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Does the Fed Create Money?

By Michael Pento, 23 November, 2010

Certain deflationists have recently gone on record saying that the increase in the Fed’s balance sheet is meaningless with regard to creating inflation because our central bank can’t print money, it can only create bank reserves. The problem with their view is that it both disregards the definition of money and ignores the process of creating bank reserves.

Money is commonly defined as “a medium that can be exchanged for goods and services and is used as a measure of their values on the market, including among its forms a commodity such as gold, an officially issued coin or note, or a deposit in a checking account or other readily liquefiable account.” The Fed creates a “readily liquefiable account” when creating excess bank reserves, so it is also creating money. Since inflation is properly defined as an increase in the money supply, the Fed unquestionably creates both money and inflation when it creates reserves.

The deflationists’ error is to suppose that because the amount of currency has not grown, the money supply hasn’t grown. But the Fed never creates currency – all the printing is handled by Treasury; instead, it creates bank deposits which are held at the Fed. In ignoring this “base money,” the deflationists make no distinction between having the Fed’s balance sheet at $800 billion or $3 trillion. Doing so is a huge mistake for both making investment decisions and predicting asset price levels.

In short, for deflationists to be correct, they must contend that only money which is currently in circulation can be considered inflationary, i.e. lead to rising prices. Therefore, they must also believe that all increases in demand and time deposits should not be included in the money supply and should not be considered inflationary. This isn’t just wrong, it’s grossly wrong.

Not only do the Fed’s monetary additions increase the money supply, but the effect can be vastly multiplied through the fractional reserve system.

Also, the process of creating bank reserves always first involves the purchase of an asset by the central bank. The Fed issues electronic credits to banks in exchange for bank assets, including Treasuries. Its purchases drive up the demand for those assets, bringing about rising prices. In fact, Bernanke has clearly stated that the purpose of his “quantitative easing” program is to raise the rate of inflation, which in his mind is too low.

What the Fed is accomplishing is a reduction in the purchasing power of the US dollar. It creates inflation by vastly increasing the money supply, and thus lowers the confidence of those holding the greenback. If international confidence in the dollar is shaken, most dollar-based asset prices will increase – with the exception of US debt.

Deflationists also ignore the rise in prices that is occurring because of the potential insolvency of the US government. It is not dissimilar to what happened to Enron shares. Once the accounting scandal broke, the purchasing power of Enron shares plummeted. It was not because of an increase in the number of shares outstanding, but because of an epiphany on the part of investors that the company was totally bankrupt. Logically, shares representing a stake in a doomed company lost all of their value. Likewise, aggregate prices will soar if global investors lose confidence in the dollar due to the realization that the US is incapable of servicing its debt.

Whatever the deflationists may claim about the money supply, the objective indicators are not looking good for Uncle Sam. The dollar’s decline is abundantly evident when compared to gold, commodity prices, other currencies, real estate, and the list goes on. The national debt now stands at over $13.7 trillion, some 94% of GDP. Either due to an insolvent currency backed by a bankrupt nation or because of the Federal Reserve’s endless money printing, I have no doubt that the deflationists have it completely wrong.

This article is written by Michael Pento of Europac and with their kind permission, O B Research has been privileged to publish their work on our website. To find out more about Europac, please visit:

Should You Buy SLV the Silver ETF?

By Peter Degraaf, Tuesday Nov 23, 2010

Charts presented in this report are courtesy Stockcharts.com.

Featured is the daily bar chart for SLV. Price has risen for five days, but volume has not yet supported the rise. This lack of volume could be because more and more people are becoming aware of the fact that JPMorgan (one of the bullion banks that is short a large amount of silver), is a custodian of SLV. As people begin to distrust the integrity (justified or not) of SLV, they could very well make a decision to avoid buying into SLV. This would show up in a slow-down in volume, even as price rises to keep up with silver bullion. The RSI and MACD are positive in this chart and a breakout at the blue arrow along with an increase in volume will be bullish for SLV and will indicate that there are still enough people interested in SLV to keep it rising. Confirmation of the theory that people are beginning to distrust SLV would first show up in a comparative performance with other, similar silver investments, where other investments outperform SLV. Some of these are shown below.

Featured is the index that compares the SLV to the Horizon silver ETF that trades on the TSX. Clearly the HZU has outperformed the SLV over the past few months.

Likewise the comparison between SLV and AGQ the silver ETF with double leverage shows AGQ to be the better performer (the double leverage has something to with this outperforming, but not to this extent).

Featured is the index that compares SLV to the Sprott silver trust. Obviously we do not have a lot of data to go with, but the short-term trend appears to favor PSLV.

The conclusion we draw from the above charts is that regardless of whether traders and investors believe in the integrity of SLV the silver ETF, there are competitive investments in the same sector that are outperforming SLV. The ‘proof is in the pudding’, as can be seen in the next chart.

Featured is the index that compares SLV to silver bullion. Although the descent is slow, it nevertheless shows SLV to be losing ground to silver itself.

In summary, and despite the fact that other investment vehicles are outperforming SLV, in the event that price breaks out at the blue arrow in the SLV chart above, on increased volume, then those who own shares in SLV will continue to profit, but those who invest in the alternatives can expect to do even better, and without having to worry about the JPMorgan influence at SLV. As most of you know, JPMorgan has at least 14 law suits pending against it for illegally manipulating the silver price. This bank is still carrying a very large large ‘short silver’ position on its books.

Disclaimer Please do your own due diligence. Investing involves taking risks. I am NOT responsible for your investment decisions. Peter Degraaf is an online stock trader with over 50 years of investing experience. He produces a weekend report as well as a daily update for his many subscribers. 

This article is written by Peter Degraaf and with his kind permission, O B Research has been privileged to publish his work on our website. To find out more about his work, please visit: http://www.pdegraaf.com/

Otago: Valley Thrives Under Eagle’s Gaze

An Otago tourist attraction is an intriguing mix of art and artefacts, says Jim Eagles.

A massive hokioi at the Oceana Gold Heritage and Art Park watches over a range of historic gold-mining relics. Photo / Jim Eagles

The ferocious figure of a giant eagle stands poised on the ridgeline, huge talons ready to strike, piercing eyes fixed firmly on the valley floor, known as Macraes Flat.

What could it be looking for? The giant moa once eaten by this monster – the Haast’s eagle, known to Maori as hokioi or pouakai, the largest eagle that ever existed – have long gone and the paradise ducks on the trout pond nearby would hardly make a mouthful.

Gold, perhaps? Miners have been extracting gold from this area of East Otago since 1862, first panning for alluvial gold, next crushing it from quartz, then dredging it from the waterways and these days extracting it from vast quantities of schist rock dug out of the ground.

But, no, it turns out the mighty hokioi is looking for tourists. Not to eat, luckily, but to fill the economic gap which will be left when the Macraes Flat gold mine eventually closes (possibly about 2020).

Twelve years ago, when New Zealand’s largest gold mining company, OceanaGold, sought to expand its operation at Macraes, one of the main concerns to emerge from community consultation was what would be left behind when all the gold was gone.

The creation of a visitor attraction, aimed at helping the development of a local tourist industry, became one of the consent requirements.

The result, the OceanaGold Heritage and Art Park, is an unusual mix of historic gold-mining relics, works of art such as the hokioi, an artificial wetland and trout hatchery and the massive mining operation itself.

The park is still taking shape but already a few thousand people a year are making the trip to East Otago, about 1.5 hours’ drive out of Dunedin, to take a two-hour $30 tour.

The tour begins at the little settlement of Macraes, once a mining boom town with four hotels but today a peaceful place with just one hostelry, Stanley’s Hotel, opened in 1882 – supposedly built by a stonemason who was paid in ale, which explains why some of the walls are at funny angles.

There is also the old billiard salon (now the tour information office), a bootmaker’s shop, a church and the Macraes Moonlight School (roll 14).

But the story really begins further down the road at Deepdell Creek, where in 1862 a prospector called James Crombie first found gold and sparked the initial gold rush.

The Golden Point Historic Reserve, on the banks of the creek, is a haven of tranquillity with just the mine manager’s house, a couple of crumbling mud-brick cottages, an abandoned tunnel and some discarded mining machinery. However the Callery brothers’ stamper battery across the creek – which is “still in working order”, says Graham Wilson, who is showing us round – provides a solid reminder that not so long ago this peaceful valley would have been a noisy place.

The vast, modern-day mining operation conducted by Oceana sends a message that making a gold omelette requires breaking a lot of eggs.

Monster trucks rumble round a network of rough gravel roads – 24 hours a day, seven days a week, 365 days a year – carrying massive loads of schist to a processing plant from a series of enormous pits (the biggest will be 1.5km by 3km and 250m deep) and an equally enormous 28km-long network of tunnels.

There the rock is pulverised, heated and treated with assorted deadly chemicals to remove the gold – about a teaspoonful in every 190-tonne truckload – before being cleaned up and trucked away again.

There’s a strange fascination in watching this dangerous and destructive process.

Yet, in many ways, the most remarkable aspect of the whole business is the way in which, at the end of the blasting and pulverising, the countryside is put back together again.

Some of the pulverised rock is being used to fill in older pits – though the largest will eventually be turned into a huge lake – and the rest is being shaped back into the typical domed hills of East Otago.

“There are very strict rules for the reconstruction of the landscape,” says Wilson.

“For instance, that hill there” – he indicates a mound nearby – “is too smooth so we’re going to have to roughen it up and add a few rocks before we’ve finished.

And you see that patch of green there?” – he points to an area on the other side of a pit that is slowly being filled in – “That’s where we tried out a new kind of grass we thought would do better in these conditions but it’s turned out to be too green.”

Amid this recreated landscape the planned tourist attraction is being developed.

In one valley a boardwalk has been built through a wetland so visitors can enjoy the birdlife.

Near the entrance to the processing plant is a trout hatchery, where up to 20,000 fish a year are being raised by mine staff in a partnership with Otago Fish and Game.

Under the supervision of artist John Reynolds, the summit of one of the rebuilt hills has been moulded into a kowhaiwhai shape and planted with 15,000 golden spaniards – spiky plants that, as I can testify, are not to be trifled with – but which combine to give the giant spiral a lovely golden colour.

Rather less successful is Reynolds’ planting of thousands of snow tussock in a grid pattern, next to the Macraes cemetery, where the old miners were buried, creating what is said to be the largest artwork in the country.

Personally I’d find it hard to disagree with the local art critic who left a toilet in the middle of the pattern.

Inside the nearby former Catholic church, artist Jason Hoon Lee has installed light boxes featuring photos of clouds taken in the area.

On a valley floor just over the hill from the main mine pit, media artist Gavin Hipkins has erected a series of billboard pictures – which I found quite intriguing – designed to lead the eye to one of the waste rock stacks soaring in the background.

According to Wilson, the Tui Brewery folk were invited to put up one of their billboards here, saying something like, “This is a work of art … yeah, right!” but the suggestion was declined because there wouldn’t be sufficient traffic. Pity.

But the highlight for me is the 9m-high stainless steel hokioi created by sculptor Mark Hill, which stands on top of the waste rock stack.

Because of my name – Eagles – I’ve always had a particular interest in the giant eagle which was once top of the food chain in this country.

It’s a particularly appropriate choice for East Otago, because bones and nest sites found in these hills suggest that centuries ago hokioi were once common.

What’s more, the great eagle has the air of a guardian, keeping a watchful eye on Oceania Gold to make sure the company lives up to its undertakings to continue restoring the landscape to its former rocky rolling beauty, and to decorate it with more works of art.

Further information: You can find out more about the Macraes Flat tours at oceanagoldtours.com or phone 0800 465 386. Bookings are essential because the information office is not permanently manned.

Jim Eagles visited Macraes Flat as guest of Oceana Gold.


Bernanke Is Making the Crisis Worse

By Bud Conrad, Chief Economist, Casey Research

The Fed is a corrupt and powerful institution, and Chairman Bernanke is making the global crisis worse. His new speech given last week in Europe was terribly misguided and will upset markets as the Chinese and Germans won’t ignore his challenges. Bernanke’s interpretations of the markets have been wrong since before he was appointed to head the Fed, and his actions are doing nothing but aggravating the situation.

In this seminal speech, titled “Rebalancing the Global Recovery,” Bernanke not only defended QE II as the right policy, but also attacked the monetary policy of China, the biggest holder of U.S. debt, an action that must be understood for how misdirected it is.

Here are a few excerpts from the speech:

On our “tepid” recovery

    In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years.
    Indeed, although I expect that growth will pick up and unemployment will decline somewhat next year, we cannot rule out the possibility that unemployment might rise further in the near term, creating added risks for the recovery.

On China

    The strategy of currency undervaluation has demonstrated important drawbacks, both for the world system and for the countries using that strategy.

    … For large, systemically important countries with persistent current account surpluses, the pursuit of export-led growth [i.e., China and its strategy] cannot ultimately succeed if the implications of that strategy for global growth and stability are not taken into account.

On defending QEII as the right policy

    Following up on this earlier success, the Committee [i.e., the Federal Open Market Committee] announced this month that it would purchase additional Treasury securities. In taking that action, the Committee seeks to support the economic recovery, promote a faster pace of job creation, and reduce the risk of a further decline in inflation that would prove damaging to the recovery.

    Fully aware of the important role that the dollar plays in the international monetary and financial system, the Committee believes that the best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar, as well as to support the global recovery, is through policies that lead to a resumption of robust growth in a context of price stability in the United States.

Mike Shedlock of Mish’s Global Economic Trend Analysis provides some sensible criticisms of Bernanke’s speech. Shedlock’s conclusion: “If Bernanke was trying to spook the markets, provoke China, cause a currency war, and get Congress to launch an extremely foolish set of tariffs, he would have been hard pressed to deliver a more powerful speech.”

[Click here for a commentary by Greg Robb from MarketWatch on the implications of Bernanke’s criticism of China.]

The basic problem with QE 2 is that printing electronic money does nothing to improve the unemployment situation. Purchasing $600 B of government debt delays the government from having to make tough decisions about its $1.5 trillion deficits for six months and coincidentally gets us from the $13.7 trillion of gross government debt to the legislated debt ceiling of $14.3 trillion that the Republicans are willing to fight over not increasing. Studies show that this kind of policy has little effect on the growth of the economy but hurts the currency.

The bottom line is this: The imbalances that the Fed is forcing on China’s central bank are difficult for them to absorb. They will lose money if they value the yuan higher, because they hold so many Treasuries, which are denominated in dollars. The difference in interest rates is also complex, but part of the reason that China is not in a position to jump to our request to increase the value of the yuan rapidly. They pay higher interest on the yuan they issue in trade for dollars, so they are not happy with receiving the close-to-zero interest on U.S. Treasuries. We should be careful how we handle our relationship with the biggest holder of our debt (as shown below).

Bernanke will achieve some terrible goals here, including escalating the currency wars and destroying the dollar even more. If his policies are moved forward, he can confirm his experiment of proving that printing money will destroy its value. Doing it so personally and aggressively will bring responses much larger than he understands from other countries, and our government is on a path of dollar destruction that will work.

Deflation is a bogus bogeyman used by central bankers to hide behind in implementing policies of money printing. We are destroying our relationships around the planet. It is also a one-way path, as there is no return (or “exit,” as the Fed watchers use the term). Once confidence is lost in our policies, this will escalate out of control. I fear this is the start of that one-way street to eventual hyperinflation. It will still take years, but I think the first steps are already taken.

[Read more about Bud’s big-picture view of the economic situation and implications of what he’s calling the “financial wars” in the next edition of The Casey Report. If you want to learn of the inevitable fallout of these financial wars and how they will affect your investments, try it risk-free for 3 full months, with money-back guarantee. Details here.]

Band-Aid Solutions

By Puru Saxena, November 19

BIG PICTURE – Lets face it, governments always try to ‘kick the can down the road’.  Rather than deal with economic issues in the here and now, they prefer to postpone the pain.  Unfortunately, in their attempt to avoid painful economic recessions, the policymakers sacrifice the purchasing power of their currencies and they end up creating even bigger troubles for the future.  

Look.  The ‘Great Recession’ in the developed world was brought about by excessive debt and consumption. In the boom years, millions of Americans borrowed copious amounts of money to buy real-estate; they used their homes as a source of funding (home equity withdrawals) and spent way beyond their means.  In those heady days, everyone was convinced that real-estate prices could not decline on a country wide basis.  Unsurprisingly, the bankers gladly supported this misconception by providing cheap fuel to the raging speculative fire.  The end result was that unworthy debtors were able to purchase several properties and real-estate prices appreciated considerably. 

Unfortunately, when interest-rates went up and credit became scarce, the house of cards collapsed.  When boom turned to bust, millions of American homeowners were left with negative equity (Figure 1) and the entire banking system came to its knees.  When that happened, the American policymakers embarked on a fear-mongering campaign and they misled the public into believing that it was essential to save the banks.  During the depth of the financial crisis, we were repeatedly told that the ‘too big to fail’ banks had to be saved, or else the consequences would be dire.

After the establishment succeeded in its scare tactics, it unleashed its ‘stimulus’ and used tax payers’ money to bail out the insolvent financial institutions.  In the name of national interest, the Federal Reserve created trillions of dollars out of thin air and it purchased toxic mortgage-backed-securities from the commercial banks.  Furthermore, instead of marking down the value of these securities, the American central bank bought the dubious assets at face value!  Thus, the American taxpayers bailed out the banks and the risk was transferred from the private-sector to the state.

In addition to nationalising the bank’s losses, the Federal Reserve dropped the short term interest rate to near-zero and it started buying US Treasury securities.  Supposedly, these Band-Aid solutions were necessary to prevent an economic depression and somehow they would revive the world’s largest economy. 

By dropping the Fed Funds Rate to almost zero, the American central bank hoped to achieve the following benefits:

a. Reduce the borrowing cost of the banks (so they paid next to nothing for deposits)
b. Stimulate private-sector credit growth

In hindsight, the Federal Reserve succeeded in lowering the banks’ borrowing cost but it failed in reviving private-sector credit growth.  After all, American households were already leveraged to the hilt and they refused to go even deeper in debt.

In our view, these drastic policy measures were unnecessary and they failed to get to the root of the problem – too much debt.  Instead of nationalising the banks’ losses by using tax payers’ money, the American government should have restructured debt in an orderly manner.  Insolvent institutions should have been allowed to fail, bondholders should have received a hair cut on their bad loans, and the total outstanding debt should have been reduced.  If anything, in order to help the masses, the American establishment should have guaranteed all the bank deposits and taken steps to assist the distressed homeowners.

Instead, the American policymakers focused on helping the banks, and in the process, they increased the public’s debt burden!  Furthermore, by transferring private sector risk on to the public’s balance-sheet, the American establishment has seriously undermined the quality of the nation’s balance-sheet. 

It is noteworthy that over the past decade, America’s federal debt has more than doubled! Today, it stands at US$13.64 trillion and has morphed to 93.5% of GDP!  The fact that this surge in debt has produced pathetic economic growth and done very little to bring down unemployment, is proof that Keynesianism does not work. 

Unfortunately, the American establishment has not learnt from past mistakes and it continues to follow disastrous economic policies.

By now, it should be clear to everyone that the first round of quantitative easing failed to stimulate the world’s largest economy.  So, if the initial ‘stimulus’ did not work, what are the odds that additional quantitative easing will do the trick? 

The truth is that quantitative easing has never worked and this time around, the end result will be no different.  In fact, we are prepared to bet our bottom dollar that quantitative easing will fail miserably in reviving economic growth in America.  To make matters worse, if the Federal Reserve continues to create money like there is no tomorrow, the stage will be set for an inflationary holocaust.

As an investor, it is crucial for you to understand that although monetary inflation causes asset prices to rise in nominal terms, it does not impact them uniformly.  For instance, when inflationary expectations are low and confidence in the government is high, monetary inflation benefits financial assets (stocks and bonds).  Conversely, when inflationary fears are elevated and investors have lost faith in the government, monetary inflation tends to benefit hard assets (precious metals, energy and soft commodities). 

Figure 2 captures this inverse correlation between financial assets and gold.  As you can see, between 1980 and 2000, monetary inflation benefited the Dow Jones Industrial Average (Dow) and during that period, gold performed poorly.  However, since the turn of the millennium, monetary inflation has benefited hard assets and American stocks have underperformed relative to gold.  At present, the Dow to gold ratio is at 8.4 and if history is any guide, over the following years, gold should continue to appreciate more than American stocks.

In our view, the ongoing bull market in hard assets will carry on for as long as the Federal Reserve and its counterparts continue to engage in quantitative easing.  Now, it is conceivable that over the following months, several central banks in the developed world will announce further stimulus and this should turbo charge the commodities boom. 

It is our contention that as long as the bond vigilantes are asleep at the wheel, the ‘risk trade’ will continue to flourish.  However, no boom lasts forever and at some point, when the bond vigilantes get spooked, sharply higher interest rates will end up killing the commodities bull.  When that happens is anybody’s guess, but we suspect that the good times will continue for another 2-3 years.

Despite the fact that quantitative easing will not succeed in the developed nations, we remain optimistic about hard assets and continue to favour the stock markets of the developing economies in Asia.

This article is written by Puru Saxena and with his kind permission, O B Research has been privileged to publish his work on our website. To find out more about his work, please visit: