The Gold Report: At the Casey Research/Sprott Inc. Summit, you gave a presentation called, “A Crisis of Confidence.” After all the government stimulus from the U.S. and the rest of the world aimed at injecting liquidity and keeping interest rates low, why didn’t any of it work? Why is the economy still hurting?

Bud Conrad: First, printing money doesn’t create wealth. Putting bits in a computer doesn’t create wealth. When politicians hand out money, they are the ones who get powerful and the banks get wealthy. The middle class with savings gets hurt. What creates wealth is people working and creating things.

Internationally, the Chinese are papering over their slowing growth rate by providing liquidity, but paper money systems will collapse. That is the reality. The global financial system is supremely unstable. When people wake up to the fact that this is a “king ain’t got no clothes” economy, we will see a run to the exits.

TGR: It seems like we are saying that the currency is going to fail because of debt to gross domestic product (GDP), not because governments can print money. If governments were disciplined, then would printing money be a problem?

BC: When the U.S., and therefore every other country, went off the last vestige of the gold standard, we were placed in a fairyland. That is even more important than the debt. It is linked. Debt is the result of the ability to print money. If there were redeemability, the U.S would have stopped issuing debt when it ran out of money. Without fiat currency, the country wouldn’t have reached the current level of debt.

No government is disciplined. My question is: “Why are people letting them get away with it? Why aren’t people out protesting in the streets?” Thousands of bankers should be in jail right now. There is an attitude of resignation in young people today that dismays me. Maybe they know they can’t fight city hall.

TGR: If we are all resigned that whatever is going to happen will happen, how can people protect themselves?

BC: A lot of people probably believe that everything will be okay. When we have a financial collapse and people stop getting their payments and they see bankers and government contractors getting rich, maybe people will take matters into their own hands. It could be dangerous to be in the streets because people who are hungry will rob you.

TGR: If the bubble has already broken in the U.S. stock and real estate market and is getting ready to burst in China, are there any upside opportunities?

BC: In a paper money/fiat currency collapse, the things to hold are real assets—gold and oil will look like you are making money. Gold doesn’t change. It is just gold. When the price goes up, the metal isn’t any different. Only the dollar is going down.

There is also a moral component to the question. A lot of people are getting out of the country. This is where I was born and where my family lives and I am an American so I probably won’t go anywhere, but a lot of people are considering moving out of the U.S. to protect themselves and their assets.

TGR: What is your biggest fear for your children?

BC: That the government has turned it into a totalitarian state where the people don’t have personal freedoms to assemble, think and live their lives without surveillance, over-taxation and subservience to the state. I worry that my children and grandchildren could be impoverished by conflict, by a society that dissipates it resources in wars that only destroy wealth, rather than creating anything.

I also worry about how they will fuel their economic growth. Fossil fuels created the abundance of our generation like humanity has never experienced before. We have used half of the dinosaur remains out there. If we use it all up, then we will have to reduce the number of people on the planet. Now we need to start thinking about what is next. I don’t know how my grandchildren will live in an abundant society when energy becomes so expensive and scarce that we have big wars over it. It’s already happening. Energy explains the conflicts in the Middle East more than religion ever could.

TGR: You have said we are entering Cold War II. Can you explain that?

BC: Everyone is uncomfortable with the role we played in the Middle East. They fear we could enter a World War III. But a cold war is not a conflict between the main parties. We didn’t battle with the Russians directly. We fought in Vietnam. The same is going on with China in an economic war over resources. The U.S. bombs the place in hopes that a new government will come in and give us cheap oil while China is busy winning contracts for the access to resources in many far-flung regions from oil in Africa to soybeans in South America. China is building cultural centers and roads to mines in an attempt to gain the favor of the people while gaining access to resources. Our approach of bombing people just makes enemies and is very expensive. It is another example of the stupidity of a late-stage empire.

TGR: You have referred to the fight over access to oil, but I hear the U.S. is the Saudi Arabia of natural gas. Can that replace oil in the future?

BC: Like any extractive resources, we have to approach this new technology with care. Fracking can leave a messed up underground and contaminate water. But natural gas is abundant and affordable and it can make a difference.

TGR: What about uranium?

BC: The problem is not just the radiation and the bad design of the early plants revealed by Fukushima. The problem is that it isn’t price competitive. We can build nuclear plants safely, but it isn’t cost effective compared to oil or natural gas. There will still be a uranium mining business in replacing spent nuclear fuel, but not in building new plants for a while.

TGR: You mentioned we will soon have two retirees collecting benefits for every one worker. What is the solution for the imbalance between workers and beneficiaries short of older people wandering off into the desert so they won’t be a liability on their families?

BC: The government will continue to print money to meet its obligations to retirees, but the problem is that those dollars won’t buy as much in the future. That is why people are trying to find protection for their retirement assets. Those relying on Social Security will find it difficult.

TGR: We have heard about a possible economic slowdown or collapse in China, but it has one of the highest personal savings rates in the world. Wouldn’t that mitigate some of the economic turmoil of a real estate bubble bursting?

BC: China is strong because it has gone through so many revolutionary problems during the lifetime of people who can still remember. The Chinese know how bad it can be so they fight to avoid returning to economic subsistence levels. What China has done economically puts Japan’s economic miracle to shame. The country has overbuilt during the last few years, but it has a lot of people and the one-child policy is being dismantled. It will manage any bubble bursting well. We, in the U.S., have an arrogance of wealth and that blinds us to possible problems. That is why we are unwilling to take the strong necessary steps to right our economic disasters of too much debt, too much government and little concern for concentrating on economic development.

TGR: You said you are expecting a recession next year and a weaker economy or “stagflation.” Will that be limited to the U.S. or will it impact the entire world economy?

BC: The U.S. economy will suffer greatly because we are unprepared for how serious the situation will become, but this is a worldwide phenomenon. Inflationary central bank printing is going on in Europe and China so they will be impacted as well. The world is interconnected so what happens in the U.S. does spill over into other economies and the other way around. The European weak countries failing will cause several big European banks to fail, be nationalized and cause debt crisis for U.S. banks as well. International contagion is particularly true when the U.S. starts wars to divert people from thinking about the economy. Wars damage productivity of personal consumption and therefore the perceived wealth of individuals.

I think of the U.S. as a late-stage empire. There are lots of ways to collapse. The Third Reich collapsed cataclysmically. The British Empire wound down in a gentlemanly fashion. I think the U.S. is headed to Roman type of collapse where the internal dissipation was as big a problem as the external conflicts. We have a culture of corruption with no accountability. In this most recent crisis, no bankers have been indicted, never mind convicted, compared to the Savings and Loan crisis, when thousands went to jail.

TGR: How are you protecting your wealth?

BC: I have some precious metals and energy. I expect interest rates to rise.

TGR: You are predicting a weaker economy. When are interest rates going to move?

BC: How about now? I warn you, I have been wrong before. I predicted the debasement of currency would require higher interest rates to get people to invest. I didn’t give enough credit to the Federal Reserve’s ability to manipulate the market. We are now at record low rates and the government deficit is at such extremes that rates can only go up. I don’t know how it will all unravel. But at some point people will wake up to this sham and they won’t want to keep their money in banks. Then they will go buy physical assets, gold and food and, sometime later, real estate.

TGR: After all this bailing out, what will be the trigger point for a collapse?

BC: We all want to know that. We look at the numbers and I can’t see it going on for the rest of the decade. When it goes, it could go very rapidly. The markets feed on themselves more now than at any other point in time. What happened over a period of years in the Great Depression could take weeks this time around. Currency collapse could happen quickly. The collapse is already happening in Europe and more countries may follow Greece.

This is not war; it is merely the collapse of a currency. People aren’t wiped out by the thousands. But their savings are. Currency disintegration is not unusual. It happens all the time—about once a generation a collapse happens in every country. The fact that the U.S. dollar is the second oldest in existence today is an anomaly, an anomaly that may come to an end soon.

Bud Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl and Tandem. Conrad, a futures investor for 25 years and a full-time investor for a decade, is also sought after as keynote speaker in Dubai, New Zealand, Vancouver, New York and many other cities. He has appeared on TV on CNBC, FOX, and on many radio shows. As chief economist at Casey Research, he produces original analysis.

I recently asked the opnion of my readers regarding the question of whether the global economy is in for inflation, deflation, or stagflation. Given the obvious issue that it may be all three at different points in time it seems as if recent market action suggests that we should be looking at the d-word.

QE1 + QE2 +…+QEn = Deflation?

Even if macro soothsayer’s favorite comparison between Japan and the US is misleading because the former has decidedly more miserable demographics than the former, it is clear that US policy makers are steering into largely uncharted waters.

Consider then Atlanta Fed President Dennis Lockhart’s recent comments before the National Association of Business Economics that the Fed would contemplate cueing in QE3 in the event that the current oil price shock proved to be more severe. On the face of it this makes sense in so far as goes the idea that the main effect from sharply rising oil price is a relapse into recession and thus deflation. Indeed, the Fed can hardly be blamed for acting in the context of events which are essentially geo-political in nature.

Yet, it is much more complicated than that.

It then stands to reason that while the Fed should certainly be forward looking in conducting policy the primary effect of ongoing measures of quantitative easing is exactly to put pressures on headline inflation and commodities in general. As I noted recently at this space;

Given that we seem to be looking at a re-run of 2008 it must be factored in that the volatility and speed (and subsequent decline) of commodity prices are a problem in itself. The famous loss function which must then be metaphorically minimised is the one which plots the trade-off between the cost of recurrent flares of commodity prices and the need to act as a counter trend to the destructive forces of a balance sheet recession. Here, it becomes a rather serious issue if one of the main collateral effects of providing buckets of liquidity is to engender strong commodity melt-ups with a subsequent deflationary outcome.

And perhaps this is what is running through the mind of Dallas Fed President Richard Fisher who, in the same picece as linked above, is quoted of voicing oppositon towards QE3 and indeed that he would like QE2 to be phased out sooner rather than later.

Which way the tide will turn at the Fed is not a trivial question. There are plenty of signs that after the SP500 having tested the 1350 level, and failed, the market is running on the evaporating fumes of QE2. As one of my many market spies noted today:

(…) it is definitely possible that the market will discount the end of QE2 ahead of time this time around. This is what happened in Japan too – the market began to rally as soon as their QE2 was announced (since it had rallied smartly on QE1) , but halfway through the implementation the Nikkei began to fall, ultimately losing 45% from the interim peak and ending below the level of the day QE2 was announced. Mind, I’m not saying it will play out in the exact same manner, this is just to point out that there can be leads and lags between QE and its effect on the stock market – the QE1 experience is not necessarily a road map that needs to be repeated.

Again, we have that comparison with Japan which is then only to say that repetitions in the market rarely occur the way you expect them to, but there is definitely an unwinding narrative emerging. Team Macro Man gives their list of bearish omens today and I find it difficult disagreeing with them on the general idea that the reflation trade might be in for a stutter; at least until the next round of QE.

To their list I would add that another favorite punt of the reflationistas, gold, is finding it mightly difficult to reach new highs above the 1420s (today, Thursday, getting a right beating back to 1405ish). Now, we should always remember that the market can move three ways, where sideways is the third. Yet, the fundamentals of the gold trade kind of black or write so the ongoing difficulty reaching new highs will be rightly worrying the g-bugs.

More generally however the SP500 is only now coming down to the 50dma (at pixel time) and I would wait to see whether it forcefully breaches that level before putting on the tin foil hat.

(click image for better viewing)

As you can see dear reader, the chart is telling you to buy the dip, but chartism on such short time scales can make plenty of widows too, so be careful out there.

Looking into the rearview mirror at the ECB

I wasn’t really sure whether to cry or laugh last week when Trichet mounted himself in front of the microphones to deliver an almost sure signal of future rate increases by invoking the idea of strong vigilance. Indeed, the ECB let it be known that it was perfectly possible that their April meeting would be accompanied by a rate increase. Game set and match then!

As I have noted before at this space, stranger things have happened than the ECB raising rates just before a global slowdown. I even ventured to call it a leading indicator. Soc Gen’s always enjoyable Albert Edwards dryly noted recently (HT: FT Alphaville); “all we need now to push the world back into the recession is an ECB rate rise.”

This seems an apt take on the situation and my good friend Edward Hugh similarly notes that all this has an alltogether well expected outcome invoking the idea of the Chronicle of a Policy Error Foretold.

Now the problem with this latest policy initiative is not only that it represents something akin to the chronicle of an early death foretold for a much troubled and highly fragile Spanish economy, where around 90 percent of mortgages are variable rate ones.

It also draws attention to an area which it would be much better for the ECB not to draw attention to at this delicate moment in its history: the convenience of having a single-size monetary policy applied to such a diverse group of economies.

I heartily agree that it is due time that we, yet again, try to evaluate what it means to have a single interest policy in the eurozone. More specifically, there is the question of divergence of fortunes when it comes to deflation and inflation;

Inflation on the periphery has much more to do with rising commodity prices and the application of a misguided policy of consumption tax increases as a way of reducing fiscal deficits than ever it has to do with economic overheating.

I think it is pretty obvious that there will be no second round effects in the eurozone periphery and if the ECB is seriously suggesting this to be the case, I would dearly like to see the empirical evidence for such a claim (even a theoretical would do actually!).

Finally, we should never neglect to mention that all this might be a bluff and that the ECB like most other rational institutions can change direction based on the evidence before them. Yet, herein also lies the rub because the current vigilance comes on a backdrop which smells a lot like the last time the ECB raised only to see the deck of cards fold before their eyes. Perhaps they ought to look closer into the rear view mirror.

Random Shots indeed

The immediate conclusion here would seem to be that Trichet should get on a plane and relieve Bernanke of his post in Washington and leave the tower of Frankfurt to Benny. As FT Alphaville (see link above) quotes from Gavekal;

Since its inception, the ECB has typically been slow to cut rates (famously rising them in July 2008!) and slow to raise them. So is the fact that the ECB is now considering a tighter monetary policy before the Fed a sign that the ECB is making a mistake? Or a sign that the Fed is starting to really fall behind the curve?

I am not sure that it is either really. Core inflation in the US is still nudging down but I think that ongoing loose monetary policy will run the risk of replicating the UK more than Japan. Put differently, I think the US economy is in a position where inflation expectations might take hold which is not the case in the Eurozone periphery at large.

At the time of writing it seems an awful lot as it the deflation trade is back and thus that the market has already sucked QE2 dry and now awaits the third version. A spike in oil prices helps no-one too, but oil at current levels is not the problem, but a quick zoom to 150ish and we would have grave problems. This would then be ample catalyst for QE3 and even if this would not prevent the correction which seems evident now, it would setup another meltup in all things unprintable and risky.

We can only hope then that central banks, on either side of the pond, are taking more than random shots at our current problems.

During the 1970s nearly all macroeconomists seemed to abandon the crude Keynesianism that I learned about at university. Why have so many reverted to it at this time? The answer might have more to do with the desire for a comfort blanket in times of uncertainty than with the merits of Keynes’ approach. The Keynesian remedy does not seem to me to be much more relevant to the current situation than it was to the stagflation of the 1970s. It suggests that when you wake up with a debt-induced hangover, then you will soon feel better if you get the government to take on some more debt on your behalf. That doesn’t sound to me like a recipe for a more healthy world economy.

So I have been looking for articles which will help me to understand why the world is in recession and what can be done about it. The best aid to understanding that I have found so far is John Cochrane’s refinery analogy:

“Imagine by analogy that several major refineries had blown up. There would be tankers full of oil sitting in the harbor, and oil prices would be low, yet little gasoline would be available and gas prices would be high. Stimulating people to drive around would not revive gas sales. Borrowing gasoline and using it on infrastructure projects would be worse. The right policy action would obviously be to run whatever government or military refineries could be cobbled together on short notice at full speed, and focus on rebuilding the private ones.” John H Cochrane, ‘Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies’.

The “major refineries” correspond to the banks that have loaded themselves with toxic assets. The oil tankers sitting in the harbour correspond to the savings that are going to government securities paying low interest rates and the high gas prices correspond to the high price of credit to businesses and consumers (in many countries). The running of government and military refineries at full speed corresponds to the government raising funds by issuing debt and lending it to businesses and consumers.

Cochrane recognizes that this analogy does not give a complete picture of the current situation. He explains that if we just had a shock to the supply of credit (blown up refineries) we would expect to see stagflation – lower quantities of goods and services sold, but upward pressure on prices. Instead we are seeing lower quantities sold and lower inflation. So, we are also seeing a demand shock as a result of people becoming much more averse to holding risks. (The refinery analogy could possibly be stretched to accommodate this. If several major refineries were blown up then investors could be expected to seek to reduce the exposure of their portfolios to other firms that might also be at risk of “blowing up”.)

Would the situation be resolved if the central banks were to target a specific rate of growth in nominal GDP (as I discussed in an earlier post)? The answer might depend on what assets the central banks purchase from the public in pursuit of this objective. If they buy government bonds this will help satisfy the increased demand for money, but not address the supply shock in the credit market. It is possible that the market could take care of this problem e.g. major firms may be able to by-pass the damaged banks by raising funds directly from the public. However, when central banks buy newly-issued commercial paper and securitized debt they are acting directly in place of the injured banks.

As a stop-gap measure this kind of by-pass intervention has the important merit of being a lot easier to unwind than alternative approaches. If central banks confine their purchases to quality assets they will not have any difficulty selling them when inflation begins to rise and people get tired of holding so much money. The effects of fiscal stimulus involving cash splashes by governments are likely to be much more difficult to unwind without a decade or more of high-tax and low-growth stagflation.

It seems to me that current debates about the effectiveness of stimulus packages in lifting aggregate demand tend to miss a more important point about consequences beyond the immediate short term (i.e. long before Keynes’ long run when we will all be dead). John Cochrane makes the point as follows in relation to the U.S. economy:

“If the resources are not there to unwind our current operations, to quickly retire … newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.”

Not surprisingly, critics of central banking – such as the great Ludwig von Mises and his protege Murray Rothbard – were never tapped by the selection committee. In fact, in the nearly four decades since the first “Alfred Nobel Memorial Prize for Economics” in 1969, the Swedish central bank has only awarded its top honor to one critic of central banking – Austrian economist Friedrich von Hayek – and he had to share the 1974 award with a Swedish socialist.

That the Swedish central bank awards the “Nobel” prize in economics is not well known, but it’s hardly a secret. Wikipedia states plainly: “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel is not a Nobel Prize. However, the nomination process, selection criteria, and awards presentation are conducted in a manner similar to the Nobel Prizes.”

So, if I used a “similar nomination process, selection criteria, and awards presentation,” could I establish my own awards for YouTube videos and call them Oscars? Maybe, if I had the power to create money out of thin air like the Sveriges Riksbank.

But what of Krugman? Does he deserve recognition as a great economist? Not according to the Austrian school. Dr. William L. Anderson, an Austrian who teaches economics at Frostburg State University in Maryland and is an adjunct scholar of the Ludwig von Mises Institute, says Krugman isn’t an economist at all: “Yes, Krugman has a Ph.D. from MIT in economics,” says Anderson, “but his writings, both popular and academic, demonstrate that he does not believe in laws of economics.”

Why does Dr. Anderson feel this way? Well, Krugman is described as an “unreformed Keynesian,” meaning a follower of the economist John Maynard Keynes, whose theories were largely the basis for the massive ramp-up of the U.S. welfare state beginning with the New Deal and lasting through the mid-70s. The problem with Keynes’s theories: they’ve been positively refuted.

For example, Keynesianism teaches there’s a “trade-off” between unemployment and inflation. When there’s low unemployment, says the Keynesian Phillips Curve, there will be high inflation, and vice versa. Therefore, if employment is too high, we can “fix” the problem by expanding the money supply – or so thought Keynes. The problem is that, in response to the gross excesses of the Johnson and Nixon administrations, we had “stagflation” in the late 1970s: high unemployment and high inflation. And we’re likely headed there again, particularly if we follow Krugman’s favored policies.

Krugman is more well known for his criticisms of the Bush administration and Iraq War than for his economics. Bush, of course, deserves as much criticism as any president in history, and the war in Iraq deserves even more. But Krugman, who made his name as a polemicist and now has new gravitas as a “Nobel” Laureate, will likely have a prominent role in the nearly inevitable Obama administration. Sadly, this could make us pine for the good ol’ days of Bush/Cheney.