This essay is based on the Premium Update posted on July 16th, 2010

We live in an era of unparalleled confusion on monetary and economic issues. It's almost like a shoot-out among the economists in the Old West, except that here you can't tell the good guys from the bad guys. You read so many conflicting reports, editorials, and newsletters that it's easy to get befuddled.

There are those who say inflation, those who shout deflation. Some say print more money, others say halt the printing presses. There are those who say bail them out, and the others who say let them fail. There are those who say gold is going up to $2,000 and even to $5,000, and those who say it's a bubble about to burst. We're in a bear market, sell all your stocks. No, we're in a bull market, buy, buy, buy.

At Sunshine Profits we follow the reports, read the newspapers to stay current, but we shut out the noise. Technical analysis is a world of its own and when you learn to listen you can hear its music. There are harmonies, rhythms and patterns, sometimes sharp, sometimes flat.

Nevertheless, we thought it might be useful to look at some of the economic theories and how they are being put into practice in these confusing times. It is very important to understand the difference between the various schools of economic thought employed by governments. After all, economic, monetary and fiscal policies affect us directly right where we feel it -- in our pockets and in our standard of living.

There are many schools of thoughts, but today's showdown with guns loaded seems to be centered between the Keynesians and the Austrians. They don't even try to hide their contempt for one another. In 1998, Paul Krugman, a Nobel Prize winning Keynesian economist plainly dismissed the Austrian theory as "not worthy of serious study." The Austrians say the Keynesians are dead wrong about how to deal with the recent subprime crisis and, in fact, are largely responsible for it. One called the Keynesian theory "a con job from day one." Another said Krugman makes "an enticing argument that is nevertheless built on rubbish."

A Brief Explanation

Keynesian economics is a macroeconomic theory based on the ideas of 20th century British economist John Maynard Keynes, without question the most influential economist in the 20th century. The Keynesians argue that private sector decisions sometimes lead to inefficient outcomes and therefore the government should step in with active monetary policy actions by the central bank. The recent economic crisis caused resurgence in Keynesian thought with U.S., British and other world leaders using Keynesian economics to justify injecting billions into the economy with bail out programs and government stimulus programs. Keynesians claim that government policies kept the world economy from collapse and that more stimuli are needed. You might recall that it was President Richard Nixon who was quoted as saying "I am now a Keynesian in economics" when in 1971 he took the United States off the gold standard. (Keynes himself called gold "a barbaric relic.") New York Times Nobel Prize winning columnist Paul Krugman is a champion for Keynesian economics.

The Austrian School takes an opposite tack. The Austrians (They are nowhere near Austria today, but that is where the economic theory began) argue for an extremely limited role for government and the smallest possible amount of government intervention in the economy, especially in the area of money production. According to the Austrian Business Cycle Theory, the central banks attempt to control the economy is ineffective and creates volatile credit cycles and periods of boom and bust. When the central banks artificially "stimulate" the economy with artificially low interest rates it causes bubbles to form, inflation and consequent recessions. Austrians predicted the subprime bust in 2006.

Austrian theorists such as Murray Rothbard, Ludvig Von Mises, and Friedrich Hayek believed in government restraint, the protection of private property and the defense of individual rights. Austrians see entrepreneurship as the lifeblood of economic development. Many Austrian School economists support the abolition of the central banks and advocate a return to the gold standard. The Austrians advocated in 2008 that the FED should do nothing, that Fannie and Freddie should be allowed to go under, and that the stimulus bill should be voted down. Congressman Ron Paul is a firm believer in Austrian school economics, as are investors Peter Schiff and Jim Rogers. Milton Friedman of the Chicago School is closely associated.

So to simplify, the Austrians say the market is a self-correcting mechanism, just leave it alone and it will follow fairly smooth and manageable cycles. The Keynesian say government should intervene with deficit spending and ever-changing fiscal policy to "guide" market cycles.

As the financial crisis unfolded the governments reacted according to the Keynesian textbook. They began pumping the printing presses, lowering interest rates and injecting billions to bail out and jump start the economy. Now, it's beginning to look like policy makers are making a startling about-face and are embracing austerity and deficit reductions, a more Austrian approach.

Congress recently failed to extend unemployment benefits and abandoned plans for another round of stimulus to combat what is the worst economic recession in over a generation. Are we really at the dawn of a new age of austerity? Has Austrian economic thinking replaced the Keynesian addiction to government spending? How does this affect the case for gold?

Stimulators Vs Austerians

Krugman, a Keynesian, is horrified by governments wanting to tighten the belt and what he calls "balanced-budget orthodoxy" instead of more stimulus spending. "We are now, I fear, in the early stages of a third depression," he wrote in a recent New York Times column. "And this third depression will be primarily a failure of policy." The policy to which Krugman is referring is the recent G-20 meeting where governments, spooked by the debt troubles in Greece, agreed about the need for belt-tightening when the real problem, according to Krugman, is not enough spending. He wrote:

It's almost as if the financial markets understand what policy makers seemingly don't: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

Krugman calls the G-20 move "the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times." He is, of course, referring to the Austrian school.

The Austrian Response

Peter Schiff had an interesting view on the growing ideological divide between the economic thinking between Europe (Austrian) and the US (Keynesian) and some answers for Krugman. Here is what he wrote in an article for Marketwatch:

Despite the apparent deficit-cutting solidarity that emerged from the G-20 meeting in Toronto, it is clear that the great powers of the industrialized world have not been this philosophically estranged since the end of the Cold War...We now are witnessing a struggle between two camps that I playfully call the 'Stimulators' and the 'Austereians' (from Austerity).

Both warn that a worldwide depression will ensue if governments now make the wrong choices: the Stimulators say the danger lies in spending too little and the Austereians from spending too much. Each side also has their own economic champion: the Stimulators follow the banner of Nobel Prize-winning economist Paul Krugman, while the Austereians are forming up behind the recently reformed former Fed Chairman Alan Greenspan. In a recent Wall Street Journal editorial, Greenspan argued that the best economic stimulus would be for the world's leading debtors (the United States, UK, Japan, Italy, et al) to rein in their budget deficits, a strategy dubbed 'austerity' by the press...

Meanwhile, in several articles for his New York Times column...Krugman has argued that those who push for austerity in the face of recession are either doing so for political expediency or out of a 'crazy' fealty to archaic economic views. Krugman has apparently judged inadequate the trillions of dollars worth of deficit spending unleashed by the United States and European governments in the last 24 months. He believes our only remedy is to spend more - no matter how much debt results.

What Krugman proposes is nevertheless built on rubbish. Economies do not grow because consumers spend; consumers spend because economies grow.

The Stimulators...believe money grows on trees and that a printing press is a legitimate creator of wealth. However, printing money merely encourages people to spend their savings now rather than wait for it to lose value through inflation. This is okay to Stimulators, because stimulating "demand" by any means necessary is the only goal they can see.

The Austereian argument is that reductions in government spending will allow the private sector to generate the additional supply of goods and services. Europe seems to understand this; unfortunately, the U.S. does not. If Greenspan and the Austereians are correct, the stimulus will fail and leave us in a much deeper hole. As long as governments create bigger deficits, we will never have a sustainable recovery.

So there you have it, the Keynesians versus the Austrians. Who is right? We continue to believe in the small government, but the history will prove to be the ultimate judge. Meanwhile, we will continue to do what we do best, study the charts.

To see how the prices of the mining stocks will do in the upcoming weeks let's begin this week's technical part with the analysis of the HUI Index (charts courtesy by http://stockcharts.com.)

The HUI Gold Bugs Index chart above gives us some insight to assist those, who are inclined to trade in precious metals stocks presently. The trend still appears to be up, but please note that after a similar trend broken in the past a sizable decline followed. In this case it may mean that we can expect a sizable decline to materialize soon.

Let's take a look at the short term GDX ETF chart for details.

The previously featured gold chart shows that the December top was followed by a big decline, though the second part of the decline was in fact smaller. The opposite appears true for mining stocks (as visible on the above GDX chart.)

Today's situation seems quite similar to December's. Both timeframes saw major tops and strong support levels tested several times. The December support level was broken on the second attempt. This could happen gain as the 50-day moving average is close to today's price level. Perhaps it has already happened (given Friday's intra-day action), but it's too early to make such conclusions.

If this is to repeat, the RSI and GDX ETF behavior have been quite similar of late. Also, Fibonacci retracement levels can be used twice to analyze the same move. The 61.8% retracement would bring us to around $52.5, close to the upper border of the trading channel. This could form if the slope of the declining trend line repeats itself here as in December.

The downside target is in the $45 - $46 area, as marked with the red ellipse on the above chart.

Summing up, even if the precious metals companies are to report huge gains, charts suggest that this information may already be "in the price" meaning that very positive earnings won't move the price while only the slightly positive one's could decrease it. It's just a matter of market's expectations. This is something that the charts could help us estimate and at this point charts suggest a move lower relatively soon, but not very likely right away. Detailed targets for gold and silver are available to our Subscribers.

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Thank you for reading. Have a great and profitable week!