The Death of the American Consumer

The American consumer is struggling to keep up with the rising prices of things he buys every day: gas, food…even beer costs more. Free Market Investor’s Christopher Hancock explores the notion that cutbacks for American consumer are inevitable – and wonders: where will your money be when Americans stop consuming?

Analysts and pundits have been calling for the death of the American consumer for quite some time. But now…I believe we’ve reached a point at which there’s no turning back. Debt financing (home equity lines or credit cards) has run its course. It’s been fueled by cheap credit (prolonged low interest rates).

Cheap credit creates more dollars. More dollars create higher prices. (We note that rising prices aren’t the only economic consequence associated with inflation. For simplicity’s sake, we’ll stick to rising prices.)

According to Nathan Lewis, author of Gold: The Once and Future Money:

"Inflation is defined as a decline in a currency’s value…Prices in the devaluing country would eventually adjust to the devalued currency. In other words, something that cost $100 (equivalent in value to 1 ounce of gold) before the devaluation will tend to cost $200 (equivalent to 1 ounce of gold) afterward. However, the price adjustment process, in practice, can take a very long time to fully play out. Prices for internationally traded commodities will tend to adjust first, typically within a year or so of devaluation. Other prices (medical expenses, rent, education expenses, etc.) can take up to two or three decades to fully adjust. The slowness of adjustment is due in large part to the existence of long-term contracts."

Lewis points out: "The dollar, worth 1/35 ounce of gold since 1934, was eventually devalued to a nadir of 1/850 ounce at the end of the Carter administration. During the 1990s, U.S. base money grew at an average rate of 7.14% per year."

In fact, M3, the fullest measure of U.S. money supply, has increased at roughly 8% per year since 1971. Lest we forget, with a stroke of the pen, as Roosevelt did in 1933 and Nixon did in 1971, the government can confiscate the currency and tear it to shreds.

Meaning the money supply increases at 12%, but the inflation rate magically stays at 2-3%. How can that happen?

First, I believe the lag effect described in Lewis’s quote has played a significant role. The price adjustment process, Lewis explains, can take up to two or three decades to fully adjust. That’s the dirty little secret regarding inflation. So while central bankers seemingly ignore the potential lag effect, they continue printing money, which we believe only exacerbates the problem.

It’s been a little more than 30 years since we’ve cranked up the printing press. The effects of that decision are just now being felt. CPI adjustments like "owners’ equivalent rent" have combined with cheap Chinese imports to help delay the lag. But goods subject to "hedonic" adjustments and Chinese deflation can’t hide the era of silent inflation forever.

As Paul Volker, former Fed chair, cleverly noted: There’s no inflation unless you have to buy something.

The second factor driving prices higher stems from Southeast Asia. "Chindia’s" insatiable demand for raw materials only amplifies the problem. Consequently, we’re not surprised to read that commodities just hit an all-time high, with the CRB at 509 and wheat over $10 per bushel.

The third factor working against the American consumer is termed "COLA."

COLA stands for "cost-of-living adjustment." Typically, salary adjustments are based on the annual increase in consumer prices (inflation) or the consumer price index (CPI).

When the money supply consistently outpaces the inflation rate, a consumer’s purchasing power quickly diminishes. Only you haven’t noticed the effect yet, dear reader, because Chinese imports have delayed the hangover. But the days of importing Chinese deflation are coming to an end.

The point: Inflation, by definition, is a decline in the currency’s value. And "currency devaluation," Henry Hazlitt, the late libertarian philospher, economist and journalist for The Wall Street Journal, The New York Times and Newsweek, pointed out:

"[Inflation] discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse."

The thief, the politician and the banker are seemingly playing the same game. They’re playing the law of large numbers. Whether they steal by the sword or by the pen, their craft effectively erodes the tangible wealth of a productive society.

Inflation robs citizens of their productive efforts. It erodes their tangible wealth. It leads, in effect, men toward desperate remedies.

Consequently, the average citizen isn’t left with many options. He can always study to become a legislator or a central banker.

If that doesn’t work, may we suggest dark hoods and dark pants?

So I ask: Where will your money be when Americans stop spending?

We believe businesses with tangible assets trading at depressed prices are a great place to look. A recent article entitled "Lake Mead Could Dry up by 2021" by Andrea Thompson, a staff writer for LiveScience, got us thinking. She writes:

"Lake Mead, a key source of water for millions of people in the Southwestern United States, could go dry by 2021, a new study finds."

The study concludes that natural forces such as evaporation, changes wrought by global warming and an increasing demand from the booming Southwest population are creating a deficit from this part of the Colorado River system.

Along with Lake Powell, which is on the border between Arizona and Utah, Lake Meade supplies roughly 8 million people in the cities of Las Vegas, Los Angeles and San Diego, among others, with critical water supplies.

The system is currently at only half capacity thanks to a recent string of dry years, researchers say.

Land and water: What could hold better value?

The world’s immediate need for fresh water remains paramount. In China, for example, two out of every three major cities have less water than they need. Cities in northeast China have roughly five-seven years left before they run completely dry.

Each year, the Gobi Desert devours 2,460 square miles of Chinese soil, an area roughly the size of Delaware.

Why is Asia’s largest desert growing so quickly?

Through a process scientists call "desertification." Basically, China’s rapid economic growth comes at a great price. Air pollution inhibits precipitation. Researchers from Israel’s Hebrew University of Jerusalem and the Chinese Academy of Meteorological Sciences found that on hazy days, precipitation from the top of Mount Hua in China’s northwestern Shaanxi province is cut by up to 50%.

Consequently, one-quarter of China currently finds itself buried beneath sand. But those lucky enough to fill their pipes have another problem: 90% of China’s city aquifers are deemed polluted. Seven hundred million Chinese drink water contaminated with either animal or human waste. In most cases, their murky glasses contain both.

Westerners, however, take water for granted. We simply turn on the tap and it flows. But that’s certainly not the case the world over. And from they way things are looking, that may not be the case here much longer. Lakes around the U.S. are running dry. In the West, we see this happening at Lake Mead. In the east, it’s Lake Lanier.

Arid landscapes, low rainfall and quickly depleting underground water tables make fresh water one of the most pressing issues facing countries.

You see, water, in essence, is a commodity. When scarce, it’s the one commodity even more valuable than either oil or gold.

Solutions vary. Some have proposed towing icebergs. Despite being highly inefficient, we’re not assured the icebergs will even be there to tow.

Others argue for heavy investment in desalination. We see two potential problems here. First, desalination requires massive amounts of energy, as well as specialized, expensive infrastructure. Saltwater conversion also produces a byproduct of concentrated seawater that some scientists claim contributes to marine pollution.

We also like to point out that desalination takes place at sea level. For flat regions like the Middle East, where desalination plants account for a majority of total world capacity, that isn’t too much of a problem.

But what about countries with steep terrain? Pumping water to higher altitudes (Nevada) presents a significant challenge both economically and physically.

And finally, for the most part, countries use desalinated water for washing, filling swimming pools and watering golf courses…they rarely use it for drinking.

We tend to believe that water rights in this century will be valued much like oil rights were in the last.


Christopher Hancock
for The Daily Reckoning
February 28, 2008

P.S. Our friend and colleague Chris Mayer has been focusing on the opportunity found in this commodity for quite some time and has written extensively on the subject.

Christopher Hancock has spent the last two years doing investment research primarily focused on emerging markets, specifically China and Hong Kong. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research.

Christopher’s desire to work for an independent firm led him to Agora Financial, where he now is the editor of Free Market Investor. Christopher travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world right now for his subscribers.

Oil held at $99 yesterday. The Dow dropped 9 points. And the dollar fell to its lowest level ever against the euro. If you want to buy a euro today, it will cost you $1.51 cents.

Gold shot up too – another $12, bringing the price to a new record of $961.

Why is the dollar falling? Why is gold going up?

You already know the answer, dear reader. Because the people who look after the dollar want it to go down. They’re doing all they can to make sure it loses its value. And so far, at least at that, they’re succeeding.

"Dollar hits low as Fed chief hints at rate cut," says the Financial Times. "Bernanke says bank will act to support growth."

The Fed is caught in the same crossfire as everyone else. On one side, housing prices are dropping…consumers are running out of money…and banks are afraid to lend. On the other, the supply of paper money is soaring…forcing up prices for just about everything that isn’t a financial asset.

Oil…gold…copper…wheat…tractors…farmland – they’re all being pushed up by inflation.

Central bankers don’t normally reduce interest rates in the face of rising consumer prices. But our poor Bernanke-led bank consortium feels it has no choice. The cannons of deflation to the left of them…the artillery of inflation making louder noises to the right – they’ll attack on the left!


Two reasons. First, they believe they can lick inflation any time. That was what Paul Volcker showed them 25 years ago. Inflation can be beaten by clamping down on lending…raising interest rates…and tightening up on the money supply.

But deflation? The present generation of the world’s central bankers watched Japan struggle for 18 years. They think they learned something.

The Bank of Japan has economists too. They read the same economics textbooks. They attended the same prestigious universities. They believed the same claptrap theories of dead economists. They cut rates down to "effectively zero" (monetary policy)…and they spent more on useless government projects than any government had (fiscal policy). What more could they do?

(Well, Anglo-Saxon critics said they were wimps, unwilling to let the big banks fail, so the economy could get back on its feet. More on that later.)

Central bankers are more afraid of deflation than they are of inflation, in other words, because they find it a harder disease to cure.

The second reason why the Fed is attacking deflation and not inflation is purely political. "Change" may be something every candidate promises, but it is something no candidate really wants…at least, not the sort of change that Mr. Market is sending their way. After a huge boom…Mr. Market is delivering a correction. That is just the way he does business. Boom…bust…and boom again. But neither the voters nor the politicians are very keen on the bust part. And they all think they can…and should…do something to prevent it. Hence, the Fed fights deflation…and leaves inflation alone, since they believe that inflation instigates growth (and is often mistaken for growth by casual observers).

But it looks to us as though BOTH deflation and inflation are becoming more dangerous.

"Inflation may be worse than we think," says a Wall Street Journal article. Yes, we wouldn’t be surprised.

One thing that is definitely going up fast is the price of gasoline. Per gallon, drivers are paying 19 cents more than they did just two weeks ago. Some experts think the price will go to $4 per gallon before the summer comes. This is very bad news for the consumer.

"You’re adding an oil shock on top of a crunch on credit and a housing collapse," said Nigel Gault, an economist at Global Insight. "Even the U.S. economy cannot withstand all of that at the same time."

As anticipated, consumers are doing the only thing they can do, they’re spending less money:

"Retail earnings dive," reports the New York Times. What happens to a consumer society when consumers stop consuming? Ah, dear reader, you know the answer to that too – it shrinks.

*** Our first extra thought is that we should move more money out of the dollar. It just keeps going down against the euro and gold.

Our second thought is that we don’t have a second thought. So we’ll go back to the first thought.

The problem with this thought is that it is too obvious. The world’s governments are flooding the planet with paper money. Gold is a kind of Noah’s ark. It can preserve our capital until the excess liquidity dries up. No wonder everyone wants to get on board.

In the United States, as we keep pointing out, the supply of paper money is rising three times the speed of GDP growth. In places like Russia…it is growing five or six times as fast as GDP. China’s inflation is at an 11-year high…and at more than 7% is becoming alarming. Don’t expect Chinese exports to hold down prices in the United States anymore…now they’re just another inflationary pressure.

Meanwhile, the masses are deeply in debt. Their major asset is what they live in, and house prices are about the only thing going down. Their only other major resource is their own labor – which is overpriced in global terms. Inflation will bring it down to more competitive levels.

The government is deeply in debt too. It has let out notes it can’t pay…sold bonds it can’t honor…and made promises it can’t keep. Inflation, there too, would reduce the burden.

What’s more, the custodians of America’s paper money – as we point out above – are desperate to avoid price stability. They want the dollar to lose value; they see it as the only way they can prevent Mr. Market from doing what comes naturally.

And we will add one extenuating circumstance just to thicken the plot: the great dollar-based empire is probably peaking out. Since WWI, America has been the world’s hegemonic power. Since WWII, the dollar has been the world’s hegemonic currency. And since 1971, the hegemonic money has been on its own…unsupported by anything harder than cellulose. But nothing lasts forever. China, India and Russia have come into the global market. They’re shaking things up…growing fast…and offering U.S. business more lower-cost competition than they’ve ever had to face before. Wealth and power is being blown across the Pacific with the trade winds…from North America to Eurasia.

All of this signals, to us anyway, a cheaper dollar and a lower standard of living – relatively – in America. In terms of gold, we expect the dollar to be worth less. Then again, since all currencies are now in competition with the dollar…we expect gold to go up against them all.

And since the U.S. authorities will likely struggle so hard to prevent this unpleasant change, it also seems likely that the price of gold will at least recover to its inflation-adjusted peak set in 1980. Then, gold briefly hit $850. But that was when the dollar was worth a lot more than it is today. Adjusting to current dollars, we expect to see the price hit $2,500 before this bull market in the yellow metal is over…and we aren’t the only ones. Our respected colleague Byron King asserts that the gold price still has quite a ways to go – and assures those who have yet to invest in the yellow metal that there’s still time – even at these prices. In fact, you can get gold out of the ground and into your portfolio for just a penny per ounce.

The only thing that bothers us about this forecast is that it is so obvious.

*** Finally, a milestone: William F. Buckley died. When we get around to it, we’ll write up an autopsy report. Here, we give you the instant coroner’s verdict: He was a handsome, well-bred, pompous, conceited and clever windbag who twisted American conservatism in such a grotesque way even its own parents wouldn’t recognize it.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning