How Paper Money Distorts Investment Cycles

THE GOVERNMENT CANNOT BEND THE ECONOMY to its will, as most economists appear to believe. The economy is infinitely complex, and instead bends to the will of billions of spending and investing choices. Yet some economists still try to tweak the economy if it does not suit a political agenda, or they try to make it “work for everyone.” Politicians advance their careers by looking at everything on the surface and ignoring the consequences of their ideas.

John Maynard Keynes, an early 20th century economist, was the most influential advocate of government influence in the economy. Thanks to him, an entire generation of voters thinks the president “manages” the economy. Keynes’ followers, who populate the halls of government and academia, think the government needs to act when the free market “fails.” They propose government solutions to problems like “liquidity traps” and “insufficient demand.”

These alleged problems became so feared that the U.S. government decided it was necessary to move the dollar to a completely paper, faith-based system — despite historical evidence that every paper money system fails. The Federal Reserve has cemented its role as price fixer for short-term interest rates. It fuels speculative bubbles when the economy slows, and denies all responsibility when bubbles burst. The cycle then repeats.

The New Deal was Keynes’ idea. The era of colossal government — the New Deal — began as a popular reaction to the Great Depression. The Depression started when an inflation-fueled bubble popped, and worsened in the mid-1930s, when the government taxed capital away from entrepreneurs and reinvested it into “make work” programs.

This is one of many examples in which government power grew at the expense of the more efficient free market. These ideas, and the proposed solutions to them, distort the free market’s investment cycles and have gotten the U.S. to the point where it simply cannot function without asset inflation.

Today, the government proposes solutions to problems caused by government interference. Specifically, it and the Fed are throwing more money and credit at a problem that was caused by their own past initiatives to stimulate money and credit. Even a mere recession has become politically unacceptable.

China’s Success Hinges on Its Support for Free Markets

Keynesian economists tend to deny the free market the respect it deserves. It has had an amazing track record in recent centuries. Despite the destructive influences of nutty paper money schemes, deficits, taxation, regulation, and wars, most countries have progressed from subsistence farming to modern living standards at a stunning pace.

The free market rests on a foundation of mutual trust, price signals, profits, free trade, and property rights. It’s important for government to respect this foundation. Communist governments simply destroy it and, predictably, get chaos and poverty. Even in some capitalist countries, popular support for this foundation is shaky.

The Chinese, still Communist in name, but hardly in action, have gained some respect for the foundation of free markets. Their leaders are executing policies that promote better living standards, and they are using free market principles to achieve it. As a result, they prosper. But prosperity doesn’t advance without occasional setbacks. China is dealing with one right now: A shortage of above-ground coal.

In China’s highly publicized winter storm delays, we see an example of how slower economic growth can lead to higher consumer price inflation. Most economists would have you believe that growth causes inflation, when in reality, it’s the opposite. Real economic growth increases the supply of goods and services. So consumer prices would fall if the money supply were held constant. The Wall Street Journal recently reported:

The coal shortage has rippled through other commodity markets, hurting China’s output of steel, copper, zinc, and aluminum as electricity is being diverted for domestic industry and household heat and electricity. China’s largest copper producer, Jiangxi Copper Co., shut down some plants, contributing to higher U.S. copper futures:

Even though the Chinese government supports free markets to achieve its political goals, it still distorts investment cycles with monetary inflation and regulation. Its manufacturing capacity has grown beyond its power grid capacity. This slows real economic growth, which is cutting the supply and raising the price of copper in the U.S. futures market.

Chinese monetary policy, like that in the U.S., ensures that money supply can grow limitlessly at zero cost. No wonder prices for nearly everything are going up. Central banks have pushed inflationary policies beyond all reasonable limits. A recent issue of Grant’s Interest Rate Observer explains why this could be the top financial market story in 2008:

In the dollar and its institutions, there is a deep-seated contradiction. The Fed is America’s central bank, but the dollar is the world’s currency. More than a billion people work and save and spend in the non-American portion of the U.S. dollar bloc. It seems fair to guess that more than a few of them are fed up, if not with the distant institution that sets an interest rate, then with an inflation problem over which they seem to be powerless.

One of the top financial stories for 2008 just might be the dawning of this unwelcome truth on the average American central banker, bondholder, and consumer. Recently, The New York Times, in a dispatch from Shanghai, speculated that China was now exporting inflation, not deflation, and that, on account of this sea change, the American CPI would presently begin to tick higher.

The onset of recession would likely push back the return of what economists will eventually learn to call the “21st century secular inflation” (mark my words). A friend of mine muses that the dramatic re-pricing of ultra-cheap oil transformed the markets and economies of the 1970s. So, too, he speculates, will the dramatic re-pricing of ultra-cheap Asian labor deliver a seismic jolt to the markets and economies of the present day. If so, the dollar, no less than the euro, is likely to suffer impairment against the kind of assets that central banks just can’t print.

If you’re a regular reader of Whiskey & Gunpowder, you probably agree that individuals make better spending and investing decisions than governments. Yet Keynesian plans to “fix” the economy — whether through regulation or inflation — remain uncomfortably popular. The conditions are set for a dramatic consumer price inflation reawakening — if not in 2008, then over the next decade. Long-term bonds are priced to provide negative real after-tax returns over the next decade. Invest accordingly.

Regards,
Dan Amoss, CFA
March 19, 2008