Free Markets, Free People

inflation

For Informational Purposes Only

I am not an investment advisor.  I’m not a guru.  I’m not qualified to give you any investment advice at all.  I’m just looking around and seeing things, and telling you what I see.  And, in this case, I’ll even tell you what I’m doing.

I do so, however, with the strong warning that you should not, under any circumstances, use me for an example, or follow my example.  What I do may not be suitable for you at all.  I just want to make that clear.

First let me recap some data points I’ve made in several previous posts:

The Fed has more than doubled the monetary base over the past year. The amount of money that is just sitting there in the economy is incomprehensible.  But, it’s not making any trouble for us in inflationary terms, because it is just sitting there.  It’s what will happen when it does stop just sitting there that is worrisome.

The Federal Budget has spiraled out of control, with the TARP, stimulus, and recession bringing additional massive amounts of debt to bear, and future deficits signifigantly larger than any in recent memory–on top of which, there is now talk of “Stimulus II”.

Despite the happy talk about the economy’s recovery, the fact is that it is still in decline–just a slower rate of decline.  If a recovery doesn’t occur soon, we will run into another leg down in the economy, as households and businesses draw down their cash reserves, hit their credit limits, and slash their spending.  The longer the recession continues, the more people and business that will be forced into bankruptcies, the more foreclosures will rise, etc.  We call things like this “black swan” events.

On the other hand, even if there is a recovery, the Fed will be faced with the task of trying to wring the extra money back out of the economy.  If they are unsuccessful, inflation will rise.  If they are successful, they may spark another recession through tightening, much as they did to cause the second leg of the back-to-back recessions in 1981-1982. A second leg of a recession will undoubtedly result in greater debt and more money funneled into the economy as the government re-imposes monetary and fiscal stimulus again to re-inflate economic activity.  This will both deepen the debt and increase the money supply, making the next round of interest rate tightenings more difficult, unless the economy comes back strongly.

Social Security is now estimated to begin having a negative cash flow in 2019.  In other words, Social Security expenditures will exceed the payroll tax receipts.  We have, until now, been running surpluses in Social Security receipts, but, of course, the government spent that money in the general fund.  There is, therefore, no pot of money saved to make up for the deficit in receipts in 2016.  Benefits will be cut.  Taxes will be increased.  Economic growth will be affected.

I discount the Robert Fisk story that Bruce linked to earlier today as implausible.  As Fabius Maximus points out:

1. Some of these nations have no reason to risk destabilizing the USA.  Esp the Saudi Princes.

2. Some of these nations have no reason to risk destabilizing the global financial system. Esp.  Japan.

3. Many of these nation have leaders who are some combination of cautious, slow, reactive, and incrementalists.

4. Something of this scale would be almost impossible to keep secret 2 days after the first discussions.

5. If multiple Hong Kong banking sources knew it, their fingerprints would be all over the US dollar – as they shorted it to the max.

Having said that, while I believe this particular story is implausible,  it is obvious that a number of countries, China and Russia chief among them, are urging that the dollar be replaced as the world’s reserve currency, or, at the very least, allow some other currency or basket of currencies to be used in addition to the dollar.  If this happens, billions of dollars will be repatriated to the US, drastically lowering the dollar’s foriegn exchange value.  China is already denominating regional trade deals in yuan, and the use of gold has been on the rise as an instrument for international settlements in Asia and Europe.

There are many more data points, but it would be both tedious and depressing to continue.

The bottom line is that the trends outlined above will, in all probability, necessitate dealing with our foreign creditors.  Such dealings may require us to reschedule our debt payments, which will devastate the bond market, make future borrowing far more difficult, and end the notion that treasury notes are “risk-free” investments. If so, we will have become a financial banana republic in which future investment will be given the gimlet eye.  We may also be required to those foreign debts off in some currency or basket of currencies other than dollars, in order to prevent the government from inflating the debt away.

These trends will also probably require devaluing the US dollar by a substantial amount, so that our imports become expensive, while our exports become cheap.  This will allow us to earn the money to pay off our foreign debts, although it will, of course, result in a lower standard of living in the USA.

This the inevitable result of allowing the government–and the voters–to loot the system for 70 years.

So here is what I have done–and this is purely for informational purposes.  I do not recommend it for you, and I urge you to consider that I may be entirely wrong.

Several months ago, I completely pulled all of my investments out of equities, and into some select bond funds with a mix of government and private bonds.  As of today, I have ceased placing any more money in to either equities or bonds.

For the forseeable future, I will be buying gold bullion.  Not gold stocks.  Not Krugerrands.  Not gold depository accounts.  I mean direct bullion purchases of gold bars or rounds.  My personal preference is for APMEX or Pamp Suisse 10g bars, or Scotia Bank 1/4 oz. rounds, since they have the lowest premiums over the spot price, and are small enough to conveniently convert at local jewelry stores, pawn shops, or gold dealers at need.

Trying to convert a 1kg bar on short notice would be…inconvenient.  Even 1oz. Krugerrands might be hard to convert as the value of each single coin is now over $1000.

I have no interest in paying a premium for “collectible” coins.  I have no interest in purchasing a depository account, where my gold holdings have to be reported to the government. In fact, prior to this month, I had no real interest in gold either.  Indeed, if you bought gold at any time from 1979 to 2001, by march of 2001, you would have lost money–perhaps quite a lot of money, depending on when you bought it.   However, in the current circumstances, let’s just say that my interest is now…heightened substantially.

Whether your interest should be heightened…well, I couldn’t say.

The Kangaroo is Still Hopping

Today was one of those days when a couple of trends came together that should be making us think seiously about changing our current fiscal and monetary policies.

The first thing I was was this debt chart from John B Taylor that shows how our current policy will effect the national debt.

Projected national nebt as a percentage of GDP

Projected national nebt as a percentage of GDP

This what you call your unsustainable debt path.

Then, there was this:

Since the crisis began, the Fed has pumped more than $800 billon into the banking system, kept the federal funds rate near zero and purchased so many Treasurys and mortgage-backed debt that the amount of assets on its balance sheets has now swollen to $2.14 trillion.

“If you think the Federal Reserve had it tough devising a strategy to rescue the U.S. economy from of the worst recession in 70 years, just wait,” wrote Bernard Baumohl, chief global economist, at the Economic Outlook Group. “We think it is going to be hellishly more complicated this time to come up with a plan that encourages growth and keeps inflation expectations well anchored.”

All of which leads directly to this:

Chinese central bank governor Zhou Xiaochuan, who supervises more than two trillion dollars worth of dollar reserves, the world’s largest, raised the stakes by calling for a new reserve currency in place of the dollar.

He wanted the new reserve unit to be based on the SDR, a “special drawing right” created by the International Monetary Fund, drawing immediate support from Russia, Brazil and several other nations.

“These countries realize that they would suffer losses if inflation eroded the value of the dollar securities they own,” said Richard Cooper, a professor of international economics at Harvard University.

Here’s the problem.  Because we are on an unsustainable debt path, we will eventually accrue more debt than we can possibly repay.  There are many people who think that–since our debt, coupled with Social Security and Medicare obligations currently outstanding, are greater than the entire capital stock of the United States–we’re there already.  We ill be unable to pay the debt, so our choices are to repudiate it outright, or to destroy the value of the currency and inflate it away, both of which amount to essentially the same thing.  In doing so, the government will destroy the life savings of everyone in the country, save those that are in hard assets

The Chinese, whatever else they may be, are not stupid.  they know this, and they want a new worldwide reserve currency now, before everyone realizes that the dollar is in very serious danger of becoming worthless.  They don’t want to be stuck holding dollars when that happens–although their holdings in bonds will probably have to be written off.

I’ve written previously that China moved their gold reserves into the BoC a few months ago.  Some international trade deals are already being denominated in gold, tool.  It looks very much like the dollar’s days as the world reserve currency are numbered.  In fact, the dollar’s days may very well be numbered.

Federal Reserve Monetary Base. Click to enlarge.

Federal Reserve Monetary Base. Click to enlarge.

And we’ve let it happen.  Over the past 80 years, we’ve sat by and watched as the Fed–whose primary mission was supposed to be the stability fo the currency–has presided over a tenfold reduction in the dollar’s value.  For the last 30 years, we’ve watched as the debt has mushroomed–yes, even during Bill Clinton’s presidency–and we’ve refused to either cut spending or to raise taxes to a level commensurate with our increased spending.  In short, we’ve looted the system, and the looting is nearly complete now.

And now, with all the trumpetings of a coming economic recovery, the Fed has to try and figure out how to re-call the more than doubling of the monetary base we’ve engaged in in the past year without completely crashing the economy.  Failure to do so, of course, means serious inflation–which will further degrade the value of the dollar.

Hop.  Hop.  Hop.

Sometimes A Picture …

Is definitely worth a thousand words.

Or a chart.

Arthur Laffer is not amused:

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That’s more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers’ expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

And what have those “panic-driven monetary policies” brought us? Well, first the picture:ed-aj638a_laffe_ns_20090609175213

The chart is certainly no laffer.

Remember, we’re being told by “experts” (*cough* Krugman *cough*) that we’ll be able to handle this with no problem, really, if we just manage it properly. A tweak here, a tweak there and bingo – no inflation.

Hmmm … let’s get a little context here, shall we?

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base.

So that means that what? Well Laffer goes into a good explanation of bank reserves and how they function, etc. etc. – bottom line, banks are going to be loaning a bunch of money, thereby injecting liquidity into the marketplace.

But.

With the present size of the monetary base, and …

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It’s a catch-22.

And what does that mean could happen? Well again, we’re in uncharted territory, but the last time we had anything even similar, eh, not so good:

It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S. To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.

Yeah. I remember it well. And here we are again – on steriods. So now what?

Per Laffer, the Fed must contract the money supply back to where it was plus a little increase for economic expansion. And if it can’t do that, it should increase the reserve requirement on banks to soak up the excess.

But Laffer doubts that can or will be done:

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury’s planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it’s a Hobson’s choice. For me the issue is how to protect assets for my grandchildren.

Nice.

Yes friends – we’re in the best of hands. I’m just wondering how the present administration is going to attempt the blame shifting when the inevitable happens.

~McQ

Podcast for 31 May 09

In this podcast, Bruce, Michael, Billy, and Dale discuss the economy and the Sotomayor nomination.

The direct link to the podcast can be found here.

Observations

The intro and outro music is Vena Cava by 50 Foot Wave, and is available for free download here.

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2007, they can be accessed through the RSS Archive Feed.

Money? Or Receipts?

Recently, while listening to the Opie and Anthony show, I heard an interview with Loius CK, the comedian.  And he said something that struck me as quite profound.  And quite true.

Back in olden times–i.e., prior to the 1930s–our paper money wasn’t actually money, as such.  Instead, it was a receipt for the real money–gold, or silver–that we had stored in the bank.  And the amount of gold we had determined how many of those receipts we could get.  The gold or silver we held had an intrinsic value, and the paper currency we carried was simply a representation of that intrinsic value.

Then, in the 1930s, we simply got rid of the metal, and kept the receipts.  Ever since then, the paper money we carry around with us has no intrinsic value.  And the value of that receipt is worth whatever the government says it’s worth.  It is a medium of exchange, and nothing more.

You may have $1,000,000 in the bank.  And if the government says that it’s only worth a cup of coffee in exchange, then that’s exactly what it’s worth.  It doesn’t matter if acquiring that million bucks was the work of a lifetime.  The government can, if it wishes or is unwise, reduce the stored value of your life’s work to a trip to Starbucks.

Just something to think about.

Our Inordinate Fear of Inflation

That’s the subject Paul Krugman addresses in his NYT Op/Ed piece today.  In fact, he implies that even talking up the possibility of inflation comes solely from bad political motives, mostly from people who don’t grasp The Fierce Moral Urgency of Change™.

Why shouldn’t we worry about inflation, according to Prof. Krugman?

Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.

But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.

But, let’s grant that the current monetary moves aren’t immediately inflationary.  What happens when the economy recovers and the banks do begin to spnd those extra reserves?  Krugman attempts some sleight of hand, in an effort to make it appear that he addresses that concern.

Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell.

Yes, they did.  But since Japan hasn’t had a real economic recovery even today, and is entering its third “Lost Decade”, that really isn’t a compelling argument.  Since 1999, Japan’s rate of GDP growth has averaged 1.31%, which is less than half of the average GDP growth rate of 3% a mature economy should experience.  Indeed, over the last decade, Japan has experienced exactly 5 quarters where GDP growth was at 3% or more. In that same period, there have been 9 quarters when GDP contracted.  The highest annual rate of growth was in 2000, when the annual GDP growth was 2.85%.

So, let’s not pretend we know how the inflationary pressures fall out in Japan once a recovery hits…until there actually is a recovery.

ON the other hand, since our policymakers seem hell-bent on following the same path the Japanese did in the 1990s, the return of inflation when the economy recovers might turn out to be worry we can avoid until sometime in the relatively distant future.

Juxtaposition

Compare and contrast this rehabilitation effort of Timothy Geitner:

After his hellish opening weeks, Treasury Secretary Timothy Geithner started inviting White House economic officials across the street to his conference room for hours-long working dinners that have helped get — and keep — the whole team on the same page.

[…]

Geithner, a former president of the New York Federal Reserve who once looked like he was floundering in one of the administration’s most scrutinized jobs, is emerging in a new position of strength with the media and the markets, just as he launches President Barack Obama’s high-stakes effort to re-regulate the nation’s financial markets.

[…]

The secretary’s advisers acknowledge that his newfound political standing is tied, in part, to the state of the economy, which is now showing early signs of improvement. But Treasury officials also have updated their playbook after his Feb. 10 speech on financial recovery, which was panned by the press and blamed for a 381-point slide in the stock market.

They decided to “let Tim be Tim” and accepted the fact that his strength wasn’t giving a speech in front of a bunch of flags. Rather, they let reporters see him in off-camera, pen-and-pad settings, where he fielded questions with the confidence that his staff saw behind the scenes. He aced an interview with PBS’s Charlie Rose, thriving in a relaxed setting where he could explain issues at length.

… with this bit of economic reality:

China has warned a top member of the US Federal Reserve that it is increasingly disturbed by the Fed’s direct purchase of US Treasury bonds.

Richard Fisher, president of the Dallas Federal Reserve Bank, said: “Senior officials of the Chinese government grilled me about whether or not we are going to monetise the actions of our legislature.”

“I must have been asked about that a hundred times in China. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States,” he told the Wall Street Journal.

[…]

The Oxford-educated Mr Fisher, an outspoken free-marketer and believer in the Schumpeterian process of “creative destruction”, has been running a fervent campaign to alert Americans to the “very big hole” in unfunded pension and health-care liabilities built up by a careless political class over the years.

“We at the Dallas Fed believe the total is over $99 trillion,” he said in February.

“This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them,” he said.

His warning comes amid growing fears that America could lose its AAA sovereign rating.

I guess since the media tried to talk down the economy for the previous eight years, they may as well try and talk it up now that their boy is in the White House. The shame of it is that as the economy worsens, a lot of people are going to be shocked.

Podcast for 24 May 09

In this podcast, Bruce and Dale discuss discuss the president’s announcement of legal indefinite detention, and the economy.

The direct link to the podcast can be found here.

Observations

The intro and outro music is Vena Cava by 50 Foot Wave, and is available for free download here.

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2007, they can be accessed through the RSS Archive Feed.

Podcast for 17 May 09

In this podcast, Bruce and Dale discuss the Nancy Peolosi’s beclownment, and the state of the economy

The direct link to the podcast can be found at BlogTalkRadio, since I inadvertently failed to record a local copy of the podcast.

Observations

The intro and outro music is Vena Cava by 50 Foot Wave, and is available for free download here.

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2007, they can be accessed through the RSS Archive Feed.

Another Troubling Sign

What if the Treasury held a bond auction and nobody came?  After today, that’s not a rhetorical question.

Weak demand at a Treasury bond auction touched off worries in the stock market Thursday about the government’s ability to raise funds to fight the recession.

The government had to pay greater interest than expected in a sale of 30-year Treasurys. That is worrisome to traders because it could signal that it will become harder for Washington to finance its ambitious economic recovery plans. The higher interest rates also could push up costs for borrowing in areas like mortgages.

We are moving closer to what I warned about in March, after the UK had a failed auction of 15-year gilts.  Apparently, the Chinese didn’t turn out in force today.  They did however, continue talking about a new reserve currency–one that isn’t the US Dollar.  And apparently they’ve been doing more than talking about it.

As we learned last week, the Chinese–who haven’t announced anything about their gold holdings since 2003–casually dropped an announcement that they’d nearly doubled their gold holdings from 19 million to 34 million ounces.  Moreover, this gold, which had previously been kept for foreign trade in an account at the State Administration of Foreign Exchange, has now been transferred to the bank of China, as part the country’s monetary reserves.

I don’t think they’re all that keen on lending us money any more.

This is important because it indicates the extent to which gold is being rehabilitated as a monetary reserve asset, not only by the Chinese monetary authorities but by central bankers around the world. It has been clear that gold was being restored as a more important part of the world’s financial system, with rising investment demand over the past nine years. The Chinese government’s decision to say that this gold belongs in its monetary reserves emphasizes that monetary authorities also are looking at gold with greater interest than they have since the 1960s.

There’s a new reserve currency in town, and it’s yellow and shiny.  What it isn’t is green with pictures of dead presidents on it.  Maybe the Fed’s doubling of M2 the monetary base over the last eight months was a bit…intemperate.

So, the key take-aways here:

1) Higher interest rates possible as auctions fail to find bidders at lower yields.

2)  Billions and billions of dollars floating around, with no place to go but back home.  “Wouldn’t you like to wear $3,000 suits and smoke $75 cigars?  I know I would.”

But, we probably shouldn’t worry. As Glenn Reynolds says, “The country is in the best of hands.”