In this exclusive interview for Matterhorn Asset Management, Robert Blumen discusses some important but widely misunderstood elements acting on the gold price. He explains that frequently cited gold demand statistics have no relationship to the gold price. In addition, he explains that the annual gold mine production is of very little influence, as gold is hoarded, not consumed like other commodities.

Robert Blumen was born in 1964 and grew up in Boulder, Colorado, United States. He is a graduate of Stanford University in physics and the University of California Berkeley in engineering. He lives in San Francisco, United States where he works in the technology sector as a software engineer, specializing in server applications and the architecture of scalable systems. He has maintained a lifelong interest in the Austrian School of Economic Thought and is an avid reader in economics and finance. His writings on gold and a variety of economic topics have been published by Financial Sense, the Ludwig von Mises Institute, LewRockwell.com, The Dollar Vigilante, and Marc Faber's Gloom Boom and Doom letter as well as other gold and financial sites.

Lars Schall: Mr. Blumen, how did you become interested in the subject of gold in general?

Robert Blumen: There were two main influences when I was growing up in the 1970s and 80s. We went through a period of very high inflation in the United States. President Nixon imposed wage and price controls in a misguided, or perhaps very cynical, attempt to fight inflation. And Nixon's successor, President Ford, handed out these silly little lapel buttons that said u201CWhip Inflation Nowu201D. I remember seeing a young man on the TV news who had reported a chain store for the economic crime of raising the price of one of their products. He was being given some kind of award for this.

The second historical event was the gold bull market of the late 70s. Then Reagan came in along with Paul Volker who he inherited from the former president, Carter. I wasn't paying much attention at the time but it stuck with me that gold had made this huge move.

Those two things came together and had a life-long influence on me. From that time I took away a curiosity about inflation. And that led me eventually to be curious about the whole field of economics. I was lucky that I came upon the Austrian School of Economics. I started reading Austrian economics in high school. The Austrian School emphasized gold as the basis of the monetary system and how well that has worked out over the course of human history.

L.S.: The growing interest in gold was underlined recently in a report that was published by the Official Monetary and Financial Institutions Forum (OMFIF), which has the title u201CGold, the renminbi and the multi-currency reserve systemu201C. (1) I think that this report is quite remarkable for various reasons. Do you agree?

R.B.: The report suggests that the international monetary system will accept gold in a more recognized way as a reserve asset. I think that this is already true, informally. There are many signs of this. Central banks have gone from selling to buying in recent years.

On the intellectual plane, I think there the consensus of many decades, namely that gold had been permanently removed from its monetary role, is changing. There is increasing discussion gold as a monetary metal among the elites. Several years ago, Benn Steil, a CFR economist wrote an opinion piece for the Financial Times (excerpted here) suggesting that the global gold standard worked better than the current system of floating rates. Robert Zoellick, who was president of the World Bank at the time, wrote a gold-friendly op-ed also in the FT a couple of years ago.

L.S.: What is your overall view on China?

R.B.: The popular perception of China an economic juggernaut on a path to eclipse the economies of the developed world. And how did that happen? Because their wise central planners chose an export-driven growth strategy. Many people now think that this strategy has gotten them to a point where they are deficient in domestic consumption, so they need to switch to a consumption-driven mode of economic growth; and that this also will be accomplished by the same wise central planners through a series of carefully designed five-year plans.

I think almost everything about this view is wrong; it is still largely a centrally planned economy and we know from the economics of the Austrian economist Ludwig von Mises, central planners cannot allocate resources.

L.S.: Why not?

R.B.: Mises wrote a paper in 1920, which became quite a famous and very controversial thesis in economics that was debated for decades. His paper was called Economic Calculation in the Socialist Commonwealth and you can find it for free at the Mises site.

If you have a very simple economy where people make consumption goods with their bare hands, this can be done with central planning. But Mises was trying to explain the economic growth that has occurred in the world from small villages to vast modern economies with millions of goods and a complex division of labor. How could this type of growth occur? The process requires the development of a complex inter-relationship of capital goods, natural resources, and division of labor.

In a modern economy, the number of things that could be produced is nearly unimaginably large. And the number of different production methods for even a single good is incalculable. Take gold for example — finding a deposit is quite complex. There are many ways to look for it. Magnetic fields, chemistry, electrical, drilling. How much drilling and where? And then, when you have the deposit, should it be open pit or underground? Should a resource estimate be established first or start mining and follow the vein? And what about the metallurgy, the chemistry? What type of electrical power? What types of labor? Refine the ore on site, or partially refine? Build roads, rail, or ship the ore? There are millions of decisions and each one needs to be fully answered down to the hire or purchase of specific pieces of capital and individual workers.

Mises' point was that all of these production decisions, not only what gets produced and what does not, but how it's done, can only be decided on the basis of prices. In particular Mises noted that the prices of capital goods are crucial to production decisions. Contrary to what you read endlessly in the financial news about consumption driving the economy, spending on capital goods is the major part of total spending.

Only with prices can you have accounting, which is the ability to calculate profit and loss. In a market economic system, the important decisions are made on the basis of an anticipated profit and loss, which is the difference between the expected prices received on sales and the costs.

Mises had the insight that prices of capital goods are only a meaningful tool for resource allocation if they are established by a competitive bidding process among entrepreneurs. Entrepreneurs must choose how much they are willing to pay to acquire a specific capital asset and hire the skilled workers they need. Entrepreneurs are people who put at risk their own capital, and will either earn a profit or suffer a loss.

The diversity of entrepreneurs is a key part of this. Each business firm or company founder has a unique view of their own market, which may be highly detailed and based on years of experience. Mises also noted that each entrepreneur has his idea about what the customer will want. The market is a decentralized process in which the entrepreneur who has the best plan for each particular asset, along with some cash, will end up in a position to choose how that asset gets used.

In my own former job, I worked for a company that was in a small sub-sector of a sub-sector. There are perhaps half a dozen people in the world who truly understood our industry, maybe fewer. The entire world is full of experts like this, people who understand a particular industry or product really well.

Can you imagine, for example, that we would have iPhones or Kindles if the technology industry was planned by a central committee? Before the iPhone, competition in the mobile industry was primarily over how many minutes per month you got on weekdays or weekends. When Steve Jobs decided to develop the iPhone, he risked $150 million of his shareholder's money and took on the US mobile industry, who did not want a disruptive phone taking away the spotlight from their monthly plans.

Central planning means the abolition of this type of competition. And that is the problem that Mises identified. There is no way to replace this competitive bidding process with a single planner or a planning committee. The central committee cannot bid against itself for the opportunity to acquire specific capital goods and labor. That would be nothing more than the left hand bidding against the right hand. They could assign fake prices to resources and pretend to calculate the best projects, but the numbers that would come out of this process would not be prices, they would be arbitrary numbers that did not reflect the best possible use of scarce productive resources. Mises showed that a central planner has no basis for making economic decisions, even if the process did not become entirely politicized, as it always does.

Read the rest of the article

Robert Blumen [send him mail] is an independent software developer based in San Francisco. Robert wishes to thank James Hickling of GoldMoney for assistance in copy editing the final version.

Robert Blumen Archives

Introduction

Most gold market research is based on the premise that the supply side of the market can be characterized by the quantity supplied and demand side by the quantity demanded. The specific cause and effect relationship between these two variables and price is often unstated; and perhaps rightfully so: is it not obvious that a greater quantity demanded is the cause of a higher price, and that a greater quantity supplied is responsible for a lower price?

No.

This article will show that market forecasts based on quantities of gold are meaningless. Widespread statements like "Gold demand was up by 15% in 2012" are true but only if they are understood in a misleading sense. The supply and demand sides of the market consist of supply and demand schedules, not quantities. A price forecast based on quantities is a non sequitur because there is no causal connection from the quantities to the price. This error has side-tracked the majority of analysts into an obsessive focus on quantities while ignoring the actual drivers of the price.

The first part of this article will examine the definitions of supply and demand and discuss their relationship to price. Most analysts define supply and demand as quantities. There are several ways to do this. If used consistently, any of these definitions are valid but none of them are useful for the purpose of the purpose of price estimation.

After establishing the definitions, I will show that the quantities supplied and demanded must conform to an arithmetic relationship that is logically true but has no causal connection with the gold price. Supply and demand totals can be any numbers that satisfy the arithmetic relationship, while at the same time the price can rise, fall, or stay flat.

The next section will explain the true drivers of the gold price: the supply and demand schedules. These schedules are not scalar quantities and cannot be measured; they can only be observed indirectly through the gold price itself. I will show that the cause and effect relationship between quantity and price runs in the opposite direction from what is widely assumed. The quantities are driven by a temporary disequilibrium between the market price and the supply and demand schedules of investors. This disequilibrium induces market participants to supply, and to demand gold to bring their portfolio in line with their preferences.

The final section delves into materials from the CPM Group, a prominent and respected gold market research consultancy, showing how their research relies on the same error.

This article does not entirely stand alone; it builds upon other articles that I have written about the gold market, and on the marginal price theory of the Austrian School. Some parts of this article will not make sense unless you are familiar with some of these concepts. I chose to do this partly to avoid repeating ideas that I have already published, and partly to control the length. I have linked to backup material that I believe is relevant.

The Usual Explanation

First, let's look at the examples. Most published analysis of the gold market is concerned with supply and demand numbers.

From the UK Telegraph, under the headline, Gold demand increases 15pc:

As the gold price increases, demand for gold and other precious metals has continued to grow. Demand for gold has continued to grow in 2012 and is predicted to increase further next year. Research by Source, a provider of exchange traded products, shows that inflows into European gold ETPs have reached $6.8bn this year to date, constituting a staggering 15.4pc growth

Almost every page of the World Gold Council's Third Quarter 2012 Gold Demand Trends deals with either the quantity supplied or demanded by a sector of the market. The following sentences are selected at random for illustrative purposes:

Third quarter gold demand was up 10% on the previous quarter but 11% lower than record year-earlier levels (p1)

Investment demand was 16% below the exceptional levels witnessed in Q3 2011. (p2)

Total demand (including OTC investment and stock flows) was 2% weaker year-on-year … (p2)

The most significant contribution to the fall in gold demand came from a drop in bar and coin investment.

The World Gold Council's web site contains the following:

Since 2003, investment has represented the strongest source of growth in demand. The last five years to the end of 2011 saw an increase in value terms of around 534%. In 2011 alone, investment attracted net inflows of approximately US$82.9bn.

My third example cites CPM Group's 2012 Gold Yearbook Press Release:

Investment demand, the key driver for gold prices, remained at historically high levels last year. Net additions to private investor gold holdings declined to 34.3 million ounces in 2011, down 5.8% from 2010 levels. Even though net additions to private investor holdings slipped lower in 2011, a year in which prices touched a record high, the decline had followed two years of double-digit growth from already high levels of net additions to investor holdings. (p2)

Gold fabrication demand rose 0.6% to 72.9 million ounces in 2011, slower than the 2.3% growth in 2010 due to higher gold prices. Despite higher prices, many consumers sought to purchase more gold jewelry, specifically in developing countries, as a hedge against inflation and form of savings. Developing countries' demand for gold in the form of jewelry rose to 50.2 million ounces, up from 49.6 million ounces. (p3)

The bearish financial planner Arthur Stein also believes that gold demand is declining (based on the World Gold Council's figures) which will result in a lower price:

Demand for Gold Declines, Will Prices Follow?

…Demand for gold has been declining worldwide, but prices haven't. What does this mean for someone investing in gold?

Gold demand declined 11 percent in the third quarter of 2012 compared to the third quarter of 2011, according to the World Gold Council (www.gold.org). Demand fell in every sector except for purchases by central banks.

Market Sectors and Flows

Most gold analysts divide the market into sectors. This section will discuss how this is done and what the quantities mean in relation to the sectors. A typical sector breakdown is: mines, industry, jewelry, investors, and the official sector (central banks). Some writers break the investment sector down into bars, coins, and ETFs. The choice of sectors is not critical to the points that follow; none of the conclusions would change if, instead of these sectors, flows between countries were used instead. Some reports combine the two approaches, dividing the developed world market into sectors and treating the rest of the world on a country or regional basis. Any of these breakdowns would serve equally well.

Below is a list of the sectors, their buying, and their selling:

Sector

Buying

Selling

Mine

Not a buyer

All production sold to the market, where it is eventually refined into investment, jewelry, or industrial products.

Industry

For electronics, dentistry, and other applications that use up gold.

Recovery from scrap

Jewelry

Raw material for fabrication.

Melt from scrap jewelry sold by people who no longer want it.

Investor

Additions to portfolio holdings.

Reductions from portfolio holdings.

Central banks

Add to gold reserves

Subtract from gold reserves

Inter-sector Flows and Quantity Balance

The quantity balance between sectors is at the core of most market analysis. The quantity balance is an equation relating all of the flows in the market to each other. (A flow is the quantity bought and sold, while a stock is a quantity held by someone over time). Quantity balance is the requirement that every movement of gold must be accounted for on the buy side and the sell side. It is similar to the way that double-entry bookkeeping works. This section will derive the quantity balance equation. The following section will discuss its significance.

Over a one-year period, every trade that takes place between a buyer and a seller is counted in the following way: the quantity of gold bought (and sold) is added the buying sector's gross quantity bought and to the selling sector's gross quantity sold.

At the end of the year, net flows for each sector are calculated. The definition of the net flow for a single sector is:

sector net flow = sector total buying — sector total selling

Sector net flow can be a positive number, meaning that the members of the sector bought more than it sold; or a negative number, indicating that the members of that sector sold, in aggregate, a greater quantity of gold than they bought.

Assuming that mines sell all of their production, which is nearly always true, mine sector net flow is always a negative number.

mine net flow = mine buying — mine selling = 0 – mine selling = – quantity mined

For every trade, the quantity bought is equal to the quantity sold. This means that the sum of all sector net flows is zero. By the rules of algebra, this arithmetic identity can be rearranged in several ways:

1. quantity mined + net industry + net jewelry + net investor + net official = 0
2. net industry + net jewelry + net investor + net official = quantity mined

The CPM Group uses a different sector breakdown than I have used here, so their quantity balance is a little bit different. They use the following market sectors: total supply (mine plus scrap), fabrication demand (industry plus jewelry), official sector and investment. Their quantity balance in their partitioning is summarized in equation (3), below.

3. quantity mined + industry sold + jewelry sold = industry bought + jewelry bought + net official + net investor

In this breakdown, official and investor sectors have a net flow on the right side of the equation but the jewelry and industry sectors have gross purchases on the left of the equation and gross sales on the right.

The preceding equations are all saying the same thing: all the gold that comes out of mines ends up as net inflow into one or more market sectors. These identities all follow directly from the laws of arithmetic. They contain no new information. They are only a restatement of the original assumptions, namely, that miners sell all of their production, and that no gold is destroyed during a trade. The mine sector net flow is always negative but the other sector net flows could be positive, negative or zero.

Gold can be destroyed not in the physical sense, but in the economic sense. This means that the industrial process renders some of the metal into a form where it would be too costly to recover. The boundary where recovering gold from industrial use is cost effective depends on many factors, especially the price of gold, which can change over time. Gold destruction occurs only in the industry market sector. The rate of gold production always exceeds gold destruction. Consequently the total of gold held above ground grows over time.

The False Logic of Quantities

I believe that the error of attributing gold price moves to quantities is based on the following invalid thought process on the demand side (with similar thoughts on the supply side not shown here):

1. The gold price is driven by supply and demand
2. Supply and demand are quantities
3. Looking at the demand side, more demand implies a higher price, less demand a lower price.
4. More supply means a lower price, less supply a higher price.
5. The key to forecasting the gold price is therefore measurement of gold supply and demand.

Arthur Stein is representative of this type of reasoning. Quoting at length from his bearish forecast,

Gold is unlike other commodities in many respects. For investors, one of the significant differences is that the supply of gold (called “above-ground gold") never decreases; it only increases. So declining demand should cause a decline in the price of gold, not an increase.

The sources of total demand are another concern. Jewelry demand has been declining since at least 1997. Jewelry demand in 2011 was 40 percent lower than 1997 and demand in the first three quarters of 2012 was 9 percent lower than the same period in 2011. … Industrial and dental demand declined in 2011 and is on track to decline another 6 percent this year. … Investment demand (bars, coins, Exchange Traded Funds, etc.) declined 3% in the first three quarters of 2012 compared to 2011.

The bright spot for gold demand was official sector (central bank) purchases. Central bank activity went from net sales to net purchase in 2010, and net purchases continued to be positive in 2011 and the first three quarters of 2012.

The main problem with this view, as I will show in the next section, is that there is no cause and effect relationship between the quantities and price.

Flows not the Cause of Price

The financial media commonly reports that buying is the cause of the price going up. Stories in the financial media usually report only one side or the other side of the market. For example, an increasing number of small investors buying coins is often cited as the cause of gold price strength. However, the same story could equally well have been written as a bearish report about the increasing number of investors willing to sell their coins. Either story would be true, at least from a quantitative standpoint and both would be wrong in attributing the movement in the gold price to one side of the market only.

If the reporter accurately described a large volume of coin buying and an equal volume of coin selling, then what conclusion about the price should the reporter draw? Exactly none. Buying as such is not the cause of the higher gold price, nor is selling the cause of price declines. If buying could take place without selling or selling without buying, then one or the other could be an independent cause of price moves. But neither can occur without the other. Buying and selling occur always in equal quantities, and, at the same time. For every purchase of gold by a buyer, an equal quantity is sold by the seller. The quantity of buying, which is always the same as the quantity of selling, is not the cause of the gold price.

While everyone agrees that the gold price is driven by supply and demand, not everyone who voices agreement means the same thing. The correct version is: the gold price is driven by supply schedules and demand schedules. Most analysis of the gold market is based on an incorrect interpretation of the statement, namely, the gold price is driven by the quantity supplied and the quantity demanded. An increase in gold demand is the cause of a higher price if an increase in demand, means a change in the preference rankings of coin buyers for more gold/less cash. In that case, all other things equal, transactions would occur at a higher price.

The quantity balance equations are logically valid at all times, but they are accounting identities, not statements of cause and effect.1 The quantity bought and sold is not an explanation of why the price moved. All inter-sector flows must balance, but flow is not the cause of the price; it is a summary quantity of gold traded, at whatever price. Any combination of positive, negative, or net inflows or outflows into any one or more sectors could occur during a year where the gold price was higher, lower, or unchanged.

Suppose during the last year that net investor inflow is a positive number and net official inflow is negative. This indicates that over one year, investors purchased gold from central banks. But this fact is an arithmetic identity, not a cause of the gold price movements during this year. If, the following year, central banks on net purchased gold from investors, we are still no closer to knowing at what price the gold was purchased, and whether that price is higher or lower than the current price.

The True Cause of the Gold Price: Marginal Preferences

The theory of equilibrium price formation is necessary to understand the remainder of this article. I will not attempt a detailed explanation of the theory here, but the interested reader may find it in one of the following references: Rothbard shows in detail how supply and demand schedules are derived from individual preference rankings in Man Economy and State, starting with his discussion in Chapter 2 sections 4-5, and Chapter 2, section 8: Stock and the Total Demand to Hold, and then later as applied to money in Chapter 11 (Money and its Purchasing Power) sections 2-5.

Each investor strives to maintain their desired holdings of all potential assets, including cash (i.e. one or more national currencies such as the US dollar or euro). As their preferences change, and as market prices change, investors adjust their portfolio holdings, at the margin, to bring them in line with their preferences. The price of an asset emerges as investors balance, bid for assets they wish to hold more off and offer assets they prefer to hold less of.

Supply and demand as they contribute to the price must be understood not as quantities but as schedules. Market prices balance the aggregated supply and demand schedules of the entire market. These aggregated schedules are also known as the more widely used supply and demand curves. In the standard micro-economic presentation, the supply and demand curves intersect at a point, marking the price and the quantity.

I have written about the application of supply and demand schedules to the gold market in Does Gold Mining Matter? There I explain that the supply schedule for gold (in dollar terms) is dominated by the owners of the world's existing stockpile of gold, and that mined gold during any one year period has a relatively small impact on the supply schedule. The price is set primarily by the reservation demand schedules of the owners of the existing gold. In the same piece, I show that the quantity mined, which many analysts incorrectly believe is "the supply", has little influence on the gold price.

The quantity balance constraint cannot be a cause of the gold price because balance equations contain only quantities. The gold price is the quantity of money exchanged for the quantity of gold. Any explanation of the gold price must contain some reference to the quantity of money involved. Equilibrium price theory provides a complete theory of the cause of the gold price, taking into account the gold and money sides of the market.

If the gold price is higher now than it was at some point in the past, that can only be due to a shift in preference schedules. One of the following must be true: 1) either buyers valued the gold more highly and thus were willing to pay higher price, or 2) sellers valued their gold more highly and were only willing to part with it at a higher price. Historical net flows provide a summary of where in the market were the buyers who valued gold the most highly, and the sellers who valued it the least.

Up to this point I have argued that the quantities supplied and demanded are not the cause of the gold price. The true causal relationship between price and quantity is nearly in the opposite direction. Transactions occur in the market because there are some investors whose mix of cash and gold holdings is not consistent with their preferences. Trading will occur until everyone has adjusted their portfolios, at the margin, to their preferred holdings. If no one changed their preferences after this moment, and no new gold were mined, then no more trading would occur.

Trading continues because people are always changing their minds about what they want to own. Individuals who did not previously consider themselves gold investors enter the market; others no longer consider gold a good investment and sell out. The more individual investors that have changed their preference rankings since the last market price, the greater the disequilibrium in the market, and the more change in the ownership of gold and cash is necessary in order for investors to reach their desired holdings. The volume of trading reflects the extent that holdings of some individuals no longer reflect their preferences.

Attributing a higher gold price to an increase in coin buying alone ignores the equal quantity of coin selling that is necessary for more coin buying to occur. More coin buying means more coin selling. The media story about coin buyers driving the gold price higher could be correct, if the buyers are the only ones whose preferences have changed. In that case they are willing to pay up, higher into the supply side of the market. But action in the coin shops could also result from sellers liquidating at lower prices, or a simultaneous set of changes by some buyers and some sellers that cancelled each other out in price action, leaving the price unchanged after a large volume of trading.

Demand Schedules Not Measurable

So far I have argued that the gold price is an outcome of the preference schedules of investors. A preference schedule is not a number. It is a spiky curve representing a range of quantities and prices. Schedules are not directly measurable in the way that quantities are, because they include hypothetical quantities that would be supplied and demanded at prices above and below the market. In order to have the complete supply and demand schedules, the analyst would have to know how much gold would be sold and purchased at every price. When gold trades, we know only that the quantity supplied and demanded at one price.

Laura Davidson explains this point in her excellent piece The Causes of Price Inflation and Deflation. In reading the quoted passage, it may help to understand that reservation demand for money is another term that means the same thing as the term that I have been using, cash holding preference, except measured against all goods in general.

When the social reservation demand for money changes, it can neither be measured nor observed directly. Whether market participants hoard money, or dishoard it, the amount of money in their wallets and their bank balances in the aggregate remains exactly the same ceteris paribus. There is no special place from which money flows, or to which it flows, when the demand for cash balances changes.

The same point can be made for any good that is demanded in order to be held in stockpiles. Examples include not only gold but most financial assets such as stocks and bonds. Reservation demand can be inferred, indirectly, by observing the price. Davidson continues,

Nevertheless, it is possible to observe the effects of the change [in reservation demand]. Suppose, for example, prices-in-general are falling, and yet the supply of goods in the market has not changed. From this it can be deduced that the exchange demand for goods must have fallen. But let us also suppose the money stock has not changed. This leaves only the reservation demand for money as the causative factor for the reduction in the demand for goods and the ultimate cause of the price deflation.

While I have spent most of this article discussing demand, the supply side of the market works the same way. Supply schedules and demand schedules together drive the gold price. Supply schedules are immeasurable as are demand schedules.

Conclusion

The main point that I have tried to show is that the demand numbers used in most gold market reports do not measure the demand side of the price formation process. The same could be said about the supply number. These two numbers are connected through the quantity balance constraint but they are not the cause of the gold price.

Gold market analysts have a tougher job other financial analysts. In Value Investors Hate Gold, I argue that it is more difficult to analyze the yellow metal than equities because quantitative measures such as yield, cash flows, balance sheet leverage, and growth rates provide a fundamental basis for analysis. Gold has none of those things.

The fundamentals of gold are the current purchasing power of money; expectations about the future purchasing power of money; the growth rates of various national money supplies; the volume of bad debts in the system; expected growth rates of bad debts; the attractiveness of other available investments; and the investor's preference for consumption rather than investment. These factors do not act directly on the gold price. Instead, they are focused through the prism of investor preferences, which are not measurable. The price is the ultimate measurement of how investors view these factors. The paradox of gold is that which drives the price cannot be measured, that which can be measured does not drive the price.

Appendix: The CPM Group

Introduction

I have devoted an entire section to The CPM Group's gold research because, of all of the major research firms, they have has the most information available about how they think. While I chose to focus on the CPM Group, as far as I have been able to determine from published reports, GFMS agrees on the basic framework of the quantity model, if not on all of the particulars. The other major research firm, the WGC, uses the numbers compiled by GFMS. From those aspects of the CPM Group's thinking that are available to the public, I have tried to reverse engineer how they see the gold price from what is available.

In the next section I will explain my interpretation of their thinking. And then, in the following section I will provide my critique of the CPM Group. I have found several problems in their model: the first, that they consider market data on a year-by-year segregated basis; the second, the belief that gold holdings are not part of the market; and third, the premise that net flows drive the gold price. I will discuss each of these points in more detail below.

The CPM Group's Model

My sources consist of the CPM Gold Yearbook 2012 (cited below as Yearbook) and a 1996 presentation to the Australian Gold Conference by the CPM Group's founder Jeffrey Christian, Gold: Supply, Demand, Price and Research (below, AGC Presentation). After reading the sources, I have synthesized what I believe to be the CPM Group's model of supply, demand, and price into the following propositions:

Gold Supply: The gold supply consists of mine production plus "secondary sales". The latter consists of melted gold sold in the form of scrap by the jewelry sector and the fabrication sector. See the Yearbook, p. 105: Gold supply, which includes gold output from mines in market economies, gold exports from transitional economies into market economies, and old gold scrap that has been refined, is estimated to have totaled 119.9 million ounces in 2011….

Gold Demand: Gold demand is the sum of the following: industrial use (electronics, dental, medical, other), gold use to make new jewelry, official sector net flow (IMF, US, Canada, other) and investor sector net flow (coins, bullion, bars, Indian). See the Yearbook, pages 6-7. Investment demand is defined by CPM in some places as the net flow of the investor sector and in other places as the net flow of the investor and official sectors combined. My citations in support of this are:

1. Yearbook, p. 4, labels on the chart titled Gold Supply and Demand shows investor demand as the difference between supply (defined as mine + secondary) and fabrication demand. From the quantity balance equation (3, above), total supply less fabrication demand must equal net investor and official sector flows.
2. Yearbook, p 11: Net purchases of gold by central banks have complemented healthy gold investment demand…. If net central bank purchases have complemented investor demand, they cannot be the same thing.
3. See the Yearbook, p. 29, Investment demand (subtitle), followed by: Net additions to private investor gold holdings declined to 34.3 million ounces in 2011

Quantity Balance: Demand equals supply. See the Yearbook, pages 6-7. The total supply consists of 31.0Moz mined, 4.5Moz secondary, and 13.2Moz from transitional economies for a total of 50.0Mz. Total demand consists of 43.9Moz fabrication, -8.7Moz official sector reserve sales, and 14.8 net investor portfolio additions, for a total of 50.0Moz.

Quantities Drive the Gold Price: Each of the terms in the quantity balance equation is a contributing cause of the gold price, with net investment demand being the most important cause. If the net investor sector flow is a large positive number, this is deemed a cause of a higher gold price, while a small positive or a negative number is deemed a cause of a lower gold price. My reason for thinking this is the following citations:

1. Yearbook, p. 8: (chart) Net Investment Demand is plotted on the left scale of the chart with the gold price on the right scale. The chart's title is Investment Demand's Effect [sic] on Gold Prices.
2. Yearbook, p. 9: Gold investment demand is one of the strongest influences on gold prices.
3. Yearbook, p. 10: …it is projected that net additions to private investor gold holdings will remain at extremely high levels, which is expected to help keep prices at elevated levels during 2012.
4. Yearbook, p. 69: "Central banks were net buyers of gold for the fourth consecutive year in 2011". (i.e. net flow into the central bank sector was a positive number).
5. Yearbook, p. 233: Strong investment demand for gold, particularly during the first three quarters of the year, pushed prices higher.
6. AGC Presentation, p. 4: my next slide [not shown in PDF -- rb] illustrates the weightings of each supply and demand sector in CPM Group's amin gold price model. Central bank activity and investment demand trends … exert much more powerful influences in determining the gold price.
7. AGC Presentation p. 8: SLIDE SEVEN: Investment Demand's Effect on Prices. My next chart compares levels of investment demand for gold to changes in gold prices. We call it our most important chart. Herein lies the key to accurate gold price forecasts: Investment demand is the most important influence on gold prices. Markets are made at the margin, and in the gold market investors are the marginal market participants.
8. AGC Presentation, p. 8: Over the past few years, investors have not been buying a great deal of gold. As a consequence, gold prices have languished. Investment demand reached a low of 184 mt (5.9 million ounces) in 1994. Investor demand increased 11.7% in 1995, but the level, at 205 mt (6.6 million ounces), remained low. A further increase, to around 239 mt (7.7 million ounces), is projected for this year. The steady increase is being reflected in the slow upward march in gold prices; the low levels overall are being reflected in the fact that prices are not rising sharply.

Forecasting the Gold Price: Knowing the cause of an event does not necessarily help to forecast the event. A cause can only be used to forecast an effect if the cause occurs far enough in time before the effect that the cause can be identified and acted on.

Mr. Christian states that net investor flows can be used to forecast the gold price. I am not clear from the following whether Christian is saying that the net investor flows in one year can be used to forecast the following year's gold price, or whether he means that a correct forecast of next year's net investor flows is the key to forecasting the next year's price. Below is a relevant passage:

AGC Presentation p. 8: SLIDE SEVEN: Investment Demand's Effect on Prices. My next chart compares levels of investment demand for gold to changes in gold prices. We call it our most important chart. Herein lies the key to accurate gold price forecasts: Investment demand is the most important influence on gold prices. Markets are made at the margin, and in the gold market investors are the marginal market participants.

Summary: Based on the above, it appears the CPM Group posits the following logic regarding the gold market, though I cannot say for certain because their quantitative model is proprietary.

1. Supply is defined as mine plus secondary
2. Demand is the sum of the various components.
3. The price on any market is set by supply and demand. If the number that CPM has defined as "demand" increases, the price will be higher.

Critique of CPM Group's Model

Consumption versus Asset

My first criticism of the CPM Group's model is that conceive the of the price formation process only in the context of annual data. In fact, annual production and consumption quantities are quite unimportant in the overall picture of gold price formation. The error of looking at gold as an annual market is widespread and follows from a failure to understand the difference between a consumption commodity and an asset.

Most commodities are produced primarily for consumption. Consumption permanently destroys the economic value of the commodity (or in some cases, makes the commodity costly to recover back to a form where it has economic value). The market demonstrates that a commodity is produced mainly for consumption by the lack of large above-ground stockpiles. A small stockpile measured in terms of production output would be several days, weeks or a small number of months at most. All commodities other than gold have stockpiles that are small by this definition.

In consumption commodity markets, production and consumption must remain very nearly in balance because on the one hand, reserves will be depleted quickly if consumption exceeds production and, on the other hand, production can only exceed consumption if stockpiles increase. Stockpiles generally will not increase much beyond a few weeks or months of production flow because users and speculators have historically demonstrated that they are not willing to hoard larger supplies. For a consumption type commodity, the supply that is produced during a given year, plus small stockpiles, is the only supply available for consumption during that year.

An asset is a good that people buy in order to hold, rather than consume. Some examples of assets are land, property, money, stocks, bonds, and gold. Nearly all of the gold ever mined still exists either as bars, coins, or jewelry. The total quantity of gold stockpiles grows by about 1-2% per year, implying a ratio of stockpiles to one year production in the 50 to 100 x range. Only a small amount of gold is truly consumed. Even jewelry fabrication is not consumption because its bullion value is retained and can be reclaimed at the relatively low cost of melting. Gold is held in a continuum of products which can be transformed from one to the other, such as bars, coins, and jewelry.

Price formation in an asset market works differently than in a consumption market. Because consumption goods are bought in order to be permanently destroyed, buyers must bid for newly mined product. The reservation demand to and from stockpiles does not play much of a role in the pricing process. All possible supply (regardless of price) is from recent production, and any possible demand (regardless of price) is demand for current consumption. In a consumption good market, the lack of stockpiles ensures that:

quantity supplied = quantity produced

quantity demanded = quantity consumed

In an asset market production and consumption (destruction) do not significantly impact the supply or the demand because they both are small compared to the above-ground supply. In a consumption market, the trade is mostly from producers to consumers, while the majority of gold trading consists of movement of gold from one stockpile to another stockpile. The supply schedules are dominated by the offers of existing stockpiles at a range of prices. The demand schedules are dominated by reservation demand to hold existing stockpiles. Selling by producers and buying by (destructive) consumers is small in comparison.

As I have explained here, the gold market is a single integrated market where all sellers compete against all buyers. It is not an annual market for the current year's supply. Buyers compete to buy any gold, not only for gold mined in the last year. All sellers compete to find buyers. The reservation demand for existing stocks, because it is so large, is the major player in the price formation process.

While I have argued above that the quantities traded do not drive the price, my point here is a different one. Consider a gold market without producers or (destructive) consumers. The market would clear at a price and quantity where the supply and demand schedules come into balance. Adding a relatively small quantity to either side of the market would not move the price much, even if the buyer (seller) were totally price-insensitive because of the large depth of the supply and demand schedule on either side of it.

Recent Activity Sets the Price

In the AGC Presentation (p. 100), Mr. Christian explains that he does not consider gold holdings to be part of the market if those holdings have not changed hands recently. This is consistent with the view discussed in the previous section, that the market price clears only the current year's supply against the current year's demand. If I understand the reasoning behind this, Mr. Christian believes that only transactions participate in price formation. After a particular gold ounce has not been traded for a long enough time, he no longer considers that ounce to be part of the market. At that point, in Mr. Christian's view, that ounce has no impact on the market price. This view is consistent with the CPM's mistaken focus on quantities traded as the keys to the gold market:

Gold also has a multiplier. For the Australian dollar, as with the U.S. dollar, I believe the multiplier is around 3 or 4. For gold, our estimate is that the multiplier is around 9 at present. That is, an ounce of gold entering the bullion market, from mine output, scrap recovery, central bank sales, or wherever, will be involved in 9 transactions before it exits the bullion market, either being used in a fabricated product or being dumped into an investor’s inventories somewhere.

Mr. Christian's view is entirely mistaken. As I have explained, the supply side of the market is formed by all of the owners of existing gold, who offer it at a range of reservation prices. The price is an emergent property of the decisions of all of the owners of gold stockpiles to not to sell below their reservation prices, and the decisions of gold bidders not to offer above their reservation prices. The reservation demand of the sellers of existing gold, no matter how long ago it last traded, is the primary reason for the gold price being where it is.

Net Sector Flows

My second criticism of the CPM Group's model is over-emphasis on net sector flows. In the preceding section, I discussed Mr. Christian's incorrect view that gold holdings are not part of the market. Removing holdings (the primary locus of price formation) from consideration leaves only quantities recently traded as a possible object of investigation. The CPM Group goes to the far regions of the earth to measure quantities. The effort expended to get the numbers is impressive. While these numbers contribute to our understanding of what is going on in the market, they are largely irrelevant to an understanding of the price.

As explained above, net sector flows are caused by preference changes, and are not a cause of the gold price. Quantity balance rules require that "total supply" as the CPM Group defines it be equal to the sum of gross fabrication demand and net investment flows (private and official). This identity is logically valid and true at all times, but it contains no information about the cause of the price, for the reasons given above: a net flow into, or out of, one sector of buyers is not the cause of the price being higher, or lower. For every inflow into one market sector, there are equal and opposite outflows from other market sectors.

As discussed above, I believe that the CPM Group's model attributes causality to net flows based on the mistaken belief that the market's price equilibration process only balances net flows during a year. As explained, flows are not a cause or driver of the price; they are a reflection of changes in preferences that have occurred since the last trading activity. These changes in preferences determine where the gold flows.

CPM Group: Conclusion

The CPM Group's approach to the gold market is consistent with common practices in the industry. Their approach is not any more mistaken than that of the other analysts who do things the same way. I have chosen CPM as the subject of this appendix because the clarity and detail of their reports has made it easier for me to follow their thinking. I do not take issue with the entire contents of the yearbook, only with their misuse of quantities.

I cannot rule out the possibility that the CPM Group has found statistical correlations between net flows into or out of one of the sectors, and the gold price and that these correlations are employed in their proprietary model. This could occur if it were generally true over many years that actors in one sector (or country) tended to be more price sensitive, or those in other sectors less price sensitive. If that were the case, then buying by the traditionally price-insensitive buyers would be correlated with a higher gold price and selling by price-sensitive buyers would be coincident with a lower gold price.

I should also give CPM Group credit for their study of macro-economic factors that do impact the gold price. These factors influence the price through their effect on investor preferences. I agree with the 2012 Gold Yearbook Press Release that "a host of economic, financial and political problems" are driving investor interest in gold. The Yearbook covers in detail macro-economic factors such as monetary policy, the business cycle, currency exchange rates, debt, and political uncertainty.

Notes

1. For another illustration of the confusion of accounting identities with causal relationships see Robert Murphy, Krugman Falls Into the Keynesian Accounting Trap.
2. I had hoped to use only free sources but I found that the yearbook, which is priced at $150, contained invaluable information in my understanding of the CPM Group's model. The CPM Group originally provided me with a free copy of the yearbook, but prior to writing this article, I purchased a copy at the normal retail price.

Robert Blumen [send him mail] is an independent software developer based in San Francisco. Robert wishes to thank James Hickling of GoldMoney for assistance in copy editing the final version.

Robert Blumen Archives

Publisher Steve Forbes, speaking to Human Events predicts “a return to the gold standard by the United states within the next five years." Why? Because it would “help the nation solve a variety of economic, fiscal, and monetary ills."

The article continues:

Such a move would help to stabilize the value of the dollar, restore confidence among foreign investors in U.S. government bonds, and discourage reckless federal spending, the media mogul and former presidential candidate said. …

If the gold standard had been in place in recent years, the value of the U.S. dollar would not have weakened as it has and excessive federal spending would have been curbed, Forbes told HUMAN EVENTS. …

[...] the idea "makes too much sense" not to gain popularity as the U.S. economy struggles to create jobs, recover from a housing bubble induced by the Federal Reserve's easy-money policies, stop rising gasoline prices, and restore fiscal responsibility to U.S. government's budget, Forbes insisted.

With a stable currency, it is "much harder" for governments to borrow excessively, Forbes said.

That’s all good stuff, Steve. But really? Are you kidding?

In politics, things generally don’t happen because they “help the nation” or “make too much sense." If we lived in that kind of world, and the 19th century gold standard had so much going for it, then why do we was it abandoned in favor of the present system?

It was abandoned for political reasons. Factors leading to the demise of the gold standard were the desire of governments to spend in excess of politically tolerable levels of taxation, the need to finance World War I and other wars, and the wishes of the banking for a lender of last resort to bail out over-leveraged banks when they had insufficient reserves to cover their losses.

Political reasons have a logic of their own quite different from the kind of logic that Forbes is using in which good things happen for good reasons. In politics, interest groups organize to gain influence over the government and implement policies for their own benefit, at the expense of the rest of society.

But why does political logic defeat common sense? The public choice school of economics has given us an explanation of the insidious process by which the few exploit the many. They point out that concentrated benefits and dispersed costs lead to rational ignorance. Translating, “concentrated benefits” are the large returns earned by the privileged groups through subsidies or bailouts. For each one of us tax players, the cost of any individual bailout or welfare program is quite small, hence “dispersed costs." In looking at political action to fight the system, the individual taxpayer faces the following set of tradeoffs: the time and effort to understand even one piece of legislation or policy is substantial, and even if opposition to a particular program were effective, it would only save a few dollars in taxes. This leads to “rational ignorance," the decision by most taxpayers that the return to working harder at your job or just enjoying life is much greater than the return to political organizing.

Given a outcomes that are dominated by public choice logic, the monetary system will not be reformed when “it makes too much sense” to do so. It will not be reformed because that would put government finances on a sound footing, nor to restrain war-making. Stabilizing the dollar won't do it either. The current monetary system (or as James Grant calls it, non-system) will be replaced, eventually, because it will fail, catastrophically.

What will the alternative to the current regime of central banks, floating exchange rates, and unbacked fiat money look like? Here I must reject the wishful thinking that "things need to get worse so people will be really angry and insist on something better." Things do not necessarily get better when there is a crisis. Things can get worse and stay worse, or get worse and then go even further downhill.

I’m not sure what Steve Forbes had in mind, because the term "gold standard" is used differently by different people. The most conventional definition a system of national currencies exchanging at fixed rates, with central-banks, each one having some gold as a reserve asset. In this world, central banks are obligated to provide a form of convertibility, though reserves held may be less than 100%. Individual nations may, under some conditions, be able to devalue their own national currency relative to the fixed rates and to gold.

For adherents to Murray Rothbard's theory of banking, the gold standard means gold as money proper with banks holding 100% reserves against demand deposits. Under these conditions there is no necessity or even any purpose to having a central bank and devaluation is a form of default.

What does Forbes have in mind? He has been associated with supply side economics, who have their own so-called “gold standard." I say so-called because it is not much of a gold standard at all, only a rule that the central bank is supposed to manage the inflation of the fiat money system in line with the gold price. Under this system, gold is not money proper, it is a good whose price is considered the best indicator of the looseness or tightness of monetary policy. As Frank Shostak points out, this system offers none of the advantages of using real gold as money. And why should anyone expect that when push comes to shove, the Fed will follow any rule when the situation seems to demand improve comedy? As Murray Rothbard wrote in his critique of a similar money supply growth rule advocated by Milton Friedman, “Of course, Friedman would then advise the Fed to use that absolute power wisely, but no libertarian worth the name can have anything but contempt for the very idea of vesting coercive power in any group and then hoping that such group will not use its power to the utmost.”

When the current system fails, there are two primary barriers to the adoption of a better system. The first is the political actors who moved to abandon the gold standard the first time around haven’t gone away. The vested interest of powerful groups who wish to use the fiat money printing press are still around; if a new opening appears, the usual suspects will apply for their jobs back. That which has not killed them has made them stronger

But the a deeper obstacle is ideology. Most economists and central bankers believe that a) an economy cannot grow without an increasing quantity of money, b) the gold standard caused the Great Depression, c) The Fed determines monetary policy, a necessary and beneficial function and, d) the banking system (and maybe the auto industry too?) needs a lender of last resort in the case of financial crises, you know, those crises that just sort of happen, that come out of no-where with no warning and hit us when we least expect.

None of the preceding propositions are true, but as long as they are accepted factoids, the next monetary system is likely to look a lot more like the current one with extra lipstick than anything that existed in the 19th century.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Robert Blumen Archives

Jeremy Grantham, a highly respected and successful value investor, wrote:

I would say that anything of which 75 per cent sits idly and expensively in bank vaults is, as a measure of value, only one step up from the Polynesian islands that attached value to certain well-known large rocks that were traded.

Elsewhere, Grantham when discussing his recent purchase of a few ounces of the despised commodity, sarcastically said:

I hate gold. It does not pay a dividend, it has no value, and you can't work out what it should or shouldn't be worth…It is the last refuge of the desperate.

Exhibit B: Warren Buffett, who needs no introduction, when asked by an eight grader whether gold should be part of a value portfolio, said:

I have no views as to where it will be, but the one thing I can tell you is it won't do anything between now and then except look at you. Whereas, you know, Coca-Cola will be making money, and I think Wells Fargo will be making a lot of money and there will be a lot – and it's a lot – it's a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that. The idea of digging something up out of the ground, you know, in South Africa or  someplace and then transporting it to the United States and putting into the ground, you know, in the Federal Reserve of New York, does not strike me as a terrific asset.

Exhibit C: James Grant publisher of Grant's Interest Rate Observer, is less well known among the general public but has achieved cult-like status among professional investors. Grant does not hate gold; he might even be called a gold bug. He shows his customary wit in referring to the yellow metal "the value investor’s guilty pleasure." We like it but we shouldn't.

Why do value investors hate gold?  Does that mean that you should hate it too?  To understand this, let’s first look at how value investors think, and then understand why they hate gold. Value investing is based on the premise that financial securities – or really any kind of asset or business – have two prices: the market price and a theoretical price arrived at through analytical methods known as intrinsic value. Value investors believe that the market should – and probably will – value an asset at its intrinsic value; when an asset trades at a much different price than its intrinsic value, the market is making a mistake. These errors are usually temporary in nature, giving the value investor an opportunity to capture a profit.

There are three ways to capture this differential: buying undervalued assets, short selling over-valued assets, or doing both at once. That there are differences between these methods is primarily due to the technicalities of managing short and long positions. For the purpose of this article, we will focus on the long-only strategy; many of the most successful value investors over the years have used this method.

An entire discipline has grown around the analysis of intrinsic value, but to keep things simple all methods come down to either assigning a price to the cash flows produced by the security or breaking the security up into assets and liabilities that can be priced on external markets.

To understand valuation by cash flows, consider a bond that pays interest and principal payments. The calculation of intrinsic value relies on a best guess of the future payments emanating from the bond and applying the appropriate discount rate applied to derive present values from future cash flows. (Without going into too much detail, prices may be averaged over time to remove transient effects.) The discount rate could be the individual investor's own subjective rate of time preference. For example, a person who needs cash right now for some other reason might assign a very high discount rate to any investment opportunity. A more objective approach is to use interest rates or yields prevailing in the market (possibly averaged over a suitably long period of time) for similar assets to arrive at a comparable price for the cash flows of the asset being analyzed. Comparing interest rates is essentially the same as comparing the prices of other securities that offer similar cash flows.

Breaking a company into smaller pieces that can be priced individually is the other major approach to valuation. A corporation has assets and liabilities. The assets may represent entire business units or individual properties that can be priced on an external market for similar businesses or properties. This approach is an alternative to the cash-flow based approach for projects that do not yet have an income stream, but still have economic value because the assets have the potential to produce economically valuable outputs in the future.

The founder of value investing, Benjamin Graham, preferred to buy companies that traded at less a market capitalization less than the value of their cash on the books.  These companies were the safest, he thought, because there is little difficultly in valuing cash itself, and even less in arbitraging it.  It does not require the investor to make too many assumptions, other than, that the management will not find a way to waste the cash by purchasing something with no economic value.  

Assets other than cash can be valued when there are external markets that provide a price. To take the gold-mining industry as an example, a deposit can be valued based on the market valuations of the ounces or pounds of a defined resource (in the ground) for similar deposits to the properties being valued. A factory can be valued based on the land and the structures.

Value investors usually look for established patterns over a period of time to give confidence in their assumptions. A business that generates steady revenues over a period of years is likely to do so in the future. The development of a mineral deposit into a mine is much more uncertain. But modern value investors have developed methods that incorporate risk into the valuation model.  Suppose, for example, one in five natural resource properties at a specific stage of development go on to become mines.  Then the market “should” price the property – and therefore the stock – at 1/5 of the value of a similar operating mine (discounted for development time).  If the analyst shows that the property is trading at 1/10th its mine value, then the property is considered theoretically under-valued even though there is still a lot of risk involved. An investor would be taking a lot of risk by putting all of their capital into a 1/5 event, but a large enough portfolio of 5:1 odds purchased for ten cents on the dollar is likely to do quite well as the winners more than outperform the losers.

With an understanding of intrinsic value, it should be clear how the investor can profit from it. All valuation ultimately derives from cash flows returned to the investor. Even assets that are priced on external markets derive their value on those markets for their ability to generate cash flows in the present or in the future. If an asset truly has the ability to deliver the investor a present value of $10 per share, and if the investor is willing to hold it for long enough, they should eventually receive the $10 (it may be more than $10 by the time they get it depending on how long the wait). If the analysis is correct and the asset is really worth $10, then eventually the market "should" eventually figure this out and then reprice the asset to $10, short-circuiting the waiting time of the investor.

It is the ability of the asset to deliver the dollars to the investor that should make the price converge to intrinsic value. Given a correct analysis of intrinsic value, then in the worst case, the investor might have to wait for a while. A better outcome from the investor's viewpoint is that the market understands the earning power of the asset sooner rather than later, and the market price reflects this. Some corporations try to force the market to revalue the asset by issuing or raising a dividend or by spinning off subsidiaries into stand-alone firms. Each firm then must have its own price while before they may have been lumped together.

Here is the reason that Grantham and his ilk are so disdainful of the yellow stuff: they cannot value it the way that they value stocks and bonds. Grantham and the like hate to buy anything they can’t value because they might be over-paying for it. Buying something without a quantification of its worth falls into the category of irrational speculation, not much different than tossing a coin. In their terminology, it has no intrinsic value. For an asset to have intrinsic value, it must have something that can be priced on a market external to itself (either cash flows or a balance sheet); gold has neither.

But if gold has no “intrinsic value” does that mean it has no economic value? Should the wise investor only purchase assets that can be valued by Graham's methods? Does that make the gold buyer a crazy speculator?

I have observed that some value investors identify value investing with economic rationality itself: any purchase that is not backed up by an intrinsic value is not only baseless speculation but an act of pure irrationality.   In my view, their mistake is that value investing is not reality, it is a model; it works, like any model, subject to certain assumptions; one must take care to apply the model within its boundaries. Intrinsic value is a term of art within the domain of value investing. A good has economic value because it is scarce and meets human needs in some way. A good may not have intrinsic value (in the analytical sense of the term) but that does not mean it has no economic value.

Value investing is a rational approach, but economic rationality is more than value investing. Economic rationality means using logic, evidence and good judgment to allocate resources. It is rational to apply value investing within its sphere of applicability and equally rational not to apply it outside of the conditions where it can work. Even the estimation of intrinsic value depends to a large extent on the wisdom and good judgment of the analyst in identifying which prices are comparable and which cash flows are sustainable. And we can act rationally even in areas that cannot be fully quantified.

As noted above, no raw commodity has an intrinsic value because commodities do not have cash flows or a balance sheet. Yet commodities do have economic value and do have market prices. Their prices are driven by economic cause and effect and the factors driving them can be understood, at least to an extent. A rational person can still develop a logical point of view about the price direction of a specific commodity using facts and evidence. The relevant facts are the commodity's past prices and the supply and demand fundamentals. Breaking this down further, the fundamentals on the supply side are: the present production volume, the lifetime of operating mines, new mine supply coming on line for the next few years, the pipeline of in-ground development projects, the cost of production of existing supply, and quantities stockpiled in warehouses.  Demand side fundamentals are: the uses of the commodity and the quantities required for those uses, unique properties of a particular commodity, the availability of substitutes, anticipated changes in the demand for consumer or capital goods using the commodity, and new scientific research identifying properties of the commodity that are not currently exploited.

The difference between fundamental analysis of the commodity and a security is that none of the data can provide a number for the future price; however rationality extends to things that cannot always be quantified. But analysis of supply and demand can provide the investor with some rational reasons for expecting the future direction of the price to be higher or lower, which is enough to make an investment decision. Is it totally irrational to think, for example, that a commodity that has no new mines coming on line, declining supply of existing mines, and increasingly popular uses will rise in price? If the people who built mines were strict value investors who insisted on an intrinsic value for every decision, then no mines would ever get built.

I have been discussing the valuation of commodities in general by supply and demand fundamentals, but when it comes to gold (as I have written in a recent TDV guest post) production and consumption are not the fundamental drivers of the gold price because mine supply is quite small compared to existing stock piles and only a tiny fraction of it is consumed. The gold market is dominated by the demand to hold existing gold, which competes against the demand to hold fiat money and demand for other assets.  The demand to hold gold is based on its historical use as money and its current function as a shadow money that competes with global fiat currencies for remonetization should the fiat money system shoot itself in the head. The more suicidal the fiat money system becomes, the greater the demand to hold gold as a store of value should fiat money fail in this function.

Investors can make a rational decision about gold. Clearly, analysis of the gold price must be based on a forecast of demand to hold the metal itself, competition from demand to hold other assets, and demand to hold fiat money. Some of the metrics that fit this approach (and have been used by others) are: the growth over time in the quantity of gold compared to the quantity of fiat money; the DOW index-to-gold-ounce ratio over time, and the total value of gold portfolio holdings compared to the capitalization of other financial assets globally.  Typically these measures showed historical extremes in gold's favor in the late 90s/early 2000s and have moved back closer to historical averages.

Is there any reason to think that gold should revert to historical means, or even overshoot them, in the same way that we think that an asset "should" trade at its intrinsic value? What keeps the value-pricing model in line with market pricing is the economic arbitrage: the investor can always hold the asset and eventually receive the intrinsic value, if they wait long enough.

Is there an arbitrage that will bring gold back in line with past measures of purchasing power? Or are we just looking at historical trends that might or might not recur? My answer to this has two parts. Measuring gold against the money supply or the DOW is a measure of purchasing power. To the extent that gold is valued as shadow money, we can expect its purchasing power to converge on a value approximating its historical purchasing power as money, adjusted for the growth in the size of the world's economy relative to the quantity of gold.

Beyond the purchasing power argument, here is a more profound and less easily quantifiable argument for holding gold. Earlier in the current article, I mentioned the finite limits in the domain of applicability of value investing. Value investing is an example of what the economist Ludwig von Mises called economic calculation. What Mises meant by this was the allocation of scarce capital goods toward the greatest expected profits using estimates of future market prices. Because economic calculation relies on prices, and prices are expressed in terms of money, calculation depends on a reasonably stable monetary system. As the monetary system is becoming increasingly chaotic, economic calculation is disrupted and investment decisions more and more irrational. We are sliding out of the zone where the inputs of value investing – prices – have any meaning.

During a monetary breakdown, variations in the supply and demand for money itself drive prices more than the supply and demand for goods.

Value investors like Grantham only want to buy something when they have a quantitative estimate of its intrinsic value. While this rule works well enough during periods of stability, it provides no guidance for rational action when the monetary system is no longer able to provide reliable money prices. Value investors have successfully invested in countries experiencing a monetary breakdown by using an external stable currency to calculate prices. The present crisis, which is global, threatens to disrupt all of the external stable currencies, making them less useful for this purpose.

As a shadow money, gold is a hedge against times when value investing becomes difficult or impossible because money has become too unstable. During those times, gold is a way of preserving purchasing power until the some stability returns. The disruption of the price system and resulting misallocation of capital will undoubtedly create many opportunities for value investors, once the monetary crisis is over and the monetary system is stabilized. Having some asset that can then be converted into stable money (which may be gold itself) will give value investors the ability to take advantage of these opportunities when they emerge.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Robert Blumen Archives

Jay Taylor: Welcome back to "Turning Hard Times into Good Times," I am your host Jay Taylor, and I'm really pleased to have with me my friend Robert Blumen. Robert is a software developer who writes and blogs frequently for the Ludwig von Mises Institute, their website. His articles have appeared in LewRockwell.com, Economic Affairs, Marc Faber’s Gloom Doom & Boom Report. We've had Marc of course on this show on a couple of times in the past. He also writes for the Agora Publications' daily emails.

Good to have you with us and I did mention to the folks your background, a little bit about your background. So welcome to "Turning Hard Times into Good Times."

Robert Blumen: Thank you, Jay!

Jay Taylor: Well really a pleasure to have you here from San Francisco. You are a lucky guy I think living in San Francisco. I wished, I would trade San Francisco for New York, I think, and probably at least the climate, that’s for sure.

Robert Blumen: I think we are in a — to see which is going to go broke fastest.

Jay Taylor: Yeah, I think you guys will beat us on that score, but not by much. We had some people on this show not that long ago, who actually talked about San Francisco and the finances in San Francisco. So we do know something about it, but the whole idea is that you can — I guess that you can have wealth and you can — you don’t really have to work for, you can just sort of imagine it and create it out of thin air.

But let’s talk about gold-mining today, Robert. This is what we wanted to talk to you about. This show as you know is so much about gold mining, about gold, about protecting wealth. And we are constantly hearing on this notion, I mean, because people really look at gold like as any other commodity. They think that higher prices of gold are going to increase gold-mining, that’s happening.

We know — I see a boom in the junior mining sector, see companies going out, spending money, putting holes in the ground and discovering deposits. We are seeing it rising, gold-mining profits are occurring now. Certainly, this is what I call a buying opportunity of a lifetime, the bull market of a lifetime for gold-mining stocks.

So normally, you would think that with rising supply you would have a declining price, but you wrote an article called Mining Doesn’t Matter, in which you claimed that gold-mining has little impact if any on the gold price. Well, what motivated you to write that article?

Robert Blumen: Well Jay, as you are just saying, anywhere you look around in the media people are aware that mine output is increasing. I read tons of these reports from analysts, people at banks, things in the media about gold. I would say 90% of the time if there is a 50-page report about gold that 40 pages of it is going to be about gold-mining and then they give their forecast.

Any one, all these analysts who hear Jon Nadler, Jeff Christian, anyone who writes about this, does quantitative studies of mine supply and they base that on their forecast.

So the reason for writing about this is I know that this is the wrong way to look at it and I wanted to help people understand how it really works.

Jay Taylor: Well why is it the wrong way for looking at it? I mean it certainly seems to be logical. If you have rising supplies, normally all other things being equal you would expect the price to decline. Wouldn’t that hold true for gold as well?

Robert Blumen: Certainly, that is true, but there are two ways of looking, or there are two different kinds of markets, there is commodities and there are assets. I’m going to define these in an idealized way, nothing really is perfect. But for the purpose of discussion, a commodity is something where there are no accumulated stockpiles of it.

So in the case of a commodity whatever gets produced also gets sold, it gets purchased and it gets consumed. And by consumed I mean it’s destroyed. It’s transformed into a form where it is taken off the market permanently.

An example of that would be gasoline or any agriculture, something you eat. You buy it and you destroy it. So for a commodity the supply and the demand have to be very tightly balanced and if one of them changes the other one has to change. And the way that is accomplished in a market economy is through price. If you would have more supply the price has to go down.

The other type of market is what I am going to call an Asset Market. And let’s say for the moment an asset market in an idealized way is the market in which there is a certain stockpile of the asset, which doesn’t change. And in asset market, you can’t really look at quantity supplied and quantity demanded, because the quantity is the same. In asset market, the quantity of the existing stockpiles is traded around among different people. So gold is an asset.

Now the gold supply does grow a little bit each year, it’s between 1% or 2%, but the market is dominated by trade among the existing stockpiles of gold, and that’s how the price is formed.

Jay Taylor: All right, so we’ve had — so basically what you’re saying is that the gold is the mine going back, maybe thousands of years is still in a stockpile somewhere —

Robert Blumen: That's right.

Jay Taylor: — or around world.

Robert Blumen: There's about five billion ounces of gold above ground according to some estimate.

And the mine supply is somewhere in a 1-2% of that amount each year.

Jay Taylor: So gold is not an annual market then, it’s more like a financial asset as you are saying, were existing holdings the trade essentially. So what’s driving the gold price. We’re seeing a rise in the gold price from $250 back in 2002 to over $1400?

Robert Blumen: You could ask the same question if you’re looking at any other financial asset like suppose there was a company you follow, Jay that had a 100 million shares outstanding and that a company for whatever reason did not see the need to issue anymore shares, and yet you see the price going up. Then I don’t think anyone who is looking at that would say that the prices moving primarily because of anything to do with the quantity of shares, that people are revaluing the existing asset.

So what is happening with gold is people are revaluing mostly the existing gold in terms of Fiat money that they are placing a higher valuation on it, and we don’t know necessarily why that is exactly but it’s got to have something to do with the quantity of Fiat money increasing or people anticipating that there will be further increases in the quantity of money. And that quantity of money I can make a pretty confident prediction that quantity of money is going to grow faster than the quantity of gold over coming years.

Jay Taylor: Well, that would seem to be a somewhat safe bet right now, Robert, I think that given — the mindset of Mr. Bernanke and others, I don’t think you’d find too many people who would be willing to take you up on that bet.

So we’re seeing a rise, a dramatic rise in the price of gold. It is definitely a spring gold-mining production, those of us who follow this industry closely know that it is a very difficult thing to put a gold mine into production, it’s not, I mean it takes years and years to do it.

But you’re saying even if there was a sudden surge in the gold supply it wouldn’t necessarily have much to do with the gold price if the quantity of money was increasing at an equal or greater pace perhaps.

Robert Blumen: I’d say that, yes. Part of if you — I was just reading an article in the Canadian Globe and Mail the othe I’d say that, yes. Part of if you — I was just reading an article in the Canadian Globe and Mail the Globe and Mail the other day, and I have probably seen a hundred articles like this. If you look at the annual figures somebody was writing about how the gold supply annually had increased from 1500 tons per year to 3000 tons per year, and that looks like wow the supply of gold has doubled.

You look it on an annual basis but if you look at the total amount of gold out there, it’s not really that impressive. It may be is up 10% or 20% over that period of time, which is probably the amount of money supply grows in a year. So definitely, money supply is far outpacing than growth in gold supply.

Jay Taylor: Of course, the last great bull market in gold ended in 1980, when Mr. Volcker slammed on the brakes, well, I don’t know if that’s the right terminology or not. Let’s say he reduced the growth and the money supply very dramatically, and we did see gold fall from 850 to I don’t know 300, ultimately to 250 or so. I guess you don’t think that prospect is very great, that’s not likely to happen again anytime soon in your view.

Robert Blumen: I don’t think there is a political will to do that. Volcker was willing to take a lot of heat and Reagan was in his corner. Reagan understood what he was doing and said, look people hang in there, things are going to get better once we get this inflation under control. I see no real understanding of that among the political class in this country anymore and no political will to endure pain for any length of time in order to fix the problem.

Jay Taylor: Well would you suggest that the pain might be greater this time around than it was in 1980 or the problems much bigger than they were in 80s, so that even if that solution were proposed or if it were, it implemented that it would resolve and considerably more pain than we had in the 1980-1982 time-frame?

And I remember, I was fairly a young man then, and I remember it was a very severe recession, it was at that point in time the deepest recession that we had since the Great Depression, but do you think it would be much worse if they tried to impose a policy like that now?

Robert Blumen: I’m sure, Jay, you and your listeners have seen these charts of Debt-to-GDP ratios and debt compared to other things. All those charts have been in a pretty steep uptrend. There is a lot more leverage in the system now than there was back then. They figured out kinds of creative ways to make things more highly leveraged, so there is a lot further to fall on the downside.

Jay Taylor: So going back to this — it’s sort of the general consensus or the approach that analysts take these days. Essentially the analysts of the gold price, you’re saying basically they are really focused on supply, do they look at the demand side at all?

Do they look at the notion that because money supply is growing very dramatically that we are going to have the surge in demand for gold as they store a value?

Robert Blumen: The majority of analysts do not look at demand in that way. What they look at is they will give a number for demand. They'll say this year demand was, for jewelry was this many ounces and investor demand was this many ounces. The reason they do that is because they are trying to compare it to this supply number, which they got from mine supply and maybe they throw in scrap. But in my view, that number, they come up with for demand is a meaningless number and let me explain that.

Suppose we were talking about shares of a stock, you had some stock, you told me to go analyze it for you, I come back to Jay, the demand for this stock last year was 10 million shares and the demand for this stock next year will be 20 million shares. What would that mean? When we are talking about something — you could look at the trading volume.

Let’s say that I went and looked up on my favorite financial website, there were 10 million shares traded. That tells you nothing about the price because as you know, a stock could go up on increasing volume or it could go down on increasing volume or it could go side-ways on decreasing volume, the trading volume tells you nothing about the direction of the price.

Now we can’t say that if there were 2500 tons mined that there is going to be a buyer for everyone of those tons or ounces so the volume of gold in the market during any given year will be greater than the amount supplied. But that still really tells you nothing about where the price is going because the real question is, what value will those ounces be traded at? And that depends on the evaluation that the existing market places on the gold versus the dollars. It doesn't depend on any kind of number. You can’t analyze gold quantitatively the way you would analyze a commodity where there is no stock pile.

Jay Taylor: So it really boils down to a confidence or not in the dollar, and if there is a loss of confidence of dollar, we are certainly seeing this happen, people are trading in their paper money internationally as well as people that sort of understand what you are talking about. To an extent, people understand that their paper money is losing value. They understand that Mr. Bernanke does these QE maneuvers that he is basically debasing the currency.

I mean, it’s amazing to me when you think about the Chinese, maybe a mass something like, what, 2 or 2.5, or 2.7 whatever the number is trillion dollars by working hard, sending us products and accumulating foreign reserves and Mr. Bernanke came with a few keystrokes to basically create two trillion dollars out of nothing, and sort of without doing anything, it’s just amazing, and I guess some people are starting to get it.

So to what extent though and to what extent do you think that some of the analysts might finally catch onto this, I mean I think you can go to place like Sprott in Canada, Eric Sprott and his analysts certainly understand this, but John Nadler has been calling for lower gold prices every year over the last ten years and we've had nothing but higher gold prices every year.

I mean you have to wonder why he doesn't change his thinking, but anyway, you wrote an article, The Myth of the Gold Supply Deficit, what was that about?

Robert Blumen: That was about, this is a related error in looking at the gold price. It’s based on the idea that there is a supply deficit. This idea of the supply deficit prominently promoted by GATA, it’s an organization. I know you had on your show and I think they do a lot of great work, but in this particular case, they are wrong. So I will explain why.

Suppose we had a commodity like oil and a given country had a 30-day stockpile of oil. Let’s say they doubled their consumption. So each day they are drawing down their stockpile by one day’s worth. We can be sure that in 30 days that process has to end. That is a reasonable definition of deficit because you are exhausting a stockpile, and when that stockpile is down to zero, either they have to produce more or consume less, which is going to require a higher price.

But in the case of an asset, let’s say the environmentalists win. No more gold mining, we just have to make due with the gold we have. So you notice that during a given year, there was ten million tons traded.

Well does it make sense to call that a deficit? I would say, no, because the gold is not destroyed. It’s simply shifted around among different ownership, and there is no limit to how much volume of shifting around can occur. You never run out because you are not destroying it, you are moving it around.

So the idea that there is a supply deficit because more gold is traded than is produced, that is an incorrect way of thinking about the gold market.

Jay Taylor: All right. We have had Bob Hoye on this show, and I don't know you’re somewhat familiar with Bob Hoye’s work. Bob has talked about these great credit contractions that occur and he’s noted that the real price of gold, that is the price of gold in terms of what you can trade gold for other commodities and other items, goes up during these major credit contractions. Bob Hoye points out that during these times it does serve to increase the gold mining profits, gold mining activity, gold mining production, and that it actually tends to then re-liquefy the banking system with honest money. But I have an idea that you wouldn’t necessarily buy that argument?

Robert Blumen: There is something really important about what you just said, I wrote an article about how the gold — mining does not really influence the gold price, but in the other direction certainly the gold price will influence the gold-mining, because the higher the price of gold, the more sub-marginal deposits become economically mineable.

So it totally makes sense what you’re seeing in the market and what Bob Hoye describes that as the price of gold goes up you would see a boom in gold production and maybe the supply grows by 2% a year rather than 1% a year.

Jay Taylor: Okay, well we’re getting this gold supply increase, that is true, and as you say it’s not very big relative to the total amount of stockpile of gold, but do you think there will be a problem with the markets absorbing this new supply? I mean, it doesn’t seem like there would be given the kind of quantitative easing that’s going on, but —

Robert Blumen: One of the things you see in all these articles that people are saying that gold supply is 1500 tons and half of that was jewelry and half of that was investor and now it goes to 3000 tons where is all the new demand going to come from?

So I went and looked up some figures for the LBMA, which is Bullion Investor Bar Market in London, it’s one of several bar markets in the world. Just based on LBMA volume, they absorb an entire year’s mine supply in about 12 trading days.

Jay Taylor: Wow!

Robert Blumen: Now there are other bar markets in other nations and there are coin markets. So the volume of these markets is so great that entire year’s mine supply can be absorbed in just a few days. So now, I see no problem in the market absorbing the supply.

Jay Taylor: Robert, I can sympathize totally with you because I am battling a cold and it’s really a difficult task. We’ve got a couple of minutes left, so I hope we can hang in there with this. If it’s not mining, so how is the gold price set then? I mean we could just be little bit more clear about that, then if it’s not the supply and the gold is coming from the mines, so what is really setting the gold price?

Robert Blumen: It’s the valuation that people who hold gold, at what valuation are they willing to sell, and the people who hold dollars at what valuation are they willing to bid. And the market brings that all into a balance where you have a price in the same way that it does for stocks or land or any other asset.

Jay Taylor: Okay, so how can we forecast the price then? Now we’re looking at increases in money supply, is that what we’ve to look at, not only the US dollar but currencies around the world?

Robert Blumen: Yeah, it’s bit of a tough asset to forecast because unlike stocks it doesn’t have a net asset value, and it doesn’t have a dividend, it’s something that people value in order to hold it and it’s a little bit hard to get your head around that quantitatively.

Really, you've got to have something to do with money supply growth, but I think anyone who has a quantitative model, they’re giving you a very precise forecast that’s probably baloney.

Jay Taylor: And baloney why because you can’t predict human behavior or what?

Robert Blumen: We can’t — in the case of — let’s say a stock that you analyze and it’s — you can get your head around the net asset value because you’re looking at what their assets would trade at in an external market, and you can make the argument that a stock should eventually trade at its net asset value. But gold, you can’t really decompose it any further. It just comes down to the valuation that people place on it, and you can’t have a quantitative model that will tell you that to any real precise degree.

Jay Taylor: Well, we’re just about out of time here, Robert, we have 30 seconds left, but let me just ask you all that said, are you bullish or bearish on gold at this point in time?

Robert Blumen: I’m bullish.

Jay Taylor: Why?

Robert Blumen: I can’t quantify it, but I give you my very confident forecast that money supply growth will be faster than gold supply growth and I’m expecting that whatever imprecision there is in that model that I can get the direction right, which is up.

Jay Taylor: All right. Well, thank you so much for that. It certainly does seem to be almost as sure as day following night these days, the way that the mindset is in terms of the Keynesian Economic Models upon which all our policymakers are operating.

Well, thank you very much, Robert Blumen, for being with us, we hope to have you on again for some of your Austrian Economic insights.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Robert Blumen Archives

I have been enjoying the cable TV series Mad Men based around the fictitious 1960s Manhattan ad agency Sterling Cooper. The show is consistently recognized for its fine writing, talented cast, and faithful period design. Sterling Cooper’s talented creative director Don Draper is brilliantly depicted by John Hamm, a relatively unknown actor prior to this role. Now in its fourth season on the AMC network, this show is a difficult habit to break.

While I do not entirely disagree with Jeff Tucker (who has written that the show’s depiction of 1960s social customs and mores is a subtle endorsement of the expanded nanny state that began in the following era), I believe that there is another dimension to the show that has not been much discussed: the show is one of the very few examples of television or film that takes business seriously.

Most which depict business portray executives in one of two ways: either motivated entirely by malevolence toward humanity in general, or, driven by short-sighted greed. They are rarely neutral and almost never positively depicted. As Alex Tabarrok explained, writing in the Wall Street Journal, "capitalists are almost invariably cast as villains. Has someone been murdered? Are the residents of a small town dying of cancer? Is an environment being despoiled? Look no further than the CEO of some large corporation."

The show is not anti-business. Nor would I describe it as "pro-business" in a Randian sense of glorification of entrepreneurs. The show is nearly alone on television in looking at the reality of business. The show observes, it does not judge. It shows business as a complex and challenging undertaking of imperfect human beings. The characters do not get everything right; they make some good decisions and some bad ones. The show is honest in its examination of success and failure.

There is one respect in which I do see the show as taking a stance in favor of commerce. The advertising industry is one of the prime targets of anti-market ideology. The series does not condemn advertising — it takes a respectful and interested stance toward the industry and the people in it. It shows the role played by advertising, especially the more creative side, in the market economy. That is in itself a political statement.

According to anti-market ideology, advertising brainwashes consumers into buying things that they don’t want or need. The writers give a fair statement of the free market view through Draper with a Berkeley undergraduate:

Student: I just don’t understand who’s in charge

Draper: You are; trust me, I work in advertising.

Student: It’s pollution

Draper: Then stop buying things.

The story lines bounce back and forth between the office and the private lives of the characters. On the business side, several economic themes emerge — consumer preference, competition, constant change, innovation, skill, and the division of labor.

As Tucker noted, the 60s itself is one of the main characters in the show. The camera often lingers over a piece of furniture, a clock, a carpet, a car, a meal, or a costume. Typewriters are ubiquitous. The arrival of a photocopier at the firm causes considerable consternation: where to put it? What will clients think when they see it? After laughing at products that were new in the 60s but now strike us as outmoded, I realized that the innovation in production and constant change in consumer preference is a theme in the show. While we are not so far removed from that era, the range of products we have available today has changed considerably.

Consumer preference is the driving force behind advertising. Don Draper frequently is shown meeting with clients to discuss the needs of their business. The executives discuss their success or failure in terms of their own customers.

A theme of the show is success and failure of products and industries. In some cases a business that has been stable for many years is going into decline; for example a bathing suit company that refuses to shift its production to what the company’s management considers risqué bikinis is losing market share as bathing dress becomes more revealing. Many of the prominent brands featured in the show no longer exist.

Responding to technological change is another important theme. Television emerged and overtook print media as a platform for advertising during this period. Harry Crane, an account manager, invents his own job by requesting to be appointed director of television for the firm, which prior to him, did not have one. Not realizing the importance of this position, senior partner Roger Sterling agrees to appoint him to this position. Over time the television department grows as a share of the firms’ revenues, and Crane advances in his career, adding subordinates to his department.

A young entrepreneur (whose wealth was inherited from a successful father) launches an expensive ad campaign based on his belief that jai-alai will become as popular as baseball. We know from the perspective of the present that this will never happen, and that the ad campaign would be a failure. The firm attempts to dissuade him from launching the campaign but in the end decide to take his business because they realize he is determined to pursue his business idea.

The writers do not shy away from addressing the issue of personal success and failure. Draper is depicted as a creative director of extraordinary talent. His ability to connect on an emotional level with the consumers is one of the main themes of the show. His success is achieved through his deep and intuitive insight into the imagination of consumers and his ability to see connections between the product and the consumer’s desires. His ability is exemplified in a scene where he presents the advertising strategy for a new invention — the slide projector. In one of the shows more memorable moments, Draper presents a slide show of family pictures and then explains, "This device isn’t a spaceship, it’s a time machine. It goes backwards, and forwards… it takes us to a place where we ache to go again." The customer is stunned. Sterling Cooper gets the account.

The show addresses personal failure in a scene where the father of the jai-alai entrepreneur explains that his son grew up in an atmosphere of success ("my success," he adds) and that only when his son has lost his inherited wealth will he face the reality and possibly do something valuable to someone other than himself. The father makes the point that wealth is acquired through performing services that are valued by others.

Division of labor is a theme of the show. Don Draper is fond of pointing out that the advertising industry exists because its customers — the producers of products — do not have the creative skills found within the ad agencies. Within Sterling Cooper, many skills are present, and as we see over the course of a season, necessary: graphic art, account management, copy writing, organization, supervision, and management.

The tension between the creatives and the account side of the firm is a recurring theme, but they also realize that they all need each other. After he loses an account with the Hilton Hotel chain, Draper admits that he is not an "account man." When Draper leaves to form his own agency, the co-founders invite the business manager Lane Price to come along as their CFO because none of them knows how to manage budgets.

Competition between firms is another theme of the shows. Sterling Cooper is a mid-tier firm that has a few of the premium brands and some lesser-knowns. In one episode, the firm has the chance to get an account with a major airline (American Airlines). A serious miscalculation results in Sterling Cooper losing one of their best existing customers and failing to win the new account. A dialogue follows between Draper and partner Roger Sterling about their nature of risk taking.

The interplay between contracts and corporate reorganization are crucial to several intricate plot turns. After Sterling Cooper is purchased by a large British firm, the new president, Duck Phillips, plans to change the culture of the merged company in a direction that is not acceptable to Draper. When Draper announces that he will not be taking part in the new direction, Phillips reprimands Draper, stating his intention to enforce Draper’s contract with the firm. Unknown to Phillips, Draper did not have a contract with the firm, and so was free to leave and work at another firm in the industry. After the firm is sold a second time, to an even larger firm that none of the principals like, they agree that they must stay on after the merger because they have contracts.

While there are other shows where characters work at a business, it’s difficult to think of any other show that is so directly about business. They even drop a few references to Ayn Rand. I am so familiar with the anti-business bias of most television shows and firms that for the first season I was expecting every scene about a business subject to be framed with the post-modern irony quotes that have become so indispensable to demonstrate the smug sense of superiority that defines our age. Somewhere into the second season I began to trust that the writers were really trying to depict business in a more realistic way — as a complex and challenging pursuit that people do imperfectly, incorporating both success and failure.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Robert Blumen Archives

"It is a gold bubble and to say otherwise it’d be nave," Gartman said. He called the trade on the precious metal: "mind boggling and unbelievably crowded," but also said he is currently long — or betting gold will go higher.

To be fair to Gartman he is a short-term trader who has been both long and short gold at various times in the last ten years. I am not original in the following observation (I think it was Bill Fleckenstein but I can’t remember for sure) but it is worth saying again. Gartman aside, many of the financial media have a pronounced anti-gold bias. Of the writers and news anchors now calling gold a bubble, not only did they fail to identify the stock market bubble in the 90s or the subsequent housing market boom as a bubble, they actively promoted the excesses of those unsustainable booms, encouraging their viewers or readers to participate. For the most part, these pundits have failed to identify a rising gold price as an investment trend at any point in the past ten years (during which gold had a positive return each and every year); and most have never recommended any form of gold as an investment to their viewers — who probably don’t own any gold either.

Few if any of the financial commentariat are presently warning investors of the government bond bubble. Yet if there is any financial event more certain than the eventual default of most government debt in the developed world, I cannot identify it.

Witness the irony of the financial media transformed from hypesters who never saw a bubble they couldn’t promote into bubble vigilantes, issuing concerned warnings to "get out, now, before you get hurt."

But so far all I have done is to make ad hominem attacks on media figures. In spite of their past failures, they could be right. Let’s have a look at the data and try to figure out whether gold is or is not in a bubble.

A bubble is a deviation between price and fair value of an asset. Because fair value is to some extent a matter of opinion, identifying a bubble involves opinion as well. There are various widely accepted methods for valuing assets, but these methods use inputs that involve judgment and opinion. Stocks can be valued on the underlying earnings or the balance sheet of the issuing corporation. Housing can be valued on the basis of rental income. While these numbers are also open to interpretation, a firm call of a bubble can be made when values are in an uptrend and reach multiples of historic valuations.

But estimating the fair value of gold is at best, less straightforward, and at worst, impossible. Other assets are valued on the income stream that they produce, or by breaking them down into pieces that have independent market prices. Gold cannot be analyzed the same way as other assets because it can’t be broken down into anything more fundamental than itself. Its current price is its only indication of what it might be worth. Its price can change from day to day. This makes it difficult to determine what is a low or a high price. Various models have been proposed to calculate the fair value of gold, but they all run into assumption-making at some point.

Paul van Eeden has published some articles (1 2) in which he proposes that the fair value of gold can be calculated on the basis of purchasing power parity of an ounce of gold, relative to the end of the gold standard (when gold was last official money). He projects the current gold price based on the growth in the supply of mined gold over this time, compared to the growth in the supply of fiat money over the same period.

I do find value in van Eeden’s work, mainly for emphasizing that gold is a global asset, one that is in demand in terms of all fiat monies. Gold has one price in each currency. The dollar price of gold is not the price of gold, only a price of gold. The dollar price of gold reflects the foreign exchange value of the dollar against other fiat monies as well as the global valuation of gold itself. Van Eeden shows, for example, that gold was not in a global bear market throughout the entire period from 1980—1995. On the contrary, much of the decline in the dollar price of gold was a rise in the exchange rate of the dollar over this time. Gold’s price over this period in other fiat currencies was not uniformly down (a fact frequently cited to "prove" that gold is not an inflation hedge). The gold price went up in some currencies and trended sideways in others, depending on their foreign exchange rate.

However, I am not convinced that gold should trade at van Eeden’s theoretical price. The exchange rate between fiat money A and fiat money B tends toward purchasing power parity because participants buy and sell goods and currencies to arbitrage away differences. This arbitrage process assumes that goods are sold in the market in terms of both A and B. But there is no good reason to expect that the price of gold should reflect purchasing power parity when it is no longer used as currency because goods are not sold on the market for gold. It is purely a financial asset at this point. Van Eeden’s model might be approximately true because gold functions as a sort of shadow money but that’s not exactly the same as actual money.

Van Eeden also ignores the likelihood that the purchasing power of gold would have grown since the end of the official gold standard, since the growth rate of the goods and services in the world economy has exceeded the growth rate of the gold supply.

Another problem with van Eeden’s model is that, while under the gold standard, currencies were redeemable for a fixed amount of gold. In that regime, any measurement of money supply should count either currencies or gold. Counting currencies and gold would be double counting. His model compares gold against currency, which would be correct if we went back on a convertible gold standard, but right now, gold trades along side currencies, so it should be counted as an addition to total money.

Professor Mike Rozeff has written several articles for LewRockwell.com showing calculations of what the gold price could be using different models. As Rozeff points out, "Numbers such as [those presented in certain models] surely give the impression that gold can go higher, but we knew that already. Any asset can go higher. These numbers give the illusion of certainty and necessity, or in other words they suggest that gold will go higher. But the model has no reasoning in it to say why this has to happen, if it has to happen at all." I agree with Rozeff’s point here: if you assume that a particular model is correct, it can be used to generate a theoretical price. But the models all depend on an assumption that gold should behave as it is modeled.

How expensive does an asset need to be to be called a bubble? During the stock market bubble, equities traded at three to four times historic valuations, with the NASDAQ index trading at something like six times or more times a realistic valuation (notwithstanding the large number of NASDAQ companies whose value proved to be zero). During the housing bubble, home prices averaged over the entire country were about twice historic valuations, but the major bubble cities saw homes reach three or more times historic valuations.

If you think that gold is in a bubble, is it trading at two times fair value? Three times? Five or six times? That would imply a fair value of anywhere from $550 to $200. During most of the last ten calendar years, gold has experienced a decline of 20% at least once during the year and then resumed its upward climb. Would a fall in gold from the recent $1100 to a low of $900 validate the bubble hypothesis? Or would it only be a medium-term correction in an ongoing bullish trend?

Can an analysis of trends and cycles tell us whether gold is in a bubble? I recall a speaker at an investment conference in the mid-00s stating that gold’s bull run was over because “the average gold bull market lasts for four years." But where did this average come from? Prior to 1971, the "price" of gold was a fixed convertibility ratio between fiat money; or at worst, an administered price. Gold has only had a market price in fiat money terms since the day when Nixon closed the gold window. How many gold bull markets have we seen that time? At most: two. Can we average together all two points of data and get a meaningful statistic?

Relying on historical valuations is useful for stocks and houses since we have a century more of data for both of those asset classes. But for gold, the world has only been on a pure fiat money standard for 40 years. How many complete bull and bear cycles have we seen during that time? Nassim Taleb, in his book Fooled by Randomness, emphasizes that, when you are collecting data about some observable phenomenon, it is difficult to know when you have seen enough data to encompass the full variability of the phenomenon. In other words, if you have 100 years of data about floods in a river bed, your data set might not include any occurrences of the once-every-200-years flood, or the 500-year flood.

It seems implausible to me that in the last 40 years we have seen the full range of variability in the relationship between gold and fiat money. I suspect we have not experienced multiple bull/bear cycles in gold; it is more likely we have not even seen one complete cycle yet. In our 40 years since Nixon closed the gold window, we have not seen the 100-year flood. It is more likely that we are now reaching the end of the first full market cycle of gold in a pure fiat world. This is now the 100-year flood. The current cycle will end with a world-wide currency crisis and a wipeout in the value of most government debt.

If I am correct, then the next phase of monetary history would almost certainly involve an informal or formal recognition of gold as a monetary reserve asset by central banks. Gold would then be revalued at a much higher level of purchasing power relative to recent history.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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According to President Obama, a health insurance crisis is upon us. He states in the New York Times that there are 46 million Americans who don’t have insurance, in some cases for as much as one day.

This exemplifies how the current debate about health care has turned into a debate about the insurance which will pay for the care, not on how people will obtain the care itself. Even on Mises.org, Dr. Robert Murphy devotes a considerable portion of his analysis to the problems with insurance. But that’s not the end of it. It is usually assumed without question that a fourth party (either the employer or government) will pay for the insurance premiums.

The most common ways that we pay for goods and services are cash out of current income, obtaining credit, or paying out of saved cash reserves. There are two parties in the transaction: the buyer and the seller. It makes sense for most of us to use insurance in a small number of purchases. The more common examples for individual and families are: residential property destruction, auto-related (liability for injury; theft), and accidental death or permanent disability.

But when it comes to health care, why is most of the discussion about ways to reform the current four-party system, not about reducing the number of parties involved from four to three or even two? Why is a cash-payment system direct from the patient to the provider not featured in most of the prominent reform plans?

I believe that the word insurance has come to mean the same thing as health care in the minds of most Americans. In the current climate of opinion, it goes without saying that a third party (know as an insurance company, but not really an insurer in the strict sense) should pay most health care expenses. The idea of cash payment — the way we pay for most services — is inconceivable. While the pathologies of the current health care system and possibilities for reform are a huge topic, I will attempt to address only a small corner of the issue: the preoccupation with three- and four-party payment systems.

First I will explain what insurance is, what it is not, why the insurance model only works for some purchases but not for others, and why most existing insurance plans are not really insurance.

Let’s look at the definition of insurance:

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating loss.

Only some future events are insurable. Insurable risks share certain characteristics: the risk of a single loss is small, the insured cannot cause the insurable event to occur, the magnitude of a potential loss would be too great for the insured to afford, and when the risk is spread over a large number of similar cases, the premium for each insured is affordable.

For market conditions to make insurance a sensible model, a risk must meet all of these characteristics. It would not make sense to obtain insurance against a certain expense — even it were possible — because the premium paid to the insurer would be equal, or greater than, the expense itself. Your house burning down is an insurable risk, while your car running out of gas or your pantry running out of grocery supplies are not.

Let’s segment health care expenses into insurable and non-insurable categories:

predictable care

annual physicals, teeth cleaning, a chronic but manageable condition, e.g. a medication or regular chiropractor visits, planned events such as giving birth

Not insurable

unpredictable non-serious care

minor injury, tooth cavity, a cut

Not worth the overhead to insure.

unpredictable but serious health emergencies

getting hit by a car, a life-threatening illness

Insurable

The first two of these categories are clearly not insurable because the risk of an event is close to 100%. In the second case, the cost does not warrant obtaining insurance. The third category is the best suited for the insurance model, presuming that the cost of obtaining care for an accident or illness is necessarily too great for an individual to afford.

One of the many bad side effects of the current system is that the meaning of the word insurance has become corrupted in public discourse. The way that the word is used in the current debate means, approximately, “a third-party payer who will provide unlimited health care at minimal or no cost to the patient.” I frequently hear people ask, “how can someone with an illness obtain insurance?” What the sick person needs is care, not (necessarily) insurance. In any case it would not make sense for an insurer to provide a policy to someone who is already sick.

When I blogged about this recently, I received several emails with questions along the lines of, "I have medical expenses that I cannot afford, therefore I need insurance." But insurance as such can only replace large unpredictable risks with small but known payments by distributing the small risk over a large pool of insured. Insurance cannot solve the problem of funding all routine or regular care because distributing a fixed and even expense does not reduce the cost — it probably increases the cost. A policy that covered predictable and recurring care would have to charge at least as much as the care itself, and then some to account for the overhead of claims processing. The insurance company must prevent fraud and ensure that the care they are paying for is necessary. This imposes additional monitoring costs. For the people who emailed me, a policy would only reduce costs if someone else paid the premium.

It is not necessarily the case that costs of care under a cash payment system would be the same as they are now. Under a cash payment system prices would have to be lower, for several reasons: people would become price-sensitive in their consumption decisions; third party monitoring costs would be eliminated in most cases; and providers would have to compete on the basis of price. See this discussion of health care in India for some insight into how a cash paying system might function.

While the current four-party system is not the only reason that costs are as high as they are, it is one reason. So we are stuck in a loop where costs are high because we have insurance but we must have insurance because costs are high. For more information about the history of the four-party system, I recommend the excellent paper The Modern Health Care Maze: Development and Effects of the Four-Party System by Kroncke and White.

Also, most people do not perceive the costs of the current system accurately. I believe that employer-provided plans are partly at fault for this. Because the plans are nominally paid for by the employer, they create an illusion that care is provided at no cost to the insured. Most employed workers do not understand that they pay for their health plan through reduced wages. The tax system is also partially responsible for this system because the employer’s expense is tax deductible, but the employee’s purchase of a similar plan out of their after-tax income is not.

People are for the most part unaware how much lower their wages are due to employer-provided plans. If your employer is providing a family plan that costs several hundred dollars per month, this is costing you thousands of dollars annually in lower wages. Having your employer purchase a policy on your behalf also creates the well-known issue of lack of portability when you change jobs. I wonder how many people do not change to a better-paying or otherwise more attractive job due to the portability issue.

Without benefits, the present employer costs would have to go back into wages. In my experience trying to explain this point, it is an unfamiliar concept and many people are skeptical. The most common response I get is that employers have the ability to simply lower wages by cutting benefits without increasing the cash component of wages, as if the level of wages is totally discretionary on the part of the employer. Economic reasoning is required to understand that the total wage consists of cash payments paid directly to the worker plus expenses incurred on the worker’s behalf by the employer. The opportunity cost of providing employee benefits is less money available for the payment of wages. (If you are not familiar with this idea, see a text on the marginal product theory of wages, for example, Man Economy and State, Chapter 7).

Another cost of the three- and four-party system is the needs and requirements of intermediaries who come in between the consumer and the provider. The provision of care now must satisfy not only (or maybe not at all) the consumer, but the insurer, the employer, and actual or potential attorneys and regulators. Another advantage of a cash payment system would be the elimination of these intermediaries.

The present debate about health care reform must not remain a debate about insurance reform. We should be talking about what is the best system for everyone to obtain care at a reasonable price. Insurance plans with high deductibles and low premiums might be part of the solution. But the word insurance should not be used to mean the same thing as care itself.

All of the energy that is presently expended arguing about insurance has crowded out the more fruitful discussion of alternative payment models, including a cash payment system directly from consumer to provider. Contrary to Obama’s statement, people would not worry so much about health insurance if health care itself were a normal good that they could afford out of current income.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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Is gold money? Many would say so, including owners of the top-level domains GoldIsMoney.com and GoldIsMoney.info. A web search returns 18,000 additional affirmative responses. If you want to start a fight with a gold bug, take the opposite view.

But is it so?

To answer the question of whether gold is money requires a definition. This one, from Wikipedia, is typical:

Money is anything that is generally accepted in payment for goods and services and in repayment of debts. The main uses of money are as a medium of exchange, a unit of account, and a store of value.

Wikipedia refers to three properties of money. However, according to the Austrian economist Carl Menger, its acceptability in trade is the defining property. While money undoubtedly does serve as a store of value and a unit of account, these properties are derivative, not definitional properties. The reason that a medium of exchange necessarily is also a store of value is the anticipation of its exchange value in the future.

On this point Menger wrote,

[I]t appears to me to be just as certain that the functions of being a "measure of value" and a "store of value" must not be attributed to money as such, since these functions are of a merely accidental nature and are not an essential part of the concept of money.

Using the above definition, the question of whether any particular good is or is not money, can be posed in this way: is the good in question accepted as the final means of payment for transactions?

At present, in the developed world, nearly every nation has its own money or belongs to a currency union, such as the EU. Some nations in the developing world use the US dollar. In highly inflationary environments, the local currency is often spontaneously rejected in favor of the dollar or another foreign currency. Hardly anywhere do we find gold generally accepted as a means of payment. So gold must fail the definitional test of moneyness.

Is this the end of the argument (and so the end of a very short article)? Not quite. Gold is not money, but it has most of the desirable properties of money, and the process by which it became money in the past gives some clues about how it may become money once again.

Read the rest of the article

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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Many writers of investment books approach the topic of saving and investing without any clear economic theory. Value investors often share the sentiments of fund manager Peter Lynch, who said, "If you spend 13 minutes a year on economics, you have wasted 10 minutes." From the other end of the methodological spectrum, MBAs trained in efficient portfolio theory look disdainfully on any suggestion that investors should at times be entirely in cash as "market timing".

In contrast to both schools, author and investor Peter Schiff approaches the issue from a top-down macro-economic view. Schiff believe that the most important issue facing investors over the next few years is a series of macro-economic crises that will impoverish most Americans.

Schiff’s book Crash Proof: How to Profit from the Coming Economic Collapse is really two books in one. The first is Peter Schiff’s analysis of the US economy, incorporating both theory and historical examples. The second consists of his strategies for surviving and even prospering.

It is not possible to approach macro-economic questions without an economic theory. A sound economic theory may not yield any useful insights for investors, but a false one is almost certain to mislead. A problem with macro investment literature is the generally poor economic foundations of most of their authors. Harry Dent, for example, shares the Keynesian-macro belief that consumption, not savings, drives economic wealth. Louis-Vincent Gave, Charles Gave, and Anatole Kaletsky believe that capital accumulation is a money-losing proposition for firms. The reader of Crash Proof is fortunate that Schiff incorporates Austrian economics in his approach.

The Further Reading section contains titles by Rothbard, Mises, Hayek, Hazlitt and J.B. Say. And unlike some authors who cite these thinkers without understanding them, Schiff displays a grasp of their thought and its application to investing.

This review will focus on Schiff’s economics. I will not say much about his investment advice. While his advice could be implemented through the investment firm of your choice, Schiff discloses that he is the founder of a brokerage firm offering investment accounts following the book’s recommendations. Schiff believes that his firm provides advantages in executing these strategies. After reading the book, I believe that his investment recommendations follow from his economics (right or wrong) and not the other way around. And by publishing his ideas in a book, an investor could implement these strategies with or without Schiff’s help.

Another common economic fallacy is we don’t need to save because our assets are going up in value. Schiff disputes this as well:

Savings? Who needs savings when you own stocks that can only go up in price and a home that gains equity every year? Let the dismal scientists worry that stock values or home equity might simply be the result of inflationary bubbles created by an irresponsible Federal Reserve, or that when the bubbles burst, all that will remain are the debts that they collateralized.

Schiff understands that savings are necessary to fund economic growth:

It is important to remember that in market economies living standards rise as a result of capital accumulation, which allows labor to be more productive, which in turn results in greater output per worker, allowing for increased consumption and leisure. However, capital investment can be increased only if adequate savings are available to finance it. Savings, of course can come into existence only as a result of [consuming less than one earns] and self-sacrifice. [pp. 6—7].

Schiff skewers another commonplace fallacy: that Americans provide the "engine of growth" in the world economy by consuming what others produce. Consumption creates demand for other products, but the point that is missed by most financial writers is that demand must be funded by supply. Unfunded demand created by printing more paper is simply a drain on the productive efforts of others.

The world no more depends on US consumption than medieval serfs depended on the consumption of their lords, who typically took 25 percent of what they produced. What a disaster it would have been for the serfs had their lords not exacted this tribute. Think of all the unemployment the serfs would have suffered had they not had to toil so hard for the benefit of their lords.

The way modern economists look at things, had the lords increased their take from 25 percent to 35 percent, it would have been an economic boon for the serfs because they would have had 10 percent more work. Too bad the serfs didn’t have economic advisers or central bankers to urge such progressive policies. [p. 14].

One area where Schiff may be on less firm ground is in his analysis of the US trade deficit, which he sees as evidence that Americans are living beyond their means and making up the difference by borrowing from foreigners. For example,

"The shift from manufacturing to services caused growing trade deficits." [p. 9]

We are financing that consumption [the trade deficit] not with money we have saved but with money we have borrowed, mostly from the same countries we’re importing from. [pp. 28—29].

A trade deficit as such is not necessarily a problem. All that a trade deficit means is that the deficit country is importing capital. If the imported capital is used to fund the development of the productive structure within the country, then the resulting financial claims are supported by production. Schiff’s view of the trade deficit could be correct but it does not follow from the mere existence of a trade deficit. To prove this, he would need to provide more evidence than he does that the imported capital is wasted.

Economic historian Sudha Shenoy has broken down some of the data to arrive at the conclusion that US trade in the private sector is balanced for the years she looked at (up to 2002), and that the trade deficit results entirely from government over-consumption. Her articles are also worth studying in full (see: The Case Against Neo-Protectionism, The Division of Labor is World-Wide, and u2018Is America Living Beyond its Means?’ — Is That the Right Question?) For another contrary view that directly addresses some of Schiff’s points, see articles (1 2 3) by economist Robert Murphy on Mises.org.

Schiff shares the skepticism of most Austrians toward central banking and inflation. How many investment books contain a section called Fiat Money: Why it is the Root of our Economic Plight? As he points out, central banks create debt not backed by any production. Schiff correctly identifies inflation as an expansion in the quantity of money. He argues that "demand created by inflation is artificial because it does not result from increased productivity" [p. 70].

This underlying economic principle is known as Say’s Law or Say’s Law of Markets…the supply of each producer creates his demand for the supplies of other producers. This way, equilibrium between supply and demand always exists on an aggregate basis. [p. 70—71].

His discussion How the Government Obfuscates the Reality of Inflation is excellent. Schiff soundly refutes a series of scapegoats for inflation used by government economists: cost-push inflation, the wage-price spiral, and inflation expectations. A sidebar [p. 93] explains that inflation not caused by economic growth, either.

He follows with a discussion of the politically manipulated inflation measurements. "Core inflation", for example, is often cited as evidence of low inflation; however, it is computed from the same data as the CPI excluding food and energy, as if price increases in food and energy don’t count. A section is devoted the questionable practice of substitutions in the basket of goods used to compute the CPI. Substitutions allegedly better reflect actual consumer spending, but in practice, as Schiff points out, they adds a bias to the CPI because things that people consume less of due to their higher prices get removed from the basket, and lower-priced substitutes get added, so the adjustments impart a bias to the CPI computation.

The underlying reason for manipulating the CPI is for the central bankers and their political allies to avoid taking the blame for the inflation that they have created:

If you really want to see the effects of inflation, just look around you. The prices are rising wherever you look, yet the CPI, the PPI, and the PCE say otherwise. That is because the indexes do not measure how much prices actually rise, but how much the government wants us to think they rise. [p. 78].

Schiff is particularly good on the deflation issue. The deflation bogey is frequently raised by Wall Street economists as a justification for further central bank inflation. According to this way of thinking, deflation is supposed to be even worse than inflation, and we should be thankful that we have the Fed to artfully charting a course between the two terrors.

Schiff dismisses this nonsense:

Deflation, which we technically define as the opposite of inflation, meaning that in deflation the supply of money contracts, is erroneously defined by government and Wall Street as falling consumer prices. Using that false definition, what is wrong with falling consumer prices? Aren’t lower prices, in general, beneficial and conducive to better living standards? Why would it be a problem if food became less expensive, or if education or medical care became more affordable? What is so bad about being able to buy things at cheaper prices? Why does the government have to save us from the supposed scourge of lower prices?

Furthermore, contrary to popular belief, falling prices are actually a more natural phenomenon in a healthy economy than are rising prices. Manufacturers recover their costs and gain economies of scale that result in lower consumer prices, which lead to greater sales, higher profits, and rising living standards. In fact, it is the natural tendency of market economies to lower prices that makes them so successful. (p. 79—80)

It is commonly alleged by Wall Street economists and central bankers that people will stop spending if prices are falling, and that business firms will not be able to make profits. Schiff takes apart these fallacies as well:

The usual fears about falling prices…simply don’t make sense. Unless an economy is in a total free fall, people don’t stop buying in anticipation of lower prices. …

Nor does the argument that corporate profits suffer from falling prices hold water. Profits represent margins, which exist independent of prices, and what is lost in dollar sales is gained in volume.

Yet under the guise of "price stability", generally defined as annual price rises of 2—3 percent, the government robs its citizens of all the benefits of falling prices and uses the loot to buy votes, thereby trading the rising living standards of their constituents for their own reelection.

His discussion of the business cycle is clearly Austrian. In a section title The Classical and Correct View of Business Cycles, we find:

According to the classical economists, like Ludwig von Mises and Friedrich A. von Hayek of the Austrian school, recessions should not be resisted but embraced. Not that recessions are any fun, but they are necessary to correct conditions caused by the real problem, which is the artificial booms that precede them.

Such booms, created by inflation, send false signals to the capital markets that there are additional savings in the economy to support higher levels of investment. These higher levels of investment, however, are not authentically funded because there has been no actual increase in savings. Ultimately, when the mistakes are revealed, the malinvestments, as Mises called them, are liquidated, creating the bust. Legitimate economic expansions, financed by actual savings, do not need busts. It is only the inflation-induced varieties that sow the seeds of their own destruction.

This flies in the face of modern economic thinking that regards the business cycle as the inevitable result of some flaw in the capitalist system and sees the government’s role as mitigating or preventing recessions. Nothing could be further from the truth. Boom/bust cycles are not inevitable and would not occur were it not for the inflationary monetary policies that always precede recessions.

Economists today view the apparent overinvestment occurring during booms as mistakes made by businesses, but they don’t examine why those mistakes were made. As Mises saw it, businesses were not recklessly over investing, but were simply responding to the false economic signals being sent as a result of inflation.

While I would quibble with Mises and Hayek being identified as classical and Austrian, as if they were the same thing, his coverage of the Austrian business cycle is sound. Schiff does not make the mistake of many writers and analysts quoted in the media of characterizing it as an over-investment theory.

Schiff forecasts a stock market crash, the bursting of the real estate bubble, and the collapse of the dollar. For the first two of these, his reasons are the over-valuations of these asset classes, runaway credit expansion and the moral hazard created by bailouts. His argument for the collapse of the dollar is tied very closely to his view of the trade deficit, which I have called into question above.

His investment recommendations consist largely of foreign stocks, which have higher earnings yields and pay better dividends than US stocks; gold and gold mining; and cash or liquid short-term bonds to preserve purchasing power until after bubbles have burst, when the money can be put to work at much more favorable valuations.

Schiff’s book falls in a long line of gloom-and-doom forecasts offering advice on how to profit from them. Many of these books even have titles containing the words "how to profit from the coming u2018X’." A search on Amazon.com for those words shows a number of titles including the coming Y2K computer crash, the coming hyperinflation (1985) and the coming currency recall (1988).

While it is possible to see unsustainable trends playing out, some of them take many years to reach the breaking point, and in the meanwhile, there can be very long counter-trend movements. While bubbles burst, getting the timing right is difficult. It is possible to be right but wrong about the timing for a long period. While there were a number of bears in the late 90′s who correctly called the stock market bubble, many of them were wrong for several years until being vindicated.

I recall reading a column by a prominent financial reporter in which she heaped scorn and ridicule upon gloom-and-doomers because they had been wrong for an entire year, so they rolled out the same forecasts for the next year. Her point was, when are they going to just admit that the economy is in great shape, is growing, and that their whole bearish worldview is out of step with reality?

My purpose in bringing up blown forecasts is not to suggest that anyone forecasting a crisis is always wrong. Crises do happen. In recent years, a number of countries have had their currency collapse or defaulted on foreign debt. Recall the Asian contagion, the Mexican peso crisis, the Russian ruble crisis in 1998, and the Argentine banking crisis. America is not inherently immune from such a crisis. The laws of economics so ably demonstrated by Schiff apply to America as well as to other places. And I believe that Schiff does as good a job as anyone making the case that the trends that he examines are unsustainable, excepting possibly the trade deficit.

I enjoyed the book and it is one of the better examples of economic writing among investment books. I recommend it for anyone who wants an analysis of current economic and investment trends from an Austrian viewpoint. While I am in general agreement with Schiff’s forecasts, time will tell whether the crises are imminent or whether we are due for an extended period of grinding sideways.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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On his Global Economic Trends Analysis Blog, Michael Shedlock poses the question Is Gold an Inflation Hedge? The answer: "Gold in many timeframes is not much of an inflation hedge." This conclusion is derived entirely from looking at the US$ price of gold over several periods of time. In this article, I will argue that the cited analysis is US-centric, and that when the US$ exchange rate is taken into account, Shedlock’s conclusions are questioned.

A US-Centric View

Gold is an international market. Its price is quoted on a continuous 5×24 basis; it is always for sale somewhere in the world. The demand for gold consists not only of the demand by elderly US investors who once held a gold coin, but by people in many different countries, some of which have never had a local currency that has gained anywhere near the mindshare as has the US$.

The problem with concluding anything based on the US$ price alone is that an analysis of US$ price of gold is as much an analysis of the US$ exchange rate against other fiat currencies as of the value of gold itself. The US$ exchange rate is affected by many political variables, including currency intervention by foreign central banks and the sometimes non-linear effects of the Fed’s inflation. Dollar inflation, working through what James Grant calls the "international monetary non-system" has in some periods had the paradoxical effect driving up the value of the dollar against other currencies. During those periods, the dollar price of gold performs poorly, but the price in other currencies outperforms.

In order to get a real answer to the question, the performance of gold against fiat money in general must be examined. In this article I will extensively cite the research of Paul van Eeden, who has analyzed the behavior of the gold price in a series of articles published on his web site. In Gold — A Commodity?, van Eeden writes:

Given that net investment demand [for gold] represents the aggregate of global economic trends, it makes no sense to try and understand its correlation to the gold price in US dollars alone, without considering the price of gold in the rest of the world, which by definition must incorporate all exchange rates. An analyst in Lusaka, for example, may find value in analyzing the gold price strictly in terms of Zambian kwacha, but in reality his analysis will reflect mainly the kwacha exchange rate, with a minor contribution from the actual gold market. The same applies to an analyst in New York, working strictly from a US dollar perspective.

In order to measure the performance of gold against fiat money in a way that is independent of the exchange rate of any particular fiat currency against other fiat currencies, van Eeden has "created a global gold price using a GDP-weighted index of 35 currencies, representing in excess of 75% of the world’s economy." A graph of the gold price from 1990-2001 (a period of time in which the US$ price of gold was in a deep decline) shows gold in a slowly rising trend against the index.

Under a section subhead "Proof," Shedlock shows several charts of the US$ gold price against the US$ index and money supply measures. The US$ price of gold does not show any particular correlation to these other measures as might be expected if it were an inflation hedge, including the unstated assumption that the US$ were the only currency in the world.

According to van Eeden, when the gold price is examined against a global weighted index of fiat currencies, it is rising approximately at the same rate as the purchasing power of fiat paper money is declining. Van Eeden’s data show that gold has done a good job maintaining purchasing power over time against fiat money inflation. In other words, gold functions as an inflation hedge. The market has priced it like other currencies on the international money markets.

In Understanding the Gold Price, van Eeden explains that from an international perspective, the gold price did not decline during the 90′s, when it did fall substantially in US$ terms:

Even though the gold price in U.S. dollars has declined by over 30% since January 1990, the average gold price in the world has increased by over 20% during the same time. This not only reinforces the concept that talking about the gold price is currency specific but more importantly, it shows that the average gold price in the world is stable and in fact steadily increasing.

This in turn is a strong indication that gold is still a safe haven for capital. Gold has not lost its value as a store of wealth.

The Overvalued Dollar

As van Eeden explains, the poor performance of the US$ gold price during the 90s was primarily a reflection not of declining monetary significance of gold, but of the dollar’s overvaluation relative to other fiat currencies. The over-valuation of the dollar resulted from several factors: a massive asset bubble in the US; a series of currency crises fueled by debt implosions in the developing world; and the reluctance of Japanese central planners to allow the Yen to appreciate as they attempted to inflate their way out of the 15 years of doldrums following the collapse of their credit bubble in the 80s. I will say a few words about each of these factors,

The US asset bubble played an important role in creating the over-valuation of the dollar. Since I have expanded on this thesis elsewhere, I will only summarize here. Peter Warburton in his book Debt and Delusion presents a compelling case that the 90s was a period of high inflation, but the as central banks relied increasingly on deficit financing through securities markets rather than bank credit, inflation was increasingly channeled into financial assets rather than those of consumption goods.

The Greenspan Fed aided and abetted the process by creating an understanding among financial players that it would inject sufficient liquidity to prevent any possibility that asset prices would be allowed to fall. This "Greenspan Put" started with the unusual measures that were taken to halt the fall of stocks in the 87 crash, and continuing with a series of bailouts and interventions throughout the latter half of the decade.

The resulting bubble in US financial assets ignited worldwide demand for US$ as foreigners, anxious to get in on the US equity market party, expressed their demand for US equities as demand for the dollars with which to purchase them. A “virtuous cycle” then resulted in which demand for US stocks reinforced demand for dollars, and vice versa, driving them both higher in an ever-accelerating upward spiral. Foreign investors profited on the capital gains and the appreciation of the dollar exchange rate relative to their home currency (until the whole thing went splat).

Van Eeden cites the role of a series of financial meltdowns in emerging markets as a factor driving demand for the US dollar. The developing world was jarred by a series of debt implosions and currency devaluations starting with Brazil (1992), Mexico (1994), the Asian Contagion (1997), Argentina (1999), and Russia (1998). In response to each crisis, there was a “flight to safety,” with capital seeking out the perceived safe haven asset class: US Treasury debt.

A point that van Eeden does not make is the connection between these crises and the dollar reserve system. The post-Bretton Woods floating fiat currency system established the dollar as the reserve asset, but exchange rates are often manipulated based on ill-advised political factors or unwise economic policies. Attempts by economic ministers of small countries to fix their exchange rates above or below market value create a buildup of imbalances between the small nations and the rest of the world, inevitably followed by a swift crisis of one kind or another.

Van Eeden illustrates the response of the US$ gold price and the dollar’s exchange rate to each crisis. He follows up with some charts of the gold price in the currencies that were in crisis (Mexico, Indonesia, Russia). Had you lived in one of those countries, gold would have been a very effective hedge against inflation — or more accurately a hedge against monetary devaluation (which is often several years of repressed inflation all at once). On a worldwide average basis, gold has not been losing purchasing power; on the contrary, it has been in a rising price trend. Van Eeden concludes:

As you can see from the above examples, even though the dollar-gold price did not necessarily respond to crises, the average gold price certainly did. But the world had become fixated on the dollar-gold price and it has become generally accepted that gold had lost its value as a store of wealth. From the above examples however, it should be clear that nothing is further from the truth.

Central Bank Sales

Research by the activist organization Gold Anti-Trust Action (GATA) suggested that gold sales by central banks are part of a pattern of intervention prevent the US$ price of gold from performing its signaling function to financial markets. GATA’s extensive research on central bank gold sales has uncovered considerable evidence of a undisclosed central bank sales in larger quantity than the disclosed sales, unreported gold-for-paper derivatives between central banks, false and misleading accounting on the books of central banks for gold that has already been sold into the market, and the buildup of a large paper short position in the gold market created through derivatives. While some of their research is quite technical, I would encourage anyone who is interested to spend some time on their web site or watch their DVD.

Van Eeden disputes the idea that central bank sales have had any effect on the gold price. Here I part company with him. While van Eeden shows that gold is weak in US$ because the US$ is strong, and concludes that central bank sales have no effect on the gold price. In his model, the direction of causality is from dollar exchange rate to US$ price in gold. However, if the US$ exchange rate is influenced by the gold price, then it could be true that the US$ was strong in part because gold has been weak. Management of the gold price itself, then, could be part of the "strong dollar policy" publicly advocated by several US Treasury secretaries.

GATA’s argument is as follows: there is a bi-directional feedback mechanism between the dollar exchange rate and the US$ price of gold. While a perception of inflation will result in a rising gold price, cause and effect could go in the opposite direction. Many traders in financial markets use a rising US$ gold price as an indicator of the extent of US$ inflation. That is, a rising gold price can drive the perception of inflation as well as the other way around. If the US$ gold price began to rise, the bond and currency markets would react by bidding down the price of bonds and the bidding up the dollar exchange rate against other currencies. GATA has located a research paper by former Treasury Secretary Summers which puts out the idea that the long-term interest rates could be managed indirectly through control of the gold price.

Gold: A Commodity?

While Mr. Shedlock agrees that gold is money and not a commodity, his analysis does not fully take this into account.   To understand the purchasing power of gold, it cannot be compared to one other currency.   If someone wanted to get an idea of the purchasing power of say, the Russian ruble, would they compare it only to the dollar? A global approach such as van Eeden takes is necessary in order to separate the individual currency-specific factors from gold.

When the dollar’s link to gold was broken in the 70s, some economists — thinking that the gold derived its value from its association with paper money — predicted that the US$ price of gold would drop to a value reflecting its use as a commodity. Instead the US$ plummeted in an inflationary crisis and has depreciated ever since, while the purchasing power of gold on a global basis has remained relatively stable.

While the memory of gold as money is vanishing in the United States, in many countries, the local currency (or one in a sequence of failed local currencies) has never earned anywhere near the prestige as has the US$. Gold has been in continuous use as a store of value more or less forever in parts of the world lacking the enlightened monetary central planning that we have grown confident with here. US investors may not remember gold but they are selling theirs to those who have never forgotten it.

In Making Sense of the Gold Price, van Eeden writes:

If gold is a commodity like rice or aluminum, then it should be priced as such. It would seem that under such circumstances, gold is the most overpriced commodity in the world. The value of gold as a commodity stems from its physical properties: electrical and thermal conductivity, resistance to corrosion, malleability and ductility. The biggest market for gold will be in the electronic industry where it will compete with other metals, notably copper. If gold were to truly compete with copper in mass production of electrical components then the price of gold would have to be competitive with the price of copper. Copper trades for around $0.80 a pound and gold for more than $4,000 a pound. This means that the gold price would have to drop to less than $0.06 (six cents) an ounce to be in the same region as the copper price. Obviously gold is not being priced as a commodity. There is a demand for gold that inspires people to pay substantially more for it than its commodity value. Gold is money.

Elsewhere on LRC, I have presented a more fully worked out analysis of gold supply and demand worldwide. My analysis shows that a large component of the present demand for gold is a demand-to-hold, or monetary demand. The next largest component of gold demand is jewelry demand, which is arguably monetary demand as well, though this would probably not convince someone who thinks that gold has been demonetized. Most of the demand for gold, worldwide, is demand-to-hold rather than demand for use. A large (and stable) demand-to-hold in proportion to total supply is a characteristic of money, not of a commodity.

Conclusion

While I am in agreement with Mises’ view that the purchasing power of money is in constant flux as money prices change, van Eeden’s work shows that gold is doing a reasonably good job of maintaining purchasing power parity on a worldwide basis. More extreme fluctuations in gold’s purchasing power when converted into US$ have a lot to do with changes in the US$ exchange rate.

The dollar price of gold can be flat or falling even when the quantity of dollars is increasing so long as the dollar exchange rate against other currencies rises. The non-buyer of gold, then, is speculating an appreciating dollar exchange rate cancelling out the effect of currency debasement.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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Analyses based on annual supply and demand of gold appear on a daily basis, whether posted to gold web sites or in the financial media, many of them by the most respected analysts of gold-mining shares. These articles typically show an imbalance between supply and demand, suggesting that there is a gold supply deficit. From there, the conclusion follows that a much higher gold price is required in order to bring supply and demand into balance.

There is no gold supply deficit. Even if there were, to cite Dick Cheney, "deficits don’t matter". The dollar price of gold is formed through the balancing of total gold supply and demand against total dollar supply and demand. The incremental supply and demand during any one-year period is irrelevant to the price. The illusion of a deficit comes about from an incorrect interpretation of supply and demand figures: annual amounts rather than totals are compared.

On the supply side, the annual production of gold has almost nothing to do with its price. Neither does decades of under-investment in gold exploration, the lack of new discoveries of gold deposits, miners’ cash cost per ounce, nor environmental delays in permitting new mines. The output of the gold-mining industry has very little impact on the gold price.

On the demand side, the "annual demand" for gold — as it is computed in the models showing a deficit — is a misleading figure. The comparison of annual amounts is relevant for a commodity that is consumed but not one that is held as is gold. For an asset that is held, the annual demand has no business being compared against annual supply, for the comparison tells us nothing about the price.

Whose Deficit?

While I could cite hundreds of examples if I had been collecting them over the years, in the interest of space, I will cite only two to make my point. These two examples were selected not to single out the particular writers, as there were many others that could have been chosen, but because they happened to pass in front of me recently.

First, this article on a mining site:

GOLD supply shortages were possible in the long-term, according to recent research produced by Canadian research house, Metals Economics Group (MEG). It said in a press statement that recently discovered deposits of more than 2.5 million ounces, enough to attract the interest of major gold producers, were not adequate to replace their production.

And this piece from a financial news site:

…JP Morgan believes the gold market outlook continues to improve. Demand continues to strengthen (even if only for one-off events such as the establishment of gold Exchange Traded Funds or ETFs), but this stronger demand is not being met by higher supply thanks to declining production from South Africa in particular. This means central bank selling is required to meet the shortfall, but the quantity of this selling is limited under agreements in place between the banks.

The Case for a Deficit

In order to understand why there is no deficit, I will explain why some people think that there is one. (To be fair, I believe that the gold analyst community is divided on this issue.) The problem with the supply deficit theory is in the interpretation of the numbers, and not the numbers themselves. Because the exact numbers don’t matter so much, I will use the gold supply and demand figures from a prominent industry source, the World Gold Council, without attempting to verify them. Values for the last three years are found in their supply and demand spread sheet (may require free registration). Even if slightly different numbers were used, the point that I am going to make would not change.

Table 1, below, is based on the WGC figures for the last two years. Note that they do not show much of a deficit for 2004 and a slight surplus for 2005. The WGC, as far as I know, has not promoted the supply deficit argument. However, I am citing their figures because they use the annual supply and demand methodology, the same methodology that is used by analysts who think that there is a deficit.

Table 1: WGC Annual Figures

(tonnes)

2004

2005

Supply

Mine production

2469.0

2520.3

Net producer hedging

-426.5

-131.1

Gold scrap

847.7

860.9

Official sector sales

469.4

660.6

Total supply

3359.7

3910.7

Demand

Jewelry

2612.8

3131.8

Industrial & dental

409.7

420.1

Bar and coin retail investment

397.1

409.2

Other retail

-56.8

-22.5

ETFs

132.6

208.1

Total demand

3495.5

3726.6

Balance (total supply — total demand)

-135.8

184.0

A report from the UK branch of the French bank Cheuvreux caused considerable discussion when it was released last year. This report, using the same flawed methodology, showed much larger supply deficits on an annual basis. It is worthwhile to understand the discrepancy between these two reports. On pages 26 and 27 of the report, the information used to construct Table 2, below, appears. While the WGC shows a surplus for both 2004 and 2005 on the bottom line a report from the Cheuvreux report, while using essentially the same numbers as the WGC, shows estimated supply shortfalls of hundreds of tons annually. (The Cheuvreux report cites the World Gold Council as the source of the data but the annual numbers differ slightly. I am not sure why but the differences are small so it doesn’t affect the argument.)

Table 2: Cheuvreux Annual Supply and Demand

(tonnes)

2004

9M2005

Supply

Mine production

2461

1842

Net producer hedging

-427

-123

Gold scrap

829

608

Supply before official sales

2864

2327

Demand

Jewelry

2613

2129

Industrial & dental

409

316

Net retail investment

342

305

ETFs

133

125

Total demand

3498

2874

Supply Shortfall

-634

-547

Official Sector sales

475

489

Balance

-159

-58

The difference between the two reports using the same raw data are substantial and must be explained. The main source of the WGC definition of supply value includes official sector sales while the Cheuvreux definition of supply does not. In the Cheuvreux report, the net supply minus demand (which they call supply shortfall) is greater than the net of supply minus demand in the WGC report by an amount approximately equal to the size of official sector sales. Because the official sector sales are a fairly large number, the Cheuvreux value for net of supply and demand is a negative number in both 2004 and 2005.

Cheuvreux shows the official sector sales in a separate row appearing in their table after Supply Shortfall. By removing official sector sales from the supply, this format implies that official sector sales were necessary in order to fill a deficit between the other components of supply and the demand. While official sector sales offered "at market" probably do affect the gold price, this impact is exaggerated by offsetting official sales against annual figures rather than totals.

Deficits Don’t Matter

Let’s look at how the WGC and the Cheuvreux arrive at a deficit.

In the WGC report, a footnote states (with some caveats) that the Balance term is partly due to residual error (presumably errors in measurement); and that the remaining Balance is the "implied value of net (dis) investment" ("includes institutional investment other than ETFs and similar stock movements"). In the WGC report, a negative Balance (deficit) would occur in any year where there are net private (non-official) sales. (I should point out that the WGC does not use the term "deficit", though many writers using these figures, or figures like this, do use that term.)

The Cheuvreux report starts from the position of the WGC report, however, Cheuvreux does not include the additional differential due to the omission of official sector sales from their definition of supply. Cheuvreux defines a deficit year as any year during which there were net private plus official sector sales.

A word can be defined to mean anything, but is the definition useful? I will argue that to define a deficit year as a year in which there are private sector or official sales is more than a little bit misleading, because it leads to thinking about the gold market as if it were a spot market for a commodity that is consumed rather than held.

For a commodity that is consumed, an annual incremental deficit would imply a higher price in the future because the deficit could only be filled by a drawdown of existing stockpiles, which would eventually become exhausted if the deficits continued. Upon the depletion of stockpiles, the price would have to rise to the point where demand was in balance against only that supply that was produced.

But gold is not that sort of commodity. There is no need at all for supply on an annual basis excluding private sales to come into balance with demand on an annual basis. It is not even true that these must balance over any number of years. The reason for this is that a sale out of someone’s stockpile of gold does not reduce the total amount of stockpiled gold. All it does is to shift the gold from the seller’s private stockpile to the buyer’s private stockpile. A market could remain in a "deficit" of this sort forever without the price ever going up (or going down) as buyers and seller shifted the contents of their stockpiles among themselves.

Stocks and Flows

We can divide economic goods into those for which the entire annual supply is destroyed in the process of consumption, and those for which new supply is hoarded. Economists call the former "flows" and the latter "stocks".

Analyzing the supply and demand over a short window of time for a flow-type good would tell you a lot about where the price was likely to go. But annual supply and demand for the second type — of which gold is the premier exemplar — tells you almost nothing about its future price movement.

First, consider a good that is consumed, where by "consumed" I mean that the economic value of a unit is destroyed over the course of its productive life. One example is DVD players. The economic value of a player is destroyed as the player wears out. All of the supply that manufacturers produce must be sold. There would be no real reason for Sony to sit on warehouses full of aging players. The price of the players can only fall as they become obsolete, and on top of that, they are costly to store. Sony must sell everything that they produce at whatever price the market will support at the time.

Competition from other manufacturers to sell, and competition among consumers to buy Sony’s players, or other goods entirely, ensures that the price at which the players are sold will be whatever price clears the market between all buyers and sellers on a very short time scale. In micro-economic jargon, most final goods have a vertical supply curve once they arrive at the market. The same would be true of any perishable good, most manufactured goods, and commodities that can only be stored for a short time, such as beef or eggs.

But for most known commodities, the aboveground supply is relatively small compared to the quantity that is permanently used up every year. Most of what is mined, drilled, grown, or raised on a farmed is consumed soon after it is produced. In some cases, large stockpiles of a particular metal — e.g. silver — have been accumulated and in other cases accumulated stockpiles have sold off (silver again). But absent a large stockpile the market price of these goods is pretty close to the level that balances the recent supply and current demand.

When it comes to a stock, total (not annual) supply and demand determine the price of each unit. Consider the following example concerning equity shares of a corporation. Suppose that an equity analyst appeared on CNBC stating that the price of a common share in company XYZ, with 100M shares issued, would rise (or fall) because they were only issuing 1M new shares this year, while the demand for those shares would be 2M. This analyst would be pricing the shares as if they were a stock-type of good. Using this method, a daily volume of 1M shares would be an annual volume of about 250M, which would create a "supply deficit" of 249M shares assuming 1M new shares issued.

It is easy to see the fallacy here. Even if the capital raised from issuing the new shares added no value at all to the corporation, at worst it would only dilute the value of the existing shares by 1%. A stock with 100M shares outstanding could easily trade 1M shares per day without the price rising or falling as people rearrange their portfolios with some who wish to hold fewer shares selling, and other investors who wish to hold more shares buying.

The True Supply of Gold

To understand the price of gold, the relevant supply is the total supply, not the new supply coming to market during the last year (or week or month). The supply of gold consists of all of the supply that exists. The relevant demand is the total demand, not the new demand coming to market during any year.

For gold, there is always a large stockpile, and it never gets smaller. The vast majority of all gold mined throughout human history still exists and is held either in bars, coins, or jewelry. According to the WGC, this quantity was around 155,500 tonnes at the end of 2005. Almost no gold is used up (in the sense of being destroyed or becoming permanently unusable) ever. In most cases when a buyer purchases gold, it moves from the seller’s hoard to the buyer’s hold.

The World Gold Council estimates that 52% of gold is held as jewelry. James Turk subdivides jewelry holdings into low carat and high carat. The former is purchased mainly for the gold value, as an alternative to buying bars and coins. The latter is purchased mostly for fashion. According to Turk’s estimate (which was published in 1996), monetary jewelry at that time accounted for about 60% of jewelry with fashion jewelry accounting for the remaining 40%. However, even when made into jewelry, the gold is not destroyed and can come back into the market as scrap. The WGC figures show significant recovery from scrap.

The reason that total supply and not annual supply matters is that the gold market is not segregated into two markets. There is not one gold market for the current year and another gold market for aboveground gold that was mined in previous years. The gold market is a single market in which all sources of supply are indistinguishable. Every existing ounce of gold competes for sale with every newly mined ounce. A buyer of gold doesn’t care whether he is buying recently mined gold or gold that was held in bars for 100 years, or the product of melted jewelry.

Every ounce of gold that is held by someone is potentially for sale at some price. While not every ounce of gold in private hands is for sale at the current market price, any ounce of gold could potentially come to market. A lot of gold is held in small stockpiles among widely dispersed owners. Some is for sale just above the current spot price, some only at much higher prices. The varying levels of prices at which different units of goods held in a stock are offered for sale is what makes the supply curve upward-sloping rather than vertical as is the case in consumption goods.

Is it true that a lot of gold is not for sale at all, so it should not be counted as part of the supply? In short, no. Gold is held as a store of value over time. The point of holding a store of value is not to hold it forever and then have it cremated along with your corpse. A person will only store value over time because they anticipate the need for the value some time in the future. Anyone who anticipated having no needs in the future would not need to store value over time. And the stored value is only stored for a finite period of time until the person holding it becomes aware of something that they need more than what they have stored. That would be the time to sell.

Note also that every new ounce of gold that is mined does not need to be sold at the current market price. Unlike most manufactured goods, gold-mining companies do not necessarily have a vertical supply curve for their product because it does not spoil or become obsolete. While many mining companies do sell all of their supply at spot soon after they have mined it, some mining companies sell their supply at a pre-determined price that in some cases was fixed years in advance through hedging contracts. And other mining companies choose to hold mined supply in reserve with the anticipation of selling it later, at a higher price. Goldcorp has done this in the past, at one point accumulating more vault gold than the central banks of a large number of small nations.

The Demand for Gold

It is easy enough to see that the supply of gold is the total supply. But what is the demand? It turns out that the demand is equal to the supply. To understand this, we introduce the concept of reservation demand. Most people are familiar with exchange demand. Exchange demand is expressed by giving up something in an exchange in order to for the thing demanded. Reservation demand is a demand that is expressed by holding onto something that you own.

People who hold gold are demanding it by holding it off the market. As Austrian economist Murray Rothbard explains,

At any point on the market, suppliers are engaged in offering some of their stock of the good and withholding their offer of the remainder. … This withholding is caused by one of the factors mentioned above as possible costs of the exchange: either the direct use of the good (say the horse) has greater utility than the receipt of the fish in direct use; or else the horse could be exchanged for some other good; or, finally, the seller expects the final price to be higher, so that he can profitably delay the sale. The amount that sellers will withhold on the market is termed their reservation demand. This is not, like the demand studied above, a demand for a good in exchange; this is a demand to hold stock. Thus, the concept of a "demand to hold a stock of goods" will always include both demand-factors; it will include the demand for the good in exchange by nonpossessors, plus the demand to hold the stock by the possessors. The demand for the good in exchange is also a demand to hold, since, regardless of what the buyer intends to do with the good in the future, he must hold the good from the time it comes into his ownership and possession by means of exchange. We therefore arrive at the concept of a "total demand to hold" for a good, differing from the previous concept of exchange-demand, although including the latter in addition to the reservation demand by the sellers.

The Total Picture

Now that we have covered the total supply and total demand, the proper rendering of the supply and demand situation would look something like Table 3, though the numbers are not exact. Note that when all sources of supply and demand are counted, there is no deficit. Total supply and total demand must always equal because every transaction has a seller and a buyer. Over time, there is a gradual accumulation of the stock of gold and a possible shifting between investment holdings (bar, coin, ETF) and jewelry.

Table 3: Total Supply and Demand

(tonnes)

2004

2005

Supply

Mine production

2469

2520.3

Destroyed by industrial/dental use

-409.7

-420.1

Recovered from scrap

847.7

860.9

Existing supply

149,131.90

152,038.90

Total supply

152,038.90

155,000.00

Demand

Industrial & dental

409.7

420.1

New bar and coin retail investment

397.1

409.2

ETFs

132.6

208.1

Reservation demand from prior accumulation

151,099.50

153,962.60

Total demand

152,038.90

155,000.00

Balance (total supply — total demand)

0

0

The price of gold is determined as is the price of any stock: by total supply and total demand. The price is that price which balances total supply against total demand, including reservation demand. The price of gold, in terms of dollars, or other fiat money, balances supply of all gold offered for sale at a range of prices in dollars with demand for gold — including both demand to exchange dollars for gold and the reservation demand for dollars and for gold.

Looking at supply and demand over a single year tells us nothing because the annual supply and demand are only about 2—3% of the total supply and demand, while the price of gold depends mostly on the other 98%.

Suppose that during a particular year, there are net sales from stockpiles. This tells us nothing about what the price of gold will do, because when gold is sold, it goes from the seller’s private stockpile into the buyer’s private stockpile. There is no limit on the number of consecutive years in which sellers of gold can sell out of their stockpiles as long as there are buyers who add to their stockpiles that same year. This type of trade in gold could go on forever without the price changing because individuals’ needs change all the time. During a given year, there will always be some people who have an increasing need of a store of value and others having a decreasing need. The former become buyers, the latter, sellers.

Annual changes to supply and demand do not influence the price much, if at all, because annual changes are small compared to the total. Around 98% of supply during any year was previously mined. And around 98% of demand is reservation demand, while only around 2% of demand is exchange demand for mined gold.

Newly mined gold does have some effect on the gold price, but only insofar as it dilutes the total supply of gold by a small amount. As previously discussed, mine supply dilutes existing supply by about 2% annually. If the supply of gold were diluted by 2% each year, and existing holders wanted to hold the same amount of gold in their portfolios measured in purchasing power terms, then existing holders would rebalance their portfolios adding about 2% to their positions and the price of gold would have to fall by about 2%.

If gold-mining were to increase by 50% from the current year to the next year, would the price of gold collapse? Not at all. After a 50% increase, the proportion of new mine supply out of total supply would only rise from 2% to 3%. Gold demand would not need to increase by 50% in terms of ounces to absorb this supply, only by about 0.98% (1.03/1.02 — 1.0).

But even this overstates the influence of newly mined gold. It is probably more relevant to measure demand in dollar terms rather than in ounces. In this example, if the price of gold in dollars declined by about 0.97% (1/0.98) while gold demand in dollars remained constant, the demand in ounces would increase by just enough to balance the new supply. With a total demand, properly counting reservation demand, absorbing the newly mined gold into the market doesn’t appear nearly so difficult.

Another way of making the same point is to suppose that gold-mining stopped entirely. Investment demand by new investors in gold would have to be met by an equal amount of disinvestment by existing holders. In that case, then every buyer would have to buy gold from a private or official sector seller. If an annual deficit year is defined as one in which there are net private sector sales, the market would be in deficit every single year. No matter how high the price moved, the market would still be in deficit. There is no price of gold that would cure the deficit because of the way that the deficit is defined. But the price would not necessarily go up under these conditions because any sales out of a seller’s stockpile are exactly offset by additions to a buyer’s stockpile. All that happens in a market like this is that stockpiles change ownership from owners who value them less at that time to owners who value them more. No general statement about the price can be made; however, during periods of the classical gold standard, the purchasing power of gold tended to rise by a few percent per year.

Silver is Not Gold

When it comes to silver, deficits do matter. Here I cite the works of silver analysts David Morgan, Ted Butler, and Charles Savoie. For most of the past few thousand years, annual mine supply was in equal or in surplus over annual consumption, and stockpiles were accumulated year after year, at one point reaching around 6 billion ounces. Over the last forty years, stockpiles have been drawn down to nearly zero. At the present time, all of the silver consumed during any given year is silver that came out of the ground that year, with a decreasing contribution from stockpiles.

With silver, it does make sense to look at net private sales from stockpiles as filling a deficit between supply and demand. Why is this true for silver and not for gold? For the most part, demand for silver is consumption demand, and most consumption demand is destructive, meaning that the silver ends up in a form where it cannot easily be reclaimed and brought back into the market.

Therefore, the deficit of mine supply relative to destructive demand implies a necessary sale out of stockpiles. These finite stockpiles cannot continue to supply the world with 100Moz of silver for consumption annually. At some point, they must be exhausted and higher prices will then be required in order to bring supply and demand into balance on an annual basis.

To the extent that the silver is held for investment purposes, then everything I have said about gold applies to silver. The same would be true for photographic demand for silver because most silver used in photography is reclaimed. Silver is partly held for investment purposes and partly consumed, so its price behavior will result from a combination of the two models.

Conclusion

Does the non-existence of a supply shortage theory make the case for gold weaker? I say no. At the beginning of this article, I stated that there is a bullish case for gold. If not the mythical shortage of mined supply, then what is it?

Analysts including Frank Veneroso, Reginald Howe, Robert Landis, John Embry, and others affiliated with the GATA organization have shown in a series of research reports published over the last five years that central banks have created what amounts to a large naked short position in the gold market using paper derivatives. The accumulation of shorts without any offsetting longs has been a negative for the gold price, especially during the late 90s.

But the ultimate bullish case for gold is none other than the bearish case for fiat money, the dollar, and central banking. Gold is money and while central banks have the ability to debase fiat money up to a point, they are in the end limited by the acceptability of their paper as money. The end game of the paper monetary system is collapse and its replacement by the natural monetary order of gold.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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Mike Shedlock, in his consistently thoughtful and informative blog, provides an excellent summary of the box canyon in which the Fed finds itself. In a post titled, Billmon Gets it — Do You?, he writes:

One of the reasons for these repetitive bubbles is the Fed does not itself know what inflation is. They think they can micromanage the economy when all they are doing is chasing their tale due to the lagging effect of their actions.

At some point, and I think we are at that point right now, a sort of economic zugzwang [chess term] is reached. I spoke about this in Red Queen Race…

In economic terms, there is no magic mirror. Bernanke is trapped in “Wonderland” but unlike Alice has no way out. Bernanke gets to choose between hyperinflation and deflation. The moment he can not run fast enough, the US economy will implode. If he runs too fast, the value of the US dollar as well as the Fed’s power will both come to a very abrupt stop. In effect Bernanke is in Zugzwang and he does not even know it.

Eventually Bernanke (like the Bank of Japan) will have to choose deflation. The reason is simple: hyperinflation will end the game, which in turn would eliminate the wealth of the Fed as well as all of their power.

I mostly agree with Shedlock’s analysis of where we are and how we got here. I also recommend his article, Inflation: What the heck is it? for an Austrian-minded view of the credit cycle and inflation.

I agree with Shedlock that the Fed will at some point face a choice between deflation and hyperinflation. I will give a short outline of why this is the case, and then suggest some reasons for choosing the inflation card.

Inflation is the expansion of money in a fractional reserve banking system. The inflationary effects on prices of monetary expansion have long been understood. The Austrian economist von Mises developed a theory of the boom and bust cycle based on bank credit expansion. His analysis showed that inflation not only affects prices in general, but also distorts relative prices between capital goods and consumption goods. This leads to an over-allocation of productive investment into more credit-sensitive parts of the economy, which is reflected in financial markets through increases in financial asset prices. The stock market bubble of the 90s was an example of this, as was the subsequent housing bubble.

Markets are always trying to bring prices back to equilibrium. Under the influence of market forces, investments that were artifacts of an inflationary boom are eventually liquidated in bankruptcy. It is the adjustment of relative prices that brings the economy back to a sustainable balance of borrowing and saving. However, this adjustment process tends to be deflationary. The deflation occurs because, as the artificial forms of life created during the credit expansion phase of the cycle fail and default on their debts, bank credit money is destroyed. When credit money is destroyed and there is a contraction of the money supply. This process can feed on itself through the inter-bank clearing mechanism and the debt-deflation spiral (see here for more discussion of this).

The corrective liquidation process can be postponed for some time through the instigation of another bout of inflation. This has been the Fed’s strategy since the mid-80s. When in doubt, print more money. (See Antony Müller’s Mr. Bailout for an excellent short history.) After the collapse of the stock market bubble, the Fed’s Brobdignagian inflation campaign has succeeded in creating a housing bubble, and now a commodities bubble.

But the ability of a central bank to reinflate is not without limit. The central bank must eventually face a final choice between hyperinflation and deflation for several reasons.

One reason is that each inflation cycle starts from a position in which the distortions of the previous cycle have not been fully liquidated. The economy becomes more fragile and less able to digest the next round of money printing. But the ultimate check on the central bank’s ability to inflate is hyperinflation.

While the expansion of the supply of money and credit can lead to rising prices, and a high rate of credit expansion will produce a high rate of price inflation, there is no specific rate of expansion that will necessarily result in hyperinflation. Hyperinflation originates in the money demand side, not the money supply side. When the population comes to the en masse realization that the central bank has no intention of ever abandoning its policy of continued inflation, they begin to reject the existing fiat currency as a medium of exchange.

Panic selling ensues, as anything that can still be bought for money is bid up in price as people frantically attempt to get rid of all their money while it still has some value. As money demand approaches zero, prices rapidly multiply then explode. For example, the current hyperinflation in Zimbabwe has driven the price of a single roll of toilet paper up to a reported $145,750 Zimbabwe.

When does the central bank face this limit? When the reinflation no longer works to maintain the artificial forms of life that were created during the boom. This limit is reached because, while the central bank can print money, they can’t control exactly where it goes.

The inflationary nature of the credit-driven boom is hidden from most people as long as the prevalence of easy credit does not translate into rising prices of consumption goods. If for example, assets that make people feel wealthier — stocks and houses — are going up in price, it will not be perceived as a process of monetary debasement. However, if the monetary injection escapes the confines of asset prices its true inflationary nature becomes more clear to the general population.

If the prices of goods that people buy every day noticeably increase, then the risk of hyperinflation looms. This process can feed on itself as people begin to sense that their money is worth less and less. There comes a point where more money expansion will not go into the artificial assets that were created by the earlier rounds, but feed into an acceleration in the increase in the prices of ordinary goods. This is the point where the central bank must choose between deflation and hyperinflation. If they do not stop the inflation at this point, the credit expansion will increasingly run up the prices of goods and a rapid destruction of the money will result.

Mises described this point of no return in an oft-quoted passage:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

When a central bank reaches this point, and they are unwilling to allow a deflation to occur, then it must inflate ever more rapidly. In the case where financial assets have been the prime beneficiaries of previous bouts of inflation, the central bank must be willing to buy up the assets of banks and other leveraged financial entities with freshly printed money in order to prevent the asset prices from adjusting in relation to goods prices. The adjustment will come instead as goods prices inflate faster than asset prices, so that asset prices deflate in relative terms only.

Must Bernanke choose deflation over inflation, as Shedlock says? Shedlock is correct in saying that hyperinflation would destroy the dollar and likely the Fed’s credibility as well. Indeed, this would argue against hyper-inflation. But here are some thoughts on why this reason alone may not be enough, and why we will probably end up with hyperinflation:

1. If the Fed chooses deflation over inflation, that would also destroy its credibility. A central bank is supposed to prevent both inflation and deflation. Milton Friedman blames the Great Depression primarily on the Fed for not inflating enough. This view is widely accepted among economists (except Austrians). Bernanke wholly subscribes to this view, to the point of literally apologizing on behalf of all central bankers for the Fed having allowing deflation before he was born. He has even promised as a central banker in good standing never to let it happen again. Who would doubt that the Fed would again be blamed by a generation of inflationist economists if it allowed the credit system to suffer a deflationary collapse?
2. While a hyperinflation would destroy the banking system, so would a massive deflation. The US banking system now has 60—80% of its assets invested in housing through the direct ownership of mortgages, as well as indirect ownership through mortgage-backed securities. A severe deflation would wipe out all of the equity in the banking system. To therefore conclude that the Fed would choose deflation to save the banking system is a fallacy.
3. There might be some constituency for deflation, other than the Fed itself (if you buy Shedlock’s view of the Fed). But I can’t think of what it would be. On the other hand, there is also political pressure from the entities that would be most harmed from a deflation, most importantly, the financial entities who survive on debt and leverage.
4. The Fed cannot reliably predict the point at which the next inflation is their last one. No button lights up on the central bankers economic control panel telling them exactly when they are on their last bubble. Even if Bernanke were worried about a bit too much inflation, it is likely that he would attempt to postpone the inevitable crisis with one more dose of inflation. After all, central banks subsist on the conceit that they can manage the economy.
5. As Hoppe argues in his book Democracy: The God that Failed, the democratic political system acts on a short time horizon. A crisis postponed is a crisis that someone else will have to deal with, after the next election. A short time horizon generates a built-in bias toward inflation. While a deflation would cleanse the system of waste and maladjustment, it would require a degree of pain and forbearance, a virtue in short supply in a democracy.
6. Under a democratic regime, there is always a demand for the authorities to "do something" to prevent a crisis. If a deflation were allowed to begin, then as banks began to fail, would there not be a great outcry for the crisis managers at the Fed to come up with some kind of a "plan to save the world," as they have done so many times? What could this plan be, other than some kind of buyout of bank assets? Recall the Long Term Capital Management crisis. A large hedge fund with loans from most of the major Wall Street banks was bailed out rather than allowed to fail.
7. Bernanke has a staunch ideological inclination toward inflation. I have written on this topic before in my piece on Bernankeism. Examination of a number of speeches and academic papers by Bernanke and his cohorts at the Fed reveals a number of crackpot anti-deflation schemes based on the monetization of financial assets. These schemes are at minimum being studied by Fed researchers, and perhaps being prepared for implementation. Their writings and speeches all suggest that the deflation card is already off the table.

Are these factors decisive? Perhaps not. No one can say for sure what will happen. But I certainly won’t be placing any bets against Bernanke and his fleet of helicopters.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Self-evident as the above propositions are, economic history is littered with a long list of attempts to disprove them. The lodestar of inflationism is the search for a way to create more real funding out of paper. Antal Fekete’s attempt to resurrect the Real Bills Doctrine is one such proposal. Fekete’s rehabilitation of this long-discredited doctrine is motivated by an argument that savings are insufficient to fund production and that this limitation can be overcome through the issuance of financial instruments.

The root of the error in Fekete’s doctrine is the confusion between finance and funding. Real Bills do not fund anything. The result of monetizing more bills is merely an increased quantity of paper claims to the same pool of funding. The alleged insufficiency of savings to fund investment is based on a serious misunderstanding of what savings are, compounded by accounting errors in Fekete’s examples.

I have dealt with these problems in a series of articles (1 2 3 4). The current essay illustrates the necessary causal connection between savings and production through the subsistence fund, a concept that appears in the writings of Austrian economist Richard von Strigl.

Wealth is ultimately the ability to consume more goods and services. In order to consume, there must first be goods suitable for consumption. (These are called consumption goods or final goods.) Prior to consumption, then, final goods must have been produced. Goods are costly to produce, so prior to production, there must be some means of funding the production.

It is here that Strigl introduced the subsistence fund to explain the relationship between consumption and production. The subsistence fund is the supply of consumption goods available at any point in time. In this model, an act of consumption is a withdrawal from the subsistence fund. The production of a final good is a deposit in the subsistence fund.

Because people must consume some goods in order to survive while they are producing other goods, productive activity can only be sustained by withdrawals from the subsistence fund.

Consider the classic example of Robinson Crusoe, who has been shipwrecked on an island. He sets out to catch fish in order to supply himself with food. In order to sustain himself, he requires a daily intake of five fish. The fish are final goods. Working from dawn to dusk, he can catch ten using his bare hands. He soon realizes that he could catch twenty fish in the same amount of time with the aide of a net. However, the net would take ten days of his time to weave. During ten days of full-time net making, Crusoe would require a total of 50 fish. Crusoe decides to dry and set aside five fish each day, until he has accumulated 50 fish to feed himself during the period of net weaving.

In the example, the 50 dried fish form Crusoe’s subsistence fund. When Crusoe adds to the accumulation of dried fish he is saving. When he consumes the fish during the net fabrication, he is investing. What is the nature of the net? The net is not consumed directly, so it is not a final good. The net is a capital good, a good that was created as a tool for use in production of more final goods. The capital stock is simply the total supply of capital goods that exists at any point.

On Crusoe’s island we can see the connection between savings, investment, the capital stock, and the subsistence fund. If Crusoe ate all his fish on the day that he caught them, then he would never increase the size of his subsistence fund. If he saves and invests in capital, then he can create a larger subsistence fund by using the capital. Strigl explains this here:

Production can only be maintained if each attained subsistence fund is used to support another round-about method of production. It is not, then, the fact that a subsistence fund exists which makes the continuation of production possible, but the way in which this subsistence fund is used: It must not be used in a "purely consumptive" way, but rather in the sense of "reproductive consumption," in the sense of consumption which simultaneously assures further production…. these consumption goods must be used in such a way that, simultaneous to their expenditure, a later attainment of a new return of consumption goods is assured. (p. 12)

[all citations to Strigl from Capital and Production]

One difference between the example and a modern economy is that in the example, savings and investment proceed sequentially, while in a modern economy they are done in parallel. In the example, the subsistence fund is produced in its entirety before the investment in the net is started, and the fund is completely consumed by the time the net is done. More realistically, in a modern economy with a large population, an advanced division of labor, and a large accumulated capital stock, the creation and the depletion of the subsistence fund proceed in parallel. Every day, some final goods are produced, while other final goods are consumed. Over the course of one year, one year’s subsistence fund is produced and consumed in continuous increments, even though one year’s subsistence fund never exists as a stockpile at any single point in time. As Strigl explains,

In addition to the subsistence fund, we always find unfinished products in the various stages of maturity. The supply of unfinished products is built up in such a way that in each following week a subsistence fund large enough for one week’s needs will be finished. Each time, the finished available subsistence fund of the economy is reduced to a minimum. (p. 13)

Another difference between the example and a modern economy is division of labor. In the example, Crusoe saved, invested, produced capital gods, and final goods. In an advanced economy, with continuous production and consumption proceeding alongside each other, some producers create final goods, while others consume those final goods and produce different final goods or capital goods, all at more or less the same time.

In the example, savings are stockpiled, while in a modern economy, the stockpiling of finished goods is of less importance. In modern times, large inventories are not necessary as long as goods are supplied at about the same time and in the same quantity that they are demanded for consumption. Under these conditions, as Strigl explains, the size of current inventories will be small compared to the total subsistence fund:

The always available subsistence fund [i.e. inventory of finished goods] will be reduced in importance even more as compared to the overall supply of goods in various stages of maturity. (p. 13)

Even in a monetary economy, in-kind savings is not entirely replaced by monetary saving-and-investing — some stockpiling does exist. For example, when a consumer purchases a refrigerator with a ten-year life, then he has saved a stockpile of ten years of refrigeration. Even if no new refrigerators were produced over the next ten years he could continue to have refrigeration by using up the saved stockpile of refrigeration. The same could be said of cars, homes, and other long-lasting consumer goods.

In the Crusoe example, the same person created the final goods (fish) and the capital good (net). In an advanced economy, different people generally do these functions. When these functions are separated, the question arises, how are people who are not producing final goods able to consume final goods? Where does their supply of final goods come from? Their supply of consumption goods can only come from the subsistence fund. Strigl here elaborates:

the production of consumer goods must also "support"…the creation of durable factors of production and the appropriation of raw materials, i.e., it must supply these production processes, which themselves produce nothing that can be directly considered consumer gods, with those consumer goods necessary for the subsistence of those employed in these production processes. (p. 19)

Over time, as capital goods are used, they tend to wear out or are used up. The capital stock requires continuous new investment in order to maintain its capacity to produce the subsistence fund. Remember Crusoe. With daily use, his net will wear out. The creation of a new net would require either another new period of savings-and-investment, or ongoing minor repairs.

The entire existing capital stock is necessary to produce the current subsistence fund. If the subsistence fund is not to gradually shrink, then the entire existing stock of capital must also be repaired, maintained, or replaced. This capital investment can only be funded out of the subsistence fund. As an economy grows and becomes more complex, the funding of capital repair and replacement consumes a large, and generally increasing, proportion of the subsistence fund itself. As Strigl explains, “the continuation of production is only possible if this subsistence fund is again used so that the various integrated production processes can be carried on continuously.” (p. 13).

How can the entire capital structure be maintained out of the subsistence fund? Strigl responds:

1. The subsistence fund must support everyone who is involved in producing the finished product.
2. The subsistence fund must support everyone who is involved in producing raw materials for the production of means of subsistence.
3. The subsistence fund must support everyone who is involved in the production of machines (relatively durable factors of production); that is, of those machines used directly in the production of consumer goods as well as those which are used in the production processes that precede the production of consumer goods.
4. Finally, the subsistence fund must also support everyone who is involved in producing the raw materials used in the machine industry. (p. 18—19)

Producers can be arranged in a sequence from those who create final goods, to their suppliers, to their suppliers’ suppliers, and so on. Each firm in the supply chain takes as input partially finished goods produced by firms at the next stage of the chain. Only those firms at the very end of the chain produce final goods.

Note the special role played by the producers of finished products: they are the only producers whose output directly contributes to the subsistence fund. All other producers only make withdrawals from the subsistence fund. The producers of capital goods indirectly contribute to the subsistence fund because the capital stock is necessary for the creation of the subsistence fund.

The employees at the firms further back in the chain must make withdrawals from the subsistence fund in order to sustain their life while they work. And so must their suppliers, and their suppliers’ suppliers. Everyone, everywhere must make withdrawals from the subsistence fund. But how do the owners and employees of the other firms obtain final goods? The firms further up the supply chain receive a portion of the subsistence fund as it is passed on down the line from the end of the chain in payment for partially finished intermediate goods. As long as all firms continue to create new capital or at least replace their capital stock, any worker wherever he is in the chain, will be able to make withdrawals from the subsistence fund. Again we turn to Strigl for commentary:

The owner of a firm producing finished consumer goods first pays from the returns of his production everyone who provides him with originary factors of production for further production, then everyone who supplies him with raw materials, and lastly, everyone who renews his stock of machines. The manufacturer of machines in turn will be able to "work" with the fund he receives from the sale of his produced factors of production. With this fund he in turn pays those who make originary factors of production available to him, those who sell him raw materials, and those who deliver replacements for used up machines. In precisely the same way, the producers of raw materials will support their production with that fund of consumption goods which they have attained through the sale of their products. (p. 19)

If firms, or their owners, did allocate part of the subsistence fund toward the repair and replacement of their capital stock when it wore out, a larger portion of the subsistence fund would be consumed, the capital stock would not be replaced, and when machines wore out, the subsistence fund would shrink.

Strigl above defines the "renewal fund" as that portion of the subsistence fund that is set aside for the construction or reconstruction of the capital structure. The renewal fund is another term for gross savings. On the renewal fund, Strigl wrote:

A consumer-goods industry equipped with durable factors of production can continue to work for a while even if no renewal takes place, if during economic fluctuations the splitting off of a renewal fund out of returns is not possible. Production will then only come to a standstill if the equipment is completely consumed. The production of factors of production is, however, entirely dependent on being supported by a renewal fund provided through the consumer good industry. It will come to a standstill once no renewal fund is accumulated in production. The renewal fund made available by the consumer goods industry is the economic successor of the expenditures in the production of durable factors of production. The renewed availability of this fund is the precondition for the production of factors of production being able to work toward the renewal of durable investments in the consumer goods industry. (p. 25)

Savings is the diversion of some part of the subsistence fund into the renewal fund. Note that up to this point, nothing has been said about money. By understanding savings as a diversion of a part of the subsistence fund to capital goods producers, the real process can be seen separately from its monetary aspects. Savings does not consist of money, nor does the creation of more money augment savings.

This is not to deny the importance of money. A monetary economy has a huge advantage over a barter economy for two reasons: the simplification of exchange (as compared to barter) and the facilitation of profit-and-loss accounting.

In particular, consider the second reason: economic calculation. Profit-and-loss accounting enables all production processes, both past and those imagined for the future, to be compared in terms of a single measure. This single measure is the monetary unit. When a firm makes a profit, it is has added more — in monetary terms — to the subsistence fund than it withdrew. Through profit-and-loss accounting, each firm can determine whether its net impact on the economy is an addition to, or a depletion of, the subsistence fund.

In a monetary economy, most people save-and-invest with money, rather than through stockpiling inventories of consumer goods. The direct purchase of capital goods, as, for example, starting a business, and the indirect purchase of capital goods, through financial assets, are both examples of saving-and-investing.

Finance can augment production as well by facilitating intermediation between borrowers and savers. Increased financial intermediation enables savings to be invested more efficiently. The creation of public impersonal capital markets provides a greater array of production possibilities to be evaluated and purchased by savers.

However, neither monetary calculation nor financial intermediation changes the nature of savings. Savings is always an allocation of some portion of the subsistence fund to the renewal fund. Monetary savings is a transfer of the saver’s ability to withdraw from the subsistence fund to the investor who receives the monetary savings. As Dr. Shostak says, "Various producers who have exchanged their produce for money can now access the [subsistence fund] whenever they deem this to be necessary." Strigl points out that, while most people think in terms of the monetary process, money is simply a representational tool:

Nothing much will change in [the process of saving and investment] if this process in a monetary economy is finally hidden behind a "veil of money"; if the entrepreneur who builds up a renewal fund does not know that the money he receives in return for his products and deposits in a bank "represents" a subsistence fund; if he who borrows money from the bank is not aware that in so doing he draws from a renewal fund of means of subsistence provided elsewhere in the economy, and that as he pays back the money, he will in turn provide a renewal fund or some products produced with its assistance.

We are now in a position to show the errors in Fekete’s doctrines about savings from the point of view of the subsistence fund.

First, his theory relies on a distinction between fixed capital and "circulating capital," which he defines here:

Similarly, the flow of myriad goods from producer to market also undergoes a remarkable metamorphosis when it gets within sight of the consumer. Adam Smith was the first to notice this interesting phenomenon. He formulated the concept of social circulating capital. By this he meant the mass of finished or semi-finished consumer goods which has reached sufficient proximity and is moving sufficiently fast to the ultimate cash-paying consumer so that its destiny of being consumed presently can no longer be in doubt.

and:

It is hard to see how thoughtful people can treat the notion, that circulating capital no less than fixed capital must be financed out of savings, with respect.

The differentiation of circulating capital from fixed is a distinction without a difference. There are capital goods and final goods. There is no third category: so-called "social circulating capital" is just plain capital. Ninety-days-from-final goods are in principle no different than 900-days-from-final goods in that they cannot be consumed. If they cannot be consumed, they are not the real means of funding for any productive activity, and therefore not part of the subsistence fund.

Production, properly understood, is the entire activity of bringing raw materials to the point of consumption. This point has been reached when no more withdrawals from the subsistence fund are necessary to goods to the point where they can be consumed. Shipping, warehousing, retailing, marketing, and other parts of the production process of moving these goods are costly. These costs can only be funded — in real terms — by withdrawals from the subsistence fund. There is no other real source of funding than the subsistence fund with which to carry out these activities.

There is nothing other than the subsistence fund with which to fund capital construction. That part of the subsistence fund allocated to investment is the renewal fund. The goods in the renewal fund must have been saved: that is the only way they could get there.

The issuance of Real Bills is a means of financing, not a means of funding. A financial instrument records an agreement concerning real funding. Bonds, bills, notes, etc. come into being to record a promise by the funder to provide a portion of the subsistence fund under their control, at some point in time, for the real funding of some productive activity. As Shostak clearly explains,

Payment is always done by means of various goods and services. For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. (Both shoes and bread are part of the pool of funding as they are final goods.)

Real Bills are a means of finance, not a means of funding. Real Bills do not form a part of the subsistence fund. Creating more "real bills" will not do the work of savings because the bills themselves cannot be consumed. On the contrary, the goods that they are issued against are capital goods, which will require additional debits from the pool of funding in order to complete their journey. An accounting that added the market value of capital goods to the subsistence fund would make the subsistence fund appear larger than it is in reality. But this would be nothing more than an optical illusion achieved by double counting.

Because the funding of productive activity is not — in real terms — done with money, creating more money, real bills, fake bills, clearing receipts, fractional reserve deposits, fiduciary media, or any other form of paper does adds nothing to the subsistence fund. These instruments are only claims that enable withdrawals to be made from the subsistence fund. Creating more of them only creates more claims against the same subsistence fund.

Fekete has been a critic the of 100% gold reserve requirement advocated by Rothbard and other Austrian economists.

It follows from my analysis above that a “100 percent gold standard” will not be able to survive for reasons having to do with the burden it unnecessarily puts on savings. There isn’t, nor will ever be, savings in sufficient quantity to finance circulating capital in full, given our highly refined division of labor and roundabout processes of production. Luckily, this is no problem, as so much circulating capital to move merchandise in sufficiently high demand by the final consumer can be financed through self-liquidating credit. Advocates of the “100 percent gold standard” must realize that they have grossly underestimated the degree of sophistication of the structure of production in the modern economy. They must also come to grips with the fact that financing circulating capital with real bills is not inflationary. Real bills enter and exit circulation pari passu with the emergence and ultimate sale of consumer goods.

As for the idea that the 100% reserve requirement puts an excessive burden on savings, I have already shown that savings alone must bear the entire burden of funding production, simply because there is no other means of funding than savings.

According to Fekete’s scheme, banks should monetize his beloved Bills. To monetize a bill means that a bank purchases the bill with new money substitutes that it creates out of nothing. (If the bank purchased the bill using its own capital or funds that had been loaned to the bank for investment purposes, then no monetization would occur.) The money substitutes are usually a checking deposit but they could be bank notes. They are money substitutes because they circulate at parity with real money, and they constitute a claim, at face value, on the bank’s (inadequate) gold reserves.

Now consider the meaning of the 100% reserve requirement in terms of the subsistence fund. What this requirement does is to enforce the rule that everyone who withdraws from the subsistence fund must also make an equal deposit of equal value in monetary terms. When a bank monetizes an asset, they have created purchasing power for the bank out of nothing. The problem with the monetization of debt (bills or otherwise) is that the bank is able to make withdrawals from the subsistence fund with its new money without having made any prior deposits to the subsistence fund. The creation of credit without savings represents unfunded consumption, an "exchange of nothing for something."

The error in Fekete’s dream of prosperity through inflation is that the monetization of Real Bills does not create any new means of funding. On the contrary it only serves transfer the ability to access the existing means of funding from other holders of money to the bank. Through monetization, the bank is privileged to make more withdrawals from the subsistence fund than they are entitled to by their prior productive activity.

Have the Austrians "underestimated the degree of sophistication of the structure of production in the modern economy"? In spite of the many differences between Crusoe’s island and modern times, the relationship between the subsistence fund and the capital stock is a logical one and does not change with size. As Strigl reminds us,

The more elaborate the temporal partitioning of production into a number of synchronized production processes, the smaller the finished available subsistence funds will be. The always available subsistence fund will be reduced in importance even more as compared to the overall supply of goods in various stages of maturity. But note that nothing changes regarding the function of the subsistence fund. [emphasis added] (Strigl p. 13)

In my series of articles on this topic (1 2 3 4), I have examined the issue of savings, investment, and Real Bills from several angles. The fundamental question under investigation has always been the same: can the creation of additional paper instruments contribute to the production of more wealth? The answer must always and for all time be no, at least not until the day that paper promises can transmute themselves into real goods.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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In 2002, then-Fed Governor Benjamin Bernanke burst into our monetary consciousness with his printing press speech. His fine work earned him the honorary title "helicopter commander." While largely a background figure since then, his recent appointment to succeed Alan Greenspan as Fed chair makes this an ideal time to review Dr. Bernanke’s views on monetary policy, and to speculate about what his chairmanship will bring.

Since the Fed emerged from its near-death experience in the 70s, it has largely been identified with the label "inflation fighting." Notably, Dr. Bernanke’s research and speaking have dealt almost entirely with the subject of deflation. While his infamous address before the National Economists Club, titled Deflation: Making Sure "It" Doesn’t Happen Here (2002) has been endlessly reported and debated, more revealing and less well known are Dr. Bernanke’s many speeches on deflation between 1999 and 2004, and a series of research papers on the same subject produced by the then-Fed governor and his colleagues.

I have identified fourteen papers and speeches dealing with deflation, seven by Dr. Bernanke and seven by other Fed governors and staff economists. These materials are all available for public download on the Fed’s web site. To steal a line from columnist Dave Barry, I’m not making this up. This article will cover the most important points from these articles. Since I had to read all of these, I consider myself quite fortunate that none of the speeches was by Alan Greenspan.

These writings deal with three themes: the menace of deflation, the Fed’s strategy for preventing it, and their contingency plans to fight it (should their prevention efforts fail).

While Governor Bernanke is not the only member of the anti-deflation wing at the Fed, the Chair apparent has emerged as the most prominent advocate of this new agenda. His leadership merits the name "Bernankeism" for this policy program.

Upon reading the source materials, three main tenets of Bernankeism emerged. I will describe them and illustrate with examples in the Fed’s own words. The three are: prevention is better than cure, learn the lessons of history, and the possibility of "unconventional measures."

The first principle of Bernankeism is that it is better to prevent deflation than to attempt a cure after the disease has set in.

The basis of the Bernanke school’s thinking on deflation is the standard (mainstream) macro-economic view that consumer spending (not saving) drives economic activity, and that insufficient consumer spending is the cause of recessions. According to this view, when recession strikes, inflation is called for.

Inflation works in three ways. One, by lowering real prices when nominal prices are for some reason "stuck" at above-market-clearing levels; and two, and by threatening a continued erosion in the purchasing power of cash, inflation motivates anti-social cash hoarders to spend, thus providing the missing stimulant to economic activity. A third is through so-called "wealth effects": when asset prices inflate, people misperceive the inflation as true wealth and then increase their spending.

Deflation is so dangerous, according to Dr. Bernanke because it is a self-reinforcing process that is very difficult to reverse once it has begun. They start from the true observation that when people spend less, prices fall. They then reason that when prices fall, people become increasingly reluctant to spend because they anticipate that prices will continue to fall. People start to hoard cash, planning to buy tomorrow when things are cheaper. The less people spend, the more prices fall, and the more that people hoard. In the grip of cash hoarding, according to Bernankeism, the entire economy would spiral down as all spending ground to a halt. This is why they think that deflation is like a chronic illness.

For an example of this view, I will cite the research paper titled Monetary Policy and Price Stability (1999) (by Fed research staffers):

If economic activity is weak or contracting and interest rates hit the zero bound, a dangerous dynamic can be set in motion. Falling inflation, or even escalating deflation, would increase real rates of interest. As this depresses aggregate demand further, downward pressures on prices would raise real interest rates further: The economy would potentially face a downward deflationary spiral.

Governor Bernanke and his accomplices are obsessed with something known as "the zero bound problem." Eight of the fourteen papers and speeches that I examined deal with this problem either as their main point or in passing.

The zero bound comes about as follows. The Fed commissars concern themselves largely with controlling a single rate of interest, the Fed Funds rate. This rate can be lowered only to near zero, but not to zero or below, because no one would buy a bond that had a zero or negative yield; they would hold cash instead. This poses a problem for the central banker bent on inflation: if the Fed Funds rate hit zero (or near-zero as it did with Japan), inflation cannot be accelerated by cutting the Fed Funds rate. In these circumstances, the Fed’s inflation program would be frustrated.

For this reason, Bernankeism advises the central bank to avoid the zero bound problem by creating a constant state of pleasant and benign inflation of around 2—3%. This will keep the economy a safe distance away from the dangerous precipice beyond which lies deflation, and gives the Fed room to cut rates.

For an example of their thinking, I cite a speech titled An Unwelcome Fall in Inflation (2003). Dr. Bernanke states:

I hope we can agree that a substantial fall in inflation at this stage has the potential to interfere with the ongoing U.S. recovery, and that in conceivable — though remote — circumstances, a serious deflation could do significant economic harm. Thus, avoiding a further substantial fall in inflation should be a priority of monetary policy. To my mind, the central import of the May 6 statement is that the Fed stands ready and able to resist further declines in inflation; and — if inflation does fall further — to ensure that the decline does not impede the recovery in output and employment.

The second principle of Bernankeism is that central bankers must heed the lessons of history. According to the papers and speeches, the Fed’s fear of deflation is based the two great 20th-century failures of central banks to inflate: America’s Great Depression and the Case of Japan in the 90s.

Dr. Bernanke accepts Milton Friedman’s theory of the Great Depression. In the Friedman view, a contraction of the money supply brought about by loan defaults and then bank failures turned what would have been an ordinary recession into the Great Depression. This catastrophe could have been avoided had Fed inflated sufficiently. The Friedmanites depict a Federal Reserve System ideologically paralyzed by the so-called liquidationists.

Our next Fed chair, in a speech given in the honor of Milton Friedman (2002), expressed contrition on behalf of central bankers everywhere in saying, "I would like to say to Milton and Rose: Regarding the Great Depression. You’re right, we [the Fed] did it [caused the Depression]. We’re very sorry. But thanks to you [Friedman], we won’t do it again." The Fed has learned its lesson.

The failure of Japan’s central bank to inflate its economy out of the mess following the bursting of the 1980s stock and real estate bubbles comes in a close second to the Depression in the Bernanke manual for deflation fighters. Four of the 14 Fed speeches deal mostly or entirely with Japan’s attempt to inflate its way out of a series of recessions that followed their bust. Despite successive Keynesian-stimulus public-works programs (that have nearly paved the entire island of Japan into a parking lot), and several years of a near-zero short-term interest rate, and a massive program of foreign exchange intervention that has left the BOJ holding hundreds of billions of dollars worth of US Treasuries, the BOJ has been unable to generate much inflation at all.

To cite one of many examples, in a speech titled Preventing Deflation: Lessons from Japan’s Experience in the 1990s (2002) (a paper by four Fed staff economists) we read:

We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy.

The term "conventional measures" figures prominently in much of the Fed’s discussion. "Conventional measures" is a term from the central banker’s dictionary. These measures consist of essentially two things: controlling the short-term Fed Funds rate and purchase and sale by the Fed of government securities by its so-called Open Market Committee.

The lesson of Japan, according to Bernankeism is that when the powers of a central bank are limited to "conventional measures," the central bank may not be able to prevent deflation, nor to fight it once it has taken hold. In the Fed’s view, Japan tried conventional inflation measures to their utmost. However, because the deflation caught them by surprise or perhaps due to the inherent limitations of conventional measures, the BOJ’s efforts were too little, too late.

The third principle of Bernankeism is the necessity of "unconventional measures."

Inflation is always the answer (according to these thinkers), but, they are afraid that it may nearly be impossible to bring it about when they most need it. Suppose that the Fed found itself fighting a stubborn deflation. If conventional measures had been tried and failed, and with the US on the brink of following Japan down the road to a long and painful deflationary morass, what would be the alternative?

I quote Dr. Bernanke himself from a paper titled Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment (2004). When the economy is at the zero bound, "a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely on u2018non-standard’ policy alternatives." What does he mean by "non-standard"? This is what passes for "thinking outside of the box" among central bankers.

The reader of the Fed’s papers and speeches will find a series of increasingly exotic plans for the dollar. From beginning to end, these methods range from the merely unsound to the bizarre and terrifying.

The paper titled Monetary Policy and Price Stability (1999) introduces some of the more mild of the so-called alternatives. The first of these tools is to expand the menu of assets that the Fed could purchase through its open market operations. The Fed’s current structure limits its activities to the purchase of short-term US Treasury bonds. When the Fed can no longer lower short-term interest rates, long-term rates are the next obvious target. Among their options for lowering long bond yields are: the purchase of long-term US Treasury Bonds, writing interest rate option contracts, purchasing foreign exchange reserves (in an attempt to lower the exchange rate of the dollar), and purchasing private sector securities like stocks and bonds. The measures described in this paper would involve massive Fed intervention in US financial markets.

If the above methods were not sufficient to "simulate aggregate demand," the Fed could loan money into existence, accepting as collateral almost any private sector asset whatever. In the paper titled Monetary Policy and Price Stability, we find:

A central bank can also attempt to spur private aggregate demand by extending loans to depositories, other financial intermediaries, or firms and households. By making the loan, the central bank turns an asset that may be illiquid for the lender into a liquid asset. This may be particularly helpful in spurring aggregate demand should the financial sector be under stress and in need of liquefying its assets.

In the United States, the Federal Reserve currently lends only to depository institutions. But in contrast to the limited type of securities the Federal Reserve can purchase, it can accept as the security for a loan virtually any security that the Federal Reserve Banks themselves deem acceptable. And in fact, the Federal Reserve accepts mortgages covering one- to four-family residences; state and local government securities; and business, consumer, and other notes. These notes can be open market securities such as corporate bonds and commercial paper or can be commercial and industrial loans extended by banks, for example.

The measures described so far rely on loaning money into existence in order to generate inflation. This channel depends on the willingness of borrowers to borrow the cheap money that the Fed prints. But what if borrowers won’t borrow? Don’t worry, say the Bernankeists, we will print the money and distribute it.

From the paper titled Monetary Policy When the Nominal Short-Term Interest Rate is Zero (2005), in a section with the ludicrous title Wealth Creation, we find:

In ordinary circumstances, monetary policy exerts its stimulative impact in part through increasing the financial wealth of the public — such as producing capital gains in bond and equity markets. If, at the zero bound, the Federal Reserve had already taken what actions it could to raise bond and equity prices, it might look to other tools it has to increase the public’s wealth. One tool commonly attributed to the Federal Reserve, at least in theory if not by the Federal Reserve Act, is that of conducting “money rains.”

Money rains are a clean way to study theoretically the effects of increases in the supply of money. In practice, it seems a bit difficult to envision how the Federal Reserve could literally implement a money rain — that is give money away either through directly disbursing currency to the public or by disbursing it through the banking system. The political difficulties that are likely to arise from the Federal Reserve determining the distribution of this new wealth would be daunting.

The above plan aims to decrease the value of each dollar by increasing the quantity in circulation. But what if the Fed prints but people are unwilling to spend? The next weapon in their arsenal is to make money pay a negative rate of interest. While that sounds difficult, in the paper titled Monetary Policy in a Zero-Interest-Rate Economy (2003), two Fed economists explain how:

No one would be willing to hold any asset that pays a negative nominal rate, as long as zero-interest money is available as a store of value. The strategy for eliminating the zero bound, therefore, is to make money pay a negative nominal interest rate, by imposing some type of “carry tax” on currency and deposits.

It’s easy to envision such a system with regard to deposits at the Federal Reserve or transactions deposits at banks; for the most part, the technology to implement such a system is already in place. A tax or fee on Reserve deposits of 1 percent per month, for example, would mean that those deposits, in effect, pay a nominal interest rate of roughly minus 12 percent.

The technological difficulty lies mainly in imposing such a tax on currency. In the 1930s, Irving Fisher of Yale University, one of the greatest [sic] American economists, proposed such a system, in which currency had to be periodically u2018stamped’, for a fee, in order to retain its status as legal tender. The stamp fee could be calibrated to generate any negative nominal interest rate that the central bank desired.

If "aggregate demand" has not been sufficiently stimulated by the above measures, the Bernanke Fed stands ready to play its final card: the direct monetization of goods and services. From the same paper, under the heading The Goods and Services Solution, we read:

Why not have the Fed just conduct an open market purchase of real goods and services? Even more so than exchange rate intervention, this strategy would represent a direct stimulus to aggregate demand.

As posed, though, the strategy has a major drawback: it violates the Federal Reserve Act. The Fed isn’t authorized to purchase goods and services, apart from those needed for the operation of the Federal Reserve System.

The strategy can be implemented, however, by coordination with fiscal policy-makers. The Federal government, for example, could purchase goods and services and finance the purchase with new debt, which the Fed in turn would buy — in technical terminology, the Fed would ‘monetize’ the resulting debt.

By coordinating with fiscal policy, the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter.

My final example is from a story that ran in The Financial Times (March 25, 2002). The paper reported:

The US Federal Reserve in January considered a variety of “unconventional” emergency measures to be taken if cutting short-term interest rates failed to arrest a US recession and prevent Japanese-style deflation. One of those steps may have been a plan to buy US stocks.

According to the reporter, an unnamed source was quoted as follows:

the Fed “could theoretically buy anything to pump money into the system” including “state and local debt, real estate and gold mines — any asset."

These "unconventional measures" all have two things in common: one, that they are more inflationary than the conventional central bank policies; two, that they are among the most absurd, bizarre, and preposterous monetary crank schemes ever proposed by anyone calling themselves an economist. Not to mention that some of these plans are illegal (according to existing Fed regulations), though who doubts that in a crisis, this would be ignored?

Setting that aside, the question remains: Do they really mean it? Or is this just a lot of musings by academic economists with time on their hands? Too many boys with toys? Is Bernankeism a serious plan? Or is it an orchestrated propaganda campaign?

In attempting to answer that question, we must not forget that everything the Fed says must be looked at as propaganda. In the realm of media relations there is surely no body on the planet whose utterances are more scrutinized than the Fed. The mere possibility of the removal of the word "measured" from the statements accompanying recent rate increases has spawned an entire body of analysis and commentary. A Google search on "removal of the word measured" yields over 500 hits.

The Fed is well aware of this and it can only be assumed that calculation plays a large part in their artifice. Every statement by a Fed governor is without doubt carefully crafted and vetted as a part of its overall message. The Fed’s management of the media, dubbed by some the "Open-Mouth Committee," is a key part of the manipulation of public opinion that preserves the Fed mystique.

Even the Fed itself is not secretive about their use of opinion management. One of Bernanke’s papers, Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment enumerates "using communications policies to shape public expectations about the future course of interest rates" as one of the three main types of non-standard policies. And in Central Bank Talk and Monetary Policy, we read:

Although effective communication by the central bank is always important, it becomes especially important when the rates are near zero. Indeed, when the proximity of the zero bound prevents further rate cuts to stimulate the economy, talking about future policy actions may be one of the few tools at the central bank’s disposal by which to influence conditions in financial markets.

However, because something is propaganda does not mean that it is a deliberate untruth. As Rothbard wrote:

To achieve a regime of big government and government control, power elites cannot achieve their goal of privilege through statism without the vital legitimizing support of the supposedly disinterested experts and the professoriat. To achieve the Leviathan State, interests seeking special privilege, and intellectuals offering scholarship and ideology, must work hand in hand.

Austrian economist Joseph Salerno has written that modern macro-economics is a "fiat profession," a manufactured discipline whose purpose is to legitimize inflation, and whose development has been funded by the same state that benefits from inflation.

Seventy years after Keynes, macro-economic inflationism has become so entrenched in the economics profession that all university-trained economists were taught this. When false ideologies have been sufficiently entrenched, propaganda no longer depends on deliberate lies. Sincerely held beliefs by properly trained experts are sufficient. Dr. Bernanke is most probably a true believer. Unlike Alan Greenspan, who got his start as a forecaster and consultant before becoming a government employee, Dr. Bernanke is a leading figure in the fiat macro profession, and his eminence in this academic field pre-dates his appointment to the Fed.

I have no doubt that the authors of these papers would like to implement their plans, if the conditions played out the way that their theories describe. But how likely is this to happen? Not very. When the Fed first started talking about deflation, interest rates were at generational lows and the economy was in the midst of a post-bubble recession.

While the media and much of the financial markets fell for what can now be seen clearly in retrospect as a deflation scare, there was no deflation. A few Austrians and assorted contrary thinkers have pointed out that the Greenspan era been one of rampant inflation. The inflation of our time has produced asset bubbles, rather than rising consumer prices. Even at the time of the 2002 deflation scare, the housing bubble was well underway. A recent Wall Street Journal series Awash in Cash: Cheap Money, Growing Risks, documents the inflation of nearly all asset classes around the world. The second article in the series explains how timberland, formerly an obscure and uncorrelated asset class, has doubled or in some cases quadrupled over the last few years.

The economic problem that has resulted from serial asset bubbles is that the relative prices of financial assets, compared to final goods, are unsustainably high. This is Greenspan’s "conundrum" of low long-term interest rates. One way or another, there must be a normalization of relative prices between credit-sensitive assets and final goods. I will call this normalization a "financial asset deflation."

There are two ways that a financial asset deflation could occur: one, a deflationary crash in financial assets that would take down stocks, housing, and blow the whole fiat money fractional reserve banking system to smithereens; the other: an accelerating consumer price inflation (or even hyperinflation), in which everything we buy gets more expensive, allowing the prices of end goods to catch up with the elevated prices of financial assets.

Some within the Fed know that they must continue to inflate or face a collapse. And when conventional measures no longer work, they must be ready to print money and buy the assets. No one knows the score better than Alan himself, who has staved off the collapse several times during his tenure by flooding the markets with liquidity when the system threatened to unravel.

Greenspan’s admission of the possibility of a financial collapse was first revealed by Lawrence Parks in his book What Does Alan Greenspan Really Think? Greenspan’s knowledge is also proved by the release, after the five-year sliding wall, of late 90s Fed meeting minutes. FOMC transcripts from the 1996 meetings show that, contrary to Greenspan’s statements at the time to the effect that a bubble cannot be identified until it has burst, the Greenspan Fed was aware that the stock market was in a bubble.

Greenspan for years publicly denied that there could even be such a thing as a housing bubble, relying on the reasoning that housing is illiquid and all housing markets are local in nature. A recent New York Times story titled Fed Debates Pricking Housing Bubble, reports that some Fed governors have publicly dropped oblique hints that they know that the recent speculative blow-off in housing is driven by the Fed’s own low interest rates.

I believe that the anti-deflation wing headed by Bernanke is telling part of the truth, but with an element of misdirection. Yes, they are worried about deflation, but relevant comparison is to Argentina, not Japan. Yes, they must stand ready to monetize anything and everything, but they are far more worried about collapsing asset bubbles than slowly falling goods and services prices. There has already been speculation that anomalously large bond purchases from Caribbean sources that have shown up in this year’s flow of funds data from the Fed are a cover for Fed purchases of treasury debt.

Yet they cannot openly state that they are playing this game without risking a run on the dollar and a collapsing bond market. The fear of deflation enables them to keep the game going, at least for a while. And who better to do this than Chairman Bernanke.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

In spite of Mises’ decisive refutation of this fallacy, it has subsequently been revived in various forms by a parade of monetary cranks and other paper money inflationists. Currently on display is a proposal for the adoption of the Real Bills Doctrine (RBD) advanced by Nelson Hultberg and Antal Fekete.

The Real Bills Doctrine holds that bills of exchange, which are short-term credit instruments collateralized by goods in process, should be monetized by banks. As with all inflationist theories, the alleged benefit is that an increase in the quantity of paper claims enables the production of more wealth.

A system of reciprocal bills of exchange may be used as a clearing system. The Real Bills Doctrine may be thought of as having two components: clearing through bills and fractional reserve banking leveraged on top of the bills. Most of Fekete’s arguments do not depend on the monetization component of the doctrine, only on the clearing component. This article will address further fallacies of Feketeism in relation to clearing.

Economic growth depends on an elaboration and extension of the capital structure. In a growing economy, the number of intermediate stages relative to final goods will grow, and therefore the transaction volume that takes place toward the production of a final good will grow as well.

Capital must be funded. Both the maintenance of the existing structure and its growth consumes economic goods that have alternative uses. Fixed capital — machinery, factories, scientific research, transportation networks and the like are costly to create.

Classical and Austrian economists from Mill to Mises have argued that production can only be funded by savings. For example, Rothbard here states, "It is evident that, for any formation of capital, there must be saving — a restriction of the enjoyment of consumers’ goods in the present — and the investment of the equivalent resources in the production of capital goods."

Antal Fekete, the modern prophet of Real Bills, argues that accumulating sufficient savings to fund economic growth is not possible in practice. Fekete believes that the vast expansion in productive capacity over the last two centuries has not come about due to savings and investment but due to clearing systems.

It follows from my analysis above that a "100 percent gold standard" will not be able to survive for reasons having to do with the burden it unnecessarily puts on savings. There isn’t, nor will ever be, savings in sufficient quantity to finance circulating capital in full, given our highly refined division of labor and roundabout processes of production. Luckily, this is no problem, as so much circulating capital to move merchandise in sufficiently high demand by the final consumer can be financed through self-liquidating credit. Advocates of the "100 percent gold standard" must realize that they have grossly underestimated the degree of sophistication of the structure of production in the modern economy.

Fekete believes that he has a discovered a miracle (heretofore overlooked by economists): that Bills of Exchange can take the place of savings. To understand Fekete’s thought process we will examine an example that he has provided:

Consider a hypothetical product called “miltonic." It is in urgent demand as a medicine that helps preventing cancer. Its production cycle takes 91 days, with as many as 90 firms participating, so that the sojourn of the semi-finished product at every one of the 90 stops takes one day. The ultimate consumer is willing to pay $100 for a bottle while the producer of the 90th order good has paid $11 for raw materials. We shall also assume that the value added to the maturing product at every stop is $1. Now if you want to finance the movement of one bottle of miltonic through the various stages of production, then the pool of circulating gold coins will have to be invaded 90 times, and you have to withdraw savings in the amount of

11 + 12 + 13 + ··· + 98 + 99 + 100 = (11 + 100) × 90 = 45 × 111

or $4995, almost 50 times retail value. In other words, there must be savings in existence in the amount of almost $5000 to move just one bottle of miltonic through the production process all the way to the consumer. This sum does not include fixed capital that also has to be financed out of savings!

Upon a brief reflection, a glaring question arises: on what planet would any profit-maximizing entrepreneur spend nearly $5000 to produce a good that could be sold for only $100? Clearly the vast expansion in the structure of production that has taken place over the last two centuries has not come about through a series of business ventures such as this, in which 98% of the savings invested were lost. After a few rounds of Miltonic, all of the accumulated scarce capital of generations will have been destroyed.

Fekete’s error is that $4995 is not savings, it is the total transaction volume during the entire production process. Cash transaction volume is not savings and it can grow much faster than savings. The reason for this is that an intermediate price at one stage of production is greater than the value of savings consumed strictly by that stage.

Why do we compare savings and not transaction volume to the value of the final product? Because it is important to know whether more economic value was produced than was destroyed by the production process. If more economic value was produced than consumed, a profit was earned; if less, a loss was realized. The transaction volume does not represent anything consumed. As I will show below, transaction volume can be increased or decreased at no cost whatever.

The full price at each stage does not represent value destroyed. Savings are consumed at each stage through the employment of additional factors of production at that stage. In equilibrium, leaving out the interest payments to capital owners and depreciation of the fixed capital stock, the price of an intermediate product would be the price of the original factors plus the price of all savings consumed by all stages up to that stage.

I will apply this to compute the total value of the savings required consumed by the production of Miltonic. This value consists, first, of some fraction of the $11 paid for raw materials, plus that fraction of the $1-value-added that was paid out in factor costs. We ignore the capital depreciation that occurs at each stage due to wear and tear on the fixed capital since Fekete does not include that in his example. This total could not exceed $89 + $11, or $100, the selling price of the end product.

To count, as Fekete does, each intermediate price as the full value of savings consumed by that stage would be double counting. For example, the price paid for the intermediate product by the capitalist at the third stage is $14, but the third stage added only $1 of savings to the production process. The cost paid for the intermediate product at the fourth stage is $15, while again only $1 of additional savings were consumed. To add $15 and $14 together and call that savings would be to count the original factors as savings and to count all of the savings in the first through fourth stages twice. To add all 90 stages together counts the original factors 90 times and each increment of Nth stage savings 90 — N times.

Fekete’s computation is a good way to come up with a large number that can be compared to a small number. But the number has no business being compared to savings.

Another way to see the difference between savings and intermediate transactions is to reorganize the multiple stages of production into a single stage. Suppose that the pharmaceutical company merged with other producers to form a single, vertically integrated firm (assuming they could get this past the anti-trust regulators). In that case, the total transaction volume would be the $11 for original factors plus the additional $89 of additional factors added by the single stage for a total of $11 + 89 × $1, or $100.

This total is far less than $4995 but the amount of savings consumed was the same. No rearrangement of the corporate structure of the producing firm without changing the physical production process would change the amount of savings consumed by a factor of 50.

To see the same thing from the other direction, suppose that each original stage is split into two stages. (After DOJ brings an anti-trust case against the Integrated Miltonic Corporation.) Each individual firm from the original structure decides to spin off the first half of its process into a distinct firm that adds $0.50 of value and then sells its product to the other half firm. I will spare the reader the arithmetic showing that the total transaction volume is 2 × $4995, or $9990.

A rearrangement of the corporate structure of the firm changes the total intermediate transaction volume, but the amount of savings consumed is the same. When there are more stages, each stage consumers fewer savings. With fewer stages, each one consumes more savings. When there are more stages, and therefore more intermediate prices, the total transaction volume is increased.

Does the increase in transaction volume present any kind of economic problem? Can transaction volume grow from $50 to $4995 without a corresponding increase in the supply of money? Most certainly it can. As Charles Holt Carroll explains, prices of whatever amount of money is available can adjust to any supply of goods:

We cannot be too emphatic in denouncing the idea that an increasing trade necessarily requires an increase of money, as an error and a delusion. It might be otherwise if value and price were the same, but as the value of property may be the same at a very different price at different periods, it is of very much less consequence to alter the quantity of the currency to suit the altered conditions of trade, than to restrict trade to the proper values of a stable currency. Indeed, to accommodate the currency to the continual fluctuations of trade, so as to regulate prices would be utterly impossible; while if the currency be let “severely alone,” trade will accommodate itself to the currency with perfect equity.

It is an error to suggest, as Fekete does, that production is funded by gold coins. The funding of fixed capital can only come out of the stream of final goods that are available. It must be emphasized the savings consists not of gold coins, but of final goods that are transferred to the producers of non-final goods. As Shostak explains,

…savings is not about money as such but about final goods and services that support various individuals that are engaged in various stages of production. It is not money that funds economic activity but the flow of final consumer goods and services. The existence of money only facilitates the flow of the real stuff.

Classical economist James Mill, in his decisive critique of the overproduction/underconsumption fallacy, gave perhaps the clearest description of savings. Mill starts out by explaining that the word consumption can mean two very different things:

The two senses of the word consumption are not a little remarkable. We say, that a manufacturer consumes the wine which is laid up in his cellar, when he drinks it; we say too, that he has consumed the cotton, or the wool in his warehouse, when his workmen have wrought it up: he consumes part of his money in paying the wages of his footmen; he consumes another part of it in paying the wages of the workmen in his manufactory.

But there is a crucial economic difference between these two types of consumption: one is the absolute destruction of final goods, leaving no legacy, while the other is their use toward the end of more production in the future:

It is very evident, however, that consumption, in the case of the wine and the livery servants, means something very different from what it means in the case of the wool or cotton, and the manufacturing servants. In the first case, it is plain, that consumption means extinction, actual annihilation of property; in the second case, it means more properly renovation, and increase of property. The cotton or wool is consumed only that it may appear in a more valuable form; the wages of the workmen only that they may be repaid, with a profit, in the produce of their labor. In this manner too, a land proprietor may consume a thousand quarters of corn a year, in the maintenance of dogs, of horses for pleasure, and of livery servants; or he may consume the same quantity of corn in the maintenance of agricultural horses, and of agricultural servants. In this instance too, the consumption of the corn, in the first case, is an absolute destruction of it. In the second case, the consumption is a renovation and increase. The agricultural horses and servants will produce double or triple the quantity of corn which they have consumed. The dogs, the horses of pleasure, and the livery servants, produce nothing. We perceive, therefore, that there are two species of consumption; which are so far from being the same, that the one is more properly the very reverse of the other. The one is an absolute destruction of property, and is consumption properly so called; the other is a consumption for the sake of reproduction, and might perhaps with more propriety be called employment than consumption.

This "employment" is the basis of the future production of greater quantities of final goods:

Thus the land proprietor might with more propriety be said to employ, than consume the corn, with which he maintains his agricultural horses and servants; but to consume the corn which he expends upon his dogs, livery servants, etc. The manufacturer too, would most properly be said to employ, not to consume, that part of his capital, with which he pays the wages of his manufacturing servants; but to consume in the strictest sense of the word what he expends upon wine, or in maintaining livery servants.

The root of Fekete’s error is the confusion between money and savings. As Mill demonstrated, savings consists of goods, not money. In a monetary economy, people save with money. What this means is that they set aside money that could have been used, to use Mill’s terminology, on extinguishing consumption, and spend it instead on reproductive consumption. The goods that are purchased with the saved money are the savings.

Without a proper understanding of the economics of savings, it might appear to the naïve mind that saved money is itself savings. This error then leads to the thinking that creating more money (or near money, claims to money, money substitutes, or whatever other intricacies proceed from the minds of monetary alchemists) will create more savings.

This fallacy is the core of the perverse logic of Feketeism. Starting with the confusion of money with savings, it would follow that all transactions settled in cash consume savings, and from there that the growth in settled transaction volume is wasteful because unnecessary cash settlement of transactions wastes scarce savings. (Fekete repeatedly refers to the settlement of a transaction in cash as an "invasion" of the pool of circulating coins). Because clearing would enable the same transaction volume to occur without the majority of transactions settling in cash, to follow this argument to its conclusion, clearing would allow savings to be used more efficiently.

But this is all nonsense: money is not savings; only savings are savings. The production of more money or money substitutes only enables them to purchase the same amount of final goods. Once the distinction between money and savings is understood, it becomes clear that an increase or a reduction in the amount of settled transactions has nothing to do with savings. Clearing reduces the number of settled transactions, and it is useful for other reasons, but it has no substantive impact on the amount of savings needed to fund production.

Fekete and Hultberg believe that there is an economic difference between the funding of capital that is closer to or more remote from final consumption, with the latter requiring savings and the former not. Here, for example, Hultberg explains that savings should not be consumed in the distribution of goods because that would diminish the funds available for building more factories:

As a result of these misperceptions, [the Austrian school] fail to see that under a 100% gold system we would have to endure a much lower standard of living because the trillions of dollars of credit necessary for the production and distribution of consumer goods would have to be taken out of savings, i.e., gold reserves, and thus could not be used to finance factories, technology, plant and equipment, etc.

While Hultberg is correct in stating that if savings were used toward the final distribution of consumer goods, they would not be available to create more factories, the reverse is equally true. The opportunity cost of producing another factory is less savings available for the distribution of final goods; the opportunity cost of distributing more final goods is less savings available to construct more factories.

Because funding is inherently scarce, the decision to produce more of a good "A" must come at the expense of either less immediate consumption or the production of less of some other good "B." There is nothing other than savings with which to fund some part of the production process. Current consumption and all stages of production are in competition for the same pool of final goods.

There is no fundamental economic difference between "production of goods" and "distribution of goods." The entire process is properly called production. Even goods that are less than 90 days from final consumption require transportation, storage, warehousing, and other activities for them to become final goods, activities that consume real resources. All goods have alternative uses, and are therefore are costly to employ. If they are employed toward the creation of final goods, then they must have been saved. There is simply no other alternative.

According to Feketeism, the logic of the distinction between costs that consume savings and costs that can be funded by bills depends on a theory of short-term interest having a different cause than long-term interest. Even if this were true, it would make no difference to the matter at hand. While I will not critique their interest theory in the present article, it has no bearing on the fact that savings is all that exists with which to fund production. Because interest is a price, and the concept of price is based on opportunity cost, opportunity cost is logically prior to the theory of interest.

Money in the end provides two services to mankind, and neither one of them is a substitute for savings: The services are, one, that it facilitates indirect exchange by eliminating the double coincidence of wants problem; and two, that it makes monetary calculation possible by providing a single set of cardinal numbers with which all production plans can be compared to each other. The ability of money to provide these services is not augmented by an increase in its quantity; on the contrary, the inflationist program only disrupts this process. As Charles Holt Carroll wisely observed, there are no shortcuts to prosperity:

Certainly the best provision for acquiring property, and for paying debts, is constant and active employment. Work must produce capital; nothing else can: the enterprise of the merchant in distributing it, in opening new markets, discovering new wants, stimulating labor, and directing it into profitable channels, is of a character to deserve success, and would secure it, were his operations sustained by an uncontractible and sound currency.

Inflationism is a wish to have something for nothing. It is the pernicious doctrine that seeks to replace work and savings with the operation of the printing press. Only to the extent that money is not altered or debased can it serve as a medium of exchange and provide a means for rational calculation. All inflationist programs, no matter how they are cloaked, can only disrupt material progress.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Antal Fekete claims to have discovered just such a mechanism: clearing. Fekete claims that clearing (implemented through his marvelous Bills of Exchange mechanism) enables production to be funded without corresponding savings.

We will show that, while there is nothing wrong with the issue of Bills, they do not perform the same work as savings. While clearing reduces demand for cash, it does not reduce the amount of savings required to fund investment.

Fekete’s error is confusing the financing of production with the funding of production. Any amount of business plans can be financed through the issue of more paper. But the funding of these plans is limited by the capacity of the economy to produce final goods. Expanding the quantity of money, credit masquerading as money, near money, or money substitutes cannot increase this capacity.

Mises and Rothbard on Clearing

In order to address Fekete’s errors on the topic of clearing, the economics of clearing and netting will be reviewed from the perspective of Mises and Rothbard. I will make a comparison to the writings of Fekete where relevant.

Rothbard gives a short explanation of clearing:

Clearing is a device by which money is economized and performs the function of a medium of exchange without being physically present in the exchange.

A simplified form of clearing may occur between two people. For example, A may buy a watch from B for three gold ounces; at the same time, B buys a pair of shoes from A for one gold ounce. Instead of two transfers of money being made, and a total of four gold ounces changing hands, they decide to perform a clearing operation. A pays B two ounces of money, and they exchange the watch and the shoes. Thus, when a clearing is made, and only the net amount of money is actually transferred, all parties can engage in the same transactions at the same prices, but using far less cash. Their demand for cash tends to fall.

The above passage applies only to cases where the transactions to be cleared occurred at the same time. In the following passage Mises discusses the extension of clearing to transactions that occur at different times. This is done through a combination of clearing and credit.

When all exchanges have to be settled in ready cash, then the possibility of performing them by means of cancellation is limited to the case exemplified by the butcher and baker and only then on the assumption, which of course only occasionally holds good, that the demands of both parties are simultaneous. At the most, it is possible to imagine that several other persons might join in and so a small circle be built up within which drafts could be used for the settlement of transactions without the actual use of money. But even in this case simultaneity would still be necessary, and, several persons being involved, would be still seldomer achieved.

These difficulties could not be overcome until credit set business free from dependence on the simultaneous occurrence of demand and supply. This, in fact, is where the importance of credit for the monetary system lies. But this could not have its full effect so long as all exchange was still direct exchange, so long even as money had not established itself as a common medium of exchange. The instrumentality of credit permits transactions between two persons to be treated as simultaneous for purposes of settlement even if they actually take place at different times. If the baker sells bread to the cobbler daily throughout the year and buys from him a pair of shoes on one occasion only, say at the end of the year, then the payment on the part of the baker, and naturally on that of the cobbler also, would have to be made in cash, if credit did not provide a means first for delaying the one party’s liability and then for settling it by cancellation instead of by cash payment.

Mises provided a further analysis of the transfer of claims. Bills that are not yet settled can be transferred within a network in place of cash payment. In this case, claims attain the status of money substitutes.

exchanges made with the help of money can also be settled in part by offsetting if claims are transferred within a group until claims and counterclaims come into being between the same persons, these being then canceled against each other, or until the claims are acquired by the debtors themselves and so extinguished. In interlocal and international dealing in bills, which has been developed in recent years by the addition of the use of checks and in other ways which have not fundamentally changed its nature, the same sort of thing is carried out on an enormous scale. And here again credit increases in a quite extraordinary fashion the number of cases in which such offsetting is feasible.

The use of credit in a clearing transaction requires the payment of interest to the party who accepts a claim that will not settle until some time in the future. The payment of interest on bills is accomplished by trading the bill at a nominal value less than its full principal value. This is called "discounting." The discount is computed from the short-term interest rate and the amount of time from the payment date to the settlement date. Mises explained how discounting enables the problem of non-simultaneity of transactions to be solved:

Since it was the general custom to make payments in this way, anybody could accept a bill that still had some time to run even when he wanted cash immediately; for it was possible to reckon with a fair amount of certainty that those to whom payments had to be made would also accept a bill not yet mature in place of ready money. It is perhaps hardly necessary to add that in all such transactions the element of time was of course taken into consideration, and discount consequently allowed for.

Fekete’s discussion of the process parallels that of Mises.

Yet the supplier can use the bill to pay his own suppliers. Endorsed on the back, the bill can be passed along a number of times, the endorsement indicating that title to the proceeds has thereby been transferred from payer to payee. This transaction is also called “discounting” as the payee applies an appropriate discount, calculated at the current discount rate, to the face value of the bill proportional to the number of days remaining to maturity. Upon maturity the last payee presents the bill for payment to the producer on whom the bill is drawn.

Mises wrote in 1912 on the origin of clearing:

The modern organization of the payment system makes use of institutions for systematically arranging the settlement of claims by offsetting processes. There were beginnings of this as early as the Middle Ages, but the enormous development of the clearinghouse belongs to the last century. In the clearinghouse, the claims continuously arising between members are subtracted from one another and only the balances remain for settlement by the transfer of money or fiduciary media. The clearing system is the most important institution for diminishing the demand for money in the broader sense.

Fekete has also written on early clearinghouses:

Let us look at another instance of clearing and self-liquidating credit that was vitally important in the Middle Ages: the institution of city-fairs. Among the most notable ones were the fairs of Lyon in France, and those of Seville in Spain. They were annual events lasting up to a month. They attracted fair-goers from places as far as 500 miles away who brought their merchandise to sell, as well as their shopping-list of merchandise to buy.

A significant proportion of Fekete’s writings concern the explication of clearing arrangements. Mises and Rothbard also have provided a full explanation of clearing, netting, settlement, and discounting. These mechanisms are well understood by economists of the Austrian School. And, there is no problem with clearing. As will be shown, clearing is nowhere near the miracle that Fekete claims.

Clearing and Transaction Costs

We now examine the economic effects of clearing. The two most important effects are the reduction of transaction costs and the reduction of money demand.

First we examine the reduction of transaction costs. Consider the following example. Suppose that there are two banks, Bank F and Bank H. Customers from one bank frequently deposit checks in their accounts drawn upon the other bank. Each bank must settle these checks against their bank of issue. The banks are in the custom of settling inter-bank balances in the following manner:

• During a business day, 1000 oz of checks drawn upon Bank H are deposited in Bank F.
• Acme armored car service transports 1000 oz of gold bars from Bank H to Bank F.
• The same day 900 oz of checks on Bank F are deposited in Bank H.
• Ajax armored car service transports 900 oz of bars from Bank F to Bank H.

There are obvious efficiencies that could be realized by netting. On the day used in the example, with netting, only 100 oz would have to be transferred, and only in one direction. This step alone would reduce the value of the cargo in the trucks, and consequently the insurance premiums by about 95%. Wage and vehicle costs and would be reduced by around one half because the truck would only make one trip rather than two. On days when the clearing balances happened to be equal, no transport at all would be required.

Further efficiencies could be gained if Bank H and Bank F loaned each other the net amount from day to day, on the assumption that a daily net clearing balances in one direction on one day would tend, over the course of a month, to approximately cancel out. Settling for the net amount (including the interest on the daily loans) once per month would reduce costs additionally, compared to daily netting, by a factor of about 30-to-1.

Further cost savings could be realized by including other banks. Suppose that there are N banks within a clearing network. If each bank settled with each other bank, there would be around 2*N2 exchanges without netting in either direction. If the net position of each bank relative to all other banks were calculated each day, then each bank could make a single transfer of its net clearing balance, for a total of N exchanges.

Once started, there will tend be a competitive process driving the adoption of clearing systems. When at first a few firms start to use a clearing system, they will be able to reduce their money demand and correspondingly the reduction of money demand enables those firms to offer higher money prices for factors. If other firms in their industry did not also adopt a clearing system, they would find that they were being outbid for factors by the firms using the system. In most cases, a rapid readjustment of factor prices will occur as the remaining firms join the clearing system.

There will be changes in wealth distribution from this shift. The first movers will have made some gains at the expense of the late adopters because they will have reduced their money demand and thus been able to purchase scarce factors at the original, lower prices. But overall the changes in factor prices reflect the reduction in money demand — factors do not become cheaper in real terms when the purchasing power of money changes. Only because of the reduction of gold bar transport will overall costs be slightly reduced.

Clearing and the Demand for Money

There are two secular influences on the long-term trend in the demand for money. Economic growth and clearing. They have opposite effects, with economic growth tending to increase money demand because more goods are produced so more transactions take place.

Clearing tends to reduce money demand because less money must be held for the settlement of transactions. Rothbard notes, the "major long-run factor counteracting this tendency and tending toward a fall in the demand for money is the growth of the clearing system." Mises explains how this occurs:

The reduction of the demand for money in the broader sense which is brought about by the use of offsetting processes for settling exchanges made with the help of money, without affecting the function performed by money as a medium of exchange, is based upon the reciprocal cancellation of claims to money. The use of money is avoided because claims to money are transferred instead of actual money. This process is continued until claim and debt come together, until creditor and debtor are united in the same person. Then the claim to money is extinguished, since nobody can be his own creditor or his own debtor

A reduction in money demand, as for any other good, shows up as a lower price for that good (assuming that supply does not change at the same time). What does it mean for money to have a lower price? The concept of "a lower price for money" is more difficult to explain than for a (non-money) good because money does not have a price as such — it has many prices. The prices of all goods, expressed in terms of money are the inverse prices of money expressed in terms of goods. If a loaf of bread sells for $2, then the price of dollars in terms of bread is . A lower price for money means higher money prices for goods.

But does this matter? Fekete suggests that it does. He proposes that a limited quantity of money per se is a constraint on production:

To put the matter differently, [under the RBD] the gold standard [i.e. the relatively fixed supply of money] is no longer a fetter upon technological progress and further division of labor, as it would be in the absence of the bill of exchange. …The bill of exchange has opened up new avenues for progress, leading to great improvements in the condition of human life on earth. Technological progress will never again be obstructed by a dearth of gold.

[Explications added - Blumen]

On the contrary, the nominal purchasing power of a single money unit (a coin, gram, or ounce) does not matter where production is concerned. Here, we join with Charles Carroll in "denouncing the idea that an increasing trade necessarily requires an increase of money, as an error and a delusion."

Economic calculation deals with ratios, nominal quantities. Ratios are formed between nominal quantities, tending to cancel out proportional variations. Workers, for example, are concerned with real wages — the ratio of their nominal wages to the nominal prices of goods that they wish to purchase. Investors are concerned not with nominal profits, but with return on equity, yields, and other dimensionless quantities.

Moreover, any quantity of money can perform any volume of transactions because the same real transaction can be performed at any money price. That is to say, there is no monetary benefit to the additional gold. (This conclusion did not come from Rothbard; it was already well known to classical economists such as David Hume).

Given a quantity of money, the same coin can turn over more, or less, frequently depending on the volume of transactions. If the money supply remains roughly constant while more transactions occur, the same coin will turn over more often. If clearing systems were not adopted in a growing economy, more turnover of each money unit would be necessary to settle the increased number of transactions. But the transactions could be performed just as well without clearing.

While it is true that clearing makes it unnecessary to use gold coin as intensively, this does not amount to any significant reduction in the consumption of scarce factors (except for the cost of loading more gold bars on trucks), only a slower turnover of the given stock of coins, whatever that is.

In the end, the nominal price changes resulting from clearing arrangements don’t make scarce productive factors cheaper in real terms. For capital to become cheaper in real terms, there must be more of it. Capital can only be created by the diversion of more final goods from consumption to savings.

Clearing and Savings

Fekete claims that savings alone are insufficient to fund capital investment, while the appearance of more Bills of Exchange provides a means of funding investment without savings. While this claim might seem incredible, I will present several direct quotations from Fekete’s own writings to establish it. Here, for example he states that savings are insufficient to finance capital investment:

Let me suggest it to you that no conceivable economy can generate savings so prodigiously as to move all the indispensable items to the consumer. I conclude that the division of labor could have never been refined, and the “roundaboutness” of the production process could have never been lengthened, beyond the level reached by the cottage industries of the medieval manors, wherein every family had to produce not only its own food and fuel, but also its clothes and shelter.

And here, Fekete writes,

…the real bill will do the miracle of financing production and distribution spontaneously, without taking one penny out of the piggy-banks of the savers, and without legal tender coercion.

As an inflationist in good standing, Fekete’s theory is firmly anchored in the confusion between money and wealth. Fekete starts with the true premise that clearing increases the efficiency in the use of cash, to the false conclusion that it allows production to be funded by a bill alone.

While the premise is true, the conclusion is false. Clearing has economic benefits, but it has nowhere near the magical properties that Fekete would have us think. Fekete’s extravagant claim regarding the ability of bills to substitute for actual savings is entirely erroneous.

Financing is not funding. Economizing the use of cash is not the same as economizing scarce real factors. Land, labor, and fixed capital do not come into being through the establishment of clearing systems. Economizing cash only enables the existing supply of factors to trade at higher money prices.

Final goods are used up in the process of producing other goods. Savings consists of the goods that are made available to producers for their consumption while they are not producing any final goods themselves. The saved goods are consumed in the service of funding greater production in the future. Mill used the term reproductive consumption to emphasize the two aspects of savings: consumption and production.

If money were savings, then more money (or more bills) would be the equivalent of more savings. But money is not savings: savings is in essence a non-monetary phenomenon. As E.A. Goldenweiser explains (quoted by Kurt Richebächer) "Saving means the withdrawal of sufficient resources from the production of consumption and services to have enough for maintenance, expansion and improvement of the plant."

Then, he adds a remark that could have been aimed at our contemporary RBD inflationists:

ever since Wesley Mitchell’s Business Cycles there has been a tendency to concentrate too much on the monetary expression of economic developments, and it has become reactionary to think in physical terms.

If a farmer were to consume an apple as a snack while on vacation, then no new production would have come about as a result.  But a farmer who sets aside some apples from the apple harvest, then eats them to sustain himself while planting some apple trees that will bear more fruit in the future has reproductively consumed the apples. 

It may come as a surprise that money is not savings. Living as we do in a monetary economy, we often think of savings as saved money because our saving is done with money. The difference between monetary savings and in-kind savings, as in the apple example above, is that with monetary savings, the transfer of money from the saver to the producer confers on the producer the ability to purchase goods on the market with the saved money. With monetary savings, the saver and the producer may be different people. The producer makes the decision of what kind of goods to save.

Conclusion

Fekete’s case for the fallacious Real Bills Doctrine relies on the alchemical properties of clearing systems. Clearing systems are said to overcome the savings deficiency that will inevitably appear in a growing economy. This conclusion is based on a serious misunderstanding of the nature of savings.

There is really nothing wrong with clearing, and Austrian economists have no issue with clearing systems, protests by Nelson Hultberg that Austrians wish to prohibit it notwithstanding. However, clearing has nothing to do with savings. More clearing does not mean more savings.

No quantity of bills of exchange could enable a single barrel of oil to be refined into twice as many gallons of gas, or a single loaf of bread to feed twice as many shoe makers. The amount of rubber, oil, bricks, computers, accountants, office buildings, or other factors of production that go into the manufacture of a car or a house would be unchanged, even if all intermediate transactions were settled in cash.

While savings are scarce, clearing is no substitute for them. The issue of Bills of Exchange, then, is a non-solution to a non-problem. Once it is understood that the fable that Fekete spins about clearing is another tall tale, there is no motivation for the rest of his doctrine.

For a bill to replace actual savings, the bill would have to be one and the same thing as a saved good, so that it could be reproductively consumed.   In reality it is only a claim to that good. As André Dorais wrote to me in an email, "if you consider a Real Bill as a good and add one each time you produce a real good you would obtain two goods.  But you did not produce two goods, only one."

To end, we can do no better than did Charles Holt Carroll when he wrote, "We cannot eat our cake and have it too; this truth was settled to the satisfaction of each one of us in the nursery."

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Case in point is Nelson Hultberg and Antal Fekete’s call for a revival of the Real Bills Doctrine (RBD). The Real Bills system is a form of monetary crankism: at its core is the fallacy that paper can create wealth. Carroll, one of the most astute critics of paper money, had it right when he wrote that the RBD is "the most remarkable and the most mischievous heresy that ever found an advocate in any science."(267)

Limiting the danger of inflation is most prominent reason for using gold as money. While the supply of gold can at best grow slowly, the quantity of paper can be multiplied without limit. The resulting inflation erodes the purchasing power of wages and savings. The Real Bills Doctrine — a theory advocating the creation more paper money substitutes — cannot be exempt from this evil.

Yet RBD theorists hold that the discounting of bills that they propose is non-inflationary. They believe that they have discovered Inflation Lite: a miraculous form of fiduciary media that facilitates more trade but does not increase prices. Implementation of the RBD would be a path to inflation; non-inflationary monetary expansion is a mythical beast.

The doctrine states that banks should be allowed to monetize short-term business loans. Part 1 presents an explanation of the monetization bills of exchange, explain the difference between transfer credit and credit expansion, and exposes the fallacy of a credit shortage. In addition, part 1 shows that only savings can fund production, and describes how forced savings occurs in response to credit expansion.

The proposal advanced by Fekete is a non-solution to a non-problem. Because it provides no benefit, there is no point in adopting it. In the best case, something that has no benefit would be harmless. However, the RBD is far from being harmless. The current article will show that adoption of the RBD would inevitably be inflationary without any limit The current article will also emphasize some subtleties of the Austrian critique of monetary expansion.

The discounting of bills as per the doctrine would introduce fiduciary media into circulation. The creation of fiduciary media is always inflationary because the paper notes have equivalent purchasing power to money itself and therefore affect prices in the same way. Carroll sees the point clearly: "Nothing is created by this operation but debt — no capital, value, or wealth whatever — but price is added to commodities thereby as effectually as if so much gold had been produced or earned by labor and added to the currency." (137)

A market price is created any time money or a paper claim functioning as money is spent. As Mises explains here, money prices are formed through the use of all real money and fiduciary media in circulation:

If notes are issued by the banks, or if bank deposits subject to check or other claim are opened, in excess of the amount of money kept in the vaults as cover, the effect on prices is similar to that obtained by an increase in the quantity of money. Since these fiduciary media, as notes and bank deposits not backed by metal are called, render the service of money as safe and generally accepted, payable on demand monetary claims, they may be used as money in all transactions. On that account, they are genuine money substitutes. Since they are in excess of the given total quantity of money in the narrower sense, they represent an increase in the quantity of money in the broader sense.

When money is loaned in a credit transaction, the increase in the purchasing power of the borrower is offset by the saver’s withdrawal of purchasing power. When a saver loans to a borrower, different prices will be created than if the saver had kept the money instead of loaning it. This is so because the money loaned will be put to different uses by the borrower than it would have by the saver. The borrower might use the money to rent office space, while the saver might have used it to purchase a car. But there will be no general tendency toward higher prices in an economy based on transfer credit even when credit transactions are common.

On the other hand, an increase in the quantity of fiduciary media necessarily results in a higher market price for some good because when they are issued, there is no offsetting savings that withdraws demand elsewhere. When a business sells its bills to a bank for unbacked paper claims, the firm might use their phony paper money to pay wages to employees, rent office space, or purchase machinery. Whatever it is, it will sell at a higher price than would be the case in the absence of the fiduciary media. As Hülsmann explains:

Suppose I get an additional fiduciary banknote of one ounce of silver sterling from my banker. This banknote permits me to satisfy wants that hitherto were not sufficiently important to be considered (they were submarginal). If I pay for a meal in a restaurant with this banknote then, without any doubt, I have affected market prices. In fact, by my very purchase I have formed market prices. These prices would have never come into being without the additional issue of a banknote. Selling the meal to other persons would have required a price reduction to attract submarginal consumers.

Suppose that a merchant is short of cash but he possesses a bill. He tries to sell his bill for cash. There are two possibilities: under a system of transfer credit, he sells the bill by obtaining credit (the transfer of someone else’s savings). Or, if the RBD were adopted, a bank would expand credit and pay the merchant with fiduciary media. The first potion, borrowing savings, is more costly to the merchant because then he must offer the saver a sufficient rate of interest to make them willing to part with their money. The alternative, fiduciary media, can be printed at nearly zero cost. The bank that prints money instead of borrowing savings can therefore offer a lower rate of interest. Credit expansion allows the merchant to pay less interest — which means to receive more cash — for his bill.

Consider the situation of a merchant who needs some quantity of cash to pay current expenses, and who owns a bill of exchange. Suppose that a bank operating according to the RBD is willing to offer him exactly as much cash as he needed for his bill. Then, under a system of strict transfer credit, the bank would offer him less than that amount because of the higher cost of borrowing savings compared to creating fiduciary media. Starting from the same initial conditions in a transfer credit system the merchant would not be able to sell his bill for enough cash to pay his obligations.

There are two possibilities here. One is that he might be bankrupt. As I explained in part 1, this is not a bad thing; it is part of the market’s process of allocating resources. The assets to do not go away, or even necessarily cease to be productive. The firm’s creditors would take over the ownership, the assets would be revalued at lower prices, and in more solvent hands might be put to better use.

The other possibility is that the merchant can reduce his costs. Suppose that he is able to do so either by negotiating with his suppliers for lower prices or with his employees for lower wages or by purchasing fewer inputs. Then transactions would occur but at lower prices than under a system of credit expansion. This example illustrates how, under a flexible price system, prices change to facilitate transactions. There is no need for an "elastic" monetary system when prices can move.

There is a difference between the prices of a bill under transfer credit and under the RBD. The difference consists of purchasing power shifted from one person to another by the monetary expansion that occurs when fiduciary media are issued. The additional purchasing power of the merchant only comes into existence at the expense of all other money holders elsewhere, by diluting the value of their monetary units. The issuance of fiduciary media, then, enables the seller of the bill to obtain something that they could not afford in economic terms, at the expense of the rest of the population who find their own money to be worth less as a consequence.

It defies logic to say that a thing is true and that it is not true. For the system of monetizing bills of exchange to be non-inflationary would mean that it did not result in higher prices. Yet the entire motivation for the system is to enable business transactions that could otherwise only take place at lower prices, or not at all.

It is claimed that paper money printing if done according to the rules of the RBD is not inflationary because the paper finances the production of particular goods and then goes away. There are two problems with this. In the first place, is a serious misunderstanding of the nature of productive activity. The paper does not fund production. There is no way that paper by itself can fund production, only the goods purchased with the paper fund production. The holder of the phony paper notes is only able to buy existing goods because he can outbid others who were not so lucky as to be sitting next to the printing press. The only way to provide goods more cheaply is to produce more of them through savings, work, and investment.

Secondly, this line of thinking rests on the idea that the certain money somehow corresponds to specific goods. Under a commodity money system, money is a good in the economy that functions as the medium of exchange. Money prices are the exchange ratios between money and goods. Money prices are formed through the interaction of all money holders and all goods owners in the economy. There is no identification between specific money units and particular goods. In the process of price formation, money is acquired to be spent, and then acquired again and spent again, forming price at each exchange along the way. The explication of this point by the French economist J.B. Say could not be improved upon:

The silver coin you will have received on the sale of your own products, and given in the purchase of those of other people, will the next moment execute the same office between other contracting parties, and so from one to another to infinity; just as a public vehicle successively transports objects one after another.

There do exist instruments that are collateralized by particular goods. These are known as bonds, equity shares, etc. But these instruments are not money. The evaluation and pricing of these instruments is complex as they are heterogeneous and carry different degrees of credit risk. Even collateralized bills of exchange are subject to market risk. Firms can produce inventory and then find themselves unable to sell it.

There are additional fallacies in the association of monetized bills with particular goods. Fiduciary media are created at a distinct point when they are loaned into existence. This is called the "point of injection." When a bank expands credit by monetizing a bill, the point of injection is the credit market. However, the point where this new paper enters the spending stream does not limit its effect on prices to that point. As Mises explained, "variations in the value of money always start from a given point and gradually spread out from this point through the whole community."

Even for short-term loans, there is nothing about spending of new money that limits its purchasing power to the production of those particular goods in process that were the collateral for the monetized bill. In the short term as in the long term people receive wages, buy groceries, pay rent, go on vacation, and fill up their gas tank.

A major point in Fekete’s writings is that bills are liquidated within 91 days or less. The fiduciary media are withdrawn from circulation after a short time, so they can’t do much harm, or so we are told. The defense of this theory rests heavily on the belief that credit extended for 91-day-or-shorter periods is economically fundamentally different than credit for longer periods.

Numerology notwithstanding, there is nothing special about the number 91. There is no economic distinction between loans shorter than or longer than some number of days. It makes as much sense to say that purchases of bananas should be paid in gold coin while strawberry consumption should be funded with bank credit expansion. All stages of production — including shipping partially finished goods in process — consume real resources that have alternative uses. All credit must be borrowed (whether for a short or a long time) from the same potential pool of savings, namely present goods. Present goods are scarce in the present. There exists nothing with which to fund investment other than present goods that have been saved. The choice is only whether the savings are voluntary (as they would be if they were offered on true credit) or forced (as would be the case when fiduciary media are issued).

The focus on the life cycle of a particular bill is misplaced. It is the total volume of credit expansion and contraction in the banking system that is responsible for inflation and deflation within an economy. The life expectancy of any particular bill of exchange does not provide a measure of the credit expansion that would occur if the RBD were implemented.

If, as Mises wrote on this subject, "When the loan is paid back at maturity, the banknotes return to the bank and thus disappear from the market," then there would be only a small amount of credit expansion, followed by an equal-sized credit contraction. But, he continues, "this happens only if the bank restricts the amount of credits granted.… The regular course of affairs is that the bank replaces the bills expired and paid back by discounting new bills of exchange. Then to the amount of banknotes withdrawn from the market by the repayment of the earlier loan there corresponds an amount of newly issued banknotes."

Mises reminds us that

The fatal error of Fullarton [a member of the Banking School] and his disciples was to have overlooked the fact that even convertible banknotes remain permanently in circulation and can then bring about a glut of fiduciary media the consequences of which resemble those of an increase in the quantity of money in circulation. Even if it is true, as Fullarton insists, that banknotes issued as loans automatically flow back to the bank after the term of the loan has passed, still this does not tell us anything about the question whether the bank is able to maintain them in circulation by repeated prolongation of the loan.

During the historical debates between the Currency School and the Banking School, the latter made a similar argument. They maintained that banks, by expanding credit, were only accommodating the "needs of trade." They argued that the issuance of unbacked paper notes was a market mechanism that arose simply to fill a need for a certain quantity of credit.

This argument runs aground on the following problem: the demand for credit is not independent of the volume of bills issued. To say otherwise ignores the impact of money supply on money demand.

Unlike for other goods, money demand depends in part on money supply. To understand this, first consider why it is non-money goods do not behave this way. It is quite reasonable to suppose that an increase in the supply of lawnmowers will more fully meet existing demand. For every new lawnmower that is produced, a previously sub-marginal purchaser will be supplied. But there is no reason to think that an increase in the supply of mowers will change the existing level of demand because the value of a lawnmower to one home owner does not depend for the most part on how many other people have them.

But money is different. Unlike other goods, the supply of money influences the demand for money. The reason for this is that the services provided by money depend on the purchasing power of a single unit, while the purchasing power of each unit depends on the total supply. This will be explained as follows.

People hold cash in order to have a certain amount of real purchasing power, not any fixed number of money units. The number of money units required to provide the desired amount of purchasing power depends on the purchasing power of a single unit. But the purchasing power of each money unit depends in part on the total quantity of money circulating. If the quantity increases through inflation, prices increase causing the purchasing power of each unit to decrease. As the unit purchasing power decreases, people will need more units of it to carry out transactions at the same real prices, so money demand will rise.

Imagine that you were in another Italy before the transition from the Italian Lira to the Euro. You are used to carrying around some quantity of Lira in your wallet. Now you must determine how many Euros to carry around for the same purpose. It is impossible to answer this question unless you know the prices, in Euros, of various goods that you might wish to buy. The purchasing power of the Euro is nothing other than the inverse of the prices in Euros of goods. If a newspaper cost u20AC1, you might carry around u20AC10 in your pocket, while if the same paper were priced at u20AC1000, you might need to hold u20AC10,000 to get through your day.

If credit expansion is taking place then fiduciary media will be issued. For the same reason that money demand increases when money supply increases, money demand will increase as credit expands. But in this case, the fiduciary media will satisfy some of the demand for money. This is precisely what would happen if the RBD were adopted. As more bills were discounted and more fiduciary media would enter the system, prices in general would increase. At a higher level of prices, more credit would be needed to finance the same investments as before. The demand for money and credit to complete the same volume of transactions would increase. A self-reinforcing spiral of increasing credit supply, increasing prices, and increasing demand that in the end would be limited only by the solvency of the banking system.

Here again we see the error in the idea that particular fiduciary media are "backed" by specific goods and therefore non-inflationary. The money prices of goods are formed by the interaction of everyone who has a money balance and everyone who has something to sell in exchange for money. This means that the goods in process, in the case of a non-monetized bill, have already been priced given the existing supply of money. When the bill becomes a fiduciary medium, new prices are formed, through the interaction of all money and fiduciary media in relation to the same set of goods. This will result in higher prices for the goods in relation to the new total supply of money and fiduciary media.

We turn to Mises for a restatement of this argument:

It is not true that the maximum amount which a bank can lend if it limits its lending to discounting short-term bills of exchange resulting from the sale and purchase of raw materials and half-manufactured goods, is a quantity uniquely determined by the state of business and independent of the bank’s policies. This quantity expands or shrinks with the lowering or raising of the rate of discount. Lowering the rate of interest is tantamount to increasing the quantity of what is mistakenly considered as the fair and normal requirements of business.

Carroll provides a historical example:

Adam Smith supposed that an excess of convertible paper currency could not be circulated, because the excess would at once return upon its issuers for redemption. This is one of his errors, and the more surprising because of the experience of France with Law’s banking sixty years before the “Wealth of Nations” was written. For four years the inflation continued there, until general prices advanced fourfold, indicating a fourfold expansion of the currency, and yet the currency did not return upon the bank for redemption to any inconvenient extent until a few weeks before its doors were closed in hopeless insolvency, although money was rushing out of the country all the time. It is a question of confidence on the part of the people; if they prefer the paper to money, and do not call upon the bank for payment, there is no difference in effect between and inconvertible and a so-called convertible currency, and, as we see in the example of France, it is easily possible to press upon a credulous community as much convertible as an intelligent people will bear of an inconvertible currency.

Inflation of consumer prices is harmful to employees and business firms for many reasons: people get inflated into higher tax brackets, retired people living on fixed incomes are impoverished, the purchasing power of wages does not keep up with prices, and others.

It is too simple to say, as Hultberg does, that Rothbard and other Austrians have rejected the RBD because it is inflationary, if they mean that a demonstration of the stability of the CPI under the RBD would rebut Rothbard’s critique. Austrian economists see inflation as more than changes in final goods prices. A further clarification of the Austrian critique of credit expansion will help distinguish the Austrian view from the RBD and show that this criticism is groundless.

While economists of the Austrian school would deplore these evils, they are have done heroic work in drawing attention to an even bigger problem. If banks can lower the rate of interest by expanding credit, one might ask, why not encourage this to enjoy the benefits of a lower interest rate all the time? Mises and later Hayek investigated the relationship between the organization of an economic system and bank credit expansion. What they found was that the below-market interest rate brought about by credit expansion is a temporary phenomenon. The below-market rate of interest distorts the productive structure of the economy, resulting in a wasteful boom-and-bust cycle. During the transition from boom to bust, the interest rate will rise to or above its market rate.

Austrian economists have been critical of inflation not only for its effects the purchasing power of money, but also because the credit cycles waste scarce accumulated savings. All credit expansion causes a credit cycle to some extent, whether or not ordinary consumer price inflation shows up. When an Austrian economist says that a monetary system, such as the RBD, would be "inflationary," they do not necessarily mean that would result in an increase in end goods prices. Nor would it be sufficient to say in response to the Austrian that "if end goods prices did not rise under that system, then everything is fine."

Credit expansion can coexist with stable or even declining prices as measured by inflation indexes, as they did for example in the 1920s and the 1990s. During a period of credit expansion alongside rapid investment in new technology resulting in high productivity growth, prices will not fall as fast (or not rise as fast) as they otherwise would have in absence of credit expansion. And this credit expansion will drive a boom and bust cycle.

Selgin’s Less than Zero: The Case for a Falling Price Level in a Growing Economy is an economic history of periods during which overall prices fell due to productivity growth in excess of the growth in the supply of money. While wages did fall in nominal terms, nominal prices fell faster. Far from being anti-labor, these were periods of rising real wages. Selgin explains that prices in England fell so rapidly during 1873—1896 that economic historians who believe that falling prices must indicate a depression cannot explain the general prosperity of this period. The standard of living of laborers improved because their lower nominal wages were able to purchase more goods at even lower nominal prices.

It is unfortunate, as Mises wrote, that "no one should expect that any logical argument or any experience could ever shake the almost religious fervor of those who believe in salvation through spending and credit expansion." The complex rationalization that Fekete presents for discounting bills of exchange should not obscure that the essence of the Real Bills system is, to cite Mises again, "Stones into Bread."

Discuss this article on the Mises.org Blog.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

The "monetary crank," wrote Mises, is one who "suggests a method for making everybody prosperous by monetary measures."  All variants of monetary crankism suffer from the same error: The printing press cannot create actual goods. The arguments for the RBD (Real Bills Doctrine) will be seen to be variants of monetary crankism. An article (by a libertarian writer on a gold site, no less) proposing a revival of the Real Bills Doctrine is a recent addition to this literature.

The RBD has a long and controversial history. Many of the key concepts originated with the monetary crank John Law. In 19th-century England, controversy over the issues around the doctrine raged between two schools of monetary thought, the Currency School and the Banking School. In the United States, the RBD was a key plank in the platform of the first generation of US Federal Reserve bankers.

The Doctrine concerns debts contracted by business firms for the shipment of goods in process, as when a firm purchases raw materials or partially finished goods on credit.. The goods in question might be for use in the purchasing firm’s own manufacturing processes. The receiver promises to pay the supplier in cash plus interest at some future date. (See the definition from Mises Made Easier for more detail).

As an example, a manufacturer of chairs purchases wood from his supplier and, instead of paying cash, pays with a bill of exchange due in 30 days. Two weeks later, finding himself short on cash to make payroll, the wood supplier takes the bill to his local bank, which purchases the note from him for 98% of its face value. The discount rate (here 2% for 14 days) annualized, would be the bank rate of interest on the transaction.

Suppose that the holder of a real bill needs cash before the bill falls due. (Perhaps he needs to pay off his own bills to his own suppliers further down the line before their bills fall due). He would then present the bill to a bank. If the bank purchased the bill for cash, then all would be well and good. However, the banker, having been persuaded by some clever monetary theorist to adopt the RBD, "discounts" the bill, that is, prints the money with which to purchase the loan. The "discount" is the purchase price paid by the bank, an amount less than the principal value of the loan.

No special banking doctrine is required to justify an ordinary loan transaction. This is simply transfer credit. Nor is any new monetary theory required when firms wish to resell their paper assets to buyers for cash on the commercial paper market. This is merely the resale of existing credit. In the workings of RBD, bills are to be funded not with the bank’s own equity capital, nor with savings loaned to the bank by its creditors.

According to the Doctrine, banks would monetize short-term business debt. Monetization of debt means to create paper credit out of nothing and then to loan this credit as money. The money exists either in the form of bank notes or checking account balances. The purchase of the bill is therefore a kind of loan from the bank, but a curious sort of loan in which the funds were not previously loaned to the bank by anyone. This is called credit expansion.

Hultberg and Fekete present a series of arguments for the adoption of this kind of discounting mechanism. This series of articles addresses some, but not all, of their arguments. The current article responds to a series of arguments advanced against transfer credit and in favor of credit expansion. Hultberg and Fekete suggest that transfer credit without expansion is not "elastic;" transfer credit by itself is "too rigid;" the limitation of total borrowing to total saving will reduce economic growth (the term "contractionist" means essentially the same thing). Equivalently, they argue that expanding credit beyond savings enables more goods to be produced; in the absence of paper credit, business firms will not be able to obtain a sufficient amount of short-term credit; similarly a "liquidity shortage" will prevail without money printing.

To understand the mechanics of inflation, the difference between transfer credit and credit expansion must be explained. Transfer credit is extended when a borrower borrows money that someone saved. When a bank is involved in this type of transaction, the bank brokers the exchange and takes on some of the risk. The bank locates borrowers and savers who wish to participate but might not otherwise know each other. When a bank is involved in this type of transaction, the bank brokers the exchange and takes on some of the risk.  The bank first borrows from the saver and then loans the money to the creditor.

Credit expansion is an entirely different type of transaction. When banks expand credit there is no saver anywhere involved. For a bank to expand credit, it creates new paper claims to money — bank notes or fractional reserve checking deposits — out of nothing at all and loans them as if they were money. These paper money substitutes "give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else," explained Hayek. He adds, "This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods," (p. 114). Paper claims of this type were are called fiduciary media by Mises, meaning, media of exchange that circulated at parity with real money but came into existence as the result of credit expansion.

Bullionist writer and opponent of fiduciary media Charles Holt Carroll clarifies the distinction between cash — either gold or fully redeemable paper — and fiduciary media. Carroll aptly termed the latter "debt organized into currency" (p 234):

Some writers have placed promissory notes and bills of exchange in the category of currency, but it is altogether a mistake; their affinity is with circulating property, not with money… They are, however, neither money, nor currency, nor property, but more records of an unfinished bargain; the purchase money is not paid, and these are memoranda or written evidences of what the debtor is to do to complete the contract. One species of property exchanges for another; this is barter, the fundamental principle of trade; and when promissory notes and bills of exchange are exchanged for money, they take the position of property as essentially different from money as the goods that were delivered for them, or for the fund upon which they are drawn.

Opponents of RBD are not attacking debt as such (either businesses-to-business or between banks and bank customers). Lending transactions are a crucial mechanism for the allocation of savings within a monetary economy. It is the distinction between debt by itself and the "organization of debt into currency" that turns debt into money that makes all the difference.

Cash is the commodity that can be most readily exchanged for any other good on the market. Rent, raw materials, payroll, or office supplies are often needed on short notice. Without credit expansion, liquidity could only be supplied by someone who is willing to reduce their own consumption.

Chief among the rationalizations for paper credit is the claim that requiring someone to save before someone else can borrow is too onerous a condition. Allegations against the gold coin system are "insufficient liquidity," an excessively rigid credit system, and an inelastic monetary system. We are told that the magic elixir of paper credit will solve these problems by "creating liquidity" and "providing elasticity".

There is always insufficient quantity of any good to meet all possible uses of a good at that time. Scarcity is the quality that defines what it is for something to be an economic good. Liquidity, another economic good, is no different. Hülsmann writes, "one has always to remember that money is a present good. It can be used now. No present good is available in a quantity that would satisfy all demands. This is precisely why it is a good. Hence, there is always demand for some more money to secure hitherto less important (submarginal) satisfactions."

A motivated borrower in search of liquidity could always obtain a loan at some rate of interest, as there would always be someone holding cash that would part with it at a sufficiently high rate of interest. As in all markets, a price for bank loans will emerge in credit markets through supply and demand. Even without adding to the supply through credit expansion, firms that need funds could attempt to borrow at the market rate of interest.

Prices ration resources. Prices by their nature exclude. The interest rate is a price that is formed in credit markets. The market rate of interest is always higher than some potential borrowers are willing to pay — that is what makes it a price.

But to call this state of affairs "insufficient liquidity" is to say that a particular amount of credit supplied and demanded at the market price is the wrong amount and rate of interest determined on the market is too high. Anyone who says that the market is getting it wrong must have some other criteria for evaluating what is enough of the good, outside of the ability of market participants themselves to supply it and demand it. But what other criteria could there be? Modern economics calls this situation "market failure," a term that substitutes the learned judgment of expert economists for the preferences of market participants.

A business that pays expenses by issuing bills to its supplier instead of cash is taking on credit risk. Suppose that the cash receivable does not arrive at the time that it was promised, or that the firm’s goods may not be sold as expected. Even if the time structure of assets and liabilities match on the firm’s balance sheet, a credit crunch is always a real possibility. Faced with such a situation, if the firm could not raise cash by obtaining more credit immediately, it would be insolvent.

Yet this is a problem for that firm, not a problem with the monetary system as a whole. A firm cannot obtain employees and office space because some other firm already is hiring the employees and leasing the office space that it wants. The problem is that goods are scarce, not money. Owners of business firms must evaluate the supply of things that they need to buy, the marketability of their goods, and the credit-worthiness of their customers.

It is the firm, not the monetary system that has made an error. "What may hurt the interests of the producer of a definite commodity," Mises observed, "is his failure to anticipate correctly the state of the market. He has overrated the public’s demand for his commodity and underrated its demand for other commodities. Consumers have no use for such a bungling entrepreneur; they buy his products only at prices which make him incur losses, and they force him, if he does not in time correct his mistakes, to go out of business."

It might be objected here that the problem is really liquidity, not insolvency: A firm that cannot obtain credit is not really insolvent, it only has a teeny-weeny liquidity problem, and if the banks were allowed to discount the bills in its possession that would solve the liquidity problem. The pain of bankruptcy is not necessary. However, the distinction is bogus: The inability of a business to pay its creditors on time is the definition of insolvency. To this it might be objected that firms only need a bit more time, such as is provided to them when a bank is willing to discount their bills. However, to say so would be to ignore the role of time in production. Present goods are scarce in the present as Hülsmann clearly explains:

If we always disposed of just a little bit more time we could be sure to have reached nirvana. With always just a little bit more time one could provide all the money in the world. Unfortunately, every means in the mundane life of the human race is limited. Time, therefore, plays a crucial role for the success of action. In every place outside nirvana one has to pay for the time-saving means called goods. There is no possibility of providing “liquidity to the market only.” One cannot pay with liquidity; one can only pay with goods.

A market, as Mises argued in his seminal critique of economic calculation under socialism, can only bring about a rational allocation of productive factors under the clear light of profit-and-loss accounting. The definition of making a loss is to consume more scarce factors of production (labor, real estate, machinery, energy, etc.) than are produced. Bankruptcy redistributes factors of production away from wasteful uses toward productive ones. It is a critical part of the market process.

Having a "liquidity problem" is the definition of insolvency. An illiquid firm is a bankrupt firm, if it cannot pay its bills. Insolvent businesses should be taken over by their creditors, not allowed to stay on life support with phony paper credit. Firms are not insolvent because of some general shortage of money but because their judgments about supply and demand were incorrect. Loss-making firms sustained through the issue of fiduciary media are artificial forms of life. They consume accumulated savings, and impoverish society.

When the smoke and mirrors are cleared away, the Real Bills Doctrine is in essence the idea that credit by itself can create wealth. But credit as such does not fund productive activity because any productive activity consumes goods and services. What the RBD theorists wrongly identify as an insufficient quantity of credit is in reality the scarcity of goods in the world. Credit expansion is an attempt to paper over this problem.

Businesses usually do not borrow solely to increase their cash holdings without the intention of spending the borrowed money. They need to earn a return that will be sufficient to eventually repay the loan. They can only do this by producing something at a profit. The demand for credit by businesses is a demand for office space, computers, machinery, employees, and raw materials. The scarcity of the real things that business firms need in order to produce goods for consumption is what limits the their ability to produce more. Mises explains this clearly:

An entrepreneur who wishes to acquire command over capital goods and labor in order to begin a process of production must first of all have money with which to purchase them. For a long time now it has not been usual to transfer capital goods by way of direct exchange. The capitalists advance money to the producers, who then use it for buying means of production and for paying wages. Those entrepreneurs who have not enough of their own capital at their disposal do not demand production goods, but money. The demand for capital takes on the form of a demand for money. But this must not deceive us as to the nature of the phenomenon. What is usually called plentifulness of money and scarcity of money is really plentifulness of capital and scarcity of capital.

Issuing more paper claims to the existing stock of goods is not the same as producing more goods. Only goods fund the production of goods, not credit. Bank credit expansion does not fund production because it does not transfer savings; it only creates new claims to the same amount of savings. In order for goods to be used to produce other goods, the original owners must set them aside, then transfer them to the producers who will use them up while creating something new and more valuable. This is why only savings can fund investment. As Mises explains,

[the masses do] not realize that investment can be expanded only to the extent that more capital is accumulated by saving. They are deceived by the fairy tales of monetary cranks. Yet what counts in reality is not fairy tales, but people’s conduct. If men are not prepared to save more by cutting down their current consumption, the means for a substantial expansion of investment are lacking. Those means cannot be provided by printing banknotes and by credit on the bank books.

Antal Fekete (cited by Hultberg) denies this fact: "the real bill will do the miracle of financing production and distribution spontaneously, without taking one penny out of the piggy-banks of the savers." It would indeed be miraculous — even violating the laws of physics — if the production of some goods could be financed without the consumption of any other goods merely by printing paper. A simple objection to Fekete’s view is to note that the employees of manufacturing firms will eat, wear clothes, drive to work, and turn on the lights at their factory. If credit could fund real productive activity, why have savings at all? Why not fund all production through credit expansion, not just short-term goods in process?

Economists have used the somewhat obscure term "forced savings" to describe the shift in the expenditure of savings set in motion by credit expansion. This term can be explained as follows. In the market, purchasing power comes from the ability to supply goods to others who demand them. When fiduciary media are created, new purchasing power is obtained, not by supplying but, by diluting the purchasing power of existing money. While the immediate recipients of the new credit have more purchasing power, they have only obtained this power at the expense of other money holders. The business firms that have borrowed fiduciary media obtain the ability to outbid other holders of money. By shifting those goods away from others who might have consumed them toward production, they exclude others who might have purchased them for consumption. That is, they save-and-invest the goods. The savings is "forced" in the sense that the loss of purchasing power by the rest of the community is not made willingly, as would be the case if the others had chosen to save and invest by loaning their funds.

Mises was overly optimistic when he wrote, "The absurdity of [inflationists'] arguments is so manifest that their refutation and exposure is easy indeed." In fact it has not been easy. Inflationism has been the most enduring and harmful fallacy of monetary economics. The progress of sound economics against this doctrine has not been without setbacks. The fantasy of wealth creation through paper inflation never loses its appeal. Each new generation of monetary cranks has rekindled hope for the long-awaited Christmas Day when the Santa Claus of money creation arrives. Only when the distinction between real savings and empty paper promises is understood will economics drive a stake through the heart of this fallacy for all time.

Robert Blumen [send him mail] is an independent software developer based in San Francisco. An earlier version of this article appeared on the web site of the Ludwig von Mises Institute.

A debate has been going on recently on several web sites among those who accept the preceding premises but disagree whether the inflation process can be pursued to its ultimate conclusion — hyperinflation — or whether market forces will at some point prevent further inflation and cause a credit collapse — deflation.

The deflation scenario consists of a cascading chain of defaults wiping out the leverage in the system and leaving physical currency as the only safe store of value. Because the dollar is, as Charles Holt Carroll said, "debt, organized into currency," debt default destroys money. When the quantity of money decreases, prices tend to fall. This increases the real value of remaining debt and therefore the difficulty of repaying it, leading to more defaults. Because the debt consists of an asset on the balance sheet of banks, at some point the banks would become insolvent. If people became nervous and withdrew their cash from banks that would decrease bank reserves even more and accelerate the process.

Advocates of the inflation view start by accepting the premises of the deflation outcome, but believe that the Fed would intervene and try to generate inflation rather than standing aside and watching the system implode.

I previously contributed to this debate with an editorial on the so-called Dollar Short Squeeze theory. In the current piece, I will take on what I consider a few of the errors and more questionable arguments that have been appearing from the deflation side.

The most obvious error in many deflationist writings is to point to the large amount of debt as a case for deflation and then to stop there. All of us agree that the debt levels are unsustainable. But there are two ways of getting rid of debt that cannot be repaid: default or inflation. Debt can be inflated away. Historically there have been far more hyperinflations than deflations.

Deflationists have claimed that debt cannot be inflated away as long as people are not willing to borrow, and that once debt reaches a certain level, the ability to borrow goes away. Whether this is true or not, the Fed has made it clear in a series of speeches that they are ready to monetize anything and everything by turning on the printing press and buying assets, gold mines, or whatever else it takes to prevent nominal prices from falling.

The reader of the Fed’s papers and speeches will find a series of progressively more effective techniques for destroying what purchasing power remains in our money. From beginning to end these methods span the range from the unsound to the bizarre and terrifying. With the likely appointment of Dr. Ben Bernanke to the chairmanship following Greenspan, this outcome becomes more probable. Bernanke has provided intellectual leadership for the "helicopter money" ideology. While volumes have been written on this topic, I will include a few short quotes here from Fed officials.

One tool commonly attributed to the Federal Reserve, at least in theory if not by the Federal Reserve Act, is that of conducting “money rains. “

Money rains are a clean way to study theoretically the effects of increases in the supply of money. In practice, it seems a bit difficult to envision how the Federal Reserve could literally implement a money rain — that is give money away either through directly disbursing currency to the public or by disbursing it through the banking system. The political difficulties that are likely to arise from the Federal Reserve determining the distribution of this new wealth would be daunting.

In other papers on their site, there is extensive discussion of the purchase of private sector securities, such as stocks and bonds. The Financial Times reported in 2002 that the Fed Considered Emergency Measures To Save Economy:

Minutes which summarized the meeting were released last week. A full transcript will not be available for five years but a senior Fed official who attended the meeting said the reference to “unconventional means” was “commonly understood by academics."

The official, who asked not to be named, would not elaborate but mentioned “buying US equities” as an example of such possible measures, and later said the Fed “could theoretically buy anything to pump money into the system” including “state and local debt, real estate and gold mines — any asset”

If the Fed is willing to purchase financial assets (other than Treasuries), then they could in essence provide a nominal floor under securities prices as long as they were willing to hold them in their portfolio. Because most US home mortgages are securitized and resold on secondary markets, they could prevent widespread mortgage defaults in nominal terms through the purchase of mortgage-backed securities (MBS). The resulting price inflation would mean that home owners were defaulting in real terms on their mortgages. But if the Fed were to acquire the mortgages, then they would be that lender.

Should all else fail, the final stage of Bernankeism is the direct monetization of economic goods.

Why not have the Fed just conduct an open market purchase of real goods and services? Even more so than exchange rate intervention, this strategy would represent a direct stimulus to aggregate demand. By coordinating with fiscal policy, the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter. In this case, the Fed would monetize government debt that had been issued to finance a tax cut.

Some deflationists have questioned the willingness of the Fed to act. But in the "welfare state of credit" to use Jim Grant’s phrase, debtors far outnumber creditors. In a crisis, there is always an intense demand for the government to "do something." The something that looks most appealing at the time usually means some action that has the superficial appearance of addressing the immediate problem, while creating far worse problems slightly out of sight and some time in the future. It is difficult to conceive of a political climate in which the inflation option would not be taken.

Another deflationist argument is that wage competition from China is deflationary, and that inflation cannot occur in the US as long as there is wage competition. This argument confuses two entirely different economic phenomena.

There are two factors that influence money prices: changes from the money side and changes from the goods side. The inflation/deflation question concerns changes from the money side. An increase in the supply of computers, for example, causing a fall in the price of computers, is not deflation, or at least it is not credit deflation. Salerno calls this “growth deflation”; in any case the fall of prices due to the increase in supply has nothing to do with bank credit contraction. One does not lead to the other, nor does growth deflation prevent inflationary bank credit expansion. As the French economist J. B. Say wrote,

The success of one branch of commerce supplies more ample means of purchase, and consequently opens a market for the products of all the other branches; on the other hand, the stagnation of one channel of manufacture, or of commerce, is felt in all the rest.

What has become known as "Say’s Law" is the observation that the ability to demand comes from the power to supply. Absent monetary inflation, all demand in the economy is generated supply of some kind. An increase in the production of some goods, according to Say, results in more purchasing power for all other suppliers of non-competing goods because the total supply of goods has expanded. The increased purchasing power for producers of goods and providers of services is a natural outcome of savings and investment in a market economy, and has nothing to do with bank credit deflation.

Some deflationists have said that inflation cannot occur while workers are facing competition from Asia depressing wage rates. In the same way, wage competition due to an increase in the supply of skilled labor in other countries might result in a fall in the wages of competing labor in the United States, and it might be considered growth deflation but it is not credit deflation and does not lead to credit deflation or prevent bank credit expansion.

Inflationists are not saying that real wages cannot decrease. On the contrary, real wages and real income tends to decrease for most people during high inflation and hyperinflation. The reasons for that are wages tend not to keep up with goods prices; tax brackets for business and wage earners generally are not indexed to the actual rate of prices increases, causing taxflation; it becomes more difficult for business to produce and invest during an inflation so the supply of goods decreases; and inflation causes a wasteful boom and bust cycle in which productive resources are misused and become idle.

There is no logical contradiction between decreasing real wages and simultaneously increasing nominal wages. If the Fed inflates at a 15% rate, then real wages would remain constant if nominal wages rose at 15%, and real wages would fall if nominal wages inflated at a lower rate than 15%. Nominal wages could increase in the US and/or in China due to monetary inflation, while real wages decreased and while the relative wage ratio between US and Chinese workers either increased, decreased, or remained the same.

China has adopted a fixed-exchange rate against the US dollar. Chinese central planners have as their motive for adopting the peg the belief that they can develop their economy by building up their export sector. An economist would point out that what they are really doing is subsidizing their export sector at the expense of their domestic consumers.

If the Chinese policy makers wanted to continue this during a period of increasing US inflation, they would have to increase their rate of purchases of US dollars and accumulate more foreign exchange reserves. Roubini and Duncan have both argued that China is near the breaking point in their ability to absorb more dollar reserves, so this is unlikely. What is more likely is that they would at some point allow the dollar to devalue against the RMB, which would mean higher US-dollar prices for Chinese imported goods.

Another similar argument is that price increases cannot occur in the US for goods manufactured in China, and that will thwart any efforts at inflating. China will always offer these goods at lower prices than they can be produced in the US, thus causing “deflation." This is also wrong for the same reasons cited above concerning nominal and real wages.

Another relevant factor, brilliantly expounded by Antony Müller in a recent daily article, is that the type of currency fixed rate that we have with China can only work for a limited period of time. Because the US cannot entirely offset purchases of Chinese goods with the sale of US-made goods to China, there is a reverse capital account flow to make up the difference. The Chinese, in effect, loan the US money through their purchases of US bonds (mostly government and Fannie/Freddie mortgage bonds). As China accumulates more dollar-denominated debt, the US must pay an ever-increasing amount of interest.

Over time, an increasing proportion of the reverse capital accounts flow goes toward interest payments to service the debt. This portion of the debt consisting of US dollar interest payments can only increase at the expense of that portion used to purchase Chinese goods. The change in relative proportions must end at the point where 100% of the outflow was going to service previous debt and 0% to purchase. Most probably well before the 100% limit, the currency peg would no longer be effective as a policy mechanism to subsidize Chinese exports.

Another reason for the unsustainability of the peg is that the US consumers are increasingly purchasing things that they cannot afford to pay for in terms of the value of goods that they are able to produce. That is not a sustainable state of affairs. China, then, is in the process of increasing their manufacturing base to produce goods for people who cannot afford them, instead of allowing the market to direct investment toward Chinese consumers who need lower cost manufactured products. These capital investments must be regarded as mal-investments in the Misesean sense of the term. They are unsustainable.

The deflation arguments that depend on the low real prices of Chinese goods are either misunderstand the difference between real and nominal prices, or assume that the process of China providing vendor financing for the over-spending US consumer can go on forever.

Inflationists have pointed out the vulnerability of the US dollar to a sharp depreciation. This case is best made in Richard Duncan’s book The Dollar Crisis and in the research paper of Nouriel Roubini and Brad Setser on the unraveling of the "New Bretton Woods Monetary System." They point out that the accumulation of dollar reserves by the rest of the world is running up against economic limits.

Some deflationists have argued that there could not be a crash in the dollar because there is not a sufficient volume of alternative currencies for people to buy, or even that the deflation crisis will be accompanied by a strengthening dollar exchange rate. The quantity of other currencies does not in itself constitute a reason that the dollar could not crash. For any good on sale, any volume of supply and demand can be balanced through price changes. At some exchange rate any supply of dollars could be sold for anything else. If the rate were 1 trillion dollar per Yen, then the entire US federal deficit could be paid off with 11 Yen.

In reality, the purchasing power of a currency never gets infinitesimally small. In the real world, we would not ever see a trillion-to-one exchange rate. Some time before any currency reaches a vanishingly miniscule value, enough people see that it is going to zero. Then, there is an abrupt run out of the currency.

Mises observed:

…a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time. 

This is the final stage of hyperinflation in which the currency is destroyed. People frantically exchange out of the currency for anything — either concrete goods or alternative currencies. If the other major central banks in the world wanted to stave off a dollar exchange rate crisis or did not want their currency to appreciate against the dollar, then they could continue, as they have been, to purchase ever-greater amounts of dollars and invest them in dollar assets. This is exactly what has been happening for some time, and has been a crucial mechanism in diverting the effects of US monetary growth away from US consumer prices.

By some estimates, the US trade and government deficits are equal in quantity to around 100% of the total world’s total savings. But that does not mean that the US is borrowing all of the savings in the world. Instead, central banks are printing a portion of the money that they use to purchase US debt. The Fed is in effect able to export of US-dollar inflation because other central banks are willing to do the job of monetizing debt.

Could this prevent a dollar exchange rate crisis? Yes, with all the major central banks inflating, they could possibly stave off a dollar crash in terms of the exchange rate but then we would experience world-wide hyperinflation: a crash of all currencies against goods.

A similar argument to the preceding one is that there are no other currencies that are sufficiently attractive. The dollar will always be the “belle of the ball." Marc Faber, in this stimulating piece, has some interesting things to say about that:

Also, since most of the crises experienced over the last 15 years, beginning with the Persian Gulf crisis of 1990, were related to problems outside the United States, there was a flight of safety into U. S. Treasury bonds not only by domestic investors, but also by international ones. This, in turn, tended to strengthen the U.S. dollar in times of crisis. But, what if the Fed were to embark on a massive money printing operation because of a really nasty economic surprise or financial accident in the United States? Would foreign investors still consider the U. S. dollar and U. S. bonds to be safe? I doubt it.

Under such circumstances a far more likely outcome would be a tsunami of dollar selling and, along with it, selling of U. S. dollar bonds. In the wake of massive selling of dollars and dollar bonds by foreign investors, interest rates would likely rise. In turn, this would force the Fed to monetize even more. A further loss of confidence in the dollar would follow.

The question here is, what would the dollar sell off against, and what would investors perceive as a safe haven in such a situation? The Euro? Not very likely! Asian currencies? Possibly, but if China were to weaken simultaneously with the U. S. economy it’s unlikely that Asian currencies would be viewed as a safe haven. I suppose that in a crisis of confidence arising from an economic or financial problem in the United States of a scale that would lead the Fed to print money in massive quantities, only gold, silver, and platinum would be regarded as truly safe currencies notwithstanding their current weakness.

Could "it" happen here, asks Bernanke? One cannot entirely rule out the possibility of deflation. It is hard to see just how it could happen. Inflation is always the easy way out. In the age of activist governments, it is difficult to imagine the Fed standing aside and watched the banking system become insolvent. It’s far morel likely that one day we will tune into CNBC and hear "Don’t worry about that black helicopter hovering over your home. It is not here to enforce the Patriot Act IV, but to drop bales of freshly printed bills onto your front lawn."

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

Although
votes were cast one week ago, the winner has not yet been determined.
The two sides have been mired in a legal struggle resulting from
a series of lawsuits
initiated by the Kerry campaign, met by the Bush
administration's counter-suits. The legal standoff has brought
into question both the vote counts in various closely fought states
and the legality of voter registration procedures. The number and
complexity of the suits threatened to tie up the result of the election
for weeks or even months.

The
BLS was an unlikely latecomer to the conflict. In an unprecedented
move, teams of lawyers from the two campaigns met in a series of
closely guarded meetings under the supervision of Supreme Court
justices to agree upon a neutral third party. A surprise emerged
from these meetings that stunned even seasoned Washington observers
when the Bureau of Labor Statistics (BLS) was given the job.

The
BLS was chosen because of their statistical expertise. Several well-known
and closely followed index numbers are produced by the Bureau on
a monthly basis, most prominently the consumer price index (CPI),
the producer price index (PPI), and the unemployment report. They
are well known among economists and financial analysts for their
number crunching abilities.

Since
taking on the task, the Bureau's job for the past week has been
to sort through the conflicting claims using their widely used statistical
models to determine who really won: Bush or Kerry.

The
BLS is not without its critics — some have suggested that the choice
of the Bureau may in the end prove even more controversial than
had the results been fought out in the courts. Many of the Bureau's
statistical procedures have come under attack since the mid-90s.
Critics of the BLS have charged that the inflation and unemployment
numbers are manipulated for political reasons.

A
prominent Austrian economist explained, "There are really two
means of funding government expenditures: taxation and inflation.
Government debt can be financed for some time by borrowing, but
it only postpones the decision whether the debt will be paid back
by future taxation or future inflation."

"Taxation
is the most direct means, but also the most easily resisted. Governments
often choose inflation because the mechanism is not well-understood
by the average citizen, so it is easier to blame the loss of purchasing
power that people are experiencing on scapegoats — greedy oil companies,
OPEC, greedy labor unions, u2018cost-push', u2018demand-pull', or by pointing
to whatever price component happens to be going up at the time.
In so doing, they distract people from the real cause of the problem,
which is central bank money printing."

Governments,
according to this economist, have a natural attraction to inflation,
but also to hiding its effects. "Inflation costs the government
a lot of revenues because social security and pension payouts are
indexed to inflation. Because income tax brackets are also indexed,
tax revenue does not go up as much as it might when there is inflation."

"And
there is the effect on inflation of the government's own cost of
borrowing. If credit markets believe that there is inflation, interest
rates will go up to reflect the loss in purchasing power of the
money that will be used to repay the debts. This will in the long
run increase the government's cost of financing its debt. And finally,
a high rate of inflation casts doubt upon the effectiveness of the
central bank's alleged policy of fighting inflation." the economist
continued.

The
Austrian economist's most controversial charge was that the BLS
manipulates the inflation number for the benefit of the government.
"The obvious solution is to inflate but then to lie
about the effects of inflation by reporting a low inflation
number. This understates the the reality of the monetary debasement
that is occurring."

The
BLS has adopted a
number of questionable procedures in figuring its final inflation
number. Among the most controversial are quality-adjusted prices,
altering the composition of the index, seasonal adjustments, and
the proliferation of different index numbers. Also, the use of the
"birth-death" model in the unemployment report has drawn
criticism.

Critics
of the BLS have drawn attention to the practice of adjusting prices
based on improvements in quality, using so-called "hedonic
adjustments". The explanation given is that a good that appears
to have gone up in price because it costs more does not really cost
more because the quality has improved. According to this logic,
it might even cost less.

For
example, computers in today's stores have faster CPUs, more memory,
and more hard drive space than computers of five years ago. These
specifications are used to compute a quality adjustment factor that
is then applied to the price of a computer. If the factor is 0.50,
then a $2000 computer will be assigned a price of $1000 for the
purpose of computing the CPI.

As
the use of these adjustments has spread from high-tech products
like computers and cell phones to cars, washing machines, and even
health care, an ever-expanding array of consumer price increases
are adjusted downwards by their "hedonic multipliers"
before the CPI is computed. The numbers used as input to the CPI
then show the prices of many goods falling that are in reality rising.
This procedure results in a lower inflation number than if the actual
prices paid by consumers were used.

The
BLS has been using the same techniques in computing the final vote
tally in the presidential race. The Bureaus is computing quality
adjustment factors for Bush and Kerry.

According
to a BLS spokesperson, "Using a base year of 1980, the quality
of Republicans has declined considerably," he said. "Republican
candidates use to at least talk about lower taxes and smaller government,
but Bush is a
bigger spender than any Democrat. We have come up with a Republican
quality adjustment factor of 0.45." Applying the factor to
Bush's vote total of 65 million votes yields a quality-adjusted
total of 29.25 million.

If
the base year were set to somewhere in the 19th century,
that was a time when the Democrats were in favor of sound money
and opposed central banking. But a base year of 1980 brings a comparison
of Kerry to the malaise of the Carter years. This comparison shows
only a small quality drop-off for Democrats. The quality adjustment
factor applied to Kerry is only 0.85 according to the Bureau.

The
arbitrary dropping of certain components from the index has drawn
attention from critics. Food and energy were dropped from the CPI
some years back because these components were deemed "too volatile"
and did not reflect the "core" rate of inflation.

"When
the central bank prints more money, the price of something will
go up. Not everything, and not by the same amount, but something,"
said the Austrian economist. "If you exclude those things that
are going up in price from your inflation index, you can come to
the phony conclusion that there is no inflation. This is equivalent
to saying that there is no inflation, except for those prices that
are rising," he stated.

This
technique is also being applied to the presidential vote totals.
The vote counts from Alaska, Hawaii, and North Dakota were dropped
from the totals on the grounds that "no one important lives
there", said the BLS, and Florida votes were excluded on the
grounds that they are "too volatile". "Look at all
the problems Florida caused for us last time", said the Bureau's
spokesperson.

Seasonal
adjustments are another of the controversial practices used by BLS
statisticians. The idea is that heating oil might be high during
December due to seasonal demand by north-eastern home owners for
oil to heat their homes during the winter months, but this does
not reflect inflation per se, only a seasonal condition that will
be evened out over the full year with lower prices in the spring
and fall.

Some
critics though, have questioned the integrity of the process. According
to the BLS
site, seasonally adjusted energy prices declined on a quarterly
basis in the 3rd quarter, in spite of record-high prices
for oil and natural gas.

Another
questionable aspect of the process is the way that energy and housing
prices interact in the computation. When home prices are increasing
by 20-30% annually in some US cities, some have questioned how the
contribution of housing to the cost of living could be decreasing.

The
explanation is that Bureau statisticians believe that some housing
rentals include energy. Energy prices are therefore subtracted from
rents to produce an energy-adjusted rental price. When energy prices
go up, energy-adjusted rents go down, resulting in a lower contribution
by housing prices to the total CPI. The energy price increases are
then removed by the seasonal adjustment, resulting in a lower contribution
of both energy and housing to the inflation index even when both
are rising.

Seasonally
adjusted vote totals were computed for Bush and Kerry. "The
apparent vote totals of about 65 million each for Bush and Kerry
are a statistical aberration", the BLS spokesperson stated.
"The election only takes place every four years, so the seasonally
adjusted number of votes is 16.25 million." By way of explanation
he added, u2018If Hillary Clinton were to run next in 2008, we would
have to adjust her vote total by a multiple of 1/12th
because she has been running for president since 1996".

The
proliferation of different index numbers is another area of controversy.
In addition to the CPI, there is the "core CPI" and the
"median CPI". The Austrian economist commented, "If
one if their index numbers goes up too much during the month, policy
makers can always point to another one of the indexes that was more
moderate and come up with a reason why the more moderate index is
the u2018real' rate of inflation. It is Orwellian because the next month,
they will use a different argument to tell you why a different index
measures the u2018real' CPI than the month before."

The
BLS will be computing three different vote totals for Bush and Kerry:
total votes cast, "core" votes, and "median votes".
The "core votes" for Kerry consist of the total number
of votes cast in the heavily Democratic cities and coastal areas
that form the Democracts' core constituency, such as Berkeley California,
Santa Monica California, north-eastern Cities, and Chicago. Core
Republican votes will consist of the number of votes cast in the
core Republican regions such as Texas, the Midwest, and the South.

One
problem with this method is that each candidate shows a substantial
lead in his own party's core vote totals, making the selection of
a president more difficult rather than less. This outcome is inherent
in the BLS' methodology, according to the Austrian economics, who
is on record as stating, "If you can manipulate the perception
of reality by putting only those things that are consistent with
the result you want, you can twist reality to fit your own agenda."

Substitution
of cheaper products for those that have risen in price is another
controversial adjustment procedure. BLS statisticians reason that
if beef goes up in price, people may eat more chicken instead, because
it costs less. They then expand the weighting of the substitute
good — chicken — in the index, while contracting the weighting of
beef. This produces a lower number for the CPI than if the higher
priced beef had been used.

"This
is one of their most dishonest techniques because they are confusing
inflation itself, which is the expansion of fiat money supply, with
peoples' response to inflation, which is to consume less of the
goods that they value more because they are losing purchasing power",
the Austrian economist noted.

The
application of this substitution effects to the election has proved
difficult for the BLS. "Because both candidates are so awful,"
the BLS representative began, "the decision to vote for one
or the other is a u2018lesser-of-two-evils' for most voters. We are
going to determine the number of Bush voters who are only voting
for him because he is not Kerry, and vice versa, then subtract these
effects from the totals because these votes represent substitutions
of a lesser good for a more highly valued one." If there had
been a viable independent or third-party candidate this year, such
as Nader in 2000, that would have confused the process of making
the calculations even more.

A
final adjustment was provided by borrowing a technique from the
monthly unemployment rate computation. Due to alleged measurement
problems in counting the number of jobs created or eliminated during
any month, a computer program known as the "birth-death model"
is used to estimate jobs that cannot be counted. This model was
developed during the booming 1990s when it was assumed that small
businesses were creating a lot of jobs under the radar of the Bureau's
data collection. Government jobs, part-time jobs, and temporary
positions are also counted as net new jobs in this process.

During
some recent months, statistical job losses were translated into
net job gains by the addition of hundreds of thousands of jobs from
the birth-death model. The King Report, a frequent critic of this
methodology, has
written:

Of
the 947,000 jobs counted by the BLS the past three months, 618,000
representing 65% of the u2018job creation' are due solely to the Birth/Death
Rate. Without going into much detail, it has to do with statistically
created jobs, not real jobs where people get pay checks.

The
Bureau's statisticians have been hard at work to adapt the birth-death
model to presidential vote counting. For the election, this model
has been revised to estimate hypothetical votes that would have
been cast by Democrat and Republican children not old enough to
vote, projected number of children based on estimated family sizes
of Republican and Democrat families, and voters who would have voted
had they not died before the election.

Computing
the correct birth/death numbers for the presidential election has
proven to be a challenging task. According to a
new study, Republicans are having larger families than Democrats.
However, "Democrats have a long history as the party of welfare
patronage, and the welfare system gives cash incentives to single
women to have more children. We are coming up with a computer model
to estimate the effects of these adjustment factors."

How
the statistical process will play out is anyone's guess, leaving
the election results very much in doubt. Some fear that the announcement
of a winner tomorrow will spark another round of controversy as
the Bureau's statistical methods become the focal point in a renewed
firestorm of debate. The real problem, though, according to the
Austrian economist is "when you trust government statistics,
you give them the right to define what reality is."

November
1, 2004

Robert
Blumen (send him mail)
is an independent software consultant based in San Francisco, who
does not plan to vote in the election.

However,
few commentators realize that these reports are evidence that the
US economy is undergoing a secular shift. The emerging reality,
slowly being recognized by economists, is becoming known as the
Housing Economy. This term recognizes the emergence of residential
real estate as the driver of economic activity.

Some
experts believe that the current changes will be comparable in their
scope to the major shifts of the past two decades, such as the change
from the Old Economy (based on manufacturing) to the Service Economy
(based on the import of consumer goods), that took place in the
80; or the transition from the Service Economy to the New Economy
(based on computers and the Internet) that took place in the 90s.

The
changing composition of the labor force illustrates the transition
that is taking place. The Wall Street Journal and other
papers have recently reported that many unemployed professionals
from fields such as information technology, management, and finance,
are now leaving
their old line of work to become real estate agents as they
realize that their old job has moved offshore or is not coming back.

Eventually,
most of the US labor force will be employed in one of a few types
of work: real estate developer, building contractor, appraisers,
real estate broker, and real estate agent. Their work will consist
of the construction, financing (and re-financing), purchase, and
sale of residential real estate. Day traders who now trade NASDAQ
issues may be able to day trade residential real estate if sufficiently
liquid markets and continuous price quotes are available.

Housing
will be more than the driver of the Housing Economy: it will be
the only form of economic activity. Other types of production, now
seen to be unnecessary, will be converted or diverted to residential
real estate, as the New York Times has reported in a
recent story:

Gregory
J. Nickels, the mayor of Seattle, is battling the Port of Seattle
and the longshoreman’s union to close one of the city’s three
port terminals in a few years, saying it makes more sense to use
the spectacular mountain-framed waterfront property for condominiums
than cargo ships going back to Asia without full loads. He argues
that even the $700 million of recent renovations on the port will
not increase cargo traffic.

“The
land values are such that when the port is only creating 13 jobs
per acre, there may be a better way to create jobs,” Mr. Nickels
said.

The
conversion of factories, transportation networks, and other capital
goods, to residential real estate will yield significant economic
benefits. A Seattle real estate developer contacted by this publication
explained the thinking behind this, "We used to need shipping
terminals because we used to have to produce goods to trade with
foreigners to get things from them in return. But production is
a lot of work, and you have to save and invest. Now how much fun
is that? Why not just build houses and condos?"

One
challenge that has been issued by critics is the likelihood of an
excessive
accumulation of debt. Only hard-core skeptics question that
home owners can perpetually refinance and extract home equity from
their rising home prices. However, a growing chorus of doubters
has raised the issue that increasing
debt levels will limit the long-term growth of the economy.

Past
generations of home owners looked forward to the final payment of
their mortgage debt prior to their exit from the work force. Of
concern are the following trends: in recent years, home equity as
a percentage of home values has sunk to an all-time low, in spite
of the aging population of baby boomers nearing retirement, several
consecutive years of strongly rising home prices, and a period of
record-low interest rates.

The
total amount of mortgage debt outstanding, now around six to seven
trillion dollars, is at an all-time high. Critics are increasingly
alarmed that the fraction of income devoted to mortgage payments
is also at historically high levels, and has been growing.

While
some have argued that the fraction of income spent on mortgages
must remain under 100%, not all economists agree. A mainstream economist
asked to comment on the issue, defended the Housing Economy.

"Using
the most modern econometric techniques, we can project where the
mortgage payments of all home owner reaches 100% of national wage
income. Basically what we do is draw a graph of the percentage over
time, lay a ruler over it, and draw a straight line. The point where
the line crosses 100% is our forecast," he stated.

Some
have charged that this type of forecasting is devoid of any economic
reasoning, and even that it violates common sense. How, for example,
could mortgage payments reach or exceed 100% of income?

The
mainstream economist responded to these charges. "Home owners
can simply extract equity from their home by refinancing and use
the cash they take out to pay the difference between their income
and their mortgage." Home owners extracted
$491 billion of equity from their homes last year according
to the Wall Street Journal. "Home owners are already
using home equity from refinancing to meet ongoing monthly expenses,"
he continued, "It is a small step forward to start using these
funds for the mortgage itself."

He
continued, "Those worry-mongers who are always complaining
about debt are laboring under the quaint notion that debt is supposed
to be repaid. The purpose of going into debt is so that you can
acquire more debt in the future. Governments have known this for
a long time, but in a democracy, why shouldn't ordinary people be
able to take advantage of this as well?"

Fed
Chairman Alan Greenspan, one of the leading thinkers in this new
paradigm, has generally endorsed
these changes, as the Wall Street Journal reported:

WASHINGTON
– Federal Reserve Chairman Alan Greenspan said Monday the
finances of U.S. households are in “good shape” despite a steep
rise in household debt and national bankruptcy rates over the
last few years, suggesting that consumer spending isn’t likely
to fizzle out.

In
a speech, Greenspan said that although nonbusiness bankruptcy
filings have risen steadily over the last few years, they don’t
reflect the true state of household finances. Household debt,
he said, has climbed in tandem with rising homeownership rates
and rising home prices, allowing most households to carry the
debt without stress.

“Overall,
the household sector seems to be in good shape, and much of the
apparent increase in the household sector’s debt ratios over the
past decade reflect factors that do not suggest increasing household
financial stress,” Greenspan told the Credit Union National Association
in prepared remarks.

If
the use of debt to fund current consumption is to be sustainable,
continually rising housing prices are required so that a plentiful
supply of home equity to be cashed out is always available.

This
might sound like a perpetual motion machine to old-school economists,
who have argued that wealth creation required savings and investment.
But thanks to recent developments in economic thinking, the use
of permanently rising asset prices as a means of wealth creation
now has a sound basis in economic theory.

Fed
Chairman Alan Greenspan was one of the first to see how rising
home values could be a source of economic growth:

As
an economic consultant in the 1960s, Alan Greenspan had a novel
insight about buying and selling homes. He noticed that when a
house changed hands, the mortgage the buyer took out almost always
was bigger than the one the seller was retiring.

Mr.
Greenspan went on to conclude that this borrowing played an unexpectedly
large role in consumer markets, by generating extra spending power
backed by the value of homes. At the time, it was an arcane thesis
that few other economists accepted or even understood.

[...]

Mr.
Greenspan’s analytic interest in housing dates to his days as
a consultant at Townsend-Greenspan & Co. He noticed that total
mortgage debt was increasing each year by more than could be explained
by mortgages taken out on newly built homes, after he subtracted
scheduled repayment of existing loans. The difference, he concluded,
had to be mortgage borrowing secured by the equity in existing
homes – borrowing that consumers used for other purposes, from
buying cars to investing in stocks.

Mr.
Greenspan called this the “monetization,” “liquefication” or “extraction”
of home equity. He believed it could explain a lot of things –
stock prices, home prices and consumer spending – better than
other economic models did. “Capital gains from home sales are
a potent force in consumer markets, far greater than … stock-market
gains,” he told the National Association for Business Economics
in Philadelphia in 1977.

[...]

“In
the old days, housing wealth was relatively illiquid and the only
way to realize it was to sell and move to smaller house,” said
Fed researcher Andreas Lehnert at a recent academic conference
in Washington. “Now you can borrow against housing wealth.” He
calls this increased role of the home as a source of cash the
“ATM effect.”

In
a groundbreaking 1996 article, the concept of using rising prices
to create wealth was extended from rising home prices to rising
asset prices in general. Economist Dr. Kurt Richebächer summarizes
this article:

For
the first time ever in the history of economic thinking, economists – that is, American economists – are claiming that growing asset
prices represent fully valid wealth creation. In 1996, an article
in Foreign Policy entitled Securities: The New
Wealth Machine effectively explained that the financial markets
have become the most powerful generator of wealth.

Verbatim:
“Historically, manufacturing, exporting, and direct investment
produced prosperity through income creation. Wealth was created
when a portion of income was diverted from consumption into investment
in buildings, machinery and technological change. Societies accumulated
wealth slowly over generations. Now, many societies, and indeed
the entire world, have learned how to create wealth directly.
The new approach requires that a state find ways to increase the
market value of its stock of productive assets. Several countries
have successfully directed their economic policies toward that
goal, achieving and sustaining faster growth rates than were once
thought possible…”

The
Housing Economy brings concept of extracting wealth rising asset
prices full circle: rising housing prices will drive not only the
entire economy, but also ensure the further increase in housing
prices. The Wall Street Journal noted
that the net worth of households recently "surpassed the
peak of $43.58 trillion reached in the first quarter of 2000,"
due to "a rebound in the stock market as well as the rapid
appreciation in home values in the past few years."

Proponents
of the Housing Economy have argued that it will be more resistant
to business cycles. One case in point is that it will be immune
to offshore movement of jobs to India or China. Real estate agents
must be local in order to be familiar with the neighborhood conditions.

However,
some social justice activists have raised concerns about what will
happen to those individuals who fall through the cracks — those
unable to get a mortgage or to find work as real estate agents or
brokers.1

One
community-based development activist recently spoke out: "We
are in danger of an unequal society, one of real-estate haves and
real estate have-nots." Indeed, this would mirror the experience
of Japan's bubble economy, in which modest homes fetched millions
of dollars. Only those who already owned a home had the means to
purchase real estate. Those who had not purchased before the bubble
were left behind.

To
avoid the specter of housing inequality, the Housing Economy will
require additional social safety net programs to ensure that everyone
can obtain a mortgage of any size, no matter what their credit-worthiness.
Recent financial innovations such as zero-percent (no down payment)
mortgages2, interest-only mortgages3,
negative amortization4, and mortgages
written for greater than 100% of the value of the home5
will provide a basis for these new programs.

Here
the Housing Economy may borrow from recent financial innovations
in auto financing. Car owners who are "upside down," that
is, owe more on their car than it is worth, can roll
the old debt into a loan on a new car. The new loan is often
for more than the value of the new car.

The
housing GSE Fannie Mae will continue to provide an important service
to home buyers by purchasing mortgages that are issued to finance
homes, securitizing them, and selling them to the Chinese and Japanese
Central Banks.

Fannie
Mae CEO Franklin Raines has emphasized the important role of the
GSEs in ensuring continually rising home prices. In a
speech to the SIA, Raines calculated the supply of credit that
would be available for mortgages. Raines then made an independent
calculation for the demand for mortgage loans, based on the entirely
reasonable assumption of continued home price appreciation.

According
to Raines, credit demand would have exceeded credit supply by a
significant margin. This would undoubtedly lead to a complete shutdown
of the housing market, as home prices remained stuck at high levels
that buyers could not afford. Fortunately, Fannie Mae was able to
step in and provide the additional credit that was needed to make
up the difference between supply and demand.

It
was thought by older economists that supply and demand could not
be permanently out of balance because the movement of prices would
occur until supply and demand were matched. In this mode of thinking,
supply, demand and price were seen as interdependent phenomena.
Indeed, without Fannie Mae, the price system would have been required
to bear the full burden of bringing supply and demand into balance.
This would have meant either higher interest rates, lower home prices,
or some combination of the two.

One
home owner, who has retired from their line of work and now lives
entirely off their home equity, summarized the impact of the Housing
Economy on his own life: "Is this a great country, or what?"

Notes

1. Some people
   will always find something to complain about.
2. I'm not
   making this up.
3. Or this.
4. Or this,
   either.
5. Or this.

March
8, 2004

Robert
Blumen (send him mail)
is an independent software consultant based in San Francisco, where
he rents an apartment.

We are living in Brazil. The future as foretold by Terry Gilliam's 1985 rich and multi-layered film masterpiece Brazil is upon us. First released fifteen years ago, Terry Gilliam's Brazil was astonishingly accurate in forecasting political trends. In a previous essay, I examined the film as a critique of socialist central planning. In this piece, I will discuss how Brazil portends Bush's War on Terror.

The world of Brazil shows a totalitarian society in which freedom has been forfeited for a false promise of protection from terrorist attacks. Gilliam shows how the threat of terrorism is manipulated by the state as a means of political control over the population. The threat of terror is created by the internal security police in order to generate public acceptance of totalitarian police powers.

Gilliam's exposition raises some important questions: Is the terror created by the power of the state in the alleged pursuit of terrorism worse than the terrorism itself? And are they really any different?

The ministers of state in Brazil have succeeded in creating a society organized around a continuous response to the threat of terrorism. Random bombings occur regularly. The protagonist Sam and his mother must go through a security check in order to enter a restaurant. And then during their meal a large explosion blows out the back of the dining room; they continue eating while bodies are dragged away.

As in modern America, there is some doubt about whether Brazil's "War on Terrorism" is really working. At the opening of the film Minister Helpmann, the Deputy Minister of information (the internal security agency), appears on TV immediately after a bombing takes place:

INTERVIEWER: Do you think that the government is winning the battle against terrorists?

HELPMANN: Oh yes. Our morale is much higher than theirs, we’re fielding all their strokes, running a lot of them out, and pretty consistently knocking them for six. I’d say they’re nearly out of the game.

INTERVIEWER: But the bombing campaign is now in its thirteenth year.

HELPMANN: Beginner’s luck.

Now in the US, we are told by the Bush administration that the war on terrorism will become a more or less permanent state of affairs.

U.S. war may last decades Military pushed to think broadly By KAREN MASTERSON

WASHINGTON – The U.S. war on terrorism may rage for decades and has forced Pentagon strategists to think more broadly than they’ve had to since World War II, a top military official said Sunday.

“The fact that it could last several years, or many years, or maybe our lifetimes would not surprise me,” Gen. Richard B. Myers, chairman of the Joint Chiefs of Staff, said Sunday on ABC’s This Week.

The film has been reissued on DVD with commentary by the director in which he states that it was his intention to convey that there were so many government plants, double agents, agents provocateurs, moles, infiltrators, etc. that at some point even the government did not know for sure whether there were any real terrorists or whether all of the terror was fabricated by the police as part of their anti-terror campaign. 

In a conversation between Sam and Ministry of Information office Jack Lint, Lint reveals how he — as a key member of the internal security department – understands the events that are taking place:

SAM: You don’t really think Tuttle and the girl are in league?

JACK: I do. Goodbye.

SAM: It could all be coincidental.

JACK: There are no coincidences, Sam. Everything’s connected, all along the line. Cause and effect. That’s the beauty of it. Our job is to trace the connections and reveal them. This whole Buttle/Tuttle confusion was obviously planned from the inside.

As the audience of the film, we know that the Tuttle/Buttle confusion was caused by a computer error within the department, and that "the girl" (Jill Layton) became involved as a concerned citizen trying to investigate a wrongful arrest. The irony here is that a random chain of events kicked off by the Ministry's own error is seen from inside ministry as further evidence of a terrorist conspiracy.

Revisionist historians have suggested that many wars and other events are staged or at least allowed to happen and then used by the government to manipulate public opinion in the direction that they want it to go. Michael Ruppert has provided voluminous research suggesting that the US intelligence agencies had foreknowledge of the 9/11 attacks and chose to allow them to occur, much the way that Roosevelt knew about Pearl Harbor and did not prevent it. And there is the tradition of US enemies having once been funded by US intelligence agencies.

Bin Laden comes home to roost His CIA ties are only the beginning of a woeful story By Michael Moran MSNBC

NEW YORK, Aug. 24, 1998 – At the CIA, it happens often enough to have a code name: Blowback. Simply defined, this is the term that describes an agent, an operative or an operation that has turned on its creators. Osama bin Laden, our new public enemy Number 1, is the personification of blowback. And the fact that he is viewed as a hero by millions in the Islamic world proves again the old adage: Reap what you sow.

[...]

What the CIA bio conveniently fails to specify (in its unclassified form, at least) is that the MAK was nurtured by Pakistan's state security services, the Inter-Services Intelligence agency, or ISI, the CIA's primary conduit for conducting the covert war against Moscow's occupation.

[...]

Yet the CIA, concerned about the factionalism of Afghanistan made famous by Rudyard Kipling, found that Arab zealots who flocked to aid the Afghans were easier to "read" than the rivalry-ridden natives. While the Arab volunteers might well prove troublesome later, the agency reasoned, they at least were one-dimensionally anti-Soviet for now. So bin Laden, along with a small group of Islamic militants from Egypt, Pakistan, Lebanon, Syria and Palestinian refugee camps all over the Middle East, became the "reliable" partners of the CIA in its war against Moscow.

Brazil shows a world of meek and helpless people, devoid of any artistic or aesthetic pleasure. There are two heroes in the film: Tuttle, the renegade heating repair engineer, and Jill Layton, a woman who takes it upon herself to fight the wrongful arrest of her neighbor's husband. The protagonist, Sam, is a happy cog in the great machine, content to waste away his life shuffling papers within a vast bureaucracy.

Social life is dominated by suspicion and fear. And who is behind this?

INTERVIEWER: Deputy minister, what do you believe is behind this recent increase in terrorist bombings?

HELPMANN: Bad sportsmanship. A ruthless minority of people seems to have forgotten certain good old fashioned virtues. They just can’t stand seeing the other fellow win. If these people would just play the game, they'd get a lot more out of life.

Compare this to President Bush’s Address on Terrorism to Congress:

Americans are asking, ”Why do they hate us?”

They hate what they see right here in this chamber, a democratically elected government. Their leaders are self-appointed. They hate our freedoms, our freedom of religion, our freedom of speech, our freedom to vote and assemble and disagree with each other.

The utter irony of this is that Bush and Helpmann depict terrorism as primarily a sort of arrested emotional development by those who did not learn in grade school to be good losers. The little boy who took his ball and went home became a terrorist when he grew up. This rhetorical tactic forestalls any inquiry into the religious or political movements that the terrorists might be seeking to advance or whether they have any real case against the American foreign policy. An irony here is that the moral virtue claimed by both Bush and Helpmann is undermined by their own terror game.

The use of propaganda is another tactic used by totalitarian regimes to generate support for their program. In Brazil as in Orwell's 1984, this takes the form of euphemisms.

KURTZMAN: I’ve tried that! Population Census have got him down as dormanted, the Central Collective Storehouse computer has got him down as deleted, and the Information Retrieval have got him down as inoperative, Security has him down as excised, Admin have him down as completed.

SAM: Hang on…he's dead.

KURTZMANN: Dead?

Besides being used to hide unpleasant meanings, euphemisms are also used to portray falsehood as truth. The sinister internal security division is darkly named the Ministry of Information Retrieval. They "retrieve" information from citizens by torture. In a visual motif reminiscent of Soviet era propaganda, posters with banal slogans appear on buildings and in offices. In case you can't read them all as they go by during the film, I have copied them from the excellent Brazil FAQ:

• “Be Safe: Be Suspicious”
• “Suspicion Breeds Confidence”
• “Trust in haste, Regret at leisure”
• “Don’t suspect a friend, report him”
• “Who can you trust?”

This is not so different from modern America. In case some American suspects a friend of theirs, Bush will make it possible for you to report him:

Operation TIPS Trips Up? August 8, 2002

(CBS) In the aftermath of Sept. 11, President Bush laid groundwork for “Operation TIPS," a program which would organize a volunteer army of citizen lookouts to report “suspicious” activities to the federal government.

Under “Operation TIPS," transportation workers, utility crews and letter carriers could sign up to snoop on members of their communities. Attorney General Ashcroft argued such vigilance could thwart terrorists, CBS News Correspondent Bob Orr reports.

“You have the ability of people who have a regular perception, who understand what’s out of order here, what’s different here, and maybe something needs to be looked into,” Ashcroft said.

The plot of Brazil is driven by a series of accounting errors that are initiated when the Ministry of Information arrests and tortures the wrong man. The arrest scene is a terrifying exhibition of police state tactics: several black-garbed troopers simultaneously burst through the walls and doors of the Buttle's apartment. They are followed a paper-pushing official who reads the banal statement of arrest to Mr. Buttle as he is about to be dragged off in a canvas sack and tortured to death:

OFFICIAL: I hereby inform you under powers entrusted to me under Section 47, Paragraph 7 of Council Order Number 438476, that Mr Buttle, Archibald, residing at 412 North Tower, Shangri La Towers, has been invited to assist the Ministry of Information with certain enquiries…

The accounting problems stem from the wrongful arrest of Mr. Buttle because they charge torture victims for the cost of their own torture. These charges are necessary for efficiency, according to the Deputy Minister.1

INTERVIEWER: And the cost of it [i.e. the Ministry's campaign] all, Deputy Minister? Seven percent of the gross national product…

HELPMANN: I understand this concern on behalf of the taxpayers. People want value for money. And that's why we always insist on the principle of Information Retrieval Charges. It’s absolutely right and fair that those found guilty should pay for their periods of detention and the Information Retrieval Procedures used in their interrogation.

Later, when the Sam is arrested for a long list of crimes and brought back to Information Retrieval for processing, the Ministry even offers him a consumer financing plan to that they provide to help torture victims bear the cost:

OFFICIAL C: Now, either you plead guilty to say, seven or eight of these charges, which’ll bring the costs down to within your reach, or you can borrow a sum to be negotiated, from us, at very competitive rates.

OFFICIAL D: We can offer you something at say, eleven and a half per cent, over thirty years. But you will have to buy insurance to qualify for his scheme.

This type of plan brings to mind Paul Craig Roberts' critique of current US judicial proceedings in which people are charged with a long list of related offences for a single crime then encouraged to plea bargain by pleading guilty to only one of them. Also, compare Sam's travails to a trial balloon that was floated by the Bush administration:

Officials consider tapping Iraqi oil to pay war costs Some in Bush administration consider oil funds to be ‘spoils of war’

WASHINGTON – Bush administration officials are seriously considering proposals that the United States tap Iraq’s oil to help pay the cost of a military occupation, a move that likely would prove highly inflammatory in an Arab world already suspicious of U.S. motives.

In another amazing parallel, the interior spaces of the rooms in Brazil are overrun with ugly meandering heating ducts. And as US citizens we are told to stock up on duct tape.

How could a film produced fifteen years ago have foreseen these developments in such remarkable detail? Perhaps because they are not new: they are recurring patterns in the way that states use and manufacture the threat of warfare in order to control their own citizens. State power tends to grow during wars because citizens become more willing to trade liberty for the security that states are willing to promise them. But when a war ends, the pendulum swings back at least partially. So why not manufacture a permanent state of war during which freedoms can be indefinitely suspended? Gilliam was writing history as well as foretelling the future. By creatively retelling the past as a work of fiction about the future, he exposes the totalitarian impulse.

Note:

1. My own thoughts on this were augmented by points made in the FAQ, part 9.

Favorite Brazil Sites

1. FAQ.
2. Script.
3. Buy the new DVD release featuring a documentary about the film and Gilliam's commentary.

Robert Blumen (send him mail) is an independent software consultant based in San Francisco.

The
world of Brazil shows a totalitarian society in which freedom
has been forfeited for a false promise of protection from terrorist
attacks. Gilliam shows how the threat of terrorism is manipulated
by the state as a means of political control over the population.
The threat of terror is created by the internal security police
in order to generate public acceptance of totalitarian police powers.

Gilliam's
exposition raises some important questions: Is the terror created
by the power of the state in the alleged pursuit of terrorism worse
than the terrorism itself? And are they really any different?

The
ministers of state in Brazil have succeeded in creating a
society organized around a continuous response to the threat of
terrorism. Random bombings occur regularly. The protagonist Sam
and his mother must go through a security check in order to enter
a restaurant. And then during their meal a large explosion blows
out the back of the dining room; they continue eating while bodies
are dragged away.

As
in modern America, there is some doubt about whether Brazil's "War
on Terrorism" is really working. At the opening of the film
Minister Helpmann, the Deputy Minister of information (the internal
security agency), appears on TV immediately after a bombing takes
place:

INTERVIEWER:
Do you think that the government is winning the battle against
terrorists?

HELPMANN:
Oh yes. Our morale is much higher than theirs, we’re fielding
all their strokes, running a lot of them out, and pretty consistently
knocking them for six. I’d say they’re nearly out of the game.

INTERVIEWER:
But the bombing campaign is now in its thirteenth year.

HELPMANN:
Beginner’s luck.

Now
in the US, we are told by the Bush administration that the war on
terrorism will become a more or less permanent state of affairs.

U.S.
war may last decades
Military pushed to think broadly
By
KAREN MASTERSON

WASHINGTON
– The U.S. war on terrorism may rage for decades and has
forced Pentagon strategists to think more broadly than they’ve
had to since World War II, a top military official said Sunday.

“The
fact that it could last several years, or many years, or maybe
our lifetimes would not surprise me,” Gen. Richard B. Myers, chairman
of the Joint Chiefs of Staff, said Sunday on ABC’s This Week.

The
film has been reissued on DVD with commentary by the director in
which he states that it was his intention to convey that there were
so many government plants, double agents, agents provocateurs,
moles, infiltrators, etc. that at some point even the government
did not know for sure whether there were any real terrorists or
whether all of the terror was fabricated by the police as part of
their anti-terror campaign. 

In
a conversation between Sam and Ministry of Information office Jack
Lint, Lint reveals how he — as a key member of the internal security
department – understands the events that are taking place:

SAM:
You don’t really think Tuttle and the girl are in league?

JACK:
I do. Goodbye.

SAM:
It could all be coincidental.

JACK:
There are no coincidences, Sam. Everything’s connected, all along
the line. Cause and effect. That’s the beauty of it. Our job is
to trace the connections and reveal them. This whole Buttle/Tuttle
confusion was obviously planned from the inside.

As
the audience of the film, we know that the Tuttle/Buttle confusion
was caused by a computer error within the department, and that "the
girl" (Jill Layton) became involved as a concerned citizen
trying to investigate a wrongful arrest. The irony here is that
a random chain of events kicked off by the Ministry's own error
is seen from inside ministry as further evidence of a terrorist
conspiracy.

Revisionist
historians have suggested that many wars and other events are staged
or at least allowed to happen and then used by the government to
manipulate public opinion in the direction that they want it to
go. Michael Ruppert
has provided voluminous research suggesting that the US intelligence
agencies had foreknowledge of the 9/11 attacks and chose to allow
them to occur, much the way that Roosevelt
knew about Pearl Harbor and did not prevent it. And there is
the tradition of US enemies having once been funded by US intelligence
agencies.

Bin
Laden comes home to roost
His
CIA ties are only the beginning of a woeful story
By
Michael Moran
MSNBC

NEW
YORK, Aug. 24, 1998 – At the CIA, it happens often enough
to have a code name: Blowback. Simply defined, this is the term
that describes an agent, an operative or an operation that has
turned on its creators. Osama bin Laden, our new public enemy
Number 1, is the personification of blowback. And the fact that
he is viewed as a hero by millions in the Islamic world proves
again the old adage: Reap what you sow.

[...]

What
the CIA bio conveniently fails to specify (in its unclassified
form, at least) is that the MAK was nurtured by Pakistan's state
security services, the Inter-Services Intelligence agency, or
ISI, the CIA's primary conduit for conducting the covert war against
Moscow's occupation.

[...]

Yet
the CIA, concerned about the factionalism of Afghanistan made
famous by Rudyard Kipling, found that Arab zealots who flocked
to aid the Afghans were easier to "read" than the rivalry-ridden
natives. While the Arab volunteers might well prove troublesome
later, the agency reasoned, they at least were one-dimensionally
anti-Soviet for now. So bin Laden, along with a small group of
Islamic militants from Egypt, Pakistan, Lebanon, Syria and Palestinian
refugee camps all over the Middle East, became the "reliable"
partners of the CIA in its war against Moscow.

Brazil
shows a world of meek and helpless people, devoid of any artistic
or aesthetic pleasure. There are two heroes in the film: Tuttle,
the renegade heating repair engineer, and Jill Layton, a woman who
takes it upon herself to fight the wrongful arrest of her neighbor's
husband. The protagonist, Sam, is a happy cog in the great machine,
content to waste away his life shuffling papers within a vast bureaucracy.

Social
life is dominated by suspicion and fear. And who is behind this?

INTERVIEWER:
Deputy minister, what do you believe is behind this recent increase
in terrorist bombings?

HELPMANN:
Bad sportsmanship. A ruthless minority of people seems to have
forgotten certain good old fashioned virtues. They just can’t
stand seeing the other fellow win. If these people would just
play the game, they'd get a lot more out of life.

Compare
this to President
Bush’s Address on Terrorism to Congress:

Americans
are asking, ”Why do they hate us?”

They
hate what they see right here in this chamber, a democratically
elected government. Their leaders are self-appointed. They hate
our freedoms, our freedom of religion, our freedom of speech,
our freedom to vote and assemble and disagree with each other.

The
utter irony of this is that Bush and Helpmann depict terrorism as
primarily a sort of arrested emotional development by those who
did not learn in grade school to be good losers. The little boy
who took his ball and went home became a terrorist when he grew
up. This rhetorical tactic forestalls any inquiry into the religious
or political movements that the terrorists might be seeking to advance
or whether they have any real case against the American foreign
policy. An irony here is that the moral virtue claimed by both Bush
and Helpmann is undermined by their own terror game.

The
use of propaganda is another tactic used by totalitarian regimes
to generate support for their program. In Brazil as in Orwell's

1984, this takes the form of euphemisms.

KURTZMAN:
I’ve tried that! Population Census have got him down as dormanted,
the Central Collective Storehouse computer has got him down as
deleted, and the Information Retrieval have got him down as inoperative,
Security has him down as excised, Admin have him down as completed.

SAM:
Hang on…he's dead.

KURTZMANN:
Dead?

Besides
being used to hide unpleasant meanings, euphemisms are also used
to portray falsehood as truth. The sinister internal security division
is darkly named the Ministry of Information Retrieval. They
"retrieve" information from citizens by torture. In a
visual motif reminiscent of Soviet era propaganda, posters with
banal slogans appear on buildings and in offices. In case you can't
read them all as they go by during the film, I have copied them
from the excellent Brazil
FAQ:

• “Be Safe:
  Be Suspicious”
• “Suspicion
  Breeds Confidence”
• “Trust
  in haste, Regret at leisure”
• “Don’t
  suspect a friend, report him”
• “Who can
  you trust?”

This
is not so different from modern America. In case some American suspects
a friend of theirs, Bush will make it possible for you to report
him:

Operation
TIPS Trips Up?
August
8, 2002

(CBS)
In the aftermath of Sept. 11, President Bush laid groundwork for
“Operation TIPS," a program which would organize a volunteer
army of citizen lookouts to report “suspicious” activities to
the federal government.

Under
“Operation TIPS," transportation workers, utility crews and
letter carriers could sign up to snoop on members of their communities.
Attorney General Ashcroft argued such vigilance could thwart terrorists,
CBS News Correspondent Bob Orr reports.

“You
have the ability of people who have a regular perception, who
understand what’s out of order here, what’s different here, and
maybe something needs to be looked into,” Ashcroft said.

The
plot of Brazil is driven by a series of accounting errors
that are initiated when the Ministry of Information arrests and
tortures the wrong man. The arrest scene is a terrifying exhibition
of police state tactics: several black-garbed troopers simultaneously
burst through the walls and doors of the Buttle's apartment. They
are followed a paper-pushing official who reads the banal statement
of arrest to Mr. Buttle as he is about to be dragged off in a canvas
sack and tortured to death:

OFFICIAL:
I hereby inform you under powers entrusted to me under Section
47, Paragraph 7 of Council Order Number 438476, that Mr Buttle,
Archibald, residing at 412 North Tower, Shangri La Towers, has
been invited to assist the Ministry of Information with certain
enquiries…

The
accounting problems stem from the wrongful arrest of Mr. Buttle
because they charge torture victims for the cost of their own torture.
These charges are necessary for efficiency, according to the Deputy
Minister.1

INTERVIEWER:
And the cost of it [i.e. the Ministry's campaign] all, Deputy
Minister? Seven percent of the gross national product…

HELPMANN:
I understand this concern on behalf of the taxpayers. People
want value for money. And that's why we always insist on the principle
of Information Retrieval Charges. It’s absolutely right and fair
that those found guilty should pay for their periods of detention
and the Information Retrieval Procedures used in their interrogation.

Later,
when the Sam is arrested for a long list of crimes and brought back
to Information Retrieval for processing, the Ministry even offers
him a consumer financing plan to that they provide to help torture
victims bear the cost:

OFFICIAL
C: Now, either you plead guilty to say, seven or eight of
these charges, which’ll bring the costs down to within your reach,
or you can borrow a sum to be negotiated, from us, at very competitive
rates.

OFFICIAL
D: We can offer you something at say, eleven and a half per
cent, over thirty years. But you will have to buy insurance to
qualify for his scheme.

This
type of plan brings to mind Paul Craig Roberts' critique of current
US judicial proceedings in which people are charged with a long
list of related offences for a single crime then encouraged to plea
bargain by pleading guilty to only one of them. Also, compare Sam's
travails to a trial balloon that was floated by the Bush administration:

Officials
consider tapping Iraqi oil to pay war costs
Some in Bush administration consider oil funds to be ‘spoils of
war’

WASHINGTON
– Bush administration officials are seriously considering
proposals that the United States tap Iraq’s oil to help pay the
cost of a military occupation, a move that likely would prove
highly inflammatory in an Arab world already suspicious of U.S.
motives.

In
another amazing parallel, the interior spaces of the rooms in Brazil
are overrun with ugly meandering heating ducts. And as US citizens
we are told to stock up on duct tape.

How
could a film produced fifteen years ago have foreseen these developments
in such remarkable detail? Perhaps because they are not new: they
are recurring patterns in the way that states use and manufacture
the threat of warfare in order to control their own citizens. State
power tends to grow during wars because citizens become more willing
to trade liberty for the security that states are willing to promise
them. But when a war ends, the pendulum swings back at least partially.
So why not manufacture a permanent state of war during which freedoms
can be indefinitely suspended? Gilliam was writing history as well
as foretelling the future. By creatively retelling the past as a
work of fiction about the future, he exposes the totalitarian impulse.

Note:

1. My own thoughts
   on this were augmented by points made in the
   FAQ, part 9.

Favorite
Brazil Sites

1. FAQ.
2. Script.
3. Buy the
   new DVD release featuring a documentary about the film and
   Gilliam's commentary.

May
28, 2003

Robert
Blumen (send him mail)
is an independent software consultant based in San Francisco.

In
this essay, I will concentrate on the film Brazil as a critique
of economic central planning. In a subsequent essay I will address
Gilliam's foresight in depicting a dystopian political system that
resembles today's domestic and international political developments.

Many
fictional representations of totalitarianism in science fiction
films have been created by script writers unaware of the Mises-Hayek
critique of socialism. Films often portray an economic system that
is a centrally planned economy wealthy far in excess of today's
world. Totalitarian powers in these films are depicted as technologically
advanced, omnipotent, omniscient and in total control of their populations.

Mises'
critique of socialism holds that only a market economy can produce
technological advancement, refuting the coexistence of totalitarianism
and economic efficiency often seen in film. I think that Gilliam
understands this problem. Brazil 's political world is oppressive,
and it exemplifies the tension between the totalitarian desire for
absolute power and the incompetence and lack of individual responsibility
inherent under such a regime, which makes the exercise of power
less effective than it otherwise might be.

In
Brazil, technological progress has gone into reverse, stupidity
has won out over innovation, shirking takes the place of productivity,
and the absurd is accepted as normal. There is a repeated visual
motif of overly complex technologies that perform simple tasks badly.
Many devices are broken, malfunctioning, or otherwise not user-friendly.
For example, data entry workers peer at tiny computer monitors through
huge magnifying glasses. A breakfast machine sprays coffee and produces
soggy toast. Alarms will not shut off. These are all clear examples
of bureaucratically imposed solutions that have not passed a market
test.

When
the internal security policy arrive to arrest terrorist suspect
Mr. Buttle — himself an innocent citizen wrongly fingered due to
a mechanical problem in a computer system — the Department of Works
who come in after them to clean up the mess have brought along the
wrong size repair kit to fix the hole in the floor that they drilled
to facilitate a surprise entrance.

JILL:
There must be some mistake … Mr. Buttle’s harmless…

BILL:
We don’t make mistakes.

So
saying, he drops the manhole cover, which is faced with same material
as the floor, over the hole in the floor. To his surprise it drops
neatly through the floor into the flat below.

CHARLIE:
Bloody typical, they’ve gone back to metric without telling
us.

A
mechanical problem that produced the mistaken identity brilliantly
ties together in a sinister closure the destinies of two otherwise
unrelated characters. This device was introduced in the script by
the anti-Communist playwright Tom Stoppard. Stoppard was one of
several writers who wrestled with the script before it reached its
final form.

At
one point, Sam Lowry (the protagonist), wakes up to find that the
heating and cooling system in his apartment is severely malfunctioning.
The call routing system that takes his call for help is also broken.
The agency that maintains the cooling system is aptly named "Central
Services."

Sam's
call is intercepted by the renegade plumber Harry Tuttle. Tuttle,
who is one of the two heroic characters in the film, had once worked
for Central Services, but resigned because he wanted to do home
repairs without the administrative burden. He pursues his career
outside of the law as a combination of Spiderman and heating engineer.
The seriousness of this choice is shown in an armed near-confrontation
between Tuttle and two Central Services engineers.

SAM:
Sorry. Wouldn’t it be easier just to work for Central Services?

TUTTLE:
Couldn’t stand the paperwork, couldn’t stand the paperwork.
Listen, this old system of yours could be on fire and I couldn’t
even turn on the kitchen tap without filling in a 27B/6…. Bloody
paperwork.

SAM:
Well I suppose one has to expect a certain amount.

TUTTLE:
Why? I came into this game for the action, for the excitement
– go anywhere, travel light, get in, get out, wherever there’s
trouble, a man alone. Now they’ve got the whole country sectioned
off and you can’t move without a form. I’m the last of a breed.

Tuttle
quickly locates and repairs the problem. Unfortunately, working
on home equipment without proper authorization by Central Services
is a crime, which has placed Tuttle on the Ministry of Information's
wanted list, which leads to the wrongful arrest of Mr. Buttle in
his place. Brazil is a world in which entrepreneurs are outlaws.
Doing good quality work on short notice to satisfy customers makes
you an enemy of the state.

Another
contrast between private enterprise and government bureaucracy is
shown in one of the funniest scenes in the film in which Sam uses
Central Services' own procedural rules against them to prevent them
from discovering the presence of Tuttle.

Another
recurring visual motif is the massive amount of paper that is delivered,
routed, stamped, sent through antiquarian pneumatic tubes, and otherwise
shuffled by the vast bureaucracies that pervade the film. Paperwork
records and tracks real events, and more importantly paperwork tracks
other pieces of paperwork, leading to an exponential growth in the
amount of paper that is generated.

An
example of the overgrowth of paper is shown when, after the wrongful
arrest of Mr. Buttle, a bureaucratic official arrives to do the
paperwork with Mrs. Buttle before he is hauled away:

OFFICIAL:
(tearing out sheet from pink book) That’s your receipt
for your husband. (taking blue book from her)

MRS.
BUTTLE: Thank you. And this is my receipt for your receipt.

Gilliam
has an astute eye for the subtleties of spiritual corruption that
occur under a police state. In the above scene, the sudden arrest
of her husband leaves Mrs. Buttle in a state of intense trauma,
near total panic. When presented with the paperwork to sign, Mrs.
Buttle emerges from her panic to become momentarily lucid while
signing the paperwork, and then lapses back into her state of trauma.
This moment reveals how the population of Brazil had become
so conditioned to signing receipts that it is like a basic metabolic
function.

The
large volume of paper that is moved through pipes and tunnels is
both a part of Gilliam's visual motif of overly complex technologies
that don't work, and serves as an elaborate system for the dispersion
and denial of responsibility by any one individual so characteristic
of governmental bureaucracies.

Gilliam
uses denial of responsibility as a key plot mechanism. After a random
mechanical error wrongly identifies Mr. Buttle as a terrorist, the
mistake must then be covered or the responsibility shifted to a
succession of ever more sinister governmental departments by those
responsible. The protagonist, Sam Lowry, is a low-level clerk in
one such entity. In this scene, Sam's boss Mr. Kurtzmann is constitutionally
unable to exercise the accountability to sign a form:

KURTZMAN:
How do I authorize a cheque?

SAM:
Here we are. Pink and blue receipts. All you’ve got to do
is sign these and the back of the cheque.

KURTZMAN
takes out his pen and tries to sign the papers but his hand is
giving him trouble.

KURTZMAN:
(exhausted after all the emotion) Oh God! I think I’ve
broken a bone. What a pathetic thing I am.

SAM:
(taking the pen from him) Here.

SAM
signs the cheque and receipts. A big CLOSE UP shows that he is
scribbling KURTZMAN's signature. SAM pockets the papers and the
pen.

SAM:
Right, I'll be on my way.

KURTZMAN:
You are good to me Sam.

The
theme of denial of responsibility is also reiterated by the visual
motif of the Executive Decision-Making Machine. It appears
several times in the film, once on the desk of arch-bureaucrat Harry
Lime and is also is given back and forth as a gift. It consists
of a weight that randomly falls off a sloping edge into either a
"yes" or a "no" box. The user, presumably an
executive, makes important decisions by random chance using this
device.

In
addition to denial of responsibility, Gilliam illustrates other
unproductive aspects of non-market bureaucracies. One is the principle
that the incompetent advance. Sam's co-worker at the Ministry of
Information Retrieval does not know how to use the computer on his
desk.

Gilliam
has the ability to make his political-economic points in a humorous
way. One of the funniest scenes shows how paper-shuffling departmental
drones have developed the skill of shirking to a high art, coordinating
their goofing off precisely to the opening and closing of the boss's
door in order to avoid discovery.

Gilliam
also conveys the decline of aesthetic life under bureaucracy. Massive
grotesque heating ducts span interior spaces. Gourmet cuisine consists
of small lumps of texturized food substances colored with food coloring.
Women are obsessed with plastic surgery that makes them uglier than
they were before. People live in hideously ugly concrete housing
projects (resembling government housing projects in modern Britain
and America) with names like "Green Pastures" and "Shangri-La."

In
this essay I have only touched on a few of the gems in this film.
It bears repeated watching to pick up actions of background characters
in many of the frames. In the family scene before Mr. Buttle is
arrested, for example, his children are playing with action toys
resembling the troopers who burst in to arrest him. Later, when
Sam arrives at the Buttle's apartment complex to deliver a refund
check to Mrs. Buttle, the children outside are playing at re-enacting
the arrest sequence.

Gilliam's
great gift in Brazil is his ability to take the darkness
of totalitarian central planning and illustrate it in a way that
is humorous and at the same time terrifying. It is my view that
Gilliam's film reveals him to be an astute economic commentator
whose work can only be fully understood as an expression of classical
liberal political values.

Favorite
Brazil Sites

1. FAQ.
2. Script.
3. Buy the
   new DVD release featuring a documentary about the film and
   Gilliam's commentary.

May
27, 2003

Robert
Blumen (send him mail)
is an independent software consultant based in San Francisco.

There
are three sectors of the economy that produce most fallacies: government,
the economics profession, and the media. By some estimates, economists'
rate of productivity in turning out fallacies has doubled in the
last five years, with government and the media close behind.

This
"productivity miracle" is believed to be due to growth
of economic illiteracy in universities, especially economics departments,
which has a "multiplier effect" on the media and government
as fallacies are created by university economics departments, and
then repeatedly propagated by government and the media.

Earlier
this year, the Chicago Tribune ran a four part series titled
"The Economics of Glut" which contained the following
fallacies:

• The economy
  is afflicted by a general overproduction crisis.
• An increase
  in the use of capital equipment causes unemployment.
• Cost-cutting
  by business firms risks sending the economy into deflationary
  spiral afflicting the entire economy.

Numerous
publications have repeatedly stated that

• Consumption
  drives the economy.
• Saving
  causes recessions.

The
production of economic fallacies was strong during the 90s. The
recently ended stock market boom produced a number of popular fallacies:

• Improvements
  in technology result in permanently higher rates of profit for
  business firms.
• A rise
  in stock prices "creates wealth".
• The central
  bank can effectively "manage" the economy, keeping
  it on a permanent growth path out of recession.
• An increase
  in the supply of money creates real wealth.

Economic
fallacies are not new. They have been a regular feature of the economy
dating back to the Depression Era. Austrian economists believe that
these fallacies are obsolete, most of them having been refuted long
ago by economists from Bastiat to Hazlitt. However, there is still
a strong demand for them by the public, which the media, government,
and even the economics profession steps forward to fill.

There
are differences, however, between the current period and the boom
years. During the boom, both supply and demand grew. In fact, demand
grew so rapidly that new, more roundabout production processes for
economic fallacies had to be developed in order to disseminate them
in the quantity and quality demanded by consumers. News media such
as CNBC and numerous financial sites were launched to compete with
established purveyors of economic fallacies such as the New York
Times and the Wall Street Journal.

What
is different now is that the supply of economic fallacies has continued
to expand while the economy searches for an elusive recovery. Demand
is not keeping pace, resulting in a glut of economic fallacies.

One
Austrian economist contacted by this publication commented on the
present trends: "Usually demand for economic fallacies increases
during a recession because there is an immense pressure on the government
to Just Do Something. This usually translates into Just
Do Something Really Stupid.

"The
public doesn't understand that it was the misguided policies of
the central bank that caused the recession in the first place, and
that the best thing they can do is to keep their hands off while
the distortions are worked off.

"Instead,
governments can be relied upon to choose policies that produce counter-productive
results, contrary to their intentions. And while they're at it,
they should reform the monetary system to 100% reserve gold backed."

Some
other recently sighted fallacies include:

• Recessions
  are caused by a deficit in aggregate demand.
• The government
  should do everything it can to encourage consumption at the
  expense of savings, including creating a housing bubble to encourage
  homeowners to fund additional consumption by taking on more
  debt.
• The government
  has the ability to inflate the economy back to prosperity.
• Cost cutting
  by business firms risks sending the economy into a deflationary
  spiral.

Fed
Governor Ben Bernanke, in a speech to professional economists, stated
that the Fed would do anything to fight deflation, including printing
unlimited quantities of money and monetizing any and all assets
within the economy.

The
Austrian Economist commented "Bernanke's remarks display a
high level of economic illiteracy. To start with, deflation is not
a dangerous self-feeding process that attacks the economy like a
disease. The type of deflation that they are trying to fight is
the consequence of a massive policy of inflation that has been pursued
since the late eighties and has created tremendous distortions in
the world economy."

With
economic fallacies continuing to be produced at a rapid rate in
the face of slack demand, inventories of unsold fallacies are reaching
an all-time high. Public consumption of fallacies is significantly
diminished. Many financial web sites have folded, and viewership
of CNBC is down.

Analysts
are predicting that this will result in heavy price cutting. Soon,
economic fallacies will be liquidated at bargain prices. "With
any luck, this will drive their price down to their intrinsic value,
which is zero," one said.

February
28, 2003

Robert
Blumen (send him mail)
is an independent software consultant based in San Francisco.