EndGame
Thursday, December 8, 2011 at 3:33PM [Editor's Note: The following is from Chris Horlacher, a new TDV Correspondent from Toronto, Canada. We recently interviewed him on Anarchast and he had excellent insights on the coming Canadian real estate implosion, amongst other things. His work is also featured regularly on the Ludwig von Mises Institute of Canada site as well as having his own blog. Below is his bio.]
Bio: Chris Horlacher, CA is the Founder and Managing Director of Maple Leaf Metals Exchange. He possesses a Chartered Accountant designation and is a former Senior Auditor for Deloitte & Touche LLP where he provided audit and assurance services to Fortune 500 companies, as well as independent businesses. He left Deloitte to aid Euro Pacific Canada Inc., an IIROC dealer-member, during its formative period by serving as Chief Financial Officer before founding Maple Leaf Metals Exchange.
ENDGAME
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
The above quote, by Ludwig von Mises, should be burned in to the heads of every economist on the face of the earth because it accurately describes exactly what happens to economies after prolonged attempts by government to meddle with society through the monetary system. The theory that this quote is derived from, the Austrian Business Cycle Theory (ABCT), has enjoyed a track record of success in predicting every major economic crises since it was developed. In applying this quote to our present situation, I suppose the first question we should ask is “Did we experience a boom brought about by credit expansion?”
The following charts answer that question quite definitively:
Credit expansion? Check.
Money supplies all over the world are soaring, especially with all the recent government stimulus programs such as TARP, TALF, QE1, QE2, Operation Twist, Currency Swaps and so on. Every time the economy begins to show some cracks, more stimulus is announced. This is little different from giving an injured athlete more and more painkillers in order to keep them in the game and playing. The painkillers may give the semblance of a recovery because they can compete for a little while longer, but they haven’t healed at all. That requires some real downtime.
Real downtime and restructuring doesn’t seem to be what the powers-that-be want. They like the current system of juicing up with cheap, new money and going on spending sprees. This allows banks to post record profits simply by trading paper back and forth between one another and continuously bidding their prices up higher and higher with each successive injection of money. Despite this, there is a large group of investors and analysts that still believe we are headed for a collapse in market valuations.
Another chart that everyone should become familiar with is the DOW/Gold ratio. This is what the world’s major industrial company stocks look like when you price them in gold. It is a much more accurate way of valuing the market over using a depreciating currency such as the US dollar as your yardstick. Since the value of the dollar has been declining by about 3% or more per year, this skews the DOW upwards by the same percentage. A stable measuring rod of value like gold allows the real story of the DOW to shine through. Gold’s supply is relatively constant, with all the mined ounces in history still being around. Global gold supplies only grow by a paltry 1% or less per year and since next to none of it is used for industrial purposes there is no such thing as a supply shock. This makes it a very reliable substance to use as money. Supply is scarce, yet constant. It’s portable, divisible and durable and makes for an excellent store of value. A fine set of clothing would cost roughly one ounce of gold in Roman times, and today still buys you the same. This is why humanity has used gold as money for thousands of years, whereas government-issued paper has only ever been a temporary experiment lasting anywhere from a few weeks, to a few decades. Our current global monetary system is about 40 years old and seems to be on its final legs.
The DOW/Gold ratio shows us, quite clearly, the three major bull markets of the western world, the Roaring Twenties, the Post-War Boom and the Tech Boom. It also shows that after the bursting of every bubble the ratio of DOW to gold collapses to less than 2. It’s interesting to note that each successive peak is 50% higher than the previous as well as each successive trough being about 50% lower than the previous. I fully expect the DOW/Gold ratio to be at 1:1 or less by the time our crisis finishes unfolding. The question is then “At what price will the DOW and gold be when that 1:1 ratio is reached?”
We have to revisit von Mises’ quote at the beginning of this article in order to speculate about the answer. This crisis could run its course in one of two ways; 1) A voluntary abandonment of credit expansion, or 2) The complete destruction of the currency system involved, in our case, the US dollar (and potentially many others that are built upon the USD). Those predicting deflation must necessarily accept that the government will voluntarily abandon further credit expansion sooner rather than later, allowing the recession that is waiting in the wings to hit our economic shores with full force and allow the people to pick up the pieces themselves. To me this is an incredible assumption that has very little basis in history, as many should have learned from the last big boom/bust.
In 1980 the inflation rate in the USA was in the double digits and had been rising for years. Unemployment was also in the double digits and rising. The combination of these two factors should have completely discredited the Keynesian school of economic thought (which predicted that higher inflation would always decrease unemployment) but this brand of economics still dominates classrooms and the halls of government. It was an era called stagflation and had been brought about by endless government deficit-spending on things such as a rapidly expanding welfare and warfare state throughout the 1950’s and 1960’s. Economists applying the ABCT theory had accurately predicted that those policies would lead to an inflationary depression and this is precisely what arrived in the late 1970’s. Gold had risen from $35/oz in 1971(when all monetary links to it were completely severed by Richard Nixon) to over $800/oz in just ten years. It was only when the crisis had reached levels most US citizens would consider extreme that the head of the Federal Reserve at the time, Paul Volker, decided to abandon further credit expansion. He increased the Fed’s discount rate to 20%, thus discouraging banks from levering up further and halting inflation.
This triggered a massive recession during the first couple of years of Reagan’s administration but ultimately the country recovered. The price of gold collapsed from a high of $850 (about $2,500 in today’s dollars) on January 21, 1980 to a bottom of $284.25 on February 25, 1985. The DOW itself had not been doing much for decades, bouncing up and down in a valuation channel ranging from about 600 to 1000 and so watching it alone would have given no indication that the markets were in any trouble. In reality, as it is today, the DOW was collapsing in real terms. On the same day gold made its all-time high, the DOW was worth 873 (making the approximate 1:1 ratio that would have signaled to a savvy gold investor that it was time to sell their gold) and by the time gold finished its decline in 1985 had continued inching upwards to 1,278. Anyone in debt when this happened would have been wiped out. However the USA was the world’s largest creditor nation and individuals had a large stockpile of savings and were able to weather the high interest rates for the time necessary for the economy to stabilize.
What needs to be taken from this episode is that the 1:1 ratio did not arrive after a collapse in the price of gold and the DOW, but when gold made an all time record high! Based on these facts alone, the deflationist’s argument seems quite out of the picture. We’re more likely to see the 1:1 ratio arrive in our current crisis at prices much, much higher than they are today for both the DOW and gold. If things play out similar to the way they did in the 1970’s then the DOW would stagnate and gold would have to rise to about $12,000/oz in order to reach parity. Afterwards, though, both the gold and DOW may crash but this will depend on whether the US dollar still has any tricks up its sleeve at that point. The high interest rates implemented by Paul Volker had restored confidence in the dollar and deep tax cuts brought investors and workers back in to the economy. The safe haven of gold was no longer necessary for investors, who sold it and returned to stocks.
Can today’s economy weather 20%+ interest rates? The US is now the largest debtor nation in the history of mankind. Every household bears a burden of over a million dollars in debt and unfunded liabilities, and that’s only if we spread out the Federal Government’s obligations. Add in State, Municipal and private debts and the USA is facing a seemingly insurmountable problem. We saw what 5% interest rates do to the US economy in 2008, massive defaults and the collapse of major financial institutions. Imagine what 20% (or more) interest rates would do! The nation is addicted to artificially-low interest rates supplied by easy money from the central bank. Any normal, healthy level of interest would bankrupt a massive number of people and institutions. So the government must continue to inflate in order to keep the music going or face a depression the likes of which the country has never seen.
Some deflationists make the argument that interest rates will naturally rise in order to outpace the inflation rate in the event that inflation gets out of hand. This is another scenario that is simply not borne out by the historical facts. Indeed, if interest rates always rose to put the brakes on inflation then no hyperinflation could ever happen anywhere! The real reason behind hyperinflations was accurately pointed out in a New York Times article describing the hyperinflation in Zimbabwe as being brought about by the following:
On Friday, the government said it would triple the salaries of 190,000 soldiers and teachers. But even those government workers still badly trail inflation; the best of the raises, to as much as $33 million a month, already are slightly below the latest poverty line for the average family of five. This will only worsen inflation, for printing too many worthless dollars is in part what got Zimbabwe into this mess to begin with. Zimbabwe fell into hyperinflation after the government began seizing commercial farms in about 2000. Foreign investors fled, manufacturing ground to a halt, goods and foreign currency needed to buy imports fell into short supply and prices shot up.
As a whole, the nation has only now sunk to standards common elsewhere in Africa. But the government may have reached the limit of its ability to do anything about it. Cutting spending seems impossible, and raising taxes further is unthinkable. That leaves one option: "much more inflation," he said. "Because this government is always going to be printing its way out of its current difficulty."
Wines, Michael. “How bad is inflation in Zimbabwe?” New York Times. May 2, 2006.
Consider the parallels. State employees in the USA already earn about 50% more than their private counterparts. Government benefits are expanding, not contracting. The Fed is printing money like madmen trying to keep the banks capitalized. 40 million Americans are on food stamps. Government is confiscating all the wealth it can get its hands on without creating a PR nightmare. The US manufacturing base is increasingly leaving the country for better opportunities elsewhere. The US dollar index is falling, which is putting the brakes on imports. Cutting federal spending is labeled as the destructive fantasies of right-wing crackpots. At the same time, raising the taxes necessary to close the $1.6 trillion dollar federal deficit is completely impossible. The USA, like Zimbabwe is left with only one option, inflation. They have demonstrated time and time again that they will always resort to printing their way out of financial difficulties and this can only spell out the second scenario outlined by Ludwig von Mises.
Catastrophe is coming to the US dollar, and we had better be prepared for it.
Reader Comments (2)
Are they laughing at us? This is the corporation that is reportedly buying up all the legendary gun manufacturers rumored to be involved with George Soros... mmm, makes one think of a cheap horror flick doesn't it?
http://www.shtfplan.com/wp-content/uploads/2011/12/cerberuslogos-freedomgroup.jpg