Second Thoughts On Stimulus


Second thoughts. After the first initial optimism that “doing something” was better than “doing nothing,” you get the sense a lot of people are having second thoughts. Are recessions really caused by a fall in aggregate demand? Or is the previous credit boom that leads to bad investments that makes recessions inevitable?

The answer to that would matter quite a bit, especially if you were about to commit billions of dollars in money borrowed from the future to test your theory. Isn’t that just high-stakes, high-brow gambling? Have our legislators become speculators? Or are they just providing further evidence that they are morons?

Over in the States, stocks fell. The Geithner plan-or TARP II as it’s imaginatively named-is facing second thoughts of its own. The banks will get more capital. But no one can figure out how to handle the toxic assets. The big idea is still setting up an “aggregator bank” to act as dumping ground/rehab clinic for the distressed and non-performing loans that securitise so many bank assets.

And in Australia? Warwick McKibbin told the Senate yesterday that, in his personal view, the stimulus is just too darn big. “Australia is very well placed to withstand the shock which is currently emanating from the world economy,” he said, according to Bloomberg. “This suggests that the scale of the Australian response should be less than the world average.”

“The current package is too large at this stage of the global economic slowdown. Given the circumstances in Australia, the package should be less than the 2 percent of GDP average stimulus recommended by the International Monetary Fund. Australia does not yet have a domestic financial crisis, but it does face a substantial reduction in exports and substantial decline in the wealth of its citizens. The first job for this package should be to help restore confidence.”

If only it were a crisis of confidence. The crisis is not what people think about the solvency of the financial sector. The crisis is in the virtual insolvency of many large banks. No amount of cheerleading will change a balance sheet, and changed perceptions do not change the reality.

Or, as economist Dr. Roger Garrison writes in a chapter on the Austrian theory of the business cycle, “The loss of confidence comes from the realisation that the economy is overextended, asset values cannot be supported, and decisions about how to allocate capital have been based on a false cost of capital and the false level of demand it ‘stimulated.’

You don’t fix any of that with new stimulus.

“The core problem for investors is financial instability,” reckons Ashok Shah, the chief investment officer at UK asset managers London & Capital. “If you look at the IMF numbers [forecasting a total $2.2 trillion loss on US bad debts], we are only halfway through the non-performing loan cycle.”

“Governments are supplying liquidity into the system and unless they sterilize it [by issuing bonds to soak up the excess money creation] they are laying the foundations for much higher inflation for years to come. These are the things gold thrives on,” he told Reuters.

Of course gold fell over $20 in New York, but his point is well taken.

And this gives us a chance to make a point we’ve neglected to make it our previous statements about gold: it is the common law version of money. People ask all the time what inherent quality gold has that makes it a superior medium of exchange to salt, pepper, oxen, or bubble gum.

Gold has at least four physical qualities which make it suitable as money. It’s durable, it’s divisible, it’s convenient, and it’s consistent, not to mention hard to counterfeit. Bars, bullion, coins, even goldsmiths notes…throughout history you could be pretty sure people were going to accept a quantity of gold in exchange for some good or service.

And that’s really the best reason to explain gold’s historic popularity as a medium of exchange. People have accepted it as such. That makes gold, in our view, a kind of common law money. If people traditionally view gold as money, maybe there’s something to it. Maybe this whole fractional reserve paper money experiment is an historical aberration in the history of money.

So for the record, yes; there are certain physical properties of gold that make it especially useful as money. And it’s worth nothing people have used it as such for thousands of years. It’s not that there’s any higher mystical principle behind the yellow metal as a medium of exchange. It’s just that it’s what people have accepted as money for a long time. This acceptance is noteworthy if you’re somewhat philosophical. It’s a voluntary exchange without coercion. In a perfect world, that’s the way you draw it up.

But as we’ve said before, money is not wealth. Neither is gold. You have to trade it for something useful. And it’s better if you receive it for what you produce and then invest in it capital goods, rather than hoard it or worse, squander it. Just ask the Spanish and the Portuguese.

“The mines of Brazil were the ruin of Portugal, as the mines of Mexico and Peru had been the ruin of Spain,” wrote Henri Martin in his History of France to 1789. Martin shows that although Spain and Portugal brought home untold amounts of precious metals from the New World (a polite way of saying they raped, robbed, and pillaged the indigenous people in South America), they merely consumed the money rather turning it into real, lasting, productive wealth.

In Portugal, “all manufactures fell into insane contempt; ere long the English supplied the Portuguese not only with clothes, but with all merchandise, all commodities, to salt, fish, and grain. After their gold, the degenerate sons of the Albuquerques and Gamas abandoned even their soil: they very vineyards of Oporto were finally bought by the English with Brazilian gold, which had only passed through Portugal to be dissipated in England.”

It is very easy for the people of a nation to mistake money for wealth, or even commodities for wealth. But any useful theory of wealth would probably focus, at least in the material world, on the production of capital goods, and not, say, the consumption of consumer goods. There is no inherent value in anything. It’s what you produce and how useful others find and what they’re willing to exchange for it that determines value.

The Spanish had tons of gold, but they imported salt and fish and textiles from England. In fact, the huge increase in precious metals flowing to Europe sparked a great inflation in British land prices. This inflation, coupled with a quirk in how land was leased in the country-side, allowed nearly all the gains from rising land values to go to the new British merchant class, rather than the crown, the clergy, or the gentry.

What’s more, gold and silver metal migrated to British and Dutch merchants as these two countries manufactured and traded with the bullion rich Portuguese and French. It was one of the first Money Migrations, a giant wealth transfer from bullion-rich consumers to producers of real goods. It’s no coincidence that shortly thereafter, the Dutch first and then later the British developed more sophisticated capital markets with which they allocated accumulated savings into risk-taking capital investments.

But that is a totally different story than the one we set out to tell today. We wanted to spend some time talking about the Austrians call the “production possibilities frontier” and how it is determined by an economy’s capital allocation and real resource limits. Oh well! It will have to wait until tomorrow.

In the meantime, keep this in mind: at least the Portuguese and Spaniards had real money on their hands! Yet they merely consumed it, exchanging it for manufactured French, British, and Dutch goods, and not building any capital assets of their own (or in the Spanish case, building a naval war machine that would run into trouble of the British coast in 1588).

The moral of today’s story: Woe to the modern economy that treats paper as wealth and fails to save or invest. We may think we have money on our hands. But paper is not metal and credit is not a substitute for saving. If things keep going the way they’re going, you may have to trade a lot of paper to get anything of substance.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.


  1. Dan, my Brazilian girlfriend says you have nailed it. And as a reward she shares this with your readers:

    men are like grapes, you need to step on them, keep them in the dark, until they become wine and they are good company for dinner.


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