Simit Patel

This is the first article in a series I'll be doing on investing and trading in a socialist economy.


The cover says it all, but Newsweek has a full article elaborating.

But what does it mean? If we are in a socialist economy, how is this different than the economy we had before -- before Newsweek declared we were all socialists? And as investors and traders, what does this mean for the financial markets?

The issue of to what extent an economy is socialist boils largely down to what extent money supply is determined by the market vs what extent it is controlled by government. While the United States was originally founded on free market principles, it has evolved, particularly over the past 100 years, into a more socialist economy in which the supply of money has become increasingly controlled by a centralized government. Below are key events in the timeline:

The Federal Reserve Act. The origin of the Fed goes back to the panic of 1907, which created a liquidity crisis in the market that may have spiralled into greater chaos had JP Morgan not stepped up and provided liquidity. Proponents of the Fed argued that JP Morgan helped avert a larger crisis, and that in order to ensure a stable business cycle going forward, an "elastic" money supply was needed -- meaning a money supply that could be contracted and expanded by government as needed in order to effectively manage the economy.

Of course, an "elastic" money supply also resulted in an easier ability to create inflation. And so the Fed instituted inflationary policies which resulted in the bubbles of the '20s -- "the Roaring '20s," as they are called. But as Austrian business cycle theory tells us, while excessive expansion of the money supply creates a short-term boom via asset bubbles, they ultimately fuel bad investment decisions -- and thus the bubble is the predecessor to the depression. Which brings us to the next big event in the timeline to socialism....

Great Depression. The Great Depression resulted in the enactment of much legislation that gave government more power regarding determining much money could be created as well as how that money would be spent. Crucially, the US dollar was repriced from $20 an ounce to $35 an ounce, and gold was confiscated -- all as part of an unsuccessful effort to reflate the economy. This is crucial to note because this was the first step to abolishing the gold standard.

End of the Gold Standard. Due to the cost of the Vietnam War, the United States was having difficulty honoring its peg of $35/oz for gold. As a result, foreign governments and central banks, particularly Charles de Gaulle of France, began to demand payment in gold. As the US government was unable to continue doing this, the gold standard was fully abolished. This is a crucial step in the journey towards socialism, as it set the stage for the central bank, at least in theory, to create an infinite amount of money out of thin air.

Nationalization of Banks. Now, the threat of increasing nationalization of banks looms in America, which is perhaps the final "nail in the coffin" in making the switch from capitalism to socialism. Under the Federal Reserve System, the Federal Reserve can create the monetary base and decide how much banks can lend -- but ultimately, banks lending is a key part of expanding the money supply (though inflation can occur in the Federal Reserve system without bank lending, through government deficit spending and a dollar sell off by foreign central banks). If commercial banks are nationalized, it makes money supply even more of a governmental matter -- not a free market matter.

What's This Mean for Trading?

If we've gone socialist, what does that mean for the financial markets?

1. All money is political; it is based not on market demands and needs, but rather on which political interests will prove to be successful in securing newly created money. Economist F.A. Hayek's book The Road to Serfdom is an excellent exploration into the dynamics of economies in which all money is political. As a result, watching legislation and understanding political motives become more important for traders/investors in socialist economies. We talked a bit about this before in our article on the Ka-Poom theory.

2. Whenever money supply is monopolized, either by government or by a private organization, there will be an incentive to increase it. After all, creating money is a very high margin business. As a result, socialist economies may be more prone to the risks of institutionalized inflation, which we discussed previously.

3. The truth, though, is that capitalism never really dies, as socialism simply increases the demand for black markets. As such, activity in "off the radar" markets may be more important to watch. In our current market conditions, a growing spread between physical gold sold by independent dealers and gold contracts traded on future exchanges (which we saw in 2008) may be one such indication traders should watch to get a better idea of supply and demand.

4. Historically speaking, all fiat currencies have ended in hyperinflation. As socialism makes money supply expansion easier (because it makes money supply less of a free market issue), the hyperinflation risk is greater, and investors/traders should factor this into their analysis accordingly.

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Airelon

You know, there's a lot I may respectfully disagree with you on (I believe Austrian economics is sort of a forgotten economic school among economists. Myself, I'm partial to New Classical, but I think the New Classical economists like Robert Lucas didn't go far enough). We'll never see hyperinflation, unless we have a Nassim Taleb 'Black Swan' event. We're in the midst of the worst deflation in the last 60 years, and despite claims of 'increasing the money supply' and 'injecting liquidity', the Fed has been clever to do everything but that in their repo agreements (which has resulted in a Balance sheet on LSD). And I don't think we've had Capitalism in the United States economy for a long, long time. We've had a Mercantilistic economy. At least for the last 150 years.

But Socialism? I'm afraid I have to agree there. It's so absolutely depressing to consider. If it wasn't for the fact that every government is in bed together? It'd be enough to make me want to move to Australia or something.

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Shootanappleoffmyhead

Great article as always Simit. I appreciate your thoughts on all of this. You too Dan. Shoot.

Simit Patel

hey shoot and airelon,

thanks for the comments guys, much appreciated.

regarding austrian economics being out of favor, i view that as a great sign, given the track record of most economists in recent history . as for inflation/deflation, long-term treasuries are off to a terrible start in 2009 while gold is rallying; i would view this as a sign of inflation concerns. i agree hyperinflation is unlikely as i think the fed will raise rates once inflation gets bad, though i think we will see significant price inflation (past previous high prices in the first half of 2008) on top of the rising unemployment we're seeing within a year.

well in either event, the markets and economies these days are quite exciting, if a little tense. we live in interesting times to say the least!

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Jerry

Hello Simit, Airelon, Shoot...

I like to read your overall fundamental thinking...Im not sure I can even articulate what I mean to say..(I rode the short bus to school)...I will try...As an American, I hate to believe the Government is into our lives this deep, but I have to admit that it is true...So is the government preventing a larger problem ? or simply postponing a larger problem...??...Back in October, I was stunned to see the ban on short selling etc... having been in the Stock market crash of 1987, I dont remember the government going anywhere close to the drastic measures that have taken place recently, about all that was done in 1987, was to lower the interest rates...this is far deeper..and the continuous request for more printed money by the government, of the federal reserve...which of coarse is a "loan" to the government, payed back via taxes...therefore, the taxpayer is the one with the final burden, no matter what party is in office...therefore, every tax payer is working for the government... So broaden the view to the world markets...seems to me that each countries government, is in the business of selling their own respective currency to anybody, business, country that sees a need to purchase it...and each government is manipulating domestic policies to try to make their own currency attractive to others... Am I correct in my assessment ??.. And as traders...can we simply watch the charts and profit (or lose) from these changes in the world.... Is this the way of todays world ???....Can you elaborate on this topic a bit more....and how it may or may not affect any one world currency impending doom.....Thanks...Jerry

Simit Patel

Not so sure about this, Jerry. The real short bus riders are the folks who don't appreciate InformedTrades!

Creating a larger problem, in my opinion. The bailouts will prove to be inflationary, in my opinion, which will essentially mean a transfer of wealth from individuals to the recipients of the bailouts. A more legitimate bailout, in my opinion, would involve debt cancellation and/or stimulus to taxpayers -- preferably without increasing government spending but rather re-allocating from the existing government budget, so as to avoid inflation. At least that is my take.

Well, I tend to think the central banks are working more in unison than as competitors; or perhaps there are teams of central banks working together against other central banks. Understanding the political situation can be a big help in forecasting the currency markets, in my opinion, as it gives an idea of the psychology of the central banks as well as what sectors the government will try to stimlate and allocate wealth towards.

I am expecting the central banks to offer a new monetary system as a solution to this problem. Perhaps it will involve more regional currencies, like a North American currency analogous to the Euro. Or a world currency. In the event of a new regional or world currency, I would expect the US dollar will be pegged at a lower exchange rate than other currencies to the newly created regional currency; this would amount to a transfer of wealth from the US to other countries, which can be offered as a solution to how US debts will be paid off to foreign debtholders.

That is just a hypothesis, although the broader point of expecting a new monetary agreeement is something I'm expecting....in light of government policies, I don't really see a way around it.

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Jerry

OUCH..that one world currency scares the heck out of me... Wouldnt that put forex traders out of business ??? Jerry

Simit Patel

LOL....yes, I think so. If such a plan were to be implemented, I think the currencies of the world would be phased out; i.e. you have to convert your US dollars into the new currency within X years. So the market might not disappear overnight.

It may also create a black market for competing currencies. This would likely be illegal, but it illustrates how currency trading could survive even if a one world currency was made the legal requirement.

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Jerry

This is probably the largest worry I have re. currency trading.... Is there any way to tell how close to such a move, (one world currency) we are..????.... I think I could stomach a regional currency first..(ameri-dollar)... If this comes to pass...then we would only lose the USD/CAD trades, as other currencies of south and central America exists, but are not widely traded.... I understand this is a HUGE topic... and really gets my attention.... I just want to make sure we will still have something to trade...possibly switching gears and trading gold, silver, oil, lumber, stocks etc.... dont want to have to learn a new system, just when Im getting good at the way I trade now....dont want to have to re-name the "Forex Mansion"....what would I possibly call it if this becomes reality ??? Jerry

Simit Patel

Hey Jerry,

I'm a fan of gold and silver for other reasons (not so much currency consolidation), but it could be useful in the event of a new global monetary agreement as well. Of course gold and silver could be declared currencies as well....

Ultimately I'm not sure there is much traders can do about this, as it is a political matter.

Maybe you'll have to turn the Forex Mansion into the Forex Museum, where guests can come to hear stories of the way things used to be and examine artifacts from the ancient world of currency trading

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