Saturday, February 21, 2009

stimulus package ?

Imagine this: A group of community organizers, aided by mesmerizing rhetoric and calls for equality, fraternity and hope, remove the privileged from power. But the government they inherit is heavily in debt to the tune of a third of the GDP. The debt comes due, the government can't pay, so the economy tanks.

What to do? Taxes are out - the taxpayers have fled (or are broke). The ingenious solution: Print more money as a stimulus package! What about interest on the printed stimulus? Piffle. Just print it also!

This is not the United States in 2009 - at least not yet. It is France, 1789, right after the French Revolution.

Why mention this history? For three reasons: First, because it is an obvious equivalent to what is happening today; second, because its ending could provide a clue to how today's events could end; and third, because a book I recently read about that period changed my thinking and made me into a semi-reluctant gold bug.

The book is Fiat Money, Inflation in France, written 50 years ago by Andrew Dickson White (a co-founder of Cornell University). I was handed the book last week when I went to visit a friend at a brokerage company, leafed through the book on the subway back, then got caught up in the narrative and finished it that day. It was delightful and terrible: Delightful, because it was written in the elegant plain style no longer in use today, and terrible, because it was so reminiscent of current events that, if the present unfolds as the past did, hard times lie ahead.

What evidence is there that today resembles that particular past so much that the ending is bound to be similar? First, in 1789, power shifted from those who had money to those who mostly didn't - similar to today. Second, the revolutionary French government tried to pay the debt racked up by the deposed regime with freshly printed money - again like today. Third, any dissenting voices in the National Assembly were shouted down with dire warnings of a "catastrophe" if the stimulus package were not approved - once more, like today.

But fourth and worst, as soon as the freshly printed money was used, the cry arose that it was not enough - and so more was printed. Then more, more and more. That last part is not yet in evidence today. However, once the recently approved U.S. stimulus is used up, more will be demanded of Congress, just as it was in 18th century France - you can bet on it.

In France, many assembly members had been bribed by debtors, and by others who benefited from the new spending - just as in U.S. Congress, where there are many who are alleged to sell their vote. And what of differences between then and now? Of course there are some. First, revolutionary France was violent, and those who refused to take the newly printed assignats - the currency of the day - or insisted on payment in gold, were arrested or guillotined.

Second, in revolutionary France, the massive printing caused inflation immediately. This is not yet the case, since the economy is so stagnant. Isn't this, then, a flaw in the argument? Not really. In 18th century France, that first money-printing caused a brief economic revival, before the inevitable slide began. Seven years later, the French economy was in ruins and Napoleon appeared, to sop up the unemployed and their anger in a continental war.

If the same scenario follows today, we are about to experience the first flush of false spring, as the first massive stimulus wends its way through the economy; but then the economy would falter, and there'd be demands for more stimulus, which would rekindle inflation and make gold rise - same as in France, more than two centuries ago.

Yes. I know I opined before that short-term gold may decline. It hasn't, though it still might. But longer term, it would likely benefit, as more and more paper money is printed. (I told you the book converted me.) Benefit until when? Until the inevitable squeeze is instituted to purge the economy of inflation - the kind of interest rate hike that Paul Volcker performed in 1982 that killed inflation, but also tanked gold.

But we are still a few years away from it, and a war to go through first, as U.S. President Barack Obama sends more divisions into Afghanistan, sopping up some unemployment, even as the Russians, Pakistanis and Iranians unite to block their supply routes and, together with China, work (out of pure national interest) to push the U.S. out of Central Asia.

So: Inflation, economic decline, an escalating war, a Volckerish purge at the end - what's a good investment in such a scenario? Treasury inflation-protected securities, gold and cash - plus a stack of good, first-edition volumes on economic history to keep you well informed.