Deflation and Counterfeiting

Steve Saville
email: sas888_hk@yahoo.com
Dec 9, 2008

Here are excerpts from recent commentaries posted at www.speculative-investor.com

Is the bond market discounting deflation?

The following chart shows that the yield on the 30-year US Treasury Bond has collapsed over the past few weeks and is now below the bottom of its long-term channel. The chart also makes the point that the recent decline in the T-Bond yield is the steepest of the past 20 years.

The recent plunge in the T-Bond yield to only 3.2% prompts the question: is the bond market discounting deflation?

Before attempting to answer the above question we'll put forward another question: what was the oil market discounting when it was pricing oil at more than $140 per barrel just 5 months ago?

The reason for asking the second question is to make the point that market prices do not necessarily contain accurate information about the future. In oil's case either July's price represented a wildly inaccurate assessment of supply/demand fundamentals or today's price does, because the supply/demand fundamentals haven't changed much in the interim. It is true that oil demand has tapered off since July, but it is also true that oil demand has been tapering off since the beginning of the year. For many months the oil market was willing to ignore the reality of falling demand because it was totally focused on US$ weakness.

Just as oil's relentless price strength during the first half of this year said nothing about that market's underlying supply/demand situation, it is quite possible that the bond yield has plummeted for reasons that have nothing to do with traditional bond-market drivers. In particular, we think it very likely that the bond market is discounting something other than deflation considering that the recent spectacular collapse in the bond yield occurred after a) the stock market had essentially bottomed, b) the US$ had essentially peaked, and c) gold and gold stocks had begun to rally.

So, if not deflation then what is the bond market discounting?

We obviously can't say for sure, but there's a distinct possibility that it is discounting central bank manipulation. With the yield on the 13-week T-Bill at zero and with the Fed Funds rate target likely to be only 0.50% after this month's FOMC Meeting, there is little additional room for the Fed to promote inflation by reducing short-term interest rates. The bond market might therefore be sensing that the Fed is about to turn its attention to longer-dated interest rates. If it chose to do so, the Fed could push T-Bond yields down to some arbitrary target by purchasing bonds using newly created money.

A central-bank price-fixing operation targeting long-term yields could be sustained for a while, but it would add to the inflation problem that continues to develop outside the viewing range of deflation-phobic analysts and financial journalists. Therefore, if the Fed chose to go down such a path it would bolster the already-strong bullish case for gold.

Should counterfeiting be encouraged?

A popular view is that an increase in the money supply would be beneficial. If so, then counterfeiting should be encouraged. If the economy would benefit from printing more money then expert counterfeiters (those able to produce currency notes that are indistinguishable from the 'real thing') would be performing a valuable service.

But doesn't counterfeiting cause an undeserved transfer of wealth from most people to the people who print the money? The answer is yes, but that's no different to what happens when the central bank creates money out of nothing.

And doesn't counterfeiting, if done on a large scale, distort price signals and thus bring about a reduction in real savings? The answer is yes, but again that's no different to what happens when the central bank creates money out of nothing.

The point we are trying to make is that counterfeiting is unhelpful, regardless of whether it is done legally by the banking system or illegally by unregulated/unofficial operators. People often forget that money is not wealth and that adding more money to the economy does not add more real savings.

The problem is not now, and never will be, a shortage of money. One of today's problems in the US, Australia, and several other Western nations is a shortage of savings, and not only will increasing the money supply not help the situation it will very likely make the situation worse because it will lead to a further reduction in real savings.

Increasing the money supply by creating new money 'out of thin air' is always a bad idea, but it is currently a popular idea and is likely to remain so. That's one reason why recession-like economic conditions are likely to prevail for many years to come.

Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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