A 5th Economic Condition?

[cowboyhat]

In the post "HB's Four Economic Environments" Tortoise noted that prosperity, inflation, recession, and deflation can be thought of as the 4 possible combinations of increasing or decreasing money supply with good and bad business conditions.

Prosperity would be increasing money supply with good business conditions
Inflation would be increasing money supply with bad business conditions
Recession would be decreasing money supply with good business conditions
Deflation would be decreasing money supply with bad business conditions

Harry Browne noted that recession is the most short lived of his four states because in a fiat system decreasing money supply is not consistent with good business conditions. He said that for political reasons in a recession the central bank must begin increasing the money supply to prevent a transition to deflation. In other words in a fiat system decreasing money supply quickly leads to bad business conditions. The other three conditions seems to be relatively stable and can persist for years.

Harry Browne noted many times that one of the hallmarks of inflation is high interest rates.

Where are we now? We have poor business conditions and a hugely increasing money supply (inflation in the scheme above), yet interest rates are low.

Are we in a transition between periods? If so why have we been in transition for two years?

I am a PP investor and this is not an idle question. Is inflation without high interest rates possible or are we not in an inflationary period? If not where are we in Harry Browne's scheme?

[moda0306]

I don't think "inflation" and "deflation" were really trying to talk about good or bad business conditions... in fact, that's exactly what "prosperity" & "recession" were referring to.  I almost think of it as the qualitative and quantitative natures of your economy.  Inflation/Deflation have to do with the money supply and price levels (quantitative), and really aren't trying to say anything more than that about the economy.  Prosperity & Recession refer to real growth and the business environment.  Yes, it may seem difficult to have deflation & a growing economy with good business conditions, but it's possible.

Recessions are bad for the business environment... now a deep "deflationary" recession or depression may be worse than a typical recession, but that's just the two axis working in tandem.  Any abrupt change in prices or money supply is likely to be disruptive to an economy... so yes they're interlinked.

[moda0306]

Further, regarding inflation, yes it's usually associated with high interest rates, but where we are now is a domestic deleveraging (deflationary to business valuations, homes, wages, etc) but growing foreign economies, structural issues demanding a certain amount of fuel be used simply to heat our homes, and depleting resources, leading to commodity inflation.  This is how you can get inflationists and deflationists screaming at each other at the top of their lungs and just want to shut the TV off cuz you don't know up from down after Krugman and Schiff are done fighting.

Gold will usually react to "bad" inflation, especially when interest rates are not. If CPI-U is growing at 2% every year (not bad inflation), but it's mostly made up of commodity inflation, and wages and homes are deflating or flat, then gold will rise, especially if risk-free short-term rates are at 0-1.5%.

So inflation is a finnicky thing, especially when looking at it in terms of gold and the PP.  One might not think that CPI rising 2-4% per year would warrant gold's rise by 20% per year, but if you look at what is structurally making up the inflation figures and the implications of that on central banks, interest rates, etc, then it all starts to make a bit more sense.

[moda0306]

I am truly curious as to what HB would have to say about inflation/deflation and gold today.  "Inflation" has been such a neutered term and so many people have taken on credit risk or leverage to hedge against it.

It's a lot more fun to ignore treasuries and buy risky bonds and growth stocks, as well as go 3.5% into a McMansion (thinking back to 2000 or so) and buy a BMW on credit than it is to buy an asset (gold) that sits in a safe and looks pretty.  People were given this dumbed-down version of inflation that was so easily to beat: "If inflation is achieved by artificially lowering interest rates, then borrow money to buy hard assets (by "hard," homes, cars, consumer goods and risky investments were all in this basket)."  This lead to a housing boom that only served that logic and it seemed so genius at the time...  Inflation had been conquered, and used against the very people trying to impose it on us.

Well that all broke down in about 2006-2007, and the SHTF for real in 2008, and we all realized that peoples' priorities can change on a dime, and we were all (or most of us) victims of groupthink.  Buying a BMW with a 5-year loan while investing every dollar you owned in stocks no longer was going to work to keep your purchasing power of things you'll actually need.  I think 2008 and still today is shining a light, for those of us willing to look, on what inflation truly means in the real world, and the short and long-term implications on interest rates.  Both 1) expanding the money supply, and 2) depletion of resources with growing foreign economies are going to have some expected and some unexpected short- and long-term effects on the prices we pay for needs & wants.  Some prices going up are much more important/scary than others, and buying consumer goods on credit and growth stocks on margin was a pipe-dream solution to inflation that was simultaneously too-good-to-be-true and so convenient for the populace to succumb to.

Ok, I'm off the soap box.  

[Gumby]

I believe Harry Browne once said that if you ask 10 economists what caused the inflation of the late 70s, you would get 10 different answers. He then went on to point out that if you can't even get anyone to agree what caused inflation 30 years ago, it's unlikely that economists will be able to determine what's actually happening right now (let alone the future).

As far as the PP goes, the idea is that one condition will eventually present itself over the long run. I think the market hasn't quite decided what's happening yet. Everyone is very confused — which makes holding the four assets even more appealing.

[moda0306]

Also, gold thrives on confusion.  The spread between its industrial value and its monetary value if all fiat currencies were to prove invalid is so absolutely massive that it acts as a leveraged fear-meter.  Any time commodities are growing in price far-faster than interest rates that fear meter is going to tick-up nicely.

[MediumTex]

Back to the OP, I wouldn't agree that the money supply is expanding dramatically right now.

The Fed is trying to offset the monetary contraction that accompanies private sector deleveraging.  I think the net effect has been that the money supply has stayed relatively constant.

With respect to the four economic conditions, the way I explain it to people is that at any given point in time the economy is either expanding or contracting, and the money supply is either expanding or contracting.  This means that there can only be four economic conditions (unless you want to define the term "economic conditions" differently).

[cowboyhat]

Okay, let's use your definitions. Expanding or contracting economy and expanding or contracting money supply.

In Harry Browne's system gold is supposed to be going up dramatically when money supply is expanding and the economy is contracting. And interest rates are also supposed to be increasing dramatically.

I think we can agree that gold has been going up dramatically.
I think we can agree that interest rates are modest.

The question is then whether gold is right about the money supply or interest rates are right about the money supply... The thing is I don't think either gold or interest rates can be wrong. Which makes me wonder if they aren't telling us about something more than the money supply. Maybe something Harry Browne didn't talk about.

[MediumTex]

We're in a deflationary period.  One would expect interest rates to be low in such an environment.

Right now, interest rates are also apparently not keeping up with inflation, which is bullish for gold.

I don't think anything all that unusual is going on right now.

I think that if there was a blind spot in Harry Browne's thinking, it was his belief that the government could create inflation if it wanted to.  We are finding that this is more difficult than it sounds when in the midst of a deflationary environment. 

I'll bet that if Harry Browne had come of age in the 1930s instead of the 1970s he would have had a more nuanced understanding of deflation.

[smurff]

Gold will usually react to "bad" inflation, especially when interest rates are not. If CPI-U is growing at 2% every year (not bad inflation), but it's mostly made up of commodity inflation, and wages and homes are deflating or flat, then gold will rise, especially if risk-free short-term rates are at 0-1.5%.

So inflation is a finnicky thing, especially when looking at it in terms of gold and the PP.  One might not think that CPI rising 2-4% per year would warrant gold's rise by 20% per year, but if you look at what is structurally making up the inflation figures and the implications of that on central banks, interest rates, etc, then it all starts to make a bit more sense.

Moda, this is enlightening.  

Residential real estate values--where Americans typically hold the majority of the wealth that they controlled--declined 30% net throughout the country since 2006.  In some places--Phoenix, Riverside, Detroit, Orlando, Miami--they have declined nearly 60 percent.  The decline would have been greater had banks been allowed to foreclose as rapidly as they wanted and dumped those foreclosed properties on the market.  They've been held off the market and released (foreclosed on) gradually to prevent an outright collapse around the USA, so there is more decline to come.  There are predictions on how much more decline to expect, but we all know about predictions.

Past inflationary periods, like the 1970s when HB did lots of his writing, saw residential real estate values increase, not decrease.  Treasury interest rates went up, but gold skyrocketed from $40+ to $800+ in nominal value (in less than a decade) a nearly 2000% increase using top-of-my-head calculations.    (Yes, there were other things to take into account:  We went off the Breton Woods standard then, but at the rate the Congress and Moody's are moving today, we're likely to go off the Treasury=AAA standard, too.)

If one were to look at the changes in 1970's residential values vs. gold prices vs. CPI-U, and compare that to the 2006-2016 (actual predicted, with the warning that we all know how wrong predictions can be) changes in residential values vs. gold prices vs. CPI-U, I wonder whether the relationship would hold. 

No, I haven't done the calculations, I'm just asking...

[Tortoise]

I think we can agree that gold has been going up dramatically.
I think we can agree that interest rates are modest.

The question is then whether gold is right about the money supply or interest rates are right about the money supply... The thing is I don't think either gold or interest rates can be wrong. Which makes me wonder if they aren't telling us about something more than the money supply. Maybe something Harry Browne didn't talk about.

This is a subtle issue, and I'm glad you brought it up. In one of his "Money Talk" radio show episodes, HB elaborated on the distinction between (a) uncertain environments, and (b) inflationary environments. He said that in both environments, people flock to money; it's just that the definition of "money" is slightly different in those two cases.

In uncertain environments, such as when wars or financial crises suddenly break out, HB said the money people tend to flock to is generally cash. They sell various assets to obtain cash and thereby increase the liquidity and stability of their wealth. If the financial crisis is particularly bad, though, and involves the risk of the government's default, then the preferred form of cash is the U.S. dollar.

By contrast, HB said that in inflationary environments--whether actual or anticipated--the value of the cash itself is now in question. So people will instead flock to a more stable form of money: either the world's reserve currency (U.S. dollars) or the world's "#2 currency" (gold). If the inflation in question pertains to the U.S. dollar itself, then the preferred form of money is gold.

Although HB didn't explicitly say this, my guess would be that if an uncertain environment is so incredibly uncertain that even the stability of the U.S. government or economy is called into question, then some people will just skip over the U.S. dollars entirely and flock into the #2 currency (gold).

That's my theory as to why gold is doing well right now while simultaneously U.S. interest rates are modest. We are in an environment of extreme uncertainty, not inflation, so some people are flocking to U.S. dollars (hence the modest interest rates) and others who feel even more uncertain are flocking directly to gold (hence the rise in gold's price).

[doodle]

The central question in my mind is what will the outcome be if the central banking system attempts to dam the natural deflationary pressures that we should be experiencing after a huge 40 year credit bubble? The potential deflationary pressures from higher commodity prices, aging demographics, international wage competition etc. are so extreme that the central bank will have to go to extreme measures to try and prop up the economy to prevent deflation.

I guess this begs the question of whether it is possible to slowly pop a balloon. Many Austrian style economists with decent if not solid track records Faber, Rogers, Schiff etc. think that continued monetary interference on the part of the Fed could result in a crisis a few years down the road.

I think we have a secular deflationary environment that we are trying avoid by reflating the bubble. Unfortunately the real problem is that the economic issues that we face seem to be more structural rather than cyclical / transitory. Addressing the symptoms while failing to address the underlying causes of our situation will only lead to a larger crisis down the road. Unfortunately, the leadership and political will to do the right thing seem to be sorely lacking. Most Americans and our leadership don't want to accept the hangover that follows the party. Unfortunately, the hair of the dog policy we are currently following (although providing temporary relief) will only make the detox that much more difficult.

My head tells me that we are in a nuanced environment where many outcomes are possible (even good ones). My gut tells me that there are darker days ahead.

[doodle]

good article about our "5th economic condition" http://www.nytimes.com/2011/07/17/sunda ... .html?_r=1

[MediumTex]

good article about our "5th economic condition" http://www.nytimes.com/2011/07/17/sunda ... .html?_r=1

That's a good article about a deleveraging economy, but the conditions the article is describing are well within Browne's four economic environment paradigm.

[stone]

Medium Tex "I think that if there was a blind spot in Harry Browne's thinking, it was his belief that the government could create inflation if it wanted to.  We are finding that this is more difficult than it sounds when in the midst of a deflationary environment."

I thought that the Fed itself said that its capacity to genuinely halt deflation by using monetary policy was much less effective than that of fiscal policy by the government. Dropping interest rates or swapping bonds for bank reserves won't get people spending. But putting money in the pockets of people who currently are foregoing consumption due to lack of money might. I guess the blind spot would be that such potential fiscal policy is actually proving politically unavailable.  Supposidly offsetting deflation by inducing commodity price spikes, as is done now, seems moronic to me.

What will it mean for the PP having ever greater mountains of bank reserves and below inflation interest rates whilst the median wage drops in real terms? I guess things will swing around ever more violently and PP returns will not be as good as they were but they will be much better than most other strategies for retail savers. My guess is that at some point some shock will have to come along to hit gold. The current set up seems to project a never ending exponential increase for gold. Surely that means that the current set up will be changed dramatically to crash gold?

[MediumTex]

What will it mean for the PP having ever greater mountains of bank reserves and below inflation interest rates whilst the median wage drops in real terms? I guess things will swing around ever more violently and PP returns will not be as good as they were but they will be much better than most other strategies for retail savers. My guess is that at some point some shock will have to come along to hit gold. The current set up seems to project a never ending exponential increase for gold. Surely that means that the current set up will be changed dramatically to crash gold?

I don't think it will mean anything for the PP.  I think the PP will continue to cruise along like a clock in a thunderstorm.

[Pkg Man]

I think part of the confusion (to me at least) is that you can't have deflation without a recession, while inflation may or may not accompany a recession.

I know many will disagree with this, but if I had to choose one, I'd say we are in prosperity.  I realize it doesn't seem like it, but GDP is in fact growing and inflation remains relatively low but positive.  HB also said that we may not know where we are at any given time, or as you said, in a transition between conditions. 

A more realistic description, which takes into account the very weak (and perhaps faltering) recovery, would be to say that we are somewhere between recession and prosperity (the recession officially ended June 2009, but we have had very tepid growth since).

[LifestyleFreedom]

Past inflationary periods, like the 1970s when HB did lots of his writing, saw residential real estate values increase, not decrease.  Treasury interest rates went up, but gold skyrocketed from $40+ to $800+ in nominal value (in less than a decade) a nearly 2000% increase using top-of-my-head calculations.    (Yes, there were other things to take into account:  We went off the Breton Woods standard then, but at the rate the Congress and Moody's are moving today, we're likely to go off the Treasury=AAA standard, too.)

Another difference in the 1970s was the oil shock.  The OPEC cartel got organized and managed to increase oil prices several-fold.  This was a huge "tax increase" on the economy, which had been designed for cheap oil (i.e., buildings skimped on insulation and cars got terrible gas mileage because energy costs had been so low for so long -- it didn't make sense to spend money up front making things fuel efficient when the price of fuel was expected to remain low over the useful life of the asset).

It's interesting that the U.S. reached its domestic peak oil production in the early 1970s (as had been predicted it would back in the 1950s) and the theory was that OPEC decided to take advantage of the situation by raising the price of this necessary but suddenly scarce commodity.  Then OPEC started to fall apart in the early 1980s due to internal squabbles and its members started cheating in terms of producing more oil than their quotas allowed.  Oil prices fell as a result, and the U.S. oil patch (e.g., Texas) went through a major recession because it was competing with cheaper oil again.

Whether the current projection for global peak oil will have the same impact or not on the global economy in the coming years remains to be seen, but it's one of those unknowns that could play a role in keeping the economy slow and the unemployment rate high for many years to come.

Another problem of the 1970s was stagflation (http://en.wikipedia.org/wiki/Stagflation) because economic theory at the time said inflation and recessions were mutually exclusive.  But they were happening at the same time and the effect was painful.  People were out of work, yet the prices they had to pay for necessities kept increasing.

Real estate prices started climbing around the mid 1970s and peaked in the early 1980s (California passed its infamous "Proposition 13" law in the late 1970s as a way to contain the higher property taxes people had to pay).  I'm not sure why real estate prices increased.  Perhaps it was the move into hard assets over paper assets (the stock market moved sideways during this period); perhaps it was the early baby boomers buying their first home, which pushed up demand.

There was a mini-bubble in real estate at the time.  One of my co-workers (who was already a homeowner) told me that he had been watching the prices for some condos under construction move from $25K to $30K to $35K (people were flipping condos while they were still being built).  He said he finally bought one when the price hit $40K.  Then he told me that I should buy a home before it was too late.  I felt like hitting him because I knew his speculation was helping to drive up prices.

[MediumTex]

Past inflationary periods, like the 1970s when HB did lots of his writing, saw residential real estate values increase, not decrease.  Treasury interest rates went up, but gold skyrocketed from $40+ to $800+ in nominal value (in less than a decade) a nearly 2000% increase using top-of-my-head calculations.    (Yes, there were other things to take into account:  We went off the Breton Woods standard then, but at the rate the Congress and Moody's are moving today, we're likely to go off the Treasury=AAA standard, too.)

Another difference in the 1970s was the oil shock.  The OPEC cartel got organized and managed to increase oil prices several-fold.  This was a huge "tax increase" on the economy, which had been designed for cheap oil (i.e., buildings skimped on insulation and cars got terrible gas mileage because energy costs had been so low for so long -- it didn't make sense to spend money up front making things fuel efficient when the price of fuel was expected to remain low over the useful life of the asset).

Are you suggesting that we are not in a nearly identical oil shock scenario right now?

Oil has gone from $15 a barrel in the late 1990s to near $100 a barrel today.  That's an oil shock similar in scale to the 1970s oil shock.

What is different today is that the 1970s oil shock was a politically induced bottleneck (i.e., OPEC's embargo actiity), while today's oil shock is a geologically induced bottleneck (i.e., in spite of 10 years of rising prices world oil production has not risen significantly).  This outcome is entirely consistent with the peak oil theory.

How do you get robust economic growth in a persistently high eneregy environment?  My opinion is that you don't.  Time will tell whether I am right or wrong long term.  Since the recession that started in 2007 I have been right.

[LifestyleFreedom]

Are you suggesting that we are not in a nearly identical oil shock scenario right now?

Oil has gone from $15 a barrel in the late 1990s to near $100 a barrel today.  That's an oil shock similar in scale to the 1970s oil shock.

What is different today is that the 1970s oil shock was a politically induced bottleneck (i.e., OPEC's embargo actiity), while today's oil shock is a geologically induced bottleneck (i.e., in spite of 10 years of rising prices world oil production has not risen significantly).  This outcome is entirely consistent with the peak oil theory.

How do you get robust economic growth in a persistently high eneregy environment?  My opinion is that you don't.  Time will tell whether I am right or wrong long term.  Since the recession that started in 2007 I have been right.

I'm using the 1970s as the overall template for what we are going through now.  But history doesn't repeat; it only rhymes.

I agree that the source of energy shortages is now nature and not politics as it was in the 1970s.  But the world was caught by surprise in the 1970s because no one believed OPEC could pull off what they did.  When the gas crisis hit in the early 1970s, for example, people had to turn to imports for fuel efficient cars because the Detroit automakers weren't making any (there was not enough demand for them by the American consumer up to that point).

Since then, we have greater fuel efficiency because of government-mandated standards.  The same is true with buildings.  I worked with someone twenty years ago who was following California's efforts to tighten the building codes for energy use for new construction.  It takes decades to turn the existing stock, but you have to start someplace.  My house is 80 years old and energy inefficient.  I will be remodeling it in a few years and will have to bring it up to the latest building codes as a result, so it will become energy efficient.

The power company installed a smart meter on my home earlier this year so they can read it electronically instead of sending around a meter reader every month.  But it's a prelude to time-of-day pricing.  Eventually, if I want to do my laundry during peak load hours, for example, I will be charged extra for this privilege.  The government and the power industry want to level out the demand load (because the power system has to be sized to the peak load requirements).

I understand that the United States has become the "Saudia Arabia of natural gas" during the last ten years.  Getting the gas out of the ground and distributed to where it can be used (by vehicles that are not yet capable of burning natural gas) is, of course, some of the many details that need to be worked out.  But at least the fuel source is there.

I understand algae-based oil becomes breakeven at $150 a barrel for oil or $8 a gallon for gas (I'm not sure which; I'm just mentioning numbers I've come across in the literature, http://www.pbs.org/wgbh/nova/tech/algae-fuel.html).  It's true that $8 a gallon gas will slow the economy, but people adapt.  They drive less and carpool more.  Over the longer term, they figure out how to live closer to where they work.  As I understand it, gas prices in Europe are much closer to the equivalent of $8 a gallon, so economies can function under these price levels (with appropriate changes in consumer behavior, which may take time to make happen).

On a longer term basis and to go further out on the innovative ideas limb, here is an audio interview with someone who claims thorium-based nuclear reactors might be the longer-term solution for generating electricity: http://www.financialsense.com/financial ... ver-bullet

If you go back to the late 1990s, the Y2K hoopla got everyone to upgrade their computer systems.  Y2K became a non-event as a result.  The recent publicity of "Carmageddon" in Los Angeles (where a major freeway was shut down for several hours for road repair) kept people off the streets and the situation turned into a non-event also.

It's possible the publicity of "peak oil" and the many alternatives in the works (electric cars, alternative energy, and so forth) might get people to prepare ahead of time.  Although the future may still be bumpy when it comes to energy, it will likely be less bumpy than it otherwise would if the energy crisis blindsided us as it did in the 1970s.

For example, companies keep leaving flyers on my doorstep for putting solar cells on my roof and showing me the payback period.  My neighbor has already participated in one of these programs and he is happy so far when his meter runs backwards in the summer months.  The information and choices are out there.  If I end up shivering in the dark because peak oil hits me at some point in the next several years, I will only have myself to blame.

[moda0306]

I like to think that the 5th unwritten economic condition lies with a 5th unwritten PP asset:

SHTF End of the world scenario where contracts are all void, $$'s are confetti, and even gold as a medium of exchange doesn't hold much value because you can't eat it or use it as a tool.

The "asset" for that scenario would be a stock of survival skills and toold, canned food, etc.  We have a thread on this with a wealth of information in "Other Discussions."

Funny thing is, most of this stuff is usable and can be worked into daily life... it's not like you have to crawl into a swamp shack and ignore the outside world.  It's just about preparing for what's likely to be a few days to a month of unrest where nobody knows the true value of anything outside of what will allow them to survive another day.

[Lone Wolf]

I think part of the confusion (to me at least) is that you can't have deflation without a recession, while inflation may or may not accompany a recession.

Actually, some of our most prosperous years took place in an environment of nearly constant deflation.  In the United States, the period from 1869 to 1913 represented nearly 50 years of mild deflation accompanying GDP growth that averaged above 10%.

Pretty incredible times.  Can you imagine GDP growth over 10% every year with the prices you pay falling the entire way?

I think that if there was a blind spot in Harry Browne's thinking, it was his belief that the government could create inflation if it wanted to.  We are finding that this is more difficult than it sounds when in the midst of a deflationary environment. 

I'll bet that if Harry Browne had come of age in the 1930s instead of the 1970s he would have had a more nuanced understanding of deflation.

I'm surprised that you don't think Browne had a nuanced view on deflation.  The 25% of the portfolio that is in government bonds certainly saved the day in 2008.  (This in spite of Browne never experiencing any serious deflation in his own investing life!)

On the issue of whether government can create inflation if it wants to, this might be fodder for a new thread.  I still believe that government can create absolutely wild, stupid inflation if it so chooses.  Maybe I need to be schooled.

[moda0306]

I think deflation of the costs of consumables can fall with new processes, technology and natural resource finds.  This is what I like to think of as "iPod Deflation," and can hardly be a bad thing.

It's when the prices of real-estate and businesses fall along with wages that you have an economic problem.  This often accompanies a deleveraging (after a leveraging up).

I'd doubt that from 1869 to 1913 that real estate was falling in price (not that that's what you were suggesting), but I could be wrong.

[Lone Wolf]

I'd doubt that from 1869 to 1913 that real estate was falling in price (not that that's what you were suggesting), but I could be wrong.

Yep, I'd agree with all of the above.  (I, too, am unsure of what happened with real estate prices during this period in history.)

[KevinW]

I think deflation of the costs of consumables can fall with new processes, technology and natural resource finds.  This is what I like to think of as "iPod Deflation," and can hardly be a bad thing.

It's when the prices of real-estate and businesses fall along with wages that you have an economic problem.

Half-kidding -- why are cheap iPads good but cheap housing and stocks are bad?  Other than that baby boomers planned on selling real estate and stocks to buy iPads?