The Era of Ponzi Finance

The role of gold in your own personal Ponzi Mitigation Kit revealed...

"KER-POW!" right to the kisser, writes Dan Denning in his Australian Daily Reckoning.

All thirty components of the Dow Jones Industrials fell in New York trading on Thursday. In total, the index fell over 200 points and 2.09%. The slap in the face came from a survey of manufacturing activity that indicated a slow-down in the rate of expansion.

If you're an optimist, the good news is that manufacturing activity – as measured by the survey – is still expanding. But investors looked at the report and must have begun thinking that the euphoria of the last six months is premature. "Maybe," they are thinking, "the rally in the stock market is completely divorced from the reality in the real economy where real things are made."

What investors need, we believe, is world-class speculations to act as the antidote to Ponzi finance. Mind you these are still speculations. And we'll get to that in just one second. It's none too soon, given the slow-motion meltdown of America's regional banks and the bankruptcy of the agency charged with insuring them (the FDIC).

"Part of the problem with the current thinking," said Dr. Steve Kates, senior lecturer on economics and finance at RMIT here in Melbourne, when we met Tuesday, "is that when you're born into it, all the assumptions and premises of the system are not things you'd actually question. It's only when the system starts breaking down that people are forced to stop and ask what's wrong.

"All of today's policy makers and economists were born and raised in Keynesianism, and that's why there are so few people who can step outside of it to see its failures."

For once in his life, your correspondent managed to shut up and let someone else continue talking. It was a great conversation, and we hope to bring you more like it in the future. One subject sure to come up is the financialization of the economy and what economist Hyman Minsky called the era of Ponzi Finance.

A brief explanation...

In the mid-1980s, Minsky showed that the longer credit-financed expansions went on, the more all economic activity became "financialized". That is, debt growth leads to excessive leverage in household, corporate, and public balance sheets. This makes the entire economy (as we're now seeing) much more sensitive to changes in interest rates (the cost of capital) and changes in asset prices (which exist at large multiples to tangible equity on the balance sheet).

In the early stages of debt growth, the economy endures what Minsky called "Hedge Finance", where cash flows are sufficient to make both principal and interest payments on debt. In the next stage, "Speculative Finance", cash flows cover interest expense but not the principal. This leads to more borrowing for the purchases of financial assets to grow the balance sheet.

When you reach the third stage, the "Ponzi Finance" stage, business cash flows are not sufficient to pay either interest or principal payments. New debt must be taken on or assets sold to keep the enterprise as a going concern. But by now, the real purpose of the business – providing goods and services that consumers want at a competitive price – has been entirely supplanted by the need to service and roll over debt.

That's where we are now, globally speaking. And it's not a good place to be. In the States, for example, the Federal Deposit Insurance Corporation (FDIC) is trying to prevent the collapse of the Ponzi Finance economy by a drip-feed of regional bank failures. These banks are generally not as leveraged as the money-centre banks in New York, and they are apparently small enough to be allowed to fail, as long as they don't fail all at once. Perhaps more pertinent still, they are not well connected politically, lacking the cover give to Wall Street by Washington.

What's killing these smaller banks is the inability to roll over new debt as assets on the balance sheet shed value. This is the ongoing deterioration in bank collateral we've written about before, and it's largely driven by a 10-year binge of speculation in residential real estate. That binge is still purging.

The FDIC – the American regulator charged with insuring depositors – is going bankrupt (if, in fact, it is not broke already). It will be funded by new money printed by the Fed. The Fed is allowing the drip-feed of failures (managing it, even) because it prevents a landslide of bank failures, which might touch off another crisis of confidence e in the banking sector (and more bank runs).

What's more, the Fed fears that an en masse collapse of US banks will lead to a repeat of the Depression era contraction in money supply. When banks failed in the 1930s, the money supply contracted and deflation set in. Ben Bernanke, ever the historian of the Depression, must reckon that a slow-motion banking collapse allows the Fed to keep the money supply from collapsing by extending huge credit to the money centre banks, which are largely nationalising the distribution of mortgage and personal credit.

But what is the fallout from this? If the Fed triages the banking system by pumping more bogus cash into the FDIC, surely that would be a death-by-a-thousand-cuts for the US Dollar, wouldn't it? But then this strategy is nothing new. The Fed has been destroying the purchasing power of the Dollar in that way since 1913. An inflation rate of 3-4% a year disguises the systematic theft of purchasing power that's inherent to fiat money. Today, the Fed hopes to prevent a large collapse in the money supply (bank's create more money than the Fed through fractional reserve banking) by incrementally distributing bank failures across the calendar. So far, it's working...or...the bit-by-bit failure strategy is not alarming people about the systemic failure of the Ponzi Finance economy.

It is failing, however. So what can you, the individual, do? Well, as often as we've written about Gold, today we will make a distinction between bullion and stocks.

Bullion, meaning physical gold you own outright, provides you with a tangible hedge to cash. It should be part of your Ponzi Mitigation Strategy.

Gold Mining stocks have a role too, we believe here at The Daily Reckoning. They give you leverage to the Gold Price. And the Gold Price should continue going up as the Dollar accelerates its terminal decline. But there are a couple of things you should know about gold stocks and gold mining.

• First, gold mining is a terrible business. Your capital costs are large and upfront. The asset is an inherently depleting asset (the mine has a life and production of the resource depletes the resource). This is arguably better than holding billions of housing-backed securities, which don't so much deplete as they disintegrate.
• But valuing gold stocks – especially the explorers – is not something Graham and Dodd would have much luck with. Most of the companies don't have regular earnings. And you have to deal with fluctuating underlying commodity prices. Plus, the companies have to get lucky and find gold in economically mineable deposits for which they've received the proper permits and government and environmental approvals.

Altogether, mining stocks are a terrible investment, but an excellent speculation. As long as you're aware of the difference, the benefits become obvious. The tiny gold stocks can go up ten and twenty times on moves in the Gold Price and upon successful exploration. That's as good as you're going to get when it comes to big profits from the decline of the Dollar.

But as a speculative position, don't go overboard. Diversify with a handful of gold speculations and make sure it's with speculative money.

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