Tax Rates for the Wealthy

The expiration of the tax cuts is in the news since they are set to expire at the end of the year.  The Obama administration has made it clear that they will not extend the tax cuts for the “wealthy”.  Of course, this use of the term wealthy is completely inaccurate.  The tax cuts are referring to income taxes.  It has little to do with wealth.  There may be a correlation, but it is not a wealth tax.

You could have somebody earning $500,000 per year and their tax rate would go up with an increase in the highest income tax rate.  Now you would think that someone making that much money is wealthy, but it is possible that the person spends every dollar they make and therefore has little wealth.

It is also possible for someone who makes $50,000 per year, yet has $1,000,000 in assets.  This person could be considered wealthy, but they would be part of the middle class tax cuts.

This move by the Obama administration is just more class warfare to try to appeal to the voters.  It will work with the typical leftist, but it doesn’t mean much to most others.  Some see right through the class warfare and it serves to hurt Obama even more.

But regardless of all of this, the extra money collected by the government (if there is any extra at all) will be little compared to the big picture.  Obama just said that he wants to spend another 50 billion dollars on roads and runways.  Even if you calculate the extra taxes collected on a static basis (which assumes that human behavior never changes), an increase in the highest tax rate will translate to a drop of water in a pool.

The government is running a deficit of about 1.5 trillion dollars per year.  This would have been unthinkable even 3 years ago.  The tax rates mean little at this point.  It just tells us how much more or less the government will inflate.  Either way, spending keeps going up and it is completely out of control.  No tax hike in the world could possibly balance the budget unless there is a decrease in spending.

Keep your eye on the ball.  The ball is government spending, not tax rates.

Velocity of Money

There seems to be a lot of confusion about the velocity of money.  It is even misunderstood by some from the Austrian school of economics.  Richard Maybury (writer of the Early Warning Report) has a good grasp on the subject.

The velocity of money is how fast money is changing hands.  Put another way, it is the demand for money.  When there is high velocity, the demand for money is low.  When there is low velocity (which is occurring in the U.S. now), the demand for money is high.  Low velocity means that money is changing hands more slowly.

Besides production and technology, there are generally two things that drive the overall price level of goods and services.  The first thing is the supply of money.  The second thing is the velocity or demand for money.  This is why price inflation does not correlate exactly to monetary inflation (ignoring excess reserves and fractional reserve banking).

Let’s say that the Federal Reserve is pumping money into the economy and causing monetary inflation of 20% per year.  However, the Fed announces that it will withdraw all of this money next year.  If people believe what the Fed is saying, then price inflation could go down (or even negative), just on the expectation that there will be monetary deflation in the future, even though there has been an increase in the money supply.

But velocity is not just about expectations of monetary inflation.  It just reflects the general mood of the public.  When the recession became apparent in the fall of 2008, the Fed more than doubled the monetary base.  However, most of this money ended up as excess reserves held by the banks.  But people have been scared and they started to save more and spend less.  High unemployment rates are scaring people and the future uncertainty is scaring people.  While the massive debt should be inflationary, the increase in demand for money has led to price stability.  People are more scared about their own debt and their own income than they are about future inflation.

Mises said that during the crack-up boom (hyperinflation), the rate at which prices increase can go much higher than the rate of increase of the money supply.  This is due to extremely high velocity.  People are desperately trying to get rid of their dollars for anything tangible because they expect an ever increasing rate of inflation.

You should understand that velocity exists and that it does affect prices.  Just because there is monetary inflation or deflation doesn’t mean that prices will necessarily follow.  Prices are likely to follow over time, but you should be careful in your speculations.  That is why investing is so difficult.  Not only do you have to read the minds of politicians and central bankers, but you have to read the mood of the public.

More Stimulus Spending

It looks like Obama is going to announce his plan for more “stimulus” spending.  The plan is to spend another 50 billion dollars on roads, railways, and runways.

There are a lot of people on the right who think that Obama is a communist and/or socialist.  This may or may not be true, but the bottom line is that Obama has surrounded himself with Keynesians.  Obama and his advisors believe that the key to economic growth is spending and in particular, government spending.

While this kind of spending may not be as wasteful as other spending, it will not help the economy.  It is more government spending which misallocates resources.  It may stimulate the economy in the short-term in the sense that it will appear that the economy is better than it is, but in the long-term, it is more malinvestment that will have to be shaken out of the system.

The government keeps making things worse, just as it did during the Great Depression and New Deal.  50 billion dollars is not huge in the grand scheme of things, but it is another straw on the camel’s back and it shows (as if we didn’t already know) that the government is incompetent and has no clue on what to do to fix the economy.

The government is basically doing the opposite of what it should be doing if the politicians really did want to fix the economy.  Hold on to your hat because it is going to be a bumpy ride until things shake out.

Hyperinflation

The lead article on LewRockwell.com this weekend is titled “How Hyperinflation Will Happen“.  I don’t really like to pick a fight with someone who is being published on Lew Rockwell’s website, but it is important that you understand some errors of the author.  I don’t know anything about the guy, but he is obviously very knowledgeable and he is probably a strong libertarian.

While I think hyperinflation is possible in this country, I don’t think it is the most likely outcome.  But the thing that amazes me most about this guy’s article is how nonchalant he is at the end of the article.  He expects hyperinflation to happen in the near future so he suggests investing in hard metals.  While this may be good advice, he is saying that it will just pass by, as if it is no big deal.

If we experience hyperinflation in this country, that is just about a worst case scenario.  It could mean a total breakdown of the division of labor.  It could mean riots and millions of people starving in poverty.  He doesn’t understand the implications of his prediction.

Now, let’s move on to his prediction of how we get there.  He basically says that there will be a crash in U.S. treasuries (please read the article yourself to see his full explanation).  Maybe I’m missing something here, but he may be getting his cause and effect mixed up.  High inflation rates is what causes high interest rates (and lower bond prices).  Investors demand a premium because they are expecting to be paid back in depreciated dollars.  An increase in interest rates isn’t what causes inflation or hyperinflation.

Inflation is a monetary phenomenon.  Individual prices can go up or down based on the supply and demand of the product.  Prices can go down due to increased technology and efficiency.  Prices can go up because of government taxes and regulations.  But the only things that can cause a general rise or decrease in the overall price level are velocity (demand for money) and the supply of money (you could include fractional reserve banking with this).

It is possible for velocity to cause hyperinflation.  If everyone turned into an Austrian economist tomorrow morning and decided that the U.S. dollar is a worthless fiat currency, then it is possible for everyone to start trying to get rid of their dollars by buying things, thus bidding up prices.  However, this scenario is highly unlikely.

The only likely thing to cause hyperinflation is a dramatic increase in the money supply.  It would also be expected by the market that the money supply would keep growing in the future.  As discussed in other posts, the monetary base has more than doubled in less than 2 years, but most of this money is sitting as excess reserves.  This has stopped massive price inflation.

While the author of this article raises some good points, his reasoning for hyperinflation fails.  Even Milton Friedman understood that inflation is a monetary phenomenon.  We will likely only see hyperinflation if we see a huge increase in the money supply on an on-going basis.

How to Beat Inflation

There was an article posted today on Yahoo Finance.  The title is “6 Ways Retirees Can Beat Inflation”.  It is amazing how ignorant some articles are.

The article talks about 6 ways to hedge against inflation.  They are all terrible ideas as far as the subject goes.  How can you have an article talking about ways to beat inflation and not mention gold, silver, oil, real estate, or other hard assets?  Most of the ideas revolve around depending on the government’s CPI calculation.  The only half decent idea is investing in stocks, but even this is not that good if you look at what happened in the 1970’s.

When you see an article like this, you can see the ignorance that is out there.  How can gold not be mentioned in such an article?

What to Read

This blog is a supplement.  It is designed to give advice, but it is just a tiny portion of what you should know about Austrian economics and investing.  For paid subscriptions, Richard Maybury, who writes the Early Warning Report, is fantastic.  He understands Austrian economics and is very practical and down-to-earth with his advice.  He also believes in Harry Browne’s permanent portfolio.  He is humble, as he doesn’t predict that you will become a millionaire if you just follow his stock picks.  His newsletter is well worth the money if you enjoy reading this type of material.  You will learn a lot about geo-politics and monetary policy.

Gary North is also a good read.  You can subscribe to his website where he puts out a huge amount of material.  He is very knowledgeable on the Fed and monetary matters.  You will also just get your money’s worth from his other advice that doesn’t have to do with investments.  In addition, you can ask questions and communicate to others on his forums.  Give it a try and cancel if you don’t like it.

Again, this blog is not in competition with anyone.  It is meant as a supplement.

You should also learn as much as you can about Austrian economics, as well as what is going on in the political world.  For this, read LewRockwell.com and Mises.org.  Learn as much as you can.

Dave Ramsey and Suze Orman

Dave Ramsey and Suze Orman (both with television shows now) offer good money advice.  You should pay attention to much of what they say.  You should not pay attention to their investment advice.  They don’t understand Austrian economics.  They don’t understand that the Federal Reserve can create money out of thin air and cause a massive depreciation of the dollar.  If they do understand it, they don’t think it is a threat.  They don’t understand the business cycle and malinvestment.  That is why they have told people in the past to invest in mutual funds.

They are both smart in their unique ways.  They offer good advice in paying off debt and living below your means.  They offer good advice on life insurance and other money issues.  It is worth watching their shows if you haven’t seen them.  Just don’t necessarily take their investment advice.  They don’t understand the dangers of a fiat currency.  They don’t understand diversifying out of U.S. dollars.

Your Investment Portfolio

This blog is meant to keep you informed and to educate you regarding money and investment decisions.  For some, it may just be confirmation of what you already know or a supplement to what you already know.  This blog is not really meant to tell you what to do.

With that said, some people want advice on their investment portfolio.  This is a difficult thing to do, as each individual’s situation is so different.  Do you rent?  Do you own a house?  If so, do you own it free and clear (deflation hedge) or do you have a big mortgage (inflation hedge or perhaps just not smart)?  Do you have any other debt?  Do you have any major upcoming expenses?

So let’s assume that you don’t have any debt with the possible exception of a reasonable mortgage.  Let’s also assume that you have an emergency fund.  Let’s also assume that you have an average income with average expenses and you are not retired (although being retired may not necessarily change this).  If you have absolutely no idea on what to do with your money, then you should probably just invest it in Harry Browne’s permanent portfolio, as laid out in his short book “Fail Safe Investing”.  You can also invest in the mutual fund that is similar (symbol: PRPFX).

If you are more experienced and you want a higher risk/reward portfolio, it would still be a good idea to have some in a permanent portfolio fund.  Here is an approximate suggestion for a portfolio in our current environment.  Please note that this could change at any time and it is also not a guarantee to make you money.  There are no guarantees.

Put approximately 15% in stocks (some index funds, some specialized funds like energy).
Put approximately 5% in gold related stocks.
Put approximately 20% in gold and gold related investments (not stocks) like GLD.
Put approximately 20% in long-term U.S. government bonds.
Put approximately 5% in silver and silver related investments like SLV.
Put approximately 35% in cash or other short-term liquid investments like a cd or money market fund.

Although bonds may seem risky, you need some protection in case of another crash.  If you had your entire portfolio in bonds in late 2008, you would have done very well.  Most other investments, other than shorting the market, did not do well.

If the Fed starts to inflate again and the banks start to loan out more money, then you will want to decrease your cash position and increase your gold and silver positions.

Again, this is a very rough estimate and each individual has a different situation.  Use common sense and what you feel comfortable with.  And again, if you have no clue, just stick with the permanent portfolio.

Interest on Excess Reserves

There seems to be a little confusion about excess reserves held by commercial banks.  The Federal Reserve started paying interest on excess reserves right around the time the economic crisis became noticeable.  It has been written by some analysts that the banks started holding excess reserves because the Fed is paying interest.

This is bad analysis, as the reason for the boom in excess reserves is probably not due to the interest paid.  The Fed is only paying one quarter of a percent on excess reserves.  Bernanke, in his recent speech in Jackson Hole, Wyoming, said that reducing the rate paid on excess reserves is a possible future weapon for fighting a bad economy (he may have used the term “disinflation” instead of bad economy).  But even Bernanke admitted that it might not have much effect.

The Fed is only paying .25% interest.  They could lower it to zero and it probably won’t make much difference.  Now, the Fed could charge a fee (a negative interest rate), but this was not discussed by Bernanke.

The most likely reason the banks are holding these large amounts of excess reserves is because of uncertainty.  The uncertainty just happened to coincide with interest paid on excess reserves and a more than doubling of the monetary base.  It is not necessarily all coincidence, but let’s not confuse cause and effect.  Just because the Fed started paying interest on excess reserves around the same time that excess reserves went way up, doesn’t mean that one thing caused the other.  The banks made a lot of bad loans in the past and they are afraid of making loans now.  They are afraid that people will default, so they are being very careful who they lend money to.  Reducing the rate to zero on excess reserves will not change these circumstances.

Monetary Base and Excess Reserves

Here are two charts.  The first chart shows the adjusted monetary base.

http://research.stlouisfed.org/publications/usfd/page3.pdf

The second chart shows the excess reserves held by banks (one year chart).

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=EXCRESNS&s[1][range]=1yr

This tells us two things.  First, the two charts are almost identical.  Money created by the Fed is going to the commercial banks as excess reserves.  This means that the newly created money is not being lent out.  This is keeping price inflation down.

The other thing you will notice is that the Fed has had a policy of stable money for over four months.  This comes after the explosion in the monetary base in late 2008 and 2009.

Until this changes, you will not see massive inflation and you probably won’t see a massive spike in gold.  You should always hold a portion of your portfolio in gold (say 20-25%) or gold related investments, but you will not see it go sky high until we see a change here.  If the economy hits another major downturn (which looks likely), then we may get a change in policy.  You should look for an increase in the monetary base or a decrease in excess reserves (without the same thing happening to the other chart).  Once you see the charts break the correlation, then you should really prepare for high price inflation.

Combining Free Market Economics with Investing