The Supply Theory of Money is Simple Enough

“There’s a time to go long…there’s a time to go short…and there’s a time to go fishing.”

Our colleague in South America, Horacio Pozzo, reminded us of Jesse Livermore’s famous remark…and went on to site a study of goalies in soccer games. Some tend to move to the right, when an attacker presents himself. Others tend to move to the left. But the ones with the greatest success stay put, squarely in the center.

In today’s markets, Horacio suggests, doing nothing may be the best move.

Inactivity comes easily to us. We almost never regret doing nothing. It’s the times we were too slack to do nothing that got us into trouble.

But this is a family publication, so we will pass over those events…and focus on the financial world.

Yesterday, the Fed took more action – cutting its key rate another 75 basis points to 2.25%. See how easy central banking is? You read the headlines. If they’re negative or scary, you cut rates. If they’re positive…or inflationary…you increase them.

“I think the Fed was pretty shrewd,” says colleague Ben Traynor here in London. “They were widely expected to cut rates by a full point. It makes 75 basis points look conservative – as if there was really nothing to panic over. And it leaves them with more room to cut in the future.”

Yes, dear reader, there are still 225 basis points from here to zero. In the ’90s, the Bank of Japan, of course, used up all its basis points. Still, the Japanese economy sank…and sank some more. Even today, an investor who bought Japanese stocks in January 1990 is still looking at a loss of more than two-thirds of his money – 18 years later.

But investors yesterday ignored the Japanese example and gathered up U.S. stocks with both hands. The Dow rallied 420 points.

“Buy the rumor, sell the news,” is another old Wall Street saying. Since we’re sticking with our Trade of the Decade – buy gold on dips…sell stocks on rallies – the news of this latest Fed intervention gives us another great opportunity to dump shares. Don’t miss it.

On the other side of the trade, the price of gold slipped yesterday…but not enough to qualify as a genuine dip. Commodities, generally, are getting whacked. But gold is a special case. It’s the ultimate money. People buy it when they suspect that there’s something with the other kind of money…the kind people use when they go to the grocery store.

What exactly is wrong with the dollar? Ah, dear reader, that’s a long, long story. Will the dollar go up or down? Ah, dear reader…we wish we knew.

We’re betting against the dollar – over the long run – for the many reasons we’ve discussed in these Markets and Moneys for the last eight years. But in the short run, anything can happen. In fact, we think it is time for a rally in the dollar…and a fall in the price of gold. We have no econometric study to back us up…and no sophisticated math that proves it. It’s just an intuition…and a worry.

The supply theory of money is simple enough. The more dollars you have, the less each one will buy. So, the question for a dollar watcher is: how many dollars are there? But there is no simple answer. Imagine we have an account at a brokerage…and we invest it in gold. Now, imagine that the price of gold doubles. Suddenly, we have twice as many dollars in my account, right? But where did they come from?

And now, we can sell the gold and buy something. We can, for example, have our brokerage wire the money to someone else’s account. That person, then, could transfer title to a house, for example. And, then that person might wire the money to yet another account where it is invested in a derivative contract, which in turn doubles in price, so that now he has twice as much money again. Where did that money come from? And all of this has happened without anyone actually touching a single dollar bill.

Now, imagine that there is a market crash…suddenly, all that money that came so easily goes just as easily. It disappears. Where did it go? Into the ether!

Right now, a lot of money is disappearing. House prices are falling. Stocks all over the world are going down. Many financial assets – specialized derivative contracts and junk bonds – are getting hammered. The amounts of “implied” wealth lost are enormous. Worldwide stock market capitalization may be down about $5 trillion. Residential housing in the United States has lost about $2 trillion.

In addition to the quantity of money, there is also the velocity of it. If we leave a dollar in a desk drawer, it may be part of the ‘money supply,’ but it is an inactive part. Prices are said to be the result of demand chasing supply. But the dollar in the desk doesn’t chase anything. So it doesn’t drive up prices.

When investors and lenders become fearful, the velocity of money tends to go down. People leave money in their safes…in their wallets…and in their accounts. They are reluctant to let it out for fear that it won’t come back. This, too, further diminishes the number of dollars chasing goods and services (not to mention financial assets).

As we have opined many times, we are witnessing a great battle – between the forces of inflation and the forces of deflation. In the last few weeks, it looked as though inflation was going to be the clear winner – with gold and oil hitting new milestones. But the battle is far from over. And despite the feds’ attempts to fix the fight – with rate cuts, bailouts and Bernanke’s helicopters waiting on the tarmac – inflation is no sure bet.

You are well aware, dear reader, there are no sure bets in the wacky world in finance…but when it comes to our favorite yellow metal, colleague Ed Bugos assures us: You ain’t seen nothing yet.

As the latest addition to the Agora Financial family with the newly launched Gold & Options Trader , you’d think Ed would want to lay low for a while…get a taste for his surroundings. But no – he’s hopped right into the mix with this claim: gold should soon hit $2,138 per ounce. And Ed’s got the data to back up that bold assertion. We think he’s going to fit in here just fine.

*** Poor Abby Cohen…she’s left her post at Goldman.

Goldman itself is not doing too badly. Its earnings were down only 53% – less of a drop than expected. Lehmann Bros. too turned in a surprisingly good report – with a 57% decline in earnings.

*** We had a conversation yesterday with a source, very close to the Bear Stearns situation.

“What went wrong?” we wanted to know. “How could this group of very smart accountants, lawyers, and investment pros have been so wrong about what they had in their own portfolios?”

There was something fishy about the whole story. One day, they think they have a stock worth $30…a few hours later, they sell it for $2 – making the whole company worth less than a quarter of the value of their headquarters building. If they had thought it wasn’t worth $30, they would have unloaded it then. Instead, they held until forced to turn it over for practically nothing.

“Well, they didn’t really know. And they still don’t really know,” said our source. “They have no reliable way of knowing what their ‘assets’ are worth. They’re not marked to market; they’re marked to whatever fantasy they have in their heads at the moment. When the fantasy was positive, the assets were worth something. When the fantasy turned into a nightmare, they panicked and wanted to get rid of them in the worst possible way.

“And the really scary thing is that the other financial institutions are in much the same situation. They don’t really know what they have…or what it is worth. There are almost certainly some more horror stories that will be coming out.

“Of course, this is good news to me. I’m in the business of buying assets cheap. Until now, the positive fantasies got in the way. There was too much silly money around ready to pay silly prices. Now, the silly money is disappearing. I’m beginning to see bargains in the financial sector. But I’m not going to buy yet. I’ll wait until the cupboards and closets have been cleaned out…and the nightmares have come and gone. I reckon there will be some very good deals in the financial sector a year from now.”

*** Treasury bonds are going up in price as investors seek a haven against risk. But over the long run, Treasuries may turn out to be the very worst place for your money.

Now, inflation is running around 4% (officially)…about the same thing as you get from government’s bonds and notes. If inflation remains at this level, a lender will get back from the government about what he put in – maybe a little less. It seems more likely to us that inflation rates will go up…if not sooner, later.

Back when we were in grammar school, the U.S. Treasury had a program in which it sold savings bonds through the school system. We don’t remember how it worked, exactly, but we recall being urged to buy them. School officials thought it was a good way to encourage thrift and savings among the young. Our parents thought it was a safe way to put aside a little bit of money for our education.

By the ’60s, however, the little tots were being wiped out. And by the ’70s, we called bonds “certificates of guaranteed confiscation,” when inflation was running more than 10% per year.

*** A friend, who is a contractor for the Pentagon, explained why there wasn’t more opposition to the expense of the war in Iraq: “Because they spend most of the money in the United States, not in Iraq.” Still, $600 billion has been sucked out of the consumer economy for Iraq-related spending over the past five years…the final tally is expected to be in the trillions.

Until tomorrow,

Bill Bonner
Markets and Money

Bill Bonner

Bill Bonner

Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America’s most respected authorities. Along with Addison Wiggin, his friend and colleague, Bill has written two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Both works have been critically acclaimed internationally. With political journalist Lila Rajiva, he wrote his third New York Times best-selling book, Mobs, Messiahs and Markets, which offers concrete advice on how to avoid the public spectacle of modern finance. Since 1999, Bill has been a daily contributor and the driving force behind Markets and Money.
Bill Bonner

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“And the really scary thing is that the other financial institutions are in much the same situation. They don’t really know what they have…or what it is worth.”

And this is the statement… Goldman and Lehman came out and said their losses weren’t as bad as what was predicted. Happy days! Give me a break. They’re covering up. All the banks are living in market to fantasy reality. And where’s Citibank? You don’t hear much about them at all anymore… Yet they had the biggest writedown of all the banks last year.

International Investment Group
International Investment Group

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