Reading time: 18 – 30 minutes
READER REQUEST
A few days ago I received an interesting request from a reader (PP) the answer to which could comprise a book.
Gary North recently posted an article [June 24, 2009] critiquing Mish’s views of deflation in which he posted and commented on John Exter and his pyramid. That is the only time I’ve seen that pyramid outside of your website. North previously criticized the “Pushing on a String” perspective in the below article [June 20, 2009 and for our discussions I add a December 27, 2001 article] …which was directly addressed [June 22, 2009] by Mish. Given your use of the pyramid and familiarity with Mish, I would welcome your thoughts on these issues — especially in the form of a blog post.
I am sorry for the loquaciousness of this response but I think it will adequately address a few of the material issues; some not picked up by The Automatic Earth. The attempt to read, digest, analyze, synthesize, hone in on the key issues, distinguish and contrast these two prolific and intelligent writers has proven a formidable task and this response is fairly brief for the book it could be. The main issue is inflation or deflation; whatever those are. Even worse is the intellectual dead end they lead to.
“Roast me! Hang me! Do whatever you please,” said Brer Rabbit. “Only please, Brer Fox, please don’t throw me into the briar patch.”
SUMMARY OF MR. NORTH
Dr. North leads off with an assertion implying Mish’s inferiority because of his photography accomplishments. This ad hominem attack is baseless and irrelevant. The written word stands or falls on its own merit irrespective of its source. I always try to keep my attacks and assertions deeply rooted in ideas and arguments. While I occasionally name those whose ideas I attack, like Mr. Mankiw and Mr. Krugman with their 0% interest rate lunacy, I try to keep the focus on logic, reason and explanation.
In 2001 he raises a great issue. ”Economists are part-time verbal magicians, kind of like Harry Potter, except that they don’t have any power. … This raises the question of what constitutes money.” Then he quotes Greenspan testifying about the problems with defining what money is.
In 2009 he brings up John Exter and not in a favorable light.
His argument remains the central pillar of the deflationist camp – a tiny band of intrepid non-economists who have seen their founder’s prediction refuted by the facts in every year since 1973. But economic events since mid-2008 seem to indicate that Exter may have been right, they insist. … At any time, the FED can get all of the banks’ money lent. But the FED knows that this will double the money supply within weeks. This will create mass price inflation. This is the central fact in the inflation vs. deflation debate. Until the deflationists answer it with a unified voice, they will remain, as their predecessors remained, people with neither a theoretical nor a practical case for their position.
Since when did things that have not yet happened become ‘central facts’? Anyway, the article directed to Mish is primarily about inflation, deflation and gold and contains an earlier version of the pyramid.
He asserts:
So, there is no historical evidence — none — that gold does well in times of price deflation, unless there is a government-run gold standard, which means a fixed dollar price for gold guaranteed by the government. … In times of deflation, gold’s price will fall. … The only argument against a falling gold price in a time of general price deflation is John Exter’s: “pushing on a string.” He says there will be a rush for gold as the most liquid asset. Here is his pyramid of solvency. … It was an untested theory in 1973. It remains untested. Notice that Exter put currency just above gold. This theory is logical.
SUMMARY OF MISH
Mr. North does a good job of synthesizing Michael ‘Mish’ Shedlock’s assertions.
“To summarize Mish’s scenario:
1. The debt pyramid will implode.
2. The Federal Reserve will not be able to stop this.
3. There will be serious, bankrupting, depression-creating monetary deflation.
4. There will be long-term price deflation.”
As Mish observes there is a difference with Mr. North:
Of those watching money supply, some concentrate on Base Money supply as Gary North does, others M2, M3, MZM, or even Austrian Money Supply as a measure of inflation. Interestingly, there are even two different versions of Austrian Money supply with a pretty big difference between the two versions.
Every one of them is wrong.
We have a credit based economy and anyone watching money supply and not watching credit is simply wrong. This is a statement of fact, not idle conjecture. Only those watching and expecting the collapse in credit and understanding the role of gold got things correct. This is a very small group of people.
Mish has also tacked the definitional quagmire with his post Inflation What The Heck Is It. In his post Nonsense About Gold Backwardation, Ameros, Yuan Devaluations, etc. he stated “There is nothing special about backwardations. Period. OK they are rare in gold. So what?”
MY ANALYSIS
I will address these definitional issues, the inflation versus deflation argument and the role of gold as money. I am a wordsmith; words are my domain.
DEFINITIONS
A reason why most individuals have such trouble with economics is that correct economics is rare! Most economists are employed by large government funded institutions. Still others work for large banks. There is a status quo and they are not to disrupt it.
Let’s face it: Most ‘economists’, like Mankiw or Krugman, are court economists. The stone-cold truth is it is in the financial best interest of most finance professionals, economists and other academics for you to remain clueless to basic economic law. There is a strong conflict of interest between you and them. On the bright side, I think neither Mish nor Dr. North are court economists.
Mr. North correctly frames the issue, ‘what constitutes money’, but fails to proceed with any meaningful economic rule statements and consequently the analysis which flows is scattered and unfruitful. Mish asserts rule statements, some I agree with and some I do not, the analysis that flows is coherent, although some is faulty, but overall it is extremely pragmatic and practical.
For example, in the first chapter of my book I address the inherent faultiness of Chartalism, the difference between a transaction being settled versus extinguished and assert an element of basic economic law that “Money must have intrinsic value by being a tangible asset.” What flows from this underlying premise is the ability to distinguish between money, money substitutes and illusions; all of which can be currency.
With that foundation in place then I march along through inflation and deflation. In this point, Mish is correct that the ‘money supply’ means all different things to all different people, even among the Austrian school.
In the first chapter I assert “Rather than spill bottle after bottle of ink, I will provide a general roadmap for this area. I will tend to stick to the fundamental Austrian School of economics. They define inflation as an increase in the money [conflating money, money substitutes and illusions] supply and deflation as a decrease in the money supply.” Notice how the distinguishing characteristics either broaden or narrow the currency or money supplies?
FUNDAMENTAL ECONOMIC LAW
With that foundation in place and still not out of chapter one I strike at the key issue.
Physical law presents conflicts that require an either/or answer. For example, either the sun revolves around the earth or the earth revolves around the sun. Both cannot be correct.
This same immutable law applies directly to determining which asset-the FRN$ or gold-is the risk-free allocation of capital. This is the single most important decision an investor can make.
When the United States packs the emergency kits for Navy fighter pilots, it includes hundred-year-old quarter-ounce British Sovereigns. Why? Because at all times and in all circumstances, gold remains money. However, with the FRN$ as the world’s reserve currency, most financial professionals assert the FRN$ is the risk-free asset.
What do Mr. North and Mish consider the risk-free asset? In other words, how do they price things? Do they use the ‘dollar’? What is a dollar?
WHAT IS PRICE AND WHO CARES?
Both Mr. North and Mish seem to price assets like houses, stocks, cars or food in FRN$. Mr. North may need to read The Golden Constant, which oddly is free of bias, to get his facts straight and because he is not a photographer but a serious economist I suppose he has plenty of free time to study select economic works.
But the real issue, both theoretically and practically, is value not price.
In The Golden Constant Professor Jastram examined 416 years of Anglo-American price data and established a statistical relationship using a price series construct for both gold and wholesale commodities. The conclusions on page 175 were very interesting.
First, gold hedges major inflations poorly. Second, during major deflations gold increases in operational (ordinary daily transactions) wealth. Third, gold’s ability to hedge yearly commodity price increases is ineffectual. Fourth, over long periods of time gold maintains its purchasing power and fascinatingly this is not because gold advances to commodity prices but because commodity prices gravitate toward gold.
As Professor Jastram observed on page 130, “As we have said, the purchasing power of gold depends on the relation of commodity prices to gold prices. A close scrutiny of this relationship over time discloses an affinity of a curiously responsive character. It could be called the ‘Retrieval Phenomenon’, meaning that the commodity price level may move away higher or lower, but it tends to return repeatedly to the level of gold.”
But Mish also misses this point. As I discussed on a Contrary Investors Cafe interview and wrote about in Gold In Backwardation:
Contango is supposed to exist because of gold’s inherently negative interest rate. The future price of gold is generally the spot price plus the future value based on the currency’s interest rate, minus cost of storage and a premium for counter-party risk. For example, if the interest rate is 12% APY and gold is $100/ounce then gold’s futures price for delivery in one month would be $101+CPR=$100+(.12/12*100)+CPR. As counter-party risk or the perception thereof increases, like an exchange’s potential failure to deliver, there is greater demand for present delivery of gold. … The question becomes: If I earn no interest on my dollars, euros, yen, etc. and lose purchasing power from inflation then I have a negative real rate of return. If I have a negative real rate of return then why should I own fiat currency instead of gold?
Gold or silver can go into backwardation and come out of it. A rising fiat currency gold price used to sound the warning call of fiat currency problems. But as Dr. Alan Greenspan testified before Congress in 1998, “central banks stand ready to lease gold in increasing quantities should the price rise.”
This raises the issue of the central bank gold price suppression scheme which has been proven by Gold Anti-Trust Action Committee. As Harvard trained attorney Robert Landis asserts, “Any rational person who continues to dispute the existence of the rig after exposure to the evidence is either in denial or is complicit.”
Now backwardation in the monetary metals is like the canary in the coal mine. Sustained backwardation will signal the failure of the rig. This will not be a garden variety exchange rate adjustment like Argentina in 2001 or Weimar Germany but instead the collapse of a worldwide monetary system; the largest in history. But for now the Fear Index, discussed in Chapter 11 of John Rubino’s The Collapse of the Dollar, is still extremely low relative to historical trends.
OSTRACISM
It is like I am a lone three-eyed fish in the investment and financial commentary world. I assert that gold is not a portfolio asset but that everything else is.
Oil is produced for fuel; wheat for food. Feet and yards are used to perform mental calculations of distance; grams and pounds are for mental calculations of weight.
Why is gold produced?
Gold is produced to perform mental calculations of value. In other words, as these three charts of over twenty in my book show; I price assets in gold and silver to evaluate their value.
GREAT CREDIT CONTRACTION
With these principles firmly in place I can give a cursory treatment of The Great Credit Contraction. First, I have updated and adapted with estimations the liquidity pyramid. Any eye trained in monetary matters should immediately recognize the signifgance of this graphic. When first published the article was immediately placed on the home page of Seeking Alpha. Jim Sinclair of JSMineset.com opined, “A very good, simple and clear representation of the problem lacking a practical solution.”
Click here for a full-size easy to read version
In summary, during The Great Credit Contraction capital, both real and fictitious, burrows down the liquidity pyramid seeking safety and liquidity. The lack of public interest in learning how to buy gold is a prime indicator that this has only begun. I am asserting that gold, silver and other commodities will be used as cash balances before this is over. Both fiat currency and fractional reserve banking pose risks to cash balances which are completely eliminated through monetary evolutions, like GoldMoney, in the Information Age.
An example of asset value evaporation from loss of liquidity is Auction-Rate securities or the myriad of assets on the balance sheets of banks. The various bailouts are designed to exchange assets lower in the liquidity pyramid for those higher. Sure, there are currently currency controls on the FRN$ and as it continues evaporating more will likely be implemented.
This is why we have seen a decline in the price of homes, stocks and commodities in both FRN$ (illusions) and in gold (money). I have been loquacious enough and I devote chapter 5 to discussing this phenomenon.
CONCLUSION
Mr. North seems mired in definitional chaos and lacking on the ability to clearly, concisely and accurately state the rules. This precludes a coherent analysis and conclusion. When he does attempt to state his factual assertion, such as there is ‘no historical evidence — none — that gold does well in times of price deflation’, it is contradicted by the excellent academic work found in The Golden Constant. Typical of those on weak intellectual ground is his reversion to ad hominem attacks about photography which appeal to emotion and feeling instead of logic and reason.
Mish on the other hand seems able to accurately state the rules, analyze the situation and form a conclusion. However, he either seems to not completely understand gold’s monetary role or does not think it is currently a material issue. If it is a timing issue, like his critique of Peter Schiff being wrong is a timing issue, then Mish is not wrong but like Schiff has not yet proven right.
By analogy Mish is like a shotgun. An adaptable lethal weapon used for short and intermediate range issues. On the other hand, Schiff and myself are more like sniper rifles. While I may disagree with Mish it is likely, as he pointed out once, violent disagreement. I think we are in an epic, perhaps millennial, deflationary credit contraction.
On page 14 of The Ascent Of Money Niall Ferguson writes:
Are we on the brink of a ‘great dying’ in the financial world – one of those mass extinctions of species that have occurred periodically, like the end-Cambrian extinction that killed off 90 per cent of Earth’s species, or the Cretaceous-Tertiary catastrophe that wiped out the dinosaurs?
I have long asserted that the last layer of the liquidity pyramid to evaporate will likely be the FRN$ illusion because it is the world reserve currency. Along with political currency illusions will likely be the practice of fractional reserve banking.
When or how that will happen is impossible to predict because it is based on the human action of billions of individuals. But fiat currency, fractional reserve banking and central banks are barbarous relics of an less sophisticated age.
Currently there are functioning alternative digital commodity currencies, like GoldMoney, with extremely slow velocity. But in the Information Age with Twitter, Facebook, etc. they will likely explode on to the scene; perhaps going viral and resulting in the derivative illusion rapidly dissipating. It is not difficult to imagine them completely changing the monetary landscape; like an iceberg that flips. Other barbarous relics like the journalism and music industries likewise undergoing rapid creative destruction.
Therefore, the critical question is not whether there will be inflation or deflation. The vital questions for your portfolio is whether and when will there be a currency collapse and how to best prepare yourself. It would be nice if those far-sighted gold bug Cassandras were still all alone but they are now being joined by Establishment Chicken Littles such as Paul Volcker, Peter Peterson and Stephen Roach.
Political currency always fails in either a deflationary depression or a hyperinflationary explosion. Ultimately, investors ensconce themselves at the tip of the liquidity pyramid within an invincible and immoveable golden forcefield which is immune to both. Those who fail to move their wealth may see entire fortunes rapidly evaporated. Some already have. Indeed, The Great Credit Contraction has only begun.
Then Brer Fox heard someone calling his name. He turned around and looked up the hill. Brer Rabbit was sitting on a log combing the tar out of his fur with a wood chip and looking smug.
“I was bred and born in the briar patch, Brer Fox,” he called. “Born and bred in the briar patch.”
And Brer Rabbit skipped away as merry as a cricket while Brer Fox ground his teeth in rage and went home.
Disclosure: Long physical gold and silver, indirect long interest in GIS and no position the problematic GLD or SLV ETFs.
NOTE: As is customary in the industry if either Dr. North or Mish would like a review copy to respond then I would be happy to provide it if you contact me. But as I mention in the first chapter:
There are plenty of ways to spill ink, so if anyone attempts to confront my assertions, it would only be courteous for him or her to use the definitions I propose without deflecting the discussion to a different and possibly tangential irrelevant issue. In the event of rebuttals to my assertions in this book, I will limit my participation to substantive and not semantic arguments.
That means my hobbies of golf and sailing will not receive any response as they are irrelevant ;)
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{ 17 comments… read them below or add one }
Gary North should not throw stones at neighbor’s glass house. Lets revisit who was the biggest Y2K doom-and-gloomer on the internet, circa 1997-1999.
:-)
Trace,
Well stated and articulated. Dealing with the established opposition – as I see both of them seem to be – can be fruitless but still entertaining. Keep up the great work!
trace… great level-headed analysis as always
my only question is this (for you or for any other readers who could provide insight)- if i’m reading the s&p priced in gold chart correctly, aren’t we at a stage where we should be moving out of gold and into stocks or at least where stocks are cheap vs. gold?
Your article kinda reminds me of the bullfight with the matador and the bull.
Trace being the matador of course.
After sufficiently proving his prowess as a game bull, he is eventually worn down by the matador and the picadores until finally he is dispatched in a tired and weakened state with a swift but exact plunge of the sword.
This happens repeatedly to ALL the bulls as very few are ever prepared for El Matador !
Nice article and thanks for reminding the intellectually deficient that name calling is indeed a sign of confusion and defeat.No matter who you THINK you are.
Jay
Thanks for the encouragement; it can be fun. El Matador …. haha :)
imkeithhernandez, The issue of whether to buy or own gold is completely different from whether to use gold to perform mental calculations of value.
Yes, gold is getting more expensive. I bought it while it was cheap and intend to sell it when it gets expensive and buy other assets that are cheap. I think there may be a few more years to go for both stocks and real estate to get cheaper when priced in gold or silver.
While I am always alert for deals my ears are going to perk up when the DOW gets close to 3 ounces of gold and when an average American house gets around 85 ounces of gold or 500-1,000 ounces of silver. I want to really increase my portfolio of cashflowing real estate.
thank you for the response trace
i guess i’ve been using the dow v. gold ratio rather than the s&p when trying to analyze when hard assets are better to hold than paper assets and vice versa so your chart brings additional perspective to how i’ve been looking to position myself
again, your work here is greatly appreciated
Hello Trace,
Very interesting discussion. Personally speaking, I fall in the Stagflation camp. You comment that when political currencies fail, the result is either a deflationary depression or a hyperinflationary explosion. This brings to mind a couple of questions: in the course of history, I’m trying to recall an example when a country’s currency collapse resulted in a deflationary depression (I don’t doubt the validity of this point; I’m just trying to think of an example). The other question is this: would it be possible for a currency collapse to lead to a hyperinflationary explosion followed by a deflationary depression?
Thanks for your help,
Tom
Trace:
Thanks for the excellent article. I’ve recently discovered your free “runtogold” podcasts on i-tunes, and I enjoy listening to your well-spoken perspectives on economic and monetary reality. Yes, the timing of the strange phone interference was quite, er, coincidental.
Mish says hyperinflation is unlikely because the banks cannot be forced or coaxed into lending. But since when does fractional reserve lending (legalized counterfeiting) cause hyperinflation? It surely causes an inflation of currency supply leading to distortions, malinvestments, and the Business Cycle, but isn’t hyperinflation distinctly different from credit expansion? I thought hyperinflations were caused only by Central Banks and Government Treasuries printing money to pay for Government deficits.
Is Mish attacking a straw-man, or am I wrong about the cause of hyperinflation? Are you aware of any hyperinflations caused by banks creating credit as opposed to government printing presses?
Confused in Baraboo,
-Pete
‘Hyperinflation’, whatever that is, is a currency event; what people generally think of as hyperinflation – wheelbarrows of currency like 1923 Germany. I do not think it takes bank lending to trigger this event.
For example, if the banks decided to rapidly move their reserves down the liquidity pyramid from FRN$ illusions into physical gold then ‘hyperinflation’ would likely be the result as the FRN$ evaporates just like when banks moved capital down the liquidity pyramid from Auction-Rate Securities into T-Bills; the Auction-Rate Securities ‘hyperinflated’ or in other words rapidly evaporated. I do not see why capital has to go up the liquidity pyramid into less safe and more risky loans in order to cause the evaporation of a lower layer in the liquidity pyramid. Consequently, ‘hyperinflation’ is actually a very deflationary phenomena because it evaporates the value when measured in gold of a large layer in the liquidity pyramid. I am probably a bigger deflationist than Mish! Michael Mross, one of the leading German financial commentators on MM News (their CNBC equivalent; Google Translator does a decent job), picked up on this.
See why I think this is an ‘epic deflationary credit contraction’? Because digital commodity currencies remove two giant layers of the liquidity pyramid by allowing holdings of cash to remove two giant risks to their cash balances: payment risk and counter-party risk by using a commodity currency without fractional reserve banking.
Anyway, I already wrote a persuasive article (not even sure if I even convince myself) that the FRN$ Is In Hyperinflation. It ties in directly with this article about Dr. North and Mish.
I remember very clearly that the problem of “inflation” or “deflation” was finally solved by president Lynden Johnson in the early 1970′s. His final solution was that we should not have either inflation or deflation. We should only have “flation.” After this brilliant discovery he had millions of buttons made W.I.N. or “Whip Inflation Now!” He was at least much smarter than our current re-tard!
Hi,
Thanks for a nice post. I enjoyed reading it. I read the Mish article about Peter Schiff was wrong and I think that this post alone could cause Gary North ad hominen attack on Mish. Gary firmly believes that Peter Schiff made it possible for Austrian School of Economics to reach causal people like me. It has reached me thanks to Peter.
I like reading Mish and often agree with him, but at the same time I would not listen to him for investment advice. He attacks Peter Schiff about being wrong in 2008 which I find equally bad style of attacks as Gary North ad hominen attack. He does not look at what Peter Schiff did for his clients before and/or does not add anything to his post what Peter Schiff did for his clients in 2009. I believe that in long-term Peter Schiff is right and I prefer to invest like him long term and not chase short term profits according to Mish advice. I find Mish complaints about wrong timing of Schiffs predictions laughable, all people striving to get the best timing are becoming in essence part of the herd of lemmings running to the cliff. Mish can be wrong one time and I fell with him of the cliff, Peter Schiff maybe wrong multiple times but I will be going away of the cliff all the time.
Mish by attacking Peter lost in my eyes much more than Gary North by attacking Mish. I like your lawyer attitude to economy. I also find it in my field that problems with definitions and inability to define simple terms and rules causes a lot of problems. Good work.
best,
Radek
Thanks Radek. I think some of us can get too emotionally attached to a piece of work or argument. It is unfortunate when we let it cloud our judgment and reason. It reminds me of a story one of my law professors told.
A client and his defense attorney anxiously awaited the verdict which was read, “Guilty.” The client turned to his defense attorney and asked, “Well, what happens now?” The defense attorney replied, “Well, you go to a jail cell to await sentencing and I go home to eat dinner with my family.”
Both Mish and Peter are in the thick of it because they are competing to manage people’s money. I am not sure how Mr. North primarily earns his money but it would not surprise me if his motivation to battle is primarily ideological which surprises me why he would use ad hominem arguments as they only weaken his position. Either way, it is a fun article and I am glad you enjoyed it and hope you found it useful.
I remember Gary North’s advice in 1999 that the world was going to stand still and we would all starve and be robbed by our neighbors due to the castrophe called “Y2K.” Some people actually sold their homes and moved to the hills! He was nuts and still is. Lets not believe anything he says about the future!
I’ve read many articles by now about inflation vs deflation and none of them have properly or fully addressed the issues.
First of all, I assume that most readers of these articles are seeking an understanding of the concepts in play and practical actions to take to preserve one’s wealth and perhaps even to gain more. If so, then it is the relative value of “assets” going forward that matters most. For example, will “digital dollars” continue to be equivalent to FRNs (Federal Reserve Notes)? Will dollars tend to purchase more or less in the future? Is owning gold and silver the best way to preserve or increase one’s wealth?
Practically speaking, it is price deflation and price inflation that matters, not whether or not “credit” or “the money supply” is decreasing or increasing. Furthermore, hyper inflation is a social phenomenon, not a currency phenomenon. When individuals en masse begin to reject a currency it then becomes worthless. The dollar has lost 95% of its value in the last 100 years and as of about 11 PM, August 16, 2010 people still accept it as payment and at essentially the same prices as yesterday. So, despite the increase in dollar denominated credit and currency, people still consider it “as good as gold” – literally. Perhaps it is the rate of change of debt and currency that triggers distrust of a currency and thus hyper inflation, not absolute quantities.
There is so much more to say. However, I’ll cut to the chase by saying that both arguments (“Mish” vs “North”) are valid, but that personally I believe that deflation will occur first which will trigger a hyper inflation later. The extant $52T in dollar denominated debt will eventually be swamped by an even greater amount of new debt/FRNs. As foreshadowed in his 2002 (?) speech, the FED can create as many dollars as it wishes at essentailly no cost. If Bernanke wants to compensate the on-going credit contraction with new dollars then hyper inflation will ultimately result. Besides, the devaluation of the dollar is the only way to pay off the Federal debt. There are many other reasons for the dollar to be devalued as well (e.g., for export trade, to increase domestic consumption, as a stealth tax, political expediency, etc.) and since dollars can be created at will then they will be.
The Fed will hit the depression button
And , when everyone panics…………Buy the Gold back for a Faction
Notice all the Non Americans Banks – hold Gold
the USA & ISREAL (OUR MASTER) will Bankrupt everyone and go to War if
necessary. China will become the next Japan>>> Been being set-up since Nixon
Merry Christmas Trace. I haven’t heard from you for awhile. Your current blog is excellent! How is South America? I can’t remember if I mentioned it, but a group of my associates ex-patriated to Quito, Ecuador a few years ago, and started an immigration assist service and WEB that has been quite successful. That area of Ecuador has a climate like southern California, but at 6000 feet. It’s a very beautiful and safe Country. I guess immigrations to many parts of South America are still going quite well. Sincerely, RH
Hi Roger,
Merry Christmas. Things are going well. Just returned from Brazil and headed back to Chile in January. Hopefully will get to check out Ecuador sometime. Hope all is well with you.
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