Eric Sprott and Sasha Solunac: The solution

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11:20a ET Sunday, November 30, 2008

Dear Friend of GATA and Gold:

The financialization of Western economies (particuarly the U.S. economy) has been noted before but maybe not as well as it is in the essay appended here by Eric Sprott and Sasha Solunac of Sprott Asset Management in Toronto. Propping up the financial system with extraordinary measures lately has done nothing for the real economy, Sprott and Solunac note; it has only thrown good money after bad. The real economy, they argue, would be supported better by raising commodity prices, which government could arrange with infrastructure programs and direct purchases of commodity inventories.

The Sprott/Solunac diagnosis won't be disputed by too many on the precious metals side, but their solution may be so much easier than they imagine. For just as central banks and their agents, the big financial houses, have used derivatives to suppress gold and silver prices, they have used derivatives to suppress the prices of many commodities as well as interest rates. Indeed, the U.S. government's refusal to regulate derivatives -- a position taken at the behest of then-Federal Reserve Chairman Alan Greenspan and most of the financial-market worthies of his time, some of whom now are being summoned into the Obama administration -- increasingly is being acknowledged as a major cause of the ongoing economic collapse.

As the British economist Peter Warburton noted seven years ago in his essay "The Debasement of World Currency: It Is Inflation, But Not As We Know It" (http://www.gold-eagle.com/gold_digest_01/warburton041801.html), derivatives were invented (and encouraged by central banks) largely to help conceal monetary inflation by diverting investment and speculative demand from real things into paper instruments. That is, derivatives were designed to manipulate markets. Just getting them out of the way or putting them under ordinary regulation by government agencies that mean to do their jobs instead of look the other way might restore the real economy against the parasites of financialization.

Franklin Roosevelt's administration did not face a financialization problem when it dealt with the collapse of the U.S. economy in 1933 but it also sought to revive the economy by raising prices -- via the National Industrial Recovery Act and the agency created by the act, the National Recovery Administration. This quickly turned into a parody of Italian fascism, with a huge bureaucracy attempting to maintain wage and price controls throughout the country. A Supreme Court decision in 1935 found much of it unconstitutional and discontinued the most bureaucratic parts of it, but government efforts to get wages and prices up continued -- efforts aimed, however clumsily, at helping the real economy, not just the banking system.

In any case, a Reuters report from Hong Kong this week suggests that China already may have seen the wisdom in what Sprott and Solunac suggest:

http://malaysia.news.yahoo.com/rtrs/20081128/tbs-china-metals-reserves-2...

Their essay is appended.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

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The Solution

By Eric Sprott and Sasha Solunac
Sprott Asset Management, Toronto
November 2008

http://www.sprott.com/pdf/marketsataglance/MAAG.pdf

It's the end of the world as we know it.
It's the end of the world as we know it.
It's the end of the world as we know it and I feel fine.

-- R.E.M.

It may not be the end of the world, but it likely is the end of the world as we knew it. However, unlike the members of the band R.E.M., there's nothing to feel fine about.

Especially for those who make their living in the financial sector. At the risk of sounding like doomsayers, we don't believe the heady days of disproportionate wealth creation through finance, for the sake of finance, are ever coming back. The prevailing hope that things will eventually return to normal on Wall Street, Bay Street, London, and the other financial centers of the world is, we believe, nothing but wishful thinking. Those days are over, never to return in the form that we knew them.

For what is "normal"? Were the decades of the 1990s and 2000s, which witnessed unprecedented prosperity in the financial sector, normal? Logic dictates that the answer is no. As we've been opining for a number of years, there was "too much finance." So much so that the "financial system was a farce." The financial sector became far too large in relation to the real economy. The compensation of those who worked in the financial sector became increasingly disproportionate, and abhorrently so, relative to the wages being earned in the real economy making real things. Too many financial instruments were being derived on other financial instruments, becoming too far removed from anything that even remotely resembled real assets or real economic activity. These were abnormal times, and were therefore unsustainable times. The heyday of finance was nothing more than a pyramid scheme, viable only until it was unable to reel in the last sucker. The world has finally come to the realization that pushing paper to other paper pushers for the sake of paper pushing doesn't, in fact, constitute real value-added economic activity. The myth of the financial system as an unbridled source of wealth has been exposed.

The pyramid has crumbled and the world is now a different place. The solutions that worked in the past aren't working this time. In the past, financial crises were "solved" by throwing money at the financial system. Although more money by far has been thrown at this crisis than at any other in history, it just doesn't seem to make an iota of difference. Not for the financial system (except to delay the ultimate day of reckoning), and certainly not for the economy.

From the standpoint of the financial system, the need for massive bailouts (most recently +$300 billion for Citigroup and the announcement of a new $800 billion TARP 2) continues unabated in spite of all the "solutions" that have already been adopted, such as sharp rate cuts, aggressive unconventional monetary policy measures, central banks around the world
taking the role of buyers and guarantors of last resort, and numerous other lifelines that have been extended to save the banking system.

Furthermore, previously announced bailouts (AIG being the prime example) seem to require a bottomless pit of government funding to keep afloat. The price tag of the AIG bailout seems to increase with the passage of time,
initially $85 billion, now $150 billion. Nor have the "solutions" made an iota of difference from the standpoint of the economy. For over a year now, central bank rate cuts haven't done a thing to lower borrowing costs for individuals or corporations, let alone increase the availability of lending. The real rates of interest for anything other than government bonds has gone through the roof. In spite of all the financial stimulus, the global economy continues to flounder and worsen with each passing month.

It wouldn't be a stretch to say that of the trillions of dollars spent globally trying to prop up the financial sector, not even a dollar has made its way into the real economy. As far as we can recall, never have such aggressive financial measures been met with such a tepid economic response. Everything that has been tried to date has backfired.

Why?

We believe it's because all the solutions thus far have focused on trying to save the financial system, but all the financial system has done in return is suck more and more money into the vortex. Too many resources are being wasted trying to prop it up, financial and political. Perhaps it's high time to let the financial system go and leave it to a market-determined fate. Papering over losses, or refusing to recognize them, or having governments buy toxic assets that no one else wants, doesn't seem to change the fact that losses are losses.

As we said, it's the end of the world as we knew it. When the facts change, the solutions need to change as well. We posit that any real, effective solution needs to concentrate on the real economy.

Therefore, first and foremost, greater efforts need to be made to save the economy, not the financial sector. Only the economy can turn the financial sector around and make it prosperous, not the other way around.

Finance, at its foundation, should always be, and has historically always been, a support industry of the real economy. Therefore, ideally, it should be peripheral to the economy and not the main component of it. It should never have been allowed to become the monstrosity that it was over the past decade.

In this context, the G20 needs to pool their resources to support the real economy. They need to concentrate on what works. Supporting the financial sector doesn't work. We believe that supporting commodity prices will.

We realize that that the solution we propose is "talking our own book," but it is our book because it is what we believe in. By now it should be clear that plunging commodity prices, thereby cutting the output of real things, is not the ticket to global economic recovery.

To be sure, this would be an unconventional idea. One that many of our readers will doubtless disagree with. But unconventional times require unconventional measures. Many would argue that the crashing of commodity prices is actually a good thing for the global economy. We beg to differ. The only thing it has done is create an environment where absolutely nothing works from an economic or investment point of view. Not financials. Not commodities. Nothing. When the financial pyramid scheme started to unwind in early 2007, at least there were segments of the real economy that were still expanding, providing employment, profits, and investment opportunities. Nowadays nothing is working and the world as a whole is poorer for it.

The problem with the world today, and what is making the financial crisis worse, is that it is in a deflationary death spiral, led by the plunge in commodity prices. It's a negative feedback loop that is difficult to reverse once it gets started. It's affecting everything on the aggregate demand side of the economic equation, including all-important consumer spending. As is well known, consumers are disinclined to spend when there is deflation.

The world is in desperate need of some inflation, and it needs it now.

We're not talking about destructive hyperinflation, which can occur only from out-of-control monetary policies, but rather the reversal of the negative vortex that commodity price deflation is causing throughout the world. In the current environment, inflation would be good. Inflation would make the repayment of debts and mortgages less onerous. Inflation would help turn around plunging housing prices. Inflation would put a sail under the stock markets. Inflation would help get new projects, which have been mothballed due to falling prices, restarted.

In this regard, infrastructure projects are a great idea from a policy standpoint, and are being adopted the world over. They stimulate the real economy and help reverse the deflation that the flailing financial sector is unable to do. Unfortunately, projects of this magnitude will take a year or more before they have any real economic impact. A quicker solution is to stop the decline in commodity prices now.

It's a short-term yet, we believe, effective solution for what ails the world today. Longer term, of course, governments should have no involvement in commodity markets, letting free markets decide. But right now, to quell deflation, the G20 should be thinking of buying commodities, even if it means stockpiling them.

We believe this would be a far more effective, and much cheaper, solution than the trillions of taxpayer dollars currently being squandered on the white elephant that is the financial sector with its glut of toxic assets. We believe that going forward, the financial sector won't be as important as the real economy. The future, as we see it, will return to normalcy, where real economic activity dwarfs financial activity.

In the interim, there is a global economic crisis to deal with. One of the solutions to this crisis, with a greater likelihood of working than any that have been tried thus far, is to reverse the deflationary impact of falling commodity prices and save the real economy today.

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