Dream of Greenspan

This is a discussion on Dream of Greenspan within the General Trading Chat forums, part of the Reception category; This was written by Dan Denning via Larry Levin. A narrative style that manages to outline with a light touch ...

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Old May 14, 2009, 1:33pm   #1
Joined Jul 2003
Dream of Greenspan

This was written by Dan Denning via Larry Levin. A narrative style that manages to outline with a light touch some fundamental issues which are fundamentally out of whack.

Don't ask us why the Maestro showed up in our dream. He just did. So we took the opportunity to ask him a few questions. We've reconstructed the conversation as best we can.

"Maestro...you hardly look yourself. It looks like twenty years have dropped from your face. It must be liberating not to have to worry about inflation anymore."

"What's inflation?"

"Ah yes. About that. Why haven't we seen it yet? You've seen massive fiscal stimulus plans the world over, a huge increase in the monetary base, and lower interest rates. But no inflation. Bond traders don't seem especially worried either. They are not demanding higher interest rates because they fear future inflation. And gold? Well, it's plodding along. But shouldn't it be going much higher as the supply of fiat money explodes?"

"You're thinking is so old fashioned. It's true. Or at least it used to be true. In the days when we had a gold standard, it was a great defense against government monetary fraud (that's what I used to call inflation, before I became a central banker)."

"Oh. What do you mean?"

"If each unit of paper currency in your hand is redeemable for gold, then each holder of paper units has the power to hold the government accountable for its fiscal and monetary policy. If the government prints too much money to pay for its spending programs, unit holders can redeem their paper for gold. This draws down the governments stores of real gold, forcing it to either reduce the supply of paper money, or lose all its gold."

"Why would it worry about that if it could just print more paper?"

"Because paper is not money. And your trading partners will not accept your paper if it is not backed by either real money or the ability to collect taxes from your people."

"I'm not sure I follow. Back up a bit for me."

"Okay. Back when everyone was on a gold standard, before the Great Depression, international accounts were settled in gold. It wasn't just citizens who could demand gold for their units. Nation states could do it to. Governments who ran up fiscal imbalances would see international holders of their currency redeem those paper units for real gold. This encouraged a kind of competition among nation states, or at least a kind of accountability. If you ran up deficits and borrowed a lot of money, gold flowed out to pay your creditors and to pay for your exports. Your inflationary monetary policy cost you your national inventory of gold and silver."

"So what happened?"

"My you ask a lot of questions."

"Hurry up. I think I have to wake up soon."

"Well, under a gold standard, governments are forced to manage their monetary system for the benefit of their people. You get a stable price level because the value of the money is not fluctuating constantly with changes in the money supply. Governments want to avoid causing a run on their gold supply that would result from fiscal and monetary mismanagement."

"Why did the world go off the gold standard if it was so good? What changed?"

"Lots of things. For example, with a gold standard, governments and people must live within their means. This is deeply unpopular with politicians, who must bribe populations with bright new shiny things to get elected. Gold makes it harder to bribe your people and win an election."

"Okay. What else?"

"For whatever reason, perhaps because it is in their nature, governments like to take their people to war. It keeps them distracted from other problems, usually caused by the government. But war is expensive. To pay for a war you must increase taxes or borrow money. If you increase taxes (directly or indirectly) you risk alienating your population and causing a tax revolt (and sending a lot of economic activity underground, out of the view of the tax collectors). So you have to borrow. It's the only way to greatly expand spending without raising taxes to punitive or socially disruptive levels."

"Ah. I see. Under a gold standard, you couldn't borrow excessively without causing a run on your nation's gold. So...a gold standard was a natural constraint on a nation's ability to make war."

"Yes. That doesn't mean nations didn't go to war before there was a gold standard. It just means that if you had to pay for your war with real money, it made it an expensive proposition. And if it undermined the value of the currency your citizens held, they were unlikely to support you. In a monarchy or dictatorship, that doesn't matter so much. But in a democracy, it matters a lot."

"If what you're saying is correct, Maestro, then there'd be a clear connection between the creation of fiat money which is not backed by gold at all, and war between nation states."

"There might be. But you're still thinking too small."

"What do you mean?"

"It's true that most nations suspended the gold standard upon entering World War I. This allowed them to run up ruinous debts to private bankers. They tried reinstating it, but then the Great Depression hit. And more than ever, governments needed the ability to print money to pay for domestic 'wars' on poverty and unemployment."

"Right. And then World War Two-which was partly a consequence of the ruinous debt and reparations Germany could not repay-came along and you saw a huge explosion in government debt, this time mostly through bonds."

"That's right. Which brings us back to inflation today. When the government finances exploding debts through the issuance of new bonds, investors typically demand higher interest rates to compensate for the inflation that results from the increase in the money supply. But today, in a kind of conundrum, bond investors are not demanding higher interest rates."

"Why not?"

"Who knows? For one, they don't see inflation. They see falling prices that come with a collapse in global demand. But it could be that they fear the worldwide recession more than they fear inflation. The contraction in global trade and national GDPs has investors fleeing for the safety of bonds. This allows governments to print money and expand the monetary base with apparent impunity."

"Apparent?"

"Yes. Why, there in Australia where you're sleeping, the government is going to announce a budget in May which may include a $50 billion deficit. This is a country that had a surplus just a short time before."

"That's not as bad as my home country. In the U.S., the government is going to run a trillion dollar deficit this year. And it's told everyone that number will double. But it doesn't seem to have dented demand for U.S. bonds yet."

"No, it hasn't. And that's because without a gold standard, governments don't have to compete for capital as fiercely as they used to. They can all sell bonds to investors to finance deficits, provided the deficits aren't too jaw-dropping and provided they can continue to collect taxes to pay interest on the debt. Plus, they're colluding with one another to eliminate tax competition among countries, which gives them an even stronger grip on your wealth."

"I'm with you Maestro. But I don't see where this is going."

"Let me show you. Governments can only raise direct taxes (income taxes) so much before it negatively affects the economy (and social cohesion), which in turns lead to falling tax revenues as real economic activity slows. So a sure sign of governments that are getting desperate for revenue is an increase in indirect taxes."

"You mean like the alcopops tax here in Australia?"

"I've never heard of that. But if it's a tax that the supplier of a good or service passes on to the consumer then yes, that's exactly what I mean. It's an efficient way for the government to raise revenue without looking like it's being grubby, desperate, or just plain greedy. It can also claim the taxes are being raised to discourage socially undesirable behavior, but this is generally just a lie to disguise the need to raise revenues."

"Ah. I see. You know the alcopops tax is illegal anyway, by the way. The government collected revenue on a tax using a law that hadn't been properly been passed by the Parliament. How is that possible? What about the Rule of Law?"

"What about it?"

"Never mind. You need to finish your lecture before I wake up. When will inflation result from the large increase in the monetary base?"

"I have no idea, my boy. You see at its core, fiat money greatly accelerates the rate at which scarce resources are depleted. Land, labour, capital, and raw commodities are allocated based on a demand that isn't sustainable. If you do that long enough-let's say for the last seventy years or so-you get an entire global economy (and population) that exists because of the increase in credit. That's the world we live in. And it's all falling apart with the credit depression you've been writing about."

"Wait a second Maestro. Are you saying that the scope and scale of this economic contraction is a lot greater than anyone expects because the fiat money system itself is failing?"

"You said it. Not me. But it does make sense to say that the last twenty years or so of building national economies around the growth of residential real estate and the finance sector has greatly hastened us to a day of reckoning, as your friend Bill Bonner might say. We will find out if all that investment made by banks is merely 'temporarily impaired,' or if it represents an enormous misallocation of our collective resources and has made us poorer for years to come."

"So what should we do?"

"This is your dream. You decide."
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Old May 14, 2009, 1:59pm   #2
 
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No wonder Mad Bad Gordo sold off our gold reserves at the bottom of the market.....
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Old May 14, 2009, 7:32pm   #3
 
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Quote:
Originally Posted by Mr. Charts View Post
No wonder Mad Bad Gordo sold off our gold reserves at the bottom of the market.....
*sigh* - and Thatcher only sold off the "family silver" :-)

Fascinating stuff, although I am not totally convinced that the Gold Standard would have been the answer to our problems.

I mean, take the postwar expansion in the USA and Western Europe. This was an incredible period of expansion. I know we had Bretton Woods, but I am not sure this was a true Gold Standard (for the US, only). The rest of the world was pegged to the dollar.

It's true that once the fixed price of gold was abandoned (by Nixon) in 1971, and Bretton Woods effectively fell apart, things got a lot worse, but even during the period 1945-1971, there was a collossal increase in real weath and production of goods, even without an apparent increase in the money supply and rampant inflation.

There is certainly a link between money and war, money and energy, and energy and war, and indeed it was probably the Vietnam War that ultimately caused Nixon to abandon the fixed gold price.

Edit/Update: Actually, the Wikpedia entry for Gold Standard has some interesting comments about/by Greenspan:

Gold standard - Wikipedia, the free encyclopedia

Last edited by montmorencyt2w; May 14, 2009 at 8:19pm. Reason: To add the Wikipedia comment and link
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Old May 14, 2009, 10:30pm   #4
 
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Yes, but the family silver was sold to us, even though it was already ours.
The gold was also already ours, but it was sold to others.
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Old May 14, 2009, 11:05pm   #5
 
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Originally Posted by Mr. Charts View Post
Yes, but the family silver was sold to us, even though it was already ours.
The gold was also already ours, but it was sold to others.
I don't disagree. Gordo's sin was the greater one.

Interesting that Mrs Thatcher was being mildly reprimanded by an old-fashioned "one-nation" Tory, well to the left of New Labour :-)
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Old May 15, 2009, 10:08am   #6
 
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Good post, and I completely agree with what's being said. Victor Sperandeo's book has a very interesting section on exactly this, relating it to what happened in France with Knox. There's also a pretty good Fast Show sketch along the same lines.
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Old May 15, 2009, 7:28pm   #7
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'Encouraged by a wicked wizard, Greenspan, Bernanke toils at his printing press' - Telegraph

More Greenspan adventures..
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