A False Sense of Insecurity?

by John Mueller
Ohio, U.S.A.
for Whiskey & Gunpowder

Sign up here for a FREE subscription!

DETERMINING HOW TO respond to the terrorist challenge has become a major public policy issue in the United States over the last three years. It has been discussed endlessly, many lives have been changed, a couple of wars have been waged, and huge sums of money have been spent -- often after little contemplation -- to deal with the problem.

Throughout all this, there is a perspective on terrorism that has been very substantially ignored. It can be summarized, somewhat crudely, as follows:

--Assessed in broad but reasonable context, terrorism generally does not do much damage.

--The costs of terrorism very often are the result of hasty, ill-considered, and overwrought reactions.

A sensible policy approach to the problem might be to stress that any damage terrorists are able to accomplish likely can be absorbed, however grimly. While judicious protective and policing measures are sensible, extensive fear and anxiety over what may at base prove to be a rather limited problem are misplaced, unjustified, and counterproductive.

Terrorism’s Damage

For all the attention it evokes, terrorism actually causes rather little damage, and the likelihood that any individual will become a victim in most places is microscopic. Those adept at hyperbole like to proclaim that we live in “the age of terror.” However, while, obviously, deeply tragic for those directly involved, the number of people worldwide who die as a result of international terrorism is generally only a few hundred a year, tiny compared to the numbers who die in most civil wars or from automobile accidents. In fact, in almost all years, the total number of people worldwide who die at the hands of international terrorists anywhere in the world is not much more than the number who drown in bathtubs in the United States.

Until 2001, far fewer Americans were killed in any grouping of years by all forms of international terrorism than were killed by lightning, and almost none of those terrorist deaths occurred within the United States itself. Even with the Sept. 11 attacks included in the count, the number of Americans killed by international terrorism since the late 1960s (which is when the State Department began counting) is about the same as the number of Americans killed over the same period by lightning, accident-causing deer, or severe allergic reaction to peanuts.

Some of this is definitional. When terrorism becomes really extensive, we generally no longer call it terrorism, but war. But Americans seem to be concerned mainly about random terror, not sustained warfare. Moreover, even using an expansive definition of terrorism and including domestic terrorism in the mix, it is likely that far fewer people were killed by terrorists in the entire world over the last 100 years than died in any number of unnoticed civil wars during the century.

Obviously, this condition could change if international terrorists are able to assemble sufficient weaponry or devise new tactics to kill masses of people, and if they come to do so routinely. That, of course, is the central fear. As during the Cold War, commentators are adept at spinning out elaborate doomsday and worst-case scenarios. However, although not impossible, it would take massive efforts and even more stupendous luck for terrorists regularly to visit substantial destruction upon the United States.

Historical Record

It should be kept in mind that Sept. 11 continues to stand out as an extreme event. Until then, and since then, no more than 329 people have ever been killed in a single terrorist attack (in a 1985 Air India explosion). And extreme events often remain exactly that -- aberrations, rather than harbingers.

A bomb planted in a piece of checked luggage was responsible for the explosion that caused a Pan Am jet to crash into Lockerbie, Scotland, in 1988, killing 270 people. Since that time, hundreds of billions of pieces of luggage have been transported on American carriers and none have exploded to down an aircraft. (And millions of passengers who checked bags at hotels and retrieved them before heading to the airport have routinely lied to airline agents when answering the obligatory question about whether their luggage had at all times been in their possession.) This does not mean that one should cease worrying about luggage on airlines, but it does suggest that extreme events do not necessarily assure repetition any more than Timothy McVeigh’s Oklahoma City bombing of 1995 has.

Since its alarming release of poison gas in the Tokyo subway in 1995, the apocalyptic group Aum Shinrikyo appears to have abandoned the terrorism business, and its example has not been followed. Some sort of terrorist inoculated Tylenol capsules with cyanide in 1982, killing seven people. However, that frightening and much-publicized event (it generated 125,000 stories in the print media alone and cost the manufacturer more than $1 billion) failed to inspire much in the way of imitation.

I do not want to suggest that all extreme events prove to be the last in their line, of course. At its time, the “Great War” of 1914-18 was the worst war of its type, yet an even more destructive one followed. Moreover, while Aum Shinrikyo may be under control, al-Qaida and like-minded terrorist groups are unlikely to die out any time soon; Sept. 11 marked, after all, their second attempt to destroy the World Trade Center.

Much of the current alarm is generated from the knowledge that many of today’s terrorists simply want to kill, and kill more or less randomly, for revenge or as an act of what they take to be war. At one time, it was probably safe to conclude that terrorism was committed principally for specific political demands or as a form of political expression. In the oft-repeated observation of terrorism expert Brian Jenkins, “Terrorists want a lot of people watching, not a lot of people dead.” Moreover, the suicidal nature of many attacks, while not new, can be very unsettling because the would-be perpetrator cannot be deterred by the threat of subsequent punishment. And terrorism likely will never go away completely; it has always existed and presumably always will.

A central issue, however, is whether such spectacularly destructive terrorist acts will become commonplace. Although there have been many deadly terrorist incidents in the world since 2001, all (thus far, at least) have relied on conventional methods and have not remotely challenged Sept. 11 quantitatively. If, as some purported experts repeatedly claim, chemical and biological attacks are so easy and attractive to terrorists, it is impressive that none have so far been used in Israel (where four times as many people die from automobile accidents as from terrorism). Actually, it is somewhat strange that so much emphasis has been put on the dangers of high-tech weapons in the first place. Some of that anxiety may come from the post-Sept. 11 anthrax scare, even though that event killed only a few people. The bombings of Sept. 11, by contrast, were remarkably low-tech and could have happened long ago; both skyscrapers and airplanes have been around for a century now.

Responding to Terrorism

Frantz Fanon, the 20th-century revolutionary, contended that “the aim of terrorism is to terrify.” If that is so, terrorists can be defeated simply by not becoming terrified -- that is, anything that enhances fear effectively gives in to them.

The shock and tragedy of Sept. 11 does demand a focused and dedicated program to confront international terrorism and to attempt to prevent a repeat. But it seems sensible to suggest that part of this reaction should include an effort by politicians, officials, and the media to inform the public reasonably and realistically about the terrorist context, instead of playing into the hands of terrorists by frightening the public. What is needed, as one statistician suggests, is some sort of convincing, coherent, informed, and nuanced answer to a central question: “How worried should I be?” Instead, the message the nation has received so far is, as a Homeland Security official put (or caricatured) it, “Be scared; be very, very scared -- but go on with your lives.” Such messages have led many people to develop what Leif Wenar of the University of Sheffield has aptly labeled “a false sense of insecurity.”

Hyperbolic Overreaction

For example, there is at present a great and understandable concern about what would happen if terrorists were to shoot down an American airliner or two, perhaps with shoulder-fired missiles. Obviously, that would be a major tragedy. But the ensuing public reaction to it, many fear, could come close to destroying the industry.

Accordingly, it would seem to be reasonable for those in charge of our safety to inform the public about how many airliners would have to crash before flying becomes as dangerous as driving the same distance in an automobile. It turns out that someone has made that calculation: University of Michigan transportation researchers Michael Sivak and Michael Flannagan, in an article last year in American Scientist , wrote that they determined there would have to be one set of Sept. 11 crashes a month for the risks to balance out. More generally, they calculate that an American’s chance of being killed in one nonstop airline flight is about one in 13 million (even taking the Sept. 11 crashes into account). To reach that same level of risk when driving on America’s safest roads -- rural interstate highways -- one would have to travel a mere 11.2 miles.

Or there ought to be at least some discussion of the almost completely unaddressed but patently obvious observation that, in the words of risk analyst David Banks, “It seems impossible that the United States will ever again experience takeovers of commercial flights that are then turned into weapons -- no pilot will relinquish control, and passengers will fight.” The scheme worked in 2001 because the hijackers had the element of surprise working for them; previous airline hijackings had mostly been fairly harmless, as hijackers generally landed the planes someplace and released the passengers. The passengers and crew on the fourth plane on Sept. 11 had fragmentary knowledge about what had occurred earlier that day and they prevented the plane from reaching its target. Similar responses are likely for future attempted hijackings. Nonetheless, notes Banks, “enormous resources are being invested to prevent this remote contingency.” There is a distinction, he argues, “between realistic reactions to plausible threats and hyperbolic overreaction to improbable contingencies.”

Moreover, any problems caused by radiological, chemical, or perhaps biological weapons are likely to stem far more from the fear and panic they may cause than from the weapons themselves. While a “dirty bomb” might raise radiation 25% over background levels in an area, and therefore into a range the Environmental Protection Agency considers undesirable, there ought to be some discussion about whether that really constitutes “contamination” or much of a danger at all, given the somewhat arbitrary and exceedingly cautious levels declared to be acceptable by the EPA. The potential use of such bombs apparently formed the main concern during the orange alert at the end of 2003. Because the bombs simply raise radiation levels somewhat above normal background levels in a small area, a common recommendation from nuclear scientists and engineers is that those exposed should calmly walk away. But this bit of advice has not been advanced prominently by those in charge. Effectively, therefore, they encourage panic. As one nuclear engineer points out, “If you keep telling them you expect them to panic, they will oblige you. And that’s what we’re doing.”

Poor Results

For their part, biological and chemical weapons have not proven to be great killers. Although the basic science about them has been well known for a century at least, both kinds of weapons are notoriously difficult to create, control, and focus (and even more so for nuclear weapons).

To this point in history, biological weapons have killed almost no one. And the notion that large numbers of people would perish if a small number of chemical weapons were to be set off is highly questionable. Although they can be hugely lethal when released in gas chambers, their effectiveness as weapons has been unimpressive. In World War I, for example, chemical weapons caused less than 1% of the total combat deaths; on average, it took a ton of gas to produce one fatality. In the conclusion to the official British history of the war, chemical weapons are relegated to a footnote that asserts that gas “made war uncomfortable...to no purpose.” A 1993 analysis by the Office of Technology Assessment finds that a terrorist would have to deliver a full ton of sarin nerve gas perfectly and under absolutely ideal conditions over a heavily populated area to cause between 3,000-8,000 deaths -- something that would require the near-simultaneous detonation of dozens, even hundreds, of weapons. Under slightly less ideal circumstances -- if there were a moderate wind or if the sun were out, for example -- the death rate would be only one-tenth as great. The 1995 chemical attack launched in Tokyo by the well-funded Aum Shinrikyo (attempted only after several efforts to use biological weaponry had failed completely) managed to kill only 12 people.

Thus far at least, terrorism is a rather rare and -- in appropriate, comparative context -- not a very destructive phenomenon. However, the enormous sums of money being spent to deal with the threat have in part been diverted from other, possibly more worthy, endeavors. The annual budget for the Department of Homeland Security, for example, now tops $40 billion, while state and local governments spend additional billions. Some of that money doubtless would have been spent on similar ventures under earlier budgets, and much of it likely has wider benefits than simply securing the country against a rather limited threat. But much of it, as well, has very likely been pulled away from more beneficial uses.

Accordingly, three key issues, set out by risk analyst Howard Kunreuther, require careful discussion but do not seem ever to get it:

-- How much should we be willing to pay for a small reduction in probabilities that are already extremely low?

-- How much should we be willing to pay for actions that are primarily reassuring, but do little to change the actual risk?

-- How can measures such as strengthening the public health system, which provide much broader benefits than those against terrorism, get the attention they deserve?

As Banks puts it, “If terrorists force us to redirect resources away from sensible programs and future growth in order to pursue unachievable but politically popular levels of domestic security, then they have won an important victory that mortgages our future.” For instance, measures that delay airline passengers by half an hour could cost the economy $15 billion a year, calculates economist Roger Congleton.

Hysteria

Filmmaker Michael Moore happened to note on CBS’s popular 60 Minutes last year that “The chances of any of us dying in a terrorist incident is very, very, very small.” His interviewer, Bob Simon, promptly admonished, “But no one sees the world like that.” Both statements, remarkably, are true -- the first only a bit more so than the second.

It would seem to be reasonable for someone in authority to try to rectify this absurdity. In Kunreuther’s words, “More attention needs to be devoted to giving people perspective on the remote likelihood of the terrible consequences they imagine.” That would seem to be at least as important as boosting the sale of duct tape, issuing repeated and costly color-coded alerts based on vague and unspecific intelligence, and warning people to beware of Greeks bearing almanacs.

What we need is more pronouncements like the one in a recent book by Sen. John McCain (R-Ariz.): “Get on the damn elevator! Fly on the damn plane! Calculate the odds of being harmed by a terrorist! It’s still about as likely as being swept out to sea by a tidal wave. Suck it up, for crying out loud. You’re almost certainly going to be OK. And in the unlikely event you’re not, do you really want to spend your last days cowering behind plastic sheets and duct tape? That’s not a life worth living, is it?”

But admonitions like that are exceedingly rare, almost nonexistent. What we mostly get is fear-mongering, some of it bordering on hysteria. Some prominent commentators, like David Gergen, argue that the United States has become “vulnerable,” even “fragile.” Others, like Sen. Richard Lugar (R-Ind.), are given to proclaiming that terrorists armed with weapons of mass destruction present an “existential” threat to the United States or even, in columnist Charles Krauthammer’s view, to “civilization.” A best-selling book by an anonymous CIA official assures us that our “survival” is at stake.

The cosmic alarmism reached a kind of official pinnacle during [winter 2003-04’s] orange alert. At the time, Homeland Security Czar Tom Ridge declared that “America is a country that will not be bent by terror. America is a country that will not be broken by fear.” Meanwhile, however, Gen. Richard Myers, chairman of the Joint Chiefs of Staff, was telling a television audience that if terrorists were able to engineer a catastrophic event that killed 10,000 people, they would successfully “do away with our way of life.” The sudden deaths of that many Americans -- although representing less than four-thousandths of 1% of the population -- would indeed be horrifying and tragic, but the only way it could “do away with our way of life” would be if we did that to ourselves in reaction.

All societies are “vulnerable” to tiny bands of suicidal fanatics in the sense that it is impossible to prevent every terrorist act. But the United States is hardly “vulnerable” in the sense that it can be expunged by dramatic acts of terrorist destruction, even extreme ones. In fact, the country can readily, if grimly, overcome that kind of damage -- as it overcomes some 40,000 deaths each year from automobile accidents. As RAND’s Bruce Hoffman put it, “Unfortunately, terrorism is just another fact of modern life. It’s something we have to live with.”

Politicians and the Media

A problem with getting coherent thinking on the risk of terrorism is that reporters and politicians find extreme and alarmist possibilities so much more appealing than discussions of broader context, much less of statistical reality. That is, although hysteria and alarmism rarely make much sense, politicians and the media are often naturally drawn to them.

There is no reason to suspect that President Bush’s concern about terrorism is anything but genuine. However, his approval rating did receive the greatest boost for any president in history in September 2001, and it would be politically unnatural for him not to notice. His chief political adviser, Karl Rove, [in 2003 said] that the “war” against terrorism will be central to Bush’s re-election campaign. The Democrats, scurrying to keep up, have stumbled all over each other with plans to expend even more of the federal budget on the terrorist threat, such as it is, than President Bush.

This process is hardly new. The preoccupation of the media and of Jimmy Carter’s presidency with the hostages taken by Iran in 1979 to the exclusion of almost everything else may look foolish in retrospect, as Carter’s secretary of state, Cyrus Vance, conceded in his memoirs. But it doubtless appeared to be good politics at the time -- Carter’s dismal approval rating soared when the hostages were seized. Similarly, in the 1980s, the Reagan administration became fixated on a handful of American hostages held by terrorists in Lebanon. At the time, Reagan’s normally judicious secretary of state, George Shultz, was screaming that we needed desperately to blast somebody somewhere “on a moment’s notice” -- even without adequate evidence -- in order to avoid looking like the indecisive “Hamlet of nations.” He apparently preferred the King Lear approach. Normally, however, only lunatics and children rail at storms; sensible people invest in umbrellas and lightning rods.

Since Sept. 11, the American public has been treated to endless yammering about terrorism in the media. Politicians may believe that, given the public concern on the issue, they will lose votes if they appear insensitively to be downplaying the dangers of terrorism (though this fear does not seem to have infected Sen. McCain). However, the media like to tout that they are devoted to presenting fair and balanced coverage of important public issues. I may have missed it, but I have never heard anyone in the media stress that in every year except 2001, only a few hundred people in the entire world have died as a result of international terrorism.

As often noted, the media appear to have a congenital incapacity for dealing with issues of risk and comparative probabilities -- except, of course, in the sports and financial sections. But even in their amazingly rare efforts to try, the issue -- one that would seem to be absolutely central to any rounded discussion of terrorism and terrorism policy -- never goes very far. For example, in 2001 The Washington Post published an article by a University of Wisconsin economist that attempted quantitatively to point out how much safer it was to travel by air than by automobile, even under the heightened atmosphere of concern inspired by the Sept. 11 attacks. He reports that the article generated a couple of media inquiries, but nothing more. Gregg Easterbrook’s cover story in the Oct. 7, 2002, New Republic forcefully argued that biological and chemical weapons are hardly capable of creating “mass destruction,” a perspective relevant not only to terrorism, but also to the drive for war against Iraq that was going on at the time. The New York Times asked him to fashion the article into an Op-Ed piece, but that was the only interest the article generated in the media.

In addition, it should be pointed out that the response to Sept. 11 has created a vast and often well-funded terrorism industry. Its members would be nearly out of business if terrorism were to be back-burnered, and, accordingly, they have every competitive incentive (and they are nothing if not competitive) to conclude that it is their civic duty to keep the pot boiling.

Moreover, there is more reputational danger in underplaying risks than in exaggerating them. People routinely ridicule futurist H.G. Wells’ prediction that the conflict beginning in 1914 would be “the war that will end war,” but not his equally confident declaration at the end of World War II that “the end of everything we call life is close at hand.” Disproved doomsayers can always claim that caution induced by their warnings prevented the predicted calamity from occurring. (Call this the Y2K effect.) Disproved Pollyannas have no such convenient refuge.

The challenge, thus, is a difficult one. But it still seems sensible to suggest that officials and the press at least once in a while ought to assess probabilities and put them in some sort of context, rather than simply to stress extreme possibilities so much and so exclusively.

Know Your Audience

It is easy to blame politicians and the media for the distorted and context-free condition under which terrorism is so often discussed. In many respects, however, that circumstance arises not so much from their own proclivities, but rather from those of their customers. Hysteria and alarmism often sell.

The record with respect to fear about crime, for example, suggests that efforts to deal responsibly with the risks of terrorism will prove difficult. Fear of crime rose notably in the mid-1990s, even as statistics were showing crime to be in pronounced decline. When David Dinkins, running for re-election as mayor of New York, pointed to such numbers, he was accused by A. M. Rosenthal of The New York Times of hiding behind “trivializing statistics” that “are supposed to convince us that crime is going down.” New Yorkers did eventually come to feel safer from crime, but that was probably less because crime rates actually declined than because of atmospherics as graffiti, panhandlers, aggressive windshield washers, and the homeless were banished or hidden from view. So it may have made sense in the months after the Sept. 11 attacks to have armed reservists parading around in airports. It is not clear how they prevented terrorist attacks, and pulling them from productive jobs hardly helped the economy. But if they provided people with a sense of security, their presence may have been worth it.

In the end, it is not clear how one can deal with the public’s often irrational -- or at least erratic -- fears about remote dangers. Some people say they prefer comparatively dangerous forms of transportation like the private passenger automobile (the cause of over 3 million American deaths during the 20th century) to safe ones like commercial airliners because they feel they have more “control.” But they seem to feel no fear on buses and trains -- which actually are more dangerous than airliners -- even without having that sense of control and even though derailing a speeding train or crashing a speeding bus is likely to be much easier for a terrorist than downing an airliner. And people tend to be more alarmed by dramatic fatalities -- which the Sept. 11 crashes certainly provided -- than by ones that cumulate statistically. Thus, the 3,000 deaths of Sept. 11 inspire far more grief and fear than the 100,000 deaths from auto accidents that have taken place since then. In some respects, fear of terror may be something like playing the lottery, except in reverse: The chances of winning the lottery or of dying from terrorism may be microscopic, but for monumental events that are, or seem, random, one can irrelevantly conclude that one’s chances are just as good, or bad, as those of anyone else.

The communication of risk, then, is no easy task. Risk analyst Paul Slovic points out that people tend greatly to overestimate the chances of dramatic or sensational causes of death, that realistically informing people about risks sometimes only makes them more frightened, that strong beliefs in this area are very difficult to modify, that a new sort of calamity tends to be taken as harbinger of future mishaps, that a disaster tends to increase fears not only about that kind of danger, but of all kinds, and that people, even professionals, are susceptible to the way risks are expressed -- far less likely, for example, to choose radiation therapy if told the chances of death are 32% rather than that the chances of survival are 68%.

But risk assessment and communication should at least be part of the policy discussion over terrorism, something that may well prove to be a far smaller danger than is popularly portrayed. The constant, unnuanced stoking of fear by politicians and the media is costly, enervating, potentially counterproductive, and unjustified by the facts.

Conclusion

The policy perspective toward terrorism I suggest may not be more valid than other ones, and no one knows, of course, how the problem will play out in future years. However, the policy advanced here seems to me a sound and sensible one, and for there to be a really coherent policy discussion, it should be part of the mix.

Deep concern about extreme events is not necessarily unreasonable or harmful. Thus, efforts to confront terrorism and reduce its incidence and destructiveness are justified. But hysteria is hardly required. As always, there are uncertainties and risks out there, and plenty of dangers and threats. But none are existential. The sky, as it happens, is unlikely to fall anytime soon.

Regards,
John Mueller

John’s the Woody Hayes Chair of national security policy and professor of political science at Ohio State University. Today, he asks this pointed and salient question: “How does the risk of terrorism measure up against everyday dangers?” The following piece originally appeared in Regulation magazine in the fall of ’04. Considering the recent events in London, this essay merits a republishing.

John has worked the above central idea into a book called Overblown: How Politicians and the Terrorism Industry Inflate National Security Threats, and Why We Believe Them. Free Press will release the book in November of this year. You can purchase it

Why Are Americans So Angry?

HON. RON PAUL OF TEXAS
Before the U.S. House of Representatives

( Watch Video )

I have been involved in politics for over 30 years and have never seen the American people so angry. It’s not unusual to sense a modest amount of outrage, but it seems the anger today is unusually intense and quite possibly worse than ever. It’s not easily explained, but I have some thoughts on this matter. Generally, anger and frustration among people are related to economic conditions; bread and butter issues. Yet today, according to government statistics, things are going well. We have low unemployment, low inflation, more homeowners than ever before, and abundant leisure with abundant luxuries. Even the poor have cell phones, televisions, and computers. Public school is free, and anyone can get free medical care at any emergency room in the country. Almost all taxes are paid by the top 50% of income earners. The lower 50% pay essentially no income taxes, yet general dissatisfaction and anger are commonplace. The old slogan “It’s the economy, stupid,” just doesn’t seem to explain things.

Some say it’s the war, yet we’ve lived with war throughout the 20th century. The bigger they were the more we pulled together. And the current war, by comparison, has fewer American casualties than the rest. So it can’t just be the war itself.

People complain about corruption, but what’s new about government corruption? In the 19th century we had railroad scandals; in the 20th century we endured the Teapot Dome scandal, Watergate, Koreagate, and many others without too much anger and resentment. Yet today it seems anger is pervasive and worse than we’ve experienced in the past.

Could it be that war, vague yet persistent economic uncertainty, corruption, and the immigration problem all contribute to the anger we feel in America? Perhaps, but it’s almost as though people aren’t exactly sure why they are so uneasy. They only know that they’ve had it and aren’t going to put up with it anymore.

High gasoline prices make a lot of people angry, though there is little understanding of how deficits, inflation, and war in the Middle East all contribute to these higher prices.

Generally speaking, there are two controlling forces that determine the nature of government: the people’s concern for their economic self interests; and the philosophy of those who hold positions of power and influence in any particular government. Under Soviet Communism the workers believed their economic best interests were being served, while a few dedicated theoreticians placed themselves in positions of power. Likewise, the intellectual leaders of the American Revolution were few, but rallied the colonists to risk all to overthrow a tyrannical king.

Since there’s never a perfect understanding between these two forces, the people and the philosophical leaders, and because the motivations of the intellectual leaders vary greatly, any transition from one system of government to another is unpredictable. The communist takeover by Lenin was violent and costly; the demise of communism and the acceptance of a relatively open system in the former Soviet Union occurred in a miraculous manner. Both systems had intellectual underpinnings.

In the United States over the last century we have witnessed the coming and going of various intellectual influences by proponents of the free market, Keynesian welfarism, varieties of socialism, and supply-side economics. In foreign policy we’ve seen a transition from the founder’s vision of non-intervention in the affairs of others to internationalism, unilateral nation building, and policing the world. We now have in place a policy, driven by determined neo-conservatives, to promote American “goodness” and democracy throughout the world by military force-- with particular emphasis on remaking the Middle East.

We all know that ideas do have consequences. Bad ideas, even when supported naively by the people, will have bad results. Could it be the people sense, in a profound way, that the policies of recent decades are unworkable-- and thus they have instinctively lost confidence in their government leaders? This certainly happened in the final years of the Soviet system. Though not fully understood, this sense of frustration may well be the source of anger we hear expressed on a daily basis by so many.

No matter how noble the motivations of political leaders are, when they achieve positions of power the power itself inevitably becomes their driving force. Government officials too often yield to the temptations and corrupting influences of power.

But there are many others who are not bashful about using government power to do “good.” They truly believe they can make the economy fair through a redistributive tax and spending system; make the people moral by regulating personal behavior and choices; and remake the world in our image using armies. They argue that the use of force to achieve good is legitimate and proper for government-- always speaking of the noble goals while ignoring the inevitable failures and evils caused by coercion.

Not only do they justify government force, they believe they have a moral obligation to do so.

Once we concede government has this “legitimate” function and can be manipulated by a majority vote, the various special interests move in quickly. They gain control to direct government largesse for their own benefit. Too often it is corporate interests who learn how to manipulate every contract, regulation and tax policy. Likewise, promoters of the “progressive” agenda, always hostile to property rights, compete for government power through safety, health, and environmental initiatives. Both groups resort to using government power-- and abuse this power-- in an effort to serve their narrow interests. In the meantime, constitutional limits on power and its mandate to protect liberty are totally forgotten.

Since the use of power to achieve political ends is accepted, pervasive, and ever expanding, popular support for various programs is achieved by creating fear. Sometimes the fear is concocted out of thin air, but usually it’s created by wildly exaggerating a problem or incident that does not warrant the proposed government “solution.” Often government caused the problem in the first place. The irony, of course, is that government action rarely solves any problem, but rather worsens existing problems or creates altogether new ones.

Fear is generated to garner popular support for the proposed government action, even when some liberty has to be sacrificed. This leads to a society that is systemically driven toward fear-- fear that gives the monstrous government more and more authority and control over our lives and property.

Fear is constantly generated by politicians to rally the support of the people.

Environmentalists go back and forth, from warning about a coming ice age to arguing the grave dangers of global warming.

It is said that without an economic safety net-- for everyone, from cradle to grave-- people would starve and many would become homeless.

It is said that without government health care, the poor would not receive treatment. Medical care would be available only to the rich.

Without government insuring pensions, all private pensions would be threatened.

Without federal assistance, there would be no funds for public education, and the quality of our public schools would diminish-- ignoring recent history to the contrary.

It is argued that without government surveillance of every American, even without search warrants, security cannot be achieved. The sacrifice of some liberty is required for security of our citizens, they claim.

We are constantly told that the next terrorist attack could come at any moment. Rather than questioning why we might be attacked, this atmosphere of fear instead prompts giving up liberty and privacy. 9/11 has been conveniently used to generate the fear necessary to expand both our foreign intervention and domestic surveillance.

Fear of nuclear power is used to assure shortages and highly expensive energy.

In all instances where fear is generated and used to expand government control, it’s safe to say the problems behind the fears were not caused by the free market economy, or too much privacy, or excessive liberty.

It’s easy to generate fear, fear that too often becomes excessive, unrealistic, and difficult to curb. This is important: It leads to even more demands for government action than the perpetrators of the fear actually anticipated.

Once people look to government to alleviate their fears and make them safe, expectations exceed reality. FEMA originally had a small role, but its current mission is to centrally manage every natural disaster that befalls us. This mission was exposed as a fraud during last year’s hurricanes; incompetence and corruption are now FEMA’s legacy. This generates anger among those who have to pay the bills, and among those who didn’t receive the handouts promised to them quickly enough.

Generating exaggerated fear to justify and promote attacks on private property is commonplace. It serves to inflame resentment between the producers in society and the so-called victims, whose demands grow exponentially.

The economic impossibility of this system guarantees that the harder government tries to satisfy the unlimited demands, the worse the problems become. We won’t be able to pay the bills forever, and eventually our ability to borrow and print new money must end. This dependency on government will guarantee anger when the money runs out. Today we’re still able to borrow and inflate, but budgets are getting tighter and people sense serious problems lurking in the future. This fear is legitimate. No easy solution to our fiscal problems is readily apparent, and this ignites anger and apprehension.

Disenchantment is directed at the politicians and their false promises, made in order to secure reelection and exert power that so many of them enjoy.

It is, however, in foreign affairs that governments have most abused fear to generate support for an agenda that under normal circumstances would have been rejected. For decades our administrations have targeted one supposed “Hitler” after another to gain support for military action against a particular country. Today we have three choices termed the axis of evil: Iran, Iraq or North Korea.

We recently witnessed how unfounded fear was generated concerning Saddam Hussein’s weapons of mass destruction to justify our first ever pre-emptive war. It is now universally known the fear was based on falsehoods. And yet the war goes on; the death and destruction continue.

This is not a new phenomenon. General Douglas MacArthur understood the political use of fear when he made this famous statement:

“Always there has been some terrible evil at home or some monstrous foreign power that was going to gobble us up if we did not blindly rally behind it.”

We should be ever vigilant when we hear the fear mongers preparing us for the next military conflict our young men and women will be expected to fight. We’re being told of the great danger posed by Almadinejad in Iran and Kim Jung Il in North Korea. Even Russia and China bashing is in vogue again. And we’re still not able to trade with or travel to Cuba. A constant enemy is required to expand the state. More and more news stories blame Iran for the bad results in Iraq. Does this mean Iran is next on the hit list?

The world is much too dangerous, we’re told, and therefore we must be prepared to fight at a moment’s notice, regardless of the cost. If the public could not be manipulated by politicians’ efforts to instill needless fear, fewer wars would be fought and far fewer lives would be lost.



Fear and Anger over Iraq

Though the American people are fed up for a lot of legitimate reasons, almost all polls show the mess in Iraq leads the list of why the anger is so intense.

Short wars, with well-defined victories, are tolerated by the American people even when they are misled as to the reasons for the war. Wars entered into without a proper declaration tend to be politically motivated and not for national security reasons. These wars, by their very nature, are prolonged, costly, and usually require a new administration to finally end them. This certainly was true with the Korean and Vietnam wars. The lack of a quick military success, the loss of life and limb, and the huge economic costs of lengthy wars precipitate anger. This is overwhelmingly true when the war propaganda that stirred up illegitimate fears is exposed as a fraud. Most soon come to realize the promise of guns and butter is an illusion. They come to understand that inflation, a weak economy, and a prolonged war without real success are the reality.

The anger over the Iraq war is multifaceted. Some are angry believing they were lied to in order to gain their support at the beginning. Others are angry that the forty billion dollars we spend every year on intelligence gathering failed to provide good information. Proponents of the war too often are unable to admit the truth. They become frustrated with the progress of the war and then turn on those wanting to change course, angrily denouncing them as unpatriotic and un-American.

Those accused are quick to respond to the insulting charges made by those who want to fight on forever without regard to casualties. Proponents of the war do not hesitate to challenge the manhood of war critics, accusing them of wanting to cut and run. Some war supporters ducked military service themselves while others fought and died, only adding to the anger of those who have seen battle up close and now question our campaign in Iraq.

When people see a $600 million embassy being built in Baghdad, while funding for services here in the United States is hard to obtain, they become angry. They can’t understand why the money is being spent, especially when they are told by our government that we have no intention of remaining permanently in Iraq.

The bickering and anger will not subside soon, since victory in Iraq is not on the horizon and a change in policy is not likely either.

The neoconservative instigators of the war are angry at everyone: at the people who want to get out of Iraq; and especially at those prosecuting the war for not bombing more aggressively, sending in more troops, and expanding the war into Iran.

As our country becomes poorer due to the cost of the war, anger surely will escalate. Much of it will be justified.

It seems bizarre that it’s so unthinkable to change course if the current policy is failing. Our leaders are like a physician who makes a wrong diagnosis and prescribes the wrong medicine, but because of his ego can’t tell the patient he made a mistake. Instead he hopes the patient will get better on his own. But instead of improving, the patient gets worse from the medication wrongly prescribed. This would be abhorrent behavior in medicine, but tragically it is commonplace in politics.

If the truth is admitted, it would appear that the lives lost and the money spent have been in vain. Instead, more casualties must be sustained to prove a false premise. What a tragedy! If the truth is admitted, imagine the anger of all the families that already have suffered such a burden. That burden is softened when the families and the wounded are told their great sacrifice was worthy, and required to preserve our freedoms and our Constitution.

But no one is allowed to ask the obvious. How have the 2,500 plus deaths, and the 18,500 wounded, made us more free? What in the world does Iraq have to do with protecting our civil liberties here at home? What national security threat prompted America’s first pre-emptive war? How does our unilateral enforcement of UN resolutions enhance our freedoms?

These questions aren’t permitted. They are not politically correct. I agree that the truth hurts, and these questions are terribly hurtful to the families that have suffered so much. What a horrible thought it would be to find out the cause for which we fight is not quite so noble.

I don’t believe those who hide from the truth and refuse to face the reality of the war do so deliberately. The pain is too great. Deep down, psychologically, many are incapable of admitting such a costly and emotionally damaging error. They instead become even greater and more determined supporters of the failed policy.

I would concede that there are some-- especially the die-hard neoconservatives, who believe it is our moral duty to spread American goodness through force and remake the Middle East-- who neither suffer regrets nor are bothered by the casualties. They continue to argue for more war without remorse, as long as they themselves do not have to fight. Criticism is reserved for the wimps who want to “cut and run.”

Due to the psychological need to persist with the failed policy, the war proponents must remain in denial of many facts staring them in the face.

They refuse to accept that the real reason for our invasion and occupation of Iraq was not related to terrorism.

They deny that our military is weaker as a consequence of this war.

They won’t admit that our invasion has served the interests of Osama Bin Laden. They continue to blame our image problems around the world on a few bad apples.

They won’t admit that our invasion has served the interests of Iran’s radical regime.

The cost in lives lost and dollars spent is glossed over, and the deficit spirals up without concern.

They ridicule those who point out that our relationships with our allies have been significantly damaged.

We have provided a tremendous incentive for Russia and China, and others like Iran, to organize through the Shanghai Cooperation Organization. They entertain future challenges to our plans to dominate South East Asia, the Middle East, and all its oil.

Radicalizing the Middle East will in the long term jeopardize Israel’s security, and increase the odds of this war spreading.

War supporters cannot see that for every Iraqi killed, another family turns on us-- regardless of who did the killing. We are and will continue to be blamed for every wrong done in Iraq: all deaths, illness, water problems, food shortages, and electricity outages.

As long as our political leaders persist in these denials, the war won’t end. The problem is that this is the source of the anger, because the American people are not in denial and want a change in policy.

Policy changes in wartime are difficult, for it is almost impossible for the administration to change course since so much emotional energy has been invested in the effort. That’s why Eisenhower ended the Korean War, and not Truman. That’s why Nixon ended the Vietnam War, and not LBJ. Even in the case of Vietnam the end was too slow and costly, as more then 30,000 military deaths came after Nixon’s election in 1968. It makes a lot more sense to avoid unnecessary wars than to overcome the politics involved in stopping them once started. I personally am convinced that many of our wars could be prevented by paying stricter attention to the method whereby our troops are committed to battle. I also am convinced that when Congress does not declare war, victory is unlikely.

The most important thing Congress can do to prevent needless and foolish wars is for every member to take seriously his or her oath to obey the Constitution. Wars should be entered into only after great deliberation and caution. Wars that are declared by Congress should reflect the support of the people, and the goal should be a quick and successful resolution.

Our undeclared wars over the past 65 years have dragged on without precise victories. We fight to spread American values, to enforce UN resolutions, and to slay supposed Hitlers. We forget that we once spread American values by persuasion and setting an example-- not by bombs and preemptive invasions. Nowhere in the Constitution are we permitted to go to war on behalf of the United Nations at the sacrifice of our national sovereignty. We repeatedly use military force against former allies, thugs we helped empower—like Saddam Hussein and Osama bin Laden—even when they pose no danger to us.

The 2002 resolution allowing the president to decide when and if to invade Iraq is an embarrassment. The Constitution authorizes only Congress to declare war. Our refusal to declare war transferred power to the president illegally, without a constitutional amendment. Congress did this with a simple resolution, passed by majority vote. This means Congress reneged on its responsibility as a separate branch of government, and should be held accountable for the bad policy in Iraq that the majority of Americans are now upset about. Congress is every bit as much at fault as the president.

Constitutional questions aside, the American people should have demanded more answers from their government before they supported the invasion and occupation of a foreign country.

Some of the strongest supporters of the war declare that we are a Christian nation, yet use their religious beliefs to justify the war. They claim it is our Christian duty to remake the Middle East and attack the Muslim infidels. Evidently I have been reading from a different Bible. I remember something about “Blessed are the peacemakers.”

My beliefs aside, Christian teaching of nearly a thousand years reinforces the concept of “The Just War Theory.” This Christian theory emphasizes six criteria needed to justify Christian participation in war. Briefly the six points are as follows:

War should be fought only in self defense;
War should be undertaken only as a last resort;
A decision to enter war should be made only by a legitimate authority;
All military responses must be proportional to the threat;
There must be a reasonable chance of success; and
A public declaration notifying all parties concerned is required.
The war in Iraq fails to meet almost all of these requirements. This discrepancy has generated anger and division within the Christian community.

Some are angry because the war is being fought out of Christian duty, yet does not have uniform support from all Christians. Others are angry because they see Christianity as a religion as peace and forgiveness, not war and annihilation of enemies.

Constitutional and moral restraints on war should be strictly followed. It is understandable when kings, dictators, and tyrants take their people into war, since it serves their selfish interests-- and those sent to fight have no say in the matter. It is more difficult to understand why democracies and democratic legislative bodies, which have a say over the issue of war, so readily submit to the executive branch of government. The determined effort of the authors of our Constitution to firmly place the power to declare war in the legislative branch has been ignored in the decades following WWII.

Many members have confided in me that they are quite comfortable with this arrangement. They flatly do not expect, in this modern age, to formally declare war ever again. Yet no one predicts there will be fewer wars fought. It is instead assumed they will be ordered by the executive branch or the United Nations-- a rather sad commentary.

What about the practical arguments against war, since no one seems interested in exerting constitutional or moral restraints? Why do we continue to fight prolonged, political wars when the practical results are so bad? Our undeclared wars since 1945 have been very costly, to put it mildly. We have suffered over one hundred thousand military deaths, and even more serious casualties. Tens of thousands have suffered from serious war-related illnesses. Sadly, we as a nation express essentially no concern for the millions of civilian casualties in the countries where we fought.

The cost of war since 1945, and our military presence in over 100 countries, exceeds two trillion dollars in today’s dollars. The cost in higher taxes, debt, and persistent inflation is immeasurable. Likewise, the economic opportunities lost by diverting trillions of dollars into war is impossible to measure, but it is huge. Yet our presidents persist in picking fights with countries that pose no threat to us, refusing to participate in true diplomacy to resolve differences. Congress over the decades has never resisted the political pressures to send our troops abroad on missions that defy imagination.

When the people object to a new adventure, the propaganda machine goes into action to make sure critics are seen as unpatriotic Americans or even traitors.

The military-industrial complex we were warned about has been transformed into a military-media-industrial-government complex that is capable of silencing the dissenters and cheerleading for war. It’s only after years of failure that people are able to overcome the propaganda for war and pressure their representatives in Congress to stop the needless killing. Many times the economic costs of war stir people to demand an end. This time around the war might be brought to a halt by our actual inability to pay the bills due to a dollar crisis. A dollar crisis will make borrowing 2.5 billion dollars per day from foreign powers like China and Japan virtually impossible, at least at affordable interest rates.

That’s when we will be forced to reassess the spending spree, both at home and abroad.

The solution to this mess is not complicated; but the changes needed are nearly impossible for political reasons. Sound free market economics, sound money, and a sensible foreign policy would all result from strict adherence to the Constitution. If the people desired it, and Congress was filled with responsible members, a smooth although challenging transition could be achieved. Since this is unlikely, we can only hope that the rule of law and the goal of liberty can be reestablished without chaos.

We must move quickly toward a more traditional American foreign policy of peace, friendship, and trade with all nations; entangling alliances with none. We must reject the notion that we can or should make the world safe for democracy. We must forget about being the world’s policeman. We should disengage from the unworkable and unforgiving task of nation building. We must reject the notion that our military should be used to protect natural resources, private investments, or serve the interest of any foreign government or the United Nations. Our military should be designed for one purpose: defending our national security. It’s time to come home now, before financial conditions or military weakness dictates it.

The major obstacle to a sensible foreign policy is the fiction about what patriotism means. Today patriotism has come to mean blind support for the government and its policies. In earlier times patriotism meant having the willingness and courage to challenge government policies regardless of popular perceptions.

Today we constantly hear innuendos and direct insults aimed at those who dare to challenge current foreign policy, no matter how flawed that policy may be. I would suggest it takes more courage to admit the truth, to admit mistakes, than to attack others as unpatriotic for disagreeing with the war in Iraq.

Remember, the original American patriots challenged the abuses of King George, and wrote and carried out the Declaration of Independence.

Yes Mr. Speaker, there is a lot of anger in this country. Much of it is justified; some of it is totally unnecessary and misdirected. The only thing that can lessen this anger is an informed public, a better understanding of economic principles, a rejection of foreign intervention, and a strict adherence to the constitutional rule of law. This will be difficult to achieve, but it’s not impossible and well worth the effort.

Waving the Warning Flags

by Puru Saxena

The eternal truth in the investment world is that every asset class goes
through boom and bust cycles, which typically last for several years.
However, it is ironic that toward the end of any bull-market, when the
risk is extreme, optimism toward the booming asset-class is usually at a
record-high. On the other hand, during the final phase of a bear-market,
when the downside risk is limited, the asset that is selling at a huge
discount is always neglected and hated by the public. The reason for this
irrational behavior is that most people find it hard to foresee and accept
change. The conditions that have been prevalent for a long time are
considered to be permanent, and investment decisions are made accordingly.

In the late 1990's, the entire world was in love with the "new era," which
was inspired by technology. Fund managers, economists, media commentators
and even the shoeshine boys were drooling over the prospects of retiring
young, thanks to their Microsoft and Intel shares. Of course, that turned
out to be the worst time to be invested in the hype as the technology
shares came crashing down to earth in March 2000. Back then, I recognized
that commodities were on the bargain table relative to financial assets.
Therefore, I started buying precious metals, but most people thought that
the "Millennium Bug" had infected me.

"Why are you buying gold? I lost a lot of money in gold 15 to 20 years ago
and I'll never touch it again," were comments I often heard. Once again,
the great majority failed to identify change, thereby ignoring the birth
of a new bull-market.

Once the great technology bubble burst and the United States slipped into
a recession, the central bankers decided to fight the slump by lowering
interest rates to a multi-decade low. In the United States, interest rates
were pulled down to a miniscule one percent. As the cost of borrowing came
down, Americans turned to real estate as the next sure thing. Real estate
prices surged, as demand rose due to cheap and abundant credit. As home
prices continued to rise, Americans started using their real estate as
collateral to borrow money.

Falling interest-rates and appreciating home values also created an
explosion in re-financing activity and the United States embarked on a
gigantic spending spree. It is worth noting that over the recent years,
Americans have extracted a ridiculous amount of equity from their homes.
In fact, since the beginning of this decade - 4.6 trillion U.S. dollars!
To make matters worse, the negative personal savings rate in the United
States highlights the fact that these loans taken out against homes
weren't saved for the proverbial rainy day; instead the money was spent on
consumption.

This recklessness has put the U.S. economy in a precarious situation.
Interest rates are now rising all over the world. After a multi-month
pause, I expect interest rates to continue their upward trend. So far, the
Federal Reserve has raised rates 17 times to 5.25% and the impact is
already being felt on American real estate. I'm afraid the property
industry in the United States is falling into a serious recession. In
June, new home sales fell to 1.49 million units, the lowest since November
2004. It's down 18.1% from the record-high of 1.81 million units during
January 2006. Furthermore, the supply of U.S. homes for sale has recently
jumped to a multi-decade high. In summary, rising-interest rates are
starting to bite into the real estate boom and trouble may be on the
horizon.

I've been warning about housing for several months now and still urge you
to get rid of your investment properties. In my opinion, we are in the
final stages of the housing boom and once again, the majority of people
can't foresee this change. The warning flags are everywhere! Recently, the
stocks of major U.S. homebuilding companies declined sharply and I
consider this an ominous development.

The S&P 500 Homebuilding Index is down 46.2% from its July 2005 record
high! Such a major sell off in this sector is the market's way of
forecasting deteriorating business conditions ahead in the real estate
industry. Moreover, if U.S. housing slips into a recession and prices
decline, consumption will also be badly hurt due an abrupt ending of the
refinancing boom. Remember, consumption accounts for roughly 70% of GDP
growth in the United States and any slowdown in this department may send
its entire economy into a recession.

Furthermore, it is my observation that apart from the United States, real
estate is generally overvalued in the majority of nations. Due to poor
wage growth and rising interest rates, housing simply isn't affordable
anymore. It may deflate over the coming months as demand continues to
evaporate. So, to reiterate, my sincere advice to you is to liquidate your
leveraged properties and invest in the world of natural resources where
the bull market is still in its infancy! A mega change is currently
underway and over the coming years, I envisage major capital flows from
financial assets to commodities.

In my view, every investor must allocate 20% to 25% of his or her total
net-worth to precious metals. This may sound extreme, but in a world where
central bankers continue to inflate the supply of money, gold and other
precious metals offer the best wealth protection.

Over the coming years, I expect the various central banks to print a
ridiculous amount of money. The United States faces a $46 trillion debt
monster and the only way it can remain solvent and pay off its debt is
through monetary inflation. Remember, the easiest way to repay debt is by
diluting the purchasing power of each unit of money. So, through monetary
inflation, the 46 trillion dollars the U.S. owes today may not "feel" like
$46 trillion in 10 years time! To complicate matters further, due to
globalization and international trade, no country wants a strong currency.

So, if every nation continues to print money in order to keep its own
currency weak against a fundamentally weak U.S. dollar, the entire basket
of "paper" currencies will decline against precious metals - the supply of
which can't be increased ad infinitum.

Precious metals are in a gigantic bull market, which is likely to continue
for as long as monetary inflation remains the norm. For sure, no bull
market continues to rise forever, and each boom is punctuated with
multi-month consolidations. After a stellar multi-month surge, the
precious metals bull market witnessed a vicious yet normal pullback in
May.

In my opinion, the worst is behind us now and this is an ideal time to add
to your positions in precious metals. After a few more weeks of
consolidation, I anticipate another strong advance over the coming six to
nine months. The rising geo-political tensions and a possible conflict
between the United States and Iran may cause precious metals to really
shine in the period ahead.

Back in 1980, on an inflation-adjusted basis, gold peaked at $2,100 per
ounce and silver peaked above $100 per ounce. Today, you can buy gold at
$630 per ounce and silver at $12.5 per ounce - absolute bargains, given
the money and credit growth we've seen over the past 26 years!

Regards,

Puru Saxena

Puru Saxena is the editor and publisher of Money Matters,
an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNN,BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes forseveral newspapers and financial journals.

HISTORY - THE GREAT TEACHER!

by Puru Saxena

At present, there is a lot of noise about a "commodities bubble." The
majority of "experts" are convinced that commodity prices have risen too
much and they'll collapse. On the other hand, stocks and bonds are being
touted as bargains - or as the foolproof road to riches and financial
freedom! These days, the mainstream media is awash with analysts who are
claiming that commodities will suffer due to rising interest rates.
Frankly, I find their argument totally absurd.

History has shown that commodity prices are positively correlated to the
direction of interest rates. On the other hand, financial assets such as
stocks and bonds are negatively correlated to interest rates.

During the 1970's, interest rates soared and this period coincided with a
gigantic bull-market in commodities. Despite sky-high interest rates, all
the commodities went up several-fold! It is interesting to note that the
1970's saw a vicious bear market in stocks and bonds. Back then, the
United States underwent a huge recession and Britain had to be bailed out
by the IMF. Interest rates peaked in the early 1980's and this coincided
with the end of the commodities boom. In the following two decades, both
interest rates and commodities declined whilst stocks and bonds witnessed
a huge boom.

There is no doubt that the previous commodities boom took place amidst
rising interest rates and a severe recession. So, next time when the
"experts" claim that commodities are about to collapse because of rising
interest rates and a slowing economy, perhaps you can direct them to a
good history teacher!

I'll let you in on a secret, which is essential to your success as an
investor. You must understand that the central banks don't raise interest
rates to fight inflation. After all, the modern-day central banking system
is inflation! Central banks raise or lower interest rates in order to
manage the public's inflation fears or expectations. During such times
when the public wakes up to the inflation problem and starts losing faith
in the world's paper currencies (present scenario), central banks raise
interest rates to show that they're fighting inflation. Interest rates are
pulled up in an effort to restore confidence in the world's currencies as
a higher yield makes currencies more attractive. On the other hand, when
the public's inflation fears are under control and confidence in the
monetary system is high, central banks lower interest rates to create even
more inflation!

During cycles of monetary easing, the rate of inflation (money-supply and
credit growth) accelerates, thereby creating an economic boom. During
periods of monetary tightening (such as now), the rate of inflation
(money-supply and credit growth) slows down temporarily, causing financial
accidents in a highly leveraged global economy. Make no mistake though,
the response or cure offered by the central banks to every financial
accident is always more inflation and credit.

At present, every central bank has assumed the role of an
"inflation-fighter!" Interest rates are being increased in the majority of
countries under the pretence of controlling inflation. However, it is
worth noting that despite rising interest rates, our world is still awash
in liquidity. Recently, the non-gold foreign exchange reserves held by the
central banks rose to a record $4.4 trillion U.S., up nearly 10%
year-on-year! Emerging nations held a record $3.07 trillion U.S. and the
developed nations held a near-record $1.33 trillion U.S.

Opinion is divided as to whether interest rates will continue to rise. The
majority seems to think that the Federal Reserve won't raise interest
rates much further for the fear of seriously hurting the housing boom.
However, I feel that the U.S. interest rates will have to continue to rise
or else the U.S. dollar may stage a dramatic decline. Given a choice
between protecting either the housing boom or an outright collapse in the
U.S. dollar, I can assure you that the Federal Reserve will choose the
latter. The truth is that the Federal Reserve exports U.S. dollars to the
entire world and it'll do everything in its power to delay the destruction
of its merchandise. In summary, I concede that the Federal Reserve may
pause during the second half of this year to offer some respite before the
U.S. mid-term election in November. However, the major trend is now up and
interest rates may well be in double-digits within five years.

If my above assessment is correct, you can bet your bottom dollar that
stocks, bonds and property are going to come under serious pressure.
Already, the real-estate market in the United States is showing signs of a
slowdown as the establishment tries to engineer a soft landing. In my
opinion, we now amidst a global housing bubble, which will eventually
deflate due to rising borrowing costs. It is interesting to note that the
bond yields fell between 1981 and 2003. As the cost of borrowing declined,
housing as well as bond prices went through the roof! However, in June
2003, bond-yields bottomed out and have been rising ever since. Over the
past three years, the cost of borrowing has become more expensive and
we're beginning to see its impact on the slowing real-estate markets
worldwide. The U.S. 10-year Treasury yield has now broken out of its
20-year downtrend and this is an ominous development. This breakout points
to much higher interest rates in the future, so I'd have to advise you to
sell your leveraged properties and bonds without further delay. The great
bull market in bonds ended in June 2003 and this is not a good time to be
invested in fixed-income assets.

In the past, I've stated that in a highly inflationary environment,
stocks, commodities and real estate can all rise at the same time.
Basically, an over-supply of paper money causes its purchasing power to
diminish. I still maintain that over the coming decade, even if all assets
(with the exception of bonds) continue to rise, I expect commodities to
outperform all other asset classes on a relative basis.

Regards,

Puru Saxena

Note: Puru Saxena is the editor and publisher of Money Matters,
an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, Saxena is a regular guest on
CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3, and he
also writes for several newspapers and financial journals.

The above is an excerpt from Money Matters, a monthly economic
publication, which highlights extraordinary investment opportunities in
all major markets. In addition to the monthly reports, subscribers also
benefit from timely and concise "E-mail Updates," which are sent out when
an important development in the capital markets warrants immediate
attention. Click here to subscribe:

Money Matters
http://www.purusaxena.com/

BIG MONEY AND MOTHER NATURE

by Byron King
for Whiskey & Gunpowder
Sign up here for a FREE subscription!

THE ANNOUNCEMENTS WERE REMARKABLE for many reasons, not the least of which was their coincidence in time. Last week, Anadarko Petroleum Corp., a large, independent oil company, announced a $21 billion deal to take over two other oil and gas firms, Kerr-McGee Corp. and Western Gas Resources Inc. And then this week began with Phelps Dodge Corp., a large mining concern, announcing a $40 billion deal to take over two Canadian mining companies, Inco Ltd. and Falconbridge Ltd. Welcome to the world in which big money meets Mother Nature.

The Anadarko Deal

Here is the background on the Anadarko deal. Anadarko is proposing to pay $16.4 billion for Kerr-McGee and $4.7 billion for Western Gas. Anadarko will finance the entire acquisition with debt. Upon completion of the deal, Anadarko will more than double its annual sales. In 2005, Anadarko, which has 3,300 employees, reported $7.1 billion in sales. Revenue for Kerr-McGee last year totaled $5.93 billion, and Western Gas Resources booked $3.96 billion in 2005 sales. Together, the three companies will ring the cash register for annual revenue of $17 billion.

“We are creating a combined company with industry-leading positions in the deep-water Gulf of Mexico and the Rockies, two of the fastest-growing oil- and natural gas-producing regions in North America,” said Jim Hackett, chairman, president, and CEO of Anadarko. Despite the recent weakening in natural gas prices, Anadarko managers are looking to the longer term. They are confident that natural gas prices will regain any lost ground and remain high, due to increasing demand and flattening output across North America. Also, in all likelihood, Anadarko wants to keep itself from falling prey to other potential buyers who may covet Anadarko’s own assets and personnel. (Shell Oil Co. has been mentioned as a possible suitor.) Hold that thought while we look at another takeover proposal.

The Phelps Dodge Deal

Here is the raw data on the Phelps Dodge deal. Phelps Dodge, one of the world’s largest copper producer, is proposing to acquire Inco, one of the largest nickel mining companies in the world. In turn, Inco will sweeten an existing offer to acquire Falconbridge, another nickel mining concern already in play, and thus complete a problematic merger.

By acquiring Inco and Falconbridge, Phelps Dodge will create a diversified mining superpower whose presence will reshape the industry in a world of booming commodity prices. If this deal closes successfully, it will create the fifth-largest mining firm in the world, behind BHP Billiton, Rio Tinto, Anglo American and Brazil-based CVRD, with a market capitalization of $40 billion.

The underlying assumption behind the Phelps Dodge deal has to be that worldwide demand for basic materials will remain strong, particularly from the factories of China. Otherwise, Phelps Dodge would be acquiring assets at a post-run-up premium price and risk getting caught at or near the top of a traditional commodity cycle.

The other side of this coin is that worldwide, the basic commodity mining business has suffered from over two decades of low investment in the infrastructure needed to bring ore to the surface and process it into a useable end product. Thus, real ore deposits with real mines and processing facilities sitting on top of them are a relatively scarce item. These big holes in the ground can and do command a premium.

According to a company press release, Phelps Dodge is proposing to pay $80 (Canadian) per share for every share of Inco. Of that amount, $17.50 will be paid in cash and the rest in Phelps Dodge stock. Inco will in turn increase its offer for Falconbridge by about C$5 a share, to about C$62 per share. Phelps Dodge has announced that it will commence a US$5 billion stock repurchase program as part of the transaction. Thus, in the end, the Inco offer will be even more valuable to Falconbridge shareholders as a result of the increased value of its stock due to the Phelps Dodge bid.

Phelps Dodge officials believe that the combined entity can save about $900 million annually as a result of the three-way combination. For example, both Inco and Falconbridge operate massive nickel mines near Sudbury, Ontario. But despite the proximity of their operations, the arrangement of their mines often verged on being silly. Ore from Inco’s operations, literally a stone’s throw from Falconbridge’s sites, was routinely moved long distances by rail to Inco operations, and vice versa.

Execution Risk

Corporate mergers and large-scale asset sales are relatively routine. But three-way deals, such as we are seeing here, are uncommon, and it is an almost astonishing coincidence that we see a simultaneous confluence of events in two natural resource sectors. It makes one wonder what is driving this phase of a business cycle in the natural resource industries. Hold that thought, too.

Buying two companies at once adds what investment bankers call “execution risk” to any transaction. Imagine the difficulty involved in merging just two corporate cultures, two sets of management, two groups of employees, and two different asset bases. Now consider the difficulty entailed when there are three distinct sets of players involved in a transaction. (And in the case of the Phelps Dodge acquisition, the joinder of the three firms spans two nations.) Aside from the financial angles, the Phelps Dodge deal for Inco and Falconbridge requires governmental approvals from authorities in the U.S., Canada, and Europe, along with Phelps Dodge and Inco shareholder approval. The transaction is expected to close in September.

Just in terms of employees, Phelps Dodge has about 13,500 on the payroll, and the proposed acquisitions will swell the ranks with 12,000 more from Inco and 14,500 from Falconbridge. Combining the three mining companies “will vault [Phelps Dodge] into super-major status within the global mining industry,” and make it easier to raise capital and develop giant projects, said Phelps Dodge chairman and CEO Steven Whisler on Monday, June 26. “Our key driver in this transaction,” said Mr. Whisler, “is the potential for significant synergies.” Ah yes, those wonderful “synergies.”

Synergies or not, the transactions present world-class financial challenges, because in both instances, management proposes vastly to increase company debt in an environment of rising interest rates. Phelps Dodge has lined up $22 billion in financing for the deal and the related share buyback program. Simply to enable Inco to acquire Falconbridge, Phelps Dodge has agreed to buy as much as $3 billion of convertible subordinated notes issued by Inco. This cash infusion would, in turn, provide Inco with the cash it requires to buy out the Falconbridge common shares and, as one spokesman put it, to “satisfy related dissent rights, as needed.”

$22 billion is, of course, a lot of money. But Phelps Dodge is focusing, according to Mr. Whisler, on the “extremely strong cash flow [estimated at $10 billion before interest, taxes, depreciation, and amortization], which will enable us to reduce debt quickly and fund growth projects.” Let’s hope that Mr. Whisler is not whistling Dixie.

Speaking of debt, Anadarko is proposing to fund its acquisition of Kerr-McGee and Western Gas by taking on debt greater than its market value. The acquisitions will cost Anadarko $23.3 billion, including assumed debt. To pay for it, Anadarko secured a $24 billion acquisition facility from UBS, Credit Suisse, and Citigroup that it proposes to pay down using proceeds from asset sales, free cash flow, and the sale of new stock over the next 18-24 months.

Because the offer for Kerr-McGee and Western Gas is all in cash, the Anadarko shareholders do not have a vote on the matter. Thus, there is no possibility of what is called a “fiduciary out” for the company (i.e., the company cannot back out by saying the shareholders voted this down.) The proposed takeover price for the two target firms is at something of a rich premium, as well. Pre-announcement, Kerr-McGee was selling for 15 times earnings. Western Gas was selling for 21 times earnings. Anadarko, by contrast, was selling at 9 times earnings, and its market capitalization dropped by $1.7 billion on the first day of trading after the takeover announcement.

Execution Benefit

For every risk, however, there are potential benefits. According to a summary provided by Anadarko, the company expects ultimately to recover 3.8 billion barrels of oil equivalent from Kerr-McGee and Western Gas at a price of less than $12 per barrel. It would certainly be difficult to find that amount of hydrocarbon the old-fashioned way, by going out in the field, acquiring acreage, and drilling wells. By way of comparison, crude futures are currently trading above $70 per barrel.

In a series of press releases, Anadarko stated:

“Opportunities to gain access to such large, high-margin resource opportunities at such economic full-cycle costs are rare…The core assets being acquired strongly complement Anadarko’s existing properties, providing the scale and focus needed to deliver more robust, predictable, and efficient growth…Kerr-McGee’s outstanding deep-water holdings (in the Gulf of Mexico) and skill sets will elevate Anadarko into the top echelon of deep-water operators.

“Similarly, Kerr-McGee’s long-lived natural gas resource plays in Colorado and Utah, along with Western Gas Resources’ [holdings] in Wyoming, will combine with Anadarko’s assets to make us one of the largest producers in several of the most prolific basins in the Rockies.”

“There Is Nothing Left to Drill”

About a year or so ago, no less a scholar of natural resources than T. Boone Pickens said of the United States oil and gas situation, “There is nothing left to drill.” Boone was, of course, being facetious. There is always “something” left to drill.

But Boone was making an important point, summing up in just a few words the notion that exploration for natural resources in the ground is always an issue that involves many variables. Among other things, exploration involves access to new areas, the quality of the prospect, the costs of drilling and production, and the return on investment. By these criteria, the U.S. environment for significant new natural resource discoveries, and future extraction, is distinctly unfavorable.

From a geological standpoint, there is not enough room between the dry holes of the American oil range to find any new deposits of oil or gas of significant size. Similarly, the most significant of the hard rock deposits of North America have been explored and fairly well defined. It is safe to say that there are few important mineral districts left to uncover in the U.S., and perhaps slightly less in Canada. Add to this the dramatically increased cost of exploration and production. Fuel costs have soared, as well as the costs for most of the basic equipment used in oil and mineral extraction. The cost of tubular goods and rock bits, for example, has skyrocketed in the past three years. And people are measuring waiting times for drilling rigs with a monthly calendar.

Sure, there is a lot of oil and gas left out there for the driller’s bit (if you can wait long enough for a delivery of drill bits), and there are significant numbers of mineralized anomalies in the Earth’s crust. But the deposits that the extraction companies will encounter will be smaller, further afield, and more expensive to develop and produce.

The Anadarko and Phelps Dodge plays certainly illustrate another point, one for which T. Boone Pickens is equally famous: that you can still “drill for reserves on Wall Street.” It was Boone who put my former employer Gulf Oil Co. into play back in 1983. The takeover that resulted, by so-called “white knight” Chevron, which swooped in to rescue Gulf from the hands of Boone, was among the first of the big takeovers within the traditional Western oil industry. So I have a certain bias when it comes to seeing oil and gas companies being taken over.

The Anadarko and Phelps Dodge deals will certainly make money for the investment bankers. This will be very good for the economies of Park Avenue, Long Island, and suburban Connecticut. And the takeover deals reward patient shareholders with a significant gain, especially the patient shareholders who took the risk of buying the variety of takeover stocks in the few days before the deal was announced (ahem!). A lot of people will sell their shares, and eventually, the tax collectors of the world will do well by this deal.

The parachute makers of the world (also known as “employment attorneys”) are probably working overtime sewing golden thread into the linings of the respective harnesses for many of the senior managers of the acquired companies. Everyone knows you cannot be too careful these days. So while the current environment in takeover land is all smiles, chuckles, camaraderie, and glowing optimism, I am sure that a good many senior employees are inspecting their ejection seats like a Blue Angels pilot just before a big air show.

To their credit, the Anadarko managers went out of their way to state that they are pleased with the potential to “acquire” the geological and other technical staff of Kerr-McGee and Western Gas. That is, Anadarko appears to want the human resource base of its takeover targets, as well as the oil and gas in the ground. Similarly, the Phelps Dodge managers have stated that layoffs of Canadian technical and production staff will be minimal.

This degree of solicitousness toward the employees is rather unusual. We used to say that the definition of an “optimist” was the geologist or engineer who brought lunch to work (as if he would be there to eat it by noon). It may truly be a reflection of management beginning to realize the severity of the shortage of human skills in the natural resource sector, after more than two decades of layoffs and declining enrollments in related earth science and engineering education programs.

The historical problem with mining and energy company takeovers is that ofttimes when one company buys another, a lot of the exploration and production people from the “other” outfit get laid off. This occurred as recently as last year when Chevron took over Unocal. And as a rule, with the merger of exploration and production departments, there tends to be less diversity of thought in the oil patch and among the rock-kickers. Fewer drilling prospects get generated in the oil and gas arena, and there is less creativity in following the mineral trend lines out in hard rock country. Considering the rising world demand for resources, and the shrunken talent pool, sooner or later it was going to become evident.

Companies that are the principal in big takeover plays almost always say something along the lines of, “Our larger size will allow us better to compete in the aggressive business climate of the modern petroleum industry.” This always a good line, and not unexpected considering the money that is in play. But it is not as if a smaller, well-managed company cannot partner up or obtain the financing it needs to pursue high-cost, risky ventures.

So the Anadarko and Phelps Dodge deals will play themselves out. We shall see what happens. Inquiring minds want to know how, when one company takes over two others, will the world be a better place? Will the combined company shoot more seismic or less? Will the combined firms drill more feet of core in the hard rocks, and drill more or fewer oil wells out in the oil patch, than the combination of the separate entities? Will the new larger entity discover and produce more stuff out of the ground than otherwise?

More on the Business Side

And now for just a few final words on the economic rationale behind the Anadarko and Phelps Dodge deals. Commentator Jim Cramer noted that “Neither deal should have ever been able to get done. But both deals reflect the playbook…that says all of these stocks must be sold because of the Fed.”

That is, the Fed has been steadily raising interest rates, causing the yield curve to turn inverted. There was, in consequence, a sell-off of natural resource stocks as people who had previously purchased shares on margin had to unload them at distressed prices. Deals that were otherwise uneconomical became possible. What this interesting coincidence of takeovers also says is that many companies involved in basic industrial activity -- mining, oil and gas, infrastructure, and basic manufacturing -- are relatively cheap. At Agora Financial, we have been saying this for a long time.

Until we meet again,
Byron W. King

Byron W. King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades. However, in the process of seeking more excitement than a man can safely obtain from flaring over-pressurized gas whipping out of a 21,000-foot well, Byron also served for many years in both the active and reserve components of the United States Navy.
While in the sea service, Byron logged more flight time in tactical jet aircraft than George W. Bush, as well as 127 more carrier landings than the recently-re-elected commander in chief. Among other assignments, Byron has served as a field historian with the Navy.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geologic history, and blends its significance into the more recent, man-made kind of tale.

Flationed Out

by Mike "Mish" Shedlock
Illinois, U.S.A.



for Whiskey & Gunpowder
Sign up here for a FREE subscription!



I HAVE BEEN pondering the word "stagflation." Nearly everyone but me seems to think we are in it or headed for it. What exactly does stagflation mean anyway?

Let's take a look at two definitions and a comment:

1. "Sluggish economic growth coupled with a high rate of inflation and unemployment" (American Heritage Dictionary)

2. "A condition of slow economic growth and relatively high unemployment -- a time of stagnation -- accompanied by a rise in prices, or inflation" (Investopedia.com)

3. "Investopedia commentary: "Stagflation occurs when the economy isn't growing, but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries...For these countries, stagnation increased the inflationary effects."

From above context, stagflation seems to be based on rising prices (instead of an expansion of credit), and furthermore, the term seems to imply that rising prices are bad only in context of the "stag."

An Austrian View of "Flation"

Inflation -- Expansion of money and credit

Deflation -- Contraction of money and credit

Disinflation -- Expansion of money and credit, but at a declining pace

Hyperinflation -- Rapid rise in inflation accompanied by a complete loss of confidence in currency

In Austrian terms, I find little use for such a term. Where exactly does it fit in?

Several days ago, I sent an article that called for "stagflation" to a good friend of mine who posts under the name "Trotsky" on Kitco. We had not discussed that term before, but knowing his Austrian leanings, his answer did not surprise me at all. It is as follows (note: He does not capitalize his sentences):

"what immediately comes to mind is that the term was coined with a Keynesian mind-set -- as if it were a new phenomenon that sort of 'just happens' without a sensible explanation at hand. at the time of the 1970s K summer, economists had been conditioned to associate economic downturns with deflation -- the inflationary recession of the early 1920s was long forgotten. when suddenly recession coincided with the effects of the concurrent inflationary monetary policy becoming highly visible, something happened that wasn't supposed to happen. so they thought it required a new term -- 'stagflation,' equaling recession cum inflation, the supposedly 'unnatural' state of affairs. Obviously, once you define inflation correctly (expansion of the fiat money supply), such a term makes no sense. especially considering that the Keynesian (as well as monetarist, i might add) recipe for 'combating economic downturns' consists of deficit spending cum monetization, i.e., printing lots of money, as a matter of course! perversely, application of this recipe leads only to bigger failures (proven by EVERY major application of it, including, IMO, the most recent one, which only created yet another surge in malinvestment, namely the housing bubble).

"the only reason why at times the inflation seemingly 'works' and at other times doesn't is that the initial conditions, as defined by the K seasons vary. IMO, there are two aspects that play a role -- the state of the pool of real funding (if it is shrinking, no amount of monetary pumping can even create the illusion of a new boom -- that's Japan from '89 onward) and the size of the private sector debt extant at the conclusion of the last boom.

"note that the term 'boom' is actually a negative term, or should be. during the boom, which is itself a result of lax monetary policy, capital is malinvested and the economy's production structure damaged/distorted. the bust is the economy's attempt at RECTIFYING the mistakes of the boom by liquidating malinvested capital and redirecting those resources to their optimal use (usually, that entails the realization that assumptions about future demand were simply wrong, as they are based on the illusion created by the credit expansion).

"anyway, the rarer condition of deflation as we understand it in the context of the fiat system is simply a credit contraction so massive that it overwhelms the countervailing attempts of the central bank to inflate. one must not forget the credit was largely created from thin air -- in a deflation, it simply goes back there.

"in any event, ultimately, 'stagflation' does not describe anything really...even though we know what it is meant to describe. simply put, it's the type of bust where the usual inflationary policy is noticed by everybody because prices and wages start to rise everywhere (because the 'debtberg' is still able to expand further)."

An Austrian Debate

Actually, I think the origin is probably far simpler. Someone wanted to talk about "stagnation" and accidentally said "stagflation" or perhaps said "stagflation" purposely trying to be cute. In any case, the word stuck, but as Trotsky pointed out, the word makes no real sense from an Austrian point of view. Yet it is only from the Austrian point of view that I wish to debate anyone on inflation.

That last sentence is key, and it has caused a lot of frustration recently. In addition, I keep responding to the same questions over and over again from e-mail and replies to blogs, many from people that do not know (or refuse to accept) what inflation is. In other cases, people are just now finding my blog and just happen to be asking a question I have addressed elsewhere a dozen times. Here are some of the typical questions:

"Mish, doesn't the rise in the price of oil prove you are wrong?"

"Mish, you still haven't explained how we can have a falling U.S. dollar and deflation"

"Mish, the U.S. is not Japan"

"Mish, how is your favorable view of gold consistent with deflation?"

"Mish, isn't it about time for you to throw in the towel?"

"Mish, inflation is our past, present, and future"

And so on and so forth, with no one adding anything to the debate.

One of the problems I face is that people want to be a part of the debate, even though they refuse to accept the terms of the debate. Austrians in general would accept the "Flation" list above (or something reasonably close); others do not. Unless one can agree on definitions, however, there can be no meaningful debate. People keep telling me I am wrong when they do not agree to the terms of the debate.

Following are three people whom I believe do agree with those "Flation" terms as defined above:

1. Marc Faber

2. Steve Saville

3. Robert Blumen

Note that I said they agree with those definitions. All of them disagree with my position. Taking the other side of a debate with Faber is dangerous, but we agree on far more things than we disagree on. Faber also admits deflation is possible (even if unlikely). Most inflationists will not even grant that.

Anyway, I want to thank Robert Blumen for his piece "Must Bernanke Choose Deflation?" simply because he not only agrees with the terms of debate, but he also made a serious effort to understand what I am saying. Hardly anyone else has bothered to try. If you are new to this discussion, not only do I ask you to read Blumen's article, but to click on all the embedded links in his post and read those too. Unless you do that, you cannot understand what I am saying or why.

Blumen disagrees with my position, but there is nothing wrong with that. Should unanimous opinion ever form on something economically related, I confidently predict we would all be wrong, and probably sooner, rather than later.

Questions Answered

I will reply later to his rebuttal, but for now, I want to address some of those questions above.

Q: "Mish, doesn't the dramatic rise in the price of oil prove you are wrong?"

A: No, the price of oil could be rising for many reasons, and perhaps much of that price is related to Peak Oil, dwindling supplies, and geopolitical concerns, rather than directly to monetary expansion. One cannot know for sure what causes any price increase, and that is a key reason why attempting to define inflation by looking at prices is dead wrong. It simply cannot be done. At any rate, prices rise and fall for many reasons, so one simply cannot look at prices to decide if there is inflation. My views on deflation are forward looking, and in response to an expected credit collapse in housing. For now, I freely admit there is inflation, as credit and money supply are still expanding, but note that it is possible for oil prices to keep rising, perhaps dramatically, even during deflation on account of Peak Oil.

Q: "Mish, you still haven't explained how we can have a falling U.S. dollar and deflation"

A: I have not explained how, because a falling dollar is not part of the equation. Inflation is an expansion of money and credit. Rest assured, there was inflation when the U.S. dollar index hit an all-time high of 120. Rest assured the U.S. dollar can sink even in a contraction of money and credit. I am not saying the dollar will fall -- I am saying it could fall. More than likely, the dollar will hold its own. If it falls, I have many reasons why it is unlikely to crash (anytime soon). For starters, it has already collapsed in just a few short years. Everyone thought the euro was trash a few short years ago, and now everyone seems to be a euro bull. That said, I do think the dollar could crash much later on down the road, after debt is wiped clean. A dollar crash will probably occur after everyone gives up on it. In the meantime, I expect savings will rise, and in a worldwide economic debacle, there will be safety in U.S. Treasuries. Note too that many other fiat currencies look just as bad from where we are now. Ideas about hyperinflation with a housing bust and loss of jobs and a worldwide economic bust seem rather silly to me. You are free to disagree, of course. For a more complete discussion of the U.S. dollar, please consider "Is the U.S. Dollar Toast?"

Q: "Mish, the U.S. is not Japan, and besides, Japan really did not have deflation anyway"

A: I never said the U.S. was Japan. And yes, there are big differences. In fact, I have outlined many of those differences between the Japan and the U.S. Some factors, such as demographics, favor the U.S. for avoiding deflation versus Japan. Other factors, most notably consumer debt, are a bigger problem here. Even though we are not Japan, I expect the deflation experience here will be quite similar. Part of that was addressed in "Inflation: What the Heck Is It?" And as for "Japan being a nation of savers" and the U.S. being not: That fact will actually make the snapback to the mean all the more vicious for over-expanded retail stores of all kinds. The U.S. was once a nation of savers, and will likely be again.

Q: "Mish, how is your favorable view of gold consistent with deflation?"

A: This question is really simple. If one views gold as money, it will be hoarded in deflationary times. Housing and equities will both plunge relative to gold, even if gold just manages to stay flat against the U.S. dollar value. That is the key idea. I believe that gold will more than hold its own, but there are no guarantees.

Q: "Mish, isn't it about time for you to throw in the deflation towel?"

A: On the verge of victory? No chance. One of the conditions required for my deflation scenario to unfold was a housing bust: a loss of jobs and income, and rising bankruptcies. Housing is just starting to bust, and eventually that will affect jobs and income. The scenario is just now finally starting to play out.

Q: "Mish, inflation is our past, present, and future"

A: Spoken like a person that has not studied history. Yes, three-quarters of the time, those believing in inflation will be correct. K Cycles are long cycles, lasting up to 80 years in length. By the time a deflationary winter is upon us, most people have known nothing but inflation all their lives. That is why no one sees deflation as a possibility. Memories of 1930 are long, long gone. Note too that length makes timing it a problem. In a 60-80 year cycle, pinpointing the start is not that easy to do. If housing is the "bubble of last resort," as I believe it to be, we can be in a world of hurt over the next seven years or more.

Those questions and similar ones keep coming up again and again and again. I thought I would address them all in one place, and of course, everyone is free to disagree with my conclusions. That said, one cannot have a rational discussion unless one agrees to definitions, and I choose to accept Austrian monetary definitions. In that regard, stagflation is simply not the answer to the "Flation" debate. It has little to do with "Flation" at all, from my point of view.

Mish Addendum: I started writing the above last Thursday. No sooner do I finish writing the article, but right before posting it, a good friend of mine going by the name "Chispas" on Silicon Investor sent me a link to a Forbes article on the topic.

What are they doing reading my mind? Or can it be vice versa? Regardless, let's briefly consider "If It's Not Stagflation...":

"It's not stagflation, but no one can seem to agree on the new term for an economy in which growth is slowing while inflation is rising, such as it is today.

"Could it be 'fearflation,' a term that means it's all just fear, rather than actual inflation that's driving the current economy? Maybe it's 'bubblenomics,' as the U.S. seems to be stuck in a bubble of higher prices, growing unemployment, high housing prices, and a falling dollar. Then again, it could be 'transflation,' the cycle of high gas prices leading to higher inflation. Or how about 'moderflation,' a slowing down accompanied by inflation?...

"Of course, if Bernanke is to be believed, it's not inflation we need to fear, but expectations of inflation...

"So maybe we should describe the current economy as 'Fedflation.'"

Eleven terms were submitted to Forbes to describe the current economy. Click on the above link to see them. YES, I agree with Forbes that it's NOT stagflation (at least someone agrees with me), but NO, we do not need another term for it. With that thought in mind, I changed the title of this article from "Stagflation Anyone?" to the current title selected, because, quite frankly, I am "Flationed Out."

Regards,
Mike Shedlock ~ "Mish"

Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish is currently doing economic and investment research for a number of clients. In addition, Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs / Mishedlo and one of the more popular boards on Silicon Investor as well, Mish's Global Economic Trend Analysis. You can see more of Mish's writing on his blog also entitled Mish's Global Economic Trend Analysis. While he is not writing about stocks or the economy Mish spends a great deal of time on photography, one of his other passions. Mish has over 80 magazine and book cover credits, for magazines such as Country Magazine, Wisconsin Trails, the Chicago Tribune Sunday Supplement, Browntrout Calendars, and numerous other publications. Some of his Wisconsin and gardening images can be seen at www.michaelshedlock.com.

SAILING WITHOUT AN ANCHOR!

by Puru Saxena
Editor, Money Matters
June 16, 2006

RECENT HISTORY – Up until the early 1970’s, our planet followed the Bretton Woods agreement of international monetary management. This system sought to secure the advantages of the gold standard without its disadvantages. The US dollar was linked to gold at the rate of $35 per ounce of gold and other nations pegged their currencies to the US dollar. At this fixed rate of US$35 per ounce, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, which was itself convertible into gold. The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world's key currency, most international transactions were denominated in dollars.

During the 1960’s, the US accumulated massive deficits and when the French demanded gold in exchange for US dollars, the US refused to redeem its dollars in gold. On 15 August 1971, US President Nixon shut the “gold window”, thereby removing gold from the monetary system. The result was inevitable – currencies started floating against each other and without gold as the anchor, nations gave up on their monetary discipline. A fabulous new era of “endless prosperity” had arrived! Central banks became obsessed with monetary inflation, world-trade benefited and the world’s foreign exchange reserves exploded. Figure 1 captures this development in all its glory. In 1971, the non-gold reserves of all countries were worth US$100 billion and today these have grown to roughly $4.3 trillion – an alarming 43-fold increase in 35 years!

Figure 1: Explosion in global non-gold reserves!

Source: www.yardeni.com

As the amount of money within the financial system increased due to the absence of gold, prices within the economy started rising. Once currencies were no longer linked to gold, the global economy became a ship without an anchor, floating from one “boom and bust” cycle to another! Rampant monetary inflation fuelled by the growth of credit turned the capital markets into one giant casino as punters worldwide (often loaded with credit) searched for the next opportunity to make a fortune.

In the 1970’s, this excessive liquidity churned out by the central banks found a home in commodities as the price of raw materials went crazy. During the 1980’s, investors piled into Japanese assets as stocks and real-estate soared. And in the 1990’s, when we were ushering in the new millennium, our world fell in love with the technology, media and telecom sector. Each of these booms was accompanied by rapid credit growth, heavy speculation based on unrealistic expectations and unfortunately they all met their common fate – the eventual bust!

Since the “tech wreck” in 2000, this excessive capital floating around the system has found a refuge in real-estate. Today, the public’s money is predominantly in property and everyone is convinced that the current boom will last forever. “What me worry? Nah, real-estate always goes up!” seems to be the common argument. Allow me to share a secret – no asset-class goes up in a straight line and property investors may be in for a rude shock if interest-rates continue to rise, which in my view is inevitable.

History has shown that rising interest-rates have always been bad news for stocks, bonds and highly-leveraged properties. Will this time be different? I guess we’ll find out!

THE FUTURE – I must admit that I don’t have a crystal ball, but wait, neither does anybody else. In the business of investing, we’re always dealing with change and all we have in our arsenal are probabilities based on the ongoing developments around us. At present, I’m most certain about the following mega-trends, which are likely to intensify over the coming decade –

· Transfer of wealth from the West to the emerging world

· Transfer of capital from financial to tangible assets

I base my above forecasts on the fact that due to globalization and the opening up of China and India, 2.3 billion people have now entered the workforce and these people are hungry for success and a better quality of life. After having lived in dismal poverty for decades, the middle-class in these developing countries has now “tasted blood” and it is determined to catch-up with the West.

To be perfectly honest, China is much more developed and its infrastructure far superior than India’s. In fact, I would argue that China probably has the best roads in the world. I might as well add that the same can’t be said of its drivers!

Last week, I traveled to Suzhou (2-hour drive from Shanghai) for a meeting with an extremely successful Chinese businessman. Mr. Wong is the new breed of entrepreneurs and represents modern, capitalist China. He established his manufacturing business 10-years ago and today his annual turnover is US$240 million. Mr. Wong is in the process of building another factory; he has just bought a luxurious Mercedes and his children study in exclusive schools in England! Moreover, I was amazed to learn that one of Mr. Wong’s friends had just built a 5-star luxury hotel in Suzhou by paying US$30 million upfront in cash! Welcome to communist China

Let’s face it, the 21^st century will belong to China. Shanghai is a phenomenal city with countless skyscrapers, huge shopping malls, great restaurants and an energetic population. Even a small town like Suzhou is home to massive factories, modern buildings and its people have an incredible work ethic. You really have to visit China to see what’s going on in the world’s fastest growing economy! For sure, its vast majority is still poor and the wealth divide is getting bigger but I am very excited about China’s future. If my assessment is correct, the world’s oldest civilization has a bright future.

© 2006 Puru Saxena
Editorial Archive

Puru Saxena Ltd.
Suite 1208, Citibank Tower
3 Garden Road, Central, Hong Kong
Phone: (852) 3589 6789 Fax: (852) 3585 5665 Email l Website

INFLATION: THE INVISIBLE TAX!

by Puru Saxena
Editor, Money Matters
May 12, 2006

THE PICTURE – Officially, the Federal Reserve’s purpose is to fight inflation and manage the economy. Meanwhile, my claim to fame is turning stone into gold! Presented below is the real agenda of the Federal Reserve.

Every human being must understand that the Federal Reserve IS inflation. The Federal Reserve was established in 1913 to create inflation and its secondary role is to manage the public’s inflation FEARS. Over the past 25 years, the Federal Reserve has done a fantastic job at both – inflation (money supply growth) has gone out of control and the public’s inflation fears have been well contained.

Figure 1 shows the consumer price level over the past 200 years. It is interesting to note that consumer prices didn’t rise at all during the entire 19^th century. However, under the “guidance” and “supervision” of the Federal Reserve, consumer prices have risen dramatically. In fact, it is evident from the chart that prices in the economy have increased the most since the early 1970’s when gold was removed from the monetary system. “But why is that so?” you may wonder. The truth is that prices in an economy respond to changes in the supply of money. When we witness inflation (money supply growth), prices rise as the value of money declines due to an increase in its supply. On the other hand, during deflation (money supply contraction), prices fall as the value of money increases due to a decrease in its supply. The reason why prices did not rise at all during the 19^th century is because there was no inflation (money supply growth). In those days, money was backed by gold and the money supply was limited. Therefore, prices remained relatively stable, money held its purchasing power and savings didn’t get destroyed due to inflation.

Once the Federal Reserve came to power, things changed. Firstly, the gold standard was eliminated and then gold was completely removed from the monetary system in the early 1970’s. Once this was accomplished, the Federal Reserve along with other central banks decided to embark on an inflationary rampage. As the supply of money accelerated, consumer prices in the economy surged and savings got totally destroyed due to inflation (money supply growth). This phenomenon is represented in Figure 1, which shows that after remaining relatively stable for 170 years (1800-1970), prices have soared 600% over the past 35 years!

Figure 1: Massive surge in prices since 1971!

Source: Grandfather Economic Report

Inflation is an increase in the quantity of money and it is created deliberately by the central banks. As Nobel Prize winner, Dr. Milton Friedman said “Inflation is always and everywhere a monetary phenomenon. To control inflation, you need to control the money supply”. So, you see that inflation is NOT a mysterious by-product, which simply emerges in an economy. But why would central banks create inflation? To answer this question, you have to ask yourself who benefits from the monetisation of the economy? Who makes money from issuing more and more debt?

In order for the present monetary system to be accepted by the public, inflation must remain concealed. If the public discovered the truth, there would be tremendous uproar. Accordingly, central banks keep up the propaganda by claiming that inflation is tame and under control. I’m sorry to disappoint you, but what’s under control in not inflation but inflation FEARS. By artificially suppressing the Consumer Price Index through complicated adjustments, central banks continue to please the public. Still not convinced? Take a look at Figure 2, which compares growth of the broad money supply (red curve) with the shrinking value of a 1950 dollar as determined by the cost of living index (blue curve). The rising red curve shows that the money supply grew from $302 billion in 1959 to over $9.5 trillion in 2004 – an astonishing explosion of 3,000%! If this isn’t inflation, then I don’t know what is! During the same period, the US dollar’s purchasing power, as defined by the blue curve, collapsed by 85%! In other words, due to money supply growth, the dollar saved in 1950 is worth only 15 cents today!

Figure 2: Money supply growth = Destruction of your savings!

Source: Grandfather Economic Report

It’s only normal to expect that the standard of living in any civilisation should get better with industrialisation and advancements in technology. After all, in today’s “modern” world of abundance, food is plentiful and modes of transportation and communication are extremely efficient due to the progress made over the past 50 years. All these factors, should’ve translated into a much more relaxed and comfortable life for everyone. Unfortunately, if you look around today, you’ll realise that despite all these advancements, human life for the average person has never been tougher! 50 years ago, families could survive on one income and debt levels were very low. These days, the average household needs two incomes, people are working longer and everybody is up to their eyeballs in debt! So, what’s gone so horribly wrong? Basically, inflation (money supply growth) has turned people into slaves! No matter how much you save, it’s never enough because things always seem to get more expensive. I’ll let you in on a secret – as long as the current monetary system continues, life isn’t going to get any easier. However, we all have to live within the system, therefore it is vital to understand the situation and invest in appropriate assets which will benefit the most from the ongoing monetary inflation.

© 2006 Puru Saxena
Editorial Archive

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise "Email Updates", which are sent out when an important development in the capital markets warrants immediate attention. Subscribe Today!

Puru Saxena Ltd.
Suite 1208, Citibank Tower
3 Garden Road, Central, Hong Kong
Phone: (852) 3589 6789 Fax: (852) 3585 5665 Email l Website

What the Price of Gold is Telling Us

HON. RON PAUL OF TEXAS
Before the U.S. House of Representatives

April 25, 2006

The financial press, and even the network news shows, have begun reporting the price of gold regularly. For twenty years, between 1980 and 2000, the price of gold was rarely mentioned. There was little interest, and the price was either falling or remaining steady.

Since 2001 however, interest in gold has soared along with its price. With the price now over $600 an ounce, a lot more people are becoming interested in gold as an investment and an economic indicator. Much can be learned by understanding what the rising dollar price of gold means.

The rise in gold prices from $250 per ounce in 2001 to over $600 today has drawn investors and speculators into the precious metals market. Though many already have made handsome profits, buying gold per se should not be touted as a good investment. After all, gold earns no interest and its quality never changes. It’s static, and does not grow as sound investments should.

It’s more accurate to say that one might invest in a gold or silver mining company, where management, labor costs, and the nature of new discoveries all play a vital role in determining the quality of the investment and the profits made.

Buying gold and holding it is somewhat analogous to converting one’s savings into one hundred dollar bills and hiding them under the mattress-- yet not exactly the same. Both gold and dollars are considered money, and holding money does not qualify as an investment. There’s a big difference between the two however, since by holding paper money one loses purchasing power. The purchasing power of commodity money, i.e. gold, however, goes up if the government devalues the circulating fiat currency.

Holding gold is protection or insurance against government’s proclivity to debase its currency. The purchasing power of gold goes up not because it’s a so-called good investment; it goes up in value only because the paper currency goes down in value. In our current situation, that means the dollar.

One of the characteristics of commodity money-- one that originated naturally in the marketplace-- is that it must serve as a store of value. Gold and silver meet that test-- paper does not. Because of this profound difference, the incentive and wisdom of holding emergency funds in the form of gold becomes attractive when the official currency is being devalued. It’s more attractive than trying to save wealth in the form of a fiat currency, even when earning some nominal interest. The lack of earned interest on gold is not a problem once people realize the purchasing power of their currency is declining faster than the interest rates they might earn. The purchasing power of gold can rise even faster than increases in the cost of living.

The point is that most who buy gold do so to protect against a depreciating currency rather than as an investment in the classical sense. Americans understand this less than citizens of other countries; some nations have suffered from severe monetary inflation that literally led to the destruction of their national currency. Though our inflation-- i.e. the depreciation of the U.S. dollar-- has been insidious, average Americans are unaware of how this occurs. For instance, few Americans know nor seem concerned that the 1913 pre-Federal Reserve dollar is now worth only four cents. Officially, our central bankers and our politicians express no fear that the course on which we are set is fraught with great danger to our economy and our political system. The belief that money created out of thin air can work economic miracles, if only properly “managed,” is pervasive in D.C.

In many ways we shouldn’t be surprised about this trust in such an unsound system. For at least four generations our government-run universities have systematically preached a monetary doctrine justifying the so-called wisdom of paper money over the “foolishness” of sound money. Not only that, paper money has worked surprisingly well in the past 35 years-- the years the world has accepted pure paper money as currency. Alan Greenspan bragged that central bankers in these several decades have gained the knowledge necessary to make paper money respond as if it were gold. This removes the problem of obtaining gold to back currency, and hence frees politicians from the rigid discipline a gold standard imposes.

Many central bankers in the last 15 years became so confident they had achieved this milestone that they sold off large hoards of their gold reserves. At other times they tried to prove that paper works better than gold by artificially propping up the dollar by suppressing market gold prices. This recent deception failed just as it did in the 1960s, when our government tried to hold gold artificially low at $35 an ounce. But since they could not truly repeal the economic laws regarding money, just as many central bankers sold, others bought. It’s fascinating that the European central banks sold gold while Asian central banks bought it over the last several years.

Since gold has proven to be the real money of the ages, we see once again a shift in wealth from the West to the East, just as we saw a loss of our industrial base in the same direction. Though Treasury officials deny any U.S. sales or loans of our official gold holdings, no audits are permitted so no one can be certain.

The special nature of the dollar as the reserve currency of the world has allowed this game to last longer than it would have otherwise. But the fact that gold has gone from $252 per ounce to over $600 means there is concern about the future of the dollar. The higher the price for gold, the greater the concern for the dollar. Instead of dwelling on the dollar price of gold, we should be talking about the depreciation of the dollar. In 1934 a dollar was worth 1/20th of an ounce of gold; $20 bought an ounce of gold. Today a dollar is worth 1/600th of an ounce of gold, meaning it takes $600 to buy one ounce of gold.

The number of dollars created by the Federal Reserve, and through the fractional reserve banking system, is crucial in determining how the market assesses the relationship of the dollar and gold. Though there’s a strong correlation, it’s not instantaneous or perfectly predictable. There are many variables to consider, but in the long term the dollar price of gold represents past inflation of the money supply. Equally important, it represents the anticipation of how much new money will be created in the future. This introduces the factor of trust and confidence in our monetary authorities and our politicians. And these days the American people are casting a vote of “no confidence” in this regard, and for good reasons.

The incentive for central bankers to create new money out of thin air is twofold. One is to practice central economic planning through the manipulation of interest rates. The second is to monetize the escalating federal debt politicians create and thrive on.

Today no one in Washington believes for a minute that runaway deficits are going to be curtailed. In March alone, the federal government created an historic $85 billion deficit. The current supplemental bill going through Congress has grown from $92 billion to over $106 billion, and everyone knows it will not draw President Bush’s first veto. Most knowledgeable people therefore assume that inflation of the money supply is not only going to continue, but accelerate. This anticipation, plus the fact that many new dollars have been created over the past 15 years that have not yet been fully discounted, guarantees the further depreciation of the dollar in terms of gold.

There’s no single measurement that reveals what the Fed has done in the recent past or tells us exactly what it’s about to do in the future. Forget about the lip service given to transparency by new Fed Chairman Bernanke. Not only is this administration one of the most secretive across the board in our history, the current Fed firmly supports denying the most important measurement of current monetary policy to Congress, the financial community, and the American public. Because of a lack of interest and poor understanding of monetary policy, Congress has expressed essentially no concern about the significant change in reporting statistics on the money supply.

Beginning in March, though planned before Bernanke arrived at the Fed, the central bank discontinued compiling and reporting the monetary aggregate known as M3. M3 is the best description of how quickly the Fed is creating new money and credit. Common sense tells us that a government central bank creating new money out of thin air depreciates the value of each dollar in circulation. Yet this report is no longer available to us and Congress makes no demands to receive it.

Though M3 is the most helpful statistic to track Fed activity, it by no means tells us everything we need to know about trends in monetary policy. Total bank credit, still available to us, gives us indirect information reflecting the Fed’s inflationary policies. But ultimately the markets will figure out exactly what the Fed is up to, and then individuals, financial institutions, governments, and other central bankers will act accordingly. The fact that our money supply is rising significantly cannot be hidden from the markets.

The response in time will drive the dollar down, while driving interest rates and commodity prices up. Already we see this trend developing, which surely will accelerate in the not too distant future. Part of this reaction will be from those who seek a haven to protect their wealth-- not invest-- by treating gold and silver as universal and historic money. This means holding fewer dollars that are decreasing in value while holding gold as it increases in value.

A soaring gold price is a vote of “no confidence” in the central bank and the dollar. This certainly was the case in 1979 and 1980. Today, gold prices reflect a growing restlessness with the increasing money supply, our budgetary and trade deficits, our unfunded liabilities, and the inability of Congress and the administration to reign in runaway spending.

Denying us statistical information, manipulating interest rates, and artificially trying to keep gold prices in check won’t help in the long run. If the markets are fooled short term, it only means the adjustments will be much more dramatic later on. And in the meantime, other market imbalances develop.

The Fed tries to keep the consumer spending spree going, not through hard work and savings, but by creating artificial wealth in stock markets bubbles and housing bubbles. When these distortions run their course and are discovered, the corrections will be quite painful.

Likewise, a fiat monetary system encourages speculation and unsound borrowing. As problems develop, scapegoats are sought and frequently found in foreign nations. This prompts many to demand altering exchange rates and protectionist measures. The sentiment for this type of solution is growing each day.

Though everyone decries inflation, trade imbalances, economic downturns, and federal deficits, few attempt a closer study of our monetary system and how these events are interrelated. Even if it were recognized that a gold standard without monetary inflation would be advantageous, few in Washington would accept the political disadvantages of living with the discipline of gold-- since it serves as a check on government size and power. This is a sad commentary on the politics of today. The best analogy to our affinity for government spending, borrowing, and inflating is that of a drug addict who knows if he doesn’t quit he’ll die; yet he can’t quit because of the heavy price required to overcome the dependency. The right choice is very difficult, but remaining addicted to drugs guarantees the death of the patient, while our addiction to deficit spending, debt, and inflation guarantees the collapse of our economy.

Special interest groups, who vigorously compete for federal dollars, want to perpetuate the system rather than admit to a dangerous addiction. Those who champion welfare for the poor, entitlements for the middle class, or war contracts for the military industrial corporations, all agree on the so-called benefits bestowed by the Fed’s power to counterfeit fiat money. Bankers, who benefit from our fractional reserve system, likewise never criticize the Fed, especially since it’s the lender of last resort that bails out financial institutions when crises arise. And it’s true, special interests and bankers do benefit from the Fed, and may well get bailed out-- just as we saw with the Long-Term Capital Management fund crisis a few years ago. In the past, companies like Lockheed and Chrysler benefited as well. But what the Fed cannot do is guarantee the market will maintain trust in the worthiness of the dollar. Current policy guarantees that the integrity of the dollar will be undermined. Exactly when this will occur, and the extent of the resulting damage to financial system, cannot be known for sure-- but it is coming. There are plenty of indications already on the horizon.

Foreign policy plays a significant role in the economy and the value of the dollar. A foreign policy of militarism and empire building cannot be supported through direct taxation. The American people would never tolerate the taxes required to pay immediately for overseas wars, under the discipline of a gold standard. Borrowing and creating new money is much more politically palatable. It hides and delays the real costs of war, and the people are lulled into complacency-- especially since the wars we fight are couched in terms of patriotism, spreading the ideas of freedom, and stamping out terrorism. Unnecessary wars and fiat currencies go hand-in-hand, while a gold standard encourages a sensible foreign policy.

The cost of war is enormously detrimental; it significantly contributes to the economic instability of the nation by boosting spending, deficits, and inflation. Funds used for war are funds that could have remained in the productive economy to raise the standard of living of Americans now unemployed, underemployed, or barely living on the margin.

Yet even these costs may be preferable to paying for war with huge tax increases. This is because although fiat dollars are theoretically worthless, value is imbued by the trust placed in them by the world’s financial community. Subjective trust in a currency can override objective knowledge about government policies, but only for a limited time.

Economic strength and military power contribute to the trust in a currency; in today’s world trust in the U.S. dollar is not earned and therefore fragile. The history of the dollar, being as good as gold up until 1971, is helpful in maintaining an artificially higher value for the dollar than deserved.

Foreign policy contributes to the crisis when the spending to maintain our worldwide military commitments becomes prohibitive, and inflationary pressures accelerate. But the real crisis hits when the world realizes the king has no clothes, in that the dollar has no backing, and we face a military setback even greater than we already are experiencing in Iraq. Our token friends may quickly transform into vocal enemies once the attack on the dollar begins.

False trust placed in the dollar once was helpful to us, but panic and rejection of the dollar will develop into a real financial crisis. Then we will have no other option but to tighten our belts, go back to work, stop borrowing, start saving, and rebuild our industrial base, while adjusting to a lower standard of living for most Americans.

Counterfeiting the nation’s money is a serious offense. The founders were especially adamant about avoiding the chaos, inflation, and destruction associated with the Continental dollar. That’s why the Constitution is clear that only gold and silver should be legal tender in the United States. In 1792 the Coinage Act authorized the death penalty for any private citizen who counterfeited the currency. Too bad they weren’t explicit that counterfeiting by government officials is just as detrimental to the economy and the value of the dollar.

In wartime, many nations actually operated counterfeiting programs to undermine our dollar, but never to a disastrous level. The enemy knew how harmful excessive creation of new money could be to the dollar and our economy. But it seems we never learned the dangers of creating new money out of thin air. We don’t need an Arab nation or the Chinese to undermine our system with a counterfeiting operation. We do it ourselves, with all the disadvantages that would occur if others did it to us. Today we hear threats from some Arab, Muslim, and far Eastern countries about undermining the dollar system- not by dishonest counterfeiting, but by initiating an alternative monetary system based on gold. Wouldn’t that be ironic? Such an event theoretically could do great harm to us. This day may well come, not so much as a direct political attack on the dollar system but out of necessity to restore confidence in money once again.

Historically, paper money never has lasted for long periods of time, while gold has survived thousands of years of attacks by political interests and big government. In time, the world once again will restore trust in the monetary system by making some currency as good as gold.

Gold, or any acceptable market commodity money, is required to preserve liberty. Monopoly control by government of a system that creates fiat money out of thin air guarantees the loss of liberty. No matter how well-intended our militarism is portrayed, or how happily the promises of wonderful programs for the poor are promoted, inflating the money supply to pay these bills makes government bigger. Empires always fail, and expenses always exceed projections. Harmful unintended consequences are the rule, not the exception. Welfare for the poor is inefficient and wasteful. The beneficiaries are rarely the poor themselves, but instead the politicians, bureaucrats, or the wealthy. The same is true of all foreign aid-- it’s nothing more than a program that steals from the poor in a rich country and gives to the rich leaders of a poor country. Whether it’s war or welfare payments, it always means higher taxes, inflation, and debt. Whether it’s the extraction of wealth from the productive economy, the distortion of the market by interest rate manipulation, or spending for war and welfare, it can’t happen without infringing upon personal liberty.

At home the war on poverty, terrorism, drugs, or foreign rulers provides an opportunity for authoritarians to rise to power, individuals who think nothing of violating the people’s rights to privacy and freedom of speech. They believe their role is to protect the secrecy of government, rather than protect the privacy of citizens. Unfortunately, that is the atmosphere under which we live today, with essentially no respect for the Bill of Rights.

Though great economic harm comes from a government monopoly fiat monetary system, the loss of liberty associated with it is equally troubling. Just as empires are self-limiting in terms of money and manpower, so too is a monetary system based on illusion and fraud. When the end comes we will be given an opportunity to choose once again between honest money and liberty on one hand; chaos, poverty, and authoritarianism on the other.

The economic harm done by a fiat monetary system is pervasive, dangerous, and unfair. Though runaway inflation is injurious to almost everyone, it is more insidious for certain groups. Once inflation is recognized as a tax, it becomes clear the tax is regressive: penalizing the poor and middle class more than the rich and politically privileged. Price inflation, a consequence of inflating the money supply by the central bank, hits poor and marginal workers first and foremost. It especially penalizes savers, retirees, those on fixed incomes, and anyone who trusts government promises. Small businesses and individual enterprises suffer more than the financial elite, who borrow large sums before the money loses value. Those who are on the receiving end of government contracts--especially in the military industrial complex during wartime-- receive undeserved benefits.

It’s a mistake to blame high gasoline and oil prices on price gouging. If we impose new taxes or fix prices, while ignoring monetary inflation, corporate subsidies, and excessive regulations, shortages will result. The market is the only way to determine the best price for any commodity. The law of supply and demand cannot be repealed. The real problems arise when government planners give subsidies to energy companies and favor one form of energy over another.

Energy prices are rising for many reasons: Inflation; increased demand from China and India; decreased supply resulting from our invasion of Iraq; anticipated disruption of supply as we push regime change in Iran; regulatory restrictions on gasoline production; government interference in the free market development of alternative fuels; and subsidies to big oil such as free leases and grants for research and development.

Interestingly, the cost of oil and gas is actually much higher than we pay at the retail level. Much of the DOD budget is spent protecting “our” oil supplies, and if such spending is factored in gasoline probably costs us more than $5 a gallon. The sad irony is that this military effort to secure cheap oil supplies inevitably backfires, and actually curtails supplies and boosts prices at the pump. The waste and fraud in issuing contracts to large corporations for work in Iraq only add to price increases.

When problems arise under conditions that exist today, it’s a serious error to blame the little bit of the free market that still functions. Last summer the market worked efficiently after Katrina-- gas hit $3 a gallon, but soon supplies increased, usage went down, and the price returned to $2. In the 1980s, market forces took oil from $40 per barrel to $10 per barrel, and no one cried for the oil companies that went bankrupt. Today’s increases are for the reasons mentioned above. It’s natural for labor to seek its highest wage, and businesses to strive for the greatest profit. That’s the way the market works. When the free market is allowed to work, it’s the consumer who ultimately determines price and quality, with labor and business accommodating consumer choices. Once this process is distorted by government, prices rise excessively, labor costs and profits are negatively affected, and problems emerge. Instead of fixing the problem, politicians and demagogues respond by demanding windfall profits taxes and price controls, while never questioning how previous government interference caused the whole mess in the first place. Never let it be said that higher oil prices and profits cause inflation; inflation of the money supply causes higher prices!

Since keeping interest rates below market levels is synonymous with new money creation by the Fed, the resulting business cycle, higher cost of living, and job losses all can be laid at the doorstep of the Fed. This burden hits the poor the most, making Fed taxation by inflation the worst of all regressive taxes. Statistics about revenues generated by the income tax are grossly misleading; in reality much harm is done by our welfare/warfare system supposedly designed to help the poor and tax the rich. Only sound money can rectify the blatant injustice of this destructive system.

The Founders understood this great danger, and voted overwhelmingly to reject “emitting bills of credit,” the term they used for paper or fiat money. It’s too bad the knowledge and advice of our founders, and their mandate in the Constitution, are ignored today at our great peril. The current surge in gold prices-- which reflects our dollar’s devaluation-- is warning us to pay closer attention to our fiscal, monetary, entitlement, and foreign policy.



Meaning of the Gold Price-- Summation

A recent headline in the financial press announced that gold prices surged over concern that confrontation with Iran will further push oil prices higher. This may well reflect the current situation, but higher gold prices mainly reflect monetary expansion by the Federal Reserve. Dwelling on current events and their effect on gold prices reflects concern for symptoms rather than an understanding of the actual cause of these price increases. Without an enormous increase in the money supply over the past 35 years and a worldwide paper monetary system, this increase in the price of gold would not have occurred.

Certainly geo-political events in the Middle East under a gold standard would not alter its price, though they could affect the supply of oil and cause oil prices to rise. Only under conditions created by excessive paper money would one expect all or most prices to rise. This is a mere reflection of the devaluation of the dollar.

Particular things to remember:



If one endorses small government and maximum liberty, one must support commodity money.

One of the strongest restraints against unnecessary war is a gold standard.

Deficit financing by government is severely restricted by sound money.

The harmful effects of the business cycle are virtually eliminated with an honest gold standard.

Saving and thrift are encouraged by a gold standard; and discouraged by paper money.

Price inflation, with generally rising price levels, is characteristic of paper money. Reports that the consumer price index and the producer price index are rising are distractions: the real cause of inflation is the Fed’s creation of new money.

Interest rate manipulation by central bank helps the rich, the banks, the government, and the politicians.

Paper money permits the regressive inflation tax to be passed off on the poor and the middle class.

Speculative financial bubbles are characteristic of paper money-- not gold.

Paper money encourages economic and political chaos, which subsequently causes a search for scapegoats rather than blaming the central bank.

Dangerous protectionist measures frequently are implemented to compensate for the dislocations caused by fiat money.

Paper money, inflation, and the conditions they create contribute to the problems of illegal immigration.

The value of gold is remarkably stable.

The dollar price of gold reflects dollar depreciation.

Holding gold helps preserve and store wealth, but technically gold is not a true investment.



Since 2001 the dollar has been devalued by 60%.

In 1934 FDR devalued the dollar by 41%.

In 1971 Nixon devalued the dollar by 7.9%.

In 1973 Nixon devalued the dollar by 10%.

These were momentous monetary events, and every knowledgeable person worldwide paid close attention. Major changes were endured in 1979 and 1980 to save the dollar from disintegration. This involved a severe recession, interest rates over 21%, and general price inflation of 15%.

Today we face a 60% devaluation and counting, yet no one seems to care. It’s of greater significance than the three events mentioned above. And yet the one measurement that best reflects the degree of inflation, the Fed and our government deny us. Since March, M3 reporting has been discontinued. For starters, I’d like to see Congress demand that this report be resumed. I fully believe the American people and Congress are entitled to this information. Will we one day complain about false intelligence, as we have with the Iraq war? Will we complain about not having enough information to address monetary policy after it’s too late?

If ever there was a time to get a handle on what sound money is and what it means, that time is today.

Inflation, as exposed by high gold prices, transfers wealth from the middle class to the rich, as real wages decline while the salaries of CEOs, movie stars, and athletes skyrocket-- along with the profits of the military industrial complex, the oil industry, and other special interests.

A sharply rising gold price is a vote of “no confidence” in Congress’ ability to control the budget, the Fed’s ability to control the money supply, and the administration’s ability to bring stability to the Middle East.

Ultimately, the gold price is a measurement of trust in the currency and the politicians who run the country. It’s been that way for a long time, and is not about to change.

If we care about the financial system, the tax system, and the monumental debt we’re accumulating, we must start talking about the benefits and discipline that come only with a commodity standard of money-- money the government and central banks absolutely cannot create out of thin air.

Economic law dictates reform at some point. But should we wait until the dollar is 1/1,000 of an ounce of gold or 1/2,000 of an ounce of gold? The longer we wait, the more people suffer and the more difficult reforms become. Runaway inflation inevitably leads to political chaos, something numerous countries have suffered throughout the 20th century. The worst example of course was the German inflation of the 1920s that led to the rise of Hitler. Even the communist takeover of China was associated with runaway inflation brought on by Chinese Nationalists. The time for action is now, and it is up to the American people and the U.S. Congress to demand it.