We hear that there is little inflation and that deflation may be the real threat. We hear that prices aren’t going up. In certain assets, like stocks or real estate, that may be the case only because they were bubbles that are trying to deflate.
Unfortunately, inflation (whether monetary or price) is a real threat. Walking through the grocery store the other day, it was hard not to notice that some of the prices had gone up. The regular price for a 12-pack of coke was $4.99 up from $4.89. It may only be a dime, but it is over 2% of an increase. About 10 or 12 years ago, a nearby gas station sold two 12-packs of coke for $5. The grocery store might have a slightly higher price, but essentially the price has almost doubled.
If banks start lending more money, watch for prices to explode. We will be lucky if the next 10 years in the United States look like the last 10 years in Japan. Pray for a lack of inflation. We would rather get a depression now than experience massive inflation and then a depression.
Federal Reserve chairman Ben Bernanke told Congress today that he is open to taking additional actions to keep the so-called recovery going. The article is here:
The article says that while there are no leading options, some of the options could include “lowering the rate the Fed pays banks to keep money parked at the Fed, strengthening the pledge to hold rates at record lows and reviving some crisis-era programs”.
The first option in particular is fascinating. The Fed funds rate is already near zero. Technically, it is set at between 0% and .25%. So the Fed is paying interest to banks for their excess reserves of around one-tenth of one percent. How can they lower it? The only option, except for some insignificant lowering, is to charge banks a fee to keep their money on reserve. If the Fed charges a high enough fee, then ultimately banks will essentially be forced to lend out their excess reserves.
The monetary base has more than doubled since the fall of 2008. This has been offset by the banks increasing their reserves. If the banks lend out all of the money that has been created since then, then we will eventually see severe price inflation. It could easily double or more in a relatively short period of time. That is why it is unlikely that Bernanke will go for this option. If he does, then he truly deserves to be called “Helicopter Ben” and he truly is an idiot.
One major mistake that many people make in economics, including many so-called economists, is that they confuse cause and effect. Deflation doesn’t cause a depression/recession any more than a wet street causes rain. Whether we are talking price deflation or monetary deflation, it isn’t really a cause of a depression. You could say that monetary deflation can trigger a depression, but the depression was already built into the cake if that is the case. The Austrian Business Cycle Theory teaches us that if there is monetary inflation, it will cause bad investments to take place, and there inevitably has to be a bust. If there is monetary deflation or even a decrease in monetary inflation, then the boom may come to an end. If there is never a slowdown in the rate of monetary inflation, then you will eventually get hyperinflation.
Going back to deflation, during the Great Depression, there was monetary deflation at the beginning. This was because there was no FDIC to bail out banks and their depositors. There were runs on banks and the fractional reserve lending process reversed itself. With the FDIC today, you won’t have a similar situation.
As far as price deflation, it is possible to have a slight decrease in prices, even if the Fed is inflating the money supply. First, you can have a situation as we have right now where the banks increase their excess reserves voluntarily. But another scenario still is that during an economic downturn, people have a greater demand for money. They are more likely to save money and spend less. Money will change hands less quickly. This can have the same effect as a decrease in the money supply. With less people spending, there will be less people to bid up prices. It is possible for prices to fall even if there is monetary inflation.
But let’s remember that falling prices aren’t a bad thing. In a recession, where the economy is trying to flush out the bad investments, it helps people that they don’t have to pay as much for food, gas, and other items. Price deflation is a cure. It should not be seen as part of the disease.
Investing is not easy. You are trying to predict how millions or billions of people are going to act. You may think the market should go up based on some kind of news you heard, but you can’t control the thoughts and actions of others.
There are a few advantages that you can gain if you understand economics, particularly free market economics. First, you should understand that economics directly involves human action. It doesn’t matter what mathematical formulas you have or what graph lines you have. What matters ultimately is how millions of human beings will act.
Another great advantage for Austrian economists is the understanding of fiat money. For most transactions that are made in our world, money is usually on one side of that trade. If you have an entity (the central bank granted by the federal government) that has a monopoly over money, it is a major factor in our economic decisions. You could have companies that are becoming less profitable and the stock prices should seemingly go down. But if the government is printing money like crazy, it might be possible for the stocks to go up in price in nominal terms.
You could be earning 12% a year on your investments, but if inflation is running at 14%, then you are losing money in real terms. The kicker is, you still have to pay taxes on your 12% “gain”.
Financial advisors will talk about the need for diversification. But one thing that often gets left out is diversification against a falling dollar (or other currency). This is the main advantage to understanding free markets. Because politics plays such a huge factor in our lives, even though it shouldn’t, we must regularly base our investment decisions on what is happening in the political world, which includes central banking.
One thing I will often remind readers of this blog is that an economy grows by production. Just because the mainstream media and the Keynesian economists tell us that we need more consumer spending, it does not make it true. There is nothing wrong with consumption. But in order to have consumption, someone has to produce something first. We could try to stimulate consumer demand in Zimbabwe, but there isn’t much to consume. Consumption is a reward that we get for previous production which comes about from capital investment and labor. If, in general, we are consuming more than we are producing, then eventually we will run out of things to consume. We will use up the wealth that had been created in the past. This sounds like a simplistic point, but if you understand this, then you are ahead of at least 95% of the population.
That is why we are likely to see rough economic times ahead. The key to growth in an economy is savings and capital investment. There is always some of that taking place, but as a whole, there is a lot less investment of capital now than there has been in the past. The government is taking so much money out of the private sector through taxation and debt, that it has to have serious negative effects at some point.
For those not familiar with Harry Browne and his “permanent portfolio”, I would recommend that you read his book Fail Safe Investing. The permanent portfolio should really be called the “sleep at night portfolio”. You simply divide up your investments into stocks, long-term government bonds, gold, and cash. If you want to speculate with other money, that is fine, as long as it is money you can afford to lose.
Some say it is out of date. But if you look at the portfolio, or the mutual fund (PRPFX), it has done extraordinarily well. It had a downturn in the fall of 2008 with most everything else, but the downturn was far less dramatic for the permanent portfolio and it quickly turned around.
I remember before Harry Browne passed away, someone called his radio show and asked how anyone could possibly buy bonds. Interest rates were fairly low and the caller was wondering how they could go any lower. I don’t remember exactly what Harry said, but he basically said that you should still hold bonds in your portfolio. There could be a flight to safety and interest rates could go even lower.
I have continued to hear people ask over the last couple of years why anyone on earth would own any bonds. Ironically, bonds have done well in the last few years. Now, I am not advocating that you speculate in bonds, but it still has a place in your permanent portfolio. We could easily see another major downturn in the economy and bonds might be the only thing that does well.
Ultimately, interest rates will probably go up. But it is impossible to say when and how much. If you short the bond market, that should definitely be a speculation with money you can afford to lose. I would not even recommend that right now as a speculation. The economy is bad and there could be a flight to what is perceived as safety. It is possible for interest rates to go lower.
There are a lot of good reasons to short the stock market right now. The best reason is the Austrian Business Cycle Theory. The Fed caused an artificial boom in the past and at some point it will go bust. It tried to go bust in 2008, but the Fed and the government pumped in trillions of dollars. The Fed did it by buying assets, particularly bad assets. The government is helping by passing stimulus bills and running trillion dollar deficits. They would not allow the previous bad investments to be cleansed out of the economy. They saw it as too painful.
The Fed created a lot of money out of thin air. Most of this money is being held by commercial banks as excess reserves. That is why we have not seen an explosion in prices. In the last 8 months or so, the Fed has had a more stable money policy, but of course all of the previous money that was created remains, mostly with the banks. At some point, we are either going to get a depression or massive price inflation. We may get both. I think the likelihood is that we’ll start to get a depression and then the government and Fed will pump in more money which will eventually cause massive inflation. Eventually, there will be a choice between a severe depression and hyperinflation. Let’s hope the Fed chooses the depression. I think it will.
In the short-term, a speculation to short the stock market may turn out to be a good play. It should only be a speculation though. This should be money that you can afford to lose. In addition, once it becomes more and more apparent that we are in another downturn, then be prepared to get out of your short positions. Once the Fed turns on the printing press or once the banks start to lend more, then prepare for high inflation. Stocks may go down in real terms, but in nominal terms (not adjusted for inflation), stocks could go significantly higher. At that point, I wouldn’t speculate for or against stocks.
Happy July 4th, otherwise known as Independence Day. We could also call it Secession Day, since that is what the American colonists did. The ironic thing is that the colonists of 1776 under King George III were, in many ways, more free than Americans of 2010. Certainly there are many differences that are hard to compare, but when it comes to economic matters, there should be little question that the colonists were far more free. Today, government at all levels take about half of our income.
We are certainly much better off than the colonists because of the great gains that have been made. There was more progress in the 1800’s than any other century in the history of the earth. The 1900’s had many great advances too, but most of it was because of the previous capital investment and progress made in the 19th century.
Today, we get to enjoy cell phones and the internet. We get to enjoy flat screen televisions and kindles. We are the richest people ever. Unfortunately, this generation of Americans may be the first generation to live worse than their parents (if you don’t count the 1930’s and early 40’s). Although we enjoy great technology, our basic needs are as expensive now as they were decades ago. Incomes have gone up slowly while the costs of food, shelter, healthcare, and education have risen substantially.
This is what happens when the government takes half of our money. We have a lot of great technology and great wealth created from previous generations, but we are starting to go backwards in some aspects. We must free ourselves from all of the oppressive taxation and regulation as well as the horrible Federal Reserve.
If we ever have American 19th century economic freedom combined with today’s technologies, the results will be unbelievable. We will have things that we can’t imagine. Let us remember on July 4 that although we are blessed to be living in these times, times could be much better if we shake off the government.
The price of gold (in terms of U.S. dollars) went down about 40 dollars today. That is a big move and many, even in the mainstream, are talking about a double-dip recession. It’s hard to call it a double-dip for me, since I’m not sure we ever came out of the first one, but regardless, it looks like the economy is continuing to head down.
The price of gold has been up as of late, but it is hard to blame inflation fears as the primary reason. If that were the case, interest rates on longer term bonds would be showing some sign of going up instead of down. There is a lot of fear in the world and gold is being used as a crisis hedge. But the point of all of this is that the gold price may take a hit in the near-term. If the stock market tanks and people get really scared, U.S. dollars will be in high demand. Gold will go down. However, it seems that foreign central banks are putting a floor on the price of gold. If gold goes down enough, don’t be surprised if the Chinese central bank makes a big purchase.
Looking a little further out, I don’t see how gold cannot go up. Nothing is ever a sure thing, but if gold takes a hit in the near-term, it will create a great buying opportunity. There is massive government debt with no end in sight and the government and Fed will continue to make things worse if we hit another major downturn. The Fed will print more money (figuratively speaking) and we may see another massive “stimulus” package come out of the government. The Fed could also take measures to force the banks to lend their excess reserves. If this happens, prepare for massive inflation (at least double digit price increases).
To sum up, don’t be surprised if the price of gold goes down in the near-term with the stock market and the rest of the economy. But it probably won’t take long for it to go back up. If the Federal Reserve continues with its destructive policies, look for the gold price to skyrocket, along with your grocery bills.
Mortgage rates are near an all-time low. They haven’t been this low in at least 39 years. It is amazing that someone will loan me money for 30 years with a fixed interest rate of 4.5% and I can pay it back in depreciating money. With such a low rate, it is telling me that the market is not scared of inflation right now. It is just scared. People are willing to accept really low rates for the safety of their principal.
The bond market is probably a bubble. I would be surprised if rates did not rise dramatically in the coming years. But who knows for sure? Maybe we will end up like Japan. Japan has a debt-to-GDP ratio in the neighborhood of 200%. This makes Greece look fiscally responsible. But Japan’s rates have remained low for 2 decades. I don’t expect this to happen in the U.S., but I’m just pointing out that it’s possible. In other words, don’t short the bond market right now. If you have a mortgage and can refinance it at a really low fixed rate, do it if you aren’t planning to sell anytime soon.