How Central Banks Provide You With The Illusion of Control

It’s pretty tough to invest in a world controlled by central bankers. They seem to be able to determine the price of anything. Their interventions stopped the stock market plunge of 2009 and ignited several rallies since then. The idea was to create the ‘wealth effect’ – people would feel richer and then spend more.

On Wednesday, the world was disappointed by what Ben Bernanke had to say to Congress. No third round of Quantitative Easing (QE3) just yet. And in Europe, the European Central Bank (ECB) disappointed the market with just half a trillion euros in the Long Term Refinancing Operation (LTRO). Yes, just a half a trillion…

You don’t have to know the ins and outs of what QE and LTRO actually mean. It’s essentially just a question of how much money central banks are going to inject into the economy now that rates can’t go any lower. More money chasing the same amount of things means higher prices. That’s supposed to be good for growth.

You are now living in a world that expects regular doses of new money. Without them – without enough of them – things could begin to get dicey. That’s why stocks around the world fell on the news of no QE3 and limited LTRO. Gold got hammered, down about 7% in six hours, falling US$89.07. The plunge began as Bernanke gave his testimony to the US congress. Pretty soon even fearful gold owners will be begging for more money from the world’s greatest central banker.

Not if Republican presidential hopeful Ron Paul has his way. At the congressional hearing, he asked Ben Bernanke whether he does his own grocery shopping. He does and therefore must be aware of the true level of inflation in the economy. Then things got heated. Waving a silver ounce coin at the Chairman of the Federal Reserve, Congressman Paul accused Bernanke of trashing the dollar.

The Federal Reserve is given the responsibility to protect the value of the dollar… 98% of the value of the dollar is gone from the 1913 dollar. That’s not really a very good record. I think what we’re witnessing today is the end stages of a grand experiment. A philosophic experiment on total fiat money.

As Ron Paul pointed out, having money that steadily loses its value is like a homebuilder whose definition of a metre steadily shrinks. ‘Imagine the houses we’d end up with.’

Most importantly of all, Paul tried to get the message across that this incredible inflation is theft. If 98% of the value of the dollar has disappeared, somebody had to gain that benefit. In fact, there are two benefactors from inflation. The first is the government, which spends the freshly printed dollars. Because central banks buy government bonds with the money they create, governments get that money. And because they are the first to spend it, prices have usually not yet risen to adjust for the increase in the money supply. Everyone else is left to deal with the higher prices.

The second benefactors of inflation are the owners of stuff. The stuff whose prices rise as the new money chases the same amount of goods. That has obvious implications for investing – you should own ‘stuff’ like commodities and shares rather than ‘money’, like savings and bonds. Ron Paul points out that this is why gold- and silver-based money is a good idea. It combines the benefits of owning real stuff with the convenience of money.

Just how well this works is demonstrated each time the metallic value of the coins in your wallet begin to exceed their nominal value. In other words, if you melted the coins down and sold the metal, they would be worth more than the number printed on them. When this happens the government is forced to rather embarrassingly change the metal content or stop minting the coins altogether. It has happened here in Australia as well as the US many times before. According to the Sydney Morning Herald, our five-cent coins are next. They already cost more than five cents to make because of rising commodity prices.

Oh by the way, if we get deflation instead of inflation (and prices fall), commodity-based money benefits too, as its nominal value stays put. This makes commodity money the perfect inflation/deflation hedge. Its metal content goes up in inflation and its nominal value stays the same during deflation. That’s why one hedge fund manager has bought something like a million dollars in five-cent coins. Perhaps you should start collecting them too.

The manipulation of our money by central bankers, with its intended and unintended consequences, investment opportunities and injustices, is the big issue of our time. But the most important thing about it to remember is …

It Will Go Wrong

The idea that a select group of people are now so powerful they can move markets and determine winners and losers is very fragile. Historically, it’s just a matter of time before it goes wrong. Ron Paul knows this well. ‘They’ve been debasing currencies for hundreds if not thousands of years and they always end badly. They always return to market based money, which is commodity money – gold and silver.’

There are plenty of ways for the story to end. Well, it actually ends in pretty much the same way each time, but a lot can happen in the meantime. Like a global financial crisis. And a sovereign debt crisis. In fact, those are the most common sequence of events before the end of the ‘experiment on total fiat money. First a financial crisis forces governments to back private institutions. And then the debt load that the government has taken up overwhelms the government itself. The final act is when the government turns to money printing to fund its deficit. That sends the currency on a path to complete destruction. More destruction than the 98% they’ve managed so far, that is.

The difference this time around is that just about everywhere in the world is facing the problem at the same time. This is what we’ll speak about at the Port Phillip Publishing symposium in two weeks’ time. We’d love to tell about our solutions to these problems too. You can make your reservation here.

If you accept these ideas about inflation and the state of the global economy, then the financial crisis of 2008 was just the warm up. It was the lesson you needed to learn the hard way to make the threat of a bigger meltdown plausible. If the crisis of 2008 was the end of the great moderation, the next crisis will be the end of any moderation at all.

In the meantime, we’ll continue to see what psychologists call the pilot effect – ‘We don’t know where we’re going, but we’re making great progress’ – that the world’s central bankers seem to think.

At the Markets and Money, we’re not sure about the progress, but we’re quite sure about the destination – inflation. The question is how many deflationary shocks (like we went through in 2008) you’ll have to weather first.

Until next week,

Nickolai Hubble.
Markets and Money Weekend Edition

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Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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