Unstated assumptions about government stimulus

Here's a link to a Yahoo video of former Wall Street analyst Henry Blodget declaring that "The Economic Argument is Over -- and Paul Krugman Won" in which Mr. Blodget asserts that government stimulus is the way to help economies grow, and that anyone who argues to the contrary has now been silenced by a recently-discovered spreadsheet error.

The spreadsheet error to which he refers is found in a 2010 study arguing that government deficits stifle growth after reaching 90% of GDP (the paper, authored by Carmen Reinhart and Kenneth Rogoff, was entitled "Growth in a Time of Debt").  The paper was widely cited by the so-called "austerians," or those who argue for government "austerity."  

The term "austerity" usually means a set of policies which force a government to spend less and -- often -- to tax more at the same time.  

Since the error in the 2010 paper went public last week, supporters of  government stimulus have been rejoicing and declaring victory, just as Henry Blodget does in the above-linked video.  He has been on record as a supporter of government stimulus packages for some time -- here is a video of him praising Paul Krugman's calls for stimulus from 2009.

Of course, just because "austerity" defenders have been embarrassed by a spreadsheet error does not mean that government stimulus is beneficial for an economy.  We believe that government "stimulus" represents a misallocation of capital, in that the government first takes money through the threat of force (taxation) and then spends it where government officials decide is the "best" place for that capital.  Instead, we believe that the decisions of the original owners of that capital, freely allocating their own capital for themselves, will always be better than the decisions of government officials allocating money that they have taxed from someone else.

Here is a previous post in which we linked to a video full of evidence that stimulus is actually harmful, not helpful.  Many authors have been surfacing lately who have been crediting the entire economic recovery, slow as it has been, to government stimulus.  But if stimulus is actually more detrimental than beneficial, then the recovery has been in spite of government stimulus, not because of it!

The whole problem with the Reinhart and Rogoff approach, in our view, is that those who use it as an argument are tacitly accepting the idea that stimulus is beneficial.  The "austerians" have basically been saying, "Yes, stimulus might be helpful, but you can't have too much of it, or the government will rack up enough debt to counteract the helpful aspects of stimulus."  The Reinhart and Rogoff study put that "harmful point of debt" at 90% of GDP, but below that at least some of them seem to think that stimulus is A-OK.

Now that the mathematics behind the 90% number has been shown to contain "spreadsheet errors," many government stimulus fans are dancing a jig, and saying that this proves that stimulus is great, and that there's no upper limit to how much of a good thing an economy can handle.  But the spreadsheet error doesn't prove a thing about whether or not government stimulus is actually good, at all.  We believe it is harmful, and quibbling over whether it stops becoming helpful at 90% or some other number is nonsense if it is actually never helpful in the first place! 

For plentiful historical evidence that stimulus is not helpful but harmful, please go back and re-visit the Dan Mitchell videos which we have linked in posts going back as far as 2009, such as this one and this one.

Furthermore, we have written about the problems with the "austerity" mantra in previous posts, including this one and this one.

Finally, Brett Arends at the Wall Street Journal has written a good article analyzing the current brouhaha over the Reinhart-Rogoff article, entitled "Why everyone is wrong about austerity."  In it, he makes some excellent points, including the point that backwards-looking studies such as that of Reinhart and Rogoff are inherently flawed from the outset. 

Analysts that appear on the financial media often hold unstated assumptions which inform the analysis that they present for their viewers.  Often, one of these unstated assumptions is the idea that government stimulus is positive for an economy.  Even those "austerians" who seem to be on the other side of the argument sometimes hold this view.  We believe it is a mistaken assumption, and we believe investors should be very aware of the evidence which call that assumption into question. 

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The gold sell-off



In our previous post discussing Cyprus, we noted that governments in general have three choices when they run up debts beyond what their income can support.

One option, of course, is to increase their income.  Governments can try to raise income by raising tax rates or, a far better option, by encouraging economic growth which will lead to greater tax revenues even if tax rates stay the same or go lower.

A second option for governments is to borrow further.  Governments do this by selling bonds.  If they do too much of this, however, it can cause their borrowing rates to go up and their credit rating to go down.  

A third option is to print more money in order to pay for their expenses.  Because a big part of those expenses are interest payments on their debt, this option is also known as "monetizing the debt."  It is  also known as inflating the currency.

One of the consequences of inflating the currency is that it takes more dollars to buy the same amount of the same thing, and one of the places this effect can be most easily seen is in the number of dollars it takes to buy a fixed amount of gold.  Since a gold bar of equal weight and equal purity made in 1970 is no better and no worse than a bar of the same weight and purity made today, the difference in the price of the same gold bar in 1970 and today is primarily a function of the inflation of the currency. 

When governments inflate a currency, the price of gold and other commodities go up in relation to that currency.  When people expect a lot more inflating activity in the future, many of them will start to buy gold or other commodities in the anticipation of the rise in commodity prices.

Gold has been on a nearly unbroken bull run since 2001, but since the publication of the previous post on Cyprus something very significant took place in the gold market: the price of gold, which had been settling slowly after reaching all-time highs in August of 2011, plunged 25% during the week of April 8th through April 12th, and then continued to plummet on Monday, April 15th with a drop of over 9% in a single day -- the biggest one-day drop in thirty years.  The price of gold ended last week just above $1400 per ounce, down more than 25% from the high of $1,900 reached in August, 2011.

Does this drop signal the end of something, or is it just a big head-fake in a landscape that has not changed?  Arguments that nothing has fundamentally changed and that the reasons for buying gold remain intact are well summarized in this article entitled "Gold Down: What Now?" by Frank Seuss, published in the Daily Bell.  In that article, the author argues that: 

Fundamentally, all of the reasons that made gold an ever more attractive asset over the past years are still fully in place, and increasingly so. The recovery story is really just that: a story. All the reasons to buy and hold gold as a medium- to long-term crisis hedge and for portfolio diversification are fully intact. The only difference is that now, or in the next few weeks, we can buy at a much better and more reasonable price.

In other words, he believes that the economic recovery is a "myth, a word he uses earlier in the article.  While this article does not give the authors reason for calling the economic recovery a myth, many who are in that camp argue that any growth the economy has experienced since the crisis of 2008-2009 has been the product of easy money from central bankers and stimulus spending from central governments.  Those in this camp note that such policies inevitably lead to more inflating, which will inevitably push up the prices of commodities including gold.  Some in that camp also believe that the situation could get so dire that it could lead to an outright collapse, in which case fiat currencies would become worthless while tangible stores of value such as gold would not.

Although we adamantly oppose inflating the currency, we believe the arguments of those in the "myth" camp are mistaken.  

One of the primary problems with the argument is the idea that the economic recovery is all a product of emergency government spending and central bank easing.  We believe this view gives far too much credence to the healthful powers of government spending and easy money.  In fact, we believe government spending and excessively easy money are harmful, not helpful, and that the recovery has taken place in spite of such actions, not because of them.  We suspect that without such obstacles, the recovery would have been much stronger over the past four to five years.

Secondly, there may have been some other factors at work fueling gold's spectacular 12-year bull run than simply fears of inflation and speculation of more government spending and monetary expansion, although those certainly contributed.  In this important blog post entitled "Gold is re-linking to commodities," published last Monday April 15, retired economist Scott Grannis argues that the surge in the demand for gold corresponded to a decade of explosive growth in China, which caused China to increase their foreign exchange reserves at a rapid pace.  

Holding foreign currency exposes a country to foreign exchange market risk, and a common move is to use those reserves to buy commodities, including oil and gold.  In his posts on this subject, Scott Grannis presents some excellent charts showing a very strong correlation between the increase in China's foreign currency reserves and the steep climb in the price of gold, beginning around the year 2001.  He explains: "This came to an end in early 2011, as net capital inflows to China approached zero, and shortly thereafter gold peaked.  Both forex (foreign exchange) purchases and the price of gold increased by many orders of magnitude over roughly the same period."

These arguments contradict the idea that "Fundamentally, all of the reasons that made gold an ever more attractive asset over the past years are still fully in place, and increasingly so," as those in the camp of the "recovery myth" believe.  

Trying to predict the next move in the price of any commodity is extremely difficult, and we believe that doing so correctly year-in and year-out for long periods of time is next to impossible.  We have always argued that it is much wiser to invest capital in businesses which can be analyzed based on their business plan and management team than to speculate on the ups and downs of commodities, including gold.

The indisputable history of governments with fiat currencies over time is to inflate those currencies.  The question is how investors should protect themselves against such depredations.  While ownership of gold is a well-known strategy in this regard, speculating on the price of gold is fraught with peril, especially because the price of gold can be influenced by numerous factors, some of which are unknown to the general public.  We believe this is a very important subject for our readers to understand.

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Investment Climate commentary, April 2013





We recently published our latest quarterly commentary, which includes some discussion of the "growth hole" that we have noticed in the market over the past several months (corresponding to a phenomenon that stretches all the way back to the bear market of 2000 - 2002), even as some of the major stock market indexes make new highs.

Check out "New Highs! Again, and Again," at the Taylor Frigon website.  Other commentaries from previous quarters are archived here.

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Lessons From Cyprus

The troubles in Cyprus may seem remote to many investors, and involve a small nation whose economy is not terribly influential to many businesses in other parts of the world, but the events unfolding there should be clearly understood by all participants in the "modern economy," no matter the level in which they participate in said economy.

The banking crisis in Cyprus provides a crystal-clear lens through which to examine some of the fundamental issues facing anyone forced to use fiat currency to obtain the goods and services they need to survive (which is to say, just about anyone reading this article).  Fiat currency means currency which is mandated by government decree (by "fiat," from the Latin verb meaning "Let there be," as in fiat lux: "Let there be light").  

Other forms of money have existed before fiat money -- forms of money which communities settled on to enable easier exchange of goods and services and to store value, whether in the form of pieces of gold or gigantic round stones with holes through their centers.  Because fiat systems are forced on the people by government dictate, and because that government then controls the supply of the money in a fiat system, the people participating in a fiat system are at the mercy of those controlling the supply of that money.

Most people know that the situation in Cyprus involves people standing in long lines at ATMs, hoping to withdraw money which they loaned to their banks, and that the banks are currently closed so that depositors cannot withdraw more money.  The reason that the banks are not allowing people to get their money back is that the banks are insolvent, and in most modern countries when banks become insolvent the government steps in to make sure that people can get their money back.  The problem in Cyprus stems from the fact that the government of Cyprus does not have the wherewithal to back up the banks (one troubled bank in particular, in this case).

Thus, the government of the Republic of Cyprus needed to turn elsewhere for help, first turning to Russia and then, as time dragged on and the government was unable to increase its income enough to meet its obligations, leading to a precipitous downgrade in its credit rating, Cyprus became a pariah whose debt  (bonds) could no longer be held in most investment funds, and its government had to turn to the European Financial Stability Facility for an emergency loan of ten billion euros.

Earlier this week, a loan was approved, after the initial proposed terms were rejected by the parliament of Cyprus.  Part of the stipulations of the final loan of ten billion euros from the International Monetary Fund included the "levying" (that is to say, "taking") of all the uninsured deposits at the failing bank, as well as the levying of 40% of all the uninsured deposits everywhere else on the island.  Uninsured deposits, in this case, means deposits of more than a hundred thousand euros (there is no explicit deposit insurance in eurozone banks, the way there is in the US, but there is an implicit assurance that deposits up to a hundred thousand euros are backed by the government; in the US, deposits are insured by the FDIC up to $250,000).

The idea that bank deposits could be seized by the government as part of the terms of a loan that government enters into because it is in dire financial straits itself obviously raises all kinds of emotional responses in those watching this crisis unfold, and the assurances that "most of" the big deposits are probably owned by shady characters from Russia (according to the press) does not change things.  After all, should honest depositors who have a lot of money see their funds levied just because other large depositors were involved in criminal activities?  Isn't that the same as punishing all the kids on the playground for the bad actions of a few of them*?

What observers of this train wreck need to understand is the fact that, while the seizing of assets in Cyprus arouses angry emotions because it is so blatant and arbitrary, and because 40% seems like such a shockingly-high figure, this same sort of money grab goes on in the vast majority of countries where fiat systems have been imposed.  It has been going on for years, and the "levying" usually amounts to a whole lot more than a simple 40% haircut.  Most governments are just a lot more careful to make it a lot less obvious.

We previously published an article discussing an American Institute for Economic Research (AIER) study entitled "A World of Persistent Inflation," in which we explained that when governments rack up a history of excessive expenditures (usually on wars or welfare or both), they can finance those expenditures by increasing taxation on their people (which is unpopular), or by increasing their borrowing through the issuance of bonds (which generally causes the rate of loans to go up, driving up the rates of borrowing on everything else, and which therefore also becomes unpopular after a while).  To artificially keep interest rates low, governments in charge of their own fiat currencies can mask the cost of their borrowing by printing more money -- inflating the currency.  The AIER study proves with extensive evidence that this last choice has been the overwhelming favorite of governments in charge of fiat currencies for the past seventy-plus years.

In the case of Cyprus, of course, the government could not really issue more bonds (their credit had been reduced to junk status), and the government could not print more money (they use the euro, so that option is closed to them, as it is for Greece, Italy, and the other eurozone countries, unless they decide to try to leave the euro).  Thus, what generally happens in a slow and stealthy way elsewhere just erupted to the surface in Cyprus like a big ugly boil for all the world to see.

But just because it isn't out in the open the way it is in Cyprus does not mean that other participants in fiat systems can breathe a sigh of relief, thankful that they do not have large portions of their wealth sitting in Cypriot banks.  As AIER has shown through their studies over the years, the inflating done by governments takes away the purchasing power of the currency that savers deposit just as surely as if those deposits were levied the way they are in Cyprus.  In fact, although a loss of 40% all at once is a heavy blow, the data AIER has been collecting since 1960 shows that the damage done by the inflation of fiat currencies over time has been far more devastating than any 40% levy (it varies by country and by currency).

This concept is one that all participants in the economy should understand very clearly.  It is one of the reasons why we have always advocated the allocation of some portion of one's wealth to the ownership of  the shares of well-run, innovative businesses, rather than simply "putting it in the bank."

* For a discussion of the morality of taking depositors' money, which the author explains really means "money loaned to highly-levered financial entities," see this article written by Austrian economist and former money manager Detlev Schlichter, published on March 20.

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ORCL earnings miss

Equity markets today are reacting negatively to an earnings miss from Oracle, seen as a bellwether for enterprise IT spending.* 

While we are not shareholders of Oracle, we do invest in many other technology companies (see discussions in previous posts here and here for example), and we believe that the same tidal wave of increased data usage that we have been writing about for years will have a huge impact on businesses of all sizes.

The Street is reacting to Oracle's miss by punishing the company's stock (down over nine percent today so far) and the stocks of many other companies involved in the "unstoppable wave" of data, but we believe this reaction is overblown.  This is especially true in light of the fact that some of the revenue issue at Oracle was likely driven by company-specific changes taking place at Oracle, which deserve to be evaluated over a longer period of time than a single quarter or even a few quarters.

The bigger picture for investors is the importance of seeing through the sensationalist tendencies of the financial media, and the inevitable over-reactions of the market (which tends to react first and ask questions later), and to focus on getting to the real story underneath the headlines on any given day.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Oracle (ORCL).

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