“Obviously, no. A gives something to B in exchange for something else and both get what they bargained for. No deficit is possible.”

“So how is it that when the farmer, or the migrant worker, or the Chinese shirt maker trade their goods and services for money, that suddenly the deficit problem pops up?”

“Because when individuals trade real goods, the exchange is complete. But when one half of an exchange is for money, the government enters the picture. Individuals create real goods and services with labor and capital, while governments create the money by “fiat” (i.e., by law), simply pushing computer keys and running printing presses. The newly created money, which cost next to zero to print, buys up real goods and services. And as the money percolates through the economy, it leaves a swath of destructive imbalances, including such things as inflation and trade deficits. Governments then step in with more laws and restrictions that purport to solve the economic problems that their fiat money policies spawned.”

“Money creation is a form of theft (and, as my friend Richard Maybury once said, theft is just a nice word for taxation), albeit so subtle that the public never seems to catch on. In a world where individuals and not governments were sovereign, the marketplace couldn’t have trade deficits or inflation, as the marketplace has feedback mechanisms to deal with anyone who creates irredeemable money. But when governments usurp the freedom of individuals by passing laws defining legal money as the money printed by the government, all manner of economic evils follow.”

“What can a sovereign individual do? Forget futile efforts to influence the politicians, and assume everything they do to ‘solve’ the trade deficit will reduce your freedoms even more. Go to the root of the problem, which is fiat money. Historically, gold and silver have been the free-market’s choice for trade, and the ultimate refuge from fiat monies. You can regain some sovereignty in the monetary arena by holding and dealing in real money whenever possible. Gold and silver, whether held as assets to defend against depreciating currencies, or as mechanisms for trade through free-market exchanges like GoldMoney.com, or LibertyDollar.org, are real money. Hold and use real, free-market money whenever you can.”

Source: Trade Deficit = Freedom Deficit

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 The Daily Reckoning:

Global financial markets are acting as though the world is about to implode. Over the past four months, the investment community has dumped all assets; regardless of their underlying economic fundamentals. We have seen unbelievable wealth destruction on a global scale and trillions of dollars have evaporated and returned to monetary heaven.

The rate of decline has been astonishing and in the past twelve months, the Dow Jones Industrial Average (Dow) has seen its worst one-year performance – ever! It is interesting to observe that the Dow’s recent plunge has been even worse than the 1929 decline which preceded the Great Depression of the 1930’s (Figure 1). So, are we really witnessing the end of the world as we know it?

Regardless of the Armageddon fears prevalent today, I would argue that this slump may turn out to be a fantastic buying opportunity for the patient, long-term investor.

Now, the mainstream media seems to be convinced that our planet is headed into a permanent global depression and investor-sentiment certainly reflects this thought process. The same cheerleaders who, only a few months ago, were gleefully shouting about the emergence of a new global economy are now forecasting eternal disaster. Furthermore, investors are liquidating all assets as images of their children living in shanty towns fill their fearful minds. ‘Demand destruction’ and ‘de-leveraging’ have replaced ‘liquidity’ and ‘global growth’ as the new buzz-words. Stocks are down significantly from the highs, corporate bonds have taken a beating and even commodities (including precious metals) have joined the bear parade. And those who naively bought structured products from private banks have seen total losses. So, where do we go from here?

The best way to begin is by reiterating that global markets are now extremely oversold and undervalued, hence attractive. This may sound counter-intuitive but it is vital to understand that a decline of 40% in US stocks (and even more in some countries) has set the stage for fantastic long-term gains. If my assessment proves to be correct, investors who buy the unimpaired sectors today should make a fortune over the coming decade.

Remember, the best time to buy is when everyone is despondently selling. As John Templeton (founder of Templeton Funds) often said, “bull-markets are born on pessimism, grow on scepticism, mature on optimism and due on euphoria”. And you can be sure that the investment community is feeling extremely pessimistic and fearful today.

At present, a lot of ‘gloom and doom’ and ‘deflation’ chatter is doing the rounds in the mainstream media. The recent selling panic is frequently being described at the worst crisis since the Great Depression. However, this hype does not imply that the economic outlook is similar to the 1930’s. One of the biggest reasons why the Great Depression occurred was due to the failure or inability of the money-supply to expand in line with the need for this money.

Furthermore, the failure of roughly 5,000 banks did not help the situation either as millions of Americans lost their savings! In the current situation, however, various central banks and governments are throwing trillions of dollars into the monetary system and all bank deposits have been guaranteed. And if need be, the authorities will print money until the world runs out of trees. So, in my view, a prolonged deflationary phase or a global depression is not likely to happen.

The recent sharp declines in the markets can be attributed to the fact that two separate negative events caught the public’s attention at roughly the same time – depth of the financial crisis and fears of a US recession. Now, as far as the first issue is concerned, it is my belief that the worst is behind us. For sure, we may hear of sporadic bank busts in the months ahead, but the recent government guarantees prevented a total collapse of the banking system. For the record, I do not agree with the recent bail-outs because they are immoral and are going to cause huge inflation in the future. However, we all have to deal with reality and for now, it seems that the credit markets are starting to function again.

Our research reveals that currently US$3.5 trillion is sitting on the sidelines, waiting to be invested. And when investors deploy this cash into the markets, it will flow towards sectors which have been unharmed in this financial crisis. Now, I do not know about you, but apart from natural resources (where supply and demand imbalances persist) and industrials (which may benefit from massive government-sponsored infrastructure projects), I cannot find any other sector which has strong fundamentals. Housing faces severe over-supply, autos are struggling, banks will suffer due to over-regulation and consumer discretionary stocks will also fare poorly as the over-stretched public in the West tightens its belts.

The one sector of the economy which remains in excellent condition is commodities. Demand is holding firm, supplies of key resources are still tight and the ongoing credit crisis will only delay many projects which were previously meant to come online. This will create additional supply shortages in the future, thereby leading to much higher prices.

As far as precious metals are concerned, it is worth remembering that our world’s financial system has been hijacked by money-printers. Whether it is the Federal Reserve, Bank of England or the European Central Bank – they are all creating money ‘out of thin air’ and inflating the supply of paper currencies.

As this rampant inflation continues, what is astonishing though is that so many investors are being hoodwinked into believing that our world faces a genuine deflationary bust. These days, opinion is divided as to whether we will witness continuing inflation or gut-wrenching deflation. In my view, this discussion is absurd and deflation (or a contraction in the supply of money) is out of the question.

Banks are in the business of lending money and debt creation is essential for their very survival and prosperity. So, you can be sure that the modern-day money lenders will find a new way to further expand the supply of money and debt.

Whilst paper currencies (cash) regained some purchasing power in the past few months due to forced liquidation in the asset markets, there is no chance that they will maintain their value over the medium to long-term. History is littered with numerous paper currencies which became totally worthless and I suspect many of the current ones will also disappear. In fact, a remarkable study confirms that only 23% of paper currencies ever issued have survived the test of time! The vast majority were destroyed due to hyperinflation and are no longer in circulation.

Accordingly, I would urge investors to sit tight with their positions in hard assets (precious metals, energy and agriculture) and add more capital at such depressed levels. Under the best-case scenario, global markets bottomed out over the past two months and even if they did not, at the very least, we should get a multi-month rally in commodities and related stocks.

Source: The End of the World…Or the Right Time to Buy?

This from Sovereign Society:

The time to start building fresh positions in oil, gold, silver and TIPs has arrived. Even distressed real estate should be accumulated if credit can be secured.

Over the next 6-12 months the United States, Europeans, Japanese and Chinese will eventually arrest deflation. And long before that materializes, hard assets will begin a major reversal following months of crippling losses.

Since peaking in July, the entire gamut of inflation assets has collapsed amid a growing threat of deflation or an environment of accelerated price declines. The last deflation in the United States occurred in the 1930s, purging household balance sheets, corporations, states, municipalities and even the government following two New Deals.

Thus far, U.S. CPI or the consumer price index has not turned negative year-over-year. Yet as oil prices continue to lose altitude and other commodities have been crushed, input costs and price pressures continue to decline dramatically since October. The only major component of CPI that continues to post modest year-over-year gains is wages. And with unemployment now rising aggressively this quarter it’s highly likely wage demands will also come to a screeching halt.

Plunging Bond Yields Discount Danger

In the span of just six months, foreign currencies (except the yen), commodities, stocks, non-Treasury debt, real estate and art have all declined sharply in value in the worst panic-related sell-off in decades. More than $10 trillion dollars’ worth of asset value has been lost worldwide in 2008.

What’s working since July? U.S. Treasury bonds and the U.S. dollar as investors scramble for safety and liquidity.

On December 5, 30-day and 60-day T-bills yielded just 0.01% – the lowest since the 1930s while the benchmark 10-year T-bond traded below 2.55% – its lowest yield since Eisenhower was president in 1955. Even 30-year bonds have surged as the yield recently dropped below 3% for the first time in more than four decades.

The market is now pricing a severe recession and – possibly – another Great Depression. Despite a series of formidable regular market interventions by central banks since August 2007, the credit crisis is still alive and kicking. The authorities have not won the battle …at least not yet.

Heightened inter-bank lending rates, soaring credit default swaps for sovereign government debt and plunging Treasury yields all confirm that the primary trend is still deflation.

To be sure, credit markets worldwide have improved markedly since the dark days of early October. Investment-grade corporate debt is rallying, commercial-paper is flowing again and companies are starting to issue debt once more – but only the highest and most liquid of companies. For the most part, banks are still hoarding cash and borrowers can’t obtain credit.

The real economy is now feeling the bite as consumption falls off a cliff, foreclosures soar and the unemployment rate surges higher. These primary trends are deflationary as broad consumption is severely curtailed, with consumers preparing for the worst economy since 1981 and rebuilding devastated household balance sheets.

But at some point over the next 12 months, the market might transition from outright deflation or negative consumer prices to some sort of disinflation or at least an environment of stable prices. That’s when inflation assets should start rallying again.

Inflate or Die: The Name of the Game in 2009

The battle now being waged by global central banks, including the Federal Reserve is an outright attack on deflation. Through the massive expansion of credit, the Fed and her overseas colleagues are on course to print money like there’s no tomorrow to finance bulging fiscal spending plans, bailouts, tax cuts and anything else that helps to alleviate economic stress.

Earlier in November, the Fed announced it would target “quantitative easing” and “monetization,” unorthodox monetary policy tools rarely or never used in the post-WW II era.

Without getting too technical, the term “quantitative easing” means the Fed will act as the buyer of last resort to monetize Treasury debt and other government agency paper in an attempt to bring interest rates down. Quantitative easing aims to flood the financial system with liquidity and absorb excess cash through monetization or purchasing of government securities.

Through monetary policy, the Fed controls short-term lending rates but cannot influence long-term rates that are largely set by the markets; the Fed now hopes it can influence long-term rates through quantitative easing. And since its announcement two weeks ago, long-term fixed mortgage rates have declined sharply.

These and other open market operations directed by the Fed and Treasury will eventually arrest the broad-based deflation engulfing asset prices. It will take time. Inflation is the desired goal and is the preferred evil to deflation, a monetary phenomenon that threatens to destroy or seriously compromise the financial system. Policy-makers have studied the Great Depression, including Fed Chairman Bernanke, and the consequences of failed central bank and government intervention in times of severe economic duress are unthinkable.

Ravenous Monetary Expansion

According to Federal Reserve Board data, the Fed is now embarking on a spectacular expansion of credit unseen in the history of modern financial markets.

The total amount of Federal Reserve bank credit has increased from $800 billion dollars to $2.2 trillion dollars (or from 6% to 15% of gross domestic product) as the central bank expands its various liquidity facilities in an attempt to preserve normal functioning of the financial system.

The Fed’s ongoing operations to arrest falling prices are targeted namely at housing – the epicenter of this financial crisis. It is highly unlikely that the United States economy will bottom until housing prices find a floor. Quantitative easing hopes to stabilize this market.

Buy Gold Now

Relative to other assets in 2008, gold prices have declined far less. The ongoing liquidity squeeze has forced investors to dump assets, including gold to raise dollars. I suspect this short-term phenomenon will end in 2009 once the ongoing panic subsides and credit markets become largely functional again.

Gold should be accumulated now ahead of market stabilization. As the financial system gradually comes back to life over the next several months or sooner, the dollar should commence another period of weakness; there will be little incentive to hold dollars with short-term rates at or close to zero percent. The Fed will be in no hurry to raise lending rates.

Still, the Japanese experience in the 1990s warns investors of the travails of long-term deflation.

The Japanese, unlike the United States, only started to seriously attack falling prices in the economy in 1998 through massive fiscal spending. In contrast, the U.S. is already throwing everything at the crisis after just 17 months.

I expect the United States to print its way out of misery and, over time, and conquer deflation. But the cost will be humungous and at the expense of the dollar, U.S. financial hegemony and calls for a new monetary system anchored by gold.

It’s literally “inflate or die” for global central banks. Inflation will win.

Source:  Inflation on “Sale” as Deflation Dominates Global Markets

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 Taipan Daily:

Today I want to talk about the concept of monetary velocity. (I know, I know… monetary what? You’ll see the importance by the time we’re done.)

Let’s start with some background. In Wednesday’s Taipan Daily we noted that short-term interest rates have fallen to multi-year lows. The flip side of falling interest rates is rising bond prices. When bond prices rise, interest rates fall and vice versa.

This means investors and traders have an impact on interest rates through their buying and selling decisions. When investors pile into bonds, for example, they push bond prices up – and interest rates down.

We can see this by looking at a chart of the 2 year treasury note, which went into lift-off mode in mid-2007 (right around the time the credit crisis began).

As you likely know, investors are piling into U.S. treasuries now (particularly short-dated ones) because they are scared out of their wits and don’t know where else to go.

And right now they are scared of deflation.

The Dreaded “D” Word

For the month of October, the Wall Street Journal reports the Consumer Price Index (CPI) saw its largest single-month decline since World War II.

This dramatic drop has the word “Deflation” on everyone’s lips.

It’s quite the switch, actually. As recently as this summer, everyone was worried about Inflation.

Now, according to some estimates, use of the word “inflation” in the popular press has dropped by nearly a third… and use of the D word, deflation, has more than tripled in the past two months.

This is a head scratcher, especially in light of what we’ve been hammering on this past week. How can the markets be worried about deflation when the Fed is printing money like there’s no tomorrow?

Better still, how is it even possible to see the specter of deflation on the horizon when trillions of dollars are being pumped into the system?

To answer those questions, let’s delve into the concept of “monetary velocity.”

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Run, Rabbit, Run

Everyone knows about the basic concepts of inflation and deflation. They are often described in terms of supply and demand: inflation is “too much money chasing too few goods,” deflation is “not enough cash to go around,” and so on.

But it’s important, too, to recognize that the inflation/deflation equation depends not just on the quantity of money in the system, but also how fast that money is moving through the system. This is where monetary velocity comes in.

It’s a slightly challenging concept to explain – the best analogy I’ve found is a bit goofy, but it works. So here we go…

Imagine you’re standing in front of a large tree trunk. There is a brightly colored marker on the trunk, and there are rabbits running in circles around the tree itself. Every time a rabbit passes the marker on the trunk, you note it down on your clipboard: one X per pass.

Now let’s say you tally up your results and note you made twenty X’s in the space of 60 seconds. Assuming you had your reasons, how could you double the number of X’s in the same amount of time?

There are two ways you could double the number of X’s on your clipboard (to forty per minute in this case). You could increase the number of rabbits running around the tree… or you could go with the same number of rabbits and try to make them run faster.

(Remember, you don’t care if it’s the same rabbit or a different rabbit when you jot down your X. You’re just counting the number of passes.)

As you might have guessed, the rabbits are analogous to money in the system. Money that’s just there is inert… In order to have an affect on the economy, the money has to move.

So when money is “hot” and the rabbits are running at top speed, fewer rabbits are needed to fill up the clipboard with X’s. The rabbits speed around the tree very quickly – analogous to high turnover, or money changing hands very quickly.

When money is “cold,” on the other hand, the rabbits are lethargic, and you need more money (i.e. more rabbits) to get a decent number of X’s on the clipboard. If money stops changing hands entirely – as it seemed to have for a brief span in late September and early October – it’s like the rabbits coming to a dead stop. They aren’t moving at all.

So when the Fed pumps the system full of money, it’s the equivalent of dumping more and more rabbits into the equation. As the Fed gets desperate, maybe they round up dozens or even hundreds of rabbits.

But if all the rabbits are half comatose, the clipboard stays blank (or fills up much too slowly). The Fed’s efforts fail to have the desired effect.

So the upshot is that the Fed can have a direct impact on the quantity of money in the system, but not the velocity of money in the system. It can’t make the rabbits run.

You’re a Rabbit, I’m a Rabbit

The “rabbits” can also be thought of as entities that buy and borrow and lend – banks and businesses and consumers (like you and me). When banks refuse to lend and consumers stop buying and borrowing, monetary velocity goes down – even as the dollars in the system pile up.

Over the years you may have heard comments like, “The Fed has absolute control over the money supply.” That is misinformation. The Fed has zero control in some very important areas. What’s more, they don’t even have the tools to properly measure many of these areas.

When we talk about the velocity of money, for example, we’re not just talking about visible dollars. We’re talking about abstract concepts like people’s willingness to borrow and lend. That kind of thing is impossible to measure on any kind of precise basis.

For example, if five million Americans wake up tomorrow with a sense the world is okay and an urge to go buy something, then that cheery mindset will positively impact the velocity of money in the system – even though you can’t put “optimistic mindset” on a balance sheet.

Conversely, if five million Americans wake up fearful for the future and determined not to borrow another dime if they can help it, that translates into a negative impact. Again, there’s no way to precisely gauge these moods. We can only make rough guesstimates.

So why do we have a grim outlook for deflation right now, even as the printing press money piles up? Because monetary velocity has crashed. Bank balance sheet woes and consumer debt overhang are such that the new attitude towards buying, borrowing and lending – creating turnover, moving cash through the system – is “Thanks, but no thanks.”

Simply put, the rabbits are tuckered out.

So Why Buy Gold?

Okay, some of you may be thinking now, so the dollars are piling up because the velocity of money has crashed. The Fed’s stimulus remains untapped, like an idle oil tanker filled with cash. But if that’s the case – and if deflation worries could worsen – then why buy gold?

It’s a good question. Most of the talking heads don’t bother thinking the answer all the way through. They stop at step one without progressing to steps two or three. “Gold’s no good in a deflationary environment,” they say. “Prices are going down and that’s that. So why would you want gold?”

Well, let’s see.

First recall that deflation is every central banker’s worst nightmare. (Particularly central bankers who spent the bulk of their academic lives studying the Great Depression.) That’s why Fed Chair Ben Bernanke gave a defining 2002 speech titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.”

If you’ll indulge this quick recap, here is the key paragraph from Bernanke’s deflation speech:

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost… We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

The underscore emphasis is mine. What Bernanke believes amounts to this: The printing press is an irresistible force. There is no deflation so immovable that the printing press cannot smash through it.

An irresistible force sounds most impressive. When we think back to the velocity problem, though – recall the lethargic rabbits – the printing press starts looking like the wrong cure for the wrong ailment.

This is because as far as money in the system goes, a velocity problem is different than a quantity problem. The printing press speaks to quantity, but on the question of velocity, it remains mute.

Going back to our tree trunk analogy: Bernanke could round up a thousand rabbits, he could round up ten thousand rabbits, or he could round up fifty thousand rabbits. If the rabbits don’t feel like running around the tree, quantity does nothing. If banks and consumers cannot be goaded into the old patterns of buy, spend, borrow and lend, then it just doesn’t matter how much the Fed pumps in.

Except for one thing: To say it “just doesn’t matter” is not wholly correct. The Fed’s stimulus-pump actions do matter in one particularly awful way. The more money a desperate Fed pumps into a non-responsive US economy, the closer we edge to systemic breakdown for the fiat currency system as a whole.

Breaking Down the Breakdown

My use of “breakdown” in this case refers to the point at which the world loses faith… the point at which investors realize in dawning horror that the world’s reserve currency is doomed.

The trouble lies in the fact that the Federal Reserve has staked its whole crisis-response plan on the power of the printing press. The Fed, in other words, has but one play in the playbook… the play outlined in Bernanke’s deflation speech.

If deflation’s grip is not broken soon, then Bernanke will double down on the printing press strategy… and then double down again. The Fed will pump and pump until the total pool of dollars in the system makes the United States look like a banana republic.

It is this scenario, by the way, that keeps Jerome Whitehead awake at night. Whitehead, now 86 years old, is a former chairman of Goldman Sachs.

“I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America,” Whitehead says. “Before I go to sleep at night, I wonder if tomorrow is the day Moody’s and S&P will announce a downgrade of U.S. government bonds… Eventually U.S. government bonds would no longer be the triple-A credit that they’ve always been.”

Mr. Whitehead is right to worry.

Wake Up and Smell the Bullion

Recall too, in case you’ve forgotten, that in times of crisis gold serves a proxy for cash. And in times of deflationary crisis, gold is the only form of cash not subject to the ravages of a printing press. (This might explain why there is a run on gold coins taking place. The U.S. Mint has been forced to ration them out.)

It may take a bit longer for Wall Street (and the world) to wake up and smell the bullion. But as to what happens in the medium to longer term, the distribution of outcomes is pretty cut and dry.

If deflation is vanquished and money starts to move again, interest rates will stay low for a good long stretch of time (so as not to cripple a convalescing economy). In this scenario inflation returns, much to the Fed’s relief, and gold resumes its upward climb.

If, instead, the Fed fails utterly, Bernanke will not go gentle into that good night. He will print his way into spectacular oblivion (as all but promised in his 2002 speech)… and Mr. Whitehead’s bad dream will be realized… and gold will respond accordingly.

Source: Run, Rabbit, Run! The Importance of Monetary Velocity

This from The Daily Reckoning Australia

Now to the big subject of the day: Inflation. You’d think evidence of even bigger deficits in the U.S. is clearly inflationary. But not everyone thinks so. The new prophet of doom, Dr. Nouriel Roubini, says at least four factors are setting up what he calls “Stag Deflation” (as opposed to the stagflation of the 1970s, where you had no growth and rising prices).

Roubini’s four forces of Stag Deflation are: a slack in goods markets, a “recoupling” of the rest of the world with the U.S. recession, a slack in labor markets, and a sharp fall in commodity prices. These factors would, “reduce inflationary forces and lead to deflationary forces in the global economy,” he writes in an article in Forbes.

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“Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets,” he writes. “There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.”

You’ll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he’s certainly right that there’s a big fall in aggregate demand in the U.S. It’s obviously passing through to manufacturers and commodity producers (China and Australia). But won’t monetary and fiscal policy designed to combat deflation…you know…cause inflation?

Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply “mop up” excess liquidity before it seeps into the real economy to cause inflationary damage.

And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that’s resistant to being “inflated away” by cranking up the printing presses. Is he right?

Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone’s expecting. And there are other landmines down the road.

In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending backstops it’s provided once the market returns to normal. But what if it doesn’t and the Fed can’t? What happens next?

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Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed’s needs. It won’t happen with an economy already contracting. Even if Obama raises taxes, it won’t be enough to meet the Fed’s immediate needs. That leaves borrowing and printing.

On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending backstops. The Fed was nearly broke.

Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG (NYSE:AIG). Some of it to Fannie (NYSE:FNM) and Freddie (NYSE:FRE). Some may go to Chrysler, Ford (NYSE:F), and GM (NYSE:GM). Who knows?

But the main point, from Roubini’s perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it’s not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn’t go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.

But if we’re right and the bond bubble began bursting in late October, well then the Treasury’s line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.

Trouble is, the U.S. can’t afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be “monetizing the debt.”

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That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you’re going to damage the confidence people have in the currency (the U.S. dollar).

But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetize the debt. It’s possible that a global contraction is truly deflationary. We don’t really know. But we’re not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.

Source: Falling Commodities and Inflation in the Wings