Well, it turns out my ultra-liberal, straight-ticket voting, French-guy marrying sister has a verifiable case of the pig flu. And guess who I had dinner with on Thursday night? You betcha, big sis.

There we have it: cause and effect.

Fortunately, my head case was short-lived. By the time my venison sausage and eggs were off the front burner on Saturday morning, I was back to my old self, almost knocking my O.J. off the table stomping my fist over a local political battle.

In Friday’s edition of notes, I quoted the following paragraph from Callum Robert’s book The Unnatural History of the Sea:

If any trawling ground be over-fished, the trawlers themselves will be the first persons to feel the evil effect of their own acts. Fish will become scarcer, and the produce of a day’s work will diminish until it is no longer remunerative. When this takes place (and it will take place long before the extinction of the fish) trawling in this locality will cease, and the fish will be undisturbed…

I used it to show that unregulated free markets often fail to self-police until it is too late.

More importantly, I promised to discuss how regulations are equal failures when it comes to the subject of protection from ignorant and greedy market forces.

I can list dozens of examples, but I will stick to the aquatic motif.

Recently, the federal government enacted an emergency ban on sea bass fishing here on the East Coast. From Cape Hatteras to all points north, the staple of the recreational fishing industry is off limits.

“Big whoop,” you say. “There’s other fish in the sea.”

That’s the problem. There are other fish in the sea, like tautog.

You see, NOAA tried to remedy the effect, not the cause.

The cause of the problem is there are too many greedy fishermen. But no government entity would ever want to anger somebody by telling them to put their $50k boat on blocks, so they simply close a specific fishery.

Meanwhile, the fleet, with its limitless supply of greed, moves a couple of miles and targets another species. Along the mid-Atlantic, the next species is tautog, a slow-growing habitat sensitive species.

Thanks to NOAA’s short-sightedness and must-act-now mentality, tautog are witnessing fishing pressure like never before. It is unsustainable, no matter how you measure it.

I have already given up hope on catching the species next year. Like I said on Friday, given the chance, fisherman will catch the very last of a species and then start asking, “now what?”

If you paid attention to last fall’s meltdown, you know much of the problem stemmed from the derivatives market.

The market for credit default swaps, mortgage-backed securities and a host of other credit-based derivatives went largely unregulated without notice until the weight of massive credit collapsed the shoulders of the market.

Now that hundreds of billions of dollars in wealth have disappeared, folks like Nancy Pelosi and Barney Frank want to regulate the market.

I say don’t bother wasting the ink.

The markets have already caught the last fish and will simply move onto something else. It always does.

Unless Congress bans all investing or the amounts we can stick in the market, bubbles are going to inflate and bubbles are going to pop.

The more the government tries to regulate the natural forces of the market, fear and greed, the bigger the bubbles will get and the harder they will fall.

Get used to it. It’s the way things work.

*** In Friday’s edition, I asked for comments on the notion of regulations. Wow. Ask and you shall receive!

Oddly enough, except for the guy that called me a commie (jokingly, of course), the response was quite bi-partisan. Overall, as was expected, the tone was overly anti-regulation.

By now, those of us that have paid any attention have learned regulations just won’t cut it. Now, if somebody would let Congress now.

Here’s a few of the most telling emails I received. Keep them coming.

“The problem is deeper than regulation as you know. Structurally it has been skewed and morphed into a large horse racing parlor where we place bets on the horses. Marx postulated that ‘man had become disassociated with his work’ and I believe the investors no longer invest, but  place bets on companies. They are no longer ‘investing in the company’. This was not what was intended when the word was ‘investing’.

“Another issue is the legal system we use has shifted from a ‘Constitutional’ based law to a ‘case’ based law. This helps make the system overly complex and contingent on the specific words and phrases used, and judges interpretation of this wording.

“Complexity leads to failure and we have ‘vested’ interests in keeping complex.  More regulation will not help.” –  Dave E.

“Get the wolves out of the sheep pen!

“Those who caused the meltdown should be fired or jailed, not running the institutions, agencies, and departments responsible for what we are facing for the next decade (or more). Legislators should not be permitted to legislate this problem away, they should be empowered only to assemble a committee of real experts to debate and recommend a course of action.

“Maybe in this way our representatives will be unable to do things like repeal Glass Steagall, enable Barney Frank to overextend loaning money to home buyers who can’t afford to pay rent, etc., etc.,etc.” — Bill S.

“The key to the dilemma is this.  Stop trying to find an ‘ism’ to subscribe to.  Life is a lot less crazy-making if a person isn’t trying to make sense of a situation by looking to ideologies such as liberalism or conservatism for explanation or guidance.” Kirk W.

“Unfettered free markets always devolve into feudalism. Excessive regulation always leads to collectivism. These are the two extremes in distribution of wealth. History has demonstrated that every society is on a watershed which tends to move slowly toward one or the other.” – Peter A.

More on the subject tomorrow. For now, keep the comments coming.

According to the latest S&P/Case-Shiller Home Price Index, U.S. home prices fell an annualized 18.6% in February, compared with February 2008 – and a 0.4% improvement on the 19% drop in January.

Some have speculated that this news means we’ve hit the bottom and the market will now begin to trend upwards again.

Not so fast. Those folks must either be eternal optimists or very shortsighted. A 0.4% improvement is one of those “you have to start somewhere” pieces of good news, not a reason to celebrate.

The truth is, average home prices are still down 30.7% from the mid-2006 peak and are running at levels last seen in Q3 2003. We’re still a very long way from a solid housing market. And given that the S&P/Case-Shiller index reports figures from the 20 largest U.S. cities, there’s no doubt that we need to see more than just one month’s worth of evidence before forming many conclusions here.

Here’s what we can say, though…

Three Housing Market Headwinds

If you’re wondering whether this housing news is the first sign of some long-awaited stability for the housing market, or just an anomaly, consider this…

While nine of 20 cities in the index showed a price improvement in February and at least provided a glimmer of hope, remember that a prolonged decline often means the market requires a longer period of consolidation before it breaks higher over the long-term. Moreover, the market is fighting a fierce, triple-pronged headwind…

• Unemployment: With U.S. companies continuing to lay off workers in a desperate cost-cutting bid, this is hardly the kind of fertile environment that will kickstart enough home sales to cut into the bloated excess supply, drive prices higher, and improve the market. Unemployed Americans won’t even be thinking about buying new houses, never mind the struggle they’d face to get a decent loan or mortgage rate. As the job market goes, so goes the housing market.
• Confidence: The current economic and real estate climate has eroded confidence among would-be homebuyers. According to the Conference Board, the number of people who said they plan to buy a home in the next six months sank to a 26-year low in March.
• Excess Supply Of Housing: With America in the grips of a recession, jumping into a beleaguered housing market is low on Americans’ priority list. Existing home sales dropped by 3% from February to March and the U.S. Census Bureau said this week that the number of vacant homes hit a record 19.1 million in the first quarter. Plus, mortgage defaults and foreclosure rates are rising.

So expect to see home prices drift along rather aimlessly for now, while the punch-drunk market drags itself back together.

The Housing Market’s Silver Lining

Now for the housing market’s silver lining…

• First, although the U.S. still has way more houses for sale than demand calls for, the inventory of new homes for sale is currently 311,000 (10.7 months of supply) – the lowest number since 2001.
• Second, with the average 30-year fixed mortgage rate still holding steady at around 4.8%, it represents an attractive entry point for buyers. However, with the Fed having spent many of its bullets to drive the rate down already, it might not dip much lower. If Ben Bernanke and his fellow bankers make this point, it could tempt would-be homebuyers into the market, for fear of missing out on lower rates if they don’t.
• And finally, there are some pockets of strength across the U.S. – in some of the hardest-hit areas, too. For example, Business Week reports that home sales on Florida’s Gulf Coast, Inland Empire in Los Angeles, and the Las Vegas area jumped around 80% in February, compared with February 2008.

Moreover, the number of available homes in California tumbled from 15.3 months worth a year ago to 6.5 months in February is a good sign in terms of clearing the market and driving up prices. However, this may be the result of speculators or first-time buyers, who don’t put a home on the market in return. The sell-then-buy equation remains very tricky and a lengthy process in many areas.

One measure that California has passed in order to boost its market is a $10,000 tax credit to anyone who buys a newly built home.

Finding The Light At The End Of America’s Long Real Estate Tunnel

As Robert Shiller, economics professor and co-creator of the Case-Shiller index, states, “The market is still doing badly. But there’s always light at the end of the tunnel.”

In other words, while depressed prices, record low mortgage rates, and government incentives worth $8,000 in tax credits for first-time buyers may spark some buying, the current recession, high unemployment, and tight lending conditions mean we’re probably still a long way from the end of that tunnel.

However, when recovery does eventually take hold, it may be perennially popular areas that have suffered the most during the bust – like California, Florida, and Nevada – that will lead the way higher.

Source: The U.S. Housing Market: Is it Time to Start Buying Real Estate?

Last week, I promised to answer this popular question:

“Hey JL, what about all that gold in the vaults of the IMF and Fort Knox? Aren’t you worried they might try to dump it on the market?”

But before we get to that, a quick correction. In Friday’s piece, Europocalypse, I made reference to Colonel Kurtz as a “deranged flyboy lost deep in the Congo.”

The film-buff contingent among you corrected me with relish. Kurtz was in Cambodia, not the Congo, at the height of the Vietnam War when the movie took place.

My apologies… in Joseph Conrad’s novella, Heart of Darkness, Kurtz is a rogue ivory trader lost in the Congo. (Conrad himself drew on personal experiences as the captain of a Congo steamer in writing Heart of Darkness.)

Clearly the book and movie are two distinct entities. In referring to “a flyboy lost deep in the Congo,” I accidentally conflated the two.

Given the glee that some of your e-mails displayed, I’m tempted to hide future Easter eggs in my pop-culture references.

Anyhow, moving on…

A Golden Sword of Damocles?

It’s true – the United States and the IMF (International Monetary Fund) have a lot of gold in reserve. Some of you fear a good chunk of that gold could be dumped on the market, acting as a sharp break to the yellow metal’s rise.

Let’s start by asking the question, just how much gold do these guys have?

The World Gold Council regularly updates the stats on official holdings of central bank reserves. According to December 2008 data from the WGC, the U.S. holds 8,133.5 tonnes (metric tons) of gold. The IMF holds 3,217.3 tonnes.

When you do the math, that adds up to 11,350.8 metric tons (tonnes), or 12,512 short tons, of gold. Converted to ounces at $1,000 per ounce, that’s a touch over $400 billion bucks worth of bullion.

Does this count as a lot? Yes and no.

On one hand, it represents 8-10% (very roughly) of all the gold in the world. On the other hand, there are a heck of a lot more dollars in the world… and demand is the key driver to consider here.

Big Buyers in the Wings

Take Russia, for example. Russia has recently stated its intent to raise total gold holdings to 10% of total reserves.

Again according to the World Gold Council, Russia held 495.9 tonnes of gold as of December ‘08, accounting for just 2.2% of reserves.

We can do the math and see that, for Russia to hit its stated target of raising gold holdings to 10% of reserves (assuming total reserve values don’t change), they would need to purchase 1,758 tonnes of gold in the open market.

By stating a desire to up their gold holdings to 10% of reserves, Russia has all but said “Yeah, we wouldn’t mind owning another 1,750 tonnes of gold or so.” And that’s just Russia.

When you think about it, 10% is a pretty modest allocation. You think China wouldn’t like to have more of its dollar mountain converted to gold?

What central bank wouldn’t want to have 10% of its assets (or more) in bullion at a time like this, with paper currencies getting debased like crazy and creeping geopolitical tensions around the globe?

Below is a table showing a cross section of central banks with sizable gold holdings and low percentages of total reserves.

You can see from the table how many tonnes (metric tons) each of these banks would have to buy in order to get their total allocation up to 10%.

Remember, the U.S. and the IMF hold roughly 11,351 metric tons of gold.

If just these 10 central banks elected to raise their reserve allocations to 10%, they could hoover up all that U.S. and IMF gold by themselves (and still be hungry for more). And believe me, there are plenty more than these 10 with the same thoughts… not to mention institutional demand, don’t even get me started on that.

This doesn’t paint anything close to the total picture, of course. But it should help give you a better grasp of supply and demand. Right now, demand for gold is high and rising… and there just isn’t that much of it left to go round in the world.

“We Hate You Guys”

Part of the reason many of these banks haven’t upped their total gold holdings, by the way, is because it’s hard for them to buy gold without running the price up. You’re just not seeing that much supply on the open market relative to total demand.

This is why some central bankers despair that they have nowhere to go but into U.S. dollars and U.S. Treasury bonds. The amount of available gold on the market is so small, relative to the amounts that would be desirable for them to own, that trying to get the reserve percentages up is a very tough task.

That is why Luo Ping, director-general of the China Banking Regulatory Commission, had this to say a few weeks ago:

Except for US Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option… We hate you guys. Once you start issuing $1 trillion-$2 trillion… we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.

If gold suddenly became easier to buy in the open market, bankers like Luo Ping would quickly change their tune.

“Oh, you want to sell gold in size? That’s wonderful, because we want to BUY in size… something, anything that will hold its long-term store of value better than these stupid treasury bonds! Thank you, Thank you!”

Remembering Gordon “Goldfinger” Brown

The world’s bankers, too, will no doubt remember the lesson of Gordon “Goldfinger” Brown.

Gordon Brown, now prime minister of the U.K., was treasury minister back in May 1999. In that capacity, Mr. Brown decided to dump half of Britain’s gold reserves at 20-year lows, as the Sunday Times reports:

GATHERED around a table in one of the Bank of England’s grand meeting rooms, the select group of Britain’s top gold traders could not believe what they were being told.

Gordon Brown had decided to sell off more than half of the country’s centuries-old gold reserves and the chancellor was intending to announce his plan later that day.

It was May 1999 and the gold price had stagnated for much of the decade. The traders present — including senior executives from at least two big investment banks — warned that Brown, who was not at the meeting, could barely have chosen a worse moment.

…”The timing of the decision was ludicrous. We told them you are going to push the gold price down before you sell,” said Peter Fava, then head of precious metal dealing at HSBC who was present at the meeting. “We thought it was a disastrous decision; we couldn’t understand it. We brought up a lot of potential problems at the meeting.”

…The decision to sell 400 tons of gold is seen in City circles as a financial bungle on the scale of the Tories’ “Black Wednesday” that cost the taxpayer £3.3 billion, according to Treasury estimates.

Dominic Hall, a former gold dealer who now runs thebulliondesk.com, a website for the gold market, said: “Brown was keen to throw mud at the opposition over Black Wednesday but this was a financial disaster on a similar scale.”

Dumping 400 metric tons of gold over the side at prices well below $300 per ounce was an epically dumb decision – something that is all too clear today. At present-day prices, that is much more than the Tories’ debacle of 3.3 billion pounds sterling lost… it is more on the order of ten billion pounds sterling lost.

So it is doubtful that many bankers today will want to emulate the stupidity of Gordon “Goldfinger” Brown, especially with the public so aware of what’s happening in the world. To sell gold now and trade it for what – Dollars? Euros, are you kidding me? – would serve as open invitation to be publicly tarred and feathered.

Bluffing Into the Nuts

We’ll close with a quick poker analogy.

In No Limit Texas Hold ‘Em, to hold “the nuts” means you can’t be beaten – that your hole cards in combination with the board give you the best possible hand.

Needless to say, it is useless to bluff a player who is holding the nuts. Why would they fold? They know they have the best hand. If you raise such a player, they will happily call… or better yet shove their own stack in the middle, a reraise to put you all-in.

If the Fed or the IMF were to dump gold onto the market in this environment, I believe it would be the poker equivalent of bluffing into the nuts. I don’t think the powers that be are that dumb.

But even if they were, what would happen? If they tried to increase the gold supply discreetly, the central banks and institutional holders who are quietly accumulating bullion would simply pick up the pace a little.

If they tried to talk down gold in the open market, blathering about how they planned to sell a huge chunk, gold might take a sizable short-term hit… but then it would bounce back, and then what they do?

Source: Why the IMF and Fort Knox Won’t Put the Hurt on Gold

Humor me. Let’s crunch those numbers.

Those gold certificates have a book value of about US$14 billion, if you include special drawing rights and coin holdings ($1.7 billion). Even if you revalued this inventory, it would still total less than $300 billion, or 12% ofthe Fed’s total assets. So far, that’s a weak defense against our allegations. And it only goes downhill from there. Assuming it still got the goods at all, a lot has changed in just three months. In August, this gold had a market value that represented over 30% of the Fed’s assets.

Back then, additionally, U.S. Treasury securities still made up half the Federal Reserve’s asset base.

Today, however, in a very short space of time, the market value of both of these assets together comprises just 30% of the central bank’s total assets. It is fruitless to discuss what makes up the rest of its “portfolio,” because whatever it is, it is of lesser quality — aka higher risk.

His proposal was interesting, however, for other reasons. In case you missed its inference, the idea of a revaluation in gold reserves on the Fed’s balance sheet is to boost confidence. It is but a keyboard stroke away, a technical matter. Most analysts already take gold’s market value into account anyway.

Still, two outcomes of such a revaluation occurred to me over and above the obvious, I think.

The first: It would align the Fed’s interests with gold prices — by increasing gold prices, it would boost the value of its balance sheet, for instance.

Second, it would inflate gold’s perceived importance — an endorsement of sorts, in the eyes of the Fed. The public and the market would have to reassess their fundamental outlook about the importance of gold, too.

On the surface, Gramley’s proposal aims at making the Fed look like some kind of gold standard bank. But in fact, this kind of thing, especially if it were spun out in reaction to a crisis of confidence, might be so bullish for gold that it sinks the Fed.

If Bernanke were smart, he would want that gold to disappear off the balance sheet without notice.

But let’s forget about what would be bullish for gold and point out what in fact is the fear of deflation.

The Great Reinflation Update

In December, the Fed shoveled another couple hundred billion new Washingtons into the banking system, out of its many open windows. B-r-r-r!

Its balance sheet expanded to over $2.3 trillion as of last week’s report, which came out the day after it decided to cut rates to nothing. My guess is that we’ve seen nothing yet. You thought “cheap money” was bad. This is the era of FREE money. This stuff grows on trees. You don’t even need choppers. Already, despite the intensity of the deflation rhetoric, the money supply numbers continue to point the other way — toward the Great Reinflation. Or should we say “because” of the intensity of the deflation rhetoric!

This week’s money supply numbers suggest the alleged credit freeze continues to thaw.

After stagnating with little or no growth, stuck at under $1.4 trillion over the past four years (since the Fed began hiking rates in 2004), even as the Federal Reserve started cutting rates in 2007 again, U.S. M1 has grown by over $130 billion, or 10%, since August alone. That’s when it stopped sterilizing its “liquidity” injections. But this kind of growth in three months is a record. Percentage-wise, too.

Most of that growth, moreover, is occurring in checkable (demand) deposits. U.S. M2 is growing at almost $100 billion per month, and it is approaching a 9% year-over-year growth rate — its strongest growth since early 2002, midway through the Fed’s last reinflation effort (2001-03).

Most of that growth is occurring in money market fund holdings.

The definitions of money supply that I put stock in suggest that the banking system is inflating deposits at roughly5% year over year, but of special significance is that this growth rate is picking up now.

It certainly is not as robust as the narrow measures of money or the Fed’s balance sheet.

But it is not deflation.

I promise to keep looking for it, nevertheless.

Source: The Great Reinflation

This from Taipan Publishing Group:

The world is clearly afraid that “Great Depression 2.0” could be at hand. Downturns come and go, but the global economy as a whole hasn’t contracted since the 1930s. Some think it could happen again next year.

We hear less about it in the news, but there is another fear that keeps investors up at night – the off chance that America turns into Japan.

The Nikkei index has made a truly awful round-trip. It’s as if Japanese equities had been transported in a time machine all the way back to 1983.

If U.S. equities were to take a similar trip, we would have to see the Dow fall below 800 – more than a 90% drop from today’s depressed levels.

But there are some powerful arguments as to why this won’t happen. In fact, if things go deeply wrong in 2009, America is more likely to look like Zimbabwe than Japan.

A Vivid Example

For one thing, the powers that be have Japan’s example staring them in the face. In hindsight, we can clearly see many of the things we don’t want to do.

Some of Japan’s key errors leading to the “lost decade” – now lost quarter century – were these:

• Propping up “zombie” companies that should have been allowed to fail.
• Being forever guilty of “too little, too late” in regard to aggressive monetary policy.
• Dropping the hammer too quickly whenever signs of inflation appeared.
• Tolerating the Keiretsu system in which entrenched managements locked arms to block change.

Of those four mistakes, the United States is most in danger of emulating the first.

When government gets into the business of picking winners and losers (or propping up the losers), the invisible hand of markets is stymied. The market relies on an ongoing process of “creative destruction” to channel capital to areas where it is most needed – and to drain it away from areas where it is not.

When we get in the way of that flow, our meddling tends to gum things up. As U.S. policies become ever more hands-on, this danger increases.

Fortunately the long-term risk is lower in this area because the creative destruction tides are stronger. America’s entrepreneurial culture stands in sharp contrast to the old Japanese motto, “the nail that sticks up gets hammered.”

Going for the Gusto

Washington will be sorely tempted to meddle in many unhelpful ways. One mistake the Obama administration will not make, however, is that of “too little, too late” on the stimulus side.

Larry Summers, one of the key members of the Obama “brain trust,” has clearly stated his view that, in times of crisis, doing too little carries far more danger than doing too much.

It’s like trying to put out a house fire in some respects. If you use too much water, that’s okay – the house might be waterlogged but it will still be saved. Don’t use enough water, however, and the house is in real danger of burning to the ground.

This is why the Obama administration is planning a $700 billion stimulus package for starters, and will have no fear of spending more if the situation calls for it. Britain is thinking along similar lines. No government wants to copy the Japan experience – the risk is too great. In the name of the greater good, fiscal propriety is thus being thrown out the window.

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Quantitative Easing

Ben Bernanke is a big fan of going for the gusto too. The Fed is now embarking on an aggressive campaign of “quantitative easing,” much like Japan did earlier on – but with some important differences.

Stephen Jen and Spyros Andreopoulos of Morgan Stanley point out that, for the U.S. Federal Reserve, “quantitative easing” means three broad strokes:

• Telegraphing to markets that interest rates will stay low for a very long time.
• Drastically expanding the Federal Reserve balance sheet – to wit, printing money. (When the Fed buys assets for its balance sheet, the banks that sell those assets get new dollars that circulate into the system.)
• Buying large quantities of U.S. Treasuries outright.

The first two elements are already underway. The third has been all but promised by Ben Bernanke. Part of the reason treasury yields dropped to record lows – and prices soared to record highs – is because Bernanke has openly stated that the Fed may buy treasuries outright, targeting long-term as well as short-term interest rates.

Use It or Lose It

You can think of the Fed’s quantitative easing as a form of friendly blackmail to force savers out of cash and treasuries and back into productive lending and investing activities.

For banks, consumers and businesses alike, the strong temptation is just to hunker down amidst all this turmoil. Safe government bonds and money in the mattress – i.e. three-month Treasury bills and other cash equivalents – are the way to do that.

But if everyone hunkers down, the economy stays in the tank.

So the Fed in effect says, “We are going to penalize all you hunker-downers for holding onto T-bonds and cash. If you keep your money in dollars, you’re going to get burned as we flood the system with dollars. If you try to buy bonds, we’ll be in there buying too… pushing bond prices ridiculously high and long-term yields ridiculously low.”

It’s basically a question of “use it or lose it.” As we have stated before in these pages, inflation is a form of hidden tax. Through aggressive pursuit of inflationary monetary policies, the Fed seeks to tax the daylights out of dead money in order to get things moving again.

Someone’s Gonna Spend It

The main reason America won’t look like Japan is because we know the stakes now. The Fed, the Treasury and the incoming Obama administration are all focused on the dangers of doing too little, rather than doing too much.

So they will do whatever it takes in that respect – with little to no regard for the inflationary forces that are stirred up. That’s the legacy of Japan’s historic tendency to slam on the brakes at any small sign of inflation. We’ve learned to lay off the brakes and hit the gas instead.

And if you and I don’t get out there and lend and spend, the government will. All the panicked investors buying Treasury bonds hand over fist may have safety on their minds first and foremost, but what they forget is that they are lending to Uncle Sam. And Uncle Sam is not afraid to run wild.

We have already seen the Fed and Treasury “leverage up” to the tune of trillions. If 2009 is as rough as some forecasters fear, then the government’s leveraging up has only just begun. To keep socking away money in cash and treasuries will only encourage the torrent of spending to pour forth.

To sum up, we won’t walk down Japan’s road because we have seen that road, we know where it leads, and we will avoid it by any means necessary. And I do mean any. While Japan embarked on its own path of “quantitative easing,” the measures taken were timid, uncreative and downright puny in comparison to what the U.S. government is prepared to do.

If we err, it will not be on the side of caution. It will be on the side of breathtaking aggression. That’s the monetary policy lesson learned. If nothing else, the implications of this are surprisingly positive for equities.

The Endorsement From Hell

The frightening aspect of all this is what we haven’t learned – and the risks we are taking with our no-holds-barred, win-at-all-costs mindset.

As Marc Faber and others have pointed out, the USA and UK monetary authorities received the endorsement from hell earlier this year – a thumbs up from the Reserve Bank of Zimbabwe.

On Page 9 of the RBZ’s “First Quarter Monetary Policy Statement,” Dr. G. Gono, Governor of the Reserve Bank of Zimbabwe, gives the following praise (bold emphasis his):

Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their National interests.

That is precisely the path that we began over 4 years ago in pursuit of our own national interest and we have not wavered on that critical path despite the untold misunderstanding, vilification and demonization we have endured from across the political divide.

As of July 2008 (the latest month for which figures have been calculated), Zimbabwe’s inflation rate hit 231,000,000%. You read that right: two hundred and thirty-one million percent.

Hard assets anyone?

Source: Why America Won’t Look Like Japan

This from Money Morning:

If you were counting on gold to boost your returns this year, chances are you’ve been cruelly disappointed. In fact, when it comes to gold-related investments, virtually every category is down, making this one of the worst years in history for gold investors.

So, why is it that the largest of the large futures traders have some of the lowest net short positions in years? And what does this tell us about gold prices in the near future?

I’ll get to that in a minute. But first …

What Went Wrong?

In my analysis, I’ve identified the three missteps most investors made. First, investors did what they’d been told to do. But in their panic, they flocked to gold on the assumption that the yellow metal would perform as advertised. They forgot the “safety first” strategy that we’ve emphasized this year – one that included a safer, more-conservative way of buying gold.

Strike one.

Adding insult to injury, very few investors (Money Morning readers aside) failed to understand that the massive “de-leveraging” process that’s been part and parcel of the global financial crisis would put downward pressure on virtually every asset class at the same time. And that includes gold. As we’ve seen in the last few months, during times of global panic, investors around the world want the safety of U.S. dollars – and a lot of them – even more than they want gold right now.

Strike two.

But, above all else, most investors failed to realize that gold, just like any other asset, produces the best returns when it is attractively priced. So most investors made the classic mistake of piling in on the basis of performance. In other words, they bought in at the top.
Strike three.

What’s Changed?

During times of crisis, investors have been taught to latch onto those asset classes with the highest relative stability – including gold and precious metals. More often than not, investors who have followed these time-proven practices have been handsomely rewarded for doing so.

This time around, however, the parameters have changed, as the increased use of such “derivative” securities as “credit default swaps” has exacerbated the fallout from the global financial crisis, and touched off the aforementioned de-leveraging process. As asset markets have melted down, hedge funds, financial institutions worldwide, and even government-controlled sovereign wealth funds have taken heavy losses, forcing them to deal with unprecedented margin calls and redemption requests. Because this has never before been part of their crisis-management process, institutional investors have engaged in a massive, concerted effort to sell anything that’s at all liquid – including gold.

Making matters worse, the so-called “carry trade” unwound with a vengeance, forcing offshore investors to buy U.S. dollars in order to offset the sell-off of dollar-denominated assets. In contrast to what you’re hearing on the news, this really is not a sign that the dollar is any stronger than other currencies. Instead it signifies that the greenback is still the global currency of choice – much to the chagrin of Russia, Venezuela and others who begrudgingly tie themselves to it.

It also highlights something that most investors forget, or perhaps never knew in the first place. For better or worse, the dollar is the most liquid of the world’s reserve currencies. Part of that’s because many assets – especially oil – are still predominately traded in dollars.

The problem is that the dollar’s healthy appearance may be just that – an appearance that covers up an inner ill health. These still-hidden maladies have been worsened by the recent machinations of “Bailout Ben” – U.S. Federal Reserve Chairman Ben S. Bernanke – and U.S. Treasury Secretary Henry M. “Hank” Paulson Jr., whose fix-it programs have created a financial Frankenstein that will chase American taxpayers for years.

When the dollar was rallying back in May, and many experts were lauding the move as a turnaround in the making for the long-languishing U.S. currency, we warned investors not to be taken in by the market’s head fake. There were just too many underlying problems for the dollar’s rally to be sustainable. Ultimately, that rally sputtered, and the dollar reversed course and continued its decline.

This time, we again suspect that the dollar is rising too far too fast and that the spike we’ve seen in recent months may be nothing more than a flameout in the making.

However, given the relationship between the greenback and the yellow metal, this leads us to believe that gold could move higher next year if investors lose faith that the dollar merits their nearly exclusive attention right now.

Two pieces of closely related information appear to support this theory:

First, even though gold prices have tanked – a reality that under ordinary circumstances would mean more supply is available – dealers of gold bullion have experienced widespread physical shortages during the third quarter, according to the World Gold Council, a top trade association for the gold-mining industry. That, in turn, led dealers to both charge more and pay more than the spot price would indicate. Particularly strong demand was noted in China, India and the Middle East.

According to a Nov. 19 press release, the World Gold Council also noted that identifiable investment demand for gold in the third quarter was up $10.7 billion to 382 tons – double the levels of a year ago. At the same time, retail investment demand rose 121% to 232 tons, with especially for gold bars and gold coins reported in the Swiss, German and U.S. markets.

At the same time, the SPDR Gold Trust (NYSE:GLD) – the largest exchange-traded fund (ETF) that invests in the yellow metal – noted that it now holds 755.06 tons of gold in trust, up 6.12 tons from the prior week. This is significant because authorized market participants like GLD have to add metal and increase their trading float when buying pressure is higher than selling pressure. This suggests that gold may be reaching the end of its downside run and that it may behave more like investors expect it to in the months ahead.

Second, we find it especially interesting that the largest of the commercial futures traders now hold the smallest net short positions they have held in several years. According to the U.S. Commodities Futures Trading Commission (CFTC), large commercial traders combined net short positions reflect only 71,116 contracts net short, one of the lowest net short positions the CFTC has reported since January 2006.

Historically, low net short positions have proven to be bullish influences. And net short levels of less than 30% total open interest have proven to be especially bullish.

The wild card here, of course, is that the markets are working through a de-leveraging process that’s far from over, meaning that normal supply and demand relationships are out of whack. Longer-term, however, everything we know about those relationships still appears to be intact.

That’s why we suggest that investors make gold a part of their investment program – if for no other reason than we are approaching levels typically associated with higher, rather than lower, returns.

But we can’t just pile in.

Short-term market conditions will transform anything other than a measured approach into a hazardous foray.

That’s why, when it comes to gold, we’ve repeatedly recited the market mantra: “Gold works over time, but not all the time.”

Source: Don’t Give Up on Gold

This from The Rude Awakening:

Citigroup did not go bankrupt yesterday, therefore the Dow Jones Industrial Average soared nearly 400 points. If Citigroup does not go bankrupt tomorrow, there’s no telling how high the Dow might go.

Joy and jubilation returned to Wall Street yesterday because the federal government tossed a $326 billion lifeline to Citigroup – $306 billion worth of loan guarantees and $20 billion of actual cash. Unfortunately, Dow points aren’t as cheap as they used to be. Remember last March, when the Treasury handed a $30 billion check to J.P. Morgan to finance the Bear Stearns takeover? The Dow rallied 187 points on the news – or about one point per $160 million of bailout money.

By comparison, each one of yesterday’s Dow points cost $823 million. Alas, a law of diminishing returns seems to be taking hold. So even if we believed that the Treasury could buy a new bull market, the results would not come cheap. At $823 million per point, the price of sending the Dow to a new record high would be a whopping $4.7 trillion.

Unfortunately, an opposite tendency pertains: the more the Treasury spends, the more the market tumbles. Would you believe that the federal government has ACTUALLY committed $7.7 trillion worth of bailouts, loans and guarantees since the credit crisis erupted last year? And would you believe that the Dow has tumbled more than 5,700 points since this bailout bonanza began?

So, let’s see, that about one Dow point LOST for every $1.3 billion of bailout monies.

In no small bit of irony, the Treasury unveiled its very first bailout facility, the $80 billion “Master Liquidity Enhancement Conduit” (MLEC) on October 15, 2007 – just one week after the Dow registered its all-time high. Although the much-ballyhooed MLEC never actually materialized, it launched a wacky, new era of subsidized corporate failure and governmental caprice. Each new bailout has arrived on the scene as a “necessary evil.” But now we’ve got so many of these little devils running around that all hell has broken loose.

It’s entirely possible, of course, that all these devilish bailout programs will transform the devastated financial markets into a heaven on earth… or at least a heaven on Wall Street.  But the early evidence is not very comforting.

According to a team of number-crunchers at Bloomberg News, “The U.S. government is prepared to provide more than $7.7 trillion on behalf of American taxpayers…This unprecedented pledge of funds includes $3.2 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s.”

The Bloomberg calculation includes a broad array of both direct and indirect bailout programs.  In addition to the Treasury’s $947 billion TARP program, for example, the Federal Reserve has pledged to protect $2.3 trillion worth of money market funds and the FDIC has promised to guarantee $1.4 trillion worth of bank deposits. Various other programs and “facilities” provide the other $3 trillion worth of loans or guarantees.

Where does all this money come from? No one can really say exactly.  But we know where it does NOT come from. It does not come from an enormous piggy bank that is sitting in some federal building in Washington, DC.  Nor does it come from a traditional bank account that holds traditional savings.  No, this money comes from that elaborate hall of smoke and mirrors known as the Federal Reserve.

This money comes from a monetary “system” that is not really a system at all; it is a work of performace art – an improvisation of a monetary system. The system utilizes an artful combination of promises, accumulated goodwill, foreign borrowings and government IOUs to validate trillions of dollars worth of a paper currency that America prints for itself. As long as this improvisation delights the dollar-holders of the world, all is well. But at some point, they might tire of the performance.

A few dollar-holders may be tiring of the performance already. On news of the Citigroup bailout, for example, the dollar slumped against both gold and the euro, while Treasury bonds also fell. One day does not make a trend, of course. But one year does. For more than a year, the U.S. government has been piling bailout liability upon bailout liability, while simultaneously forcing the Federal Reserve to bury the actual costs inside the complexity of its balance sheet and the opacity of its monetary machinations.

For now, the exact cost of socializing America’s recent financial sins remains a mystery. But even without the details, a couple of observations seem self-evident:

1. Nation’s do not usually purchase their prosperity, especially not with banknotes that they manufacture for themselves. Nations EARN their prosperity by the sweat of their brows.
2. The American government and its monetary authorities do not actually possess all the money they are spending, loaning and pledging in their various bailout programs. To the extent, therefore, that these bailout programs must deliver actual cash, the risk of inflation mounts. In other words, the money that does not really exist must come into existence somehow. And all of the possible sources of non-existent cash are inflationary.

Net-net, an inflationary cycle may return sooner than most folks currently imagine. To be sure, a sort of deflation now envelopes the globe. But if the current bailout bonanza continues, this deflationary episode may yield very suddenly to a new inflationary episode…in which case the bull market in commodities might resume on very short notice. Already, gold has rebounded more than $120 from its recent lows of $700 an ounce. And many other commodities are showing signs of life as well.

Source: Meal Ticket

“The air will be clean within the next one month and we can get a fairly good rebound starting from the middle of October until the spring of next year,” he said in a Bloomberg Television interview.

Faber also warns that AIG (NYSE:AIG) may be a “much bigger problem” than Lehman…

In June Faber said, “If I’m a bad businessman and I go out of business, who’s gong to help me? But Bear Stearns and the Wall Street elite, because they are tied into the Treasury and the Federal Reserve and they have lunch together, it’s a club and so forth, they’re bailed out. It’s a joke!”

“I think a lot of banks are already bankrupt … but they hide their rotten assets … in categories where you don’t really need to value them,” Faber said. “I think the financial sectors, by-and large, has much larger problems than is perceived by the investment community and the stock market to some extent is telling you that.”

Investors should go into gold as its price did not rise as fast as that of other commodities while the central bank keeps printing money, Faber said.

The Fed has been “misleading” investors on wanting a strong dollar, Faber said, as it kept lowering the interest rates. “When it comes to action, they show no concern about inflation.”

He also blamed the central bank for forcing investors to abandon safe deposits in banks for riskier strategies by keeping rates so low.

“The Federal Reserve is the greatest speculator—they force people to speculate,” he said.

“I think they should have stopped cutting rates at say 4 percent … you could stop cutting rates and pursue a tight monetary policy. You can take other measures, mop up liquidity,” Faber added.

There is no doubt in my mind that since the early 1970’s the global economic boom has been largely financed by an ever-expanding quantity of money and credit. Once gold was removed from the monetary system in 1971, central banks were free to create as much paper currencies as they wanted. This reckless monetary inflation and credit growth has caused the value of “money” to diminish significantly over the past three decades and created a gigantic boom in global asset prices. Each time an asset “bubble” has burst in the past 35 years, central banks have responded by reducing interest-rates, thereby encouraging even more credit growth, which has spawned further speculative manias down the road. This time around, in the aftermath of the Anglo-Saxon housing bust, Mr. Bernanke and his comrades are desperately trying to do the same and the trillion dollar question is whether they will succeed.

In the current circumstances, I suspect it will be extremely difficult for the central banks to further expand credit growth, thereby inflating their way out of trouble. Below I present the reasons why I am doubtful about the continuation of the credit bubble:

First and foremost, in the current credit crisis, the entire banking system is being brought to its knees. This is very different to the previous crises when perhaps a handful of financial institutions or hedge funds got into trouble. Unfortunately, the financial alchemy (creation of structured products, over the counter derivatives, collateralized debt obligations, credit default swaps etc.) over the past few years has been so severe that the entire banking system is now on the verge of a total collapse. So, even if the central banks tried to further inflate the credit bubble by keeping interest-rates low for an extended period of time, I doubt if the commercial banks are in any position to expand their balance sheets. With billions of dollars of write-downs in the past year and humungous “Level 3″ liabilities still undisclosed, the commercial banks have no other option but to try and repair the damage to their balance sheets by tightening credit standards. So, I doubt very much if they (for the foreseeable future) will participate in the central banks’ sponsored credit and inflation agenda.

Secondly, I also happen to think that as a result of so many ridiculous tax-payer sponsored bail-outs of Wall Street banks, the U.S. government and regulators will tighten their grip over the ministry of inflation (the banking industry). Therefore, tighter regulation in the months ahead will also prevent the commercial banks from inflating the credit bubble further.

Another reason why I believe we have reached the inflection point in this credit cycle is the state of the U.S. dollar. With the U.S. dollar trading at record-lows against major world currencies and soaring energy and food costs, I doubt very much if the Federal Reserve is in a position to lower interest-rates further. In fact, I would argue that the situation is totally out of the Federal Reserve’s control and the entire global economy now depends on the mercy of the owners of U.S. Treasuries. I have to admit that so far, given the amount of bail-outs and the state of the U.S. dollar, holders of U.S. government bonds have been rather well behaved. However, it may only be a matter of time before foreign holders of U.S. Treasuries start liquidating their holdings. When that occurs, long-term interest-rates in the United States would rise rapidly and the Federal Reserve would have no other option but to raise its Fed Funds rate.

Finally, given the level of indebtedness of the U.S. consumer and falling asset prices, I wonder how the average American household would be able to take on even more debt. Once the technology bubble burst at the turn of the millennium and the Federal Reserve lowered interest-rates, Americans were quick to borrow and speculate in real-estate. However, this time around in the aftermath of the housing bust, even though the cost of borrowing has been reduced, Americans are not going deeper into debt. U.S. bank credit peaked earlier this year and is now in a decline. So, if American households are really tightening their belts and repaying their outstanding debt, there is no way the credit bubble would continue to inflate.

It is my observation that we have now entered a new era of credit contraction and deleveraging. The abrupt bursting of the credit bubble is likely to have a profound impact on asset prices in the West. If my view is correct, we are likely to see a period of poor economic growth and deflating asset prices in the developed world. The U.S. economy is clearly struggling, Europe faces its own problems and Japan cannot seem to turn things around. So, I would not advise you to invest your capital in stock markets or real-estate in the industrialized nations.

There can be no disputing the fact that U.S. financial assets have provided disappointing returns since the beginning of this decade. It is worth noting that even though the Dow Jones index is flat in nominal terms since 2000, it has lost more than half of its value against gold over the same period. At the turn of the millennium, the level of the Dow Jones could buy over 40 ounces of gold. Eight years later, the level of the Dow Jones can only buy roughly 12 ounces of gold! Clearly, gold has been a much better investment than U.S. stocks over the past eight years. In the years ahead, I expect to see further underperformance of financial assets and maintain my position that hard, tangible assets will continue to provide superior returns.

Regards,

Puru Saxena
for The Daily Reckoning

Source: End of an Era?

The US Labor Department said prices increased by 0.6% in May, a higher increase than forecast.

John Mauldin examines the causes of inflation in in Outside the Box…

President Nixon instated price controls on the 15^th of August, 1971. Inflation was a little over 4% at the time. Price controls manifestly did not work (resulting in shortages of all sorts and a deep recession) and were rescinded a few years later. President Ford went to Congress with programs to fight inflation that was running closer to 10% in October of 1974, with a speech entitled “Whip Inflation Now” (WIN). He famously urged Americans to wear “WIN” buttons. That policy too was less than effective, and the buttons, in a history replete with silly gestures by governments, should stand on anyone’s top ten list of such silly gestures.

Cynics more thoughtfully wore the buttons upside down and said the inverted letters (which looked like NIM) stood for “No Immediate Miracles.” They were right. There was no miracle, just eventual pain and lots of it. Ultimately, Paul Volker defeated inflation, but at the cost of two serious recessions and a lot of economic misery, with unemployment levels over 10% for nine months in 1983.

This week we were given the data that inflation as measured by the Consumer Price Index (CPI) over the last year was 4.2% and unemployment is now 5.5%. Some call for the Fed to raise rates so that we do not have to experience another lost decade like the ’70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that “core” inflation is what should be paid heed to, and urge caution.

This week we look at the cost of what could be a renewed effort to Whip Inflation Now, not just here but in countries worldwide. Will Trichet in Europe raise rates even as the European economy seems to be slowing down? If you think inflation is bad in the US and Europe, take a peek at Asia. And I ask, “What will Ben do?” It should make for an interesting letter.

Whip Inflation Now

Nixon and his advisors thought inflation at 4% was serious enough to institute price controls. Headline inflation in the US is now 4.2%. What kind of economic policy should we pursue to bring inflation back into the Fed’s comfort zone of 1-2%? Would it work and would it be worth the pain? To get a handle on the question, let’s go to the data from the Bureau of Labor Statistics and see where inflation is coming from.

And let me note, this is the same exercise we could do for a host of countries. The answer will be roughly the same: there are no easy solutions.

Core inflation, or inflation without food and energy, grew at 2.3%. Inflation without food costs was an even 4% and without energy was 2.7%. Clearly energy was the leading contributor to inflation in the past year.

But the recent trend in rising inflation is even more worrying. If you look at just the last three months of data and compute an annualized rate of inflation, you find that overall inflation has risen to 4.9%, energy inflation is running at a staggering 28%, and food costs have risen 6.2%. Meanwhile, core inflation during that period dropped to 1.8%. You can see all the data at http://www.bls.gov/news.release/cpi.nr0.htm.

Now, gentle reader, let’s think about these numbers. Food (over 14%) and energy (over 9%) combined make up roughly 24% of the CPI, yet were responsible for over 60% of the recent three-month trend in inflation. By the way, housing was up 4.9% and transportation up 8.7%, so it was not just food and energy.

What would it take to drop headline inflation back to under 2%? Well, one way would be for food and energy prices to fall. Let’s look at the possibilities.

As Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season. You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.

This growing season is not off to a good start. It looks like the yield on the corn crop will be lower than normal, and that is if we get very benign weather this fall. Given how late much of the US corn crop was planted, and how torrential rains in the corn belt have devastated crops (not to mention flooding cities, and our thoughts and prayers go out to those who have lost their homes to flooding), an early frost would be disastrous.

Because we have devoted so much of our arable land to corn (in a very misguided policy to turn food into ethanol), we have less for soybeans, which is putting upward price pressure on beans and other grains that are used to feed cattle, hogs, chickens, etc. In fact, it costs so much to feed livestock that ranchers are shrinking their herds.. This means more meat is coming into the system now, which is dampening prices. Increased supply will reduce prices in the short term, but next fall we will find that supplies of all types of meat will be short. That will potentially send meat prices soaring. Cereal and bakery products are up 10% over the last year. They could continue to rise in the fall if the corn crop does not yield more than currently projected. It will cost even more to feed your household and feed the animals we need for meat.

Food is the most basic of commodities. Demand is fairly consistent, and supplies may come under pressure. Looking for food inflation to drop back by the fall to 2% is not realistic in the current environment.

What about energy? There is some more hope there, at least on the oil front. High prices have reduced demand in the US, with gasoline usage down about 4%.

I think we have reached a tipping point. The psyche of the US consumer has been permanently scarred. Slowly, this country is going to replace its fleet of cars with smaller, more fuel-efficient cars. Over time, we will see demand continue to fall. We could see further drops in the demand for gas in the next few months.

Much of Asia used to subsidize oil prices to their consumers. That is changing, as Indonesia, Sri Lanka, and Taiwan have announced they are decreasing their subsidies, as the cost is simply too much. Malaysia now spends 25% of its budget on oil subsidies, and must raise prices or cut other services – or watch inflation get worse. India is now contemplating how to cut its subsidies. Even China is likely to start to raise costs after the Olympics. These countries are going to go through their own price shocks. All this will reduce world demand for oil.

Inflation rises in the UK will have a devastating effect, says Ben Traynor in Fleet Street Daily:

Once inflation starts to rise, consumers notice. How can we not – we all have to buy things. And – with the exception of the terminally unobservant – we notice when the prices of things we buy go up.

And when there’s an expectation that prices will rise, there’s a very great likelihood that they will rise. The main mechanism that drives this process is wage demands. Faced with a rising cost of living, people ask their employers for more money. If employers refuse, they’re left with an unhappy and truculent workforce. Not good for businesses.

But if employers concede, their profit margins are squeezed. In order to maintain profits, they pass the cost of their increased wage bill onto the consumer, in the form of higher prices. Voilà! We have inflation.

Then, the whole dance begins again. This is the classic wage-price spiral. It is through this mechanism that higher inflation tends to beget higher inflation. We’re seeing it right now – prices rising, and consumers factoring that into their expectations.

So what can the Bank do? Simple – slam the brakes on! Confound those expectations!

The bond market has priced in three rate rises over the rest of the year. Why not just do them all at once? Send a clear message that the Bank means business. We’ll see an immediate inflow of funds into sterling, and a stronger pound will make imported commodities like food and oil less expensive for us.

Of course, a steep rate rise will play havoc with the housing market. But last I looked, that was on the critical list anyway.

However you look at it, the economy’s in a bind. We’ve had some good years. Now we’re going to have some bad. Boom and bust never went away, whatever New Labour might have told us to the contrary.

Either we raise rates, and people (especially those with loans to repay, such a mortgages) feel poorer. Or we allow inflation to keep creeping up. Faced with ever rising prices, people will feel poorer.

Some of those who feel poorer will, depending on their line of work, ask for a pay rise. Of those, a significant number will be knocked back, or offered something they deem unsatisfactory. Today sees the start of the Shell tanker drivers’ strike – a four-day bid to secure a 12.5% pay rise.

But this won’t be the last strike we see this year. Things will get really interesting when public sector unions decide to take on Brown’s weak government…

Get ready for some dramas.