There is more open talk about U.S. states filing for bankruptcy.  Although I don’t see the Republicans in the House of Representatives doing any great things, it does seem that a Republican majority in the House makes it less likely that state governments will get a bailout from Washington DC.

The states that are the worst off financially are blue states (perhaps not coincidentally).  Some of the states that are in real trouble are Illinois, California, New York, and New Jersey.  Why would the Republicans help in a bailout for states that usually vote Democratic?

It is hard to say which state is the worst.  New Jersey has a Republican governor now and he is actually somewhat fiscally conservative, at least compared to others that we hear the term used for.  New York, while in trouble, did not get as big of a bust in the housing market.  New York City is still a place where a lot of people want to live and work and there isn’t much land there.

I think the two leading contenders for bankruptcy are California and Illinois.  Both state governments are in massive debt and they have almost kicked the can down the road as far as they can.  They are in severe debt.  They are both in a situation similar to Greece or Ireland.  State governments cannot print money to hold off the problem.

This is why state bankruptcies will be a precursor to any implosion in DC.  The federal government can continue to kick the can down the road until it faces massive inflation or hyperinflation.  It can continue to run massive deficits because of the Fed’s monopoly on the money we use.  The states do not have this privilege.  The states will truly run out of money and will be unable to pay the bills.  The only choice will eventually be bankruptcy and dramatic cuts in spending.  Overall, while it will be painful for many, it will be a good thing for the long-term.

If you own any municipal bonds, get out.  If you are dependent on a state or city pension, start saving more money and be prepared for this money to be cut.  If you are in a college pre-paid fund for your child, you might want to consider pulling the money if you can, especially if your child is years away from going to college.

All of this talk of states filing for bankruptcy would have been unheard of just a few years ago.  It just tells us how dire of a situation things are in.

Last night, Obama delivered his state of the union speech.  You can read a full transcript here:
http://www.nytimes.com/2011/01/26/us/politics/26obama-text.html?pagewanted=1&_r=1

Bottom line, I don’t seen anything new here.  It was a typical speech given by a typical Keynesian president.  The conclusion you can reach from the whole thing is that he will try to maintain the status quo of big government, big spending, and continued war.

Obama said that he is proposing a freeze on annual domestic spending (whatever that means) for the next five years.  I’m not sure if that includes Social Security or Medicare, but I doubt it.  There is little chance that his proposal will come to fruition.  He is speaking meaningless words.  But even if it did happen, he says that it will reduce the deficit by more than $400 billion over the next decade.

Let’s make sure we understand the difference between deficit and debt.  The national debt is about $14 trillion.  The annual deficit right now is about $1.5 trillion.  That means we are adding $1.5 trillion every year to the national debt.  So if we reduce the deficit by $400 billion, then that means we will get an annual deficit of $1.1 trillion in a decade.  In other words, we will continue to add more than a trillion dollars a year to the national debt every year for the next decade.  Do the terms “massive inflation” and “default” mean anything now?

Obama also talked about innovation.  He did cite some past innovations that were done with little or no government.  But then he talks about innovations as if the government has to somehow help.  He talked about electric vehicles and high speed rail.  Of course, his plan is to subsidize these things with taxpayer money (or perhaps printed money).

Obama is a Keynesian.  He is a believer in big government, just as Bush before him.  Obama believes that the government has to help innovate.  He does not understand that if something is worth doing, then it shouldn’t have to be subsidized.  As Austrian economists, we talk about malinvestment as it relates to the Fed printing money.  But there is almost always malinvestment when the government spends any money at all.  If consumers want high speed rail, it should be profitable for a business to provide the service without government subsidies.

Obama also mentioned regulations and said that he ordered a review of government regulations.  He said that when we find rules that put an unnecessary burden on businesses, we will fix them.  Um, can you say “Obamacare”?

In conclusion, this speech was nothing new.  The federal government is heading over a cliff.  Maybe it will speed up or slow down a little before reaching the edge, but there is no stopping it.  Prepare accordingly.

Harry Browne, the two-time presidential candidate for the Libertarian Party, wrote some brilliant pieces.  He was well-versed in all things libertarian and also contributed greatly in investing.  He even wrote a self-help book.  Today, I want to focus on an article he wrote back in 1992 dealing with economic fallacies.

One of the great things about Harry Browne is that, although he passed away almost 5 years ago, you can read his material today and most of it still seems relevant.  Even things that were written 40 years ago seem relevant today.  This article from 1992 is no exception.

If you listen to much economic analysis (if that’s what you want to call it) from the mainstream media, you are likely to hear that we need more manufacturing in our country.  Of course, when I hear that, the commentator who says it doesn’t usually offer up a specific solution.  Does he want to force people to do certain jobs?  Does he want protectionist tariffs?  Does he want us to be forced to buy certain products made in the U.S.A.?

This topic is brought up more frequently now because of China.  For some reason, some people in the U.S. think that the Chinese are a threat.  Does it really matter that we buy a lot of “stuff” from the Chinese?  Does having an imaginary line between two countries (called a border) somehow make trade wrong?  If the Chinese have a comparative advantage in manufacturing things, while Americans sell services, so what?

If there is less manufacturing in the U.S. because of government and central bank policies causing malinvestment, then that is certainly a problem.  But that is not what a lot of people are talking about.  If that is the case, then of course the solution is to get the government and central bank out of the way and let the free market prosper.  The market will allocate resources the most efficiently and if that means more or less manufacturing for Americans, then I don’t really care.

Harry Browne’s arguments from almost 20 years ago are as relevant today as they were then.  We would be wise to listen.

Last week, there was an article on Mises.org by Vijay Boyapati.  He says that there are two classes of people that operate the state: the political class and the banking class.  He says that the banking class (which includes the Federal Reserve) is in charge of monetary policy in the U.S.

He makes a case that hyperinflation will not happen in the U.S.  He says that the banking class will not let this happen because doing so would be destroying their own system.  I generally agree with this assessment.  At the very least, I don’t think that the Fed will intentionally cause hyperinflation.

The author of this article goes further.  Not only does he not see hyperinflation in our future, but he actually sees a controlled deflation.  He makes an interesting point near the end of his piece that it doesn’t matter what Bernanke says.  He says that the Fed’s institutional structure is more significant.  In many ways, I agree, although I don’t think Bernanke’s personal views are irrelevant.

Boyapati’s prediction of a controlled deflation is contrary to what a lot of other Austrian economists believe.  I tend to be more in the camp of Gary North on this one.  I think we will see high price inflation, certainly in double digits.  We may even see massive price inflation of 20 to 30 percent.  But I think that the Fed will pull back eventually and take a depression over hyperinflation.

Articles like these are very good to consider.  It gives us a different viewpoint from an Austrian perspective.  We need to ask ourselves: what if he is right?  He makes a decent case.  What will this do to our investment portfolio?  This is why I am an advocate of the permanent portfolio that was promoted by Harry Browne.  Although I think high inflation is more likely in the near future, I don’t want to bet everything on this scenario.  Boyapati makes a good case for a scenario more like Japan.  While I don’t think it is the most likely scenario, it certainly is a possible scenario, and we should be prepared for it.

The housing market is obviously depressed and has been for a few years.  It is not depressing for someone looking to buy a house, but it is obviously tough for those who own a house, particularly for those who bought at the height of the boom in 2005/2006.  But where will housing prices in the U.S. go from here?

First, housing prices vary considerably depending on the region.  Prices are higher in some areas and prices will go up or down faster in some areas.  With that said, this analysis is just based on the overall trend.

There are some conflicting arguments in regards to housing, especially for the medium to longer term.  In the short term, housing prices seem like they will continue to go down.  There are a lot of short sales and foreclosures and there are also people waiting to sell until prices move back up.  This is all bearish for housing prices.

Interest rates, while they have moved up a little in the last few months, are still at near historical lows.  You can still get a 30 year fixed rate mortgage for around 5 percent if you have decent credit and a decent down payment.  When you compare this to the double digit rates of the 1970’s, they are very low.  But housing prices have stayed down in spite of these low rates.  If interest rates go up, this could depress housing prices even more.

If interest rates (and mortgage rates) rise, it will make payments more expensive.  This will probably lower housing prices.  But if you own a piece of property that you rent to someone else, the rent amount may not fall.

But you could also look at rising rates another way.  It may depend on why rates are rising.  If it is because the market views a greater risk of default, then housing prices probably will go down.  But the more likely scenario is that interest rates go up because the market fears inflation.  Interest rates go up with fears of inflation to compensate the lender, since he will be paid back in money that is worth less than before.  But if inflation is raging, then this could have a counter-effect and cause housing prices to go up or at least go down slower.  Real estate is a hard asset and that is what you want to own in a high inflationary environment.

My overall take on housing is as follows:

If you are planning to live in the same location for a while, and if you currently don’t own a house or are willing to rent out your current property, and if you have a decent down payment and good credit, and if you can buy a house where your payments will be comfortable for you (that’s a lot of “ifs”), then you should consider shopping for a house.  You can find some good deals out there if you are patient.  If you can lock in a low fixed interest rate for 30 years and you keep the house for that long, your last payment will probably be the cost of a nice lunch.

There is an article by Michael Pollaro saying that the money supply is firing on all cylinders.  It is an interesting article to read.  He talks about TMS or the True Money Supply which is a measure of the money supply developed by Austrian economists.

I have my own opinions on the money supply.  First, although a lot of libertarians didn’t like it when M3 was no longer published, I think M3 is overrated.  I usually follow the adjusted monetary base because it is the money supply that the Fed directly controls.  It is also important to follow the excess reserves held by commercial banks.  This was not an important statistic in the past, but it has become important in the last couple of years with bank reserves increasing in great amounts (over $1 trillion).

The charts for these two things are here:

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

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

Looking at money supply charts still cannot accurately forecast future price inflation.  They can help us take a good guess, but there are other variables.  First, price inflation does not happen uniformly.  Five years ago, we saw massive price inflation in housing.  Over ten years ago, we saw massive price inflation in the stock market, particularly in technology stocks.  The next thing we see go up may be gasoline, food, gold, or maybe all of them.  The point is that prices do not move up uniformly.  New money finds certain sectors and causes bubbles.

Another reason we can’t completely rely on money supply charts is because it is only one side of the equation.  The other side of the equation is the demand for money (also called velocity).  It is how quickly money is changing hands.  It is surprising that more Austro-libertarians do not talk about velocity.  If money is changing hands very slowly, then we can say that there is a high demand for money.  This means people are not spending as much.  This has the same effect as a deflation in the money supply.  It can offset monetary inflation and keep prices from rising.  I think this has played a big role in keeping prices down in Japan over the last two decades.

In the U.S., it seems that the demand for money has been higher since the fall of 2008.  People are trying to pay down debts and save money.  They are being more conservative with their money because of the uncertainty in the economy.  This has helped to keep price inflation in check, along with the massive excess reserves accumulated by the big banks.

If banks start to lend and the velocity picks up at the same time, we could see some massive price inflation.  We are not there yet, but it is something to keep an eye on.  It is probably the biggest financial threat that we face.

There is an article via Drudge saying that Japan has hit a critical point on state debt.  Japan’s debt-to-GDP ratio is around 200%.  This is higher than the U.S., Ireland, and even Greece.  It is amazing that interest rates have stayed so low for so long in Japan.

The Japanese central bank has not created money out of thin air to the same extent that the Fed has.  This has kept inflation relatively low there.  Still, with a debt so high, there have to be a significant number of buyers in the bond market.  Since foreign governments are not buying Japanese debt the way they buy U.S. government debt, I assume that the biggest bond buyers are Japanese citizens.  It has been a decent investment so far, just as real estate was a good investment in the U.S. up until 2006.

This kind of debt cannot be sustained forever.  Something will eventually have to give.  Either the Japanese government will cut spending or interest rates will rise and the debt will become unmanageable.  Then we will see the Japanese central bank in action or we will see a government default.  This is why I don’t see the yen taking over as the world’s reserve currency.

If this whole story proves one thing, it is that we shouldn’t underestimate how long an insolvent government can kick the can down the road.  With a central bank and gullible investors, the day of reckoning can be delayed for longer than we might think.

U.S. foreign policy plays a big role in the investment world.  It may not seem so, at least directly, but there is more to war and occupation than the lost and broken lives.  The cost of war and the cost of running an empire around the world places a heavy burden on the debt and the dollar.

Richard Maybury, who writes the Early Warning Report, is the best I’ve seen at tying foreign policy and investments together.  He has a great understanding of the world around him and the effects that it has.  Paraphrasing him, it is usually a safe bet that governments will be corrupt and incompetent and continue to do the wrong things.

The occupations  and wars of Afghanistan and Iraq will play a big role in destroying the dollar.  In turn, the economic troubles will eventually cause these wars and occupations to end.  How soon, will depend on how long the Fed can keep things from collapsing.

We can safely bet that the U.S. empire will continue until the money runs out.  When the dollar is severely weakened and the Fed has to raise rates to save the dollar, the economy will come crashing down.  When congress is forced to cut spending, the American people will choose Social Security and domestic programs over war.  The politicians in DC will finally be forced to support a withdrawal of troops.

In the meantime, defense stocks could easily outperform the broader stock market.  If you are going to speculate in stocks, this might be a sector worth looking at.  In addition, the massive expenditures overseas will continue to take their toll on the American economy.  You can count on the dollar to continue its weakening, but I don’t know that I’d place a big bet on any other fiat currencies either.  Commodities will do well, just as they did in the 1970’s.

Investments in real assets will be the winners.  Investments in dollars, bonds, and other fiat currencies will eventually be the losers.  Unless the wars and occupations come to an unexpected end, you can count on a weak currency in the future.

Chinese President Hu Jintao has stated that the U.S. dollar-denominated currency system is a “product of the past”.  The article is here.  Chinese politicians have been more critical of the Federal Reserve lately due to low interest rates and the second round of quantitative easing (money creation), also known as QE2.

These statements by the Chinese president remind me of American politicians criticizing the other party.  I don’t disagree with a lot of what he said, but have you looked in the mirror lately?  China has had monetary inflation above 20% per year.  This has fueled a speculative boom in real estate, similar to the one experienced in the U.S.  The bust is coming in China and it is all because of the same or similar policies.

It is true that the U.S. dollar is slowly losing its status of being the reserve currency of the world.  It is not because of China or any other country.  It is simply the incompetence and corruption of the U.S. government that has caused this.  The big spending and money creation has led to a decline in confidence in the U.S. dollar.  I hate to break the news to the Chinese politicians, but the yuan will not be taking the place of the dollar as the reserve currency any time soon.

China is still referred to as a communist country.  In some ways it is, but in some ways it is freer than the U.S. and other western countries.  China does not have the American for Disabilities Act.  It does not have as much red tape in many areas.  China has come a long way in the last 3 decades.  It has liberalized its markets in a lot of ways, but it also has a long way to go.  They have loosened their grip on the yuan, but it is still not a freely traded currency like the dollar, euro or yen.

I see a crash coming in China.  It will be painful for a country that has never had a big boom-bust cycle before.  When you are always in a state of bust, as China was, you are not used to a bust after a boom.  I see the growth in China over the last 30 years in two ways – part of it is illusory (artificial boom) and part of it is real.  The real part of it has actually contributed to an increase in the standard of living of tens of millions of Chinese people (maybe hundreds of millions).

China’s president is right to criticize the Fed.  His government is going to get stiffed by all of the U.S. bonds that it owns.  The problem is that China is still a mercantilist country.  At least it seems to be heading in the right direction.

I try to practice what I preach or maybe it is more like preach what I practice.  My investment advice is no different except for the fact that each individual’s situation is different.  I remember reading an article by Michael Rozeff talking about how he didn’t always follow the same advice that he wrote in articles (or something to that effect) when it came to investing.

It is hard to give investment advice to everyone because each person’s situation really is different.  Each individual is a different age, with a different net worth, with a different personality, with a different risk tolerance, etc.  That is why I like to recommend things, but at the same time provide a disclaimer of being a speculation, particularly with the higher risk moves.

With that said, let’s talk about shorting the bond market.  Currently, I do not have any short positions in the bond market, or at least not directly.  I am a big advocate of Harry Browne’s permanent portfolio, which happens to consist of 25% long-term government bonds.  I think for people who are less knowledgeable about investments and also less risk tolerant, they should just consider putting all of their investments in a permanent portfolio setup.  Then they can forget about it and sleep better at night.  Even many experienced investors would be better served by using the permanent portfolio.

Now, I have no idea what will happen with bonds tomorrow or one year from now.  If I had to guess, I would say that bonds will most likely move lower in the next several years.  It is not up to me to decide.  It is up to the market and the decisions of millions of people, along with the non-free market forces of politicians and the Federal Reserve.  But again, if I had to guess, I think that interest rates will eventually rise and will lower the price of bonds.

Since I am an advocate of the permanent portfolio, but I also want to speculate that interest rates will eventually go up, I have lightened up on bonds.  I see no point in directly shorting bonds, because I’m not confident enough at this point, particularly with the Fed buying them.  Instead, I have chosen to carry less than 25% of my investments in bonds.

There is nothing wrong with shorting bonds, even if you do have bonds elsewhere in your portfolio.  It is really up to you on how you want to go about it.  Again, I think there are heavy risks in shorting bonds right now, especially with QE2 (money creation) going on.  It is a risky play, but it is also a play that could pay off well if you are right.  So my recommendation is to lighten up on bonds from your permanent portfolio, but only for speculation purposes.  If you don’t want to speculate (although everything carries some risk), then just put your investments in the permanent portfolio fund and forget about it.  For a mutual fund that somewhat mimics this, see symbol PRPFX.