Harrisburg Fails to Get the Word

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Municipal bondholders have something else to worry about. If Occupy Wall Street has legs, and, if labor unions handcuff the protestors' agenda ("Major Unions Join Occupy Wall Street Protest" - New York Times, October 5, 2011), will that effectively downgrade general obligation (G.O.) bonds another notch? That is unlikely. In fact, trends over the past few months have shown states and municipalities are more inclined to meet general obligation bond payments as long as they possibly can. Union workers who press municipalities into bankruptcy (the Harrisburg, Pennsylvania bankruptcy might be interpreted as such) should take heed.

States and municipalities are averse to filing for bankruptcy. If they wobble, the courts remind them of their priorities. The State of Minnesota could not reach a budget agreement this past fiscal year (ending June 30, 2011). In advance, a June 29, 2011, District Court expressed its opinion: "Only minimal levels of staff and operating expenses that are necessary" should continue. "All others are recommended to close." Of "activities recommended to continue" number one on the list (although it is not stated if the sequence is in order of priority) was "bond payments and related activities."

Minnesota political alliances belie such a full-throated bondholder decree. The attorney general petitioned the District Court for an Opinion; the governor opposed the attorney general's Petition, arguing executive and legislative authority over budget priorities are not judiciable. In private, the political actors agreed that payments to bondholders were more important than paying a single salary. (The impasse, during which bondholders were paid and non-critical state employees were idled, lasted until July 20, 2011, when an agreement was reached.) Such a cordial behind-the-scenes concord can be expected in other states and municipalities. The consequence of not paying bondholders includes the assumption they will be unable to issue general obligation bonds for several years and, even then, at higher interest rates.

A second reason to remain current is to retain control. When a municipality enters bankruptcy, the court can exert enormous control over the legislative bodies. The court will decide who gets paid in the case of Harrisburg, leaving aside for the moment the Commonwealth of Pennsylvania's legislative and legal attempts to thwart the bankruptcy filing, as well as the mayor of Harrisburg's legal action against the city counsel's decision to file. (Note: this discourse addresses situations when it is not necessary to default. There will be many situations when there is no choice.)

This "clearing of the decks" allows us to suppose the court adapts the "Municipal Financial Recovery Act Recovery Plan [for the] City of Harrisburg" submitted (by several concurring organizations) on June 13, 2011. Since Harrisburg's finances are no better than four months ago (at best), the court may save itself some time by reviewing this 422-page, 11-megabyte plan.

Among its conclusions, the Plan states: "[T]he City must [note: "must"]... outsource [its] commercial sanitation collection; eliminate [its] Park Ranger program; combine Park Maintenance in the Department of Public Works..." These are only a few of many structural changes. Henry Kravis has a bigger heart.

The Plan does not shrink from expressing its disgust at backroom City deals by certain politicians: "The City must contain fast growing employee compensation by immediately challenging the extensions made by the previous Mayor immediately prior to his leaving office that increased compensation for employees despite the looming financial crisis..."

The nexus between previously negotiated employee compensation - particularly by unions - and the dwindling revenues to fulfill their legally negotiated pay and benefits (both parties signed), will be a battle royale. Although the Plan does not state a specific reduction, it is unambiguous in regard to which is Peter and which is Paul: "[T]he city is forced to reduce its existing operating budget by a minimum of $2.5 million to pay debt service and compensate for lost revenue...."

Although not generally mentioned, both the municipalities and the unions understand which comes first. The unions know it is better to press their demands up to the point before default and (possibly) bankruptcy. This puts them in accord with the politicians' top priority: to make bond payments. A central figure in the mid-1970s, New-York-City negotiations recalls: "Union leaders need to look as tough as they can. When they have to back down, they vilify the city's negotiators. It's a macho thing."

Why, then, did Harrisburg file for bankruptcy, given that many parties did not think it was necessary? This is a big country and not everyone gets the word. Mistakes will be made. That's why they are where they are.

The 8% Solution

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

The terminal stage of Dr. Frankenstein-style central banking is disgorging ridiculous claims of authority motivated by reckless efforts to retain control. One such pincer attack is the Federal Reserve's purported 2% inflation target. Behind our very eyes, this fictional mandate is being raised, all the more reason that savers need to speculate, not a welcome prospect with both inflationary and deflationary influences expanding and bound to burst.

A certainty of this age (post-Western-Civilization) is the ease with which libertine policies escalate to fantastic proportions even as they are failing. The Federal Reserve mumbles its 2% inflation target while the "economic literature" has sown the garden for an 8% inflation rate, in the name of "price stability."

To be more precise, "inflation" to the Federal Reserve is conveniently defined as the consumer price index - without including food and energy. This 2% or 8% target should be understood as a negative interest rate. The Federal Reserve will (through its current policy, although this will boomerang at some point) hold Treasury yields at zero-percent. It will target inflation at 2% to 20%.

In The Beginning, at least in this short narrative, a Harvard economist told a Senate committee the United States must accept a 2% inflation rate as the cost of prosperity. That was in 1957, a very good year to wrap such a career-advancing declaration inside a Cold War mandate. "Growth" would defeat the Soviet Union.

Federal Reserve Chairman William McChesney Martin did not agree. On August 13, 1957, Martin warned that recent inflationary pressures had risen from a period of strong economic growth fostered by "'imbalances in the economy' in which 'rising costs and prices mutually interact upon each other over time with a spiral effect.' . . . The person most likely to be injured in the inflationary cycle was the 'hardworking and thrifty...little man' on fixed income who could protect neither his income nor the value of his savings."

Martin was doomed to lose this battle and the media misunderstood hemorrhaging inflationary tendencies. Inflation was National Worry #1 when the business editor of the New York Times calmed his readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as it has happened recently in other countries." That was in 1966.

President Richard Nixon held a farewell gala for Martin in 1970. The soon-to-be ex-Federal Reserve chairman sobered up the tipsy revelers when he removed the punch bowl during his valedictory speech: "I wish I could turn the bank over to Arthur Burns [the next Fed Chairman] as I would have liked. But we are in deep trouble. We are in the wildest inflation since the Civil War."

Moving ahead, Professor Ben S. Bernanke wrote a book that was well received in the right circles: Inflation Targeting: Lessons from the International Experience (2001). One of his co-authors was Frederic Mishkin. Those in the know understand the implications of Mishkin's cooperation. The book propagated the awful euphemisms ("the zero-bound" and "inflation targeting") used to disguise their mandate to inflate. Rather, they could have simply stated: "Let's ruin the dollar."

Some economists took exception. Lee Hoskins, president of the Federal Reserve Bank of Cleveland from 1987 to 1991, wrote: "Pundits, economists, and some Fed officials often talk about the fight against inflation or the battle against it or the need to contain it as if it is some preternatural event. The Fed does not have to battle or contain inflation, it creates inflation.... So when a Fed official says the goal for inflation should be 2 percent, he is explicitly choosing to create that rate of inflation." ("Zero Inflation: Goal and Target," 2005) Hoskins is not a regular on CNBC's short list. (See "The Education Gap.")

Federal Reserve policy of 2% inflation is a product of failure and verbal repetition. Bernanke's Fed needs room to maneuver ("infinite bound"), and a wide fairway to compound its broadening failure, while not losing credibility. Thus, this fictional authority is repeated over and over. Current Federal Reserve Governor Janet Yellen: "This increase in core inflation was below the 2 percent rate that I and most of my fellow Fed policymakers on the Federal Open Market Committee (FOMC) consider an appropriate long-term price stability objective."

Note the structure of Yellen's statement. She hides the arbitrary ("consider an appropriate") under legal cover ("price stability"). The Fed and its accomplices in the professorate train the public mind through such repetition.

Even with 2% inflation touted as a mark of price stability, higher figures are working their way into the public conscience. N. Gregory Mankiw, a Harvard economics professor who consistently establishes new lows in personal integrity, wrote a column in the April 19, 2009, New York Times: "It May Be Time to go Negative."

It should be remembered that Mankiw made his proposal because Federal Reserve Chairman Ben S. Bernanke's grand theory was failing. In October 2011, we know it has failed. Bernanke's foolish interpretation of the Great Depression has done nothing to halt the housing bust. It is far worse today than in 2009, and probably about to take another tumble. This was an inevitable consequence of the credit binge, of which Bernanke's Fed has no understanding. We have paid a heavy price for this ignorance. Investment continues its drift towards short-term trading gains and not into industries that need long-term investment to prosper. The result: a country with an inflation-adjusted median income that is 6.7% below that of June 2009.

In his 2009 column, Mankiw wrote: "[T]here is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates - interest rates measured in purchasing power - could become negative. Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation...." That's enough. Mankiw consistently makes Eddie Haskell's syrupy conversations with Ward Cleaver sound like General Patton's misadventure with the hospitalized soldier.

Note that Mankiw was behind the times. He needed to justifying negative interest rates even though such a course is inconsistent with the Fed's mandated goal of "price stability." No insufferably pliant economist would make that mistake today - note Yellen, above.

It is obvious that Mankiw is vying to head the Fed, with such maneuvers as his recently announced post as Presidential candidate Mitt Romney's economic adviser. Romney has stated he will jettison Bernanke. (Romney's other adviser is Glenn Hubbard - See: Inside Job) The resourceful Bill Black, author (The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry) and currently professor of Economics and Law at the University of Missouri - Kansas City recently quoted from a paper written by Mankiw in 1993: "[I]t would be irrational for operators of the savings and loans not to loot."

Harvard economics professor Kenneth Rogoff, author of This Time is Different: Eight Centuries of Financial Folly, told Bloomberg News on May 19, 2009: "I'm advocating 6 percent inflation for at least a couple of years." Rogoff has not changed course, recently advocating 6% inflation in the Financial Times.

Mankiw was quoted in the same article as declining to "put a number on what inflation rate the Fed should shoot for, saying that the central bank has computer models that would be useful for determining that." The "model" trick is the mental ghetto that permits fourth-rate economists to become Federal Reserve chairmen.

But Mankiw is on to something. Why pin yourself to a rate, when triple-digit inflation may be required to really ruin the country?

The following sequence is a lesson in how bureaucracies insinuate their failures into accepted policy.

Stanley Fischer, current Governor of the Bank of Israel, doctoral Ph.D. thesis adviser to Ben S. Bernanke and to Greg Mankiw (at MIT), with stops at every institution of impeccable prestige among the anointed (chief economist at the World Bank, vice chairman of Citigroup) professed in 1997 that: "The fundamental task of a central bank is to preserve the value of the currency." That is the first sentence in "Maintaining Price Stability," a paper published when Fischer was First Deputy Managing Director of the International Monetary Fund. Five paragraphs later (wasting no time) Fischer wrote: "Barro (1995) and Sarel (1996) do not find a clear negative relationship below 8 percent inflation..." That is, as long as it remains at 8 percent or below, inflation is not a burden to economic growth.

We can be sure the conclusion rested on the result of some computer model. Barro (1995) and Sarel (1996) cited as their authority Fischer (1993), which is noted later in Fischer (1997).

In 2001, IMF economic researchers Mohsin S. Khan and Abdelhak S. Senhadji wrote a staff paper "Threshold Effects in the Relationship between Inflation and Growth." The authors declare "[F]irst identified by Fischer (1993)" [addressing inflation below an 8 percent rate], "inflation does not have a significant effect on growth, or it may even show a slightly positive effect." Note the change from the (1997) model Fischer from whom they quote: from "do not find clear negative relationship below 8 percent inflation," to "it [8% inflation] may even show a slightly positive effect." This sequence was arranged by Sheehan (2011)

In 1978, Federal Reserve Governor Henry C. Wallich spoke before the graduating seniors at Fordham University. His topic was inflation. Wallich explained the loser is labor. "Inflation becomes a means of exploiting labor's money illusion."

His speech is interesting in a contemporary context. The Wall Street protestors, who are probably building igloos in front of the Nome, Alaska city hall by now, are on to something; or, it seems, some things; but they are diffusing their influence. One of the protestors' tendencies leans towards a government solution. This is a barren tangent. A supersized government uses supersized banks to remain supersized.

Wallich told the Fordham students, that government is one of the winners in an inflation. From this Federal Reserve official: "It [inflation] allows the politician to make promises that cannot be met in real terms, because, as the government overspends trying to keep those promises, the value of those benefits shrinks." This creates a "diminishing ability of households to provide privately for the future.... One may ask whether it is not an essential attribute of a civilized society to be able to make that kind of provision for the future."

Wallich went on to emphasize "the increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government." If alive today, he would not be surprised the protestors are looking to the government for help. Wallich (1914-1988) grew up in Berlin and lived through what he warned against (1978).

Wallich added that inflation "creates a vacuum in the private sector into which the government moves." He worried that the consequences of the inflation would be "a shift into the third dimension, away from democracy and toward authoritarianism."

In Wallich's Germany, Joseph Goebbels (1897-1945) spoke at Nuremberg (1934):

"It is no sign of wise leadership to acquaint the nation with hard facts over night. Crises must be prepared for not only politically and economically, but also psychologically. Here propaganda has its place. It must prepare the way actively and educationally. Its task is to prepare the way for practical actions. It must follow these actions step by step, never losing sight of them. In a manner of speaking, it provides the background music. Such propaganda in the end miraculously makes the unpopular popular, enabling even a government's most difficult decisions to secure the resolute support of the people. A government that uses it properly can do what is necessary without running the risk of losing the masses."

The Golden Constant

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

The following is a brief outline of "Gold and the 'Flations," published in the April 2005 Gloom, Boom & Doom Report.

General talk has it that gold is a hedge against inflation. We might take this a step further and conclude that a unit of gold will purchase a constant basket of goods when prices are inflating.

Standard advice does not include gold in one's asset mix during non-inflationary periods. The evidence presents a more complicated picture.

Taking the data alone, gold has been a better wealth gatherer, and preserver, during deflations than inflations. (The following discusses gold vis-à-vis goods prices, not asset prices.) That is beside the point today: Gold has consistently been of greatest value during times of disintegration.

Roy W. Jastram, professor of economics at the University of California, Berkeley, spent two decades collecting data and sifting through the evidence. He published his conclusions in The Golden Constant (1977). (There is a recent successor book that is not consistent with Jastram.)

Jastram's interest was the value of gold in relation to purchasing power. Given most, if not all, paper currencies' decline in this regard, the author's findings are worth studying.

First, over long periods of time, gold maintains its purchasing power. "The intriguing aspect to this conclusion is that it is not because gold eventually moves towards commodity prices but because commodity prices return to gold." The author called this "the retrieval effect." The implication today is the price of goods, which have increased in the low single-digits over the past decade according the government, will catch up to the 18%-or-so annual increase in the spot gold price over the same time. Gold and Silver Stocks made the case that the miners are primed for heady gains. The farcical characters ruining the world's paper currencies make an even better case that gold is headed to 36,000 (as prophesized by Glassman and Hassett. They identified the wrong market. )

Second, gold has held purchasing power to a greater degree in deflationary periods than during inflationary times. That distinction is not important today, since this is a time of disintegration. Thus, we come to the heart of the matter:

Third, "gold has served as a financial refuge in political, economic, and personal catastrophes." The current collapse of central banking, the practitioners of which are destroying the world's financial system in an attempt to salvage their reputations, fits all three. Jastram labeled this the "Attila Effect."

That is the case, pace Jastram, for owning gold and the miners today.

Following are some very brief comments on Jastram's methods and review of his figures, originally published at much greater length in "Gold and the 'Flations."

Jastram collected data from two countries to produce his "purchasing power of gold." These were England (1560-1976) and the United States (1800-1976). England is a country "for which data are available over unusually long spans of time" and "with constant political boundaries for many centuries." Jastram recognized the United States cannot "match all of the attributes cited earlier for the choice of England" but "it is fully justified by its great importance both as a national economy and as an economic influence on the rest of the world."

He approached this excursion into economic history as a statistician: "I do not presume to take on the role of an economic historian or a monetary economist as well." Nonetheless, patterns of monetary behavior under analogous historical events do repeat themselves.

In England, the purchasing power of gold declined during inflationary periods: 1623-1658: -34%, 1675-1695: -21%, 1702-1723: -22%, 1752-1776: -21%, 1793-1813: -27%, 1897-1920: -67%, 1933-1975: -25%.

Again, in England, the purchasing power of gold rose during deflationary periods: 1658-1669: +42%, 1813-1851: +70%, 1873-1896: +82%, 1920-1933: +251%

The numbers require interpretation. Gold has been a much better hedge against inflation than is shown. For instance, during the inflationary period of 1933-1976 in England, gold lost 25% of its purchasing power but prices rose 1,434%. (As to what might have kept pace with inflation, "crime" comes to mind, the tendency at Too-Big-to-Fail banks.)

Importantly - for the investor and shopper - Jastram concentrated on periods that lasted a generation or more. He was "not concerned with a transient swing of upward or downward price movements of short duration, but rather with fundamental changes in price levels of substantial duration." He emphasized that gold is an ineffective hedge against yearly commodity price increases.

Jastram's findings should be compared to the traditional investment adviser's rationale for owning or not owning gold. As outlined:

Gold is a poor hedge against major inflations.

Gold appreciates in operational wealth in major deflations.

Gold is an ineffective hedge against yearly commodity price increases.

Over long periods of time, gold maintains its purchasing power.

Gold has no equal during times of disintegration. The "Attila Effect" is coming soon to stores near you.

Measuring Financial Productivity

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

"An Absolute Zero" discussed the relationship of credit growth to economic growth. (The measurement used in the article was the change in non-financial domestic debt divided by the change in nominal Gross Domestic Product.) The productivity of credit has sharply deteriorated over the past 30 years. In fact, the additional credit creation today may actually be a cause for economic shrinkage rather than growth. It is making us poorer. There are other ways to look at the efficiency of finance. I would like to hear from anyone who has given this some thought. Josh Friedlander, friend and Online Editor of Absolute Return magazine, has already chipped in. Josh writes: "I really loathe GDP." That makes two of us. If given the opportunity, I would ban the government from calculating GDP. Josh goes on to ponder whether GDP "probably [gets] some rise simply from the transfer of (newly issued) government securities from one place to another.... [B]ut maybe this is exempt from GDP." I don't think issuance of government securities changes total GDP, but would like to hear from someone who knows. Josh asks whether I've "done this analysis as a ratio of debt to government revenue. Agreed, taxes change, but that's how I'd value the U.S. if it were a business." The tables I found for tax receipts are organized by fiscal year. Some more research would surely turn out monthly figures which would be comparable, but my entire staff is draped in black so unable to function. Some Red Sox thing. Back to the measurement used: the change in non-financial domestic debt divided by the change in nominal Gross Domestic Product. There are at least two advantages to using GDP in this comparison. First, it is widely recognized as a measure of growth. Second, since it is a widely publicized economic number it is manipulated - to the government's advantage. Thus, the measure of financial efficiency used in "An Absolute Zero" understates the deteriorating relationship of new debt to economic growth. It is better to err on the conservative side. Error in such comparisons must be accepted. There is no perfect measurement. Economic numbers are always estimates and patterns within the object being measured change over time. The employment figures, for instance, are not an exercise in counting every working noggin in the country. Cutting-and-pasting from the Bureau of Labor Statistics website: "The confidence interval for the monthly change in total non-farm employment from the establishment survey is on the order of plus or minus 100,000... there is about a 90-percent chance that the "true" over-the-month change lies within this interval." Now, for those who watch Bubble TV, think of all the hoopla when the employment numbers are announced each month. What an exercise in fatuity. (Bill King - The King Report - just reminded his readers of an August 19, 2009, story in The Onion: "CNBC: Anyone Who Owns a Suit Can Come on Television" From the story: "'Just come on down, run a comb through your hair, and if you're here by 8 a.m., we'll have you on Squawk Box at 8.15 making stock picks. But don't forget your suit!'") Modern Kremlin watching includes the change in relative importance of economic numbers. GDP, the monthly employment figures, and the CPI are ascendant. Thus, they should be treated with the greatest skepticism. Income is rarely mentioned. Given that income, as a whole, have not risen since 2008, it is wise of the government mandarins to ignore it. The media's reason for not pursuing such a hot lead is a mystery. At least The Onion is publicizing the root of the problem. A descending figure is productivity. In the late-'90s, an exhilarating productivity announcement (+0.1% was all Bubble TV needed) was good for a $50 boost to Webvan and theGlobe.com. This was Fed Chairman Alan Greenspan's doing, in a complicit alliance with heralded economist Michael Boskin. (See "Economists Serving Their Political Masters") The torturous destruction of GDP and productivity can be reviewed in "The Government's New Math: 3.5% - 5.1% = 1935." Chapter 12 of "Panderer to Power" is devoted to the subject. Today, the quarterly productivity announcement is barely discussed. Again, this is for good reason, from Washington's point-of-view. Productivity is falling. Non-farm business productivity per hour fell -0.6% in the first quarter and by -0.7% in the second quarter of 2011. If this were 2000, Webvan might have gone out of business three weeks sooner. As an aside, I don't think we can measure productivity today. It may have revealed some trends when a large proportion of America's work was shipped from River Rouge. Comments on how to measure the change in the efficiency of finance over the decades are welcome. This includes the return on capital, and on equity, even though one only need be alive to see the obvious deterioration in how we allocate our capital investments.

An Absolute Zero

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

The Federal Reserve Open Market Committee (FOMC) concluded a two-day meeting by initiating "Operation Twist." The FOMC's press release explained: "The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative."

This announcement initiated sell programs in almost every market. There are many reasons for this reaction, one of which was the recognition that every initiative has failed, and now, all they can think to do is drive down yields that are already below 2.00%!

A reason for the Fed's failure is the array of topics that never enter the mind of economists such as Federal Reserve Chairman Ben S. Bernanke. These include money, credit, debt, and capital.

The productivity of capital is an important consideration, one which most people understand, in their own words. A bank does not lend money to a business that can not earn its way to paying back the loan. A potential borrower understands the banker's hurdle. (This refers to the majority of smaller banks in the country where the officers lose their jobs or worse when the bank fails if it adopts such a strategy.) An investor buys shares of common stock in a company that will produce the most from the least. The higher the profits produced per share, the more the shares should be worth.

Ben & friends do not think this way. During the Fed's quantitative easing schemes, the additional debt has produced nothing. The Federal Reserve, including the Board, the FOMC, and the thousands of Ph.D. researchers may not know even know of this relationship, but there is a growing understanding, intuitive or quantitative, that sees the Bernanke Fed as failing by a greater degree with every new initiative.

During the 1980s, the change (rise) in non-financial domestic debt divided by the change (rise) in nominal Gross Domestic Product was 2.2. That is, for every $2.20 borrowed, the United States produced $1.00 of additional goods and services (nominal). In the 1990s, debt was less efficient. It took extra debt to accomplish the same. The ratio (rise in debt-to-GDP) was 2.7:1. Between 2001 and 2008, even more debt was needed to produce more stuff: the ratio rose to 4.2:1.

The Fed has been rolling out its various quantitative initiatives since early 2009. The ratio of debt to production has been 3.7:1 (through June, 2011). But, the increase in transfer payments (1-in-7 Americans now receive food stamps, Cash for Clunkers, shovel-ready bank bailouts) exceeds the rise in nominal GDP by a wide margin. As a measure of financial efficiency, the ratio is now meaningless.

The additional debt being manufactured is not producing any additional goods and services. The more Bernanke applies his senior thesis to the real economy, the less the economy is able to pay down old debt, much less manufacture additional goods and services to pay down the new debt.

The Fed has pegged short-term interest rates at zero; Operation Twist is an attempt to drive long-term rates to zero (or, close to it); the rise of incomes in the United States since 2008 has been zero; "real" GDP growth since QE1 has been less than zero; the FOMC is an absolute zero.

Somebody in the past couple of weeks, I forget who (my apologies), compared the central bankers' Mad Hatter policies to the strange physical transformations when approaching absolute zero (-273 Celsius). Solids, liquids, and gases behave strangely.

We have arrived at that point with financial markets. The Authorities have lost control of the markets they have been manipulating. Desperate tactics, with untold unintended consequences, such as the Swiss National Bank doubling its monetary base last month, ensure more fanatical outbursts from the Fed, the ECB, and the Bank of Japan. In this setting, gold fell more than $150 last week. Other than remote islands, this is the best bargain around.

The Financial Times Discovers Gold Stocks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Having read "Gold and Silver Stocks", the Financial Times decided to follow the trend with "Investors Bet Miners Will Follow Gold's Gain." (September 20, 2011) The article discusses efforts of gold miners to distinguish themselves from Gold ETFs: "[G]old miners are beginning to respond to their share-price underperformance. The most popular response is to raise dividends, offering investors one thing an ETF cannot: a yield." (See "Gold and Silver Stocks" for the same discussion.) The Financial Times continues, discussing two companies that are increasing dividend payouts, Newmont Mining and Gold Resource Corporation. These are the same two miners discussed in "Gold and Silver Stocks." The Financial Times relays Newmont Mining's Monday announcement (September 19, 2011) that it will pay out an additional 10 cent dividend for every $100 above $2,000 an ounce. The FT discussed a novel dividend payout being considered by Gold Resource Corporation. The miner "might start paying dividends in physical gold." This is fine but the FT story may cause confusion. The reason for owning gold is easily misunderstood. This ambiguity will continue to be the greatest problem for potential and current owners of precious metals. Gold will be bought and sold at the wrong times by many of the misinformed. (Note: what follows only fleetingly addresses an important consideration - prices and cash flow should rise.) A lack of precision may lead to a misunderstanding just as a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie. Quoting from the FT: "Investors increasingly buy gold as a form of insurance against further economic turbulence. Mining companies - which can miss production targets, suffer strikes, accidents and higher taxes, or see their profits eroded by cost inflation - appear to offer less protection against this scenario." The sequence is correct. It runs from (first sentence) gold to (second sentence) gold stocks. Gold stocks derive their price from gold, but they are stocks. The second sentence is a good synopsis of why the derivatives (gold stocks) have performed so poorly in comparison to the metal. Their attraction lies with the probability that these shortcomings have been excessively discounted. The FT describes gold as being bought as a "form of insurance against further economic turbulence." That is true but not the whole truth. One might interpret this to mean "I should own some gold as a hedge against further volatility [my stocks might go down 30%]. I don't care about volatility because I read Stocks for the Long-Run, so I don't need to buy gold" Quoting from "Gold and Silver Stocks": "The real story is that gold is money but only speaks up when the credibility of states and their currencies deteriorate." The great minds at the central banks, by manipulating every market under the sun, have lost control of the world's financial system that, they apparently thought was a chalkboard theory. Official interference has failed. Last week, the great minds showered European banks with dollars, because some European banks are having great difficulty borrowing dollars. This massive flood has not regenerated trust. Siemens disclosed that it withdrew more than 500 million euros from French commercial banks and deposited them at the European Central Bank. (The ECB, itself, is extraordinarily leveraged. This should not simply be dismissed as a "boys will be boys" curiosity.) From Reuters: 9/19/11:LARGE CHINESE BANK STOPS TRADING WITH SEVERAL EUROPEAN BANKS DUE TO FEARS REGARDING EUROPEAN DEBT CRISIS - Sources say the unidentified Chinese bank has stopped all swaps and foreign-exchange forward trading with Societe General (GLE.FP), Credit Agricole (ACA.FP), and BNP Paribas (BNP.FP). The bank has also stopped trading with UBS (UBSN.VX) due to worries about UBS's loss from the new rogue trading affair. (Remember the hastily planted rumor, just last week, and for the 63rd time, that China was buying Europe's debt?) We are witnessing the insolvency of the fractional-reserve banking system, at the highest level. (At the lowest level, local banks and small insurance companies should be buying precious metals. Tell the regulators to scram.) It would be a mistake for the average investor to buy and sell gold and gold shares depending on one's view of market volatility over the next month or year. Gold, silver and other inanimate objects are assets without liabilities. Unlike dollars, these...things, do not bear the government's Lewis Carroll promise: "This note is legal tender for all debts, public and private." The dollar's value is a derivative of the loony professors who run the country. Choose your weapon.

Gold and Silver Stocks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

The prices of gold and silver shares are derived from the price of their reference metals. The referral method has gone astray, akin to a renegade ETF.

Osiris Investment Partners L.P. in Boston, under the authorship of Principal and Managing Member Paul Stuka, wrote to clients on August 18, 2011. The XAU Gold Index was down 6% for the year-to-date, and the GDXJ Gold Stocks Index of smaller gold miners had fallen 10%. On that same mid-August date, gold - the real stuff that hardly anyone owns but of which everyone within the media's range is expected to express an opinion - had risen 26% in 2011.

The gap between gold and the diggers will close - when is hard to say. In which direction we will discover. The view here is that the stewardship of paper currencies, the medium in which gold, silver, and oil (crude, canola, and palm) are priced, has never been in worse hands. This is saying less than might be thought since it was not until 1971 that official money went untethered from impartial restraint (usually, gold). Alas, the world is slow to grasp central banks are peopled by political hacks (as Senator Harry Reid called then-Federal Reserve Chairman Alan Greenspan in 2005, but equally true of today's empty suit) so now is the time to make money.

Money is to be made by holding anti-dollars. Federal Reserve Chairman Ben S. Bernanke continues to decompose before our eyes, stating on September 8, 2011, that the United States is blessed with lower inflation than other countries and "Low inflation means that the buying power of the dollar, in terms of domestic goods and services, remains stable over time." It does not take a trial lawyer to see the inconsequentiality, inconsistency, or mendacity in that labored claim. Ben may be fishing turtles from the local creek, painting his barbarous equations on their backs, and selling them at the local five-and-dime (which would still be overvaluing his scholarship by at least a nickel), but shoppers at local farmer's markets are paying the price for purchasing with dollars.

Osiris Investment Partners went on to write: "[S]ince the early 1980s, when the XAU Index was first constructed, until the fall of 2008, this ratio remained in a range of .16 to .38, even during the depths of the gold bear market. [That is the ratio of the XAU Gold Stock Index divided by the price of an ounce of gold in U.S. dollars. - FJS] During the financial crisis of 2008, this ratio dropped briefly to .09. Since that time, it has traded up to .16, but it has never exceeded the former floor. As I write today the ratio is .114. In other words, the gold shares are currently the cheapest that they have ever been, excluding a one-month period in the fall of 2008. On a fundamental basis, gold stocks have historically traded at 10 times or more annual cash flow. We are presently seeing many companies priced at one to three times potential forward cash flow, if they can execute their plan. Clearly, not all of them will realize the potential. However, many will."

Of the cash flow, Erste Group, (Erste Bank, Vienna: "In Gold We Trust;" July, 2011; Ronald-Peter Stoferle), estimates the "aggregate free cash flow of the 16 companies in the Gold Bugs Index will amount to [$8.5 billion] this year and will increase to [$14 billion] by 2013." Erste Group continues: "The companies in the Gold Bugs Index currently command an estimated 2011 [price-to-earnings ratio of] 14x, which is expected to fall to 12x in 2012. This is extremely low in terms of its own history (average PE 2000-2010: 33x) and in relation to many other sectors." (The Gold Bugs Index consists of 16 mining companies that do not hedge their gold production. This is not necessarily true of the miners in the XAU Index.)

Potential investor seek the potential catalyst. What might that be?

First, the correlation among sectors in the S&P 500 has never been greater. ETFs and high-frequency trading rule the waves. Machines trade stocks in bulk, with little distinction among industries and companies. Such periods of over-zealous gimmickry and of intimidated investors are often good times to buy stocks that will later assert their superior characteristics.

Second, gold- and silver-mining shares are underowned in relation to one-stop-shopping ETFs. The miners know this. Shareholders have enlightened management: they need to pay out dividends to distinguish themselves as real companies. Recently, Newmont Mining stated it will increase its dividend by twenty cents per share for every $100 rise in the price of gold. Gold Resource Corporation has set a target of paying out one-third of its cash flow in dividends to shareholders.

Third, the argument of whether the world is inflating or deflating is tangential to the price of gold. Better expressing the "price of gold": how many units of paper currency (such as the dollar) does it cost to buy an ounce of gold? (We are returning, now, to the reference metal). Gold has performed better in deflations than inflations, but the cause and effect that this relationship addresses ("gold is an inflation hedge") may be misleading. Monetary, military, and political chaos have more often corresponded with deflationary than inflationary times. The real story is that gold is money but only speaks up when the credibility of states and their currencies deteriorate.

Fourth, the proportion of people who own gold and silver is small. (Particularly so in the United States, but that is not the point, here.) This is the greatest flaw of the "gold in a bubble" chorus. There has been no panic into gold, or, more likely for the Average Joe, into gold shares. At some point, the sight of Bernanke may be worth a quick $500-an-ounce trading profit. It should be, already.