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“I think the Fed is underestimating the severity of the coming economic downturn. Essentially they spent their bullets. It is very difficult to follow through with QE3 right here, because you have gold prices going ballistic, and you have the dollar being very weak, and so there are unintended consequences with implementing QE3 right here.” — Marc Faber
Recent audio interviews with a few market gurus:
If you’re in the same camp as David Rosenberg and Gary Shilling you believe that the economy is in the throes of a deflationary cycle.
Whether or not I agree is irrelevant to this article. However I’d like to point a critical flaw in the deflationist’s investment strategy.
A deflationary economy will cause bonds to rally. This is because the present value of future payments rises with the purchasing power of a dollar. The purchasing power of a dollar rises if prices fall. This is true of the first effects of a deflationary spiral, and at this point the logical strategy is to own long-term government bonds.
It’s the second round effects that most deflationists fail to fathom – this is where the long term government bond strategy fails. If the economy was truly gripped by deflation, the banking system would collapse, risk assets would plummet, businesses would fail and millions would be added to the unemployment lines. (Debating whether these are the causes or effects of deflation is as fruitful as tracing the egg-to-chicken-to-egg.) The point is that if deflation grips the economy, business activity will plummet.
As business activity falls, government tax revenues drop and spending (to stimulate the economy) rises. Consequently, one might find that a deflationary episode increases budget deficits and, for an already indebted country like the United States, the risk of default. As default risk rises interest rates rise to compensate bond investors for the additional risk. As interest rates rise, bond prices fall.
So you can see how the typical deflationist strategy of investing in long-term goverment bonds could become an investing nightmare. Always watch for the secondary and tertiary effects of a trend, particularly when an economy, like the US today, is operating somewhere outside of its ‘normal’ state.
Gold could hit $1900 by October, and the economy could crash worse than in 2008, according to John Taylor, chairman and founder of FX Concepts LLC:
Hoisington Investment Management Company has released their most recent commentary on the economy, and this one is a great read.
The three competing theories for economic contractions are: 1) the Keynesian, 2) the Friedmanite, and 3) the Fisherian. The Keynesian view is that normal economic contractions are caused by an insufficiency of aggregate demand (or total spending). This problem is to be solved by deficit spending. The Friedmanite view, one shared by our current Federal Reserve Chairman, is that protracted economic slumps are also caused by an insufficiency of aggregate demand, but are preventable or ameliorated by increasing the money stock. Both economic theories are consistent with the widely-held view that the economy experiences three to seven years of growth, followed by one to two years of decline. The slumps are worrisome, but not too daunting since two years lapse fairly quickly and then the economy is off to the races again. This normal business cycle framework has been the standard since World War II until now.
They conclude by restating their deflationary view and commitment to the long-bond. However, they suggest that if deficits aren’t addressed, there is a risk exists that rates rise. This would be detrimental to an economy that is already sputtering when money is virtually free. Also, it would trash their long-bond position.
This is great – I love the history of money. Nothing is new – the names and technology changes, but human nature stays the same.
(By the way, if you want to learn about the hyperinflationary episode of 1920s Germany, subscribe to Plan B Economics and I’ll send you a copy of “The Inflation Threat”.)
Learn…and don’t repeat the mistakes of our ancestors:
Two of my favorite books on the history of financial speculation and bubbles. If you only read two books on economics and investing, these are what you should read:
Judging by the chart below, the relationship between real interest rates and real GDP growth is weak. Negative real interest rates seem to be connected to an uptick in GDP growth for the following 5yrs. However, real GDP growth doesn’t appear dependent on low or negative real rates, since positive growth regularly occurs while real rates are relatively high. So, while negative or low real interest rates may act as an economic defibrillator by jump-starting a dying economy, it appears they are not a prerequisite for strong real GDP growth.
Instead, although I didn’t research this here, one might expect real negative rates to provide a cushion to the banking system by way of a steep yield curve. A steep yield curve essentially benefits any entity that can borrow short from the Fed and lend long to businesses, consumers, governments. A steep curve also discourages cash-hoarding and encourages financial institutions to move money into financial and real assets.
So what does lead to real economic growth? The two most essential ingredients are population growth and productivity gains. Other variables can lead to real economic growth – such as credit growth by way of financial ‘innovation’ – but tend to be less robust and enduring.
…and you thought Andy Xie, the outspoken former Morgan Stanley economist, was missing in action:
Loose monetary policy is the cause of inflation, and its intended purpose is to stimulate growth. But when such policy is sustained despite inflation, it signals deeper problems. When stimulus fails to revive growth, it suggests structural problems.
In today’s world, deep structural problems are impeding economic growth. But most governments don’t have the political will or power to deal with them. Instead, they pursue easy solutions such as printing money, which leads to stagflation.
The United States and China have structural problems that can’t be solved through monetary policy. The wrong medicine may push the global economy toward another crisis, possibly in the last quarter 2012.
Addressing 5 of the biggest ‘givens’ in today’s market:
i) China will continue to boom;
ii) Emerging markets forever,
iii) The world will run out of commodities;
iv) An inflationary blow-off is surely underway, and
v) The US dollar will fall to oblivion
Fernando Aguirre, who experienced the devastation of the Argentinian hyperinflation and economic collapse first hand, has authored a book that describes the survival strategies that worked best – you’d be surprised.
In an article on Chris Martenson’s site, Aguirre provides a sneak peak into survival strategies during a period of economic collapse:
Step #1: Secure a percentage of your savings in bullion.
Step #2: Stock up on food.
Step #3: Acquire the essentials by putting together a survival/emergency kit.
Step #4: Improve your personal and home security.
Step #5: Embrace a different mindset.
I recommend reading the article (here) – it is scary to see how quickly a civilized society can devolve into barbarism.
I also recommend getting a copy of his highly-rated book.
A must-listen interview with Felix Zulauf of Zulauf Asset Management AG analyzing the future of the EU, the risk of higher inflation, a potential revolt of the bond market, and much more…
Jim Grant speaks with Consuela Mack about the threat that inflation will appear swiftly and suddenly:
Are we experiencing inflation or aren’t we?
Those paying attention to commodity prices, manufacturing input costs, insurance costs, grocery prices, healthcare bills, parking costs, etc. may have noticed that prices are rising. And with commodities acting as a leading indicator – because they’re part of the first step in the production process – it looks like prices will continue to rise. Those who define price rises as ‘inflation’ would certainly argue that we are in an inflationary phase.
(For the Austrian economists who define inflation as the growth in money supply, there’s also no shortage of inflationary fodder.)
The deflationists out there point to the output gap, unemployment, wages and housing costs as the offset to inflation case. While I agree that cheaper housing can have a long-term impact on a NEW household’s debt-service to disposable income ratio, it doesn’t negate the fact that existing households are locked into higher prices. Moreover, the argument that a big output gap, weak employment and stagnant wages somehow prevents inflation simply ignores the fact that prices are rising despite the state of economic affairs. Regardless of the economic conditions, if money supply doubles (for example) prices will rise. If inflation weren’t a monetary phenomenon central banks would simply print enough to pay off everyone’s debts and we’d all be rich. If theory isn’t compelling enough, look at the experience during the 1970s. America’s 20th century brush with near-hyperinflation happened during a time of economic stagnation…hence the term ‘stagflation’.
Inflation is at least a threat, if not a reality. So why does it seem like Ben Bernanke doesn’t notice? There are several reasons:
1. According to the quantity theory of money, inflation is dependent on the quantity of money circulating the economy AND the velocity of money circulating the economy. Money velocity refers to the speed at which individuals and businesses spend money after they receive it. The faster they spend, the higher the velocity and the bigger the inflation. Money velocity rises with inflationary expectations, which can make inflation a self-feeding monster. If people expect higher prices tomorrow, they’ll buy goods today – but because more people are spending today prices rise. By playing down the threat of inflation Ben Bernanke is probably attempting to calm the psychological driver behind inflation, thus preventing it from becoming self-fulfilling.
2. During the current scenario, prices are rising while consumer and government indebtedness remains extremely high. All things equal, higher policy rates may send the global ponzi scheme back into a tailspin – a double-whammy within the span of 3yrs could make a future recovery even weaker than the current recovery. This is something Bernanke (and his buddies on Wall Street) likely doesn’t want to risk.
3. High commodity prices eventually destroy consumer demand – in many respects, this makes commodity cycles self-limiting. Pushing the contractionary monetary policy lever at a time when rising commodity prices are eroding consumer discretionary incomes would essentially double the amount of drag on the economy. Central bankers likely rest on the hope that commodity prices will temper demand and lead to a soft landing as commodity prices revert to the mean. Applying the monetary brakes while prices are placing pressure on the consumer could tip the economy into a hard landing. Ben Bernanke himself published research in 1997 that argued that the best response to an oil shock is to do nothing.
4. History has shown that commodity spikes tend to be temporary phenomenon, which eventually reverts to the mean. With this frame of reference, Ben Bernanke has suggested that current inflationary trends are ‘transitory’ implying that once commodity prices decline again so will inflation.
5. What reason #4 fails to acknowledge is that we may be in a secular uptrend in commodity prices. Growing emerging markets demand, increasing scarcity, rising production costs and shrinking energy ROI are the fundamental arguments for the secular commodities bull market. We may be nearing our limits on this planet and this is being reflected in the prices of everything. Assuming this is the case, does monetary policy degenerate into an accelerant to the busts caused by high commodity prices and inflationary booms caused by loose money? Said differently, can expansionary monetary policy stimulate real growth when physical resource constraints restrict real growth? And does contractionary monetary policy simply aggravate weak-to-negative real growth rates in a resource-constrained environment? Unfortunately, the Federal Reserve can’t print oil, silver or copper and Ben Bernanke knows this – perhaps he understands the physical restrictions to real economic growth and has accepted the limits of monetary policy.
From a central banker’s perch, the failing banking system in 2008 required copious amounts of liquidity, despite the inflationary risks. Now that those inflationary risks are materializing outside of the traditional monetary policy transmission mechanism, the Federal Reserve really has no option but to ignore the inflationary data over which it has no control.
For those trading the markets, whether this is right or wrong doesn’t matter. Because it’s reality. Perhaps this is why gold closed Friday at a record $1486/oz.
…and you thought getting those two together could never happen…
