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Post US Stock Market Running on "Wishful Thinking"?
Created by John Eipper on 04/16/13 8:23 AM

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US Stock Market Running on "Wishful Thinking"? (Tor Guimaraes, USA, 04/16/13 8:23 am)

John Eipper is indeed quite justified in asking (14 April): "I'd like to hear more about Tor's claim that the US stock market is running on 'wishful thinking.' I hope this is not the case, but I'm the king of wishful thinking." John is probably more right than I am, at least for the immediate future.

I would say at least half or more of the Wall Street respectable people I know believe the market is fairly valued, and they have been right. Some even believe it is cheap to buy now, just like some thought gold was cheap at $1600. The precious metals miners have been crushed and gold seems to be in a major correction. However, the stock market (DOW and S&P) is a different story: I also believe there might be more upside, possibly above 16,000 in the immediate future, but the market is too risky for me for three main reasons:

1. The Fed's money printing has flooded the market with cash and cheap money while the bond market is looking more risky with unprecedently low rates; thus the money has found its way to the stock market. When there is a hint the Fed is ready to slow down the pumping, bond rates will spike, money will flow to bonds and the stock market might collapse.

2. Company profits have been in general quite high, not because of healthy revenues, but mostly due to gimmicks like stock buybacks and huge piles of cash, which show lack of demand for their products. Thus they don't invest the money in new productive operations. That does not bode well for the stock market, even though superficially things look positive.

3. The world seems increasingly full of nasty potential surprises for the US: North Korea, Iran/Israel, Islamic Jihadists, etc. Each may become a catalyst when the market decides it is time to crash.

JE comments: To add to item 3, after Boston have the renewed threat of terrorism on US soil.

I'm especially convinced by Tor's point 1: if the supply of loose money evaporates, capital will flow from stocks into bonds. WAIS isn't supposed to do investment advice, but is it time to rediscover bonds?

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  • US Stock Market Running on "Wishful Thinking"? (Istvan Simon, USA 04/16/13 6:01 PM)
    Tor Guimaraes (16 April) stated that the US stock market is running on "wishful thinking." I disagree. The stock market forecasts profitability of companies in the future. It is not running on "wishful thinking," but rather on intelligent analysis.

    The problems of the world economy are stagnation in Europe, the stupidity of austerity policies in Europe, and similarly the austerity policies of the Republican Party. On the other hand, as I already analyzed previously on WAIS, the housing industry is finally on a roll, and this is in many areas of the United States, not just in one market, but in multiple markets all across the US.

    For example, home prices where I live have pretty much recovered all that they had lost in the 2008 crash, and home prices are still increasing at a very robust pace. After years of meager sales, the current market is definitely a seller's market, with multiple people bidding on homes for sale, and selling prices systematically above the initial asking price.

    The housing industry is a major engine of growth. So in spite of the troubles in Europe, and the bad policies of the United States Congress, The United States economy is on a solid path of growth. The growth would be much higher if Europe were not in crisis, and if the Republican Congress did not insist in doing everything it can to ruin the economic recovery. But in spite of this there will be growth, and that means record profits for companies, and therefore the stock market is forecasting higher profits. I think that the stock market is correct in forecasting growth, and consequently Tor Guimaraes will turn out to be wrong.

    JE comments: Now that's a vote of confidence in the US economy. But the stock market is based on "intelligent analysis"? I would give greed, fear and emotion equal billing.

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    • Stock Market Running on "Wishful Thinking"? (John Heelan, -UK 04/17/13 2:35 AM)
      Istvan Simon rebutted Tor Guimaraes's comment (16 April) that the US stock market is running on "wishful thinking" with: "I disagree. The stock market forecasts profitability of companies in the future. It is not running on 'wishful thinking,' but rather on intelligent analysis" (17 April).

      Presumably, then, there was no such "intelligent analysis" by Wall Street operators in the 1929 pre-Wall Street Crash and 2008 the pre-collapse of major financial institutions as a direct result of the derivatives market and toxic assets?

      JE comments: In my comment to Istvan's post, I added that greed, fear and emotion are just as influential as intelligent analysis. On further thought, I've noticed a redundancy in my prose: greed and fear are the emotions that impact the market.

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    • Fear and Greed in the Stock Market (Tor Guimaraes, USA 04/18/13 3:46 AM)
      My thanks to the WAIS contributors who set Istvan Simon straight regarding the true nature of the stock market. Far from being a mechanism driven by Istvan's "intelligent analysis," as John Eipper pointed out it is moved primarily by greed and fear. Regardless of how intelligent the analysis, I hope Istvan is right and we see Dow 18,000 by 2014's end, as long as it not due to inflation.

      The Market can be extremely irrational. It suffices to say that probably the wisest economist and market expert ever, John Maynard Keynes, once remarked that it "can stay irrational longer than one can stay solvent," perhaps because it is driven by greed and/or fear. Taking this and some other wisdoms to heart can save investors a lot of money. Other very important/practical wisdoms are: don't fight the Fed, don't fight the tape, never short a dull market, be disciplined about stopping losses but let gains run, don't grab a falling knife, even dead cats bounce once, etc. These all make great sense to me from personal experience.

      On the other hand, while I find it entertaining to muse over these informal maxims from seasoned market players, some make no sense to me because I barely know how to use them in practice. For example, the most simple minded buy low and sell high (really?), or sell in May and go away (perhaps until September?) works some years when the stock market seems way overbought in May. One of my least-appreciated but widely quoted ones is "bulls make money, bears make money, but pigs get slaughtered." I have no idea how to use this one or of knowing when I am being greedy in the stock market.

      I thought we were all supposed to be greedy all the time?

      JE comments: Gordon Gekko taught us that greed (for lack of a better word) is good. The "dead cat bounce" refers to a brief recovery after a period of sharp price decline. According to Wikipedia, it's an expression of Cantonese origin, and its use in the financial sense dates from 1985.

      Note the abundance of animal metaphors in market lingo.

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      • Fear, Greed *and* Intelligent Analysis (Cameron Sawyer, USA 04/18/13 9:15 AM)
        While it is not true that the price levels on the stock market are determined solely by "intelligent analysis" (Istvan Simon), it is also not true that they are driven solely by "fear and greed" (Tor Guimaraes).

        The stock market is a real thing--it is a conduit for turning money into productive assets. Over the long term, it goes up because the money is used productively and produces value--that is, for real, not psychological reasons.

        Banks do the same thing--they take depositors' money, pay interest on it, and then lend it out for other purposes. This is another way to put money to work. But the form of this use of money is debt--the return is fixed, and the lender (depositor) does not participate in the risks with the borrower beyond the borrower's covenant--that is, the borrower's ability to pay in case things go wrong. The stock market puts money to work in the form of equity--co-ownership--so investors do take all the risks of the company they invest in by buying its shares. But likewise, they participate in the growth of value of the company, which a lender does not.

        So naturally there is a certain amount of intelligent analysis involved in investing in the stock market, but again, that is far from the only factor at play.

        Another extremely important factor at play in the stock market which has not been mentioned by anyone is the general situation of money supply and liquidity in the economy. When the money supply is limited, prices, including stock prices, will be low--this is an elementary effect of supply and demand. When there is a lot of money chasing the same amount of assets, then naturally prices go up. After the 2008 crisis, massive amounts of capital were pulled out of the stock market and converted to cash. "Cash is king" became the word when asset values had collapsed, the stock market had crashed, real estate was largely "underwater" (worth less than the mortgages on it), and so forth. In order to prevent a complete collapse of asset values, and a deflationary death-spiral, central banks around the world created massive quantities of new money. Most of that vast amount of newly created money continues to sit on balance sheets doing nothing. But that cannot go on forever, and eventually the money will be spent. When it does, there will be inflation, because the quantity of assets and productive capacity of the world's economies are not elastic enough to absorb the gigantic increase in the money supply. When inflation starts, cash will suddenly not be king anymore--on the contrary, there will be a panic to move out of cash and back into assets. The recent increases in the stock market are signs of that very phenomenon. And this is not a healthy sign. This is not a vote of confidence in our economies; it is a vote of no-confidence in money, which has been debased all around the world. And indeed it is not "intelligent analysis," or "fear and greed," which are primarily driving the stock markets today. Primarily, it's the monetary/liquidity situation.

        Another important factor in this is the mechanism of new money creation which is being used. "Quantitative easing" works by the large-scale purchase of financial assets, mostly bonds, by the state. The state converts assets into money itself, therefore easing the panic for investors to do it themselves. Investors are fleeing from assets, as it were, and the state is there vacuuming them up, so that they don't turn into a huge junk pile, leading to another collapse. But not all the cash which thus appears on investors' balance sheets gets simply hoarded. Even a modest leakage into the stock markets will drive them up. Here is how one Chinese economist described it:

        "The most visible byproduct of QE [quantitative easing] is rising stock prices. After QE1 and QE2, stock prices around the world did well for six to nine months. When the Fed buys assets, some investors get the cash. The ones who get the cash first have the incentive to buy stocks to front-run the ones who would get the cash later. This dynamic is self-fulfilling in pushing up stock prices."

        http://english.caixin.com/2013-01-21/100484613_1.html [more about this guy below]

        In a recent post, Istvan Simon scoffed at the idea that we could have any inflation as a result of world-wide increases in the money supply. Spare productive capacity, he said, would absorb all the new money without any problem. Well, this is not a view shared by any serious economist; certainly Ben Bernanke would never say such a thing. It's a fairly simple mathematical problem. Capacity utilization in the US economy was running at 78.5% in March. The average capacity utilization since 1972 is 80.2%. The highest capacity utilization we ever had during that period was 85.2%, in 1988-89, when the economy was red hot. So we have about 1.7% spare capacity compared to the average, and 6.7% spare capacity compared to the all-time peak of capacity utilization. See: http://www.federalreserve.gov/releases/g17/current/ . In the meantime, M2 has increased from 7,500 billion to 10,500 billion--an increase of 40%. http://www.tradingeconomics.com/united-states/money-supply-m2 (actually, by some measures, the monetary base of the US has tripled since 2008). During this time the economy has been growing at an average rate of 0.6% per annum. But no problem, 1.7% of spare industrial capacity will absorb it all. Right . . . This is even more silly if you consider that industry is only 19.2% of the whole US economy. If industry has spare capacity, and sees a boom of orders, it can respond within days to add another shift and fill them (although you can be quite sure that it will take advantage of any boom in orders to raise prices). For services, it's a whole different ball game. To create new capacity among accountants or lawyers or dentists, you have to increase the work force, who take years or decades to educate and train and put into production.

        And for assets--which is the real story, by the way--there is never anything like spare capacity. It takes many years to build a new company or a new shopping center, or a new subdivision of houses. So an increase in money available to buy shares or shopping centers or houses almost instantly results in an increase in prices.

        The debate going on right now about inflation and monetary policy is actually miles away from this. In fact no one doubts that quantitative easing causes inflation--in fact, causing inflation, or preventing deflation, which is the same thing, is an explicit goal of QE. The real debate is about the limits of its effectiveness. When should the taps be shut off? And what else needs to be done to get the world economy back on its feet? These are things that economists disagree about.

        I think it's important to remember that the same medicine that may prevent the death of a patient from fever, will not necessarily be the same thing the patient needs to grow and be healthy. Everyone agrees now that money matters (even Keynes abandoned his early positions contrary to this). But money cannot create economic growth. Here is a rather sharp expression of this idea, from a profoundly brilliant young economist from China: http://english.caixin.com/2013-01-21/100484613.html .

        You may agree or disagree with any or all of his arguments, but I think everyone will find this article interesting. It is another sign of the rise of China, I guess, that we are now reading Chinese economists on our own economic problems. But actually, if you think about it, the Chinese perspective is extremely relevant to US problems, because the symbiosis of the US and Chinese economies is at the center of what is happening in the world economy. The level of globalism we have achieved by now means that no one country determines its own economic fate now, not even the US. What is happening in China has an extremely great effect on what is happening in the US economy. Yet we know little about the Chinese economy, or what Chinese economists think.

        And here is an excellent primer on quantitative easing, for background:


        JE comments:  The author, Andy Xie, writes of the US and China undertaking the largest experiment in monetary stimulus in history.  This does sounds like a recipe for inflation.  It's definitely worth giving this article a read.

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        • Fear, Greed *and* Intelligent Analysis (Tor Guimaraes, USA 04/19/13 2:39 AM)
          I could not find anything to disagree with in Cameron Sawyer's 18 April post, except he incorrectly stated, "another extremely important factor at play in the stock market which has not been mentioned by anyone is the general situation of money supply and liquidity in the economy."

          In my 16 April reply to John Eipper's question regarding why I believed the stock market was going up on wishful thinking, making it too risky in the short term, the first reason was "the Fed's money printing has flooded the market with cash and cheap money while the bond market is looking more risky with unprecedentedly low rates; thus the money has found its way to the stock market. When there is a hint the Fed is ready to slow down the pumping, bond rates will spike, money will flow to bonds and the stock market might collapse."

          Another misunderstanding was by Istvan Simon (also 16 April), who stated, "I think that the stock market is correct in forecasting growth, and consequently Tor Guimaraes will turn out to be wrong." I hope Istvan did not forget to include the possibility of corrections for specific sectors. For example, gold stocks have had a massive crash, and gold bullion is presently in the middle of a major correction. The financial sector (my primary area) has corrected significantly since Istvan made the above statement, enough for me to reposition and set up for a possible return to the up trend. It is not about being right or wrong; it is about making hay with whatever the markets dish out.

          JE comments: Turn your market lemons into lemonade: this is why the contrarian was invented.

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          • on the Gold "Correction" (Istvan Simon, USA 04/20/13 2:58 AM)

            Gold is a hedge against expected inflation. A correction in the gold market means that the market does not except inflation. This is against some of the things that Tor Guimaraes has said, together with some of the things that Cameron Sawyer has said. I disagree with Tor about the reason for the stock market's rise.

            JE comments:  A valid point.  Gold has presently gone back to its price levels of early 2011.  Is this simply the sign of a bubble, or is it a vote of confidence in the world's fiat currencies?

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            • on the Gold "Correction" (Cameron Sawyer, USA 04/20/13 4:50 AM)
              In response to Istvan Simon (20 April), the price of gold, to some extent, is a leading indicator of anticipated inflation. It's more complicated than that--more about anon--but let's start there.

              A falling gold price does not mean that the market expects no inflation. It means that the market expects less inflation, or inflation occurring later, compared to what it expected x amount of time ago. Less inflation might still be a whole lot of inflation.

              I trust that every WAISer can appreciate this extremely simple truth.

              So gold was at about $845 at the beginning of 2008. In September it jumped up to over $900, then fell down to $720. This was partially the result of the spike up in the dollar after September, 2008 (which was no vote of confidence in the dollar!), but also partially from an expectation of deflation, which WAISers will recall was the real danger at that moment.

              By September, 2009, by which time the global Quantitative Easing movement had gotten underway, gold was going up, up, and up. It passed $1,000 and never looked back. That's a 39% increase at a time when inflation was running about 0%. What does that tell you? It tells you that the market was running away from fiat currency, and since it still didn't want to run back into assets, it chose what is neither assets nor fiat currency, namely gold. Why did the market run away from fiat currency? Because it was being debased--the volume of it being created made it clear that at some point in the future it would be worse less relative to other "stuff."  In other words, the market expected inflation.

              In 2011, gold reached its peak of about $1900. This occurred at a time when it appeared that there could be a widespread collapse of the European banking system. Since then it has fallen back to about $1400. Does that mean that the market does not expect any inflation? Gold today is almost double the price it was in October, 2008. It's up 55% compared to the beginning of 2008. If the gold price were a pure proxy for future inflation, those figures mean that we're in for at least 50% more inflation during a short enough time horizon to be built into prices today. That's a shockingly huge amount of inflation! Just because today it might be 50%, instead of 100% as it looked in 2011, doesn't mean that the market doesn't expect a tsunami of inflation.  It just means that the tsunami is 15 meters high, rather than 30 meters high, according to the collective estimation of the market. What the gold price of $1900 meant, in terms of anticipated inflation, doesn't even bear thinking.

              Of course, gold is not a perfect proxy for future inflation, for the same reasons that gold-backed currency is not a perfect currency. However, it is extremely interesting that the development of the gold price between the beginning of 2008 to today roughly parallels the growth of the US M2 during the same period. That's partially a coincidence, because M2 is historical while the gold price is prospective. Nevertheless, both indicators imply, in one way or another, each in their own way, the very same thing--that we have about 40% to 55% too much money, compared to the stuff there is to buy with it. If the velocity of money returns to a normal level, it means that it would take three or four years of 10% to 15% inflation to bring stuff and money back into balance. Of course we don't know that exactly, because the mechanisms are all much more complicated than that. For example, the gold price is much more speculative, that is, it reflects a relatively greater proportion of "fear and greed," than share prices--because gold does not issue earnings statements; there is nothing to do "intelligent analysis" on, other than the money supply. But still--we do get a rough picture, of a certain amount of inflation, which everyone expects.

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              • Historical Trends in Gold Pricing (Istvan Simon, USA 04/21/13 3:16 AM)
                Cameron Sawyer (20 April) is right that the price of gold falling does not necessarily mean that the market expects no inflation, but it may mean that the market expects less inflation (or I may add, less uncertainty) than it expected some time prior. In my opinion, though, the rest of Cameron's analysis is faulty.

                Cameron reviews what happened to the price of gold since 2008, and attaches his interpretation of the price fluctuations since then. First of all, why since 2008? Why not since August 1971, when Nixon ended the link between the dollar and gold?

                In 1971 gold was $35 per ounce. It had been at that price ever since the Bretton Woods agreement in 1944, which fixed the rate of exchange between gold and the US dollar. This act of President Nixon, its causes and antecedents and what followed, is described as usual quite well and accurately in Wikipedia:


                The price of gold shot up to $400 shortly after 1971. But then it went up to as much as $800 before falling back to $400, where it more or less then remained for decades. One has to mention, of course, other things that were happening during this period which had much to do with these fluctuations in the price of gold, in particular the rapid rise in the price of oil as a result of OPEC and the Egypt-Israel war in 1973.

                I will not even attempt a turn-by-turn explanation of the fluctuations in the price of gold since 1971. It is in my opinion futile to try to do so, because the price of gold at any one time is determined by a complex set of factors and therefore superficial analyses are bound to be simply wrong. My purpose here is simply to bring a much longer perspective to this question and to make a few general observations:

                1) From 1944 to 1971 the price of gold remained constant at $35. But in the same period the stock market rose very significantly, and there was also significant inflation. So the price of gold, when compared not to the dollar, but to the price of other goods, fell by a very significant margin. It is therefore not at all surprising that when the artificial link between the dollar and gold was abolished, the price of gold shot up more than 10-fold.

                2) However, the price of gold then remained after its relatively brief excursion into the $800 level territory, at $400 or less for again several decades. This means again that relative to other goods, it fell constantly! An investor that put his money into gold in 1980 made a terrible mistake. While in dollar terms his investment was relatively safe and did not significantly lose dollar value, over a long period of time the dollar itself lost value, and therefore with it so did gold. To give an example of this, 3% inflation per year is considered quite tolerable and even desirable. But over 20 years, 3% inflation amounts to an 80% drop in value!

                Compared to stocks, 1.38 ounces of gold would buy 1 DJIA (Dow Jones Industrial Average) in September 1980. It would take 38.92 oz. of gold to buy the same in September 2000. Gold then would start to gain value relative to the Dow, but when President Obama took office in January 2009, so at the height of the financial crisis, it still would take 8.7 oz of gold to buy 1 DJIA. Today it takes 10.49 oz of gold to buy 1 DJIA. Our hypothetical gold investor in 1980 is still losing big time today.

                All of this points to the need for a longer view on the relative price of gold against other goods. And if an analysis is made in those terms then the current price of gold is not that much different than what it had been during various times of its history.


                JE comments:  Another factor that has impacted gold pricing is the emergence of China, India and other nations as major gold purchasers.
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                • Historical Trends in Gold Pricing (Cameron Sawyer, USA 04/21/13 5:31 PM)

                  Istvan Simon (21 April) is making my point for me.

                  Gold shot up in 1971 because the Nixon left Bretton Woods and, by fiat, rescinded the right of holders of US dollars to redeem them in gold. This at the same time Nixon announced his own "quantitative easing" program, with the famous (or infamous) remark that "we're all Keynesians now." The market anticipated that the dollar would be debased by the unfettered printing of them--in fact, Nixon specifically admitted he was going to do that. The market understood at that juncture that unfettered printing of dollars would cause a lot of inflation, just like the market understands the exact same thing today. The market was right; we all know what happened after that, with inflation in the US hitting nearly 20%. The gold price is telling us the same thing today, and the fact that it went down to 55% above its level just before the crisis, down from nearly 100%, just tells us that the patient's temperature is down to 105 degrees from an almost certainly fatal 110 degrees. He's still in the hospital. The market will be right, just like it was in the 1970s. We have better quality central banking today than we had in Nixon's day, so we can hope that things won't turn out so badly as then, but inflation at 20% in the next few years is not entirely out of the question.

                  The price of gold fell again, as Istvan mentions, after Paul Volcker's monetary about-face was announced, and it fell especially after Ronald Reagan forcefully announced that he would keep Volcker and continue the monetary reforms started under Carter. That was another leading indicator of inflation--the market understood that the state had decided that come what may, inflation was going to be reduced, which meant that dollars were going to be worth more in the future than what the market had been assuming theretofore. Hence the fall in the gold price.

                  The price of the DJIA in gold is entirely irrelevant to this discussion. Unlike gold, the DJIA is not primarily a monetary phenomenon. The companies represented by shares listed on the Dow are not static things like gold bars, but entities which can increase their sales and profits, or decrease them, go bankrupt, merge, etc. Over the long term, the Dow consistently outperforms any kind of money, from dollars to Euros to Swiss Francs to gold--really as a function of economic growth over the long term, reflected in the performance of large listed companies, exceeding inflation. The point of pricing the Dow in gold is simply to demonstrate to investors that gold is not an investment--it is a dead asset which, over the longer term, rises only when fiat currencies are debased or are expected to be debased. Holding gold is like keeping hundred dollar bills in a coffee can. I'm not ridiculing that; there might be perfectly good reasons to keep 100 dollar bills in a coffee can, under some circumstances--if you are a Ghanian, say, and you know that the latest revolutionary government is going to print a bunch of worthless money in order to rob people of their savings and pensions, or if you are a Cypriot with more than 100,000 euros of savings. Likewise, we might perfectly reasonably hold gold if we know that currencies are going to be debased (today might be such a time). But other than that, holding gold is not an investment, unlike investing in the stock market, which increases in value quite apart from any monetary phenomena. That is why economists draw charts like the ones Istvan has referred to.

                  I'm not sure why Istvan persists in this argument. Is he forming his own one-man Flat Earth Society? The relationship between increases in the money supply and inflation is one of the least controversial things in economics. In fact, the word "inflation" itself originally referred to an increase in the money supply without any reference to prices at all. It's an extremely simple principle--if you sharply increase the amount of money, then prices shoot up, because the amount of stuff (assets, goods) is relatively inelastic. Changes in the velocity of money also affect prices, because it is not only the amount of money, but its motion through the economy, which determines the balance between stuff and money. In economic crises, we often have sharp drops in the velocity of money, which causes deflation when the money supply stays the same. Deflation is an extremely dangerous phenomenon--that's what caused the Great Depression. So these days, big increases in the money supply are used to intentionally cause inflation, in order to counteract deflation. Causing inflation is the specific purpose of these measures. It is important to grasp that prices have already shot up, compared to what would have happened to them without Quantitative Easing--and that was the whole point.

                  If anyone doubts these simple principles, the tiniest bit of reading will quickly chase away the fog. A good place to start, as is so often the case, is with the excellent, succinct, and clear Wikipedia article on inflation:

                  "The term ‘inflation' originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term ‘inflation' to refer to a rise in the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation.' Economists generally agree that in the long run, inflation is caused by increases in the money supply."


                  The Wiki article on inflation is well worth a read for anyone even slightly interested in the subject. Particularly interesting is the History section, which goes through a long list of occurrences of money supply increases and associated rounds of inflation, going back to the Song Dynasty in China in the 11th century.

                  JE comments:  Another historical instance of inflation was Peru in the 16th and 17th centuries, when so much silver was available that the prices of actual stuff became astronomical.  Even precious metals, if too abundant, can act more or less like fiat currency.

                  I wonder how much gold a bag of potatoes cost in the Warsaw ghetto?

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                  • Historical Trends in Gold Pricing (Istvan Simon, USA 04/24/13 2:00 AM)
                    Cameron Sawyer wrote on 21 April: "Istvan Simon is making my point for me." I don't see where and how, but if I am making your point for you, Cameron, why you spend so much effort rebutting it?

                    Cameron "explains" what happened to gold prices since 1971. It is amazing how he can recall exactly what happened to gold prices in the last four decades with just a few comments. For example, not a word on gold mines or production, or what others have been doing in terms of buying and selling gold, all of which obviously have a lot to do with the price of gold at any one time. For Cameron everything can be "explained" with a few simple comments about what Nixon did, or Carter did, or Reagan did. Anyway, after this "explanation," he says: "The market was right; we all know what happened after that, with inflation in the US hitting nearly 20%."

                    Unfortunately, Cameron's recollections are wrong:


                    Inflation in the United States never hit nearly 20% since 1971. Its two peaks were in 1974 at 11.80%, after which it eased to 6.72% in the next year, 1975, and 13.91% in 1979, which was in the Carter presidency. In both cases this had more to do with oil prices, not fiscal irresponsibility by either President Nixon or Carter. If any one was fiscally irresponsible, it was Ronald Reagan, who was very much a Keynesian, except that he tried to sell his deficits with the novel theory of supply-side double talk--which in turn was correctly termed voodoo economics by George H. W. Bush. Inflation data, however, disproves Cameron. There were large increases in the money supply under Reagan, but there was no major inflation.


                    Cameron then says: "The price of the DJIA in gold is entirely irrelevant to this discussion. Unlike gold, the DJIA is not primarily a monetary phenomenon. The companies represented by shares listed on the Dow are not static things like gold bars, but entities which can increase their sales and profits, or decrease them, go bankrupt, merge, etc."

                    I beg to disagree. The of DJIA in gold is not irrelevant. It is a valid comparison of investments. There are gold investors, just like there are stock investors. Cameron is also wrong in saying that gold bars are static. They are not--the price of gold depends on supply and demand very much like the price of everything else. There is absolutely nothing special about gold. It is a commodity needed in the economy for electronics, jewelry, dentistry and so on, and also used by some as a hedge against inflation and uncertainty. Nonetheless, its price is determined no differently than the price of copper or steel or lumber. If a new mine is discovered or starts producing gold, it affects the price of gold the same way as a new copper mine affects the price of copper.

                    Cameron asks: "I'm not sure why Istvan persists in this argument. Is he forming his own one-man Flat Earth Society? The relationship between increases in the money supply and inflation is one of the least controversial things in economics."

                    I respond: I have explicitly acknowledged the relationship between inflation and the money supply in this discussion (please re-read my posts on the subject), so I am not quite sure why Cameron accuses me of things I have never done or resorts to the Flat Earth Society metaphor. I should say that I am in good company--I read Paul Krugman and Joseph Steiglitz on these matters, and I think that it is safe to assume that both these Nobel Laureates know about monetarist theories at least as well as does Cameron. Yet neither forecasts anywhere 20% inflation (or even 10% inflation) as does Cameron. I'll let WAISers or anyone else reading these lines decide for themselves which is more likely.

                    JE comments:  Can gold really be called an investment?  It pays no dividends or interest, but real estate doesn't, either.

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                    • Real Estate as Investment (David Duggan, USA 04/24/13 3:26 PM)
                      In response to JE's comment of 24 April (see Istvan Simon's post), real estate, meaning anything that is attached to the land, can yield rents, produce, timber, rights of way, easements, and other monetizable assets. Depending on the state, you may also get mining and water rights, "fly-over" rights, and the right to access to the courts to protect your investment as against adjacent owners, even if it is intangible (such as a view or prohibition from noxious odors).

                      JE comments: But of course; I realized I was wrong as soon as I hit "send" this morning. My excuse?  The hour was early, and it's been at least ten years in Michigan since anyone made money from real estate...

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                    • Historical Trends in Gold Pricing (Robert Whealey, USA 04/26/13 1:52 AM)
                      Istvan Simon (24 April) is 100% correct on the inflation figures for 1974 to 1979. I taught my students for twenty years, that Pres. Carter merely passed the oil cartel price rise on to the US industrial sector. Paul Volcker was an honest Keynesian and drove the interest rates up and created unemployment, because he was an honest Federal Reserve Chair and followed the law as it should always be followed since 1913. If he did not raise the interest rates, the free Deutsche Mark and Yen could continue to rise against the free dollar. The price of oil was not the only cause of inflation. Also one must include the ever-rising arms budget promoted by the Pentagon in the name of the sacred god of "defense."

                      I disagree that Reagan was a Keynesian. Supply-side economics is contradictory to Keynesian ideas. Keynes said that a short-term inflation for the purposes of creating emergency unemployment payments to the lower classes would create "effective demand." In a few years the free market would rise again.

                      Wartime inflation is caused by the government spending year after year until victory on the battlefield achieves a lasting peace based on a territorial border. World Wars I and II left the US with a surplus of gold and paper dollars and left Germany bankrupt two times. The US Civil War gave victory to the North, and new production rolled back the greenbacks in 10 or 20 years after 1865 with production and new dollars backed by gold. We hardly need to mention that George W. Bush had no victories in the Greater Middle East. He could have bought oil cheaper than he could conquer it.

                      US World War II debts were rolled back in five years by production. The Korean War was a stalemate. Truman raised taxes to pay for war from 1950-53. Presidents Johnson, Nixon were military deficit spenders. In their minds, the debts could be passed on forever. Neither brought victory on the battlefield. There is little productive potential to squeeze out of a Third World jungle.

                      The financial crisis of 2005-2009 proved that debt does indeed matter. The only reason the US has a mild inflation is because EU and Chinese spending is at a higher level at this time. I voted for Obama, but his Federal Reserve Bank can only kick the can down the road for three months at a time.  Obama may muddle through to 2016, if he can keep the Pentagon and the Middle Eastern panic machine at bay. So Istvan may call himself a Keynesian, but John Maynard Keynes in 1944-46 put limits on inflation with the IMF. Keynes still followed Adam Smith's factors of production. Keynes was no finance capitalist, and he knew that World War I had destroyed five or six empires. None of them could perpetuate the 19th-century gold standard. The gold exchange standard worked from 1944 until 1971, when the unsustainable debt of Vietnam forced Nixon off the fixed rate of $35 per ounce.

                      Will Germany and France sell dollars sometime in the future? Gold could rise again.

                      JE comments: Gold will rise again--it always has. The uncertainty is whether it will rise soon, sink lower before eventually rising, or stay at its present rate for another five to ten years. In any case, I'm quite certain the big players here are no longer Germany and France, but China, Russia and the Middle East.

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                      • Was Reagan a Keynesian? (Istvan Simon, USA 04/26/13 6:31 AM)
                        In response to Robert Whealey (26 April), Ronald Reagan's economic policy was Keynesian, because he spent a lot of money when the economy was in a recession and there was a general economic malaise in the United States, which was the case in the Carter years. Reagan did this mostly by spending huge amounts on the Pentagon, including some boondoggle projects like Star Wars. Star Wars was completely useless, but it did accomplish one thing: it scared the Russians and that in turn led to the collapse of communism in the Soviet Union and Eastern Europe. Ronald Reagan also restored confidence and optimism about the future of the United States, and that was a great accomplishment in my opinion.

                        Is it better to spend on defense or social programs? The truth is that sometimes it is necessary to spend on defense, and Robert Whealey is incorrect that defense has been consuming larger and larger portions of US resources. The opposite is true. But from an economic point of view, it matters only a little bit what the government spends money on. By spending on defense, Reagan created jobs. Jobs in the defense industry, jobs that improved the economy, lowered unemployment and therefore increased consumption, which is what mostly drives the United States economy. So therefore Reagan's economic policies were Keynesian, and quite successful in reviving the United States economy.

                        Robert Whealey says that deficits really matter. Well, I'd say they matter in the long run, but in the medium run they matter very little. That was the case of Reaganomics, and that is the case now as well. Deficits do not cause inflation if they are handled properly. And in the United States they have been handled properly by good policies of the Federal Reserve.

                        JE comments: Reagan (more precisely, his advisers) would have stridently denied any Keynesian tendencies, but perhaps Nixon said it best. Aren't we all Keynesians?  The only disagreement has to do with where you want your stimulus to go:


                        Yesterday in Dallas, all five living US presidents gathered for the inauguration of the George W. Bush Presidential Library.  Was it a meeting of five Keynesians?  I've always enjoyed these photo ops of the world's most exclusive club.  (Well, the ex-Pope Society might be even more exclusive...)

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                        • A Meeting of Five Presidents...and At Least Two PMs (John Heelan, -UK 04/27/13 4:03 AM)
                          JE asked on 26 April: "Yesterday in Dallas, all five living US presidents gathered for the inauguration of the George W. Bush Presidential Library. Was it a meeting of five Keynesians?"

                          I suspect it was also a meeting of the "Carlyle Group Pension Fund for Senior Retired (and Incumbent) and Wannabe Presidents." Even Blair and Berlusconi were there!

                          JE comments: Suddenly, it's 2006! We've experienced a lot of '90s nostalgia lately, but the Dallas meeting may be the first articulation of "Oughts Fever."

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        • Too Big to Fail and Too Big to Jail: Sheila Bair (Bienvenido Macario, USA 04/19/13 3:00 AM)
          In an interview, former FDIC Chair Sheila Bair said the Dodd-Frank finance reform law explicitly bans taxpayer bailouts of too-big-to-fail, and should they go bankrupt the government-controlled procedure will ensure the losses will be incurred by the shareholders and creditors. This way the taxpayers are protected. Perhaps this is why Wall St. analysts are pushing for the break-up of the big banks.

          "Too big to jail" sounds ridiculous. It's the Attorney General's job to protect the public by prosecuting those who violate the laws. I don't buy the excuse that prosecuting big banks is bad for the economy. On the contrary, investors and the public will lose confidence in the market if the government fails to enforce laws. This would be detrimental to the world economy in the long run.

          Here's an example: US charges ex-KPMG auditor in tips-for-cash scheme:

          By Emily Flitter | Reuters - Thursday, April 11, 2013


          JE comments:  The problem with insider-trading prosecutions is that they always seem so selective and arbitrary.  Making an example of somebody from time to time may be sufficient to keep the majority honest, or at least careful, but is it ever more than the tip of an enormous iceberg?

          It would be interesting for the WAIS rank-and-file if someone could walk us through how insider-trading offenses are selected for prosecution.  Do they usually begin with a tip from a snitch or whistle-blower?

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        • Fear, Greed *and* Intelligent Analysis (Randy Black, USA 04/19/13 3:32 AM)
          Cameron Sawyer's 18 April opinion on the ups and downs of the stock market and banks, along with the whys and hows of how markets and banks react and operate, coupled with how money is created, is perhaps the most intelligent and succinct of any financial essay I've ever read.

          I can think of nothing to add to Cameron's wise, accurate description other than to add, "I wish I'd said that."

          JE comments: WAIS (a modest organization by nature) doesn't usually publish "attaboys," but this one is so heartfelt and descriptive that I couldn't resist. As they say in Internet parlance, I'll give my "+1" to Randy Black's appraisal.

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      • A Memory of London Banking (John Heelan, -UK 04/18/13 12:46 PM)
        Tor Guimaraes opined on 18 April that "the Market can be extremely irrational."

        More decades ago that I care to admit, I started my business life working as a very junior clerk in one of the City of London's oldest established banks in Lombard Street. It was built on the site of one of the original coffee-houses where City banking per se is alleged to have started: as an indication of its age, the Directors' room was still called "The Parlour." Each Friday before noon, discount bankers from other "houses" would arrive wearing their formal morning suits complete with shiny top-hats reminiscent of a bygone age to "take sherry" and negotiate rates for the next period.

        The bank was within a stone's throw of the Stock Exchange. During a period of substantial market fluctuations, I recall a senior banker remarking to me in a disgusted tone, "those brokers are just a bunch of old women reacting to the latest gossip and running around like headless chickens!"

        It seems little has changed in the last half-century.

        JE comments: But the banking sector isn't what it used to be!  I wonder when they did away with the morning suits and sherry ritual.  

        (My warmest thanks to John Heelan, who has already responded via PayPal to this morning's WAIS appeal.  ¡Mil gracias, Tocayo!)

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  • Thoughts on Bonds (Tor Guimaraes, USA 04/17/13 2:24 AM)
    John Eipper added to my 16 April post that after Boston, there's a renewed threat of terrorism on US soil. Indeed, our country is so huge and vulnerable compared to a little country like Israel. It is practically impossible to preclude acts of terrorism which can be directed at so many soft targets.

    John also commented: "I'm especially convinced by Tor's point 1: if the supply of loose money evaporates, capital will flow from stocks into bonds. ... but is it time to rediscover bonds?"

    Please let's be clear about two things: 1. The loose money from the Fed is not going to evaporate very quickly. It will take a long time for the Fed to clean up its balance sheet, but the stock market will move at the mere hint that the Fed is going to stop or even slow the "quantitative easing" program. 2. When the bond market (usually more sensitive than the stock market) also gets such a hint, interest rates will spike for any new fixed-rate instruments (treasuries, corporate bonds, loans, etc.), which concurrently will make the price of existing fixed-rate instruments go down significantly. Therefore, I would wait for the rates to go up (and bond prices down) before "rediscovering bonds."

    JE comments: Thanks; in my modest portfolio, I've always been a bargain-hunter. (I prefer not to call it bottom-feeding, but there are always tasty morsels on the ocean's floor.)

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