Tertium datur

People tend to think in terms of black-and-white. Many of my correspondents think that either hyperinflation or deflation is in store for the dollar; tertium non datur (no third possibility given). I would say tertium datur. The third possibility is a hybrid of hyperinflation and deflation. I described this scenario in my previous article "Opening the Mint to Gold and Silver". It is possible, even probable, that we shall witness collapsing world trade and collapsing world employment together with competitive currency devaluations, as the three superpowers compete in trying to corner gold. The lure of gold is very strong. "There is no fever like gold fever" and, contrary to conventional wisdom, governments are especially susceptible.

A large part of the problem is that the Central Bank is helpless in the face of bond speculation. The Fed is no Sorcerer. It is the Sorcerer's Apprentice. It can pump unlimited amounts of "liquidity" into the system, but cannot make it flow uphill. As we shall see, new dollars flow to the bond market causing a lot of mischief there, instead of flowing to the commodity market as hoped by the Fed.

Up to now leading commodities have outperformed gold. That could change. A select few commodities might continue in the bull-mode for a time, although gold could easily beat them. Most other commodities might go into a bear-mode similar to that of the commodity markets of the 1930's. If that's what was in store, then most investors would be totally lost. They would be navigating without a compass. There would be endless debates whether the country is experiencing deflation of hyperinflation. Your motto in this hybrid scenario should be: "expect the unexpected".

Of course, the Fed will keep printing dollars like crazy. Few of them, if any, will go into commodities. Indeed, most of the newly created dollars will go into bond speculation. Why? Because commodity bulls are running into headwind and face grave risks. By contrast, bond bulls enjoy a pleasant tailwind. Bond speculation is virtually risk-free. Under our irredeemable dollar bond bulls have a built-in advantage. The Fed has to make periodic trips to the bond market in order to make its regular open-market purchases of bonds to augment the money supply. In order to win, all the bond speculator has to do is to stalk the Fed and forestall its bond purchases. This is the Achillean heel of Keynesianism: it makes bond speculation inherently asymmetric favoring the bulls, and that will ultimately derail the economy on the deflation-side of the track.

Uncle Sam in agony

Russia is not as enigmatic as China. The Russians' game is gold. China is the big unknown. It looks as if China prepares to corner silver. Will the Chinese force a silver standard on their trading partners? It is quite possible that their pile of paper profits in silver is already so huge that they can well afford to gamble. They find trading T-bonds most profitable. Indeed, theirs is the greatest U.S. T-bond portfolio ever, anywhere. They can overwhelm any opponent bidding against them. Just think about it. The financial destiny of the U.S. is in China's hand. The good news is that the Chinese have vested interest in keeping the bond bull charging. They also have a vested interest in keeping the dollar on the life-support system. The bad news is that the Chinese insist that it is their finger that must be on the switch. Here is an incredible sight, the U.S. being under the thumb of China. Not because the Red Army is a match for the U.S. military, but because Uncle Sam has voluntarily put his head into the noose. The Chinese ask: why fight shooting wars when you know that your antagonist is painting himself into a corner anyhow? They know that Uncle Sam will sooner or later start crying: "Uncle!" in agony. They have all the marbles. The marbles of saving. The marbles of producing. The marbles of silver. Maybe, one day, they will also have the marbles of gold.

The Logarithmic Law of Deflation

Most economists are ignorant of the mathematics of depressions. They have certainly never heard of what I call the Logarithmic Law of Deflation. It states that halving interest rates brings about the same proportional increases in bond prices, regardless at what level the halving takes place. It makes no difference whether you go from 16% to 8% or from 2% to 1%, the value of long-term bonds will increase by about the same factor. It can be seen that a much smaller drop in interest rates could bring about the same proportional increase in bond prices, provided that the rates are low enough.
Why is this important? Because it gives away the secret of the deadly deflationary spiral. It is wrong to describe Fed action as cutting interest rates. We should think in terms of the Fed halving them. The bull market in bonds can go on indefinitely under the regime of the fiat currency. People assume, wrongly, that the Fed will run out of ammunition when the rate of interest is approaching zero. The bond-bull will run out of breath. Not so. The Fed will never run out of ammunition. The lower the rate, the smaller cut will do. The Fed can halve interest rates any number of times without ever reducing them to zero. The bond-bull will never run out of breath.

"Gigolo of science"

The trouble is that the bond-bull is the root cause of depressions. Falling interest rates create capital gains for bondholders, yes, but these gains do not come out of nowhere. They come right out of the capital losses of producers. They are the very stuff out of which depressions are made. The serial cutting of interest rates by the Fed is the grave-digger of the economy: it causes wholesale bankruptcies in the producing sector. The large-scale dismantling of the producing sector in America during the past twenty-five years is a direct consequence of the regime of falling interest rates. Production stopped as a result of the financial sector siphoning off capital from the producing sector. Industrial jobs were exported as there was no capital left to support them at home. This shocking truth was never investigated by mainstream economists, sycophants of Keynes. They did not want to expose the gravest error of their idol in confusing a low interest-rate structure with a falling one. Keynesianism is the gigolo of science (Ayn Rand).

"Moral cannibalism"

As the example of Japan shows, we are not looking at a ditch into which the Japanese economy has stumbled. We are staring a black hole in the face, the black hole of zero interest. It can suck in the Japanese economy. It can suck in the economy of the United States. It can even suck in the entire world economy. It is powered by the regime of the irredeemable dollar, and the Fed's policy of serial interest-rate cuts.

Ayn Rand called the confiscation of gold in 1933 by F.D. Roosevelt "moral cannibalism". As I have shown elsewhere, the epithet is apt. The removal of gold as the chief competitor of government bonds was one of the main causes of the Great Depression in triggering, as it did, a protracted fall in interest rates. (The other cause was the deliberate manipulation of interest rates lower by the Fed.) The latter-day equivalent of moral cannibalism is risk-free bond speculation by the banks, perpetuating the bull market in bonds. It is made possible by the open-market operations of the Fed that have been clandestinely and illegally introduced and, by now, have become the mainstay of the management of fiat currencies. The result is another protracted fall in interest rates. Could they herald another Great Depression?

What American Century?

There is an historical lesson to learn here. The twentieth century was not the "American Century" as advertised. The sun started setting on America as early as 1913 when, in imitation of the Europeans, Americans embraced the idea of a central bank. An earlier attempt to establish a central bank in the United States was found contrary to the Constitution, and the Bank's charter was not renewed. But by 1913 the visionary admonition of Thomas Jefferson was totally forgotten.

"If the American people ever allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive the people of all property, until their children wake up homeless on the continent their fathers conquered. The issuing power of money should be taken from banks and restored to Congress and the people to whom it belongs. I sincerely believe that the banking institutions having the issuing power of money are more dangerous to liberty than standing armies."

In less than a generation after 1913 adventurers invaded America's institutes of higher learning and exiled monetary science, replacing it with a hodge-podge of dubious nostrums. America's economy and finance started to be run on a completely false theory. Gold, and the power to create and to extinguish money was taken away from the people. It was given to the banks.

Operating on the basis of this false theory Americans scrapped the foundations of the international monetary system: they threw out positive values (such as that of gold and silver) and replaced them with negative values (such as debts and deficits). As a consequence, outstanding debt can no longer be reduced through the normal course of retirement. Total debt can only grow. In no time at all America has turned itself from the largest creditor into the largest debtor nation of all times. Not only did the U.S. government allow its debt to grow exponentially; it also allowed it to accumulate in the hands of America's adversaries. At the same time America's industrial heartland was dismantled. Well-paid industrial jobs were exported and replaced by low-paying service jobs.

Hedging versus gambling

The United States is like a train running downhill without brakes. The derivatives monster is the proof of that. It has its own dynamics, but it cannot be grasped without a solid understanding of gold. Under the gold standard interest rates, and hence bond values, were stable. In fact, that is the main excellence of a metallic monetary standard: it makes interest and foreign exchange rates stable. There are no derivatives markets on interest and foreign exchange rates, because the lack of volatility makes trading unprofitable. Under a metallic standard "bond trading" is an oxymoron, as is "bond insurance". Private issuers of debt must set up a sinking fund that will buy up all bonds offered in the market below par. People buy bonds as a vehicle of saving. Today, you would have to be insane if you wanted to buy bonds as a vehicle of saving.

Why then are bonds still in demand? They are in demand because they are by far the best vehicle of gambling. As I shall now show, under the regime of irredeemable currency, speculation in bonds is risk-free.

When the gold standard was thrown to the winds, interest rates started gyrating and bond values were totally destabilized. After all, bonds promised to pay principal and interest in terms of a currency of uncertain value.

Mainstream economists betrayed their sacred duty of searching for and disseminating truth. They started preaching the false gospel that it is possible to take out insurance against losses in the bond portfolio. However, the thesis that bond futures can be used for purpose of hedging the bond price (in exactly the same way as wheat futures can be used for the purpose of hedging the wheat price) is an outright lie. Only those price risks can be hedged where the price variation is nature given, as in the case of agricultural commodities. If the price variation is artificial, that is, subject to government and central bank manipulation as are foreign exchange and bonds under the regime of irredeemable currency, then it is preposterous to talk about hedging. One should talk about gambling instead of hedging. As in the casino, the so-called hedger is placing a bet against the house, in this case the central bank, whose job it is to manipulate the price.

The Derivatives Monster

The derivatives tower is just a layered pyramid of "bond insurance", so-called. Nobody asks the question whether insuring bond values is possible in principle. As I have stated, it is not. Insurance means spreading the risks over a larger population than that needing compensation. Insurance is the very opposite of gambling where the player wants to increase his risks in the hope of a large payoff, not to decrease it.

Now think of an inverted pyramid delicately balanced on its apex. The apex represents the bond market (layer 1). The next layer is bond insurance (layer 2). But since the value of bond insurance is inherently even more unstable than that of the bond, it is in need to be insured as well (layer 3). And so on it goes. The pyramid is growing at an exponential rate as the need for reinsurance keeps increasing.

There are several problems. First of all the whole idea is hare-brained, much the same as the idea of "operation boot-strap". A soldier, no matter how strong he is, cannot lift himself by his own boot-straps. Similarly, you can't insure bond values without an anchor. The second problem is that the slightest hitch at any layer will bring down the house of cards. The principle of insurance assumes that no tornado will destroy all the insured homes simultaneously. The same assumption cannot be made about bond insurance. The volume of outstanding bond insurance is much higher than the existing supply of bonds. It is even larger than the existing money supply (and goodness only knows that it is very large.) Therefore it is a physical impossibility to compensate insurance-holders in case of global trouble. If any doubt arises at any level about the validity of the insurance policy, the whole Ponzi-scheme collapses. The Derivatives Monster is meant for simpletons.

The Presidential election year of 2008

I find it frightening that none of the Establishment candidates for the presidency even vaguely refer to the on-going self-destruction of the nation's monetary and banking system. Like an ostrich they ignore the problem. A presidential election year should be a great opportunity for the nation to discuss its most urgent problems and take remedial action wherever necessary. In this election year the country is blessed with the running of a competent and upright candidate who sees and understands the problems involved, and is willing to engage in a public discussion of the gold standard as a way to avert national and world economic disaster. This candidate is Dr. Ron Paul, a physician who did not go into politics with the idea of making money or accumulating power. He went into politics as Cincinnatus*, patriot and hero of the old Roman republic. When Cincinnatus was drafted to become consul, the messengers who came to tell him about his new dignity found him ploughing on his small farm. He answered the call, but after solving the problems of the nation he declined the offer to become dictator for life. He returned home to pick up the plough again.

Already in 1985 Ron Paul called for the opening of the U.S. Mint to gold and silver as a way to stop the threatening monetary and banking crisis in his address The Political and Economic Agenda for a Real Gold Standard. If the country had listened to him then, people would have been spared of the economic pain of 2007, and the possibly much greater pains that may be in store.

Ignorance or lust for power?

Not one among the Establishment candidates is willing to take up the challenge of Ron Paul, thus depriving the electorate of a singular opportunity to learn about the dangers threatening the Republic. We are left wondering whether their ostrich-like behavior is due to ignorance, or to lust for power.

The electorate cannot make an informed decision in November without understanding the current monetary and banking crisis and its connection to gold. It is not too late to have a great debate on the gold standard and on the consequences of maintaining the irredeemable dollar standard in the face of an escalating monetary and banking crisis. Labor leaders and captains of industry should demand an answer to all those questions that the representatives of the financial press refuse to ask of the candidates.

* Lucius Quinctius Cincinnatus (c.519-433 B.C.) Cincinnati was named in honor of Cincinnatus.

References:
Ron Paul, The Political and Economic Agenda for a Real Gold Standard, www.lewRockwell.com, January 19, 2008
A.E. Fekete, The Double Whammy of Geopolitical Global Gold Games, www.safehaven.com, January 30, 2008
A.E. Fekete, Fiat Currency: Destroyer of Labor, www.professorfekete.com
A.E. Fekete, Fiat Currency: Destroyer of Capital, www.professorfekete.com
A.E. Fekete, Opening the Mint to Gold and Silver, www.safehaven.com, February 5, 2008

GOLD STANDARD UNIVERSITY LIVE
Session Three, will be held in Dallas, Texas, February 11-17, 2008.
For details, see: www.professorfekete.com.