Perpetual Cycle of Life

Prof. Ishida was a very kind Sensei/Senpai (teacher/mentor). He was responsible for starting my career at Intel Japan in the late 1970’s. He mentored me while I was a research student at the University of Tokyo (‘Tokyo Daigaku). He was the Director of the Computer Center (which housed a Hitachi supercomputer when I was there) at the University. He translated several computer science books into Japanese. He was an Internet pioneer.

Ishida-Sensei has passed away in March of this year. I should have continued to keep in touch with him. If I did, I am sure I would have learned so much, not only about digital stuff, but about life itself. I was a heady student: I always looked forward and never looked back. We only met once again after I arrived in the U.S., in 1985. He attended a conference in San Francisco, which gave me an opportunity to meet him for the last time and take him on a tour of the city.

If I could do it all over again, I would have kept him as a very good friend. Friends come and go, but there are some that I would have wanted to keep, and Ishida-Sensei is certainly one of those. I really feel bad that I did not even know until now that he has passed away.

I am no Warren Buffet, who can see beyond balance sheets and have an expansive view of a company in one look. I am just a mortal being with a simple economic viewpoint: when you increase the supply of anything beyond the demand for it, its price drops. The dollar supply has increased by trillions as a result of Fed actions to fix the financial crisis of 2008, and its price relative to other commodities must drop. This is my conviction, and I will not be swayed by daily fluctuations of the dollar index.

One way to take advantage of the dollar drop is to buy gold, which is what I have done when the price of gold was about 940. Indeed, there has been a close correlation between the price of gold versus the dollar index: as the dollar index drops, the price of gold increases. September 1st marked the first time that the price of gold did not depend on the dollar, and Yesterday, September 2nd, the price broke out of a 6-7 month triangular pattern, to close at 978 in New York. If I am looking for a signal to indicate the correctness of my conviction, this must be it. The stampede to gold has started, and it feels good to finally see what I have been waiting for, for months.

Why the loss of correlation between the price of gold and that of the dollar index? The dollar index compares the dollar to a basket of six other currencies. Well, those other currencies have also been inflated, in varying degrees. The increase in stock prices worldwide can be attributed to the same debasement of currencies, and now that it is becoming clear that there is no reason for the stock prices to increase by that much, they are starting to come down. This has then become the catalyst for the start of the stampede towards gold: that giant sucking sound you hear starting to deplete the stock market bubble is money now chasing gold.

It’s not too late to buy gold, because the next stop is $1,032 per ounce, and we are far from there. The next stop after that is $1,140, and I don’t think it will end there…

Gold dipped to $921 per ounce Yesterday. Today it’s even lower at $915. It may go lower than $900, but I don’t expect it to go lower than the previous dip, which bottomed at about $860, in early April. This may be the last opportunity to buy.

Last May 22nd I predicted that gold would fetch $1000 an ounce by this month. It doesn’t look like it’s going to, this week being the last week of June. I am now looking at gold to reach $1000 in July.

I have just completed reading “Money Meltdown” by Judy Shelton. Even though this book was written in the context of the communist rout and not the context of the current world financial calamity, I would recommend it to anybody who wants to know where we’re headed. Ms. Shelton is advocating a second Bretton Woods accord, similar to the one enacted by tens of nations in 1944. The 1944 accord was heavily influenced by Keynes, who believed that government has the right and obligation to manipulate a nation’s currency. The Bretton Woods accord was dealt its death blow by Nixon in the early 1970s, because the U.S. was unable to honor the convertibility of the dollar to gold. Ms. Shelton traces the history of world currency relations from Bretton Woods on, and in the process examines various experiments and adventures that world currency relations have gone through. It is very convincingly clear to me that we need to go back to a gold standard, in which first the dollar and then other currencies start being convertible to gold. Artificial inflation, inflation brought upon by governments by increasing the money supply, is evil. We have to get rid of this scourge of the earth as soon as we can, for the sake of our children and grand-children.

“It will be helpful if Geithner can show us some arithmetic.” That’s a quote from Chinese economist Yu Yongding, poking fun at Geithner’s mission to assure the Chinese that their investments in the U.S. are safe. The U.S. dollar is now starting to lose value, which affects China in two ways: one, it reduces the value of all the bonds and U.S. securities that the Chinese government owns; and two, it raises the price of Chinese exports from the standpoint of the U.S. consumer.

There is no mopping up of all the trillions of dollars that the Fed has injected into the world economy. There is no way to prevent the increase in interest rates without also funding the gargantuan deficit of the U.S. government. These are the symptoms of an incipient hyper-inflation: interest rates shoot up as the currency value dives down.

Gold has started to creep up as the dollar has gone down. There will be another panic, and it will be worldwide. The panic will result in an extreme rout of the dollar. Imagine the dollar losing half of its current value, and you will start to understand the kind of panic that will ensue.

Standard & Poor’s sovereign rating of the U.S. will most probably go down a notch in the coming months. The U.K.’s outlook has already been downgraded because it has borrowed against 100% of its GDP. The U.S. borrowing is currently at about 70% of GDP, and increasing.

The market has already figured this out. U.S. equities have started to come down, and both the 10-year and 30-year treasury bonds have gone down in price (which means that interest rates for government borrowing have gone up). Geithner has commented on the issue and Bill Gross, manager of the world’s biggest bond fund, has said it is now a certainty.

Standard & Poor’s also reports that China is continuing to look for ways to park their large surpluses other than funding U.S. debt. This has in fact strained the U.S. – China relationship.

What this all means for gold is that it has already gone up in value, and the market has started to move in this direction in a big way. This past week, gold has broken through an important resistance at $945-950 and is now at $956. If this continues next week, it should break through the $1000 barrier by June. I expect gold to shoot up shortly thereafter.

It’s not too late to buy gold now, but by June there will be a stampede and it will be difficult to get hold of it without getting crushed.

Last May 4th, during an interview in CNBC’s Squawk Box, Mr. Buffett stated that “A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, it’s going to inflate its way out of the burden of that debt”. He also added: “That becomes a tax on everybody that has fixed-dollar investments”.

He should have said that inflation is a tax on anybody who don’t owe any money. The only people who will benefit from inflation are those with credit card debt that exceeds their net worth, and those paying mortgage.

The Original Definition of Inflation

Almost two centuries ago, the word inflation meant an increase in the money supply. Increasing the supply of any commodity (including money) causes its economic value to go down, but this effect comes only later when the market adjusts. The original definition of inflation therefore focused on the cause of price increases, namely the increase in money supply. It was convenient for nineteenth century politicians to redefine inflation to focus on the effect rather than the cause: dissociating the word “inflation” from the increase in money supply allowed them to increase the money supply without political consequences. And so today we have arrived at this confused state of economic language in which, after having increased the money supply by trillions of dollars, the Fed has the temerity to declare that “inflation” is not an immediate concern and can be controlled when it does arrive.

 Gold Will Go Up

By its original definition, inflation has already arrived, and therefore the price of everything will have to go up. By how much, when, and for which commodities we can’t tell precisely. The question is not whether they will go up, the question is when. Therefore the price of gold will go up, if only because the value of all fiat money will go down. The Chinese government knows this and has acted accordingly (although, of course, they claim that they have been doing it for some time, even before the current crisis).

Gold is not only safe, but investing in it now will also be profitable. Protect your family from financial ruin by getting into gold now.

How to Invest

I do not buy gold directly because it’s difficult to put in a safe place. Instead, I buy exchange traded funds (ETFs) like COMEX Gold Trust (IAU) and SPDR Gold Shares (GLD).

An Economy Stalled?

No matter how much the Fed injects money into the system, it doesn’t seem to be responding. The U.S. economy right now feels like an airplane that has just stalled: it’s still pointed up, but instead of going up its altitude is decreasing fast, tail first. All the trillions of dollars of stimulus is not providing enough thrust to push this airplane up, and the momentum so far is still downward. That false lift we felt the past weeks in the stock market may be just the start of a flip.

When an airplane stalls, it’s difficult to put it back in control. It requires a lot of skill on the part of the pilot to put it back in control. Unfortunately, I think our leaders don’t have the requisite skills and knowledge to right this airplane. Nobody really knows what’s going to happen next. All the macroeconomic models so far devised are useless. Could it be that all of current macroeconomic thinking and its resulting models, even those that consider dynamics (feedback loops), is wrong?

Macroeconomic Models

Macroeconomic models are a necessary tool for economic policy making. The Fed is guided by models; however, these models most likely are not correct. In fact, the whole idea of macroeconomics is suspect.

I propose that macroeconomics is not a science. Like the notorious earth atmospheric models produced by over-zealous environmentalists that predict a non-existent catastrophe, macroeconomic models have so far been useless to policy makers. As proof of this, observe the helplessness of current policy makers in predicting when to stop injecting tons of money into the U.S. economic system. If the amount they inject is not enough, it’s a big problem (their fear in this case is deflation). If, on the other hand, they inject too much and do not stop injecting at the right time, runaway inflation can result. When should they stop? They are watching a number of indicators, and hopefully the indicators will tell them exactly when to stop the money flowing into the economic system.

Just today, White House Economic Adviser Lawrence Summers said as much:

"The thing about an inflation is that … the moment it’s absolutely clear you have the problem is a moment when you may have been too late in addressing it," Summers said. "So I think it’s a very difficult balance the policy is going to have to walk."

Summers claims that, although difficult, it’s a matter of balancing. If you can point to me any economic model that can help policy makers in the current situation and that can tell them exactly what to do, then I stand corrected in stating that macroeconomics is not a science. The fact is that economists steeped in computer modeling themselves will tell you that their models, although very complex, are still of very limited use. Just think: if someone has come up with a good model, he would have started a business with it and made tons of money. A good model is pursued not just by policy makers, but businesses as well.

Aggregate Decisions

Why can’t macroeconomics be properly called a science? Its problem is two-fold:

• There is the philosophical issue of volition. Each human actor in an economy has “free will”, and no mathematical model can capture the statistical significance of this. I cannot predict with much certainty what you will decide to do in a given situation, much as you can’t predict how I would react to the same situation. This is true even in extreme cases like if a gun were pointed at your head and you were being forced to leave your own offspring to die. I cannot predict what you would do, and probably neither can you yourself. We are very complex economic actors.
• There is the issue of aggregate decision and action. Sometimes we behave like lemmings: our individual decisions are influenced by those around us. Given a situation in which we are given very few information by which to decide, we simply follow what everyone else is doing. Any computer model has to “recognize” situations in which the lemming effect can occur, and also recognize those in which it is not possible (as in the case of the secret ballot box). There are other aggregate effects to be considered (follow the leader, group panic, etc).

Only in very limited cases can we assign probabilities of occurrence. One case that comes to mind is nationwide elections. We poll a small percentage of the population, and as long as that small sample is randomly chosen, the predicted results can have a high probability of occurring. But even in this case, multiple feedback loops can render the polling result problematic: the polling result, if published, can affect the final outcome of the election. Potential voters whose candidate is predicted to lose may not vote at all, thereby causing their candidate to lose votes even more. The act of measuring population sentiment can affect that sentiment itself.

When a large majority of economic actors start seeing a recession, most of them will react and reduce their spending. By how much? We can’t predict, even though we can measure after the fact. It is only as a historical fact can we categorically say that “pessimistic outlook has reduced output an additional 10%”.

Feedback Loops

Even our minutest actions are guided by large amounts of information fed back to our senses. The mere act of walking is very complex: every step is a delicate balancing act in which the muscles involved are commanded to give just the right amount of exertion at exactly the right time. Every muscle exertion is a result of very complex calculations with feedback inputs from all the senses. If the next step happens to land on a banana peel, the feedback loop changes its configuration so that the slip signal is given primacy over all others.

Every little decision we make is also the result of a highly complex feedback loop. Therefore, if we take an individual and consider her apart from the rest as an independent economic actor, she is by herself one complex system of feedback loops. As part of an economic system, an individual becomes part of a very complex loop with connections both local and global. If local feedback loops are complex by themselves, imagine the complexity of an economic system in which each actor is also receiving feedback from a large number of global signals. We don’t even understand how our brains work, how can we claim to understand a system with hundreds of millions of brains!

Past Performance is no Guarantee of Future Performance

So far we have taken it for granted that the U.S. dollar has held its value and will continue to do so. We accept as natural the small daily fluctuations in its value, including a small, general trend towards inflation. In this economic regime the U.S. dollar has held its place as the global standard.

What if such assumption is false and the dollar does fall in value (say half of what it is now)? I believe this is now in the realm of possibilities, and we can’t dismiss it like most of us did the housing market crash before it happened. Let me summarize where we are now and where we may be heading.

First, let me establish the framework of this alarmist viewpoint. There is an obscure but influential group of economists, adherents of Ludwig von Mises, who have held all along that fiat money, along with necessary government interventions, is the cause of business cycles. (Practically all currencies today are fiat money, including the mighty U.S. dollar.) Fiat money is not subject to market forces but instead is the subject of constant manipulation by central banks, whose avowed purpose is to keep employment high without eroding the value of money (i.e., control inflation).

Control Feedback Loop

Like any economic good, the U.S. dollar’s value can be controlled by either increasing or decreasing its gross quantity in circulation (the law of supply and demand). The Fed increases the money supply (lowers the dollar value) in order to make it easy for business to obtain money and increase production and the consumers to buy products. In short, increasing the money supply fosters a boom. Just before the economy overheats and inflation sets in, the Fed decreases the money supply in order to slow things down. Politicians like it when the Fed eases (increases the money supply) because, with more money, everyone seems to be lifted: employees get more pay and companies can get more capital. Incumbents have a much better chance of winning elections when people are happy.

Misesians claim that this government manipulation of the value of money is unsustainable, that it’s causing the bust that is now expected to follow every boom. Moreover, the boom/bust cycle swings get bigger and bigger until it all ends in an apocalyptic total loss of value. This is very similar to a fundamental problem in control engineering: when flying a model helicopter, you have to be careful with the control sticks. There is a delay from the instant you send the control signal to the helicopter reaction, and another delay from the time of reaction to the time you decide to either push or pull the lever. Until you get the “feel” of it, you tend to over-control, causing the helicopter to oscillate up and down. This is a case of delays in both control and feedback (your eyes watching the helicopter) causing control overshoot and ever-increasing oscillation until the helicopter goes out of control and crashes.

The problem with government control of the money supply is not that there are delays, but rather that the feedback is not directly connected to the controlling mechanism. Imagine flying the helicopter blindfolded and your only feedback is a friend yelling at you to either push or pull the control lever. In the current financial system, it is the banks that ultimately determine the money supply (controlling mechanism), and the Fed is the indirect feedback mechanism.

Solutions being proposed by mainstream economists to the current crisis range from tightening control of the banks (your friend needs to yell louder at you) to nationalizing the banks altogether (your friend grabs the remote control away from you).

A Little Bit of Control Engineering Theory

In order to prevent oscillation, several control engineering algorithms have been invented. One is called the Proportional Integral Derivative Controller (PID controller in short), and a more elaborate one is called the Kalman filter. Basically you try to eliminate the bad effects of delay by predicting the state of things from one control loop cycle to the next. The Kalman filter is by far the best, and is now used in most control loop situations like missile flight control.

To get rid of the business cycles, Misesians propose the following:

• First of all get rid of central banks (get rid of the Fed to remove unnecessary delays in the control loop).
• Next, let the banks receive individual feedback and let them control their own destiny. Banks are much better able to predict each of their immediate future solvency than any one body (say the Fed) can predict what’s going to happen next in the macro economy.
• Finally, the Misesians propose that each bank be allowed to issue its own fiduciary media (money) backed by gold. The corollary is that no bank should be rescued if it gets in trouble. If any one individual bank issues too much fiduciary media, its clients can circulate among themselves such media without straining its (the bank’s) reserves. However, its clients can and do deal with non-clients, and when such fiduciary media is used with these non-clients, the other banks will have to clear any amount against the expanding bank’s gold reserves. The feedback is in the depletion of the expanding bank’s gold reserve: if it doesn’t stop expanding its fiduciary media, it runs the risk of becoming insolvent.

The only problem with the Misesian solution is that it is still politically impossible. Decades of Keynesian practice has lulled us into thinking that it is both natural and ethical for governments to control the money supply.

Where We are Now and Where We may be Heading

The latest business cycle bust so far looks deeper than any recession since the Great Depression; and, Fed pronouncements to the contrary, we may not have reached bottom. According to MarketWatch, "The U.S. government and the Federal Reserve have spent, lent or committed more than $10 trillion to stem the economic downturn since the financial crisis began.” However, George Soros has just recently declared that such actions of the U.S. government are still not having the intended effect, and that the banking system is now insolvent. A prominent analyst has backed Soros’ assertion. Gold has gone down in price a bit, but that is largely because the Internation Monetary Fund (IMF) is planning to sell about 400 tons of the yellow metal.

Are we now in the final, apocalyptic bust predicted by Ludwig von Mises? May be not, but at the very least, the uncertainty of the immediate future is palpable. I am watching the price of gold because its rise is a sign that traders around the world are losing confidence in fiat money. I should also watch how much gold is being sold by central banks and the IMF, because increased sales means that rampant inflation has started and that the governments are beginning to get desperate and are propping up fiat money. Central bank gold reserves, although very large, are still finite. In fact, the total value of all gold ever mined was valued at U.S. $4.39 trillion using the price of gold as of last February.