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February 2012 Aftershock Newsletter Inflation or Deflation? As readers of our books already know, we have been predicting that future inflation and rising interest rates will put increasing downward pressure on our falling bubble economy, eventually popping the bubbles and causing a massive economic Aftershock here and around the globe. So far, nothing has happened to change our minds about any of that, especially about future inflation and rising interest rates. Even if we did not have a falling multi bubble economy, inflation and rising interest rates would be a drag on any economy. However, given that we do have a falling bubble economy, future inflation and rising interest rates will help cause the coming big multi-bubble pop. Other books also predict economic troubles ahead, but none seem to see the falling multi-bubble economy and many don’t foresee future inflation and rising interest rates that will surely be the undoing of any economic recovery. Some authors, such as Harry S. Dent in his most recent book, The Great Crash Ahead, even go so far to say that instead of inflation, we will have deflation. Dent’s arguments for deflation have created a lot of confusion and questions for many people, and not surprisingly we get a lot of questions from readers asking about which one it will be—Inflation or Deflation? Clearly, both predictions cannot be correct. Either we will have deflation and the value of the dollar will rise, or we will have inflation and the value of the dollar will fall. Knowing which one is right is critically important because the steps to take for protection in each environment are entirely different, depending on which macroeconomic view you believe. For example, if you think the value of the dollar will fall (inflation), then it makes sense to convert some dollars to assets that will not decline when inflation rises, such as gold. On the other hand, if you think the value of the dollar will rise (deflation), then hanging onto dollars is smart and owning gold is not. Of course, you don’t NEED to make some of these investments until we get nearer to having significant inflation although some investments that protect against inflation will do very well even before we have significant inflation, such as gold. The point is that while you don’t necessarily need to make inflation-protected investments right now, you do need to have the correct macroeconomic view about whether we will eventually have inflation or deflation, because they each mean something very different for the active management of your portfolio. So which is it, deflation or inflation? We feel confident that, when given the facts, you will conclude for yourself what we see. None of this is too hard to figure out, it’s just that you are rarely given the right information you need to see it clearly. Our goal, as always, is to clear the fog and give you the correct macroeconomic view so you can decide for yourself the right protective actions. A Fundamental Misunderstanding about Inflation: Symptoms Are Not Causes At the heart of this debate about whether or not we will have future inflation is a fundamental misunderstanding about what actually causes inflation. There is a natural tendency to confuse symptoms with causes. While it is true that prices generally rise during inflation, it is not true that rising prices cause inflation. Rising prices are a symptom, not a cause of inflation. The only thing that can cause inflation is the expansion of the money supply at a rate that outstrips economic growth. In other words, if you print money faster than your economy grows, you get inflation. That is why in 1970, Nobel Prize winning economist Milton Friedman famously said: “Inflation is always and everywhere a monetary phenomenon.” By “monetary,” Friedman meant that inflation is always a function of the money supply. Increase the money supply too quickly (faster than the economy grows) and you get inflation. Why? Because money is just like any other commodity: increasing the supply too much lowers its value. Think of diamonds. As long as diamonds are rare, their value remains high. However, if you flood the market with diamonds, their value falls. The same is true of dollars: print a lot of them and the value of the dollar drops. As a result of the dollar being worth less, you need more dollars to buy things. Therefore inflation causes the cost of goods and services to rise. In contrast, deflation is just the opposite of inflation. A money supply that either grows slower than the economy or a money supply that is made smaller by removing money from the money supply eventually causes deflation, which boosts the value of the dollar. Again, like diamonds, when dollars become more scarce, each dollar is worth more. As a result of the dollar being worth more, you need fewer dollars to buy things. Therefore deflation causes the price of goods and services to fall. Inflation causes rising prices, deflation causes falling prices. But that does NOT mean that any time prices rise it is always due to inflation, and it does not mean that any time prices fall it is always due to deflation. Symptoms are not causes! To summarize: • Inflation and deflation are both “monetary phenomena,” meaning they both result from changes in the money supply, relative to the growth of the economy. • Inflation is the result of increasing the money supply, causing the value of the dollar to fall and the cost of goods and services to rise. • Deflation is the result of decreasing the money supply, causing the value of the dollar to rise and the cost of goods and services to fall. A Fundamental Fact: Massive Money Printing by the Fed Will Cause Future Inflation In response to the global financial crisis of late 2008, the US Federal Reserve has roughly tripled the US money supply with two rounds of quantitative easing (QE1 and QE2) since March 2009, expanding the money supply from $800 billion to roughly $2.8 trillion in less than three years. Tripling the money supply in such a short period of time is unprecedented in recent history. Clearly, the economy did not triple during that time, so this massive new money printing was not done in order to keep pace with a rapidly growing economy. In fact, just the opposite is true—the Fed fired off two massive rounds of money printing in a desperate attempt to stimulate the falling economy, not to keep up with a growing economy. So this was “extra” printed money and a whole lot of it. For the most part, this massive money printing stimulus has had its intended affect—at least for now. Clearly, the post-2008 stock market has benefited tremendously from QE1 and QE2, and no doubt the recession of the last few years would have been far worse without the Fed’s massive money printing. However, the boost to the stock market and overall economy from QE has not been enough to create a real and sustainable recovery, and now the Fed is talking about the potential of doing even more QE in the future, “as needed.” Given that we have a falling bubble economy, we know it will be needed, so instead of QE ending, it will continue. Big Money Printing Means Big Future Inflation All this big money printing will most certainly cause very significant future inflation, not deflation. Future rising inflation will also naturally cause rising interest rates, which together will help fully pop the already falling multi-bubble economy. (For more details about QE, future inflation, and rising interest rates, please see Chapter 3 of Aftershock second edition, Wiley 2011.) It is important to understand that had we increased our money supply by only 10 percent or even 20 percent, the resulting future inflation would be far less. But we increased our money supply by a whopping 200 percent. Expecting only low future inflation to result from such a massive increase in the money supply is pure fantasy. If there was no threat of inflation from massively printing money, why haven’t we been massively printing money all along? Why does the government need to borrow any money if they can just print all the money they want, whenever they want, with no negative consequences? In fact, why do they need to collect any taxes? Just print instead! Come to think of it, why do any of us need any income at all? Why don’t we all simply print money whenever we wanted to go shopping? Clearly, there must be a serious downside to massive money printing or we would all be doing it all the time. Printing massive amounts of money, beyond what is needed to keep up with the growth of the economy, does have a serious downside: inflation. Nonetheless, there is some ongoing confusing over whether we will have inflation or deflation. So let’s tackle each of the pro-deflation arguments one at a time: Pro-Deflation Argument #1: Falling Prices When prices decline, such as when real estate values fall, some people say “See, that’s deflation!” Not true. As explained earlier, just because an asset loses value does not necessarily mean it is due to deflation. While it is true that deflation means the dollar is worth more and therefore goods and services will cost less, it is also true that other forces can cause the prices to fall, too. Besides deflation, what other forces can make prices fall? How about a popping bubble? That certainly causes prices to drop, doesn’t it? And even if there are no popping bubbles, the powerful forces of supply and demand always impact prices to some extent. Any time supply rises or demand falls, asset values are negatively affected. For real estate this will be a double whammy because not only will demand fall (fewer people able to buy) and supply rise (growing inventory for sale), there is also the fact that real estate prices were in a bubble (overpriced relative to income) in the past and that bubble is still falling. So even though future inflation will drive up general prices of goods and services, home values (in inflation-adjusted dollars) will fall. That is not deflation, that is declining demand, rising supply, and a popping real estate bubble! We know this intuitively because when real estate prices were going up during the housing bubble, nobody called that inflation; they called it a GREAT INVESTMENT! In general, falling demand and popping bubbles will cause many asset prices (in inflation-adjusted dollars) to fall. That is not deflation; that is a price drop. However, sometimes prices fall due to both falling demand and deflation, as was the case during the Great Depression, beginning in 1929. At that time, there really were too few dollars relative to the size of the economy and the federal government needed to print more dollars to boost the economy. Today, with the Fed tripling the money supply in less than 3 years and likely to print even more money in the future, a lack of new dollars is hardly our problem. We do not currently have deflation nor will we later face future deflation. Pro-Deflation Argument #2: Demographics This is where Harry Dent comes in. Dent has made a seemingly persuasive case for the coming change in demographics and how it might impact the economy. Dent argues that as people near retirement, they tend to spend less and to invest and save more. This, he says, is problematic because the very large Baby Boomer generation is now on the verge of retirement, and they are saving their money by putting it into stocks, bonds, CDs, etc. As they retire, they will need to convert these investments back into dollars to live on, and that big wave of selling will push these asset prices lower and cause a recession. We agree that changing demographics will have some impact on the future economy but it will not be nearly as significant as Dent believes. More importantly, even if it did cause a recession, a recession does not cause deflation. Only decreases in the money supply (relative to the size of the economy) cause deflation. In a recession, prices may fall, but that is not necessarily because of deflation, but because of falling demand (more sellers, less buyers). In addition, Dent also says that as Baby Boomers increase their savings rates, dollars will be hoarded into savings accounts and therefore dollars will become scarce, in effect decreasing the money supply and causing deflation. In reality, Boomers are hiding money under their mattresses or burying it in their backyards, all that “saved” money is still very actively moving through the economy. That is because when you put money into a bank savings account, it does not go into hibernation. The bank lends that money to other people and businesses. Money does not leave the economy or the money supply simply because it was deposited into a bank! But even if Boomers did bury all their extra savings in their backyards and did not put it into banks to be lent out to others, the idea that Boomers will be able to remove so much money from the money supply that it will offset the massive money printing by the Fed is ridiculous and impossible. Pro-Deflation Argument #3: Debt Write-offs and Bankruptcies Another common argument for future deflation made by Harry Dent and others is that when debts cannot be repaid, the resulting write-offs and bankruptcies will effectively decrease the money supply, causing deflation. This argument seems to come from the idea that money is created as debt, and that therefore when debt is destroyed, so is the money. But that is not the case. If you lend me $20 for lunch and I never repay you, that $20 is still out there in the money supply, moving from me to the restaurant to the wholesale food distributor, etc. It is still in circulation. Destroying my debt to you does not destroy the money itself. Lending increases the money supply, and so it is true that a slowdown in lending does create a slowdown in enlarging the money supply. But any potential contraction caused by financial institutions lending less or going into bankruptcy will be more than offset by the Fed’s massive money printing. Therefore it will not decrease money supply and it will not cause deflation. Pro-Deflation Argument #4: The Fed Won’t Allow Too Much Inflation and We Will End Up with Deflation Instead The pro-deflation idea here is that the Fed is not made up of fools who never took Econ 101. They know that printing money can cause future inflation and they have a plan to nip inflation in the bud, before it becomes significant. That will allow the other problems (listed in #1, 2, and 3 above) to cause deflation, not inflation. We agree that the members of the Fed fully understand that printing money causes inflation. That danger is the main reason they have never printed this much money before and they only did it now because they felt they had little choice. While we cannot know for sure what the Fed is thinking, our best guess is that they are hoping they will eventually be able to sell the bonds they bought with QE, essentially taking that extra printed money out of the money supply, in effect doing “reverse quantitative easing,” reducing the money supply before inflation gets too high. In other words, they hope to decrease the money supply and stop inflation before it gets out of hand. However, this plan simply won’t work because it is missing one vital ingredient: a booming economic recovery. In order to sell the bonds and reverse the money printing, they would need a booming economy in which there are investors willing to buy these bonds. So far, that hasn’t happened. Not only do we not have a booming economy in which the Fed can do reverse quantitative easing, we have a falling bubble economy that will lead the Fed to do even more money printing. That will cause significant future inflation, not deflation! If QE Causes Inflation, Why Don’t We Have Inflation Right Now? Having addressed the major arguments for deflation, let's turn to the subject of containing the increase in the money supply to prevent significant inflation. Since 2008, when the Fed began supplying banks with huge amounts of liquid reserves through quantitative easing, it has encouraged banks to keep those reserves on hand rather than lending them out by paying interest on them. This is an attempt to stave off inflation by limiting the effect of the money multiplier. Earlier, we mentioned that quantitative easing increases the monetary base, from which all other measures of the money supply are derived. The way this works is that banks are only required to keep a certain percentage of their deposits in reserve. So when the Fed increases a bank's reserves by purchasing bonds, the bank can lend out most or all of that money (and has a strong incentive to do so in order to earn interest). Once they lend out the money, sooner or later it ends up in a deposit account either at that bank or another, which can then lend most or all of it out again. This cycle can continue many times over until the initial increase in one bank's reserves has led to an exponential increase in the overall money supply. By paying interest on reserves of 0.25 percent (the equivalent of the federal funds rate), the Fed hopes to avoid the massive inflation that would undoubtedly follow if banks lent out those new reserves. There are three problems with this. First, the nearly $2 trillion increase in the monetary base is not just theoretical money. It goes into client accounts at the banks that do business with the Fed and has a direct effect on the money supply, regardless of the multiplier effect. Holding excess reserves may slow inflation, but it can't stop it. Secondly, and more importantly, this strategy is based on the idea that eventually the Fed can pull that money back out of the economy. But when is this supposed to happen? As we said earlier, the Fed can't contract the money supply while the economy is still recovering. The results would be devastating for the markets and for employment. And even if we did see a major recovery, not only would a contraction jeopardize those gains, but the only way the Fed can pull that money out of the economy is by selling $3 to $5 trillion worth of government bonds, which would send Treasury yields skyrocketing and make an already precarious public debt situation much worse. Thirdly, as inflation and interest rates rise, the interest paid on excess reserves will become excessive. Eventually, the government won’t be able to afford to pay it and banks will lend out the money rather than keep it on deposit. That will further push up inflation. In other words, there’s just no good time to pull money out of the economy once it’s in circulation, especially in a bubble economy. In the meantime, banks are sitting on a huge pile of excess reserves which earn a very low rate of interest. How long will they continue to ignore the profit potential of lending out those reserves at significantly higher interest rates? Sooner or later, that money is going to be lent out and inflation will follow. It is already happening to some extent now. Why the Delay? So if quantitative easing began in 2008, why haven't we seen inflation already? First of all, inflation customarily has a delay of about 2 years following an increase in the money supply. And, as expected, inflation is increasing. As measured by the Consumer Price Index (CPI) inflation has risen from just over 1 percent in 2008 to 3.64 percent in 2011. That's a noteworthy increase, but it's certainly far from an alarming inflation rate. It should be said that we don't consider CPI to be a completely reliable measure of inflation — the basket of goods monitored is not necessarily reflective of dollar-value changes. This is partially due to changes in the way CPI is calculated in the 1990s. By the old measure of CPI, inflation would be over 7%! That being said, there are numerous factors we think will make inflation even slower to respond to the recent money supply increase than usual. In addition to the excess reserves on hold, current economic factors and the traditional “safe haven” status of the dollar makes people reluctant to see the dollar bubble for what it is. It's literally never happened before that a stable, wealthy economy of this size has printed money on this level, and the economy is naturally slow to understand the consequences (see the real estate and stock bubbles). But make no mistake: a down economy and a good reputation will not save the dollar in the long term. Inflation happens even in poor economic times, and the laws of supply and demand are bound to catch up with us eventually. And while inflation often starts slow, it can snowball very quickly. An Even Bigger Issue: More Big Money Printing Ahead As we mentioned earlier, the monetary base has tripled since 2008. This alone is an enormous and unprecedented increase. But more importantly, we believe that it is very likely that even more — much more — money printing in the next few years. Quantitative easing was originally employed to boost struggling markets and contain unemployment. It has worked (somewhat), which is why we are not in worse shape right now. However, later, as the bubbles deflate further and investors begin to panic, the Fed will have no choice but to continue administering the medicine of money printing. But like any drug, the more it's used, the less effective it becomes, and it takes more and more meds to achieve the same results. As inflation rises to significant levels, interest rates rise, and this just compounds the problem. Liquidity crises and bankruptcies around the country lead to bailouts. The federal government will be forced to offer higher and higher yields on its bonds in order to refinance its mounting debt, and it will be forced to print more and more money in order to finance an increasing federal deficit, which will suffer not just from increased costs but also from lower tax receipts due to high unemployment. Eventually, after inflation rises past 10 percent, the Fed will eventually have to put a stop to money printing altogether, but by the time that happens, the huge damage will be done. We don't predict the death of the dollar, but it certainly will be a very different dollar than we've grown accustomed to. Rather than a strengthening dollar due to deflation, we will have a falling dollar due to both rising inflation and declining demand for dollars and dollar-denominated assets. In the Aftershock that follows, we will see the odd mix of prices rising due to inflation, and asset values falling (in inflation-adjusted dollars). That won’t be deflation. It will be a popping bubble economy. ©Copyright 2012 Aftershock Publishing, all rights reserved. Aftershock Advisors, LLC 560 Herndon Parkway, Suite 130 Herndon, VA 20170 (703)787-0139 (703) 787-0267 Director of Customer Relations Christine Peglar [email protected] [email protected] Office Manager Nancy McSally [email protected] [email protected]