Battle of the Titans

Bob Moriarty
July 8, 2004

Below the surface and well under the radar scopes of most investors, a monumental battle takes place between giant forces. We can think of inflation as the irresistible force and deflation the immovable object. For those with good memories, try this test from yesteryear.

What happens when an irresistible force meets an immovable object?

Unmeasurable energy.

Well, we better find some way of measuring this force and figuring out how to cope with it because as sure as God made little green apples, inflation is in the midst of an historic battle with deflation.

Even the well lettered often confuse themselves with the issue of what inflation is. Actually it may be more important to know and understand where inflation comes from. If we understand where inflation comes from, perhaps we can figure out the real problem.

Here's something you have never read before. With the exception of wartime periods, between 1783 and 1913, inflation was zero. Essentially we had no inflation. But as soon as the Federal Reserve system came along, here comes inflation. If you go here, you can compare today's dollars with those of yesteryear. Using the government's own figures, we can soon see that to equal the purchasing power of $100 in 1913, we would need $1840 today. All the product of the Federal Reserve system.

The cause is simple. In a fractional reserve system, even a gold fractional reserve system, all money is created by loaning money into existence. And the more loans you make, the more profit you can make. It is a perpetual motion machine. Just as long as you keep expanding the money supply (inflation) everything works. Or until people borrow far more money than they can afford to pay back. At that point the system implodes and deflation sets in as the money supply collapses.

There is another titan on the block. It's called derivatives and these are financial instruments which derive their value from other products. An option, either a put or a call on the S&P, would be an example of a derivative. Actually the S&P would be a derivative as well, the measure coming from the value of the individual stocks. And preparing a package of mortgages could be a derivative where the fixed rate mortgages are sold to one group of investors and the variable rate mortgages to yet another.

Up until August of 1971 the United States was on a hooker's gold standard. It was and wasn't a gold standard. Here in the land of the free and home of the brave, Americans couldn't be trusted to own gold, it was illegal. But foreign governments could and did make claims on the gold hidden in Fort Knox and the vaults of the NY Fed. When Nixon dumped the gold standard for all time, investors worldwide began to make bets on the day-to-day value of currencies and interest rates. For better or worse, one of the main functions of a gold standard is to create stability. And without a gold standard, the financial system of the world began to wobble.

In 1971 the total value of derivatives world wide was too small to measure. It was possible to buy puts and calls on common stocks but all trades were OTC and negotiated individually for each trade. It wasn't until 1973 that the CBOE even came up with the idea of standardized strike prices and expirations. Currency trading and options took place on a formal basis even later.

Today, the total value of worldwide derivatives, still mostly OTC and totally unregulated, is over $210 trillion dollars. This immense market consists mainly of interest rate-based instruments (89%) where even the issue of what constitutes a default is often in legal debate. The mere size of the market is so big (about 4.5 times the world's yearly GDP) that it is not "too big to fail" it is rather, "too big not to fail."

It should be obvious to anyone paying attention that the Fed has committed themselves to a destructive test of our financial system. (Which means for all practical purposes, the world's financial system). The Fed is going to print money at an ever-increasing rate until the system breaks. Where once the Fed attempted to manipulate interest rates and currencies in order to keep inflation at the desired rate of increase, it is obvious to anyone with eyes that now they just lie in all their figures. If you can't keep control of inflation, just lie about it, no one will notice.

But financial markets do notice and with the first increase in the Fed Funds rate now under their belt, the Fed has started a snowball rolling which cannot be stopped. And since the use of complex and misunderstood derivatives allows leverage to a degree never before in recorded history, the question is no longer, "Will the system fail?" But, "When will the system fail?"

The system will fail. It doesn't really matter how it fails, it will fail and gold will once more provide an alternative to government stupidity for those wise enough to see and prepare for a dismal future.

The note below came from a subscriber of Richard Russell and provides the best explanation of the inflation/deflation issue I have ever read. I wanted to share it with our readers.

From Richard's Remarks 7/6/04

Richard,

There are 3 aggregated balance sheets we need to track: government, corporate and individual. In the '90's one watchword was privatization, and one thing that was privatized was debt. Increases in government revenues at all levels went to increased spending (as in your own California) and to debt reduction. You may recall that Greenspan supported the Bush tax cuts on the grounds that federal government surpluses would eventually pay off its debts in full and force the feds to buy private assets. (Could he really have believed this?)

While governments reduced their debt levels in the '90's, corporations and individuals expanded their debts. In the corporate sphere perhaps the most bizarre expansion of debt was among corporations borrowing to buy back their own overpriced stock, instead of issuing new stock at historically high prices in order to reduce debt. (This was the economically irrational fruit of stock option plans, for the most part.) Meanwhile individuals borrowed for consumption and, to a lesser extent, to "invest." In sum public debt shrunk while private debt expanded.

Now corporate balance sheets are being repaired while individuals' debts continue to rise. "Luckily" the government has begun the process of re-socializing debt. Taxes have been cut while military spending increases and entitlement program spending starts to accelerate with inevitably expanding drug benefits and the coming drains on social security and Medicare from the boomers. It is clear that federal debt has only one way to go: up, and sharply up at that. As individuals hit the wall, as indicated for example by reduced expectations at Wal-Mart and Target and also by rising bankruptcy rates, the feds are stepping into the breach.

To oversimplify a bit, with no U.S. domestic savings the only buyers for government debt are abroad. Foreign individuals have already stepped aside, so that leaves foreign central banks trying to keep their own currencies from strengthening vis a vis the dollar. If the consumer stops increasing consumption (let alone reduces it), foreign trade surpluses stop increasing and their capacity to buy t-bills and t-bonds stops increasing. As the federal debt increases, then, the expanding supply can find only one home -- the fed. In a grand irony, Greenspan, if he's still around, gets to buy the debt he predicted would not exist. If the fed doesn't buy, then interest rates soar and we are faced with domino bankruptcies. This is the scenario that the fed has said it will avoid even if it has to resort to helicopter money. Of course monetizing the debt pushes inflation and weakens the dollar. Private debt is reduced in real terms, but it is not clear that private incomes will rise with inflation to the degree required to get the full benefit of that effect. The best part, of course, is that we get to repay those foreign holders of federal debt in lower valued dollars.

A financial accident might trigger a situation that leads to deflation, but if the economic process is allowed to unfold in stately fashion, it looks like inflation to me.

Best wishes to you from a devoted reader,

Jeffry Klugman

July 8, 2004
Bob Moriarty
President: 321gold Inc
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