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.

It is really a bizarre time in history for Americans and for many others throughout the world.  The standard of living for Americans has increased over the last 200 years almost continuously.  There were a few setbacks with Lincoln’s war and the Great Depression, but life got easier for most Americans throughout the 19th and 20th centuries.

The growth in the 1800’s was really unbelievable.  It was a relatively peaceful time (with exceptions) and there was a relatively stable monetary system.  The federal government played a very small role in the lives of most Americans.  Progress continued greatly in the early 20th century, building off of the capital and technology of the 19th century.  Unfortunately, the 20th century also brought us much bigger government. The Federal Reserve, the income tax, and the 17th amendment (dictating that U.S. senators would be directly elected instead of chosen by the state legislatures) all came about in 1913.  Then Americans had to endure World War I.  Then there was alcohol prohibition.  Prohibition was repealed by FDR (about the only good thing he did), but he gave us a continuation of Hoover big government policies.  We saw FDR make holding gold illegal for Americans.  He gave us the New Deal, including Social Security.  Then he got the U.S. into World War II.

The growth of big government has been relentless since then.  Every president has been a disaster for liberty since before FDR.  Some have been worse than others.  Carter is seen as a disaster, but looking back he did less bad things than most others.  Reagan is seen as the closest thing to a libertarian.  While much of his rhetoric was libertarian, his policies were mostly a disaster as he approved big spending and big deficits.

It is really amazing that we saw as much progress as we did in the later part of the 20th century.  This is a tribute to the free market, or at least what is left of it.  Despite government interfering in virtually every aspect of our lives, the market has still found ways to flourish.  The electronics industry has been the most remarkable as we have seen prices drop with technology increasing at an exponential speed.

The areas with the most government involvement (healthcare, education) have seen the worst results.  Health insurance and medical care get more expensive.  The same goes for education.  Meanwhile, we see little improvements with quality compared to earlier times.  With education, we actually see it getting worse in government schools.

It is hard to compare our standard of living with previous times.  It has been said that the people of America of 200 years ago would have more in common with the people living when Christ walked the earth than they would with us today.  This really is an indication of the massive exponential growth in the last 200 years.

When you compare our living today with the 1950’s it gets a little tougher.  Our basic needs are more expensive today in some ways because of government.  That is why there are far less stay-at-home moms.  They need to work to pay the tax bill and the expensive health insurance.

But we also need to acknowledge the great things that we have today.  The families of the 1950’s did not have flat panel televisions.  They were lucky to have one TV at all.  They did not have microwave ovens.  They didn’t have computers.  They didn’t have internet and cell phones.  They did not have information at their fingertips.

It really is amazing what we can do today.  If you are curious about something, you can solve your curiosity in seconds by doing a google search.  You can use wikipedia.  You can look up directions, or the weather, or the latest sports scores, or what is happening on the other side of the planet.  You can use skype to see your friends and family who are hundreds or thousands of miles away.  You can communicate with the world almost instantly.

There are a few areas where we are worse off today than generations before us.  These can be attributed to big government.  But big government will not stop the technology train.  It can’t be stopped at this point.  While we may experience some setbacks in the near future, our long-term outlook should be bright.  Technology will continue to increase exponentially.  It will eventually phase out big government.

With all that has happened with the unions in Wisconsin, and now spreading to other states, some people are wondering what the libertarian position is on unions.

First, let’s distinguish between what are referred to as private sector unions and public sector unions.  Private sector unions are made up of union workers in the private sector (think General Motors, although this may be a bad example now that it has been bailed out by the government).  Public sector unions are made up of union workers who work for the government.  The battle in Wisconsin was over public sector unions.

A consistent and principled libertarian would actually have no problem with private sector unions if they were not supported by the government.  Libertarians are often viewed as “anti-union”, but it doesn’t give the whole picture.  The reason most libertarians are anti-union right now is because the unions, in general, push for government protection, in this case meaning government force.

The unions have been known to use violence themselves against other workers trying to replace them.  But aside from this, even the so-called peaceful unions are advocating that the government use force on their behalf.  Libertarians have no problem with a group of co-workers getting together and demanding better wages or better working conditions from their employer.  If they are not obligated by any contracts, they can even go on strike.  The problem is that the government uses force against the employers in not allowing them the option to fire the employees.  Freedom of association is a two-way street.

Things get trickier with so-called public sector unions.  An anarchist libertarian does not believe in any government, so there is no issue there.  A panarchist libertarian does not really care what any other governments do, as long as they or any other individual is not subjected to any governments in which they don’t want to participate.  The issue could arise for a minarchist libertarian, but even there you are really only talking about judges and police officers.  No government school teachers would exist in a minarchist society.  If you only had to deal with police officers and judges in a minarchist society, the total spending would be so small that unions would not be that much of an issue.

But let’s deal with the situation we are currently in.  Although consistent libertarians are against having government schools, the reality is that we have them right now.  So should the teachers be able to unionize and bargain collectively?  It really is very hard for a libertarian to answer, but I would think that if the government is spending taxpayer money, it should find the best deal it can (with what is considered acceptable for quality).  If a government is putting a contract out for bid, it should go to the company with the lowest bid that can meet the acceptable standards, so why can’t the same thing be done for government school teachers?  I know, you can hear the wailing that teachers are underpaid and under appreciated, etc.

The whole problem goes back to government schools.  There are probably many teachers that are overpaid and many that are underpaid.  We don’t know because there is no free market.  If teachers had to compete in the marketplace, the best teachers would be those who would tend to get rewarded the most.

In conclusion, libertarians believe in freedom of association.  When it comes to so-called public sector unions, it is difficult for principled libertarians to take a position because they already oppose the state.

The unemployment rate has been high for the last couple of years.  The Austrian Business Cycle Theory helps explain why the rate has been so high and has remained high.  The Federal Reserve, under Greenspan, artificially lowered interest rates and created new money out of thin air.  This sent false signals to the market and injected money into places where it most likely wouldn’t have otherwise gone.  For example, money flowed into stocks and real estate.  When Bernanke became Fed chairman, he actually stopped the loose monetary policy for a while.  This revealed that much of the previous investment could not be sustained.  It revealed a misallocation of resources.

The reason for the high unemployment is that these resources are trying to realign with consumer demand.  Some of the people that became real estate agents and construction workers due to the housing boom should not have gone to those jobs in the first place.  This error, caused by the Fed’s monetary policy, has to be corrected (without government interference).  To make matters worse, the Fed has been printing money like crazy since 2008 with very low interest rates.  In addition, the government is bailing out certain businesses as well as running huge deficits.  With all of these things and all of the uncertainties, it has prevented the unemployment problem from correcting itself.

Now let’s forget about the Federal Reserve and monetary policy for the sake of discussion.  If the Fed kept a neutral stance and did not change the money supply (I know this is virtually impossible over the long-run), what would unemployment look like?  Now we have to consider all of the other interference by government.

In a completely free market, there would be virtually no unemployment for anyone wanting a job.  I wouldn’t say it would be zero, because there would be temporary unemployment for those in between jobs.  It is also the case that there may be a very tiny percentage who are too sick or disabled to work at all.  But in a truly free market system, unemployment would be close to zero.

The government causes unemployment in a number of ways.  Regulations on businesses cause unemployment.  Taxes cause unemployment.  Labor laws cause unemployment.

If you are willing to wash my car for $10 and I am willing to pay you $10 for my car being washed, then I can employ you to wash my car.  Let’s say that the government imposes an income tax of 20%.  Now you will only make $8 to wash my car, but that may be too low for it to be worth your time.  I could pay you more so that your take home pay is $10, but I may not be willing to pay over $12 to get my car washed.  My time is not worth that much, so I would rather do it myself than pay that much.  So, because the government instituted the income tax, it broke our deal.  It caused unemployment.

Of course, minimum wage laws are the biggest job killer.  If there were no minimum wage, just about anyone could find a job at any time.  I would be willing to pay someone $1 a day to be my personal assistant.  Sure, the wage is extremely low and most people would be foolish to do it, but it is a job offer.  But I can’t make that job offer because of the job destroying minimum wage.  With no minimum wage, I’m sure someone else would be willing to pay someone at least $20 per day to be their assistant.  If you were unemployed, you could at least do this until you found something better.

To top it all off, not only does government do things to destroy jobs, it actually subsidizes not working.  Unemployment “benefits” encourage people not to work.  I have personally heard stories of people intentionally collecting unemployment benefits with no intention of getting a job.  I heard of one person who got displaced and was about to retire anyway, but collected unemployment because it was there.

There are people that have been on unemployment for over 2 years now.  While we can certainly sympathize with people who lose their jobs, it is hard to sympathize with someone who has been out of work for over 2 years.  You can work in a fast food restaurant if you have to.  If it is beneath someone to do that, then it should also be beneath them to collect unemployment.  I don’t blame people who collect unemployment as many of them are just getting some of their money back from the government.  But the system is horrible and it just encourages people to stay unemployed.

To summarize, there are a lot of reasons for unemployment and they all go back to government.  In a truly free market environment, there would be work for anyone who wanted a job and was willing to work.