Allocation of Resources

Every individual in this world is different.  We all have some of the same basic needs, but our desires and preferences vary greatly.  Two people both need to eat food to live, but they might choose different foods to eat.  This is just one thing.  If we start comparing desires, the differences are vast.  Even if the two people have similar interests, their priorities will still differ in some ways.

When you earn a dollar, whether it is through selling something or working for someone or getting a gift, you will choose what to do with that dollar.  You may use it to buy a basic need like food, shelter, or clothing.  After these initial needs are taken care of, there are other things on your priority list.  Maybe it is buying a car or taking a vacation.  Maybe it is buying more expensive food or eating out at a restaurant.  The point is, you are going to do what you want with it.

When the government takes your money, politicians are deciding on how they want it to be spent.  The best you can hope for is that they will spend it on something near the top of your priority list.  But everyone’s priorities are different.  Therefore, everything the government spends is a misallocation of resources.  If the money were left in the hands of the individuals that earned it, it would be spent or saved how that person wanted.

With all of the taxes, government regulations, and money creation of the past 100 years or so, the government has created huge distortions.  The market tries to work around these things as best as possible, but there are still severe distortions.  The boom and bust cycle is a shorter term version of this whole thing.  The Fed creates money out of thin air and distorts interest rates and causes a boom, whether it is in stocks, housing, or something else.  When the money creation stops or slows down, there is a correction or a bust.  The market is trying to correct the previous misallocation of resources.

This is why there will continue to be tough times ahead.  The government did not allow a correction to fully take place in 2008 and instead dumped vast more amounts of money in bailing out failed companies and trying to prop up the economy.  The government and the Fed will not allow the sick economy to take its tough medicine.  Instead, it just uses a pain reliever to delay the inevitable and ultimately make the problem much worse.

Even if the government did everything right from here on (about as good of a chance as the sun rising in the west), we would still have a severe correction.  The reason is because of the huge misallocation of resources that has previously taken place.  It would take some time for the market to straighten everything out and get things in line with where consumers and investors want them to be.  In a true free market, there might be half as many colleges.  Half of the college professors might need to find another line of work.  Or perhaps the market will demand just as many as now but at a lower pay.  Without subsidized loans and subsidized education, perhaps we would see a dramatic reduction in prices.

It is hard to say how any of this would play out, but that is really the point.  Nobody can determine the preferences of millions of people.  Only each individual and their family can determine where best to put their resources.  Until we dramatically reduce government spending, taxes, regulations, and artificial money tampering, we can only guess what a true free market would look like.

The Dollar and Other Currencies

The U.S. dollar has been strong in the last couple of weeks, at least compared to other currencies.  The Euro has done poorly and probably for good reason.  The PIIGS countries are a mess and the European Central Bank is risking a collapse of the euro by bailing out the irresponsibility of European governments.  The collapse of the euro is unlikely to happen overnight, but it will slowly degrade as people realize it is in trouble.  It may take a year or it may take 10 years.

It is surprising that people still flock to the U.S. dollar when uncertainty hits.  This will change eventually, but it may take longer than what it seems like it should.  For some reason, people still have some faith in the U.S. dollar and some put their money there when times get tough.  Look at the fall of 2008 when the stock market plummeted and all of these other events were happening.  Even with a giant bank bailout from the Fed, the dollar still did well during that time.

When it comes to investing, I don’t think investing in other currencies should be a major part of your portfolio.  My favorite mutual fund, PRPFX, somewhat mimics the permanent portfolio as described by Harry Browne.  However, PRPFX does invest a little portion in foreign currency, particularly the Swiss franc.  There is nothing wrong with this because it is a small portion and the fund is so well balanced.  But generally speaking, I don’t see the need to invest in foreign currencies.

If you want diversification from the dollar (or whatever currency you use for your income and expenses), then  hard assets will serve you fine.  Gold in particular is really the best hedge against a falling currency.  Other things like silver and oil can also do well, but gold is probably the best.

Just to be clear, there is nothing wrong with speculating in foreign currencies, but it should be seen as speculating.  Long-term, I don’t see why you would choose to invest in foreign currencies.  Yes, the dollar is a bad bet long-term, and it will eventually lose its status as the reserve currency of the world.  But, why would the yen, the euro, or anything else be any better?  They are all fiat currencies and can be debased by governments and central banks.  That is why they should not serve as part of your long-term investment portfolio.  You should leave foreign currencies for speculation with money that you can afford to lose.

Update on Commodities

The general direction of commodities in the next year or so will depend on everything else.  The biggest thing to watch is whether the Fed fully goes through with QE2 and, if so, whether the banks lend this money out or hold on to it as excess reserves.

There is also an issue of velocity, or the demand for money, but this may be determined by the supply of money active in the economy.  If this new money stays locked up in the banks, then price inflation may be minimal in the near term.  We may see the stock market retreat and see signs of another (or continuing) recession.  Either way, we will continue to see high unemployment.

If the banks start lending money, we could see a sharp rise in the money supply that is not being held by banks.  We will see the fractional reserve process take over.  This could also lead to an increase in velocity, where people would rather spend their money on “things” than keep it sitting at a bank and depreciating.

If the banks do start lending out this money, expect commodities to do very well.  Some will do better than others.  Silver may do better than gold.  But in the first scenario where banks don’t lend this additional money, gold will fall less than silver.

Oil will follow the same trend.  A recession will keep oil from rising dramatically.  If banks lend like crazy, then the price of oil will probably go up like crazy and that is under the assumption that there will be no new conflicts in foreign nations.  If there are new conflicts, particularly in the Middle East, then oil prices could go to the moon.

Food is another commodity that will go up with high price inflation.  Owning a mutual fund or ETF that invests in a broad range of food will do well in such an environment.

In an environment of high price inflation, expect commodities to go up even higher.  That is why they are important for an investment portfolio.  TIPS (government bonds that adjust for inflation) will not serve you well.  Even if the CPI were accurate, the bonds would only be going up as much as the price inflation indicator and no more.  This is not a good hedge against inflation.

Black Friday

I hope everyone had a good Thanksgiving.  Today is Black Friday.  Today is the day that shoppers go to the stores looking for good deals.  Today is the day that businesses are supposed to do well and go into the “black” (profitable).  Today is also a good day to go over some basic economics.

First, there is nothing wrong with shoppers hitting the stores for good deals.  If people want to deprive themselves of sleep and get up at 4:00 in the morning to save a few bucks, then that is their choice.  If businesses want to sell some of their products for low prices to bring customers to their store, then that is fine too.

There is one economic fallacy that does need to be addressed though.  Spending is not good for the economy as is normally thought.  There is nothing wrong with spending, but consumption does not mean that there is growth and production in the economy.

There is somewhat of a correlation between consumption and production.  But we have to understand cause and effect.  Consumption does not drive an economy.  Consumption does not make an economy good.  Production is what is good for the economy.  Production is what allows consumption to take place.  You can only consumer what is first produced.  Even if something is consumed on credit, somebody else had to have produced something.

In a poor country, like Ethiopia, there is not a lot of consumption compared to the U.S.  Most people living in Ethiopia do not have big screen televisions and luxurious cars.  I’m sure most of the people there would love to have these things, but it is not possible right now given that production is extremely low as compared to other places.  In the U.S. a lot of people can afford to buy big screen televisions because of the large amounts of capital and investment that have given us the technology and the wealth to have things.

With all of that said, consumption by itself does not mean an economy is strong and growing.  I could use my life savings and take a luxurious vacation for the next two months that would make me look like a Hollywood celebrity.  But it doesn’t mean I’m all of a sudden really rich.  I would just be consuming past savings in a huge way.  I would eventually have to go back to work and drastically reduce my standard of living.  In the same way, it doesn’t necessarily mean anything if Americans go out and spend big for this Christmas.  Maybe their confidence is up, but there is no way to know for sure if production and technology have increased that much or if Americans are simply consuming more than they probably should.

The lesson in this is that you shouldn’t pay too much attention to the news.  Even if Black Friday is a huge “success” and people are spending like crazy, this is not necessarily good.  It might mean that consumers are going into too much debt and that low interest rates have enticed people to spend more than they should and save less.  Whatever you do, don’t base your long-term investments on the results of Black Friday.

China and Russia to Drop U.S. Dollar

This is headline news on today.  This article says that China and Russia have agreed to use their own currencies in trading with each other, instead of using the U.S. dollar as they have done in the past.

This action in itself is not really significant.  But it is another sign that the dollar is losing its status as the world’s reserve currency.  The U.S. government has gotten away with much more than it could have because of the dollar’s status.  It has allowed the U.S. government to run up debt more than it otherwise could have without interest rates rising.  Countries like Japan and China have been buying U.S. government bonds and have kept interest rates lower and allowed the Fed to buy less.

This news of Russia and China, slowly turning away from the U.S. dollar, is bearish for the dollar.  We can expect the dollar to go down in relation to other currencies in general.  Of course, anything can happen in the short-term.  The Euro may weaken due to the problems with Ireland and Greece, with Portugal and Spain possibly following.  A severe downturn in the economy here could also strengthen the dollar as it did in the fall of 2008.  But overall, the trend is down for the U.S. dollar.  It will continue to lose its status as the world’s reserve currency and the Fed will continue to inflate the money supply.

In the long run, you should have a good portion of your investments in hard assets.  This could include stocks, but why bet on the performance of companies?  A better speculative play is commodities that are almost sure to do well with a weakening dollar.  Look at gold investments, silver investments, oil investments, and maybe even real estate down the line.  The party is over for the dollar and it is soon to be over for the U.S. empire.

Happy Thanksgiving everybody!

Is Deflation Possible?

There is a lot of confusion with the term deflation.  The term really should be defined as a contraction of the money supply.  Most people use it in reference to prices.  Either way, is it possible in today’s environment?  The short answer is yes, but it is also unlikely.

It is hard to talk about deflation when it comes to prices.  The reason is because it is hard to get an accurate reading of the overall price level.  In the last few years, housing prices have dropped dramatically while food prices have continued to increase, even if slowly.  It is also hard because of other factors.  Healthcare and education costs continue to skyrocket, but part of that can be blamed on government laws and regulations, not just fiat money.  Meanwhile, flat panel televisions get better and cheaper.  Increased productivity and increased technology can both lead to decreasing prices, even in the face of monetary inflation.  This is a good thing.

With that said, are we likely to see deflation any time soon, whether we use the consumer price index (CPI) or a money supply statistic?  I think it is highly unlikely.  The closest thing we might see is that as the money supply continues to increase, banks will just increase their excess reserves.  This will put a lid on prices from rising dramatically.  We might be lucky to see a flat or slightly increasing CPI, similar to what we see now.

With all of the stimulus money, bailouts, and “quantitative easing”, there are severe distortions in the market.  The distortions that were trying to correct in 2008 were not allowed to correct.  In the past 2 years, the government and the Fed have increased these distortions on a monumental scale.  We need to go through a severe recession to shake out all of the misallocations.  The government and Fed are not allowing this to happen.  The longer they continue to avoid it, the worse it will be.

I would not bet on deflation.  This would be betting against the Fed’s ability to create money out of thin air.  This is highly unlikely in the near future.  When we start to see high price inflation and the Fed pulls back to prevent a runaway inflation, then we might see something like deflation.  At the very least, we might see price deflation as the demand for money increases.  This is what we should hope for.  We should hope for it sooner rather than later.  Unfortunately, I think we are years away before the really big shakeout begins.

Will We See Catastrophe?

Things look bleak on the horizon.  If you have some knowledge of Austrian economics and monetary policy, then you are probably pessimistic right now and for good reason.  This statement is probably overused, but we are living in unique times right now.

In the fall of 2008, the Fed more than doubled the adjusted monetary base.  A move like this in such a short period of time has never happened in the U.S. since the Fed was created almost 100 years ago.  The government debt to GDP ratio is close to 100%.  There are unfunded liabilities for Medicare and Social Security that are estimated to exceed $100 trillion, a ridiculous number.  The government is running deficits over $1 trillion per year now.  There really isn’t much to be optimistic about.

So will we see catastrophe?  I suppose it depends on your definition.  There will be very hard times ahead. However, I think it is unlikely that we will see a total collapse.  I think to prepare for a total collapse is futile, unless you are willing to go all out.  By all out, I mean that you would be living on a farm, out in the country.  Even with that, how would you survive if everything turned to chaos?  What do you do when you need new shoes?  Do you have any medications that you take?  I hope you don’t need to go anywhere, because there won’t be any gasoline to start your car.

While anything is possible, I don’t think a total collapse scenario is likely.  A more realistic view is that we will see hard times ahead, maybe some chaos, but not a complete breakdown of the division of labor.  The biggest fault of most libertarians is that they underestimate the power of the free market.  It is hard to believe since libertarians are the most staunch defenders of the free market.

While we live in unique times as far as the size of the government, we have a competing force.  We also live in a unique time where technology has never been so great.  We have the internet, cell phones, and all of the other latest electronic wonders.  Communication is easier than ever.  The government can’t stop it.  Americans will not easily give up their high standard of living so that we can have more war and more government programs.  Americans will give up some of their standard of living, but there is a breaking point and we are about to hit it if we haven’t already.

While we will certainly see some tough times ahead (the Austrian business cycle theory ensures that), the long-term outlook should be positive.  Don’t underestimate the power of the free market.  Don’t underestimate human nature and people’s desire to live freely.  The free market can beat back the government.  People are starting to resist more.  It is just a matter of time before the tide of big government is turned back.

Monetary Base and QE2

It seems that the Fed has not started QE2.  What is taking it so long?  Here is a chart of the latest adjusted monetary base, which should go up with “quantitative easing”.  There is no monetary inflation yet, at least in the last 6 months.  Once the Fed starts with QE2, assuming it does, it will be interesting to see what happens to excess reserves.  It will also be interesting to see what happens to interest rates.

Robert Murphy on QE

Robert Murphy has written another great article, this time on the Fed and quantitative easing.  In the latter half of the article, he describes a black swan scenario where price inflation all of a sudden gets out of hand. I want to focus on one particular part of his article.  It is something that I’ve written about before.

Towards the end of the article, Murphy states,
“The problem is that Bernanke is sitting on huge piles of US government debt, which have just gotten decimated in the bond market. For example, if Bernanke in 2010 had created $1 billion of new reserves by buying $1 billion in additional Treasury debt, those securities would now be worth (say) only $650 million. So even if Bernanke sells them all back into private hands, he will only be able to eliminate 65 percent of the new reserves he had earlier created. Open market operations will not allow him to drain the system.”

This is what I discussed in the past with mortgage backed securities.  If the Fed bought all of these mortgage backed securities back in 2008 to bail out the banks and the Fed paid the original value of these things, what happens when the Fed tries to sell them?  After all, a lot of these mortgages have gone bad.  We hear about the horrible housing market and all of the short sales and foreclosures.  So let’s say that all of these mortgage backed securities are only worth half of what the Fed actually paid for them.  If high price inflation becomes a problem and the Fed tries to sell these assets, they will only be able to sell them for half of what they paid.

Just for example, let’s say the Fed paid $1 trillion for mortgage backed securities.  Now the Fed sells these and can only get half or $500 billion for them.  What happened to the other $500 billion?  That money is already in the system.  The Fed can’t soak it up.  It has no exit plan.  All it can do at that point is prevent future monetary inflation.

The only other possibility is forcing the banks to buy them back for the original value.  But why would the Fed do this when one of its main unstated purposes is to prop up banks?  Also, this would severely weaken the banks and could cause banks to fail.  Then the FDIC would have to bail out depositors and the Fed would have to bail out the FDIC.  This would defeat the original purpose of trying to soak up the excess money in the system.  Therefore, this is an unlikely scenario.

I don’t think the Fed would intentionally cause hyperinflation.  The bankers would be destroying themselves.  The fear that I do have is that they somewhat unintentionally destroy the dollar.  They think they can pull back at any time, just as Volcker did in the late 70’s and early 80’s.  But based on the discussion above, it may be impossible for the Fed to soak up all of the excess money once price inflation becomes bad.  If Bernanke and the Fed really do have an exit strategy, I sure would like to hear what it is.

Bush is Back

George W. Bush has been back in the news lately with the release of his book.  He basically admits to allowing torture and he is as arrogant as ever.  He is also as incoherent as he has ever been.  The guy can’t admit any mistakes and of course he still thinks he made the right decision in invading and occupying Iraq.

This is something that ruffles a lot of feathers, but Bush and Obama are a lot more alike than most would care to admit.  They are both arrogant and full of themselves.  They both surround themselves with horrible people.  Can you think of two more sleazy people than Karl Rove and Rahm Emmanuel?  These people are pretty much the scum of the earth.  This only shows that Hayek was correct in his assessment that the worst rise to the top in politics.  The presidency is the top and we continue to see the worst.

Ultimately, politics is not our answer to having a more free society.  The game has been rigged for a long time.  The Republicans and Democrats are in on it together.  There was not much of a choice between Bush and Kerry or between Obama and McCain.  Either way, we get an establishment politician that will continue with more war and more welfare.

If you want to help in bringing a more liberty-oriented society, the best thing you can do is to educate yourself and educate others.  Many libertarians neglect the first part.  They are not well versed in libertarianism.  How can you educate others on the benefits of liberty if you yourself cannot explain your position to others?  We should all seek to better ourselves at all times and we should always work on making our position more understandable for others.

We don’t need to elect a libertarian to the presidency to move in a libertarian direction.  You should remember this when investing too.  We could have a total socialist in office, but it doesn’t mean that you should move out of the country or bet on a horrible economy for the rest of your life.  A libertarian revolution could be happening right under your nose, but you just don’t see it because you are watching the mainstream media talking heads and looking at the fools in Washington DC.  We should not underestimate how much the politicians can wreck the economy, but we also shouldn’t underestimate how much the free market can overcome.