PP = inflation

[Storm]

I see a great deal of logic in the argument for deflation, but I can't reconcile it with the price if gold over the past decade.  Any explanations?

Adam, I don't necessarily know why, but gold has historically done well in times of inflation as well as deflation.  Perhaps it's safe haven status gives it a boost during all times of financial instability.  You could look at gold prices during the 1930s as a good measure of what happens during long term deflation, although those may be somewhat skewed due to government manipulation of the market at the time.

[Gumby]

One thing I have enjoyed about this forum, and this particular discussion, is that the PP allows us to debate deflation/inflation with a purely neutral mindset. In any other forum or discussion, participants would almost certainly have a bias that followed their investment positions. It's strangely surreal to not be emotionally wound up about which path we go down.

[6 Iron]

RE inflating our way out of debt, take a look at this month's Contrary Investor commentary:

http://contraryinvestor.com/mo.htm

Nice link, Tex. Do you subscribe to their newsletter, or are you familiar with their investing philosophy?

This has been my favorite thread; it is like a mini econ course. Thanks to all.

[MediumTex]

RE inflating our way out of debt, take a look at this month's Contrary Investor commentary:

http://contraryinvestor.com/mo.htm

Nice link, Tex. Do you subscribe to their newsletter, or are you familiar with their investing philosophy?

No, I just read their free monthly market commentary.  It is always outstanding.

[moda0306]

I just tried searching for the term "malinvestment" on PK's blog.... nothing.  He does a good job of knocking down quasi-straw men (low-intelligence politicians on the right), but when it comes to addressing the point of lowered interest rates and government spending actually leading to worthwhile production, he falls flat.  To him, anything that gives someone a "job" (one person digging a ditch and and another filling it in) is worth stealing from productive citizens for.

[Storm]

Here's a great little video showing how QE actually works:  http://hosted.ap.org/specials/interacti ... index.html

[Wonk]

I see a great deal of logic in the argument for deflation, but I can't reconcile it with the price if gold over the past decade.  Any explanations?

Even before the introduction of the Fed in 1913 and while the U.S. was on a gold standard, there are repetitive business cycles(cyclical and secular).  Capital gets allocated (and misallocated) during prosperous times and destroyed during lean times as malinvestments are cleared.  Since 1913, the business cycles have been magnified.

Historically, gold has been thought to be the best form of money with no risk of default.  When the day of reckoning arrives in an overheated economy, investors seek the refuge of gold and sell off paper assets like stocks, bonds and other debt instruments until they perceive the environment to be safe again.

Under a gold standard (for instance, the U.S. in the early 30's), U.S. dollars were as good as gold, so investors sought the safety of cash.  Under a fiat system, The Fed is able to debase the currency since it has no intrinsic value (soft default).  A good case study would be the 1970s when the U.S. defaulted on it's international obligations under Bretton Woods I to provide gold upon redemption.  Faced with the threat of a debased store of value, gold remains a strong alternative.

Gold is also useful in a deflationary environment where the government is attempting to debase the currency, but can't.  This scenario is usually accompanied by copious amounts of deficit fiscal spending by a sovereign entity.  If investors feel there is an increased threat of outright sovereign default(hard default), they'll use gold as insurance to hedge the perceived default risk.

In either scenario, the market perceives higher risk in typically safe stores of value, so it increasingly prefers the alternative that can't be debased or defaulted on--gold.

[MediumTex]

For anyone who hasn't actually watched Richard Nixon's 1971 announcement of the closing of the gold window, please watch it at the link below.  It's a good investment of four minutes.

http://www.youtube.com/watch?v=iRzr1QU6K1o

Here is where he is talking about fixing the inflation problem through wage and price freezes:

http://www.youtube.com/watch?v=Wv4gpyfL ... re=channel

In retrospect, it is a truly astonishing piece.

One of the many bizarre things about this speech is that Nixon was a highly intelligent person.  I'm surprised that he wouldn't have told his people to come up with something better than this moronic description of a bunch of moronic policies.  Maybe people didn't follow the financial news as closely then as they do today and it didn't sound as dumb back then.

No matter how many times I watch this speech or read the text, I'm always left scratching my head.

[Lone Wolf]

Sincere thanks for the link to the two Nixon clips.  "Astonishing" is right.  I'd of course read plenty about these policies but to hear them actually announced and (very weakly) "justified" is surreal.

There's something stupid in almost every sentence of that speech.  I find myself feeling no better when Nixon assures me that I've no need to worry about the "bugaboo" of devaluation.  Not to mention the "temporary" suspension of convertibility... all in the interest of "defending the dollar"!

You've got tariffs, mysterious references to eeevil "speculators", protectionist tariffs, and as the cherry on top, a general freeze on all prices and wages.  It's wrapped up in a patchwork of bad economics and nonsense explanations, all delivered in that creepy Nixon style that makes you wonder if he's holding an ax behind his back.

Note to self: Do not ever rely on politicians to enact sensible policies or in fact even have the slightest idea what they are talking about.

[MediumTex]

There's something stupid in almost every sentence of that speech.

Just so that we can approach the matter with good resources, the text of the speech is below.

There are a few more stupid things that weren't in the two clips I posted.

Good evening:

I have addressed the Nation a number of times over the past 2 years on the problems of ending a war. Because of the progress we have made toward achieving that goal, this Sunday evening is an appropriate time for us to turn our attention to the challenges of peace.

America today has the best opportunity in this century to achieve two of its greatest ideals: to bring about a full generation of peace, and to create a new prosperity without war.

This not only requires bold leadership ready to take bold action – it calls forth the greatness in a great people.

Prosperity without war requires action on three fronts: We must create more and better jobs; we must stop the rise in the cost of living; we must protect the dollar from the attacks of international money speculators.

We are going to take that action – not timidly, not half-heartedly, and not in piecemeal fashion. We are going to move forward to the new prosperity without war as befits a great people – all together, and along a broad front.

The time has come for a new economic policy for the United States. Its targets are unemployment, inflation, and international speculation. And this is how we are going to attack those targets.

First, on the subject of jobs. We all know why we have an unemployment problem. Two million workers have been released from the Armed Forces and defense plants because of our success in winding down the war in Vietnam. Putting those people back to work is one of the challenges of peace, and we have begun to make progress. Our unemployment rate today is below the average of the 4 peacetime years of the 1960’s.

But we can and we must do better than that.

The time has come for American industry, which has produced more jobs at higher real wages than any other industrial system in history, to embark on a bold program of new investment in production for peace.

To give that system a powerful new stimulus, I shall ask the Congress, when it reconvenes after its summer recess, to consider as its first priority the enactment of the Job Development Act of 1971.

I will propose to provide the strongest short-term incentive in our history to invest in new machinery and equipment that will create new jobs for Americans: a 10 percent Job Development Credit for 1 year, effective as of today, with a 5 percent credit after August 15, 1972. This tax credit for investment in new equipment will not only generate new jobs; it will raise productivity; it will make our goods more competitive in the years ahead.

Second, I will propose to repeal the 7 percent excise tax on automobiles, effective today. This will mean a reduction in price of about $200 per car. I shall insist that the American auto industry pass this tax reduction on to the nearly 8 million customers who are buying automobiles this year. Lower prices will mean that more people will be able to afford new cars, and every additional 100,000 cars sold means 25,000 new jobs.

Third, I propose to speed up the personal income tax exemptions scheduled for January 1, 1973, to January 1, 1972 – so that taxpayers can deduct an extra $50 for each exemption 1 year earlier than planned. This increase in consumer spending power will provide a strong boost to the economy in general and to employment in particular.

The tax reductions I am recommending, together with this broad upturn of the economy which has taken place in the first half of this year, will move us strongly forward toward a goal this Nation has not reached since 1956, 15 years ago: prosperity with full employment in peacetime.

Looking to the future, I have directed the Secretary of the Treasury to recommend to the Congress in January new tax proposals for stimulating research and development of new industries and new techniques to help provide the 20 million new jobs that America needs for the young people who will be coming into the job market in the next decade.

To offset the loss of revenue from these tax cuts which directly stimulate new jobs, I have ordered today a $4.7 billion cut in Federal spending.

Tax cuts to stimulate employment must be matched by spending cuts to restrain inflation. To check the rise in the cost of Government, I have ordered a postponement of pay raises and a 5 percent cut in Government personnel.

I have ordered a 10 percent cut in foreign economic aid.

In addition, since the Congress has already delayed action on two of the great initiatives of this Administration, I will ask Congress to amend my proposals to postpone the implementation of revenue sharing for 3 months and welfare reform for 1 year.

In this way, I am reordering our budget priorities so as to concentrate more on achieving our goal of full employment.

The second indispensable element of the new prosperity is to stop the rise in the cost of living.

One of the cruelest legacies of the artificial prosperity produced by war is inflation. Inflation robs every American, every one of you. The 20 million who are retired and living on fixed incomes – they are particularly hard hit. Homemakers find it harder than ever to balance the family budget. And 80 million American wage earners have been on a treadmill. For example, in the 4 war years between 1965 and 1969, your wage increases were completely eaten up by price increases. Your paychecks were higher, but you were no better off.

We have made progress against the rise in the cost of living. From the high point of 6 percent a year in 1969, the rise in consumer prices has been cut to 4 percent in the first half of 1971. But just as is the case in our fight against unemployment, we can and must do better than that.

The time has come for decisive action – action that will break the vicious circle of spiraling prices and costs.

I am today ordering a freeze on all prices and wages throughout the United States for a period of 90 days. In addition, I call upon corporations to extend the wage-price freeze to all dividends.

I have today appointed a Cost of Living Council within the Government. I have directed this Council to work with leaders of labor and business to set up the proper mechanism for achieving continued price and wage stability after the 90-day freeze is over.

Let me emphasize two characteristics of this action: First, it is temporary. To put the strong, vigorous American economy into a permanent straitjacket would lock in unfairness; it would stifle the expansion of our free enterprise system. And second, while the wage-price freeze will be backed by Government sanctions, if necessary, it will not be accompanied by the establishment of a huge price control bureaucracy. I am relying on the voluntary cooperation of all Americans – each one of you: workers, employers, consumers – to make this freeze work.

Working together, we will break the back of inflation, and we will do it without the mandatory wage and price controls that crush economic and personal freedom.

The third indispensable element in building the new prosperity is closely related to creating new jobs and halting inflation. We must protect the position of the American dollar as a pillar of monetary stability around the world.

In the past 7 years, there has been an average of one international monetary crisis every year. Now who gains from these crises? Not the workingman; not the investor; not the real producers of wealth. The gainers are the international money speculators. Because they thrive on crises, they help to create them.

In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation’s currency is based on the strength of that nation’s economy – and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators.

I have directed Secretary Connally to suspend temporarily the convertibility of the American dollar except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.

Now, what is this action – which is very technical – what does it mean for you?

Let me lay to rest the bugaboo of what is called devaluation.

If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today.

The effect of this action, in other words, will be to stabilize the dollar.

Now, this action will not win us any friends among the international money traders. But our primary concern is with the American workers, and with fair competition around the world.

To our friends abroad, including the many responsible members of the international banking community who are dedicated to stability and the flow of trade, I give this assurance: The United States has always been, and will continue to be, a forward-looking and trustworthy trading partner. In full cooperation with the International Monetary Fund and those who trade with us, we will press for the necessary reforms to set up an urgently needed new international monetary system. Stability and equal treatment is in everybody’s best interest. I am determined that the American dollar must never again be a hostage in the hands of international speculators.

I am taking one further step to protect the dollar, to improve our balance of payments, and to increase jobs for Americans. As a temporary measure, I am today imposing an additional tax of 10 percent on goods imported into the United States. This is a better solution for international trade than direct controls on the amount of imports.

This import tax is a temporary action. It isn’t directed against any other country. It is an action to make certain that American products will not be at a disadvantage because of unfair exchange rates. When the unfair treatment is ended, the import tax will end as well.

As a result of these actions, the product of American labor will be more competitive, and the unfair edge that some of our foreign competition has will be removed. This is a major reason why our trade balance has eroded over the past 15 years.

At the end of World War II the economies of the major industrial nations of Europe and Asia were shattered. To help them get on their feet and to protect their freedom, the United States has provided over the past 25 years $143 billion in foreign aid. That was the right thing for us to do.

Today, largely with our help, they have regained their vitality. They have become our strong competitors, and we welcome their success. But now that other nations are economically strong, the time has come for them to bear their fair share of the burden of defending freedom around the world. The time has come for exchange rates to be set straight and for the major nations to compete as equals. There is no longer any need for the United States to compete with one hand tied beyond her back.

The range of actions I have taken and proposed tonight – on the job front, on the inflation front, on the monetary front – is the most comprehensive new economic policy to be undertaken in this Nation in four decades.

We are fortunate to live in a nation with an economic system capable of producing for its people the highest standard of living in the world; a system flexible enough to change its ways dramatically when circumstances call for change; and, most important, a system resourceful enough to produce prosperity with freedom and opportunity unmatched in the history of nations.

The purposes of the Government actions I have announced tonight are to lay the basis for renewed confidence, to make it possible for us to compete fairly with the rest of the world, to open the door to new prosperity.

But government, with all of its powers, does not hold the key to the success of a people. That key, my fellow Americans, is in your hands.

A nation, like a person, has to have a certain inner drive in order to succeed. In economic affairs, that inner drive is called the competitive spirit.

Every action I have taken tonight is designed to nurture and stimulate that competitive spirit, to help us snap out of the self-doubt, the self-disparagement that saps our energy and erodes our confidence in ourselves.

Whether this Nation stays number one in the world’s economy or resigns itself to second, third, or fourth place; whether we as a people have faith in ourselves, or lose that faith; whether we hold fast to the strength that makes peace and freedom possible in this world, or lose our grip – all that depends on you, on your competitive spirit, your sense of personal destiny, your pride in your country and in yourself.

We can be certain of this: As the threat of war recedes, the challenge of peaceful competition in the world will greatly increase.

We welcome competition, because America is at her greatest when she is called on to compete.

As there always have been in our history, there will be voices urging us to shrink from that challenge of competition, to build a protective wall around ourselves, to crawl into a shell as the rest of the world moves ahead.

Two hundred years ago a man wrote in his diary these words: “Many thinking people believe America has seen its best days.”? That was written in 1775, just before the American Revolution – the dawn of the most exciting era in the history of man. And today we hear the echoes of those voices, preaching a gospel of gloom and defeat, saying the same thing: “We have seen our best days.”?

I say, let Americans reply: “Our best days lie ahead.”?

As we move into a generation of peace, as we blaze the trail toward the new prosperity, I say to every American: Let us raise our spirits. Let us raise our sights. Let all of us contribute all we can to this great and good country that has contributed so much to the progress of mankind.

Let us invest in our Nation’s future, and let us revitalize that faith in ourselves that built a great nation in the past and that will shape the world of the future.

Thank you and good evening.

[Wonk]

Swinging to the other side of this topic, I went back to take a look at Clive's PP data from Japan: 2.5% real.  PP investors close to retirement and planning on a 4% SWR should be crossing their fingers for some stateside inflation.  Otherwise, a 4% WR would look to be a failure in a Japaflation context.

[MediumTex]

Swinging to the other side of this topic, I went back to take a look at Clive's PP data from Japan: 2.5% real.  PP investors close to retirement and planning on a 4% SWR should be crossing their fingers for some stateside inflation.  Otherwise, a 4% WR would look to be a failure in a Japaflation context.

Didn't the yen appreciate 65% over the last 20 years?

Is that included in the 2.5% real?  I assume that a 65% appreciation in the currency means that it will buy more than it used to.

[Lone Wolf]

Swinging to the other side of this topic, I went back to take a look at Clive's PP data from Japan: 2.5% real.  PP investors close to retirement and planning on a 4% SWR should be crossing their fingers for some stateside inflation.  Otherwise, a 4% WR would look to be a failure in a Japaflation context.

This might need a closer look.  With no 30-year bonds available to Japanese investors, I think that the Japanese "PP" had to make a pretty serious compromise in its LT bond holdings.  I'm pretty sure its overall Treasury barbell was too short in duration to behave properly in the deflation.

[Wonk]

MT,

Stronger relative to what? USD or commodities?  As far as I know, Clive just used nominal returns and subtracted inflation figures.

LW,

You're correct about 30yr bonds.  I believe the 25/25 barbell was replaced with 50% 10yr bonds--yielding about the same results. 

[Gumby]

Stronger relative to what? USD or commodities?  As far as I know, Clive just used nominal returns and subtracted inflation figures.

Be sure to see Purchasing Power Parity as well as the Big Mac Index when looking into this.

For instance, in 1986 a Big Mac in Japan cost ¥370. In 2006, a Big Mac in Japan cost ¥250.
(Source: http://www.bigmacindex.org)

[MediumTex]

I think Wonk and Clive make good points that a Japanese PP may not have provided as impressive a performance as a U.S. PP in recent decades.

I wonder how other Japanese allocation have done.  Is there a Japanese Wellesley?  I wonder how a 65/35 bond/stock approach has done in Japan.

In a few years, however, we may look back on things and note how a Japanese investor REALLY needed the protection offered by the PP.  I think the Japanese economic nightmare is only in about the sixth inning right now.

[moda0306]

MT,

What do you see the 7-9th innings looking like for Japan?  Currency collapse?

[MediumTex]

MT,

What do you see the 7-9th innings looking like for Japan?  Currency collapse?

I really don't know.

What I do know is that Japan's economy will continue to contract simply because its population is contracting.  Population contraction pinches both production and consumption.  Thus, even if you were able to automate the entire economy where no one needed to engage in any productive activities, if the population is declining there will still be less demand across the whole economy for whatever the economy is producing.

The idea that Japan can just cruise along with trade surpluses in a way that neutralizes the contraction in the domestic population is, IMHO, naive.

The nice thing for the U.S. is that whatever happens to Japan will give us a good heads up regarding what we may be looking at 5-10 years later.

A country can't run up a debt equal to 200% of its GDP against the backdrop of a structural contraction in the economy without something bad happening sooner or later.  What that bad thing is, I don't know.

[Wonk]

IMO the endgame on Japan is debt service.  When they can no longer service the debt, there will be a great awakening.  Whether that is at 300% or 15000%, I don't know.  But as MT says, at least they'll serve as a canary in the coal mine for us.

[longeyes]

Demographics is destiny.  As is culture.  Japan is a country trying to use monetary policy as human growth hormone.

[fnord123]

My bet is on Japan devaluing/inflating their way out of it.  As far as I know most of the Japanese bond issues have been fixed rate type bonds rather than TIPS-like instruments.  So they can just print print print, ala The Bernank.  This would make their exports cheaper (although input prices would go up, to some degree countering this).  In any case it would reduce their standard of living, which is unavoidable given their debt burden and demographics, but it would avoid a catastrophic default.  If they do it judiciously, they might even avoid hyperinflation.

This is exactly what I expect the USA to do (and in some ways is already doing, with the Fed monetizing the majority of all Federal debt issuance over the last few months).