The lead article today on LewRockwell.com is by Fred Reed.  If you’ve read much of his stuff, he is very witty and certainly puts things in an interesting perspective.  I agree with much of what he says in this article today, but I would like to focus on a few things where I disagree.

First, he says that “if a country does not manufacture things, it does not have an economy, and manufacturing has fled American shores.”  This really isn’t true on several levels.  Manufacturing perhaps has declined in the U.S., but it is not like it has vanished.  But even if it had completely vanished, this doesn’t mean that there isn’t an economy and that there isn’t wealth.  We often make this mistake of drawing these artificial lines around countries as if they matter.  If what he says is true of a country, would it also not be true of a state or a city?  New York City has very little in the way of manufacturing and I wouldn’t say that NYC has no economy.

He speaks highly of China, but Hong Kong is far richer than mainland China (per capita) and Hong Kong is not a big manufacturing country.  These are the benefits of free trade and comparative advantage.  You don’t have to make all of the food you eat.  In fact, you really don’t have to make any of it.  You don’t have to make the car you drive and the car doesn’t have to be made in your country of residence.  There is nothing wrong with providing services.  There is nothing wrong with having doctors, therapists, hair stylists, salesmen, financial planners, athletes, singers, etc.  This is a sign that we are a rich society.  We only need a small fraction of people to produce food now because of capital investment and technology.  We don’t all have to work on a farm because it is not necessary.  We don’t all have to work in a car factory because other places can do it cheaper or at least in comparison to other things.

The CEO of McDonald’s might be the best burger flipper there is, but does it mean he should be in the kitchen flipping burgers all day?  This is comparative advantage.  He is better off doing more important things and letting other people flip burgers, even if they aren’t quite as good at it.

The second thing in the article that I don’t agree with is his view of competition with China.  He seems to imply that a gain in wealth for the Chinese is detrimental to America.  He does not directly say this, but it is implied.  We certainly don’t want China to overtake the U.S. in wealth because the U.S. gets poorer.  But if China simply becomes wealthier, this is not a loss to the U.S.  It benefits everyone for China to open its markets and become wealthier.

There is one more thing to point out in this article.  He says that “America is the world’s greatest debtor nation, China the greatest creditor.”  I agree and the national debt is a serious concern.  But the one thing I would like to point out is that the Chinese people are subsidizing Americans because of this.  The game will not last forever, but the Chinese are going to get stiffed on all of the U.S. bonds that are held.  As Reed says, “we must either default or inflate.”

Fred Reed is a great writer and I don’t mean to nitpick his work.  I just want to make sure that people understand some basic fallacies that are out there.  America has a lot of problems, but it has little to do with manufacturing or China.

Robert Wenzel, who blogs at EconomicPolicyJournal.com, has a piece today on price inflation.  He goes through seven things, identified by AOL, that will cost more in 2011.  The seven things listed by AOL as likely to rise are food, gas, medical care, clothing, college, raising kids, and bank fees.

Medical care and education may go up without high price inflation, just because government is so highly entrenched in these things.  Bank fees are too small to worry about and raising kids is too general.  For the other three things, food, gas and clothing, I agree.  There is no guarantee these things will go up in price in 2011, but it is likely, and if it doesn’t happen this year, it will most likely happen shortly after.

If your net worth is less than 6 figures, I think the best way to hedge against inflation is to buy things now that will likely go up in price later.  You can’t really store a lot of gasoline, or at least you shouldn’t.  It is hard to hedge against rising gas prices unless you play options/ futures.  It is even hard to find stocks and ETFs that correlate to the price of gas.

For clothing, you should consider buying clothes now that you might need in the future.  This is a tough one though because there might be a tendency to buy what you want instead of what you will need.  If you are disciplined, go ahead and buy some new clothes now and put them away for when your current clothes are worn out.  Just make sure not to gain or lose too much weight if you do this.

For food, it is hard to buy a lot of things in advance.  You can’t buy milk, but you can buy canned foods and some other items that last for a while.  Just make sure you follow the FIFO method – first in first out.

There are other things you can buy in advance.  You can buy paper towels, toilet paper, soap, razor blades, kleenex, shaving cream, toothpaste, makeup, shampoo, laundry detergent, and a whole host of other things.  Again, you should use the FIFO method so that things don’t get too old.  If you don’t have a lot of storage space, look in closets to see if you can put any shelving up high for more storage.  You should look for sales when you go to stores like Target or Walmart.  I hope you aren’t buying these things at the grocery store unless they are on sale or you are rich.  You can usually find them elsewhere cheaper.    When you see a sale, load up on the item (within reason).  It is an investment that you can’t really lose on.  What are the chances that prices will be lower this time next year?

If you are a millionaire, ignore this, unless you think there is going to be a total collapse in the division of labor.  If you are a millionaire, you are better off focusing on the big picture and taking care of the money  and assets that you have.  Anyone with any significant amount of wealth should be finding ways to hedge against inflation, whether it is real estate, gold, silver, or certain stocks.  I think inflation is the biggest threat to our standard of living right now.

Robert Murphy has written an article related to the efficient-markets hypothesis or EMH.  It is certainly worth a read, as most of Murphy’s work is interesting and accurate.

EMH is an interesting, yet wrong, hypothesis.  It is true that markets adjust according to what is known.  Prices also adjust in the present based on what is probably going to happen in the future.  If Apple announces that it has the latest and greatest gadget that will exceed all expectations, then there is a good chance the stock price will go up.  Apple does not have to have any sales of the new product and you may not even know specifically what it is, but just the expectation of future sales, and hence profit, will drive up the price of the stock.

At the same time, this doesn’t mean that everything is known equally.  It doesn’t mean the price is rational, other than the fact that the price is what it is.  The market has set the price, so who am I to argue on what is rational or irrational?  As I often mention in this blog, it doesn’t matter what the fundamentals are or what you think the price of something should be.  It matters what the billions of people in the world think.

EMH reminds me of a joke (I wish I could give credit where credit is due).  There are two guys walking down the street and one of them is an economist.  The other guy says to the economist, “hey, look, there’s a twenty dollar bill on the street.”  The economist doesn’t even look down and keeps walking.  He says, “That’s impossible.  If there were a twenty dollar bill on the street, somebody would have already picked it up.”

Austrian economics does not allow us to predict the future with certainty or accuracy.  Again, you can’t predict anything with certainty that involves the thinking of millions or billions of people.  But we can make some good assessments using Austrian free market economics and see where the market does not seem to correlate with the fundamentals.

The housing market is a good example of all of this.  It seems obvious now that there was a housing bubble, but it was not obvious at the time.  But it is certainly conceivable that if someone gave some serious thought to the whole thing, they could have seen that the exuberance in the market would wear off when more people started struggling to make their payments.  There were some Austrian economists that did predict a crash in the housing market.  They were aware of the boom-bust cycle.  They realized that housing prices were going up much faster than other prices.  They could have been wrong, but it was a reasonable prediction to make.

Let’s look at gold now.  Some say it may be in a bubble of its own.  We may very well see a sell-off in the near future on profit taking.  But we can also look at the fundamentals and see that the Fed has created massive amounts of new money and says that it will continue to do so.  If this new money gets out of the banks and into the economy, prices will rise drastically.  Commodities will most likely explode.  Gold has the potential to double or triple in price in a short time frame.  Again, this is not to say that this will happen, but only that it is a good possibility based on what we know.

There are many people that don’t analyze this.  There are many people that don’t understand this.  They are missing opportunities.  Perhaps the people that know little believe in the EMH because they really do have no chance of beating the market.  These people don’t understand monetary policy and inflation and do not understand that gold might rise significantly due to the policies of the Fed.  There is a twenty dollar bill on the street.  Will you look down to pick it up?

Michael Rozeff has the lead article on LewRockwell.com today.  He says that the U.S. is insolvent.  I’m not sure if this is technically true or not, but it certainly will be if it is not now.  It really depends on whether you count the unfunded liabilities of Medicare and Social Security.

If the U.S. government severely cut spending, including Medicare, Social Security, pensions, and the military, then the government could make good on its promises in regards to treasuries.  Of course, this is a major “if” that will not happen.  It will only happen when Congress is forced to because of the threat of hyperinflation and/or default.

If the government cut every single program other than the military, Medicare, and Social Security, it most likely would still not be able to fulfill its promises.  As time goes on, the hole just gets deeper and deeper.

At the end of his article, Rozeff says, “it is prudent to take measures to make oneself as independent of government as one possibly can.”  This is really the key point.  There is really nothing you can do about the train wreck that is about to occur.  The only thing you can do is prepare yourself and those you care about (if they’ll listen).  The best way to do that is to try your best not to rely on government.

There is one other thing you can do too.  You can help in the education process.  You can inform people of what is to come (again, if they’re willing to listen) and you can let them know that, in the words of Reagan, government is not the solution, it is the problem.  The more people that realize this, the better chance we have of being in a state of liberty after the U.S. government comes crashing down from all of its promises and debt.

The train wreck coming will be quite a sight to see.  For those paying attention, it is easy to see it coming.  Others will continue to keep their eyes closed to the obvious.  These people think that there is such a thing as a free lunch.

Terry Coxon has written an article called “How the Fed Could Become Insolvent”.  If you haven’t seen it, it is certainly worth a read.  He basically points out that if interest rates rise, there will be a certain point where the Federal Reserve is operating at a loss.

I don’t think this means that the Fed becomes insolvent and he even acknowledges this.  His conclusions are similar to mine in that the Fed will have more limited choices as rates rise.  I think the Fed will eventually have to choose between hyperinflation and depression and I think and hope it will choose the latter.

I generally agree with what he says and I think interest rates will play a key role when we start to see things unravel.  But in the grand scheme of things, a loss to the Fed is not that big.  The bigger issue is the national debt, which is now over $14 trillion.  The Congress will have to pay interest on this debt and when it has to rollover debt or issue new debt, it will be at higher rates when rates do in fact rise.  The Congress will either have to spend less, tax more, or get the Fed to create more money out of thin air.  The first two options are limited.  Congress could certainly spend a whole lot less, but even if it cut the budget by one-third, there would still be a yearly deficit right now.  The problem is that the politicians are unwilling, at least at this time, to make any substantial cuts to the military or “entitlement” programs.

Raising taxes won’t really help either.  It will just stifle the economy that much more and it may even lead to less taxes collected by the government (we’ll give Art Laffer, a non-Austrian economist, a little bit of credit here).

So basically, that leaves the Fed to create more money.  More inflation will lead to even higher interest rates down the road, just as Coxon has written in his article.

The Fed will eventually have to slam on the brakes to avoid hyperinflation and I think it will.  The ultimate solution will be for government to be dramatically cut, including the military, Social Security, Medicare, and pensions.  The other thing that will probably happen is a default.  It will happen first through inflation and then there will be some kind of outright default.  You don’t want to own a lot of government bonds when that happens.

The national debt has been in the news lately.  It just went over $14 trillion.  You can view it here:
http://www.brillig.com/debt_clock/

You can view more details here:
http://www.usdebtclock.org/

The sites differ a little bit, but they are both an estimate.  They may differ by a few billion dollars, but that isn’t much in this context.  There is a debt ceiling that is fast approaching.  The Congress has to vote to raise the debt ceiling.  This has always happened in the past.  It is usually the party in the majority that votes in favor of raising it.  It is a political ploy by the party in the minority, but the debt ceiling always gets raised.

This time will be no different except that there might be more political posturing.  Some Republicans are threatening to vote no on raising the limit.  The establishment says this is impossible.  They say that it will have to be raised.  They say it has to be raised because otherwise the government would default on some of its debt and that is just impossible in their world view.

The Republicans could refuse to raise the debt limit.  They could, but they won’t.  They will cut a deal with Obama.  Perhaps they will tell Obama they want some token spending cuts.  Perhaps they will ask for a reduction in corporate taxes of a few percentage points.  But in the end, they will vote to raise the debt limit.

When it comes to the national debt, I think repudiation of the debt is an option that, while seems to be ridiculous to most, is actually a good idea from a libertarian standpoint.  I have written on this before.

But even if you don’t think repudiation (defaulting) on the national debt is a good idea, there is still another option.  Congress could actually cut spending.  Now, it would have to cut it significantly.  It would have to cut about 1.5 trillion dollars out of the annual federal budget.  But we have to get rid of this idea of non-discretionary spending.  Everything is discretionary, whether it is Social Security, Medicare, pensions, or the military.

The problem is that Congress does not want to make these hard choices.  They do not want to cut spending.  Even most of the new politicians who helped get elected by the Tea Party do not want to make tough cuts in spending.  They talk in generalities, not in specifics.

There may be a few that follow Congressman Ron Paul.  Most will not.  They will keep spending, even if it means at a slightly slower pace.  The national debt ceiling is a joke.  It might provide some good entertainment in the near future, but it will not put a limit on the debt.  The only thing that will eventually limit the national debt is the destruction of the dollar.

Is a bond crisis inevitable?  That is the question that Pat Buchanan is asking.  Buchanan is not a libertarian, but he certainly has libertarian leanings.  I tend to agree with him on foreign policy more and economics a little less.  He does not understand the benefits of free trade and that is the main area where I part ways with him.

With this article on the national debt and bonds, he understands what he is talking about.  His last sentence says it all: “We may be closer to the falls than we imagine.”

Europe has already seen a lot of problems and they have a lot more to come.  The state and city governments in the U.S. are struggling.  Illinois is on the verge of default and California is not far behind.  It will be amusing to watch politicians, particularly Democratic politicians, having to cut money from their main constituents – union and government “workers”.

The big trouble will hit the states and cities before it hits Washington DC.  The reason is the central bank.  The Fed can keep creating money out of thin air.  The Fed can temporarily drive down interest rates and keep bonds attractive.  This allows the deficit spending to go on.  But the day of reckoning is coming for DC too.  The Fed will eventually have to choose between funding the debt and hyperinflation.  I think the Fed will eventually tell Congress to figure it out.  Hyperinflation would wreck their own game and would cause massive upheaval.

It will be an interesting day when the checks from DC bounce.  They will either have to default on the debt or massively cut spending.  Actually, they will probably have to do both.  It has been a long time coming and the moment is almost here.  Even if it takes another 10 years, it will be unbelievable to watch when it happens.  The vote buying politicians will be walking on thin ice if they aren’t already.  Let us hope that the American people (along with people everywhere else) finally turn their backs on government and withdraw their consent.

If you want an updated chart of the adjusted monetary base, go here:
http://research.stlouisfed.org/publications/usfd/page3.pdf

This is what the chart looks like through 12/30/2010.

This chart does not correlate to QE2 (Bernanke’s money creation).  It was announced at the beginning of November and the Fed is supposed to buy $75 billion in assets each month (not counting rollovers) that will total up to $600 billion by the end of June (8 months times 75 = 600).  This new money should appear in the monetary base.  Meanwhile, it has barely moved since QE2 was announced.  It looked like it was finally going up, but then made a move back down in the last week.

What is going on here?  Is it possible that Bernanke would announce one thing and do another?  It certainly is possible, but I just can’t imagine how he would get away with it, particularly in today’s world of the internet.

I can’t explain what is happening right now other than the fact that it looks like the Fed has not expanded the monetary base like it said it would.  We will continue to monitor this chart weekly and look for a move upwards.  If the chart continues to stay flat or near flat, we might have to revise our outlook.  All signs point to price inflation and higher commodity prices in the future.  If Bernanke is lying and the Fed doesn’t go through with QE2 and the banks continue to keep their excess reserves high, we might have to plan for a depression sooner than we originally thought.

Gary North has written an excellent article on capitalism.  His article is titled “In Defense of Shopping Malls”.

This is the beginning of a new year and it is good to step back once in a while and appreciate all that is around you.  Our lives are so incredibly easy in so many ways compared to the rich of 100 years ago.  It’s not to say that we don’t have difficulties and tragedies.  It is just to say that, on average, our standard of living is amazingly higher than people of just a few generations ago.  There are still people all over the world who are on the verge of starvation.  But we are also at a point where we can safely say that over half of the earth’s population is not on the verge of starvation.  For Americans and other people of first world countries, our standard of living is in luxury mode.

It really makes you realize how bad the government is, how much better our lives would be with much smaller government, and how much we still have in spite of the government.  The things that the government is highly involved in (healthcare, education) are the things that we struggle with in terms of quality and cost.  When it comes to things where government interference is more minimal, things thrive.  Electronics is the obvious example that comes to mind.  You can buy a big screen television that is less than 2 inches thick for $1,000.  This is truly amazing.  This technology did not exist 20 years ago and not only is it available now, it is available to the middle class.  Quality goes up, while prices go down and this is in spite of the Fed’s monetary inflation.

Yesterday, I bought a $5 bottle of champagne at the grocery store just so that we would have something to celebrate with on New Year’s Eve.  For 5 bucks, it wasn’t bad.  It might have been bad to some people, but I am not an expert champagne drinker.  Not only that, but the plastic cork screwed off and you could screw it back on easily to put the bottle back in the fridge.  It is just one small example of our wonderful division of labor.  Most people could not make a glass bottle, let alone actually making champagne.

Walmart and other retailers have been incredible in making things affordable for the little guy.  You don’t even have to shop there and you have still benefited by the increased price competition.  It is the same way that the internet is forcing retailers to lower prices.  Our standard of living really is incredible.  It is unimaginable to think what we would have if the government at all levels did not regulate and tax us so onerously.

I think this is why liberty will eventually prevail.  Our standard of living will go down in the near future, but Americans and other westerners will only tolerate so much.  The wars overseas will end when Americans realize that it is hurting their standard of living.  Welfare at home will be curtailed greatly when Americans realize that it is hurting their standard of living.  Americans like their big screen televisions, their cell phones, and all of their other gadgets.  They will not easily give them up.

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

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

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

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

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

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

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

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