Inflate or Die
The Daily Reckoning PRESENTS: “Inflation” in different terms…but Strategic Investment’s Dan Amoss sees it as the Austrian school of economics does: as increase in the supply of money. And you can be sure that before the housing markets spins out of control, our friends in Washington will do a bang-up job of printing money at no cost…
INFLATE OR DIE
Stock and commodity markets around the world have hit an air pocket on the tough talk by central bankers. Their fears of CPI inflation and inflation expectations spiraling out of control are the stated reasons for the current round of global monetary tightening. Hope springs eternal that a soft landing can be engineered in asset markets without touching off a liquidity crisis.
Yet these synchronous tightening initiatives have repeatedly stood out as the catalyst for Long Term Capital Management-like blowups and stock market meltdowns over the past decade. It amounts to removing the stimulus that set into motion the stock and housing market malinvestments in the first place. This potential market-disrupting event is on the minds of many. Especially those who respect the lessons of history.
Whatever may happen this summer as this tightening campaign plays out, the fact remains that the developing world is industrializing at a rapid pace. Twenty-plus years of perfecting a comparative advantage in financial engineering in lieu of investments in tangible wealth production will grow to haunt the United States. Dan Denning’s well-outlined thesis of the Asian “Money Migration” is not dependent upon the fed funds rate, but instead reflects the outsourcing of real wealth production capacity. A hedge fund blowup or a rise in the cost of capital will not end this gradual process.
This line of thought infects many modern academic economists who seek to explain the growth of an enormous credit bubble that is rooted in excessive consumption. The credit bubble will deflate under its own weight as the household savings rate drops further into negative territory. Those who promote government intervention in free markets will be itching to “clean up” the mess left behind by this spending contraction, because there will not be another housing bubble on deck to provide a bailout on the scale we have witnessed in recent years.
The cycle of credit bubble formation, inflation, and bursting finds its origin in a combination of a benefit-for-votes electoral system and an elastic view toward the Constitution. Interventionists hold onto the fallacy that government can apply knobs and levers to a global economy and interest rate markets that are more complicated than any group of minds can possibly comprehend. What we are left with, after decades of evolution, is a monetary system whereby the debt created by every previous credit bubble must be papered over in true Ponzi fashion in order for the real economy to function at a level that provides full employment.
Credit that is self-financing is one thing, but credit that is taken out in return for a pledge of future payments out of a 30-year household income stream is quite another. BP issuing bonds to finance the extension of an oil well’s life in a high-energy-price environment is an example of wise credit use. The profit generated by the extra years of oil production eliminates the credit balance and compensates the company for the risk undertaken by the project. Not to mention it serves as a prudent use of credit to relieve a capacity constraint in the economy.
Conversely, consumer credit and mortgages are financed through a combination of two options: house price inflation or pledging a percentage of future household income toward installment payments. Lately, the servicing of this debt has been accomplished by option one. Now that this option is near its point of exhaustion, option two must become a larger part of the payment mix. The share of household income devoted to paying down debt must go up in the long run.
The burden of financing the demand for mortgages in recent years has fallen largely on foreign lenders. But there are signs that their checkbooks are not unlimited, because of the worries over domestic inflation and the demand for a more Western standard of living. The much-celebrated “We think, they sweat” theory of explaining why foreign creditors should have an insatiable appetite for U.S. Treasury bonds and mortgage-backed securities has an Achilles’ heel: the low labor intensity of the 21st-century “knowledge economy.”
I wouldn’t underestimate the likelihood that the next revolutionary technologies originate in the United States. Instead, I’m focused on the fact that the mortgage and credit bubbles rest on a shaky foundation: the continuation of the U.S. middle class spending far in excess of what it produces. Add this to the deflating value of what many in the middle class produce; nearly all manufacturing, and an increasing number of services, can be done overseas for a fraction of the cost.
For reasons of simplification, not to mention the fact that its case has been successfully argued by the most proven economists in history, I define “inflation” as the Austrian school of economics does: an increase in the supply of money. Prices for goods and services can rise and fall for a variety of reasons: labor strikes, wars, OPEC actions, Hurricane Katrina, recessions, overcapacity, etc. But the ultimate root of inflation is the money that the Fed prints in the course of its open market operations to monetize short-term government securities.
CPI inflation ensues when the growth rate in the money supply exceeds the growth in supply of goods and services. The current CPI does not resemble that of the 1970s, because U.S. dollars are flowing overseas at a rate of $2-3 billion per day. If this fire hose of foreign-bound liquidity decelerates, the pressure on the recently accelerating CPI numbers will increase; if it reverses, it’s lights out for the dollar reserve standard.
When the Fed lowers rates, it prints money and buys up Treasury Bills in the banking system, effectively raising the amount of loanable cash on bank balance sheets. This buying pressure bids up T-bill prices, and the inverse price/yield relationship inherent in all interest-bearing securities forces the targeted rates lower.
Banks are not in the business of holding cash with no yield, so they become more aggressive about loaning out the newly printed cash on their books; this is the crucial step where malinvestments often originate. Easy monetary policy inevitably aggravates boom/bust cycles. Consider how many hundreds of thousands of bad mortgages have been written over the past three years. The coming wave of defaults will exacerbate a housing/credit/consumption correction that is long overdue.
To complicate things further, rookie Fed Chairman Ben Bernanke brings to the FOMC his ivory tower “inflation targeting” theory. Chairman Bernanke is trying to sell his compatriots on implementing his theory as a new direction in policy. The theory involves using backward-looking, highly doctored statistics like core CPI to conduct open market operations that raise and lower short-term interest rates.
These rates clearly work their way into the economy with a lag. Therein lies the serious flaw in this theory: In the time between when the doctored core CPI stats are crunched and the policy works its effect on the economy, recessionary conditions may approach quickly. We are in the midst of such a time. Credit addicts are fast approaching withdrawal symptoms. This inflation-targeting policy can be compared to a driver trying to build a legendary NASCAR career by racing while looking mostly through the rearview mirror. Its implementation would only worsen future boom/bust cycles.
Central bankers can talk down markets with their rhetoric, and may even go so far as to cause a financial accident, but every developed economy around the world is dependent on an edifice of credit and derivatives that makes future policy a foregone conclusion: Inflate or die. Before the housing market enters a tailspin, you should remain confident that the Fed and Congress will team up, do a marvelous job at printing money at no cost, and providing it to debtors who are clamoring for it. There is legal precedent for this behavior in the savings and loan crisis and the New Deal.
Dan Amoss, CFA
for The Daily Reckoning
July 25, 2006
P.S. The point in evaluating the monetary system is not to lament its development, but to protect investment capital from the unwinding of its imbalances. Part of what I’ll be talking about at the Agora Financial Wealth Symposium this week is how you can even selectively profit on sector themes where the wind is at your back. Investment cycles tend to be lengthened within fiat currency monetary systems. The greatest long-term investment opportunities I see today are in energy, precious metals, and mining. These asset classes were at the bottom of a 20-year investment cycle at the turn of the millennium and remain in the early innings of a bull market.
Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.
Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst® designation, a professional designation widely recognized within the investment community.
“The Five E’s.” Earlier this year we identified five major trends that were reshaping the world. Then, we stopped writing about them because we could never remember what they were. But these days, it’s hard to forget at least one of them. So, over the next few days, we will be providing you with updates.
Energy. The first E. Yesterday, the Associated Press reported that gasoline in the United States was at an “all time high.” Meanwhile, our old friend Jim Rogers tells the world that “you ain’t seen nuthin’ yet.” He says oil at $100 a barrel is a “sure bet.”
What’s going on? Is the world running out of oil? No. As far as we can see, there is plenty of the stuff. At today’s oil prices, all the producers are adding capacity as fast as they can. New wells are being drilled. Old wells are being re-opened. They’re also busy trying to squeeze oil out of sand, tar, rock, turnips, or at least, find substitutes. In the United States, one of the substitutes, ethanol, is becoming a major swindle. Of course, it takes more energy to produce a gallon of the stuff than you can get from it. And it costs more to make a gallon than a gallon is actually worth. But it’s the kind of boondoggle that everyone seems to like. Congress likes it because the pols get to hand out more of other people’s money. Farmers like it because it helps hold up grain prices. And a lot of other people like it because it sounds “green,” and they believe the country ought to be “energy independent.”
So, there is plenty of E. Only, it’s not cheap E and the U.S. economy depends on cheap E. Your typical American family spends all that it earns from its work – and a little more – in a house that needs a generous input of E. But as home prices rose in the last 10 years, people started looking for bargain housing farther away from town and the suburbs began to stretch farther and farther into the boondocks. Meanwhile, the average fuel economy of American automobiles – at 21 mpg – stayed the same as it was in 1982. Now, with gasoline at $3 a gallon, a lot of people must be wondering if moving so far out was such a good idea. As the price of E rises, the amount of money the family has left over goes down. It must either spend less, which would cause a recession immediately, or burrow deeper into debt, which would cause an even worse recession eventually.
No question, oil is getting more expensive. And no question that with no further home equity against which to borrow, American consumers are beginning to cut back on discretionary spending. Wal-Mart, where the lumpen go shopping, has seen its stock sink to the lowest level in five years. Middle-American sit-down restaurants – Red Lobster, Outback Steakhouse, Applebee’s, etc. – are seeing the worst fall-off in sales in industry history. Retail stocks, overall, are down. Builders have taken a hit, with confidence in the homebuilding industry at a 14-year low. Transports are sliding. All of which looks to us like the beginning of a consumer-led economic slump.
But back to the Big E. Energy. Energy, we believe, is going to get more expensive and it’s going to put into jeopardy the lifestyles of the people most dependent on it – Americans. The reason is obvious. While users are proliferating like energizer bunnies, the supply of ready fuel, which took millions of years to build up, is going nowhere. Indeed, it’s running out rapidly. On one hand, India and China devour energy for capital development. On the other, North America needs it for consumption. But while the Asians earn the money to pay for their energy, the typical American has to face higher energy costs without cash in his pocket. No wonder his standard of living is going down.
More of the Big E’s as the week continues.
More news from our friends at EverBank…
Chris Gaffney reporting from St. Louis:
“This morning we see the dollar trending off before the release of the consumer confidence and existing home sales reports later this morning. These reports should highlight slower growth in the United States.”
Back in Vancouver…
*** Vancouver is a nice city – maybe the nicest in North America. But it has a disadvantage. It is too far from Europe.
“Good morning,” we said to the customs officer at the airport.
“You mean, good evening, eh?” she replied.
That’s the problem. We don’t know whether it is morning or evening. We will have to wait a few hours to find out which way the sun is going.
[Short Fuse’s note: We promised we would report back on the happenings from the Agora Financial Wealth Symposium, and today the conference kicks off with speeches from Bill and Addison.
If you won’t be joining us here in Vancouver, you can still stay on top of the action; starting tomorrow, check your inbox for an additional e-mail update from us. We’ll give you a brief synopsis of the speeches and fill you in on a way you can feel as though you had attended the conference.
And – if you’ve never attended a Wealth Symposium before, never miss out on one again! Members of the Agora Financial Reserve get free admission to the conference…and that’s on top of receiving all of our best services and advisories for life!
*** “Dad, I need 100 euros,” said Jules yesterday. “You know…I told you…the university requires blood tests. I had to get them done here in Paris.”
“Why didn’t you tell them to mind their own business?” we asked.
“Thanks, Dad, I know that will help my college career,” was Jules response.
“But seriously, Jules, who do these people think they are? Why should they want to have your blood? What if you didn’t believe in blood samples…or in sharing your blood information with every Tom, Dick and Harry?” your editor replied.
“What kind of world do we live in?” we went on, warming up, and to no one but ourselves. “The whole idea of privacy and liberty has simply disappeared completely. Instead, everyone everywhere is always asking you for information. Every time you open a bank account, you practically have to have an FBI background check. Why can’t you just give them some money, take a receipt, and walk away? And when you travel, you have to show your papers over and over again and answer a lot of idiotic questions. ‘Did you pack these bags yourself?’ It’s none of anyone’s business who packed the bags, for Pete’s sake. It’s just amazing that so many people think they have the right to boss other people around. Do this…do that…go here…go there. But what’s even more amazing is that people allow themselves to be bossed around. Grown men and women. Everyone, perfectly willing to have others tell them what to do. It’s enough to make one feel sorry for smokers…”
And then, Jules responded: “Dad…it’s nice you’re campaigning for freedom and the American way, but could you just give me those 100 euros?”