"Occupy Wall Street" Should Have Occupied the Fed

This is not a political blog. And though I have definite political views, I've tried to stay away from partisan opinions here. Both American political parties share some of the blame for the dismal state of our economy.

That said, the policies which have brought the world to its present state of indebtedness and relying on central banks to artificially stimulate economies are much more widely embraced by those on the left. Liberals believe that government can better the lives of people through regulation and manipulation, even to the point of attempting to violate economic laws. Many moderate Republicans have more or less accepted these policies. Richard Nixon himself famously said, "We're all Keynesians now." Even so, most conservatives shy away from these policies. And libertarians loath them.

Keynesianism, conceived by John Maynard Keynes, is an economic philosophy which holds that in times of economic hardship the government should deficit spend and make money cheap (lower interest rates) to stimulate economic activity. This policy more or less works, much like a drug--that is, until the drug itself becomes the problem, which it has. We have reached what is known as the "Keynesian End-Point," that place where its policies no longer work because the problems it is attempting to solve have been caused by the policies themselves.

Whether such policies are always bad is a matter of endless debate. What is no longer a matter of debate is whether our government has abused them. There is no doubt it has. We now own a record $16 trillion debt, and the U.S. dollar has lost 95% of its value in the last 100 years due to the inflationary effects of too much money creation.

Even so, there are those, mostly on the left, who continue to insist that the problem is not government policies, but that we still don't have enough of them. In other words, they want to administer more of the same medicine that got us here in the first place. Because they've cast their lot with government as the ultimate solution, they are blind to the fact that it is government fiscal and monetary mismanagement that brought us to this state. So they continue to blame "Wall Street," and "big business" and "capitalism" and all the other usual suspects, instead of the one entity with the real power to ruin the economy--the government.

So why does the government do these damaging things? Because they seem to work in the short term--that is, just in time to get re-elected! Keynes himself famously scoffed at the long term, saying, "In the long run we're all dead." Well, the long run has arrived, and some of us are still here and have to deal with it.

Wall Street does bears some blame, as does Main Street. And capitalism is not perfect. But none of these could have produced the damage that was done without the cheap money policies brought on by our government. As Peter Schiff told us, Wall Street got drunk, but it was the government that served the free drinks.

Peter Schiff Explains What Caused the Financial Crisis

In this video, financial expert Peter Schiff explains what caused the financial crisis, how the U.S. economy got in such terrible shape, and why the government is just making things worse. Recorded September 12, 2012.

China Has Us by the Ying Yangs

In the second presidential debate with President Obama, Mitt Romney thumped his chest and pledged to call China on the carpet as a "currency manipulator." His assertion is that China is using its peg of its currency, the yuan, to the dollar as a means to gain unseemly economic advantages.

First, what does all this currency talk mean? What does it mean for China to "peg" its currency to the dollar? Basically it means that China is using its economic reserves to buy and sell dollars and dollar-denominated securities to manipulate global currency prices in order to hold the value of the yuan in lockstep with the U.S. dollar. They do this to keep the value of the yuan low in order to make their exports cheaper so that foreigners will buy them.

It is true that China's currency shenanigans are causing artificial imbalances in the world's markets. What's not true is that U.S. politicians really want China to drop its peg and let the yuan rise in relative value as it naturally would. Or at the very least it's not true that these threatening politicians are being completely open about what would really happen if China dropped its peg.

Why? Because China's dropping the peg would spell economic misery for the United States, at least in the short term.

China holds its currency down in part by buying U.S. Treasuries--in other words, loaning us money. If they stopped buying our debt and loaning us money, who would we sell our bonds to? There wouldn't be enough buyers, and interest rates would have to rise to attract new buyers. Rising interest rates are exactly what our government does NOT want. They want to keep rates low in desperate hope of stimulating borrowing in order to jump start the economy. Rising interest rates would not be good for the economy in the short term.

So China knows our woofing about the peg is likely just posturing. They know they have us by the ying yangs. That's where our being the biggest debtor nation and their being the biggest lender nation has gotten us.

However, in the long run, dropping the peg would ironically be good for the U.S., because it would force us to get our economic house in order. China essentially has us strung us out on debt drugs and is profiting from our addiction. In the short term, getting off the drugs (China dropping the peg) would spell hardship for the United States. Romney either doesn't realize that or is keeping it to himself because it's not an attractive election season message.

Meanwhile, China keeps pegging the yuan, and yawning at us.

Inflation = Stealing from Savers

In a previous post I wrote that inflation is a tax. That's one way to look at it. Actually, the more accurate description of it is stealing. It's just governments that are doing the stealing.

One of the biggest misconceptions is that inflation is a natural and inevitable economic phenomenon, a kind of cost of prosperity. This is false. Inflation is the result of government action, plain and simple.

Everyone knows prices are higher than they were twenty years ago. Few actually know why. Well, here's the reason: The government wants them to be higher, so the government creates more money than the economy actually needs, devaluing the currency, causing prices to rise.

Why does the government do this? Essentially inflation is supposed to act as a cattle prod to get the cattle, I mean people, to spend their money rather than save it--because why save if the money will be worth less in the future? Spending supposedly stimulates the economy and makes it hum, so the government feels it is worthwhile to incite people to spend, even at the cost of reducing the value of their dollars. Are they going to tell you that they are intentionally reducing your savings account value? Nope. They'd just as soon you believe it is a natural occurrence, like El Niño or weeds popping up in your yard.

Another factor is that inflation reduces the size of debt. It's a way the government addresses its debt problem. But by using inflation to reduce debt, they are also reducing savings. So it's a tax. It's an unauthorized, regressive, stealth tax.


Where is the evidence that the threat of inflation causes people to spend? Most people buy what they want when they decide they need it. Do you ever say, "I'd better buy a car this year because next year they are going to cost more?" I don't know of many people that do this.

By the same token, the government fears that falling prices will cause people to delay purchases indefinitely. But prices for electronics have been falling for years, and people generally buy them when they want them. Falling prices have not hurt the sales of electronics. In fact, ultimately they should help.

Is any of this moral? If a citizen works hard and saves his money, shouldn't the government be obligated to protect his wealth? Shouldn't the value of the nation's currency be something the government seeks to maintain above all, or even increase the value of? It seems downright dishonest for a government to set up a currency as the sole means of exchange and then year after year systematically debase that currency. It sounds like stealing.

Don't think for a second that inflation is natural or inevitable. It isn't. But the government wants you to think it is.

Fire or Ice? Inflation or Deflation?

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

Fire and Ice, Robert Frost, 1920

One would think with all the attention on the world's economic problems that people could agree on the ultimate bad outcome. But wouldn't you know it, that is not the case. Some experts are warning of massive inflation--an economic world consumed by the fire of money printing and overspending. Other experts are predicting deflation--an economic world frozen in ever-declining employment and prices.

Inflation and deflation each call for different financial strategies. What's an investor to do? Why does all this have to be so complicated? I'll try to address these questions in this post.

From a natural standpoint, the world is in a deflationary economic period--the result of too much government and personal debt, hyper-speculation, and aging baby boomers moving past their peak spending years. There are just too many obstacles and too little potential for spending to naturally push the world into an inflationary growth period. In short, the economies of the world want to contract. That means deflation. But governments don't like deflation and are willing to use their ability to create money out of thin air to try to shake the world out of its deflationary mood.

Deflation scares governments to death because, as I discussed in an earlier post, they like the appearance of growth (even though nobody is really getting ahead), inflation reduces debt (and unless you've been living on Jupiter for the last twenty years you know that most governments are hopelessly in debt), and inflation is effectively a tax (a way to transfer wealth from citizens who have assets to governments which have debt).

So the governments of the world are going to do everything they can to prevent the deflation that is naturally occurring. By doing so they risk making things worse in the long run. By printing so much money the government is risking hyperinflation.

What would hyperinflation mean? Well, on the positive side everyone's debt would vaporize because they would have more cash than they knew what to do with. The problem is savings would vaporize, too, along with the ability to buy anything, because all that cash would be worthless. Nobody would be able to afford anything. Hyperinflation is more common than people think. It just rarely happens in large countries. It's usually the ultimate result of a government taking the path of least resistance. Sound familiar?

What if on the other hand we moved into real deflation? Well, those in debt would suffer, because everything would become cheaper, including salaries, but debts would remain the same. On the other hand, savers would prosper, because their savings would buy more. Deflation is what happened when the housing bubble popped. People with big mortgages suffered. People with no mortgages but a lot of money in the bank gained, because their dollars could buy more. But deflation also means that jobs are scarcer. The big problem with deflation is that the economy can become a victim of too much frugality. Remember your parents staying in the same job for thirty years because of their memories of the Great Depression?

That said, it's my opinion that all the hand-wringing about deflation is mostly governments justifying their spendthrift ways. Deflation is the natural result of over-speculation. 

Regardless, whether we have inflation or deflation depends on just how much governments are willing to do to prevent deflation. They want to think they are simply lighting a fire to keep us from freezing. The problem is they may end up burning the house down--particularly if they don't honestly address underlying problems, like too many promises paid for with too much borrowing.

Severe inflation and deflation are both bad, but what is most important is knowing how to protect yourself in each. I'll try to keep this as simple as possible:

If severe inflation threatens, you want to be out of cash and invested in commodities like gold and oil. These will go up when there is inflation. Also, you can invest in foreign currencies that are resisting inflation because these will go up relative to the dollar. Some debt is not a problem in inflation. 

If severe deflation threatens, you want to be out of debt and in cash--U.S. dollars. You can also be in short-term bonds and other cash-like equivalents.

The stock market is not a good place to be in either extreme. Severe inflation or deflation are not good for the business environment, to put it mildly.

Note: This article is for informational purposes only and is not a recommendation to invest in any financial instruments.

Is Social Security Broke?

The short answer is it depends on how you look at it. The even shorter answer is yes.

A Facebook friend of mine recently posted a link to an article written by a Democrat who claimed that Social Security was solvent and would continue to be solvent for many years. This writer then accused Republicans who said otherwise of lying, demagoguery, worshiping Ronald Reagan and other loathsome acts.

The problem is the writer didn't tell the whole story, if she even knew it. Since Social Security's inception certain tax money has been earmarked from workers' paychecks for Social Security. This is part of the FICA tax (the other part being for Medicare). If all this money ever collected had been only spent on Social Security payments, then Social Security would have a surplus and it would be solvent. The problem is all the surplus has already been spent. There is no money in the "trust fund"--only IOUs and hungry moths. The government spent the Social Security money on other things.

How do politicians sleep at night knowing they are raiding the citizens' retirement fund? Well, besides possible self-hypnosis, one way they do it is to consider all this spending as "investment." Realize that the government cannot invest money as citizens can. What investment is it going to buy? Its own bonds? Then it would just be paying interest to itself. Should it loan the money to other countries at interest? It could, but considers that too "risky" (as if blowing all the money isn't more risky). Basically, politicians consider the best investment for America is America. Sounds patriotic, doesn't it? This gives them the green light to spend money on anything they think is "good for America," which, as we all know, covers a lot of territory.

That might help them sleep at night, but it's still not much more than a rationalization to spend now, pay later (in other words, to work to get re-elected). If would be the same thing as you setting aside monthly retirement money for yourself and then spending all the money every month on whatever you wanted, all the while considering that spending an investment in your future. Good luck with that retirement strategy.

A while back the Republicans came up with the "nutty" idea of investing Social Security money in the stock market. When the stock market crashed and lost half its value, Democrats crowed and gloated over how stupid the Republicans had been. But maybe they weren't so stupid. Think about it this way: If Social Security surpluses had been invested in the stock market, with no allowance for the government taking it out and spending it, then at least half the money would still be there, even after the crash. That's better than none of it, which is the situation today.

Why Does the Dollar Go Down When the Stock Market Goes Up?

Or, asked another way, why does the stock market get stronger when the dollar gets weaker? This isn't always the case, though it has been true, more or less, for the last ten years.

The short answer is stocks are valued in dollars, so, all else being equal, when the buying power of the dollar drops, the price of stocks rises. It's basic inflation. But that's not the whole story.

For the last ten years the stock market has moved practically in lockstep with the inverse movement of the dollar. Look at the following chart. The orange line is the movement of the U.S. stock market. The green line is the movement of the U.S. dollar.  Note the inverse symmetry since about 2003, and especially since 2008.

This inverse relationship suggests that increases in the stock market lately have not been due to economic growth, but due to the government's money policy. When the dollar gets weaker that often means inflation, i.e. money printing, is going on. When QE3 (more money printing) was recently announced, the stock market rallied and the dollar got crushed. Why? Because the markets realize that though the new money will likely increase stock prices, it will also debase the dollar. So in the end, these stock gains could theoretically just be a wash. That is, if the stock market increases 20% in value and the dollar falls 20% in value, the resulting profit is zero. This is assuming we are buying imports. And since most things we buy these days are manufactured outside the U.S., that is the case.

Sometimes the stock market and the dollar go up together. This suggests high confidence in our economy, because not only is the price of stocks going up, the means to buy them and what you get back when you sell them--dollars--are increasing as well. This is what happened in the late 1990s. Real wealth was being transferred to Americans who held stocks and dollars.

Alas, this is not the case now. It's just a lot of money moving around from market to market--a kind of financial Whack-a-Mole, where you hope you're not the mole that gets whacked.

Why Does the Stock Market Go Up When the Fed Prints Money?

As expected, the Federal Reserve Bank, led by Chairman Ben Bernanke, just announced another round of quantitative easing (QE) to try and jumpstart the economy. Quantitative easing, as I discussed in my last post, can include buying bad debt with newly printed money.

Now, anyone can see that the Fed buying bad debt with money made out of thin air is a risky game. But the markets responded favorably to the news. Stock markets jumped, gold went up, commodities rallied. What's going on? Why do markets rally when money gets printed?

What the government would like you to believe is that QE promises to improve the economy and so markets are moving in anticipation of that improvement. Happy days will be here again!, they want you to think. That might be a reasonable expectation if this were a normal business downturn. But it isn't. The real reason markets rally at the news of more QE is not expectation of prosperity, but of another bubble.

For the last twenty years or more, the central banks of the world have been blowing bubbles. They print too much money to try to goose economies, and much of that money finds its way into stocks and other markets. They get inflated and eventually pop. This is an all-to-familiar pattern. In the last fifteen years we've had three major bubbles. The stock market bubble, the commodities market bubble and the real estate bubble. Now the Fed is trying to blow up another bubble. That's all QE3 can really accomplish.

When government apologists are asked what causes these bubbles, they invariably answer something like "investor excess" or "Wall Street greed." And make no mistake--Wall Street is greedy. But Wall Street cannot go crazy with money unless the Fed makes money abundantly cheap. If Wall Street are the drunks, the Fed is the bartender. Sure Wall Street should drink more responsibly. But if you are at a party and the bartender keeps serving up free drinks, doesn't he bear some responsibility for the mayhem that ensues? Of course he does. In the same way, the Fed is ultimately responsible for the excessive, speculative bubbles we've witnessed.

The problem is the Fed can't come up with any solutions to our current economic funk other than printing more money. But the funk was caused by too much money in the first place! Money became so cheap, and credit became so easy, that people borrowed rather than saved, and lived in the expectation that soaring stocks and real estate equity would be their "savings." That is a bubble economy, and it amounts to dancing with the Devil.

Now the Fed is still printing money and putting it in banks--only people aren't borrowing it. They are starting to figure out that more debt isn't the answer. But the banks aren't just going to sit on that money. So what will they do with it? They'll use it to buys stocks and commodities and anything they think might get a return, which will inflate those markets. But that is just another bubble. It's not real prosperity. Nothing is being produced--just more printing, borrowing and market manipulation.

And since so much money is available, interest rates are next to nothing. So in order to try to stay ahead of inflation (that is caused by all the money printing!), people are compelled to play the stock market/real estate game, subjecting their hard-earned money to the risk of another collapsing bubble.

And collapse it will--ending badly, again, for most people.

So get out your dancing shoes. The Devil wants another round on the dance floor and the drinks are on him. The Alka-Seltzer, however, you'll have to pay for yourself.

Peter Schiff on Operation Screw: What the Fed is Doing to Your Future

Schiff describes how the Fed is trying to create another housing bubble.

 

What is Quantitative Easing?

You've probably heard the term "quantitative easing," or QE, in the news. You may have heard of QE1 and QE2, and now are hearing of QE3. You may understand that these have something to with the government trying to help the economy, but don't know quite what they are.

Quantitative easing happens when the Federal Reserve Bank buys long-term US debt or bad  private debt with newly created money.

In normal economic downturns, the Fed makes more money available in the financial system by buying government bonds, usually short term, on the open market with newly created money. This puts money out in banks, making more money available to be borrowed at lower interest rates. This, theoretically, encourages people and businesses to borrow and thus stimulates the economy. This effort is called "open market operations." When you hear of the Fed lowering interest rates, one way it does it is through OMO.

QE does the same thing, with a major difference. In OMO the Fed buys top-quality debt--U.S. bonds, considered the safest investment in the world. In QE, the Feb can buy longer term Treasuries. But it can also buy toxic mortgage debt, bad debt left over from the sub-prime mortgage crisis. This is like a person who has always eaten at Ruth's Chris Steakhouse suddenly switching to McDonald's.

In both OMO and QE the Fed creates money out of thin air and injects it into the economy. The difference is when the Fed decides to take money out of the economy, in OMO it is easy to sell the bonds it earlier bought. With QE, who is going to buy the toxic debt the Fed earlier purchased? That is a problem for the future, however, as the Fed has bigger fish to fry in the present.

QE involves massive amounts of money. QE1 in 2008-2009 totaled $2 trillion in debt purchases. QE2 in 2010 totaled $600 billion (but included no toxic debt). QE3 is projected at another $500 billion. That's total of $2.1 trillion, or one-eighth of the total economic activity (GDP) of the United States in 2011.

The Feb engages in QE both to place money in circulation and also to provide a haven for bad debt. This is intended to support the economy while it heals. Does it work? Well, it can protect from a complete meltdown in the short term when there is so much bad debt that the credit market freezes, as it did in 2008. But there is no evidence that QE actually stimulates a recovery. Japan has been depending on QE for twenty years, and their economy has remained in deflationary stagnation the entire time. In fact, QE may in the long run hinder true recovery.

The problem with QE is, again, it does not allow the markets to naturally unwind bad debt. It prevents the natural consequences of bad investments to correct so that the economy can truly heal. To wax a little gross, it's like giving someone with food poisoning massive amounts of Pepto-Bismol instead of just letting him throw up and get the toxic food out of his system. Thus the historic result of QE is ongoing malaise. Burp.

So, today (Sept. 13, 2012), the Fed will give some clue on whether another round of QE is in the works. Get ready for more Pepto-Bismol.

Why the Government Likes Inflation

In my last post we learned that inflation is caused by the government's central bank putting more money into circulation than the economy can handle. This dilutes the value of each dollar, causing prices to rise.¹

In a perfect world the central bank (the Fed) would maintain precisely the amount of money in circulation to cause neither inflation nor deflation.² However, it is difficult for the Fed to be so precise with the money supply because exactly what the money supply is supposed to correspond to in the economy is not universally agreed upon; and even if it were agreed upon it still might not be possible to know the level of that thing or things in real time. Managing the money supply is a lot like piloting a super tanker. You have to make course changes long before you see the results of them, and then you have to continue to make adjustments based on lagging and possibly misleading feedback.

The Fed, however, always seems to err on the side of inflation. We have almost never had a spat of annual net deflation unless there was some unforeseen economic crisis that caused it. Besides a 2009 rate of -0.34 caused by the credit crisis, the last time we had annual net deflation was in 1955, and then the amount was only -0.28%. While in 1979 through 1981 we experienced inflation rates of 11.22%, 13.58% and 10.35%. So the government is clearly more than willing to tolerate some inflation, usually about 2-4% per year but often more, rather than risk any deflation at all. Why is this?

The official answer you will hear is that they regard deflation as the worst thing an economy could experience. Their fear, which goes back to the Great Depression (the last time we experienced significant deflation) is that falling prices will discourage buying because consumers will hold out for even lower prices, which will cause prices to drop more, causing lower profits, layoffs, less spending, and on and on, in an unstoppable "deflationary spiral."

However, falling prices in electronics over the years haven’t discouraged people from buying HDTVs, computers and smartphones. People buy things when they become affordable to them. Also, true spiraling deflation is only caused by an economic upheaval, like that which caused the Great Depression, not by prices falling -2% a year because the Fed did not print enough money.

So the fear of deflation is an overblown and somewhat disingenuous excuse to always err on the inflation side. The real reasons the government prefers inflation are based on less than stellar motives.

The first reason the government likes inflation is that, all else aside, it gives the impression of growth when there is none. This is because wages increase with inflation as well. Most people are familiar with “cost of living” raises which are supposed to help earners keep pace with inflation. Even though inflation-caused cost of living raises and deflation-caused cost of living reductions would effectively produce the same result, the fact is cost of living raises are much more politically palatable. This is true even though, as we shall see, inflation punishes saving and deflation rewards saving. Politicians want people to think that the economy is growing, so they point to the growth in Gross Domestic Product and leave out the fact that some, most, or all of it was simply inflation.

The second reason the government prefers inflation is that it benefits debtors, and the United States is in debt. Inflation over time lowers the value of debt. If you borrowed a dollar last year and this year a dollar is only worth 97 cents (3% inflation), you’ve saved three cents. In ten years it will only be worth 74 cents, so you would save 26% on your debt simply by the effect of inflation!

Deflation on the other hand causes debt to increase over time. With 3% deflation over ten years, one dollar of debt would become $1.35 of debt, and this in not even counting the interest on the loan.

By the same token, inflation punishes savers. At 3% inflation, a dollar saved would be worth only 74 cents in ten years. Today’s passbook savings accounts pay less than 3%. So even while paying interest such a savings account would lose value over time.

Since inflation punishes savers and rewards borrowers, it discourages savings and encourages borrowing. This suits the government just fine because such a situation encourages borrowing and spending instead of saving and investing. Why in the world would the government want to do this?! The answer is because borrowing and spending stimulates the economy in the short-term, while hurting it in the long term, and saving and investing do the opposite. And since politicians are only interested in the short-term, they prefer borrowing and spending, i.e. inflation.

The third reason government likes inflation is because it is effectively a tax. It is a way an in-debt government can reduce its debt by reducing the wealth of citizens. The last time I checked, that's a tax. It is also a flat tax and a regressive tax--which is ironic considering the multitude of liberal Democrats who support the Keynesian economics that produce inflation. It hits the poor and those on fixed incomes the hardest.

You may have heard of "vice taxes." Well, inflation is a virtue tax. It punishes the thrifty and rewards the spend-thrifts. This matters little to an in-debt government, because as it gets more drunk on debt, the more attractive inflation becomes, and the more undesirable deflation becomes.

Notes:
1. Nobel prize-winning economist Milton Freidman famously said, “Inflation is always and everywhere a monetary concern." He meant that true inflation is caused by increasing the money supply, not by price shocks.

2. This is, supposedly, the advantage of keeping a currency on the gold standard, because tacking a currency to gold prevents the willy-nilly printing of money for any reason. However, the gold standard is not a perfect solution.

Inflation and Deflation

Everyone has heard of inflation and deflation, but many people don't know what they really are and what causes them.

Most people think inflation means rising prices. This is true, but there are two main causes of rising prices. One cause is shortages. For example, as oil gets scarcer its price rises. Most people understand this intuitively.

The other cause of inflation is an increase in the money supply. This is the kind of inflation I'll be focusing on, because it is the most insidious and the one with the most potential to cause economic disaster.

The amount of money in an economy goes a long way in determining how much things cost. Imagine a simple economy where there are only ten $1 bills and ten oranges. In this case, each orange would cost one dollar. What would happen if we added ten more $1 bills to the economy? In that case, the cost of each orange would rise to two dollars. The money supply would double and the buying power of each dollar would be cut in half. That is monetary inflation. So inflation is largely determined by the amount of money in the economy; and the amount of money in the economy is determined by how much the government, the Fed, creates.

Deflation is caused by a decrease of money in the economy. When the money supply decreases, the buying power of each dollar increases, because there are less of them. This drives prices down.

Now, I oversimplified things because inflation and deflation are not just caused by the amount of money in the economy, but also by the speed the money moves around in the economy. If there is a lot of money out there, but no one is spending it and it is not moving around, that can cause deflation, too. This is what happens when an economy is sick. And this is why when the economy gets sick and threatens deflation, the Fed, as it is doing now, feverishly tries to pump up the economy by creating money. It also explains why, even with all this money being printed, inflation is not a big threat; because when an economy is sick it just wants to lay down and get better. It doesn't want to be given a stimulant so it can get up and run around the bed. This is the state of our economy at this time.

True economy-wide deflation rarely happens in the U.S., while inflation seems ever with us. Is this because inflation is hard to tame, or is it because the government chooses to create some inflation?

Remember that modern governments, via central banks, in our case the Fed, can create or remove money any time they want to. The Fed says that its dual mandate is to maintain high employment and low inflation. But if you watch what they do you'll see they are actually trying to produce some inflation. In fact, since the creation of the Fed in 1913, the U.S. dollar has lost 95% of its buying power to inflation.

Each year for the last 22 years the Fed has kept inflation below 5%. But the fact is they could drive it to -5%, that is, 5% deflation, or more, if they wanted to. But they don't. They act like inflation is this beast they are fighting to tame, when actually they are the ones producing it by printing money.

So why do they choose to reduce the buying power of the dollar on a regular basis?

We'll see in the next post.

How Markets Interact, Part 5: Tying It All Together

Okay, so we’ve looked at the four major global financial markets--stocks, bonds, commodities and currencies--and learned a little about them and how they interact. Now let’s get them all on the table and try to get an overall grasp of how these markets react to and influence each other.

First let's look a little in general at how markets interact, then we'll examine in more detail.

Market Relationships (during typical inflation) 

• Stocks and bonds usually trend together. 
• Bonds usually change direction before stocks. 
• Stocks and commodities usually trend together. 
• Commodities usually change direction after stocks. 
• The U.S. dollar trends in the opposite direction of commodities and inflation. 
• Inflation moves up as stocks get higher. 
• Interest rates rise to fight inflation, causing bonds to turn down, then stocks, then commodities. 

During periods of economic health, stocks and bonds should both trend up, because this shows full confidence in the business environment. Commodities should trend slightly up, showing increased demand, but not overly inflationary demand. Inflation should by the same token be slight. However, vigorous growth in the economy will also cause dollar to rise, pushing inflation and the cost of commodities down. This reflects a time of great expansion and prosperity.

Prosperity that is driven too much by monetary expansion and not enough by real growth causes inflation. Inflation causes interest rates to rise, which eventually signals an end to the expansion. 

In deflationary economies, which are rare but not unheard of, stocks and bonds decouple and begin to move in opposite directions. Stocks down and bonds up. This is because a deflationary environment is much more uncertain. Money becomes more scarce and begins to seek out the safest haven, that being bonds. This is known as the "flight to safety" or "risk-off."

We have seen this come and go in the last fifteen years because of deflationary pressures on the world's economies. Stocks and bonds moving markedly differently are a clue the economy has an underlying deflationary problem--as they have been lately with bonds being very strong and stocks being so-so. Central banks have been pumping massive amounts of money into economies to stave off deflation. So far they've been fairly successful. But because of the huge amounts of world-wide debt, deflationary pressures are still there and aren't going away soon.

A Full Business Cycle

Below is a diagram showing a full business cycle from late contraction (recession), through early and late expansion (recovery), to early contraction. Let's go through this from left to right. (Note that in this example rising inflation implies a falling dollar, and vice versa.)

• Stage 1: In the late stages of an economic contraction or recession, stocks, bonds and commodities have been falling. The economy has slowed markedly. Finally, interest rates fall to attract borrowing, causing bonds to rise.
• Stage 2: Commodities continue to fall, but interest rates begin to drive down inflation. Stocks begin to rise with bonds in anticipation of a recovery.
• Stage 3: Inflation is down. Due to expansion, however, commodities begin to rise with stocks and bonds. Who cares? The recovery is on! Happy days are here again! Buy! Buy!
• Stage 4: Rising commodities and other prices mean rising inflation. Interest rates rise to control inflation, causing bonds to fall.
• Stage 5: Rising interest rates signal to investors that the party is nearing an end. They begin to dump stocks, pushing the stock market down. Commodities continue to rise however, because inflation is not under control yet.
• Stage 6: High interests rates have slowed inflation. But the evacuation is full tilt. Commodities, stocks and bonds all fall together. Investors run for cover! The world is coming to an end! Sell! Sell!
  
  Until.... back to Stage 1.

Understanding how markets interact is a great help in understanding what in the world is going on in the world's economies. I'll refer to these principles again and again in later posts.

How Markets Interact, Part 4: Stocks

The stock market is the glamour girl of financial markets. It's the one that gets the most attention and press. But actually the stock market is less important to the economy than both the bond and currency markets. Even so, many people are interested in the stock market as they see it as an indicator of the state of the economy, not to mention they may have some money invested in it.

The stock market exists, interestingly, as a side result of companies needing to raise capital. When a new, growing company decides it needs to raise funds for growth, it can make arrangements to "go public," that is essentially sell some or most of the company to the public in the form of "shares" which each represent a tiny bit of ownership of the company. This "initial public offering" of shares, or IPO, raises a lot of money for the company, which it reinvests in itself. But the company's status has fundamentally changed. It has lost its innocence, so to speak, and now the shares it sold can be traded on the open market. The price of those shares show the public's perception of the value of the company at any given time.

The stock market's overall valuation is a generalization of all the values of all the stocks which comprise it. These values are indicated by published indices--like the Dow Jones Industrial Average, the S&P 500 and the Nasdaq indices. These index levels are determined, when all is said and done, simply by the buying and selling pressure on the shares which make up the stocks in them. News, profit expectations, economic outlooks, world events and other things affect stock buying and selling, but it is the pure and simple buying and selling which determines price.

Stock prices respond favorably to low inflation and low interest rates, as these things reflect the availability of money to be spent in the economy on many things, including, not coincidentally, buying stocks!

Since bonds also respond well to low inflation and interest rates, bonds tend to lead stocks and stocks tend to follow bonds in the same direction. This is the normal healthy relationship between them. There is a big exception to this, however. In a deflationary environment, stocks and bonds tend to move in opposite directions.

I'll leave it here for now and try to summarize in the next post.

Next up: Tying it all together

How Markets Interact, Part 3: Bonds

Sooner or later, just about everyone needs to borrow money. Modern economies probably could not survive without the means to loan and borrow. When a government or company wishes to borrow money, they sell bonds to the public. Bonds are IOUs which represent a promise to repay a loan plus interest after a specific period of time.

After being issued, bonds can be traded on the open market. The bond market is second only to the currency market in size. Loaning and borrowing money is big business.

What makes bonds interesting is that the cost of bonds is affected by interest rates, and vice versa--and interest rates directly affect the economy. If investors are buying bonds and driving up bond prices, they are also driving down interest rates. If bond prices are dropping, interest rates rise. Since interest rates are essentially the cost of borrowing money, the bond market directly affects the availability of money in the economy.

Bonds are considered the safest of the four main markets. Some bonds, namely U.S. Treasuries, are considered the safest investment in the world. However, with the United States' debt woes this might be changing. Regardless, safe doesn't mean risk-free. Although repayment plus interest is guaranteed at the end of the bond's term, there is always the chance that the issuer could default.

Also, if the bond holder does not wish to hold the bond fully to maturity, he must sell the bond on the open market, where an increase in interest rates may have driven the bond's price below the amount he paid for it. Of course, the bond price may have risen during this time, too. But there is no guarantee of this.

Several things can cause bond prices to rise. Prices will rise when investors feel the bond issuer, whether a government or company, is strengthening. If the Fed lowers interest rates to stimulate growth, existing bond prices will rise, because they will then offer a higher yield relative to new interest rates.

Also, bonds are considered a safe haven in uncertain times. So sometimes when the stock market goes down, the bond market will go up. This due the "flight to safety" effect. Investors are selling stocks and putting the money into bonds because they feel bonds are a safer investment, at least at that moment.

Another factor to consider with bonds is inflation. When inflation begins to become a problem, interest rates rise to compensate for money being too available. This drives the price of bonds down. But falling bond prices could be looked at in another way--that demand for bonds is waning because of lack of faith in the issuer. If these are government bonds, then if foreigners are selling them they are likely selling our currency, too, to convert the money back into their own currency. This would drive the value of our dollar down, which would exacerbate inflation, causing interest rates to rise more and bonds to fall more. In other words, a chain reaction.

That is how a crash happens, and there may be one of those in the United State's future if we cannot pay our debts and a run on our bonds breaks out.

I'll talk more about bonds in the coming segments.

Next up: Stocks

How Markets Interact, Part 2: Commodities

Commodities are probably the easiest markets to understand. They are comprised of products and materials which are so basic that they generally are bought and sold at one standard price set by the open market. Some examples of commodities are oil, natural gas, gold, silver, corn, wheat, rice and live cattle.

Futures contracts, the means by which commodities are bought and sold, allow buyers and sellers, called hedgers, to lock in future prices. They also allow speculators to attempt to profit from fluctuations in prices. In any event, the prices of commodities are set by this trading in the futures markets.

As I said, commodities are fairly easy to understand. If prices of commodities overall are rising, that is indicative of inflation. Falling commodity prices are indicative of disinflation, or even deflation. Said another way, commodities signal expectation of economic expansion or contraction. If commodity prices are rising, that shows an expectation among investors that demand, hence prices, will be higher in the future. If they are falling, investors are voting that economic contraction is coming. What’s interesting is that this tends to be self-fulfilling. Rises and falls in market prices both signal and help bring about rises and falls in economic activity.

When currencies rise in value, commodities prices tend to fall. This makes sense, because if currencies increase in buying power then the amount of currency needed to buy things, and hence the price of those things, decreases.

In the case of the U.S. dollar, this relationship between currency value and commodity price is often more pronounced. This is most dramatically seen with oil. Since the price of oil is measured internationally in U.S. dollars, when the dollar falls the increase of the price of oil is immediate, and vice versa. As I write this the price of oil is at a multi-month low and the dollar is at a multi-month high. This is no coincidence. When oil prices are rising, most likely the dollar is falling.

Some currencies are called commodity currencies. This means they come from countries whose economy is directly tied to particular commodities, because they major in the production of those commodities. Canada (oil) and Australia (gold) are both examples of commodity currencies. In the case of commodity currency countries, the relationship between the value of the currency and the price of the commodity is direct instead of inverse. Generally speaking, when the prices of their respective commodities rise, so does the value of their respective currencies. This is because instead of buying these commodities, they sell them. So buyers, in order to buy the commodities, must convert their currencies into the exporting country's currency, that is buy the currency. So they buy the currency first, then use it to buy the commodity. This drives the price of both up. Another way to look at it is that the flow of money into the exporting country enriches the country, and so adds value to its currency.

Next up: Bonds.

How Markets Interact, Part 1: Currencies

Have you ever noticed that when the stock market goes up, the dollar goes down? Or when bonds go up, the stock market goes down? Maybe you've noticed that when oil goes up, the dollar goes down.

What’s going on here? Just how do the markets influence each other? In today’s financial markets, just about everything is interconnected.


There are four main markets which trade globally on an almost daily basis. These are stocks, bonds, commodities and currencies.

• Stocks represent part-ownership in companies, like Apple or Google.
• Bonds are IOUs for money loaned to companies, nations or cities.
• Commodities are basic goods with a standard price, like oil, gold or grains.
• Currencies are the money used for exchange in countries or regions, like the U.S. dollar, the European euro or the Swiss franc. 

You may have heard of other markets, like futures or real estate. Futures includes commodities as well as derivatives of the other three markets. Real estate is an important market and does have influence, but it is not an easily tradable, or liquid, market like the main four. For this discussion we'll focus on these main four globally liquid markets.

Currencies

Since finance starts with money, let's start with currencies. Almost all currencies today are "fiat" currencies, which means they have value based solely upon the relative strength of the economy which issues them. Relative is an important word. All currencies values "float" based on their value as compared to other currencies. If you have U.S. dollars and want to buy something from Europe, you must convert your dollars to euros. How many euros you get for your dollars depends on how the two compare in strength at the moment. So a "strong" dollar compared to the euro is good for our imports, because it makes European goods cheaper for us. Then again, a "weak" dollar is good for exports, because it makes it easier for Europeans to buy our goods.

Since currencies are themselves kind of commodity, they are bought and sold on the open market. When the dollar is in demand, its value goes up. Again this makes sense, because the dollar wouldn't be in demand unless people thought it had value; and if it does have value, then that must mean there is some strength in our economy. If there is strength, it makes sense that foreign products should be affordable for us, since that is one thing a strong currency tends to ensure--low inflation.

Why would a certain currency be in demand? Well, if a lot of people want to buy products from a particular country, they need to use its currency. This is how strong exports strengthen the currency of the exporting country. But in the case of the U.S. dollar, there is an added feature. Our dollar is the world's "reserve currency." This means that it is the standard currency for much international trade. For example, oil prices are tracked in U.S dollars. This reserve currency status gives the dollar added demand and strength. This can be good and bad. It can be good because it adds resilience to our economy. It can be bad because it masks real underlying problems in our economy which might have been exposed earlier. This is exactly what is going on now.

Currencies are directly affected by inflation, and they themselves affect inflation. When the dollar goes down, that means inflation is up, because the dollar has lost buying power. So a strong dollar tends to keep prices down, while a weak one tends to do the opposite. When you see the prices of commodities rising, that means the dollar is losing value.

Another way to view inflation is that it is directly influenced by the amount of currency in the market place. If the U.S. Treasury suddenly doubles the amount of dollars in circulation, that will weaken the dollar and increase inflation. This is why the actions of the Fed in increasing the money supply can have a major affect on the future buying power of Americans.

I'll talk more about currencies and inflation in the coming segments.

Next up: Commodities.

It's All About Debt, Part 2

You've probably heard about America's debt problem. (If you read "It's All About Debt, Part 1," you learned a bit about it from me.) But if you are like most people you probably don't know exactly the extent or cause of the problem, what its consequences will be, or what to do about it.

The extent is bad. So bad that we will never repay our debt. We will either attempt to inflate it away or we will default on it. Either option will cause great financial hardship to Americans, but that's the reality of the situation. It's as much a fantasy to believe we will grow ourselves out of this debt as it is to believe it can be endlessly ignored. We don't have the will to cut spending, let alone pay anything back, let alone pay anything back approaching the amount we owe.

Before I say more, it's important to face that our debt problem is not a Democrat or Republican problem. Republicans blaming big-spending Democrats and Democrats blaming tax-cutting Republicans are like two little siblings bickering over who broke their mother's lamp. It misses the point, and may even be designed to miss the point. Both parties have indulged in our national vice of living beyond our means for decades, and we citizens have enjoyed the benefits. But the chickens are coming home to roost, and blaming tax cuts or entitlements in the same old politics-as-usual way is just childish finger-pointing and won't solve anything.

Although balanced budgets are worthy goals, our problems go deeper than that. The United States became the world's biggest debtor nation because almost all our leaders have embraced an economic philosophy that addresses almost all economic problems by deficit spending. In Washington, where politicians never look past the next election, there is now never a good reason not to deficit spend.

Truly, we've reached the point of being like drug addicts. The drug is killing the the addict, but it's the only thing that makes him feel good. Debt has become our drug. Debt has become the only way to forestall the inevitable crash that debt itself is causing. We are trapped in it. They don't call it a vice for nothing.

Another factor is that we have gone from being a productive nation to being a consumptive nation--from having net exports to having net imports; or, said another way, from having a trade surplus to having a trade deficit. When a country imports more than it exports, it must make up the difference by exporting money. When it doesn't have the money it must borrow it. That's exactly what we do.

Borrowing money is not all bad when you borrow to invest to become more productive. But we don't do that. We borrow to consume. Consumption is not bad; in fact, it's the ultimate point of production. But if you consume more than you produce you are digging yourself into a hole. That's exactly what we are doing. Politicians like consumption, though, because it gives the appearance of economic vitality, that is until the bottom falls out. 

So who are we borrowing from? More and more it's not from American investors, but from foreigners--first and foremost China. Basically China is buying us. They loan us money by buying our bonds, we blow the money on non-productive consumption, keeping our "standard of living" high. We are like a family that eats out every night, charges the bill to our credits cards, with no intention of ever paying the balance. 

So what should we do? The way to begin answering that is to say we will get a major economic recession one way or the other. We can put it off with more borrowing, but that will just make the inevitable crash and hangover worse. So what we must do is severely restrict our borrowing. This will force us to stop spending so much, and will likely force us to restructure, or default on, most of our debt. The status and living standards of America will be significantly reduced, but at least we will give future generations a chance to climb out of a shallower hole.

AIG, Bear Stearns Pay Off Government Loans with Interest

Remember AIG, the insurance company which became the credit crisis' poster child for "Too Big to Fail?" Well, apparently they have paid off all their government loans, with interest.

Bear Stearns, another big casualty of the credit meltdown of 2008, also repaid all its loans.

This is good news for taxpayers, though I don't know all the details.

"The repayment of loans by AIG represents a turnaround for an insurance company that many had given up for dead during and even after the financial crisis. The insurance company has slimmed down its operations, closed down many of its loss-making divisions and has been profitable for two years."

It’s All About Debt, Part 1

What in the world is going on with the world’s economies? After a twenty-year stock market boom, we had the tech bubble and crash in 2000. Then there was the housing bubble and crash in 2008, followed by the credit crisis. Now Europe seems to be going down the tubes. Markets rally, then crash. The days of steadily rising 401ks seem to be over. What’s going on?

In short, debt is what’s going on--not only personal debt, but even more importantly government debt. This is not just a typical economic slump. Nations all over the world are drowning in debt and this has created a situation which cannot be solved in the typical way--because the typical way governments address economic problems is by taking on more debt. It's not hard to understand that you can't solve a debt problem by borrowing more.

So how did we arrive at this place?

A Very Short History of Economics

Economics refers to how societies distribute limited resources. This distribution is largely done by trade, and people have developed sophisticated ways to do this. Money was invented to make trading more convenient. In a sense, money is now the problem, because although money was once measured and distributed as things that had real value (e.g., salt, silver, gold), or that at least were backed by something else that had real value (e.g., gold certificates), now money is simply created out of thin air and is “backed” only by the belief that others will honor it. This is called fiat money, and it is the way of the world now.

Fiat money is created by central banks. Almost all nations now have some kind of central banking system. The United States central bank is called the Federal Reserve, or just the Fed. The Federal Reserve has the power to literally create money out of thin air. You may have heard of the “quantitative easing.” That is simply the Fed creating money and distributing it to banks with the hopes of stimulating the economy.

Years ago, an economist named John Maynard Keynes came up with the theory that government borrowing and spending and creating money out of thin air was actually good for a nation's economy, because it could help smooth out economic rough patches. Most leaders over time have assumed this attitude, mostly because it makes their short-term goals of getting re-elected easier. People have come to think it's primarily the government's responsibility to ensure prosperity. Politicians don't mind this because it allows them to take credit for good times and blame their opponents for bad times. Voters mostly just tend to back whomever's ideas seem to be working at the moment. Everything has become about the short term.

That, as Yoda said, leads to the dark side. Once a central banking system and fiat money are in place, the restraints on leaders to make wise long-term economic choices are greatly reduced, and the incentives to make convenient short-term choices are greatly increased. If you were a political leader and all you had to do to stimulate the economy right before an election was to borrow and spend money, what would motivate you--the long-term effects of debt or the election? This, in a nutshell, is the world’s problem.

So the world has gotten itself into a situation where it’s just too easy for governments to borrow money they don’t have (and which often really doesn’t even exist!). Some pundits are screaming that we need to borrow and create even more money. People in general wonder if this process is really so bad, since it seems to have worked for so long.

The answer is as long as investors are willing to buy debt with hope of future profit the day of reckoning will be pushed into the future. Although we will see signs of it approaching; that’s what all these bubbles and crashes have been. But if we continue on the path we are on, investors will at some point refuse to buy our debt, and the real day of reckoning will arrive. And when it does, the medicine we will have to take then will taste a lot worse than the medicine we could take now.

More in Part 2...

It's All About Risk

Why is investing so hard?  Why is it so difficult to know how any investment will perform?

The answer is simple: Investors and traders are paid, if they are paid at all, for assuming risk, and risk precisely means that you don't know what is going to happen. Investors and traders perform a service to society by providing money for potentially productive projects and thereby absorbing financial risk. For their services they are offered only the potential for profits. Their risk is the possibility of not getting paid, or of even losing money.

Risk by definition means you don't know what is going to happen. If you knew what an investment was going to do, then there would be no risk, so there would be no reason to expect payment. Riskier investments offer to pay more precisely because their outcomes are more uncertain. The dumbest investment is one that is very risky but doesn't pay much, like going on Wipeout for $500.

But if you don't know what is going to happen, why make an investment? The answer is because you have determined that the probabilities are in your favor. Note: Probabilities, not certainties. So that means the key to investing and trading is learning how to handle risk, not pretending you know for sure what the outcome of the investment will be. The former is doable, the latter is impossible.

To handle risk you must define risk. That is you must consider the probabilities and decide how much you are willing risk to find out if a certain idea works out. Most investors and traders don't do this. They just throw their hat full of money in the ring and hope for the best, with no plan for what to do if the investment doesn't work out. This usually means they lose more money than they vaguely planned to lose, precisely because their plans were vague.

You can't know for sure what any investment idea is going to do. But you can plan for what you will do when it does whatever it does. You should always have a plan for what you will do when it works and when it doesn't.

All success in life is based on taking some kind of risk. Nowhere is this more true than in the financial markets. Never forget that there you are being paid to assume risk, which means risk will always be a factor. The key then is to research the probabilities, define beforehand what you are willing to risk, design an action plan for all outcomes, and, only then, take on the risk.

Four-Minute Finance Debut

You may have heard that most people put more thought into buying a $1000 refrigerator that into investing their $100,000 retirement account. This may be true. But if it is, I don't think it's because people are reckless. I think it's just that the subject of finance overwhelms them.

Of all the subjects that directly affect our lives, finance, investing, markets and economics are probably the most confusing. We hear that the trade deficit is up, or the dollar is down, but we don't know if those are good or bad. Is it time to buy a house, or time to sell one?  Should I invest my retirement account in stocks or bonds, or get into cash? Why do stocks and bonds go up together, and why do they sometimes go in opposite directions? No wonder most people just throw up their hands and hope for the best.

To make matters worse, even though finance offers a hope of wealth, it is, to most people, boring. Economics has been called "the dismal science." But I don't think these subjects are so much boring as they are just hard to understand. People simply don't know where to begin. In addition, some of the seemingly best financial analysis can just turn out to be flat wrong. And there is so much disagreement. It's easier to predict the weather than the future conditions of economies and markets.

In fairness, prediction is hard. As I'll explain in my next post, the best you can do is go with probabilities. But before you can do that, you have to have some sense of how things actually work. 

Finally, people just don't have a lot of time to devote to learning this subject. They'd rather spend time on things they have some hope of predicting or understanding, like the NBA playoffs or American Idol. So I came up with the idea of writing short blog posts which explain some things about our economic world in quick, readable, and hopefully interesting ways. In doing so, I'll learn more, have some fun writing, and maybe help a few people along the way.