Posts Tagged ‘Murray Rothbard’

Expectation of US Dollars (USD) printing creates an Australian Dollar (AUD) bubble?

Sunday, October 10th, 2010

Everyone on the streets know that the Australian Dollar (AUD) is rampaging towards parity with the US Dollar (USD). Joining the media circus, some forex pundits are even prophesying that the AUD could reach $1.20 against the USD. The masses in Australia are cheering because it is now cheaper to buy stuffs overseas due to the ?strong? AUD. Politicians (Wayne Swan) are cheering because it is a great excuse to brag about the ?strength? of the Australian economy under the stewardship of their political party. Businesses that has their costs paid directly or indirectly in terms of USD are cheering (e.g. retail import). Businesses that receive their revenue in terms of USD (directly or indirectly) are in pain (e.g. mining, tourism).

We wouldn?t be surprised if the next round of readings for consumer confidence in Australia will show a marked increase. We have no doubt that this in turn will add fuel to more cheering by politicians and the media circus.

But as contrarian investors, you have to understand the context and big picture behind the surging AUD. Do not be like the masses by being caught up with the euphoria. Instead, be prepared and even profit for what is to come.

Firstly, it is not just the AUD that is rising against the USD. The euro, yen, base metals, gold, silver, etc are also rising too. However, the expectation of more interest rate rises by the Reserve Bank of Australia (RBA) is acting like rocket boosters to the already rising AUD (see Return (and potential crash) of the great Aussie carry trade). In other words, it is more of the USD that is deprecating, not the AUD appreciating. As we wrote in What if the US fall into hyperinflation? on April 2008,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

Already, the Japanese central bank are cutting interest rates, taking token measures to intervene in the forex market to weaken the yen and even talking about buying government bonds (i.e. ?printing? money). Basically, the Japanese want to devalue the yen. For Australia, we would hazard a guess that one of the major contributing reasons why the RBA did not raise interest rates last week is because of the surging AUD (that was also the suggestion of one of the economists in CommSec).

To put it simply, the depreciating USD is creating a bubble-like conditions for the currencies of foreign countries. That is problematic, not the least because it is making their exports uncompetitive (just ask any Australian mining company). What is the solution for these countries? Devalue their currencies too (if it can be done without the masses being aware, all the better).

The next question is: why is the USD depreciating?

The reason is simply because of the expectation that the Federal Reserve is going to embark on a second round of massive money printing (see Bernanke warming up the printing press). What is the background behind the Federal Reserve?s money printing idea? To answer this question, we would refer to the late Professor Murray Rothbard?s book, Mystery of Banking:

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M?. Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D?, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

Murray Rothbard wrote this book more than 25 years ago. Yet, it is pertinently relevant for today?s context. The US government?s budget is in great deficit. It will get worse as they have to spend even more money to prop up and stimulate the economy. The current environment of deflationary expectations is providing an excellent cover for Bernanke to print money (see Bernankeism and hyper-inflation).

But as Murray Rothbard continued,

But let the process continue for a length of time, and the public?s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: ?We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.? As this psychology takes hold, the public?s thinking in Phase I changes into that of Phase II: ?Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.? The public?s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

Given the large and exponentially growing debt of the US government, monetary inflation is the only path they can take as far as the eye can see.

There is a lot more in Professor Murray Rothbard?s Mystery of Banking if you want to learn how money and credit are related to each other through the banking system work. You can read a sample of this book here (at the right of that page, click on the ?Read First Chapter Free? button).

Real economy suffers while financial markets stuff around with prices

Thursday, October 9th, 2008

In yesterday’s ABC 7:30 Report, Associate Professor Steve Keen commented that in the context of today’s global financial crisis,

Well I think Kerry I can actually make a reference to what’s happened to the Australian dollar say every price you see is crazy.

There is no way the prices of anything make any sense at the moment.

Prices in the financial markets are extremely volatile right now. Even prices of commodities (e.g. base metals, oil), gold and silver are moving much more rapidly then we expected (remember a few weeks ago when gold rose by almost US$100 in 2 days?). Currency exchange rates are also very extremely volatile, as we witnessed the fall of the Australian dollar from around US$0.97 to US$0.64. It was just a couple of days ago when the Aussie dollar was around $0.73. Now, at this time of writing, it is US$0.70.

Such volatility and irrationality of prices, if sustained over a much longer period of time, can eventually damage the economy structurally. To understand why, consider what we said in The myth of financial asset ?investments? as savings,

… saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

The accumulation of capital goods requires a time lag whereby current consumption is postponed for future benefits. Improved standards of living come to the public from the fruits of capital investment.

For example, producing metals is a very capital-intensive activity. The stages of production includes:

  1. Exploration
  2. Digging large quantities of dirt, which requires expensive, complex and expensive equipment.
  3. Construction of nearby infrastructure (e.g. roads, railways, power stations, development of water supplies and townships) due to the remoteness of mining projects.
  4. Protection of environment, which increase capital and operating cost.
  5. Extraction of ore from dirt.
  6. Processing of ore.
  7. Refining of metal concentrates.
  8. Shipping and transporting to destinations.

Thus, a mining project from start to finish can take several years. Therefore, you can see that the accumulation of capital goods is long term processes in the economy. As such, all these industrious activities require long-term planning.

What if in the interim, prices are extremely volatile, ‘crazy’ and irrational?

As the late Professor Murray Rothbard wrote in What Has Government Done to Our Money?,

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations.

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinders long-term planning.

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades (see Example of a secular trend- commodities and the upcoming rise of a potential superpower and The Problem that can throw us back into the age of horse-drawn carriages). Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

With long-term planning made much more difficult, how is it possible to engage in investments that allows the nation to continue to accumulate capital goods? Without the ongoing accumulation of capital goods and too much monetary capital wasted on either hoarding, bailing out bad investments and patching a dysfunctional financial system, there wouldn’t be a proper and efficient allocation of monetary capital. The economy will be engaging on capital consumption. If a nation starts to consume its capital, how can there be real economic growth. Without real economic growth, how can future generations enjoy a more plentiful and prosperous existence?

As we ponder on the long term implications of today’s volatile, ‘crazy’ and irrational prices, we saw a sampling of such a phenomenon in one of the news article today, Volatile economic conditions unsettle farmers,

UNDER normal circumstances, an interest rate reduction coupled with a devaluing of the Australian dollar would make farmers very happy indeed.

But not this time, according to National Farmers Federation vice-president Charles Burke.

“There are some other factors at play at the moment that none of us really know how to measure,” Mr Burke said.

“Nor do we know how to deal with it because we don’t know how long it will last.”

That’s why the Austrian School of economic thought advocate a painful deflationary liquidation of mal-investments (read: severe recession/depression) in order to clean out the rot in the system, put on a sound monetary system so that the economy can get back on its feet as soon as possible from a clean slate. But central bankers and governments are trying their utmost to drag on this war between deflation and inflation indefinitely, which means more uncertainty ahead for the foreseeable future.

Effects of inflation on value of investment

Sunday, July 6th, 2008

Continuing from Measuring the value of an investment, we learnt about measuring the value of an investment relative to the risk-free returns of long-term government bonds. But that does not take into account the effects of inflation on your investment. This is a factor that is often forgotten, which in this age of rampant monetary debasement will seriously undermine your investment returns in real terms. As we said back in February 2007 in Have we escaped from the dangers of inflation?,

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the [global] financial system.

The world was lulled in to a false sense of seemingly low price inflation through the rise of Chinese manufacturing power. Consequently, this gives investors a false confidence of fiat money being a reliable store of value. Today’s climate of rampant global price inflation is payback time for such economic folly. If we are right, the world is marching towards stagflation (low/negative economic growth, rising unemployment and rising prices) along with a deflation in asset prices. This is the worst environment for investors.

Inflation is a relatively new phenomenon in the latter half of the 20th century. As we quoted the late Professor Murray Rothbard in A brief history of money and its breakdown- Part 2,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.

Under the good old days (prior to the First World War) of the gold standard, there was no such thing as inflation (except for periods of war). Prices were relatively stable over the centuries. In fact, they tended to fall because of economic growth (similar to why the prices of computers and technology products fall because of increased productivity). For more information, you may want to refer to our guide, What is inflation and deflation?.

Therefore, as investors, you have to understand the relation between the value of your investments and inflation.

First, how are long-term government bonds priced? As you may already know, the free market sets the prices of long-term government bonds. As we explained before in Measuring the value of an investment, the price is inversely related to the rate of return (yield).

In theory, the price of long-term government bonds reflects the market’s expectation of long-term price inflation. Assuming that the market is right about long-term inflation in its pricing of the bonds, the value of your investments will automatically factor in inflation. Hence, as we said before in Is the value of an asset its price?, since the value of an asset is relative to the long-term government bond, the value of a long-term government bond is relative to price inflation.

Now, what happens if you believe that the market is severely underestimating long-term price inflation (i.e. the price of long-term government bond is way too high)? This is the situation that we reported in Marc Faber: Bernanke Policy Will ?Destroy? U.S. Dollar, where Marc Faber said that the 10-year and 30-year US Treasury bond market was (and still is today) a “disaster waiting to happen.” Notice what he said:

The arguments for stocks is frequently that you take the earnings yield of the stock market and compare it with the bond yield and people compare it to Treasury bonds. I think you should take the earnings yield of equities and compare it with, say, a typical S&P company, and that is a yield that correspond to, say, a triple-B, and so, basically as of today, some bonds are more attractive than equity.

What do you think will happen to stock prices if one day, the US Treasury market correctly reflects price inflation?

A brief history of silver and bimetallism

Wednesday, February 27th, 2008

If you have been with us for a long time, you would know that we cover gold extensively. If you have not already, we suggest that you read our guide, Why should you invest in gold?, before reading the rest of this article. The material for today’s article comes from Professor Murray Rothbard’s book, What Has Government Done to Our Money?.

Today, we will talk about gold’s troublesome sister, silver. As we quoted the late Professor Murray Rothbard in our earlier article, What about silver?,

It is very possible that the market, given free rein, might eventually establish one single metal as money. But in recent centuries, silver stubbornly remained to challenge gold.

Why did silver stubbornly remain in circulation as money? As Professor Murray Rothbard continued,

Silver remained in circulation precisely because it was convenient (for small change, for example).

As we said before in Properties of good money, a commodity has to be sufficiently rare to qualify as money. But it cannot be too rare. Silver, the less rare sister of gold, was useful for smaller transactions because gold was too rare for further smaller sub-divisions.

Hence, in the free market of the past, both gold and silver circulated side-by-side,

The relative supplies of and demands for the two metals will determine the exchange rate between the two, and this rate, like any other price, will continually fluctuate in response to these changing forces. At one time, for example, silver and gold ounces might exchange at 16:1, another time at 15:1, etc.

In that sense, we can see gold and silver as two different ‘currencies’ whose values fluctuated freely against one another according to the free market. But then, the government came in to ‘help’ the market to ‘simplify’ matters by fixing the exchange rate between gold and silver. The fixed gold-silver ratio was known as bimetallism. The next step after bimetallism was to give specific weight of gold (and silver) a national name (e.g. dollar, pound, etc). Once these national names (instead of a specific weight of gold and silver) take root, it eventually became an abstract unit of value of its own, thereby losing its original meaning in terms of a specific weight of gold and silver. Eventually, these abstract units became the national currencies of today.

Bimetallism helped the government to manipulate money. But it introduced its own set of problems. The free market’s exchange rate between gold and silver would always be freely fluctuating, depending on the supply and demand relative to each other at each instance of time. But by fixing the exchange ratio between them, it introduced the situation whereby one will always be artificially undervalued or overvalued relative to each other. When that happens, Gresham’s law will kick in (see Artificially undervalued coins: government interference cripple the free market for an explanation of Gresham’s law), which resulted in the state of affairs that Rothbard described,

Gold then disappears into cash balance, black market, or exports, when silver flows in from abroad and comes out of cash balances to become the only circulating currency in Ruritania [hypothetical country used as an example]. For centuries, all countries struggled with calamitous effects of suddenly alternating metallic currencies. First silver would flow in and gold disappear; then, as the relative market ratios changed, gold would pour in and silver disappear.

Eventually, what happened? As Rothbard continued,

Finally, after weary centuries of bimetallic disruption, governments picked one metal as the standard, generally gold. Silver was relegated to “token coin” status, for small denominations, but not at full weight.

The next question for investors is this: assuming that one day the world will return to the gold standard, will silver regain its free-market status as secondary money? We will explore more on this idea next…

A brief history of money and its breakdown- Part 2

Wednesday, January 10th, 2007

In today?s topic, we will continue from the previous topic, A brief history of money and its breakdown- Part 1 by touching on the gradual breakdown of the monetary system from two centuries ago till now. Today, the world?s money is totally fiat (money that enjoys legal tender status through the authority of the government instead of through the choice of the free market). Again, the recommended reading for today is Murray Rothbard?s What Has Government Done to Our Money? As Rothbard said in that book:

To understand the current monetary chaos, it is necessary to trace briefly the international monetary developments of the twentieth century, and to see how each set of unsound inflationist interventions has collapsed of its own inherent problems, only to set the stage for another round of interventions. The twentieth century history of the world monetary order can be divided into nine phases.

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury. At this point, we must stress that gold was not any arbitrary choice by the government. Rather, it was the choice of the free market over the course of centuries as the best money. Thus, at that time, the world had a uniform money medium, which as Rothbard said, ?facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labour.? Furthermore, such an international gold standard put a rein on government inflating the money supply as well as helped kept the balance of payment of each nation in equilibrium. Though it was not perfect, it ?provided us with by far the best monetary order the world has ever known, an order which worked, which kept business cycles from getting out of hand, and which enabled the development of free international trade, exchange, and investment.?

Next, the First World War arrived. Under the confusion of a wide-scale war, each warring government (except the United States) came off the gold standard and printed money to fund the prohibitive cost of waging war, which would not be possible under the gold standard. Thus, national currencies were devalued and fell in relative value to gold and the US dollar.

After the First World War, the most logical step would be to return to the gold standard at a redefined weight of gold for each national currency. However, British insistence at maintaining the unrealistic pre-war definition (due to national pride) led to their economic malaise. Instead of rectifying the folly of their ways, they induced and coerced foreign governments into the same mistakes at the Genoa Conference of 1922. This resulted in a gold exchange standard whereby (1) the US remained in the gold standard, (2) the British remained in a pseudo-gold standard and ?US-dollar standard,? and (3) the rest on the ?pound standard.? The outcome was a ridiculous pyramid of US dollars on gold, pounds on dollars and the other European currencies on pound. By 1931, as expected, the absurd gold exchange standard collapsed.

At this point in time, it was back to the post-war chaos of fiat currencies again. The US went off the gold standard partially?US dollars were only redeemable to foreign governments and central banks at a re-defined rate of 1/35 of an ounce. International trade and investment were at a standstill and ensuing economic conflict was said to be one of the leading causes of World War Two.

After World War Two, the United States led the way to a new monetary system?the Bretton Woods system. In this system, the US remained in a partial gold standard?US dollars were redeemable for gold by foreign governments. Other countries pyramid their currencies on top of the US dollars. Initially, the US dollar was undervalued and European currencies were overvalued. However, as time went by, with the US inflating their supply of dollars, their gold was increasingly being redeemed by European governments. Soon, it became harder and harder for the US to maintain the free market value of gold at $35.

By 1968, there was a crisis in confidence in the US dollars. The US then decided to abandon maintaining the US dollar at $35 in the free market. From then on, the US decided to ignore the gold free market and maintain the inter-government gold peg at $35. As expected, the free market value of gold soared above $35.

In August 15 1971, the US severed the last link between gold and the dollar. As a result, from then on, the world?s monetary system became totally fiat.

In December 1971, the Smithsonian Agreement was introduced to create some order by maintaining fixed exchange rates among currencies and without any gold backing. With the US continuing to inflate their dollars, fixed exchange rates were untenable. Finally, the agreement collapsed in February 1973.

Finally, that is what we have today?freely fluctuating fiat currencies. As Rothbard said,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.


A brief history of money and its breakdown- Part 1

Monday, January 8th, 2007

Today, for this part, we will give a brief introduction on the history of money. For the next part, we will then look at how the monetary system had (and are still today) broken down. For a more in-depth coverage of this topic, we recommend Murray Rothbard?s excellent book: What Has Government Done to Our Money?, which is just only 58 pages?a quick read over the weekend. This background knowledge is highly useful for understanding the value of gold (and the corresponding absurdities of the fiat monetary system that we now have) with regards to today?s monetary system.In the beginning of history, mankind simply used barter for economic exchange. Obviously, barter is problematic because it requires a coincidence of wants. Even if coincidence of wants exists, they require costs to search for them. Also, for some goods (e.g. a live cow), there is no way to divide them for exchanges with more than one counter-parties. Thus, barter is highly restrictive.

The next stage of monetary development is indirect exchange. For this, if you have A and wants C, you exchange A for B and then exchange B for C. Though this way may look inefficient at first glance, it actually works because B may be a more highly sought-after good than A. Therefore, it makes sense to acquire B first as the intermediate step towards acquiring C.

At this third stage of monetary development, a highly marketable good will eventually emerge as the most sought-after intermediate good for the purpose of exchange with other goods. This intermediate good functions as money as we know it. Obviously, such an intermediate good must have characteristics of portability, divisibility, durability and sufficiently rare (but not too rare). Historically, goods like tobacco, cattle, grain, cooper and tea had functioned as money. But over the course of centuries, gold and silver, for whatever reason, were eventually selected by most civilisations as money?gold for larger exchanges and silver for smaller exchanges. That is why we must not make the mistake of following the market?s error by seeing gold and silver as industrial commodities (see Is gold a commodity?).


Artificially undervalued coins: government interference cripple the free market

Saturday, December 23rd, 2006

We wonder at the wisdom of government intervening into the free market to maintain the status quo. Granted, sometimes the government have no choice but to impose controls in order to prevent a full-blown crisis from developing. But our question is: how did such condition (that require government interference) occur in the first place? The fact that control imposition is required points to the fact that something has gone wrong in the first place. Worse still, sometimes government prove their ineptness through their policy. The recent Thai government decision (and subsequent retraction) to impose capital restrictions to control its currency is a case in point.

Today, we look at the situation described in our previous article, One funny effect of monetary inflation: ?New rules outlaw melting pennies, nickels for profit?. This is exactly a repeat of what happened in the 1960s when the US government made it illegal to melt silver coins. The fact that the underlying value of a coin far exceeds its face value proves that there is a serious underlying problem in the monetary system. As Murray Rothbard said in What Has Government Done to Our Money?:

Government imposes price controls largely in order to divert public attention from governmental inflation to the alleged evils of the free market. As we have seen, “Gresham’s Law”?that an artificially overvalued money tends to drive an artificially undervalued money out of circulation?is an example of the general consequences of price control. Government places, in effect, a maximum price on one type of money in terms of the other. Maximum price causes a shortage?disappearance into hoards or exports?of the currency suffering the maximum price (artificially undervalued), and leads it to be replaced in circulation by the overpriced money.

In other words, the US dollar notes (artificially overvalued money) will eventually drive out nickels and pennies (artificially undervalued money) out of circulation. Even if the people faithfully obey the law by refraining from melting their nickels and pennies, we can be sure many of them are thinking of hoarding them right now. If ever the nation should be plunged into a financial crisis of hyperinflation, we are sure those coins will be traded as money at their worth far above their face values. In that case, even if the government is still inept enough to impose another law to prevent it from happening, such usage of the coins will be driven underground as a result.

We heard rumours that this state of affairs is also happening elsewhere in the world?South Korea and Philippines (where people are exporting Filipino coins to China to be melted). This is indeed another sign of the times. Be warned. Buy gold. Hoard the coins.