An Impassioned Libertarian's Journal

 “I see green shoots” said Fed Chairman Ben Bernanke on 60 Minutes back in March, doing his best rendition of Haley Joel Osment from the movie The Sixth Sense.  Since then, every poor economic headline has been preceded with the word “unexpected” by the lapdog media, as if the clueless Bernanke’s words were suddenly the Gospel and the economy had indeed recovered.

Phantom U.S. Economic Recovery

Common sense tells us that if a phenomenon A causes a problem B, B cannot be rectified unless A is first removed.  As an adherent of the Austrian School of Economics, I can confidently tell you that a sustainable U.S. recovery is not at hand.  A sustainable recovery must not be mistaken for an upward blip in the GDP reading (itself a flawed measure of material well-being) especially when government borrowing is unprecedented and a lot of input parameters, not the least of which is the GDP deflator, can be fudged.

I’ll borrow an analogy from Peter Schiff.  Imagine if you will a victim at the unfortunate end of a Brock Lesnar knuckle sandwich.  The blow has knocked him out cold and the medics try to revive him.  The best suggestion they can come up with is to have Lesnar pound the man’s head even harder with his fists.  When the man has seizures from the repeated pounding, a medic (coincidently named Bernanke) screams gleefully “Hurray, he’s moving”.

Sadly, such is the equivalent response to our present crisis provided by the policy makers in Washington DC (perhaps soon to be renamed Barackistan).  To solve a problem caused by malinvestments resulting from easy credit at 1% interest rates, the Fed is supplying even more easy money at 0.25%.  None of the malinvestments have been allowed to be liquidated.  Housing prices have been propped up with tax breaks and Fed purchases of MBS, banks and auto companies have been bailed out, regulations have increased, debt covenants have been violated, unemployment insurance has been extended.  In addition, there’s a cap-and-trade bill and a health care bill, and a “czar” of something seemingly around every corner. All of these increase the already humongous burden on wealth creators.  In short, the problems that caused the Great Recession have been compounded.  Real output must then necessarily decline.  How can anyone thinking logically then assert that we are in the beginning of a recovery? 

Declining output is not the answer to keep a system with a debt-to-GDP ratio nearing 400% (800% if you include Social Security and Medicare obligations) solvent.  From this vantage point, one can conclude that the real recession is ahead of us, not behind us.  One then must decide whether it will be a deflationary recession or an inflationary recession.  Intelligent people can disagree on this but my take is an inflationary recession.

What’s Happening Below the Surface?

Since the Lehman collapse over a year ago, the cracks in the banking system have been papered over with an unprecedented amount of money created out of thin air.  However, underneath that surface, the real pool of savings is continually being channelled away from wealth creators to malinvestments such as housing, autos and banking.  This means that total output will decline eventually because there are no investments being made to maintain capital and improve productive capacity.  There may be a blip here and there but this is more likely to be the result of capital consumption than any sustainable increase in output.  Meanwhile, for reasons detailed below, the money supply will constantly increase.  We then have the textbook case of more money chasing fewer goods, leading to rampant price escalation.

Deflation Begets Inflation

If you happen to catch a NASCAR race on TV, you might hear a driver screaming over his radio “Tight, tight, tight…..LOOOSE!” followed invariably by a crash.  What he’s referring to is his race car’s inability to turn the corner.   A “tight” condition means the car doesn’t want to turn and is heading straight for the wall.  A “loose” condition means the car turns too readily and wants to spin out.  When a car is difficult to turn, the driver ends up putting so much wheel into it that when the car eventually turns, it overshoots, spinning out of control and the driver rear-ends the car into the wall.

This is the exact scenario I envision for the impending price inflation.  Bernanke and company are screaming that there is deflation everywhere they see.  To combat this deflation, the Fed will keeping printing money and adding reserves by buying all kinds of assets until general prices violently overshoot on the other side causing runaway price inflation.

The M2 Money Supply Barometer

The M2 money supply is used by a lot of economists as a barometer to gauge price inflationary pressures.  Over the past six months or so, this metric has declined marginally.  So if one defines deflation as a reduction in the M2 money supply, then we are indeed experiencing deflation.  On the surface, consumers are finally getting religion, curbing their spending habits and paying down debt.  Paying down debt is a deflationary activity because it reduces money supply.  Unfortunately, not everyone will be able pay-off their debts.

For a fractional reserve banking (FRB) system to stay solvent, the money supply needs to ALWAYS be increased by at least the weighted average interest rate i.e. money supply needs to grow exponentially.  Consider a system with $100 in loans due in a year @ a 10% interest rate.  The total amount of money in the system is only $100 but the amount due at the end of the year is $110.  Where will the $10 come from?  It has to be lent into existence at some point prior to when the $110 is due.  Absent this increase in money supply, the loan will default.  On the other hand, an ever increasing money supply will quickly lead to runaway price inflation as I have detailed why real output will be unable to keep pace with money supply growth.

In a sound money, 100% reserve banking system, an over-whelming majority of loans are made to wealth creators.  These loans are funded by real savings and are eventually liquidated (to simplify the explanation) by the lenders purchasing the produce of borrowers.  They can be called self-liquidating loans.  I’m not implying there will be no bad loans, just that bad loans will be minimal compared to our current system as underwriting will be very strict and the fallout of bad lending decisions will stop with a bank’s shareholders.  Of course, the vast majority of housing loans and auto loans made during the last boom can barely be classified as self-liquidating because both of these (I hesitate to call them assets) do not produce anything that can be exchanged for money.

Loan Defaults And Banking System Collapse

In a FRB system where debt is being paid down, money supply will decline and eventually prices will follow suit.  Businesses will reduce wages to stay profitable.  Any debtor will find his debt burden becoming more onerous as there is less money to go around.  Eventually, defaults will begin with assets moving from debtors to creditors.  The banking system will implode and depositors will be wiped out until reserves in the system back up deposits outstanding entirely.  This is the exact process that should have been allowed to happen since 2008.  Left alone, nothing could have prevented this catastrophic collapse.  Asset prices would’ve decline massively considering that the system had about $10 in credit money for every $1 in reserve before Bernanke injected about $1 trillion more in reserves.

Why Inflation, Not Deflation

It goes without saying that deflation would have been very painful for any debtor.  Consider the most indebted entities: the government, banks, powerful corporations, private equity funds run by insiders, and home owners.  Given these debtors, is it any wonder that the government choose bailouts rather than letting the market work its exorcism?  Every time there is even the slightest deflation, we’ll hear Bernanke et al saying that all hell will break loose unless something is done about it.

If the market were allowed to work, loan defaults would cause bank failures en masse.  Bank failures would also wipe out the savings of depositors as the banks debt holders will have seniority in bankruptcy proceedings.  Yes, all hell will break loose but only for the people who took imprudent risks like borrowing recklessly or depositing money in unsound banks.

If one bank is allowed to go under and depositors allowed to be wiped out, you can bet your last dollar that there will be a run on every bank the next day, exacerbating the problem exponentially.  The entire banking system would be ruined in a couple of days with utter chaos, pandemonium and possibly violence being the rule rather than the exception.

Rather than letting all debtors and depositors be wiped out (and defaulting on its obligations), the government will intervene via the Fed to shore up the system.  The Fed will print money to purchase troubled assets.  The Fed will also print money to fund the U.S. government as tax revenues will decline precipitously even as government mandates increase (normal operations, transfer payments, unemployment payments, wars, etc.).  Once the FDIC runs out of funds to make depositors whole, it will tap into a $500 billion credit line with the Treasury which in turn will sell bonds to the Fed to raise the money to repay depositors. 

Note that when a bank fails but the depositors are made whole, that is inflationary because the original money is still in the system and now we have the new money in addition.  M2 destruction will be replaced by M1 creation.  Deflation causes debt defaults which in turn cause bank failures which in turn result in inflation as depositors are bailed out.  In trying to save debtors and depositors, the policy makers ensure that everyone loses due to loss of purchasing power via inflation.  This cycle cannot continue endlessly.  One fine day, it will blow sky high.  Any event may trigger it from foreigners unloading US dollars and Treasuries or US citizens realizing that their money is fast losing its purchasing power.

Conclusion: Being a follower of Austrian Economics, I know that real output will continue to decline.  Declining real output will result in lower real savings.  Lower real savings put pressure on debt repayments and defaults will result.  Defaults will wipe out banks and depositors and would also cause the government to default on its debt.  The Fed will bail out all affected parties by creating money.  Bailouts cause malinvestments that lower real output setting off the above cycle again.  This cannot continue forever and will eventually result in a runaway inflationary depression.

Introduction

India’s obsession and fascination with gold is well known around the world. To most commentators, particularly western commentators, this obsession seems irrational and Indian people are deemed incurable gold bugs. However, on closer examination, gold ownership in India is neither excessive nor is it irrational. In fact, when religious, cultural and historical perspectives are considered, India’s appetite for gold seems rather matter-of-fact indeed. Nonetheless, it is not lost on any Indian worth his or her salt that gold is the asset class that best protects wealth and freedom.

When my father, a pediatric surgeon, wanted to buy land to construct his clinic and supplement his meager government income, he purchased land by mortgaging my mother’s jewelry. Similarly, millions of people in India have capitalized or recapitalized their businesses or farms by pledging their gold jewelry, not to mention securing their basic necessities after severe business reversals. India herself pledged her gold to secure a loan from the World Bank in 1991 when she was on the verge of defaulting on her international obligations. As we shall see below, were it not for gold, the average Indian’s lot through history could’ve been a lot worse. Further, I believe that India’s gold could, if tapped wisely, speed the country’s economic growth and alleviate poverty in the country over time.

India’s per capita gold holdings

India’s private gold ownership is difficult to determine accurately. However, several websites such as Gold Eagle estimate the total private gold holdings to be about 15,000 metric tons. Compared to that figure, the Indian government owns a negligible 360 metric tons of gold. Given that total gold mined in history is about 160,000 metric tons, India’s stake then amounts to 9.6% of the world’s total gold stock. In contrast, India accounts for just over 17% of the world’s population. Therefore, India’s large gold ownership is just a function of its large population and its per capita gold ownership is well below average.

While India’s per capita gold ownership is well below the world average, there can be no doubting their desire to own this metal. Demand from India consumes some 20%-25% of annual gold output. Much of this desire to continually acquire gold dates back almost 4,000 years to the Indus Valley Civilization.

Religious and Cultural Reasons For Gold Ownership

Gold jewelry was worn by ancient Indians dating as far back as the Bronze Age Indus Valley Civilization, some 2,000 years B.C. Gold also has a rich tradition in the Hindu epics, the Ramayana and the Mahabharata. It was associated with the pomp and splendor of the gods and kings who appeared in these mythological stories. The Ramayana, the earlier of the two epics, can be traced back to around 900 B.C., so even back then, gold had risen above all other commodities to be associated with power, prestige and wealth.

Let me narrate a short story to illustrate how deeply gold and wealth are imbibed into the Hindu culture. The world’s richest temple, at Tirupati, was built on the legend of Sri Venkateswara, an incarnation of Lord Vishnu. Legend has it that Sri Venkateswara, who was born poor, sought the hand of Princess Padmavati, the incarnate of Vishnu’s celestial consort, Lakshmi. Her father decreed that Venkateswara could marry Padmavati only if he possessed comparable wealth as the king himself. Venkateswara sought a loan of gold and jewels from Lord Kubera, the Hindu god of wealth. To help Venkateswara repay this loan symbolically, Hindu devotees to this day, donate money at Tirupati. This is but one of many thousands of stories from Hindu mythology, all of which involve gods, kings and wealth in some way, shape or form. Therefore, it is not an exaggeration to postulate that generations of Indians reared on these stories have come to associate gold with mythical qualities.

Historical usage of Gold

Silver coins were widely used in India during the reign of the Mauryas circa 250 B.C. The first gold coins were issued widely doing the Gupta dynasty around 250 A.D. Interestingly this period was also known as the Golden Age of India’s history. On the face of it, all emperors issue coins to commemorate and accentuate the significance of their reigns. However, there was a still more practical reason for Indians to use gold as money.

India, over the past 4 millennia, has been a collection of many thousands of kingdoms and fiefdoms. Every once in a while, an emperor or a dynasty such as Chandragupta Maurya or the Mughal dynasty appeared on the scene and was able to consolidate a majority of India under their rule. However, no sooner than an able emperor passed away than his empire disintegrated as infighting and ineffective rulers followed him. Even with the big empires, there was always plenty of fighting on the edges of the empire and border territories constantly changed hands. Millions of Indians could, in their lifetime, expect to be subjects of several rulers and be part of more than a few different kingdoms.

Gold, being of high value, could easily be hidden during times of strife, presenting ordinary citizens an avenue to prevent being looted by marauding armies. Further, a gold coin issued by one king could serve as money under any other king as long as the weight and purity of the issued coin could be assessed. Therefore, gold was the preferred medium of exchange and store of wealth.

The history of dowry in India is almost as old as the Hindu religion itself. Dowry, before the negative connotations of today, was a gift from the bride’s family to a newly married couple. It was to compensate the groom for the additional expenses he would incur taking care of his stay-at-home bride and in time to come, a family. Add in the fact that the chances of a woman being widowed at a young age were high given rampant disease and almost constant warfare, the practice of dowry was prudent for much of India’s history. Although different commodities were used to pay dowry, gold was the preferred option simply because of its wide acceptance and the ability to safeguard it during the many times of strife. The practice of giving gold and gold jewels as dowry continues to his day. While I’m not condoning the practice of dowry in the modern day or the atrocities associated with it, I’m only giving a historical perspective on why that custom came into existence.

Another offshoot of the rich tradition of gold in the Hindu religion explains why Indians mark every auspicious and festive occasion with the purchase of a token amount of gold, particularly the observance of Akshaya Tritiya. In fact, the parents with daughters begin accumulating gold in anticipation of their daughter’s weddings in small quantities yearly on these occasions.

Other Contemporary Reasons For Gold Ownership

The above historical and cultural reasons explain the long entrenched practice among Indians to acquire gold. This deeply ingrained practice continued into contemporary times despite India having a unified currency since the British acquired complete control of the country in 1857. The reason was primarily because of the continued struggles for the average Indian, first under the British and then under socialist India.

Since India’s independence, India followed a socialist economic policy with the government running constant deficits to fund its five-year plans. Needless to say, these plans proved very inefficient, resulting in plenty of wastage and constantly increasing prices. India’s disastrous war with China in 1962 severely depleted India’s foreign reserves and removed the backing for the rupee. To prevent a massive flight out of the rupee, the government established the Gold Control Act in 1962 forbidding the ownership of gold in bullion form and mandating the conversion of all private gold bullion into gold jewelry. This prevented the rise of an alternate currency if the rupee should flounder. As with all government intrusions, this law had unintended consequences. Because licenses were required to hold gold bullion, many unconnected goldsmiths lost their livelihood, seemingly overnight. The prohibition also gave rise to gold smuggling and a huge black market in gold, which no doubt claimed many lives and livelihoods. The restrictions on gold were eased only in 1991 when the Indian economy was liberalized following it’s near bankruptcy.

Further, in 1969, the Indian government under Indira Gandhi nationalized the banks and licenses were required for almost anything. This was the beginning of ‘License Raj’ in India that instituted rampant corruption in all levels of the bureaucracy. Since the state controlled all the banks, loans were made to special sectors so as to buy votes, of course with the requisite kickbacks for the bank staff processing the loans and their political patrons.

To top this, the 1970s were a tumultuous period politically in India. A state of emergency was declared from 1975 to 1977 giving almost dictatorial powers to Indira Gandhi. When democracy was restored in 1977, Ms. Gandhi was ousted by Morarji Desai. However, the common man still couldn’t catch a break as marginal tax rates hit a scarcely believable 95% and with the rupee’s value declining steadily.

In light of these circumstances, gold was the average Indian’s best friend. Due to a ban on gold, the value of gold in relation to other commodities and the rupee soared. The high marginal tax rates gave rise to a huge black market. Citizens needed a way to hide and protect their assets from the taxman and gold was one of the two asset classes that proved effective in accomplishing this task, the other being real estate.

One last reason why extensive gold holdings are prudent in today’s context is the paltry level of insurance provided to bank deposits. A fractional reserve banking system is inherently insolvent and needs government insurance to prevent a run on deposits. In India, the amount covered under deposit insurance is just Rs.100,000 or USD 2,170. In contrast, FDIC insurance in the US was increased to USD 250,000 from USD 100,000. To put things in perspective, Rs.100,000 is about 5 months rent for a decent 3BR apartment in Bangalore whereas USD 250,000 is about 4-5 years worth of living expenses for a couple in Chicago, including a mortgage or rent. In other words, Rs.100,000 is an insignificant sum of money. Realizing that the banking system is shaky due to the low level of insurance, many savvy consumers hedge by holding a portion of their savings in gold. Moreover, millions of people in rural India completely bypass the banking system because they don’t understand it, preferring to hold their savings in gold. When in need of money in a crunch, they pledge their gold with a local money lender in return for currency.

In summation, India’s ancient and deep religions traditions combined with a plethora of historical, cultural and practical reasons have fostered an unflinching desire to acquire gold as a means of protecting one’s wealth. In this light, one can hardly dismiss this desire as irrational. Given what’s in store for the world at large when the inevitable currency crisis occurs, citizens from other countries could do worse than taking a leaf out of India’s history with gold.