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.