Gyroscopic Investing

There was a recent debate from the 30-year bond thread on the inflation/deflation issue.  I'd like to revisit that debate and make a few points as to where we are right now IMO:

1. I like to stick with the definition of inflation as an increase of the money supply (all: MB, M1, M2, M3).  I do understand the argument for using CPI calculations, but I tend to see changing prices as symptoms, not causes.  Credit has an affect on CPI inflation directly and Austrian inflation (money stock only) indirectly. 

2. As we all know, MB has increased dramatically over the last few years.  We have made frequent mention that the reserves are not seeping into the broader economy, but are we looking hard enough?  Here's what I mean...

It's true that the consumer is deleveraging, which is deflationary.  Total consumer debt has been dropping since the beginning of the crisis.  But the consumer doesn't make up the total credit market.  The total credit market (Z1) has expanded since 2010 Q1:

http://www.federalreserve.gov/releases/ ... /z1r-4.pdf

While the consumer has been retrenching, corporate credit in all forms (especially in the financial sector) has been increasing.  As we all know, government credit has been increasing at every level: federal, state, local.  These increases have overwhelmed the credit contraction in the consumer space.

One other point about credit is that expansion in credit leads to the expansion of broad monetary aggregates.  The broadest gauge of monetary aggregates is M3 (also the best source to measure expansion of the shadow banking system).  The Fed uses M2.  The Austrian gauge of money is True Money Supply (TMS).  All three have been expanding in the last year while MB has remained relatively steady at $2T.  As long as the monetary aggregates continue to grow and credit does not contract faster than money creation, we'll continue to see price increases at the earliest stages of the supply chain.

Notes: I calculate my own figures for TMS using Rothbard's formula.  The components are listed here:

http://mises.org/content/nofed/chart.aspx?series=TMS

M3 is updated & posted weekly here:

http://nowandfutures.com/key_stats.html

3. Wage Inflation/CPI Inflation

I think it's important to keep a global perspective when it comes to wage inflation.  The U.S. and western Europe have seen consistent outsourcing due to wage arbitrage.  However, low cost countries who are either fully dollarized or who import U.S. monetary policy are most definitely experiencing wage inflation.  Will that show up in the U.S?  Probably--albeit in a lumpy way.

What I find most interesting is the amount of U.S. debt held by foreigners.  As a share of M3, it's enormous.  Effectively, foreigners are absorbing most of the U.S. monetary inflation.  Will they continue to take a beating?  I don't know, but they sure have a penchant for abuse.  If they send that debt back to the U.S., CPI inflation will make a dramatic entrance.

Overall, I can't say that money and credit will continue to increase like it has.  But with no real hawks on the Fed Board, I just can't see a probable case for severe and prolonged destruction in either scenario.  What I can see is the possibility of another liquidity crunch--but I also see the Fed stepping in to ensure consistent money/credit growth if such an event occurs.

In the meantime, be sure to track broad monetary measures and total credit to get a better picture of the inflation/deflation debate.

I think the bottom line is that it's impossible to predict which will we have more of in the futre (inflation or deflation).

Deflationary pressure is huge right now b/c of all the bad debt in the form of mortgage backed securities that are still plaguing our financial institutions.

So far, we have monetized only a small amount of this debt (unbelievable that bailouts to the tune of trillions of dollars are just a small amount). 

The future will depend on how much debt we ultimately attempt to monetize. 
The resistance to this will become more and more of an issue.  There is already outcry against debt monetization.  There will only be more and more in the future as people become more aware of the hidden tax (inflation) involved. 

On the other hand, there will also be pubilc outcry the first time someone goes to their bank and is told they can't have the money that is supposedly in their account. 

Either way, it's not good. 

Adam

Adam,

Doesn't the fed own over half of the issued debt of the US?  That's hardly a small amount.  I don't know a ton about the risks of monetizing debt, but I think people, as deep in debt as many are today, wouldn't mind a little inflation.  The problem is the assets they own that could improve their balance sheet (cars, homes) are extremely difficult to inflate right now, because it was all based on a huge expansion of credit.

Maybe if people had barrels of oil and bricks of gold instead of homes and cars, they'd enjoy the monetization a little more.

I think that's true (with regard to the fed's ownership of US debt), but I think that discounts a lot of the side monkey business with derivatives, etc, a lot of which I think that a lot of this is still on the books of a lot of the banks (although I don't really know this for a fact).

I don't think that all in all people are rooting for inflation.  Look how low the interest rates on US Treasuries are right now.  This doesn't really point to a big bet on inflation in the near future.  That's not to say we won't have it (crowds are are very often wrong), just that the masses won't be happy if we do have it (granted a large portion of this debt is owned by foreigners).

Adam

Thought this was interesting:
http://politicalcalculations.blogspot.c ... -debt.html

I believe that disincludes the fed, but yes, it's interesting.  Did you know Japan's is much more heavily toward's their citizens, and their 30-year bonds trade at somewhere just north of 1% if I remember right?

One comment I would like to make on the inflation/deflation topic is that although I find the secular deflation thesis convincing, I would expect extended periods of inflation within that longer deflationary trend.

I think we saw the first wave of this inflation in early 2008--rising commodity prices translating into higher gas, electricity and food prices (just to name a few).  I would expect to see something similar again in coming months and years.  

The key, though, is observing the effects of these bouts of inflation.  Do they create a new symbiotic relationship between prices and wages where wages begin to be pulled up by workers' demands for some compensation for falling purchasing power, or will the higher prices run into the brick wall of static wages, which will lead to another recession as aggregate demand softens in response to the same number of dollars pursuing more expensive goods and services.  This question regarding the effect of inflation is key.

What happens if prices rise and wages don't?  In the short term it will be called stagflation.  In the longer term it will be called the period that preceded a recession, and during the recession that follows rising prices are very likely to reverse as demand collapses.

If this process continues long enough future historians may use the word depression to describe the period we are living through.

I'm not sure what causes this process to end.  Normally, one would expect more favorable economic conditions to follow once the bad debts were purged from the system.  What we are doing, however, is socializing the debt that common sense would suggest should be written off.  As a result, future economic conditions would appear to have strong headwinds to deal with even if conditions are otherwise favorable.

It is tempting to say that something in the system will break before the grinding unpleasantless I am describing will have a chance to unfold over a long period.  Note, however, that if you had told someone in Japan in 1990 that 21 years later they would still be struggling to recover from their property bubble, they might have given you one of those Spock-chops to the neck.  It sounds absurd, and yet look where Japan is today.  What reason is there to think Japan will be in any better shape 20 years from now?  I don't see any.  That's really an astounding thing to say about the second largest economy in the world.  

Consider what the Japan example may mean for the U.S.  Imagine decades of delusional U.S. policies steadily grinding against reality as the immense wealth of the U.S. is gradually converted from capital to consumption without a serious debate about the matter ever even occurring.

As you visualize the fantasy-world of central bankers and politicians repeatedly rubbing against the immovable force of reality, imagine the stresses that would place on a society and its economy.  

For another example of what the future of the U.S. might look like, study how the mighty British Empire of the 18th and 19th centuries turned into a bankrupt board game for statists like Winston Churchill in the 20th century.  (To get a sense of how damaging this process of decline was to the collective psyche of the British people, consider the twisted social logic that would have been needed to produce an entertainer like Benny Hill.)

I was listening to an interview a while back and the following comment stuck in my head: "In modern times, world powers are not defeated, they are decommissioned."  I wonder if we are not watching a decommissioning process unfold right before our eyes, with the inflation/deflation discussion merely the portion of the iceberg that is above the waterline.

Interesting post, MT. 

I think we would be lucky to get off as easily as the Japanese (not they are getting off that easily).  They were a creditor nation at the time their bubble burst.  The majority of the debt that they did carry was to their own people.

We may be in a situation where other nations may stop lending to us, at which point, we will likely have to monetize our debt even further.  If we are successful, we will probably experience severe inflation.  If we are not successful, we will experience severe deflation.  Some think we would even have to default on our debt (which I realize is a very extreme view). 

In either scenario, the end result is the same...a lot of people will, one way or another, lose a lot of their purchasing power. 

I think that even if the US does "decomission" (very interesting perspective, by the way) the PP will still function.  But I think the gold holding will be very very very important if we experience an extreme scenario. 

Adam 

Desert wrote: But .. maybe something else will happen.  So, I continue to throw away 75% of my hard earned wealth in soon-to-be-useless stock, bonds, and cash.
Desert

I pretty much feel the same way, at some point the dollar is likely to be toast.  But we don't know when, and if it does occur I think the stock portion may still be ok as a share is a claim on the cash flows of a company.  So it depends on what happens to the economy in general.  Losing reserve status would be a hit, no doubt, but not necessarily a devastating one.

Desert, I understand you are suggesting an outcome that differs a bit from mine.  Let me just pose a few questions comments below.

Desert wrote: Inflation is the obvious answer.  The Fed can (and is) creating new money to hold down long term interest rates.

But isn't this new "money" just more debt?  It's not as if it's being printed from nothing.  Each of these new debt based dollars are new obligations of the U.S. government.  That's different from printed money, which isn't an obligation of anyone.

The ability of the fed to do this is limited - at some point the buyers of long term US debt will go away.

With the number of U.S. dollars floating around the world due to our trade deficits, I'm not sure that these buyers can just go away.  There's isn't anywhere else to take those dollars than the U.S. bond market.

The fed now owns more than half the U.S. debt.  How high can that total go before the dollar loses its reserve status?  I would guess not much further.

Why not?  The same logic would have suggested it could have never gone on this long, but it has.  Look at Japan--they are in approximately twice as bad a shape as the U.S. from a debt to GDP perspective.

Increasing money supply always results in increased prices.  It already has - look at gold, commodities, food, and even the stock market.

I would say that money supply has to be considered in conjunction with velocity.  If I get a billion dollars and bury it in my back yard no prices will go up.

Investable assets are inflating.  Big screen TV's are not, because the little guy doesn't get much of this new money.  As Ron Paul points out in his latest book, the increasing money supply tends to transfer wealth from the bottom to the top.  That's what we're seeing.  Prices are going up, but it doesn't really hurt anyone except those for whom food and gas (and Natural Light and cigarettes) represent a significant portion of their expenditures.  So yes, there is inflation.  The CPI is brought down by the failure of the rent-to-own and cash-out-refinance crowd to be able to afford new sectional sofas and plasma TV's.  But yes, prices are going up - and the money supply continues to increase.  Inflation is a fact already.

Until the price of labor--i.e., wages--start rising I will not be convinced that inflation has any traction.  I think consumers are going to just stop spending (as they must if they don't have the money to pay the higher prices).  

And the dollar will soon lose its reserve status, and a new currency will take over.  It always happens - this is not a new phenomenon.

I don't understand what the mechanism will be for this loss of reserve status.  What possible replacement could there be in the world today for the dollar?  The yen?  The pound?  The euro?  I don't see it.  The euro's days are probably numbered as it is.  The dollar only looks bad until you look at everything else.  A formal international gold standard isn't going to happen--it's too confining to central bankers and politicians.  I don't know what will happen, but I think the dollar is going to hang around longer than some people might think.

Don't be so certain about inflation.  Although the typical argument (more printed dollars chasing fewer goods) seems impossible to refute, it ignores the huge deflationary pressures that the global economy is experiencing right now. 

Americans are becoming increasingly aware of the government's attempts to inflate.  There could easily be enough backlash to prevent further bailouts, in which case the dollars that survive could do quite well.

When talking about the devaluation of the dollar and related matters, I think it's important to remember that the dollar today is about 10% higher today than it was in 2008 before the financial panic started.

In other words, everything that Bernanke has done since the crisis started has basically done nothing to weaken the dollar from a longer term perspective.

With all the talk about inflation and dollar collapse in the last couple of years, one wouldn't think that the dollar had actually strengthened during that period.

"With all the talk about inflation and dollar collapse in the last couple of years, one wouldn't think that the dollar had actually strengthened during that period."

I think this a key point.  There is extreme bullish sentiment with respect to gold at present, and almost everyone is bearish on the dollar.  The crowd is with gold, and markets love to embarrass crowds. 

I'm not saying the bull market for gold is near the end, but I definitely think it's a mistake to write off the dollar (and the possibility of deflation) at this point.  If I had to pick between owning only gold or owning only treasury bonds for the next five years, I'd probably choose treasury bonds.

Again...all academic as far as the PP goes, but fun to discuss.

Adam

I was going to make a point about the dollar index relative to real goods, but Desert beat me to it...

We have to put the USD in proper context when we talk about its value.  The index is simply a value relative to a basket of other fiat currencies.  In effect, if all currencies are racing towards the bottom at the exact same pace, the USD could stay at 78--precisely where it is today.  The true test of a fiat currency is its exchange value with real goods such as commodities and money in the form of gold.

The jury is out regarding the dollar's fate.  People were calling for a replacement in 1980 as well until Volker got serious.  We all know how that turned out.  We might see the same scenario again--albeit with foreign investors taking most of the inflationary haircut.

Gasoline, oil, natural gas and electricity are all lower today than they were in 2008 before the financial crisis.

The dollar will buy you more house, more car, more TV, and more computer than it would in 2008 before the financial crisis.

Interest rates are lower today than they were in 2008 before the financial crisis.

Wages have been virtually unchanged since mid-2008, before the financial crisis.

If we are truly seeing the early stages of sustained inflation, wouldn't you expect to see some of the items above making new highs (or at least breaking through their highs of three years ago)?

Wouldn't you expect to see interest rates higher than they were three years ago if the market is efficient at pricing in future inflation?

And wages......you all know how I feel about this topic.  No rising wages=no inflation.  Prices will rise, people will run out of money, demand will soften, the economy will tip back into recession and prices will begin falling again.  It's the early 2008 formula all over again.

We are in a secular deflationary period.  Bad demographics, huge debt overhang, change in consumer attitudes toward debt, static wages, and overcapacity.  It's a classic deflationary setup that the Fed is trying like crazy to get out of (so far, with little success).

It's weird, but the day to get scared about inflation is the day you get your next pay raise.

MT - thanks for your views...you pushed me over the top to complete the PP to include my least favorite part, the LT bonds. As one who has bought into the inflationary narrative, it was very difficult to convince myself to devote funds to the LT bonds.

i'm curious your view on gold rise over past few years...is the driver the fear of financial collapse (which is a deflationary event?) ?  i recall seeing that gold does well in both inflation & deflation.

murphy_p_t wrote: MT - thanks for your views...you pushed me over the top to complete the PP to include my least favorite part, the LT bonds. As one who has bought into the inflationary narrative, it was very difficult to convince myself to devote funds to the LT bonds.

i'm curious your view on gold rise over past few years...is the driver the fear of financial collapse (which is a deflationary event?) ?  i recall seeing that gold does well in both inflation & deflation.

I think that ever since terrorism came into focus with the 9/11 attacks, it was clear to the smart money around the world that the U.S. had gotten itself into a spending contest on military activities with a group of shadows that could never be defeated (primarily because we don't really even know who "they" are).  This new target of limitless government spending happened to come at a bad time for U.S. finances in general (unfunded government liabilities, bad demographics, bad consumer balance sheets, etc.).  I think it was obvious that such a situation could not have a happy fiscal ending.  This cluster of events made gold look like a safe bet, which it has been for 10 years now.

I think part of the gold play is that we all know central banks are not going to sit by and let deflation get a foothold.  The problem is that anti-deflation measures are, in the long run, probably a cure that is worse than the disease.  We will get inflation someday, and it may be much more disorderly and chaotic than Bernanke and co. would like.  I just think we are many rounds of QE away from that day, for the reasons I have listed before, and that deflation is a secular trend with a lot of room to run.

All fiat currencies end up worthless.  That will happen again as it has always happened in the past.  The question is what the timeline will be and how many bad things are going to occur between now and when the world economy gets to steadier ground.  It could be decades (as usual, see Japan).

I don't mean to sound so dire.  It's sort of like when the weatherman says rain is in the forecast--he's not being a pessimist, he's just telling you what he sees coming (and he is often wrong, and I may be as well).

Happily, the success of the PP doesn't depend on one's ability to guess correctly.

MediumTex wrote: I think part of the gold play is that we all know central banks are not going to sit by and let deflation get a foothold.  The problem is that anti-deflation measures are, in the long run, probably a cure that is worse than the disease.  We will get inflation someday, and it may be much more disorderly and chaotic than Bernanke and co. would like.  I just think we are many rounds of QE away from that day, for the reasons I have listed before, and that deflation is a secular trend with a lot of room to run.

And I think this is where the views of the "inflationists" and the "deflationists" converge.  I happen to believe that Ben will be successful sooner rather than later (whatever that's supposed to mean) but the overall picture you're painting matches my view of the world very well.

It's interesting how hard these subtle points make it to "pick" investments.  Even with a thorough, nuanced (but inevitably incomplete) understanding of the present situation, it's hard to say for sure where things go from here.

Predicting the future is really hard.  Predicting the future in a complete enough way to make money is even harder.  Think about market prognosticators like Peter Schiff who made some excellent calls in regard to the collapse of the housing market, its immediate aftermath and how the government would react... yet still took some incredible investment beatings when the dollar showed unexpected strength.

How to invest in times like these?  Since this is a PP forum, I think I'm allowed to spam you all with hymns of praise for how glad I am to be in the Permanent Portfolio.  Consider yourselves spammed.

Let me start by saying I have the utmost respect for you MT, especially when we disagree on a topic.  That said, we may disagree what's going on now, but we may actually share the same long-term view depending on how things play out.

MediumTex wrote: Gasoline, oil, natural gas and electricity are all lower today than they were in 2008 before the financial crisis.

The dollar will buy you more house, more car, more TV, and more computer than it would in 2008 before the financial crisis.

I would counter that the broadest measure of commodity prices can be found in the CRB index, which is presently higher than pre-crisis levels of 2008. 

Medium Tex wrote: Interest rates are lower today than they were in 2008 before the financial crisis.

I would counter that since 2008 The Fed has been buying all along the yield curve, so we're not entirely sure what true market yields look like at the moment.

Medium Tex wrote: Wages have been virtually unchanged since mid-2008, before the financial crisis.

That is true in the U.S.  In countries that import monetary inflation from the U.S. (China), wage inflation has been especially strong.

Medium Tex wrote: And wages......you all know how I feel about this topic.  No rising wages=no inflation.  Prices will rise, people will run out of money, demand will soften, the economy will tip back into recession and prices will begin falling again.  It's the early 2008 formula all over again.

We are in a secular deflationary period.  Bad demographics, huge debt overhang, change in consumer attitudes toward debt, static wages, and overcapacity.  It's a classic deflationary setup that the Fed is trying like crazy to get out of (so far, with little success).

It's weird, but the day to get scared about inflation is the day you get your next pay raise.

The deflation thesis in the U.S. may play out as you mention MT, but it all hinges on what The Fed is willing to do.  When the next crisis erupts, what is the most likely response?  Will they let debt liquidate accordingly and subsequently destroy monetary aggregates and credit?  Or will they provide more facilities to swap bad debt for fresh money at par?  I suggest the latter is more likely.

Since the USD is the main world reserve currency, we need to look at its inflationary impact wherever trade is conducted in USD across the globe--not just the U.S.  Because of currency pegs and dollarization, much of the emerging world imports the inflation intended to increase U.S. exports and ease the real burden of debt.  We may see 1.5% CPI, but that is confined to the U.S. (and the calculation itself is suspect for a variety of reasons). 

We're seeing monetary inflation at the earliest stages in the supply chain: commodities.  Just because it hasn't reached U.S. CPI estimates doesn't mean it doesn't exist.  For those in the developing world where basic commodities make up the largest share of their personal expenditures, they are seeing massive inflation--hence the riots and revolutions. 

It's true that M3 + Z1 credit have not yet exceeded their highs of 2008, but they have been increasing nonetheless.  We will need to see further destruction of M3 & Z1 if we are to see deflation.  If we see another crisis where The Fed is unwilling to backstop current levels of money and credit from being destroyed, then I'm with you on the "Japanese deflation" thesis, MT.  I just don't think they will have a sudden change of heart.  I think the most likely scenario is a stagflationary environment for the next 5-8 years with low-growth, high unemployment and elevated inflation eating away at the real value of earnings.  But again, it all hinges on what The Fed is willing to do when the next crisis erupts.

Great discussion.

I think we will know a lot more in a year or so.  By then, higher commodity prices will have worked their way into final prices, and that will either trigger some sort of wage increases to at least acknowledge higher prices for the same basket of goods (though I would definitely not expect these pay raises to actually track inflation), OR the higher prices will simply lead to much softer aggregate demand as people cut out more and more discretionary purchases to make the same amount of money go far enough to purchase the essentials, which would lead us back into recession.

I think what we are seeing right now is very similar to what we were seeing in early 2008--a strongly building inflationary sentiment.  If anyone remembers early 2008, inflation is all anyone was talking about and gold was topping $1,000 for the first time ever.  We saw the curveball that came later in the year, however.  I see no reason to think this time will be different (especially since we still have so much bad debt to work out of the system).

To me, the core issue isn't whether we will get SOME inflation--we definitely will; rather, the issue is whether this initial bout of inflation will trigger an inflationary spiral, and I personally think it will not, primarily because I do not think people will have the money (either cash or credit) to actually pay the higher prices for an extended period.  I think this is one of the reasons that it is so hard to get an economy going again after a credit-fueled asset bubble pops--it's impossible to print money faster than it is being extinguished through the destruction of credit and decline in asset values. 

I highly recommend Irving Fisher's Debt Deflation Theory of Great Depressions.  It's 21 pages and will get you thinking:

http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

This is a great exchange, though, and I am happy we have so many thoughtful perspectives here. 

I agree that we'll know much more in a year or so.  The big elephants in the room at the moment are local & state entitlements.  Do they get liquidated, take a haircut or stay fully guaranteed?  We'll know soon enough. 

Additionally, reversion to the mean is a powerful concept--especially in secular markets.  With the S&P trading a tick below 24, it's nearly 50% overvalued on historical terms but can get even more overvalued (1996-2000).  Do we see deflation a la 1929-1932 (or Japan 1990-?) or do we see in/stagflation a la 1970-1982?  Both markets reached bottoms, although via different paths. 

What would people call it if--in 2018--the S&P was trading at 800 and we have 3-7% inflation in the U.S. from now until then?

Why do we hear such diverging PE ratios?? Are there vastly different ways of calculating it?

moda0306 wrote: Why do we hear such diverging PE ratios?? Are there vastly different ways of calculating it?

I'm referencing PE10, sometimes referred to Shiller PE, or Graham PE.

http://www.econ.yale.edu/~shiller/data/peratio.html

http://www.multpl.com/

One other note on the inflation issue: rising commodity prices and weak consumer purchasing power force companies to reduce product sizes to pass costs along and maintain profitability.  If prices don't rise at the store (indicating tame CPI inputs), but you get less product for your money, isn't that inflation?

http://www.nasdaq.com/aspx/stock-market ... costs-rise

http://www.voiceamerica.com/Show/Episod ... u-do/54791

Here's a great link with the arguments for both inflation and deflation. 

Playback time is about an hour.

30 minute interview with Ron Paul.  30 minute interview with Robert Prechter. 

Adam