The Commodities Bubble, Stocks, Gold, and Money.

The debate now is when to raise rates to prevent inflation. The debate later will be why monetary policy is failing society.

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In my view at this time, gold is a bubble financed by low interest rates. The narrative in the financial press is that gold is a hedge against future inflation. But I am pretty sure that gold is being pumped up by the same forces pumping up equity markets. Super high leverage from low rates has pumped more money into the system--but it does not "print money" as the common metaphor (again, see the Schiff/Ron Paul post) has said. The Federal Reserve and all other monetary incentive to invest policies only create the option to create money out of thin air. It is NOT a guaranteed event. Let's run through a scenario.

Let's just say we have 1 billion dollars in a a hedge fund. The hedge fund borrows 9 billion more at a 1% rate. It now takes 10 billion and attempts to invest its money at a profit. To clear things up, why does it want to borrow money if it has 1 billion already? The short answer is so that it can magnify profits. A 1 billion dollar investment with an 8% annual return nets 80 million, a 10 billion investment at the same rate of return is 800 million. The gains are magnified--but so too are potential losses. But the interest rate in question plays a huge role in monetary policy, because if the initial borrowing rate is 7% then the return on our hedge fund investment is the difference between 8% and 7%. A 1% rate of return.

So given the nature of our current monetarist regime, the one that has ruled the economy since the late 1970s, the missing link in the money printing and inflation discussion is that money only gets printed when it gets borrowed and invested. And right now, money is being borrowed and invested. The S&P is up 50% or so since March 2009. However, this money is being made on money in the same way that houses were mysteriously worth twice as much in 3 years during the housing bubble. Given the extra push and incentives on profitability (low rates, combined with the government buying up assets that the private sector couldn't sell except for at a major loss), it's understandable that a herd of investment is being plowed into anything that can be bought and sold for a profit. And that's where you get the money printing business coming into the discussion. The money gets printed when it gets borrowed and magnified into circulation. Monetarists use the following metrics to break down the money supply: M0, M1, M2, and M3. If the hedge fund $1 billion puts that billion into the stock market then the aggregate value will go up by whatever buying impact that $1 billion has on the market. If the fund pumps $10 billion in, then the demand impact goes up by ten times as much, and the value of the market will reflect that as well.

The take home lesson here is that ALL inflationary scenarios are built on the investor class taking the low interest rate bait and plowing it into the markets. They are most likely highly leveraged bets which makes me instinctively feel that once the losses start, it will be a very rapid decline because of the magnification of losses on the way down--and the subsequent lack of incentives and "risk aversion" (fear) will pull private investment out of the market.

For more on this, and some extra history, see my prior post.