Dealing with Financial Repression

Given the article posted today by Econophile on the WSJ and inflation, I thought it timely to submit some quantitative considerations for anyone with savings who has to deal with interest rates on savings that are below the rate of price increases for consumer goods and services.

The WSJ writer's view is that the authorities "should" inflate away debts. I fully agree with The Daily Capitalist's different viewpoint about what "should" be done. It is further my view that what Mr. Arends of the WSJ advocates has in fact been "the plan" ever since the economy began collapsing in 2008. I believe that the Consumer Price Index understates price inflation and that if one removes housing from the CPI (because houses are financial assets rather than costs for most adults), the real cost of living has been rising at least at 5% per annum for the past year for the "average" American. I further believe that this policy of imposing negative real interest rates on savers, which is being called "financial repression", will continue for some time.

Thus gold ownership in various forms remains appropriate in my view even for small savers unless they may need access to those savings soon (e.g. retirees or people who are not able to save from their income). To review the reasonableness of current gold prices, which are around $1540/ounce, I have gone back to 1976 prices and interest rates, when gold was in the $100-140 range.

Whither the Markets?

Yours truly has been following the news and much Internet/blog commentary lately with interest and calmness. On The Daily Capitalist website, we have seen Econophile opine about a stagflationary outcome, and Keith Weiner provide a futuristic view of some sort of hyperinflationary "crack-up boom", a term used by von Mises.

My view is more toward Econophile's but with some differences in the short term. Here's why. Mr. Weiner suggests that we watch, some years from now, for gold to trade at a higher price in the near-term months on the futures market than in the more distant months (i.e. "backwardation"), and that this will be a warning sign of what he calls a coming financial Armageddon. Without beating a theoretical horse that may or may not occur, I can think of a number of reasons why gold could go into sustained backwardation without leading to a breakdown of trust in the financial system. Reasons could include demonetization of gold, manipulation, mania, off-market contracts for gold delivery, and a general deflationary trend in prices of tangible goods, as well as the possibility of centrally-dictated negative interest rates.

In any case, perhaps a hyperinflationary depression is in our future, as Mr. Weiner posits. Shorter-term, I think we truly need to worry about a global industrial recession. My read of the commodity markets is consistent with that.

There is one very interesting topic in Econophile's linked post that I will address. That point relates to his statement that not all capital was consumed by the crash. I wonder. Certainly the physical structures of the United States were not damaged. There were no enemy bombs bursting in air, no giant toxic radioactive leaks, etc. But what if all banks, more or less, were bankrupt? Then, all the fiat claims and counterclaims tied into worthless bank deposits.

The way I am putting the Armageddon-lite events of the 2008 era together is as follows. The U. S. and Britain suffered a collective financial major myocardial infarction following Fannie and Freddie going into receivership in late summer 2008. This was followed by Lehman's collapse, Sunday evening panicky special broadcasts starring Hank Paulson and the like, President Bush admitting he was violating capitalist principles to save capitalism, and crony capitalism the likes of which America had not seen for many decades. The serial bailouts and intense subsequent money-printing just might be because the authorities took a look at the 40:1 leverage of the investment banks, the (perhaps) 100:1 leverage of the GSEs, and the unknown but high leverage of the other large financial institutions and realized that there was no equity left.

Therefore they just decided to create enough new dollars ("fiatscos") as were needed to begin the cycle anew. Of course, under a debt-based system of money creation, this could only be accomplished with ultra-low interest rates. Thus, "ZIRP". Thus, the Bank of England and "the Bernank" were charged with inventing any excuse to not see price inflation that the whole world sees, or to call it transitory. Thus, periodic endings of money printing, QE 1, QE1.5, QE 2.0, etc., in order to see if the economy was self-sustaining yet. Sort of like a cook taking a dish out of the oven to see if it needed more cooking. If no self-sustaining recovery, well, OK, let's cook it some more (i.e. print more money).

Thus, biflation, as the massive and leveraged capital that went into building too many homes, and too expensive homes, had perhaps destroyed all financial capital in the country, after accounting for debts to foreigners, and without selling the physical country and its mineral rights etc. to the foreigners.

Of course, this is just a theory, and I'm interested in comments. To me, it fits the facts as I see them, and it explains why hyperinflation has not happened and why we may be entering into a period of general disinflation and commodity price deflation as an industrial recession looms. The human, physical and intellectual capital exists, but when the accounting is/was done properly, perhaps the value of all those assets expressed in terms of the money stock that existed as of the summer of 2008 was zero.

If I am correct that the cyclical economy is on the rocks, stocks that will rise or at least hold steady will be few and far between over the next months. These may include utilities, McDonald's and retail discounters. Personally I have taken several short positions to offset my few longs, but mostly I am in cash with a reserve of gold. If I am correct, oil could easily hit $80/bbl on the downside this summer/fall and perhaps could go much lower. $60 has very strong support if $80 decisively fails. If we see $60/bbl, watch for gold to test $1000/ounce before, perhaps, doubling in short order to $2000+. If oil hits $80 and holds, then rebounds on an economic rebound plus QE 3.0 or its equivalent, then gold might hold above $1400 at its worst and then head to new highs by year-end.

Thus I am presenting a somewhat different potential scenario for the months ahead. Let's see what happens. As always, I am data-driven. Anybody who has a high degree of confidence in any sort of prediction and who lacks inside information is in my view overconfident.

Copyright (C) Long Lake LLC 2011

Financial Media Drumbeat for Money-Printing CONtinues

That's not a typo in the title. Because there's a con game going on. It's the con that the threat is imminent deflation.

In his weekly Emailed commentary today, the well-known financial man John Mauldin differentiates between good and bad deflation. In the category of the latter, he quotes insufficient demand.

You know things are loony when an American can look around him, see the obesity epidemic, and with a straight literary face, cite insufficient demand!

Let's also see-- one vehicle per capita; 20 times as much oil used per capita as in India, etc.

Excess commercial real estate and by world standards double or triple as much residential real estate as is really needed.

And so on. Some insufficiency of demand.

What ties many financial people together in their wails that we need to fear collapsing prices is that they benefit from money printing. One reason for this is obvious: more money in the financial system means more assets under management. Another reason is subtler, and relates to Uncle Warren Buffett's parable of the Gotrocks family. In this story, a family with money keeps getting sold on making the management of their savings more and more complicated, with the only winners being the financial community. Thus, if the Government were to start paying off its debts, there would a simpler system, and thus less reason for the great unwashed to pay financial types fees to invest their money.

Mr. Mauldin is on the more conservative side of the spectrum, so his major point is to keep the Bush tax cuts. Presumably he will do well with that personally, and so will his clients. Others such as Nouriel Roubini always pound the drums for eternal depression, and their solution is greater government spending.

Neither of those camps address the overriding problem of creating a stable financial system. If society wants Sweden or wants Hong Kong, it can have either, but it can't have Swedish social benefits (plus war in Eastasia) with a Hong Kong-level of Federal income (14% of GDP at latest count). Continuing the giant deficits is great for financial types and keeps the Roubini Global Economics business thriving as well.

On the other side of the financial sea from debt-based finance and money printing is gold. The media is all over that one. Barron's is out today with the Abelson article titled A Contrarian's View of Gold.

The "contrarian" works not for some small contrarian enterprise in Nowheresville, but rather for the globe-girdling Bank Credit Analyst. No evidence in the article indicates why this gentleman is called a contrarian at all. The article goes so far as to point out that the negative view on gold that Mr. Berezin espouses is not contrarian at all. To wit:

. . .he gets some support from Barclays Capital's latest commodity forecasts, which sees gold averaging $1,195 an ounce this year, $1,180 next year, $1,010 in 2012 and $850 for "the long-term."

Oh, those wild-eyed crazies at Barclays! Always taking the non-consensus point of view (NOT).

Why is Mr. Berezin negative on gold? Because he expects:

1) An increase in real interest rates, which he feels are bound to rise as the global economy continues to recover.

2) A decline in inflation expectations. Disinflation, he notes, is "gold's archenemy" and, he believes, over the next few years, deflation is the biggest risk.

We should stop right here. What actually happened to real interest rates in the U. S. at least in the Ponzi boom of 2005-7/8 was that real interest rates dropped to zero as inflation surged to at least 5%. In fact, a sign that the boom was built on sand was in fact that the economy could not even tolerate truly restrictive interest rates, unlike the economy of 1980-2. So his idea that real interest rates will rise with a boom is unlikely, given tattered balance sheets all over. Re inflation expectations, well he's a better man than anyone else if he is suggesting you invest on what expectations will be. Predicting facts is hard enough; expectations are second derivative stuff.

He also sees:

. . . the greenback as "among the best houses in a bad neighborhood" that, over time, will strengthen against the euro and the yen, sparking a reassertion of the negative trend between bullion and the trade-weighted dollar index.

My view is different. It is in line with Bill Fleckenstein, and certain bloggers such as Econophile, who see money printing and stagflation as reasonably likely.

The powers that run America financially are great powers. They say that they will do everything they can to make sure that deflation does not take root here. With the lowest short term rates in America and globally in history and 3% Treasury rates despite massive supply, you can expect either a strong economy to put all the monetary stimulus waiting in reserve to start stimulating pricing power and/or more money printing to purchase more financial assets, some of which new money will filter out to the real economy.

What would really be bad for gold, as it was 30 years ago, would be true tight money policies, plus a revival of pro-entrepreneurial policies. Since these are not likely to be forthcoming from Washington any time soon, it makes sense to resist the growing media pressure from multiple sides of the economic-political spectrum that deflation is a serious threat and prepare for a resumption of something like 2003-7.

And to be aware that as in that era, the defining characteristic was a crash.

I suspect that another crash is coming. I just don't know when.

Copyright (C) Long Lake LLC 2010