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Below is an extract from a commentary
originally posted at
www.speculative-investor.com on 27th November, 2008.
Few people seem to appreciate that
the increasing instability within the financial world, as evidenced by price oscillations
of progressively greater magnitude, is being driven by government attempts to manage
the economy. Recent attempts to stimulate the economy and mitigate the financial
crisis are classic examples of what we are talking about.
No reasonable person would be against
economic stimulus schemes involving increased government spending if these schemes
actually worked as advertised, or even if they only smoothed the transition from
one growth period to the next. But as we've noted many times in the past, such schemes
cause long-term damage by a) preventing or delaying necessary economic adjustments
and b) reducing the quantity of real savings in the economy. It must always be kept
in mind that the government does not have any real savings of its own, so it can
only fund its various job-creating/economy-boosting packages by borrowing or plundering
the private sector's savings. It then uses these savings in a sub-optimal way, usually
by targeting spending with the primary goal of increasing its own popularity. It
should also be noted that the less real savings the private sector has to begin
with the more long-term damage will be done by an increase in government spending.
By preventing or delaying necessary
adjustments and destroying real savings, the government's counter-cyclical economic
policies lead to greater imbalances, slower real growth during the next economic
upturn, and, quite likely, an even bigger bust in the future. Furthermore, the monetary
inflation stemming from the attempts to counteract the bust will eventually cause
boom conditions to emerge somewhere in the economy, which, in turn, will promote
more mal-investment. But whereas busts are considered bad, inflation-fueled booms
-- the natural precursors of busts -- are considered good. Therefore, monetary and
fiscal policy will typically be framed with the aim of extending the boom for as
long as possible, even though the longer the boom the greater the misallocation
of real savings and the more devastating the ensuing bust.
The logical consequence of government
intervention designed to prolong booms and curtail busts should be a long-term boom-bust
cycle with increasingly large oscillations, which is exactly what the following
chart of the Dow/Gold ratio shows is occurring (it's nice when the data meshes with
the theory). Over the years we have referred to the long-term chart of the Dow/Gold
ratio as the most important chart in the world for investors because it so clearly
reveals the secular trends in the financial world.
Chart Source:
www sharelynx.com
Note that we've drawn a vertical
line on the chart to mark the birth of the Federal Reserve. Not coincidentally,
this line also marks the time at which Dow/Gold's long-term oscillations began to
increase in magnitude. The connection is that once a central bank was created it
became possible for credit to expand much more during the booms and for the government
to spend much more during the busts.
On the chart we've also marked the
point at which the last official link between the dollar and gold was severed. From
this point forward there was no objective limit to the amount of monetary inflation,
which goes a long way towards explaining why the oscillations have since become
even bigger.
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