Michael, Dueker, Michael and Wheelock, David. Aggregate Price Shocks and Financial Instability: A Historical Analysis. Federal Reserve Bank of St. Louis Working Paper 2000-005B, 2001 24 Ben Bernanke. Monetary Policy and the Housing Bubble Speech. American Economic Association, 2010

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prominent economist John Taylor (inventor of the Taylor rule which guides monetary policy), criticized Alan Greenspan, the Federal Reserve chairman from 1987 to 2006, for recommending consumers take on variable-rate home loans, as well as alluded to economists among those at fault for the financial crisis, which exposed major flaws in prevailing ideas (such as those advocated by Keynes)25. John Taylor disputes Bernanke by pointing out, "the evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust. You brought the economy to the brink of a Great Depression26,” respectively. Furthermore, William Dudley, President of the Federal Reserve Bank of New York, alludes to, how in fact, contrary to Bernanke27 and Jean-Claude Trichet28, ECB President, enough evidence is indeed available when he alludes to, "Over the past 25 years … I can identify at least five bubbles that one could reasonably have identified in real time: 1. Dollar appreciation in 1984-85; 2. Stock market overvaluation in 1987; 3. Credit market spread widening in 1998 associated with the failure of LTCM [hedge fund Long-Term Capital Management]; 4. Dotcom and Nasdaq bubble of 1999-2000; 5. Regional U.S. housing bubbles that are currently in the process of unwinding. I say this with some confidence because I tried to speculate against three of the five bubbles listed above myself (with limited success I might add, indicating why I remain an economist rather than have transitioned to being a trader). And I probably would have tried to speculate against the other two had good market instruments been available to do so29."

25 26 27

Lanman, Scott. Stiglitz Says Crisis Exposed ‘Major Flaws’ in Economics Ideas. Bloomberg, 2010 Matthews, Steve. Taylor Disputes Bernanke on Bubble, Blaming Low Rates. Bloomberg, 2010

"Central banks should adjust monetary policy actively and pre-emptively to offset incipient inflationary or deflationary pressures. Importantly … that policy should not respond to changes in asset prices" - Ben Bernanke. On Bubble Prevention. WSJ, 2009 28 "I would argue that, yes, bubbles do exist, but that it is very hard to identify them with certainty and almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not." - Jean-Claude Trichet. Asset Price Bubbles and Monetary Policy Speech. Mas lecture, 2005 29 Ben Bernanke. On Bubble Prevention. WSJ, 2009

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Today’s Prosperity, Tomorrow’s Peril
The total borrowing of the US is supposed to be restricted by its debt ceiling, just like a consumer's credit is restricted by his/her credit card limit. However, when it comes to the U.S. government, that debt ceiling is seldom adhered to. Since 1940, it has been raised 90 times, so the government can continue to borrow, crowding out private investment as interest rates are driven up, and spend its way towards (short-term) prosperity to make it seem like they know what they're doing to the voting public, and literally believing what, as Harvard Professor Ken Rogoff aptly put it, "We borrowed too much, we screwed up, so we're going to fix it by borrowing more." Again, this is influenced by none other than the "maestro" himself, Keynes, who in 1934 penned an article that indeed a country, he was referring to the U.S., can spend its way into recovery and that the government should solve problems in the short run rather than waiting for market forces to do it in the long run. The politicians and their policy makers ignore the long-term implications of their actions because after all "in the long-run we're all dead," a famous Keynes quote. Keynes' short-term thinking jives with a politician's thinking; by advocating deficit spending, instead of letting the excesses work out themselves (i.e. productive firms taking over unproductive ones in a recession), Keynes suggested policymakers keep interest rates low and government spending should increase, ignoring that in the long-term investors will demand higher yields and the deficit will worsen (as it has). The outstanding U.S. public debt has climbed 60% to $7.27 trillion from $4.537 trillion in December 2007 as the government has borrowed to fund two stimulus programs and fund record budget deficits, which reached $1.4 trillion for fiscal 2009. In his client memo, Howard Marks talks about leverage, "Leverage is what James Grant of Grant’s Interest Rate Observer calls “money of the mind,” meaning it can vanish if the lender is able to take his money back. And any combination of fundamental difficulty (i.e. weak economic growth), falling asset prices (i.e. deflating housing prices), reduced market liquidity, collateral value tests and margin calls can be the ruination of investors employing leverage30." Only in this case, the leverage is being utilized by the government, and contrary to Keynes belief that when the government borrows it does so from its people (back during Keynes time it did, but that has changed over time), the US government relies a lot more on foreigners than Japan, who has been able to avoid yield increases (so far but not for long) by investors as only 6% of its debt is held by foreigners, given the share of share of public debt that is owed to foreign nationals has risen from 31% in 2000 to 46% in 200931. Yale’s history professor Paul Kennedy aptly put it, “No amount of lecturing by free-market economists and bankers will convince me that a sovereign nation’s growing dependency upon foreign bondholders (each of them calculating the odds of staying with the dollar, or dumping it) is somehow a good thing. It is not. But to reduce that dependency means that Americans have to bite the bullet and close the gap between federal spending and federal income. That means, unavoidably, taxes—which the White House hates, and the Congress fears32.” As the economy becomes more and more leveraged (i.e. reliant on debt)

30 31

Marks, Howard. Touchstones. Oaktree Memos, 2009 Stiglitz, Joseph and Bilmes, Linda. The $10 Trillion Hangover. Harpers, 2009 32 Kennedy, Paul. In The News. Yale Bulletin & Calendar, 2007

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the marginal utility, or in this case productivity, drops, resulting in increasing bad investments and inefficient allocation of resources, which leads to GDP contracting and greater unemployment. The image below does a good job of depicting the law of diminishing returns for each dollar of new debt in the U.S. economy.

Politicians make extravagant promises in order to get elected, most commitments are scheduled to come due years after they leave office, and most civil servants are not very disciplined about making sure that those promises are paid in the purchasing power with which they were incurred. A good example of extravagant promises is current U.S. President Barack Obama’s jobs promise. During his election campaign in 2008, President Obama promised that if elected he would create, first it was 2.5 million jobs and later the number was revised upwards, 3.5 million jobs by the end of 2010, through Keynesian deficit spending policies through an economic stimulus package, which amounted to roughly 12% of GDP. Little did President Obama’s economic advisors realize the effects of negative marginal productivity of debt (i.e. as marginal productivity goes into negativity territory, each dollar of new debt has a contractionary effect on economic activity). For example, if marginal productivity of debt is 1, each new dollar in debt increases GDP by $1; if marginal productivity is 0.5, this means each new dollar in debt increases GDP by half; and if marginal productivity is 0, each new dollar in debt has no effect on GDP, so as the marginal productivity slips into negative territory given the increasing fiscal deficits projected33, thus having a contractionary effect on GDP. In 2008, the U.S. lost 2.6 million jobs and in 2009 3.3

William Cline's projections show, the level of US debt will climb from under $5 trillion now t o more than $50 trillion, and the annual cost of servicing that debt will soar to $2.5 trillion. By 2030, the United States will be transferring seven percent of its entire annual output to the rest of the world. In order to pay for its previous profligacy, the United States will have to forego $2.5 trillion—equal to the nation's current total annual spending on health care—of domestic consumption, investment, and government expenditures each year. At a minimum, this will lead to a long-term erosion of living standards in the United States. Bergsten, Fred. The Dollar and the Deficits: How Washington Can Prevent the Next Crisis. Peterson Institute for International Economics, 2009

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million jobs have been lost and unemployment has increased to 10% (in my opinion a true picture of unemployment is the U6 which is around 17%, which counts people seeking full-time jobs, part-time workers who want to work full-time but cannot and discouraged workers who have stopped looking but still want to work; see unemployment in the appendix). When President Obama made his 3.5 million jobs promise, total employment stood at 135.1 million, which meant that the 3.5 million jobs would take the number to 138.6 million by December 2010 as per the President’s promise. However, due to the continuing weakness in the economy since then to year-to-date, when President Obama promised the 3.5 million jobs the unemployment rate (U3) was at approximately 7% vs. the current 10%, and as per the latest jobs report, total U.S. employment fell to 131 million in November. As such, President Obama’s employment deficit has increased to 7.5 million. According to J.D. Foster of the Heritage Foundation, closing the Obama jobs gap would require monthly growth in employment of 583,000 over the 13 months between the start of December 2009 and the end of December 2010. To ascertain whether this is feasible consider that, as J.D. Foster highlights, the greatest 13month average increase in employment in modern American history (401,000) occurred during the peak of the Reagan boom in the 13 months concluding September 1984, dwarfing even the strongest similar period of job growth during the Clinton Administration. Closing the Obama jobs deficit would require significantly faster monthly job growth than ever before34.

Inflation, Pros & Cons
According to a recent study by Joshua Aizenman and Nancy Marion, inflation of 6% over four years could reduce the U.S. debt/GDP ratio by a significant 20%35. Inflation is a powerful method of wealth transfer or wealth confiscation, just as (and ironically) Greenspan and Keynes point out on the first page, because taxes are levied not in real terms but on the nominal price increase or interest payment. The U.S. government’s borrowings to spend on items that have no lasting value can have significant inflationary problems; as debt increases, well beyond the rate of actual economic growth, it is considerably easier to debase the purchasing power of currency than to tax citizens. Ignoring these can lead toward societal destruction. Debt collapse, colossal unemployment and negative economic growth can destroy societies and lead to hostility and authoritarian governments (i.e. Germany in the 1930s, leading to the rise of Hitler, as well Benito Mussolini, the fascist party Italian Prime Minister from 1922-1945, both of whom were democratically elected) which create large changes in the basic fabric of life. Given that inflation cycles are typically a fiscal phenomena that come about by prolonged wars (i.e. Afghanistan and The Iraq War) and immense social programs (i.e. Social Security and Medicare), then the temptation from a monetary policy perspective is to raise inflation expectations and inflate away debt (i.e. inflation of 6% over four years could reduce the U.S. debt/GDP ratio by a significant 20%, as we discussed above) because devaluing the U.S. dollar reduces the value of debt in real terms, thus enabling the government to


Foster, J.D. Obama Jobs Deficit Up Again, Real Jobs Strategy Needed. The Heritage Foundation, 2009 Marion, Nancy and Aizenman, Joshua. Using inflation to erode the US public debt. VOXEU, 2009

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manage higher public debt as each future dollar to service debt is worth less than today. However, prolonged inflation can have the same effects. They can be catastrophic, and history is filled with examples of societies wrecked by massive debasement of currencies and the destruction of people’s savings36; the latest example would be Zimbabwe, where currency notes were issued equaling to a billion Zimbabwean dollars, and in the late 1990s the Argentineans and Latin America as a whole. The rise in Gold price signifies the market participants belief that the U.S. Congress, and the Federal Reserve system that which creates new money by fiat, are the reasons for the erosion of the US dollar’s buying power, and subsequent rise in the price of the negative-carry, lack of industrial usage hard-asset such as Gold.


See point 15 above

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"Enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects." - Warren Buffett (World’s Greatest Investor)

“The unprecedented explosion of the US fiscal deficit raises the specter of high future inflation. But now the large fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth.” - Martin Feldstein (Economist)

Preserving the long-term purchasing power of the fiat currency (i.e. US dollar, British Pound and the Euro) is a near impossibility. Even when government officials understand the dangers and are determined to avoid debasing their currency, the drift toward inflation in fiat money regimes is virtually inevitable. Why? The primary reason: when Paul Volcker contracted the money supply to get rid of the inflationary era, as we discussed above, his tough medicine, during which the economy was under a nine month recession, eventually proved extremely successful evident in inflation dropping to 4% from an average of 14% during 1979. However, Paul Volcker was famous for doing things his way, and as Jerome Tuccille points out in his book, “Alan Shrugged: Alan Greenspan, the World's Most Powerful Banker,” he didn’t appreciate receiving advice on how to conduct monetary policy from Don Regan and Jim Baker. Paul Volcker’s belief that monetary policy should be conducted independently was the main reason he was not elected for a third year despite his willingness to continue, because the then-U.S. President to be George Bush Sr. and Jim Baker didn’t think they could count on him, like most administrations do on Federal Reserve Chairmen (e.g. Arthur Burns, the Federal Reserve Chairman from 1970 to 1978, who according to an article by Bruce Bartlett, “Burns had offered Nixon an implicit bargain. In 1971 Nixon controlled prices, and in 1972 Burns supplied money by the bushel. The policy helped reelect the president but also assured the next cycle of boom and bust… (concludes) that Burns used the Fed to help Nixon with full knowledge of the disastrous consequences for the economy37”, to facilitate their political goals (i.e. print money if needed to give a boost to the economy during economic downturns instead of letting the excesses work themselves out). The secondary reason: the alternatives are unpleasant choices such as i) increasing taxes (something Keynes was against, “tax rates should never have to be increased to pay for the new debt. The money borrowed and spent will revive the economy38.” This is surprising because Keynes contradicts himself by also advocating that, “instead of increasing interest rates (when “full-employment” arrives) government should raise taxes, run a budget surplus and keep the extra cash idle39.” That’s possible only in wonderland; ii) a drastic cut in government spending, iii) or default on its obligations, none of which a politician would implement (as the Paul Kennedy alludes to on page 14). These

37 38 39

Bartlett, Bruce. (More) Politics at the Fed? National Review Online, 2004 Lewis, Hunter. Where Keynes Went Wrong. New York, NY: Wiley, 2009 (pg 67) Lewis, Hunter. Where Keynes Went Wrong. New York, NY: Wiley, 2009 (pg 22)

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unpleasant choices were relatively easier to avoid in the past when the debt to GDP ratios of governments was lower. However, in today's environment where governments have spent enormous amounts of money to recapitalize banks, this has changed. The rising debt to GDP ratios of the developed countries (US, UK, Japan, Europe) has made it much harder to stand behind their obligations. According to Kenneth Rogoff, Former IMF Chief Economist and Harvard Professor, “Banking crises dramatically weaken fiscal positions in both groups, with government revenues invariably contracting, and fiscal expenditures often expanding sharply. Three years after a financial crisis central government debt increases, on average, by about 86 percent40.” So far, in the rescue and recovery process the U.S. government’s deficit has soared to more than 11% of the GDP, the highest level since World War II.

Going forward, I do not believe the current level of nominal GDP growth will be sufficient to meaningfully grow profits to pay for the U.S. stimulus (see appendix), let alone the Social Security and Medicare benefits nor the fiscal deficits-ex Medicare and Social Security, as Keynes suggested that deficits incurred to revive the economy will balance out once the economy is back on track; create the jobs the current U.S. President Barack Obama has promised (i.e. 3.5 million jobs by the end of 2010); tax revenues, or service the continually growing debt mountain, especially as the marginal productivity reaches towards zero. The low interest rate policy Keynes advocated resulted in the mal investments increasing to such an extent that now, according to Richard Koo, an erudite economist on Japanese balance sheet recession, argued recently that, "I can assure you if the government doesn't spend much more, your budget deficit will continue to


Rogoff, Kenneth and Reinhart, Carmen. This Time is Different: A Panoramic View of Eight Centuries of Financial Crises. Princeton, NJ: Princeton University Press (2009)

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increase. During the past 15 years, we in Japan tried to cut the budget deficit twice. On both occasions, the economy collapsed, and tax revenue dropped. The U.S. will experience that, too. If you say it's political suicide [to spend], not doing it will be an even bigger suicide41." Being long gold to preserve one’s wealth and prosper seems like a rational choice, especially given the structural differences this time round. Before getting into those differences, I would like to bring to the reader’s attention (one more time) the quote of Alan Greenspan, Former Federal Reserve Chairman, as a big factor as to why they should consider gold, “the financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” To reiterate the points outlined above, these differences include i) incredible increases in monetary base and excess reserves, which the banks will lend out once economic conditions improve; ii) low gold holdings of foreign governments, especially relative to their FX reserves (see appendix); iii) continuous decline in fiat FX, resulting in purchasing power of consumers being eroded because devaluing the U.S. dollar reduces the value of debt in real terms, thus enabling the government to manage higher public debt as each future dollar to service debt is worth less than today; iv) the need for fiscal stimulus to keep GDP from dropping below zero as firms and consumers deleverage; v) the rhetoric from the Federal Reserve is anti-dollar (not that they can help since they realize full well that increasing interest rates now, when the fiscal stimulus is close to completion, will bring about the 1937-1939-like recession, when the fiscal stimulus was removed and monetary policy turned contractionary) evident in Federal Reserve Governor Elizabeth Duke's comments to an economic forum that interest rates will be kept low for an extended period of time42; and vi) according to the latest gold supply stats from the World Gould Council, total supply decreased by 5% year-over-year in Q309 after increasing 1% in 2008 relative to 2007. In contrast, the monetary base, money supply, fiscal deficits and central bank balance sheets in the U.S., UK and ECB increased exponentially (see appendix). Given the decreasing value of these fiat currencies, especially the U.S., we have seen surplus nation’s echo sentiments that do not bode very well. For example, Luo Ping, Director-General of China Banking Regulatory Commission, “Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . . we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do43,” and Zhu Min, Deputy Governor of the People's Bank of China, "The United States cannot force foreign governments to increase their holdings of Treasuries…Double the holdings? It is definitely impossible44.”

41 42 43 44

Norton, Leslie. A Japanese Rx for the West: Keep Spending. Barrons, 2009 Lawder, David. Fed's Duke sees low rates for "extended period." Reuters, 2010 Robinson, Gwen. We ‘hate you guys’ even more now. FT Alphaville, 2009 Xin, Zhou and Subler, Jason. Harder to buy US Treasuries. Shanghai Daily, 2009

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Appendix – Anticipating Inflation, Jobs, Japan’s Recession, Central Bank Balance Sheets & Growth post-Deleveraging
Anticipating Inflation via Money Velocity and Bank Credit

The charts below provide a look at the stratospheric rise in monetary base, money supply, excess reserves, but the two charts that I would like to focus your attention on are i) Money Velocity (derived by dividing the money supply by the monetary base) and ii) Loans & Leases in Bank Credit plotted against the Monetary Base (% of yoy change). In my opinion, these two graphs are key to anticipating inflation because once the money velocity increases (i.e. the average frequency with which money is spent) and the loans and leases in bank credit (i.e. the blue line in the second graph) both rise (the second and fourth graphs also show that as monetary base has increased, it has not resulted in inflation because banks have held a higher amount of excess reserves, partly due to Federal Reserve paying interest on those reserves and partly due to corporate and consumers deleveraging, which means their appetite for borrowing has decreased; this case was also seen in Japan when banks, contrary to popular belief, were willing to lend but appetite was non-existent due to the deleveraging of non-financial firms and consumers45), this will result in money being spent and credit being lent out, respectively, in the economy, thus giving rise to inflation.

Money Velocity (1959 to YTD) and Total Loans & Leases of Commercial Banks (1974 to YTD)

Monetary Base (1918 to YTD and 2008 to YTD)


Koo, Richard. The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. Singapore, Asia: Wiley, 2009 (page 46)

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Excess Reserves at Depository Institutions (1959 to YTD and 2008 to YTD)

Money Supply (1981 to YTD and 2008 to YTD)

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Expected Inflation & Gold

In the chart below we have the University of Michigan’s survey of expected inflation over one year plotted against the price of Gold. As the reader will note, Gold and expected inflation closely followed each other since the 1980s till about 2004. In the early 1980s it was because of the inflation fighting policy of Paul Volcker, which up until then had skyrocketed from 1% to 14%. While the Federal Reserve kept monetary policy loose under Greenspan, it was not until 2004 when interest rates were brought down to 1%. The loose monetary policy in the 21st century, which led to the housing prices overshooting, worried investors of the long-term implications such as continuous fall in the value of dollar (or as Keynes would put it “debauching” the currency), another asset bubble; as a result we see Gold, like other commodities, starts to outpace expected inflation, which remained too low and more recently have started to creep up as evident in the rising break-even rates, on fears of increase in monetary base and debt burdens of fiat countries (primarily U.S., Japan and U.K.).

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A Look at U.S. (un) Employment

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A Few Key Charts from Richard Koo's Book & Presentation on The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (except the last one)

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The U.S., U.K. and ECB’s Balance Sheets

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Central Banks & Gold; Asset Price Inflations; Foreign Debt Ownership; and Real GDP Growth post-Deleveraging

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