American Monetary Act (Stocks & Central Banking)

[Charles Brown <cbrown@xxxxxxxxxxxxxxxxx>]

American Monetary Act (Stocks & Central Banking)
To: a-list@xxxxxxxxxxxxxxxxxxx

April 11, 2007

The Daily Reckoning PRESENTS: With all that_s going on in the U.S. markets
right now, it_s easy to overlook an area like Zimbabwe - at least in a
financial sense. But, as John Paul Koning explains, failing to notice this
market could be a colossal mistake. Read on...

ZIMBABWE: BEST PERFORMING STOCK MARKET IN 2007?
by John Paul Koning

CNBC and other stock market tabloids are notorious for making simplistic
linkages between the stock market and gross domestic product (GDP). They
tell us that any event that stimulates GDP growth inevitably drives stock
prices up, and any event that hurts GDP growth pushes stocks down.

Since the largest share of GDP is consumption, consumer demand becomes the
all-important figure driving growth. When the consumer gets too excited,
the Fed must step in to cool them down with interest-rate hikes. When the
consumer isn_t spending, Fed interest-rate cuts stimulate demand.

The tragedy currently occurring in Zimbabwe completely contradicts this
sort of logic. Zimbabwe is in the middle of an economic disintegration,
with GDP declining for the seventh consecutive year, half of what it was
in 2000. Ever since President Mugabe_s disastrous land-reform campaign (an
entire article in itself), the country_s farming, tourism, and gold
sectors have collapsed. Unemployment is said to be near 80%.

Yet something odd is happening.

The Zimbabwe Stock Exchange (the ZSE) is the best performing stock
exchange in the world, with the key Zimbabwe Industrials Index up some
595% since the beginning of the year and 12,000% over twelve months. This
jump in share prices is far in excess of increases in consumer prices.
While the country is crumbling, the Zimbabwean share speculator is keeping
up much better than the typical Zimbabwean on the street.

CNBC logic fails to explain the coincidence of a rising ZSE and collapsing
GDP because it entirely ignores the monetary side of the economy. At this
point Austrian economics makes its contribution to our story. According to
Austrian Business Cycle Theory (ABCT), the peak-trough-peak pattern that
economies demonstrate is not their natural state, but one created by
excess growth in money supply and credit. New money is not simply
parachuted to everyone equally and at the same time - it is sluiced into
the economy at certain initial "entry points." From these entry points, a
number of initial goods are bought by recipients of new money causing a
rise in price for these initial goods relative to other goods.

Because entrepreneurs react to this observed but unjustified change in the
structure of prices by investing their capital, misallocation occurs. As
money-supply growth continues and prices become more contorted, more and
more ventures are undertaken that would not be undertaken in a regime
without money-supply growth. When, for whatever the reason, money supply
finally contracts, the artificial strength in prices that encouraged
unprofitable ventures is removed, prices collapse, and large numbers of
ventures go bankrupt. Thus we have the recession part of the business
cycle, the simultaneous failure of many firms at the same time.

If, as the Austrian theory states, money enters the economy at certain
points, it is likely that a nation_s stock market will become a prime
beneficiary of any monetary expansion. Fresh money enters the economy
first through banks and other financial entities who may invest it in
shares, or lend it to others who buy shares. Thus stock prices rise
relative to prices of things like food and clothes and will outperform as
long as this monetary process is allowed to continue.

This is what we are seeing in Zimbabwe. With the country suffering from
Mugabe_s catastrophic policies, increasingly the only means for the
government to fund itself has been money-supply growth. This has only
exacerbated the economy_s problems. The flood of new money that
authorities have created has caused the existing value of money in
circulation to plummet, i.e., the prices of all sorts of goods to explode,
some rising more than others.

As prices become more misaligned, basic decision-making abilities of
normal Zimbabweans are impaired and the day-to-day functioning of the
economy deteriorates. Perversely, all of this has forced the government to
issue even more currency to make up for budget shortfalls and to buy
support. At last measure, the country_s consumer price index was rising
(i.e., the purchasing power of currency declining), at a rate of 1,729% a
year.

The ZSE is growing some three times faster than consumer prices. This
relative outperformance versus general prices is a result of stocks being
a chief entry point for the flood of newly created money. Keep Zimbabwean
dollars in your pocket, and they_ve already lost a chunk of their value by
the next day. Putting money in the bank, where rates are pithy, is not
much better. Investing in government bonds is the equivalent of financial
suicide. Converting wealth into foreign currency is difficult; hard
currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of
companies to invest in their already-losing enterprises since economic
prospects look so bleak. Very few havens exist for people to hide their
wealth from the evils created by Mugabe_s policies. Like compressed air
looking for an exit, money is pouring into shares of ZSE-listed firms like
banker Old Mutual, hotel group Meikles Africa, and mobile phone firm
Econet Wireless. It is the only place to go. Thus the 12,000% year over
year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock
prices can be driven by monetary conditions, and not changes in GDP. New
money gets spent or invested. In Zimbabwe_s case, because there are no
alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western
world too. Though western central banks have not been printing nearly as
fast as their Zimbabwe counterpart, they do have a long history of
increasing the money supply. It forces one to ask how much of the growth
in Western stock markets over the preceding twenty-five years has been
created by a vastly increasing money supply, and how much is due to actual
wealth creation. Perhaps stock prices have increased faster than goods
prices for the last twenty-five years because, as in Zimbabwe, Western
stock markets have become one of the principal entry points for newly
printed currency.

Regards,

John Paul Koning
for The Daily Reckoning

Editor_s Note: John Paul Koning is a stock market researcher at Pollitt &
Co, a brokerage based in Toronto, Canada.