Since the national debt is in the national news, now is a good time to review it.  The national debt is over $14 trillion and growing.  It is slightly less than the GDP.  The debt-to-GDP ratio will be over 100% soon enough.  So what are the consequences of this?

We hear so often that we are putting a burden on our children and grandchildren because they will have to pay this back.  There is an element of truth to this, but let’s examine it closer.  Our children and grandchildren technically don’t have to pay back anything.  They can stiff all of the bondholders.  If there are enough people who understand the issue and take a stand, then it will be the bondholders that will suffer.  That will include foreign governments like China and Japan, foreign investors, American investors, and I suppose the Federal Reserve.

The national debt has real consequences and they are happening right now.  When the government spends money, it is misallocating resources.  It is draining resources from the free market economy.  There is less capital investment on the so-called private side.  It is wasting resources.  This diminishes our standard of living.  By not completely reforming our system – that is, by not withdrawing our consent to be governed – Americans are hurting themselves by allowing this debt to continue to grow.  It really comes down to Bastiat’s philosophy of what makes a good economist.  We can clearly see the so-called benefits that the government hands out.  What we don’t see is all of the products and services that would have been invented, improved, and more affordable.

The reason that the national debt is hurting our children, grandchildren, and future generations isn’t because they will have to pay it back.  The reason is because of the lack of capital investment that is taking place because of the national debt and out-of-control government spending.  The government is misallocating resources on a massive scale.  It means that there will be less to consume in the future.  It means that there won’t be as much growth in technology and production.  With less capital investment, the standard of living will not be as high as it should be for future generations.

The national debt will probably never be paid off.  It certainly won’t be paid off in dollars that are worth as much as today.  The national debt has very real consequences though in making our standard of living far lower than what it should be.

There probably won’t be a government shutdown (unfortunately).  If there is, it probably won’t last long.  If there is, it doesn’t mean that all troops will be coming home and that Social Security checks will stop.  It means that some government employees won’t be reporting for work for a short while.

This whole debate is for show.  The Republicans have to show a little bit of allegiance to the tea party people and the Republican politicians need to pretend that they care about cutting spending and reducing government.

The Republicans originally proposed about $100 billion in cuts.  Much of this turned out to be decreases in proposed spending.  The real cuts amounted to about $62 billion.  This didn’t pass the Senate.  Now they are talking about cutting $33 billion below current spending.

This whole thing is a joke.  This is a debate about nothing.  The national debt is over $14 trillion.  The annual deficit is over $1.5 trillion.  The DC politicians are arguing over amounts that total less than 1% of the total federal budget.

This whole thing is symbolic.  What it is really symbolic of is the coming fiscal collapse because the spending in DC is out of control.  The Fed will continue to print money to fund the bad habit.  We will have to wait for high price inflation and higher interest rates before the Fed will consider putting on the monetary brakes.

We will see fiscal discipline forced on the DC politicians, much like we are seeing in many states.  The DC politicians can keep their game going longer because of the central bank.  When the dollar is on the verge of collapse and the Fed has to stop creating new money, then we will finally get to see the show.  Then we might see a true government shutdown where the troops really do come home.  If it is really bad, we might even see Social Security checks stop.

I am a strong advocate of the permanent portfolio, as recommended by Harry Browne in his little book Fail Safe Investing.  For those not familiar, I recommend reading it and implementing it.  To give a very brief summary of the permanent portfolio, it is a portfolio in which you divide up your investments as follows:

25% stocks
25% long-term government bonds
25% gold
25% cash (or cash equivalents)

The idea of this portfolio is asset protection with some growth.  It is highly diversified so that it will be protected (and possibly grow) in any economic environment.  There are variations of the portfolio such as the permanent portfolio mutual fund (symbol: PRPFX), but the idea is still the same.  The portfolio has done remarkably well over time with very few down years and significant growth.

One thing about the permanent portfolio (including the mutual fund) is that it has an inflationary bias.  In other words, the portfolio performs much stronger in a highly inflationary environment.  This is because of the 25% weighting in gold.  The mutual fund is similar, with a small portion in silver.  This is much higher than the typical investment advisor would recommend.  It is surprising when you get an investment advisor recommending as much as 10% in gold  or gold related investments.

This inflationary bias with the permanent portfolio is just as it should be.  If you are in a period of deflation and falling prices, you don’t need your portfolio to do really well.  You just need it to stay the same and your purchasing power would be increasing due to falling prices.  But in an inflationary environment with rising prices, you want your portfolio to be going up more than the price inflation rate.

If prices are going up at 10% per year, then you want your portfolio returning 15 or 20%.  If prices are flat, then a return of 5% on your investments is reasonable.  When looking at it this way, the permanent portfolio is even stronger than just looking at the charts (which is impressive anyway).  The returns, when factoring in price inflation, are even more steady for the permanent portfolio.

I recommend having your core holdings in something that is set up similar to the permanent portfolio.  I am not against speculating, but I think that should be done with “play money”.  There is nothing that is guaranteed in this world, but the permanent portfolio is the closest thing to safety as you will find and you may even get some decent returns with it.

After a lawsuit was filed by Bloomberg, a case that went all the way to the Supreme Court, the Federal Reserve has released over 29,000 pages of documents which gives us some detail of the bailouts that took place 2 and a half years ago.  Although much of it will be called lending from the discount window, it is still a bailout nonetheless.    If a bank, or any firm, has to get a loan from the Fed’s discount window, it is being subsidized.  No private party would make a loan under the same conditions.

The documents show that some of the biggest “borrowers” were not even American firms.  The most ironic of them all shows that a company which is partly owned by the Libyan central bank (part of the Libyan government) borrowed billions of dollars.  This pretty much fits in line with U.S. foreign policy: “we were for them before we were against them”.

If you are not outraged by this, then you are either a long-time libertarian who has become numb to what is happening or else you are just not with it at all.  The American people were overwhelmingly against the bailouts that took place in the fall of 2008.  Despite the outrage, Congress, along with Bush, passed the bailouts, telling us that the whole system would have collapsed otherwise.

This was hard enough to fathom at the time, but now we know the Fed was also bailing out foreign banks and, apparently, foreign governments.  Where does this end?  I suppose the answer to that is with a collapsing dollar.

This whole episode is another black eye for the Fed and the federal government in general.  The American people are starting to figure out that these clowns in DC are not on their side.  They do everything for themselves.

Since Ron Paul’s campaign in 2007, the Fed is being questioned more and more.  The internet has played a huge role in spreading all of the information and disinformation.  Although the numbers are still small, more people are becoming educated about monetary policy and the central bank.  More people understand that the Fed simply creates money out of thin air, which then makes the dollars we have worth less.

While this release of documents should outrage the average American, I think it is a good thing overall because it alerts people as to who the enemy is.  When high price inflation becomes more apparent, I want people to know who the culprit is.  I want people to blame the Fed, just as they should.  The Fed has gotten away with things for almost 100 years and finally, the tide is starting to turn.

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.