I don’t like making predictions, particularly when it comes to economics and investing.  The problem is that there are too many variables.  The economy (and hence investments) are dependent upon human action.  The market is made up of billions of people acting according to their own needs and wants.  In addition, in a somewhat government controlled economy, we are also dependent on the actions of public figures and politicians.

I will not make a prediction for 2011 except that I think there will be more interesting times.  I think we will see gold cross well over $1,500 per ounce OR we will see the stock market drop by 20% or more.  It will mainly depend on the Fed and the banks.  Will the Fed carry out its QE2 (money creation) like it said?  Will it do even more?  If so, will the banks lend out this money or continue to increase excess reserves?

At some point, the Fed will have to choose between inflation and depression.  If it chooses more inflation, it will eventually have to choose between hyperinflation and severe depression.  I don’t think the latter choice will have to be made in 2011.  The Fed will try to string things out for as long as possible.  It is much the same way that Congress deals with Social Security and Medicare.  Everyone tries to kick the can down the road so that the tough decisions have to be made by someone else.

The situation of state and city governments will grow more interesting.  These governments do not have the luxury of printing money.  Their day of reckoning is closer at hand because of this.  States like California, Illinois, and New York are in real trouble.  If DC bails out these states, it only pushes up the day of reckoning for DC and the Federal Reserve.

These state governments will have to default on at least some of their promises.  The sooner this happens, the better.  In Florida, there is a pre-paid tuition plan that parents can pay into when their child is young.  It is then promised that the child can go to any state university at no cost later on.  If you are a participant in such a plan in your own state and there is any hint of financial trouble for your state government, you should seriously consider pulling your money out if you can, particularly if your child is still young and years away from college.

As far as politics, 2011 will also be an interesting year to watch.  It is doubtful that Obama will get any serious challenge for the Democratic nomination, but the Republicans will be in campaign mode fairly soon.  The most interesting person to watch is Ron Paul and whether he runs for president.  Any other Republican will most likely be a typical establishment politician.  The only other exception may be Gary Johnson (former governor of New Mexico).  I would have to hear what he would say to see if he is worth supporting.

We will continue to watch the monetary base and excess reserves in 2011 to see if you should worry about a stock market crash or massive price inflation.  We will see how Ron Paul does chairing his subcommittee and we will see what kind of answers Bernanke provides to him.  We will see if this calms Bernanke down or if he will live up to his nickname of Helicopter Ben.

Pay attention to what is going on in the world, but remember to focus on things that you can control.  Do something good for you and your family.  Happy New Year to everyone and I wish you a safe, healthy, and prosperous new year.

According to many, Japan has essentially been in a recession for the last 20 years or so.  Some of the “experts” say that Japan has been in deflation mode and we (meaning the U.S. government and Fed) need to make sure that it doesn’t happen here.  There are a lot of myths to sort through here.

First, Japan has not really been in deflation mode, whether you define it in terms of the money supply or prices.  The central bank of Japan has inflated the money supply, but not anything like the Fed has inflated in the last couple of years.  Japan has had a few years with very minor decreases in the overall price level, but there have been many years with minor increases too.  Basically, the price level has been fairly flat over the last two decades.  Even in terms of prices, there hasn’t been any significant deflation.

The Japanese people tend to save more and spend less than the American people.  This means that the velocity of money is lower as money changes hands less frequently.  This keeps prices down.  This explains why there has been some monetary inflation while prices have stayed relatively flat.

Of course, the biggest myth is that deflation causes recessions and depressions.  While deflation (prices or monetary) could be an effect from a recession, it doesn’t cause it any more than a wet sidewalk causes rain.  Price deflation is actually a good thing for people as their money buys more, even if wages are going down.  In a free market economy (including a free market in money), there would be a tendency for prices to gradually fall.  This would represent an increase in technology and production which would allow people to buy more with their money.

There is one thing that is amazing about the Japan situation.  The debt to GDP is around 200%.  This is by far the highest of any first world country.  The debt to GDP in the U.S., as bad as it is, has not hit 100% yet.  The really amazing thing is that with such high government debt, that interest rates have remained as low as they have.  It just goes to show that human action is all that matters.  It seems that it would be irrational for people to buy bonds at really low rates when the debt is so astoundingly high.  But it doesn’t matter what you and I think.  It matters what everyone else thinks and does.  There are obviously investors who think that bonds are a good investment despite the low rates.  I can’t argue with the market.

If the Japanese government does not stop its Keynesian ways, rates will eventually go up.  But they have stayed low for 20 years, so maybe they will stay low for another 20 years.  It isn’t likely, but anything is possible.

The people of Japan have a lower standard of living than Americans.  The Japanese government is ripping off the people of Japan as all governments do.  But the Japanese people tend to be hard workers and good savers.  Americans could learn a few lessons from the Japanese people on this.  The Japanese people could learn a few lessons about free market economics.  For the amount of productivity and investment by the Japanese, their standard of living should be much higher than it is.

This topic is discussed frequently on this blog, but it is a very important one.  It affects the economy in huge ways and it therefore affects our investments.  In most transactions that take place (which is billions of transactions in a day), money is on one side of them.  That is why money is such an important topic.

After the fall of 2008, the federal government, hand in hand with the Federal Reserve, bailed out failing businesses, particularly the banks.  The Fed more than doubled the adjusted monetary base, which is the money supply that is directly controlled by the Fed.  This doubling of the monetary base was unprecedented as nothing anywhere close to this had occurred since the Fed was created in 1913.  Many Austrian free market economists thought this would lead directly to price inflation.

However, another historic thing happened in all of this.  The banks are required to keep a certain percentage of money in reserve that is on deposit.  In the U.S., it is currently around 10%.  If someone deposits $100 into a bank, the bank will typically lend out $90 and keep just $10 in reserve.  The banks are counting on the fact that most depositors will show up at the same time to withdraw their money.  If this did happen (a run on a bank), then the FDIC would reimburse the depositors.  This protects the banks from runs and it allows riskier behavior for the banks.  But 2 years ago, the banks dramatically increased their excess reserves voluntarily.  The money that was created by the Fed did not flood the system.  Banks did not lend this new money.  This kept the fractional reserve process from taking place.

This is one of the major reasons that we have not seen massive price inflation.  There is one other reason too and that is velocity.  Velocity is the speed at which money changes hands.  After the fall of 2008, people became more conservative with their money.  As people were losing their jobs, housing prices were going down, stocks were going down, and people were becoming more concerned with the future, habits changed.  People did not spend as much.  Instead they paid down credit card debt and other debts.  They saved more money in their checking and savings accounts, even if the interest rate was really low.  The demand to hold cash went up.  In a recession, cash is king.  This means that money changes hands less frequently.  This has the effect of keeping prices down.  There are less people bidding prices up.  It has the equivalent effect of a deflation of the money supply.

This is why we have not seen massive price inflation.  While the CPI is certainly questionable, there is no doubt that the rate of increase has been low.  Prices also vary depending on what it is.  Housing prices have gone down lately while gold prices have gone up.  Food prices are going up, but certainly not as much as they could.

This is an important subject that should be monitored constantly.  Keep an eye on the monetary base and the excess reserves held by banks.  But it’s also important to realize that velocity is a huge factor and it could change at any time.  It is almost impossible to measure velocity, but sometimes you can get a sense just by talking to people and listening to what is happening in the world around you.  When people start buying things because they expect the prices to go up later, then we should expect prices to go up even higher as velocity increases.

The end of a year and the beginning of a new year is always a good time to assess things.  The new year is just a date on the calendar, but for some reason people use it as a time to reflect and look forward.  People make resolutions for the new year, but they could just as easily do this in the middle of July.

As far as resolutions, there is nothing wrong with them and you should do them if they work.  However, you shouldn’t put off to January things that should be done before then.  Also, if a resolution consists of a good habit (like eating well or spending less), then this should be done year-round.  It is better to form good habits with exceptions than bad habits with exceptions.  It is better to eat well for most of the year but let yourself indulge during the holidays than it is to eat poorly for the year and then spend a couple of weeks in January trying out your resolution.

The end of the calendar year can be a good time to assess your situation in life and this includes your financial situation.  It is a good time to figure our your net worth and where you can do better financially.  You could just as easily do this in July or any other month, but will you remember to do it then?  That is why the end of the year is a good time.  You will be more likely to remember to do this exercise.

Take a piece of paper and write down your assets and liabilities.  Take your year-end statements from any 401ks, IRAs, brokerage accounts, bank accounts, etc.  Write down the amounts.  If you have anything else, estimate the value and write down the amounts.  Also, do this for your liabilities.  If you have car debt, a mortgage, or any other debts, write them down.  Figure out your net worth.  If you do not rent, figure out two figures.  Figure out your net worth with your house (minus your mortgage) and figure out your net worth without your house (also leave out any non-investments like cars or furniture).

After you do this, put this in a place where you can find it next year.  It may be in a filing cabinet or you may want to put it on your computer.  It will interest you to see what changes have taken place and if you are saving and investing the way you want.

In addition to this being a good exercise to seeing what you have done right and wrong, it is also good looking forward.  You can see where you can do better.  If you are not an active trader, it is also a good time to re-balance your portfolio.  If you like to keep an equal amount of stocks, bonds, cash, and gold, and stocks have gone up significantly in the last year, it is a good time to sell some stocks and add this to an investment that had done poorly.  Don’t count on stocks to keep going up.  Put your investments back into balance.

Again, you can do this any time of year, but you will more likely remember to do this at the end of the year.  You weigh yourself to see where you stand.  Do the same for your finances and step on the scale.

I was talking to a libertarian friend the other day who said that we would have hyperinflation in this country (the U.S.).  I said that I didn’t think it would happen here and we debated the topic.  I said that I would bet him 100 bucks that I would be right.  I figured that even if I was wrong, then I would be paying him 100 dollars that was basically worthless.

It is important to define hyperinflation.  Different people have different definitions.  Austrian free market economists talk about inflation as an increase in the money supply, which was originally the definition.  Most people today, when they talk about inflation, are referring to a general increase in prices.

The next question is what the “hyper” part means.  Does it mean an increase of 100% or more annually?  Does it mean an increase of 25% or more?  If someone says that hyperinflation means that prices will go up by 25% or more, then I wouldn’t disagree with them that hyperinflation is a good possibility.

My friend was defining hyperinflation as prices going up every day.  It means that when you receive a paycheck or other money, you will be running to the store to spend it on almost anything.  It means that the velocity of money is very high.

I don’t think this scenario is likely.  I think we will see massive inflation.  I think we may see prices going up 20% or 30% annually.  I think at that point, the Fed will pull back like it did in the late 1970’s and early 1980’s.  Bernanke is an elitist and a Keynesian, but he is not completely stupid.  I understand that hyperinflation has happened elsewhere.  I don’t think we are in the same position as Zimbabwe of a couple of years ago or 1920’s Germany.

You can never say never, but hyperinflation is not a high possibility in today’s world in the U.S.  The Fed cannot get away with things as easily now.  With the internet and the virtually free flow of information, there will be too many people that understand that the Fed and its increasing of the money supply is what leads to massively rising prices.

In addition, I don’t see why the Fed and bankers would allow this to happen.  They would be destroying themselves and the system that they built.  Gary North has made this point before.

When people talk of hyperinflation, I don’t know that they think through the ramifications.  If I thought it was coming here, I would be looking for another country to live in.  We have a high division of labor society.  We are not farmers like 1920’s Germany or 21st century Zimbabwe.  If hyperinflation happens, the trucks and trains will stop and there will not be food in your grocery store.  We are talking massive food shortages and riots.  You would not want to be here.

You should prepare your investments for a depreciating dollar.  You should expect 5 or 10 dollar per gallon gasoline in the next few years.  You should expect your grocery bill to double.  Let’s hope I’m wrong and it isn’t this bad.  If it is worse and we go to hyperinflation, don’t worry about your investments.  Worry about moving yourself to another side of the earth.

Merry Christmas to everyone!

Walter Block has an article on LewRockwell.com in which he lists all of the Austrian (free market) economists who predicted the housing bubble.  In it, he does give some interesting commentary about economics and making predictions.

Although I am not against making predictions, I always try to caution readers about them.  If I could predict the future with great accuracy, I would be richer than Warren Buffett and Bill Gates.  If there is one thing that Austrian economics teaches us, it is that humans act.  Because of this, it actually is impossible to predict the future with certainty.  For anyone who says they are 100% sure that something is going to happen (economically speaking), you would be wise to proceed with caution and take what they say with a grain of salt.

Because humans act freely, anything can happen in the economy.  Ben Bernanke could wake up tomorrow morning and read Mises and decide that he needs to stop expanding the monetary base at once.  He could take all of the Fed’s documents and turn them over to WikiLeaks.  Now of course this is highly unlikely and we can predict with a fair amount of certainty that this is not going to happen, but anything is possible.

We could be sure that interest rates will be going up in the next few months due to the fear of a depreciating dollar.  And while you may be correct that the dollar is depreciating, not everyone else will see things the same way.  There might be some rich investors who are waiting to buy bonds at the beginning of the new year because they think it is a sound investment.  There is no way for you to know this.

If Keynes got one thing right, it is when he said that the market can stay irrational longer than you can stay solvent.  This is so true.  Nothing is a sure bet when it comes to the economy.  The closest thing to a sure bet is that governments will be incompetent and corrupt, but there are even exceptions there at times.

This is important to remember when investing.  It is important to get a good education in free market economics and it can certainly help you in your investing strategy.  At the same time, human action always makes investing unpredictable at least to some degree.

I read an interesting comment a couple of weeks ago, but unfortunately I don’t know who to credit for it.  The person said that with the Fed’s announcement of QE2, it would give cover for the Chinese government to sell U.S. bonds.  The Chinese government has a little under a trillion dollars in U.S. bonds.  If and when the Fed keeps debasing the U.S. dollar, then the Chinese government will get paid back in dollars that are worth far less.  In other words, U.S. bonds may be a bad investment to have and the Chinese government has a lot of them.

Let’s say that Bill Gates wants to sell a bunch of his Microsoft stock.  He would not sell it all at once.  Doing so would tank the stock and he would get less money for the sale of his stock.  He would sell it slowly so that he could get as much as he can for it.  The same goes for the Chinese government or another major holder of U.S. bonds like the Japanese government.  To the individual bond holder, he can sell at any time and he doesn’t have to worry about moving the market in any significant way.  If a foreign government that owns hundreds of billions of dollars of U.S. bonds wants to sell, then it can’t just sell it all at once or it would crash the bond market.

With the Fed’s announcement of QE2 and buying $600 billion or more in U.S. bonds, it provides a buyer to those who want to sell.  All of a sudden, it would make sense for the Chinese and/or Japanese governments to sell their bonds since they have a willing buyer in the Fed.  This would have the effect of preventing interest rates from going lower, which is actually what we’ve seen since the Fed announced QE2.

This is all under the assumption that foreign governments would want to sell their U.S. bonds.  It makes sense to me why they would, but these politicians aren’t always that bright, so it is hard to say what their mindset is.  But don’t be surprised to see interest rates not go down while we see a big increase in the adjusted monetary base.  Wouldn’t it be ironic if the Fed’s big QE2 announcement to lower interest rates simply provides cover for the Chinese to sell their bonds?  It may be the perfect way out of the falling dollar for the Chinese and others.

The bond market is very unpredictable in the short run.  Other than a small portion for your permanent portfolio, I wouldn’t bet a lot either way on bonds these days.  There will be a good time to short the bond market.  It might be now, but I still wouldn’t bet against the Fed and its money creation.  Interest rates will eventually go up, but the Fed still may succeed in the short-term of keeping rates fairly low.

For anyone who has been paying any attention, the U.S. government is in over its head in debt.  The national debt is almost $14 trillion and the unfunded liabilities (mostly Medicare and Social Security) are estimated at as much as $100 trillion or more.  This will never be paid.  The “benefits” for Medicare and Social Security will be cut.  It is just a question of when, how much, and by what method they will be cut.

Now what about the national debt?  To pay back $14 trillion isn’t totally impossible.  It would take considerable restraint and discipline by the government, so I guess it really is impossible from that aspect.  It is an interesting question for libertarians on what to do with the national debt.  Some libertarians believe that the debt should be paid back because the government entered into a contract with others.  There are many holders of U.S. bonds including foreign governments, foreign citizens, U.S. citizens, U.S. corporations, and the Federal Reserve.

It seems that the libertarian thing to do is to honor contracts and that usually is the case.  There is a major problem here though.  These contracts are not legitimate from a libertarian standpoint.  The U.S. government has sold bonds to others with a promise to repay the buyer with the interest agreed upon.  But the problem is that the government does not create any wealth of its own.  The only wealth the government has is by confiscating it from others, whether through taxation or inflation.

If person A loans person B some money and person B agrees to pay back person A by stealing money from person C, then this isn’t a legitimate contract.  If person B is broke, then person A should take the fall, not person C.  Person C did not enter into the contract.  Just because his name was on the contract doesn’t mean he should have his money stolen from him for person B to make good on his contract.

The same holds true for the government.  Since the government has to confiscate (tax) Americans to pay for the bonds, then the contracts are not legitimate.  The bondholders should take the fall.  The only other option is to treat it like any corporate bankruptcy.  You liquidate the assets and pay off the creditors.  In this case, the federal government should sell off its properties to make good on at least some of its promises.  Although we can’t know the amount, there is property worth at least hundreds of billions of dollars, but probably more like trillions of dollars.  There are forests, national parks, oil fields, government buildings, government monuments, and many more things to auction off.  These should be sold to the highest bidder and the funds can be used to pay off bondholders (at least a portion) and those currently dependent on Social Security and Medicare.  This is similar to what Harry Browne suggested when he ran for president.

The government does not want to default, but it will be forced to eventually.  It will default through inflation first.  It will be painful.  At some point, it may default outright.  From a libertarian standpoint, this would actually be a good thing as compared to the alternative of hyperinflation.

There are a lot of mixed emotions on the latest legislation to extend tax rates and increase spending.  The legislation extends the current income tax rates for 2 more years.  The estate or death tax goes up, but not quite as much as what was scheduled to happen.  The payroll tax on the employee portion of Social Security will be cut from 6.2% to 4.2% for one year.  Meanwhile, the legislation also includes increased spending, particularly an extension of unemployment payments.

The Republicans and Democrats compromised on this.  The Republicans got the tax cuts extended and the Democrats got more spending.  Meanwhile, we all get a bigger national debt.  Ron Paul supported the legislation because he said doing nothing would mean that taxes would rise.  I almost always agree with Ron Paul’s votes, but I disagree with him on this one.  I completely understand his position and I am sympathetic towards it, but I think he should have voted no.

This legislation was a bribe to get the tax rates extended.  Other than the payroll tax being cut, this was not a tax cut.  This was preventing current tax rates from going higher.  If the tax part of this bill had stood alone as its own bill, then it would be appropriate to support it.  But it wasn’t.  This was legislation that contained good and bad.  Ron Paul has typically voted against such legislation.

Extending unemployment is a joke.  If someone can’t get a job after 2 years, they are either severely handicapped or they are just not trying hard enough.  Obviously 99.99% of the people fall into the latter category.  It is understandable.  If you are collecting unemployment checks and you can’t find a job making significantly more, what is the incentive?  There are many people that wouldn’t be looking for a job anyway.  Some people may have wanted to leave the workforce anyway and unemployment payments are just icing on the cake.  Any person that is not severely handicapped can find a minimum wage job within 2 years.  The government is just encouraging unemployment.  Unemployment paid by the government is unconstitutional and unlibertarian to start with.  Having it go for longer than 2 years is just plain ridiculous.

This legislation will just add to the deficit and debt because it doesn’t address spending.  The federal government keeps on spending money like crazy and there seems to be no end in sight.  The end will be when the Fed has to stop buying bonds because of massive inflation.  Then interest rates will go really high and the government will be forced to cut back.  Then we will get a depression.  This is all reasonably predictable.  The hard part is trying to time it.

Robert Murphy has written an article discussing the payroll tax cut and its possible effect on unemployment.  Murphy is a clear writer and clear thinker.  This article today may be a little bit harder to follow than some of his other material, but you can still get a good idea of what he is talking about even if you don’t understand his graphs.

The gist of the article is saying that the payroll tax cuts probably won’t help the unemployment situation and may even hurt it.  Obama and the Republicans compromised on a tax and spending package.  It will retain the current income taxes and, like most things coming out of DC, will increase or retain spending on programs such as unemployment.  The other piece of the legislation is that it will cut the Social Security payroll tax from 6.2% to 4.2% for one year, but just on the employee portion.

In this article, Murphy discusses and confirms comments by Bryan Caplan.  Basically, he says that by reducing the employee portion of the payroll tax and not the employer portion, it could actually cause an increase in unemployment.

This makes some sense.  There are several ways to reduce unemployment (reducing government), but basically wages need to fall or productivity needs to increase.  If we have high inflation in the future, this could help with unemployment in one sense because it could reduce real wages even if people don’t see a number reduction on their paycheck.  In giving a payroll tax cut to the employee, it actually increases their take home pay.  This has actually increased wages, in a sense.  But we need wages to fall if the market is going to clear the unemployment problem.

Aside from this argument, the problem once again is spending.  The Republicans and Democrats compromised.  The Republicans got tax cuts and the Democrats got more spending.  We need lower taxes with lower spending.  This whole thing just adds to the deficit and the debt and brings us closer to the day of reckoning.  We should take advantage of any money that we can get now and convert it into real assets, whether it is gold, silver, housing, food, or toilet paper.  You don’t want to be in dollars when the massive inflation comes.