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Having studied economics for four years, I have little use for most economists. Today, such skepticism is widely-shared – after these “experts” displayed their lack of comprehension for all the world to see. Apart from a handful of economists (generally all rebels against current, economic dogma), this entire community showed itself incapable of even seeing the largest asset-bubble in history – let alone understanding the consequences of that bursting bubble.

In my case, my lack of confidence in these “experts” dates all the way back to the 1980's, when I was studying economics. I was both frustrated and mystified that it was impossible to engage these people in “real world” debates – since the economics professors I studied under were simply incapable of recognizing anything that was not included and explained by their economic “models”.

This strikes at the core of the failings of economics: its dependency on models. The desire to construct economic models of market behavior and analysis is understandable: a good model can be a powerful forecasting tool for the future. The problem is that every economic model is based upon a long list of assumptions. In every case, some of these assumptions are dubious, while others are simply ridiculous.

Modern economics is based upon the theories and models of “neoclassical” economists. Often they are simply referred to as “Keynesians” - in recognition of the hero of neoclassical theory, John Keynes. Critics of these ivory-tower academics (like myself) disparagingly refer to the slogan of such economists as “deficits don't matter”. However, what I didn't truly understand previously is that this mantra actually understates the gross deficiencies of this “school” of economics.

Once again, I tip my hat to economist, Steve Keen – whose Debtwatch blog I have referred to in the past. Though his own name bears a great similarity to the icon of neoclassical economics, Dr. Keen is a harsh critic of Keynes. This is because Dr. Keen is among the minority of economists who reject neoclassical theory in favor of a branch of economics generally associated with the Austrian School of economics – with the most acclaimed theorist of this camp being Ludwig von Mises. More recently, this branch of economics was championed by Hyman Minsky.

Rejecting neoclassical theory doesn't require an economics degree, or any economics training at all. Any child who has mastered the fundamentals of arithmetic can point out the absurdity of the assertion that “deficits don't matter”. As deficits are piled atop each other, year after year, the simple addition of these debts (along with their compounding interest payments) will inevitably reach a point where the costs of servicing this debt become so large that it becomes impossible for an economy to grow any further – as too large a percentage of total resources becomes consumed through interest payments on debt (with none of the “principal” ever being repaid).

To reduce this to a simple analogy, the grossly excessive debts of several Western economies (with the U.S. and U.K being the “poster boys” for such recklessness) have grown to become a burden equal to a homeowner trying to make monthly payments on a $1 million mortgage – while only earning $10,000/year.

Describing a process of this nature is referred to as “dynamic” analysis, since it includes and explains changes over time. The other form of analysis is “static” analysis. This can be thought of as an analytical “snapshot” since static analysis never accounts for changes over time.

It was always utterly incomprehensible to me how anyone could embrace neoclassical theory – since presumably everyone with an economics degree had to successfully “pass” elementary school arithmetic first. Dr. Keen has enlightened me on this point with his own, recent blog-posts. Quite simply, neoclassical economics is an entirely “static” form of analysis – which never accounts for or explains the consequences of economic policies such as fiscal deficits. Worse still, not only does neoclassical theory not include the consequences of compounding debt, according to Dr. Keen, it simply excludes debt from its economic “model” completely.

Suddenly, the monumental ignorance of neoclassical economists becomes clear for all to see. Obviously economists who don't even recognize the existence of debt cannot be expected to understand the consequences of something they pretend does not exist. Perhaps that is an unduly harsh characterization, and it would be more accurate to state that they simply assume that debt is an irrelevant component of analysis.

The Keynesians “justify” ignoring debt/deficits by simply assuming that governments will always keep the growth of debt lower than the overall growth of an economy – thus in proportional terms debts/deficits never become a “significant” variable to their model. Obviously we all know how absurd an assumption that has been!

For neoclassical theory to possibly be valid, our governments would have to exercise absolute discipline with respect to their spending. In economic downturns, governments need to engage in “stimulus” to counter those forces of contraction. This always means deficit-spending above the rate of economic growth. Thus, for the Keynesian model to be sustainable over the long term, after every economic contraction, governments would have to reduce deficits substantially below the rate of growth of the economy – to pay-off the additional debt (plus interest) which was accumulated.

In the real world, however (a place never visited by the Keynesians), very few governments have shown such discipline in running (ruining?) their economies. Among G-8 economies, only Canada has engaged in sustainable fiscal policies in recent years – and this was only after a debt-crisis which nearly destroyed this economy. Every other G-8 government has engaged in a level of deficits (and debt) which totally invalidates neoclassical theory, and even the current policies of the (new) Canadian government have regressed back to unsustainable deficit-financing.

Despite this fact, the Keynesians simply continue to bury their heads in the sand. They refuse to acknowledge the obvious fact that one of their key assumptions has been rendered completely invalid. They have little choice – unless they are willing to swallow their pride, go back to “the drawing board”, and refine their analysis into a dynamic model which accounts for changes in debt (i.e. the growth of debt) over time.

The problem is that the governments of most industrialized economies continue to base their fiscal policies (and analysis of those policies) on an economic model which has been proven to have no validity in the real world. It is this massive “blind spot” which explains why governments believe they can “solve” problems which were caused by excessive debts/deficits through even more excessive debts/deficits.

Thus every time you read/see/hear of yet another government policy, adding yet more debt to the current (unsustainable) deficits, know that no one in your government is even considering the consequences of that additional debt (let alone understanding those consequences). Yes, these talking-heads will say that they understand the consequences – however, all of these governments are relying upon policy advice from a group of academics, who (as a matter of dogma/bias) never consider the consequences of additional debt.

There are still Western economies which have not yet become so over-burdened with debt that their economies have reached a “point of no return” with regard to their debt-spirals. However, the majority of industrialized economies can be characterized as vehicles which are not merely driving toward a cliff, but rapidly accelerating as they race toward that chasm.

While gold-bears, and novice-bulls (who have just jumped on the bandwagon) like to refer to gold as only a “hedge against inflation”, the reality is that in addition to that quality precious metals are the ultimate “insurance policy” against current fiscal insanity. With “fiat currencies” officially backed by nothing, these scraps of paper can only have an intrinsic value based upon the net worth of the economy which is issuing that currency.

As more and more of these economies descend into a status of negative net worth (due to exponential increases in debt), the currencies of these economies are literally worth nothing. Among all currencies, only precious metals are beyond the reach of governments in destroying their value.

Remember that inflation is always a “monetary phenomenon”. In other words, real “inflation” is nothing more than the value of a currency being destroyed. Thus, when unsophisticated gold bulls and bears talk about gold as a “hedge against inflation”, what they are really saying (if their comprehension was greater) is that gold protects the people of a society from the continuous destruction of their currencies by governments.

Ultimately, these governments will “succeed”: they will literally drag the value of their paper currencies down to zero. Given those dynamics, gold suddenly looks exceedingly cheap – even at $1200US/oz.

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written by JsJ, December 03, 2009

I meant the solid fundamentals for the metals, not the stocks. Stocks are not where smart money is or where it is going.

Even when I talked to him about the benefits of foreign mining stocks (Can/Aus) and the double benefit of 1) currency benefit by using non USD-denominated investments and 2) potential upside from metals profits, he still refuses to believe that the U.S. market is fundamentally unsound.

It's odd that goldbugs are characterized as stubborn and unrealistic, while those who insist on holding the conventional (i.e., profitable last century) investments are judged as 'mainstream'. I love my brother, but he is too stubborn for his own financial good.

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written by Jeff Nielson, December 03, 2009

Hi JsJ.

As I mentioned in a previous commentary, the most important responsibility for all investors is to find and follow REALISTIC data on inflation.

The worst thing that could happen to the U.S. would be for the Dow to hit 20,000 - because this could ONLY take place after hyperinflation had already started.

As things stand now, even if NOMINAL prices of U.S. equities keep going up, it will be nothing more than a reflection of inflation. U.S. markets are more-than-fully valued, people who mindlessly put money into this market simply because nominal values are rising are going to get badly hurt (as they were in '0.

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written by JsJ, December 03, 2009

And yet, even with these solid fundamentals, "stock bugs" like my brother insist that equities are the way to go...

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