Beware the Money Illusion Coming to Destroy Your Wealth

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A money illusion sounds like something a prestidigitator performs by pulling $100 bills from a hat shown to be empty moments before. In fact, money illusion is a longstanding concept in economics that has enormous significance for you if you�re a saver, investor or entrepreneur.

Money illusion is a trick, but it is not one performed on stage. It is a ruse performed by central banks that can distort the economy and destroy your wealth.

�that people prefer a raise over a pay cut while ignoring inflation is the essence of money illusion.

The money illusion is a tendency of individuals to confuse real and nominal prices. It boils down to the fact that people ignore inflation when deciding if they are better off. Examples are everywhere.

Assume you are a building engineer working for a property management company making $100,000 per year. You get a 2% raise, so now you are making $102,000 per year. Most people would say they are better off after the raise. But if inflation is 3%, the $102,000 salary is worth only $98,940 in purchasing power relative to where you started.

You got a $2,000 raise in nominal terms but you suffered a $1,060 pay cut in real terms. Most people would say you�re better off because of the raise, but you�re actually worse off because you�ve lost purchasing power. The difference between your perception and reality is money illusion.

The impact of money illusion is not limited to wages and prices. It can apply to any cash flow including dividends and interest. It can apply to the asset prices of stocks and bonds. Any nominal increase has to be adjusted for inflation in order to see past the money illusion.

The concept of money illusion as a subject of economic study and policy is not new. Irving Fisher, one of the most famous economists of the 20th century, wrote a book called The Money Illusion in 1928. The idea of money illusion can be traced back to Richard Cantillon�sEssay on Economic Theory of 1730, although Cantillon did not use that exact phrase.

Economists argue that money illusion does not exist. Instead, they say, you make decisions based upon �rational expectations.� That means once you perceive inflation or expect it in future, you will discount the value of your money and invest or spend it according to its expected intrinsic value.

In effect, inflation is a hidden tax used to transfer wealth from savers to debtors�

Like much of modern economics, this view works better in the classroom than in the real world. Experiments by behaviorists show that people think a 2% cut in wages with no change in the price level is �unfair.� Meanwhile, they think a 2% raise with 4% inflation is �fair.�

In fact, the two outcomes are economically identical in terms of purchasing power. The fact, however, that people prefer a raise over a pay cut while ignoring inflation is the essence of money illusion.

The importance of money illusion goes far beyond academics and social science experiments. Central bankers use money illusion to transfer wealth from you � a saver and investor � to debtors. They do this when the economy isn�t growing because there�s too much debt. Central bankers try to use inflation to reduce the real value of the debt to give debtors some relief in the hope that they might spend more and help the economy get moving again.

Of course, this form of relief comes at the expense of savers and investors like you who see the value of your assets decline. Again a simple example makes the point.

Assume a debtor bought a $250,000 home in 2007 with a $50,000 down payment and a $200,000 mortgage with a low teaser rate. Today, the home is worth $190,000, a 24% decline in value, but the mortgage is still $200,000 because the teaser rate did not provide for amortization.

This homeowner is �underwater� � the value of his home is worth less than the mortgage he�s paying � and he�s slashed his spending in response. In this scenario, assume there is another individual, a saver, with no mortgage and $100,000 in the bank who receives no interest under the Fed�s zero interest rate policy.

Suppose a politician came along who proposed that the government confiscate $15,000 from the saver to be handed to the debtor to pay down his mortgage. Now the saver has only $85,000 in the bank, but the debtor has a $190,000 house with a $185,000 mortgage, bringing the debtor�s home above water and a giving him a brighter outlook.

The saver is worse off and the debtor is better off, each because of the $15,000 transfer payment. Americans would consider this kind of confiscation to be grossly unfair, and the politician would be run out of town on a rail.

Now assume the same scenario, except this time, the Federal Reserve engineers 3% inflation for five years, for a total of 15% inflation. The saver still has $100,000 in the bank, but it is worth only $85,000 in purchasing power due to inflation.

- Source, Jim Rickards via Daily Reckoning

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Financial War and Currency Wars Are Very Different

I have discussed financial war, which is different from currency war. Currency war is an economic policy countries use to fight deflation and encourage inflation by cheapening the currency and creating inflation in the form of higher import prices. It�s a way of creating monetary easing. It�s an age-old economic policy, used most famously in the late 1920�s and 1930�s in what became known as �beggar they neighbor.� Countries were stealing growth from each other by debasing their currencies, trying to import inflation and improve their trade balances by causing cheaper exports to foreign buyers and more expensive imports for domestic buyers. That combination was seen to bolster growth.

Financial war is different. Financial war involves countries that are traditional rivals or even enemies, for instance the US, Russia, and China, with competing interests everywhere from Eastern Europe to the South China Sea. Countries have fought wars in the past using traditional kinetic methods � armies, navies, air forces, missiles, submarines and so forth. We now live in an age where, thinking about warfare, you have to look at asymmetric forms of warfare � not just traditional forms � like chemical, biological, radiological weapons, guerilla warfare, terrorism, and financial warfare. So the scenario I was discussing that involves China buying gold and selling the dollar was not a currency war; it was a financial war. There you are trying to destroy the economy of your opponent, which is a very different situation.

- Source, Jim Rickards via Proactive Investor

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Jim Rickards on Oil Shocks And The Global Economy.

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The World is in a Depression and There is No Getting Out

We are in a depression. This is a global depression. It started in 2007 and it is going to continue indefinitely. Depressions are structural, monetary solutions are cyclical: you cannot solve a structural problem with a cyclical remedy - monetary policy will not work. What it could do eventually is cause inflation. So far people say: �Where is the inflation?...We printed trillions of dollars, there is no inflation�. That is because we would have had deflation, extreme deflation, but for the money printing. It did produce inflation to the extent that it offset the deflation� The world is in depression, we are not getting out of it.

- Source, Jim Rickards via RT

Chinese Growth is Set to Slowdown Further

I have been going for Chinese growth to get to 3 or 4%. I would say that China`s growth is already at 4%. I know they print 7.5%. But about half of the GDP they produce is wasted. So if I build a $5 billion train station in a small town that is $5 billion of GDP- this money is completely wasted because 10 people getting on the train are not going to pay for a $5 billion station. So you go around China with these ghost cities we have talked about before... So it is generating GDP, but it is completely wasted. If you adjusted the published GDP figures for the amount of waste, their actual growth is probably already roughly 4%. That is going to go lower.

- Source, Jim Rickards via RT

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Even as the unemployment rate drops, foreclosures dwindle, and the economy slowly recovers from the Great Recession, financial insecurity is on the rise in American urban areas according to a study conducted by the Corporation for Enterprise Development. Nearly half of all households in major cities don�t have enough money saved to cover essential expenses in an emergency. Erin weighs in.

Then, Erin sits down with Warren Mosler, president of Valance Incorporated, to discuss the many issues surrounding the US economy, the Fed, and employment. Of particular note are Mosler�s views on the recent price cut in Saudi crude prices and the negative impact it could have on production of shale oil in tight oil formations in the US.

After the break, Erin talks to frequent Boom Bust guest Jim Rickards to get a hold on currency wars � specifically regarding the Euro. He argues that the currency wars wax and wane but they are always there. Right now the currency wars are back in the spotlight.

And in The Big Deal, Erin and Edward Harrison discuss Alibaba�s record-breaking IPO. Do big IPOs outperform the market? No, they underperform if you look at the historical record.

- Source, Russia Today

Six Major Flaws in the Fed�s Economic Model

The U.S. dollar is the dominant global reserve currency. All markets, including stocks, bonds, commodities, and foreign exchange are affected by the value of the dollar.

The value of the dollar, in effect, its �price� is determined by interest rates. When the Federal Reserve manipulates interest rates, it is manipulating, and therefore distorting, every market in the world.

The Fed may have some legitimate role as an emergency lender of last resort and as a force to use liquidity to maintain price stability. But, the lender of last resort function has morphed into an all-purpose bailout facility, and the liquidity function has morphed into massive manipulation of interest rates.

The original sin with regard to Fed powers was the Humphrey-Hawkins Full Employment Act of 1978 signed by President Carter. This created the �dual mandate� which allowed the Fed to consider employment as well as price stability in setting policy. The dual mandate allows the Fed to manage the U.S. jobs market and, by extension, the economy as a whole, instead of confining itself to straightforward liquidity operations.

Janet Yellen, the Fed chairwoman, is a strong advocate of the dual mandate and has emphasized employment targets in the setting of Fed policy. Through the dual mandate and her embrace of it, and using the dollar�s unique role as leverage, she is a de facto central planner for the world.

Like all central planners, she will fail. Yellen�s greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that do not correspond to reality. This approach is highlighted in two Yellen speeches. In June 2012 she described her �optimal control� model and in April 2013 she described her model of �communications policy.�

The theory of optimal control says that conventional monetary rules, such as the Taylor Rule or a commodity price standard, should be abandoned in current conditions in favor of a policy that will keep rates lower, longer than otherwise. Yellen favors use of communications policy to let individuals and markets know the Fed�s intentions under optimal control.

The idea is that over time, individuals will �get the message� and begin to make borrowing, investment and spending decisions based on the promise of lower rates. This will then lead to increased aggregate demand, higher employment and stronger economic growth. At that point, the Fed can begin to withdraw policy support in order to prevent an outbreak of inflation.

The flaws in Yellen�s models are numerous. Here are a few:


1) Under Yellen�s own model, saying she will keep rates �lower, longer� is designed to improve the economy sooner than alternative policies. But if the economy improves sooner under her policy, she will raise rates sooner. So, the entire approach is a lie. Somehow people are supposed to play along with Yellen�s low rate promise even though they intuitively understand that if things get better the promise will be rescinded. This produces confusion.

2) People are not automatons who mindlessly do what Yellen wants. In the face of the embedded contradictions of Yellen�s model, people prefer to hoard cash, stay on the sidelines and not get suckered by the bait-and-switch promise of optimal control theory. The resulting lack of investment and consumption is what is really hurting the economy. Economists call this �regime uncertainty� and it was a leading cause of the length, if not the origin, of the Great Depression of 1929-1941.

3) In order to make money under the Fed�s zero interest rate policy, banks are engaging in hidden off-balance sheet transactions, including asset swaps, which substantially increase systemic risk. In an asset swap, a bank with weak collateral will �swap� that for good collateral with an institutional investor in a transaction that will be reversed at some point. The bank then takes the good collateral and uses it for margin in another swap with another bank. In effect, a two-party deal has been turned into a three-party deal with greater risk and credit exposure all around.

4) Yellen�s zero interest rate policy constitutes massive theft from savers. Applying a normalized interest rate of about 2% to the entire savings pool in the U.S. banking system compared to the actual rate of zero, reveals a $400 billion per year wealth transfer from savers to the banks from the zero rates. This has continued for five years, so the cumulative subsidy to the banking system at the expense of everyday Americans is now over $2 trillion. This hurts investment, penalizes savers and forces retirees into inappropriate risk investments such as the stock market. Yellen supports this bank subsidy and theft from savers.

5) The Fed is now insolvent. By buying highly volatile long-term Treasury notes instead of safe short-term treasury bills, the Fed has wiped out its capital on a mark-to-market basis. Of course, the Fed carries these notes on its balance sheet �at cost� and does not mark to market, but if they did they would be broke. This fact will be more difficult to hide as interest rates are allowed to rise. The insolvency of the Fed will become a major political issue in the years ahead and may necessitate a financial bail-out of the Fed by taxpayers. Yellen is a leading advocate of the policies that have resulted in the Fed�s insolvency.

6) Market participants and policymakers rely on market prices to make decisions about economic policy. What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation, then you rely on the �price� to guide your policy going forward. This is the blind leading the blind.

The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run. But once you change the psychology, it is extremely difficult to change it back again.

If the Fed succeeds in raising inflationary expectations, those expectations may quickly get out of control as they did in the 1970�s. This means that instead of inflation leveling off at 3%, inflation may quickly jump to 7% or higher. The Fed believes they can dial-down the thermostat if this happens, but they will discover that the psychology is not easy to reverse and inflation will run out of control.

The solution is for Congress to repeal the dual mandate and return the Fed to its original purpose as lender of last resort and short-term liquidity provider. Central planning failed for Stalin and Mao Zedong and it will fail for Janet Yellen too.

Regards,

Jim Rickards
for The Daily Reckoning

Rickards: Stock market reality check

by James Rickards

Listening to mainstream market commentary on television and reading the financial press leaves one with the impression that the economic recovery is gaining strength and that stock market indices, at or near all-time highs, will go higher still.

The litany of market happy talk is impressive. The unemployment rate has dropped to 6.1%, down about 4 percentage points from its peak, and is expected to go lower in the months ahead. The economy created about 230,000 jobs per month in the first half of 2014, which brings the increase in jobs to nine million since the economic recovery began in mid-2009. Interest rates remain low, which supports high asset valuations in stocks and housing. Inflation is tame and expectations about future inflation are well anchored. To hear the stock market bulls tell the story, all is right with the world.

But all is not right. In fact, the fundamentals of the U.S. economy are in awful condition and are getting worse. Almost everything about the happy talk story is superficial, and falls apart under scrutiny. There is an alternative narrative of bad news that is seldom discussed on mainstream business channels but is well known to analysts. When these adverse trends are taken into account one conclusion in inescapable. The stock market and economic fundamentals are on a collision course. One or the other will have to swerve. Either the economy will have to improve rapidly and unexpectedly and reverse its fundamental weakness, or inflated stock values are heading for a precipitous fall. The evidence suggests that the latter is more likely.

The first weak link in the happy talk chain is the nature of job creation. For example, it was reported than 288,000 jobs were created in June. But full-time jobs declined by 523,000 while part time jobs increased by about 800,000. The widely reported increase in net jobs masked a disastrous loss of full-time jobs offset by a huge increase in part-time jobs. The part-time jobs offer fewer hours, lower pay and few benefits. They may be better than no job at all, but they are not the kind of jobs that will support discretionary consumer spending on which the economy relies for growth.

This trend in part-time jobs is not new. There are 7.5 million people working part-time on an involuntary basis compared to about 4.4 million doing so in 2007. This rise in part-time jobs is expected to continue because it is driven in part by Obamacare, which does not require coverage for part-time workers. Employers are aware of this and simply cut full-time jobs and replace them with part-timers to reduce insurance costs.

Nor is there any comfort in the declining unemployment rate. Much of the decline is attributable not to job creation but rather to the decline in the number of people looking for work. Once people stop looking for a job, they are no longer technically �unemployed� and the unemployment rate drops even though no job has been found. As columnist Mort Zuckerman said, �You might as well say that the unemployment rate would be zero if everyone stopped looking for work.� Only 62.8% of Americans participate in the work force today � the lowest level since 1978.

The news gets worse. Not only is labor force participation low, and full-time employment collapsing, but the productivity of those working is now in decline. This decline in productivity is another drag on growth. The reason for it is even more disturbing. Productivity is declining because capital expenditure has slowed. Businesses are keeping up with demand by employing part-time workers instead of investing in the plant and equipment needed to make full-time workers more productive.

Not surprisingly, this triple-whammy of declining full-time jobs, declining productivity and slowing capital investment means that real wages are stagnant. If workers can�t make more, they can�t spend more without borrowing. Borrowing is more difficult because home equity has not recovered from the 2007 housing crash and lending standards are the most stringent in years. Companies won�t invest in equipment if consumers can�t spend.

The result is a death spiral of lower consumption, lower investment, declining productivity, stagnant wages, and underemployment all feeding on each other and making the overall economy weaker. This is the real reason for the shocking 2.9 percent decline in first quarter GDP. It was not the result of �cold weather,� which by the way happens every winter.

There are other signs of ill health in labor markets. In a dynamic labor market, net job gains reflect large numbers of new jobs and lost jobs as employees confidently quit their jobs in the expectation of finding new ones. But evidence reported by Goldman Sachs and James Pethokoukis of the American Enterprise Institute shows that job turnover has declined sharply as employees are extremely reluctant to quit their jobs in an uncertain environment. This tends to lock-out the unemployed who lose job entry opportunities and to weaken wage growth as employees lose leverage to demand raises.

Labor force participation is unlikely to rise significantly partly because of generous benefits that provide an adequate lifestyle for those out of the labor force. The U.S. has over 50 million on food stamps, 11 million on disability, and millions more on extended unemployment benefits. Prospective loss of these benefits creates a high hurdle to motivate a return to the workforce.

The news from abroad is no better. China is slowing precipitously and may be on the brink of a credit collapse. European growth is near zero and even the mighty German economy, the locomotive of Europe, is slowing partly because of weaker demand from Ukraine, Russia and China.

Against this backdrop, mainstream voices are beginning to call U.S. financial markets a bubble. The New York Times recently featured a front page story with the title, Welcome to the Everything Boom, or Maybe the Everything Bubble. The conservative Bank for International Settlements in Switzerland recently warned that stock markets had become �euphoric.� Even Janet Yellen of the Federal Reserve, the institution with the worst record for spotting asset bubbles, said that valuations of some securities �appear stretched.�

So, the conundrum is complete. Stock indices march to all-time highs while economic fundamentals fall apart. The two will be reconciled either with a spectacular turnaround in growth or a spectacular collapse in stock prices. The problem is that a turnaround in growth can only come from structural reform, not money printing. Structural reform is the job of the White House and Congress, not the Federal Reserve. Since the White House and Congress are barely speaking, no help should be expected from that direction. Therefore a stock market collapse is almost inevitable and is probably coming soon.

James Rickards is portfolio manager for the West Shore Real Return Income Fund and the author of �The Death of Money,� a New York Times best seller from Penguin Random House. Follow on twitter @JamesGRickards

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