The Inflation Versus Deflation Argument - Part 4

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

While it is true that the U.S. experienced consumer price deflation in the 1930s and Japan did so in the 1990s and both experienced sharp drops in bank credit, there are few if any other similarities to the current situation in the United States in 2008. The situation in the 1930s U.S. and 1990s Japan is also a bit more nuanced that the deflationists would have you believe. In the late 1920s, the U.S. did see a big rise in money supply and credit, just as occurred in the U.S. in the early 2000s. According to the deflationists, this should have resulted in rising U.S. consumer prices at some point. It did not. Prices actually fell between 1926 and 1929. A similar thing happened in Japan in 1986. While consumer price deflation did appear in Japan after its banking system literally fell apart, it didn't show up consistently until 1999, nine years after the Japanese asset bubble began to burst. Based on these observations, the relationship between consumer prices and money supply and credit seem to be rather tenuous at best.

The deflations in the 1930s U.S. and 1990s Japan did have an important element in common that does not exist today - dropping commodity prices. As early as the spring of 1929, farm commodities in the U.S. experienced a sharp drop. All commodities declined in the crash month of October and then they crashed themselves in the spring of 1930 . While commodity prices didn't crash in the 1990s, they were weak throughout the decade. Oil reached its price low of just over $10 a barrel in 1998. Ten years later it would be almost 15 times higher. Not only were commodities not declining in the 2000s, but they were experiencing major price increases resulting in significant inflation in the U.S. and most of the world. The commodity picture in the 2000s was just the opposite of the early 1930s U.S. and 1990s Japan.

The import/export and deficit picture has no similarity to the contemporary U.S. either. In the late 1920s, the U.S. had a massive trade surplus and was the biggest creditor nation in the world. Its boom had been built on exports as was the case for Japan in the later twentieth century. Drops in exports damaged both economies. On the other hand, the U.S. in the 2000s was the biggest debtor nation in the world having both a massive trade deficit and government debt, which required heavy borrowing and had inflationary implications. Japan in the 1980s was similar to the U.S. in the 1920s and both were very dissimilar to the U.S. in the 2000s.

Currency also plays a different role in all three scenarios. The U.S. was on the gold standard until 1933 and even after that the currency didn't float. The Japanese yen traded relatively flat during the 1990s. In neither case, did currency have a significant deflationary or inflationary effect, in contrast to the U.S. in 2008 where currency played an inflationary role. The U.S. dollar dropped to all time lows in late 2007 because of the Federal Reserves easy money policy. Since the U.S. imported much more than it exported, this raised import prices and had a bigger inflationary impact than it would have had otherwise.

NEXT: The Inflation Versus the Deflation Argument - Part 5

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21

The Inflation Versus Deflation Argument - Part 3

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

For a theory to be valid, it must produce results consistent with reality. Neither the deflationist arguments in Wiemar Germany in the 1920s, nor those made in 2008 in the United States could meet this most basic of all criteria. The contemporary U.S. deflationists are claiming that an era of lower prices is upon us even though consumer prices are continuing to rise and the rise seems to be accelerating. Both groups of deflationists redefined inflation to be something else, or in other words, they changed reality to match their theory instead of the other way around. In neither case was any relationship demonstrated by them between their definition of inflation and changes in consumer prices.

The deflationists claim that inflation is an increase in money supply plus bank credit. While everyone could agree that bank credit in the United States was falling in 2008, the same could not be said for money supply. Their are many definitions of money supply and M3, a broad category that would include the Federal Reserves newly created money pumping operations such as the TAF, TSLF and PDCF was expanding rapidly. Since the deflationist argument would fall apart using their own criteria if M3 figures were used, they chose to look at much narrower definitions of money supply such as M2 to try to support their theory. Even then, M2 was experiencing robust growth of over 6% until the second quarter of 2008, when it slowed to around 1%. This was hardly the dire collapse that the deflationists claimed to be happening.

Logically, the deflationist definition is inherently defective because it considers inflation to be a local rather than a global phenomenon. In an era with worldwide commodity trading, prices are set globally for key components of consumer inflation such as energy and food products, not based on what's happening in a single country. Under such circumstances, currency fluctuations then determine the different rates of inflation between countries.

The deflationists argument is also too limited in that it considers money supply and credit, but not assets. In a rich developed country, people can spend their wealth (liquid and tangible assets) as well and they will if they need to do so to buy necessities. This is exactly what happened in Wiemar Germany, where the middle and even upper classes sold their family's prized possessions in order to eat.

The U.S. deflationists also try to bolster their case with comparisons to what is happening in the United States now and what happened in the deflationary periods of the 1930s U.S and the 1990s Japan. Only the most superficial comparison shows any similarities between the U.S. in 2008 and these earlier time periods. Under closer examination the deflationist comparisons completely fall apart.

NEXT: The Inflation Versus Deflation Argument - Part 4

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21

The Inflation Versus Deflation Argument - Part 2

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Inflation can only get out of control if the monetary authorities act irresponsibly by failing to stop rising prices and respond with denial and duplicity instead. In general, the worse the denial the greater the final inflation rate. In no case was this more clearly demonstrated than during the German hyperinflation when prices rose a 100 trillion percent between 1914 and 1923. Toward the end, consumer prices more than doubled every two days.

Eminent financiers, economists, politicians and Wiemar government officials all denied that inflation even existed in Germany, at least right up to the time of its final hyper phase and some of them continued with their denials even in the midst of those explosive price increases. Minister of Finance, Helfferich, assured the public that there was no inflation in Germany because the 'value' of currency in circulation was covered by a greater amount of gold reserves than it had been before prices began rising. Eminent professors, Elser and Wolf, echoed his argument. President of the Reichsbank, Havenstein, categorically denied that the German central bank was creating inflation and was convinced he was following a restrictive monetary policy. The Statistical Bureau of the German Government concluded in a study that there was a shortage of currency in Germany, but a great deal of inflation abroad!

How did these government officials and eminent economic authorities justify their continued assertions that there was no inflation despite rapidly rising consumer prices? They used one of the oldest tricks in the book, simply redefining inflation to be something else. By saying X really isn't X, but X is really Y and Y has certain attributes so X must have those attributes, you could of course prove almost anything. And the Wiemar German experts did just that by defining inflation as an in increase in the real value of currency in circulation (instead of the nominal value, which would essentially be the current definition of money supply) plus credit . While the total face value of currency in Germany was increasing dramatically, the total actual value was declining and this was interpreted as 'proof' that deflation was taking place. The accurate interpretation would have been extreme consumer price increases can take place when real money supply and credit are decreasing.

If instead of defining inflation as a function of real money supply and credit, Wiemar economists had defined it as the change in the value of a nations currency, they would have arrived at the correct conclusions about consumer price inflation. The exchange rate of the German mark essentially went to zero as price increases in Germany approached infinity. Since that time, globalization has only made the importance of currency as the key determinant of inflation even more important.

While the mistakes of the Wiemar German officials and financial experts seem laughable today, almost the exact same arguments about inflation began circulating in the U.S. in 2008. If such absurdities only surface prior to a massive outbreak of inflation, serious trouble was obviously ahead for the U.S. financial system.

NEXT: The Inflation Versus Deflation Argument - Part 3

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21

The Inflation Versus Deflation Argument - Part 1

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

One of the Federal Reserves two major purposes is to provide price stability for the American economy, a goal they chose to abandon in September 2007. While the Fed's interest rate policies after that time were highly inflationary, Fed officials excused their actions by denying that inflation was a problem, making rosy predictions that it would subside, and by assuring the public that they were capable of handling it and taking care of it in case it became a problem. None of this was true of course and the Fed's position increasingly lost credibility as gasoline and food prices skyrocketed in the U.S.

The Fed's biggest cover for its actions was the official inflation figures produced by the U.S. government statistical agency, the BLS (Bureau of Labor Statistics). The method of calculating the CPI (Consumer Price Index) was modified several times during the 1980s and the 1990s, with each modification producing a lower reported inflation number. Essentially these modifications involved reducing the importance in the CPI calculations of anything that was experiencing significant prices rises, thereby automatically lowering the final reported inflation numbers. It was hard for significant inflation to show up in the official government figures given this approach. By May of 2008, year over year CPI was only 4.2% in the U.S. despite rapidly rising energy and food prices during that period.

Recalculating CPI using the 1970s methodology indicated U.S. inflation was more likely around 12% (for more info: http://www.shadowstats.com/), almost as bad as it had been at its height in 1980. It became increasingly hard to convince the public otherwise, when the average U.S.consumer saw regular price increases at the gas pump and in the supermarket. Nevertheless, U.S. media continued to dutifully report the unrealistic official inflation figures as if they were true, helping the Federal Reserve perpetuate the fantasy on which it based its irresponsible monetary policy.

While the Federal government altered inflation calculations to produce the desired numbers in order to fool the general public about current inflation, lying about future inflation could not be done so easily. The augurs of where inflation was going, the money supply, are generally only looked at by the financially sophisticated. To solve this problem, the Federal Reserve simply stopped publishing the broad M3 money supply figures, the most telling number series of all, in 2006. Since many people realize that when a government hides information, its almost always information that would be particularly damaging if known, attempts to reconstruct M3 by private parties began immediately. By the spring of 2008, the reconstructed figures indicated that M3 was growing at approximately 20% (MZM, zero money, or cash and its equivalents was growing at an over 30% rate). The money supply figures indicated that U.S. consumer inflation was likely to peak at a minimum of 20% to 30% sometime around 2011. Depending on future readings, much higher inflation levels were possible.

The U.S. government's long-term misinformation campaign about inflation rates and its secrecy concerning money supply figures apparently didn't provide enough cover for the Federal Reserve. One group of apologists for the Fed (and the Fed had a legion of apologists who were feeding off the easy money gravy train that it was providing them at the expense of the American public) began publishing arguments about the risks of deflation in the U.S and how this justified an even easier money policy. Claiming that deflation actually existed in a period when inflation was getting out of control was by no means a new idea. It was in fact a prelude to some of the worse inflationary episodes in history.

NEXT: The Inflation Versus Deflation Argument - Part 2

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery,
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21

Gold, Silver, Oil, and Stocks - Spring 2008

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Please see our video related to this entry: Gold, Silver and Oil - March 2008
http://www.youtube.com/watch?v=wVpcdxh1Jv8


Gold and silver both had price lows in mid-August of 2007, with gold around $640 an ounce and silver just under $11. Both started a long rally just as the U.S. Federal Reserve began it's rate lowering campaign by dropping the discount rate on August 17th. Rallies in gold and silver indicate that the Fed has set interest rates too low and its interest rate policy is inflationary. Gold and silver both did indeed rally during almost the entire period when the Fed lowered rates sending a clear message about the inflationary implications of the Fed's actions (clear to almost everyone but the Fed that is).

Since the Fed was in a race against time to prevent a recession in a presidential election year and it takes about six months for a Fed rate cut to have full impact on the economy, it was quite predictable that the Fed would be finished lowering rates by March 2008 (only one additional quarter point drop took place after that) and the gold and silver rally might end (temporarily) around that time.

Gold and silver both peaked at the time of the Fed's March meeting and began selling off immediately thereafter. Gold had psychological resistance at $1000 an ounce (a nice round number that many traders were looking for it to reach and where they planned to sell once it did). It hoovered around this level for several days and actually reached 1033 in overnight trading before the selling began. Silver, like gold, was technically overbought and even more overextended on the charts making it even more vulnerable to a sell off. Both gold and silver dropped sharply. Within only 3 days, silver lost 20% of its value.

Oil (Nymex light-sweet crude) followed a different pattern from the precious metals. It had psychological resistance at 100 and got stuck around this level in November and December of 2007. It finally broke through the 100 level in February 2008 and rallied into July until it got just over $147. While oil was rallying, gold and silver sold down in a choppy fashion until they
hit a price low in the beginning of May.

The notes for our talks on this subject can be found at: http://investing.meetup.com/21/files
1. Gold, Oil, Silver, and Stocks - March 2008
2. Gold, Silver, and Oil - April 2008

NEXT: The Inflation Versus Deflation Argument - Part I

Daryl Montgomery
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21

Gold, Silver and Oil - Basics of Price Movements

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The Fed's easy money campaign that began in August 2007 started when the U.S. dollar was hoovering just above its historical low. It was inevitable that lowering interest rates at that time would weaken the dollar till it hit a new all-time low and once this happened how far the dollar would fall would not be predictable and stopping its fall would prove to be difficult. Since commodities are priced in dollars and gold and silver move opposite to the dollar, a new rally phase began for oil, gold and silver.

Price movements for oil, gold and silver usually do not take place simultaneously, but in sequence. Oil tends to move first and since it has such a strong impact on inflation, people then bid up gold because prices are rising and the U.S. dollar is falling. Gold is being purchased during this time because it is seen as a monetary substitute that will retain its value unlike paper currency. Since gold is the preferred monetary substitute, its price moves up first. When the gap becomes too big in the price between gold and silver, the price of silver, the second choice for 'real' money, then starts to rise.

The value assigned to gold and silver as monetary substitutes is minimal during periods of steady prices, but this aspect overwhelms their pricing during periods of high inflation and their value for jewelry and industrial purposes can become almost irrelevant. Nevertheless, analysts and financial 'pundits', continue to estimate reasonable prices for the precious metals as if their functional uses were the only source of their value. This approach will have worked successfully during the as much as 20 years of steady prices that precede an inflationary period, so it is continued even though a period of rising inflation has begun. During this period, gold and silver appear to become increasingly overvalued based on the exclusively non-monetary price calculations of analysts. The claims that the precious metals are overvalued become widespread and shrill in articles with charts 'proving' they are overvalued. The vested interests, such as jewelery makers, who want the prices of gold and silver to come down because high prices are affecting their profits are behind much of the news warning investors against buying 'overpriced' gold and silver.

It is highly likely if not inevitable that oil, gold, and silver will experience price bubbles once inflation starts rising. The cries that they are in a bubble will first occur years before the actual end of the bubble and it's blow off phase when prices explode upward. By the spring of 2008, claims that gold was in a bubble as it's price reached a $1000 an ounce were already being heard. Late in the spring, as oil soared way past $100 a barrel the same was being said about it. Experts on bubbles were wondering when in the decade of 2010 and 2020 these bubbles would actually end.

NEXT: Gold, Silver and Oil - Spring 2008

Daryl Montgomery

Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21

Credits of Mass Destruction

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The New York Investing meetup has made a companion video to this blog entry. You can find it at: http://www.youtube.com/watch?v=qjGoOE2SwhY.

In the week of February 14, 2008, the Auction-Rate Securities market collapsed with almost 1000 auctions failing. Auction-rate bonds were long-term debts that had their interest rates reset in a Dutch Auction every one to 35 days. The market had been created in 1984 and from that time until the end of 2007, only 44 auctions had failed. The market had grown to over $300 billion and was a favorite place to borrow for local governments, hospitals, museums, student-loan agencies and closed-end mutual funds. As long as the auctions worked the rates for these borrowers remained as low as 3%, but if they failed (something no one worried about since this almost never happened), the rates could be punitively high - as much as 20%. Wall Street raised money from some of its best clients to fund these auctions, with promises that these investments were 'as good as cash'. After 24 years without problems, the end came suddenly and without warning. The big banks and brokers withdrew their support and overnight their clients who had invested in these 'good as cash' investments couldn't get their money back. The borrowers suddenly found themselves paying junk bond rates.

At almost the same time, VIEs 0r variable interest entities (also known as conduits or special purpose vehicles) made the news. VIEs are off-balance sheet items for banks (contary to popular belief, the Enron scandal did not do away with off-balance sheet items) and their amounts were revealed to be around $800 billion. The first major news of off-balance sheet items for banks concerned SIVs (structured investment vehicles), which are a type of VIE. This news appeared in the fall of 2007. SIVs were estimated to have an original value of $400 billion and this amount was considered so great that the U.S. Treasury department attempted to arrange an SIV bailout. This effort never got anywhere and was abandoned by December. Only two-months later, the off-balance sheet problem was revealed to be twice as large as originally thought. Furthermore, it was estimated that the VIEs were worth only 27 cents on the dollar. In an SEC filing, Citibank indicated that it had $320 billion in VIEs, which would mean it might have lost approximately $240 billion off-balance sheet. It had only written off $22 billion in losses up to that time.

While problems with the auction-rate securities market and VIEs had not been predicted and appeared seemingly out of nowhere, warnings were being made about the Credit Default Swaps market (CDSs). These were derivatives that were a type of bond insurance and the functioning of this market was threatened on a number of fronts - particularly from bond insurers losing their top credit ratings or a failure of a major counter-party (any large bank or broker). The Fed would have to publicly bail out Bear Stearns in mid-March 2008 to prevent the collapse of this market. The CDS market was so huge at $62 trillion that it was four times the size of the U.S. economy and was effectively a financial nuclear weapon that could wipe out the entire system. If this happened, it would likely be sudden and without warning just like the collapse of the auction-rate security market (and Bear Stearns).

NEXT: Gold, Silver, and Oil - The Basics of Price Movements

Daryl Montgomery
Organizer, New York Investing meetup

For more about us: Please see our web site: http://investing.meetup.com/21.