Chinese President Hu Jintao has stated that the U.S. dollar-denominated currency system is a “product of the past”.  The article is here.  Chinese politicians have been more critical of the Federal Reserve lately due to low interest rates and the second round of quantitative easing (money creation), also known as QE2.

These statements by the Chinese president remind me of American politicians criticizing the other party.  I don’t disagree with a lot of what he said, but have you looked in the mirror lately?  China has had monetary inflation above 20% per year.  This has fueled a speculative boom in real estate, similar to the one experienced in the U.S.  The bust is coming in China and it is all because of the same or similar policies.

It is true that the U.S. dollar is slowly losing its status of being the reserve currency of the world.  It is not because of China or any other country.  It is simply the incompetence and corruption of the U.S. government that has caused this.  The big spending and money creation has led to a decline in confidence in the U.S. dollar.  I hate to break the news to the Chinese politicians, but the yuan will not be taking the place of the dollar as the reserve currency any time soon.

China is still referred to as a communist country.  In some ways it is, but in some ways it is freer than the U.S. and other western countries.  China does not have the American for Disabilities Act.  It does not have as much red tape in many areas.  China has come a long way in the last 3 decades.  It has liberalized its markets in a lot of ways, but it also has a long way to go.  They have loosened their grip on the yuan, but it is still not a freely traded currency like the dollar, euro or yen.

I see a crash coming in China.  It will be painful for a country that has never had a big boom-bust cycle before.  When you are always in a state of bust, as China was, you are not used to a bust after a boom.  I see the growth in China over the last 30 years in two ways – part of it is illusory (artificial boom) and part of it is real.  The real part of it has actually contributed to an increase in the standard of living of tens of millions of Chinese people (maybe hundreds of millions).

China’s president is right to criticize the Fed.  His government is going to get stiffed by all of the U.S. bonds that it owns.  The problem is that China is still a mercantilist country.  At least it seems to be heading in the right direction.

I try to practice what I preach or maybe it is more like preach what I practice.  My investment advice is no different except for the fact that each individual’s situation is different.  I remember reading an article by Michael Rozeff talking about how he didn’t always follow the same advice that he wrote in articles (or something to that effect) when it came to investing.

It is hard to give investment advice to everyone because each person’s situation really is different.  Each individual is a different age, with a different net worth, with a different personality, with a different risk tolerance, etc.  That is why I like to recommend things, but at the same time provide a disclaimer of being a speculation, particularly with the higher risk moves.

With that said, let’s talk about shorting the bond market.  Currently, I do not have any short positions in the bond market, or at least not directly.  I am a big advocate of Harry Browne’s permanent portfolio, which happens to consist of 25% long-term government bonds.  I think for people who are less knowledgeable about investments and also less risk tolerant, they should just consider putting all of their investments in a permanent portfolio setup.  Then they can forget about it and sleep better at night.  Even many experienced investors would be better served by using the permanent portfolio.

Now, I have no idea what will happen with bonds tomorrow or one year from now.  If I had to guess, I would say that bonds will most likely move lower in the next several years.  It is not up to me to decide.  It is up to the market and the decisions of millions of people, along with the non-free market forces of politicians and the Federal Reserve.  But again, if I had to guess, I think that interest rates will eventually rise and will lower the price of bonds.

Since I am an advocate of the permanent portfolio, but I also want to speculate that interest rates will eventually go up, I have lightened up on bonds.  I see no point in directly shorting bonds, because I’m not confident enough at this point, particularly with the Fed buying them.  Instead, I have chosen to carry less than 25% of my investments in bonds.

There is nothing wrong with shorting bonds, even if you do have bonds elsewhere in your portfolio.  It is really up to you on how you want to go about it.  Again, I think there are heavy risks in shorting bonds right now, especially with QE2 (money creation) going on.  It is a risky play, but it is also a play that could pay off well if you are right.  So my recommendation is to lighten up on bonds from your permanent portfolio, but only for speculation purposes.  If you don’t want to speculate (although everything carries some risk), then just put your investments in the permanent portfolio fund and forget about it.  For a mutual fund that somewhat mimics this, see symbol PRPFX.

The lead article today on LewRockwell.com is by Fred Reed.  If you’ve read much of his stuff, he is very witty and certainly puts things in an interesting perspective.  I agree with much of what he says in this article today, but I would like to focus on a few things where I disagree.

First, he says that “if a country does not manufacture things, it does not have an economy, and manufacturing has fled American shores.”  This really isn’t true on several levels.  Manufacturing perhaps has declined in the U.S., but it is not like it has vanished.  But even if it had completely vanished, this doesn’t mean that there isn’t an economy and that there isn’t wealth.  We often make this mistake of drawing these artificial lines around countries as if they matter.  If what he says is true of a country, would it also not be true of a state or a city?  New York City has very little in the way of manufacturing and I wouldn’t say that NYC has no economy.

He speaks highly of China, but Hong Kong is far richer than mainland China (per capita) and Hong Kong is not a big manufacturing country.  These are the benefits of free trade and comparative advantage.  You don’t have to make all of the food you eat.  In fact, you really don’t have to make any of it.  You don’t have to make the car you drive and the car doesn’t have to be made in your country of residence.  There is nothing wrong with providing services.  There is nothing wrong with having doctors, therapists, hair stylists, salesmen, financial planners, athletes, singers, etc.  This is a sign that we are a rich society.  We only need a small fraction of people to produce food now because of capital investment and technology.  We don’t all have to work on a farm because it is not necessary.  We don’t all have to work in a car factory because other places can do it cheaper or at least in comparison to other things.

The CEO of McDonald’s might be the best burger flipper there is, but does it mean he should be in the kitchen flipping burgers all day?  This is comparative advantage.  He is better off doing more important things and letting other people flip burgers, even if they aren’t quite as good at it.

The second thing in the article that I don’t agree with is his view of competition with China.  He seems to imply that a gain in wealth for the Chinese is detrimental to America.  He does not directly say this, but it is implied.  We certainly don’t want China to overtake the U.S. in wealth because the U.S. gets poorer.  But if China simply becomes wealthier, this is not a loss to the U.S.  It benefits everyone for China to open its markets and become wealthier.

There is one more thing to point out in this article.  He says that “America is the world’s greatest debtor nation, China the greatest creditor.”  I agree and the national debt is a serious concern.  But the one thing I would like to point out is that the Chinese people are subsidizing Americans because of this.  The game will not last forever, but the Chinese are going to get stiffed on all of the U.S. bonds that are held.  As Reed says, “we must either default or inflate.”

Fred Reed is a great writer and I don’t mean to nitpick his work.  I just want to make sure that people understand some basic fallacies that are out there.  America has a lot of problems, but it has little to do with manufacturing or China.

Robert Wenzel, who blogs at EconomicPolicyJournal.com, has a piece today on price inflation.  He goes through seven things, identified by AOL, that will cost more in 2011.  The seven things listed by AOL as likely to rise are food, gas, medical care, clothing, college, raising kids, and bank fees.

Medical care and education may go up without high price inflation, just because government is so highly entrenched in these things.  Bank fees are too small to worry about and raising kids is too general.  For the other three things, food, gas and clothing, I agree.  There is no guarantee these things will go up in price in 2011, but it is likely, and if it doesn’t happen this year, it will most likely happen shortly after.

If your net worth is less than 6 figures, I think the best way to hedge against inflation is to buy things now that will likely go up in price later.  You can’t really store a lot of gasoline, or at least you shouldn’t.  It is hard to hedge against rising gas prices unless you play options/ futures.  It is even hard to find stocks and ETFs that correlate to the price of gas.

For clothing, you should consider buying clothes now that you might need in the future.  This is a tough one though because there might be a tendency to buy what you want instead of what you will need.  If you are disciplined, go ahead and buy some new clothes now and put them away for when your current clothes are worn out.  Just make sure not to gain or lose too much weight if you do this.

For food, it is hard to buy a lot of things in advance.  You can’t buy milk, but you can buy canned foods and some other items that last for a while.  Just make sure you follow the FIFO method – first in first out.

There are other things you can buy in advance.  You can buy paper towels, toilet paper, soap, razor blades, kleenex, shaving cream, toothpaste, makeup, shampoo, laundry detergent, and a whole host of other things.  Again, you should use the FIFO method so that things don’t get too old.  If you don’t have a lot of storage space, look in closets to see if you can put any shelving up high for more storage.  You should look for sales when you go to stores like Target or Walmart.  I hope you aren’t buying these things at the grocery store unless they are on sale or you are rich.  You can usually find them elsewhere cheaper.    When you see a sale, load up on the item (within reason).  It is an investment that you can’t really lose on.  What are the chances that prices will be lower this time next year?

If you are a millionaire, ignore this, unless you think there is going to be a total collapse in the division of labor.  If you are a millionaire, you are better off focusing on the big picture and taking care of the money  and assets that you have.  Anyone with any significant amount of wealth should be finding ways to hedge against inflation, whether it is real estate, gold, silver, or certain stocks.  I think inflation is the biggest threat to our standard of living right now.

Robert Murphy has written an article related to the efficient-markets hypothesis or EMH.  It is certainly worth a read, as most of Murphy’s work is interesting and accurate.

EMH is an interesting, yet wrong, hypothesis.  It is true that markets adjust according to what is known.  Prices also adjust in the present based on what is probably going to happen in the future.  If Apple announces that it has the latest and greatest gadget that will exceed all expectations, then there is a good chance the stock price will go up.  Apple does not have to have any sales of the new product and you may not even know specifically what it is, but just the expectation of future sales, and hence profit, will drive up the price of the stock.

At the same time, this doesn’t mean that everything is known equally.  It doesn’t mean the price is rational, other than the fact that the price is what it is.  The market has set the price, so who am I to argue on what is rational or irrational?  As I often mention in this blog, it doesn’t matter what the fundamentals are or what you think the price of something should be.  It matters what the billions of people in the world think.

EMH reminds me of a joke (I wish I could give credit where credit is due).  There are two guys walking down the street and one of them is an economist.  The other guy says to the economist, “hey, look, there’s a twenty dollar bill on the street.”  The economist doesn’t even look down and keeps walking.  He says, “That’s impossible.  If there were a twenty dollar bill on the street, somebody would have already picked it up.”

Austrian economics does not allow us to predict the future with certainty or accuracy.  Again, you can’t predict anything with certainty that involves the thinking of millions or billions of people.  But we can make some good assessments using Austrian free market economics and see where the market does not seem to correlate with the fundamentals.

The housing market is a good example of all of this.  It seems obvious now that there was a housing bubble, but it was not obvious at the time.  But it is certainly conceivable that if someone gave some serious thought to the whole thing, they could have seen that the exuberance in the market would wear off when more people started struggling to make their payments.  There were some Austrian economists that did predict a crash in the housing market.  They were aware of the boom-bust cycle.  They realized that housing prices were going up much faster than other prices.  They could have been wrong, but it was a reasonable prediction to make.

Let’s look at gold now.  Some say it may be in a bubble of its own.  We may very well see a sell-off in the near future on profit taking.  But we can also look at the fundamentals and see that the Fed has created massive amounts of new money and says that it will continue to do so.  If this new money gets out of the banks and into the economy, prices will rise drastically.  Commodities will most likely explode.  Gold has the potential to double or triple in price in a short time frame.  Again, this is not to say that this will happen, but only that it is a good possibility based on what we know.

There are many people that don’t analyze this.  There are many people that don’t understand this.  They are missing opportunities.  Perhaps the people that know little believe in the EMH because they really do have no chance of beating the market.  These people don’t understand monetary policy and inflation and do not understand that gold might rise significantly due to the policies of the Fed.  There is a twenty dollar bill on the street.  Will you look down to pick it up?

Michael Rozeff has the lead article on LewRockwell.com today.  He says that the U.S. is insolvent.  I’m not sure if this is technically true or not, but it certainly will be if it is not now.  It really depends on whether you count the unfunded liabilities of Medicare and Social Security.

If the U.S. government severely cut spending, including Medicare, Social Security, pensions, and the military, then the government could make good on its promises in regards to treasuries.  Of course, this is a major “if” that will not happen.  It will only happen when Congress is forced to because of the threat of hyperinflation and/or default.

If the government cut every single program other than the military, Medicare, and Social Security, it most likely would still not be able to fulfill its promises.  As time goes on, the hole just gets deeper and deeper.

At the end of his article, Rozeff says, “it is prudent to take measures to make oneself as independent of government as one possibly can.”  This is really the key point.  There is really nothing you can do about the train wreck that is about to occur.  The only thing you can do is prepare yourself and those you care about (if they’ll listen).  The best way to do that is to try your best not to rely on government.

There is one other thing you can do too.  You can help in the education process.  You can inform people of what is to come (again, if they’re willing to listen) and you can let them know that, in the words of Reagan, government is not the solution, it is the problem.  The more people that realize this, the better chance we have of being in a state of liberty after the U.S. government comes crashing down from all of its promises and debt.

The train wreck coming will be quite a sight to see.  For those paying attention, it is easy to see it coming.  Others will continue to keep their eyes closed to the obvious.  These people think that there is such a thing as a free lunch.

Terry Coxon has written an article called “How the Fed Could Become Insolvent”.  If you haven’t seen it, it is certainly worth a read.  He basically points out that if interest rates rise, there will be a certain point where the Federal Reserve is operating at a loss.

I don’t think this means that the Fed becomes insolvent and he even acknowledges this.  His conclusions are similar to mine in that the Fed will have more limited choices as rates rise.  I think the Fed will eventually have to choose between hyperinflation and depression and I think and hope it will choose the latter.

I generally agree with what he says and I think interest rates will play a key role when we start to see things unravel.  But in the grand scheme of things, a loss to the Fed is not that big.  The bigger issue is the national debt, which is now over $14 trillion.  The Congress will have to pay interest on this debt and when it has to rollover debt or issue new debt, it will be at higher rates when rates do in fact rise.  The Congress will either have to spend less, tax more, or get the Fed to create more money out of thin air.  The first two options are limited.  Congress could certainly spend a whole lot less, but even if it cut the budget by one-third, there would still be a yearly deficit right now.  The problem is that the politicians are unwilling, at least at this time, to make any substantial cuts to the military or “entitlement” programs.

Raising taxes won’t really help either.  It will just stifle the economy that much more and it may even lead to less taxes collected by the government (we’ll give Art Laffer, a non-Austrian economist, a little bit of credit here).

So basically, that leaves the Fed to create more money.  More inflation will lead to even higher interest rates down the road, just as Coxon has written in his article.

The Fed will eventually have to slam on the brakes to avoid hyperinflation and I think it will.  The ultimate solution will be for government to be dramatically cut, including the military, Social Security, Medicare, and pensions.  The other thing that will probably happen is a default.  It will happen first through inflation and then there will be some kind of outright default.  You don’t want to own a lot of government bonds when that happens.

The national debt has been in the news lately.  It just went over $14 trillion.  You can view it here:
http://www.brillig.com/debt_clock/

You can view more details here:
http://www.usdebtclock.org/

The sites differ a little bit, but they are both an estimate.  They may differ by a few billion dollars, but that isn’t much in this context.  There is a debt ceiling that is fast approaching.  The Congress has to vote to raise the debt ceiling.  This has always happened in the past.  It is usually the party in the majority that votes in favor of raising it.  It is a political ploy by the party in the minority, but the debt ceiling always gets raised.

This time will be no different except that there might be more political posturing.  Some Republicans are threatening to vote no on raising the limit.  The establishment says this is impossible.  They say that it will have to be raised.  They say it has to be raised because otherwise the government would default on some of its debt and that is just impossible in their world view.

The Republicans could refuse to raise the debt limit.  They could, but they won’t.  They will cut a deal with Obama.  Perhaps they will tell Obama they want some token spending cuts.  Perhaps they will ask for a reduction in corporate taxes of a few percentage points.  But in the end, they will vote to raise the debt limit.

When it comes to the national debt, I think repudiation of the debt is an option that, while seems to be ridiculous to most, is actually a good idea from a libertarian standpoint.  I have written on this before.

But even if you don’t think repudiation (defaulting) on the national debt is a good idea, there is still another option.  Congress could actually cut spending.  Now, it would have to cut it significantly.  It would have to cut about 1.5 trillion dollars out of the annual federal budget.  But we have to get rid of this idea of non-discretionary spending.  Everything is discretionary, whether it is Social Security, Medicare, pensions, or the military.

The problem is that Congress does not want to make these hard choices.  They do not want to cut spending.  Even most of the new politicians who helped get elected by the Tea Party do not want to make tough cuts in spending.  They talk in generalities, not in specifics.

There may be a few that follow Congressman Ron Paul.  Most will not.  They will keep spending, even if it means at a slightly slower pace.  The national debt ceiling is a joke.  It might provide some good entertainment in the near future, but it will not put a limit on the debt.  The only thing that will eventually limit the national debt is the destruction of the dollar.

Is a bond crisis inevitable?  That is the question that Pat Buchanan is asking.  Buchanan is not a libertarian, but he certainly has libertarian leanings.  I tend to agree with him on foreign policy more and economics a little less.  He does not understand the benefits of free trade and that is the main area where I part ways with him.

With this article on the national debt and bonds, he understands what he is talking about.  His last sentence says it all: “We may be closer to the falls than we imagine.”

Europe has already seen a lot of problems and they have a lot more to come.  The state and city governments in the U.S. are struggling.  Illinois is on the verge of default and California is not far behind.  It will be amusing to watch politicians, particularly Democratic politicians, having to cut money from their main constituents – union and government “workers”.

The big trouble will hit the states and cities before it hits Washington DC.  The reason is the central bank.  The Fed can keep creating money out of thin air.  The Fed can temporarily drive down interest rates and keep bonds attractive.  This allows the deficit spending to go on.  But the day of reckoning is coming for DC too.  The Fed will eventually have to choose between funding the debt and hyperinflation.  I think the Fed will eventually tell Congress to figure it out.  Hyperinflation would wreck their own game and would cause massive upheaval.

It will be an interesting day when the checks from DC bounce.  They will either have to default on the debt or massively cut spending.  Actually, they will probably have to do both.  It has been a long time coming and the moment is almost here.  Even if it takes another 10 years, it will be unbelievable to watch when it happens.  The vote buying politicians will be walking on thin ice if they aren’t already.  Let us hope that the American people (along with people everywhere else) finally turn their backs on government and withdraw their consent.

If you want an updated chart of the adjusted monetary base, go here:
http://research.stlouisfed.org/publications/usfd/page3.pdf

This is what the chart looks like through 12/30/2010.

This chart does not correlate to QE2 (Bernanke’s money creation).  It was announced at the beginning of November and the Fed is supposed to buy $75 billion in assets each month (not counting rollovers) that will total up to $600 billion by the end of June (8 months times 75 = 600).  This new money should appear in the monetary base.  Meanwhile, it has barely moved since QE2 was announced.  It looked like it was finally going up, but then made a move back down in the last week.

What is going on here?  Is it possible that Bernanke would announce one thing and do another?  It certainly is possible, but I just can’t imagine how he would get away with it, particularly in today’s world of the internet.

I can’t explain what is happening right now other than the fact that it looks like the Fed has not expanded the monetary base like it said it would.  We will continue to monitor this chart weekly and look for a move upwards.  If the chart continues to stay flat or near flat, we might have to revise our outlook.  All signs point to price inflation and higher commodity prices in the future.  If Bernanke is lying and the Fed doesn’t go through with QE2 and the banks continue to keep their excess reserves high, we might have to plan for a depression sooner than we originally thought.