As Though It Were Real Money

"Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own." -- Joseph Schumpeter

How do we interpret the words of Schumpeter? Is the Austrian School of Economics right? Should the Federal Reserve have allowed the US (and thus the world) to go into a deep recession in 2001-02? Did we just postpone a Day of Reckoning only to have one in the future which will be even worse? What about gold? We look at these questions and more as we continue looking at the "debate" between the gentleman from GaveKal and Bill Bonner and Addison Wiggin.

But first, let me note there is still time for you to get copies of my latest book, Just One Thing for your Christmas tree. If you are in the investment business, it makes a great gift for clients. And if you want an autographed copy personalized to you or your friends, I can do that (see below).

"What a brilliant publishing idea! It's a page turner and each contribution is priceless. A great idea for many disciplines. Also, it took care of my Christmas book gift campaign for this year. Congratulations!" - Ole Bredberg

Just One Thing is a collection of 11 of the world's best investment minds (as well as your humble analyst, to make 12 chapters in all) writing about the one thing they are most passionate about. Richard Russell, Gary Shilling, George Gilder, Bill Bonner, Andy Kessler and seven other equally brilliant minds give you their one best shot. The reviews have been quite good overall. It seems that everyone has a different favourite chapter. Just the top two from Amazon:

"Excellent collection of investment wisdom, with each chapter written by a different person. One can pick up the book and read the chapters in any order. I liked the style and the fact that the contributing authors have different perspectives and approaches to the market. There is a lot of information in this book that can be gleaned without committing to reading a few hundred pages by any one of the individual contributors. Well worth the time. - Kendra Loomis"

"I love finance but have a hard time understanding the hard core stats that get tossed around in typical literature. Just One Thing puts the best, most concise concepts and packages them so that I can understand and benefit. I can look for ways to put the concepts into practice by searching for the basic idea put forth, rather than a specific trend. - Kenneth Lynch

You can get the book by going to or from your local store. If you want an autographed copy, just reply to this email and my staff will get you the form, and we can ship in time for the holidays! And now back to our regularly scheduled program.

Empire of Debt, Part Two

As noted above, this is the fourth installment in our series where we ask the following question: "Do trade deficits matter or is it different this time?" The team at GaveKal eloquently asserts that it is indeed different this time. We reviewed their book, "Our Brave New World" for two letters. Bill Bonner and Addison Wiggin say, "Not no, but hell no." The trade deficit will end in a soft depression and a seriously diminished dollar. We started out review of the book "Empire of Debt" last week and finish up this week. You can read the prior letters by going to and going to the archives. (Please note the November 18 letter was not part of the series, otherwise it is November 11, 25 and December 2.)

Judging by the letters you are writing, there is very little fence sitting. You either like one position or the other. And like is too mild a word for many readers. It seems that when I start with my own views next week I will be able of offend both sides equally. I am generally comfortable being in the middle and hope to persuade the 27 readers who have not yet made up their mind to join me.

As noted last week, there are two stories in Empire of Debt. The first is the traditional argument of the Austrian economic school. You cannot forever run trade deficits. Eventually your currency will collapse, as people will not want any more of it.

"The economy in its entirety must continue to decline so long as more is being consumed than produced, and some part of consumption therefore takes place at the expense of the existing capital stock." - Friedrich August von Hayek (Nobel Laureate, 1974)

But the evidence of that decline is not yet present. America and its currency seem to continue to prosper, even when no other nation has ever run such huge deficits without seeing a major, if not disastrous, currency revaluation.

Can we in fact borrow our way to success? Rather than save and invest in new capital production, we ship production of our goods and now even our services offshore, and hope other nations will finance our debt.

"As the Anglo-Saxon economies lost their competitive edge in manufacturing, they tried to make up for it by encouraging consumption. This is the biggest fraud of all. At first, higher consumption feels good. It is like burning the furniture to keep warm; it feels good for a moment. But the sense of well-being is extremely short-lived. When people borrow and spend, they feel as though they are getting richer--especially when their houses are rising in price. The increased consumption even shows up, indirectly, in the GDP figures as growth. But you don't really become wealthier by consuming. You become wealthier by making things you can sell to others--at a profit. The point is obvious but, at this stage of imperial finance, it was inconvenient." - Empire of Debt, page 224.

There is no question but that Bonner and Wiggin lay the cause of the problem at the feet of the Federal Reserve and personally at Sir Alan Greenspan. In essence, they feel that the Fed, by providing cheap money, has misled the market.

"The deception that sent credit expansion soaring between 2001 and 2005 came eagerly from America's own central bank. By setting its key lending rate below the current inflation rate, the Fed misled almost everyone."

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This has resulted in a series of bubbles. First was the stock market, and then as the Fed aggressively eased rates to compensate for the crash of the stock market, we see the excess money supply show up in the housing market, creating yet another bubble. Further, they suggest the easy money did not create an economic boom and a massive growth in income and jobs in the US, but in China and Asia, as cheap money encouraged consumers to borrow and consume Asian assets.

The argument in Empire of Debt rests on what they consider to be many huge deceptions that they describe in the book. A list of some of these deceptions are:

That one generation can consume--and stick the next with the bill.

That you can get something for nothing.

That the rest of the world will take American IOUs forever--no questions asked.

That house prices will forever go up.

That American labor is inherently more valuable than foreign labor.

That the American capitalist system is freer, more dynamic, and more productive than other systems.

That other countries want to be more like America, even if it is forced on them.

That the virtues that made America rich and powerful are no longer required to keep it rich and powerful.

That domestic savings and capital investment are no longer necessary.

That the United States no longer needs to make things for export.

For most of the above points, I find myself, and I suspect the vast majority of readers will find themselves, nodding in agreement. For instance, it seems to me silly to think housing prices will go up forever on its current path. While I can readily accept that housing prices in most places in the US and the developed world will be higher in 20 years (inflation and demand will kick in), to think there will be no price corrections discounts the experience of multiple corrections of the last century.

(Just for the record, I strongly disagree with the notion that the American capitalist system is not freer, more dynamic and more productive than other systems.)

But while agreeing with those points it does not necessarily follow that you should buy their final conclusion: that the US will soon enter a soft depression. But that is not to deny the magnitude of the problem of debt in the country. And they are certainly right in pointing up the future crisis that a lack of savings will bring about. Let's look at this excerpt from Empire of Debt.

Americans Get Poorer...

"This is the greatest crisis facing the country that people can do something about," writes Ben Stein in Forbes . Stein is talking about people who fail to save enough for retirement.

"With less than 20 percent of U.S. workers now in employer pension plans (many of those plans are on shaky financial footing) and with Social Security typically replacing less than 40 percent of pre-retirement income, personal saving has never been more important," continues Stein. And yet, few people save any money.

"Savings rates have never been lower," Stein explains. "In 1999, the national savings rate dipped below 3 percent for the first time since 1959, according to the U.S. Commerce Department. It has been declining further since then, and in 2004 it was at a mere 1 percent. The low savings rate, coupled with large deficit financing by Asian banks, is dangerous for the U.S. But it's more dangerous for individuals."

People are forever crying alarm about this or that. There is a crisis in health . . . a crisis in moral values . . . a crisis in the Middle East . . . or in the newspaper trade. For all the whining, there is usually little that can be done about the emergency, and if it is left alone, it generally takes care of itself in its own way.

"Nearly 28 million U.S. households--37 percent of the total--do not own a retirement savings account of any kind," continues the Forbes article, among the households who owned a retirement savings account of any kind as of 2001, according to a 2004 report by the Congressional Research Service (CRS), the average value of all such accounts was $95,943. That number was distorted by the relatively few large accounts, and the median value of all accounts was just $27,000.

"The median value of the retirement accounts held by households headed by a worker between the ages of 55 and 64 was $55,000 in 2001," the CRS says. To that, Stein adds that "just 11 percent of all Americans have retirement savings of $250,000 or more."

"You can jabber to people about saving money until your jaw falls off; they're not going to put an extra dime in a savings account--not when property prices are going up at 10 percent per year and the Fed is still giving away money. Eventually, however, the things that must happen sooner or later do happen. Of course, that's when people wish they had saved money. That's when they'll really need it. That's when the whining really begins.

"Saving--like manufacturing--is one of those early-empire virtues that was once an important part of the American economy . . . but seems to have gotten exported. The Chinese now make our products and do our saving for us. They save more than 25 percent of their income. According to Ben Bernanke, they now have so much of savings, they are thankful to us for taking it off their hands."

As Though It Were Real Money

"But the world's financial plumbing has become so curiously put together that the oddest things have been mistaken for commonplace. We turn on the stove and champagne fizzes out. We open the faucet and it runs with Kentucky bourbon; the whole thing is strange, but it doesn't take long to learn to like it. The U.S. economy has been so strong for so long, people all over the world have come to accept its currency as though it were real money; they take it and ask nothing in return. In exchange for a shipment of TV sets, the Japanese take a wad of $100 bills and call it even. And here is another remarkable thing: The bills tend to stay overseas-- where they are used to buy another form of U.S. paper, Treasury bonds. The United States can print as many $100 bills as it wants. So can it issue as many bonds and notes as it pleases. As long as people don't try to exchange them for other forms of wealth--all is well."

The key sentence in the above paragraph is: "The U.S. economy has been so strong for so long, people all over the world have come to accept its currency as though it were real money."

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It is an article of faith among certain groups that the only "real" money is gold. Fiat, or paper money, is subject to manipulation by governments, and in all cases, in all times and in all places, has been subject to devaluation when governments can set its price.

Indeed, a dollar from 1900 is only worth about 5 cents today. An ounce of gold, on the other hand, will buy roughly the same suit or amount of food or other "stuff" that it did back then. Gold has held its value. Paper currencies, including the dollar, have not.

But that does not mean gold would have been a good investment. The price of gold was fixed at $35 in 1934. It is roughly up 15 times since that "fix."

However, the S&P 500 average was at 9.8 in 1934. It is up almost 120 times over the same period. Which has been the better investment or store of value? Even US bonds would beat gold over the same period.

I have never thought of gold as a long term "investment," per se. It is occasionally a trade, as it has been for the last few years. For the 80's and 90's, gold was not a good investment. I would point out that I called the bottom in gold in February 2002; although full disclosure requires that I admit I was not so much bullish on gold as I was bearish on the dollar. And gold since then has doubled.

Of course, oil is up 4 times, natural gas is up 8 times, copper has been the better trade, etc.

Gold at $10,000

So why would I want to own gold? In the first place, I divide gold into two piles: "insurance" gold and "investment" gold. As an investment it is a useful diversification and a neutral currency. I am still quite bullish on gold today.

However, I feel more strongly about insurance gold. I think everyone should own some gold.

Insurance gold is not an investment. It is not intended for sale or profit. Ever. If you are buying something with no intention of selling, it is not an investment.

My fondest dream is that I will give what insurance gold I have to my grandchildren (assuming that one of my 7 children actually have some kids) and that THEY will give it to their grandchildren. If that happens it means that nothing disastrous happened in our lives to force us to part with the insurance gold.

I read a lot of history. Most of the time the world rocks along just fine. But then, out of the blue, something comes along and upsets the apple cart. War, famine, invasion, disease, weather patterns, gun-powder; you know, the usual litany of suspects. But it is precisely because everything was going along so well that most people were unprepared. And 99% of the time the unprepared have nothing to worry about. For most of the world the next day is much like the last one. It is for that 1% of the time when life deals you a terrible blow that you are glad you have insurance.

I have life insurance. I sincerely hope my great-grandchildren reap the benefits from it much later rather than sooner. I rather think the biotech guys will stop the aging process in the next 20 years. But I still pay the premiums for my life insurance every year, even though the doctor and my genes tell me I will live into my 90's. I buy health insurance, and usually my only visit to the doctor is for my annual allergy shot. But I still buy it.

I also think you should buy gold. I don't think your insurance gold should be 20% of your net worth, but you should have some. There is no set amount or percentage. It is what you feel comfortable with. My theory is that if there is really a crisis or disaster, then a little gold will go a long way. And that means physical gold, by the way.

Now, I also think that in 100 years (or less) the current dollar will also probably be only worth 5 cents or less. Gold will be up 20 times if it holds it store of value. Gold at $10,000? Count on it. Of course, making it to the next century may be the trick.

In the shorter term, would I buy gold today? Not as a medium term trade. Gold tends to peak in late winter and bottom in the late summer, due to demand cycles. We (as in buyers all over the world) buy more in the holidays and at year end. Assuming the Russian central bank does not start buying large amounts of gold, historical trading patterns suggests gold will be cheaper at some point next year than it is today.

But I think a "correction" is all it will be, although it may last for more than a few months from the high. Gold is still in an impressive bull run, and I think it has more room to run. By the way, gold is in a bull in dollars and euros and yen. We have seen the recent run-up even as the dollar has risen. This is not just a currency move. This bull is for real. For gold traders, I would buy on any significant pullbacks. Insurance gold should be accumulated on a steady basis. You are not buying for investment.

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That being said, gold is not the only real money. The dollar is also real money. Now while Bonner gets his paycheck in pounds (he is living in London this year), Wiggin gets his in dollars. And they spend it just like "real money." They take dollars when you buy their book or their publications.

Money is a medium of exchange, and right now, the world takes dollars and euros and yen and Renminbi and pounds. Sometimes central banks can destroy their currencies (Argentina or Zaire or any scores of examples). So, paper currencies may not be the best "real" money, but it is money as long as people accept it.

There are about 5 billion ounces of gold in the world. That is a value of $2.5 trillion, which is a small fraction of world currency. And that includes the gold in Aunt Mimi's jewelry. I am told gold would need to be about $4,000 to be able to cover the paper value of money. (I have not independently verified this.) Of course, that would leave no room for money supply growth if the world were to convert to a true gold standard. And does anyone really think a major central bank or government would so hobble itself? At least willingly?

So, we have a dollar standard world. And we have had one since 1971 when Nixon shut the gold window. Consequently, the value of the dollar has dropped. And gold has been a better investment since, with the S&P 500 only being up about 12 times vs. gold's 15 times.

I think you can count on the dollar losing 50% of its buying power due to inflation over the next 15-20 years and perhaps more, assuming inflation of only 2-3%. Given the nature of the Medicare crisis coming to our shores in the middle of the next decade, it could be a lot worse. Gold over the longer term will do well in this environment, although it will be volatile as always.

Should the Fed Sit On Its Hands?

There are many of the Austrian school of economic theory that agree with the Schumpeter quote at the beginning of this letter: "Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own." -- Joseph Schumpeter

Should the Fed have allowed the country to go into a deep recession in 2001-2002? Should they have kept the cost of money higher than it was, maybe risking actual deflation and Japanese disease and maybe a deflationary depression? The answer is a simple no.

The culprit is not Greenspan. He is simply the latest in a string of accomplices. It is Nixon and Johnson where the problem started (although some would say Wilson in 1913 with the creation of the Federal Reserve and the income tax). It was fellow Texan Lyndon Johnson who built the basis for ever increasing government debt with his welfare programs, Congress for going along with increasing indebtedness and Nixon for shutting the gold window.

Once that die was cast, there has been no real check, other than societal and peer pressure, on the Federal Reserve. They get to make their own rules, and the market reacts. Yes, they are sensitive to the market, which is a form of peer pressure. But they can choose to ignore it if they want. Schumpeter's quote holds true in a gold standard world. But you cannot expect the Federal Reserve to not act to help growth in the economy when there is a recession. Its part of the DNA transplant they get when the join the board of governors of the Fed.

Would not we be better off with a machine at the Fed which simply grew the money supply at a reasonable rate of growth, coupled with a federal government that ran slight surpluses? Both of those are apparent fantasies. It would also be nice to have less regulation and free trade and unfettered capital markets. Oh, and could we get Medicare and our other next generation problems in order? Let's not forget the savings problems of the Baby Boomers. And that damn pesky trade deficit. And since we have our Christmas wish list out, what about even lower taxes and a smaller government? And let's not forget world peace.

We are in a very complicated, interwoven world. There are no easy solutions or simple analogies. It is like we are trying to solve a jig-saw puzzle where the shape of the pieces change every time we find another piece that seems to fit. The venerable Peter Bernstein teaches us:

"We live in a complex system: each piece tends to function as both symptom and cause. This inescapable truth makes life very complicated. Efforts to restore balance in one sector may accomplish no more than to upset the balance in another. The taxes the Democrats want to restore are likely to cut deeply into household savings rates, already uncomfortably low. Exhorting households to save more will mean lower consumption, which means loss of jobs, and dissaving by the unemployed - to say nothing of lower tax revenues and a widening government deficit. The permutations are endless."

Next week I start with my take on these issues. A brief preview? Lord Keynes drives me nuts (sorry, Paul, although he has the best one-liners). I do not like government interference in the market place, except to act as cop. Yet the real world is Keynesian to its core. Fighting that is pointless. Better to figure out how the world is really working and act accordingly than to sit around talking about how it should work and miss the action, or even worse "fight the tape."

As an aside, you can get your copy of Empire of Debt at you can also subscribe to Bill Bonner's free daily letter, the Daily Reckoning, at

Home, Narnia and a Little Research Help

It looks like I am actually going to be allowed to stay home until the middle of January. I am not missing the airports, although the latter part of January and February bode to be hectic. (London, Toronto, New York, La Jolla, Detroit and adding cities weekly) I am going to try and stay near home March, April and June. I am starting to work on my next book and want to do research and write. In my next book, I want to peer over the valleys and see if we can get a handle on how the future will arrive in the next 10-20 years.

In that regard, I need some help. I am looking for 4-5 people, probably retired, but perhaps a student, who would like to help me research some specific areas. I need someone to sift the literature, work the phones and bring me the cream. I need some help in some technology areas, medical, energy, information, demographics, etc. You should be a bit of a futurist and insatiably curious. I should note that your only reward will be a mention in the acknowledgements section of the book and the fascination of learning. If you are interested, let me know.

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I am excited that the Chronicles of Narnia (The Lion, the Witch and the Wardrobe) is finally at the movie theaters. I have been waiting impatiently for about 30 years for someone to do it right and the reviews suggest they have. I think C. S Lewis is one of the most fascinating men of the last century. That he was best friends with that other giant of fantasy, J.R.R. Tolkien, is amazing. This is one movie to take your kids to, as well as your friends. I hope they do the whole series.

It's time to put up the Christmas tree. I always enjoy that. You have a great week.

Your ready to be a kid again analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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