For some reason, foreign governments and foreign central banks continue to buy U.S. government debt.  The Chinese and Japanese governments are by far the largest holders.  The “leaders” of these countries are mostly Keynesians or some sort of off-shoot.  You could also call them mercantilists.  They are stupid to continue to fund Congress’ spending spree.  The Chinese and Japanese governments would be better off buying gold.  Actually, they would be better off accumulating nothing and just allowing their economies to be free.  Although the Chinese government has been more openly talking about buying gold, it is not anywhere near to the extent of U.S. government debt.

These foreign governments are basically subsidizing U.S. consumers.  This is good for most U.S. residents, at least in the short-term.  The bad part is that the foreign governments are helping to support a bad habit (spending by Congress).  It is like a parent that keeps giving money to the irresponsible kid.

When foreign governments buy U.S. treasuries, it means that the Congress can keep running up the debt without having to worry about who will buy its bonds.  If, for example, the Chinese government said “no more”, or even worse, if it started selling U.S. debt, then other buyers would have to step in.  It could be other foreign governments.  It could be foreign citizens.  It could be U.S. citizens.  And of course, it could be the Federal Reserve.

In order to entice buyers, interest rates would go up.  This means the federal government would have higher interest costs.  This means that there will be even more deficit spending, unless Congress makes cuts to the budget (yeah right).

It is just hard to grasp how these foreign governments could be so stupid.  They should easily see the writing on the wall.  With QE2 in full force, the dollar has nowhere to go but down in the future.  The Chinese and Japanese will get paid back in dollars that are worth less, while getting paid tiny amounts of interest.  They are central planners and they don’t understand economics.

The free ride in the U.S. is almost over.  The politicians in DC will continue to spend like crazy until they are forced to cut back.  The Chinese and Japanese politicians will continue to be stupid for a while longer and hold onto U.S. government debt.  But the market will straighten things out eventually.  There will be a day when rates will go up and the Fed will be forced to create new money to support the spending habits in Congress.

The ultimate day of reckoning will be when the Fed faces a complete destruction of the dollar.  The Fed will have to stop the money flowing or else face hyperinflation.  When the Fed stops the money flow in an attempt to save the dollar, then the politicians in DC will really be squirming.  They will face angry voters.  They will be forced to cut spending on a massive scale.  They will face a similar circumstance as what many states are facing.  It will just be on a much larger scale.

The Federal Reserve has a monopoly on the money supply in the United States.  No individual or business can legally do what the Fed does.  Although the Fed supposedly has a dual mandate of keeping stable prices and maintaining low unemployment, it does neither.  In fact, the Fed causes higher unemployment and less stable prices.  The real purpose of the Fed is to protect the big banks and allow Congress to deficit-spend.

Although more Americans are understanding that the Fed creates money out of thin air, most do not understand how it is done.  Basically, the Fed buys assets and it does so by creating digits.  These new digits represent money.  So when the Fed buys assets, it is creating money out of thin air, essentially with an accounting entry on the computer.

Now, many of us like to say that the Fed prints money.  This is technically not correct, but it does get to the point.  The Fed creates digits.  If more people try to redeem these digits from the banks, then actual money will be printed.

Before 2008, the Fed only bought U.S. government treasuries/ bonds.  In late 2008 and early 2009, the Fed bought huge amounts of so-called toxic assets.  These were mortgage-backed securities that were owned by the big banks.  These mortgages (pooled together) were in trouble because of the crash in the housing market and the recession.  More and more people were defaulting on their mortgages and these assets were declining in value.  The Fed bought many of them from the failing banks in order to save the banks.  The Fed bought them at their original value, instead of their lower market value.

Usually, if the Fed wants to lower its balance sheet (take money out of the system), it can simply sell some of its assets.  These assets are typically U.S. treasuries.  But in the case of these mortgage-backed securities, they may only sell on the open market for half of what the Fed paid for them.  Therefore, the Fed will have trouble pulling back the money supply with these.  And the Fed will not dare sell them back to the banks at the original values or else it would sink the big banks.

The Fed can create money out of thin air by buying anything.  The Fed could start buying cars and televisions.  But since the Fed typically buys government debt, it allows the federal government to run up its debt to very high levels as we currently see.  This has an effect on interest rates because of what the Fed is buying.  If the Fed bought cars and televisions, it would distort those markets, but it would not impact interest rates anything like buying government debt does.

With QE2 in full force, the Fed continues to create new money at a staggering pace.  Usually this new money would be lent out by the banks and the fractional reserve banking process would take over.  But this new money has gone into excess reserves, which has kept price inflation in check (for now).

It will just be a matter of time before the Fed has to make a major decision.  It will either have to continue to create new money and fund the Congress or it will have to stop and maybe even reverse.  If the Fed continues, it will eventually risk hyperinflation and a complete destruction of the currency.  If the Fed stops (which I think it ultimately will once we have high price inflation), then we will experience a major depression and the federal government will be forced to cut spending dramatically.

We have many reasons to be optimistic in the long-term.  We also have many reasons to be pessimistic in the short-term.  Hold onto your hat for a wild ride ahead.

Libertarians understand that government interference in our lives generally makes things worse.  This holds true in any area, but particularly in economics.  We know that when the government taxes or regulates, it harms free individuals trying to freely associate.  Taxes and regulations harm employers, employees, customers, etc. and they also distort production.

One thing that is overlooked outside of Austrian economic circles is the importance of the monetary system.  You can have a limited government as far as taxes and regulations, but if the monetary system is bad, then the economy will suffer greatly.

The United States saw the greatest growth in productivity and living standards in the 19th century as ever before.  People who have some grasp of free market economics attribute this to the low taxes and regulations during that time.  And while this aspect was certainly important, I believe the monetary system was even more so.

During the 1800’s, the U.S. had a fairly stable monetary system.  It was not exactly an Austrian economist’s dream, but it was definitely a lot better than what we have today.  There was not a complete free market in money and there wasn’t even a pure gold standard.  But it was still a monetary system based on gold and silver.  Although it had its flaws (due to government interference), the monetary system of the 19th century kept a very strict limit on government inflation and debt.

The 19th century provided the people of the U.S. with price deflation (oh the horror).  But this was not deflation like during the Great Depression.  This was an increase in purchasing power for the average guy. He was able to buy more with his money as technology and productivity increased.  Capital was accumulated and invested like never before.  People saw their standard of living increase, even though the early 20th century really exploded off of the capital investment and technology from before.

The fact that the monetary system was reliable and predictable really set the stage for booming business.  Although there were “panics” and mild swings in the 19th century (again, usually caused by government), it was actually a much more stable time.  Since the Federal Reserve was formed in 1913, we have seen booms and busts like crazy.  These wild swings are attributable to the Fed’s monetary policies.

If the U.S. (and any other country) really want great prosperity going forward, the first thing that needs to happen is to get rid of the central bank and allow a free monetary system.  To start this process, we should all advocate the repeal of legal tender laws.  We should all be allowed to do business with whatever currency or other form of money we wish to use.  The Fed should not have a monopoly on money.  This should be a major goal for those who love liberty.

Understanding economics, particularly Austrian economics, can help us in our investing.  Austrian economics teaches us that the study of economics is really the study of human action.  While charts and formulas can be helpful, predicting economic trends is really trying to predict human behavior.

This is also why it is so tough to time investments.  There were some people that called the housing bubble back in 2003 and 2004, a few years before the actual peak.  There were a few that called the tech bubble in the 1990’s years before the actual peak.  So while they were right in their predictions of the bubbles popping, their timing wasn’t right.

Keynes did get something right during his lifetime.  He said that the market can stay irrational longer than you can stay solvent.  This really is a great statement.  It is why it is so tough to play the futures/ options market.  It is also why you should never go “all in” (to borrow a poker phrase) and put all of your money in one basket.

Let’s say that you think the price of gold is going to go to the moon.  The current price is just over $1,400 per ounce.  Let’s say you think it will double and go to $2,800 in the next year.  If you put all of your money into gold and it does as you think, then you will double your money.  But what if that doesn’t happen?  What if it goes down over the next year to $1,000 before actually going to $2,800 the following year?  In that scenario, you lost the opportunity to buy it at an even lower price and make even more money, but at least you still doubled your money.  It just took longer than you thought.

Of course, there is the possibility that you could have been totally wrong and lost money.  Someone could have predicted in 1981 that gold would surpass $1,000 per ounce and they would have been right if they were willing to wait over 25 years.

The point is that even if you can make some accurate predictions as to what will happen in the economy and with certain investments, you should still remain somewhat conservative.  You should speculate with money that you can afford to lose and you should always keep some cash.  You may think that you see the investment of a lifetime, but what if something even better comes along in another 6 months?  You would be better off keeping some cash on the side.  In the case of the gold example, if you thought it was a great buy now because you think it will go to $2,800 per ounce, then what if the price drops over the next few weeks?  Wouldn’t it be nice to have some extra money to buy more gold at $1,000 instead of the $1,400 price?

This is not to say that you should wait on things either.  I am a believer in the permanent portfolio as described by Harry Browne in his book Fail Safe Investing.  I believe everyone should put a majority of their investments in something similar and do it immediately.  But if you are going to take some big risks with some play money, I would still suggest that you not bet it all at once.  Leave some money aside so that you can play another hand later on.  After all, you may be right in your prediction but wrong on your timing.

Don’t become insolvent while the market stays irrational.  You may think that something should happen now, but the billions of people that make up the market may not act that way right now.

The adjusted monetary base continues to go up at a staggering rate.  It has nearly tripled in the last 3 years.  You can view it here:

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

The excess reserves held by commercial banks continue to go up with the monetary base.  You can view it here:

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

One question I haven’t really seen answered (or at least not very well) is whether we can still have significant price inflation if excess reserves continue to increase with the monetary base.  I am not absolutely sure of the answer either, but I have thought hard about it and think I can answer it.  Because there is still slight doubt in my mind, please allow me to revise my answer in the future if I need to.

There are two things that will cause price inflation.  You can have an increase in the supply of money or you can have a decrease in the demand for money (a.k.a. high velocity).  With an increase in excess reserves, the fractional reserve banking process is prohibited.  The Fed is buying assets and more money is being kept on hand at the banks.  The increase in excess reserves means that banks are not lending this new money (probably out of uncertainty).

So basically, the amount of money in the system is increasingly available, but it is not being used.  Unless the reserve requirements are changed, the banks could change their minds any minute and decide to loan out the new money.

But even aside from the supply of money, I believe that the demand for money could also be affected by all of this.  First of all, there is just an expectation of future price inflation due to the easy money policies (QE and QE2) and the massive debt.  In addition, there is actually more money in the system for people to spend.  At some point, the checking account balances of certain individuals and certain businesses will get high enough that they will start to spend more money.  So even if the total money in the banking system basically stays the same, the money may start changing hands faster.  This means there is less demand for money.  Another way to put it is that the velocity of money is higher.  The faster that money changes hands, the more prices will go up.

Just to use an extreme example, let’s say that the Fed buys $10 trillion in government bonds at one time.  The government instantly uses this money to hand out checks to every American citizen in the amount of $30,000.  Americans put this money in the bank and the banks hold it as excess reserves, as opposed to lending it out.  Even though it is sitting as excess reserves, people will undoubtedly start buying more things like cars, televisions, organic food, furniture, etc.  Prices will be bid up, even as money in the banking system stays there (but changes hands).  Money will change hands more quickly and prices will be bid up.

Aside from this, just the announcement of the Fed buying $10 trillion in government bonds would be enough to trigger massive price inflation.  It would happen just upon the announcement.

In conclusion, I have not seen this question answered well by anybody, even the great Austrian economists of our time, but I do believe it is possible and maybe even quite likely that we could see significant price inflation even as bank excess reserves are increasing.

Portugal is in the news today.  The prime minister resigned as the country will soon become the third European country to seek a bailout.  Just like the other welfare states of Europe, the Portuguese government spends an excessive amount of money and the government refuses to cut back in any meaningful way as many voters continue to demand a free lunch.

The situation in these European countries is similar to what is happening in many states around the U.S.  It is also similar to what is happening in Washington DC, although there are a few major differences.  Although Americans have become more dependent on big government, there is still a streak of individualism and independence in the American culture.  That is the good news.

Now for the bad news.  When these European countries are on the brink of disaster, they have to get bailed out by other European countries.  They depend on the European central bank.  There may be a limit as to how much bailing out there is because, eventually, other countries will refuse.  But it is different with the federal government of the United States.  The U.S. government has the Federal Reserve.  The Fed has a monopoly on the money supply in the U.S. and can continue the deficit spending for much longer as it buys government bonds.  The only limit that the Fed faces is that of hyperinflation and citizen outrage.

The next few years will be painful for almost everyone.  It will be painful for the masses of people that will suffer due to the horrible policies of their governments.  It will be painful for those who are used to getting a free lunch (think unions in Wisconsin).  It will be painful for politicians who have to deal with voter outrage.  Don’t get me wrong; I am not feeling sorry for some of these people, especially the last group.

Voters will continue to demand the impossible.  Politicians will continue to promise the impossible.  These things will all come to a climax and something will have to give.  Voters want reduced taxes and less government on the one hand, but then flinch when specifics are mentioned.  In particular, the majority of voters say they don’t want to see significant cuts in Medicare and Social Security.

What seemed like a free lunch is almost over.  The Fed can keep the game going a little bit longer, but even the Fed has been taken down a few levels.  It cannot get away with as much now.  The Fed will continue to finance deficits, but price inflation will show up in a big way eventually.  The Fed will face massive inflation or hyperinflation and will have to refuse to buy any more government debt.  Interest rates will skyrocket.  The politicians in DC will be forced to cut back.  It is just a matter of time.

It is being reported that new home sales plummeted in the month of February.  This is being reported as bad news for the housing market and bad news for the economy.  I am not trying to be a contrarian just for the sake of doing so, but I disagree with the so-called mainstream opinion on this one.

Unless you have been living under a rock, you know that housing prices are way down, a lot of people are underwater on their homes, and foreclosures are high (and would be even higher if the banks had their acts together).  Unless you are shopping for a house right now, news in the housing market is really bad.  But why is a drop in new home sales seen as a bad thing?

Although the government has intervened a lot in a lot of different areas, there is still some semblance of a free market.  The fact that new home sales are dropping is the proper response of the market to the situation.  There are a lot of vacant homes and a lot of other occupied homes in which the owners would like to sell.  If there is already an oversupply of houses, then home builders should not be building new homes, or at the very least should be cutting back on the number of new houses being built.  A drop in sales of new homes is a signal to home builders to slow down or stop.

While this may not be good for the bottom lines of home builders, this will help clear the market from an oversupply of houses.  There are a few people that will insist on buying a new house and that is fine.  But most people looking to buy will be willing to buy a used house if the price is right.

The free market is working here and it should be allowed to work.  Prices need to continue to go down until the excess inventory is cleared.  At that point, housing prices will stop falling and may even start to go up.  At some point, it will be profitable for home builders to start building new houses again.

There are a lot of things to be fearful of in this economy.  We are drowning in taxes and regulations, the federal government is running massive deficits, state and local governments are on the verge of bankruptcy, and the Fed is creating massive amounts of money out of thin air.  But don’t be fearful of a slowdown in new home sales.  That is just the market trying to correct the previous screw-ups caused by the government and the Federal Reserve.

Investing in the stock market is not a good hedge against inflation.  If you look at the 1970’s, the stock market did not do well, while price inflation was in double digits.  An inflationary environment will hurt profits for many companies.  Inflation (monetary or price) will not necessarily translate into an increase in the stock market in the short-term, even nominally.

In addition, even if stocks did go up with inflation in the short-term, it is still not a good hedge against inflation.  For something to be a good hedge, you want it to overcompensate.  A good hedge against inflation would go up at a greater rate than the inflation rate.  This is why gold is a good inflation hedge.  It will go up in dollar terms faster than the actual inflation rate, during a high inflationary time.  A good hedge should help compensate for the losses in other investments in your portfolio.

In the very long-term, stocks actually are somewhat of an inflation hedge.  At the very least, stocks will tend to keep up with inflation.  In fact, I would argue that the stock market would go up very little, if at all, if there were no monetary inflation.

If the money supply remained constant over a long period of time, why would the broad stock market go up in any significant way?  Some individual stocks would go up as others went down, but generally, the overall market would not go up.  If it did, where would the money come from?  This is a hard concept for most people to grasp because we are so accustomed to living in a world of fiat money and inflation.

So what would be the point of investing in the stock market if it didn’t go up?  Well, stocks would pay dividends.  This is really supposed to be the point of stock investing anyway.  In addition, in a free market environment, due to increases in capital, technology, and production, things would actually get cheaper.  So even though your stocks might not be going up in nominal terms, the value of your money would be increasing as you could buy more goods and services with it.

The whole stock market system is highly distorted because we don’t have a truly free market.  Monetary inflation, regulations, and taxes all distort how the stock market functions.  It discourages dividends and encourages capital gains.  It also makes investing very difficult.  This is just another reason that we need a free market in money.

The United States, joined by other countries, is now attacking Libya. (As a side note, before the massive centralization of power that was occurring even before Lincoln’s war, it would have been “the United States are…”, instead of “the United States is…”)

Of course, when I say the United States, I really mean the U.S. government.  The U.S. government is firing missiles to take out certain targets of the Libyan military.  People have been protesting in Libya for weeks now and the Libyan dictator, Gaddafi (spelled a million different ways), has not backed down.

This article by Lew Rockwell makes the point that it is possible to both oppose Gaddafi and oppose a war on Gaddafi and that is the position Americans should take.  As a libertarian, I am aware that in most situations, the opposite actually occurs of the stated purpose for a government program.  If the government passes a law to help poor people, it will inevitably make people more dependent on government and more poor.  If the government tries to save water by mandating low flush toilets, it ends up using more water trying to flush a toilet several times because it doesn’t work.

The same thing will happen with war.  By intervening, the U.S. government actually reduces the chance for liberty in Libya.  By giving orders and blowing things up, it will only turn the people of Libya against the United States.  It may actually strengthen Gaddafi from this perspective and even if Gaddafi is exposed of, who will take power and will it be a puppet of the United States?

The executive branch (presidency) of the U.S. government really does have dictatorial powers at this point.  There has been no declaration of war by congress.  There hasn’t even been an authorization, like what took place preceding the Iraq war.  This is not a compliment to Bush in any way.  It is just to point out that Obama is just as evil as Bush and that Obama does not favor peace.

If the Libyan people have an overwhelming desire for liberty, then they need no help.  If they don’t have a widespread desire for liberty, then why would the U.S. government get involved?  If the liberty movement became widespread enough in Libya, then Gaddafi would fall just as others have.  The men in the military would feel great pressure from friends and family and would turn on Gaddafi.  This needs to happen naturally without the U.S. military bombing buildings and causing massive death counts.

As far as the economy and your investments, this whole episode should just confirm to you that spending will not be reduced in any way until a financial Armageddon hits.  The cost of these missiles is actually very low when you compare them to the trillion dollar deficits.  But this whole thing is another straw on the camel’s back.  Don’t expect Obama and the congress to stop adding straws.  They will continue to spend money like crazy until the Fed refuses to buy U.S. treasuries.  The Fed will only stop buying treasuries when it faces the prospects of massive inflation or hyperinflation.

I have written a few blog posts lately on buying a house.  I had written that for someone buying a house, you should take out a 30-year fixed rate mortgage and pay back the loan in depreciating dollars.  I received a comment from someone asking, “If I had no debt (other than my mortgage) and an extra $1000/month to spend, would it be better to put that $1000 towards the principal of my 5% fixed-rate mortgage, or to invest/use it in some other way?”

I used to be an advocate of paying down the principal on your mortgage with the goal of paying it off early.  I agreed with Dave Ramsey on this.  The reason for this is because it is a guaranteed return on your investment.  If you have a 5% interest rate on your loan, then you are getting a guaranteed 5% return on your money by paying down the principal on your loan.

It is amazing how many people disagreed with me on this strategy.  The most common comeback was, “well, what about the tax deduction on the interest paid?”  First, the tax deduction is overrated.  There are some married people with a small enough loan who don’t even benefit because they can’t itemize their deductions.  The mortgage interest deduction is not in addition to the standard deduction, it is instead of it.  So in many cases, people are not benefiting nearly as much as they think.

In addition, the tax situation works both ways.  The guaranteed 5% return (or whatever rate) is a return that you don’t owe taxes on.  To get a 5% after-tax return on other investments, you would actually have to earn around 6% to 8%, depending on the type of investment, how long you owned it, where you live, and what tax bracket you are in.

So why have I changed my mind (somewhat) on this strategy?  My only answer is because of the political environment.  With quantitative easing (money creation) by the Fed and huge deficits by the politicians in DC, inflation (monetary or price) is a huge threat.  If we are going to experience massive inflation, why not pay off your debts in depreciated dollars?  If your mortgage payment is currently the equivalent of 10 weekly grocery bills and in 20 years it will be the equivalent of one weekly grocery bill, why would you want to hand over 10 weeks worth of groceries now instead of one week worth of groceries 20 years from now?

If you are retired or near retirement, I would suggest using your Social Security checks or some other fixed income to make your fixed monthly mortgage payments.  If you get an increase due to inflation, then I’m sure you can find something to do with your extra money.

If you are younger, and assuming you aren’t wealthy, then you should take out a 30-year fixed rate mortgage if you buy or refinance a house.  I would not recommend anything shorter (like a 15-year) because it is like paying it off early, without the flexibility.

I understand the appeal of paying off your mortgage and owning your house free and clear (even though you will continue to have property taxes).  It can be a powerful feeling.

So for someone with an extra $1,000 per month who wants to pay down their mortgage, why not split the difference?  Investing and managing money isn’t an all-or-nothing game.  Take $500 per month and make an extra payment toward the principal on your home loan (assuming you have an emergency fund and other debts are paid off).  This will give you a guaranteed return and a good hedge against deflation.

Take the other $500 per month and put into an inflation hedge to offset your deflation hedge of paying down your mortgage.  Use this $500 to by gold, gold investments, silver investments, oil stocks, etc.  Then you will be covered either way.

If you have money and you are heavily invested in things that do well in an inflationary environment, then take extra money and pay off your mortgage.  But for the vast majority of people who are very vulnerable to inflation, paying off their mortgage is probably not the best thing to do with any extra savings.  Of course, there are a lot of worse things they could do with it too.

UPDATE:  I have written a special report on this subject.  You can buy it for your Amazon kindle for just $0.99.  It will take the average reader about half an hour to read.  It goes further into depth on whether you should pay down your mortgage.  There is no definitive answer on whether paying down your mortgage is a good idea.  It depends on your personal situation and your goals.  In this special report, I discuss both the advantages and disadvantages of paying down (or paying off) your mortgage.