The lead article on LewRockwell.com this weekend is titled “How Hyperinflation Will Happen“.  I don’t really like to pick a fight with someone who is being published on Lew Rockwell’s website, but it is important that you understand some errors of the author.  I don’t know anything about the guy, but he is obviously very knowledgeable and he is probably a strong libertarian.

While I think hyperinflation is possible in this country, I don’t think it is the most likely outcome.  But the thing that amazes me most about this guy’s article is how nonchalant he is at the end of the article.  He expects hyperinflation to happen in the near future so he suggests investing in hard metals.  While this may be good advice, he is saying that it will just pass by, as if it is no big deal.

If we experience hyperinflation in this country, that is just about a worst case scenario.  It could mean a total breakdown of the division of labor.  It could mean riots and millions of people starving in poverty.  He doesn’t understand the implications of his prediction.

Now, let’s move on to his prediction of how we get there.  He basically says that there will be a crash in U.S. treasuries (please read the article yourself to see his full explanation).  Maybe I’m missing something here, but he may be getting his cause and effect mixed up.  High inflation rates is what causes high interest rates (and lower bond prices).  Investors demand a premium because they are expecting to be paid back in depreciated dollars.  An increase in interest rates isn’t what causes inflation or hyperinflation.

Inflation is a monetary phenomenon.  Individual prices can go up or down based on the supply and demand of the product.  Prices can go down due to increased technology and efficiency.  Prices can go up because of government taxes and regulations.  But the only things that can cause a general rise or decrease in the overall price level are velocity (demand for money) and the supply of money (you could include fractional reserve banking with this).

It is possible for velocity to cause hyperinflation.  If everyone turned into an Austrian economist tomorrow morning and decided that the U.S. dollar is a worthless fiat currency, then it is possible for everyone to start trying to get rid of their dollars by buying things, thus bidding up prices.  However, this scenario is highly unlikely.

The only likely thing to cause hyperinflation is a dramatic increase in the money supply.  It would also be expected by the market that the money supply would keep growing in the future.  As discussed in other posts, the monetary base has more than doubled in less than 2 years, but most of this money is sitting as excess reserves.  This has stopped massive price inflation.

While the author of this article raises some good points, his reasoning for hyperinflation fails.  Even Milton Friedman understood that inflation is a monetary phenomenon.  We will likely only see hyperinflation if we see a huge increase in the money supply on an on-going basis.

There was an article posted today on Yahoo Finance.  The title is “6 Ways Retirees Can Beat Inflation”.  It is amazing how ignorant some articles are.

The article talks about 6 ways to hedge against inflation.  They are all terrible ideas as far as the subject goes.  How can you have an article talking about ways to beat inflation and not mention gold, silver, oil, real estate, or other hard assets?  Most of the ideas revolve around depending on the government’s CPI calculation.  The only half decent idea is investing in stocks, but even this is not that good if you look at what happened in the 1970’s.

When you see an article like this, you can see the ignorance that is out there.  How can gold not be mentioned in such an article?

This blog is a supplement.  It is designed to give advice, but it is just a tiny portion of what you should know about Austrian economics and investing.  For paid subscriptions, Richard Maybury, who writes the Early Warning Report, is fantastic.  He understands Austrian economics and is very practical and down-to-earth with his advice.  He also believes in Harry Browne’s permanent portfolio.  He is humble, as he doesn’t predict that you will become a millionaire if you just follow his stock picks.  His newsletter is well worth the money if you enjoy reading this type of material.  You will learn a lot about geo-politics and monetary policy.

Gary North is also a good read.  You can subscribe to his website where he puts out a huge amount of material.  He is very knowledgeable on the Fed and monetary matters.  You will also just get your money’s worth from his other advice that doesn’t have to do with investments.  In addition, you can ask questions and communicate to others on his forums.  Give it a try and cancel if you don’t like it.

Again, this blog is not in competition with anyone.  It is meant as a supplement.

You should also learn as much as you can about Austrian economics, as well as what is going on in the political world.  For this, read LewRockwell.com and Mises.org.  Learn as much as you can.

Dave Ramsey and Suze Orman (both with television shows now) offer good money advice.  You should pay attention to much of what they say.  You should not pay attention to their investment advice.  They don’t understand Austrian economics.  They don’t understand that the Federal Reserve can create money out of thin air and cause a massive depreciation of the dollar.  If they do understand it, they don’t think it is a threat.  They don’t understand the business cycle and malinvestment.  That is why they have told people in the past to invest in mutual funds.

They are both smart in their unique ways.  They offer good advice in paying off debt and living below your means.  They offer good advice on life insurance and other money issues.  It is worth watching their shows if you haven’t seen them.  Just don’t necessarily take their investment advice.  They don’t understand the dangers of a fiat currency.  They don’t understand diversifying out of U.S. dollars.

This blog is meant to keep you informed and to educate you regarding money and investment decisions.  For some, it may just be confirmation of what you already know or a supplement to what you already know.  This blog is not really meant to tell you what to do.

With that said, some people want advice on their investment portfolio.  This is a difficult thing to do, as each individual’s situation is so different.  Do you rent?  Do you own a house?  If so, do you own it free and clear (deflation hedge) or do you have a big mortgage (inflation hedge or perhaps just not smart)?  Do you have any other debt?  Do you have any major upcoming expenses?

So let’s assume that you don’t have any debt with the possible exception of a reasonable mortgage.  Let’s also assume that you have an emergency fund.  Let’s also assume that you have an average income with average expenses and you are not retired (although being retired may not necessarily change this).  If you have absolutely no idea on what to do with your money, then you should probably just invest it in Harry Browne’s permanent portfolio, as laid out in his short book “Fail Safe Investing”.  You can also invest in the mutual fund that is similar (symbol: PRPFX).

If you are more experienced and you want a higher risk/reward portfolio, it would still be a good idea to have some in a permanent portfolio fund.  Here is an approximate suggestion for a portfolio in our current environment.  Please note that this could change at any time and it is also not a guarantee to make you money.  There are no guarantees.

Put approximately 15% in stocks (some index funds, some specialized funds like energy).
Put approximately 5% in gold related stocks.
Put approximately 20% in gold and gold related investments (not stocks) like GLD.
Put approximately 20% in long-term U.S. government bonds.
Put approximately 5% in silver and silver related investments like SLV.
Put approximately 35% in cash or other short-term liquid investments like a cd or money market fund.

Although bonds may seem risky, you need some protection in case of another crash.  If you had your entire portfolio in bonds in late 2008, you would have done very well.  Most other investments, other than shorting the market, did not do well.

If the Fed starts to inflate again and the banks start to loan out more money, then you will want to decrease your cash position and increase your gold and silver positions.

Again, this is a very rough estimate and each individual has a different situation.  Use common sense and what you feel comfortable with.  And again, if you have no clue, just stick with the permanent portfolio.

There seems to be a little confusion about excess reserves held by commercial banks.  The Federal Reserve started paying interest on excess reserves right around the time the economic crisis became noticeable.  It has been written by some analysts that the banks started holding excess reserves because the Fed is paying interest.

This is bad analysis, as the reason for the boom in excess reserves is probably not due to the interest paid.  The Fed is only paying one quarter of a percent on excess reserves.  Bernanke, in his recent speech in Jackson Hole, Wyoming, said that reducing the rate paid on excess reserves is a possible future weapon for fighting a bad economy (he may have used the term “disinflation” instead of bad economy).  But even Bernanke admitted that it might not have much effect.

The Fed is only paying .25% interest.  They could lower it to zero and it probably won’t make much difference.  Now, the Fed could charge a fee (a negative interest rate), but this was not discussed by Bernanke.

The most likely reason the banks are holding these large amounts of excess reserves is because of uncertainty.  The uncertainty just happened to coincide with interest paid on excess reserves and a more than doubling of the monetary base.  It is not necessarily all coincidence, but let’s not confuse cause and effect.  Just because the Fed started paying interest on excess reserves around the same time that excess reserves went way up, doesn’t mean that one thing caused the other.  The banks made a lot of bad loans in the past and they are afraid of making loans now.  They are afraid that people will default, so they are being very careful who they lend money to.  Reducing the rate to zero on excess reserves will not change these circumstances.

Here are two charts.  The first chart shows the adjusted monetary base.

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

The second chart shows the excess reserves held by banks (one year chart).

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

This tells us two things.  First, the two charts are almost identical.  Money created by the Fed is going to the commercial banks as excess reserves.  This means that the newly created money is not being lent out.  This is keeping price inflation down.

The other thing you will notice is that the Fed has had a policy of stable money for over four months.  This comes after the explosion in the monetary base in late 2008 and 2009.

Until this changes, you will not see massive inflation and you probably won’t see a massive spike in gold.  You should always hold a portion of your portfolio in gold (say 20-25%) or gold related investments, but you will not see it go sky high until we see a change here.  If the economy hits another major downturn (which looks likely), then we may get a change in policy.  You should look for an increase in the monetary base or a decrease in excess reserves (without the same thing happening to the other chart).  Once you see the charts break the correlation, then you should really prepare for high price inflation.

The Federal Reserve has a choice to make, whether it knows it or not.  The choice is inflation or depression.  There is no in between.  The government has created this situation with all of its horrible economic policies.  Bush gave us two wars while continuing to increase domestic spending.  Greenspan helped with creating money out of thin air.  Before Bush left office, he bailed out the car companies and did a massive bailout of the banks.

Obama has continued these policies.  He continued the bailouts and signed a massive “stimulus” package right after taking office.  The federal deficits are huge and the overall debt to GDP is nearing 100%.

There was a lot of malinvestment prior to 2008.  Interest rates were kept artificially low by the Fed and the government spent like crazy.  It caused bubbles in our economy and misallocated resources.  When Bernanke took over at the Fed, he actually stabilized the money supply.  This exposed all of the bad investments and it drove the economy into recession.  This is what needed to be done.  If Bernanke had continued to create new money, it only would have made the problem worse in the future.

Unfortunately, Bernanke and the Fed did not keep this stance for long.  When the fall of 2008 came, the Fed more than doubled the adjusted monetary base.  Most of this new money went to the banks and the banks kept it as excess reserves.  This is why we haven’t seen significant price inflation.

Instead of letting all of the bad investments get cleansed out, the government tried to prop things up with more spending, more bailouts, more money creation, and more debt.  This has only caused more bad investments and a severe misallocation of resources.  At this point, the economy needs to cleanse itself in the form of a severe recession.  This is what the government should let happen.  It will be tough medicine, but it is the right cure.

More likely, the government will continue to spend and create money out of thin air.  If and when the economy shows another recession (did the first one ever end?), the Fed will most likely choose the wrong path of more inflation.  This will make things worse still.  It would be wise to prepare for massive inflation in the next several years.

It is unlikely that we will see hyperinflation.  We probably won’t see price inflation of 100% per year.  We could easily see price inflation of 20% per year.  The future is unpredictable and you never know what will happen, but it is unlikely that the Fed will go to hyperinflation because they will destroy themselves and the banks in the process.  The most likely scenario is high inflation, followed by a severe recession or depression (call it what you want).  It might play out like the 1970’s and early 80’s, but more severe.

Just remember, the damage has already been done.  There are bad investments that need to be liquidated.  There needs to be a shifting of resources and we need people to save and invest, which is the basis of growth.  The government should allow this to take place.  It will probably do a lot more damage before it does.

Rumor has it that Cramer on CNBC is advocating holding some gold positions in your portfolio.  If ever there was a perma-bull, it is Cramer, and even he is concerned and cautious about the stock market.  The Dow is hanging just above 10,000 right now.  If you have any money in stocks that you care about, you should get it out, unless it is balanced with other investments like bonds.  If you have any more than 25% of your portfolio in stocks right now, you are taking a big gamble.  There is a lot of malinvestment in the economy and it is trying to fix itself.  The government is not allowing the fix to take place.

Although we may still see rallies, it is unlikely that stocks are going much higher from here in the short-term.  The only thing that can drive them a lot higher is massive inflation.  In that case, you are better off in other investments anyway.

The future is unpredictable and anything can happen, but stocks are not looking good right now.  When Cramer is cautious about stocks, that means “sell, sell, sell”.

If you pay much attention to the financial news, you will hear how we (meaning Americans) don’t want to end up like Japan of the last 10 or 20 years.  If the American economy, in the next ten years, is like Japan’s economy of the last ten years, we will be lucky.

We hear that Japan has been trapped in a deflationary spiral that it can’t get out of.  First, it is hard to call it deflation.  There have been a few times where the price index reports show a slight drop.  Basically, Japan has experienced stable prices over the last couple of decades.

But even if Japan really did have deflation (monetary or price), it is a myth that it is trapped.  The Japanese government has had some horrible policies in the past.  It has done its fair share of stimulus packages and the debt to GDP ratio is near 200%, bigger than any major country.  The one thing it hasn’t done is gone crazy creating money out of thin air (at least relatively speaking).

Any central bank that wants to avoid a “deflationary spiral” can do so.  The Federal Reserve or any central bank can buy assets at any time.  The Fed could buy more bonds.  That is the most typical method.  It could buy mortgage-backed securities as it did in 2008.  It could buy stocks.  It could buy baseball cards and used furniture.  Bottom line, the Fed can create money out of thin air any time it wants.  It doesn’t do this because it could eventually lead to hyperinflation.  The Fed is walking a tightrope right now, but it can cause high price inflation at any time.  Bernanke has said so himself.  The Fed just has to credibly threaten to dramatically increase the money supply.  It could also force banks to lend.

The purpose of this commentary is not to predict inflation, but just to make you aware that the Fed and any other central bank can inflate at any time.