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Memo to Richard Russell: On the Margin Baby

"There's nothing I like less than bad arguments for a view that I hold dear" (Daniel Dennett).

That sums it up on most days that I read the arguments of supposed gold bulls and libertarian writers. It's no surprise that when the going gets tough they abandon ship - because their theories usually don't stand up to the light of day in the first place.

What was one to do, for instance, if buying gold in 2001 solely on the basis of growing Japanese demand due to a collapsing yen when soon afterwards the yen turned up? Had they turned bearish on gold then it would have been at exactly the wrong time.

Just like some buyers of gold may have failed to realize the true significance of the budding bull market then, many of today's gold bulls - who may think that gold has been benefiting from the drop in nominal interest rates - are remiss in their concern that when interest rates turn up, the dollar wont' be far behind, and that gold is going to collapse, as if the only reason the dollar fell was because interest rates did.

It doesn't work quite so neatly. Indeed, the simple correlation coefficients going back to 1972 are as follows: between gold and interest rates (10 year Tnote yield) it is -3.7%; and between the USd index and interest rates it is +28.0%.

The veracity inherent in the inference that the currency's value is affected by changes in interest rates is limited to relative movements in real interest rates and the steepness of the yield curve. Indeed, one of the strongest correlations I know of is that between money supply and the yield curve; using M3 the coefficient is -45.4% back to 1972.

This would suggest that as money supply grows there is about a 45% chance that the yield curve is flattening, or that as the yield curve steepens there is a 45% chance that money supply is contracting. In reality, there's a lag time for the relationship in yields to affect money supply - both in fact and theory - so the correlation would be more direct and significant were that taken into account. And at the moment the yield curve is still as steep as it has ever been in the past thirty years, which is what's inflationary - not merely the actual level of rates.

In any case, there are a myriad of sources of demand for the dollar today that have nothing to do with anticipating or exploiting changes in yields between currencies, or the sudden inclination for a borrowing dependent society to pay down its debts and increase its collective balances of Federal Reserve Notes relative to other assets and goods.

In fact, although we hope to disprove it in this column, Richard Russell's interpretation assumes that higher interest rates would lead to a decline in the growth of money supply on account that borrowing demand will falter. But this for instance would only hold good if by higher interest rates we meant that the Fed would shut down its open market manipulations and let the market decide the true (unopposed) level of interest; or if a Volcker type were put in charge to do practically the same thing.

Be that as it may, Russell, the highly accredited author of the Dow Theory Letters, has begun to waver on the bull market case for gold as near as I can tell.

He's been arguing, apparently, that since everyone is so bearish on the dollar, it's due for a bounce; and it seems that in order to rationalize that conclusion he has pulled together a mish-mash of incoherent premises cloaked in a deflationist dogma.

To be fair, other writers previously in the gold camp have made similar observations lately... that there are too many dollar bears. But this isn't our main contention.

Thus, before we elaborate further on the dollar, and Mr. Russell's deflation fallacies, let me emphasize that there is no malice or defamation intended here. While I don't personally subscribe to his letter, I have enjoyed the occasional snippets encountered throughout my career and life. His courageous contrarian knack deserves respect if only because it's been correct often enough. And of course it was nice to have him on board the gold bull for a while, even though it's bucked him now.

The objective here is not to change his mind (although that would be nice) or to tell you that the renowned Dow Theorist doesn't know the first thing about inflation; it is to illuminate some of the common fallacies about the subject of money and gold.

Russell's views undoubtedly reflect those of a large segment of the investing population, and so in criticizing his widely read arguments I only hope that you may reflect on some of the common misconceptions in the case for gold.

USD Not Oversold, Don't Take Your Eye Off the Trade Ball
The US dollar has fallen about 30 percent in a little over two years against a basket of trade-weighted currencies, which is about as fast as it has ever fallen. However, there are at least two facts that suggest it is not oversold (on foreign exchange markets):

1) the trade deficit keeps widening (recall, a trade deficit arises when prices rise faster in the domestic economy, or fall faster abroad - in other words, because the dollar is falling slower on the currency markets than it is in exchange for domestic goods and services); and

2) if it weren't for the massive interventions last year by the Bank of Japan and China the US dollar would have fallen even faster than it did (and the trade deficit might then have narrowed).

Indeed, our explanation for the reason the trade deficit has continued to grow is that the Fed's inflation is causing the value of the medium to fall relentlessly faster in the US economy than on the market against other currencies - which is due to the artificial policy induced intervention-related demand by central banks abroad.

But the bottom line now is that this Asian demand appears to be going away along with all the other reasons to buy dollars (like rising stocks and bonds) leaving only one probable resolution: ultimately a correction in the trade deficit on a sharply lower dollar. I emphasize probable because there are other possible resolutions - such as the Fed pushing up ahead of the curve to target money supply growth itself - which isn't likely.

Indeed, the argument that a collapse in asset values will result in a deflationary bust where consumers cash in their goods in exchange for dollars to pay down their massive debts with does not hold good in an environment where the central bank stands ready to lend below market, as you shall see today.

It is probably true that there are more dollar bears than there used to be; but I would stop short of saying there are too many. If there were "too many" gold would have done better than put in a move that paled in comparison with the 1985-87 bear market rally, bond yields would have long ago exploded upward, and as already suggested, the trade deficit would probably have narrowed.

Besides, anecdotally I personally can't find all that many dollar bears today. My bearish dollar outlook is often challenged - investors seem widely diversified in their outlooks for the dollar. The only dollar bears left, besides the remaining gold bulls, are those primarily that believe the weak dollar is deliberate policy - and hence to whom the Dennett quote aptly fits also. Even many devout long term dollar bears (gold bulls) have resigned to a more stable prognosis at least until after the election in November.

But Russell has embraced the deflation outlook to argue for a dollar rally; which would be bullish for the dollar if it were possible - and it is not, yet. Hence he's gone to the other side. His argument is basically that the forces of deflation are indeed hard at work, but that the central bank will keep them at bay until the consumer is "tapped out," since it is the consumer presumably that drives the credit cycle from the demand point of view.

Understandably, Mr. Russell seems confused over whether the central bank is a hero or villain. We'll try and clear that up for him today too.

I had refuted the premise that money supply changes were determined solely by the market - or by the demand for credit as if the credit system were elastic - in my last issue to subscribers by referring to Ludwig von Mises' theory on money and banking written almost 100 years ago (just before the Fed was born) discrediting just that very concept, but which still dominates most contemporary financial literature alongside the multitude of other misguided dogmas long ago disproved.

Mises' theories are typically not contested; they're merely ignored.

Central banks would like to have you believe in the elasticity of credit because then you don't need a gold standard. We shouldn't need to refer to Mises to refute it; the arrival of Ben Bernankiasm should have been plenty proof that it is the central bank in control of money supply. But now, since interest rates are going to rise, there's confusion about the whole thing again.

I've been writing on the subject of inflation for years but as quickly as I can elaborate on one fallacy another takes root. Notwithstanding that, our outlook has been mostly confirmed and our conviction vindicated. There are a lot of difficult things to predict in this world - but the general direction of money supply (as long as the dollar is a Federal Reserve Note) is one of the surest things on this planet besides death and taxes. In fact, once you understand inflation you'll certainly conclude it is only another tax.

Richard Russell figures the whole thing is still up in the air. And he misses the point that the central bank is in the business of sustaining inflation. This is what it does.

That's just voodoo. As I've frequently quipped, however, I can guarantee you that at least some of the Fed's governors find genuine comfort in that very popular contention.

It's true that the central bank can abandon its inflation policy at any time and embark on a deflationary policy, or in the extreme, dissolve itself and put the country on a gold standard. But nobody is going to accept a deliberate deflation "policy," clearly, and how much deflation a gold standard would cause is debatable - it merely comes down to what gold price would work. I think this is all fairly obvious.

But what isn't obvious is that there are no other deflationary forces at play but this possibility. We've argued in prior articles that falling prices aren't deflation unless they are caused by a contraction in money. Prices move up and down for many real reasons unrelated to monetary policy; inflation is a monetary phenomenon. The Internet and Wal-Mart are not deflationary forces; Japan is not experiencing deflation. The former are productive market forces, and the latter is a currency issue. There is nothing wrong with falling prices if they are not influenced by changes in money; it is the achievement of capitalism that it produces a greater amount of desired goods at increasingly affordable prices. This doesn't mean that money is becoming scarcer as Russell implies in his definition of inflation/deflation (discussed further below).

I have a few objections to Richard Russell's reasoning but I'll just comment on the two that stand out most. First, underlying his contention is the presumption that consumers drive the credit cycle; that money growth is a manifestation of the demand for credit driven by various things such as incomes, and consequently constrained by the consumer's debt service ratio (the proportion of disposable income that goes to paying the interest on debts), or rationings of wealth.

It is one of the most significant underlying currents to the entire deflation side of the debate. The (debt) cycle supposedly ends when the economy busts (i.e. asset values decline) and/or when the debt service ratio reaches some arbitrary level beyond which consumers can no longer service their debts; so they liquidate their assets in exchange for increasingly scarce dollars to pay their debts off with, and even begin to save.

As Russell puts it:

The problem is that somebody's got to USE the paper, and if American consumers are "tapped out," so to speak, they'll be cutting back on their spending and (God help us) possibly beginning to save - Russell on Gold, 12 June 2004

What he's saying essentially is that because the Fed is ardently fighting deflation they are printing so much money/credit that they'll saturate the credit markets, demand will fall off, and people, instead of borrowing, will now save.

There are three main problems with this line of thinking:

1) The printing presses aren't determined by the demand for credit. Or, at least, that the demand for credit isn't a force au naturale. On the contrary, the institution that controls the price of credit exerts an incredible influence on both the supply and demand for it.

2) Wages can rise, as well as other developments may occur to alter the numerator or denominator in the debt service ratio enabling the cycle to continue ad infinitum.

3) Dollars aren't scarce to begin with. For the dollar short thesis to work the aura of scarcity would need to exist beforehand - people would have to naively believe that the Fed couldn't come up with new ways to inflate.

The Inflationary Effects of Pricing Credit Below Market
The price of credit is, you guessed it, the interest rate.

In the section on Banking Policy (the Elasticity of Credit Circulation) in the Theory of Money & Credit Ludwig von Mises uprooted the fallacy that money supply changes are determined by the demand for credit, by showing that the issuing banks or the issuing authority influenced this demand by manipulating interest rates:

"The issuers of the fiduciary media are able to induce an extension of the demand for them by reducing the interest demanded to a rate below the natural rate of interest, that is below that rate of interest that would be established by the supply and demand if the real capital were lent in natura without the mediation of money (central banks), whereas on the other hand the demand for fiduciary media would be bound to cease entirely as soon as the rate asked by the bank was raised above the natural rate" - pp. 340, Chapter 17 TM&C

The underlined is mine. This is the key; it's what the deflation camp don't get.

What people don't seem to grasp is that interest rates are determined by the market but heavily influenced by the largest central planning body on the face of the earth - rates are almost completely controlled at the short end. And their influence has only grown.

Even if interest rates go up, so long as the Fed keeps them lagging behind where the market would otherwise have them it creates an advantage to transacting credit that didn't exist before. The yield curve is usually important to the incentive for the issuers of credit and credit derivatives; but if interest rates on the curve are artificially kept below market it will stimulate demand for credit, period... like a good that's priced below market except that credit is virtually unlimited because there is a central bank.

If interest rates happen to go up it is usually for one sole reason - inflation. Changes in interest rates do not reflect changes in the nation's profitability.

If that were true then rates wouldn't have fallen after 1980 because supposedly the US was from then on producing the most profits! Right? A credit transaction involves the exchange of a future good (money) for a present good (money). Thus the most significant factors determining the level of interest are monetary.

The interest rate is essentially the product of negotiation in the market between the relative value that the borrower places on the consumption of a good now rather than in the future (his time preference rate), and the value lenders place on the choice of whether to save or spend (same). But central banking and the arrival of fiduciary media has brought the costs of issuing credit down to the bare essentials - to the technical logistics of granting credit and issuing money out of virtually nothing.

So lenders aren't really having to face the choice of forgoing one good for another, or the opportunity cost of lending rather than consuming. Hence there is a surplus of available credit, which helps drive interest rates down, down, and down - normally.

The lower they go, artificially, the more they induce the consumption of goods today rather than tomorrow, or rather than to save - in fact, the Austrians fittingly refer to this process as a type of "forced savings." But it is technically inflation and it affects a debasement - though not in a straight line. When the debasement picks up speed at some point the level of interest begins to increasingly reflect expectations about further devaluations in the future value of money. Again, the main reason for large swings in the determinants of interest rates today are inflation and inflation expectations.

The key point though is that theoretically, higher rates do not slow the issuance of credit and money (fiduciary media today) unless they are higher than the natural rate - that is, that rate which reflects the truest possible inflation reality and time preference rate (it's always changing; there's no fixed equilibrium - it would defeat the purpose).

Nevertheless, if when interest rates rise they don't affect a contraction in the money supply the determinants of the commodity bull will remain; the only effect they will have on prices is in asset prices whose values are dependent on a future stream of income (money) discounted at record low interest rates and inflation.

To sum up, the demand for credit is influenced by the Federal Reserve System, by its interest rate policy, while the issue of credit is unlimited.

Hmmm. Yeah, the forces of deflation these are. The central bank does not exist to fight deflation, it exists to sustain inflation. As you'll see, the policy has a specific aim.

Breaking Down the Credit Cycle; Laws of Physics Need Not Apply
In theory a debt (or credit) cycle can continue indefinitely so long as:

  1. the debtors are willing and able
  2. the creditors are willing and able

Let's briefly recount how theory applies. Starting with the creditors; there is no question of their ability to issue credit (or stimulate the demand for it), and since it is virtually unlimited the question of whether they are willing depends solely on the price - or interest rate - that they might receive. Debtors too are willing to borrow so long as there is an advantage in forgoing future consumption; so long as rates are kept below market it is made artificially cheaper to consume now than to put it off. Another related incentive to borrowing lies in terms of the ultimate effects of the inflation - debasement.

If rates are at a level that underestimates the future erosion of the value of the currency being transacted the advantage to borrow materializes.

A decline in rates relative to the natural rate, everything equal, might induce individuals to place a higher value on current consumption while an increase relative to the natural rate would encourage more savings. However, this 'natural' rate is a moving target, and because the Fed's easy credit policy produces increasing inflation, how easy it may be to catch up to it are up to circumstances beyond the Fed's reach. In many countries where similar policies reigned and subsequently broke down interest rates have been known to soar to the hundreds of percent range without helping the currency find support or preventing the central bank from expanding its quantity.

I realize that in most of these cases the market system is far less developed - hence less able to adjust. But historically even quasi market economies have been known to fall victim to such chaos, amounting to demonetization.

Now, it is conceivable that if the Fed today were to target money supply in order to close the gap between current rates and the market rate it could inspire the outcome that Richard Russell and Rick Ackerman propose in their "dollar short" hypothesis - and thus essentially abandon the boom, or credit cycle.

But it's a reality that is far from likely for what I hope are obvious reasons. Besides, it is not what they are talking about.

Their reasoning is that borrowing demand will peter out and people will turn into savers when the cost of servicing their debts has reached a constricting threshold. In other words, they are focusing on the borrowers "ability" to borrow as per the above equation.

Ever Heard of a Wage-Price Spiral?
What if the denominator in the debt service ratio could rise along with or more than the numerator? In other words, what if incomes or wages could participate in the inflation? No way you say; the economy is too productive and the labor market is weak.

It was weak in the seventies also, and yet wages soared. The price of labor, like any other good, is also influenced by inflation and its consequences... to the extent those consequences are perceived. The fact that unions were more powerful in the seventies might well be related to the massive devaluation in the dollar that occurred that decade.

If the interest rate is a price - especially one that is supposed to reflect inflation - then let's look at it in the context of what else is going on when rates are rising: other prices are too; inflation awareness is rising; hence, why wouldn't wages start to rise faster? Wages tend to lag inflationary trends normally, especially those that are fixed.

Wage earners are the losers in this particular system (see below on the redistribution of wealth through inflation) in other words until they start budding in line like gold bulls hope to. It is true that it is not entirely predictable when this will be but it is safe to say that once a commodity cycle has begun it isn't far behind - because a commodity cycle basically reveals the inflation that the central bank has tried to hide for decades. This is the point at which the prior downtrend in interest rates reverses; since the inflation is more visible it is more acutely priced into financial assets.

How much longer will people believe that the increase in oil and gas prices is temporary for example? How about Lumber, Cocoa, and the other metals? How about Platinum which keeps making new all time highs?

These things make up a small proportion of total production costs, and so haven't completely returned pricing power at the retail end; but who can argue that these price increases aren't beginning to be noticed by the little guy today?

Soon enough even the layest of laymen must interpret this as a decline in the value of the currency that he is getting for his labor. As this ball gets underway, production costs are going to rise, followed by retail prices, and so on. The bottleneck to the onset of a wage price spiral has so far been the unwillingness of the labor market to participate for whatever reason - whether insecurity or ignorance.

But at the point when the wage earner starts to barter up his wages the process takes off - the Fed wants to prevent this with all its might. Yet it is this point of recognition that gold bulls are waiting for, that we believe will ignite the bull market. Moreover, it is also this point that could raise the denominator in the calculation of debt service ratios.

Or forget about theory and just look at the facts. The credit expansion has continued to grow essentially uninterrupted since the gold standard was abandoned in 1933.

The dollar short / deflation prognosis has never materialized since. The only deflation we've seen since 1933 were its symptoms (falling prices), occassionally, and they're explained by the work of capitalism or other ad hoc developments in the currency market before deflation in the technical sense of the term (definition below).

A theory is only as good as it fits the facts.

What's Too Much Money Then?
Russell puts it like this:

Another area of confusion -- one that I've been writing about. In the background we have the global forces for deflation, which stem from world over-production and its accompanying pressure on pricing power. Add the deflationary forces of giant Wal-Mart plus the Internet, and it's enough to give Alan Greenspan the "heebie-jeebies." Against these deflationary forces we have our heroes, the central banks of the world -- led by the Greenspan Fed. These guys (I believe they all talk to each other) are printing the paper that is calculated to hold deflation at bay. Remember, the classic monetary definition of deflation is too many goods lined up against too little money - Richard Russell on Gold, 12 June 2004

First off, there's no such thing as "world overproduction." There's only the problem of whether we're producing the right stuff - whether we're overproducing the wrong stuff and under producing the right stuff. Otherwise, as already pointed out, capitalism is supposed to provide us with generally more stuff.

But besides that Russell's "classic" definition misses on several other fronts. What's too little or too much money? In other words, is there a proper ratio between the stock of goods and the stock of money? If so, the assumption is that prices are supposed to be stable. And if the volume of goods increases does that increase the demand for money?

Obviously there is a relationship between money and other goods. But it would never exist without a human. So it is subjective. Money allows us to acquire goods more easily because it's something everyone else recognizes for holding that precise property - it allows for transactions that would not occur otherwise; it facilitates free exchange.

It is worth only what can be gotten with it. It has no value as a consumption or capital good (even though the good that represents money may). It's value is affected by changes in the way humans value other goods, and also by the factors that affect the demand and supply of money - independently of those that affect the value of goods. Improvements in the clearing system affect a decline in the demand for money balances, broadly, for instance, while the increasing reliance on money substitutes decreases the demand for money balances in the narrow sense. But it doesn't affect changes in the way we value other goods; just changes in price that has nothing to do with the real factors directing the nation's productive resources.

When people talk about money as the root of all evil because "others" would do anything for it they're confusing it with wealth, or capital, or even power. What people seek is wealth. They don't want to carry change around. Money is only a proportion of wealth that is meant to cover the uncertainties that might give rise to daily transactions that can only made with cash. If people wanted money they'd cash in their assets to get it. They want to be able to acquire more goods, not money balances.

Now that we got that out of the way...

The key point is that because money doesn't produce anything and its sole utility is in its ability to facilitate exchange it almost doesn't matter how much there is. It is the opposite with the nation's stock of goods or capital. The more capital there is the better. But more money doesn't do a darn thing to increase the amount of real wealth. The exact quantity of money that is appropriate is determined by the market when it makes a particular good the object of money, or a common medium, in the first place.

Beyond that, there is no real need for additional money, the Austrians proved. The only effect is on prices; there is no change to "total" real wealth and there is no incentive to producing real wealth that can be derived from increasing money, or liquidity as the Fed would have it. If one were to imagine, for instance, two identical economies perhaps on different planets or in different dimensions (?), and one were endowed with twice the money the other was - assuming everything else was exactly identical we're arguing the only difference would be that in one economy prices will be roughly twice the other. There would be no difference in the quantity of goods one could buy with their money.

Hence, the relationship between goods and money Russell depicts is not relevant in the manner implied. The exact ratio between the stock of goods and money that could be declared optimum is nebulous at best. What I'm saying is that if we could vary the ratio between money and goods in a series of controlled experiments that almost any ratio would work as well as the other.

We can only define what is too little or too much money once this is understood because it is the specific impact of changes in the money stock on prices that do the real evil; it is not the impact arising from changes in the ratio between the quantity of money and the stock of goods on the real side that matters; and it is not the absolute price level that matters. It's the changes in the supply of money relative to the demand for it (not relative to the stock of goods outstanding) that determine inflation or deflation, and subsequent variations in the value of money - the impact on prices from the monetary side - which matters. And these are wholly unnecessary.

But more importantly, it's in the way that these changes do affect prices that affect real wealth and its redistribution that is. If the true hero, Richard Russell, saw this he wouldn't consider the central bank as hero... I'm confident.

Anyhow, the classic definition of inflation AND deflation then, according to Mises, is:

In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur. Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for very long - Ludwig von Mises, The Theory of Money and Credit - Chapter 13, section 7, "Excursus: The Concepts Inflation and Deflation" pp. 272

Russell's definition further presumes the old mechanistic quantity theory of supply and demand, which ignores the doctrine of subjective valuation.

That means to say that in the way he defines inflation or deflation he forgets about the individual's role in determining the ratio between the stock of money and the stock of goods, that a human might value the goods one way today and another way tomorrow - relative to each other as well as in total. For instance, it is not necessarily true that by doubling the stock of goods while holding the money stock stable the value of money would double. It would rise, but by how much depends on many unforeseeable factors.

Russell thus simply assumes that any change in the quantitative relationship between the stock of money and goods creates an inflationary or deflationary circumstance as though it weren't supposed to change. But the fact is, that relationship is always changing not simply because the existing quantities do but primarily because these quantities are themselves changing according to the constantly changing demands of individuals... it's a requirement of the market that they do.

Put another way, changes in these quantities don't determine changes in value, and especially not proportionately as the old discredited version of the quantity theory of supply and demand would have it; rather, changes in human preferences affect changes in these quantities by expressing changes in valuation through exchange.

The subsequent unavoidable variations in the ratio are thus not "just" due to inflation or deflation. These latter concepts are solely meant to describe the effects on prices originating from the monetary side. Unfortunately, the vast majority of investors have adopted the Fed's definition (changes in the price level) which lump together all the effects on prices - monetary and real - and even then often poorly calculated.

Those effects originating on the real side (i.e. actual changes in tastes and preferences driving demand) don't need the term inflation or deflation; it only confuses matters. What economists need to understand when defining these particular concepts is the effect on prices on the money side, if only in order to deduce what is real.

In any transaction there are basically two independent valuations being made; on the one side there is the supply and demand for the consumption or capital good; on the other side there is the supply and demand for the monetary good.

Both valuations are assessed largely independently and culminate in a "price" - the final expression of all the independent valuations that go into the process up until the moment of exchange of which the value of money is only one.

The relationship between money and goods is important on almost every level except in the aggregate total relative quantities in existence at any given time, or in their definition of inflation and deflation. Too much money is any change in money supply relative to demand (for money) that affects changes in prices that don't represent real changes in total wealth but do nevertheless affect changes in the distribution of wealth.

Redistribution of Wealth via the Intervention in Prices from the Money Side
How inflation works is basically that the new money, once created, is passed along from one economic agent (individual or institution) to the next in exchange for goods, and that the variations in the value of money are made as it is passed along; that is, the devaluation of money is not uniform as one would think by trading the USd index.

If it were, the policy would have no value at all and we'd be left wondering, why do we have inflation if the price "level" doesn't matter?? It's true, the price level doesn't matter - it's the relative position of prices that determines the nature of production, and it's because the variations in money aren't uniform that it dislocates the market mechanism. In other words, through inflation the Fed basically appropriates the price function of the market to itself. The main effect an increase in money supply relative to demand has is to change prices; but it's in the way that prices change that they derive their benefit.

We depend on the market to signal what is "really" needed relative to what isn't. The influence from the monetary side is thus artificial (it mainly represents the tastes of those who get the money first; the economy's resources get misdirected to the production of those ends - too much money causes malinvestment not world overproduction).

Anyhow, instead of looking at it in terms of the new money being passed along and spent, passed along and spent, and so on, which is correct nonetheless, it is important to understand that the process of wealth redistribution (hidden taxation) relies on the effects of the inflation on the value of the money being passed along. In other words, the variations that are passed along is the mechanism of the redistribution of wealth.

So here's how it works: the first benefactors of the new money (the borrowers - government and private - as well as the banks) suddenly have more money than they know what to do with. In other words, the value of money in their eyes has already dropped because the proportion of their wealth that money comprises has increased and they don't need to keep so much of it on hand; this occurs to varying degree depending on the participant. Hence, they go out and spend it, which manifests as greater final demand, and they don't mind paying slightly higher prices because they've already acknowledged that the value of the money they're using has dropped "some."

It will drop more as it is passed along further. This process repeats itself as the new money is passed on in each transaction so that the earliest benefactors are buying goods at yesterday's prices before the money has made its way through the whole economy and completed its devaluation cycle. Those people receiving a fixed wage don't get the benefit of this increase in final demand, or money; they receive the same amount of money each month, or week, or what have you. So it's not a win-win; it's a zero sum game where the winners are closest to the front of the line.

This is how wealth is redistributed - from those earning fixed incomes, who can buy fewer goods each month as a result to those at the top of the food chain who benefit directly from their proximity next to the Fed - like the government or banking cartels, and those that do business with them.

The money is devaluing constantly even when it is rising on foreign exchange markets. But at times, the devaluation is so severe that it becomes apparent to all.

To sum up, neither debt service ratios nor free market forces drive credit demand. The Fed does, and henceforth it controls all manner of note issue as well. The dollar short idea cannot work because there is nothing to cause the squeeze. People aren't just going to turn frugal themselves. The Fed jumps on any excuse it can to keep the price of credit below market, and wages in this environment are ultimately destined to rise. too much money has nothing to do with the total stock of goods; it has to do with how it affects the composition of that stock of goods.

Ironically, Russell's theories are a service to the Fed to the extent they keep people from believing that there is a revolution in prices underway, and that it is unstoppable. Every day the Fed tries to convince you that prices aren't going to go up forever.

History says otherwise.

The Fed doesn't exist to fight deflation; it exists to sustain an inflation policy directed at the redistribution of incomes, both at home and abroad (through trade). As Rothbard said in the "Mystery of Banking," the Fed is the engine of inflation.

That said, if the Fed itself abandoned the boom then deflation would come. But this means driving rates up to intolerable levels, and shutting down the engine of inflation - dissolving the Fed in the end. The main thing standing before that result is the naive belief that prices won't rise forever. In Russell's case it is premised on a model that expects market retribution for the credit excess to manifest as a deflationary crunch.

But the real retribution we believe comes in what happens to value of the common medium. Any theory that infers a natural deflation as the response to too much credit and money in the absence of a gold standard is so off base it might as well be in another world. Like I've often said, you can't apply the laws of physics to human action.

The end of this state of affairs is one devaluation (debasement) after another - which again is precisely what has occurred since abandoning the gold standard - until one day people wake up and say this crap ain't money; because they realize that the policy of inflation is endless. At that point supply won't matter as much because it'll be the fall off in the demand for the Federal Reserve note that'll drive prices increasingly higher - the kind of fall off in demand that is relative to a better money: gold we would argue.

In other words, one day the market WILL demonetize the Federal Reserve Note (I didn't say the dollar). Maybe not in my lifetime, but then again maybe.

We learned that central banks cannot be heroes because the aim of their policy is an insidious method of additional taxation for which the government could not possibly find consent - this is the only reason it is pursued, since as Mises showed, methods of direct taxation could help achieve their aims better and more predictably.

We argued that a debt cycle can grow indefinitely so long as the difference between the rate demanded by the lender and the rate desired by the borrower can find middle ground, and so long as interest rates are below their natural rate. And lastly, our view is that the foreign exchange value of the dollar is far from oversold.

I've always liked Richard Russell and I hope he reads and ponders our objections to his reasoning on this subject. I'm sure that he's one of the best newsletter writers in the business. It is possible that we're wrong that the Fed is stuck in an inflation trap, and that the likelihood that the gold bull be interrupted by anything more than a deflation "scare" is almost nil. However, if we're wrong about that I would suggest it won't be due to a consumer led bust in the credit cycle - except for a temporary one perhaps; it would almost certainly involve something we've overlooked entirely.

There is no mystery here. The central bank is the engine of inflation and it will produce it until you're sick of it.

In the end gold is not an asset without liabilities; it is merely money. And unlike the Federal Reserve Note its supply is largely limited. The effects on production from the monetary side would be far less if it were money. Today the value of gold rises in price - significantly - when the market devalues the Fed's paper, or in the extreme when the market finally demonetizes it. From the policy perspective, as Mises said, people must not be allowed to believe that the policy of inflation is endless.

Such is the border between here and demonetization.

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