Are Bonds Really "Safe" Investments?

A mutual fund company, which shall remain unnamed, has a series of funds which are named based on the year investors wish to retire. For example, the ABC-2025 Fund (pseudonym) is recommended for those who plan to retire around 2025. The company offers several of these and the only thing that differs about them is the relative percentage each fund invests in stocks or bonds. The 2015 fund is 55% stocks and 45% bonds. The 2025 fund is 75% stocks, 25% bonds. And so forth. The idea is that the closer one is to retirement the more one should be invested in bonds over stocks.

This idea, that bonds are a safer investment than stocks, is one that has been peddled for years to investors, but in fact it is very misleading.

First off, let's define the difference between stocks and bonds. Stocks are part ownership in a company. If you own a stock and the company's market value goes up, your wealth increases. If the market value goes down, your wealth decreases. If the company goes out of business, you lose everything.

Bonds are promises from a company (or government) to pay you back for money you have loaned it, plus interest. If interest rates drop, the values of bonds go up, and your wealth increases. If interest rates go up, the value of bonds drop, and your wealth decreases. If the company (or government) goes out of business, you lose everything. But if you hold a bond to maturity, as long as the company (or government) is solvent, you are guaranteed your money back plus interest. Even if the market value of the bond has dropped, if you don't sell it before maturity, you are guaranteed what the bond promised. This is one reason bonds are considered safer, and it is a legitimate reason.

Another reason bonds are considered safer is that their prices just don't move as fast or as much under normal circumstances. Stocks are the rabbit; bonds are the turtle. Sure, bonds will on average lose less money, but they will also gain less.

But here's the important point: If you plan on selling a bond before it matures, then other than its lower volatility a bond is really no safer or risk-free than a stock. The market prices of bonds can fluctuate quite a bit. This is particularly true in this age of economic crises and central bank interest rate manipulation. Below are charts of the stock market and five-year bond market for the last two years. Note that these bonds went down. They went down less than stocks went up, but the point is they lost money. This can happen at any time. So being invested in bonds does not guarantee protection from losses.

But, you say, I'll just hold my bond fund to maturity, that way I'll get all my money back plus interest. But that brings us to the most important point in this article. You cannot hold a bond FUND to maturity. Buying a bond fund is just like buying bonds that you must sell before maturity--its value is based on the market value of the fund's shares. So if you place your retirement money in a bond fund, and interest rates go up and stay up, you will lose money. The safety feature of holding a bond to maturity is not possible with a bond fund, and if you have a typical IRA, 401k or Keogh account, you are probably only invested in stock funds or bond funds. Few investors actually buy bonds directly, though it is possible to do so if you have a broker which offers them.

This is not to say that bonds are not a good investment, or that stocks are better. Both have their place. The point is that both involve definite risks.

Here's a recap:

• Stocks can go up in value.
• Stocks can go down in value.
• Stocks can become worthless.

• Bonds can go up in value (though are usually less volatile than stocks). 
• Bonds can go down in value (though are usually less volatile than stocks).
• Bonds can become worthless.
• Bonds held to maturity guarantee money back plus interest (as long as the issuer is solvent). 

• Bond FUNDS can go up in value. 
• Bond funds can go down in value.
• Bonds funds can become worthless (though highly unlikely). 
• Bonds funds DO NOT guarantee money back plus interest. 

So if you are near retirement and your investment adviser suggests moving your money into a bond fund, ask him what the outlook is for the bond market. If he says it doesn't matter, fire him.


This article is for information only and is not intended as a recommendation to buy, sell or hold any financial instruments.

The Inevitable Minsky Moment

Economist, traveler and general nice guy John Mauldin recently talked about Hyman Minsky, whose theory of economic instability I'd known of, but hadn't thought about in a while. Minky's Financial Instability Hypothesis is one of those ideas which seem to sum up things simply, elegantly and accurately, with an enticing hint of paradox. Minsky's hypothesis basically goes like this:

Stability leads to instability. The more stable an economic trend is, the more people will come to depend on it. The more they depend on it, the more they invest in it. The more they invest in it, the more imbalanced things become. The longer this goes on, the bigger the inevitable crash when it happens. The moment of collapse has been coined as "The Minsky Moment."

Here's an illustration. Imagine you are on a cruise ship with thousands of passengers on board. At one stage of the trip, passengers begin to notice the view from the port side is particularly pleasing. More and more passengers line up on the rail on the port side to enjoy the view. Due to their weight, the ship begins to lean slightly to port, enhancing the view, making it easier to stay on the port side, and less likely to move to the starboard side, since the view there is now obscured. Passengers begin to call their friends and family on board to join them. Even so, the ship, being well-constructed, holds its current pitch. Waiters and stewards now keep mostly to port, bringing food, drinks and deck chairs. The band moves to port side, and its music attracts even more people. As the trend continues, the remaining laggards, not wanting to miss out, join the party. Someone warns that the situation cannot continue. But everyone ignores him, as they are now fully invested in the belief that things will continue the way they are. Just then the ship capsizes. The trend is over. The Minsky Moment has occurred.  

In the analogy, the ship's view is the current promising economic trend. The problem is the more attractive the trend the more people tend to get over-invested in it, and the more inevitable the collapse becomes. This explains business cycles, bubbles, and even the ongoing up and down nature of stocks charts on every time frame. The excesses of the boom are the seeds of the bust. It's built into the nature of things. 

The end of the trend is inevitable. The question is not if, but when. The key then is knowing when to get on board and when to jump ship. 

Are the Markets Self-Regulating?

Recently I watched the movie Inside Job, a documentary about the 2000s housing bubble and credit crisis. It was a bit one-sided, focusing almost exclusively on the greed and corruption of Wall Street investment banks, but pointing few fingers at the Federal Reserve or Washington.

Still, the outrageous swindling and chicanery of Wall Street financial companies, coupled with obscene compensation given out to executives who wrecked their own companies, ruined investors and drove the economies of the world to the brink of disaster was (it seems too little to say) hard to deny or defend. The fact is a bunch of rat finks made themselves filthy rich by exploiting a system which allowed them—no begged them—to pass the risk to others and keep the benefits for themselves.

In Margin Call, a fictional movie about the same subject, the head of an investment firm—played with elegant ruthlessness by Jeremy Irons—sagely notes, "There are three ways to win in this business: Be first, be smarter, or cheat." In the 2000s Wall Street cheated. Risk, as I once wrote, is the price investors pay for seeking profit. Risk can be controlled; but the only way it can be eliminated is to cheat. Wall Street sought to make high profits at little risk. So, being the greedy but craven bunch they were, they cheated.

They were able to cheat because of wrong-headed deregulation, lack of enforcement of laws which did exist, obscurely complex investment creations, perverted incentives, and failure at the highest levels of government to do anything to challenge the problem, including turning off the flow of cheap money that fueled the binge.

It is jaw-dropping, given the abuse of deregulation by Wall Street, that their lobbyists are still to this day chirping the free market song in brazen resistance any to real reform.

Now, I believe in free markets, until they start sending us over the brink of oblivion. But the problem isn't really markets per se. In a pure sense a market is a good thing: An open arena of up-front, transparent buying and selling where deals and profits are sought and the shrewdest traders and investors win. Nothing is wrong with that.

Wall Street, at least as practiced by these major investment banks in the 2000s, wasn't really a market anymore. It was casino where the odds were so slanted to the house that the game wasn't even fair anymore. Here were the rules of the game: Investment firms sought profit by engaging in risky investments. If the investments succeeded, they won. If they lost, they still won because someone else got stuck with the risk. And even if the risk did come home to roost the top players had already pocketed their bonuses and deployed their golden parachutes. Heads I win, tails you lose. These rules have not changed much yet.

A lot of outrage is expressed over the compensation of financial executives. But that compensation doesn't bother me except to the extent that it motivates those getting it to indulge in practices which threaten the rest of us. I don't care how rich someone gets. It's no skin off my nose unless what he does is destructive  Unfortunately, it's more than clear it is. There is so much money lying around that the feeding frenzy threatens to destroy the whole food chain. If that's not a situation that begs for common-sense regulation I don't know what is.


Markets are self-regulating in the sense that if something is a bad investment, eventually investors figure it out and stop pouring money into it. No human organization could manage the millions of actions and reactions which automatically set prices in the market place. The Soviet Union tried, and collapsed under the burden. The beauty of a free market is that much of it actually is self-regulating.

But market participants aren't self-regulating. I'm a trader and I know. There is nothing more unhinged than the average trader or investor wide-eyed with greed or hysterical with fear. The most basic, raw, selfish human emotions can consume those who engage in the financial game. Forget for a moment about regulation to protect the rest of us. They need it to protect themselves.

Why are the Poor Poor?

My church pastor has defined being poor as not having "enough." That seems a good starting point. But it raises the question, What is enough? I would say that enough means having adequate food for health; adequate clothing and housing to be safe and to function in the society in which one lives; and something left over to enjoy. Provision, protection and pleasure. Those are the basic human needs.

But, however one defines "enough," the question remains--Why do some not have it? Why are some people "poor?"

A lot of ideas are thrown around to explain poverty, including lack of education, lack of opportunity, bad luck, laziness, greed, discrimination, exploitation, social unrest, karma, fate, God’s will, etc. All these reasons may play a part, and many do.

But, however "poor" is defined, the economic explanation for it is always the same: The poor are poor because they do not produce enough to either meet their own needs or to trade for the things they need. In other words, poverty is a production problem. 

So it seems that any effort to address poverty, except those done in the very short term, should in some way address this production problem. This isn’t anything new or ground-shaking. However, those of us who feel that helping the poor should be part of our life’s calling seem to lose sight of it.

There is no good reason why any society cannot come to be productive, or why we should expect any society to be destined to be poor forever. Obviously, if someone is starving, correcting his long-term lack of production is not his most pressing need. At the same time, programs which simply address short-term needs and are not complemented with efforts to improve the productivity of those aided should expect no long-term improvement in the problem. In other words, poverty will continue to be a problem as long as the poor do not, somehow, learn to produce enough for themselves. This, of course, assumes a social order where production is even possible. But, eventually, without production, a society is doomed to poverty and dependency, or worse.

This is not to diminish short-term efforts to help the poor, whether secular or spiritual. Immediate needs must be met, and genuine charity enlarges us all. Further, personal attention to the poor can help them in ways money transfers cannot. An aid worker who cares for the health and feeding of a Third World person may be saving the future leader who turns his village around. A missionary who implants values, faith and confidence in those in her care is affecting the future in ways the biggest check written may not accomplish.

But addressing the long-term poverty problem, though it may begin with placing food in mouths, must continue on to place thoughts in minds. A person or society that is not sufficiently productive will always be dependent on others or will never have enough--or both.

Why are Health Care Costs Rising So Fast?

Everywhere you go Americans are concerned with health care costs. It seems like every few months insurance companies raise rates and providers raise prices. What's going on?

Since the late 1960s, increases in health care costs have steadily accelerated to a present rate of 2.5 times that of inflation. This out-of-proportion increase began with the establishment of Medicare and Medicaid in 1965, and with the massive amount of money they began to channel into the health care market.

Why is this? There is one central reason. Economics 101 says when money chases a market, the price of that market rises. This is called demand-push inflation. Since the introduction of Medicare and Medicaid, the huge amounts of money forced into the health care market by the US government has caused health care costs to skyrocket.

Think of it this way. Imagine the US government decided to initiate a major spending program to buy, say, lots of pinwheels for every American. Now you might not want a pinwheel and I might not, but that doesn't matter because the government is creating the market. Say it earmarks $10 billion for pinwheels and increases that amount every year. What do you think would happen to the price of pinwheels? If you said "go up" give yourself a Ben Bernanke gold inflation star. That's exactly what would happen. And that's what has happened with health care costs.

Massive government spending on health care is the main cause of its severe inflation, and all other causes depend on or are related to this main cause.

What are some other reasons? One is the amazing advances in health care technology. Health care is just a lot better than it was fifty years ago. That jump in technology is in part due the profit potential companies see in the health care market. You can bet the one thing every health care company and entrepreneur counts on is that the government is going to be channeling a lot of money into health care. So they go after it. This is a great incentive for innovation. Unfortunately it also wasteful, because companies come up with all kinds of medical technology that is superfluous but that doctors use just because it's there. In fact, doctors feel compelled to use any technology that exists because they feel the need to protect themselves from lawsuits, which, ironically, are also a product of too much money being in play.

Another cause of high costs is inflated physician compensation, particularly for specialists. The Center for Medicare and Medicaid Services, the government body which sets Medicare and Medicaid rates, pays much more to specialists than they are paid in peer countries. This is done, purportedly, to attract top people into specialization. But most likely, in a freer market, specialists would be paid less than they are. The physicians, knowing a good thing when they see it, take full advantage of this arrangement by demanding the wages the market will artificially bear. Are they greedy? You could say that. But they wouldn't have had the opportunity to fulfill that greed if government hadn't thrown so much money at them.

There are other reasons for high health care costs: pharmaceutical pricing, higher administrative costs due to single-payer model paperwork, and hyper-litigiousness and resulting defensive medicine. But all these things have their root in too much money being artificially channeled into health care.

It may seem strange that the more money you throw at a problem the more expensive it gets. But that's the way economics works sometimes.

Dispelling Urban Myths About Income Taxes

Tax season is in full force. So now is probably a good time to dispel some myths about US income taxes. These myths are so regularly deployed by certain political segments that they've become part of the common dialogue. But that doesn't make them any less false.


Myth #1
Americans pay too much in income taxes.

Fact #1
"Too much" is a relative term. But Americans pay an average overall income tax rate of only 11%. It's hard to make the case that is "too much."


Myth #2
The rich don't pay their fair share in income taxes.

Fact #2
"Fair" is a judgement call. But the US income tax is very progressive. The top 1% of taxpayers pay an average overall tax rate of 24%. The other 99% of taxpayers pay an average overall tax rate of only 8.4%. Hardly "unfair."


Myth #3
The rich make out like bandits exploiting loopholes and end up paying less in taxes than the average taxpayer.

Fact #3
Even after credits and deductions the tax system is very progressive. Those who earn over $250k pay an overall rate of over 23%. Those who earn between $100k and $250k average about 13%. From $50k to $100k it's about 8%. From $30k to $50k it's about 3%. Below that people actually pay negative taxes--they get refunds (credits) for taxes they didn't pay

Myth #4
Every year the rich pay less of the tax burden. It's an example of the rich getting richer and the poor getting poorer.

Fact #4
Actually the reverse is true. Since 1986, the rich have paid a progressively higher and higher percentage of the tax burden. In 1986, the top 10% of taxpayers paid 54.7% of the taxes. In 2010 they paid 70.5%. In 1986, the bottom 50% of taxpayers paid 6.5% of the taxes. In 2010, they paid only 2.3%.


Myth #5
More and more people have to pay taxes because the rich aren't paying as much.

Fact #5
Actually the percentage of income tax filers who end up paying no tax is higher than it has ever been. In 2010 42% of income tax filers paid either no tax or got money back for taxes they didn't pay.


Myth #6
The gains of the rich come at the expense of other Americans.

Fact #6
The truth is the fortunes of the rich and those of more modest incomes have risen and fallen together. In booming years, all averages of incomes rise. In bust years, all averages fall.


Myth #7
If we just taxed the richest Americans more we could solve the budget deficit problem

Fact #7
Even if we taxed those who make $1 million a year or more at a 100% tax rate, the budget would still not balance.


Myth #8
US income taxes punish investment and reward consumption.

Fact #8
Unfortunately, this is true.


Source: The Tax Foundation

"Capitalism Without Bankruptcy is Like Christianity Without Hell" (and other financial facts you may not have known)

Most politicians have less understanding about money, finance and economics than the average undergraduate business major. Yet these are the people making laws that affect your financial future.

The prices of oil and gasoline are NOT set by oil companies. They are set by the buying and selling of future contracts by traders in the open commodities market. When gas prices go up it is in reaction to speculators believing that they will continue to go up. When gas prices go down it is in reaction to their believing that they will continue to go down. Speculators cannot manipulate the market--they can simply place bets based on what they think the market will do in the future. Those bets themselves drive the market. However, no speculator can be sure that any bet he or she places will be profitable. The idea that speculators can manipulate the market to make a profit is a myth perpetuated by politicians looking for scapegoats.


Five reasons health care has become more expensive:

1. It’s a lot better than it used to be. Medical technology has made incredible advances in the last thirty years. Those advances cost money. 
2. Prices go up when something is in demand and/or when a lot of money is allocated to be spent on it. The rise of aging baby boomers and the government allocating huge amounts of money to Medicare and Medicaid have increased the demand for health care and thus driven prices up. If less money was allocated for health care, prices would drop. It’s simple economics.
3. Doctors regularly prescribe needless procedures in order to avoid lawsuits and boost profits, because...
4. The health care system is being crushed by required government procedures, paperwork and other inefficiencies. 
5. Somewhere along the line we got the idea that others are obligated to try to keep us alive for as long as possible. Apparently we think it’s okay to bankrupt the nation in order to make this happen.

Ever since governments have coined or printed money, they have found ways to debase (decrease the value of) that money. The word “debase” itself comes from the practice of ancient governments adding base metals to gold and silver coins in order to make more coins—thus lowering their value and creating inflation. Why do governments do this? One reason is because inflation is an invisible tax. It’s a way governments transfer money from people that have it (savers) to people that don’t (debtors). With the development of central banks and fiat (non-backed) currency, governments have perfected the efficiency of creating inflation.


Inflation is not a fact of nature. It is a deliberate practice by governments which control the money supply. In the one hundred years before the creation of the Federal Reserve Bank, the U.S. dollar actually increased in buying power. What cost $100 in 1812 only cost $56 in 1912! But since the creation of the Federal Reserve Bank in 1913, what cost $100 in 1912 would cost $2342 in 2012, a 95% loss of buying power.


Despite what hysterical politicians and central bankers tell you, sometimes deflation is the best thing for an economy. Politicians don’t like deflation because it makes it hard for them to get re-elected.


Fat cat executives should be held accountable when they drive their businesses into the ground. They should not be allowed to escape with golden parachutes. Aside from the rank injustice of it, it’s a matter of applying the proper incentives. Executives convicted of fraud or malfeasance should be allowed to keep a modest retirement, while the bulk of their wealth should be used to reimburse defrauded investors. Those who caused the failure should have to start over like everyone else.


The housing bubble and the ensuing credit crisis was created by banks, financial companies, but mostly the US government. Banks and mortgage companies gave home loans to people who had no business qualifying for them. These lenders did this because they could package these loans into investments and pass the risk onto to clueless investors. However, although the financial community bear some responsibility, the government and the Federal Reserve Bank bear the most responsibility because (1) they encouraged lending to unqualified borrowers (“everyone deserves a piece of the American dream”) and (2), most importantly, they held interest rates artificially low, allowing buyers to buy more house than they could really afford, spurring demand for home loans, driving up prices, and inflating the bubble. When unqualified buyers began defaulting on loans, the bubble collapsed.


As I said, the Federal Reserve’s holding interest rates too low for too long produced the housing bubble and credit crisis. The Fed's proposed solution is to... keep interest rates even lower indefinitely! Got that? This is what Japan has done for over twenty years and it has produced a zombie economy there, a twilight realm where little fails but little grows too.  Japan’s suicide rate is one of the highest in the world.


So what should the US do? Simply put we should allow capitalism to take its course—we should allow failing businesses to fail.  When businesses fail, the losers are cleared out, someone else steps in, acquires the assets and has a fighting chance of doing something better the next time. But by propping up failed businesses, the government is ensuring that the same mistakes will continue to be made and that resources will continue to be misallocated. As former astronaut Frank Borman said, “Capitalism without bankruptcy is like Christianity without hell.” As I noted, it's a matter of incentives.


Motivated people will always find a way to profit from circumstances. This includes the unlikely circumstance of capitalism being dead--and just about any other you can think of. That is the genius of human nature, and an expression of people's right to act in their own interest.

Who Does the U.S. Owe Money To?

The United States of America is in more debt than any country in the history of the world.

There are two basic ways to measure this debt. One is to measure the actual amount of money the US has already borrowed. The other way is to measure that amount plus the amount the US is committed to borrow because of future mandated entitlements.

As of today the US in hock for $16.7 trillion dollars. That’s money we owe. But if you project US mandated entitlements over the next 75 years and subtract the projected tax revenues for that period, you come up with an $87 trillion dollar shortfall. In other words, if we continue the way we are going for the next 75 years the US will be over $100 trillion in debt, not counting interest.

Of course, that’s not going to happen--if only because the US will be crushed by bankruptcy long before that point. But the important thing to remember is we are running larger and larger deficits every year. It took us 20 years to go from $1 trillion to $6 trillion in debt. It took us 12 years to add another $10 trillion. Now we are adding more than $1 trillion a year, and there is no projected end to it.

What is going on? Several factors are contributing. Baby boomers are aging and producing less, but consuming more, particularly healthcare, which they expect to be world class. US citizens are demanding more and more benefits from government, but seem to think these things can be bought on the cheap, or for nothing. The US cannot compete with overseas manufacturing, where workers can be paid a fraction of what they would demand here. So we don’t export much anymore. Cargo ships from overseas come to US ports loaded with imports, then leave empty. So instead of exporting products, we export dollars, which we’ve borrowed. All of these together are a prescription for unsustainable debt.

So who do we owe the almost $17 trillion we’ve already borrowed? The answer may surprise you.

One third of US debt is owned by foreign governments and investors. China is our largest creditor, owning about $1.16 trillion. Japan is second with $1.13 trillion. Oil exporting countries own about $250 billion. Brazil, Taiwan, Switzerland, Russia, Hong Kong and the United Kingdom round out the largest holders. This is a big change from the past when we owed the vast majority our debt "to ourselves." Now foreigners have us over a barrel for a third of our debt.

Another third of our debt is held by domestic government entities and domestic investors. The Federal Reserve owns $1.66 trillion (and growing). Mutual funds and private pension funds own $1.4 trillion. State and local governments own $710 billion. Banks own $300 billion. Insurance companies own $260 billion. US saving bonds account for another $185 billion. Another trillion is held by various domestic investors--individuals, brokers and dealers, trusts, and businesses.

The last third of our debt is owned by US federal government agencies. Does that sound strange? US agencies that run a surplus, like Social Security (which owns $2.7 trillion of our debt), buy US Treasuries and basically loan their surpluses to other parts of the government. The good news is we loan the money to ourselves. The bad news is money that was meant for the future gets spent immediately. So taxpayers now owe money plus interest--over and above future contributions--to Social Security and other agency programs, such as the Federal Employees Retirement Fund and Federal Supplementary Medical Insurance Trust Fund. In essence we've raided our federal trust funds to pay for things we want now.

So, roughly speaking, one-third of our debt is owned by foreigners, and one-third by domestic governments and investors (including the Federal Reserve Bank) and one-third by US federal agencies.

The portion owed to foreigners means that we are that much more at the whim of foreigners who might not want to finance our debt anymore, and could throw our economy into a tailspin by refusing to buy it or demanding higher interest rates.

The portion owed to domestic entities means that if the US defaults, we will be shafting ourselves. The portion of this third owed to the Federal Reserve means that more and more the Fed is simply printing money with which to buy our debt, a practice known as “monetizing the debt,” a potentially highly inflationary course of action.

The portion owed to government agencies means that going forward taxpayers have to pay not only for future entitlements, but also for ones that have already been consumed.

No wonder Shakespeare wrote:

    Neither a borrower nor a lender be;
    For loan oft loses both itself and friend,
    And borrowing dulls the edge of husbandry.*

* Hamlet, Act I, Scene 3

Do You Like the Stable Price of Coffee? Thank a Speculator!

When oil prices went through the roof in 2008 (regular gas went over $4 a gallon near my home), outraged pundits everywhere blamed speculators--those greedy traders who drive up the price of necessities just to line their pockets. When oil prices then crashed through the floor in 2009, I was stunned to see regular gas selling for $1.48 a gallon. But I was not surprised to see that no one gave speculators credit for driving those prices down.

Speculators get castigated for making things more expensive. Alas, they never get praised for making them cheaper.

Most people think gas prices are set by oil companies (read: greedy oil companies). But actually they are set in the open market by speculators and hedgers (together known as traders) who trade oil and gas futures contracts. Why is this done? Because we have not found a fairer, more reliable way to discover the price of oil and other commodities like corn, wheat and coffee, than the free, open and competitive buying and selling of thousands of traders.

Futures contracts exist to allow buyers and sellers to lock in future prices of commodities, and thus hedge uncertainty. Starbucks, for example, is keenly interested in keeping the price of their coffee products stable. The actual price of raw coffee beans on the future market--what it would cost someone to buy raw coffee at any moment--fluctuates, sometimes dramatically.  Below is a chart showing how the price of coffee rose steeply from 2010 to 2011, almost doubling, and then by 2013 collapsed back below its pre-2009 price.

Now, I like to drink Starbucks coffee, and I did not notice the price of a tall house blend doubling in 2010 and then dropping like a rock in 2011. In fact, I've been amazed how their coffee has maintained basically the same price for at least eight years running. Why didn't Starbucks products reflect the price changes in raw coffee seen on the chart? Because thanks to the futures markets Starbucks was able to lock in coffee prices that favor them as much as possible. This allowed them to anticipate how much coffee will cost them in the near future, to smooth out fluctuations, and offer a predictably priced cup of coffee.

But in order for Starbucks to hedge the future price of coffee to their benefit, there has to be someone on the other side of the trade who hopes to benefit as well. But that trader hopes prices will do exactly the opposite of what Starbucks hopes for. The trader who enters into the trade with Starbucks is called a speculator--someone who hopes to profit by betting on the short term movement of prices. The futures markets could not operate with only hedgers. It needs speculators to take the other side of trades. Without speculators, prices of retail products, like coffee, would fluctuate much more dramatically than they do now.

Like I said, we haven't been able to find a fairer way to set prices than the open markets. What would be the alternative? A coffee pricing committee? And just how would they decide what the fair price of a Venti latte is? For all the accusations of greed in the financial markets, you can bet a global coffee pricing committee would be the target of all kinds of unseemly influence by everyone with a vested interest in either raw coffee being expensive (like growers) or being cheap (like Starbucks).

Yes, speculators sometimes drive prices in irrational ways. But over time, they help give us the closest we can hope to get to correct prices. So the next time you pay that same $1.65 plus tax for a tall Blonde Roast at Starbucks, thank a hedger for locking in the price, and a speculator for taking the other side of the trade.

"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.