Growth & Inflation Debate

In the current monetary system, the supply of money is not constant and the central banks of this world are free to create as much inflation (money-supply growth) as they want. There is a catch – the central banks can only do so as long as they can keep inflationary fears in check by constantly reminding the public of the threat of deflation. Puru Saxena explains…

Over the past few months, we have heard numerous times in the media that the Federal Reserve and the other central banks have a choice between economic growth and rising prices (wrongly defined as inflation). In fact, most investors have been brainwashed into believing that the policies that stimulate strong economic growth automatically result in higher prices within the economy. For example, in our current situation, it is now widely believed that by slashing rates and adding liquidity to the financial system, the Federal Reserve is opting for strong economic growth in the United States. which in turn is causing the consumer price levels to rise. In other words, most people are being hoodwinked into believing that the prices are rising due to strong growth.

In my view, the above assessment is totally incorrect. After all, any student of economics will be able to tell you that if the money supply was constant, strong growth would not lead to higher prices. On the contrary, strong economic growth (increase in the production of goods and services) would result in price declines as the supply of "things" increased in relation to the amount of money available in the economy. Conversely, a weakening economy (decrease in output) would assert upward pressure on prices as the production of goods and services declined in relation to the amount of money available to purchase those "things".

In the current monetary system, however, the supply of money is not constant and the central banks of this world are free to create as much inflation (money-supply growth) as they want. There is a catch – the central banks can only do so as long as they can keep inflationary fears in check by constantly reminding the public of the threat of deflation. Turning over to the current situation, it should not come as a surprise that in the past few weeks the media has published various stories comparing the recent downturn in the United States to the Japanese deflationary bust or the Great Depression of 1929. This "deflation" propaganda is crucial to further promote the Federal Reserve’s agenda of creating even more inflation as a "cure" for the ailing economy. Let there be no doubt that the Federal Reserve is now desperately trying to inflate the system via rate-cuts, pumping of liquidity and bailouts. And it is this monetary inflation and weak economic growth which is causing commodity and consumer prices to rise. Unfortunately, for the average American, this is occurring at a time when their economy is weakening, incomes are falling and unemployment is rising. In other words, I would argue that the Federal Reserve’s inflationary efforts are making things a lot worse for the majority of people.

My intention is not to criticize Mr. Bernanke, as I honestly feel that he is simply a cog in the wheel, an insignificant part within the overall system. Rather, I sympathize with him since he is now dealing with the mess which Mr. Greenspan created by leaving the Fed Funds Rate at a ridiculous 1% long after the U.S. recession ended earlier this decade. It is my firm belief that Mr. Greenspan’s ultra-loose monetary policies in the aftermath of the technology bust largely created the ongoing financial and credit crisis. And now, Mr. Bernanke is left with no choice but to continue with the inflationary program or else there would be a global economic depression. Due to Mr. Greenspan’s record-low interest-rates, American home prices skyrocketed between 2001 and 2005. However, they have fallen sharply in the past three years – and show no sign of bottoming out.

As an investment-manager, it is not my role to pass a moral judgment on the actions of central banks and governments. To be fair, given the level of debt imbedded in the West, central banks have no other option but to inflate. The problem though for the U.S. economy stems from the fact that this newly created money seems to be finding a home in commodities rather than financial assets. It is interesting to note that since the Federal Reserve started slashing interest-rates in August last year, energy, metals and food prices have gone to the moon, whereas the U.S. dollar and American stocks have plummeted. Unfortunately for the U.S. establishment, the "cure" of monetary inflation seems to be going horribly wrong as it is translating into even higher consumer and producer prices. I have long maintained that this decade would belong to commodities and the markets are proving me correct.

Over the past few months, the prices of commodities have gone through the roof due to supply and demand imbalances and massive monetary inflation. However, given the turmoil in the markets and loss of confidence, resource stocks have been punished by investors. This development is strange to say the least, and it has paved the way for a massive buying opportunity in the most coveted sector of the future. I find it absurd that the investment-community is dumping quality resource stocks at a time when the underlying commodity prices are super strong. At the end of the day, businesses are valued based on their corporate earnings, and with sky-high commodity prices, I can assure you that elite resource-producing companies are going to announce fantastic results in the months ahead. Today, top-quality diversified mining companies are selling at 12-13 times earnings (bear-market valuations) and I can only guess this is due to the fact that most people expect commodity-prices to crash in the months ahead. However, if my homework is correct and commodity prices continue to soar in the future, we will see a major re-rating in the valuations of resource-producing stocks. Some of you may remember that during the technology mania at the turn of the millennium, technology companies (even dodgy ones) sold for ridiculously high valuations. Well, we can expect to see the same type of madness in relation to commodity stocks in the future.

Regards,

Puru Saxena
for The Daily Reckoning
May 20, 2008

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action.

Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm, which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

Yesterday, the Dow rose 41 points. Oil and the dollar held steady. But the big news today – the price of gold went back over $900. This morning, the yellow metal is trading at $910.

Is the correction in gold over? Seems so… Will gold fever soon take over?

We interrupt our look at the gold market with the following song lyrics from the Rolling Stones:

Who wants yesterday’s paper?
Who wants yesterday’s girl?
Who wants yesterday’s paper?
Nobody in the world.

What prompts this musical interlude is a thought: U.S. stocks are yesterday’s news. Maybe the U.S. economy is yesterday’s news too. Maybe the United States itself is yesterday’s news.

But what we reckon with today is not a dreary story of the decline and fall of the American empire. No, today…we bring you a cheerful message of hope for the future.

Our Trade of the Decade – buy gold, sell stocks – has done pretty well…though not as well as expected. Gold has almost quadrupled. U.S. stocks went down…then came up. Now, they’re back to about where they were 10 years ago. In real, inflation-adjusted terms, however, they’re down about 30%.

Of course, the decade is not over and we’re expecting to squeeze a lot more juice out of this trade before 2010. Still, we’re already looking ahead to the Trade of the NEXT Decade. We’ll take a peak at that below…but first, let’s look at the broad sweep of history. What was the number one success story of the 20th century? America. Oh…yes… there were more frightening stories…and stories with more suffering and more sturm and drang in them. WWI brought down the leading families in Europe – the Hohenzollerns in Germany…the Hapsburgs in Austro-Hungary…the Romanovs in Russia, not to mention the Ottoman Empire in what is today Turkey. Then, the Soviet Union lost 25 million people in the Great Patriotic War, known in the West as WWII…the Chinese lost tens of millions in Mao’s purges and famines. But as for stories with a happy ending, there was none bigger…and none happier…than the story of the United States of America.

And now, Will Hutton writes in The Observer that the United States will stay ahead of China in the 21st century, because it has more knowledge and brainpower…more universities…and a commitment to new technologies. Maybe Mr. Hutton is right. We had the same idea ourselves, when we were about 14 years old. We recall thinking that America was unbeatable…because she had created an almost perfect meritocracy, in which the brightest people – among whom we immodestly counted ourselves (remember, we were just 14 years old) – would always rise to top positions in government and business. These people could go to public schools and state universities, learn all the latest ideas and useful knowledge, and then apply what they had learned in their careers. The system was self-perfecting all the time.

Later, we realized that the brightest people are capable of making the greatest errors and suffering the biggest delusions…and that even the best systems are inevitably gummed up by self-seeking parasites and corrupted by time. We are, as Aristotle put it, a "deathward going tribe." All our institutions age…decay…and die.

Universities are just are part of the lifecycle…from birth to decadence. Universities follow money and power, not the other way around. People get rich; then they build universities to celebrate and eliminate their wealth. People who could be doing good work on assembly lines or road crews are shunted off to ivy-covered campuses, where they undertake discussions of the role of gender in Egyptian history…or a metaphysical interpretation of the cinematic experience in, say, Dude, Where’s My Car?

Universities impoverish society; the scholars inevitably reduce the net knowledge of the population with foolish ideas and preposterous plans. After a few generations, the professors have introduced not only gender studies and film interpretation, but Social Security, ethanol, Medicaid, central banking, option pricing models, wars on terror, tax rebates, subprime mortgages, progressive taxation, direct election of senators – and all the other bugaboos and balderdash of modern societies.

Naturally, all these humbugs cost a lot of money. Yesterday, USA Today gave us an accounting. In the last year alone, it figured, the real deficit of the federal government increased $2.5 trillion. USAT did what we have done many times before – it looked at government finances as if it were a business. Sharp pencils in hand, it found that the federal government has net unfunded obligations of $57.3 trillion – or about half a million dollars per household. Add in state and local budget shortfalls, and you get to $61.7 trillion. This year alone, Medicare added $1.2 trillion to federal obligations. Social Security made the situation worse by $900 billion…and veterans’ benefits tacked on another $34 billion.

The last time we looked, the average American household had net assets of only about $70,000. How is it going to pay more than $500,000 to support government’s promises? In effect, the typical family is broke, with liabilities far greater than its assets.

We only bring this up to explain how it is possible for such a great nation – with so many great universities – to fall into decline.

And now, looking ahead, Bloomberg says the "sub-par growth is the New Normal in the US."

Naturally.

When you reach a certain maturity, with so many burdens on your back, you slow down.

Here in London, Mervyn King, head of the Bank of England, has noticed the same thing. The "NICE" 10 years are behind us, he says. By ‘NICE’ years, he means the years of Non-Inflationary Continuous Growth.

Now, inflation is a fact of life. Central banks have to fight it with higher rates – which cause slower growth.

*** Back to our good news. If the U.S. boom was yesterday’s boom…what is today’s and what will be tomorrow’s boom? What will our Trade of the NEXT Decade be?

Well, we don’t know. But we’re beginning to think our colleague, Manraaj Singh, is right. This is the Century of Emerging Markets.

"The first oil shock of the ’70s was fundamentally a transfer of wealth from the Western oil users to the oil producers," he says. "Now, we’re seeing a transfer of wealth to the oil producers…and to the food and raw material producers too."

The latest news is that the emerging markets have already recovered from their October-March losses. You’ll remember, dear reader, that they were hit especially hard by news of a credit crunch in the West – even though they, generally, had no exposure to subprime debt. But now they’re booming again.

The MSCI Emerging Market index has gone up four times in the last five years. Compare that to the Dow – which is flat.

Much of that growth can be traced directly to the boom to the commodities that these countries export – but not all. Some emerging markets – notably China – export neither food, nor fuel, nor raw materials. Instead, they are the biggest importers of these things in the world. In other words, they should be the countries that suffer most when prices rise. Instead, they’re booming too.

"In 1990, China imported 20,000 metric tons of copper. Today, it’s over 1 million…a 50-fold increase in less than two decades," Capital & Crisis’ Chris Mayer tells us. "China is now the world’s leading copper consumer."

China’s not the only market to keep your eye on. Chris has been eyeing up India, whose modernization is about 13 years behind China’s, for a while now…and with good reason.

"Copper is one of the essential materials for any developing economy – for housing, for commercial construction and especially for an ever-expanding electrical grid…and you can imagine how copper use in India is about to explode."

And copper is the main business of the next great Indian opportunity Chris has identified. In fact, this company is by some accounts the lowest-cost producer of copper in the world – at just 7 cents a pound.

What seems to be happening is that the emerging markets are doing just what you’d expect. After listening to so many lectures from so many American advisors and busybodies, they’ve finally turned on and tuned in to the new paradigm of modern development. It doesn’t seem to matter what kind of government they have, by the way. Oligarchy, communist dictatorship, old-fashioned dictatorship, popular democracy, monarchy – George W. Bush tells the world that it must have an American-style democracy in order to get rich; he needs to open his eyes. All these emerging markets have access to capital and technology…they have the desire… and they have globalized markets that allow them to sell what they make and buy what they need.

Will mistakes be made? You bet. Huge mistakes. Costly mistakes. But, at least from what we can see, there seems to be no stopping them. Which also makes sense. One of the universal laws of economics is ‘regression to the mean.’ The United States – along with other developed countries – must be expected to regress to the mean. There is no inherent reason why they should be richer than other countries – at least no reason we can see. Now, with the emerging markets growing fast…and sub-par growth the "new normal" in the United States…one rises, while the other falls. Before too long, they will meet – at the mean.

*** Finally, there’s a new gold rush – in Northern California.

The Daily Telegraph tells us that the hills of California are attracting prospectors – just as they did during the Gold Rush of 1848. Walt Eason of the Gold Prospectors Association say a guy might find $15,000 to $20,000 worth of gold in a week.

But "Klondike" Mike LaBox, who’s been panning for gold in Northern California for 50 years, says, "Too many people think there’s gold just lying along the rivers waiting to be picked up."

Instead, finding gold is hard work. Many new prospectors don’t even find enough gold to buy fuel, says Mike.

Regards,

Bill Bonner
The Daily Reckoning

P.S. More on gold…tomorrow… In the meantime, learn how you can add some of the yellow metal to your portfolio without breaking the bank. Don’t let over $900 an ounce gold scare you away – it’s still our Trade of the Decade…and you can still get the precious metal at just a penny per ounce.