One major mistake that many people make in economics, including many so-called economists, is that they confuse cause and effect. Deflation doesn’t cause a depression/recession any more than a wet street causes rain. Whether we are talking price deflation or monetary deflation, it isn’t really a cause of a depression. You could say that monetary deflation can trigger a depression, but the depression was already built into the cake if that is the case. The Austrian Business Cycle Theory teaches us that if there is monetary inflation, it will cause bad investments to take place, and there inevitably has to be a bust. If there is monetary deflation or even a decrease in monetary inflation, then the boom may come to an end. If there is never a slowdown in the rate of monetary inflation, then you will eventually get hyperinflation.

Going back to deflation, during the Great Depression, there was monetary deflation at the beginning. This was because there was no FDIC to bail out banks and their depositors. There were runs on banks and the fractional reserve lending process reversed itself. With the FDIC today, you won’t have a similar situation.

As far as price deflation, it is possible to have a slight decrease in prices, even if the Fed is inflating the money supply. First, you can have a situation as we have right now where the banks increase their excess reserves voluntarily. But another scenario still is that during an economic downturn, people have a greater demand for money. They are more likely to save money and spend less. Money will change hands less quickly. This can have the same effect as a decrease in the money supply. With less people spending, there will be less people to bid up prices. It is possible for prices to fall even if there is monetary inflation.

But let’s remember that falling prices aren’t a bad thing. In a recession, where the economy is trying to flush out the bad investments, it helps people that they don’t have to pay as much for food, gas, and other items. Price deflation is a cure. It should not be seen as part of the disease.

Investing is not easy. You are trying to predict how millions or billions of people are going to act. You may think the market should go up based on some kind of news you heard, but you can’t control the thoughts and actions of others.

There are a few advantages that you can gain if you understand economics, particularly free market economics. First, you should understand that economics directly involves human action. It doesn’t matter what mathematical formulas you have or what graph lines you have. What matters ultimately is how millions of human beings will act.

Another great advantage for Austrian economists is the understanding of fiat money. For most transactions that are made in our world, money is usually on one side of that trade. If you have an entity (the central bank granted by the federal government) that has a monopoly over money, it is a major factor in our economic decisions. You could have companies that are becoming less profitable and the stock prices should seemingly go down. But if the government is printing money like crazy, it might be possible for the stocks to go up in price in nominal terms.

You could be earning 12% a year on your investments, but if inflation is running at 14%, then you are losing money in real terms. The kicker is, you still have to pay taxes on your 12% “gain”.

Financial advisors will talk about the need for diversification. But one thing that often gets left out is diversification against a falling dollar (or other currency). This is the main advantage to understanding free markets. Because politics plays such a huge factor in our lives, even though it shouldn’t, we must regularly base our investment decisions on what is happening in the political world, which includes central banking.

One thing I will often remind readers of this blog is that an economy grows by production. Just because the mainstream media and the Keynesian economists tell us that we need more consumer spending, it does not make it true. There is nothing wrong with consumption. But in order to have consumption, someone has to produce something first. We could try to stimulate consumer demand in Zimbabwe, but there isn’t much to consume. Consumption is a reward that we get for previous production which comes about from capital investment and labor. If, in general, we are consuming more than we are producing, then eventually we will run out of things to consume. We will use up the wealth that had been created in the past. This sounds like a simplistic point, but if you understand this, then you are ahead of at least 95% of the population.

That is why we are likely to see rough economic times ahead. The key to growth in an economy is savings and capital investment. There is always some of that taking place, but as a whole, there is a lot less investment of capital now than there has been in the past. The government is taking so much money out of the private sector through taxation and debt, that it has to have serious negative effects at some point.

For those not familiar with Harry Browne and his “permanent portfolio”, I would recommend that you read his book Fail Safe Investing. The permanent portfolio should really be called the “sleep at night portfolio”. You simply divide up your investments into stocks, long-term government bonds, gold, and cash. If you want to speculate with other money, that is fine, as long as it is money you can afford to lose.

Some say it is out of date. But if you look at the portfolio, or the mutual fund (PRPFX), it has done extraordinarily well. It had a downturn in the fall of 2008 with most everything else, but the downturn was far less dramatic for the permanent portfolio and it quickly turned around.

I remember before Harry Browne passed away, someone called his radio show and asked how anyone could possibly buy bonds. Interest rates were fairly low and the caller was wondering how they could go any lower. I don’t remember exactly what Harry said, but he basically said that you should still hold bonds in your portfolio. There could be a flight to safety and interest rates could go even lower.

I have continued to hear people ask over the last couple of years why anyone on earth would own any bonds. Ironically, bonds have done well in the last few years. Now, I am not advocating that you speculate in bonds, but it still has a place in your permanent portfolio. We could easily see another major downturn in the economy and bonds might be the only thing that does well.

Ultimately, interest rates will probably go up. But it is impossible to say when and how much. If you short the bond market, that should definitely be a speculation with money you can afford to lose. I would not even recommend that right now as a speculation. The economy is bad and there could be a flight to what is perceived as safety. It is possible for interest rates to go lower.

There are a lot of good reasons to short the stock market right now. The best reason is the Austrian Business Cycle Theory. The Fed caused an artificial boom in the past and at some point it will go bust. It tried to go bust in 2008, but the Fed and the government pumped in trillions of dollars. The Fed did it by buying assets, particularly bad assets. The government is helping by passing stimulus bills and running trillion dollar deficits. They would not allow the previous bad investments to be cleansed out of the economy. They saw it as too painful.

The Fed created a lot of money out of thin air. Most of this money is being held by commercial banks as excess reserves. That is why we have not seen an explosion in prices. In the last 8 months or so, the Fed has had a more stable money policy, but of course all of the previous money that was created remains, mostly with the banks. At some point, we are either going to get a depression or massive price inflation. We may get both. I think the likelihood is that we’ll start to get a depression and then the government and Fed will pump in more money which will eventually cause massive inflation. Eventually, there will be a choice between a severe depression and hyperinflation. Let’s hope the Fed chooses the depression. I think it will.

In the short-term, a speculation to short the stock market may turn out to be a good play. It should only be a speculation though. This should be money that you can afford to lose. In addition, once it becomes more and more apparent that we are in another downturn, then be prepared to get out of your short positions. Once the Fed turns on the printing press or once the banks start to lend more, then prepare for high inflation. Stocks may go down in real terms, but in nominal terms (not adjusted for inflation), stocks could go significantly higher. At that point, I wouldn’t speculate for or against stocks.

Happy July 4th, otherwise known as Independence Day. We could also call it Secession Day, since that is what the American colonists did. The ironic thing is that the colonists of 1776 under King George III were, in many ways, more free than Americans of 2010. Certainly there are many differences that are hard to compare, but when it comes to economic matters, there should be little question that the colonists were far more free. Today, government at all levels take about half of our income.

We are certainly much better off than the colonists because of the great gains that have been made. There was more progress in the 1800’s than any other century in the history of the earth. The 1900’s had many great advances too, but most of it was because of the previous capital investment and progress made in the 19th century.

Today, we get to enjoy cell phones and the internet. We get to enjoy flat screen televisions and kindles. We are the richest people ever. Unfortunately, this generation of Americans may be the first generation to live worse than their parents (if you don’t count the 1930’s and early 40’s). Although we enjoy great technology, our basic needs are as expensive now as they were decades ago. Incomes have gone up slowly while the costs of food, shelter, healthcare, and education have risen substantially.

This is what happens when the government takes half of our money. We have a lot of great technology and great wealth created from previous generations, but we are starting to go backwards in some aspects. We must free ourselves from all of the oppressive taxation and regulation as well as the horrible Federal Reserve.

If we ever have American 19th century economic freedom combined with today’s technologies, the results will be unbelievable. We will have things that we can’t imagine. Let us remember on July 4 that although we are blessed to be living in these times, times could be much better if we shake off the government.

The price of gold (in terms of U.S. dollars) went down about 40 dollars today. That is a big move and many, even in the mainstream, are talking about a double-dip recession. It’s hard to call it a double-dip for me, since I’m not sure we ever came out of the first one, but regardless, it looks like the economy is continuing to head down.

The price of gold has been up as of late, but it is hard to blame inflation fears as the primary reason. If that were the case, interest rates on longer term bonds would be showing some sign of going up instead of down. There is a lot of fear in the world and gold is being used as a crisis hedge. But the point of all of this is that the gold price may take a hit in the near-term. If the stock market tanks and people get really scared, U.S. dollars will be in high demand. Gold will go down. However, it seems that foreign central banks are putting a floor on the price of gold. If gold goes down enough, don’t be surprised if the Chinese central bank makes a big purchase.

Looking a little further out, I don’t see how gold cannot go up. Nothing is ever a sure thing, but if gold takes a hit in the near-term, it will create a great buying opportunity. There is massive government debt with no end in sight and the government and Fed will continue to make things worse if we hit another major downturn. The Fed will print more money (figuratively speaking) and we may see another massive “stimulus” package come out of the government. The Fed could also take measures to force the banks to lend their excess reserves. If this happens, prepare for massive inflation (at least double digit price increases).

To sum up, don’t be surprised if the price of gold goes down in the near-term with the stock market and the rest of the economy. But it probably won’t take long for it to go back up. If the Federal Reserve continues with its destructive policies, look for the gold price to skyrocket, along with your grocery bills.

Mortgage rates are near an all-time low. They haven’t been this low in at least 39 years. It is amazing that someone will loan me money for 30 years with a fixed interest rate of 4.5% and I can pay it back in depreciating money. With such a low rate, it is telling me that the market is not scared of inflation right now. It is just scared. People are willing to accept really low rates for the safety of their principal.

The bond market is probably a bubble. I would be surprised if rates did not rise dramatically in the coming years. But who knows for sure? Maybe we will end up like Japan. Japan has a debt-to-GDP ratio in the neighborhood of 200%. This makes Greece look fiscally responsible. But Japan’s rates have remained low for 2 decades. I don’t expect this to happen in the U.S., but I’m just pointing out that it’s possible. In other words, don’t short the bond market right now. If you have a mortgage and can refinance it at a really low fixed rate, do it if you aren’t planning to sell anytime soon.

I don’t usually “listen” to the so-called experts on tv. Sometimes I pay attention to what they say. I am always curious to hear what Cramer (of Mad Money) will say on CNBC after a bad day for the stock market. You can even sometimes pick up good pieces of advice. But I would not model your portfolio around what any of them have to say.

I pay attention to people that understand economics. There aren’t many of them. Even some who understand economics get investment advice wrong. Remember what Austrian economics is all about. Just think of Mises’ most famous book. The name is Human Action. That is what Austrian economics is all about. Humans act freely. You should take this into account when making investment decisions. You may think of all of the reasons in the world why gold should go up or stocks should go down or whatever, but it all depends on the individual decisions of millions of people. You may think than interest rates should go up tomorrow, but if enough people make a decision to buy bonds on that day, your opinion doesn’t really matter.

With all of that said, the people that I trust most in economics and investments, all seem to come to one opinion. The economy is going to get much worse before it gets better. I couldn’t agree more. I just can’t believe the consensus. The opinions are more mixed in the mainstream media (although there is even some pessimism there), but the people that I read and listen to who know their economics all seem to agree that the economy is going to get really bad. There are some varying opinions (hyperinflation, massive inflation, depression), but they are all bad. Of course, it will depend on certain things, like what the Fed and the government decide to do. But with all of the previous malinvestment, there is little doubt that there has to be a severe correction. It is just a question of how much the government allows it to happen.

If you are under the age of 50, you are going to get the shaft. If you are over 50, it is not quite as clear, but you will probably get the shaft too. There are estimates that the unfunded liabilities of the U.S. government (primarily Medicare and Social Security) are over $100 trillion. That is over 6 times the annual GDP. The number is staggering. While it is important, you may as well ignore it. The government can’t make good on it. It can’t even make good on half of it. There will be changes down the road. The only question is when and what those changes will be.

There will be “benefit” cuts. This could come in various forms. One way is to raise the retirement age. This is likely. Another way is to decrease benefits (less Medicare coverage, higher deductibles, and smaller checks from Social Security). Still another way is through inflation. This will be like decreasing benefits, but in a more devious way. But if the problem is “resolved” through inflation, then the government will have to change how it calculates its cost of living increases or it will have to lie about inflation by understating the CPI. Both are possible.

Perhaps it will be a combination of all of these things. But for senior citizens already collecting Social Security, you should worry about inflation more than anything. If you are a senior citizen, you should be advocating for the Fed to raise rates and put on the monetary brakes. If you are a senior, you want deflation. Deflation means that prices will go down and you will be able to buy more with the money you have. You would rather have a deflationary depression than inflation.

The same goes for younger people, but to a lesser extent. One way or another, we will eventually get a depression to cleanse out all of the malinvestment that the government has caused. It is better to do it now than do more damage still. But for a younger person, if we have a period of high price inflation, at least the younger person can eventually recover by earning more money. It is much harder for someone in retirement on a fixed income.

If you are younger than 50 (maybe this should even be 60), then don’t plan on getting anything out of Social Security. If you are over 60, pray for a depression quickly. Better now than later when your money is nearly worthless.