Congressman Ron Paul is in the news again, this time for calling for an audit of America’s gold reserves. He issued the call in an interview with a news service run by a gold dealer, Kitco News, which reported that the congressman intends to introduce legislation calling for such an audit of what we hold at Fort Knox and other sites, such as the New York Federal Reserve Bank in lower Manhattan. It’s the kind of thing people tend to laugh at, the way they once did when Dr. Paul launched his legislative campaign to audit the United States Federal Reserve. Yet after years of persistence by the Texas Republican, Congress finally passed a law requiring an audit of the Fed. It passed the mandate by a wide margin and a bi-partisan vote. So whatever snickering there will be over Dr. Paul’s proposal for an audit of the gold holdings, it will be more muted.

We are not in the camp that believes a vast conspiracy has stolen America’s gold. But neither are we in the camp that sees any harm to an audit. As Dr. Paul put it to Kitco News: “If there was no question about the gold being there, you think they would be anxious to prove gold is there.” He has been pressing the point, on and off, since the early 1980s, when he was a member of the United States Gold Commission. He reminded the interviewer from Kitco that his recommendation back then that Congress audit the gold reserve was rejected by 15 of the Gold Commission’s 17 members. It strikes us that it would not be a bad thing were an audit to keep our national mind focused on our gold holdings — particularly at a time when the value of the dollar has collapsed to less than a 1,200th of an ounce of gold.

If that weren’t enough of a warning, the Bloomberg wire reports that “gold’s most-accurate forecasters” are predicting that the value of the dollar may fall to but a 1,500th of an ounce of gold. It reports that what it calls the most widely held option on gold futures in New York is for the dollar to fall to but a 1,500th of an ounce of gold by December. The lowest value to which the dollar has plummeted so far is a 1,266.50th of an ounce of gold, which was the value of the dollar recorded on June 21. Bloomberg reports that holdings through what it calls “bullion-backed exchange-traded products” are within a 10th of a percent of the all-time high of 2,075 metric tons. It quotes one Deutsch Bank analyst, Dan Brebner — whom it calls “the most accurate forecaster so far this year — as predicting the value of the dollar may drop to a 1,550th of an ounce of gold.

Suddenly the question to ask is not why in the world is Dr. Paul asking for this audit but why is he the only member of Congress making our gold holdings an issue. It was only a decade ago, at the start of the presidency of George W. Bush, that a dollar was worth nearly a 250th of an ounce of gold. As it started dropping, these columns warned repeatedly that it was a signal to be heeded, starting with “The Bush Dollar,” which was issued in December, 2005, and carrying on up through “The Pelosi,” “The Greenspan,” “The Bernanke,” “Ron Paul’s Prescience,” “$1,000 Gold,” “The Obama Dollar,” “Golden Opportunity,” and “Paul Ryan’s Question,” just to name but a few of the editorials of the Sun that have touched on this topic.

By our lights a weak dollar policy is a strategic mistake for America. We felt that when President Carter and his treasury secretary at the time, W. Michael Blumenthal, were running a weak dollar. We’ve never credited the idea that one cannot have a strengthening dollar and a growing economy, an idea that should have been thoroughly discredited during the Reagan years and the Clinton years. One could say that a strong dollar is a good idea that is bi-partisan in pedigree. But what good can come of a weak dollar policy, such as the one being pursued by Messrs. Obama, Geithner, Bernanke, Mrs. Pelosi and the others who have various levels of constitutional — or, in the case of Mr. Bernanke, non-constitutional— authority over policy in respect of America’s money? As the value of the dollar evaporates, why in the world wouldn’t ordinary Americans want to have the gold holdings they’ve been told about for so many years given a full and independent audit?

“I’d rather have the Europeans running the U.S. central bank than the people running the U.S. central bank, least they know how to try to build for the future,” Rogers told CNBC Monday.

“In America, Bernanke just says we’ll print more money, we’ll spend more money, even though the United States is now the largest debtor nation in the history of the world.”

Rogers pointed out that economies in trouble should be allowed to fail, like bad companies.

“The things that have worked in the past…will be you go bankrupt then you re-organize and you start over. You have a painful period for a while, and then you start over. This has been done in the past 3 or 4 thousand years, and that’s the way you do it,” said Rogers.

How the ratings agencies have managed to emerge from the credit crisis unscathed and unregulated is a mystery…and a sham…

If Wall Street is a foggy valley of shadows where wise bankers pick the pockets of the wandering masses, then rating agencies act as the surrounding hilltops. No – not the pillars of transparency and relief from the villains below. Rather, they’re the unscaleable, daunting cliffs that trap and thicken the fog. (This is the case almost literally, in fact. Moody’s, Standard and Poor’s and Fitch Ratings’ major offices surround the lowest tip of Manhattan eerily… Moody’s to the west, S&P at east and Fitch at the southernmost point of the island.)

While it is the duty of ratings agencies to assess investment risk and provide a clear playing field for investors of every kind, we all know that they have done just the opposite. From mortgage-backed securities to municipal bonds, sovereign debt to CDOs, ratings agencies have notoriously mispriced risk over the last decade, and nearly all of us have paid the consequence.

Yet they not only remain, but prosper. They’re still used by every major firm in America (if not the world). And they’re left largely untouched by regulators and investigators. Why?

Last month, a long-running Senate study determined that over 91% of the AAA mortgage-backed securities issued from 2006-2007 have since been downgraded to “junk” – BB or lower. Surely, a screw-up this gigantic can only be attributed to some extremely smart people. A man off the street would have better odds just flipping a coin. Only geniuses can be so, so wrong.

In fact, that’s the best explanation for what happened to the “big three” ratings agencies. They were run by brilliant quantitative economists, with models derived from statistics dating back decades. Whether the housing statistics from the Great Depression were lost, or if the raters willfully left them out of their models, we don’t know. But there was no model in use that took into account a generational crisis – one where home prices might drop 20% in one year. So investment bankers were able to stuff securities full of bad loans and still get their precious AAA ratings.

“Their quantitative models appeared to have a Mensa-like IQ of at least 160,” bond legend Bill Gross sums up nicely, “but their common-sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.”

“It’s easier to be smart than good,” we also wrote in Empire of Debt. “Smart men get elected to high office. They run major corporations…

“But it is virtue, not brainpower, that pays off.”

Of course, all the raters and bankers were more than just too smart for their own good. Their lack of virtue exposed a conflict of interest obvious to any functional adult;

Investors want AAA-rated securities

Investment banks deliver whatever their clients want

Investment banks pay ratings agencies for their services

The service of a ratings agency is to rate securities.

You can pick your metaphor. It’s like a student who pays his teacher to grade his papers. Or a plaintiff paying the judge’s salary.

Cultural differences only exacerbated the problem. Investment bankers might pay the ratings agencies, but it’s the bankers – by selling those securities the agencies rate – who make the big bucks. It’s quite common for a junior man at a ratings agency to one day work for Goldman Sachs or JP Morgan (though not the other way around).

Thus, there is further incentive, though widely unspoken, for raters to play ball. After all, what’s the Wall Street life expectancy of an S&P analyst with a…[hard-nosed], no-games reputation? (This same relationship, by the way, is also a real issue with the SEC.)

And so the game was played. Together, the rater and banker would decide what combination of loans garnered what rating. Of course, the banker wanted AAA notes to sell to the Icelandic government or a Fidelity retirement fund, and the rater wanted the banker’s business…if not to become a banker himself one day. The models played along, too, having never known a crisis like the one that was around the corner.

Even when things got really crazy – when there were just way too many bad loans to make a AAA security – bankers and raters found a solution. They split the security into different partitions of risk, each with separate yields, but all under the same rating. They called these “tranches,” as if it weren’t complicated enough – a French word for a “slice” or “portion.”

Shareholders and taxpayers, of course, paid the biggest price for the subprime fallout. Bankers have taken a few jabs, too…sort of. But ratings agencies managed to emerge largely unscathed. The big three, Moody’s, Fitch and S&P, are not only still in business, but they remain highly relevant.

Even as we write, traders are waiting to hear from them with bated breath…the fates of debt-strapped euro-nations, Greece in particular, is in their hands. S&P likes to boast that they insist on sending not one, but two ratings analysts to every country to help determine its credit sovereignty. “It’s been our practice, and it’s worked well,” said S&P’s John Chambers.

S&P rated Iceland “A+” in March 2008, about six months before its currency collapsed.

Late last month, Chambers helped knock Spain down to AA, a “bold” move, defying Moody’s and Fitch’s AAA rating on Spanish debt. “Here’s a country,” Bill Gross continues, “with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!”

That’s the biggest bond investor in the world calling agencies out with a crystal-clear example of their inability to function. Yet global credit still lives and dies by their ratings.

Despite all the obvious, common-sense issues – incompetence, conflict of interest, past performance – Congress is turning a blind eye to this tawdry corner of the financial services industry.

Even the free market seems to have failed in this instance. There are more than just three ratings agencies in this world, after all. Some of them even managed to do their jobs. “Second tier” agency Egan Jones comes to mind. Its analysts are paid by the buyers of the securities it rates, not the issuers. What a novel idea! Yet Egan Jones is not the No. 1 agency in the world, for reasons we can’t explain.

Even if American investors are content to continue this charade, the Chinese are not. An upstart Chinese ratings agency, Dagong Global, has begun to offer a competing perspective. (Check out the rating on lucky nation #13 in the chart below!)

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There’s one easy takeaway: You still can’t trust Wall Street. The same players and the same rules that created this mess – largely for their own benefit – are still a part of the game.

The other pill is a little harder to swallow. In the current market environment, the individual, independent investor has the best chances of long-term capital appreciation when he invests outside of “The Wall Street Fandango.” When it comes to the truly important investments in life, leave the indexes, blue chip stocks, sovereign bonds and super funds to lower Manhattan.

Ratings agencies and their banker clients do not bother with small companies, commodities, smaller funds and other securities that have little potential to make them large amounts of money. What’s more, they have no stake whatsoever in the status of your small- to medium-sized business, your family, your education or your local under-the-radar investments.

It’s in these arenas, where Wall Street has no dice to roll and no purses to snatch, where your failure or success is determined by little more than willpower, wit and some luck. That’s the best a good investor could ask for.

Tax payers will be paying around $600 billion in interest on the national debt by 2012, the chairman told students and local leaders in Detroit.

“That’s one year’s worth of defense budget,” he said, adding that the Pentagon needs to cut back on spending.

“We’re going to have to do that if it’s going to survive at all,” Mullen said, “and do it in a way that is predictable.”

He also called on the defense industry to hire veterans and become more robust in the future.

“I need the defense industry, in particular, to be robust,” he said. “My procurement budget is over $100 billion, [and] I need to be able to leverage that as much as possible with those [companies] who reach out [to veterans].”

Mullen highlighted the unity of purpose between the government and industry as well, in working to solve national security issues.

“I have found that universally, [private-sector workers] care every bit as much about our country, are every bit as patriotic and wanting to make a difference … as those who wear the uniform and are in harm’s way,” he said.

Investors face defaults on government bonds given the burden of aging populations and the difficulty of increasing tax revenue, according to a Morgan Stanley executive director.

“Governments will impose a loss on some of their stakeholders,” Arnaud Mares in the firm’s London office wrote in a research report today. “The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take.” The sovereign-debt crisis is global “and it is not over,” he wrote.

Rather than miss principal and interest payments, governments may choose a “soft” default in which they pay back debts with devalued currencies resulting from faster inflation or force creditors to take lower returns, Mares said in an interview.

Borrowing costs for so-called peripheral euro-region nations from Greece to Ireland surged today, resuming their ascent on concern that governments won’t be able to cut their budget deficits. Standard & Poor’s lowered Ireland’s credit rating yesterday on the rising cost of supporting nationalized banks.

Population trends may be a better predictor of the ability to meet obligations rather than debt as a percentage of gross domestic product, which doesn’t reflect governments’ available revenue and is “backward-looking,” Mares wrote.

While the U.S. government’s debt is 53 percent of GDP, one of the lowest ratios among developed nations, its debt as a percentage of revenue is 358 percent, one of the highest, the report said. Italy has one of the highest debt-to-GDP ratios, at 116 percent, yet has a debt-to-revenue ratio of 188, Mares said.

Double Dip

“Outright sovereign default in large advanced economies remains an extremely unlikely outcome, in our view,” the report said. “But current yields and break-even inflation rates provide very little protection against the credible threat of financial oppression in any form it might take.”

Mares, who didn’t identify which nations may default, once worked at the U.K.’s Debt Management Office and is a former senior vice-president at credit-rating company Moody’s Investors Service.

“Note that a double-dip recession would not invalidate this conclusion,” Mares’ report said. “It would cause yet further damage to the governments’ power to tax, pushing them further in negative equity and therefore increasing the risks that debt holders suffer a larger loss eventually.”

Investor concern that the U.S. may fall back into recession has grown in recent weeks…

http://www.kitco.com/

Texas (Kitco News) — U.S. Rep.  Ron Paul , R-Tex., plans to introduce a new bill next year that will allow for an audit of US gold reserves, he told Kitco News in an exclusive interview.

Paul dropped the news in the interview, indicating that the bill still does not have an official name yet but will be unveiled at the start of the new U.S. Congress.

“If there was no question about the gold being there, you think they would be anxious to prove gold is there,” he said of the Federal Reserve.

This is not the first time the congressman has made his pitch. “In the early 1980s when I was on the gold commission, I asked them to recommend to the Congress that they audit the gold reserves – we had 17 members of the commission and 15 voted not to the audit,” said Paul. “I think there was only one decent audit done 50 years ago,” he said.

Though Paul did not say whether there is any truth to claims that there is no gold in Fort Knox or the New York Federal Reserve, he said, “I think it is a possibility.”

“If we ever get around to deciding we should use gold in relationship to our currency we ought to know how much is there,” said Paul.  “Our Federal Reserve admits to nothing and they should prove all the gold is there. There is a reason to be suspicious and even if you are not suspicious why wouldn’t you have an audit?” he said.

The gold audit follows his crusade last year looking to audit the Federal Reserve, which he says is the chief culprit behind the economic crisis.

“I don’t think the Federal Reserve should exist – it would be best for congress to exert their responsibilities and that is find out what they are doing”’ said Paul.  ”It is an ominous amount of power they have to create money out of thin air and being the reserve currency of the world and be able to finance runaway spending whether it is for welfare or warfare; it seems so strange that we have been so complacent not to even look at the books.  If we knew exactly what they were doing, who they were taking care of, there would be a growing momentum to reassess the whole system,” he told Kitco News.

Before the creation of the Federal Reserve however, the US saw 16 recessions from 1850 to 1910; they averaged 22 months long. During this time, the U.S. was in recession 60 out of 91 months. Many would argue that the severity of these recessions led to the creation of the Federal Reserve System.

“I think they would be exaggerating what happened before 1913,” Paul responds. “We had some panics …they were usually short and there were no long depressions,” he said.  “The Fed creates the bubbles and they are much worse since 1913, if you think of the size of the government and the valuation of the dollar, we are down to about a 2 cent dollar from the 1913 dollar.”

Paul said everyone accuses him of wanting the gold standard but he said he doesn’t accept that.  “I accept the idea of a gold coin standard and I think we can do much better than what we had,” he said. “There was a lot that they did pre-Fed that was not exactly right but we never had a disastrous loss of purchasing power long-term, we didn’t have a great depression, we didn’t have the 1970s with stagflation and we wouldn’t have what we have right now.”

Since the Fed’s creation in 1913 the dollar has lost more than 96% of its value, and by inflating the money supply the Fed continues to distort interest rates and intentionally erodes the value of the dollar said Paul.

Paul’s solution is to not replace the Fed with anything.  “It would make the dollar strong… who wants money to be devalued? I want a strong dollar and if it were equivalent to gold it would remain strong.”

Paul also said he wants to legalize the freedom for people to choose.  “My proposal for now is to legalize the constitution to use gold and silver as legal tender in a parallel standard and have it compete with paper money. If people get tired of using the paper standard they can deal in gold or silver,” he said.

On the topic of gold price manipulation, Paul said, “I think it is probably true.”

“I am not the one to lay out proof of this, others have done a lot of investigation.  One of the reasons I don’t dwell on that is they are not going to listen to us” he said. “But I think it is very important somebody talks about it and emphasizes it just as a warning to be careful; you don’t have to only anticipate what the markets are doing, but you have to anticipate what the government is doing.”

The best example of manipulating the ratio of gold to paper would have been from the late 1950s to 1971, said Paul. “We printed money like currency, we printed too many dollars against the gold, so they said, ‘we will take your gold.’ …if they are capable of that they are capable of doing this as well, because they don’t want their cover blown, ” said Paul.  If the markets are saying not to trust paper money, they have to do everything they can to “destroy gold,” said Paul.

Recounting a visit with Paul Volcker, former Chairman of the Fed Reserve, Rep. Paul said the Chairman walked straight into the room, went immediately to his staffer and asked what the price of gold was. “They know gold is important. I think they are quite willing to manipulate it. That is the only way they can maintain this false illusion about gold.”

“If they are involved isn’t it pretty amazing what has happened in past year? What will happen if they throw in the towel?” said Paul.

The current economic situation is very healthy for gold,  said Paul. “You see people rushing just to put their money in any place …they don’t even care about making money.”

New Regulations

When asked what regulations the Congressman is currently worried about, he said, “All of them.” However, Paul specifically points to the 1099 provision, a portion of the health-care act, passed earlier in the year.  “For every transaction of over $600, gold dealers have to fill out a form, it is a lot of paperwork,” said the congressman. Entities must file a Form 1099 with the Internal Revenue Service whenever they make transactions paying out $600 a year to another party.

US economy

It is going to continue to go downhill said Paul on the US economy. “I don’t believe in a double dip, I believe we have single-dip and it has been continuous.”

“The only reason it doesn’t look so bad is if you spend $2 trillion dollars and you have a $5 hundred billion increase in some GDP figures, you didn’t get much for your trillion dollars but it might improve your statistics,  so it was a fake recovery.”

As for another presidency run, Paul says it is too early to tell.

[Selected News Notes]

August 17 – Bloomberg (Wes Goodman and Daniel Kruger):  “China cut its holdings of Treasury notes and bonds by the most ever, raising speculation a plunge in U.S. yields that sent two-year rates to a record low has made government securities unattractive.  The Asian nation’s holdings of long-term Treasuries fell by $21.2 billion in June to $839.7 billion… Total Chinese investment in U.S. debt declined 2.8% to $843.7 billion, the least in a year, following a 3.6% slide in May.”

August 20 – Bloomberg (David Wilson):  “Nationalizing the U.S. mortgage- finance system would turn taxpayers into servants of the ‘housing investment and debt complex,’ according to David Stockman, a former head of the Office of Management and Budget.  This shift would complete a transformation that started during the 1970s, when federal housing subsidies were expanded, Stockman wrote… ‘All principled political opposition to Pimco-style crony capitalism has been extinguished,’ wrote Stockman, a senior managing director at Heartland Industrial Partners… ‘Indeed, the magnitude of the burden already created is staggering.’”

August 20 – Bloomberg (Dunstan McNichol):  “Taxpayers must cover at least a third of a $3 trillion bill for public employee pensions even if lawmakers eliminate cost-of-living increases and raise the retirement age, according to an academic study.  ‘Even if states uniformly eliminated generous early retirement deals and raised the retirement age to 74, the unfunded liability for promises already made would still be more than $1 trillion,’ Joshua D. Rauh, associate professor of finance at Northwestern University’s Kellogg School… said…”

Selected Money Notes:

August 19 – Bloomberg (Prashant Gopal):  “U.S. mortgage rates set a record low for the ninth straight week… The average rate for a 30-year fixed mortgage dropped to 4.42%…”

M2 (narrow) “money” supply rose $8.3bn to $8.644 TN (week of 8/9). Narrow “money” has increased $132bn y-t-d, or 2.5% annualized.  Over the past year, M2 grew 2.7%…

International reserve assets (excluding gold) – as tallied by Bloomberg’s Alex Tanzi – were up $1.459 TN y-o-y, or 20.6%, to a record $8.547 TN.

Global Credit Market Watch:

August 18 – Bloomberg (Andrew MacAskill and Simon Kennedy):  “The Basel Committee on Banking Supervision said proposed bank regulations would have a ‘modest’ impact on economic growth, a rebuff to warnings from financial institutions that the new rules threaten growth and job creation.  The annual growth rate would be reduced by an average of 0.04 percentage points over a four-and-a-half-year period, said the committee…”

Global Government Finance Bubble Watch:

August 16 – Market News International (Brai Odion-Esene):  “Influential bond trader Bill Gross… called on U.S. policymakers to implement a nationwide refinancing scheme that he argued will provide a boost to the economy of between $50 billion to $60 billion.  In prepared remarks during a panel discussion to begin the Obama administration’s conference on the future of housing finance, Gross… said he favors the consolidation of all the housing finance agencies into a single public entity fully backed by the government.  He said policymakers should quickly re-engineer a refinancing opportunity for all borrowers that are current with their payments and are included in the GSEs securitized mortgages… PIMCO’s proposal to introduce refinancing opportunities on a large scale, Gross said — where 5%, 6% and 7% mortgages are turned into 4% mortgages — will provide a stimulus of $50 billion to $60 billion in consumption as well as a potential lift of 5% to 10% in terms of housing prices. PIMCO also advocates a 100% public housing finance system, Gross said…”

Currency Watch:

August 16 – Bloomberg (Candice Zachariahs and Ron Harui):  “China, whose $2.45 trillion in foreign-exchange reserves are the world’s largest, is turning bullish on Europe and Japan at the expense of the U.S. The nation has been buying ‘quite a lot’ of European bonds, said Yu Yongding, a former adviser to the People’s Bank of China… ‘Diversification should be a basic principle,’ Yu said… adding a ‘top-level Chinese central banker’ told him to convey to European policy makers China’s confidence in the region’s economy and currency. ‘We didn’t sell any European bonds or assets, instead we bought quite a lot.’”

August 18 – Bloomberg (Frances Yoon):  “China more than doubled South Korean debt holdings this year, spurring the notes’ longest rally in more than three years, as policy makers shifted part of the world’s largest foreign-exchange reserves out of dollars… China should allocate some reserves to ‘financial assets in major Asian economies,’ Ding Zhijie, a former adviser to China’s sovereign wealth fund, said… China’s holdings of Treasuries fell 6% in the first half to $843.7 billion…”

August 16 – Bloomberg (Yasuhiko Seki):  “The Japanese yen, the best performer among major currencies this year with a 7.9% gain against the dollar, may surge further as concern grows that U.S. efforts to boost economic growth will fail.  ‘What we are seeing is not appreciation of the yen but weakness of the dollar, reflecting concerns that the U.S. economy may falter,’ Eisuke Sakakibara, formerly Japan’s top currency official, said… ‘There is a chance the yen will reach an all-time high and stay at that level for the time being.’”

The dollar index added 0.1% to 83.01 (up 6.6% y-t-d).  For the week on the upside, Swiss franc increased 1.7%, the Brazilian real 0.9%, the Japanese yen 0.7%, the Singapore dollar 0.5%, the Swedish krona 0.5%, the New Zealand dollar 0.1% and the Australian dollar 0.1%.  For the week on the downside, the Canadian dollar declined 0.5%, the British pound 0.4%, the euro 0.3%, the Danish krone 0.3%, the Mexican peso 0.3%, and the Norwegian krone 0.3%.

Commodities Watch:

August 18 – Bloomberg (Rebecca Keenan and Jesse Riseborough):  “BHP Billiton Ltd., the world’s largest mining company, made a hostile $40 billion takeover offer for Potash Corp. of Saskatchewan Inc., seeking to become the biggest fertilizer producer.”

August 20 – Financial Times (Javier Blas and William MacNamara):  “The rise of China and India has sparked a renewed surge in aggressive dealmaking in the resources sector, with more than $50bn in proposed takeovers this week alone wagering on continued strong commodities demand… In the first concrete signs of Beijing’s interest in the deal, Li Qiang, a spokesman for Sinochem, said the company was paying ‘close attention’ to the takeover battle, adding that it was ‘interested in overseas potash investment opportunities’.”

August 20 – Financial Times (Jack Farchy):  “Coffee and sugar prices spiked to fresh highs as tight physical markets encouraged speculative interest in the soft commodities. The price of Arabica coffee – the high-quality variety prized by espresso lovers – jumped 3%… [to a] a 12-year high.  October raw sugar rose above 20 cents a pound for the first time in five months.

August 16 – Bloomberg (Jennifer A. Johnson and Elizabeth Campbell):  “Cotton may climb to the highest price since 1995 as rising demand in emerging markets for everything from shirts to bed sheets forces textile makers to restock inventories that are the tightest in 13 years.”

The CRB index declined 0.7% (down 5.8% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 1.4% (down 3.7% y-t-d).  Spot Gold rose 1.0% to $1,228 (up 11.9% y-t-d).  Silver slipped 0.6% to $18.055 (up 7.2% y-t-d).  October Crude declined $1.73 to $74.04 (down 7% y-t-d).  September Gasoline declined 0.7% (down 6% y-t-d), and September Natural Gas sank 4.6% (down 26% y-t-d). December Copper added 1.3% (down 1% y-t-d).  December Wheat retreated 3.0% (up 32% y-t-d), while December Corn gained 2.1% (up 5% y-t-d).

China Watch:

August 16 – Bloomberg (Dan Levy):  “China surpassed Japan as the world’s second-largest economy last quarter, capping the nation’s three-decade rise from Communist isolation to emerging superpower… The country of 1.3 billion people will overtake the U.S., where annual GDP is about $14 trillion, as the world’s largest economy by 2027, according to Goldman Sachs Group Inc. chief economist Jim O’Neill.”

August 16 – Bloomberg:  “Agricultural Bank of China Ltd. boosted the size of its initial public offering to $22.1 billion after selling more stock in Shanghai, making it the world’s largest first-time share sale.”

August 17 – Bloomberg (Sophie Leung):  “Hong Kong’s jobless rate fell to the lowest level since December 2008, encouraging consumers to spend and aiding the city’s recovery.  The rate for the three months ended July 31 was 4.3%, compared with 4.6% in the second quarter…”

Japan Watch:

August 19 – Financial Times (Michiyo Nakamoto):  “Chitose, a small city of 93,000 on Japan’s northernmost island of Hokkaido, seems an unlikely destination for Chinese home buyers.  But when Nitori Public, an advertising company, put 17 houses on the market there, they were snapped up by wealthy Chinese willing to pay about Y30m ($353,000) for a second home in Japan.  The city, which has an airport that serves Sapporo… is not the first choice among Japanese for a country home, but for Chinese visitors it offers a base in a popular holiday destination.  From Hokkaido in the north to Fukuoka in the south, estate agents report rising interest among Chinese for property for their own use and as an investment.”

Asia Bubble Watch:

August 18 – Bloomberg (Shamim Adam and Ranjeetha Pakiam):  “Malaysia’s economy grew near the fastest pace in a decade last quarter… Gross domestic product increased 8.9% in the three months through June from a year earlier, after expanding 10.1% in the first quarter…”

August 18 – Bloomberg (Max Estayo and Joel Guinto):  “The Philippines expects the economy to expand 5% this year and grow more than 7% from next year to 2016, Economic Planning Secretary Cayetano Paderanga said…”

Latin America Watch:

August 16 – Bloomberg (Helder Marinho and Telma Marotto):  “Banco do Brasil SA, Latin America´s largest lender by assets, said second-quarter profit rose 35% as economic growth encouraged consumers and companies to take out more loans… Outstanding loans in the country expanded almost 20% in June from a year earlier, to a record 1.53 trillion reais. It was the 16th consecutive month of credit expansion.”

Unbalanced Global Economy Watch:

August 17 – International Herald Tribune (Jack Ewing):  “Higher energy prices drove inflation in the euro area to an annual rate of 1.7% in July, the highest level in 20 months but still within the range considered acceptable by the European Central Bank…”

August 19 – Financial Times (Ralph Atkins and David Oakley):  “Germany’s economy will grow by 3% this year, according to a sharply upwardly revised Bundesbank forecast… The economic recovery in Europe’s largest economy was increasingly generating its own momentum, the country’s central bank reported… with positive ripple effects spreading to other eurozone countries.”

August 17 – Bloomberg (Johan Carlstrom):  “Swedish house prices rose for a 15th consecutive period in the three months through July even after the central bank raised interest rates to stem further gains.”

U.S. Bubble Economy Watch:

August 17 – Bloomberg (Joshua Zumbrun and Scott Lanman):  “Demand for loans at the majority of lenders in the U.S. failed to rise last quarter even as banks eased standards for the first time since the credit crisis began, a Federal Reserve survey showed.  Banks eased standards and most terms on loans to businesses of all sizes… The Fed described the change as ‘a modest unwinding of the widespread tightening that occurred over the past few years.’ Credit standards for small firms were loosened for the first time since late 2006.”

Central Bank Watch:

August 20 – Bloomberg (Christian Vits, Jana Randow and David Tweed):  “European Central Bank council member Axel Weber said the ECB should help banks through end-of-year liquidity tensions before determining in the first quarter when to withdraw emergency lending measures.  ‘Most of these discussions about the continuation of the exit I think will be focused on the first quarter,’ Weber, who heads Germany’s Bundesbank, said… ‘It’s clear that we need to re-embark on a normalization procedure.’”

August 17 – Bloomberg (Jennifer Ryan):  “Bank of England Governor Mervyn King said inflation is likely to exceed the U.K. government’s upper 3% limit in coming months as higher sales taxes drive gains in consumer prices.  King was today forced to write a third public letter this year after the Office for National Statistics said prices rose 3.1% in July from a year earlier after climbing 3.2% in June. Under U.K. law, King must write to the Treasury every three months when inflation exceeds 3%.”

GSE Watch:

August 20 – Bloomberg (Gregory Mott):  “U.S. Representative Barney Frank said the Obama administration must ensure the Federal Housing Finance Administration is using its full legal authority to recover money from banks that used fraud and deception to shift losses to Fannie Mae and Freddie Mac.  ‘Private companies sold Fannie and Freddie loans or securities based on fraudulent documents,’ Frank… wrote in a letter to President Barack Obama… ‘These transactions created private profits at public expense, and they should be fought with every tool at the companies’ and the agency’s disposal.’”

California Watch:

August 20 – Los Angeles Times (Alana Semuels):  “California employers cut their payrolls by 9,400 jobs in July, adding to worries that the labor market is weakening and the recovery is losing steam. The state’s unemployment rate remained constant at 12.3%.”

August 19 – Financial Times (Matthew Garrahan):  “California will be forced to issue IOUs to public workers and other creditors in lieu of cash in the next two months if a budget deadlock cannot be broken, the state’s financial controller has warned.  America’s most populous state faces a repeat of 2009, when a slumping economy and its failure to agree a budget caused an unprecedented fiscal crunch and the issuing of $2.6bn of IOUs, which damaged California’s credit rating and forced it to scrap some social programmes.”

August 16 – Bloomberg (Nicole Gelinas):  “The struggling city of Bell has ousted its overpriced executives. But its money troubles are far from over, thanks to a huge debt load.  By the end of the credit and real estate bubbles, Bell had amassed more than $77 million in direct debt. The city’s debt burden today clocks in at nearly three times its annual revenues. Debt in far wealthier New York City, by contrast, is less than 1.5 times its revenues.”

August 17 – Bloomberg (Dan Levy):  “Southern California home sales dropped the most in two years in July as unemployment and the end of a federal tax credit cut demand, MDA DataQuick said.  A total of 18,946 homes sold in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties, down 21% from both June and a year earlier…”

August 19 – Bloomberg (Dan Levy):  “San Francisco Bay Area home sales dropped to the lowest July total in 15 years as unemployment and the end of a federal tax credit kept buyers from making purchases, according to MDA DataQuick.”

New York Watch:

August 20 – Bloomberg (Michael Quint):  “New York State, which earlier this month closed a $9.2 billion deficit, expects a gap of $8.2 billion next year because of declining federal aid and the expiration of a temporary increase in income-tax rates.”

Speculator Watch:

August 18 – Bloomberg (Katherine Burton):  “Hedge-fund icon Stanley Druckenmiller is shutting his firm and ending a 30-year career after amassing one of the best long-term trading records in the industry and generating $1 billion for George Soros by forcing a devaluation of the British pound. Druckenmiller… said he was tired of the stress of managing money for others and frustrated by his failure in the past three years to match returns that had averaged 30% annually since 1986. His Duquesne Capital Management LLC, which oversees $12 billion and has never had a losing year, is down 5% in 2010.”

August 19 – Financial Times (Julie Creswell):  “They were revered as the brightest minds in finance, the ‘quants’ who could outwit Wall Street with their Ph.D.’s and superfast computers.  But after blundering through the financial panic, losing big in 2008 and lagging badly in 2009, these so-called quantitative investment managers no longer look like geniuses… The combined assets of quantitative funds specializing in United States stocks have plunged to $467 billion, from $1.2 trillion in 2007, a 61% decline, according to eVestment Alliance… One in four quant hedge funds has closed since 2007, according to Lipper Tass.  ‘If you go back to early 2008, when Bear Stearns blew up, that’s when a lot of quant managers got blown out of the water,’ said Neil Rue, a managing director with Pension Consulting Alliance… ‘For many, that was the beginning of the end,’ he added.”

The critical issue these days is whether global debt markets have succumbed to Bubble Dynamics…Are central bankers and markets accommodating history’s greatest expansion/inflation of non-productive government debt?

Nowhere from this (“inflationists”) camp do we see any recognition of the potentially catastrophic Bubble that – after years of migrating from one market to the next – has finally found its home right in the heart of our monetary system.

August 19 – Bloomberg (Laura Litvan):  “The U.S. Congressional Budget Office predicted the budget deficit for fiscal year 2011 will be $1.066 trillion, revised up from an estimate of $996 billion in March… CBO Director Doug Elmendorf said the agency’s projections haven’t changed significantly since its March forecast… ‘Unfortunately, this is a case where no news is not good news,’ Elmendorf said. ‘The country faces serious budget problems and serious economic problems.’ …The CBO said… the deficit for the current fiscal year ending Sept. 30 will be $1.34 trillion. That is 9.1% of GDP, or the second largest shortfall in the past 65 years, exceeded only by last year’s 9.9%.”

August 19 – MarketNews International (John Shaw):  “Congressional Budget Office director Doug Elmendorf said… his agency’s new fiscal report may ‘significantly underestimate’ the nation’s short-term deficit outlook because of the requirements of budget estimating.  …Elmendorf emphasized that under budget law the CBO must make its baseline estimates by assuming that current tax and spending laws are unchanged. He added the U.S. fiscal outlook would be ‘quite different’ if other, arguably more plausible, assumptions were made.  …‘This is an extraordinarily high level of debt’ when viewed in the context of American history, he said…”

“It’s important to be a diplomat for the diplomatic corps, it’s not so important for a central bank.  I think it’s very important for central banks to be clearly focused and also, if necessary, to deliver undiplomatic messages to governments.”  Bundesbank President Axel Weber, August 20, 2010 (interviewed by Bloomberg)

Push the inflation/deflation debate to the backburner.  The critical issue these days is whether global debt markets have succumbed to Bubble Dynamics. Are investors and speculators, once again, participating in a historic bout of (Hyman Minsky) “Ponzi Finance”? Is flawed policymaking fomenting yet another dangerous speculative Bubble and period of deepening economic maladjustment?  Are central bankers and markets accommodating history’s greatest expansion/inflation of non-productive government debt?

As an analyst who has for some time been warning of mounting risks associated with a Global Government Finance Bubble, it now seems obvious that the situation has taken a decided turn for the worst:  Bubble Dynamics have become more entrenched and dangerous, while policymaking has reached the precipice of outright failure.

There reaches a point in the evolution of a Credit Bubble where things really begin to get out of hand; the “terminal phase of excess.”  If policymakers fail to act forcefully to rein in “terminal” government borrowing excesses, they will be held hostage to escalating risks from an out of control Bubble (think mortgage finance Bubble 2005/’06).  There would be no turning back.  A consensus view is taking shape that would amount to the worst-case policy scenario from a Credit Bubble analysis perspective.

Some claim (reminiscent of views held back in 2002) that “fat tail” deflation risk is the critical issue. They argue forcefully for more extreme inflationary policymaking – larger deficits and additional Federal Reserve monetization.  With inflation now effectively out of the picture, they believe the only policy risk is a lack of resolve for inflating/stimulating sufficiently.  There is increasing contempt and ridicule directed at the Fed, Administration and Congress for not stimulating more aggressively.

Some argue that the Federal Reserve has a profound duty to balloon its balance sheet by monetizing Treasury debt.  They state that the Fed has a profound duty to sacrifice its independence, as it works in concert with extreme fiscal measures to eliminate deflation risk.  This is no more than New Age theorizing and experimental policymaking lacking of any historical basis of support.  It is, at the same time, a skillfully sophisticated version of age-old inflationism propaganda and monetary quackery.

Nowhere from this (“inflationists”) camp do we see any recognition of the potentially catastrophic Bubble that – after years of migrating from one market to the next – has finally found its home right in the heart of our monetary system. Indeed, the inflationists have deep disdain for Bubble analysis.  They write off the mortgage finance Bubble as a housing boom led astray by one-off failures in underwriting standards and supervision.  Such analysis ignores the key policy, monetary, and global market dynamics that only a few years ago were allowed to destroy the creditworthiness and market confidence in our system’s (non-government guaranteed) mortgage Credit (almost bringing down the global financial system).

I have posited that the 2008 bursting of the mortgage/Wall Street finance Bubble unleashed an even bigger (“mother of all…”) Bubble throughout global fixed-income marketplaces.  I trace today’s Bubble back at least to the Greenspan Fed’s 1987 post-crash systemic reliquefication. Resulting late-eighties’ excess led to severe early-90’s banking system impairment; followed by an another aggressive monetary policy response; the 1992/93 bond market Bubble; the 1994 bond bust and Mexican crisis; expanded monetary largess; the South East Asian Bubbles and collapses; additional policy accommodation; the Russian and LTCM fiascos; more extreme monetary stimulus; the resulting technology Bubble; and historic monetary stimulus and reliquefication leading to the mortgage/Wall Street Bubble.  Recent history of monetary disorder fueling serial boom and bust cycles is unequivocal.

From my analytical perspective, we’re in the midst of history’s greatest and most perilous financial Bubble.  And I am beside myself that nobody in a position of influence seems to care.  We’ve witnessed momentous analytical and policy errors over the years – and these blunders are allowed to repeat themselves without thorough analysis and review.  All this talk about fighting deflation and helping Main Street misses the point – and only feeds the Bubble.  I’m fed up with ideology trumping sound analysis.

Why is there no consensus recognizing that the number one priority must be to protect the soundness of our government debt market – the heart of contemporary “money.” For me, talk emanating from bond fund managers about how to help the average guy rings hollow.  It is fundamental to our nation’s future that we stabilize the government debt Bubble and secure the integrity of our monetary system.  The chorus of calls for larger deficits and greater Fed monetization is fueling distortions that risk financial calamity.

The Treasury Department’s conference this week on housing finance overhaul epitomizes the dysfunctional backdrop.  These days, Fannie, Freddie, Ginnie, the FHA, etc. ensure that mortgage borrowing costs are quite low and mortgage Credit reasonably available.  The mortgage market has already essentially been nationalized, and the GSEs are an unmitigated financial black hole.  Enough already.  Yet policy proposals are presented including a massive refinancing of current mortgages to reset at today’s historic low rates.  The idea seems impractical.  Yet such notions – proving that there are no longer any bounds on policy reasonableness or government intrusion – along with the possibility for a tsunamis of mortgage refis throw additional weight upon the Treasury yield collapse, while spurring general market instability (and big profits for those on the right side of the trade).

The U.S. housing mania was historic – and it’s over.  Mortgage Credit will not provide a meaningful source of system Credit expansion for some years to come.  This post-Bubble reality is misdiagnosed as “deflation.”  As we’ve already witnessed, even enormous fiscal and monetary stimulus does little to incite mortgage borrowing.  Just as post-tech Bubble reflation bypassed the technology sector in favor of inflating mortgage Credit, the MBS marketplace, and housing prices, today’s reflationary forces flow vigorously to government (and related) debt markets.

I found it interesting that hedge fund legend Stanley Druckenmiller announced his retirement this week, ending an incredible 30-year run in hedge fund management.  And today’s New York Times ran a story highlighting the ongoing difficulties suffered by the “quant” hedge funds.  Massive government stimulus may be benefiting bond fund managers, but it’s certainly not improving the overall functioning of the financial markets.  I would not be surprised if sophisticated market operators such as Mr. Druckenmiller look at the current backdrop and are content to exit the game before the bloody havoc of the next bursting Bubble.

As the great German economist Dr. Kurt Richebacher was fond of saying, “The only cure for a Bubble is not to allow it to inflate.”  Regrettably, there is little government policymaking can do in the short run to improve the situation.  There is, however, a great deal policymakers are doing to make a bad situation worse.  The current backdrop – certainly impacted by the Greek debt crisis, related market tumult and a faltering U.S. recovery – has created an elevated risk of further policy mistakes.

A multi-decade Credit Bubble badly distorted our economy’s underlying structure.  The harsh reality is that this structural maladjustment can only be rectified gradually over a period of many years.  There’s just no quick fix.  Ongoing massive fiscal and monetary stimulus only exacerbates our economy’s ills.  Moreover, it risks an inevitable crisis of confidence in our debt markets and monetary system.

The economy is muddling through right now.  It’s frustrating and discouraging but, under the circumstances, this is about the best we could have hoped for.  I am increasingly troubled by the direction (and tone) of economic analysis and policy discussion.  All the inflationism histrionics, including the notion that the Fed and Congress are committing a dereliction of duties by not stimulating more aggressively, are unhelpful.  Describing fiscal policy as increasingly “austere” is ridiculous.  But mostly, calls for the (un-independent) Federal Reserve to monetize a massive federal spending plan are as irresponsible as they are dangerous.

An increasing weight of evidence supports the global government finance Bubble thesis.  But, of course, there’s nothing like the euphoria associated with rapidly inflating asset prices (in this case bonds) to embolden those dismissive of Bubble analysis.  All the more reason that it is imperative that we not ignore this Bubble as we did the mortgage/Wall Street finance Bubble.  The risks and costs today are infinitely greater.

“The Fed should, and probably will change its tune by the fall and fire up the printing presses. Its current stance of watchful waiting in the face of slowing economic growth, inflation cycling below its preferred target rate of 1.7% to 2% and naggingly elevated unemployment strikes some observers as nothing short of mind-boggling. With good reason, these critics are pushing the Fed to adopt the deflation-fighting strategy that Bernanke mentioned in 2002, when he was a newly minted Fed governor. He suggested that the Fed could always buy long-term government bonds and corporate debt to mainline more liquidity into the financial system to counteract incipient deflation.”

Bernanke was correct back in 2002 when he pointed out that the Fed could always devalue the dollar by increasing its supply, but as far as we can tell that’s the only important economics concept he has ever been correct about. The problem with the whole approach of mainlining “more liquidity into the financial system to counteract incipient deflation” is manifold. First, creating more money doesn’t create more wealth or more real savings. Money, after all, is simply the medium of exchange. Second, when money is devalued by inflation (that is, by increasing its supply) the devaluation isn’t uniform; rather, some prices rise more than others. In fact, in the early stages of an inflation-driven monetary devaluation some prices — often the prices that the central bank and government are trying to support — will not rise at all or will continue to fall. These distortions of relative prices lead to mal-investments, which, in turn, lead to the destruction of real wealth. In other words, not only does increasing the money supply fail to expand the size of the ‘wealth pie’, it eventually brings about a reduction in the size of the pie. Third, devaluing money by increasing its supply punishes savers and anyone on a fixed income. This is not just misguided from a pragmatic economics perspective; it is ethically wrong.

One of the main reasons for the on-going popularity of the money-printing ’solution’ is the widespread belief that consumer spending — what many economists refer to as “aggregate demand” — drives economic growth. If you believe that economic strength is due to increasing aggregate demand and that economic weakness is due to falling, or inadequate, aggregate demand, then anything that gets consumers borrowing and spending will be seen as a plus. The reality, however, is that an increase in consumer spending is an effect, rather than a cause, of economic growth. The economic growth chain begins with saving/investing, moves along to increased production and ENDS with an increase in consumer spending. Is it really so hard to understand that for someone to consume more he must first produce more?

It’s actually not quite that simple, because it isn’t just a matter of producing more; it’s a matter of producing more of what people want today and will want in the future. For example, due to the inflation-fueled boom of 2003-2007 the US economy and many other economies geared up to produce far more houses per year than would be required to meet genuine/sustainable demand for new houses. Consequently, it is now essential for some of the resources dedicated to the housing industry to be reallocated. Exactly how should these resources be reallocated? The answer is that neither we nor anyone else is qualified to say. Price signals will determine the correct allocation, which is why the central bank and the government must avoid taking actions that distort prices. But instead of getting out of the way and letting the market clear, the policy-making clique has been doing what it can to support house prices and boost the demand for new homes.

The fear is that if the market is left to its own devices the economy will experience deflation. This fear is expressed as follows in the second-last paragraph of the Laing article:

“Once an economy succumbs to deflation, it’s often hellishly difficult for a nation to escape the trap. Companies and consumers alike tend to defer their spending on the assumption that prices for goods and services figure only to get cheaper in the future. Real interest rates spiral higher, making debt burdens all the more onerous. Forced collateral liquidations result, driving asset prices ever lower.”

In other words, the fear is that falling prices cause purchases to be postponed, leading to even lower prices and economic contraction.

If falling prices really did endlessly feed on themselves and result in the continual putting-off until tomorrow of purchases that would otherwise be made today, then almost no computers would be sold each year. After all, everyone knows that computing power gets cheaper every year. Also, if falling prices got in the way of economic growth then there would have been no growth in the US economy from the mid 1870s through to the mid 1890s, but the US economy grew more during this 20-year period of relentless “price deflation” than it did during any subsequent 20-year period. The fact is that there will always be many things that people want to buy in the present, even if they believe that these same things will cost less in the future. The fear of falling prices is therefore an imaginary hobgoblin designed to alarm the populace and provide justification for more inflation.

Laing’s article ends with: “It’s high time to get out the money-printing machines. Damn the risks of triggering a bit of inflation and some modest investment bubbles. The alternatives are far worse.”

Was absolutely nothing learned from the events of the past decade? Is it reasonable to believe that the US economy would be in a worse situation today if the Fed had let the market clear after the dot.com bubble collapsed, as opposed to fomenting new investment bubbles in housing, mortgage finance and securitisation? Given that the US economy has achieved ZERO growth in private-sector employment over the past 10 years, how much worse could the situation realistically be?