Sunday, December 20, 2009

The State of the Economy and Some Physical Economics

The Reserve Bank of India (RBI) appears ready to raise interest rates thanks to the predictable price inflation that has resulted from their stimulus efforts. On the margin, this is bullish for gold as it should cause a rise in the rupee against the dollar, and India is the largest market for gold in the world. The FED appears content to continue to ignore any consideration of exchange rate and continue its suicidally loose monetary policy, allowing the dollar to become toilet paper. The monetary base continues to rocket skyward: In the wake of the collapse of Fannie Mae and Freddie Mac, the FED appears to have decided to single-handedly take over the responsibility of financing the nation's mortgage markets. Its balance sheet now consists of almost half mortgage-backed securities, with this asset class rising the fastest. I guess the FED has decided that openly flooding the housing market with money is better policy than all that beating around the bush. If it ever stops, look out below. So, all around it looks like we are in for an inflationary future. However, on the other hand... Beware the commodities markets! Oil inventories are up. Copper inventories are up as well.
As much as you may hear that commodities are the place to be, beware the fact that idle factories don't buy materials. A strong build in inventories generally presages a large decline in prices and perhaps a general economic slump. Commodities may do well in the long run, but in the short run, they can be extremely volatile and are prone to fantastic price crashes when things slow down. If they do fall substantially, I would expect stocks to follow suite. Recent unemployment numbers don't look any better. Again, idle factories employ few people. And despite the FED's atrocious behavior, the dollar actually rallied late last week, probably temporarily and driven by the circumstances just described. After all, when you're selling everything under the sun, you're implicitly buying money. Gold and silver, being among other things commodities, may be facing a serious correction in the coming weeks or months as well. So, even though I'm bullish on gold long term, if present conditions continue over the short term, we could be looking at yet another broad asset price correction like we saw in late 2008. In a really screwed up way, this actually makes sense, because monetary policy of the first eight months of 2009 was "tight" in comparison with the last half of 2008. So, we should expect a correction now that we live in a bizarro world where a ~17% increases in the monetary base is actually small in comparison to the previous year. This will be a good buying opportunity, supposing of course that it happens, for those with the stomach for it. If you don't have any gold yet, this may be your last chance to get it under $1000 an ounce. But again, remember that nothing is a sure bet, especially in the short term. Unfortunately, I would expect extreme volatility in the markets for a long while to come as government attempts to prop up markets mask the underlying catastrophe and markets repeatedly correct downward. It's all going to be very confusing. The FED and Congress cannot continue this game forever. Watch for attempts to "withdraw the stimulus." Any attempt to stem the flood of government money will almost certainly meet with recessionary consequences. The whole "priming the pump" analogy is completely false. The present pricing regimen is dependent on an expanding money supply. When it dries up, price correction and recession sets in. If it does not dry up, expect a nasty case of price inflation to begin to take hold. For the market to "stay good" the stimulus must be permanent. Just for fun, I'm going to go out on a limb here and invent a new branch of economics to try to explain what I think is going on. I'm going to call it "Physical Economics." Don't take any of it too seriously, as I'm making it all up as I go along. (Actually, that's probably a good rule of thumb, as it can't be healthy to read anything I write, much less actually think about it.) Anyway, FEDsters like to use a "tightrope" analogy is often used to describe FED policy. According to the analogy, if monetary policy is too lose, inflation sets in. If it is too tight, recession takes hold. Borrowing a tool from the physical sciences, the phase diagram, we could depict the FEDster's philosophy something like the following: FEDsters imagine themselves scrambling around trying to keep the interest rate "just right," using their monetary voodoo to fight that terrible, most destructive force of capitalism, the evil business cycle. In this phase diagram representing the imaginary physics of FEDworld, the interest rate increases along the vertical axis and the business cycle advances along the horizontal. By plunking one's finger down at the point that describes some hypothetical condition, one can determine the corresponding "state" of the economy -- recessionary, inflationary, or "just right" non-inflationary growth. The solid lines represent phase transitions, so that if the FED decides, for example, to dial down the interest rate from point A, the economy will undergo successive transitions from recession, to non-inflationary growth, to inflation. Assuming, of course that we could hold time/the business cycle still. Likewise, if we are at point B and the FED simply allows time to pass without adjusting interest rates, marching along to the right one finds that the economy will slip into recession as the business cycle undulates past and a point of the cycle is reached that requires interest rates to be lowered. I have also included a dashed line representing the free-market rate of interest -- the theoretical rate of interest that would naturally prevail under a regime of a fixed money supply. The FEDsters seem to take this model for granted. It doesn't seem to occur to them that, first of all, the business cycle is not a natural phenomenon of capitalist economies but is actually caused by their own activities and the activities of their crooked cronies the banksters, and second that the upper and lower bounds that constitute their "tightrope" might not actually run parallel at all, but wind up crossing one another as the insidious effects of interest rate manipulation distort the economy. Their supposed "just right" zone is a figment of their deluded imaginations. Because the business cycle itself is dependent on how interest rates are manipulated and the money supply tampering implied by these manipulations, a more accurate phase diagram would have to run in multiple dimensions as unique business cycles sprouted perpendicular to each unique point of any particular phase diagram. I don't want to try to do this because my head would probably explode, and I don't think it's worth it for a blog post. But allowing ourselves the approximation of a fixed business cycle, I think the phase diagram should look more like this: The "just right" zone is merely an illusion. Just right is the market interest rate with a fixed money supply, which results in no inflation and no business cycle. Keeping the interest rate below the market rate, which is where the perpetually inflating FED keeps things, can have several different effects depending on just exactly where one is in the business cycle. Early on, it results in a market boom as capital asset prices surge ahead of consumer prices, which the FED and the general public confuse for "just right." Later on it results in outright price inflation, either as recessionary inflation (stagflation) or a more serious case of inflationary expansion, depending on how far the rate is suppressed and how badly the economy was distorted in the boom phase. Only if the economy goes through a period of recession will it recover. There must be a period of time for prices to re-equilibrate so that rational economic calculation can take place again. Either capital goods prices must be allowed to fall, or consumer prices must catch up to the inflated capital goods prices caused by the artificial boom to bring things back into line. So, contrary to the FEDster's line of reasoning, by manipulating interest rates and the money supply, the FED isn't so much walking the tightrope as walking the plank of the artificial boom. Eventually it runs out of plank and must decide which school of sharks it would rather hazard to dive into. So far, Bernanke appears to have put us into the stagflationary phase. He has opted for near zero interest rates. He could put us into the expansionary inflation phase by effectively dropping them past zero and charging banks interest for not lending out their reserves, or he could put us into non-inflationary recession by raising them. But a true recession would be a political disaster, and he seems to be unwilling to cross the zero-interest threshold. Likely we'll just sit here for awhile until the truth sinks in -- we won't be able to get growth without inflation. Meanwhile, unemployment and the deficit will climb and the standard of living decline. The inflationary expansion transition line will eventually undulate back up and the non-inflationary recession transition line back down, but there may be some powerful political pressures to "do something" in the meantime. OK, OK, so there already has been. There will also be the unfolding of national default to answer for. Who knows where all this ends? Maybe the FEDsters will come to their senses and stop inflating. Then we can get back to meaningful economic transactions that build wealth instead of government enforced economic behavior that destroys it. Doubtful, but it might conceivably happen. Otherwise, we are doomed to a prolonged, steady economic erosion as economic reality takes its toll on the fantasies of the FEDsters. At least, those are my best guesses, which probably aren't as good as any despite the assurance of the cliche to the contrary.

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