Storm Watch Update
CHANGING PREFERENCES"
the velocity of money & the short seller's nightmare - part 1
by Jim Puplava
www.financialsense.com
June 14, 2002

The Great Bear of Wall Street - Jesse Livermore

In his biography of Jesse Livermore, author Richard Smitten wrote, "He was the most famous bear on Wall Street, a trader who was as likely to sell short as to buy long. He didn’t care; he knew that stocks went down as often as they went up -- but when they declined, they did it twice as fast as when they went up…” ¹ Livermore was able to make money in any kind of market, bull or bear, or in any kind of asset class -- stocks, bonds or commodities. In the 1920’s he was one of the few men who had made it to the top of the ladder of financial success. He was the best there ever was at spotting trends in the market and then capitalizing on them. During the 1920’s stock market bubble, he got out of stocks early and then went short before the October '29 stock market crash. Simply genius.

Before the crash, he had sensed the market's overvaluation and had shrewdly calculated its fall. He would simply profit from its decline. “He had a line out at the present time of over one million shares, well over $100 million. It had been placed months ago, slowly, secretly, and silently, using more than 100 stockbrokers, so nobody could tell what he was doing. He was short the market - he had sold stock that he would later supply, at a much lower price. He was living up to his reputation as the Great Bear of Wall Street.” ² On that fateful day, Livermore’s profits were close to $100 million. He was unnerved by what had happened in the market. He had anticipated its move. Now he would simply profit from it. Like a predator on the prowl, he took advantage of the sheep, who were running scared. He was taking advantage of the two emotions that drove the markets: fear and greed.

Unemotionally attached, he went home that fateful day as one of the richest men in America; while other men were jumping out of windows or shooting themselves. In a strange twist of fate, he would die in the same way. On November 28, 1940, Livermore walked into the restroom of one of his favorite restaurants. He sat down on a stool at the end of the cloakroom. He pulled out a 32-caliber Colt automatic pistol, pointed it at the right side of his head and pulled the trigger. He died instantly. The fortune he had so cleverly made in the boom years of 1920-1930 had been lost. After the crash, distractions and tragedy in his personal life clouded his judgment. He lost his insight and trading skills. His financial fortunes snowballed downhill. He began to lose money as easily as he had made it. On March 5, 1934 he filed for bankruptcy. He had gone long too early and lost the majority of his fortune. For the last six years of his life, Jesse Livermore lived comfortably before his premature death thanks to annuities he had set up when his fortune was still intact.

As this graph of the great stock market crash indicates, the Dow, which was thought to have bottomed in 1930 at around 200, would fall another 150 points, losing an additional 75%. At the bottom of the market, the Dow had lost 90% of its value. It would be another 25 years before the Dow was able to surpass the pinnacle reached in the fall of 1929. This was the trend that Livermore was unable to discern. The money and credit bubble of the 1920’s, combined with the fiscal policies of the New Deal, would lengthen the Depression and the bear market. It would be 1952 before the Dow Jones Industrials Average was able to surpass its former peak.

Fear & Greed - Emotions That Rule The Markets

In reading Charles MacKay’s Extraordinary Popular Delusions & The Madness of Crowds, Charles Kindleberger’s Manias, Panics, and Crashes: A History of Financial Crashes, Joseph De La Vega’s Confusion de Confusiones, and Garet Garrett’s Where The Money Grows and Anatomy of The Bubble, one common theme emerges. Fear and greed are constants in the markets and they run throughout all of financial market history. To quote Richard Smitten again from his biography on Jesse Livermore, “…human history never changes. Therefore, the stock market never changes. Only the faces, the pockets, the suckers and the manipulators, the wars, the disasters, and the technologies change. The market itself never changes. How can it? Human nature never changes, and human nature runs the market — not reason, not economics, and certainly not logic. It is our human emotions that drive the market, as they do most other things on the planet.” ³

Reluctant to Change

Human beings accept change reluctantly. Once a trend is in place for a long, long period of time, it is only natural to assume it will remain in place in the future. It is only after a long established trend has been discredited and a new trend has replaced it, that humankind accepts what has become inevitable. We embrace change slowly. It is resisted, often denied, and reluctantly accepted. This fact holds true for the financial markets. The great bull market that began in August 1982 ended in March 2000. Many still believe it never ended; while others think it will shortly return. This is the third consecutive year of losses for the major stock market indexes. Yet we are reminded each day that this trend will soon change. Like last year and the year before, the experts are predicting a second half recovery. Like last year and the year before, they will be wrong once again. Trends in the financial markets are never permanent — no matter the market. Once a long-term trend is broken, it is replaced by a new trend. In the words of wise King Solomon, “To everything there is a season...” ⁴

In my view, this new trend since 2001 has been in natural resources, otherwise known as “things.” Like the last bull market in tangible assets, it is being driven as a consequence of the financial bubble that preceded it. The speculative mania that was made possible through the excess credit creation of the 1990’s found its way into the stock market. It produced malinvestments in technology, gross imbalances in the economy with record debt, negative savings, a burgeoning trade deficit, and a mania in stock prices. Now that mania is unwinding with stock prices heading lower; while new bubbles in housing and the dollar have yet to unwind. The Fed is doing what it always does when faced with a crisis — it is flooding the financial system with money.

Under a fiat-based money system such as we have today, the government can increase the supply of money at any rate it desires. The only limit to the supply of money created by government is the total destruction of the demand for money. The relationship between the quantity of money and the demand for money is often referred to as the velocity of money.  According to George Reisman, "To state the relationship in terms of the velocity of circulation of money, the more rapidly the quantity of money increases, the higher tends to be the velocity of circulation of money; the less rapidly the quantity of money increases, the lower tends to be the velocity of circulation.” ⁵ In a plain English, the velocity of money expresses people’s preference for holding or spending cash.

FOUR FACTORS THAT IMPACT THE VELOCITY OF MONEY

Four factors change people’s preference for either spending or holding money.

Factor #1  Change in Price
The first factor is the change in price for goods and services. When prices rise rapidly, as they do in periods of inflation, consumer’s desire for holding money diminishes. This is because they perceive money to be less valuable because it will buy less in the future. Therefore, there is a preference for spending money now before prices rise for goods. Inflation erodes the purchasing power of money, so there is a desire to hold less of it. Conversely, when the supply of money contracts and the prices of goods and services fall, there is a greater demand for money because falling prices enables money to buy more in the future.

Factor #2  Availability of Substitutes
A second factor influencing money velocity is the ability to find substitutes for holding money. Examples of substitutes are gold and silver and other tangible, hard assets. When the supply of money is rapidly increasing or eroding its purchasing power, there is a desire on the part of consumers to hold other assets such as commodities. In the same manner, if the supply of money is decreasing, then the demand for money increases along with its purchasing power. Therefore, consumers desire to hold more cash because during periods such as a depression or deflation, holding on to cash affords greater security. During times of depression and severe deflation, the individual is less confident in financial institutions and their solvency, so they prefer to hold on to their money, thereby decreasing its velocity or circulation within the economy.

Factor #3  Credit Supply
The other two factors that influence the demand for money are the supply of credit and the rate of interest offered on holding money. When credit is ample and easily obtainable, then there is less of a desire to hold money. Conversely, if credit is tight and the ability to borrow money is difficult, businesses and consumers will increase their desire and preference for cash. The supply of money in the financial system affects both the preference and the desire to hold or not to hold onto cash. When the supply of money is expanding and the financial system is flush with cash through rapid money creation, then money velocity increases. Loans and credit are amply available. The opposite situation holds true when the supply of money contracts as it does during a recession or depression. During a recession or depression, money supply contracts as a result of loan defaults, delinquencies, bank failures, and tightening credit standards. During a depression, consumers and businesses hold onto money because they desire the ability to meet their payment obligations when they come due. So, money velocity decreases as the desire to hold money increases, thereby lowering the velocity of money or its circulation within the economy.

Factor #4  Rate of Interest
The final factor that influences the desire to hold or not hold money is the rate of interest offered on holding cash. A rapid increase in the supply of money can lower the rate of interest offered for money in the short-term. To prevent the rate of interest from rising requires a larger and more rapid rate of credit creation. This becomes a trap. In order to keep the rate of interest from rising, there is an increased requirement for even larger and larger amounts of money creation and credit to be provided to the system. Eventually, the only course of action is to allow the rate of interest to rise or the government risks the destruction of the monetary system. This is exactly the point where we are presently. As the graph of M-3 clearly shows, the supply of money has been expanded at ever increasing rates to keep the system supplied with money, replace the destruction of credit that has been destroyed through default, and prevent interest rates from rising.

We have now arrived at a situation similar to the one we were in between 1929-1933. Like the 1920’s, the 1990’s was a period of rapid money creation and credit expansion that actually began under the Clinton Administration in 1994. The increase in the money supply that began in 1994 reduced the demand for money and raised money velocity. The increased supply of money went into our financial markets as it did throughout the money and credit boom of the 1920’s. Back then, the supply of money and credit could not be sustained. When the supply of money did not expand at a rapid rate, the velocity of money contracted as the demand for money increased. The result was spending on goods and services fell, thereby reducing revenues and income to business and consumers. This decreased the ability to service debts. Businesses and consumers defaulted on their debts, which led to bank failures and a sharp contraction of money and credit in the financial system. The contraction of the supply of money, the increase in the preference for money, the reduction in spending, and the fall in the stock market produced The Great Depression.

Caught in a Trap

Scenario One
Today the Fed finds itself in a position where it must continuously expand the supply of money to the financial system or risk a financial collapse. It must supply even greater amounts of credit to the system to keep interest rates from rising, the velocity of money high, and the demand for money low. It must inject new money in the financial system to replace the supply of fiduciary media that is lost through default. In many ways, it is building a house of cards built on easy money and debt that can easily be toppled if confidence is lost. The value of credit money as we have today lies in confidence in money and in government. The money we hold has nothing backing it other than blind faith. What governments want to avoid is a loss of that confidence and a shift to alternative media such as gold and silver. The Fed is caught in a trap of its own making. One outlet is inflationary and the other is deflationary. If investors show an aversion for money because of loss of purchasing power, they could purchase commodities or any other medium that would be able to holds its value against fiat money. The preference of exchanging fiat money for real goods would raise the price of those goods by means of lowering the value of fiat money. If this happens, we then have inflation.

Scenario Two
The other alternative is for a sharp contraction in the supply of money through the collapse of debt, which contracts the supply of money in the system. Under this scenario, we would begin to see that money supply contracts, the demand for money increases, spending is curtailed, prices fall, banks fail, and we have real deflation and a depression. Either outcome is unacceptable. But it will be either one or the other or perhaps both depending on what happens to the dollar. To quote Professor George Reisman from his book, Capitalism: A Treatise on Economics, "Given the prevailing still relatively low state of demand for money that has resulted from decades of inflation, such rapid rates of increase in the money supply are necessary to prevent the greater demand for money corresponding to moderate increases in the money supply from resulting in a decline in total spending in the economic system and thus launching a depression… Not surprisingly, in late 1990 and in 1991 and 1992, the economic system seemed poised for a major depression.” ⁶ 

In an effort to overcome a possible depression, the government cranked up the money presses during the last recession in 1990-91. The Fed furiously drove down interest rates and reliquified the banking system. A depression was avoided and a new bubble began. "To put it mildly, the present monetary situation is highly unstable, possessing as it does the potential both for major inflation and for major deflation. Under present monetary conditions, the economic system is poised between both dangers, with the government undertaking to prevent the one only by means of unleashing the other and then hoping to be able to change course quickly enough to overcome the momentarily greater danger by enlarging and setting against it the momentarily smaller danger."⁷ 

The Point of No Return

Today we have reached the point of no return. Either outcome (inflation or deflation) will now be the result. Confidence is waning and the preference for alternative money is growing. It should be pointed out that once confidence is lost, it is unlikely to return. When people no longer trust a fiat currency or they think there is a major risk to holding paper, they resort to real money or the money of last resort, which is silver and gold. This is exactly what is going on now in Latin America, Japan, throughout all of Asia, the Middle East and in Europe. All currencies have been depreciating. Up until recently, it has simply become a game of landing on the paper that depreciates the least. However, in many parts of the world, investors are changing their preference from paper to gold and silver. Gold and silver have broken out from underneath their decades-long bear market as shown in the graphs below. Since the summer of 2001, the rise in gold and silver equities has signaled the coming rise in bullion prices. These graphs of the HUI and the XAU stand in sharp contrast to declining equity markets worldwide.

Looking For Alternatives

When the value of money becomes questionable, people begin to look for alternatives. One of the most important factors determining the demand for money is its security. When its value becomes subject to arbitrary confiscation through depreciation, investors begin to switch their savings and assets from government-created paper to precious metals. This is what is now happening in Japan and in Latin America. On the day this article was written, Brazil was struggling to restore investor confidence. Fearing currency devaluation similar to Argentina’s peso, the Brazilian real, has lost 15% of its value this year. The government plans to draw $10 billion from a $15 billion credit line with the IMF to shore up government finances. Brazil’s most actively traded dollar bonds now yield 16.4%. Brazil’s debt has ballooned to $344 billion or three-quarters of its GDP.

The quantity theory of money tells us that the value of money is determined by its quantity. The greater the quantity of that money, the lower its value becomes in relation to the price of other goods and services. The reason for the persistent rise in prices over these last three decades can be explained by the continuous increase in the supply of money issued by governments. Most of the major industrialized powers, including the U.S., have steadily expanded their supply of money and thereby depreciated their currency in the process. In the past two decades during times of crisis, the U.S. dollar was the currency of preference. The dollar had replaced gold and silver as a traditional safe haven. However, today with its looming trade deficits, faltering financial markets and vulnerability to terrorist attacks, the U.S. is no longer viewed as the only safe haven. In fact, many governments and financial institutions around the globe perceive the dollar to be at risk. The explosive growth in U.S. money aggregates are now viewed as inflationary. When inflation risks are perceived to be serious, the demand for gold and silver as an inflation hedge or a hedge against credit risk increases. Ultimately, if this demand rises sufficiently, the stage is set for the remonetization of precious metals.

This stage is precisely where we are today. Demand for gold and silver is rising around the globe. Central bank selling, producer hedging, gold and silver leasing, and the dishoarding of metals by investors have kept the price of precious metals suppressed. This has prevented gold from acting as a true barometer of inflation and currency debasement. Gold has risen and preserved its value in countries that have depreciated their currency such as Japan, Argentina, Turkey, and now Brazil. When the value of a nation’s currency declines, the price of gold will rise in that nation. Gold and silver are the only real form of money that has existed throughout recorded human history. Its price rises in direct proportion to the depreciation of the currency. The only exception is when it isn’t free to rise. Then you have Gresham’s Law which states, ”Bad money drives out good money.” Although in most countries citizens are now free to own gold and silver, governments have acted to discourage it either through restrictions on its sale, taxes on its purchase, or through outright intervention in suppressing its price. In the words of Alan Greenspan written more than thirty-five years ago in Gold and Economic Freedom, ” …gold and economic freedom are inseparable. In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.” ⁸

Next week I will cover the complexities of the gold and silver markets, the fundamentals of supply and demand, and the scarcity of investment choices. This leads me to conclude that a dramatic rise in price for precious metals lies directly in front of us. Moreover, the leasing and shorting of bullion, especially silver, and the short selling in precious metal stocks will lead to the short seller's worst nightmare.  ~ JP
Part 2  published 6/21/2002

Endnotes

1  Smitten, Richard, Jesse Livermore: World's Greatest Stock Trader, John Wiley & Sons, 2001, p. 5-6.
2  Ibid., p.6.
3  Ibid., p. x-xi.
4  Ecclesiastes 3:1a.
5  Reisman, George, Capitalism: A Treatise on Economics, Jameson Books, 1991, p. 519.
6  Ibid., p. 525.
7  Ibid., p. 526.
8  Greenspan, Alan, Gold and Economic Freedom, The Objectivist, 1966.

© 2002 James J. Puplava
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