In Denial of Crisis : An Economy Undermined by Failures of the Monetary System, the Concentrated Media, and Political Will

June 2005 David Jensen is the Principal of Jensen Strategic (www.jensenstrategic.com) a Vancouver-based strategic planning and business advisory services company. The following commentary is not investment advice.

With economic growth estimates for 2005 of 2.5% and 3.4% respectively, Canada and the US look forward to steady if not stellar growth of their economies in the coming year. The Bank of Canada notes for 2005 that the prospects for continued robust growth are quite favorable1 . Yet all is not as promising as it seems. Central Banks (Canadas and the U.S.s included),on false grounding in economics and using a monetary system based-upon an endless cycle of debt creation, have for decades maintained that the economy could be controlled by central planning and manipulating the amount of money and interest rates in the economy. This has allowed over-spending for massive government programs, unsupportable promises of future benefits to retirees, and costly military adventures all incredibly coupled with seemingly endless growth in consumers net worth and consumption. In a repeat of errors committed in the 1920s, failure of central bank monetary policy led to the1990s dot.com stock market bubble and correction in 2000 which now reveals a distorted economy saturated with unsustainable and increasing levels of debt just to continue the economy. The post-bubble response of the US Federal Reserve Bank in lowering interest rates to 1% now leads to rampant and destabilizing financial speculative bubbles in the economy including the North America-wide real estate bubble. We have a concentrated media in both Canada and the U.S, which has provided little critical analysis of economic policy choices, and a political ruling class most interested in short-term crises and solutions, which hand-off chronic but acute problems to the next elected official. The result is in that we have not had any accountability and correction of highly visible economic policy failures by our government and monetary authorities that have been visible for years. We are now on the brink of a strong economic correction likely impacting our populations for generations. Immediate and bold remedial action by government is required to mitigate the impact of the coming correction. ----------------------------------Under the placid surface [of the economy], there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. Paul Volcker, Former US Federal Reserve Bank Chairman 2 April 10, 2005. ----------------------------------If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered Thomas Jefferson The Debate Over the Recharter of the Bank Bill, 1809 -----------------------------------

The above two statements were made almost 200 years apart, however, they have a common concern the consequent damage from the manipulation of the money stock (i.e. the money that exists in society) for economic gain. Economists and politicians have long known that increasing the money stock has the beneficial consequence of stimulating the economy. The initial short-term effect is that it increases the money available to be spent and invested which for a period increases economic activity. However, manipulation of the money supply has negative consequences which have damaged countries (including Canada and the U.S.) who travel down this road, including: 1. Inflation. In simple terms, with a fixed amount of goods in an economy, increasing the stock or amount of money (called the money stock by economists) results in more dollars being available for a basket of goods, causing inflation (or a rise) in the price of goods. Damaging because it impoverishes those holding savings and those on fixed incomes, price inflation of goods in the economy has a further negative impact in that, once it starts to climb, hoarding behavior by consumers and businesses to forward purchase goods creates artificial shortages driving prices even higher in a damaging spiral. Once the inflation spiral is started, it can only be shaken from the economy through an economic slowdown usually induced by sharply higher interest rates. 2. Investment bubbles and mania. Examples include: ! 1920s stock market mania leading to the 1929 Crash followed by the 1930s Depression; ! the 1989 Nikkei stock market and real estate bubble in Japan followed by a 15 year malaise in Japan; and ! the 1990s dot.com stock market bubble followed by its correction in 2000; a market bubble and crash which created by and has now been so mal-addressed by the US Central Bank (the Federal Reserve or Fed) that we face our impending economic correction 3. Inevitable internal economic distortion resulting in growing imbalances which ultimately correct with economic busts, deep recessions and depressions. It is the last item which politicians, central bankers, and economists popular in the political realm have denied is a consequence of their centrally-planned monetary control. Readers in Canada or the U.S. will likely not have a concern regarding the current economy however, as Chairman Volcker notes, large distortions exist beneath the surface which will manifest themselves. These distortions and coming correction are visible to our political leaders, but while Volcker notes that urgent action is needed, he also notes governments tend to react after the fact which in this case will impart great damage to the both the U.S. and Canada. The coming economic fall-out now militates that the damaging, anachronistic centrally-planned attempts by central banks and politicians to steer the economy using the monetary system must be curtailed. Jeffersons Insight If we read Jeffersons comments with todays definition of inflation and deflation, it makes little apparent sense. However, the meaning of the words inflation and deflation have changed over time so that they now mean, respectively, an increase or decrease in consumer goods prices. In their more classic economic sense, inflation refers to an in increase in the money stock (cash and debt) outstanding in the society. Deflation refers to a decrease in the money stock. Jeffersons warning now becomes a little clearer. History is riddled with monetary inflation accompanied by uneconomic activity, speculative booms, and investment mania, all resulting from the excess inflation of the money stock, followed by crashes. There is nothing surprising or even unreasonable about market speculation so long as one realizes the dynamic causing the speculation and limits exposure be it real estate, equities, bonds, interest rate derivatives, and other financial instruments. However, few retail investors do understand

when a bubble is underway and the top usually occurs after the flow of new credit or increases in the money stock starts to slow a visible signal within the financial system but not to the average investor. Extraordinary Popular Delusions and the Madness of Crowds3 was initially published in 1841 and documented excess credit and money creation inducing trading bubbles and collapses such as the Dutch Tulip Mania (Holland - 1630s), John Laws Mississippi Scheme (France 1720 : a stock market bubble engulfing France induced by massive inflation (or debasement) of Frances money stock), The South Sea Bubble (England 1720 : investment mania where even Sir Isaac Newton lost his family fortune), etc. In a more recent work4, Edward Chancellor documents more than a dozen historical and contemporary monetary and credit booms that drove speculative mania including the 1920s stock boom, the late 1980s Nikkei stock market and real estate boom in Japan, and the 1990s dot.com stock market bubble in the US. The excess which can be attained during an investment bubble are well illustrated by the following words from an investment prospectus to raise money during the South-Sea Bubble of 1720: A company for carrying on an undertaking of great advantage, but nobody to know what it is. 5 Creation of investment bubbles and their subsequent crashes are directly and obviously negative as they simply result in the transfer of wealth from the public to those promoting investments (such as through Initial Public Offerings (IPOs) of a stock ) during an investment bubble. Thus, the phenomenon of speculative boom and bust acts as a wealth ratchet. The financial industry, speculators, stock industry promoters and traders make enormous profits on the ascent stage and, if savvy, can roll-out of investments with gains into cash or other stable asset positions before a correction, then buy assets at prices of pennies to the dollar in the subsequent bust when investors must liquidate assets to settle losses. Key bankers, politicians, and Wall Street traders wanted the creation of the U.S.s central bank in 1913 and worked through a White House insider Edward Mandell Colonel House to see the Federal Reserve Act developed and passed. ( Colonel House was a wealthy Texas patrician who had never served in the military and whose family fortune was acquired by his father in the South during the American Civil War. ) Although called the Glass-Owen Bill (after Congressman Carter Glass and Senator Robert Owen), the Federal Reserve Act was the creation of President Wilsons point-man on banking matters, Colonel House. The immediate effect of the creation of the new central bank (The U.S. Federal Reserve Bank) to control the money supply was the price inflation of 1914 to 1920, then the 1920s stock market mania and crash of 1929 which revealed that average citizens who were skeptical of the wisdom of creating a central bank were correct. That the Fed caused the stock market bubble resulting in the crash of 1929 and the Great Depression is not argued by todays supporters of the Fed. In 2002, at the 90th birthday party for famed economist and monetarist Milton Friedman, then Fed Governor Ben Bernanke commented You were right, we did it. But thanks to you we wont do it again. 6 Whether the Fed and other central banks can prevent another financial rupture is a question on which the jury is still very much out. Our Stable Economy Stable or a Redux to Another Apparently Stable Time? So what is former Chairman Volckers concern today? The economy is healthy: inflation is apparently low, the stock market has corrected to lower stock price to company earnings (p/e) ratios, the housing market is booming, we are looking forward to further growth: whats the problem? First, The US (and in fact the Worlds) economy is still very much in recovery from the dot.com stock market crash of March 2000. As we will see, Mr. Greenspans declared victory when stating we were very much correct in our decision to address the after-effects of the bubble rather than the bubble itself may have been a little premature. The stock market bubble of the late 1990s was a textbook recreation of the 1929 bubble and the late 1980s Japanese Nikkei stock market and real estate bubble. They all relied upon the creation of excess credit in turn brought about by excessive monetary policy of central banks (note that money enters the economy as loans from banks to borrowers. Increasing the money stock therefore means increasing the debt level in the economy).

The origin of the 1920s stock market bubble, notes Economist Murray Rothbard was that, in order to assist Britain in artificially maintaining the strength of its currency while it was in economic decline, America increased its money stock by an average of 7.7% annually over an 8 year period from 1921 to 1929. In his words, it was a very sizable degree of (monetary) inflation 7 and the entire monetary expansion took place in money substitutes which are products of credit creation The prime factor in generating the (monetary) inflation of the 1920s was the increase in the total bank reserves. 8. Yet, like today, while the 1920s economy roared ahead, consumer price inflation was apparently tame while the stock market appeared reasonably priced. Rothbard notes The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.9 Economists who support manipulation of the economy by varying the money stock and interest rates are dubbed monetarists. The father of modern monetarism and the Quantity Theory of Money, which is the basis of central bankers expansion of the money supply, is Irving Fisher, who was himself so enthused about future prospects that in October 1929, one week before the markets crashed, he made his famous (mis)statement: Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months 10 Irving Fisher The DOW would decline 89% from its 1929 peak value of 381 bottoming 3 years later in 1932 at 40. Fisher who had a net personal wealth of $10 million from designing and patenting the Rolodex, lost his entire fortune in the crash and ultimately died penniless. But his Quantity Theory of Money still built favor with economists, politicians and central bankers of the future. What Fisher missed, and one of the reasons there are so few billionaire economists, was their fundamental misunderstanding of the economy and the distortions engendered by their monetarist economic theory. Like today, after administering the wrong thing (excess money (debt) creation), they were measuring the wrong things (goods inflation) and had a crucial misunderstanding regarding the apparently limitless suspension of the 1920s economy distorted by more than a decade of excess monetary and credit expansion. To this day, monetarist economists suggest that there was nothing wrong with the stock market in 1929. The National Bureau of Economic Research (NBER) issued a working paper in December 2001 titled The Stock Market Crash of 1929 Irving Fisher was Right (McGrattan and Prescott) in which they stated We find that the stock market in 1929 did not crash because the market was overvalued. In fact, the evidence strongly suggests that stocks were undervalued, even at their peak. The Federal Reserve agrees. In March 1999, the Federal Reserve Bank of San Francisco issued an Economic Letter that stated that with stock prices at 30 times dividend yields, the market was not overvalued 11. (For a clear-eyed comparison of todays and the 1920s economy, see the article How Could Irving Fisher Have Been So Wrong? by Doug Noland - available on the internet 12 ) The standard response by economists of todays Milton Friedman / Irving Fisher monetarist school is that the depression of the 1930s was caused by Fed incompetence in not increasing the money stock adequately in response to the crash starting in 1929. In fact between January 1930 and December 1933, the Fed did intervene by increasing their purchases of bonds from Banks by 98% per annum thereby injecting dollars into the banking system13. This added $2 Billion to bank reserves which should have resulted in further loans and an attendant increase in economic activity. However, bank credit contracted 30% during this period as the initial contraction had revealed the non-productive nature of many enterprises and speculative investments and their dependence upon repeated rounds of financing used to sustain the boom. The excess credit financing of speculative and unproductive activities dried-up as did consumer stomach for debt a form of credit revulsion took hold and the economy slowed (ultimately declining almost 50% by the mid 1930s) shaking-out the unproductive enterprises that had grown in the economy after a decade of loose credit. That economists like Milton Friedman and Fed Chairman Greenspan could today advocate that a stock market bubble and crash caused by excess credit accompanied by resultant economic distortions could and should be addressed by even more excess credit, raises serious questions. And yet, that has been Chairman Greenspan

and the Feds response to the correction of the 1990s dot.com stock market bubble the Fed and Treasury Secretary Robert Rubin started in 1995 with their strong dollar policy (we will see it was anything but). The U.S. and Canada now find themselves in an economic corner. There is a need to continue raising interest rates to combat rising inflation yet we are surrounded by investment bubbles and a housing bubble which will strongly correct if the required action is taken by our central banks. Origins of the dot.com Bubble and Post-Bubble Federal Reserve Action In 1993 and 1994, the Fed increased the broad money stock (called M3) by roughly $80 Billion each year. In 1995 the Fed suddenly reversed policy and started growing the money stock in the U.S. by larger amounts each year thereafter ( up $267 Billion in 1995 and rising until it was increased $597 Billion in 1998) the stock markets immediately responded with the Dow Industrials Index growing 34% in 1995 vs. an historical annual average of 10%. In December 1996 when the Dow was at 6,500 (up 71% from it level of 3,861 in January 1995, 2 years earlier ) Greenspan warned of irrational exuberance. Instead of cutting the annual growth of the money stock, The Fed accelerated its growth and all US stock markets grew tremendously until the bubble pop in March 2000. From 1998 on, Greenspan lost his concern about irrational exuberance lauding the new economy and technologically driven productivity as justifying the elevated stock market levels. The Dow closed 1999 at 10,970 having increased more than 7,000 points (gaining more than 200%) in just 5 years and the NASDAQ gained more than 500% from a starting value of 752 points in January 1995 to an ultimate peak of over 5,000.

U.S. Stock Markets vs. Annual Money Stock (M3) Growth

600
$597 B.

$650
$577 B.

500

$550
$479 B. $507 B.

U.S. Stock Markets . (1993 = 100)

400
$347 B.

$350 300
$268 B.

$250 200 $150

$80 B. $83 B.

100

$50

0 1993 1994 1995 1996 1997 1998 1999 2000

-$50

Year End

Dow Jones Year End (1993 = 100) NASDAQ Year End (1993 = 100) M3 Money Stock Growth ($ Billions)

Source: U.S. Federal Reserve (Money Stock Data)

The creation and crash of the dot.com stock market bubble represented a complete failure of the Federal Reserve central bank yet no accountability or consequences have stemmed from this failure either at the Fed, in the financial industry or in the media which all cheered on and justified the wildly inflated market as it grew 14. Unchastened, Greenspan went on in 2001 to encourage the massive Bush administration tax cuts despite the fact that the Congressional Budget Office warned that capital gains and other taxes received by the Government would drop along with the declining stock market craze and corporate profits were projected to grow modestly until 2010 15.

Annual M3 Growth . ( $ Billions )

$450

Given the Feds money (debt) creation combined with further government deficits, the U.S. economy is now more financially indebted than at any other time in history exceeding even the debt vs. GDP levels of 1934 which were only attained after the U.S. economy GDP declined almost 50% during the great depression.

Source: Clapboard Hill Investment Partners; Barrons Magazine

In the aftermath of the crash in 2000 of the dot.com stock market bubble, the Fed and U.S. Treasury Department (now under the auspices of President Bushs Treasury Secretary Paul ONeill) stood ready to make sure that everyone could continue to access credit to rescue the economy and the markets. In January 2001 interest rates were first lowered from an initial 6.5 % Fed Funds Rate to an ultimate 1% (the Fed Funds determines short term interest rates in the credit system).

Before the Feds low interest rate response to the dot.com market crash, there were clear warnings made to the Fed about an already developing real estate bubble. The Fed insisted that a real estate bubble was not possible as the U.S. real estate market was composed of many small markets. The Fed now says it has heard anecdotal evidence that some real estate markets may be somewhat frothy. Single family homes in the entire state of California, representing 20% of the U.S. real estate stock, have increased 35% in price in the last 2 years where single family dwellings are currently 290% of their 1997 price level. The California market has now hit the silly stage where home purchases are financed with risky financing methods such as increasing principal loans where the borrower does not pay the full monthly interest on a mortgage (and hopes the house increases in value at a faster rate than the increase in the loan principal). Home prices in North America increased by double digit rates in 2004.

Source: www.prudentbear.com

With low interest rates and sharply rising real estate values, consumers were quick to spend their new found wealth through cash-out home mortgage refinancing and home equity loans. However, this only represents an increase in indebtedness relying on artificially inflated assets as collateral, not a creation of new or sustainable wealth in the U.S. economy (Noland). The low cost of borrowed money fed speculative finance activity not only in real estate, but also in bonds, derivatives, and the stock markets. Although the stock markets have corrected from historically high valuations, they continue to be over-valued on historical terms. US stock market performance has tracked the Nikkei post 1989 crash profile while, with the lowering of interest rates, yet speculation has returned to the stock markets along with increasing overvaluation of stocks. Excess has returned the market value of the internet stock Google is now over $76 billion with a p/e ratio of 109.

In aggregate, stocks are still over-valued compared to historical norms:

Source: Century Management Inc.

A Distorted Economy Item: The U.S. has a total debt (Government, Corporate, and Household combined) of $38 Trillion. In addition, in 2002 Treasury Secretary Paul ONeill commissioned a report identifying that the U.S. had future unfunded entitlement liabilities (Medicare, Medicaid, and Social Security) with a present value of $43 Trillion16 which in 2002 would have required an immediate and perpetual income tax of 69% if they were to be met. The U.S.s net annual economic production (Gross Domestic Product or GDP) is $11.75 Trillion with a current budget deficit of $500 Billion per year (includes Iraq War costs). It is clear from these numbers that, even if the economy was healthy, these debts and liabilities cannot be paid. Item: According to the Fed, In 2004 U.S. debt (government, corporate and household combined) increased by $2.72 Trillion dollars17 (23% of GDP) yet this debt spending in the U.S. Economy can only produce economic growth this year of 3.4% of GDP. Thus $6.50 of debt increase is producing $1 of growth in the economy. Item: The U.S. requires an injection of $2 Billion in foreign investment each day to sustain its economy absorbing more than 80% of the Worlds annual savings. Something is amiss. After decades of monetary and debt injections to provide a fix for the economy, the U.S. economy now stands saturated and severely distorted by its credit excess. From a vitally productive and inventive society to one where financial speculation reigns supreme, the US economy has been transformed to a financial betting parlor. Where, historically, manufacturing had accounted for 45% of business profits and financial services accounted for 15%, this relationship has been turned on its ear in the new economy with less than 15% of profits now generated by the manufacturing sector and 45% of profits generated by shuffling paper in the financial sector (stocks, bonds, derivatives, mortgage financing, etc.) . According to the U.S. Bureau of Labor Statistics, the Financial Services Industry accounts for 6% of current U.S. employment giving a sense of outsize profits being generated by the Financial Services sector.

Source : Bridgewater Associates; The Money Shufflers Vig

Globalization was one of the critical component of the Greenspan / Rubin strong dollar policy talk which was initiated in 1995 it was actually a gross, inflationary dilution of the US dollar (the strong dollar policy position is today amusingly repeated by the Bush Administration Treasury Secretary John Snow despite U.S. Federal Reserve policy, deficit spending and trade policy which is flooding the world with US dollar debt and money). The service industry jobs which were supposed to be generated by globalization have been muted. Instead, the internet driven global arbitrage in labor, as identified by Morgan Stanleys Chief Economist Stephen Roach, has led to a transfer of high skills job out of the U.S. service industry. Operations in China and India using highly educated and skilled workers can provide overnight legal, accounting, engineering and business services over the internet at a fraction of the price of North American service providers. Instead of gradually transitioning to a free trade environment, the U.S. markets door has been swung wideopen. While this has gutted the production base of the U.S., the pressure of Chinese worker salaries of $0.50 per hour and lax Chinese environmental laws on the U.S. factory worker wages until recently kept consumer goods price inflation at bay. Cheap imports have effectively served as a substitute for prudent stewardship of the money stock by obscuring central bank monetary inflation. This allowed the Fed and Treasury under the Bush Administration to lower interest rates to 1% resulting in a further injection of debt into the economy thereby delaying the consequences of the popping of the dot.com stock market bubble. The correction we face with a housing bubble added to the fray will now be much worse. The depressing impact of cheap imported goods in the manufacturing industry, in combination with the distorting economic impact of the Feds decades of credit creation on the U.S. economy, have resulted in the economic recovery since the 2001 post-bubble recession posting no net private sector job growth despite claims the economy is healthy. According to Morgan Stanley, the U.S. now has 10 million fewer jobs post the dot.com economic decline than it would in an average previous recovery18.

Source: www.jobwatch.org May 4, 2005 Bulletin.

While the official unemployment rate has declined from 6.3% in 2003 to 5.2% in 2005, the actual percentage of the workforce that is employed has declined from over 67% of the population in 2000 to 65.5% of the population in 2005 this despite an increase in the number of elderly forced back into the workforce after the 2000 stock market correction19. These contradictory figures arise because the U.S. and Canada both define those unemployed only in terms of individuals actually looking for work. If jobs are not available and an unemployed person is discouraged and in recent weeks has not actively searched for a job, they are no longer counted as unemployed and the government can ignore them in the unemployment survey. The Chinese economic miracle with unheard of 15+ % per year economic growth is itself the product not only of the U.S. export market but also of central bank monetary distortion within the Chinese economy. In the headlong rush to develop Chinese infrastructure and import technology in the shortest term possible, rather than grow at a measured pace that can be maintained over the long-term, loose Chinese central bank policy has resulted in Chinese banks now sitting on $US 800 billion of bad (or in banking parlance non-performing) loans equating to 50% of GDP. Also like the U.S., China maintains interest rates below the inflation rate. Chinese goods are thus subsidized by their own expandable elastic money system and with prices that do not reflect the true cost of production within China. With a declining U.S. economy and rising inflation, it will be increasingly difficult for foreign investors to continue to finance the U.S. deficits at 4% interest on a 10-year bond and sustain the real estate and speculative investment booms in the U.S. Not covered well in the media, is that in September 2004 and November 2004, the Japanese and Chinese, who had been the major purchasers of U.S. Treasury debt, veritably stopped their purchases. How long Caribbean Banking Centers 20, who initially filled the gap as foreign purchasers of U.S. bonds, can sustain the U.S.s debt addiction is open to question. All the while, both Canadian and US household debt is increasing each year by more than 10% per annum. This path is unsustainable, yet U.S. and Canadian leaders have chosen the path of cheerleading the economy along with an obeisant media. And each day consumers are led on by rising and unsustainable housing market prices and a sense that the economy is healthy, to walk deeper and deeper into the quicksand of debt.

The Central Bankers Delusion : The Root of Our Economic Malaise In his book Debt and Delusion: Central Bank Follies that Threaten Economic Disaster 21, Peter Warburton identifies that deregulation of the worlds financial markets since the 1970s allowed central banks to embark on a trajectory of inflating the money stock thereby also inflating by multiples the worlds stock, bond and real estate markets - this all while apparently containing price inflation (for an good summary of Warburtons book, see the paper Debt and Delusion commentary by Robert Blumen at www.mises.org/fullstory.aspx?control=1579&id=71 ). The containment of inflation depends upon ones definition of inflation. With the monetary injection into the economies of the West, investment values in almost all financial asset classes have ballooned with the stimulus of the money injected. The worlds equity (stock) markets are now valued at more than $26 Trillion; the bond market has grown from less than $1 trillion in 1970, to $23 trillion in 1997, and $43 trillion in 200222. Real estate is in a bubble. And the derivativesi markets have grown to total invested values of $9.1 Trillion and using financial leverage to multiply the opportunity for gain (but also loss), the levered exposure value of these derivatives (what the Bank of International Settlement optimistically calls notional value) has grown from $47 Trillion in 1995 to now exceeding more than $200 Trillion more than 500% of the worlds entire annual economic output23. Inflation, while very much around us, has until recently been constrained to financial investments while central bankers have claimed that their inflation of the money supply has not produced classic consumer goods price inflation.

Derivatives are financial instruments reflecting a bet upon some underlying market characteristic such as interest rates or the price of commodities. Derivatives include instruments such as futures, puts, calls, swaps etc.

Interest rate related derivative instruments (70% of outstanding derivatives), in particular, are sensitive to sharp interest rate moves. ii Fed intervention to buffer investment losses are a previous pattern of Chairman Greenspan as the Fed has invariably turned to liquidity injections and bail-outs of destabilized market participants in times of crisis ( 1987 stock market crash, 1997 Asian currency crisis, 1998 LTCM bail-out, etc.). Lulled by past Fed Intervention and soothing words during Greenspans tenure, spiking interest rates are something the bond and derivatives speculators are betting wont happen. The financial system risk which derivatives represent have long been known (derivatives have been labeled weapons of mass destruction), yet Greenspan has for years argued against regulation of the derivatives market. If there is a sufficient interest rate acceleration, this market can quickly lock-up as the levered nature of derivatives which multiplies losses means that, without regulated derivatives exchanges, large amounts of money can quickly be lost and derivatives holders on the wrong side of a trend can be quickly financially bankrupted. Given the level of unstable and levered risk in this market which exceed greatly exceed the assets of all financial trading institutions combined and entering a period where inflation has started to rise, the financial system is particularly vulnerable. Past Fed monetary policy and intervention has combined to form this lethal mixture: excess liquidity and low interest rates combined with the creation of moral hazard as market speculators believe that any crisis brought on by speculative excess will be buffered by a Federal Reserve bailout. In this vein, Warburton notes the danger in central banks serving as the interventional saviors or lenders of last resort (LLRs) to bail-out with public money not just banks but private sector entities which are designated as too big to fail. In Warburtons words Central banks unquestioned roles as LLRs to the commercial banks and guardians of the financial system maintain an ambiguity over the ultimate responsibility for catastrophic loss, however and wherever it occurs. This ambiguity has promoted excessive risk-taking in the private sector and has fostered the very circumstances in which financial disasters have occurred before. 24 Until recently, consumer goods inflation were restrained in their price rises because (1) Globalization providing cheap imports have until now capped consumer goods prices, (2) our governments have defined inflation measures in a way that understates true price rises (see discussion below), and (3) financial investment vehicles have absorbed the lions share of the profligate money creation bloating all investment classes during this period.

Much has been written about the unregulated derivatives market and the threat of systemic instability that it poses to the monetary system (for a derivatives primer, see: http://www.financialpolicy.org/dscprimers.htm; for a discussion regarding the dangers posed by derivatives, see: http://www.ex.ac.uk/~RDavies/arian/scandals/derivatives.html & http://www.financialpolicy.org/fpfspr8.pdf )

ii

This is the failure of the Fed and the all the worlds central banks: they have viewed inflation in terms of prices of goods in society as opposed to an increase in the money stock and have increased money and debt in society believing they were free to do so without understanding distortion this engenders in the operating structure of the economy. While the inflationary monetary liquidity is locked in the financial markets, our notion is that consumer price inflation remains apparently stable however, if speculation in commodities and then goods inflation occurs or if investors seek stability by investing in commodities and traditional safe havens such as precious metals, then even a relatively small portion leaking from the multi-trillion dollar financial investment silos can drive commodities prices skyward thereby resulting in an explosive appearance of consumer price inflation, forcing up interest rates to contain the inflation. The kimono so cleverly hiding central bank fiat monetary inflation for decades will suddenly be dropped. In a perverse replay of the 1970s, we may potentially see loose monetary policy followed by weak economic growth and rising commodity prices (or stagflation) except in this version we will have twice the debt-to-GDP ratio and investment bubbles as the inflation starts to manifest itself. Speculation in commodities has already started. Driven both by international demand as well as a hedging against currency declines, the past 4 years have seen a 65% increase in the price of commodities shown in the CRB Commodities Index chart below. Inflation has now also reared its head in the U.S. consumer price index which is rising at an annualized 6.2% in the first quarter of 2005 and 3.5% in the 12 months through the first quarter. And these price rises are in spite of cheap import compressing price rises in the economy.

The manifestation of strong goods price inflation can result in one of two responses by the Fed and the Worlds central banks : With an aim to maintaining foreign investor confidence, defend the dollar and ultimately other fiat currencies by strongly raising interest rates. This would eventually control inflation but pop the debtdependent investment and asset bubbles (including the real estate bubble) with severe economic fallout. This would leave heavily indebted consumers in a form of indebted servitude unable to paydown debt incurred in a low interest rate, real estate bubble environment. Abandon defense of the dollar injecting massive amounts of liquidity (money) into the banking system resulting in a hyper inflationary spiral and ultimate collapse of existing paper currencies. There is third scenario which is unlikely. However, the loss of personal privacy and freedoms in the US and Canada since the 9/11 War on Terror was initiated makes what would have seemed absolutely impossible a decade ago now at least a considered, although remote, possibility. That would be to declare the free market too dangerous and the imposition of tighter government control over the economy and individuals (a scenario

suggested by Jim Sinclair Mr. Gold of www.jsmineset.com ). It would be an irony indeed that an economic emergency caused by the failed paradigm of central planning in turn applied by central banks to a mal-designed monetary system should be deemed a failure of the free market. The game now remains one of confident statements by central bankers and politicians worldwide to continue the debt, investment and speculation cycle in financial markets. Inflation is contained; commodities price surges are temporary; the world foresees steady growth. It is essential that the silos of investment capital, that have temporarily enabled their policies, be maintained and constrain capital from flowing into commodities and precious metals. Former Federal Reserve Governor Ben Bernankes 2002 statement that the Fed stood ready to drop money from helicopters if deflation becomes a threat, perhaps becomes clearer. What sounded like an irresponsible boast made some look the wrong way (away from speculation in commodities) by giving the impression the Fed was fighting deflation, an environment where commodities lose value, not the explosive inflation that lies in the wings. The irony in Bernankes statement is that the Fed and central banks have been figuratively dropping money from helicopters for decades. A U.S. national savings rate being below 1% of GDP ( a record low vs. an historical norm of approximately 6% of GDP) has been driven by the Fed interest rate being lowered to its low of 1% (and at 3% today, still below the rate of inflation). This has made the U.S. dependent upon foreign sources for financing of budget deficits and trade deficit requiring the daily injection of $ 2 billion of foreign capital. With the Japanese and Chinese pause in US Treasuries purchases, a sustainable source of foreign financing for the US has not yet appeared. Foreign investors already hold more than $5 Trillion in U.S. Treasuries, currency and stocks alone. A decline in foreign appetite for U.S. investments can send investment paper washing back to the U.S. Just a slowdown of US debt purchase by foreigners, not a full stoppage or dumping of U.S. dollars, is all that is required to cause a further fall in the US dollar and interest rates to rise steeply disrupting markets and precipitating a further decline of US investments held by foreigners. Compounding the tenuous nature of the current situation is that 60% of the outstanding $4.5 trillion U.S. Treasury bonds (net $2.7 Trillion) in the hands of the foreign and domestic public will mature within the next 3 years. Thus in addition to the $500 billion in treasuries that need to be floated each year to finance the budget deficit and the Iraq war, another $900 billion on average must be rolled-over into new bonds to continue the U.S. debt at the current low interest rates 25. In total, $1.4 trillion of U.S. Treasuries need to be purchased each year by foreign and domestic investors unless the Fed wishes to print more money and purchase the bonds itself. This is perfectly possible but will be attended by much higher interest rates as even the lethargic bond vigilantes recognize the aggressive dollar dilution this signals. How did we ever get to this point? That the money stock can today be manipulated at will by central banks is a consequence of our current unbacked (or fiat ) monetary system. In years past, the worlds industrial economies were limited in their ability to manipulate the money stock as most currencies were on a strict gold standard. Gold backed a countrys money at a fixed ratio and currency was freely redeemable for gold from a countrys treasury and banks at that fixed ratio. Because the gold standard monetary system prevents limitless creation of money, it has been noted: Gold is an unimaginative taskmaster. It demands that men, banks, and government be honest. It demands that they create no debt without seeing clearly how these debts can be paid But when a country creates debt light-heartedly, then gold grow nervous. There comes a flight of capital (gold) out of the country. 26 Benjamin M. Anderson Much to the bane of politicians and central banks, currency backed at a fixed gold ratio and freely redeemable for gold coin from a countrys banks and Treasury allows that currencys citizen holders to convert that currency to gold coin and to either hold it in hand or safety deposit boxes within a country. Foreign holders could also

remove the gold from a country that exercises economic policy that cannot be supported by reasonable taxation and fiscal policy. By removing the backing mechanism (gold) from banks and the Treasury, such action essentially removes money from circulation within that country forcing-up interest rates and forcing a change in policy by the offending government (Fekete). This disciplinary problem was addressed gradually over the 20th Century by governments transition to todays monetary system where no currency redeemable in gold thus allowing central banks to control the money supply by central bank edict or fiat - a privilege that all have abused. With the elastic, fiat monetary system where the money stock is freely expandable, Governments are able to generate large debts by issuing government bonds then dissipating the debt at a later date by printingiii currency to consume that debt by inflationary dilution and devaluation. Creation of money to stimulate an economy is nothing new. The Romans secretly diluted their silver coins and the Chinese (the first to use paper money) experienced monetary inflations in the 1300s. During the 20th Century the world witnessed Weimar Germany undergoing hyperinflation (defined as more than 50% per month) in 1922 1923 which consumed its WW I reparations debt. Serbia issued 500 billion dinar notes as recently as 1993 with daily rates of inflation of 100%. Hyperinflationary periods result in currency crashes so the helicopter money scenario discussed by Ben Bernanke is not an attractive scenario. In the U.S., the United States Revolutionary War in 1775 was financed by the Continental Congress issuing notes (Continentals) which were unbacked by gold or silver and were predictably printed and inflated to worthlessness leading to the saying not worth a Continental and George Washington to comment A wagonload of currency will hardly purchase a wagonload of provisions. 27 This as well as other bank currency schemes in the 1800s left a deep and abiding distrust for irredeemable paper currency in the American people. ---------------------------------------------------------------How is money created and the money stock controlled? This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system Robert H. Hamphill, Formerly of the Atlanta Federal Reserve Bank Three concepts are key to understanding the creation of money,. 1. When we think of money, we tend to think of cash both bills and coin. However, less than 5% of money exists in this form - the majority of money in existence exists as bank deposits. They are merely accounting totals. 2. All money in existence has come into existence as a loan and reflects a current loan in the financial system. The constant increase in the money stock reflects a continual increase in debt in the fiat money banking system. Conversely, if loans are paid-down, the money stock contracts. 3. Money is created by Banks , not the government or the central bank, with loans injecting money into the monetary system and economy. Banks simply credit accounts by making loans in response to two mechanisms: Money is lent from the central bank to chartered banks which in turn lend out multiples (typically 10 times the amount received ) thus creating money in the economy. This is referred to as fractional reserve banking. If interest rates are held constant and central banks lend money beyond demand in the banking system, banks lower credit quality requirements for borrowers to stimulate demand and deploy their assets.
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Note: the term printing money is used loosely to denote an increase in the money stock as today the majority of money in society are number entries indicating holdings in bank accounts.

 Central banks lower interest rates thus stimulating demand for loans which are then offered by banks, again as multiples of their cash deposits, to create money by simply crediting accounts. Contrary to popular belief, a loan does not necessarily come from someone elses savings. It is merely created as an account entry as a response to the issuance of a loan. The flip side of this consideration is that if all loans were paid-off, the money stock disappears - thus Mr. Hamphills comment that our system exists without a permanent money stock and the need for increasing debt levels. By the broad monetary measure called M3, all the money in existence (Canada roughly $930 billion and in the U.S. $ 9.6 Trillion) reflects institutional loans that require the payment of interest.

Our central banks, the US Federal Reserve and Canadas Bank of Canada are relatively new creations they are not the inevitable result of using currency whether or not that currency is backed by gold There is an alternative to this monetary system and that is one where the Treasury of Canada or the U.S. would issue money which is permanent (whether backed or unbacked by gold is another discussion). In such a system, the Treasury would issue money, typically through government spending, without money being created through bank loans. Such money would be permanent and exist without being originated as a loan however this would remove a major profit generating mechanism from our financial institutions as it would greatly slow the growth of debt. ---------------------------------------------------------------The Fiat Cat Keeps Coming Back In America, the failed Continentals were followed in 1861 by another attempt at issuing a central currency because, as noted by the Federal Reserve itself, once again the need to finance a war provided the impetus for a change to the monetary system. 28 That war was the Civil War. Thus, in 1861 Congress authorized Demand Notes (called greenbacks due to their green ink) which were unbacked by gold and then in 1862 also began issuing United States Notes which, during the Civil War and until 1879, were also made irredeemable in gold and silver coin. Both the Norths Notes and the Souths Confederate Notes were printed (and counterfeited) en masse during the Civil War deepening the mistrust of U.S. citizens (North and South) for irredeemable paper currency. (It should be noted that the Federal Reserve on its website states the fact that paper currency U.S. Notes issued by the North starting 1861 (Confederate notes were in the end worthless) are still redeemable for modern monetary

notes at face value is important for the record or currency stability which this represents 29. That this currency only has a fraction of its original buying power seems to escape the Fed.) The US Federal Reserve Bank was created in 1913 when the American people were reticent to have a central bank a sentiment arising both because of numerous upheavals from previous failed currency manipulationiv in the U.S. and in other countries. The reticence also existed because of a fear of concentration of power which many believed would be abused by Money Trusts in the Eastern financial banking centers. To address the concern of American citizens about a Central Banking System, the Federal Reserve Act of 1913 created a system of 12 regional banks now overseen by 7 governors appointed by the President. In theory, this was a system of regional banks. In reality, these reserve banks formed the U.S.s Central Bank overseen by the Board of Governors and its principal policy making body, the Federal Open Market Committee (FOMC). The creation of the Federal Reserve was on the eve of World War I which began in 1914 and the Federal Reserve Act was passed on December 22, 1913 by the U.S. Senate by a vote of 43 to 25, at a time when 28 Senators were away for Christmas vacation, and signed by President Wilson on December 23. With the creation of the Fed, money was backed by gold but could be created in greater quantities than held in gold by Treasury. After running on an election platform promising to retain the gold standard, President Franklin D. Roosevelt (FDR) reneged in 1933, confiscated gold held by U.S. citizens in their Bank deposit boxes and suspended the right of citizens to own gold or redeem U.S. notes and Federal Reserve notes for gold (although foreign holders could). Finally in 1971, after having run an exceptionally loose monetary policy and creating money at multiples of the official gold reserves of the US to finance the Vietnam War, after France (initially) then other countries redeemed massive amounts of U.S. currency for gold. To prevent such further delivery of national assets for outstanding debt, ending all pretenses, President Nixon officially defaulted and made all U.S. currency and debt instruments held by foreigners also irredeemable for gold. The U.S. public was once again able to own gold by law. The dollar has lost 92% of its buying power since the Feds initiation of operation in 1914 while during the 1800s, despite bouts of currency manipulation, the buying power of the gold-backed dollar was ultimately steady when the interventionist schemes subsided. Central Banks and Their Elastic Currency The founding fathers, being aware of the withering effect of monetary inflation which had occurred with the unbacked Continentals during the revolution forbade the use of a currency that was not gold or silver backed. Specifically Article 1, Section 10 of the Constitution stipulates : No State shall coin Money, emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; . Despite clear and express opposition of those who wrote the Constitution to un-redeemable fiat money as Legal Tender, through a series of hand-wringing decisions, U.S. courts in 1878 finally ruled paper money constitutional allowing the future removal of gold and silver from any disciplinary role in the issuance of US currency 30 There are many who have voiced concerns about the creation of the Federal Reserve and the elastic money it created including Warren Buffetts father 31 (Congressman 1943-49, 1951-53) as well as Alan Greenspan himself in a previous manifestation 32. From 1914 and on in the U.S. and in Canada we have the current age of central bank fiat currency, where the central bank in each country modulated the amount (stock) of money and its cost (the interest rate) in an effort to control the economy. Freed by the suspension of the fixed convertibility of money into gold, Canada and the U.S. were able to finance their war activities with an elastic (expandable) money stock.

Central Bank and currency manipulation preceded the Depression of 1819 caused by currency inflation by the Second Bank of the U.S.; Slump of 1836-37 again caused by inflationary distortion of Second Bank of the U.S. enough that President Andrew Jackson prevented its re-charter; 1873 post Civil War downturn following the excesses of Civil War greenback money creation (ref. Lawrence W. Reed; Great Myths of the Great Depression, Mackinac Center for Public Policy)

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Since the creation of the Federal Reserve, the U.S. has had three major price inflations corresponding with an increase in the money supply: 1914 to 1920, 1939 to 1948, and 1967 to 1980 33 coincidentally corresponding to WW I, WW II and the Vietnam War, respectively. The Federal Reserve Bank, while permitted to operate U.S. monetary policy by the U.S. government, are not Federal at all and they have no hard reserve backing the Federal Reserve notes. Instead, the Feds shares are fully owned by a combination of national banks (who must own shares in the Fed) and state banks (who may own shares in the Fed). Thus the U.S. monetary system (interest rates, money stock growth, etc.) is controlled by an institution (the Federal Reserve), that, while approved to operate by the Federal Government, is a private institution owned by banks operating in the U.S. In conjunction with the Fed, the U.S. Treasury prints Federal Reserve Notes (todays paper dollar currency) at the directive of the Federal Reserve. The Secretary of the Treasury is the principle economic advisor to the President and thus works with the Fed although he does not have authority over the US money stock only the Fed Board of Governors and the Feds FOMC has that control and operates independently. The interest rate setting FOMC is composed of the 7 Fed Governors plus the president of the New York Fed plus 4 other presidents selected from the remaining 11 Fed Regional Banks. The Fed has grown in its powers over time. Initially limited to controlling the money supply under the directive of the Secretary of the Treasury, the Feds powers have been increased both by Congressional action and by the Feds own edict. As an example of the latter, the Fed states that in order to maintain its independence the Fed of its own volition in 1962 began to intervene in foreign currency markets 34 that had been the strict purview of the U.S. Treasury. This raises the question how an independent, non-government body can expand its own powers giving it the ability to act in contravention to the Department of the Treasury which is overseen by the President and the executive branch of government. In Canada, monetary policy is set by the Bank of Canada. Established in 1934 as a privately held bank, the Bank of Canada was nationalized in 193835. Since Confederation, Canadas dollar had been redeemable at a fixed quantity for gold. Due initially to World War I, from 1914 to 1926, and forward from 1931 (de facto) and officially (by Cabinet Order) in 1933, Canadas currency was removed from the fixed gold standard. The Age of Monetarism Already Looking for a Place to Happen In 1911, the famed economist, Irving Fisher published his quantity of money theory in his work The Purchasing Power of Money where he postulated that the level of economic activity was somehow related to the amount of money in an economy. What Fisher did not show with his theory was causality that the government could effect greater sustained and real economic activity by increasing the money stock. This was not an issue as the central banks in 1914 did not rely on Fishers economic theory as justification for their massive increases in the money stock. A war was on and money needed to be created and spent in relation to the war effort they now had the elastic money stock needed. That there was immediately a price inflation in 1914 in both the U.S. and Canada followed by the stock market mania and crash of the 1920s tells us the machine was not quite perfected. A tangible sigh of relief must have swept through central bank and government circles with the publishing of John Maynard Keynes General Theory in 1936 which put forth that during economic slow-downs, falling prices were evidence of insufficient money in the economy and not only could the money stock affect the level of economic activity, the government and central banks should intervene with government spending and central bank injections to the money supply to counter this insufficiency made evident by falling price levels this theory is accepted even today by government and central bank economists. Keynes theory relied on humans acting neatly and predictably as aggregates who, no matter what the money stock levels, could and should be steered by government and central bank intervention using their mathematical models. Not all embraced Keynes. As noted by economist Henry Hazlitt:

I have been unable to find in [Keynes General Theory] a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, even much that is fallacious in the book is not original, but can be found in a score of previous writers. 36 However, the ball was already rolling and Governments and central banks now had the ammunition backing the monetary and government expansionist policy they had already been using creating money to allow activity beyond their means. In the long run we are all dead. - Keynes Keynes trite argument for not waiting and rather intervening to spur on the economy should give us pause for our current monetary intervention in the economy. Before monetarism and Keynes belated theory to justify central bank expansion of the money stock and government spending to boost the economy, there was what is now referred to as the Austrian School. Starting in the late 1800s the name Austrian was applied as a derisory term by German economists to attempt to portray this group as not being part of the mainstream Prussian-German body of economists. In the Austrian school started by Carl Menger in the 1870s and extended most famously by Ludwig von Mises (1881 1973) in the 20th century, the central tenet of this school was that analysis of economic phenomena and then attempted explanation by various mathematical models was not possible humans are complex and cannot be predicted by aggregating their average behavior according to neat mathematicians curves. The nub of von Mises theory was as follows: the complexity of human behavior required that you could only develop a rational and objective economic theory based upon fundamental logical principles (deduction) of human action as opposed to the monetarists and Keynesians selected observation followed by attempted mathematical modeling (induction). (The latter method being the source of endless frustration of those who rely on economists predictions as mathematical forecasting models have shown their failure. To wit: President Lyndon Johnsons exclamation Will someone get me a one-armed economist! after tiring of hearing On onehand. Yet on the other hand. from his economists with their insufficient models and need to hedge their predictions.). von Mises correctly identified that all individuals are independent actors and the effect of addition of money to the money supply would see individuals using it in different ways that could not be predicted only observed after the fact. von Mises identified that the pool of funding (loan availability from savings) in a gold standard economy is set by organic growth of the economy through productive enterprise and consequent savings. As a medium of exchange, the money stock in the economy and the associated bank interest rate of money transfers critical information about the state of the economy, self-adjusted economic activity and were thus not to be manipulated. The Austrian / von Mises model works as follows: in a system with a given money stock, the availability of money through savings in bank accounts sets interest rates according to the laws of market supply and demand. With high consumer spending, bank accounts would be drawn-down and interest rates set by market forces would increase to attract savings so that banks could still provide loans. These higher interest rates would focus industry on activities which would give short-term financial return on the loans by satisfying current consumer and industry demand. As consumer/industry needs were met, demand for goods would slow somewhat and savings would increase thereby lowering interest rates as more money was available for lending. Less costly loans at lower interest rates allow industry to undertake longer-term project which give a return over a longer period. When a central bank expands the money stock, it does not enlarge the (real) pool of funds. It gives rise to the consumption of goods, which is not preceded by production (and savings). It leads to less means of sustenance. As long as the pool of funding continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downwards plunge. The most aggressive loosening of money will not reverse the plunge 37 Frank Shostak

Under a gold standard monetary system, the availability and cost of money, as the signaling mechanism for selfadjustment of the economy, is continually adjusted by economic activity as a consequence of the decisions of consumers. Because there is no central bank intervention into interest rates and the money supply, the continual self-adjustment of the interest rate and industry and consumer response to these movements results in interest rates tending to be stable and varying little over time. As a result of this continual market driven adjustment of interest rates, economic growth and recessions also tends to be more steady under the gold standard. From 1850 to 1910, the U.S. average economic growth of 1.3% per worker38 per annum which speaks to the relative strength of the economy during this period of industrialization and social upheaval. Compared to the contraction of GDP by nearly 50% during the Great Depression, the gold standard performed in a far superior manner compared to the Federal Reserves elastic money era which quite literally started with a bang (and will likely end thus). As a result of this stability, under the gold standard there is little variability between various bond maturities be they 1-year, 2-year, 5-year, or 10-year bonds; because interest rates vary little, bond market speculation over interest rates would be stopped and they would simply hold value for their intrinsic interest rate return of the bond. What economists today call the yield curve which graphs variations in bond yields based upon their maturity, simply reflects anticipation of central bank error and correction of interest rates. This guessing game and speculation over what the central bank will do with interest rates disappears under the gold standard39 as does the opportunity for outsize trading profit, which depends upon changing sentiments as to where interest rates are headed. This would free up some of the greatest talents in our society to pursue truly productive activity minds which today are locked-into the financial markets trying to find opportunities to make profit by clever trading of financial assets. The effect of central planning intervention by central banks in manually enlarging the money pool and manually setting the interest rate, forces interest rates down to levels far below the natural market set-point, thus malstructuring the economy and the demand for goods and services by distorting the market pricing mechanism of money. In addition, with excess money and credit available in the economy, growth of ineffective commercial enterprises, investment wagering, bubbles and crashes occur that otherwise would be limited when the availability of money meets the natural productive needs of society. Artificially inflating the money supply (savings pool) to drive demand is no replacement for preceding organic growth and savings in the economy. von Mises saw the folly of central planning of the economy and the distortions and overshoot created by interfering with the natural market pricing mechanism of money by central banks interfering with the money supply and the natural market rate of interest. The resulting distortions in the economy caused by excess credit creation ultimately reveal themselves when the credit and interest rate policy of the central banks are normalized as they always must (if not, crippling inflation explodes within the economy as the excess money creation starts to manifest itself in higher commodity and goods prices driving the price level higher). von Mises also identified that in prolonging the expansion of credit, in addition to mal-structuring the economy, by definition dictates that continually lower credit quality borrowers must be brought into the credit pool which further destabilizes the financial system. When these distortions and uneconomic activities are revealed and shaken-out by rising interest rates, a sharp recession follows while restructuring the economy for future productive. If the credit and money supply distortions continue for a long-enough period, then this correction is strong and prolonged as was the 1930s Depression von Mises indelicately named such a collapse and general depression a crack-up boom. von Mises noted that when rationally arguing the monetarist/Keynesian model be abandoned because of the inevitable unsustainability, economic distortion and busts it produces, he found: It could not influence demagogues who care for nothing but success in the impending election campaign and are not in the least troubled about what will happen the day after tomorrow. But it is precisely such people who have become supreme in the political life of this age of wars and revolutions Nearly all governments are now committed to reckless spending and finance their deficits by issuing additional quantities of unredeemable paper money and by boundless credit expansion. 40

On Keynes new economics he noted: The policies he advocated were precisely those which almost all governments, including the British, had already adopted many years before his General Theory was published. Keynes was not an innovator and champion of new methods of managing economic affairs. His contribution consisted rather in providing an apparent justification for the policies which were popular with those in power in spite of the fact that economists viewed them as disastrous. His achievement was a rationalization of the policies already practiced. He was not a revolutionary, as some of his adepts called him. The Keynesian revolution took place long before Keynes approved of it and fabricated a pseudo-scientific justification for it. What he really did was right an apology for the prevailing policies of governments. This explains the quick success of his book. It was greeted enthusiastically by the governments and the ruling political parties. Especially enraptured were a new type of intellectual, the government economists. 41 ( One of Keynes great advantages was that his theory necessitated legions of economists analyzing data and creating mathematical equations in an attempt to model the results and thus it was quickly embraced and promoted by economists in both government and academia. It is telling that today there is no unifying and complete theory of monetarism and Keynesian intervention. Economics textbooks invariably state that the real world can be explained by macro-economic theory which is a patchwork of monetarism, a bit of Keynesianism, several other concepts and a pinch of moon dust. Almost nowhere in University macro- economics texts can we find analysis of the Austrian school. This writer in completing his MBA heard months of monetarism and Keynesian theory. On the last day of lectures, the professor mentioned that there was another school of macroeconomic thought and that they were called fiscalists - that was it. Fiscalists, indeed. They are also called the Austrian School. ) In discussion of the Keynesian philosophy of active monetary and government intervention with economists, one typically gets the response that monetary intervention is correct youve just got to know when to stop. That government spending intervention, central bank monetary intervention and suppression of interest rates distorts the market pricing mechanism structuring the economy with unproductive enterprise and attendant speculation, and that the consumption of savings today at the cost of tomorrows economic growth, is beyond their ken. A final note on Keynes. Keynes well understood the damaging effect of a system of inflating elastic money. In 1919, in his book The Economic Consequences of the Peace, he made the observation about inflation: ..By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.. von Mises theory did not win him many friends because they worked against the perceived interest of the political class, economists and academics, bankers and the investment industry. The tragedy of von Mises remains that, as a Jewish intellectual living in Switzerland during WW II, upon the publishing of his major work Nationalokonomie in 1940 which was written in German but went against the prevailing socialist winds of the National Socialist (Nazi) party in Germany (the book was later published as Human Action in 1949 by the Yale University Press), von Mises was pressured to leave Switzerland narrowly escaping through France to the United States. While almost all other socialist and communist economists who emigrated to the U.S. could find employ and despite von Mises keen and productive mind and extensive publishing of economic thought, he could find no paid economic tenure in the U.S.42 The real testament to von Mises strength of character is he never capitulated. He steadily supported an economic approach that he knew was superior despite the fact that easy personal reward, which his peers so easily accessed, lay in promoting monetarist economics. ---------------------------------------------------------------Creative Numbers von Mises saw the occasional and shallower slow-downs in the economy under the gold standard as a healthy restructuring of the economy for future growth where ineffective and unproductive enterprise are weeded-out. During periods where there is higher measured unemployment, those with jobs tend to spend less until the economy strengthens. Keynes called this phenomenon the Paradox of Thrift43.

According to Keynes theorem, citizens response to an economic slowdown makes slowdowns worse than need be. During these periods, Keynesians and many political leaders feel that more money needs to be injected into the economy and government spending enacted to overcome this natural economic characteristic. In the 1970s during a period of economic turmoil and high inflation, we saw the introduction of the unemployment rate that only included individuals actively looking for work; the unemployed who were discouraged were not counted as unemployed. In this way, citizens were presented with a better picture to prolong their spending (but deepening imbalances) and politicians, who liked to pretend they create jobs during good time yet not wanting responsibility for slow-downs and job losses, were offered an out. As noted above, today we hear from Washington that inflation is subdued, the economy is strong, and unemployment is declining. If we look at the employment participation rate which is the percent of the population actually employed, we find that there has been a steady decline from 67% of the U.S. population employed in 2000 to 65.5% of the population employed in 2005. This while the Bureau of Labor Statistics states the Unemployment rate has dropped from 6.3% in 2003 to 5.2% in 2005. In addition to inflations human toll which aggravates voters, governments are averse to acknowledging inflation because it triggers the hoarding response which creates artificial shortages worsening the price inflation condition. Price inflation also increases the cost of entitlement costs (old age pension / social security payments, welfare payments, etc.) limiting the amount of new government initiatives that can be undertaken. Yet inflation is a feature of the fiat money system. Weve also had the introduction of the core consumer price index (CPI) that excluded volatile items such as food and energy. If a government understates inflation, pension and employment wage increases which are indexed to the Core CPI are diminished Social Security payments alone constitute a $480 Billion per year expense for the U.S. government. Containing benefit increases that compound annually in the social security budget is not a trivial matter. In addition, the Consumer Price index is now calculated using a tool called hedonics. The term is derived from the Latin word pleasure. For example, if a product such as a computer were to feature a 50% greater speed for, say, the same price year-to-year, the product would be deemed to be 33% cheaper ( 100% / 150% ). More than 35% of the U.S. basket of goods in the CPI is hedonically adjusted including clothing. For a summary of how government statistics are massaged to make the consumer and business leader feel better while having less money left over see links below for papers by Gillespie Research v. In Canada, the CPI shelter component in Canada is now broken down into two components: Rented Accommodation and Owned Accommodation that together constitute 26.8% of the total CPI basket. The Rented Accommodation component accounts for roughly 1/3 of the Shelter Component while Owned Accommodation accounts for 2/3 of the Shelter Component. The art in the Canadian CPI calculation is interesting. The Rent Paid portion accounts for approximately 6.0% of the total CPI basket while the Owned Accommodation cost is calculated using an imputed user cost or what rent for which a homeowner could rent the accommodation back to themselves. In calculating the imputed user cost, the mortgage interest composes 5.4% of the total CPI basket, building depreciation costs (excluding property value) are calculated at 2% per annum of the building value (3.3% of the total CPI basket) and property taxes (3.2% of the total basket) are utilized - it is assumed that the
For an analysis of government massaging of numbers see the following series of articles by John Williams of Gillespie Research: ( http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=35446; http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=35770; http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=36238 )
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property is not amortized (i.e. the mortgage is never paid-off). Adding the above, the total direct Owned Accommodation housing costs (excluding insurance, hydro, water, maintenance, etc. ) accounts for 18% of the CPI. When all shelter costs are included, shelter composes 26.8% of the CPI. According to the Royal Banks Housing Affordability Index, rent accounts for 40 to 70% of renters pre-tax median income while home ownership costs (including amortization of the home loan but excluding maintenance) accounts for 20 to 30% of home owners pre-tax median income in Canada. In total, the Royal Bank finds that shelter costs for all households in Canada (overall rental and ownership costs combined) total 25 to 40% of Canadians pre-tax household income. This compares to a total CPI shelter component of 26.8% of the consumer goods basket which would reflect post-tax costs and assume no amortization of mortgages. New housing purchasers in Vancouver and Victoria will be heartened by the following March 2005 CPI statistic: without adjusting for inflation, owned accommodation dollar costs in Vancouver are 95.3% of their 1992 costs and in Victoria they are 96.9% of their 1992 adjusting for the Bank of Canada estimate of 26.6% inflation since 1992, owned accommodation costs today are 75.3% of the 1992 cost for Vancouver and 76.5% of the 1992 cost for Victoria. (for reference: The Real Estate Board or Greater Vancouver gives a current detached house average selling price of $555,000 vs. $300,000 in 1992 (and $400,000 at the beginning of 2003) for an increase of 85% and a similar 81% increase in condo housing prices over the 1992 to 2005 period) as amortization is ignored in the index. In July of 2004 with interest rates at their bottom, it was determined that the mortgage interest cost at 8.4% of the Consumer Price Index basket was excessive and this component was reduced to 5.4% of the basket total (a 33% decrease). The total shelter component of the CPI was also decreased by 8% from its previous weighting this at a time when real estate costs were climbing steeply across Canada and interest rates would start to climb. What the CPI reflects is not clear, however, it should not be used to inflation adjust pensioner income and cost of living increases in labor agreements. --------------------------------------------------------------Back to the Gold Standard A major benefit of the gold standard was the fact that it was unencumbered by nationality and therefore could not be operated in a capricious irresponsible manner; Americas policy on the dollar policy clearly is We have long discussed Americas growing financial imbalances and its consequent vulnerability to third world-style debt trap dynamics. 44 Marshall Auerback, 2001. It is clear from the past 8 decades of expanding central bank power and their expansion of the money-stock, the antiquated central-planning approach of central banks forcing interest rates and the artificial manipulation of the money stock can not nearly replicate the delicate self-adjustment, stability, and balancing of the gold standard monetary system. A central banking committee cannot ever hope to read the tea leaves of the economy and replicate the continual balancing of interest rates and economic activity effected by trillions of consumer decisions each day. There will be many criticisms of a return to a gold standard currency and statements that it will be absolutely impossible to reinstitute this currency system by parties who have an interest in todays volatile markets and interest rates (Greenspan suggested in 1981 that such a transition back to the gold standard was possible and even desirable 45 ). The volatility begets opportunity for trading gains in stocks, bonds and interest rate sensitive instruments such as derivatives, ultimately spawning bubbles. However, the volatility, bouts of inflation and ultimate busts are not in interest of a stable or just society. Investors have today been lulled into a sense of security regarding perpetual low-interest rate while the potential for an inflation shock to the economy as a result past central bank monetary inflation begins leaking into commodities speculation / safe haven hedging or a shock from foreign investors slowing their purchases of the US debt is very real. The consequent rise in interest rates and the attendant investment and economic slowdown can rapidly deplete the inflated paper value of stocks, bonds, real estate and derivative investments

and lead to a massive wealth transfer; those who are liquid and without debt will be presented an opportunity to acquire assets at significant discounts as investors scramble to stop losses and debt by disposing of losing asset classes which then overshoot to the downside. Given the U.S.s investment and real estate bubble, its dependence on foreign financiers, the unprecedented level of indebtedness, and Canadas almost complete dependence upon the U.S. economy through trade since the implementation of the Free Trade Agreement in 1989, both countries face the risk of economic disruption if interest rates are forced-up by the onset of inflation or outside economic shock. Government action to restructure and stabilize the monetary system and to mitigate the economic consequences which approach is needed. Gold : An Unwelcome Barometer of Fiat Currency Health Gold ( and silvervi ) are viewed unfavorably by central bankers exercising monetarist expansion of their money stock. Keynes referred to gold as a barbarous relic and pop economists such as Paul Krugman have applied other epithets to describe it. Why the hard feelings against a metal that has been used as money for 5,000 years? Gold is an unwelcome barometer of the health of any paper currency but especially the US dollar that has had the privilege of being the Worlds central bank reserve currency (60% of central bank reserves have to date been in US dollar instruments). That status has allowed the U.S. to create and pay all its debt in its currency which other central banks were usually happy to hold. When a money stock is inflated, the price of gold in that currency compensates by rising thereby giving a signal of that dilution this poses a problem for Keynesians and monetarists when they wish to increase the amount of currency to, in their minds, further spur or continue the economy. Given golds signal of inflation, investors and citizens can roll-out of currencies that are being diluted (inflated) and into gold to maintain the buying-power of their savings and also indirectly influencing the bond market to demanding higher interest rates for bond and other debt instruments (please note: while central banks control the short term interest rates, longer term rates, while tempered by market intervention by the Fed and Treasury, are set by the bond market). Larry Summers who was Deputy Treasury Secretary until Rubins retirement in July 1999 and then himself Treasury Secretary until December 2000, noted in his co-written paper Gibsons Paradox Revisited 46. (The Paradox was so-named by Keynes as he notes the gold price moved inversely to the real interest rate which is defined as interest rates minus inflation. Keynes noted if interest rates in debt markets give insufficient return while inflation rises, then the price of gold will shoot up. Interest rates would thus respond not to the published rate of inflation but instead to the absolute price level of gold as the indicator of inflation. This makes sense as gold has a long history as money. However it was an obstacle to Keynes as it limited application of his theory. Thus, in addition to the Paradox of Thrift, he also called this natural phenomenon a paradox. ) The U.S. has established the U.S. Treasurys Exchange Stabilization Fund for exchange market intervention policy and is utilized as a stabilization fund to effect an orderly system of exchange rates. Accordingly, the Treasury Secretary may deal in gold, foreign exchange, and other instruments of credit and securities 47 Chairman Greenspan says that the Fed and Treasury do not trade in gold48 James Turk, a noted expert in the gold markets notes evidence to the contrary 49. Given Greenspans word parsing and obfuscation over the past 18 years, it will be interesting to see exactly what Greenspans words on trading in gold mean a critical question would be whether the Fed and Treasury, or their designees, trade in gold derivatives (a paper financial instrument rather than gold itself) which can steer the price of physical gold by holding dollar instruments rather than gold itself (see further discussion below). In the 1960s during the U.S.s monetizing effort to support its war in Vietnam, the United States, U.K. and other European Powers central banks openly coordinated gold sales in what was called the London Gold Pool to oversupply the market with gold bullion in an effort to keep its price from appreciating in U.S. dollars from the $35/oz. official peg. Again, in 1968 France realizing there would be no end to the printing of U.S. currency,
Since 1945, 6 billion ounces of U.S. silver bullion stocks have been dishoarded onto the world silver market depressing the price of silver. The U.S. mint is now a buyer of silver for silver eagle bullion mintage. World silver bullion stocks stand at 200 million oz. ($1.4 billion at $7/oz. ) and there is an annual mine production deficit of approximately 100 million oz.
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asked for conversion of US dollar denominated debt and currency to US government gold as these instruments permitted at the time leading to the end of the visible central bank manipulation of the gold price. The visible London Gold Pool coordinated central bank intervention to contain the price of gold was extremely costly to the gold reserve of participating central banks as shrewd investors (not just the French government) could see U.S. monetary policy, and knowing that the price of gold could not be contained forever, simply backed their trucks up to the London Gold Pool and waited for the gold of participating nations to be unloaded at obviously discounted prices. In the final days of the London Gold Pool, purchasers were taking delivery of up to 225 tons of gold per day 50. Ultimately 55% or 10,000 thousands tons of the U.S.s gold stock which started at 18,000 tons in 1957 was consumed before Nixon decoupled the dollar from the gold standard and let its currency float. When gold is suppressed for a period to prevent its signaling of monetary dilution (inflation), it tends to explode in value when correcting to its true value. When President Nixon made the US dollar irredeemable to all foreign holders of U.S. currency and debt, the price of gold rose dramatically from its fixed price of $US 35/oz. to over $US 850/oz by 1980 ($2,100 in 2005 dollars) before settling lower to average $400/oz. during the 1980s. As frequently quoted statement by Warren Buffett is intervention always fails. And sometimes spectacularly. From 1995 to 1999 with the implementation of the Feds dollar printing spree, the dollar gained 18% against other currencies and gold declined 38% during the same period in US dollars from roughly $400 in 1995 bottoming out at $250 in 1999. How can this be when the markets when the M3 money stock was itself increased (the dollar diluted) during this period by 45% according to the M3 broad money measure? Instead of gold strengthening by 45%, gold weakened by 38%. A number of factors contributed to the decline of gold during this period. Investors were keen to hold U.S. investments gold was not seen by some as a necessary store of value when U.S. dollar denominated assets were appreciating in the U.S.s new economy home of the dot.com stock market. Exporters to the U.S. such as Japan and China were keen to invest the U.S. dollars that they received for the goods they exported back in U.S. government securities such as Treasury Bonds a massive form of vendor financing (Warburton). This helped recycle the dollars that they received without flooding the worlds currency markets with billions of U.S. dollars which would depreciate the dollar and driving up the price of exports to the U.S. although the U.S. economys productive manufacturing base was being gutted by globalization, the U.S. had a base of addicted vendor financing countries who couldnt say no to buying U.S. debt thereby contributing to the containment of interest rates at their historically low level. Instead of the public and extreme gold depleting policy used by the London Gold Pool in the 1960s, a 3-pronged approach appears to have been used by central banks to continue their monetary expansion and inflation of investments without gold signaling fiat currency weakness: 1. Central banks such as the Bank of England, the German Bundesbank and other European and Asian countries allied with the U.S. have made substantial independent gold sales since the mid 1980s (often counterproductively announced beforehand which lowers the price for the gold that they later sell). This has contributed approximately 10 to 15% of annual supply to the worlds annual gold market. 2. Gold leasing: there is considerable evidence that central banks have also engaged in coordinated (and unannounced) leasing of their gold reserves. Leasing allows large amounts of gold to be introduced to the world gold market without Central Banks having to show it as a disposed-of asset from their balance sheet. Thus for a price of roughly 1% of the leased gold per year, central banks leased their gold to bullion banks which would then sell the gold onto the world gold market. This is a very profitable business for a bullion bank so long as the price of gold falls or remains constant (dollars could be accessed for 1% per year and then rolled into guaranteed profits in the bond or stock markets which would carry the interest of the gold thus the term the carry trade). However, if the price of gold rises, these bullion banks would have to repurchase

gold at the end of the lease period at a higher price than they were able to sell the gold thus incurring a loss on the transaction. The other conundrum with such activity is that the worlds gold supply from mines is approximately 2,500 tons per year (and declining) while world gold demand is approximately 4,500 tons per year and increasing. A substantial body of work has been completed by international banking consultant Frank Veneroso in his book The World Gold Book Annual 1998 and subsequently, which analyzes historical bullion flows from England and has calculate that roughly 10,000 to 15,000 tons of all the worlds official central bank gold reserves of 32,000 tons have been leased onto the market in off balance sheet transactions. If indeed 10,000 to 15,000 tons of gold have been leased onto the world gold market; simply drying-up such supply would send the gold price much higher and central banks are indicating that their planned sales of gold are slowing. If such an amount had to be purchased by bullion banks for return of the leased gold to the central banks, the price of gold would climb much higher. Given the supply/demand fundamentals of the worlds gold market, it is very difficult to see how the leased gold can be returned to the central banks without substantial losses to those who leased the gold and without driving the price of gold strongly higher. 3. Derivatives: Gold derivatives reflect a bet on the underlying price of gold and are traded on exchanges such as the Commodities Exchange (Comex) in New York. It is well understood that shorting futures of a stock or a commodity can drive down the price of that item by influencing the daily selling price (or spot market) for that good by signaling to traders that someone selling an item short (for future theoretical delivery at a price lower than todays price) believes the price will be lower in the future. Derivatives sell for a fraction of the underlying commodity. For example a call option contract derivative (or bet) for gold at $10 dollars below the current price of gold which expires 3 months later is currently $1,380 for 100 oz. of gold (currently $43,000 worth at $430/oz.) Such trades are almost always settled in dollars to cover the loss or the gain for the trader giving an instrument which can influence the price of gold without having to acquire and sell the gold itself. The Bank of International Settlement (BIS) notes that gold derivatives are approximately 26% of the worlds commodity derivatives market yet gold only composes 1% of the worlds annual commodity production51. Thus there are 26 times or 2,600% more derivatives structured against gold than against other commodities. This is a market in which there is a strong interest. Peter Warburton provides his assessment of the current interest in controlling the price of gold and other commodities to prevent speculation from the 100 Trillion dollars of financial market investments which, if they roll sufficiently into commodities, would cause an explosive manifestation of central bank monetary inflation in the worlds economies: What we see at present is a battle between the central banks and the collapse of the financial system fought on two fronts. On one front, the central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold, oil, base metals, soft commodities or anything else that might be deemed an indicator of inherent value. Their objective is to deprive the independent observer of any reliable benchmark against which to measure the eroding value, not only of the US dollar, but of all fiat currencies. Equally, their actions seek to deny the investor the opportunity to hedge against the fragility of the financial system by switching into a freely traded market for non-financial assets. It is important to recognize that the central banks have found the battle on the second front much easier to fight than the first. Last November, I estimated the size of the gross stock of global debt instruments at $90 trillion for mid-2000. How much capital would it take to control the combined gold, oil and commodity markets? Probably, no more than $200 billion, using derivatives. Moreover, it is not necessary for the central banks to fight the battle themselves, although central bank gold sales and gold leasing have certainly contributed to the cause. Most of the worlds large investment banks have over-traded their capital so flagrantly that if the central banks were to lose the fight on the first front, then their stock would be worthless. Because their fate is intertwined with that of the

central banks, investment banks are willing participants in the battle against rising gold, oil and commodity prices. 52 Warbutons commentary was written in 2001 when there was little visible commodity price inflation. Commodity prices have risen by 65% since then. And the control of the price of gold with derivatives could only be maintained while there is physical metal supply available to satiate the current market. Physical gold held by central banks is limited and, if indeed a large portion has been leased onto the markets over the past years, as with the London Gold Pool scheme, market control by intervention cannot be maintained in perpetuity. In addition to the work by Veneroso on the control of gold via leasing (oversupplying) of the market combined with derivatives on the various commodity exchanges, the Gold Anti-Trust Action Committee (GATA, www.gata.org ) and former V.P. of Canadas Royal Bank, John Embry 53 voice concern about the likelihood of such manipulation of markets which are said to be free markets. The Veneroso / GATA / Embry information is dismissed by some, however it is first difficult to envision that the worlds central banks would embark upon their inflationary monetary policy especially with the inflation of the U.S.s money stock starting in 1995 - without a more effective tool to contain gold and commodity inflation, and thus consumer price inflation and interest rates, as they had previously attempted to do in the 1960s. Second, the open and clumsy London Gold Pool gold price manipulation by central banks in the 1960s was extremely inefficient and costly in its consumption of central bank gold reserves. If with derivatives market intervention giving a flat/declining gold price, investors could be made to believe that inflation was dead while allowing stimulation of the economy via money creation, then theoretically the best of both worlds could be obtained while minimizing the consumption of central bank gold and maximizing the amount of time such a policy could be effected. What is very difficult to understand is, as with the Feds 1995 rapid expansion of the money supply and consequent stock market bubble creations then the follow-up 1% emergency interest rate spawning multiple bubbles(stocks, bonds, derivatives, and real estate), exactly what the Fed exit strategy for such a policy would be. If the price of gold has been manipulated and other of what the Fed refers to as unconventional methods have been utilized in a scheme to hide inflationary monetary policy by distorting economic indicators all the while juicing the financial markets and ultimately destabilizing the U.S. and Canadian economies, all citizens not just gold investors need to be concerned. Finally, it should be noted that Barrick Gold Corp. has been sued in U.S. Federal Court in New Orleans. The Statement of Claim54 alleges that Barrick Gold Corp in conjunction with its investment bankers J.P. Morgan Chase combined in manipulating the gold market by funneling central bank leased gold onto the gold market while, at strategic points of such physical gold injection, shorting the price of gold using derivatives to gain $2 Billion in profits. Barrick has maintained that such activity is a part of its normal business activity. Former Prime Minister Brian Mulroney is a director of Barrick and Former President George Bush (Sr.), former U.S. Secretary of State James A. Baker (3rd ) and former U.S. Senator Howard Baker have all served on Barricks advisory board. This matter is still before the courts and none of the accused are guilty until proved so nor is either party guilty by association. The trial is expected to start in the summer of 2005 and will be keenly watch by those with an interest in currencies and gold. Barrick continues to hold 13,300,000 oz. of forward sold gold contracts on its books at an average price of approximately $290/oz. representing a current book loss of $US 1.8 Billion with gold at $425/oz. It may be a matter of market intervention always failing or a prudent corporate policy carried too far. Whether Barrick was innocently generating profit on a declining gold price or whether it was engaged in contributing to the decline will be determined in court from the facts of this case. The plaintiffs recently withdrew their claim again J.P. Morgan Chase. The suit now only makes claim against Barrick.

Failures That our monetary system and economy could now face its current peril is the end-result of a gradual process. Expansion of an increasing debt cycle dramatically increased by loose monetary policy and low interest rates starting in the mid-1990s exacerbated a consumption and speculation dynamic by telling consumers they were worth much more than they were in reality. During this process, consumers have not been discouraged from speculating and incurring debt in fact, in 2004 Chairman Greenspan coyly noted that consumers could have saved substantially had they been using variable rate mortgage credit. No money down, interest only and also variable rate mortgages have been at the core of the current real estate speculative bubble. Speculation in financial instruments has also undervalued commodities during the period of monetary expansion. North American cities have been structured on the premise of cheap energy with the number of car miles in the U.S. more than doubling since 1992 due to urban sprawl and in 2004, the D.O.T. noted that the average weight of an American vehicle had exceeded 4,000 lb. Our cities are now exactly incorrectly structured for the future high energy costs. Central bankers have been desperate during this period to stimulate any economic activity possible to avert the post bubble decline. However, their policies and enticements have been retrograde in increasing unsustainable debt load and economic distortion with diminishing economic returns while compounding instead of mitigating the consequences. Greater and greater growth rates of debt are now needed just to sustain the economy. A coherent strategy is wholly missing and Fed policy appears to be more of a form of delay of consequences and denial of the sum of their cardinal errors during the past decades rather than prudent and rational forward guidance. When confronted with questions about its policy, the Fed has obfuscated and insisted on the rightness of its policy decisions. Governments and central bank officials have passed on opportunities to address the negative consequences that have resulted from monetary and fiscal policy error always seeming to insist that desperate times call for further desperate measures like lowering interest rates to 1%. And there has never been a public accounting, public policy analysis or changing of the guard at the Fed even after dot.com stock market bubble broke in 2000 and Feds policy error became clear to all (presumably because the Feds loose monetary policies were encouraged by Government and the financial communities). The blow-off of this monetary cycle will leave many questions to be answered as well as opportunities for improvement in society. At the core of our current predicament is the failure of central bank fiat monetary systems and, at best, imprudent risk taking with the economy of the U.S. Because of the consequences and dependency of Canada and, for that matter, the worlds economy on US consumption, the stakes are very high. Morgan Stanleys Stephen Roach notes55 that from 1995 to 2002 the U.S. accounted for 98% of the Worlds net GDP growth. Beyond the odd article voicing the concerns of Paul Volcker, Warren Buffett and John Templeton, the mainstream media has been virtually absent from any critical, substantive analysis of monetary and economic policy acting more as cheerleaders of the stock markets and economies in Canada and the U.S. Typical is the hyping the headline releases given by various government agencies. Consumer confidence is down but the unemployment rate is dropping. Inflation is up, but core inflation is mild. The producer price index is rocketing but inflation is expected to remain tame. With little critical and real analysis, a media hooked on providing infotainment, and with soothing words emanating from government, the average individual in society has no chance to understand the greater dynamics at play and they have little chance of taking defensive investment positions given the hype created around stocks and housing encouraged by government policy and the media. Ultimately, the responsibility for the current situation lies with individuals in society who have not held the government and financial institutions to higher standards demanding prudent policy and responsible advice. The ability to vote both with the ballot and with investment dollars is a strong incentive and has not been used as citizens appear to be willing to suspend critical analysis and performance demands in favor of optimism. The latter is much easier than the others and it is actively encouraged by media, government and the financial industry.

For individuals to plan responsibly, fidelity of information is required and this has not been provided by our media which has been concentrated to a greater and greater extent in both Canada and the U.S. In his paper My Beef with Big Media, Ted Turner notes: When media companies dominate their markets, it undercuts our democracy. Justice Hugo Black, in a landmark media ownership case in 1945 wrote: The First Amendment rests on the assumption that the widest possible dissemination of information from diverse and antagonistic sources is essential to the welfare of the public.56 Turner presents information as to how major corporations influence media content and how, even with the internet, the top 20 US internet media new sites are owned by the same media conglomerates that control the broadcast and cable networks. Here in Canada, media concentration has grown to the extent that 84% of Canadian media is owned by the five largest media companies, resulting in increasingly homogenous perspectives 57. We now have CanWest Global controlling 30% of the Canadian media market58 (for instance, owning both major daily newspapers in Vancouver) and CanWest firing the editor of the Ottawa Citizen paper in 2002 when he dared write an editorial critical of the Prime Minister. Canadians tolerate this level of concentration. With this level of media concentration and implicit messages that in these troubled times that every citizen needs to support the team, it is no surprise that little critical analysis and correction of destabilizing government and central bank policy exists. But again, this situation ultimately exists because citizens do not play a vigilant role and prefer to be fed the ins-and-outs of movie star and politicians private lives rather than boring, or unsettling, economic information. Our political leaders respond with endless rounds of gotcha politics and debating trivial matters while the economy declines. The government to whom citizens throw their trust is also fed money by business interests who have been directly benefited by imprudent short-term Fed and government policy. The academic establishments researching the economy are themselves fed research grants from Government and central banks who do not wish to be criticized or forced to make tough decisions. It would not be in the interest of academics to make themselves redundant by pointing-out that the economy shouldnt be manipulated by a cohort of economists and central bankers. The greatest danger going forward will be that the message is transmitted and accepted by citizens of both our countries that the economic correction is a consequence of free markets and that more government control is necessary in order to protect citizens in the future. The destabilizing monetary system and economy which enriches the few is a direct consequence of archaic central planning intervention and distortion of an extremely beneficial mechanism the monetary system and the natural market pricing mechanism. As noted by von Mises, intervention into the monetary system by central bankers breeds distortion and cannot ever hope to match the daily decisions of citizens in our society enacted in the economy. The concentration of power and ability to intervene in the monetary system by a group of central bankers, only invites error, abuse, and economic volatility. And Canadas now almost total economic dependency upon trade with the U.S. raises questions about the wisdom of the US-Canada Free Trade Agreement that encouraged this dependency. Some may seize on the failure of the Fed as evidence that government is only damaging. However, experience of deregulation in the U.S. during the 1980s, while showing many improvements, also revealed the potential for abuse without government regulation. Abuses during deregulation in the airline industry (safety violations), cable television industry (collusion to monopolize and price fix), and the savings and loan (S&L) industry (fraud) dictates that some government regulation is necessary. The concern going forward is that we not face a repetition of the 1930s where government punitive policies and attempts at central planning the economy deepened and prolonged the Depression. Ultimately, prosperity and limitation of economic damage going forward will depend on mitigating and corrective action by our governments. This action is needed today. Awaiting a correction and panic virtually dictates disruption and extraordinarily deep economic damage. Whether our governments, who are well aware of these matters and the source of concerns voiced by former Fed Chairman Volcker, will simply watch the economy go over the edge and act surprised remains to be seen. A key element needed will be a debt forgiveness mechanism otherwise further and unprecedented wealth transfer precipitated by government error, from an impoverished and indebted consumer to an extremely small financial elite, will occur.

Finally, Fukuyama in the book Trust: The Social Virtues and The Creation of Prosperity 59 identified that a key determinant of a societys sustainable wealth is a culture of ethical behavior. We have seen a degradation of ethical behavior in both the Canadian and U.S. realm of business and government over the past decades. If we now take this opportunity for correction not only of the monetary system but of ethics standards within our society, we have the opportunity to resurrect what many hope will be a prosperous future for North America.

Addendum: Canadas Position Trade Asymmetry : Canada is fully economically dependent upon the U.S. With the implementation of the Canada US Free Trade Agreement in 1989, Canada has now built an almost total dependency on the US export market to fuel Canadas economy. Exports to the U.S. constitutes 25% of Canadas economic activity (GDP) and represent 88% of Canadas total exports. In comparison, U.S. exports to Canada constitute 1.5 % of U.S. GDP. Combined US/Canada trade (imports + exports) constitutes 43% of Canadas economy and 3.8% of the U.S. economy. If any economic dislocation were to occur in the U.S., this type of economic asymmetry results in Canada being in a poor negotiating position for access to even diminished U.S. markets. Ontario, in particular, is vulnerable to economic disruption because of its manufacturing base dependence upon the U.S. Canadas Banks do not have robust balance sheets The following are extracted items from the Consolidated Balance Sheets of all Canadian Banks 60 as of March 31, 2005. ! Assets: Bank Reserves: ! Cash: Gold: Government Bonds Deposits with other institutions $ 4.7 Billion $ 3.6 Billion $ 216.0 Billion $ 88.5 Billion $ 312.8 Billion : Total

Assets: Outstanding Loans to customers: Loans $1,030. Billion

Liabilities: Customer Bank Account Balances $1,271. Billion

These balance sheet elements indicate that Canadian Banks assets are fully deployed in order to generate profit. Very little tolerance for economic shock is built into the banks balance sheets if there were to be a sudden liquidity demand or if a larger portion of outstanding loans became non-performing. Constitutional Weakness: Canadas Charter of Rights and Freedoms affords no property rights to its citizens (governments in Canada can expropriate private property without compensation) and individual rights to freedom of conscience, religion, expression, life liberty and security of the person etc. as in the Charter can be overridden using S. 33 Override provisions for repeated 5 year intervals by Federal or Provincial Governments provided that such government vote on the denial of rights every 5 years. During times of crisis, governments typically argue additional centralized power is needed with our current Charter, such intervention and suspension of individual rights is possible without approval of citizens.

Canadas Gold: In 1985, Canada had 20 million oz. of gold in its treasury. Strong gold sales from 1985 until 1993 resulted in disposal of 14 million oz. Gold sales continued from 1994 until 2003 at which point Canada retained 100,000 oz. 61

2005 David Jensen. All rights reserved.

Bank of Canada, Monetary Policy Report - Summary, April 2005. Washington Post, April 10, 2004. http://www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html 3 Charles Mackay; Extraordinary Popular Delusions and the Madness of Crowds, Prometheus, 1852. 4 Edward Chancellor, Crunch Time for Credit? An inquiry into the state of the credit system in the United States and Britain, Harriman House, 2005. 5 Charles Mackay; Extraordinary Popular Delusions and the Madness of Crowds, Prometheus, 1852, pg. 55. 6 www.federalreserve.go/boarddocs/speeches/2002/20021108/default.htm 7 Murray N. Rothbard, Americas Great Depression, The Ludwig von Mises Institute, 1963, pg. 92 - 93 8 Murray N. Rothbard, Americas Great Depression, The Ludwig von Mises Institute, 1963, pg. 93 9 Murray N. Rothbard, Americas Great Depression, The Ludwig von Mises Institute, 1963, pg. 169 10 Irving Fisher, 15 October 1929. 11 Dr. Sam Wakind Ph.D., The Bursting Asset Bubbles, www.globalpolitician.com/articles.asp?id=647&print=true 12 Doug Noland, How Could Irving Fisher Have Been So Wrong?, http://64.29.208.119/archive_comm_article.asp?category=Guest+Commentary&content_idx=10665 13 Frank Shostack, Does a Falling Money Stock Cause Economic Depression?, http://www.goldeagle.com/gold_digest_03/shostak041903.html 14 Dean Baker, Dangerous Minds: The Track Record of Economic and Financial Analysts, http://www.cepr.net/dangerous_minds.htm 15 Dean Baker, Dangerous Minds: The Track Record of Economic and Financial Analysts, http://www.cepr.net/dangerous_minds.htm 16 The Boston Herald, Debt Level Places U.S. at Risk, April 4, 2004. 17 www.federalreserve.gov/releases/z1/current/z1r-2.pdf 18 Stephen Roach, www.morganstanley.com/GEFdata/digests/20050606-mon.html#anchor0 19 Dean Baker, Dangerous Minds: The Track Record of Economic and Financial Analysts, http://www.cepr.net/dangerous_minds.htm 20 U.S. Treasury Monthly Foreign Holders of Treasuries Data: http://www.ustreas.gov/tic/mfh.txt 21 Peter Warburton, Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, 1999, Penguin. 22 Peter Warburton, Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, 1999, Penguin Pg. 3 and Robert Blumen www.mises.org/fullstory.aspx?control=1579&id=71 23 www.bis.org/publ/otc_hy0505.pdf 24 Peter Warburton, Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, 1999, Penguin Pg. 42 25 See U.S. Department of Treasury presentation : http://www.treas.gov/offices/domestic-finance/debt-management/qrc/2005/2005-q1charts.pdf and http://www.publicdebt.treas.gov/opd/opds042005.htm 26 Benjamin M. Anderson; Economics and the Public Welfare, a Financial and Economic History of the United States, 1914 1946, Chapter 64 cited Antal E. Fekete; Lecture 13 - The Unadulterated Gold Standard, www.gold-eagle.com/gold digest 02/fekete102802pv.html . 27 Federal Reserve Bank of San Francisco www.frbsf.org/publications/federalreserve/annual/1995/history.html 28 Federal Reserve Bank of San Francisco www.frbsf.org/publications/federalreserve/annual/1995/history.html 29 Federal Reserve Bank of San Francisco www.frbsf.org/publications/federalreserve/annual/1995/history.html 30 Eugene C. Holloway, J.D., L.L.M., Gold, Money and the U.S. Constitution, www.gold-eagle.com/editorials_03/holloway011303.html 31 Chris Leithner, The Other Notable Buffett, www.leithner.com.au/circulars/circular89.htm 32 Alan Greenspan, Gold and Economic Freedom, www.321gold.com/fed/greenspan/1966.html 33 www.econlib.org/library/enc/moneysupply.html 34 www.rich.frb.org/publications/economic_research/economic_quarterly/pdfs/spring1996/hetzel.pdf 35 www.bankofcanada.ca/en/dollar_book/dollar_book-e.pdf 36 See also : Chris Leithner, A Tale of Two Islands, http://www.leithner.com.au/circulars/circular98.htm 37 Frank Shostak, Inflation, Deflation, and the Future, www.mises.org/story/309 38 Louis D. Johnston, More Light on a Statistical Dark Age: Output and Employment in the US, 1800 to 1930, Department of Economics, Saint Johns University, 2004. 39 Robert Blumen www.mises.org/fullstory.aspx?control=1579&id=71 40 Ludwig von Mises, Planning for Freedom, October 30, 1950, from Lord Keynes and Says Law, www.mises.org/story/1803 41 Ludwig von Mises, Planning for Freedom, October 30, 1950, from Lord Keynes and Says Law, www.mises.org/story/1803 42 See von Mises Biography: www.mises.org
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Maurice Levi, Economics and the Modern World, D.C. Heath and Company, 1994, pg. 500. Marshall Auerback, Americas Strong Dollar Policy and Argentinas Default: A Root Cause That Dare Not Speak Its Name, http://www.prudentbear.com/archive_comm_article.asp?category=International+Perspective&content_idx=8977 45 Alan Greenspan, Can the U.S. Return to a Gold Standard?, The Wall Street Journal, September 1, 1981. 46 For a discussion of Gibsons Paradox, see : http://www.gold-eagle.com/editorials_01/howe082201.html 47 US Treasury Exchange Stabilization Fund : http://www.treas.gov/offices/international-affairs/esf/ 48 www.usagold.com/gildedopinion/greenspan-gold.html 49 http://www.resourceinvestor.com/pebble.asp?relid=10302 50 Philip Judge, Lessons from the London Gold Pool, www.gold-eagle.com/editorials_01/judge052101.html 51 http://www.bis.org/publ/otc_hy0505.pdf 52 Peter Warburton, The Debasement of World Currency: It Is Inflation, But Not As We Know It, http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=8763 53 http://groups.yahoo.com/group/gata/message/1149 ; See also : Not Free, Not Fair from Sprott Asset Management http://www.sprott.com/pdf/pressrelease/press_release_not_free_not_fair.pdf 54 Statement of Claim: http://www.gata.org/BlanchardClassAction092204.pdf 55 Morgan Stanley Macro Page; May 14, 2004 see : www.morganstanley.com/GEFdata/digests/latest-digest.html 56 Ted Turner, My Beef with Big Media; How government protects big media and shuts out upstarts like me, Washington Monthly www.washingtonmonthly.com/features/2004/0407.turner.html 57 Journalists Question Media Ownership in Canada, The Dominion,http://dominionpaper.ca/accounts/2003/11/10/journalist.html 58 Journalists Question Media Ownership in Canada, The Dominion,http://dominionpaper.ca/accounts/2003/11/10/journalist.html 59 Francis Fukuyama, Trust: The Social Virtues and The Creation of Prosperity, Free Press Paperbacks, 1995. 60 http://www.osfi-bsif.gc.ca/WWWapps/fdat/dti-1-3-e.htm 61 www.econstats.com/IMF/IFS_Can1__1AD_.htm
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