Endless Money THE MORAL HAZARDS OF SOCIALISM

While credit crises, which date as far back as the great Roman Republic, are nothing new, the meltdown of the financial sector in 2008 still took the world by surprise. With currency created at the click of a mouse—or produced in quantity when a central bank credits its balance sheet in exchange for government debt, mortgages, or the equally formless currency of other nations—an era of Endless Money was born. And now, we find ourselves in a very unenviable position.

Nobody understands this better than author William Baker—a financial professional with over twenty-five years of experience in investment research and equity portfolio management. With Endless Money, he skillfully examines how the U.S. government and the country’s financial systems have embraced socialism, and why cultural deterioration reinforces the trend and jeopardizes democracy. Along the way, Baker reveals how socialism is embodied in two things—the socialization of income and the socialization of credit—and discusses why this is so dangerous.

Page by page, you’ll discover why today’s economy and capital markets are facing the long-term buildup of public and private credit, and how—as we incur more debt through greater government spending, and take on higher taxes—our leaders fail to find few realistic solutions to this situation. Divided into six comprehensive parts, Endless Money offers an honest assessment of where we’re heading and why we cannot continue down this road.

Filled with in-depth insights and practical advice, this reliable resource highlights how the combination of a centrally managed fiat currency system and a tax code that confiscates  earned income, rather than mildly taxing changes in wealth, could produce a knockout punch to entrepreneurship and our society

From Chapter 1 – Unknown Unknowns

Today the economy and the capital markets are faced with the long - term buildup of public and private credit. Moreover, promises to tax and spend future income may even be the greater influence. How we got here is more a story of what has happened to our culture than it is one of a particular central bank or government policy. Combined, our private and public liabilities are multiples of the income of the United States, and the situation is no different in Europe. The change to a system wherein liabilities could pile up without eliciting much concern happened so slowly that few noticed any change, yet a time traveler from a century ago would not recognize the financial or governmental institutions of today. Interestingly, a citizen of the Roman Empire would see certain parallels: His empire spared the aristocracy from taxation, and protected it in credit crises. The treasury of the Roman Republic flooded its economy with 50 tonnes of freshly minted silver denarii annually at its peak, driving up real estate prices. Yet the cost of living remained subdued with free bread and entertainment.

Often long - term trends such as this work in the background, like the Coriolis force giving birth to a tropical storm which then builds into a hurricane. Save for the 1970s, the system of fiat currency has been spectacularly successful: Recessions have been tame and short, while the cost has been tolerable inflation during expansions. Ironically, tapping into the people’s credit and spending power through Keynesian fiscal policy and aggressive central banking builds up more Coriolis force, but dampens the perception of risk in the near - term. The credit crisis of 2008 may be remembered as a gentle rain, with downpours in certain small regions. Or what we feel may be bands of moisture preceding a category five deluge, or a reminder that the next season might be worse. There is a huge difference between forecasting the weather and being prepared for inevitable dangers. The former is almost impossible to do; the latter ought to be easy. But, as the victims of Katrina in 2005 would attest, not having known of such loss of life since the 1928 Okeechobee Hurricane bred complacency.

It is almost impossible for humans to be concerned with what in retrospect seems so logical a course of action when the benefit from doing so is actually the denial of some short - term pleasure. Shoring up levees is a costly and constant necessity. Even simply leaving town for a few days is inconvenient. Before advance warning and flood insurance was available, folks simply did not build in the flood plain.

The timing or eventuality of financial calamity is unable to be forecast. At best it might be like a hurricane warning: The tempest may strike here, it may hit there, it may be downgraded to a tropical storm, or it may go elsewhere entirely. But that doesn’t mean one should whistle through the graveyard. Man has developed ways, though crude, to help those who dare to live in dangerous regions.

The capital markets are the nerve center for all things economic. They flash signals of future events, sometimes warning of danger, sometimes transmitting aggregate foolishness: a mirror to our psyche. But many times the commentary from the experts is dead wrong when longstanding trends give way. What follows here is a framework for thinking about how to recognize what might be happening beneath the surface and affecting the long term. A few anecdotes from times past are salted in to provide more color — one insider’s view from the highest level of money management.

Humans are especially prone to faulty judgment at points of inflection, that is, when a trend is reversing. This is particularly so when what is to come is well outside the realm of expectations. At such points, there is a minority of market participants who are sensitive that the change is occurring. Members of this group, like Dickens’ signal - man, have glimmers of the change to come. It is not necessary that they completely understand what is occurring. In fact even completely bogus input could yield the proper result to those acting upon the new information.

On the other hand, the majority are so hardwired to the established direction they will insist that the reams of information put in place during the historical trend prove they are in the know. Another way to think about inflection points being invisible to the majority is to draw an analogy to how fish might view swimming in a pond that is surrounded by the first winter cold front capable of freezing it. They live in the dimension of water, and cannot know what the air is doing unless they are among the few who might be jumping. Similarly, humans have an inherent difficulty with factors existing in another dimension, for these can remain unapparent to observers even sometime after an inflection occurs. In 2007, banking CEOs were saying their institutions were sound and some even had their boards of directors authorize massive share repurchases to defend against slight drops in valuation. Charge - off ratios and delinquencies were manageable. But depositor funds, leveraged near 20 - to - 1, had been invested in mortgages secured by real estate whose value had skyrocketed; a slight drop might wipe out the thin coverage inherent in loan - to - value ratios and the banks ’ capital ratios. To many banks it did. Even well into the crisis there was little acknowledgement of the debacle that has occurred in the real estate market. One of the real estate industry ’ s principal news sources, Inman News, published an article in late August 2008 by economic commentator Lou Barnes that typifies the real estate agent mindset of denial. Barnes rants, “Case Shiller continues its hysterical mismeasurement, insisting that home prices fell 15.9 percent in the last year. The excellent www.ofheo.gov data has national prices down 4.8 percent.”

From Chapter 18: The Elephant Killer: Gold

Flexible Gold

Probably the most workable solution would be a new gold standard that would be flexible. Countries could establish the value of their currency in ounces of gold, but vary this price depending upon international confidence in it and the terms of trade. If, for example, the United States believed its major trading partner, China, was maintaining its currency at low levels to maximize export earnings, it would have the option to devalue the dollar relative to gold instead of accusing China of manipulation. In today’s system, China can exercise considerable power to softly peg the yuan to the dollar. But if under a gold standard it fixes its paper to a commodity equivalent, gold, it would be forced to export that commodity upon demand if it made an ounce equivalent to too many yuan. That would happen if it chose to competitively devalue in synchronization with the United States — but only if the U.S. dollar was not itself undervalued also. In that case, both countries would suffer a drain of gold.

The U.S. dollar and all other fiat currencies, having been printed relentlessly since the abandonment of the gold standard, would all need to be reset at a price which equilibrates a high number of currency units per ounce of gold, otherwise there would not be enough gold to be used for currency value linkage, and because debt would be overvalued and a run on gold reserves would ensue. In 2008 and 2009 there has been a substantial amount of currency volatility, which confirms that the massive trade imbalances of many countries (particularly the United States and China) are in need of settlement but may not have a mechanism through which to clear. Gold may be that tool. In the past, a chief objection to its use was the volatility it might introduce into price - rigid world economies, heightening unemployment. But with permission to revalue and devalue, currency volatility would be no more than it is now, and in the world’s shaken and unstable environment, high unemployment is likely anyway.

There still would be political obstacles to restoring gold. For one, China has had a policy that encourages exports and retention of savings. Facing its own recession, it can hardly induce its citizens to step up consumption of imports now. But its government could import a proxy for commodities — gold. If the United States and other countries were part of a flexible gold standard, then the drain of gold from countries that have large trade deficits, such as the United States, would cause pressure for them to increase their local price of gold. This would stimulate gold production or dishoarding, but longer term the beneficial effect would be to engender the development of industries that would suddenly be that much more competitive globally at the new exchange rate. Alternatively, if the United States chose to maintain a high level of consumption and not join the new flexible gold standard, then China could continue to convert dollars into gold. In the past this would have seemed irrelevant or barbaric, but in the aftermath of the great financial bubble, it may be exactly what is required to unlock the credit markets and balance trade (classifying gold as a commodity proxy). Yes, the dumping of dollars would transmit a measure of inflation to the United States, but with deflation and conventions that make prices and wages sticky to the downside, that may be a welcome surprise. In essence it would be the mirror image or reverse of the low consumer price inflation and rapid revaluation of asset prices seen during the great financial epoch, for there would be a rebalancing that shifts the upward price movement back into the real (and productive side) of the economy, while prices of non productive assets, such as real estate and overpriced stocks, might remain depressed or rise comparatively less.

Even after a 20 percent equity market selloff in the first three months of 2009, most institutional money managers and analysts assigned a very low probability that the countries of the world would ever return to a gold standard. Instead, they would hold out for a conventional recovery driven by the white knights at the Federal Reserve System, the natural cyclical forces of capitalism, or if they have faith in Democratic solutions, the American Recovery and Reinvestment Act of 2009. So, besides the geopolitical obstacles, it is hard to imagine much popular passion for gold restoration. One must turn to scenario analysis, where a possibility that unusual world financial events could suddenly lead to this outcome. The most interesting case is a scenario that eerily echoes the events of May 1931, when the collapse of Creditanstalt triggered a wave of currencies defaulting on gold exchangeability by the fall of that year.

European banks as a whole took on more leverage than their U.S. counterparts, because capital risk weighting guidelines allowed them to borrow almost with impunity against AAA - rated investments, which included many of the mortgage pools assembled into CDO securities by U.S. investment banks. Also largely represented in AAA holdings are securitizations of credit cards and corporate loans. Note that in this sense government regulation in Europe may have been the proximate cause of the mortgage bubble, along with the complicity of Fannie Mae and Freddie Mac. This vulnerability is compounded by these banks having acquired Eastern European banks and having made loans in these nations, often low - interest - rate mortgages denominated in what are today very strong currencies: the yen, Swiss franc, or compared to local scrip, the euro. Since the borrowers ’ income is denominated in heavily compromised local currencies, defaults have risen rapidly. It is not hard to imagine the unexpected failure of a significant Central European bank under the circumstances. In 1931, Creditanstalt received a rescue package, just as today the IMF has been injecting funds into the region to keep it propped up. In the 1930s, even the Fed was involved in the rescue, and today it is no different with the largest item on its newly ballooned balance sheet being currency swaps with foreign central banks. Some believe the IMF itself could be insolvent, which might trigger it to dump its 3,200 metric tonnes of gold onto the market. The holdings of the IMF are second only to the United States (8.1 thousand tonnes) and Germany (3.4 thousand tonnes), and are 11 percent of all central bank reserves.

China could step in and offer to quietly do a block trade at a firm price, thus saving the IMF from pressuring the gold market (disrupting the market is actually codified as against IMF policy). Such a transaction would not be large compared to the international currency markets, for at nearly $ 1,000 per ounce the IMF holdings are worth just over $ 100 billion, which would be a fraction of Chinese holdings of U.S. government securities. However, such a trade would be viewed dimly by the United States, because it would underscore the fundamental weakness of the dollar and it would release a small but significant quantity of U.S. government bonds for sale by the IMF to help clean up the mess in Eastern Europe. Like China National Offshore Oil Corporation ’ s $ 18 billion tender offer for Unocal that was nixed in August 2005 as a security threat, such a transaction could be vetoed as well. But China is in a stronger position today, and the necessity of bailing out the IMF might bring the world ’ s countries together in conference to distribute the gold and establish a rejuvenated Bretton Woods system that would signal a tilt back toward the usage of gold to restore confidence in the dollar and the health of central banks generally. Perhaps with this in mind in April 2009 China revealed that it had been buying gold, increasing its reserves from 600 tonnes (in 2003) to 1,054 tonnes five years later. In late 2008 rumors that China was buying gold surfaced. Note that China has grown its M2 money supply at double digit rates historically, and by April 2009 monetary stimulus advanced at a 26 percent clip. China would likewise need to buy massive amounts of gold to back the yuan, and it would face devaluation compared to gold and perhaps even the dollar. Despite the aforementioned leaks about its increasing gold reserves, China has accumulated even greater levels of foreign exchange reserves, diluting the hard backing of its currency.

When Roosevelt devalued the dollar in 1934, this turned the tide and fostered monetary expansion that transformed deflation into slight inflation. Before that point, savings had begun to increase as well, another prerequisite for a sound banking system. However, relative to the Roosevelt era, as discussed earlier in the book ’ s inflation – adjusted bracket analysis, nowadays taxes are already high. Moreover, state and federal governments occupy a greater percentage of the economy than they did in the 1930s. Consequently, Roosevelt - inspired fiscal tinkering may be of diminished benefit, if indeed one could concede that it had any positive effect in the fi rst place back then. The proclivity of government to borrow and spend puts pressure on the Fed to be accommodative and makes further increases in taxes politically thorny and perhaps even revenue reducing outright. Should a return to gold or silver be forced upon us through world events, there might be an irresistible run on Treasury gold or silver unless very harsh fiscal restraint was exercised. About the only imaginable way that this could come to be would be if politicians knew they were cut off from the unlimited funding they enjoy through the Sixteenth Amendment, which enables government to expropriate property. A political backlash strong enough to bring this about might be the predation of IRA accounts or pension funds, which of course would be foisted onto the public as a temporary necessity.

If a new Bretton Woods meeting does not produce a flexible gold standard, the free market may move toward the adoption of an ETF - like currency, anyway, whose value is expressed in the weight of the gold or silver backing it. This was the original meaning of the “ pound ” adopted by Britain, and in fact the “dollar” is a name derived from a 16th century Bohemian coin known as the “ Joachimsthaler,” shortened to “thaler,” which was defined by weight. 2 This concept of having currency based upon the physical metal is known as free metallism. Gresham’s law dictates that the current poorly backed currencies would keep new well - backed ones from emerging, so long as countries are willing to accept payment for their exports and return of their capital in the form of depreciating paper currencies. But in reality gold and silver never disappeared. Rather it was held by the populace in savings and withdrawn from usage to transact business and pay taxes, for which inferior currency was used. Conversely, paper currency was no longer useful for savings. The specie that disappeared from circulation in the 18th century was not destroyed; it was exported to nations that honored sound money, or it was hoarded.

As an alternative to the inflationist view, demand for gold may continue to rise even though a deflationary threat emerged in late 2008. U.S. citizens fearing encroaching statism and reckless finance may see physical gold and ETFs as an alternative store of value. Investment demand has soared. Physical gold purchases doubled in 2008, reaching almost 800 tonnes, and ETFs added over 300 tonnes that year, a 24 percent rise. Since 2000, investment demand has grown by 900 tonnes, nearly offsetting an almost 1,100 tonne falloff in jewelry demand. Once investment demand more than backs out jewelry usage, the price of gold is likely to reset closer to its equilibrium point for utility as money rather than where supply and demand for ornamentation sets its value. Some think ETFs could fail because the custodians of their gold may be leasing out their deposits to traders at bullion banks who are selling the metal short to earn an interest spread. This may explain the churning in the gold markets in 2008 - 2009 and the heavy technical resistance seen at about $ 1,000 per ounce. In response to this fear, many have begun to buy specie instead, which would reveal this subterfuge and also suspected naked short selling by bullion banks generally. An interesting alternative to specie is digital gold, essentially deposit accounts that enable electronic transactions for commerce that are 100 percent reserved. James Turk pioneered this product, goldmoney.com , which had about $ 700 million of holdings in mid - 2009. To alleviate the credit crunch of 2008, politicians are considering unprecedented increases in government spending and borrowing. This in turn has begun to trigger monetization of government debt through the direct purchase of such obligations by the Fed, which could expand. A key element of a successful currency is its scarcity. Borrowing can be discouraged by concerns over creditworthiness, to which even the United States might be subject. Unbacked currencies have been shunned before, and they tend to reach a tipping point as was seen after World War I in Europe. When money moves to a natural, unleveraged form, it starves oxygen from bubble - fed assets and securities, which are much riskier.

The question was asked of the “I.O.U.S.A.” town hall panelists whether our trading partners might sell off their holdings of Treasury notes. Warren Buffett offered that they not only would not, they could not, because they would need to convert into some other currency, which would be little better than ours. The other panelists concurred by silence. Enter the elephant of fiat currency: Buffett’s answer assumes that there is no alternative, because for generations all the world’s currencies have been backed only by the promise that governments would accept them in payment of taxes. But that ignores a currency that has been used effectively by man for thousands of years: gold. China and other countries might exchange their U.S. dollars for it now.

Clearly Buffett and other billionaires benefit from a fiat currency system, because it provides gently rising asset prices against which they can borrow to obtain cash flow in a tax - free manner. The derivatives market can even take out the repayment risk by maintaining a floor for collateral valuation. So the last thing Buffett would want to do is to alert the movie ’ s viewers to the possibilities of using gold to back the dollar, for it would cut off the über - rich’s tax - free ATM machine. Speaking at Harvard in 1998, Buffett said “gold gets dug out of the ground in Africa or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head. ” Yet when governments are undisciplined spenders and wish to monetize their debt, gold is the only means investors may have to preserve their wealth; in this case it possesses unparalleled utility. Mr. Buffett is a humanist with absolute conviction that man can construct economic and governmental systems that are failsafe. Those who see the train wreck central planning will nearly always produce (as long as enough time has elapsed) realize they would rather place their faith in something absolute as opposed to paper money, which is readily manipulatable by men.