Based on preliminary data for January-2012, the YOY rate of growth in US TMS has accelerated to 15.4% over the past month. The situation is illustrated below. This leaves no doubt that a new US monetary inflation record (the longest period of double-digit money-supply growth in US history) will soon be set.

The question is: considering that there has been so much monetary inflation over the past few years, why hasn’t there been much “price inflation”?

The above question is misleading, because it is based on the false premise that prices generally haven’t risen by much in response to the growth in the money supply. The reality is that a lot of prices have been driven upward by monetary inflation and are now much higher than they would otherwise be. For example, monetary inflation explains why the S&P500 Index, despite being 12 years into a valuation-compressing secular bear market, is only about 13% below its 2000 peak in nominal dollar terms. For another example, monetary inflation explains why copper is priced at around US$4/pound and oil is priced at around $100/barrel, despite the economic problems in Europe, China, the US and Japan. It also explains why the soybean market, which for decades had a price floor at US$5-$6 and a price ceiling at US$10-$11, now appears to have a price floor at US$10-$11 (the old ceiling is the new floor).

The idea that prices haven’t risen by much is based on government price indices that purport to measure the economy-wide movement in prices. These indices clearly understate the extent to which prices have risen, meaning that the amount of “price inflation” reported by the US government is a lot less than the actual amount of “price inflation”.

That being said, the actual amount of “inflation” in consumer prices has certainly been less, to date, than we expected to see in response to such a large expansion of the money supply. This is not a shock to us, though, because we understand how monetary inflation works. One of the dangerous characteristics of monetary inflation is that it is never possible to know, in advance, exactly how it will distort the price system. What we do know is that a large increase in the money supply ALWAYS leads to large price increases somewhere in the economy. The best we can do is make an educated guess as to which items/investments will be the main beneficiaries of monetary inflation.

The bottom line is that monetary inflation in the US is doing what it always does. It is boosting prices in ways that can’t be predicted with complete accuracy by anyone, let alone by central bankers employing hopelessly flawed Keynesian theories.

The NYU professor of economics Nouriel Roubini said in Davos, Switzerland, on January 25, 2012, that tight policies are making the recession in the euro zone worse. According to Roubini what Europe needs is less austerity and more growth. In particular, the NYU professor is concerned about the deep recession in the eurozone’s peripheral countries: Spain, Portugal, Greece — all are on a strict regime of austerity. For instance, in Spain the yearly rate of growth of government outlays stood at minus 12.4 percent in November against minus 15.7 percent in the month before. In Portugal the yearly rate of growth stood at minus 3.6 percent in December against minus 2.5 percent in November. In Greece the yearly rate of growth fell to 2.9 percent in December from 6.2 percent in the prior month.

A visible tightening is also observed in the two major European economies of Germany and France. Year-on-year government outlays in Germany stood at minus 1.6 percent in November versus minus 1.7 percent in October. In France the yearly rate of growth stood at minus 12.4 percent in November against minus 12.3 percent in the prior month.

According to Roubini and other experts, a tighter stance undermines already-depressed euro zone economic activity. The yearly rate of growth of real GDP eased to 1.3 percent in Q3 from 1.6 percent in Q2 and 2.3 percent in Q3 in 2010. Also the growth momentum of industrial production displays softening. Year on year, the rate of growth fell to minus 0.3 percent in November from 1 percent in the month before and 8.1 percent in November 2010.

Roubini is making the point that austerity won’t let euro zone countries grow their way out of their predicament. What is now urgently required to improve the eurozone’s economic situation is to devalue the euro by 30 percent, argues Roubini. Note that the price of the euro in terms of US dollars fell from 1.48 in April last year to 1.29 in December — a fall of 12.8 percent. Yet despite this depreciation of the euro, the yearly rate of growth of industrial production has fallen from 5.4 percent in April to minus 0.3 percent in November. So why then should a depreciation of 30 percent as suggested by Roubini revive the economy?

According to popular thinking the key to economic growth is demand for goods and services. It is held that increases or decreases in demand for goods and services are behind rises and declines in the economy’s production of goods. Hence, in order to keep the economy going, economic policies must pay close attention to overall demand.

Now, part of the demand for domestic products emanates from overseas. The accommodation of this demand is labelled exports. Likewise, local residents exercise demand for goods and services produced overseas, which are labelled imports. Observe that while an increase in exports implies an increase in the demand for domestic output, an increase in imports weakens the demand. Hence exports, according to this way of thinking, are a factor that contributes to economic growth, while imports are a factor that detracts from the growth of the economy.

From this way of thinking it follows that, because overseas demand for a country’s goods and services is an important ingredient in setting the pace of economic growth, it makes a lot of sense to make locally produced goods and services attractive to foreigners. One of the ways to boost foreigners demand for domestically produced goods is by making the prices of these goods more attractive.

For instance, the price of an identical bag of potatoes in the United States is $10 and €10 in Europe. Also, the exchange rate between the US dollar and the euro is 1:1 (one-to-one). At the exchange rate of €1 to $1, an American can get for his $10 one European bag of potatoes.

One of the ways of boosting their competitiveness is for Europeans to depreciate the euro against the US dollar. Let us assume that, in response to the European Central Bank (ECB) announcement to loosen its monetary stance, the rate of exchange falls to 50¢ per Euro. This means that €10 is now worth $5, which in turn implies that a European bag of potatoes in the United States is offered for $5, all other things being equal. Consequently, an American can now purchase for $10 two European bags of potatoes instead of one before the depreciation of the euro. In other words, the purchasing power of Americans with respect to European potatoes has doubled.

If we apply the potato example to all goods and services, we reach the conclusion that, as a result of currency depreciation and all other things being equal, the overall demand for domestically produced goods is likely to increase. This in turn will give rise to a better balance of payments and stronger economic growth in terms of GDP.

Note that, to lift foreigners’ demand, Europeans are now effectively offering two bags of potatoes for one American bag of potatoes. This also means that the price of the American bag of potatoes in Europe is now twice as much as before the depreciation of the euro. This most likely will lower Europeans’ demand for American potatoes. In short, what we have here as far as Europe is concerned is more exports and fewer imports, which according to mainstream thinking is great news for economic growth.

Why a Boost in Exports on Account of Currency Depreciation Damages Wealth-Generation Process

When a central bank announces a loosening in its monetary stance, this leads to a quick response by participants in the foreign-exchange market through selling the domestic currency in favour of other currencies, thereby leading to domestic currency depreciation. In response to this, various producers now find it more attractive to boost their exports. In order to fund the increase in production, producers approach commercial banks, which, because of a rise in central-bank monetary pumping, are happy to expand their credit at lower interest rates.

By means of new credit, producers can now secure resources required to expand their production of goods in order to accommodate overseas demand. In other words, by means of newly created credit, producers divert real resources from other activities. As long as domestic prices remain intact, exporters record an increase in profits. (For a given amount of foreign money earned, they now get more in terms of domestic money.)

The so-called improved competitiveness resulting from currency depreciation in fact amounts to economic impoverishment. The “improved competitiveness” means that the citizens of a country are now getting fewer real imports for a given amount of real exports. While the country is getting rich in terms of foreign currency, it is getting poor in terms of real wealth — i.e., in terms of the goods and services required for maintaining people’s lives and well-being.

As time goes by, the effects of loose monetary policy filter through a broad spectrum of prices of goods and services and ultimately undermine exporters’ profits. A rise in prices puts to an end the illusory attempt to create economic prosperity out of thin air. According to Ludwig von Mises,

The much talked about advantages which devaluation secures in foreign trade and tourism, are entirely due to the fact that the adjustment of domestic prices and wage rates to the state of affairs created by devaluation requires some time. As long as this adjustment process is not yet completed, exporting is encouraged and importing is discouraged. However, this merely means that in this interval the citizens of the devaluating country are getting less for what they are selling abroad and paying more for what they are buying abroad; concomitantly they must restrict their consumption. This effect may appear as a boon in the opinion of those for whom the balance of trade is the yardstick of a nation’s welfare. In plain language it is to be described in this way: The British citizen must export more British goods in order to buy that quantity of tea which he received before the devaluation for a smaller quantity of exported British goods.

Contrast the policy of currency depreciation with a conservative policy where money is not expanding. Under these conditions, when the pool of real wealth is expanding the purchasing power of money will follow suit. This, all other things being equal, leads to currency appreciation. With the expansion in the production of goods and services and the consequent falling prices and declining production costs, local producers can improve their profitability and their competitiveness in overseas markets while the currency is actually appreciating. Note that while within the framework of loose monetary policy exporters’ temporary gains are at the expense of other activities in the economy, within the framework of a tight monetary stance gains come not at any one’s expense but are just the outcome of the overall real-wealth expansion.

It must be appreciated that, contrary to popular thinking, both tight fiscal and monetary policies provide support to wealth generators while undermining non-wealth-generating activities. Roubini and other experts, by pleading for looser policies, are in fact asking to strengthen wealth-destructive activities and thereby recommending a prolonged economic slump.

Summary and Conclusion

According to some experts, what is required to “fix” the euro zone is not tighter fiscal policies but a strong devaluation of the euro. Commentators such as Nouriel Roubini advocate a depreciation of up to 30 percent. Between April and December last year, the euro weakened against the US dollar by almost 13 percent, yet economic activity has continued to slide. Why then should a depreciation of 30 percent revive the economy? We suggest that the recommendation for currency depreciation to fix the euro zone is based on an erroneous framework of thinking. If anything, such a policy can only make things much worse as far as euro zone economic conditions are concerned.

It has been quipped that history might not repeat but it certainly rhymes. Who can read the following quote from Andrew White recounting the hyperinflation of the French assignat in the eighteenth century and not see some striking similarity to current events?

“The first result of this issue was apparently all that the most sanguine could desire: the treasury was at once greatly relieved; a portion of the public debt was paid; creditors were encouraged; credit revived; ordinary expenses were met, and, a considerable part of this paper money having thus been passed from the government into the hands of the people, trade increased and all difficulties seem to vanish. The anxieties of Necker, the prophecies of Maury and Cazales seemed proven utterly futile. And, indeed, it is quite possible that, if the national authorities had stopped with this issue, few of the financial evils which afterwards arose would have been severely felt; the four hundred millions of paper money then issued would have simply discharged the function of a similar amount of specie. But soon there came another result: times grew less easy; by the end of September, within five months after the issue of four hundred millions in assignats, the government had spent them and was again in distress. The old remedy immediately and naturally recurred to the minds of men. Throughout the country began a cry for another issue of paper; thoughtful men then began to recall what their fathers had told them about the seductive path of paper-money issues in John Law’s time, and to remember the prophecies that they themselves had heard in the debate on the first issue of assignats less than six months before…” 

Obviously, Mr White’s quote is unlikely to be anyone’s idea of humour but permit me to add the laugh track so to speak. For those of you unfamiliar with the assignat or for that matter Europe’s track record with fiat inflations, France and Germany alone have had 4 noteworthy and complete fiat currency failures (and counting?): 

1) France 1716:  John Law introduced paper money to France in the form of livres. Louis XV required that all taxes be paid in livres. Ostensibly, the currency was backed by coinage. However, the new paper currency was rapidly inflated until nobody wished to hold worthless paper and demanded the coinage. After making it illegal to export any gold or silver, and the failed attempts by the locals to exchange their paper currency for something of actual value, the currency collapsed. 

2) France 1791:  In the latter part of the 18th century, the French government tried fiat currency again – called “assignats”. By 1795, inflation of assignats was running at approximately 13,000% per annum. 

3) France 1930s:  In the 1930s, the French government took over the Bank of France and introduced the paper “franc”. It took only 12 years for them to inflate their currency until it lost 99% of its value.

4) Germany:   Post-World War I Weimar Germany is one of the most well known episodes of hyperinflation in history. The Treaty of Versailles imposed heavy reparations on Germany. The German government took the expedient of printing the money to make the repayments. Inflation was so high that it was cost effective to burn marks to heat your home. Here is a brief timeline of the Mark/U.S. dollar exchange rate at 2 year intervals:  April 1919: 12 marks, November 1921: 263 marks, December 1923: 4.2 trillion marks.  

And yet they keep on trying.  Full marks for determination.  Though given the asymmetrical distribution of the benefits and the costs perhaps there is something more sinister than meets the eye in their dogged Keynesian devotion to nominal GDP growth. Cui bono anyone? In any event, their perseverance has finally borne fruit as European politicians can now proudly claim to have discovered the holy grail of economics in the form of a perpetual motion machine whereby bankrupt nations bail out other bankrupt nations and so on. Why didn’t someone think of this sooner? 

Sadly you and I don’t live in the nominal GDP world inhabited by politicians, central bankers and celebrity Keynesian economists. We live in the much more demanding real GDP world – you know the one with cash-flow, assets, liabilities, products, customers and all those other bothersome details. But you say, surely we must expand the money supply to lower interest rates, to stimulate demand, to save the economy. 

Perhaps it’s a case of “financial crisis attenuation sickness” but I feel compelled to rely on the wisdom of others to make my points this week. Let’s reflect on the thoughts of Jean-Baptiste Say on consumption: 

“The encouragement of mere consumption is no benefit to commerce because the difficulty lies in supplying the means, not in stimulating the desire for consumption; and production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.” 

How comic and also convenient that the political class and their Keynesian court advisors have been obsessed with the wrong part of the economy for almost 40 years. Unlimited, deficit driven consumption is only possible, granted sometimes for an intoxicatingly long period of time, via the illusion of wealth created by an ever-expanding fiat currency. It does not, however, create long lasting prosperity as ultimately becomes apparent. 

Just how bad are our problems? Difficult to quantify in the limited space available here, so permit me to fall back on another quote, this time from the venerable Ludvig von Mises. Though 60 years old it seems almost purpose written for today. 

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” 

For once I hope Mises is wrong. Regardless, let’s not tell the Germans shall we, as Greece is still hoping to collect a $150 billion donation or are we still calling them loans?  

As much fun as it is to mock hapless politicians and central bankers I do want to talk about something important if still  somewhat removed from this stage of the financial crisis – the conclusion. More specifically what form the conclusion is going to take. The issue comes down to how complex systems correct where risk and failure have been allowed to accumulate almost indefinitely through bail-outs? Do they go through a gradual purging of mistakes? Or do they collapse? These are not trivial questions as they bear directly on how we as investors conduct ourselves over the next decade. I tend to err on the side of the sudden discontinuous events model but we shall see.   

In supposedly free market economies why is the cost of one of the most important commodities set by government agencies – the commodity being interest rates on money and the agencies being central banks? Can that give anyone comfort given government track records in administering even simple tasks let alone controlling the yardstick by which all economic activity is measured?  I do not mean to make an ideological observation here, just a mathematical one. The track records of the so-called right and left are equally uninspiring in their respective areas of focus.  

I digressed.  Unless market forces are allowed to re-assert themselves in the interest rate markets, our governments and their proxies in the banking sector will continue to lurch from one crisis to another, each progressively larger and more unexpected (at least by the Keynesian powers that be). More alarmingly is that the solution will continue to be massive bail-outs in the form of the purloined savings of millions of innocent and long-suffering taxpayers. Savings that the same taxpayers need desperately to fund their dwindling prospects of retirement.

Hungary went through the worst inflation ever recorded between the end of 1945 and July 1946. In 1944, the highest denomination was 1,000 pengő. By the end of 1945, it was 10,000,000 pengő. The highest denomination in mid-1946 was 100,000,000,000,000,000,000 pengő. A special currency the adópengő – or tax pengő – was created for tax and postal payments.^[22] The value of the adópengő was adjusted each day, by radio announcement. On 1 January 1946 one adópengő equaled one pengő. By late July, one adópengő equaled 2,000,000,000,000,000,000,000 or 2×10²¹ pengő. When the pengő was replaced in August 1946 by the forint, the total value of all Hungarian banknotes in circulation amounted to ¹/_1,000 of one US dollar.^[23] It is the most severe known incident of inflation recorded, peaking at 1.3 × 10¹⁶ percent per month (prices double every 15 hours).^[24] The overall impact of hyperinflation: On 18 August 1946, 400,000,000,000,000,000,000,000,000,000 or 4×10²⁹ (four hundred octillion (short scale)) pengő became 1 forint.

Some historians believe that this hyperinflation was purposely started by trained Russian Marxists in order to destroy the Hungarian middle and upper classes.

http://www.youtube.com/watch?v=m0w6-llvZr4

WTF???, I can practically hear everyone say. The fundamentals would point to gold being a safe haven play—it should not be falling: If anything, it ought to be rising.

But a fall of 8.6%? In a week?

The first thing that pops into my head is, Don’t Panic!!

The second thing that pops into my head is, This is to be expected—and is only a temporary pullback.

Let’s take the second notion first: The reason the fall in gold is to be expected—and the reason it might well fall further—is because of the euro.

As is becoming increasingly obvious, the eurocrats trying to sort through the European Debt Crisis don’t have a clue as to what they’re doing. They’re meeting—constantly—and wringing their hands—constantly—but they’re not actually getting anything done: They’ve become deers in the deadlights.

The obvious solution which would calm the markets and restore a semblance of normalcy would be for the European Central Bank (ECB) to act as the “lender of last resort”—that is, to print the eurozone out of trouble, just like the Federal Reserve has done with its iterations of Quantitative Easing.

Caveat: I’m not saying this is the right solution—I’m saying that this is the obvious, expeditious solution which would calm the markets.

But the ECB is not doing this—and apparently won’t be doing this—mainly because of German pressure: The ECB is sitting tight, not printing, letting the debt situation spiral out of control as the European Commission tries—and fails—to come up with a Grand Solution.

How is the debt crisis spiraling out of control? Well, sovereign debt yields are rising, to the point where Greece, Ireland, Italy and now Spain’s debt is becoming impossible to service—even as major funding requirements begin to loom on the calendar; the February–May period of next year is looking particularly ugly, on a Continent-wide basis. In fact, even the Germans are having a hard time selling debt, as was seen by last week’s failed auction of €6 billion worth of German bonds: They only managed to sell €3.6 billion, at a paltry bid-to-cover ration of 1.1. And this is the Germans we’re talking about!

This leads the markets to realize that it is only now a matter of time before the euro breaks up. The very reason that the ECB is not doing its own version of QE—fear that the euro will weaken irretrievably—is the very cause for the irretrievable weakening of the euro. The proposed Stability Pact that the United Kingdom famously vetoed last Friday—and which so dominated the news for a few cycles—was a side-show: Everyone realizes that the euro is through.

Thus the euro is falling—hard—against the dollar and the other major currencies. Consider the following two charts—the first of the euro over the last three months:

The second is of gold, also over the last three months:

Notice the last few weeks: The euro and gold falling in tandem—just when the euro breaks through its magic resistance levels.

This is not a coincidence.

We have to remember the situation we are currently in. Apart from a sovereign debt crisis, we have a financial crisis in Europe: The banks over there are in terrible shape. No need to go through a list—they are teetering, one and all.

But then so are the American banks.

Because of this, when the euro falls against the major currencies, banks around the world are forced to shore up their capital requirements: The falling euro hits their capital tiers, forcing them to sell off assets in order to cover the hole in their balance sheet.

What commodity or investment has been rising steadily over the past three years? What asset class is the only sure bet against currency collapse?

Gold, obviously—and gold is fungible with any currency, instantly.

Hence what we are seeing—and what we will see again—is major players exiting gold positions in order to cover holes in their balance sheets.

In fact, from here on out, every time there is a big fall in any major currency, we can expect an attendant fall in the price of gold and silver.

Right now, we are seeing this in the eurozone: The euro broke through that magic $1.30 barrier—and gold fell 8.6%, like a rock.

This is the bad news.

The good news? These falls are technical, predictable, momentary, and so should not be cause for panic—

—rather, they are an opportunity: They are the time to buy.

Why is it a time to buy precious metals? Because the fundamentals of the situation are unchanged: The major countries are over-indebted, with over-leveraged banks teetering on the edge of insolvency. The only solution is for currency devaluation, in order to cut the real cost of these massive loans without causing an outright default or bankruptcy.

Gold and silver will counteract this currency devaluation. Thus gold and silver are the hedges against what is coming.

However, on the road to currency oblivion, inevitably we will see pullbacks in gold. These pullbacks will be because of two reasons: One is speculators—who are obviously riding the precious metals bandwagon—who will periodically get spooked and decide to cash out their winnings.

The second reason for these jolting pullbacks in precious metals will be because large institutions will need to cover their capital requirements, in the face of the collapse in the currencies.

Such as what is happening now.

When this happens, you have to remember two things: One, it is momentary, and two, it is a time to buy.

Why should you continue buying gold and silver, even after a fall of 8.6%? Because the fundamentals have not changed: The nations are all overindebted, and the banks are all insolvent. Devaluation—or collapse—are the only outs for this situation. And in either case—devaluation or collapse—gold and silver will be the only safe haven.

Think back a year: On December 14, 2010, the London afternoon fix was $1,395. On December 14, 2011 it was $1,600—a $205 rise, corresponding to just shy of 15%.

Has any other asset class risen 15% in a year? Has there been a galloping 15% inflation rate (according to official indices) over the past year? More to the point: Has the European situation been solved? Are the European banks hunky-dory?

To all these questions, the answer is one and the same: No. We are pretty damned far from hunky-dory. And in the absolute best case—that is, barring any catastrophic crisis, such as the (likely) break-up of the eurozone—we’ll continue to muddle along, while the central banksters continue their race to the bottom via stealth devaluation. 

Thus gold and silver remain as sound an investment in the current macroeconomic climate as ever.

Remember that no investment ever goes up in a straight line—except of course Bernie Madoff’s investment funds. And we all know how that ended.

So to repeat: Don’t Panic!!, and also, This is to be expected—and is temporary.