Inflation on Its Way

In the spirit of humility, let’s take a moment to examine whether we’re simply wrong about our main investment thesis: that extraordinary measures adopted by central bankers and government officials will result in tremendous inflation, and thus boost commodities and resource shares.

The first strike against the theory is the global recession. It now looks like the global economy will grow a lot less fast in 2009, if it grows at all. Investors are busy re-pricing commodity stocks for a world where resource demand drops along with consumption in the developed economies.

But a cyclical recession in resource stocks is a manageable event. The bigger challenge to the inflation argument is, well, deflation. The argument here is that there was simply much more leverage in the system than even we expected. As that leverage disappears-hedge funds selling assets to meet redemptions, for example-all assets fall in value.

So far, it looks like the deleveraging of the global financial system is destroying wealth faster than central banks can create new credit to replace it. Europe organized US$1.7 trillion in guarantees on bank loans last week. And in the States, it won’t be long before every institution and every debt is guaranteed by the full faith and credit of the American government. This should lead to the first trillion dollar fiscal deficit in American history. Heck, it might even be two trillion.

South Korea guaranteed $100 billion in bank debt this weekend, and provided banks $30 billion in loans. The Dutch government “injected” $19.6 billion into ING this weekend. Yet as large as these government guarantees and capital injections are, they might not be large enough.

These amounts are small compared to the amount of value already destroyed in the residential real estate market and in the share market. $20 trillion has already been wiped off global shares. Real estate markets in the U.K. and the U.S. are imploding.

What we may have underestimated is how quickly this deleveraging and value destruction would spread to the commodity markets, which we thought would provide relative safety with the backing of tangible value. Resource stocks did not hold up for long at all. Why not?

On the one hand, it now looks like a lot of investors were long commodities with borrowed money. Those investments have been sold to raise cash and pay back loans. Secondly, when it’s a bear market in stocks, there aren’t too many stocks that do well, full stop.

But isn’t inflation in tangible assets just a matter of time as the global money supply grows to re-flate credit markets? And what about all the new government loan guarantees and capital injections? Don’t they have to be inflationary?

Well, if governments borrow to finance these various programs, they’ll issue new bonds. Bonds soak up the available pool of global savings. To that extent, the borrowing crowds out other ventures, which might put the savings to a productive use. But financing the scheme with bonds is not, at least, right away, inflationary.

However, if governments can’t find takers for the bonds they issue to finance the scheme, they will have to either raise taxes (not likely in a recession), or simply print the money. And here’s a hint. That’s what they always do, from Argentina to Zimbabwe. That is why we maintain the preferred response to huge debt levels is outright money-printing.

Besides, simply making credit more available by lowering interest rates stops working after awhile (like when you can’t lower rates any further…zero bound.) How do get available credit out of bank computers and into consumer wallets? It’s not easy. Bankers are suddenly quite shy where they were once promiscuous.

Then you have to get people to spend the money instead of stuffing in mattresses. The banks have been stuffing their money in mattresses (overnight accounts with Central Banks). So now, governments are simply taking over the banks. Let the new loans begin!

This government nationalization of the banks solves another problem with run-of-the-mill credit creation. You can make the credit flow, but you can’t always determine where it goes. But in these unusual times, the government is in the position of deciding where it wants the money to go. Right now, it’s simply shoring up bank balance sheets with more capital.

But to really “get things going again” and “fight the recession” the money will have to get back into the real economy. This is where see the inflation coming. Not in asset prices for houses or shares. But in real goods. Why? If the government engages in massive public works projects as a way of stimulating demand in the economy and keeping up growth, it’s going to be resource intensive.

In a way, this is just another kind of phony boom, but with the free-market varnish stripped off to reveal it as an uber-lending program by some kind of pan-governmental agreement. We already had one simultaneous global credit bubble. Now we’re getting the mother of all government debt bubbles. Only this one will not simply be a collection of various national bubbles.

Instead, it looks like we’re going to get a kind of Global New Deal. Leaders from world’s nations are already suggesting a system where the world’s top thirty banks will operate under the supervision of a government panel of some sort. You’ll see more “super banks” and greater control of the levers of global banking and a concerted program to flood the world with new fiat.

How this prevents future bubbles or leads people away from their addiction to debt, we’re not sure. But we’re pretty sure it’s not a promising development on either score. And inflation? It’s coming…

Dan Denning
October 23, 2008