Austrian Economics and Forecasting

Robert Murphy wrote a blog post last week that I thought I would comment on.  He commented on Paul Krugman’s analysis on inflation and how Krugman hadn’t expected the current developments of an uptick in inflation.  The more interesting part comes after that when Murphy comments on his own analysis from the past.  Murphy had expected a much higher CPI at this point and was admitting that he was wrong, or at least that his timing was off.

Bob Murphy is really one of the best Austrian economists there is, if not the best.  He knows his stuff and he is also a good teacher.  If he cannot make accurate economic predictions based on Austrian economics, what hope does that leave for the rest of us?

His analysis does give us some benefits of seeing where he may have gone wrong.  Murphy says, “What I can say for now is that the specific mistake I made, was in thinking that other people would see the end-game as I perceived it.”  He says later in the post, “I thought other investors would start agreeing with my views by now, whereas I still think most of them are being incredibly optimistic.”

This provides us some great insight for followers of Austrian economics who also happen to be investors.  As I’ve said many times before, we have to remember the number one thing about Austrian economics and that is that humans act.  Because of human action, it is impossible to predict anything with certainty.  We could see all of the stars align for a particular investment, but if other people don’t see it that way, then it won’t pan out the way you think it should.

As investors and free market thinkers, we must remember that not everyone else thinks the same way that we do.  And even if more people did start following and understanding Austrian economics, there is also a perception of what other people think.

For example, if everyone turned into an Austrian follower overnight, yet nobody knew it, then things might not change right away.  I personally think government bonds are a ridiculous investment in a lot of ways, given the huge monetary inflation and the massive debt. Yet I own some funds that invest in government bonds only because I know that not everyone else sees the world the same way that I do.  If there is a stock market crash, investors will likely flock to government bonds.  As long as there are idiot investors, idiot mutual fund managers, and idiot foreign governments who are willing to continue buying bonds, then I will be an idiot myself and join them.  I just want to be the first idiot out the door when the selling actually begins.

Bob Murphy has admitted that he made a mistake in his timing because others did not see things the same way as him.  Learn from his mistake.  Don’t assume that things are obvious to others that are obvious to you.  Fundamentals matter in the long run, but we should not discount human action in the short run.  This is why I think everyone should take a somewhat conservative approach in investing and speculate with only a small portion of their portfolio.

Will We See $5 Gasoline in 2011?

Apparently, Goldman Sachs is predicting $5 gas this summer.  Goldman Sachs is also proclaiming that oil will hit $135.  Meanwhile, JP Morgan Chase is predicting oil at $130.

This should not come as a surprise and it should not come as a surprise if it actually happens.  With the way the adjusted monetary base looks over the passed few years, we are lucky we don’t have $20 per gallon gas right now.  The only thing that has saved us is the huge increase in excess reserves held by commercial banks and the high demand for cash that typically comes with a struggling economy.
Although problems in the Middle East have certainly exacerbated the situation, the rise in oil prices is primarily a monetary phenomenon.  When the Fed creates new money out of thin air by buying assets (typically government bonds), this new money will raise prices as there is more money chasing the goods and services already in existence.  This new money does not spread out uniformly though.  It often goes into certain sectors, which is why we have bubbles.
I don’t think highly of Goldman Sachs and JP Morgan Chase, mainly because of the elitist bankers tied to the government.  But just because I don’t like the companies, it does not mean I would bet against them.  In fact, assuming they are not trying to mislead anyone on this subject, they probably know a lot more than you or I.  This puts the chances of $130 or $135 oil prices as a good possibility for this summer.
Until we see some reason that the Fed will pull back and execute its so-called exit strategy, I see more monetary inflation in the short-term and mid-term.  There may be a break after QE2, but we could easily see QE3 if the economy shows more signs of weakness.
You should continue to implement a strategy of safety and a strategy of hedging against inflation.  For safety, I recommend the permanent portfolio as described in Fail Safe Investing.  For hedging against inflation, I recommend hard assets that can’t be made on a printing press and I recommend against U.S. dollars and U.S. bonds.  We should look for price inflation to rise and for Americans to feel more pain at the pump and in the grocery store.

Set Up Your Own Permanent Portfolio

I am a strong advocate of Harry Browne’s permanent portfolio, as described in his short book Fail Safe Investing.  I believe you should have at least half of your investments in the permanent portfolio or something similar to it.  If you are a more conservative investor, I would suggest at least 80%.  As Richard Maybury says, it is not the perfect plan, but until we find something better, it is the best thing out there.

One easy way to invest in something similar to the permanent portfolio is to simply buy the mutual fund PRPFX.  It is not an exact match, but it is the closest thing you can get in one package.

With the popularity of exchange traded funds (ETFs), you can easily set up a permanent portfolio with a typical online brokerage account.  The set up of the permanent portfolio is to put 25% in stocks, 25% in gold, 25% in long-term government bonds, and 25% in cash or short-term instruments.  You can easily do this with ETFs.

For the stock portion, you can buy the ETF with the symbol SPY.

For the gold portion, you can buy the ETF with the symbol GLD.

For the long-term government bond portion, you can buy the ETF with the symbol TLT.

For the cash portion, you can leave it in the money market fund of your brokerage account, or simply hold it in a money market fund or cd in a bank.

I am not saying this set up is ideal.  I think you should own some gold coins before you put money into GLD.  I think you should consider tax consequences and also the options of your 401k or other retirement plan if you have one.  You may also have other factors in your financial life that come in to play.

The point is though, between PRPFX and the new popularity of ETFs, there is no excuse that you can’t set up a good permanent portfolio plan, at least outside of your 401k.  These are risky and uncertain times and you should make sure that you have your financial ducks in a row.

Imagine the Unseen

Frederic Bastiat, a French economist and theorist of the early 19th century, wrote about that which is seen and that which is unseen.  Much like Henry Hazlitt wrote about in his book Economics in One Lesson, Bastiat said that a good economist does not just look at the seen benefits, but also the unseen costs of a government program.

It actually makes me a little sad to think of this in regards to today’s society.  Just imagine what life could be like in today’s world without big government.  Imagine if we didn’t have all of the piles or regulations, taxes, and other violations of our liberties.  Imagine if we didn’t have a central bank tampering with our money.  Imagine if we lived in a free world.

I suppose I should look at the glass of milk being half full.  We do live in the best of times.  Although the economy is rough (and probably getting worse) and it is expensive to fulfill our basic needs, we are still much better off than anyone before us.  I wouldn’t trade this time period for, say, the 1950’s.  Although life was simpler in a way back then, we still have many luxuries that we take for granted that did not exist 50 or 100 years ago.  We have washers and dryers, dishwashers, microwave ovens, central air conditioning and heat, expanded cable, ipods, cell phones, and big screen televisions.  Of course, we also have high speed computers that would have been unimaginable a couple of decades ago or less.  The internet revolution has been life changing, and mostly in a good way.

All of these great things happened, not because of government interference, but in spite of it.  It is hard to imagine what we would have now if we had lived the last 50 years with minimal government.  We literally might be living something close to the Jetsons.  We might have backpacks that we could strap on to fly to the store.  We might be able to order things from the store and have it delivered within minutes with little or no cost for delivery.  We might have 6 hour work days, instead of 8 or 9 hour work days.  Bottom line is, we would have more free time (if that is what you wanted) and we would have more wealth.

Wealth (not to be confused with money) provides more freedom to do what you want.  It provides more luxuries.  It provides better overall health.  It provides more safety.  It can make life less stressful.  This is a generalization of course, but it is all true.  Who would give up a life of living in a first world country of today to live in a world 100 years ago or even in a third world country today?

It really is sad to think how much better and easier our lives could be if people would just stop consenting to more and more government.  If we ever gain our freedom back and we see a free market economy combined with 21st century technology, the sky is the limit.  We are already seeing an explosion in technology with big government around.  Instead of missing out on more unseen benefits in the future, let’s withdraw our consent from the government and seek freedom where we can enjoy many more benefits that can be seen.

Volatility in Precious Metals

It seems that precious metals have been bouncing around all over the place.  I have written before on silver being far more volatile than gold.  It has shown that in the last few months.  Silver went up to almost $50 per ounce and then tumbled in the matter of days to below $35.  I has been slowly creeping back up.

Gold also went down, though not nearly as much.  It is back above $1,500.  Gold and silver usually move in tandem, with more volatility from silver.  The last few days has been a little strange in that they seem to be almost alternating days on which one does well.  One day silver will be up with gold flat.  The next day gold will be up with silver flat or even down.

The precious metals market is trying to find some direction.  If we don’t get hit with a hard recession with the ending of QE2, then I expect both metals to go up.

When there is high volatility in the stock market, it is often very bearish for the market.  I don’t see the same thing with precious metals.  When there is high volatility with gold and silver, there is as good of a chance or better that the prices will go up instead of down.  The high volatility can be frightening to investors, but it can be beneficial to those with a strong stomach for risk.

As far as precious metals go, it may also be worth looking at platinum.  I generally advocate that you get your exposure to precious metals through gold and, to a lesser extent, silver.  Platinum used to be double the price of gold.  With gold over $1,500 and platinum at under $1,800, there is less than a $300 spread between the two.  If you are looking to speculate a little, platinum might be worth a look.

Precious metals may take a big hit if there is another big correction like we saw in the fall of 2008.  Barring that, I expect them to go up.  However, it will not go straight up.  It will be a roller coaster ride.  We are not in a bubble yet.  I still see way too many ads trying to convince people to sell their scrap gold.  If we were in a bubble, you would see more advertisements telling people to buy gold.

Look for the day when gold goes up $100 per ounce in one day.  Maybe then we will be in a bubble.  We won’t see an end to the bull market in metals until the Fed decides that it cannot risk the complete destruction of the dollar and tells Congress that it will stop buying government debt.

Your Money and Your Location

There are many decisions to be made in your life regarding money.  The big questions tend to revolve around things like making money, saving money, investing, etc.  One thing that does not get discussed as often is where to live.  I don’t just mean a decision of whether to buy or rent, but a decision of what city to live in or even what country to live in.

Everybody’s situation is different.  Some people really have little choice in where they can live.  Many people are tied down by family, real estate, businesses, or jobs.  There are others who have far more flexibility.

If you have flexibility, particularly if you are young, you should really take this decision seriously on where to live.  I am not a big fan of moving to another country unless you live in a third world country that doesn’t have much opportunity.  If you are young and flexible, it is not a bad idea to see the world, but I would advise against moving somewhere until you have seen it and spent some time there.  It may sound like a great idea to move to some exotic location for someone living in the U.S., but you may be surprised at the culture shock.

Within the U.S., I would recommend staying away from the really big cities.  New York City, Chicago, and Los Angeles are all expensive with high taxes.  Of course, there are always exceptions.  If you are a big-time banker on Wall Street or a movie star in L.A., then you will probably want to stay where you are. But for most people, it really isn’t worth it.

It is hard to stay away from bigger cities because that is where the most opportunity tends to be.  Your profession will play a big role in your location.  For someone who works at home, you should really take advantage of your flexibility.  If you want to be near a big city, live in the suburbs.  Keep a distance from downtown.  It will be safer, cheaper, less crazy, and more family oriented.

Try to stay away from states that are in big trouble, fiscally speaking.  California, Illinois, New York, and New Jersey are just a few of the states that come to mind.  They are deep in debt and they already have really high taxes.

There are currently 9 states without an individual income tax.  They are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.  You can view the list here:

You should consider each one with your own situation.  For instance, if you are retired and have income from stocks and bonds, then Tennessee may not be that good since they do have a tax on that.  New Hampshire, home of the Free State Project, does not have an income tax or sales tax.  There is a tax on interest and dividends.

Of course, climate and lifestyle will also play a huge role.  But when researching a place to live (if you have the flexibility), you should research the taxes, regulations, and cost of living.  Again, I understand that it is easier for some than others, but you really should take time to see some of the great places to live if you have the option.

Libertarianism vs. Austrian Economics

Austrian economics is a term used for free market economics.  It is named so not because Austria had or has a free market economy.  It is named so because the people who originally studied and advocated it were from Austria.  The best place to read up on Austrian economics is the Mises Institute, which is named after Ludwig von Mises.  Although there were some that came before him, Mises is really the epitome of Austrian economics.

So what is the difference between Austrian economics and libertarianism?  Can you advocate Austrian economics without being a libertarian?  Can you be a libertarian without advocating Austrian economics?

There is a difference between the two, besides the obvious.  Obviously Austrian economics just deals with economics, while libertarianism deals with all issues political.  But the differences do go beyond that.

First, there are some people who call themselves libertarians, but they don’t necessarily follow Austrian economics.  It could be contested whether these people are actually libertarians, but they are going to call themselves whatever they want.  For example, there are followers of Milton Friedman who would describe themselves as libertarians, but these people obviously aren’t the radical libertarians that would be more likely to follow Austrian economics.

But there is another point to be made here.  It is possible to be a follower of Austrian economics without being a libertarian.  It is a strange thing to think because it is so rare.  I have seen this pointed out before, but don’t have a link available right now.  I believe it may have been Walter Block who made this point.

With libertarianism, it is really just an advocation of what the law should be.  If you are a libertarian, you think there should be laws against murder (whether this is a government law or private law).  You think that laws should prohibit the initiation of force and perhaps enforce contracts.  You don’t think there should be laws which redistribute wealth or make things a crime where there is no victim.

Austrian economics is the study of free market economics and uses human action as its basis.  Most followers of Austrianism would advocate laws permitting a free market environment.  But you could technically be a follower of Austrianism and still advocate statist policies.  You could have a politician who understands the Austrian Business Cycle Theory and also understands the other evils of monetary inflation.  Yet, he might care more about his job and pleasing his constituents and advocate statist policies.  He understands that these policies are not good for most people (although he probably wouldn’t say that), but he acts in his own short-term self-interest by advocating bad policies.

I see morality playing a big difference between the two.  Libertarianism really involves moral principles. You can certainly advocate utilitarian outcomes with libertarian policy, but it tends to be backed by moral arguments as well.  While many Austrians will, for example, call taxation theft, it really does not go to the heart of Austrian economics and is more of a libertarian argument.  Austrian economics tells us that humans act freely and that government interference in the marketplace will likely lead to bad and unintended consequences for the general populace.

So while these two terms overlap, there can be a difference.  You could have someone study Austrian economics to help them with their investing and yet they may not care one iota about living in a free society.

Excess Reserves and the Federal Funds Rate

There was an article on by Michael Pollaro.  The full article can be read here.  He is obviously a supporter of Austrian economics, or at least he likes to use it for his analysis.  I think he makes many valid points and I certainly don’t want to step on someone’s toes who is promoting Austrian economics.

With that said, I would like to point out a disagreement I have with something he wrote and I believe it is relevant in studying the current economy.  About halfway through his article he writes, “First, the Federal Reserve may be ending its current QE II asset monetization program, but it’s not it seems looking to hike its zero to 25 basis point targeted federal funds rate any time soon.  And that means it will more than likely be having to supply at least some base money to the banking system (whether that be through Federal Reserve loans or asset purchases) to keep the federal funds rate in check.”

He goes on to say, “Second, and far more important, the private banking system will by June’s end be sitting on somewhere between $1.6 and $1.7 trillion in excess reserves, meaning the fuel for the banking system to expand the money supply is in a word explosive.”

This guy knows what is happening on the one hand, but then contradicts himself on the other.  Let me explain.  He is right that there are massive excess reserves held by the commercial banks.  Usually, banks are only required to keep about 10% of deposits on reserve.  They would typically loan out the rest and hope that not everyone comes to withdraw their money all at once.  This is fractional reserve banking.

Since the Fed started creating massive amounts of money in the fall of 2008, most of this new money has gone into banks as excess reserves.  In addition, the Fed now pays interest on money held at the Fed as excess reserves.  Although the rate is currently .25%, it is still better than nothing for these banks.  With the economy still shaky, banks are afraid to lend and are keeping huge excess reserves instead of what they have typically done, which is lend out 90% of the money on deposit.

Now, what is the federal funds rate?  It is the rate charged on overnight borrowing for banks.  If a bank falls below their required reserve ratio of 10%, then it will borrow money overnight to settle its accounts and remain in compliance.

But since most of these banks have huge piles of reserves, why would they need to borrow money so that they don’t fall below their reserve requirement?  The answer is, they wouldn’t.  Therefore, contrary to what Pollaro says, the Fed will not have to supply base money in most cases to the banking system.  The Fed doesn’t have to do much of anything right now to keep the federal funds rate near zero because most banks don’t need overnight loans as long as there are huge excess reserves.

This point was made in an article by Kel Kelly.  He says that “the banks – not the Fed – are in charge of interest rates.”  He basically says that the only way the Fed can raise rates is by paying the banks significantly higher rates on their excess reserves.  He also points out that this would likely cause a recession.

I think the biggest thing to take away from this whole thing is that we should not pay too much attention to the federal funds rate right now.  This is not driving the Fed’s monetary policy.  We should pay attention to what the Fed is doing directly and what the banks are doing.  In other words, monitor the adjusted monetary base and the excess reserves held by banks.  Don’t pay much attention to the federal funds rate, especially now with the banks holding huge amounts of excess reserves.

Adjusted Monetary Base as of May 19, 2011

You can view the short-term chart of the adjusted monetary base here:

It had pulled back slightly for a few weeks, but it has resumed up.  It should go up some more through the end of June at which time “QE2” is set to expire.

We should continue to monitor this closely.  The Fed is playing with fire here.  The central bankers must really be scared of falling back in to recession (if we ever actually got out).

It will be even more interesting to see what happens after June.  I think it will depend on price inflation and the overall economy.  If price inflation picks up even more, then we should expect the Fed to stop expanding the monetary base for a while.  If the economy turns down again and unemployment starts going back up, then we should expect more money creation.

The most interesting scenario will be when we have high price inflation along with a down economy.  Then the Fed will really have to choose on whether to save the economy or save the dollar.  The economic crash will come eventually.  We just don’t know when it will be and how big it will be.

The American Economy

Things are tough right now in the U.S. and throughout much of the world.  In some ways, things have never been better.  We have access to more information than ever.  We can communicate with anyone, even if they are on the other side of the earth, and there are many ways to communicate.  We have computers that are exponentially greater than those of just a few years ago.  We have big screen televisions with great picture quality at a price that would have been unimaginable just 10 years ago.

Yet, with all of these new great technologies, our standard of living is going down in other ways.  Our basic needs are more expensive.  These include medical care and food.  You could also include housing if you ignore the peak of the boom from 5 years ago.  In the 1950’s it was common for the man to go off to work and for the woman to stay home and take care of the kids and keep up the house.  This has become increasingly difficult for families to do.

Part of this can be attributed to the fact that we want our gadgets like televisions and cell phones.  But it is hard to believe that this is the main reason, especially when these new technologies get cheaper and cheaper.  I believe the primary reason is government.  In the last 50 years, government has grown by leaps and bounds.  Some periods have been worse than others, but it has been a continuous trend of more laws, more regulations, and more taxes.  In addition, the U.S. has been completely off the gold standard since 1971.  This has allowed more tampering by the Fed.  Inflation redistributes wealth and it misallocates resources.  This is harmful to production in our society.

If you add up government at all of the levels (federal, state, and local), we fork over about half of our income to the government and this doesn’t even account for all of the things made more expensive due to government mandates and regulations.  It is not hard to believe that the average American is struggling financially.  Until the American people stop allowing politicians to have so much power, there will be more of the same.  There is certainly an economic limit as to how far the government and the Fed can destroy things, but the day of reckoning won’t be pretty.

The Fed has tripled the adjusted monetary base since 2008.  This is unprecedented.  The federal government is running deficits of over 1.5 trillion dollars.  This is also unprecedented.  The national debt is almost 100% of GDP.  There is no sign that any of this madness will stop.  The only thing that will stop it is the laws of economics.  The government will eventually have to tighten its belt or risk destroying the dollar completely.

The government surpassed the debt limit this week.  Now they are playing accounting games and borrowing money from government pensions.  They are adding problems to the already existing ones.  The politicians want to try to delay the day of reckoning.  They may succeed for a little while longer, but it seems that they are running out of tricks and don’t have much more time.

You should take every precaution you can at this point to get your financial house in order.  You should be prepared for some rough times ahead.  Don’t get caught off guard.  Most Americans can sense that something is wrong, but most don’t understand the magnitude of the problems we face.  I think with technology and an increasing awareness among Americans, we will see a rollback of government eventually.  Until then, you should be prepared for some hard times.