A 5th Economic Condition?

[AgAuMoney]

For the average person, their two most valuable assets are their home and the personal services that they offer in the marketplace for wages and salaries.  In the last ten years I would say that these two assets have either fallen in value or stayed the same for most people.  When your two most valuable assets are either falling in value or just treading water, the world doesn't feel too inflationary.

I agree they have fallen in value or stayed the same, but I disagree on your "feel" for inflation.

I don't buy a house every day, or even every month, and changes in value of my house really don't affect me.

Grocery, gas, the utility bills, movie, dinner out, a baby sitter, those kinds of things are where I and I'm quite sure most people get their "feel" of inflation.  And people are feeling inflation today.  Nobody I talk to believes prices and the cost of living went down, yet the CPI says they did because the CPI is 40% composed of imputed rent.

I'm less sure on the whole salary thing.  When trying to live on less money, I feel every little price increase even more than before, but I'm not participating in any price decreases.  I would say that a lower salary feels like worse inflation, even tho you can tell yourself intellectually it is only because of lower wages, it still feels like prices are rocketing up.

(I took a significant (for me) pay cut in 2009 vs 2008 when starting a new job.  And this year I quit that job and struck out on my own.  Now I'm enjoying my freedom and hope to make 1/2 what I made in 2010, which will just about break even in the bank account but won't buy any extras or do any good for my portfolio.  (anybody need any custom driver software or firmware? )

Oh and re. the CPI_U...  The low was 210 for the 2008-12 report.  Previous time when it was that low was 2007-11 and 2007-12.  It is now 225.7 compared to 225.9 last month, the highest it has ever been.  Prices and the cost of living are up, not down even with 40% of the CPI coming from imputed rent.  That's the official inflation.  (If you are quoting some other metric than the CPI_U, it is even more bogus...  so don't do it.  Let's still with the official number.)

[AgAuMoney]

That sounds like the definition of home country bias to me.

The context in which I was making the comment was that doodle was saying he didn't like the idea of tying up so much of his assets in the U.S. treasury market.  I was trying to make the point that we are buying treasuries BECAUSE they are denominated in our home currency.  We're not buying them because we believe the U.S. is a great manager of public finance, but rather because the store on the corner only accepts U.S. dollars for purchases.

For a U.S. investor, the fact that the U.S. dollar is the world reserve currency and the U.S. treasury market is the safest in the world is just gravy.

Exactly.  Which means that the PP has a home country bias.

Most likely if you drive a car designed and built in North America it has a bias when steering straight ahead.  Euro designs tend not to have that, and many americans find euro designs twitchy because even the smallest change in the steering wheel changes the direction of the car.  It's a bias.

The PP is supposed to have that home country bias.  That bias is how it accomplishes most of what it does.  A bias isn't bad unless the reason for it is bad, but it is still a bias no matter how good or bad the reason.

[AgAuMoney]

Given that the U.S. government is the largest owner of gold in the world, to what extent does anyone think that this backstops the U.S. dollar in some roundabout way?

Insignificant.

Somewhere I've seen the numbers, but U.S. gold holdings compared to currency in circulation and bank deposits mean something like a $5000 gold price and it quickly gets a lot worse from there.

[AdamA]

It would depend on what people spent the money they collected from the helicopter drop on.

If they used it to pay down debt, I would say no inflation (inflation being defined as a rise in prices of the things people buy).

But then wouldn't the bankers just re-circulate the money?  More mortgages, cars, etc, which would likely cause inflation.

[WildAboutHarry]

"That's right kids, she's going to help us by taking our picture.  No, she didn't bring any food.  I know, I'm not very happy about it either."

Not to make light of the Great Depression, but it looked a bit better in color:

http://www.dailymail.co.uk/news/article ... ssion.html

Of course many of these are early WWII vintage.

[Gumby]

Given what I know, I fully expect the U.S. dollar to collapse.  Every fiat currency has since the first one documented hundreds of years ago in China.  I just don't know when it will happen to ours.  Everything is in position that it could be now.  But we've been on the brink like this before (maybe not as bad, but who can tell?) and pulled it out so it might not happen in my lifetime.  I want to prepare either way.  The consequences elsewhere have always been really ugly.

AgAu,

Thanks for posting that. I think you're living proof of what I was trying to express. If one truly believes (or is worried) that the dollar is going to collapse in his or her lifetime, an ETF-based investing strategy alone will not be enough to provide any real security. It also requires a lifestyle that can provide for basic necessities and some hard assets in the hand.

[MediumTex]

AgAuMoney,

Thanks for the thoughtful response.

If the inflation you are expecting is as inevitable as you describe, why do you think the bond market (not just in the U.S. but also in Germany, Japan and the UK) isn't pricing it in in the form of higher interest rates?

I am assuming that you are anticipating an inflationary spiral at some point, not just the plodding 1-3% CPI inflation we have seen in recent years.

[Gumby]

AgAuMoney,

Thanks for the thoughtful response.

If the inflation you are expecting is as inevitable as you describe, why do you think the bond market (not just in the U.S. but also in Germany, Japan and the UK) isn't pricing it in in the form of higher interest rates?

I am assuming that you are anticipating an inflationary spiral at some point, not just the plodding 1-3% CPI inflation we have seen in recent years.

AgAuMoney,

As a follow-up question to MT's, what are your thoughts on a liquidity trap?

A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective. The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.

Source: http://www.newyorkfed.org/research/econ ... lgrave.pdf

And from Krugman...

Nobody else has the right to create monetary base, which can in turn be used either as currency or as bank reserves. When the Fed expands the money supply, the key thing isn't that it's buying Treasury bills, it's the fact that it's doing so by expanding the monetary base, which increases liquidity to the economy as a whole.

But in March [2008], and again this week [Sep 22 2008], interest rates on T-bills fell close to zero — liquidity trap territory. What does that do to the Fed's role?

You still see people saying, in effect, "never mind the zero interest rate, why not just print more money?" Actually, the Bank of Japan tried that, under the name "quantitative easing;" basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn't have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed's balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it's basically taking away with one hand what it's giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there's no market impact. That's why the liquidity trap makes conventional monetary policy impotent.

But why not purchase stuff other than T-bills? This can be thought of as changing the composition of the Fed's balance sheet, rather than enlarging it; and Ben Bernanke, in happier days, thought that might be an effective policy in a liquidity trap.

There are, however, three reasons to be doubtful about this stuff:

1. The Fed is now trying to move a much bigger rock: it is, in effect, trying to raise the price of financial assets other than T-bills by selling T-bills and buying other stuff. There's only (yes, "only") $800 billion of monetary base. There are, by contrast, many trillions of stuff other than T-bills, so the Fed has to make huge changes in its balance sheet to achieve any noticeable effect.

2. T-bills and other assets, such as long-term bonds, are probably much better substitutes for each other than T-bills are for monetary base — money is unique as a medium of exchange, whereas once you get past that you're only talking about competing stores of value. So it should take much larger changes in relative supplies to get major changes in asset prices.

3. The reason T-bills are an imperfect substitute for, say, corporate bonds — to the extent they are — is risk. Therefore, the reason changing the composition of the Fed's balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn't a role the central bank is meant to play; you're sliding over into fiscal policy.

Nonetheless, I guess the Fed had to try the "Bernanke twist." And it did — the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.

Source: The humbling of the Fed (wonkish)

Additional 'Liquidity Trap' Resources:

http://www.newyorkfed.org/research/econ ... lgrave.pdf
http://en.wikipedia.org/wiki/Liquidity_trap


Do you not see a possibility of us getting stuck in such a trap (as Japan has)?

Again, I appreciate your insight. This is a fascinating conversation.

[moda0306]

AgAu,

CPI-U may be up even with imputed rent... but, while that may be a valid measure of daily expense, people make decisions, often, based on balance sheets.  Right now, their debts overhang their assets.  Those debts represent PAST money "generated" by the private sector through borrowing.

Further, with growing foreign economies and limited commodity & food supply, is it any surprise these things are getting more expensive?  Is this a result of printing money or just supply & demand working as our population pushes our planet to the brink of productive capacity?

A couple of things can help make currency collapse self-fulfilling, 1) risk of default, causing higher interest rates, and therefore higher risk of default (lather, rinse, repeat) 2) complete distrust and loss of faith in all-things government and/or very bad social unrest, or 3) the kind of workforce bargaining power and balance-sheet flexibility our populace had in the 70's, that allowed higher oil prices and the dropping of a gold standard to create a spiral... #3 being quite a bit more based in prosperity than #1 and #2, so likely that's why we could get ahold of it.  As MT said though, without the ability for the private-sector to take on more debt and/or bargain for higher wages, #3 can't really generate... though foreign demand may continue to bring up oil prices, that is a natural effect of having to compete with 6 Billion other people for limited natural resources, not some monetary evil.

If you disagree with me, and think there's another factor, please share.  If you don't disagree with me, and think we'll suffer #1-#3, please walk me through how #1, #2, or #3 applies to us, or how it might soon apply to us.

Most fiat currencies that have collapsed have had very huge non-monetary-policy weights placed on their governments through war, currency pegs, social unrest or vast, widespread corruption and social distrust.  Blaming currency collapse on "fiat currencies" might be akin to blaming government collapse on having a military.  Maybe this is a correlation, not causation, type of scenario.

[moda0306]

I'll also add, that if commodity prices are going up, but aren't going to lead to the kind of 1970's-style balance-sheet expansions and wage increases, then they could very quickly go back down as we snap back into recession and reduced expected future demand.

If the only think the banks of the world can invest in to beat CPI-U (as our short-term bonds are not) is commodities (since our currency-collapse will certainly lead to our stocks doing poorly), then they have to take a chance on one of the most risky-volatile asset classes out there.

Back to the natural result of our banks expelling their dollars in a revolt of our money-printing, since they won't be buying our bonds anymore, we'll look at the more broad view that they either have to buy our products or could buy a factory or our stocks.

Does that really sound like a currency collapse scenario?  All of a sudden our stock prices surge and factories open up in the US because China's "sick of our dollars" and starts bidding up the prices of those things?

Sounds a lot more like a somewhat inflationary prosperity than a currency collapse.

If a collapse is imminent, China won't be buying our factories and stocks, and to reverse that, if China starts "investing in America," that's hardly some kind of hyperinflationary scenario as our business-assets get bid-up.

I guess I'll sum it up like this: I can't walk myself through a scenario of foreign USD holders divesting themselves of the dollar without some sort of prosperous, welcomed demand making its way to US shores, whether it be China buying our lead-free toys, Russia bidding up our stock-prices buy buying a bunch of the S&P 500, Germany buying a bunch of natural gas,or India sending dollars here to open up a currey factory.  This will be inflationary, but for "all the right reasons," for lack fo a better phrase.  How this fits into the hyperinflationary scenario I can't see for the life of me.

[Gumby]

A little more from Krugman about Liquidity Trap economics:

In an otherwise useful article about divisions in the Fed, Jon Hilsenrath says this:[code]
     The Fed is better equipped to solve some economic
     problems than others. As Mr. Bernanke noted in a now-
     famous 2002 speech, the Fed has the power to fight
     deflation—or falling wages and prices—by printing money.

     But the bank's tools aren't perfectly suited to reducing
     unemployment, which is influenced by a range of factors
     including fiscal policy, regulation and global demand.[/code]
Sorry, but that's totally wrong. The question is whether, at the zero bound, the Fed has the ability to increase aggregate demand — full stop. If it can increase aggregate demand, it can fight both deflation and unemployment; if not, not.

In a way, the problem with Bernanke's speech was that he made increasing demand and fighting deflation sound too easy. The Fed can print money, if you increase the supply of something its price will fall, end of story.

But as I tried to point out a long time ago, this simple story breaks down when short-term interest rates are near zero.

Here's one way to think about it: when the Fed conducts an open-market operation, buying short-term debt with newly printed money, this normally affects the short rate because bonds and money are imperfect substitutes: money yields less, but has the advantage of being something you can use directly to make payments, that is, it's more liquid.

But when you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they're holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.

So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.

In my simple 1998 model, there's only one way the Fed can affect things at all: by promising, credibly, to print more money in the future, when the zero lower bound no longer binds.

In practice, things are more complicated, because long-term bonds aren't perfect substitutes for short-term — so the Fed can get some traction by buying at longer maturities. But I always felt than Ben was overstating the effectiveness of such purchases. It's worth noting that in his "it" speech Bernanke's more-or-less specific proposal was to set a ceiling on the yield on two-year securities. How much would that accomplish now, when even the 2-year yield is only 0.67 percent?

Anyway, back to the original point: it's depressing to realize that two years into liquidity trap economics, the WSJ still doesn't seem to understand the basic point of why the zero bound is a problem.

Source: Nobody Understands The Liquidity Trap (Wonkish)

AgAu, I get the feeling that a lot of your concern about high inflation comes from a fear of a "helicopter drop." But there seems to be some logic in the idea that helicopter drop would do no good when rates are stuck at the zero bound (i.e. a Liquidity Trap). I would feel uncomfortable ignoring that theory as a possibility.

[doodle]

then they have to take a chance on one of the most risky-volatile asset classes out there.

I'm not sure that commodities are the most risky asset class currently for a number of reasons.

#1 - They can't go to zero.

#2 - They provide great hedge against currency crisis

#3 - A growing world both in population and in economic prosperity will continue to demand more of them

#4 - New supplies of many commodities are constrained by long period of underinvestment

[doodle]

Back to the natural result of our banks expelling their dollars in a revolt of our money-printing, since they won't be buying our bonds anymore, we'll look at the more broad view that they either have to buy our products or could buy a factory or our stocks.

Does that really sound like a currency collapse scenario?  All of a sudden our stock prices surge and factories open up in the US because China's "sick of our dollars" and starts bidding up the prices of those things?

Sounds a lot more like a somewhat inflationary prosperity than a currency collapse.

If a collapse is imminent, China won't be buying our factories and stocks, and to reverse that, if China starts "investing in America," that's hardly some kind of hyperinflationary scenario as our business-assets get bid-up.

I think the argument you are making is why Jim Rogers believes that commodities are in a long term win-win situation. If we return to a period of prosperity and growth then prices for commodities will rise. If we stay stuck in a deflationary spiral central banks around the world (China included) will print more money.

[Gumby]

then they have to take a chance on one of the most risky-volatile asset classes out there.

I'm not sure that commodities are the most risky asset class currently for a number of reasons.

#1 - They can't go to zero.

#2 - They provide great hedge against currency crisis

#3 - A growing world both in population and in economic prosperity will continue to demand more of them

#4 - New supplies of many commodities are constrained by long period of underinvestment

You're forgetting that commodity prices are often driven up by speculation. And when people speculate the price can rise quicker than the actual typical consumption of that commodity. People then start to conserve on their consumption, for fear of a shortage. This causes dramatic swings in the price. So, while you may be correct over the long term that, say, oil may hit an all-time high seven years from now, the price of oil can certainly crash over short term periods. When a market has the propensity to crash after speculative run-ups, that's a pretty risky and speculative market to be in.

That's why negatively correlated assets (such as LT Treasuries) tend to help soften the blow of those ups and downs. If you haven't experienced a 40% drop in your net worth (even after a nice run-up), then you don't know what I'm talking about. It's not as fun as you think it's going to be.

[Gumby]

I think the argument you are making is why Jim Rogers believes that commodities are in a long term win-win situation. If we return to a period of prosperity and growth then prices for commodities will rise. If we stay stuck in a deflationary spiral central banks around the world (China included) will print more money.

Just because more money is printed doesn't mean that commodities will rise. Commodities prices tend to be speculative. In a severe deflation, or a deflationary crash, there wouldn't be much real demand for oil, lumber, coal, or other commodities. The speculative prices would crash as they did in 2008-2009.

You really ought to learn more about 'liquidity trap' economics (when rates are stuck at the zero bound no matter how much money is printed) before you jump to conclusions about helicopter drops and spiraling inflation.

[moda0306]

A helecopter drop is one thing... but if we think about it QEII is hardly a helecopter drop.

A helecopter drop is a $5,000 debit card sent out to each individual out there.

QEII is taking one form of investment at a low rate of interest owned by a bank (ie, 1 year treasury bond), and buying it back with the same value cash out of thin air to add to the bank's reserves.

That cash is still looking like a good enough investment that they don't go buy a bunch of gold or other commodities with it.

I don't 100% know how to put this into macroeconomic terms, but there seems to be a fundamental difference between "trading" cash for bonds with an entity that WANTS to save/invest, and "giving" (helecopter) cash to those who want to consume...

...and to be honest, even with the helecopter money, most of that would end up paying back the banks for loans anyway, so in a roundabout way it may lead to a lot of the same effect.

People have deep balance sheet issues, which means cash is going to naturally gravitate not to consumption, but to repairing those balance sheets, either buy saving for a rainy day, investing in bonds, investing in stocks, or paying down debt... MAYBE buying some gold.... most likely though, it'll be paying down debt, as 5%-20% guaranteed return looks pretty good to most people right now.

This is why the big increase in money supply is having little effect on aggregate demand.

[doodle]

With regards to agriculture....how do prices fall significantly when about 75 million more mouths are added to the planet every year?

I am also wary of the argument that speculation is capable of driving prices too far past the supply/ demand price equilibrium. At the end of the day there must be a physical delivery. If you are a speculator that is holding contracts for 100 tons of corn but there isn't a demand for it, then you will be forced to sell at a big loss. Speculators cannot drive the price too far outside of the realm of real demand before it takes a violent snap back.

[Gumby]

On a side note, Does the Fed even have the legal authority to do a helicopter drop? (Perhaps this is a good question for HB Reader).

I'm not sure they do. The Fed would have to buy government debt and the Treasury would then hand out the money. The Treasury can't hand out the money without enabling legislation. And you can't get the legislation to hand out free money without Congress.

[Gumby]

With regards to agriculture....how do prices fall significantly when about 75 million more mouths are added to the planet every year?

I am also wary of the argument that speculation is capable of driving prices too far past the supply/ demand price equilibrium. At the end of the day there must be a physical delivery. If you are a speculator that is holding contracts for 100 tons of corn but there isn't a demand for it, then you will be forced to sell at a big loss. Speculators cannot drive the price too far outside of the realm of real demand before it takes a violent snap back.

Wow, you really don't think commodities aren't driven by speculation??

http://www.zerohedge.com/article/blame- ... peculation

[code]CME corn futures trade at a rate that is 10Xs global consumption of 861 million tones.

CME wheat turns over 5Xs global consumption.

NYMEX Crude volume is equal to trade at 5Xs total global consumption of 32 billion barrels. [/code]
Source: http://www.zerohedge.com/article/blame- ... peculation

If the Fed prints more money — to try to pull us out of a liquidity trap — it may just lead to more speculative bubbles and crashes in commodities. Jim Rogers wants you to take that roller coaster ride. You may do well over the long run, but it will be an awful ride along the way. That's why I see his portfolio possibly being a good VP for you (with money you can afford to lose). But, the Jim Rogers portfolio doesn't make sense as a replacement for your PP because it will be too volatile to stomach.

[moda0306]

doodle,

Ok, Let's for a second assume there's not only a disgust for our bonds, but China & others aren't looking to buy our stocks either because, as you say, commodities look so appealing.

To divest themselves of dollars, it still brings us back to foregners spending them here... otherwise it's just a shell game.

So instead of buying our widgets, building a factory, or buying the S&P, China & World will buy our natural gas and drive the price up.  In fact, to actually have a deep divestment of dollars directed towards commodities, I'd imagine they'd be buying our natural gas, steel, food, oil, etc.

This is probably the scenario closest to a stagflation or hyperinflation that's possible to imagine, but it's still way off the mark IMO, not just in plausibility, but in being able to associate any disastrous economic event with this new demand for our natural resources.  It's still money coming into the US demanding a product we have a lot of.  Maybe it's not the best product for job-growth and cheap energy, but it's still demand-pull inflation and I have a lot of trouble seeing how this is the beginning of a hyperstagflationary event.

Backing up a bit, I see any mass-demand for commodities as a somewhat unlikely but (oddly) in some ways perfectly natural last-ditch effort of players in a growing world economy with depleting resources.  This is fundamentally different than a collapse of a reserve-currency (and world economy as a result (I agree with Gumby)), as the very reason for the commodity hoard in the first place was unprecadented global growth and/or depleting resources.  The daily movements of a reserve currency still function around those realities... those realities, to me, don't seem to lead to hyperinflation, just "sh!t that people need and are running out of costing more."

[MediumTex]

The problem with most commodities is that when the price runs up the market delivers more of them, which tends to push the price back down.

Corn goes up, next season more farmers plant more corn, guess what happens next season?  Corn prices drop.

Oil has a different dynamic.  In the last 10 years the price of oil has risen by a factor of 8 but world oil production has only increased a little.  An economist would tell you that this price runup should have resulted in an enormous world oil glut.  A geologist, however, would tell you it's not that simple.  The story for gold is similar.

[doodle]

Medium Tex,

On the surface that should happen with ag commodities, but there are limits to the current green revolution that is heavily dependent on mechanized machinery (fossil fuels), limited nutrient and fertilizer supplies, crop yields that have been increased greatly over the past 50 years....

I would be interested to see if the growth in crop yields per acre of land approximate a "peak oil" type flattening over the last decade. If this is the case then I think it bolsters the ag commodity secular trend.

The reality is that global stores of grains are at some of their lowest levels in decades despite the huge runup in price. It seems there are supply contraints. 

[moda0306]

doodle,

Looking forward to hearing your retort to my assertion regarding a foreign dollar divestment into the US to buy our commodities...

Don't leave me hangin'.

[MediumTex]

Medium Tex,

On the surface that should happen with ag commodities, but there are limits to the current green revolution that is heavily dependent on mechanized machinery (fossil fuels), limited nutrient and fertilizer supplies, crop yields that have been increased greatly over the past 50 years....

I would be interested to see if the growth in crop yields per acre of land approximate a "peak oil" type flattening over the last decade. If this is the case then I think it bolsters the ag commodity secular trend.

The reality is that global stores of grains are at some of their lowest levels in decades despite the huge runup in price. It seems there are supply contraints. 

As long as we are burning crops in the form of ethanol and devoting premium farmland to a killer like tobacco I'm not concerned about world food supplies.

Modern famines are more a political failure than a food supply failure.  Hungry people are easier for oppressive regimes to keep in line.

[moda0306]

Hungry people don’t stay hungry for long
They get hope from fire and smoke as the wheat grows strong
Hungry people don’t stay hungry for long
They get hope from fire and smoke as they reach for the dawn

Anybody listen to Rage Against the Machine, here?  Pretty much lefty anarchists, but they are probably in my top 5 favorite all-time bands.