Not Even Harry Browne Thought It Was Going To Be This Bad

[MediumTex]

Obviously I'm never going to convince you that my position is not based on political considerations.

It would be easier to believe you if you could provide maybe a single shred of evidence that your decision is based on some kind of impending threat to our economy.

But, all you've done is told us that, as an Austrian, you don't like US monetary policy — which is just a political statement that has no bearing on the real economy or actual inflation. Having a big government that spends money — no matter how distasteful — does not automatically result in an impending monetary collapse.

If things are so dire for our future, why not at least explain what you think the risk is?

As far as I know, I'm not obligated to explain anything to you, and given your attitude that you know more about me than I do, I see no incentive to do so.

I've read Gumby's posts for a long time and he can sometimes be a bit short, but IMHO he always wants to engage in a fair discussion.

What you seem to be saying is that there are good reasons to tilt one's investments toward an inflationary future, but your reasons do seem to be tied to a belief that a certain type of government meddling in the economy and monetary system will always lead to inflationary outcomes that culminate in currency collapse.  The problem with this position, however, is that it doesn't provide a very good explanation for the incredible economic growth that occurred in the 20th century with governments all over the world endlessly meddling in their economies, and with relatively few currency collapses occurring among productive economies that were not involved in a war.

I think what you are being asked is how you would respond to the following question: "Hey Libertarian666, I really like your take on things and I would like to understand your investment philosophy better.  Can you give me an overview of what you believe and your rationale for those beliefs?"

Please don't feel defensive.  I'm just interested in picking your brain a little.

[Libertarian666]

It would be easier to believe you if you could provide maybe a single shred of evidence that your decision is based on some kind of impending threat to our economy.

But, all you've done is told us that, as an Austrian, you don't like US monetary policy — which is just a political statement that has no bearing on the real economy or actual inflation. Having a big government that spends money — no matter how distasteful — does not automatically result in an impending monetary collapse.

If things are so dire for our future, why not at least explain what you think the risk is?

As far as I know, I'm not obligated to explain anything to you, and given your attitude that you know more about me than I do, I see no incentive to do so.

I've read Gumby's posts for a long time and he can sometimes be a bit short, but IMHO he always wants to engage in a fair discussion.

What you seem to be saying is that there are good reasons to tilt one's investments toward an inflationary future, but your reasons do seem to be tied to a belief that a certain type of government meddling in the economy and monetary system will always lead to inflationary outcomes that culminate in currency collapse.  The problem with this position, however, is that it doesn't provide a very good explanation for the incredible economic growth that occurred in the 20th century with governments all over the world endlessly meddling in their economies, and with relatively few currency collapses occurring among productive economies that were not involved in a war.

I think what you are being asked is how you would respond to the following question: "Hey Libertarian666, I really like your take on things and I would like to understand your investment philosophy better.  Can you give me an overview of what you believe and your rationale for those beliefs?"

Please don't feel defensive.  I'm just interested in picking your brain a little.

Ok. I believe that we are approaching a phase-change, after which very little will look as it does now. My reasons for this include the following facts:

1. The historically unprecedented case of a peacetime US economy with gigantic deficits being covered by money printing by the Federal Reserve.
2. The ever-increasing intrusiveness of the US government's demands for detailed information on any possible assets that its subjects might have that aren't immediately seizable at its whim.
3. The attempts of all major currency blocs worldwide to devalue their currencies to gain an advantage for trade purposes.
4. The increasing militarization of the US police forces and federal agencies.
5. The revelations that the US is spying on everyone all the time to the maximum amount imaginable.

My analysis, based on these facts, is that the current "powers that be" will not give up their power until they can no longer enforce their will. The only event I can foresee that could cause them to lose that ability is currency collapse, which given the competing devaluation would have dire consequences for paper assets in the major currencies.

If that's political, so be it.

[MediumTex]

Ok. I believe that we are approaching a phase-change, after which very little will look as it does now. My reasons for this include the following facts:

1. The historically unprecedented case of a peacetime US economy with gigantic deficits being covered by money printing by the Federal Reserve.
2. The ever-increasing intrusiveness of the US government's demands for detailed information on any possible assets that its subjects might have that aren't immediately seizable at its whim.
3. The attempts of all major currency blocs worldwide to devalue their currencies to gain an advantage for trade purposes.
4. The increasing militarization of the US police forces and federal agencies.
5. The revelations that the US is spying on everyone all the time to the maximum amount imaginable.

My analysis, based on these facts, is that the current "powers that be" will not give up their power until they can no longer enforce their will. The only event I can foresee that could cause them to lose that ability is currency collapse, which given the competing devaluation would have dire consequences for paper assets in the major currencies.

If that's political, so be it.

Thanks for articulating it in that way.  I know that's just a quick summary.

You may be right about all of those things.  The arguments for that future are not unreasonable.  Happily, I think that the PP would probably hold up fine under those conditions, which is all a PPer ought to really care about.

[Gumby]

1. The historically unprecedented case of a peacetime US economy with gigantic deficits being covered by money printing by the Federal Reserve.

So, this is a common misunderstanding. The Federal Reserve does not (currently) fund our government spending.

The truth is that permanent open market operations merely change the composition of outstanding private sector assets and serve no role in helping to fund the US government.  It’s true that the government could use the Fed to fund the US Treasury’s spending, but that would involve a full blown rejection of bonds by the Primary Dealers.  In other words, the only time the Fed would be required to purchase bonds in a funding short-fall is in the case where the Primary Dealers reject their mandate to purchase bonds and the Fed must fill the void.

Source: http://pragcap.com/understanding-quantitative-easing

The purpose of the fear mongering over the term “monetization”? is to imply that the Fed is funding the US government.  The term is used with an intended negative connotation that implies some sort of solvency constraint, as if the government couldn’t fund itself without this back stop which would result in us looking more like Greece with yields surging and on the brink of bankruptcy.  This is just patently wrong and those fear mongering over “debt monetization”? have seen their scary inflationary or default scenarios fall flat in recent years.  In other words, they’ve been wrong because they’ve misinterpreted what the Fed is doing.

In the end, this debate is rather simple and has already been won by those of us who predicted the market reactions in real-time.  If the Fed were needed to fund the US government then the fear mongers would have all been right when QE2 ended and yields would have surged because there would not have been enough demand for US government debt.

Source: http://pragcap.com/read-of-the-day-the- ... ut-the-fed

(I routinely quote Cullen Roche because he does the best job of anyone spelling out these myths in plain English. And by understanding this, he correctly predicted what would happen when QE2 ended.)

The Fed doesn't conduct helicopter drops and the Fed does not fund out government — those are myths.

Your other points are valid though. While nothing is perfect, Harry Browne designed the Permanent Portfolio in order to protect investors from those risks.

[happyspec]

I don't like anything that I consider subject to great risk at the hands of obvious lunatics such as the Federal Reserve. That eliminates all US-based securities.

I for my part consider the Austrian economcic Theory - especially von Mises and Rothbard - as the work of the most enlightening economists of the last century. But when it comes to investment I'm not willing to follow the mainstream of Austrian economics. In a nutshell this would mean avoiding Treasuries in all cases and investing primarily in gold and perhaps in udervalued stocks. I often hear "Austrians" talk about the bright outlook for gold etc. because the Fed is a gigantic Ponzi scheme. This is true as economic analysis but as an investor I'm primarily a risk manager who depends on the time he is living in and I have to deal with the reality of the fiat money world. So if the crowd flocks to Treasuries in the times of crisis and deflation why shouldn't we profit from this? We have got to be flexible - and the Permanent Portfolio allows us to do just this without losing course in the sharky waters of the investment world.

[Pointedstick]

I don't like anything that I consider subject to great risk at the hands of obvious lunatics such as the Federal Reserve. That eliminates all US-based securities.

I for my part consider the Austrian economcic Theory - especially von Mises and Rothbard - as the work of the most enlightening economists of the last century. But when it comes to investment I'm not willing to follow the mainstream of Austrian economics. In a nutshell this would mean avoiding Treasuries in all cases and investing primarily in gold and perhaps in udervalued stocks. I often hear "Austrians" talk about the bright outlook for gold etc. because the Fed is a gigantic Ponzi scheme. This is true as economic analysis but as an investor I'm primarily a risk manager who depends on the time he is living in and I have to deal with the reality of the fiat money world. So if the crowd flocks to Treasuries in the times of crisis and deflation why shouldn't we profit from this? We have got to be flexible - and the Permanent Portfolio allows us to do just this without losing course in the sharky waters of the investment world.

Oh so well said.

[glennds]

The truth is that permanent open market operations merely change the composition of outstanding private sector assets and serve no role in helping to fund the US government.  It’s true that the government could use the Fed to fund the US Treasury’s spending, but that would involve a full blown rejection of bonds by the Primary Dealers.  In other words, the only time the Fed would be required to purchase bonds in a funding short-fall is in the case where the Primary Dealers reject their mandate to purchase bonds and the Fed must fill the void.

Source: http://pragcap.com/understanding-quantitative-easing

A couple of multi-part questions if I may:

1. Do you believe that the Primary Dealers could make a market for Treasury Bonds at current yields, without the Fed's intervention? If yes, then please explain why you think that. Also, if the answer is yes, then what is the purpose of the Fed's purchases? If the yields would need to increase materially to make a market among non-Fed participants, do you feel it would place any particular strain on our Federal Government to service the higher cost of debt?

2. Do you believe the monetary base has increased materially over the past few years if excess reserves in the banking system are included in the calculation? If yes, then what might the effect be if those excess reserves were deployed into the economy through lending and investing activities?

Disclaimer: These are not intended to be sarcastic, rhetorical, or critical questions. I'm genuinely interested in further my understanding of what is happening around us.

Thanks

[systemskeptic]

If one's asset allocation is a reflection of one's knowledge and beliefs in the market, it is probably not surprising that anyone advocating the permanent portfolio (e.g. 50% in USG bonds) also believes that USG bonds have low default / interest rate risk.

One concerning observation I have about some posts in this thread is that the level of confidence in future performance seems quite high and the assigned probability of negative events quite low -- that is perhaps [fundamentally] a very dangerous sign in investing.

[MediumTex]

If one's asset allocation is a reflection of one's knowledge and beliefs in the market, it is probably not surprising that anyone advocating the permanent portfolio (e.g. 50% in USG bonds) also believes that USG bonds have low default / interest rate risk.

One concerning observation I have about some posts in this thread is that the level of confidence in future performance seems quite high and the assigned probability of negative events quite low -- that is perhaps [fundamentally] a very dangerous sign in investing.

There is zero default risk with treasuries.  There is significant interest rate risk.

The confidence in future performance arises from the belief that the PP covers the full spectrum of possible future economic environments. 

I am confident that tomorrow it will rain or it will not rain.  I am confident in this prediction not because I can predict the future, but because I believe that my prediction covers all possible future conditions and thus isn't really a prediction at all (at least as I see it).

[systemskeptic]

There is zero default risk with treasuries. 

The confidence in future performance arises from the belief that the PP covers the full spectrum of possible future economic environments. 

I believe that my prediction covers all possible future conditions and thus isn't really a prediction at all

I think these three statements together sum up my observations, all three are extremely dangerous beliefs IMHO.

[Gumby]

A couple of multi-part questions if I may:

By all means! We are all here to learn from each other.

1. Do you believe that the Primary Dealers could make a market for Treasury Bonds at current yields, without the Fed's intervention? If yes, then please explain why you think that.

Obviously Fed intervention is necessary in certain situations, such as a credit crisis. But all that happens is that the Fed procures overnight loans, a repo, or an swap assets with Primary Dealers if they need a little help. It's not like the Fed is doing helicopter drops.

So, to answer your question, yes. Primary Dealers are required to make a market for Treasury Bonds and they should have no trouble doing so. When things go smoothly, the money to buy Government Bonds is always available in the private sector, thanks to previous government spending swelling reserves. This may seem hard to believe, but the money to buy Government Bonds generally comes from previous government spending (mind blowing, I know) as well as private credit that must be redistributed in the private sector in order for the private sector to remain solvent on all it's private credit to itself.

It works something like this...

The Fed and Treasury are working in tandem with the Primary Dealers. As mentioned, part of the agreement in becoming a Primary Dealer is to make a market in treasuries:

“The primary dealers serve, first and foremost, as trading counterparties of the Federal Reserve Bank of New York (The New York Fed) in its implementation of monetary policy. This role includes the obligations to: (i) participate consistently as counterparty to the New York Fed in its execution of open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii) provide the New York Fed’s trading desk with market information and analysis helpful in the formulation and implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.”? [Source]

Therefore it is misleading to imply that the auctions might fail due to a lack of demand or some sort of funding failure. The Primary Dealers are required to make a market in government bonds. None of this means auctions can’t fail or that the US government couldn’t choose to default.  It could. But that would be political folly and misunderstanding.  Not due to a lack of funding.

This “symbiotic relationship”? can be best seen in a recent US government 10-year bond auction.  This auction occurred just weeks after QE2 ended and just before the debt-ceiling debacle occurred in July 2011 so one would have expected this to be a very unstable auction.  Many prominent market pundits said the government might not be able to find buyers of the bonds.  In fact, it was business as usual.  As you can see below, the US government was able to auction off $21B in 10-year notes with the Primary Dealers tendering more than 2X the entire auction.  Indirect bidders tendered almost half the auction, but were not needed at all to accomplish the total sales.  The bid to cover at 3.1 was extremely strong.

[align=center][/align]

For emphasis, it’s important to understand how deficit spending occurs in this regard.  Remember, government bond sales do not create the final means of payment or result in “money printing”?.  Bond sales procure funds in the form of existing inside money and redistribute it to other economic agents.  For simplicity, let’s take a simple example where Peter buys a bond via Treasury Direct.  Peter will send the government his inside money (which was created by a private sector loan) and the government will issue Peter a government bond in exchange.  The government will then redistribute Peter’s inside money to Paul who will then deposit it at a private bank.  As you can see, the government simply redistributes money when it spends.  Taxation is obviously even simpler as taxation is a pure redistribution of money without the bond sale.  As previously mentioned, the Treasury technically settles funds in its reserve account at the Fed, but this should not confuse us on the actual flow of funds that occurs within the system.

The key distinction here is that deficit spending results in the creation of a net financial asset.  That is, unlike private loan issuance, which creates both a private sector liability AND asset, government deficit spending results in no corresponding private sector liability and only a private sector asset (the government bond).

Lastly, this understanding of “inside”? and “outside”? monies exposes an important difference between the government’s balance sheet and that of private sector entities.  There is no operational funding constraint for the issuer of the currency.  There is a constraint to the extent that private sector entities can borrow and spend, however.  So the key takeaway here is that the government balance sheet is not like a household’s or a state’s balance sheet. The US government, as an issuer of currency can never be said to be “running out of money”?.

The constraint for a currency issuer in a fiat system like the USA is never solvency, but rather inflation or real constraints (such as real resources or the output of the economy).  One role of the government is to help influence the money supply and supply of financial assets so that it does not impose hardship on the private sector.  The goal is always to maximize living standards of the monetary system’s users in accordance with public purpose.  While growth and living standards are ultimately a byproduct of the private sector’s ability to produce and innovate, the people can utilize government and its many tools to influence the composition and quantity of the currency and financial assets.  It does so via managing monetary and fiscal policy in an effort to maintain a balance between the public’s desire for net financial assets and private credit.

Source: http://pragcap.com/understanding-the-mo ... m-part-3-2

Also, if the answer is yes, then what is the purpose of the Fed's purchases?

Remember, the Fed does not directly purchase bonds from the Treasury. The Fed does not have the authority to do that (though, interestingly, Japan's BOJ does have that authority to buy government bonds directly from their Treasury. And it all works perfectly fine.). So, the Treasury auctions generally serve two purposes. First they act as a reserve drain (banks don't want excess reserves) and they allow the Fed to target interest rates. The auctions don't really "fund" the government when you really think about it.

If the yields would need to increase materially to make a market among non-Fed participants, do you feel it would place any particular strain on our Federal Government to service the higher cost of debt?

Nope. To paraphrase Cullen's quote, above: There is never a solvency constraint for a fiat currency issuer, such as the United States — only inflationary constraints or real constraints (resources our output of the economy).

2. Do you believe the monetary base has increased materially over the past few years if excess reserves in the banking system are included in the calculation?

I assume you mean the broad money supply. Because just looking at the monetary base and excess reserves isn't really that helpful. Excess reserves are regularly converted into Treasury Bonds (both are a private sector asset). So, reserves rise and fall with spending and auction issuance (remember, T-Bond auctions act as reserve drains). The broader money supply has certainly increased. But, keep in mind it was done to offset a huge private credit hole.

The overwhelming majority of our money supply is private credit — to the tune of roughly $57 trillion. This seems obscene at first glance, but it makes more sense when you realize that all money (except coins) comes from either public or private debt. That's where money comes from. We live in a debt-based fiat world.

So, in reality, government spending is a pretty small in comparison to private credit and the increase in recent government spending was simply done to take the place of the private credit that was either lost or wasn't being issued during the credit crisis. Whether that was a good thing or not is certainly up for debate (I'm not arguing for or against it) but the reality is that you have to look at total private credit in conjunction with government spending.

If yes, then what might the effect be if those excess reserves were deployed into the economy through lending and investing activities?

I'm sure someone else (moda, pointedstick or others) can answer that better than I can.

Disclaimer: These are not intended to be sarcastic, rhetorical, or critical questions. I'm genuinely interested in further my understanding of what is happening around us.

Absolutely! Btw, what we are discussing is known as Monetary Realism ("MR" for short). MR simply describes how our debt-based fiat monetary system operates (i.e. no underlying political agenda). Conservatives, independents and liberals alike can all use MR to understand the operational side of our monetary system. Cullen Roche keeps a paper that he regularly refines and updates with help from those who are also trying to make sense of it all...

See: http://pragcap.com/resources/understand ... ary-system

Cullen also takes regular questions on his blog as well. Hope that helps!

[MediumTex]

There is zero default risk with treasuries. 

The confidence in future performance arises from the belief that the PP covers the full spectrum of possible future economic environments. 

I believe that my prediction covers all possible future conditions and thus isn't really a prediction at all

I think these three statements together sum up my observations, all three are extremely dangerous beliefs IMHO.

Can you elaborate on why you think they are dangerous?

Is there an economic condition that the PP doesn't cover?

How would a fiat currency issuer default on debt denominated in its own currency, other than purely by choice (which would be an incredibly stupid and pointless thing to do)?

To me, a fiat issuer defaulting on debt denominated in its own currency would be akin to a fortune teller turning away customers because she "ran out of fortunes to tell."

[D1984]

The confidence in future performance arises from the belief that the PP covers the full spectrum of possible future economic environments.

Can you elaborate on why you think they are dangerous? Is there an economic condition that the PP doesn't cover?

An environment of stagnation, deflation, and a rising currency (think Japan from 1990-2011) will kill the PP because LTTs can only fall so far in yield so long as physical currency still exists and creates the problem of the zero lower bound (long story short: long-term rates are a function of short-term rates plus a risk/term premium for inflation and/or potential expected rate rises in the future; as short-term rates fall and stay low, long-term rates will follow to some extent BUT since short-term rates can never go much below zero for any appreciable length of time--because everyone would just hold physical cash rather than take, say, negative 4% on a Treasury bill, Treasury note, or MM fund--LTT rates have a "floor" below which they can never fall further; said floor seems to be between 1% and 2%....I'm not sure LTTs could ever fall to zero or anywhere near it because why would someone take 0% on an LTT when STTs are paying 0% as well?); since this is the case, LTTs cannot rise in value fast enough and far enough to offset a truly devastating and long-term deflationary bear market like Japan's during its two lost decades. Of course, one could possibly mitigate this by holding some of the 25% quity portion of the PP as world stocks (and not just your own country's) so if your country experiences a long-term period of deflationary stagnation and balance-sheet recession then you're not totally screwed....but HB for some reason recommended against that and most people here seem to generally hew pretty closely to what he recommended.

Also, the PP has never really been "torture-tested" in an environment of rising LT bond yields from the still fairly low point they are at now, falling gold prices, a secular bull market, and interest rates positive above inflation (or at least interest rates gradually beginning to rise to that level). Never from 1968 to the present have we had all of the above conditions at once. We did probably have something similar from roughly the early 50s to 1967 but gold was price-controlled (and illegal for private citizens to own to boot) so a 4x25 PP during that period would not have suffered as badly as it would have had gold did what it typically does (which is drop like a rock) during periods of above-inflation real interest rates, prosperity, and a bull stock market.

The closest thing we've really had to "rates rising/bonds falling/stocks rising/gold falling" has pretty much been the last 15-18 months or so and we all know how that tirned out for the PP (not so hot). If this is a mini-taste of what we'de get in an enviroment of higher rates, falling bonds, falling gold, and rising stocks that streches out for years (or even for a decade or more) then the "oh-so-safe" PP (and those who hold it) are in for a bitter surprise in the future.

[moda0306]

To the question of whether reserves lent out into the market could be harmful... A couple things, and this is from a phone so be patient with my lack of detail.

Thinking that banks will lend reserves plies that banks are reserve constrained.  They really aren't.  There's some absolutely mind-blowing MR work on this.

Also, for rampant new investment to occur, demand or expected demand would have to fill up current capacity much more fully or a new housing boom. I really can't see either happening.

That's all I can say for now.  Just too cramped for time.

[Libertarian666]

So now Reuters is part of the great conspiracy to make us think that the Fed creates money out of nothing to buy bonds! Is nothing sacred?

"To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds. "

from http://www.reuters.com/article/2012/09/ ... CT20120913

[MediumTex]

D1984,

Why would rates be rising if there was no inflation, as evidenced by gold falling?

What would be driving the rise in interest rates if inflation was very low?

In the scenario you describe, why wouldn't rising rates in t-bills and rising stocks protect you from overall portfolio declines?

[Gumby]

So now Reuters is part of the great conspiracy to make us think that the Fed creates money out of nothing to buy bonds! Is nothing sacred?

"To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds. "

from http://www.reuters.com/article/2012/09/ ... CT20120913

Yes, the Fed created money out of thin air to perform a swap with the private sector. The private sector is no richer or poorer after the transaction is complete. And Austrians everywhere faint from the thought of it all — despite the fact that its not much different than swapping four quarters for a dollar.

[Libertarian666]

So now Reuters is part of the great conspiracy to make us think that the Fed creates money out of nothing to buy bonds! Is nothing sacred?

"To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds. "

from http://www.reuters.com/article/2012/09/ ... CT20120913

Yes, they make money out of thin air to perform a swap with the private sector. The private sector is no richer or poorer after the transaction is complete. And Austrians everywhere faint from the thought of it all — despite the fact that its no different than swapping four quarters for a dollar.

This is completely wrong. The bonds that the Fed buys STILL EXIST, whereas the money they create out of nothing adds to the total of nominal assets in the economy. So the total amount of nominal assets in the economy is increased by the amount they print.

Let's bring this down to earth. Let's say you have 4 quarters. I print an additional dollar bill out of thin air and give it to you for your 4 quarters. Now instead of you having 4 quarters, you have a dollar bill AND I have 4 quarters.

Come on. This isn't rocket surgery.

[moda0306]

So now Reuters is part of the great conspiracy to make us think that the Fed creates money out of nothing to buy bonds! Is nothing sacred?

"To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds. "

from http://www.reuters.com/article/2012/09/ ... CT20120913

Yes, they make money out of thin air to perform a swap with the private sector. The private sector is no richer or poorer after the transaction is complete. And Austrians everywhere faint from the thought of it all — despite the fact that its no different than swapping four quarters for a dollar.

This is completely wrong. The bonds that the Fed buys STILL EXIST, whereas the money they create out of nothing adds to the total of nominal assets in the economy. So the total amount of nominal assets in the economy is increased by the amount they print.

Let's bring this down to earth. Let's say you have 4 quarters. I print an additional dollar bill out of thin air and give it to you for your 4 quarters. Now instead of you having 4 quarters, you have a dollar bill AND I have 4 quarters.

Come on. This isn't rocket surgery.

This is actually completely wrong.  The fed is part of the government.  The bonds only exist on the fed balance sheet, which they only would end up trading back to the private sector if they so chose.  They are pulled from the private sector.

[Gumby]

The bonds that the Fed buys STILL EXIST, whereas the money they create out of nothing adds to the total of nominal assets in the economy. So the total amount of nominal assets in the economy is increased by the amount they print.

Nope. The bond that the Fed buys is no longer part of the private sector. It can't possibly affect anyone's spending power once the Fed purchases it. For all practical purposes, the bond is buried in a hole and any profited interest payments are returned to the Treasury. And if anything, the private sector potentially has less money after the swap because the private sector doesn't receive the interest payments.

Let's bring this down to earth. Let's say you have 4 quarters. I print an additional dollar bill out of thin air and give it to you for your 4 quarters. Now instead of you having 4 quarters, you have a dollar bill AND I have 4 quarters.

Come on. This isn't rocket surgery.

Sorry, but you're not making any sense. If you give me 4 quarters for a freshly printed dollar bill, you (the Fed) keep the dollar bill on your balance sheet and I (the private sector) keep the 4 quarters. I am no richer or poorer after the transaction.

[Gumby]

Libertarian666,

The mechanics of these benign Feds swaps  — which do not make the private sector any richer or poorer — are explained here:

http://pragcap.com/mechanics-qe-transaction

The media and Austrians come along and try to make us believe this is highly inflationary, but it's no more inflationary than your bank moving your money from your Savings account to your Checking account. It's not a helicopter drop by any means.

[Pointedstick]

Libertarian666, imagine that the Fed prints money, buys my bond, and then deletes the bond. Now I have the capital value of my bond in dollars. I am no richer or poorer. The fed is also no richer or poorer since they deleted the bond. So when the Fed prints money to remove financial assets from the private sector, they are essentially deleting them because they are removed from circulation in the economy.

Does that make any more sense?

[Libertarian666]

The bonds that the Fed buys STILL EXIST, whereas the money they create out of nothing adds to the total of nominal assets in the economy. So the total amount of nominal assets in the economy is increased by the amount they print.

Nope. The bond that the Fed buys is no longer part of the private sector. It can't possibly affect anyone's spending power once the Fed purchases it. For all practical purposes, the bond is buried in a hole and any profited interest payments are returned to the Treasury. And if anything, the private sector potentially has less money after the swap because the private sector doesn't receive the interest payments.

Let's bring this down to earth. Let's say you have 4 quarters. I print an additional dollar bill out of thin air and give it to you for your 4 quarters. Now instead of you having 4 quarters, you have a dollar bill AND I have 4 quarters.

Come on. This isn't rocket surgery.

Sorry, but you're not making any sense. If you give me 4 quarters for a freshly printed dollar bill, you (the Fed) keep the dollar bill on your balance sheet and I (the private sector) keep the 4 quarters. I am no richer or poorer after the transaction.

Please try to read what I wrote. I didn't say YOU were richer or poorer, but that there is more money in existence.
But here's the complete version:

1. You have an uncle who likes to spend more than he earns.
2. He asks you to lend him 4 quarters.
3. You lend him the 4 quarters, and he gives you an IOU.
4. You sell the IOU to me for a freshly printed dollar bill.
5. Your uncle spends the four quarters to buy ammo.

What is the result of all this? Yes, you have the same amount of money as before and I have the IOU, which I am keeping and not circulating.
But we are forgetting something: that the people that your uncle bought the ammo from have an additional $1 that never existed before I printed it. Thus, the total amount of money in circulation has been increased by $1.

Hope that helps.

[Pointedstick]

Here's a more accurate example:

1. You have an eccentric uncle who happens to be a very good counterfeiter.
2. You own a bond worth $1,000.
3. He asks to buy the bond from you.
4. You oblige; he prints $1,000 and takes your bond.
5. He burns the bond.
6. The $1,000 is such a good counterfeit that nobody ever notices. You proceed to use it to buy things; maybe even a new bond!

If your uncle sold the bond and used that money to buy ammo, then yes, you're right. But he doesn't. He always destroys the bonds that you sell him. What a weird guy.

[D1984]

D1984,

Why would rates be rising if there was no inflation, as evidenced by gold falling?

MT,

Rates can rise significantly (and be positive in real terms) even if there is little or very little inflation. From 1952-1967, inflation averaged about 1.5% a year (I chose 1952 as the starting point because it was after the burst of inflation in late 1950 through mid-1951 that was associated with the Korean War; I chose 1967 as the endpoint because 1967 was the last year gold wasn't free-market priced)...even if you look at the whole 1950 to 1968 period you still get inflation of around only 2% on average per year (which is still lower than what we have had from 2000 to 2012, much less 1982 to 2012 or 1982 to 2000). Despite the low inflation during the period from the early 50s to 1967-68, short term rates rose from about one percent a year to around six percent a year and long-term rates rose from approximately 2.5% a year (early 1950s) to around 5.6% a year by late 1967 and close to 6% a year by the end of 1968. So, during this period, both LTT and STT rates were both: A. rising, and B. generally above the rate of inflation. Needless to say, positive (and rising) real rates are not good for gold, inflation or no inflation. Gold responds mostly to whether real rates are positive (or trending positive) or negative, not to inflation per se. Just look at what the HINT that the Fed MIGHT stop QE and/or and start raising rates by PERHAPS a percent or so (even though it indicated that even if it did this it might do this almost a year and a half in the future i.e. towards the end of 2014) has done to gold over the past few months.

What would be driving the rise in interest rates if inflation was very low?

Possibly rising demand for money and for loans, improving economic performance, and a Fed that would began tightening again ("taking away the punch bowl just as the party was getting started" ) to avoid the economy overheating and inflationary expectations setting in. Why do you think rates rose from the early 50s to the late 60s despite the fact that inflation was low (on average between 1 and 2 percent) during those times?

In the scenario you describe, why wouldn't rising rates in t-bills and rising stocks protect you from overall portfolio declines?

Rising stocks alone probably can't offset both bonds AND gold if they both fall at once; from 1982 to the final blow-off top of the stock bubble in mid-2000 rising stocks could easily offset falling gold only because they also had the "tailwind" of rising bonds brought on by falling rates and the greatest bond bull market in history....when/if gold starts falling again as rates rise, LT bonds will be of no use and may actually be WORSE than cash as they get killed by rising rates (also bear in mind that a LT at,say, 3% has both a lot more room to fall PLUS less of a cushion in the form of coupon payments than one at say, 5%, 6%, 7%, or 8% does...LT bonds were already in the 5-8% range during the 1968 to 1972 period--which is when when most people's PP backtests start--so they miss the first part of the bond bear from around 1950 to 1967 when LT bonds started from less than 3% which is also about where they are today).

As for T-bills and MM funds...well, they simply lack the upside volatility to offset two "volatile assets" (a volatile asset is something like gold, stocks, or LTTs that can fall 30 or 40% a year but can also rise by mid double-digits or more) falling at once. They are the 90-pound weakling of the PP's four asset classes. Even if rates were to rise to where Volcker took them in 1981, cash would only provide about a 19% or 20% return per year (and God help the PP if interest rates rise that high with anything resembling any deliberate speed from their current levels...although FWIW I don't believe--barring serious double digit inflation--they'll get anywhere near that). If rates only rise to about 4% or 6% when inflation is at maybe 2% to 4% then that probably won't be exactly positive for gold; what we very well could end up with then is gold falling due to positive real rates, bonds falling due to rates being on an overall rising trend, and even if stocks are rising like they did from 1921-late 1929, 1950-68, or 1982-99 (which I find somewhat unlikely in and of itself...I think that from current PE/10 levels they can still rise but not by anywhere near the way they did during those years) the combination of rising stocks and rising cash (or rather better interest rate returns on cash since it doesn't really "rise" or "fall" like the other three assets) won't be nearly enough to offset falls in gold and in LTTs.

Oh, and that's not even considering that many people's STT portion is not in T-bills but in one to five year Treasuries...what do you think a rise of 3-year Treasury rates from their current level to around, say, 5% over the next few years would do to the capital value of that STT?