The Sixth Day
Wednesday, December 31, 2008
  A Rally within a Bear Market
From the lows reached a few days before Thanksgiving, stock indexes have risen about 20%. Do not be fooled by this rally into thinking the Bear Market is over .

A true Bear Market is characterized by falling price earnings ratios. Serious bear markets usually end with P/E ratios in single digits, often in the six to eight range. According to the estimate of Standard & Poors Corporation, based on reported earnings as of December 23rd, the S&P 500 price stands at about 18 times 2008 earnings.

If the P/E ratio falls to nine times earnings, then the S&P 500 could to fall to about 450. In recessions during the last forty-five years, earnings have fallen by ten to twenty-five percent. If that is factored into the equation as well, you can imagine that we are still in for a lot of pain.

I say "we" and not just "investors" because the recession will produce more job layoffs, serious distress for state and local governments, and enormous federal deficits.

Investors would be wise to sell on rallies and keep cash in short-term U.S. Treasury securities. This is a good time to invest with the philosophy of Depression era comic Will Rogers' who said, “I’m more concerned about the return ‘of’ my money than the return ‘on’ my money.”

In my next post, I will spell-out why deflation is the problem we now face and why the government can do so little to stop it.

Never forget, times of financial stress are also times of financial opportunity.

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Wednesday, December 24, 2008
  Three blind mice. Three blind mice. See how they run.
There are three schools of thought concerning recessions and the business cycle:

Keynesian thought is that recessions are bad and should be fought vigorously with low interest rates and deficit government spending, even on make-work projects, to “prime the pump” and stimulate economic growth.

Monetarist thought is that recessions are bad and should be fought vigorously with consistent and predictable money supply growth irrespective of interest rates or government spending.

Austrian thought is that recessions are normal and a natural part of the business cycle. In a boom, investment and production tends to get out of alignment with consumer preferences so that a retrenchment is beneficial as well as necessary.

U.S. economic policy is entirely dominated by Keynesian and Monetarist thinking. Alan Greenspan and Ben Bernanke “successfully” steered the U.S. through more than twenty years with only two relatively short and shallow recessions by keeping interest rates artificially low and the money supply growing at a rate that was probably at least double the rate needed to match economic and population growth.

Low interest rates produced low saving rates.
With little savings in the U.S., we turned to China and the Gulf States of the Middle East to finance our government deficits. At the same time we neglected our factories, preferring to purchase imported goods, and paying for them with plentiful paper dollars. We thought we could have capitalism without capital, without production, and without risk of failure.

These policies led to the development of an economy based more on consumption and less on production. This is a sure route to excessive debt, much of it used to finance imports.

Keynesian and Monetarist policies can make an economy grow when it otherwise would not. However, preventing recessions is like trying to only breathe in. The U.S. economy is collectively exhaling now and will for some time.

Where will we go from here? The pursuit of Keynesian and Monetarist policies following a collapse will bring stagnation. Witness the eighteen years of stagnation in Japan since its stock market bubble burst in 1989. Stocks there have recently touched a twenty year low.

We’ve seen this movie before. Government spending did not end the unemployment problem in the 1930’s – all it did was to create an enormous debt. That was the opinion of Henry Morgenthau, Treasury Secretary under Franklin Roosevelt.

Economic theories are blind. They operate based not on the stated intent of bureaucrats, but on the incentives inherent within them. Austrian economic theory is like tough-love. In return for pain in the short run, it will yield prosperity in the long run, especially when combined with sound money.

Bureaucrats and congressmen get their perks and raises; we are the blind mice whose tails are cut off.

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Tuesday, December 16, 2008
  A Disturbance in The Force
I promised to tell you about a shock that I believe is coming to America. Well, this is it: I expect currency devaluation sometime in the next two years. In currency devaluation a country makes its currency less valuable in relation to a fixed standard or in relation to other currencies. This may well happen as part of a series of competitive devaluations by the U.S. and other G-7 (or G-20) countries.

Why do I believe this will happen?
1. It has happened before. In 1933, F.D.R. devalued the dollar from $20.67 per ounce to $35.00 per ounce of gold.
2. Americans are drowning in a sea of debt from a credit expansion that has gone on for more than fifty years. The collapse of the debt bubble is pushing us toward deflation that can best be stopped by creating an inflationary shock through devaluation.
3. Inflation may be the only hope (did I say “Hope”?) of helping people to pay off the mountains of debt they have accumulated. An inflationary shock of 20%, for example, would tend to cause wages (except perhaps for those of overpaid auto workers) to jump by ten to twenty percent allowing debtors to pay off their debts more easily.
4. Home prices have fallen dramatically and are likely to continue falling without a shock to the system to make them bottom quickly.
5. Prices for numerous assets are falling because of forced liquidation. Falling prices have wiped out over $2 Trillion of net worth. A bump in inflation may begin to bring some of that back, at least in nominal dollars.
6. In the 1930’s at least eighteen countries devalued their currency and most emerged from the depression fairly quickly when they did so.
7. The biggest debtor of all is the U.S. Government and the only prayer it has, (not that the government actually prays) short of taxing everyone to their eyeballs, is to inflate the currency enough to pretend to have paid off its debts.
8. Currency devaluation robs creditors to the benefit of debtors. Government bailouts so far have mainly benefited creditors. A backlash is brewing and devaluation may be the java that we all get to drink as a result.

Devaluation is a way to kick-start inflation, which I believe is coming with or without devaluation. Now, I could be dead wrong and no devaluation will ever happen, but inflation is baked into the cake. In this environment, commodities and precious metals will be the best performing assets beginning at some point and continuing for a long time thereafter. Because the U.S. Dollar is the world’s primary reserve currency, dollar devaluation will definitely qualify as a disturbance in The Force.

And now for the good news! It is a good time to assess the value of the “stuff” in your life. Chances are that if its value can be measured in dollars, it is not really all that important. Life, health, family, friends, freedom; these are gifts from God that can not be valued in dollars.

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Thursday, December 11, 2008
  The End of Dollar Hegemony  By Hon. Ron Paul
I'm still working on my next post, so I decided to post this interesting and provocative (and abbreviated by me) speech from Ron Paul. Please note that this speech was given in 2006, but is mighty relevant today! If you want a copy of the full speech, (about twice as long), just let me know. *All boldface was done by me. It does not appear in the original.*

HON. RON PAUL OF TEXAS
Before the U.S. House of Representatives

February 15, 2006

The End of Dollar Hegemony
It has been said, rightly, that he who holds the gold makes the rules.
In earlier times it was readily accepted that fair and honest trade required an exchange for something of real value. First it was simply barter of goods. Then it was discovered that gold held a universal attraction, and was a convenient substitute for more cumbersome barter transactions.

Though money developed naturally in the marketplace, as governments grew in power they assumed monopoly control over money. In time governments learned to outspend their revenues, so it wasn’t long before Kings and Caesars learned how to inflate their currencies by reducing the amount of gold in each coin-- always hoping their subjects wouldn’t discover the fraud.

This helped pressure leaders to seek more gold by conquering other nations. Financing extravagances by conquering foreign lands seemed a logical alternative to working harder and producing more. This system of government worked well for a while, but the moral decline of the people led to an unwillingness to produce for themselves. There was a limit to the number of countries that could be sacked for their wealth, and this always brought empires to an end.

That general rule has held fast throughout the ages. When gold was used, and the rules protected honest commerce, productive nations thrived. Whenever wealthy nations-- those with powerful armies and gold-- strived only for empire and easy fortunes to support welfare at home, those nations failed.

Today the principles are the same, but the process is quite different. Gold no longer is the currency of the realm; paper is. The truth now is: “He who prints the money makes the rules”-- at least for the time being. Although gold is not used, the goals are the same: compel foreign countries to produce and subsidize the country with military superiority and control over the monetary printing presses.

Since printing paper money is nothing short of counterfeiting, the issuer of the international currency must always be the country with the military might to guarantee control over the system. This magnificent scheme seems the perfect system for obtaining perpetual wealth for the country that issues the de facto world currency. The one problem, however, is that such a system destroys the character of the counterfeiting nation’s people-- just as was the case when gold was the currency and it was obtained by conquering other nations. And this destroys the incentive to save and produce, while encouraging debt and runaway welfare.

The pressure at home to inflate the currency comes from the corporate welfare recipients, as well as those who demand handouts as compensation for their needs and perceived injuries by others. In both cases personal responsibility for one’s actions is rejected.

When paper money is rejected, or when gold runs out, wealth and political stability are lost. The country then must go from living beyond its means to living beneath its means, until the economic and political systems adjust to the new rules-- rules no longer written by those who ran the now defunct printing press.

“Dollar Diplomacy,” a policy instituted by William Howard Taft and his Secretary of State Philander C. Knox, was designed to enhance U.S. commercial investments in Latin America and the Far East. This new policy came on the heels of the “gunboat” diplomacy of the late 19th century, and it meant we could buy influence before resorting to the threat of force. By the time the “dollar diplomacy” of Taft was clearly articulated, the seeds of American empire were planted. And they were destined to grow in the fertile political soil of a country that lost its love and respect for the republic bequeathed to us by the authors of the Constitution. It wasn’t too long before dollar “diplomacy” became dollar “hegemony” in the second half of the 20th century.

This transition only could have occurred with a dramatic change in monetary policy and the nature of the dollar itself.

The 1944 Bretton Woods agreement solidified the dollar as the preeminent world reserve currency, replacing the British pound. Due to our political and military muscle, and because we had a huge amount of physical gold, the world readily accepted our dollar (defined as 1/35th of an ounce of gold) as the world’s reserve currency. The dollar was said to be “as good as gold,” and convertible to all foreign central banks at that rate. For American citizens, however, it remained illegal to own. This was a gold-exchange standard that from inception was doomed to fail.

The U.S. did exactly what many predicted she would do. She printed more dollars for which there was no gold backing. But the world was content to accept those dollars for more than 25 years with little question-- until the French and others in the late 1960s demanded we fulfill our promise to pay one ounce of gold for each $35 they delivered to the U.S. Treasury. This resulted in a huge gold drain that brought an end to a very poorly devised pseudo-gold standard.

It all ended on August 15, 1971, when Nixon closed the gold window and refused to pay out any of our remaining 280 million ounces of gold. In essence, we declared our insolvency and everyone recognized some other monetary system had to be devised in order to bring stability to the markets.

Amazingly, a new system was devised which allowed the U.S. to operate the printing presses for the world reserve currency with no restraints placed on it-- not even a pretense of gold convertibility, none whatsoever! Though the new policy was even more deeply flawed, it nevertheless opened the door for dollar hegemony to spread.

Realizing the world was embarking on something new and mind boggling, elite money managers, with especially strong support from U.S. authorities, struck an agreement with OPEC to price oil in U.S. dollars exclusively for all worldwide transactions. This gave the dollar a special place among world currencies and in essence “backed” the dollar with oil. In return, the U.S. promised to protect the various oil-rich kingdoms in the Persian Gulf against threat of invasion or domestic coup. This arrangement helped ignite the radical Islamic movement among those who resented our influence in the region. The arrangement gave the dollar artificial strength, with tremendous financial benefits for the United States. It allowed us to export our monetary inflation by buying oil and other goods at a great discount as dollar influence flourished.

This post-Bretton Woods system was much more fragile than the system that existed between 1945 and 1971. Though the dollar/oil arrangement was helpful, it was not nearly as stable as the pseudo gold standard under Bretton Woods. It certainly was less stable than the gold standard of the late 19th century.

During the 1970s the dollar nearly collapsed, as oil prices surged and gold skyrocketed to $800 an ounce. By 1979 interest rates of 21% were required to rescue the system. The pressure on the dollar in the 1970s, in spite of the benefits accrued to it, reflected reckless budget deficits and monetary inflation during the 1960s. The markets were not fooled by LBJ’s claim that we could afford both “guns and butter.”

Once again the dollar was rescued, and this ushered in the age of true dollar hegemony lasting from the early 1980s to the present. With tremendous cooperation coming from the central banks and international commercial banks, the dollar was accepted as if it were gold.

In recent years central banks and various financial institutions, all with vested interests in maintaining a workable fiat dollar standard, were not secretive about selling and loaning large amounts of gold to the market even while decreasing gold prices raised serious questions about the wisdom of such a policy. They never admitted to gold price fixing, but the evidence is abundant that they believed if the gold price fell it would convey a sense of confidence to the market, confidence that they indeed had achieved amazing success in turning paper into gold.

Once again the effort between 1980 and 2000 to fool the market as to the true value of the dollar proved unsuccessful. In the past 5 years the dollar has been devalued in terms of gold by more than 50%. You just can’t fool all the people all the time, even with the power of the mighty printing press and money creating system of the Federal Reserve.

In the short run, the issuer of a fiat reserve currency can accrue great economic benefits. In the long run, it poses a threat to the country issuing the world currency. In this case that’s the United States. As long as foreign countries take our dollars in return for real goods, we come out ahead. This is a benefit many in Congress fail to recognize, as they bash China for maintaining a positive trade balance with us. But this leads to a loss of manufacturing jobs to overseas markets, as we become more dependent on others and less self-sufficient. Foreign countries accumulate our dollars due to their high savings rates, and graciously loan them back to us at low interest rates to finance our excessive consumption. (And excessive Federal Budget deficits. - GBH)

It sounds like a great deal for everyone, except the time will come when our dollars-- due to their depreciation-- will be received less enthusiastically or even be rejected by foreign countries. That could create a whole new ballgame and force us to pay a price for living beyond our means and our production. The shift in sentiment regarding the dollar has already started, but the worst is yet to come.

The agreement with OPEC in the 1970s to price oil in dollars has provided tremendous artificial strength to the dollar as the preeminent reserve currency. This has created a universal demand for the dollar, and soaks up the huge number of new dollars generated each year.

The artificial demand for our dollar, along with our military might, places us in the unique position to “rule” the world without productive work or savings, and without limits on consumer spending or deficits. The problem is, it can’t last.

Price inflation is raising its ugly head, and the NASDAQ bubble-- generated by easy money-- has burst. The housing bubble likewise created is deflating. Gold prices have doubled, and federal spending is out of sight with zero political will to rein it in. The trade deficit last year (2005) was over $728 billion. A $2 trillion war is raging, and plans are being laid to expand the war into Iran and possibly Syria. The only restraining force will be the world’s rejection of the dollar. It’s bound to come and create conditions worse than 1979-1980, which required 21% interest rates to correct. But everything possible will be done to protect the dollar in the meantime. We have a shared interest with those who hold our dollars to keep the whole charade going.

Most importantly, the dollar/oil relationship has to be maintained to keep the dollar as a preeminent currency. Any attack on this relationship will be forcefully challenged—as it already has been.

In November 2000 Saddam Hussein demanded Euros for his oil. His arrogance was a threat to the dollar. In 2001, Venezuela’s ambassador to Russia spoke of Venezuela switching to the Euro for all their oil sales. Within a year there was a coup attempt against Chavez, reportedly with assistance from our CIA.

It is an unbelievable benefit to us to import valuable goods and export depreciating dollars. The exporting countries have become addicted to our purchases for their economic growth. This dependency makes them allies in continuing the fraud, and their participation keeps the dollar’s value artificially high. If this system were workable long term, American citizens would never have to work again. We too could enjoy “bread and circuses” just as the Romans did, but their gold finally ran out and the inability of Rome to continue to plunder conquered nations brought an end to her empire.

The same thing will happen to us if we don’t change our ways. Though we don’t occupy foreign countries to directly plunder, we nevertheless have spread our troops across 130 nations of the world. Our intense effort to spread our power in the oil-rich Middle East is not a coincidence. But unlike the old days, we don’t declare direct ownership of the natural resources-- we just insist that we can buy what we want and pay for it with our paper money. Any country that challenges our authority does so at great risk.

Ironically, dollar superiority depends on our strong military, and our strong military depends on the dollar. As long as foreign recipients take our dollars for real goods and are willing to finance our extravagant consumption and militarism, the status quo will continue regardless of how huge our foreign debt and current account deficit become.

Using force to compel people to accept money without real value can only work in the short run. It ultimately leads to economic dislocation, both domestic and international, and always ends with a price to be paid.

The economic law that honest exchange demands only things of real value as currency cannot be repealed. The chaos that one day will ensue from our 35-year experiment with worldwide fiat money will require a return to money of real value. We will know that day is approaching when oil-producing countries demand gold, or its equivalent, for their oil rather than dollars or Euros. The sooner the better.

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Tuesday, December 02, 2008
  The Seven Lean Years - Part 2
Humpty Dumpty sat on a wall.
Humpty Dumpty had a great fall.
All the king's horses and all the king's men
Couldn't put Humpty together again.

In the last post I discussed why, neither the Fed, nor the Treasury, nor the President will be able to get the economy out of crises and going again by getting consumers to splurge on cars or houses (or other consumer goods) because we are, on average, far too deeply in debt.

There is a second set of reasons the government will be unsuccessful in getting Americans to spend freely again and it has two related aspects. They are demographic and generational.

I’m sure everyone knows that the Baby Boom generation (born 1943-1960) is due to begin retiring in huge numbers every year for the next twenty years. Boomers have done well and spent freely, but that is going to change. Or perhaps I should say it already is changing.

Shell-shocked by market losses, millions of Boomers have likely decided they no longer need a second home, a lake cottage, a time share, or even a bigger house. They also know they can keep the car another year, if not two or three more years. Priorities have changed.

When the dotcom bubble burst and the market fell from 2000 through 2002, retirement did not seem quite so close and besides, everyone knew it had been a bubble. The recession in 2001 was neither long nor severe and real estate was rising quickly in value with gains there more than offsetting stock market losses for many people.

Now, with real estate in decline, markets sinking, and great economic uncertainty, Boomers are no longer inclined to spend. Many, if not most, have good credit and are less likely to be too far in debt to borrow for new cars and bigger houses, they simply will not in the face of current circumstances.

And now, the generational aspect. Different generations have different values and different ways of looking at the world. There are two highly acclaimed books about this topic written by William Strauss and Neil Howe. (Generations: The History of America's Future, 1584 to 2069, and The Fourth Turning, an American Prophecy) Their analysis concludes that there are four generational types that repeat in a cycle that normally lasts from 70 to 110 years altogether.

During a full cycle, our county goes from what they describe as spring to summer to fall and to winter and in each season what our country experiences is determined by which generation or generations are in power. Strauss and Howe conclude that we are entering a winter or “crises” season. Past winters have produced the American Revolution, the Civil War, and the Great Depression & WW II. Scary stuff! If you care to read their work, you can draw you own conclusions.

What I have to say about the economy and the ability of the government to get it jump-started again is not dependent on whether or not you agree with Strauss and Howe. You can observe for yourself, I believe, that there is truth in what I write below.

Gen-X (b. 1961-1981) and the Millennial generation (b. 1982-2001), as compared to Boomers, tend to put a higher value community and a lesser value on consuming. Think myspace, facebook, and text messaging vs. McMansions, SUV’s, and nice suits.

This is not to say that Boomers do not value community and that Gen-Xers and Millennials don’t buy houses, cars, and clothes, it is to say that there is a marginal difference in how each generation values these things and that over time these differences will produce a pronounced change in the economy. According to Merrill Lynch economist David Rosenberg, “The savings rate is soaring, .., and (this) is a shift that we believe should be seen as secular, not merely cyclical.” (Emphasis added.) I believe this is part of a change that will make it difficult to go back to a 1990’s style market and economic boom at anytime soon.

The government seems to have gone wild with bailouts, borrowing, and binge spending. A big shock to our economy, the nation, and the world is likely to come. In my next post, I will tell you what it is and why I believe it is coming.

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Monday, December 01, 2008
  Comment from a Reader...
Here is one comment that came from Eric in response to my last post, along with my comments:

I think your observations are dead on. However, as bad as the situation is on the household debt situation, I fear the more serious problem is the situation our nation is in. Our perpetual creation of dollars through the fed seems akin to a consumer adding more and more credit cards and using promotional balance transfers to roll over an increasing amount of debt. Eventually, the foreign nations who are extending this credit will have to realize that we do not have the ability to repay our debts, and will have to stop lending to us. Could this happen? Why or why not?

I believe you are correct in the way you describe our debt situation as a country. The crazy thing is that foreigners may go on lending to us for a lot longer than anyone can believe. They could stop next year, or it could continue for the next 50 years.
If I can find it, I will post the text of a speech by Congressman Ron Paul in which he makes the argument that foreign countries will accept our IOU's for as long as we are a great military power and that should we fail in that respect, then we will begin to decline as an economic power as well.
The Fed's money creation is a problem and it will have serious consequences at some point. In a week or so, I will describe what one consequence may be and tell you why I believe it is coming sooner than most people believe.
 
Commentary about all things human; life, the Christian religion, ethics, politics, economics, sociology, art, anything to do with twenty-first century American culture. Perhaps I will inform, perhaps I will anger and frustrate, but I hope always to make you think!

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Location: Fort Wayne, Indiana, United States

I grew up in Kansas in the 1950's - 60's. I attended Kansas State (B.S. in Soc. Science) and Washburn Law School (J.D.). My wife and I have been married for over thirty years and are the parents of three grown sons.

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