A HARBINGER OF THINGS TO COME?

by BOB EISENBEIS

The Federal Reserve’s Vice-Chair Janet Yellen provided a spirited defense of the Fed’s quantitative easing program at the American Economic Association annual meeting last week.  She laid out what clearly seems to be the conventional wisdom inside the Fed as to the effects of its crisis programs, the results of the current additional $600 billion of additional asset purchases, and the hoped-for path ofemployment flowing from those policies.  The claim is, among other things, that the Fed’s purchases were designed to lower longer-term interest rates.  Furthermore, based upon model simulations, the $600 billion of additional securities purchases will create 700 thousand more jobs, and the full program will create an additional 3 million jobs. 

Now, one can quibble with reliance upon models that in the past have had significant difficulties in capturing movements in the economy, especially since the forecasts and simulations are out-of-sample extrapolations.  That is, the models were not estimated with data that include economic downturns like the one we are currently experiencing. 

Additionally, to present point estimates with no indication of the confidence intervals around those estimates implies a degree of precision greater than is justified.   In fact, in the main paper that Governor Yellen cites, the error bands are huge and are consistent with almost any result one might imagine.  With everyone at the Fed looking at the same simulations, there is the danger of group-think and believing that models are in fact the real world.  Keep in mind that these are 700 thousand and 3 million simulated job forecasts, not actual jobs to which policy makers can point. 

As for QE2, while Governor Yellen provides evidence that interest rates did decline somewhat leading up to the Fed’s November QE2 decision, she fails to note that those declines were temporary.  Within one to two weeks following the November decision, medium- and long-term rates not only erased all of their declines but increased substantially.  The aftermath of the November QE2 is higher nominal rates, not the lower rates the models predicted.

Governor Yellen also repeated assertions made by Chairman Bernanke and other FOMC members that the Fed’s tool kit is adequate to reverse policy when the time comes.  But she did not address how the Fed would deal with its potential market-value insolvency, how it could absorb the losses that would be associated with asset sales, or how it might deal with an abrupt shift in long-term rates that would surely accompany liquidation of private-sector bond positions, when a policy reversal commences as investors seek to avoid large capital losses.  Repeating difficult-to-support assertions is not good communication. 

One gets the impression that the scenario the FOMC envisions, when the time comes to change policy, is one in which the economy is growing above-trend, unemployment has dropped, slack in the economy has disappeared, wages are on the rise, inflation is somewhere in the 2% to 3% range, and the FOMC can gradually raise interest rates as needed.  Indeed, this is essentially the scenario implied in the simulation results mentioned above, with policy tightening beginning in 2014.

This may not, however, be the policy problem the Fed will face. The scenario emerging in Europe may be equally or more likely. 

Like the US, both the Bank of England and the ECB injected huge sums of liquidity into their financial markets.  The Bank of England increased its balance sheet by about 2.5 times, and the ECB’s balance sheet has roughly doubled over the course of the crisis.  However, despite this stimulus, unemployment remains distressingly high.  UK unemployment is about 7.9% and rising, not falling.  EU unemployment is in excess of 10% and it is not evenly distributed across countries.  In some EU countries unemployment is extremely high.  In Spain it is over 20% and in Ireland it has topped 14%. However, in other countries, like Germany, unemployment is at 6.7% and has been declining steadily. 

At the same time, both central banks are charged with a single mandate that targets low inflation.  In the UK, inflation is outside the officially acceptable upper bound of 3% relative to its 2% target, and the Bank of England has had to explain why it has continually missed its target for about a year.  The ECB similarly is faced with the prospect that, at 2.3%, existing EU inflation is now above the ECB’s official target of 2% for the second month in a row.  Inflation rates are also not evenly distributed across the EU, making it difficult for the ECB to infer the overall path for inflation.  The lowest rate was in Ireland at -0.8%, but other countries have substantially higher rates (Romania 7.7%, Estonia 5.0%, and Greece 4.8%).  Real GDP growth in the euro zone is less than 1%, and about 2.7% year-over-year in the UK. 

The policy problem is that despite slow-growing economies and increasing unemployment rates, the inflation situation would call for monetary tightening by single-mandate central banks.  But for either the ECB or Bank of England, to begin tightening risks choking off growth and exacerbating the unemployment situation.  These central banks could act to tighten policy, but obviously have not, despite their single mandate.  They are behaving as if they have a dual mandate, even though it isn’t explicit.  Indeed, the ECB has embarked upon additional quantitative easing in announcing its intention to purchase the sovereign debt of Portugal in an attempt to preempt another financial crisis. 

How would the Fed deal with policy choices if presented with the combination of growth, inflation, and unemployment facing the ECB and Bank of England, especially given its dual mandate?  Would the FOMC be induced to expand its quantitative easing policy in the name of creating even more jobs, even if it meant tolerating higher and higher inflation rates?  My guess is that it would.  The simulations that Governor Yellen cites clearly suggest that core inflation will be 40 basis points higher down the road than it would without the extra $600 billion of QE2.  But inflation could be much higher.

What the EU and UK experience tells us is that central bank mandates don’t really matter when economies are in extreme states.  Changing the Fed’s mandate, as some in Congress are now suggesting, won’t likely impact the Fed’s behavior.  What really matters – as the UK and EU experience demonstrates - are the preferences, insightfulness, and skills of the people in decision-making positions as they seek to do what is right for their countries. 

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.  He may be reached at Bob.Eisenbeis @ cumber.com.

http://www.financialsense.com/contributors/bob-eisenbeis/a-harbinger-of-things-to-come

National Commission Report on BP-Deepwater Horizon Oil Spill

http://www.oilspillcommission.gov/final-report

GOLD OUTLOOK 2011

Submitted by Nick Barisheff on Mon, 10 Jan 2011

Irreversible upward pressures and the China effect

Download the PDF version with charts and imagery

Good afternoon. It is a pleasure to return to the Empire Club to discuss the outlook for gold and precious metals in 2011. I know this may appear to some to be an enviable job—getting to speak about the one asset class that seems to continually out-perform all others year after year—but it is a double edged sword.

I've struggled to find an appropriate simile. The best I can come up with is that speaking about gold is like one of those good news bad news jokes, you know the ones—your doctor phoned with some good news and some bad news. The good news is they will be naming a new incurable disease after you.

The good news is that gold is rising in value; the bad news is—well nearly everything else about the economy.

This year we travelled to the Middle East, the Far East and South and Central America to discuss gold. The different mindsets about gold we encountered there surprised all of us. Most people in these countries see gold as the protector of wealth. In the West, we view gold as a commodity for speculation.

Western economists treat the act of buying gold as an admission of defeat and their attempts at disparaging gold's steady rise became even more tenuous than ever this past year. Some of these disparaging opinions include:

• "Financial tightening will cause commodity prices to fall."
• "Gold is in a bubble."
• "The gold stocks haven't confirmed the gold bull."
• Perhaps most desperate of all—"The economy is on the road to recovery."

Despite these protests, gold had another remarkable year. It was up 25 percent in 2010, which marked its tenth straight annual gain.

Although we are speaking about gold today, I would be remiss in ignoring silver's performance. Silver is up 78 percent in 2010 as it is, like gold, beginning to assume its role as a monetary metal. Platinum was also up 17 percent.

When we look at a ten year chart of the US and Canadian dollars, the Euro, the British Pound and the Yuan, we see that these five major currencies have lost between 70 to 80 percent of their purchasing power against gold over this 10 year period. In truth, gold is not rising, currencies are falling in value and gold can therefore rise as far as currencies can fall.

THREE SHORT TO MID-TERM TRENDS

I'd like to pick up where we left off last year with a review of three dominant medium term trends that put upward pressure on the price of gold in 2010 and will likely continue to in 2011. Then I'd like to look briefly at three longer term, irreversible trends that will put downward pressure on currencies resulting in upward pressure on gold for decades.

First, the three dominant mid-term trends we discussed last year.

These are:

1. Central bank buying
2. Movement away from the US dollar
3. China

CENTRAL BANK BUYING

In 2009, for the first time in 20 years, monetary gold, or central bank and investment buying, outpaced gold buying for industrial or jewellery purposes. In 2010 China, Iran, Russia and India's central banks were all significant buyers as they moved cash reserves to gold.

In Q3 of 2010, Russian central bank gold holdings rose seven percent to 756 tonnes. In 2010, the Russian Central Bank bought two thirds of its own gold production.

In December we learned that China had imported 209.7 metric tonnes of gold in the first 10 months of the year. This was a 500 percent increase over the same period of 2009 and on top of their world leading domestic gold production.

By the third quarter, India's gold imports, both commercial and private, for the year were 624 tonnes, putting them 100 tonnes above the previous year's total of 595 tonnes. Fourth quarter purchases could put India's annual total over 750 tonnes.

China and Russia need to acquire gold to bring their gold reserve ratio to outstanding currency closer to Western central banks. Russia needs to acquire at least 1000 tonnes and China at least 3000 tonnes to remain on parity with the US. Chinese officials have stated publicly that China would like to acquire at least 6000 tonnes. Unofficially they have stated targets as high as 10,000 tonnes.

MOVEMENT AWAY FROM US DOLLAR

Last year we quoted a November 2009 story written by veteran journalist Robert Fisk claiming Russia and China along with France, were working on an agreement to trade oil with Arab states using currencies other than the US dollar. As expected, central bankers fervently denied these rumours. The US dollar has since 1973 been the only currency that oil could be traded in. This is the only reason the US has been able to amass nearly $14 trillion in debt. Loss of the petrodollar's hegemony would have a devastating effect on the US as this is essentially the only reason foreign countries in the past needed to hold US dollars.

On November 24, 2010, China and Russia officially ``quit the dollar`` and agreed to use each other's currencies for bilateral trade—including oil. Official trading on Moscow's MICEX Index began December 15th, 2010.
In 2009, Robert B. Zoellick, made his well-publicized comment that, the US would be "... mistaken to take for granted the dollar's place as the world's predominant reserve currency." And that, "... looking forward, there will increasingly be other options to the dollar." In 2010 he continued hinting at a new reserve currency made up of five currencies with gold as the "reference point." He also called for a new Bretton Woods agreement this year. Mr. Zoellick is no lunatic goldbug. He's the President of the World Bank.

CHINA

Last month, I was a speaker and panellist at the China Gold and Precious Metals Summit in Shanghai. I can confirm that Chinese buying, both official and public, is a major trend that is not only well in place, but may be the single most important influence on the price of gold in 2011. As I said, the Chinese see gold quite differently from the way we see it. If we are to understand gold's price direction in 2011 and beyond I believe it is essential to understand the "mindset" the Chinese have built around gold.

ECONOMIC MINDSETS AND GOLD

Although the forming of economic mindsets is a complex topic, I'd like to simplify how major financial mindsets are created in one sentence. What our government, our banks and financial media tell us about money is what most of us will accept as our financial mindset or financial reality. If anyone doubts the power of government economic policy to shape mass economic reality, just look at how we have changed our attitudes towards debt, saving and economic value over the past 40 years. Our current debt based mindset began to form the day the US dollar, the worlds reserve currency, was removed from its final international peg with gold in 1971.

DIFFERENT ATTITUDES ABOUT GOLD

Although the West shares many common economic principles with the East, as the capitalist banking systems are similar, there is one area where there is a clear distinction—this is how Easterners view the role of gold as money.

Western governments fear gold. It restricts their ability to create currency.
In the West, governments borrow and encourage their constituents to follow their example. Banks encourage us to borrow for everything from vacations to widescreen televisions made in China. They tell us we are "stimulating" the economy through consumption. Generally speaking, the investing public in the West sees gold as a wealth gaining asset to be traded like stocks and bonds. This is why Westerners are constantly fretting about the price of gold in currency terms.

The Chinese government, on the other hand, respects gold. This is evident by the laws they have passed to facilitate mining and private gold ownership. China currently leads the world in gold production.

The government encourages the public to put five percent of their savings—yes they encourage savings—into gold. This is significant because the Chinese can save up to 40 percent of their annual salary. In the West, most middle class families are lucky to break even. The Chinese see gold as a wealth preserving asset that will weather all seasons. This is the difference that I believe anyone who wishes to fully understand gold's rising price must comprehend. Inhabitants of older countries, who have lived through the destruction of an inflation fuelled currency crisis, do not need to be reminded that gold is the most effective hedge against inflation and a currency crisis.

Former CEO of Newmont Mining, Pierre Lassonde also feels that it will be buying by the Chinese public that will eventually propel gold prices into the stratosphere.

THREE IRREVERSIBLE TRENDS

Clearly, the three medium term trends we noted last year are still firmly in place. Now I'd like to look at three longer irreversible trends that I believe will affect the price of gold and currencies for decades. These are:

• The aging population
• Outsourcing
• Peak oil

THE AGING POPULATION

The aging population is a combination of a population that is living longer and the "pig in the python" effect of a huge tidal wave of "baby boomers" born between 1946 and 1963 who are just starting to enter retirement age. As people age, they spend less and downsize. GDP and tax revenues are reduced and a much smaller workforce follows the baby boomers so this is a triple whammy. This problem is universal. In China, it is further exacerbated by their one child per couple policy. Governments will have no choice but to create more currency and further debase it.

OUTSOURCING

Outsourcing has almost entirely destroyed the manufacturing sectors of many first world countries like the US and Canada and much of Europe. The Chinese worker who built your IPhone made $287 a month; this was after a well-publicized raise. The West simply can no longer compete with these labour costs. The United States was the world's largest manufacturer after WWII and has driven the world's economy ever since. However, the US consumer can no longer buy things as they lose their jobs. As factories move off shore the high unemployment becomes systemic. Without jobs, the GDP and the tax revenues of the US fall. The mountain of federal, state and municipal debt will become even harder to service and the government will be forced to go even deeper in debt and to further debase its currency.

PEAK OIL

Peak oil is the point at which the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline. This has already happened in the US, Alaska and the North Sea. In the next few years Mexico will become an importer of oil and the US will lose its third largest supplier. Our fragile, highly indebted economy relies on this land based cheap oil to continue and it cannot withstand the shock of transitioning to more expensive alternatives. In September of 2010 a

German military think tank reported that the German government is taking the threat of peak oil seriously and preparing accordingly. Numerous studies around the world have concluded that we are very close to peak oil production, which will be accelerated due to gulf drilling bans.

This will lead to higher price inflation for most goods. This will be another blow to the fragile US economy, which currently pays less for oil and gas than any of the first world countries. When added to the effects of the waning strength of the petrodollar the results will be devastating.

May I remind you that if China, which currently has one tenth the number of cars per capita as Americans, was to reach par with the US, we would need, by one estimate, seven more Saudi Arabia's to meet their needs.

These three mega trends will continue to lower the GDP, lower the tax revenue, create higher trade deficits, create higher unemployment, resulting in the need for further currency creation. This will cause inflation to rise as currencies depreciate in value and create higher universal debt. All of this means the gold price will continue to rise.

COMPETITION FOR THE WORLD'S GOLD

Finally, as a direct result of world-wide debt and currency debasement, more people will be competing for the world's available gold. We discussed peak oil, but gold is also reaching a peak as fewer and fewer new deposits are being found. Smaller, lower grade deposits with none of the "economy of scale" benefits of larger deposits are being put into production out of desperation. Mine supply has been in a decline since 2000.

As safe haven demand accelerates, there will be a transition from the $200 trillion of financial assets to about the $3 trillion of above ground gold bullion. Of the $3 trillion of above ground gold bullion about half is owned by central banks and half is privately held. The privately held gold is largely held by the world's richest families and is not for sale at any price. The central banks are now net buyers. If the world's pension funds and hedge funds moved only five percent of their assets into gold, which these days seems quite conservative, gold would trade above $5,000.

So in conclusion, I will say that without any new financial crisis, both mid-term and long term trends are in place to ensure gold and silver will continue rising through 2011 and well beyond. For those of you who are looking for a prediction...last year at the Empire Club, I forecasted that the price of gold to be between $1300 and $1500 at the end of 2010. We ended up right in the middle at $1405. For 2011, I recently forecasted it may climb to $1,700 to $2000 per ounce based on the last five years performance and the factors I have presented today.

I encourage you to follow the example of those who know how devastating a currency crisis can be and buy gold to protect wealth and not treat it as speculation. I'd like to close with a quotation that seems to put all of this into perspective. It comes from Norm Franz's appropriately titled book, Money and Wealth in the New Millennium. He said, "Gold is the money of kings; silver is the money of gentlemen; barter is the money of peasants; but debt is the money of slaves."

http://www.financialsense.com/contributors/nick-barisheff/gold-outlook-2011-irreversible-upward-pressures-and-the-china-effect

Deepening crisis traps America's have-nots

By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, January 9, 2011

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/824918...

The United States is drifting from a financial crisis to a deeper and more insidious social crisis. Self-congratulation by the US authorities that they have this time avoided a repeat of the 1930s is premature.

There is a telling detail in the US retail chain store data for December. Stephen Lewis from Monument Securities points out that luxury outlets saw an 8.1pc rise from a year ago, but discount stores catering to America's poorer half rose just 1.2 percent.

Tiffany's, Nordstrom, and Saks Fifth Avenue are booming. Sales of Cadillac cars have jumped 35 percent, while Porsche's US sales are up 29 percent.

Cartier and Louis Vuitton have helped boost the luxury goods stock index by almost 50 percent since October. Yet Best Buy, Target, and Walmart have languished.

Such is the blighted fruit of Federal Reserve policy. The Fed no longer even denies that the purpose of its latest blast of bond purchases, or QE2, is to drive up Wall Street, perhaps because it has so signally failed to achieve its other purpose of driving down borrowing costs.

Yet surely Ben Bernanke's "trickle down" strategy risks corroding America's ethic of solidarity long before it does much to help America’s poor.

The retail data can be quirky but it fits in with everything else we know. The numbers of people on food stamps have reached 43.2 million, an all time-high of 14 percent of the population. Recipients receive debit cards -- not stamps -- currently worth about $140 a month under President Obama's stimulus package.

The US Conference of Mayors said visits to soup kitchens are up 24 percent this year. There are 643,000 people needing shelter each night.

Jobs data released on Friday was again shocking. The only the reason that headline unemployment fell from 9.7 to 9.4 percent was that so many people dropped out of the system altogether.

The actual number of jobs contracted by 260,000 to 153,690,000. The "labour participation rate" for working-age men over 20 dropped to 73.6 percent, the lowest the since the data series began in 1948. My guess is that this figure exceeds the average for the Great Depression (minus the cruellest year of 1932).

"Corporate America is in a V-shaped recovery," said Robert Reich, a former labour secretary. "That's great news for investors whose savings are mainly in stocks and bonds, and for executives and Wall Street traders. But most American workers are trapped in an L-shaped recovery."

It is no surprise that America’s armed dissident movement has resurfaced. For a glimpse into this sub-culture, read Time Magazine's "Locked and Loaded: The Secret World of Extreme Militias."

Time's reporters went underground with the 300-strong "Ohio Defence Force," an eclectic posse of citizens who spend weekends with M16 assault rifles and an M60 machine gun training to defend their constitutional rights by guerrilla warfare.

As it happens, I spent some time with militia groups across the US at the tail end of the recession in the early 1990s. While the rallying cry then was gun control and encroachments on freedom, the movement was at root a primordial scream by blue-collar Americans left behind in the new global dispensation. That grievance is surely worse today.

The long-term unemployed (more than six months) have reached 42 percent of the total, twice the peak of the early 1990s. Nothing like this has been seen since World War II.

The Gini Coefficient used to measure income inequality has risen from the mid-30s to 46.8 over the last quarter century, touching the same extremes reached in the Roaring Twenties just before the Slump. It has also been ratcheting up in Britain and Europe.

Raghuram Rajan, the IMF's former chief economist, argues that the subprime debt build-up was an attempt -- "whether carefully planned or the path of least resistance" -- to disguise stagnating incomes and to buy off the poor.

"The inevitable bill could be postponed into the future. Cynical as it might seem, easy credit has been used throughout history as a palliative by governments that are unable to address the deeper anxieties of the middle class directly," he said.

Bank failures in the Depression were in part caused by expansion of credit to struggling farmers in response to the US Populist movement.

Extreme inequalities are toxic for societies, but there is also a body of scholarship suggesting that they cause depressions as well by upsetting the economic balance. They create a bias towards asset bubbles and overinvestment, while holding down consumption, until the system becomes top-heavy and tips over, as happened in the 1930s.

The switch from brawn to brain in the internet age has obviously pushed up the Gini count, but so has globalization. Multinationals are exploiting "labour arbitrage" by moving plant to low-wage countries, playing off workers in China and the West against each other. The profit share of corporations is at record highs across in America and Europe.

More subtly, Asia's mercantilist powers have flooded the world with excess capacity, holding down their currencies to lock in trade surpluses. The effect is to create a black hole in the global system.

Yes, we can still hope that this is a passing phase until rising wages in Asia restore balance to East and West, but what it if it proves to be permanent, a structural incompatibility of the Confucian model with our own Ricardian trade doctrine?

There is no easy solution to creeping depression in America and swathes of the Old World. A Keynesian "New Deal" of borrowing on the bond markets to build roads, bridges, solar farms, or nuclear power stations to soak up the army of unemployed is not a credible option in our new age of sovereign debt jitters. The fiscal card is played out.

So we limp on, with very large numbers of people in the West trapped on the wrong side of globalization, and nobody doing much about it. Would Franklin Roosevelt have tolerated such a lamentable state of affairs, or would he have ripped up and reshaped the global system until it answered the needs of his citizens?

Standard & Poor’s Triple A Ratings Collapse Again. The Question is Why?

by Jesse Eisinger

ProPublica, Jan. 5, 2011, 4:31 p.m.

Two weeks ago, Standard & Poor’s put out a press release: The credit rating agency warned it was poised to downgrade [1] almost 1,200 complex mortgage securities.

So what? Isn’t that dog-bites-man at this point?

Well, two-thirds of these mortgage bonds were rated only last year, long after the financial crisis. And S&P was supposed to have taken the distress of the housing crash and credit crisis into account when it assessed them. But in December, the ratings agency admitted that it had made methodological mistakes, including not understanding who would get interest payments when.

As everyone knows by now, the credit ratings agencies played an enormous role in creating the conditions that led to the financial crisis. Their willingness to slap Triple A ratings on all manner of Wall Street- engineered mortgage rot was enormously lucrative for the raters but a disaster for the global economy.

Unfortunately, as the episode in December shows, the credit ratings agencies are still struggling [2] to get it right. These likely downgrades arose in a small corner of the market called “re-remics.” What you need to know about them is that they were do-overs. Wall Street took bonds that had collapsed (and which the agencies had mis-rated the first time) and re-bundled them again. Generally, the top half was rated Triple A, supposedly exceedingly safe.

The agencies rated billions of dollars worth of these bonds, mostly just in the last two years. With shocking rapidity, even some of those Triple As have defaulted.

The lesson is that the agencies are still susceptible to problems that plagued them before the crisis. “What we’ve seen in re-remics truly does encapsulate everything that was wrong not just with ratings agencies, but with banking system as a whole prior to the boom," says Eric Kolchinsky, a former Moody’s executive who tried to blow the whistle [3] on ratings problems at the firm.

During the mortgage securities boom, bankers knew more about their bonds than the ratings agencies and took advantage. A similar problem occurred here. “Chances are that if a bond is getting re-remicked, it’s a bad bond and the holder wants to forestall the inevitable reckoning,” says Kolchinsky. The ratings agencies somehow missed that.

There also looks to have been “ratings shopping,” [4] in which issuers seek out the most lenient firms, rather than the best. S&P, according to Kolchinsky, was slower to downgrade residential mortgages than Moody’s. Lo and behold, it nabbed the bigger market share in new offerings of residential securities. And then it had the big debacle.

An S&P spokesman didn’t respond to a question about the ratings shopping issue. In an email, he said: “A great deal has changed at S&P over the course of the past three years. We have significantly strengthened the ratings process.” One new aspect, he pointed out, is that the firm now has a policy to correct errors publicly.

The state of the ratings agencies might be less worrisome if effective regulatory oversight were coming. Unfortunately, the Dodd-Frank reforms of credit ratings are in limbo.

Here’s the problem: Credit rating companies have long contended that their conclusions are protected by the First Amendment, much as if their ratings were as irrelevant to the markets as, say, your average financial column. Dodd-Frank tried to change that, designating the agencies “experts,” just like lawyers or accountants, when their ratings were included in S.E.C. documents for certain kinds of offerings. That would make them liable for material errors and omissions in their ratings.

But the agencies revolted. They refused to allow their ratings to be used in offering circulars, freezing up the markets. Panicked, the S.E.C. immediately suspended the rule for six months, pending more study. Then in late November, the SEC extended the delay indefinitely [5].

“For ratings reform to be successful it needs to provide incentives for rating agencies to be objective. The Dodd-Frank Act achieves some of that, but absent the legal liability, or accountability, it’s much weaker,” says Gene Phillips, a former Moody’s analyst who runs a ratings consulting firm.

So much for that. And the news gets worse. In early December, the SEC issued an obscure notice [6] that it doesn’t have the money to implement big parts of the Dodd-Frank reforms. And now that Republicans have taken over the House, the SEC’s budget for fiscal 2011 (which started back in October) is an even greater question mark.

One thing on hold [7]: Creating the “Office of Credit Ratings” to oversee the powerful firms.

This office could wield enormous influence. You see, Dodd-Frank tabled many of the most important ratings agencies controversies, pending studies [8] of the issues. If the S.E.C actually produces the zillions of reports it’s supposed to over the next several years, every employee should be awarded an honorary Ph. D.

But since the S.E.C. can’t afford to create the office in the first place, we’ll probably still be waiting by the time the next crisis hits. Meanwhile, the agencies’ rubber stamp factories are humming, much to the delight of those on Wall Street with very short memories or very deep pockets.

You can contact Jesse Eisinger at jesse@propublica.org

2011 – The year when money starts to die

by Alasdair Macleod

 Between 1716 and 1720, John Law tried to rescue the French government from bankruptcy with a scheme that came to be called “The Mississippi Bubble”. His strategy was to set up two entities: a bank whose purpose was to issue paper money, and a company whose primary but undeclared function was to refinance government debt.  Law realised that he had to confiscate all gold and silver other than smaller quantities, and force French citizens to pay their taxes and buy shares in the Mississippi Company, only with the bank’s newly issued notes. These were the three essential elements of his scheme.[i]

This is precisely what central banks in the US, Europe, Japan and the UK are doing today. They are rigging the markets by buying government debt at artificially high prices with freshly created paper money, having previously excluded gold and silver from any role as legal tender.  The following quote from John Law, could equally be attributed to a central banker of today: “An abundance of money which would lower the interest rate to two per cent would, in reducing the financing costs of the debts and public offices etc. relieve the King.” This is quantitative easing, pure and simple, and John Law had fully anticipated modern central banking.  Law’s scheme ended in disaster and as a precedent for today’s central banking this should worry us greatly.

Many of us recognise the government debt bubble, which ensures that today’s rulers are relieved by the artificially low cost of their debt.  But most of us are unaware of the other bubble, that of the value of money, which is also held up at artificially high levels.  The money bubble is inflating primarily in quantity rather than price, making it easier to deceive the public. There is also a fundamental difference from the usual bubbles, which end with a collapse while money’s value is unaffected: in this dual bubble both  debt and money will eventually collapse together; the former as nominal yields rise and the latter being reflected in rising precious metal prices.

In Law’s time, it was made illegal to hold more than a minimal quantity of gold and silver coinage.  Today the central banks have had a different approach, removing gold and silver from circulation altogether.  Naturally, central banks have also convinced themselves that precious metals are now redundant, fully replaced by paper money, so they have carelessly reduced their own holdings to suppress prices.  At the same time commercial banks offering gold and silver accounts have developed large uncovered liabilities with their customers through their fractional banking practices.  Through these uncovered, undeclared positions, the strategy of depressing bullion prices has become dangerously dependant on confidence remaining in both the central banks and the banking system.

We can expect the collapse in money values to be reflected in gold and silver prices rather than other paper currencies, and the warning signs are now upon us. Bullion has been climbing in value for a decade, and in 2010 buyers found it regularly difficult to get physical metal delivered to them by the banks. It is becoming clear that the ability of the central banks to keep a lid on bullion prices is at last coming to an end.

And it is not just bullion prices getting out of control.  In the last three months the yield on government debt has risen in spite of fresh rounds of monetary inflation.  Markets are now becoming wary of future currency issuance to support the government bond markets, and they are beginning to question risk, rather than value stability.  We are learning how it must have felt in Paris in the early months of 1720, when the Mississippi Company share price, as proxy for government debt, began to fall.  And if the last few months of 2010 marked the beginning of the end for today’s government bonds, this new year of 2011 will mark the beginning of the end for paper money. The two bubbles are now fully interdependent.

This is why we might call 2011 the year money starts to die.  The central banks are beginning to lose control over bubbles one and two, and also bullion. The destruction of private sector savings has coincided with expanding budget deficits so the expansion of the money bubble will have to continue to contain the situation, because there is no alternative.  As monetary inflation translates into price inflation, government bond yields will rise again, developing into a self-feeding loop of government bond prices and currency purchasing-powers falling, as the prices of commodities and raw materials rise further. This process is already underway.

Rising price inflation should lead to rising interest rates, which will be unwelcome to the bubble inflators. Higher interest rates will wreck what is left of government finances, and lead to substantial losses for the banking system as well, due to the impact on the economy and asset prices.  Suddenly, there will be negative feedback loops everywhere.  That is what John Law discovered through the summer of 1720, and it is safer to expect history to repeat itself than not. 

This time, the implosion of government debt and paper currency values will not be confined to the destructive popping of the Mississippi bubble.  The bubbles today are global and taken together are far bigger. The values of specie are greatly suppressed today[ii], which was not the case in John Law’s time. The adjustment, when it comes, should be far sharper, even catastrophic as a result, and the loss of confidence sudden.  It will confound those who trust in a mechanistic link between the quantity of money and the general price level.  It will wreck the Keynesians’ cherished experiment with expanding deficits as a means of economic regeneration. It will destroy the central banks. It will be a poor consolation that these last two consequences will at least be a pyrrhic good.

Now, the New Year, reviving old desires, the thoughtful soul to solitude retires. It is the time for investment strategists to dream their forecasts, which are invariably optimistic. But there is only one question to ask of these soothsayers, and that is the fate of the two bubbles, and the suppression of gold and silver prices.  Will it all unravel in 2011?

Maybe, but if money does not actually die this year, this is the year money starts to die.

5 January 2011

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[i] The financial aspects of the Mississippi Bubble are best described in Douglas French’s book, Early Speculative Bubbles and Increases in the Supply of Money, published by the Mises Institute.

[ii] See Financeandeconomics.org: Dollar to gold ratio (1 Dec 2010)

http://www.financeandeconomics.org/index.htm

2011: Year of the Yellow Brick Road

Axel Merk, Portfolio Manager, Merk Funds

January 6, 2011

The Wizard of Oz would be proud of our policy makers: perception may be reality when it comes to investor confidence, even if we live in a fairy tale. However, investors that can afford to build a yellow brick road paved with gold may outshine those who build theirs with magic.

Let's enjoy the dream for a moment: the Federal Reserve (Fed) has sprinkled money on the economy, Congress has kept taxes low and we see signs of a recovery. A recovery driven by consumers with more disposable income. Where do they get it from? The reduced payroll tax? Maybe, but how about all the money consumers have at their disposal now that they have stopped paying their mortgage? What a wonderful life this must be! Because the Fed doesn't quite believe in the recovery, we believe QE2 will run it's course - Fed Chairman Bernanke has repeatedly stated that one of the grave policy mistakes during the Great Depression was that monetary policy was tightened too early. He appears committed to not letting history repeat itself; investors may want to trust him on that, as well as his commitment to push inflation higher. Ultimately, the Fed would like to engineer higher home prices so that consumers are no longer "under water." The challenge the Fed has, of course, is that while it can create asset inflation, the Fed has a difficult time influencing which assets inflate. Having said that, the Fed has at least some success: easy money has pushed at some company’s valuations higher, just look at Facebook, now valued at $50 billion, which may bode well for Palo Alto real estate. This is the Fed's contribution to the wealth gap: those with assets may do well under Bernanke's leadership, but don't expect a boom in underprivileged neighborhoods, unless someone convinces Facebook to relocate there.

Congress in the meantime will do what it does best: talk. There will be lots of it. Specifically, the debt ceiling may be the talk of the day, month and year. The new spirit amongst Republicans is to stop wasteful spending. And what better opportunity but to raise that point to appease voters this year. Granted, talk is cheaper than spending and indeed some spending projects may be halted. But let's remember that the grand compromise on tax reform did not require anyone to make tough choices. Washington wizardry is in full swing, make no mistake about it. After all this talk, we believe odds are extremely low that policy makers will wake up from the dreamworld and engage in urgently necessary, real reform required to stop the US from going down the path of Greece. While we are not there now and don't need to go down this route, all it would require is for policy makers to close their eyes, click their heels three times and say "I want to wake up; I want to wake up; I want to wake up!"

Don't look for the Fed or Congress to disturb the dream. The bond market may need to be called upon to rattle us. As the first signs, investors my interpret falling bond prices as a sign of economic recovery; but as the selloff may continue, the chief Wizards may be called upon to do something about those mean speculators that dare to wake us up from our dreamworld. Think volatility, think falling dollar. Think you wish your yellow brick road was paved in gold. But if enough believe in the dream, we might be able to keep on dreaming. Unfortunately, little has worked out the way our policy makers have wanted, so at the very least, investors my want to consider taking into account the possibility that we have woken up from this fairy tale.

It turns out that Bernanke's dream has real implications for the rest of the word. Asia is waking up with a hangover called inflation. Much of Asia has been importing U.S. monetary policy; given that the U.S. is curing its disease with the virus that created the disease in the first place (cheap credit), Asia has been catching a cold. Aware that a cold can turn into pneumonia, Asia has been struggling to neutralize the disease. In the spirit of keeping the dream alive, China is getting creative: deploying its vast reserves to invest in Greece; the latest proposal is to buy Spanish bonds. The beauty about this latest initiative - for China anyway - is that Greece has been, and Spain may be willing to sell important infrastructure that allows access to the respective ports. However, as inflation is picking up steam, more earnest measures may need to be taken, most notably a further appreciation of Asian currencies.

Indeed, while the US is in denial about inflation - after all wages are not budging -, the rest of the world has started to tighten monetary policy - that includes the eurozone where hundreds of billion in euros have been mopped up. This increasing interest rate differential has contributed to a rather weak U.S. dollar, only masked by a wobbling euro.

Talking about the eurozone, the bond vigilantes have already arrived to wake up European governments. It may only be a matter of time before the U.S. gets it's wakeup call. We have seen the drama unfold in Europe - the U.S. promises to be no less "entertaining." In our assessment, the question is not whether there will be bailouts for some states, but what strings will be attached to them. Let's also remember that the U.S is more vulnerable because of its current account deficit; the treasury market may be at risk of following the municipal bond market's decline. The U.S. situation particularly concerns us since Bernanke has shown a greater willingness to use the printing press to touch up problems than the European Central Bank (ECB).

In the meantime, Europe has wiped its eyes and is now wide awake and alert. In Europe, this doesn't translate to swift action, but may well lead to a process in which weaker states cede control of their budgets in return for aid. While not a perfect process, when coupled with expected restraint from the ECB, this could well turn the euro into a champ this year. A widely disliked investment such as the euro may hide a lot of value.

Overall, we see the world as increasingly unstable. U.S. policies are likely to rattle the rest of the world, while not fixing domestic issues. By all means, the Fed has to worry about the U.S., and cannot be held responsible for all the ills of the world, but we happen to believe that a more prudent Fed policy would also be in the interest of the U.S.

As far as gold is concerned, the continued concerns over sovereign solvency - not the eurozone in particular, but globally, combined with the U.S drive to achieve growth at any cost, make the yellow metal worth considering. What's in your vault? Is your yellow brick road made of dreams or gold? Just because policy makers are dreaming, doesn't mean investors need to.

Currencies and commodities may well dominate headlines yet again. If nothing else, they will be in the news because of the ongoing volatility we are likely to see in the market. We also expect continued active participation by policy makers. This may bode poorly for traditional portfolio diversification, as asset classes may move in tandem – both up and down – when trillions are thrown at the markets.