If I could send a fortune cookie to those future leaders - five, ten, or twenty years from now - it would contain the Magic Formula of economic success. Here it is:

Low Taxes
Stable Money

If you look at any of the great economic successes over the past two hundred years, you will usually find this combination. Likewise, most of the great failures have the converse: high (or rising) taxes, and unstable money.

Today, a rather energetic discussion of economic policy is taking place, but you will notice that almost nobody suggests anything that is in line with the Magic Formula. On the contrary, the trend is toward the opposite. Economic weakness begets heavy spending; heavy spending begets large deficits; large deficits beget a political trend toward higher taxes. They will eventually find out that higher taxes beget economic weakness.

President Obama has already outlined his preferences for a reversal of the Bush tax cuts, plus still higher taxes on upper-income earners, plus a removal of the upper-income cap on payroll taxes, plus additional increases in capital gains taxes. But this is just the beginning; there is serious talk of introducing a national VAT in the US.

What about the stable money part of the equation? The most stable money, historically, has always been produced by a gold standard. That is the gold standard's purpose. However, beginning especially in the 1930s, a new ideology arose. We no longer wanted stable money. We wanted money we could manipulate, so we could fool people into doing things they would not otherwise do. Alas, this sort of thing has consequences, and they are usually not too pleasant. The US dollar has already fallen to 1/50th of its original value due to our belief in monetary manipulation. The next 50-fold decline might take place in a much shorter period.

Thus, we have higher taxes and, I expect, increasingly unstable money. On top of a dozen other things you could name. Do you see what I mean about an era of economic decline?

I know that many learned economists will say: "Yes, that is interesting, but we can't afford a major tax cut at this time. Plus, we need all the help we can get from monetary policy." This is what people always say in the early period of an era of economic decline.

The fact of the matter is that you can always reduce taxes. Some of the most brilliant tax cut strategies have come from governments in the direst situations imaginable.

Russia was a disaster zone when Vladmir Putin introduced a 13% flat income tax in 2000. Over the next seven years, the average worker's salary (in US dollars) increased by an astonishing 30% per annum.

Germany was in even worse shape in 1949. In the years after the war, hyperinflation raged and millions died of starvation. Much the same was happening in Japan. Both enacted huge tax cuts in the early 1950s. Japan even went so far as to require a balanced budget by law. Both introduced gold-linked currencies at the same time.

This is the kind of thing that happens in the early stages of an era of economic success. The results were very much in line with Russia or China over the past few years. You'll notice that Russia and China today have little interest in monetary manipulation, but are teaming up to establish an international currency regime that promises more stability than the mismanaged US dollar. Russian president Dmitry Medvedev even presented a 1/2 oz. gold bullion coin at the most recent G-8 meeting, as an example of the international currency of the future.

Why did Germany and Japan go this route? They did it because they finally got fed up. Once they got fed up enough, they started to look for answers. The answer was the Magic Formula, although they didn't call it that in those days.

Politicians today, especially in the US, are nowhere near that point. They still think they can spend and tax and devalue their way... not to prosperity exactly... but to a continuation of the status quo. The status quo in which they are somewhere near the top.

Maybe one of them is reading this essay right now. If they hadn't heard of the Magic Formula before, they know about it now. And what are they thinking?

"Hmmmm, some kind of libertarian crank by the looks of it."

It's just too early in the process. Louis XIV's finance minister Vauban wanted to replace the hideously corrupt and oppressive French tax system with a simple 10% income tax. Louis fired him.

Maybe Louis XIV himself was corrupt and oppressive. Plus, he was already the Sun King. Why fix what ain't broken? Taxes got higher and higher, until finally the French "voted" for lower taxes by exterminating the aristocrats altogether.

The French example is from a wonderful book by Charles Adams, called For Good and Evil: the Impact of Taxes on the Course of Civilization. Adams also offers an example from ancient Egypt:

"Scholars have tried to determine what went wrong in Egypt under the Ptolemies, when an empire that had survived for over three thousand years simply withered and died... Egypt had suffered no military disasters, famines or plagues..."

The most impressive analysis of Egypt's demise came from the great Russian scholar Rostovtzeff... Rostovtzeff felt that the continual and unabated tyranny of Egyptian tax collectors produced a nationwide decline in incentive. Egyptian workers and farmers lost their desire to work - agricultural lands fell into disuse, businessmen moved away, and workers fled. Sound money disappeared as a raging inflation destroyed what capital there was. The land became filled with robbers who wrecked commerce and brought fear and despair to the populace.

Remember the Magic Formula. It will come in handy someday.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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People in other countries are beyond such simple mechanisms of control. For an international currency, there must be reasons to use the currency voluntarily.

The best currency is the one that is most stable in value. Historically, the premier international currencies, whether the US dollar after World War II, the Dutch guilder in the seventeenth century, or the Athenian owl in the fourth century BC, were those reliably pegged to gold. Gold has been the superlative monetary standard for thousands of years.

Even after the US dollar left the gold standard in 1971, it remained the most stable currency in the world, which allowed it to maintain its prominence up to the present day. There was no better alternative.

During the 19th century, the US was considered an emerging market. The premier international currency was the British pound.

In 1914, the British pound had been pegged to gold (with brief lapses) for 233 years. However, the beginning of World War I tossed all the European powers into turmoil, including Britain. The pound's link with gold was broken. People in Europe looked for a reliable store of their financial assets. They observed that the United States was untroubled by war and had by then a long history of gold-linked currencies and protection of property rights.

In the 1930s, all European governments devalued their currencies again. The United States did as well, in 1933, but the dollar remained pegged to gold afterwards while most European currencies (and the yen) floated. World War II cemented the transfer of financial prominence to the US To put it quite simply: the US Treasury bond - denominated in gold-linked dollars - was the most reliable store of value in the world.

Financial theorists divide the world of investments into two asset classes: the risk-free asset, and all other risky assets. With currencies mismanaged constantly by central banks, nothing today even approaches the ideal of a "risk-free asset." In marketing-speak, a vast demand goes unsatisfied.

How could China establish an international currency? I predict it will happen when a person anywhere in the world is able to say: The Chinese government bond is the most reliable store of value in the world - the closest approximation to the "risk-free asset."

Obviously, we are not there yet. How could the Chinese government promote this process?

The Chinese yuan would have to be reliably stable in value. In the past, this has always meant a gold standard. Fiat floating currencies managed by bureaucrats are never very reliable, and have a nasty tendency of disappearing altogether. In the past, the international currency was always the one that remained pegged to gold, while the alternatives sank into chaos and devaluation.

Chinese authorities may claim that their floating currency managers are better than the US or European floating currency managers, but nobody would believe them.

The yuan would have to be a reliably independent alternative to the dollar, euro or yen. Since 1950, the yuan has had one form or another of a dollar peg. It is completely pointless to use yuan instead of dollars, if the yuan is pegged (tightly or loosely) to the dollar. The desire for stable exchange rates is entirely reasonable. However, the Chinese government has not established any record of being able to manage an independent currency.

Simply having a floating currency is not enough. Both the euro and yen float, but they are not really independent of the dollar. Monetary policies at all three central banks are eerily similar. The Bank of Japan, in particular, seems to be subject to political pressure from the United States. If the dollar were to fall in value considerably, it is likely that the euro and yen would also be guided lower to avoid disadvantages to trade. They would all decline together, if not quite at the same speed.

To put it a slightly different way: Even though people are getting nervous about the reliability of the US Treasury bond, neither the German government bond nor the Japanese government bond are clearly better.

If China adopted a gold standard policy, this would establish true independence from the dollar. However, if the dollar fell in value considerably, then the yuan/dollar foreign exchange rates could change dramatically. Instead of about 7:1 today, perhaps it could go to 1:1 in the future. This would be due to a dollar fall, not a rise in the yuan.

Many countries could not tolerate such a situation. Switzerland tried, in the early 1970s, but the trade consequences were too great. It would be quite unpleasant for China as well. However, China already has significant trade advantages, so even large forex moves like this could be withstood.

The Gulf States - and Russia to some degree - have an even larger advantage in this regard. They have no real competition for their primary export, crude oil.

A credible military remains, unfortunately, an important component of political independence, and consequently currency independence. The US is not likely to hand over its mantle of world leadership without complaint. While hostilities are unlikely, certain political pressures by the US can be imposed upon governments who, in schoolyard terms, seem like they can be pushed around. Japanese leaders remember the military exercises the US Navy conducted in Tokyo Bay in 1989, a rather blatant reminder of the Black Ships of 1853. Russia is well aware of political incursions in the former Soviet republics, and even Germany still hosts enormous US military bases.

China is establishing itself as a military power. An alliance with Russia, and acquiescence among the other Asian states, would help establish real political independence.

There remains a little problem of exactly how to manage a gold standard system. This is not very difficult, but the Chinese monetary authorities apparently have not yet mastered the basic concepts involved. Fortunately, there is now a handbook on these subjects - Gold: the Once and Future Money (2007), which is available in a Chinese edition.

The US dollar is, quite frankly, not a very good currency. It would not be difficult to develop a better alternative - a currency pegged to gold. Once the Chinese authorities had demonstrated that they can manage such a system, people everywhere would flock to yuan-denominated assets. Lenders would demand that their loans be denominated in reliable, gold-linked yuan. Shangahi would become the financial capital of the world.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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It is a total fantasy.

"Inflation is always and everywhere a monetary phenomenon," we are told. Almost everybody understands that when a currency loses value, it eventually takes more and more currency to buy things.

It works the other way as well. When a currency rises in value, it takes less and less currency to buy things. Let's call this process "monetary deflation."

This hardly ever happens. Inflation has natural temptations, but there is normally little political support for sustained deflation. Beginning in 1985 - with a bit of international arm-twisting known as the Plaza Accord - Japan experienced probably the longest and most dramatic monetary deflation (rising currency) in the last 500 years, if not all of human history.

This is obvious in foreign exchange rates. Beginning in late 1985, the yen soared above 250/dollar level that it traded in the early 1980s, eventually peaking at 80/dollar - a threefold increase - in 1995. Ouch. The yen's rise is more definitively described by the ratio of the yen to the eternal measure of value, which is gold.

This may puzzle some people. Wasn't the Japanese economy roaring into a bubble in the late 1980s? Indeed it was - driven in part by the 300 basis point decline in interest rates that resulted from the soaring yen. You can imagine the effects on the already-overheated property sector. Also, the government was engaging in a series of dramatic tax cuts, in line with the similar Reagan tax cuts in the U.S.

This, plus a healthy dose of irrational exuberance, was enough to keep the economy humming even though the CPI hovered around a negative 2.0% in 1987, 1988 and 1989 (when adjusted for an increase in the consumption tax).

However, once the asset bubble popped, the full effects of the monetary deflation were felt. The yen kept rising, eventually hitting a peak near 28,000/oz. of gold in 2000. This was about a seven-fold rise in the yen's value from its 1980 nadir near 200,000/oz., and a threefold rise from the mid-1985 value of about 90,000/oz.

I think it is fair to characterize the property market of the late 1980s as a "bubble" similar to the one we've experienced in the U.S., but it did not die naturally. No, the Japanese property market was pushed.

The government, aware of unsustainable asset valuations, embarked in a draconian series of steps to depress property prices throughout the 1990s. This not only blew away the froth of unsustainable valuations, it also demolished the real, fundamental value of property. They began with a series of tax measures on January 1, 1990 - the first day of the bear market - which eliminated certain preferential capital gains tax treatments for property. To take a few of a great many such steps which followed: In 1992, the tax rate on short-term capital gains (under 2 years) on property was raised to 90%. Long-term gains were taxed at 60%. A 0.3% National property tax was introduced (this was several multiples greater than existing property taxes). A City Planning Tax of 0.3%. A Registration and License Tax of 5% of the sale value of a property. A Real Estate Acquisition Tax of 4%. An Office Tax of 0.25%. A Land Ownership Tax of 1.4%. Even the regular property tax, the Fixed Assets Tax, was effectively raised by several multiples. From 1990 to 1996, Japanese property values imploded by as much as 70%. However, the revenues from this tax rose by 46%. You can do the math.

All of this resulted in epic levels of bad debts at banks. For some reason, the banks managed to get the blame for this, as if they were responsible for the unprecedented monetary deflation during the decade, or the tax assault on property owners.

Banks wrote off and liquidated loans continuously during the decade. However, the economy was unable to improve due primarily to the hideous monetary deflation, so more bad debts kept piling up as one borrower after another reached the end of their resources. This gave the appearance that the banks "weren't doing anything about their bad debts." As fast as they bailed out their boat, new water was coming in.

In 2000, the government, still convinced that banks "weren't doing anything about their bad debts," undertook an extensive audit of bank assets on a loan-by-loan basis. They wanted to determine if there were any "hidden bad debts," borrowers that had effectively gone bust but were being carried as performing loans. Then, having dug all the skeletons out of the closet to their satisfaction, they mandated that the banks resolve all these bad debts over the course of the next few years. Banks were required to state their progress under this plan in their financial statements.

Thus, we can see with great precision what banks were up to. As of September 30, 2000, Sumitomo Mitsui Financial Group had "bankrupt and quasi-bankrupt assets" of 653 billion yen. These were the real bad loans - those that had defaulted. There were another 2,594 billion of "doubtful assets" - these were loans that were paid in full, but where the borrower was in some difficulty (a large cohort after 10 years of recession).

By March 31, 2003, SMFG had reduced this original group of "bankrupt and quasi-bankrupt assets" to 144.5 billion, a decline of 78%. Problem solved? As of March 31, 2003, the bank had 524.9 billion of "bankrupt and quasi-bankrupt assets," with the difference made up not by leftovers from a decade earlier, but the brand new bad debts caused by the recession of 2001-2002.

Banks were doing more-or-less what they should have been doing. The government, far from "doing nothing" about the problem, was actually carpet-bombing the economy with the most destructive sorts of new taxes, on top of the horrible monetary deflation that persisted until about 2003.

The Bank of Japan eventually figured out the problem and implemented its "ryoteki kanwa" plan, which was translated into English as "quantitative easing." With the decline of the yen beyond its 10- and 20- year moving averages, monetary deflation was not a problem in Japan after 2003. Finally free of the crushing monetary deflation, the economy managed a modest rebound. Yet, the economy has been strangely moribund, even taking into account the difficulties happening worldwide since 2007.

Is the government still "doing nothing?" Hardly. The Japanese government's tax barrage continues to this day. Already there is an annual rise in payroll taxes, scheduled for every year between 2004 and 2017, which will eventually take the payroll tax rate from 13.6% to 18.3%. (Employers match this, and there is no maximum income to which it applies.) And what about the increase in taxes on dividends from 10% to 20%? Or the introduction of a brand-new capital gains tax on equities of 20%, which had effectively been tax-free before? Or the effective 25% increase in personal income taxes, the result of the elimination of a 20% tax cut introduced in 1998? On top of all that, politicians are talking about increasing the consumption tax (similar to a sales tax) from 5% presently to 10% or higher. Until a 3% consumption tax was introduced in 1989, there was no consumption tax at all in Japan, not even at the prefectural or municipal level.

This performance is spookily similar to the policies of both Herbert Hoover and Franklin Roosevelt, both of whom raised taxes throughout the 1930s and squandered boatloads of money on public works and other such spending "stimulus," with little long-term effect.

There is certainly a lesson to be learned from Japan, but it is not the one that most people think. The lesson is: keep your money stable, and taxes low. When Japan was on the gold standard in the 1950s and 1960s, and reduced taxes steadily, it was the growth wonder of the world.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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Hoover Dam is perhaps the most iconic of all of these efforts. Although environmentalists might argue, in terms of its benefits such as electricity generation and water supply for agriculture and eventually urban use, it is about as useful and worthwhile a public work as anyone could ever hope for. When it was completed, it was the world's largest electric-power generation facility and the world's largest concrete structure.

Planning for Hoover Dam began in 1922, and was overseen by Herbert Hoover himself. Construction on the project was approved by Congress in December 1928 - long before the economic problems emerged. It was, in contemporary terms, as close to a "shovel-ready" project as you'd find. The initial appropriation for construction was made in July 1930.

The project officially began in September 1930. The contract for construction was awarded to a joint venture of six private companies in March, 1931. The first thing they had to do was to make a small city for the workers who would be working on the project. Boulder City was occupied in the spring of 1932. Roughly 16,000 workers were part of the construction, and many brought their families to live in Boulder City.

Initial construction on the dam project itself began with the upper cofferdam in September 1932. Construction was completed in March 1936. It was considered a great accomplishment to complete such an ambitious project so quickly.

As a result of these spending programs, the Federal budget ballooned enormously. In 1929, the government had $3.862 billion of tax revenue, and spent $3.127 billion, enjoying a surplus of $734 million. In 1932, the government spent $4.659 billion, a 49% increase despite the "deflationary" environment.

In 1931, the government had its first deficit in eleven years, of $462 million. Perhaps this, and the spending commitments upcoming, is why Hoover pushed through an enormous tax hike in April 1932, which was enacted in June of that year. The top income tax rate in the U.S. rose to 63%, from 25% previously. Inheritance taxes were doubled, corporate tax rates rose, and a long list of excise taxes were imposed. It was predicted to raise $1.1 billion in new revenue, in an effort to close the budget deficit.

The tax didn't help the economy much, however, and revenues remained weak. In 1932, revenue had collapsed to $1.924 billion, and were only $1.997 billion in 1933. The budget deficit exploded to $2.735 billion in 1932 and $2.602 billion in 1933.

John Maynard Keynes once argued that, in a depression, it would be worthwhile to pay workers to dig holes, and to pay other workers to fill them up. But how is this different than paying workers to do absolutely nothing? The main advantages appear to be psychological. "Workers" maintain a better morality and work ethic, and are less likely to revolt, than "welfare recipients." And, they can be counted as "employed," while a welfare recipient might remain "unemployed" until they actually found something productive to do in the economy.

We can see that it is not so easy to just "push money into an economy" via public works projects. The more useful they are, the more likely it is that they will take years of planning and construction. If the goal is to supposedly avoid some sort of downward spiral over the next six months, it is more likely that the funds will end up directed into something more like Keynes' hole-digging exercise.

Thus, we can see that, when short-term "stimulus" becomes the focus, the effect is more likely to be short-term welfare. There is nothing particularly wrong with welfare in a depression. Better than having people dying in the streets. But, increased welfare spending isn't much of an economic program in itself.

In retrospect, Hoover Dam was probably a worthwhile project. It produced something of value, and kept 16,000 workers busy over the 1931-1935 period, the worst part of the Depression. However, one effect of this aggressive deficit spending was an eventual rise in tax rates, which did additional economic harm. Roosevelt continued along the same path: spending soared up to $9.468 billion in 1940, and tax rates soared higher as well, with the top rate hitting 81% in 1940 (and 94% in 1945).

Politicians always like to spend other peoples' money, so it is no surprise that they - always and everywhere - flock around those economic advisors that tell them that enormous spending projects are the key to resolving economic difficulties. Nor is it a surprise that economists are quick to tell people what they want to hear. If you're going to be wrong all the time, you might as well be popular, well-paid, and wrong. Economics being what it is, you can always argue later that you were wrong because "people didn't do enough."

These ideas were solidified in a book written by John Maynard Keynes and published in 1936. Since governments had already been hard at work at "stimulus" for a half-decade or more already by that point, you could say that the book was a how-to guide for economists to justify policies that were already popular.

When you get past the cloud of nonsense surrounding "stimulus spending," with its output gaps, multipliers and so forth, it seems to me that government spending during a recession accomplishes roughly what it does during any other time. Mostly, it is a big waste of money, but it might keep some people employed and maybe you'll even be left with something useful afterwards. I would suggest a decent rail system, at least as good as that of France. Since we're spending trillions anyway, how about as good as the U.S. had in 1910? That would be, I argue, the least bad of all possible boondoggles.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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Let's look at a specific example. This is for my own parents, who turned 65 last year. (That puts them just before the Baby Boomers.) They live in a nice suburb outside of New York City, on the coast of Connecticut. Like many older people, they would like to stay in the house they have owned for about 20 years now, in the community they are accustomed to, and near the friends they have. It's not so easy to start over when you're over 65.

Even people who have been able to accumulate significant assets, pensions etc., might be a little nervous. Trying to depend, for the next 20 or even 30 years perhaps, on financial abstractions and government promises would be a little scary. I usually tell them that they should be scared! Or, at least don't put too much faith in various Wall Street promises (and pensions are ultimately Wall Street promises too). You aren't going to make a smooth 8% per year in your 401(k) just because some financial advisor told you so. But, I guess you've figured that out now. Anything can happen. Particularly as we are sort of in a depression right now. Owning a big house in a nice neighborhood is not cheap, even if it is 100% owned with no mortgage. The annual costs of a house look something like this:

Property tax: $8000 (and that could go up)

Insurance: $2000 (could be higher)

Maintenance: $2000 (could be higher)

Utilities (phone, internet, cable, electric, trash collection) per month: $200 or $2400/year.

Heating oil: $2000 per year (could be higher).

Total: $16,400. That is probably on the low side. So, let's just budget it at $18,000.

Then, you've got a car and all the other expenses of living. And what happens when you get a little frail, and want living assistance?

Have you seen the prices for nursing homes?

It's not that these burdens are unbearable. It's rather that they are burdensome. Just house-related costs could chew up most of your Social Security check right there. And, if things really go to hell in the future, they might become unbearable. Who knows what things will look like in 20 years? Only your financal advisor knows for sure.

Let's look at it from the financial side. Maybe you can get 3% of cashflow from a "safe" muni bond portfolio, or dividends from stocks. And, you have to take into account inflation ... over the next twenty years. How do we "take into account" the unknowable? What happens if there's not enough fifteen years from now, and I'm still alive? To get $18,000 of income would take $600,000 of muni bonds. And, muni bonds are looking kinda risky these days. Dividends from stocks might take more than $600,000, because you have to pay taxes on dividends. Stocks go up and down a lot too. Sickening.

Now, like I said, they've been living in the area for a while and have some good friends, who are about the same age and in similar circumstances.

So, here's the plan:

You get together with your friends. You say: "We're all retired now. I've got a big empty house. You do too I suppose. Maybe we can think of living together. That would help reduce our living expenses. Plus, it might be fun, and it would be a good way to keep an eye on each other. That can be important when you're getting older."

Everyone is repulsed at first, because we Americans are all taught that we have to live as far away from each other as possible. But, they remember that, when they were in college, they used to share houses, and it was kind of fun. Also, everyone is older now and a lot better behaved than when they were in college. And, it is true that it might be good to have someone keeping an eye on you.

So, everyone decides to move into one house, owned by the Owner. The people who move in, two other retired couples, are the Renters. The Renters pay the Owner $800 a month to rent a bedroom, and agree to pay 1/3 of the utility and heating bills. The Renters' cost of living looks something like this:

Rent: $800 * 12 = $9600

Utilities: $100/month = $1200

Heat: $700

Total annual costs: $11,500.

Now, indeed renting turns out to be cheaper than owning the big house, even when the big house is fully paid for. They could sell their big houses if they wanted to. But, they are nervous about just selling the house they have owned for twenty years, and moving in with someone else. It might not work out. Let's not burn any bridges. So, instead of selling their now-empty houses, they rent them out.

Rent: $3500 per month = $42,000 per year (typical, actually a little low). Heckuva lot cheaper than paying the mortgage on a million-dollar house. Just the thing for a Wall Streeter with a family that needs to downsize quickly. Real quickly. Utilities are paid for by the renters.

Costs:

Property tax: $8000

Maintenance: $3000 (higher with renters)

Insurance: $2000

Total: $13,000

Net cashflow: $42,000 - $13,000 = $29,000.

Now, they're getting $29,000 in rent net of property expenses. Then, they pay their $11,500 it costs to live in the shared house.

$29,000 - $11,500 = $17,500.

Now, look at the renters:

Before: $18,000 per year of housing costs.

After: Housing and utilities are paid for, and an extra $17,500 per year of free cashflow, plus probably some tax benefits.

Wow, all of a sudden, you're living for free, and getting paid too! You just created, out of thin air, the equivalent of a $1,200,000 muni bond portfolio. Maybe more, if you consider tax benefits (rental properties can charge depreciation.) And, you still own your house.

For the Owner, it looks like this:

House costs: $13,000

Utilities: $1200 (1/3)

Heat: $700 (1/3)

Total: $14,900

Rental Income: $800 * 2 * 12 = $19,200

Net cashflow: $19,200 - $14,900 = $4,300.

So, the Owner is also living for free! However, their cashflow is not as high as the Renters. That's probably the way it should be, because the Renters will probably want a little extra incentive to move out of their house into someone else's.

So, now where are we? All three couples are now living for free, and getting some extra cash on top of that. And, there are things you can do in a shared house, like splitting cooking duties. Instead of cooking every night for two, the cook can cook twice a week for six. That's a lot easier, and would probably result in a more ambitious menu, and would resolve the question of how three people can cook in one kitchen. If the men are smart, they will encourage a little friendly competition among their wives, to "keep up the pace" for their two dinners a week. You can finally use that formal dining room every day. Then, everyone has a house's worth of furnishings. The antiques, boutiquey stuff, art and heirlooms, and the grand piano, all goes into the house where everyone is living. The more generic, replaceable stuff can go into the houses that are being rented out. Maybe you can charge an extra $500 a month for a furnished house. $500 a month is $6000 per year. That's another $200,000 muni bond portfolio-equivalent, that you created out of some used furniture. You would have had to save $400,000 before income taxes, to get a $200,000 portfolio after taxes.

After a while, in a shared house, there is always the issue of who does what house chores, and do they do it adequately, and so forth. The easy way to solve this problem is to get a housekeeper to come in one day a week, and do the vacuuming, laundry, bathrooms and all that. It's $100 a week, or $5,200 a year, or $1,735 per couple per year. Covered by their extra cashflow. Over time, people are over 70 and a little frail. Maybe they would like a little more help with shopping or even cooking, or they are no longer able to drive safely by themselves.

So, they get a live-in full-time housekeeper. The housekeeper lives in the fourth bedroom. The housekeeper gets room and board and use of a car, plus $1,000 a month in salary. Not a bad deal for a housekeeper. That's $12,000 per year or $4,000 per couple. That is also within their net cashflow. So, now everyone has their housing and utilities and a live-in housekeeper paid for. Make it $2,000 a month and you could get a registered nurse, probably. Now you've got a private nursing home.

Being older with lots of free time, it would probably be good to get outside for some light exercise. The house sits on two acres, of which perhaps there is one full acre of lawn. Instead of growing grass, let's grow some vegetables. This is prime farm country, or it was in the colonial days. You can grow a lot of vegetables on a full acre. Heck, you can grow a lot of vegetables on a tenth of an acre. A tenth of an acre is 4,356 square feet, or 43 feet by 100 feet. Not a small garden, that. So, you drop some seeds in the ground, and have fresh vegetables all summer. You even do some canning and put some away for winter. It's all organic, you get some exercise, and no more big-ticket trips to Whole Foods.

So, now, instead of paying out $18,000 a year in housing expenses, you're living for free, with your friends, with a live-in housekeeper, with some extra cashflow on top of that, and a lot of your food costs are covered as well. What is there to be worried about? Pass the 401(k) on to your kids. Don't worry about the corporate pension. Consider the Social Security check to be your entertainment budget. If there's inflation, just raise your rents.

And all it took was a little cooperation among friends, to make better use of what they already own.

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Unfortunately, there was a flaw in this plan. Interest rate manipulation, as practiced by the Fed, was surging in popularity. It was hoped this currency tomfoolery would prevent another Great Depression, and every other little recession along the way. This "monetary policy" and currency manipulation was contrary to the simple, automatic currency board-like mechanisms by which gold standard systems should be operated. The result was that the fixed exchange rates and gold link came under constant pressure.

For a while, governments attempted to have it both ways. They imposed various capital controls to keep exchange rates fixed - while at the same time their central banks played games that caused exchange rates to diverge. The dollar/gold peg was not maintained by judicious supply adjustment, as a currency board would operate, but by heavy-handed intervention in the gold market in London.

Eventually, the conflict between manipulative central banks and the gold link became overwhelming. In January 1970, Richard Nixon installed his friend Arthur Burns as Chairman of the Federal Reserve. Burns immediately opened the monetary floodgates to help offset the recession of the time - following the day's conventional wisdom. In August 1971, the conflict between Burns' manipulation and the gold link became too great, and, rather than abandoning Burns' currency games, it was decided to abandon the gold link instead. The dollar had become a floating currency. By 1973, all the major currencies floated.

An economic catastrophe ensued, the inflation of the 1970s. Even in the 1980s and 1990s, as currencies were stabilized somewhat, economies never regained the health they showed in the 1950s and 1960s. Emerging markets, in particular, were beset by regular currency disasters.

The environment of monetary chaos that we have lived in for the past thirty-seven years has finally produced a political willingness to fix the problem. Governments sense that, if they do not take action now, a worldwide crisis may ensue. Just as in 1944, governments want to return to the monetary stability upon which capitalism was founded. On November 15, governments will gather to talk about a "New Bretton Woods." There is even some talk that gold will play a part. The creators of this New Bretton Woods, if they are able to agree on anything at all, would do well to recognize the successes and faixlures of the original Bretton Woods.

Bretton Woods was, overall, a great success. This was due to the link with gold, and the fixed exchange rates worldwide. Capitalism since the Industrial Revolution had been based on this monetary principle, and it worked again as it had in the past.

The reason that the Bretton Woods gold standard did not persist indefinitely was not government deficits, or insufficient gold bullion reserves, "current account imbalances" or any other such thing. The only reason that governments decided to abandon the gold link was that they preferred to play central bank games with their currencies. A New Bretton Woods must wholly and completely abandon such practices.

Without these guiding principles, this month's discussions are likely to devolve into an unworkable hodgepodge of currency baskets, CPI targets, promises likely to be broken, and rhetorical vagaries. Certainly no usable system would emerge, although an unusable system might.

A New Bretton Woods, of gold-linked currencies worldwide, would be very easy to create. It could be done in a weekend, and wouldn't cost a dime. It is merely a decision to manage currencies one way - a gold link - rather than another way. Unfortunately, I don't think today's generation of monetary bureaucrats in the U.S. and Europe have the talent, skills or understanding to accomplish this solution. They can't even identify it.

I place my hopes on Russia, China and the Middle East. Their monetary bureaucrats don't have the skills either, as far as I can tell, but they are willing to learn. As outsiders, they can see that the G7's conventional wisdom isn't working.

I wish the best for those governments willing to step up with a solution to the problems that have plagued the world since 1971. I just hope they get on with it before things get too out of hand.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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This doesn’t mean that it is easy to make money. Rather, it demonstrates that it is hard. I don’t know a single example of significant success with this simple strategy. Why not? Many things can happen in four centuries. One thing that seems to happen, with regularity, is currency devaluation, possibly to the point of worthlessness.

In 1935, a stockbroker named Gerald Loeb wrote a book called The Battle for Investment Survival. It is considered a classic today, and is still in print. The dramatic title might be ascribed to the dramatic period in which it was first published. Disaster-mongering books were popular in the late 1970s as well. However, in the book (which was revised in the 1950s and 1960s), Loeb makes clear that the “battle” he had in mind was with inflation. “The greatest threat to successful preservation of capital [is] the varying purchasing power of money,” Loeb wrote. People who held their cash at a “safe” 2% or 3% were sure losers in the long-term Battle for Investment Survival, Loeb argued.

Sometimes, cash was a good option. But in the long term, even just to stay even, it was necessary to speculate. The best defense is a strong offense. “Because I am personally completely convinced of the inevitability of loss when attempting to secure a safe income of small return, that I constantly suggest speculation rather than investment [investment-grade bonds] as the policy less apt to show a loss and more apt to show a profit.”

The funny thing is, Loeb lived almost his entire life under a gold standard. There was a devaluation in 1933, but that was the only one of consequence for most of his adult life. Oddly enough, money did keep its value in those days. It wasn’t until the floating currency period started in 1971 that Loeb’s worst fears began to be realized. He died in 1974. Maybe his last words were: “I told you so.”

Loeb wasn’t the only one worrying about keeping up in the Battle for Investment Survival. It is no surprise that government bonds were popular in the 1930s and 1940s, what with Depressions and World Wars and all. In 1949, the 10-year U.S. government bond traded for about 2.0%! That was the peak of the great bond boom. You might even call it a bubble, to the extent that there can be a bubble in government bonds.

People then began to come to their senses. At first, they noticed that stocks were yielding five or six percent in dividends. But, later, they listened to what was being said by their leaders in Washington, and decided that they didn’t like the way things were going. Ten-year Treasury yields ended 1967 at 5.7%. They ended 1968 at 6.03%. They ended 1969 at 7.65%. Bondholders were intensely aware of the risk that inflation – currency devaluation – posed to their capital. Their fears came true in 1971, when, after 182 years on the gold standard, the U.S. dollar’s link with gold was severed. The dollar was floated and devalued. It eventually lost about 90% of its worth during the decade.

After a twenty-six year bull market in bonds, since 1982, we now have 10-year Treasury bond yields again under 4%. This might have made sense when the dollar was “as good as gold,” as it was in 1949. However, the dollar has spent the last seven years declining against every possible benchmark: gold, foreign currencies, a basket of consumer goods, and commodities. The situation that people feared in the 1960s – currency devaluation – has been going on for years now.

It will probably continue until a Paul Volcker-like character appears to put an end to it.

Yet, there is little concern. The government’s CPI statistics are widely regarded, by big-name bond gurus like Pimco’s Bill Gross for example, as something between an honest mistake and a dishonest one. However, the entire Treasury yield curve is now trading below even this artificially low hurdle. The latest CPI readings show an increase of 5.6% from a year earlier.

Government bondholders today think they are “safe” from market turmoil, but, I argue, they are likely to be certain losers in the Battle for Investment Survival. The only safety today, as Loeb argued, is in speculation. Loeb recommended equities. That might not be such a good idea at the present juncture.

Does Loeb offer an alternative to both bonds and stocks? “In the history of the world we find the record of savings really saved through buying gold, hoarding precious stones, and other forms of ‘hard wealth’ privately secreted. In the future history of America most of us will, in my opinion, learn this lesson too late,” he wrote.

Gold, silver, and other commodities have had a tough couple months. They seem exceedingly risky, compared to the apparent safety of T-bills. For an inexperienced speculator, these wild moves can lead to catastrophic losses. For the experienced speculator, these hard assets are merely tools in the Battle for Investment Survival – perhaps the best tools for the present situation.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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Sorry: not quite so easy.

Inflation is childishly simple to understand, but economists like to remain confused. When a currency loses value, markets gradually adjust to reflect this new development. When the dollar's value falls in half, things that cost $10 eventually cost $20, more or less. It's no more complicated than that. The dollar's decline is best measured against gold - for centuries considered a stable measure of value. The dollar is now worth about 1/900th of an ounce of gold, compared to about 1/350th on average during the 1980s and 1990s. You can do the math yourself and figure out what this means for prices going forward.

Conversely, if a currency remains stable - pegged to gold for example - then there is no inflation, whether an economy collapses (as in the early 1930s) or expands (as in the 1960s).

One of the reasons why inflation went on so long in the 1970s is that people imagined that stopping the inflation would be very painful. I call it the Volcker Myth: that "we need a recession so horrible that it breaks the back of inflation." The power of this inflation myth was so intense that, in effect, people tried their hardest to make it come true, and the 1982 recession was the result.

This inflation myth continues today with the idea that there is a "tradeoff" between inflation and growth. Baloney. Inflation is bad for economies, and a stable currency is good. You can't devalue yourself to prosperity. Nor can you recession yourself to a sound currency.

Ronald Reagan took a different view. If inflation is bad for an economy - this had been fairly well proven by 1980 - then certainly stopping inflation must be good, right? Reagan's plan was to put the dollar back on the gold standard in 1981, and also to cut taxes dramatically. The combination of sound money and a hefty tax cut would create lower interest rates and an economic boom.

If sound money and lower taxes are good for an economy - and they most certainly are - then the result should be a better economy, not a worse one.

This idea has been proven out many times since 1980, particularly in the former Soviet sphere. Over the past eight years or so, one country after another has stabilized their currencies and implemented amazing "flat tax" programs. Russia led the way with its 13% income tax in 2000. The result has been a tremendous economic advancement, with falling interest rates and expanding finance. Many of these countries are experiencing their biggest economic boom since before World War I.

Unfortunately, Reagan's plan was a little too sunny for the American imagination circa 1980. For the election that year, Reagan recorded television commercials promising a gold standard, but they were never broadcast. Instead, the Fed undertook the "Monetarist experiment" in which short-term interest rates went as high as 18%. Instead of cutting taxes right away, the tax-cut plan was delayed until 1983, watered down, and phased in over years. Tax cuts might have got in the way of the plan to have "a recession so horrible that it breaks the back of inflation."

Economists these days are madly, insanely, pathologically fascinated by interest rate manipulation. They believe that, with a sufficiently high short-term interest rate target, inflation can be resolved. This rarely works. To solve the worsening inflation, in September 1973 Fed Chairman Arthur Burns went to an average Fed funds rate of 10.78%. It was a flop - the dollar kept falling in value until late 1974. It was a flop in the long term as well, with inflation worsening until the early 1980s. Often, these high interest rate targets effectively cripple the economy, the currency falls even more, and inflation gets worse. Many Asian government found this out the hard way in 1997 and 1998, until they learned to ignore the IMF's bad advice.

Low interest rates don't work. High interest rates don't work. The Monetarist experiment stopped the 1970s devaluation trend, but it produced such chaos and mayhem that it too was abandoned in 1982, after only three years.

The solution to inflation isn't a recession. The solution is not high interest rates. Reagan had the right idea: peg the currency to gold, and slash taxes to rev up the economy. The Russian 13% flat tax plan would do just fine. With this combo, the U.S. economy could have the best economic boom since the last time the U.S. enjoyed a gold standard and a big tax cut, which was 1964-1966.

Or, perhaps the Russian or Chinese governments will discover the high road to economic success - a gold standard and low taxes - leaving the U.S. to destroy itself with cheap-money solutions.

Eventually, central bankers are likely to respond to worsening inflation with rate hikes. The rate hikes will likely cause economic stress, but fail to solve the inflation problem. At this point, the central bankers will blame everything under the sun for the mysterious "stagflation," except themselves. It will become apparent that the central bankers are much better at producing excuses than solutions. Then the central bankers will be replaced.

That is the point where the Reagan of the future will be able to step to the forefront. Cut taxes. Peg the currency to gold. Enjoy the results.

Nathan Lewis
for The Daily Reckoning Australia

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I told you it was simple.

The "supply" comes from the currency manager. Today, that's the central bank and Treasury Department or Ministry of Finance. They produce base money, which is actually the only money in existence. Base money is mostly coins and bills, and a little electronic bank reserves. Every other sort of "money" is actually credit, not money.

The "demand" comes from everyone else, who is holding the currency, or, as is sometimes the case with the U.S. dollar today, choosing not to hold the currency.

I bring this up because, at some point in the not too distant future, people may begin to clamor for a solution to the world's worsening monetary problems. Perhaps, as inflation worsens, there will even be interest in a gold standard system. At that point, there will have to be someone who can actually solve the monetary problems. That person will have to understand the fundamental principle of currency management - supply and demand - because, if they don't, their system will eventually collapse as well. Probably sooner rather than later.

People have long believed that a currency "backed by gold" will remain stable, but there is no such guarantee. If you take a mammoth amount of gold, and lock it in a vault, it does not emit magical energy waves that automatically manages the value of otherwise worthless paper currencies. There are many methods of keeping a currency pegged to gold. Some of them involve large hoards of gold, or even making coins of gold, and some do not. However, all of them, if they are to be successful, have at their core the fundamental principle.

Which, as I mentioned, is supply and demand.

Indeed, if you understand this fundamental principle, you can peg a currency to gold even if there are no gold reserves at all.

Everyone knows that a central bank, or other currency manager, can "print money," either electronically or physically. It is not as well recognized that a currency manager can "unprint money," or remove base money from circulation. The currency manager does this by selling something, typically a government bond, and making the money received in payment disappear. This happens nearly every day in the course of the Fed's regular operations.

For example, the Fed has been rather vigorously lending money to banks. The Fed "prints money" and lends it to the banks. However, the overall supply of base money, according to the Fed's statistics, hasn't changed much. This is because the Fed is "unprinting money" elsewhere to compensate for its direct lending.

Central banks don't really control interest rates. What they do is to print money and unprint money in a fashion that influences interest rates. Or, a central bank could adopt a different operating mechanism. During the early 1980s, the Fed printed money and unprinted money - in other words, altered the supply of money - in an effort to influence various credit statistics such as M1 or M2.

A currency board system prints money and unprints money in an automatic fashion that keeps the currency pegged to another currency. Typically, a currency board has a "reserve" of foreign currency, but this reserve is not necessary if supply is being properly managed. If supply is not being properly managed, then the foreign exchange reserve is typically depleted in short order, and a crisis results.

A gold standard is essentially a currency board linked to gold. Doesn't it make more sense to peg to gold, the ultimate currency of mankind, rather than some government's paper plaything? This used to be very obvious.

It seems that every gold standard advocate has their own special system, involving some idiosyncratic policy of reserve holdings or coin issuance. They will work, if they are based on the fundamental principle. If not, they would soon collapse.

My own idiosyncratic system is the gold standard that involves no gold at all. There are no gold coins, and no government gold reserves. Gold bullion is freely traded on the open market, just as it is today.

In my system, the currency manager (governments today) would adjust the supply of currency on a daily basis to maintain its value at the gold peg. When the value is a little low, you unprint money. When the value is a little high, you print money. In effect, it is a currency board linked to gold.

The idea of a gold standard with no gold usually drives the traditional "gold bug" insane. They are very attached to their piles of ingots and eagles. I use it mainly as a teaching device. When a person fully understands the fundamental principle - supply and demand - they say: "Yes, of course that would work." If they are still attached to the idea of locking gold in a vault, they think it's ridiculous, because there's no vault.

Because many gold standard advocates do not understand the fundamental principle, they fall back on another, more primitive principle, which is to use gold coins exclusively. This system is best suited for a more primitive world. Yes, gold or silver coins are better than a wheelbarrow of paper money when you're trying to buy bread in a hyperinflation. But consider: Warren Buffett just took part in a buyout by Mars Inc. of Wm. Wrigley Jr. Co. for $23 billion. What if they had to make payment in gold? Would they put $23 billion of bullion in an armored car? In the ninth century, this is how businessmen in China made large commercial transactions. The process of loading ships and wagons with silver coins was so cumbersome that they invented paper money, pegged to silver.

In 1910, the gold standard centered on the British pound and the Bank of England encompassed the world. At the time, the Bank of England held only 7.2 million ounces of gold. This was only 4% of all the gold held by governments and central banks in 1910, and only about 1.2% of all the gold in the world. The Bank of England didn't have much gold, because they didn't need it. They understood the principle of supply and demand.

When the U.S. left the gold standard in 1971, the government held 291 million ounces of gold. This had been depleted from 630 million ounces in 1942. Unfortunately, the Fed did not understand the principle of supply and demand. They were printing money aggressively to pump up the economy, with the result that everyone (especially the Bank of England and the Bank of France) wanted to dump the excess paper back on the Fed and get the gold in return. The system failed, even though the U.S. held forty times more gold than the Bank of England did in 1910.

In a fairly short time, as central bankers' embarrassment becomes total, people may again search for someone who can manage a currency like the Bank of England did in 1910. Prepare now, or we will have to bear further decades of monetary chaos and ignorance, instead of the Golden Age we deserve.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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However, we may be nearing an end to this process. Other currencies have risen, against the dollar, to the point where European companies, for example, are feeling unfairly disadvantaged. Where are all the domestic tourists? This "competitive disadvantage" is unpleasant at any time, but it is particularly unwelcome when there is a slowdown due to other reasons, like the property and financial bust which has become a worldwide phenomenon.

So what do these foreign central banks do? They can kill two birds with one stone. They can handle the uncomfortably high currency, and the domestic softness, with what amounts to an "easy" monetary policy. Thus, we see the Bank of England and Bank of Canada cutting their policy rates recently. The Bank of Japan is still stuck at a puny 0.50%. The European Central Bank has been speechifying about inflation recently, but the pressure is on to do something about today's problems. Yes, the official CPI might be rising faster than they'd like, but it's not enough of a problem yet that anyone is willing to suffer higher interest rates or a further rise in the currency to do something about it. Besides, isn't inflation caused by China?

In this way, we come to the point at which all currencies decline in value together, while their exchange rates remain relatively stable. Sort of like today's dollar bill, ten-dollar bill, and the quarter. They all decline in value together, and their exchange rates remain stable.

This is what happened in the early 1970s. The world's currencies were pegged at fixed exchange rates to the dollar in those days, while the dollar was pegged to gold. After the dollar left gold in 1971, and its value declined, other countries' governments said: "Hey, wait a sec. I'm not sure of what you're trying to do with this cheap-dollar stuff, but we don't want any part of it." Sort of like the Middle Eastern dollar-pegged currencies today, or the Chinese yuan recently.

So, in the spring of 1973, they all depegged from the dollar. See ya later, greenback! That was the beginning of the floating currency system we have today.

Immediately after the depegging and floating, the dollar fell against all major currencies (and the minor ones too). The Fed's dollar index, which remains popular today, shows this drop. This index, by the way, starts in 1973 because it was not necessary before then.

Then what happened? Governments of the time began to chew over the problems that emerged, and came to the same conclusion as governments today. Damn the inflation, we have to keep these foreign exchange rates under control!

The dollar index stopped falling. All in all, it only fell about 20%, as all the governments in the world inflated together. During the great dollar collapse of 1978-1979, foreign exchange rates were nearly unchanged.

The dollar actually fell in value by about 10:1 during that decade. It took only $35 to buy an ounce of gold in 1970. In the 1980s and 1990s, it took more like $350. However, this decline became invisible to a lot of people. The dollar/euro rate affects everybody, but the dollar/gold rate directly affects almost nobody.

It was no longer so obvious that inflation was being caused by a "falling dollar." When it took more dollars to buy things, most people did not figure out that the dollar -- and the deutschemark, franc, pound, and yen -- were simply losing value. On November 19, 1973, Newsweek magazine proclaimed on its cover that the world was "Running Out of Everything."

Either that, or those horrible Arabs! It's true, there were some oil disruptions during the decade. Many people still blame these for the inflation of the time. None of these people has an explanation of why, years after the crises had passed, oil prices didn't fall back to their 1960s levels around $2.50 a barrel.

A few people saw the way that currencies were losing value compared to gold, the timeless standard of value, and understood instinctively where the inflation was coming from. The government economists, however, didn't see it that way. They couldn't quite figure it out, but they were pretty sure that they didn't want to add to the growing problems with a restrictive monetary policy. The Fed remained "accommodative," until finally the crisis reached a point that Paul Volcker gained a political mandate to do something about it.

If there is a difference between those times and today, it must certainly be the amazing deterioration of financial conditions around the world. This is matched by a consensus on what to do about it: central bank policy rates that are low, low, low. The big yield curve inversions of the 1970s aren't coming back right away. Barring some unexpected twist -- the Chinese pegging the yuan to gold for example -- it looks likely that currencies will all go down together, as they did in the 1970s.

The only place to hide would be in physical things: cattle, corn, steel, and eventually property.

For the 1980 presidential elections, Ronald Reagan actually recorded a television advertisement that promised a return to the gold standard. The departure from gold in 1971 led to the first major episode of inflation in U.S. history. Wasn't it obvious? The ad didn't run. He was talked out of it.

Soon, politicians will have another chance. I think the next gold standard will appear in a place that nobody expects, like Moldova, Morocco or Vietnam. Home mortgages denominated in gold have been available in Vietnam for some time, and apparently some shopkeepers there are already adjusting retail prices according to gold exchange rates. They are, in effect, already on a sort of underground gold standard. Not everybody in this world is quite so benighted as our friends at the United States Federal Reserve.

Regards,

Nathan Lewis
for The Daily Reckoning Australia

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