There was an article posted today on LRC by Peter Schiff. Schiff understands Austrian economics and can explain it simply to the average person. The article talks about Fed inflation, but the most interesting part is near the end when he talks about bonds.
Schiff states: “A confounding factor is the strong performance of US dollar-denominated bonds. When the Fed creates inflation, that erodes the value of fixed-asset investments like bonds, which can’t adjust their returns to the new price level. So many commentators are pointing to the record-low bond yields as evidence that inflation is not a threat. But this is a misreading of the situation.
What is overlooked is that when the Fed prints more dollars, it typically uses them to buy bonds. Traders know this, so they are stocking up on bonds at ridiculous prices just to flip them to the Fed. They don’t care that, in the long run, the Fed’s policies will destroy the bonds’ value because in the short run, the weak dollar policy serves as a tremendous subsidy to bond sellers.”
Schiff is saying that low interest rates don’t mean that there is a low threat of inflation. The Fed buys bonds when it is inflating, thereby driving down interest rates, at least for a while. He is certainly right in what he is saying. I do think that rates will go up quickly, if and when inflation is perceived as a major problem by the general population or even by the investment community.
This subject has been discussed often here before. I think it is unlikely that we will see gold go to $2,000 an ounce without seeing rates go up. But Schiff’s point should not be taken lightly because gold may be a warning sign to interest rates. Perhaps this is what is happening in the latest rise in the gold price.
The point is, don’t wait for interest rates to rise to protect yourself against inflation. Interest rates and bonds may lag because of the Fed trying to suppress rates. The Fed may “succeed” for a little while, but it will fail in the end. Get your inflation protection now.
There is often talk of the trade deficit. It is also referred to as the balance of payments. This is not to be confused with the national debt. While I don’t think the trade deficit is completely irrelevant, I believe there is misunderstanding.
There really is no problem with having a trade deficit if it occurs naturally. The U.S. government has a trade deficit with China (to use one example). China has a trade surplus. China sells products to people in the U.S. Instead of using the U.S. dollars to buy U.S. goods, the dollars are often used to buy U.S. treasury bonds. This represents the trade deficit.
Again, there is nothing wrong with a trade deficit. The Chinese (whether it’s the government or a businessman) could also put dollars into U.S. stocks. They might prefer to invest there. New York City runs a massive trade deficit. Money flows to Wall Street, but Wall Street isn’t producing consumer goods. Nobody seems to have a problem with that (although there’s probably someone).
One of the problems with the massive trade deficit is that much of it may be caused by excessive debt. If the government weren’t running a huge deficit every year, then it wouldn’t need to sell treasury bonds. If the U.S. government had no national debt, there would be no trade deficit to worry about. If there were a trade deficit, it would be foreign countries (governments or people) investing their dollars in other things.
The only threat of a trade deficit is that a foreign government could decide to unload U.S. treasuries all at once and drive up interest rates quickly. But again, we wouldn’t be in that predicament if there were no national debt. But the same could happen if U.S. citizens decided to sell bonds also.
There are three main buyers of U.S. treasuries. There is the Federal Reserve. There are individual investors (U.S. or foreign). And there are foreign governments/central banks. These treasuries could be unloaded by any one of these parties. The only one controlled at all by the U.S. government is the Fed.
Don’t get all worked up over the trade deficit. We should get worked up over the massive national debt that causes the massive trade deficit.
The adjusted monetary base has been flat or even declining a little in the last several months. The explosion in the monetary base occurred almost 2 years ago. The chart is here:
The excess reserves held by commercial banks has practically mimicked the monetary base. The chart is here:
The rise in gold does not seem to be because of imminent price inflation. Perhaps it is based on fear that there will be severe price inflation once the banks start to lend. We’ll continue to look at these charts. If the excess reserves start dropping rapidly without the monetary base falling, then we should look for price inflation to follow. The same could be said if the monetary base increases but the excess reserves don’t.
It is important to pay attention to what is actually happening instead of what is being reported. We had high monetary inflation 2 years ago, but the banks have kept that money out of the system. The Fed is not inflating now. Perhaps the Fed will start again soon, but we can’t be certain until it actually happens.
That is what an article from the Wall Street Journal says. Of course, the article starts off wrong right out of the gate. It says, “The Federal Reserve spent the past three decades getting inflation low and keeping it there.” Sure, maybe if you compare it to the awful 1970’s or to Zimbabwe. While price inflation rates were not in the double digits annually in the last 30 years, it was still significant. And of course it is hard to completely trust the CPI. While the CPI is not totally useless, it doesn’t fully account for all of the bubbles that have taken place in stocks, housing, and other things.
The rest of the article is still worth reading only to realize that Fed inflation is a real possibility in the near future. The Fed and the government really are worried about the economy and the politicians don’t really know what to do about it. While I think most of the politicians in DC are dishonest, along with Bernanke at the Fed, it wouldn’t matter much if they were honest. They don’t understand Austrian economics. They don’t understand the business cycle that is caused by fiat money creation. Bernanke is probably not quite as dumb as the rest of them, but he is still somewhat clueless. If anybody at all had a clue, it was Alan Greenspan. But that just makes Greenspan evil because his policies were bad and he knew it, but did it anyway and continues to lie to this day.
The only solution the Fed has right now is more monetary inflation. They like to call it quantitative easing now, but that is just word games. If and when the economy shows signs of more weakening, the Fed will likely create more money out of thin air. It doesn’t want to see a depression, so it will kick the can down the road and try to hold it off, even though it will just make things worse.
We’ll continue to pay attention to what the Fed says. More importantly, we will pay attention to what the Fed actually does. I don’t see a Paul Volcker moment coming soon. I see more monetary inflation first.
Gold was up again today, hitting a new record at about $1,340 per ounce. It is hard not to comment while running a blog called “Libertarian Investments”. Gold represents sound money, everything that big government is against. It is really amazing that gold is at all-time highs (at least in nominal terms) while mortgage rates are near all-time lows.
So what should we be doing right now in terms of gold and how it fits in with our investments? If you don’t have any gold or gold related investments in your portfolio, do what you can to get some as soon as possible. Every portfolio should have some exposure to gold at all times.
If you have some gold, let’s say 10 to 20 percent, then it would be wise to increase your exposure a little bit, but you should wait for dips to buy. Needless to say, today would not be considered a dip. But you shouldn’t sell with that amount, especially in today’s frightening environment.
If you have over 25% of your portfolio in gold and gold related investments, you might actually consider selling a little bit. You might ask why a libertarian would sell his gold. First, just because gold would be the most likely choice of the market in a free market for money, it doesn’t mean we are in that situation now. Whether we like it or not, the U.S. dollar is the money we use in the U.S. If you try to shop at Walmart or your local grocery store with gold coins, they will look at you like you’re nuts. You still need U.S. dollars as that is what acts as money in our world today as it exists.
Second, you should consider selling a small amount of your gold investments (if you already have a lot) because it is good to take some profits off the table, even if those profits are denominated in dollars. Think of it this way – if you sell a little gold and the price goes down, you will be able to buy back even more in the future.
Gold is making a good run (while the dollar declines) and it is not surprising. At the same time, we shouldn’t be surprised if there is a pullback below where it is now. The bond market doesn’t see price inflation right around the corner. The gold market may be telling us something different. Is it acting as the canary in the coal mine or is it a false alarm? Only time will tell.
The debt to GDP ratio will soon be at 100%. This counts the IOUs for Social Security and Medicare. It does not count all of the unfunded liabilities (promises) that include Social Security and Medicare. The IOUs consist of money that was collected through payroll taxes in the past and spent on other things (vote buying). The rest of the promises are unfunded liabilities. Unfunded liabilities are estimated to be as much as $100 trillion. This will never be paid. There will be benefit cuts which will include an increase in the retirement age.
The debt to GDP ratio hitting 100% is not something really meaningful other than it being a milestone. Japan’s ratio is close to 200%. The biggest thing about hitting this number for the U.S. is that it will make some headlines and remind people of how much trouble our government has gotten us into. The debt is somewhat manageable right now for the government because interest rates are low and foreign governments continue to buy, or at least roll over, U.S. debt.
The ratio will continue to increase and eventually rates are likely to rise. This will be a tough scenario that seems inevitable at this point. The U.S. will be discussing austerity measures like Greece if we are not discussing mass inflation or hyperinflation. Mass inflation seems like a good possibility. Gold seems to think so right now too. We could easily see price inflation of 20% or more. Hyperinflation is much less likely. It would destroy the banking system and cause revolution.
We’ll keep an eye on the debt to GDP ratio in the next several months. When it hits 100%, it should at least be fun to read some headlines. Some will be alarming and others, written by Keynesians, will say “no big deal”. It is a big deal. It is taking capital away from the private sector and lowering our standard of living.
Keynes is quoted as saying that markets can stay irrational longer than you can stay solvent. This is probably one of the better things that Keynes said. Austrian economics can teach us a lot, but it can’t really teach us how to time our investments very well.
That is one of the reasons that I am an advocate of the permanent portfolio (as described by Harry Browne in his book Fail Safe Investing) even for advanced investors and investors that understand Austrian economics.
Many libertarians will criticize the permanent portfolio for investing 25% in bonds. They say interest rates will go up and bonds will be a loser. These people will be right one day. The problem is, when? There were libertarians predicting higher interest rates 5 or more years ago. Bonds have been a great investment over the last 5 years, especially compared to stocks.
I don’t disagree that interest rates will eventually rise and that bonds will fall. The problem is that I have no idea when this will happen. Most people are not rich enough to continue to bet against bonds. And even if you just avoid them, then where will you put all of your money? Stocks have been horrible. Gold has done very well, but even gold could take a major hit if the economy goes into free fall again.
The most difficult thing about investing (for those that aren’t Keynesians and understand some free market economics) is the timing. That is why I think everyone should put at least half of their money into a setup like the permanent portfolio. Use the rest of your money for speculation if that is what you want to do. And just remember that markets often seem irrational and the market doesn’t care about your reasoning or about your solvency.
This blog doesn’t address geo-political events that often, but it is important. Not only is it important for the world we live in, but it can also affect our investments. This article today claims that Pakistan has blocked a vital supply route for NATO troops fighting in Afghanistan.
Don’t be surprised to hear more stories like this. The “operation” in Afghanistan is not going well and it will likely get worse. It is hard to say how the Obama administration will react, but another “surge” would not be out of the question. This in turn will only make the deficit worse and make money creation (sorry, quantitative easing) worse.
The U.S. empire continues to expand. Afghanistan helped lead to the death of the Soviet Union and it will help lead to the death of the U.S. government. The U.S. government is in over 140 countries throughout the world and fighting two wars (sorry Obama, Iraq is not done yet). The deficit is running around 1.5 trillion dollars. More than one-third of the money spent by the federal government is borrowed or created out of thin air. We are probably already past the point of no return.
This doesn’t mean that America won’t exist. It doesn’t mean that our culture will vanish. It means that the U.S. government is bankrupt and will default on its promises. There will be some tough times ahead for the American people, but a restoration of free markets would allow Americans to snap back quickly. We should hope that more freedom and less government is right around the corner.
The occupations and wars will end eventually. They will end through bankruptcy.
Gold has been holding above $1,300 per ounce for the last couple of days. This is a new nominal high. It continues to be a tug-of-war between the gold market and the bond market. Interest rates remain low, which means bonds remain strong.
The bond market may see trouble ahead, but it isn’t inflation trouble. The gold market also sees trouble ahead, but it sees more inflation and weakness of the dollar. One of them will win out eventually.
Bonds could easily win out in the short-term. If there is another stock market crash and another panic, people may flock to “safety”, which to many means bonds. The reason “safety” is put in quotation marks is because bonds are not necessarily safe, especially with the threat of higher inflation and higher interest rates.
Ultimately, the gold market will win out. The federal government is so far in the hole, that it is likely to default. Whether it defaults outright by repudiating the debt (unlikely in the near term) or it defaults by creating money out of thin air (more likely), it will not be good for the bond market in the long-term. While there are no guarantees, gold is a better long-term bet.
Should you invest in foreign currencies? I’m not against investing in foreign currencies for speculation. At the same time, there are better plays to hedge against the U.S. dollar.
If you live in the U.S. and work in the U.S. and your income is in U.S. dollars, then it is important to diversify yourself out of U.S. dollars. But remember that your debts are also in U.S. dollars. If you have a fixed rate mortgage, then you don’t really have to worry about inflation as far as that goes. You do have to worry about your investments and your general cost of living.
While investing in foreign currencies may provide a hedge against a falling dollar, it is still a speculation. All of the major currencies used on this planet are fiat currencies. They are not backed by gold, silver, or anything else other than the taxing and printing power of the governments. You could invest in Japanese yen or the euro to diversify out of the U.S. dollar. It might work, but they might also go into free fall together.
That is why gold is still the best investment to hedge against the U.S. dollar. You don’t have to worry about someone printing gold. The only way there will be additional gold is by the hard work of mining. Even then it is unlikely that there would be an explosion in the supply of gold.
If you want to speculate in the euro, yen, yuan, New Zealand dollar, or any other currency, then go for it. Just remember that, just like the U.S. dollar, it is a fiat currency.