The whole discussion.

Update: David has confirmed he did not attempt to block my IP, I have been able to submit comments to his blog since this post. I look forward to his follow up post on this topic.

[1] There are many other allegations not related to the discount window that Congress would like to pursue, is secrecy also justified in those cases? Even questions regarding 30 year old events? Why doesn’t the Fed respond to access to information requests?

[2] No it shouldn’t be given the benefit of the doubt because I don’t know what Bernanke and Obama will do to prevent the Fed from ever losing a penny if conditions deteriorate in the future. I won’t speculate here, but there is precedent:

“Because of the slowdown, Federal Reserve district banks were transacting less business with member banks and hence earning so little funds it was feared that some banks would not meet their expenses. So, Fed banks purchased government securities at a great pace through the first half of 1922 to improve their earnings positions.”

http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3826

I don’t want to draw inappropriate conclusions, but I will simply say the 1920s didn’t end well. My point regarding MBS was that things can happen for the first time, open market operations didn’t begin until 1922. Also, the quote below is not particularly comforting for obvious reasons.

“Assets purchased under this program are fully guaranteed as to principal and interest by Fannie Mae, Freddie Mac, and Ginnie Mae”

http://www.newyorkfed.org/markets/mbs_FAQ.HTML

[3] I haven’t read your entire paper but I read parts of it, and for what it’s worth I find it strangely reminiscent of a partially discredited concept in Engineering often practiced by the Soviet Union:

http://en.wikipedia.org/wiki/Security_through_obscurity

From wikipedia:

“Operators and developers/vendors of systems that rely on security by obscurity may keep the fact that their system is broken secret to avoid destroying confidence in their service or product and thus its marketability, and this may amount to fraudulent misrepresentation of the security of their products. Instances have been known, from at least the 1960s, of companies delaying release of fixes or patches to suit their corporate priorities rather than customer concerns or risks.”

Sound familiar? There are well documented risks with this approach, I’m willing to bet many of them translate.

From your paper:

“In competitive economies, the disclosure of high-frequency information unrelated to an asset’s “long-run fundamentals” may be detrimental to economic welfare when claims to such assets serve as high-velocity payment instruments.”

Who determines which information is related to an asset’s long-run fundamentals? How do I determine whether this information is a catalyst for insider trading if it never becomes public? You said you weren’t asking me to trust Bernanke, unless I missed something, your paper infers otherwise.

[4] As a matter of fact I do. If they take the gold then people can use silver. If they take the silver then people can use tally sticks. If they take the tally sticks then people can use seashells. If they take the seashells then people can use feathers. Obviously that’s a little tongue-in-cheek, but the point is clear — multiple circulating competing private currencies. The government can’t steal them all.

Here is where it gets interesting — despite the collapse of shadow bucks, the shadow banking system still dwarfs the official banking system. That means the process of people fleeing to dollars could continue longer than many first assumed. Or conversely, it also means there is a time limit. At some point, should the shadow banking system fail completely or the economy recover and assets reverse direction, there are no more economic refugees from the shadow banking system and the bid currently supporting the dollar market disappears. But more importantly, should the flow of refugees continue, there is also no fixed reason these people must trade their shadow bucks for US dollars. They could just as easily buy any other currency or form of money. So in trying to determine whether the US dollar will withstand inflation and quantitative easing without collapse, the question is reduced to whether the supply of refugees will continue and whether they will continue to choose US dollars.

Here is where it gets really interesting — given the extent to which the shadow banking system still dwarfs the official banking system, you would be shocked to know the extent to which the official banking system dwarfs the gold market. If even a few players drop some pocket change into the gold market, the price will soar. There is no guarantee this will happen, but there is also no guarantee they will buy dollars. The problem with forecasts in our current state is that we no longer have free markets, we are largely gambling based on the future decisions of powerful people we have never met. All we can do is guess, but the reality of our current global economy is that many other currencies are equally challenged, if not more so. The best alternative to US dollars as a means for savings and exchange, anywhere in the world, should the need for an alternative arise, is gold.

Should people insist on saving and the government insist on resisting their decision with inflation and quantitative easing, the most likely outcome will not be sudden enlightenment and a resurgence of unsustainable consumption, it will be a shift to alternate forms of savings: gold, food, fuel, etc. In fact, the more money is printed in a failed attempt to revive demand the more money will ultimately pile into alternate forms of savings, causing prices to rise even faster. If we intervene to “put out the fire” (and we are) the more ominous the risk of deflation, the more money is printed, the more gold will ultimately advance.

But that assumes people lose faith in dollars, even if the dollar doesn’t collapse and currency markets remain strong, gold can still advance. Other than a few years, commodities advanced throughout the 1930′s deflationary depression because supply dropped faster than demand.

But that assumes supply will drop, even if commodities don’t increase in price, gold can still advance. It’s not just a commodity, it’s an instrument of savings. Gold is money, just like dollars. If dollars advance in a deflationary bust, so should gold.

And remember, those are the deflation scenarios. There are just as many inflation scenarios, all of which also result in gold going up. And please take note of the irrelevance of “capacity” to this debate. Prices can rise despite spare capacity because the existence of capacity does not prove the existence of relevant capacity, factory A can not produce the same goods as factory B because they’re both called a factory. And the longer a factory sits idle, the more it costs to bring it back online.

Under what scenario would gold collapse? Legitimate economic growth. An economy with abundant savings, faith in its currency and abundant productivity improvements from successful companies doing useful things has a diminished need for gold. Since we’re reduced to identifying scenarios and guessing probabilities, I think everyone can agree that is the least likely outcome.

In order to understand how I see the world, you must come to the conclusion (as I have) that many businesses currently “idle” should never have existed in the first place, they only exist because demand has been skewed by years (or decades) of government interference and stimulus of other forms (including monetary). Each time the government intervenes these businesses become more convinced of their soundness, but in reality it was always an illusion from the beginning, they are addicted to government heroin. These businesses are like an infection, the infection wants to live, it wants to grow and thrive, but it damages the body (the economy) and survives by consuming resources other beneficial cells could have used more productively. If our immune system (the market) attacks the infection or takes away its resources, we shouldn’t complain that it’s idle, we should let it die. The process of killing it isn’t fun, we could get a fever and a headache and feel like crap (recession) but ultimately we emerge stronger without that weight holding us down. A business that consumes resources and loses money makes the whole country poorer.

The economic argument is basically Hayek’s argument that interest rates are not an arbitrary number, but serve a coordinating function in the economy. It’s a signal to producers about the relative willingess of people to consume today or in the future. When people save, the cost of capital goes down and long term projects become economic. When people spend, cost of capital increases and businesses can only get funding for short term projects intended to meet current demand. When both long term and short term projects are economic at the same time (low interest rates, stimulus) we get booms that inevitably lead to excess capacity and busts. The bust is not the problem, the boom is the problem. The government stimulus argument says we must create demand to fill the capacity. The Austrian argument is the capacity should never have been created in the first place and must be liquidated for mis-allocated resources to be freed for more productive purposes. Each time we strap on another bandaid the more infections survive the bust and the larger the imbalances ultimately become. The transition is painful, but the longer we delay the restructuring the greater the pain will be. It’s just a matter of time. Again, excluding the potential of game changing miracles (like cold fusion or something).

Listen an decide

Furthermore, just as the recovery from 2003 to 2007 with hindsight now appears to be an illusion, it’s not impossible the multi-trillion dollar stimulus packages will yield something that feels like an economic recovery, also to be dismissed as an illusion a few years from now. GDP is supposed to be inflation adjusted, but nobody really believes the GDP deflator these days. Rising prices will give the government more cover for their fictitious measures and with rising numbers later this year or next I would not be at all surprised to see politicians and economists line up to claim credit. Once that happens everyone becomes vested in the recovery’s continued success. If the stimulus dollars stop flowing and the economy tanks once again, they will all look like fools, therefore the stimulus will likely continue until inflation tips and the government loses control.

Very few people in public office have the humility to admit their mistakes and reverse course, especially not on such a major defining issue. And once large businesses get a taste for government largess, I find it unlikely government officials will ever be able to withdraw the punch bowl without suffering a tremendous backlash. The least surprising result of all this inflation would be rising prices, but don’t confuse that for genuine economic growth.

The problem with currency unions like the Euro is that each country has a different level of productivity. Just as tremendous wealth in Alberta causes a strong Canadian dollar that punishes the maritime provinces, the same thing happens in Europe between Germany and Italy. The union in Europe is supposed to be a union of independent states, but so too was the United States of America until Lincoln (that was the real cause of the civil war) and FDR came along. The currency union in Europe will make that relationship impossible to sustain. In the United States and Canada the problem isn’t as severe because it’s much easier for people to move (similar culture, language, religion, etc) but even we have some form of transfer payments to help the poor regions cope, and that’s not the case in Europe. The same movement towards socialistic big government ideas that swept the US and Canada will eventually hit Europe and decades from now it will look very similar to the US and Canada today, with European wide pension plans and an ever increasing amount of resources allocated by the central European government to level the playing field between states. That’s the covert process by which power is usurped from individual regions and centralized in the hands of a few men.

But here’s the problem, everybody knows this story now, so it’s unlikely China and Brazil and especially Russia will get suckered into this scheme on a global scale like the American states and the European states. All of that is why I believe it will be an electronic currency that exists only on computer. If they go ahead with this plan, it probably won’t be a currency like the Euro that individuals can touch and hold and use at the store. It will be a replacement for the US dollar as global reserve and essentially act exactly as gold used to act in previous centuries as a mechanism for automatic re-balancing of current account deficits. Every country will have their national currency pegged to this international currency, at different rates based on their productivity, and if a country over consumes and thus has diminishing reserves of the international currency, they must devalue their national currency or default. Exactly like the gold standard, but without the gold, at least that’s how it will be sold. Nobody will sign up unless it works like this.

The advantage of course is no need to waste resources digging metal out of the ground. The disadvantage is the ease with which people can inflate this new currency like any other fiat currency. Gold was not used as money because it’s easy to spell, it’s because it imposes discipline. You can’t print gold. There is no difference between the new currency and the US dollar, except one will be new and the other will be old. The new currency may even initially be backed by gold, the IMF claims to have 3000 tons of gold. But so too was the US dollar, they still claim to have 8000 tons of gold. So the initial backing will only be a ruse to get support. One day 40 years from now there will be another deflation scare or war that needs to be fought (but instead of fighting each other we’ll be fighting carbon dioxide or something) and the world will leave the gold standard just as it did 40 years ago. There’s always another crisis behind the curtain.

I’m actually 100% convinced such a plan could work flawlessly for a few decades then once we’re all convinced it’s the best thing since sliced bread and completely vested in its success, they will create another crisis to push the process one step further.

At least that’s how the story goes…

The de-coupling theory has always been dependent on a dramatic appreciation of Asian currencies. I have always been a little skeptical of their intent to allow such an appreciation, which is the reason I generally avoided too much exposure to their equities, however my mood is beginning to shift on this issue. The herd that rushed into China 2 years ago has now been wiped out and my gut is telling me 2009 will be a pivotal year in world history. Some day people will ask, were you born before or after 2009? The status quo can not continue indefinitely, something must change.

It has been widely reported that China is pressuring the American government to “protect” their “investments”. Translated, that’s a warning not to inflate away their debts, but it’s becoming increasingly clear that quantitative easing (“printing money”) is around the corner, if not already here. It could be the only way to save politically connected banks and insurance companies from insolvency. Even Warren Buffet, the guy who famously declared he couldn’t care less about macro-economic issues is now warning of a possible “onslaught” of inflation.

If America debases the US dollar to wipe away excessive debts (much of which is owed to China) what will they do to retaliate? There is no guarantee China will shift to a more confrontational policy, but at least now there is a path to appreciation that didn’t previously exist. Whether any of these plans or retaliations will succeed is another matter, but the probability of de-coupling in the near future is now higher than at any time in recent history. Sentiment couldn’t be more bearish for emerging economies, that’s the sign of a bottom, not a top.

part 2 of 2