Gold & Fiat Money

“I do not under any circumstance favor raising the price of gold. It would perpetuate that “barbarous metal” in international monetary use. We have quite rightly broken the link between gold and our domestic money. We should also break the link between gold and international money. The supply of money, neither domestic nor international, should not be dependent over the long run on the accidents of supply and demand in the marketplace for just one commodity.” July 12, 1968 – Darryl R. Francis, President of the Reserve Bank of St. Louis. 1.

And so it came to pass not long after the speech by Mr. Francis that in August 1971 US President Richard Nixon unilaterally broke the US$/gold peg and declared the US$ no longer convertible to gold. The convertibility of US$’s to gold was the last tenuous link between fiat currencies pegged to the US$ and gold. I pick up the tale of Gold and Fiat Money in January 1971 and will tell this tale with graphs. Graphs of fiat money; of consumer inflations and asset inflations; interest rates; central bank activities; gold prices; and official gold movements.

Placing the fiat money year of 1971 in the context of gold requires a pit stop at inflation. Often we are lulled into a sense of security by looking at the inflation rate. This time perhaps we should first look at the traditional inflation index, the CPI.





1971 certainly looks like an important point in consumer inflation history. The index chart is revealing but the traditional inflation rate chart is also required to complete the picture.





The inflation rate was 5.3% in January 1971 and after an initial decline, it increased to peak at 14.4% in May 1980. The actual index data is much more telling than the annual rate of change data.

Consumer inflation is but one facet of inflation. A less obvious inflation is asset inflation. There are no official statistics to extract asset inflations and no consensus measurement of an asset inflation index. The DJIA will be used as a proxy for asset inflation in this analysis.

Gold and the managers of fiat money.

Gold has always been the unofficial informant on inflation activity. A precious metal much maligned and feverishly coveted. It is said that it has no purpose and no industrial application. Snide comments about a barbaric metal ruling human emotions are common. What about the role played by gold in human relationships? Relationships between men and women, lovers, friends and family? What about the gifts of jewelry, of dowry or of inheritance?

Gold has always been a store of value in the history of mankind and still is, despite 1971. In 2010 the gold price confirms that gold as a monetary metal is still the ultimate go-to store of value in times of trouble. Mr. Francis, in the same speech as quoted from above, warned in 1968 that the then international trade and currency crisis may cause a “run on gold”. In 2010 we look back upon the gold price rise since 2000 and again contemplate a run on gold.

The largest concentrations of holdings of this scarce metal, of which the total above ground stock will only make up a cube of less than 20 cubic meters, are still held officially by Sovereigns and International Institutions (IMF, BIS, EPU/EF, EMI and others). The World Gold Council has kept a record from 1948 of the Gold Reserves of Major Official Gold Holders. They held 29,727 tons of gold at the end of 2008, down from a peak of 38,347 tons in 1965. My generous guess of the US$ value of Official Gold Reserves in July 2010 would be about $1.167 trillion (30,000 tons * 32,151 troy oz * $1210).

We can take a picture of the interaction between the $ gold price and the managers of fiat money since 1971 by observing the activity of the Major Official Gold Holders. Did they buy or did they sell?





For now we just gather the components and observe the dynamics. Observe a first phase of official selling activity from 1971 to 1980. Note a second phase of official selling; slow at first from about the middle of the eighties but accelerating into 2006 and easing off since then. Both phases climaxed in a dichotomy of high official sales and a parabolic rise in gold price.

The moves in Official Gold Reserves are a good proxy for gold movement between the “Global Public Sector” and the “Global Private Sector”. The inclusion of International Institutions with the Global Public Sector will avoid the distraction of interactions and gold movements between Sovereigns and International Institutions.

The chart is clear, the Official Holders have sold gold reserves sine 1971 and have been growing total sovereign reserves by buying each other’s sovereign debt rather than increase gold holdings. Gold is nobody’s debt, safe from default. Exchanging fiat money debt for the reality of gold, the plenty for the scarce, an ever increasing promise to pay for a historic store of value will for now remain a logical and philosophical puzzle.





The global Official Foreign Exchange Reserves ratio to the Global Official Gold Reserves valued in US$ has increased from 3.2 to 1 in 1995 to a staggering 10 to 1 in 2008. The increase in currency reserves happened in spite of a doubling of the annual gold price from 1995 to 2008.

Interest rates.

Interest rates feature prominently in any analyses of fiat money and of gold. Gold pays no interest but is claimed to be a better store of value than fiat money, a claim supported by the inflation indexes. The inflation index has shown what happened to fiat money but what about the influence of interest rates?

The Federal Funds Rate will be the proxy for short term rates and the 10 year Treasury Rate (constant maturity) will be the proxy for long term rates.





Here a dominance of the short term rate higher than the long term rate can be observed for the period 1971 to 1981. The short term rate dominates to the downside from the long term rate from 1982 to 2010. The Federal Funds Rate for the two distinct phases was 4.14% in 1971 raising to peak at 19.1% in June 1981 and falling from there to a low of 0.11% in January 2010.

USA Central Bank (Board of the Federal Reserve System) activity.

The on balance sheet fiat money activity of the central bank requires scrutiny.

The first variable is the Currency in Circulation. It grows from $56 billion in January 1971 to $ 941 billion by June 2010. In the context of gold compare the growth in Currency in Circulation with the value of the Global Official Gold Reserves.

The next variable for scrutiny is the Reserve Balances with Federal Reserve Banks from the banking sector. It has a history of almost no significance other than diminishing to mostly below $10 billion by August 2008 when suddenly it gains a significant new prominence.





These two major footprints explain the origin of the liabilities of the central bank, where it gets its balance sheet liquidity from. The near trillion dollar growth in Currency in Circulation (interest free) for the period January 1971 to June 2010 is significant but the explosion in Reserve Balances by $1,02 trillion from August 2008 to June 2010 will require explanation.

Some of the answer lies with the asset side of the balance sheet of the central bank.





The Reserve Bank Credit series defines the asset side of the balance sheet and is described by the Board of the Federal Reserve (the Fed) as:

“Reserve Bank credit is the sum of securities held outright, repurchase agreements, term auction credit, other loans, net portfolio holdings of Commercial Paper Funding Facility LLC, net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility, net portfolio holdings of Maiden Lane LLC, net portfolio holdings of Maiden Lane II LLC, net portfolio holdings of Maiden Lane III LLC, float, central bank liquidity swaps, and other Federal Reserve assets.”

It includes all the facilities and programs implemented by the Fed in acting as the central bank for the banks and as manager of the sales of central government debt including all the emergency measures taken since August 2008. The emergency facilities fill the gap between August 2008 and late November 2008 to January 2009 when purchases of mortgage backed securities were announced and implemented.

The dominant asset component in the Reserve Bank Credit variable is that of Securities Held Outright.

The securities held by the Fed prior to August 2008 were predominantly Public Sector securities. Since introducing emergency measures in response to the Global Financial Crises in August 2008 the mix has changed and the “Securities Held Outright” series is currently defined as:

“The amount of securities held by Federal Reserve Banks. This quantity is the cumulative result of permanent open market operations: outright purchases or sales of securities, conducted by the Federal Reserve. Section 14 of the Federal Reserve Act defines the securities that the Federal Reserve is authorized to buy and sell.”

Mortgage-backed securities as part of Securities Held Outright amounted to $1.119 trillion as at 30 June 2010 and are described as:

“On November 25, 2008, the Federal Reserve announced a program to purchase mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. The goal of the program is to provide support to mortgage and housing markets and to foster improved conditions in financial markets. Purchases of these securities began on January 5, 2009.
Additional information on System transactions in mortgage-backed securities is available at www.newyorkfed.org/markets/mbs/.”

These numbers are important for it shows that the Reserve Balances of the banking sector as a liability of the Fed is near matched with the investment in mortgage backed securities. The monetary activity of venturing into mortgage-backed securities has been sterilized by the growth in the Reserve Balances of the banking sector. Here it is important to understand that the mortgage-backed facility quarantines what would have been a deflationary implosion of the housing bubble (a major debt inflated asset bubble). The Reserve Balances cannot be released into the banking sector while the Fed is invested in mortgage-backed securities without unleashing significant inflation risks. The interest received on the mortgage-backed securities will finance the interest payable by the Fed on the Reserve Balances of the banks.

The activities of monetary authorities as expressed in the assets and liabilities can be summarized in the Reserve Bank Credit series (asset side of the balance sheet) or in the Sum of Currency in Circulation & Reserve Balances (liabilities of the Fed).





The mortgage-backed facility of the Fed is close to full utilization at $1.25 trillion.

The central bank is active in providing liquidity to the banking sector. This activity is behind the achievement of the targeted Federal Funds Rate. Rapid debt formation is the result of stimulatory central bank liquidity provision.





The decline in Household Debt in the presence of historically low interest rates and easy access to liquidity is indicative of debt saturation (see War on Savings available on my blog at http://sareloberholster.blogspot.com/).





Government stepped up Public Debt formation when Household Debt started to collapse.

Liquidity provision also spilled over into the rest of the economy and gave rise to investor facilitation of additional debt formation beyond the banking sector. The chart of Commercial Paper outstanding will be the proxy for this development. The housing bubble and mortgage-backed securities supply accounts for most of the growth from 2004 to 2007 and for most of the decline from 2007 to 2010.





Inflations and the gold price.

How did the gold price perform against the inflation indexes?





The sales activities of the Major Official Holders of gold help to explain the delays in the gold price response to inflations. The relative importance of gold over time as a commodity and as a monetary metal is visible in the gold price. See for example the decline in gold price prior to the decline in the PPI in 2008/09 which raises a question, how did the gold price anticipate the decline in the PPI? The rise in gold price since 2008, given the information presented in these charts, certainly seems monetary in origin.

The relationships are not constant but the influences are visible. Stock exchanges are a popular asset class for asset inflation. Observe the interaction between the traditional inflations and the DJIA as a proxy for asset inflation.





The period from 1971 to 1981 saw significant inflation in both PPI and CPI but no DJIA asset inflation is evident. The rising and high interest rates during this period probably caused the muted asset inflation response but it requires a chart of its own. The DJIA shows significant asset inflation rising from 875 on monthly data in December 1981 to 11,497 in December 1999. Then came the period of instability from 2000 to 2010. First the Tech crash of 2000 to 2003, followed by the housing bubble pick-me-up into late 2007, together with the global economic crises and finally (for now) the rebound out of March 2009.

How did the gold price interact with the DJIA as asset inflation proxy?





The gold price responded to the inflations of the CPI and the PPI in the 1971 to 1981 period when DJIA asset inflation was absent but failed to respond to the intense initial asset inflation period of the DJIA. The gold price only took off with the arrival of the period of instability.

Interest Rates and Inflations.

The presentation of the asset inflation proxy and interest rates in one chart provides valuable insights.





The rising interest rate phase from 1971 to 1981 kept asset inflation at bay but the declining phase from the Federal Funds Rate of 19.1% to around 3% in 1993/94 set the stage for significant asset inflation. Observe also the more stable decline in the long term rate. Interest rates of around 5% and generally declining, on observation, point to strong asset inflation. The invest-with-debt characteristic so evident during the housing bubble may be behind this phenomenon. The asset inflation in the period 2001 to 2010 required additional declines in interest rates to prevent asset deflation. These interventions drove interest rates to near zero while attempting to maintain the asset inflations.

The gold price did not respond in the same manner as asset inflations did towards interest rates.





Note how the gold price rose into a parabolic spike together with interest rates in the period 1971 to 1980. It then declined with interest rates into 2001 just to break away in contradiction, into another parabolic rise but this time with interest rates declining into the absurdity of the zero bound. The gold price responded to factors which had an impact on interest rates but the gold price and interest rates seem to have little in common. This is significant since gold responded to traditional inflations and since 2001 also to asset inflation. Interest rates may have a connection with the rate of change of the inflation index but the actual performance of inflation indexes and asset inflations are not well correlated with interest rates. This statement is consistent with an economy where the interest rate is decided by the managers of fiat money and not established with price discovery in the markets.

The Gold price as a whistleblower on inflation is warning that the cumulative effects of traditional and asset inflations on the gold price in the era of fiat money can no longer be contained by official gold sales. In 2010 as in 1968, again there is global debate with reference to international currency instabilities and international trade structural stress due to merchantalistic currency practices by export orientated countries.





The declining trend in Federal Funds Rate from 2001 to the present is no longer consistent with the movements in the inflation indexes, particularly with asset inflations for the same period. The gold price has decided to side with risk and inflation given this altered state between interest rates and all the inflations.

Multiple Variable Charts








Summary of Observations.

1. Inflation is not as muted as indicated by the consumer inflation rate when viewed form the perspective of the PPI, CPI and asset inflations.
2. Official gold sales have been depressing the Gold Price since 1971 yet failed to contain the 2001/2 to 2010 strong advance in the gold price.
3. Lowering interest rates into the zero bound has contributed significantly to the creation of asset inflations and the zero bound is now a necessity in preventing further collapse of the asset inflations.
4. Balance sheet expansion, lowering interest rates and liquidity provisions by the central bank had facilitated parabolic debt expansions which have lately become unsustainable even with unrestrained liquidity provision and near zero interest rates.
5. Quarantining the housing bubble and sterilizing the potential liquidity spill into the economy have trapped the central bank in stasis between the powerful forces of hyperinflation and deflation.
6. A rising gold price is responding to economic risk generally, store of value risks particularly that of fiat money, economic structural instability and the risk of hyperinflationary events in currencies.
7. Household debt formation and private securities debt markets have turned negative while already high US government debt is rising in a new parabolic spike.
8. Default risk on Sovereign Debt and a rising gold price have restrained gold sales by Major Official Holders of gold reserves since 2006 and may well turn around a philosophy of official selling which have prevailed since 1965.
9. The spike in the gold price since 2009 coincides with the purchase of mortgage-backed securities by the Fed as the main component in placing the housing asset inflation in quarantine.
10. The period from 2007 to mid 2010 is typified by extreme PPI changes, gold price movements, stock exchange movements, central bank balance sheet activity, interest rate adjustments and debt formation activity. Nothing in the charts can be interpreted as economic harmony while extreme volatility writes “risk” in neon letters.

The tale in the charts from the dawn of irredeemable fiat money to a dusk of economic structural distortions is but a footnote in the economic history of gold.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA).
14 July 2010

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

© Sarel Oberholster

Reference:
1. Francis, Darryl R, (1968), The Balance of Payments, The Dollar and Gold, Speech at a Rotary Inter City meeting Webster Groves, YMCA, p 13, published by the Federal Reserve Bank of St Louis at http://fraser.stlouisfed.org/historicaldocs/DRF68/download/38004/Francis_19680712.pdf .

Like Hungry Lions

(Preamble: This essay contains economic charts which are explanatory on a technical level but you can skip them without affecting general content as they are there to underpin technical validity.)

Government is often compared to a parasite in economic context. It produces nothing yet takes from the economy for its own needs and for the needs of voters. I believe that a better analogy for government’s presence in an economic system is that or a predator.

Prey gathers the resources of the earth and converts it into desirable protein. Predators hunt the prey and consume the proteins directly. A sustainable ecosystem in which there is dynamic harmony and balance between predator and prey ensures the survival of both hunter and prey within the boundaries of available resources of food and water. A sustainable dynamic harmony will survive the changing of the seasons, climate cycles and even some catastrophes.

A similar harmony exists inside an economic system between the private sector and the public sector.

Contemplate for a moment that the predators get access to a new refined hunting technique which turns natural prey into abundant “canned prey”. The predators will enter a growth phase that will vastly increase the numbers of predators. The harmony and balance of the ecosystem will slowly change. Initially the targeted canned pay will sustain the growth but the increased numbers of hunting predators will place pressure on the supply chain of prey. Growth of the prey population will contract in a dynamic exchange process relative to the growth of the predator population. This process will accelerate with the growth of predators’ numbers while dwindling numbers of natural prey will force greater harvesting of “canned prey” for predator growth and survival. Natural prey is overharvested and the renewal of the herds gets destroyed. In time natural prey will all but disappear. Hungry predators will hunt all remaining natural prey to extinction with the new irresistible hunting technique, while progressively starving on their way to their own extinction.

It is a somewhat nasty outcome as the change in “hunting technique” must be counterbalanced by a change in “escaping technique” for prey to restore a sustainable harmony in the ecosystem.

Modern monetary policy has handed to the governmental predator a new hunting technique on private sector prey. Digital monetary creation hides the overharvesting of production surpluses mostly manifested in savings and capital, the flesh that governments consume. Predatory government growth explodes and it hunts the production surpluses to extinction. Then it hunts all remaining capital and savings to extinction. Politicians throughout history have often claimed to be at war with the markets. To be at war with the markets or the economy generally is to be at war with one’s own citizens.


The predators in my analogy have a “licence to kill”. We know that as society we give to governments also a licence to kill. We know further that we must diligently watch and monitor government’s use of its licence to kill, for a government that develops an excessive appetite for killing is a dangerous and probably harmful government which will soon find itself at odds with its population. Voters in democratic systems will kick out and probably prosecute such a government in no time.

Society also grants governments a “licence to hunt” in the economy by way of taxation. We diligently watch government’s taxation for a government that similarly develops an excessive appetite for taxation is a harmful government and will soon find itself at odds with its population. Voters in democratic systems will similarly kick out such a government in no time.

Governments being predatory are always on the lookout for ways to grow its presence. It needs taxation or debt to fund its growth. Voters are not too diligent on government debt and if governments can hide debt growth in accounting practices then so much the better. Success means no general voters’ revolt against government debt formation. Government can grow somewhat but before long it vests the majority of economically available savings upon itself and voters get restless.




(Click on the chart for a larger image)

Predatory government then needs to find a new refined hunting technique. A technique that will allow it to continue to grow by way of debt, without causing a voters’ revolt.

It finds the refined new hunting technique in the creation of digital money with which it can increase the liquidity quantity of savings by counterfeiting money. It uses the central bank to achieve this objective and disguises its own hand in the arrangement in the pretence of an independent central bank. In modern monetary economics governments have realised that it need not arrange with the central bank to hand over all the counterfeit money, it only needs to have access to more-and-more debt without appearing to consume all the savings and liquidity for itself. By not claiming all the newly created liquidity governments successfully bribes the institutional economy and private sector leadership with early access to and super profits from the newly created liquidity.

“Money is the root of all evil”, is a general misquote from the Good Book. The more correct quote is "For the love of money is a root of all sorts of evil," [see Wikipedia on Root of all Evil.] Debt is not evil and very useful to the economy when it is utilised in a responsible and sustainable manner. Love of debt from liquidity creation is a root of all sorts of evil.

This sets into motion a process of unsustainable debt formation. A process that once started, is almost impossible to turn around. A process that will destroy the harmonious coexistence between predator and prey until both are extinct. A self destruction process unless the ecosystem/economic system finds a way to rebalance the coexistence between predator and prey.




(Click on the chart for a larger image)

The intervention and liquidity provision not only increase the amount of available debt, it also cause a reduction in interest rates. A fantastic outcome for the predators but for the unintended outcome on supply of savings from production surpluses.

The economic system can only generate sustainable debt at the lower savings supply level before the addition of liquidity provision and at the higher interest rate which sustains that level of savings formation. The new normal for sustainable debt at the lower interest rate is an even lower level of savings formation at that lower interest rate.

The new economic reality is that the economic system can no longer facilitate repayment of the debt levels unless some future external economic rescue happens, for example a major technological advance with significant economic benefits. Thus the system now generates unsustainable debt, not capable of repayment from savings. Debt not capable of repayment from savings is debt not capable of repayment at all. Thus this monetary model generates bad debts. Bad debts that the private sector users of debt will eventually find impossible to repay from private sector savings. Bad public debt that the governments will eventually be unable to repay from politically viable tax collections.

This process of liquidity creation will accelerate and feed upon itself until it drives the economy into zero interest rates and drive savings towards extinction. Zero interest rates are no impediment against further expansions of digital liquidity.




(Click on the chart for a larger image)

This process is hyperinflationary in the extreme but the hyperinflation can manifest in CPI or in asset bubbles. In fact, modern monetary policy prides itself on avoiding the CPI outcome. The most notable asset bubble is the overvaluation of debt based financial assets. The global economy discovered some of that overvalued private debt in 2007. Discovering the overvaluation of government debt lies at the end of this road. Discovering also that government will default on its obligations against all populist expectations is another systemic shock in waiting. Government debt default arrives first covertly, but eventually overtly. We have already seen the incremental defaults on pension liabilities by increasing the pension age. Proportional international debt default is usually achieved through currency devaluation, presently captured in the desperate race between governments towards having the weakest currency. Early signs of public default are governmental debt collapse around the fringes. Will Greek citizens be forced to repay in euro savings or will the Greek government be forced to abandon the euro and devalue a new Greek currency in partial debt default? The true nightmare is the reality of pension fund savings invested in mispriced, hyper inflated private and public debt. Monetary liquidity provision destroys savings with no regard for international borders. Defaults will similarly not pay homage to international borders. Governments will be forced to protect their national savings base against predatory monetary policies of other governments.

Hyper inflated equity prices are yet another manifestation of the digital liquidity hyperinflation wrapped in palatable form, if not extremely attractive marketable form.

The liquidity provisions from digital money must be removed from the global economy for structural harmony to be restored. Either through a long term return to a culture of savings without any further increases in liquidity provision via digital money, debt default or a combination of both. Most of such renewed saving will probably be expropriated through taxes by governments to the extent that they need to reduce their predatory debt levels.

Furthermore, substantial new savings formation cannot happen at zero interest rates. It follows that the division between default and savings formation will be decided at interest rate level. If zero interest rates are a given, then await the default process. Higher taxes and increased interest rates will see a gradual return to harmony. Point out those politicians who will be able to sell higher interest rates and higher taxes and survive at the polls then calculate the odds for systemic default. Voters won’t vote for order and will harvest chaos.

We have already entered the final phase of this process. Look around and know that you are prey even if only for the pension savings flesh that you can provide. Know that governments will hunt your savings like hungry lions in their quest to preserve the pride. Know that your savings cannot prevail against the hungry lions unless you have nimbly removed it from the hunting grounds and placed it into assets far removed from prying eyes of hungry lions. Know also that banks cannot survive without deposits. When most deposits are driven into hyper inflated traded debt or equity in search of alpha, know that a banking system built upon monetary liquidity rather than savings is a system that cannot survive in that form. Know thus that banking systemic risk will untimely rear its ugly head once more when government defaults consume the last available true savings in the system.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA).
1 July 2010

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster

Rouletteconomics

“In December of 1639, Pascal's father had moved the family to Rouen where he took a job as tax collector for the region. Pascal's invention of the mechanical calculator in 1641 was borne out of a desire to help his father in collecting taxes. … Pascal worked on many versions of the devices, leading to his attempt to create a perpetual motion machine. He has been credited with introducing the roulette machine, which was a by-product of these experiments.” - Inventor of the Week Archive, Lemelson-MIT Program, May 2003

The simple economics of supply, demand and price are probably the widest known and most used part of economic life for the majority of all participants. We know the basics, too much supply and the market is flooded with a product, the price drops and the producers are encouraged to produce less of that product and look for another opportunity. Simple, or not? On the other side, rules of demand state that a lower price would actually encourage demand to absorb at least some of the over supply. Huge demand and insufficient supply and the opposite happen.

The truth is that there is an endless interaction between price, supply and demand in a dynamic process of price discovery which, like infinity, can be conceptualised in the abstract but one can never quite get your hands on it. Nobody tries to interfere with infinity or to manage infinity but managing price is always fair game.

Now add the tendency of humans to manipulate their environments to their advantage and we see that economics is studied mostly for insights to manipulate for a gain. Nobody pays more for these insights than government for it has unbridled power to manipulate at a macro level. A myriad of other manipulators are much less ambitious and will stick to “niche” markets where they will often attempt to access government power to manipulate their chosen niche market.

Free market economists are seldom as much in demand as economists specialising in market manipulation so why do these unwanted economists refuse to die out and where do they get gainful employment? These economists have learned to look beyond the manipulation and know that, in time, someone will be needed to attend to the repairs to the economic fabric torn by a multitude of manipulations.

Taking our cue from Pascal, where government economic manipulators are looking to maximise taxes in an economic model of perpetually increased tax flows, a peek into market manipulation can be demonstrated by looking at a roulette table. The rules of the table are devised and the roulette table market is set into operation. All participants to the market event (the betting, the spin of the wheel and the roll of the ball) know the rules and the odds.

Two very important preconditions exist. The wheel and the ball must spin and roll without interference and the fall of the ball be left in the unbiased hands of chance. All the punters must be treated equally.

What happens at the table? A redistribution of the pool of bets at the hands of chance and the “House” as operator of the “roulette market” gets a “house percentage”. That is it, and it repeats endlessly for as long as money enters the table. Pool established, turn of the wheel and roll of the ball, the house cut and redistribution according to the placing of the bets and the outcome of the roll. The house cut in roulette is its statistical edge generally calculated to be 5.26%. The House has to manage its income as it would realise the house edge only once it has a statistically large enough number of events.

The game of manipulation immediately gets under way. Certain punters want to find a system to improve their odds. The House wants to find a way to improve its odds and the “marks” just trust in blind luck.

The House has a vested interest in maintaining a status quo and will go as far as prosecuting punters who “game” the system for the roulette market will collapse should the redistribution be taken from the hands of chance. The House will lose its cut or the punter will walk away from a rigged market. Perpetual motion in the roulette market cannot have a single or a few winners and everybody else a loser, or can it?

Say Mr Well Connected arranges with the House special rules that would ensure that he gets a guaranteed winning percentage of the pool. What would happen? Would the punters simply stop punting?

Say Mr Government wants to do the same but it wants an upfront guaranteed cut irrespective of how the redistribution is done thereafter. What needs to be done? Engage the power of governance.

Say Mr Well Connected wants punters to be forced to continue to punt so he can get his slice. What would need to be done? Engage the power of governance.

Governance is a crude intervention and breeds rebellion so alternatives are always sought. The best solution would be to ensure that there is always a lot of money in the pool for punters, the House and Mr Government to take cuts.

The solution is to flood the betting with counterfeit money of such good quality that nobody can see the difference. Who better to do that than the original source of money, the Central Bank? Central Bank money creation will express as debt and too much of it as reckless private or sovereign debt. No matter, Mr Well Connected and Mr Government enters into a Public Private Partnership whereby Mr Well Connected arranges for the orderly distribution of the counterfeit money on behalf of Mr Government in exchange for a percentage of the cash at the table.

Mr Big Spender at the table soon gets into trouble with too much punting while having too little money and far too much debt. He begs Mr Government for a bailout. Mr Government arranges special “F” chips for Mr Big Spender backed by special counterfeit money because Mr Big Spender must be kept at the table else the whole game collapses.

The House has since also made a deal with Miss Lightning Fast Punt who now has a special arrangement, for a fee. She gets to bet first and can withdraw bets one nanosecond before the ball falls. She manages her bets to time the ball and make sure she hardly ever gets a loosing punt. Mr Government does not like the deal very much but Miss Lightning Fast Punt can sure fill a table fast with bets and makes the game look very good so Mr Government just makes unhappy noises but does not interfere with the arrangement.

Round and round the betting would go, the House makes money, Mr Well Connected makes money, Mr Government makes money, Miss Lightning Fast Punt makes money and even lots of lucky punters on the right side of the wheel make money. Mr Big Spender keeps loosing money but with an unlimited credit line to counterfeit money plays like never before. The money pool at the table is saturated with counterfeit money, gambling on debt, a deadly game that always ends in disaster.

The pool money must remain at the table. It can never be withdrawn from the table to enter the economy of goods and services, of real things. It must remain at the table where the game of illusionary wealth is the reward while Mr Well Connected, the House, Miss Lightning Fast Punt and Mr Government spends their cuts in the real economy. The betting pool, however, must remain at the table or else Mr Government will be called upon to pay its debt, a debt that will have to be taken as taxes while using the power of governance. A debt that may be reneged upon in the interest of "the people".

The roulette market is no longer the willing participants market but a market controlled and managed to maintain the money pool at the table at all costs. It now also needs tinkering with the bets and payouts. For instance, the black and red simple bets may now only be played with “I” chips and Mr Government will decide the payout.

What aught to be and what will be are seldom the same so in the end the pool money will escape or a punter will find that the “chips” simply cannot be cashed in and then the game is up. The game is always up when the “mark” is cleaned out. In the game of economics that is when the savers have been cleaned out.

Until then, Mr Government drains the real money form the roulette pool, spends it and runs up a debt that is impossible to repay. Mr Well Connected and Miss Lightning Fast Punt bets at the table and always win, the House is happy with activity, Mr Big Spender can play at will while the punters enjoy their illusion for as long as it lasts.

In time the rouletteconomy becomes unstable and collapse. Then for a short period there will be strong demand for free market economists to repair what is broken before the counterfeiting of money returns as a pacemaker for economic activity. Benign at first, menacing at the end.

The game at rouletteconomy is a dangerous game but fortunately it is just a figment of my imagination, or is it not?

When the chips are down make sure that your payback will not be all illusion for the “real” economic calculator will apply when more Mr Governments are caught at running up bills they cannot hope to ever repay. If you are a saver, know that you are the mark and convert your savings in good time into a reliable store of value far away from the hands of manipulators.

Sarel Oberholster
BCom (Cum Laude), CAIB(SA).
28 May 2010

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster

The Independence of the FED

There is a thesis that the banks are in control of the Fed and as a result had gained control over the issuance of the currency of the US. This thesis is based on the fact that the shares of the Federal Reserve Bank are held by these private banks. Does that mean that the private banks own the Fed? The short answer is yes but it is a hollow ownership with very restricted rights, basically to provide a smokescreen for the claim that the fed is independent. It is appropriately described as follows in the publication by the Fed available on its website, “Federal Reserve System Purposes & Functions” (1):

“The holding of this stock, however, does not carry with it the control and financial interest conveyed to holders of common stock in for-profit organizations. It is merely a legal obligation of Federal Reserve membership, and the stock may not be sold or pledged as collateral for loans. Member banks receive a 6 percent dividend annually on their stock…” (p12)

This is exactly the manner in which Special Purpose Vehicles (or Special Purpose Entities) are created in the corporate world. There is usually a promoter who does not wish to be seen to own an entity but who wishes to derive some benefit from the existence of such an entity without the burdens of ownership, which more often than not, would adversely impact on the presentation of its financial reporting.

The authorities and regulators including the Fed are very aware of these structures as are the accounting profession and rules have been devised and implemented to assess any such arrangement to establish its true nature. It is therefore appropriate to assess the Fed independence or alternatively interdependence according to the very rules that it uses to assess Special Purpose Entities. First let’s draw the simple ownership structure.






Anyone with a rudimentary knowledge of accounting principles would know that ownership of an entity without control over that entity requires further investigation. Consolidation of a group of companies can become complex when ownership and control are split. Ownership will be ignored and focus will be shifted to control according to GAAP (Generally Accepted Accounting Principles).

For example, a right to appoint the majority of the Board of Directors even in the absence of ownership would trigger a consolidation of that entity. Thus the controller and the entity would be seen as part of a group and collectively as a single interdependent consolidated entity. It follows that the above simple structure of the Federal Reserve Banks is a split structure where “ownership” is of limited significance and “control” must be established. Control will tell us whether the entities are independent or interdependent.

All regulation targets “control” and not just the legal form of ownership.

Accounting principles of consolidation have evolved from Special Purpose Vehicles, to Special Purpose Entities and very lately with the revision in June 2009 for implementation in January 2010 of Financial Accounting Standard 46(R) (“FIN 46(R)”) to the concept of a “Variable Interest Entity”. One can simplify the concept to question whether they are a family and the DNA test is to check for a “variable interest”. FIN 46 (R) defines a “variable interest” as follows:

“Paragraph 1A:

The enterprise with a variable interest or interests that provide the enterprise with a controlling financial interest in a variable interest entity will have both of the following characteristics:

a. The power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance

b. The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.”(2)

The first test is to check for “the power to direct the activities…” Who exactly holds that power?

Here we turn to the Federal Reserve Act which instructs the Regional Federal Reserve Banks to elect each their own Board of Directors of which the Chairman and Vice Chairman of the Regional Board will be appointed by the Board of Governors of the Federal Reserve System. The Regional Boards must have nine directors in 3 classes of 3 each (A, B and C directors). Three A directors chosen by the stockholders; three B directors to represent the “public”; and three C directors to be appointed by the Board of Governors of the Federal Reserve System. The Board of Governors of the Federal Reserve System will appoint the Chairman and Vice Chairman from the ranks of the three C directors.

Two important concepts now present. The Board of Governors of the Federal Reserve System seems to have powers which could indicate “control” including the appointment of the power positions of Chairman and Vice Chairmen. The second is the question, “do the Regional Boards have independent powers normally associated with ownership and control or are their powers restricted and controlled in any manner?”

The answer again lies in the Federal Reserve Act, Section 4, par 8:

“8. Administration of Affairs; Extension of Credit
Said board of directors shall administer the affairs of said bank fairly and impartially and without discrimination in favor of or against any member bank or banks and may, subject to the provisions of law and the orders of the Board of Governors of the Federal Reserve System, extend to each member bank such discounts, advancements, and accommodations as may be safely and reasonably made with due regard for the claims and demands of other member banks, the maintenance of sound credit conditions, and the accommodation of commerce, industry, and agriculture. The Board of Governors of the Federal Reserve System may prescribe regulations further defining within the limitations of this Act the conditions under which discounts, advancements, and the accommodations may be extended to member banks. Each…”

The Regional Boards are limited in their abilities to perform the primary functions of the Regional Federal Reserve Bank in terms of the act and under the control of the Board of Governors of the Federal Reserve System. It is clear from the Federal Reserve Act that control does not vest in the Regional Federal Reserve Boards, nor are they independent but they take instruction and are controlled by the Board of Governors of the Federal Reserve System.

It is now appropriate to update the simplified structure above to add these two steps of control.






The question of “who has control?” is not yet resolved as the nature of the Board of Governors of the Federal Reserve System must be investigated next. Is the Board of Governors of the Federal Reserve System an independent body or beholden to another entity?

Federal Reserve System Purposes & Functions on page 4 describes the nature of the Board of Governors of the Federal Reserve System:

“The Board of Governors of the Federal Reserve System is a federal government agency. The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate.”

“The Chairman and the Vice Chairman of the Board are also appointed by the President and confirmed by the Senate. The nominees to these posts must already be members of the Board or must be simultaneously appointed to the Board.”

The Board of Governors of the Federal Reserve System is a federal government agency and power to appoint all its members, Chairman and Vice Chairman is vested in the President of the USA, with a veto power over any appointment for the Senate.

The first requirement for a “variable interest”, “the power to direct the activities…” is answered in the affirmative.

Federal government at Presidential level holds “the power to direct activities”.

The final version of the structure of control is as follows:






The next requirement which must be met for a “variable interest” is any one of (i) an “obligation to absorb losses” or (ii) a “right to receive benefits”.

I would argue that the right to create currency granted to the Fed together with the vested interests of Federal Government are more than sufficient to infer an “obligation to absorb losses”. The Federal Reserve Act adds a complication to this argument by holding the shareholders responsible to the extent of their stockholding for the liabilities of the Regional Federal Reserve Banks. The “obligation to absorb losses” is not a requirement that needs to be met, provided that the alternative “right to receive benefits” requirement is met and since it is not clear cut, it is better to concentrate on the latter right. Note that the obligation or the right need not be an absolute.

Again we can turn to the two sources, the Federal Reserve Act and the Fed publication Federal Reserve System Purposes & Functions for guidance.

Federal Reserve Act:

“Section 7. Division of Earnings

Dividends and Surplus Fund of Reserve Banks(a)

1.

A. After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders of the bank shall be entitled to receive an annual dividend of 6 percent on paid-in capital stock.

B. The entitlement to dividends under subparagraph (A) shall be cumulative.

2. That portion of net earnings of each Federal reserve bank which remains after dividend claims under subparagraph (1)(A) have been fully met shall be deposited in the surplus fund of the bank.

(b) Transfer for fiscal year 2000.

1. The Federal reserve banks shall transfer from the surplus funds of such banks to the Board of Governors of the Federal Reserve System for transfer to the Secretary of the Treasury for deposit in the general fund of the Treasury, a total amount of $3,752,000,000 in fiscal year 2000.

2. Of the total amount required to be paid by the Federal reserve banks under paragraph (1) for fiscal year 2000, the Board shall determine the amount each such bank shall pay in such fiscal year.
During fiscal year 2000, no Federal reserve bank may replenish such bank's surplus fund by the amount of any transfer by such bank under paragraph (1).”

Federal Reserve System Purposes & Functions, page 11:

“The income of the Federal Reserve System is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other major sources of income are the interest on foreign currency investments held by the System; interest on loans to depository institutions; and fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations.

After it pays its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury. About 95 percent of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914. (Income and expenses of the Federal Reserve Banks from 1914 to the present are included in the Annual Report of the Board of Governors.) In 2003, the Federal Reserve paid approxi¬mately $22 billion to the Treasury.”

The statement “about 95% of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914” says it well enough. It is an irrefutable fact that the Federal Government is the overwhelming recipient of the “right to receive benefits”.

The outright undisputable conclusion is that the Fed, when tested against GAAP as is used by it in it’s assessment of those it regulates, is a Special Purpose Entity of Federal Government or according to the latest definition is a Variable Interest Entity of Federal Government. The rules of consolidation therefore apply and the Fed must be seen as controlled by Federal Government, indivisiably part of Federal Government. The pretence of independence is no more that that, a pretence.

There is, however, no denying that the banks have tremendous vested interest in influencing the policies of the Fed and that the power so narrowly vested in the President makes the President a special target for influence. Still, the power to control the Fed is not in the hands of the “owners” but firmly in the hands of Federal Government and the President of the USA.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
7 March 2010


© Sarel Oberholster

1. Board of Governors of the Federal Reserve System Washington, D.C., Ninth Edition June 2005, Federal Reserve System Purposes & Functions.
2. Financial Accounting Standards Board of the Financial Accounting Foundation; Connecticut, No 311; June 2009, Statement of Financial Accounting Standards No 167.


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Zero Cost Carries

Interest rates as a pricing mechanism in the economy go much deeper than the superficial assessments of mortgage loan rates or what one earns on deposit. Arguably one of the most significant jobs of interest rates as a pricing mechanism is the “cost of carry”.

This in plain language means how much it would cost to buy any item for resale at a future date. A simplified example may help. Say a store buys a product for resale at $100 with the aim of selling it within one month. Now let us state that interests rates at that time was 12%. That would translate into an interest rate of 1% for one month. So the store owner would have a cost of carry of $1.

The store owner paid $1 to carry the stock for one month. Say in this example that the store owner would have expected to make a net profit of $10 on the sale before paying for the cost of carry. That would imply that the store owner’s cost of carry would have calculated as 10% of the net profit. The importance of cost of carry is yet but partially explained.

What happens should the product not sell as expected in one month and the store owner is only able to achieve the sale after 12 months? Cost of carry now amounts to $12 and has wiped out the entire expected net profit and some. Accountants developed a measure to manage cost of carry in a stock turnover ratio. The manager would ensure that the total stock turns over as fast as possible to keep cost of carry as low as possible. The store owner would be encouraged to purge slow moving unwanted stocks from inventory through the cost of carry mechanism. A desirable and economically efficient behaviour trait operating on autopilot without outside intervention.

The principles of cost of carry translate directly into financial markets and financial speculation. Interest rates are not the only component in cost of carry but have always been an important component, that is before the advent of the zero bound interest rate policies of central banks.

Say you want to speculate on a rising oil price. Calculating the cost of carry on your position follows this economic and accounting logic. You borrow the cash required to make the purchase. Buy the oil and store it. Cost of carry will be the interest paid on the loan and the cost of storage for the period from when you entered into the transaction until you chose to exit. That’s the basics. Why should it be significant?

Cost of carry cascades through the economic fabric in millions of ways. A real estate owner for profit would purchase a commercial or industrial property and the expected profit would be the rental incomes, less cost of carry, less operating expenses. A speculator in shares would expect a profit equal to the difference between the buying and selling prices, plus dividends, less cost of carry. Interfere with this mechanism and it impacts as wide as supply and demand variables of property. Too low interest rate and access to easy credit would drive up demand and prices in no time for example. That is the birthplace of property bubbles (and all other asset inflations also known as asset bubbles).

The whole economic cosmos of derivatives is priced on a cost of carry basis. Forward cover on foreign exchange (say $/Yen) is based on the perfect hedge of borrowing the dollars and purchasing yen at inception. Invest the yen for the period. Cost of carry for the period would be the dollar loan cost less the yen income, both interest rate denominated. Thus the forward price of Yen would be the spot (today’s price) plus the cost of carry, which may be positive or negative. A neat little cross border trick performed by interest rates in this pricing mechanism. Mess with the interest rates in one or both sovereign economies and the exchange rate pricing mechanism get similarly messed up.

Interest rates are an invisible spider’s web influencing every price of every type of good or service produced in the economy. No matter where you touch it, it reverberates throughout the whole structure. Interest rates would regulate the allocation of scarce savings, and yes savings are always scarce without huge quantities of debt facilitating liquidity provision from the central banks. This job of allocation by interest rates when interest rates are free form manipulation or outright control is performed as a delicate harmonious melody throughout the economy in that invisible spider’s web. The dynamic takes cognisance of economic merit right down to the smallest individual transaction maintaining an intricate economic balance which in turn contributes to the harmony of all other pricing mechanisms.

Just try and imagine the corps of central bankers required to perform the same functions previously performed by interest rates without the interfering central bankers. It is not only probable but guaranteed that these delicate operations will no longer take place. At first the interest rates just gets distorted. The distortion in interest rates distorts all other pricing mechanisms and influences the choices and behaviour of economic participants. The previous dynamic harmony is lost.

Sadly it does not stop there. Every intervention breeds another intervention to sustain the distortion of the previous intervention. All interventions breed like germs on rotting flesh left outside in the sun and spread like a virus on a university open website. The interventions accumulate and compound and monetary policy interventions reach the pinnacle of absurdity when it attains that final resting place of the zero bound.

The central bank has effectively discontinued the base interest rate from the economic landscape. Of the spider’s web which were tattered and torn by interventions now only remains a few malfunctioning strands. Interconnecting harmony and relative rebalancing is but an abstract memory.

Then again why would it matter? Unfortunately it matters very much. Visualise an economic pickup truck with no intricate wiring. Nothing works and it is simply being pushed around by government and central bank officials. Having destroyed the fabric of pricing mechanisms are not without consequences. Those consequences are as varied and as complex to pin down as were the contribution of interest rates to the pricing mechanisms.

Cost of carry is but one component where consequences will manifest. Staying with the examples given we can see that inventory management has been compromised and dead stocks can be carried without cost, which will certainly diminish efficient management of stock levels; the oil speculator can double or triple his position and carry it for longer with an immediate consequence that the price of oil may rise for everyone else though the general tendency would be for oil prices to become unstable and subject to violent unpredictable adjustments; the most obvious consequence for real estate is similarly boom bust pricing cycles but a menacing economic rot in the encouragement to banks to roll and refinance bad debs while in reality becoming owners of the properties on a zero interest cost of carry is a less obvious outcome; perhaps the most devastation to pricing mechanisms are the consequences of a zero cost of carry on derivative markets distorting macro pricing of exchange rates between currencies, hedging and arbitrage in all commodities and financial securities across all forms of derivatives from the plain futures and options to the exotics. No pricing mechanism is spared the taint.

A very real example which carries influences from cost of carry on inventory, to finance, to derivatives and even sovereign currency pricing is copper. Thus we can observe the absurdity of huge stockpiling and rising prices concurrently in real time.








The global economy is now cursed with the affliction of the zero bound interest rate policy in all the major economies. Thus all micro and macro pricing mechanisms must function with the heavy hand of central bank bureaucrats allocating with bias, subject to vested interests and central government direction. They only allocate where they can see and how they desire in the absence of the delicate spider’s web of dynamic interest rate allocation on economic merit.

Adam Smith’s invisible hand of the market has been chopped off at the elbow.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
31 January 2010


© Sarel Oberholster



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Twin Peaks – Jumping in Mud

In this edition of Twin Peaks we continue to monitor the unfolding developments in the Global Financial Crises (yes it is still with us) and the developments of the post Dec 1989 crises in Japan as expressed in the Dow and the Nikkei. The thesis as has been discussed at length in previous Twin Peaks series, is that the USA and Japan are following similar monetary policies of excessive monetary stimulation which achieved an artificial market condition described as “the zero bound” where short term interest rates are stuck at zero or near zero for extended periods. The 1989 economic collapse in Japan initiated its drive towards the zero bound and the USA started its march towards the zero bound after the 2007 economic crises. Both economies have achieved the condition of being stuck in the zero bound but the USA is about 18 years behind Japan. The zero bound monetary policy combines with Quantitative Easing and fiscal policies of budget deficits to generate an explosion of public debt.

The present tale of the charts is one of divergence. The USA chose aggressive monetary and fiscal interventions while the Japanese took a more measured approach. It is the Bernanke theory that this difference is what will distinguish the USA from Japan, where the USA will recover to rapid economic growth as opposed to the Japanese experience of a low level deflationary depression stretching over two decades and entering its 3rd.

The aggressive policies of the USA are showing up in the charts. That does not mean that the Bernanke theory is proven, it simply means that the markets reacted in predictable fashion to the very aggressive government policies. Government and central bank interventions are not self sustaining and must be repeated in ever growing tranches to simply maintain a stimulation effect. The next stimulation will need to be even greater than the previous two but it may not be as visible due to the adverse political consequences attached to the previous spectacles.

Stimulation decay sets in after a while unless, and this is what is hoped for, the spark provided by the government is sufficient to get the economy going. The jury is out on whether stimulation will be a gasoline and newspaper bonfire burning fast and bright for a while to sputter and die or not. Everything rides on that outcome.




(Click chart to enlarge.)

The peaks of the Nikkei and the Dow are matched in this chart and not rebalanced thereafter to allow for significant deviances. The peak of the 1929 Dow has been added just to spice up the test against depressionary conditions. The aggressive US intervention has now carried the Dow upwards beyond the levels of the Nikkei, for a similar period as unfolded. The positive divergence in itself is not compelling as the initial equally aggressive reactions to the 2007 crash caused a similar positive divergence then, which was resolved with a dramatic convergence and negative divergence between October 2007 and April 09. This chart does not show it but the long term bottom of the Nikkei since Dec 1989 is as recent as 10 March 2009 at 7054.98.

The decay in the stimulations is already showing up in the momentum inherent to the move from April 2009.

The Momentum chart hereunder needs some explanation in interpretation. It measures the relative change in the gap between the 50 day moving average and the 200 day moving average, counting backwards. A 180 degree flip-over (negative to positive) in data occurs when the 50 dma crosses over the 200 dma.

Here’s what the chart tells us. The momentum in the bear move down was failing for weeks before late March, early April 2009. The bear market momentum gave way to a negative momentum bear, i.e. a bull market momentum since early April 2009. The flip-over/crossover occurred just before the end of June 2009. Momentum still spiked unto mid July but since then bull momentum has been in decline. The “jumping in mud” period started in late October 2009 where the market is still in bullish trend but just can’t get going.

Presently we are still in the “jumping in mud” phase but the beginning of a downward trend is showing up in the negative momentum bull, i.e. the bull marked momentum is failing. We have not yet reached a point where we can make a call to say that the bull marked has failed. The historic indications are that a -1.5% to a -2% recording is required to indicate a high probability that a bear market move is underway. The highest recording was -0.7% on Dec 31st 2009. So for now it is simply “jumping in mud” time until momentum picks up in either direction.




(Click chart to enlarge.)

The here and now is where the bulls will believe in the Bernanke thesis that this time it will be different for we acted faster and with more aggression in our stimulations. The bears will continue to claim that the speed and extent of intervention will not alter the outcome of a deflationary depression only how we get there. They would further insist that the likely outcome of a too fast and too furious monetary response will harvest an even worse outcome of a hyperinflationary depression in an effort to escape the deflationary depression. Already gold, silver, copper and every other commodity are being stuffed in custody and warehouses discounting such excess. Another vote of no confidence in official policies and not a sign of economic recovery.

The Japanese economy in this phase was typified by warehousing growing bad and delinquent debt with central bank and central government support. Mortgage debt for instance was warehoused in the Jusen structures, with similarities to the Freddie Mac and Fannie Mae structures in the USA. Every stimulation, regulation and intervention was aimed at reviving the asset inflation pre 1989 and denying the accumulation of decay in the economy. The economic events forced Japan to disprove the Keynesian theories of sticky downwards salaries and wages when after endemic unemployment, salaries and wages stated falling. Asset inflations never revived and in fact continued to deflate as each stimulation and intervention to prevent that outcome failed. Minuscule rises in interest rates or in direct or indirect taxes dumped the economy right back into crash mode, stumbling through two decades of economic decline until government debt equalled national savings in this previously high net savings nation.

Perhaps this time the outcome of Zero Bound and Quantitative Easing monetary policies combined with budget deficits and excessive government debt will be different, but probably not.

May you trade with wisdom and reward in 2010.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
6 January 2010

Ps. I will post a news flash update should the Momentum chart post a negative 1.5%.


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .