Take a look at these two charts:

Adjusted Monetary Base

Excess Reserves

If you look at them together with the same time period (1 year, 5 years, etc.), they look very similar. This is no coincidence. In the fall of 2008, the Fed began creating money at an unprecedented rate. It eventually more than doubled the monetary base, which is really the monetary chart that the Fed most controls.

When the Fed created all of this new money, it went to the banks. The banks were, and still are, scared to lend. They are afraid of future defaults (and probably rightly so). They would rather keep their excess reserves sitting at the Fed earning less than .25% interest instead of lending out this money. The banks could loan out this money as they are only required by law to keep about 10% on reserve.

The fact that the banks have kept these excess reserves with the Fed instead of loaning out the money is what has kept price inflation from skyrocketing. If the banks start to lend and the Fed doesn’t reign in this new money, then we will see prices jump substantially. Keep an eye on these two charts. If the monetary base goes up without excess reserves going up, or if the monetary base stays about the same with excess reserves going down, then you should be prepared for massive price inflation and should prepare your investments accordingly.

Yesterday, I wrote on the low mortgage rates. There is a strong benefit to buying a house right now. Prices are low compared to what they were a few years ago and rates are low. If you aren’t buying a house for investment purposes (to rent, fix up and sell, etc.), then buying a house is buying a consumable good. Spending more on a house is not necessarily a good financial move. But taking a vacation to the Alps is not necessarily a good financial move either. There is nothing wrong with buying your dream house or just a house with a little more than needed, but you should be able to afford it and you should not consider it an investment.

While there is a good argument to buying a house right now with a fixed rate mortgage, it does not mean that goes for everything else. You need to live in a house (or some kind of shelter) and although it should depreciate over time, in most cases they appreciate because of the land and because of inflation. There is also a good argument that with a fixed rate mortgage, you will be paying back the loan in depreciated dollars.

Although inflation benefits borrowers, it doesn’t mean that you should collect debt. If you need a car right now, then of course you need to buy one for transportation. But cars depreciate, so it is the opposite of an investment. The investment is the transportation part of it (getting to your job, to the store, etc.). Anything beyond the transportation part is really a luxury. It is not to say that you shouldn’t get certain features that you may want, but it is to say that you are making a bad financial decision if you buy a $30,000 car while your net worth is not even that much.

Debt is a bad thing, generally speaking. You are wasting money on things that you don’t need. You should only go into debt for something like a house or an inexpensive car that you need for transportation. You should never go into credit card debt unless you need to in order to put food on the table.

Stay away from the bad debt.

Mortgage rates continue to be at or near all-time lows. You can get a 30 year fixed rate mortgage for just over 4.5% if your credit is decent. If you own a home and plan to stay there and your rate is above 5.5%, refinance it if you can. If you are buying a home, get the fixed rate mortgage for 30 years.

Under normal conditions, I am an advocate of paying off your mortgage if the rest of your financial situation is in order. If you have a 6% rate, you can pay down your mortgage and get the equivalent of a 6% rate of return on your investment.

With rates as low as they are now and with potentially high inflation in the future, you probably can’t go wrong with a 30 year fixed rate for under 5%. You should obviously have payments that you can afford. If you get a fixed payment of say $1,000 a month, when you make that last payment in 30 years (assuming you keep the house for that long), that payment might be the equivalent of a nice dinner out.

A week or so ago, I heard a commentator on CNBC say that we should be worried about deflation because inflation can be stopped at any time, but that you can’t stop deflation. I have been hearing this theme surprisingly often lately. If you hear anybody say this, don’t ever take advice from them on anything dealing with economics because they have no idea what they are talking about.

If anything, inflation is the thing that could possibly not be stopped. The Fed bought up a bunch of near worthless assets back in 2008 and they will only be able to sell them back at a fraction of the price for what they paid. One option for fighting inflation down the road would be to increase the reserve requirements for banks, but even this is not a sure thing and beside the fact that it would not be supported by the banks (which work hand-in-hand with the Fed).

As far as price inflation goes though, if the public realized one day that the deficits are too high and our fiat currency is not backed by anything (like gold) and that the Fed will create mass quantities of new money, then a rush to the exits could mean the end of the dollar. If the demand for money goes down enough (high velocity), then it may not even matter how much money the Fed is creating. If enough people reject the currency, this in itself could sink it.

But let’s move on to the deflation issue. This guy (and there are many more like him) think that the Fed can’t stop deflation. Seriously, does this guy know anything about what the Fed does? The Federal Reserve can buy any asset that it wants with newly created money. The Fed could start buying stocks, old furniture, baseball cards, or farmland. Or it could keep buying U.S. treasuries. It doesn’t matter. It could flood the market with new money. Ben Bernanke has said it himself. The Fed can create inflation just by credibly threatening to print money.

Of course, as has been discussed on previous posts, the Fed could also impose a negative interest rate on excess reserves held at the Fed by the banks. This would essentially force the banks to loan out their excess reserves. After a more than doubling of the monetary base, this in itself would create massive inflation.

It is one thing to predict that the Fed will take a deflationary course, but please don’t listen to anyone who says that the Fed can’t get out of a deflationary situation.

We hear that there is little inflation and that deflation may be the real threat. We hear that prices aren’t going up. In certain assets, like stocks or real estate, that may be the case only because they were bubbles that are trying to deflate.

Unfortunately, inflation (whether monetary or price) is a real threat. Walking through the grocery store the other day, it was hard not to notice that some of the prices had gone up. The regular price for a 12-pack of coke was $4.99 up from $4.89. It may only be a dime, but it is over 2% of an increase. About 10 or 12 years ago, a nearby gas station sold two 12-packs of coke for $5. The grocery store might have a slightly higher price, but essentially the price has almost doubled.

If banks start lending more money, watch for prices to explode. We will be lucky if the next 10 years in the United States look like the last 10 years in Japan. Pray for a lack of inflation. We would rather get a depression now than experience massive inflation and then a depression.

Federal Reserve chairman Ben Bernanke told Congress today that he is open to taking additional actions to keep the so-called recovery going. The article is here:

http://www.cnbc.com/id/38347202

The article says that while there are no leading options, some of the options could include “lowering the rate the Fed pays banks to keep money parked at the Fed, strengthening the pledge to hold rates at record lows and reviving some crisis-era programs”.

The first option in particular is fascinating. The Fed funds rate is already near zero. Technically, it is set at between 0% and .25%. So the Fed is paying interest to banks for their excess reserves of around one-tenth of one percent. How can they lower it? The only option, except for some insignificant lowering, is to charge banks a fee to keep their money on reserve. If the Fed charges a high enough fee, then ultimately banks will essentially be forced to lend out their excess reserves.

The monetary base has more than doubled since the fall of 2008. This has been offset by the banks increasing their reserves. If the banks lend out all of the money that has been created since then, then we will eventually see severe price inflation. It could easily double or more in a relatively short period of time. That is why it is unlikely that Bernanke will go for this option. If he does, then he truly deserves to be called “Helicopter Ben” and he truly is an idiot.

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.