Tuesday, November 30, 2010

Allocation of Resources

Every individual in this world is different.  We all have some of the same basic needs, but our desires and preferences vary greatly.  Two people both need to eat food to live, but they might choose different foods to eat.  This is just one thing.  If we start comparing desires, the differences are vast.  Even if the two people have similar interests, their priorities will still differ in some ways.

When you earn a dollar, whether it is through selling something or working for someone or getting a gift, you will choose what to do with that dollar.  You may use it to buy a basic need like food, shelter, or clothing.  After these initial needs are taken care of, there are other things on your priority list.  Maybe it is buying a car or taking a vacation.  Maybe it is buying more expensive food or eating out at a restaurant.  The point is, you are going to do what you want with it.

When the government takes your money, politicians are deciding on how they want it to be spent.  The best you can hope for is that they will spend it on something near the top of your priority list.  But everyone's priorities are different.  Therefore, everything the government spends is a misallocation of resources.  If the money were left in the hands of the individuals that earned it, it would be spent or saved how that person wanted.

With all of the taxes, government regulations, and money creation of the past 100 years or so, the government has created huge distortions.  The market tries to work around these things as best as possible, but there are still severe distortions.  The boom and bust cycle is a shorter term version of this whole thing.  The Fed creates money out of thin air and distorts interest rates and causes a boom, whether it is in stocks, housing, or something else.  When the money creation stops or slows down, there is a correction or a bust.  The market is trying to correct the previous misallocation of resources.

This is why there will continue to be tough times ahead.  The government did not allow a correction to fully take place in 2008 and instead dumped vast more amounts of money in bailing out failed companies and trying to prop up the economy.  The government and the Fed will not allow the sick economy to take its tough medicine.  Instead, it just uses a pain reliever to delay the inevitable and ultimately make the problem much worse.

Even if the government did everything right from here on (about as good of a chance as the sun rising in the west), we would still have a severe correction.  The reason is because of the huge misallocation of resources that has previously taken place.  It would take some time for the market to straighten everything out and get things in line with where consumers and investors want them to be.  In a true free market, there might be half as many colleges.  Half of the college professors might need to find another line of work.  Or perhaps the market will demand just as many as now but at a lower pay.  Without subsidized loans and subsidized education, perhaps we would see a dramatic reduction in prices.

It is hard to say how any of this would play out, but that is really the point.  Nobody can determine the preferences of millions of people.  Only each individual and their family can determine where best to put their resources.  Until we dramatically reduce government spending, taxes, regulations, and artificial money tampering, we can only guess what a true free market would look like.

Monday, November 29, 2010

The Dollar and Other Currencies

The U.S. dollar has been strong in the last couple of weeks, at least compared to other currencies.  The Euro has done poorly and probably for good reason.  The PIIGS countries are a mess and the European Central Bank is risking a collapse of the euro by bailing out the irresponsibility of European governments.  The collapse of the euro is unlikely to happen overnight, but it will slowly degrade as people realize it is in trouble.  It may take a year or it may take 10 years.

It is surprising that people still flock to the U.S. dollar when uncertainty hits.  This will change eventually, but it may take longer than what it seems like it should.  For some reason, people still have some faith in the U.S. dollar and some put their money there when times get tough.  Look at the fall of 2008 when the stock market plummeted and all of these other events were happening.  Even with a giant bank bailout from the Fed, the dollar still did well during that time.

When it comes to investing, I don't think investing in other currencies should be a major part of your portfolio.  My favorite mutual fund, PRPFX, somewhat mimics the permanent portfolio as described by Harry Browne.  However, PRPFX does invest a little portion in foreign currency, particularly the Swiss franc.  There is nothing wrong with this because it is a small portion and the fund is so well balanced.  But generally speaking, I don't see the need to invest in foreign currencies.

If you want diversification from the dollar (or whatever currency you use for your income and expenses), then  hard assets will serve you fine.  Gold in particular is really the best hedge against a falling currency.  Other things like silver and oil can also do well, but gold is probably the best.

Just to be clear, there is nothing wrong with speculating in foreign currencies, but it should be seen as speculating.  Long-term, I don't see why you would choose to invest in foreign currencies.  Yes, the dollar is a bad bet long-term, and it will eventually lose its status as the reserve currency of the world.  But, why would the yen, the euro, or anything else be any better?  They are all fiat currencies and can be debased by governments and central banks.  That is why they should not serve as part of your long-term investment portfolio.  You should leave foreign currencies for speculation with money that you can afford to lose.

Saturday, November 27, 2010

Update on Commodities

The general direction of commodities in the next year or so will depend on everything else.  The biggest thing to watch is whether the Fed fully goes through with QE2 and, if so, whether the banks lend this money out or hold on to it as excess reserves.

There is also an issue of velocity, or the demand for money, but this may be determined by the supply of money active in the economy.  If this new money stays locked up in the banks, then price inflation may be minimal in the near term.  We may see the stock market retreat and see signs of another (or continuing) recession.  Either way, we will continue to see high unemployment.

If the banks start lending money, we could see a sharp rise in the money supply that is not being held by banks.  We will see the fractional reserve process take over.  This could also lead to an increase in velocity, where people would rather spend their money on "things" than keep it sitting at a bank and depreciating.

If the banks do start lending out this money, expect commodities to do very well.  Some will do better than others.  Silver may do better than gold.  But in the first scenario where banks don't lend this additional money, gold will fall less than silver.

Oil will follow the same trend.  A recession will keep oil from rising dramatically.  If banks lend like crazy, then the price of oil will probably go up like crazy and that is under the assumption that there will be no new conflicts in foreign nations.  If there are new conflicts, particularly in the Middle East, then oil prices could go to the moon.

Food is another commodity that will go up with high price inflation.  Owning a mutual fund or ETF that invests in a broad range of food will do well in such an environment.

In an environment of high price inflation, expect commodities to go up even higher.  That is why they are important for an investment portfolio.  TIPS (government bonds that adjust for inflation) will not serve you well.  Even if the CPI were accurate, the bonds would only be going up as much as the price inflation indicator and no more.  This is not a good hedge against inflation.

Friday, November 26, 2010

Black Friday

I hope everyone had a good Thanksgiving.  Today is Black Friday.  Today is the day that shoppers go to the stores looking for good deals.  Today is the day that businesses are supposed to do well and go into the "black" (profitable).  Today is also a good day to go over some basic economics.

First, there is nothing wrong with shoppers hitting the stores for good deals.  If people want to deprive themselves of sleep and get up at 4:00 in the morning to save a few bucks, then that is their choice.  If businesses want to sell some of their products for low prices to bring customers to their store, then that is fine too.

There is one economic fallacy that does need to be addressed though.  Spending is not good for the economy as is normally thought.  There is nothing wrong with spending, but consumption does not mean that there is growth and production in the economy.

There is somewhat of a correlation between consumption and production.  But we have to understand cause and effect.  Consumption does not drive an economy.  Consumption does not make an economy good.  Production is what is good for the economy.  Production is what allows consumption to take place.  You can only consumer what is first produced.  Even if something is consumed on credit, somebody else had to have produced something.

In a poor country, like Ethiopia, there is not a lot of consumption compared to the U.S.  Most people living in Ethiopia do not have big screen televisions and luxurious cars.  I'm sure most of the people there would love to have these things, but it is not possible right now given that production is extremely low as compared to other places.  In the U.S. a lot of people can afford to buy big screen televisions because of the large amounts of capital and investment that have given us the technology and the wealth to have things.

With all of that said, consumption by itself does not mean an economy is strong and growing.  I could use my life savings and take a luxurious vacation for the next two months that would make me look like a Hollywood celebrity.  But it doesn't mean I'm all of a sudden really rich.  I would just be consuming past savings in a huge way.  I would eventually have to go back to work and drastically reduce my standard of living.  In the same way, it doesn't necessarily mean anything if Americans go out and spend big for this Christmas.  Maybe their confidence is up, but there is no way to know for sure if production and technology have increased that much or if Americans are simply consuming more than they probably should.

The lesson in this is that you shouldn't pay too much attention to the news.  Even if Black Friday is a huge "success" and people are spending like crazy, this is not necessarily good.  It might mean that consumers are going into too much debt and that low interest rates have enticed people to spend more than they should and save less.  Whatever you do, don't base your long-term investments on the results of Black Friday.

Wednesday, November 24, 2010

China and Russia to Drop U.S. Dollar

This is headline news on drudgereport.com today.  This article says that China and Russia have agreed to use their own currencies in trading with each other, instead of using the U.S. dollar as they have done in the past.

This action in itself is not really significant.  But it is another sign that the dollar is losing its status as the world's reserve currency.  The U.S. government has gotten away with much more than it could have because of the dollar's status.  It has allowed the U.S. government to run up debt more than it otherwise could have without interest rates rising.  Countries like Japan and China have been buying U.S. government bonds and have kept interest rates lower and allowed the Fed to buy less.

This news of Russia and China, slowly turning away from the U.S. dollar, is bearish for the dollar.  We can expect the dollar to go down in relation to other currencies in general.  Of course, anything can happen in the short-term.  The Euro may weaken due to the problems with Ireland and Greece, with Portugal and Spain possibly following.  A severe downturn in the economy here could also strengthen the dollar as it did in the fall of 2008.  But overall, the trend is down for the U.S. dollar.  It will continue to lose its status as the world's reserve currency and the Fed will continue to inflate the money supply.

In the long run, you should have a good portion of your investments in hard assets.  This could include stocks, but why bet on the performance of companies?  A better speculative play is commodities that are almost sure to do well with a weakening dollar.  Look at gold investments, silver investments, oil investments, and maybe even real estate down the line.  The party is over for the dollar and it is soon to be over for the U.S. empire.

Happy Thanksgiving everybody!

Tuesday, November 23, 2010

Is Deflation Possible?

There is a lot of confusion with the term deflation.  The term really should be defined as a contraction of the money supply.  Most people use it in reference to prices.  Either way, is it possible in today's environment?  The short answer is yes, but it is also unlikely.

It is hard to talk about deflation when it comes to prices.  The reason is because it is hard to get an accurate reading of the overall price level.  In the last few years, housing prices have dropped dramatically while food prices have continued to increase, even if slowly.  It is also hard because of other factors.  Healthcare and education costs continue to skyrocket, but part of that can be blamed on government laws and regulations, not just fiat money.  Meanwhile, flat panel televisions get better and cheaper.  Increased productivity and increased technology can both lead to decreasing prices, even in the face of monetary inflation.  This is a good thing.

With that said, are we likely to see deflation any time soon, whether we use the consumer price index (CPI) or a money supply statistic?  I think it is highly unlikely.  The closest thing we might see is that as the money supply continues to increase, banks will just increase their excess reserves.  This will put a lid on prices from rising dramatically.  We might be lucky to see a flat or slightly increasing CPI, similar to what we see now.

With all of the stimulus money, bailouts, and "quantitative easing", there are severe distortions in the market.  The distortions that were trying to correct in 2008 were not allowed to correct.  In the past 2 years, the government and the Fed have increased these distortions on a monumental scale.  We need to go through a severe recession to shake out all of the misallocations.  The government and Fed are not allowing this to happen.  The longer they continue to avoid it, the worse it will be.

I would not bet on deflation.  This would be betting against the Fed's ability to create money out of thin air.  This is highly unlikely in the near future.  When we start to see high price inflation and the Fed pulls back to prevent a runaway inflation, then we might see something like deflation.  At the very least, we might see price deflation as the demand for money increases.  This is what we should hope for.  We should hope for it sooner rather than later.  Unfortunately, I think we are years away before the really big shakeout begins.

Monday, November 22, 2010

Will We See Catastrophe?

Things look bleak on the horizon.  If you have some knowledge of Austrian economics and monetary policy, then you are probably pessimistic right now and for good reason.  This statement is probably overused, but we are living in unique times right now.

In the fall of 2008, the Fed more than doubled the adjusted monetary base.  A move like this in such a short period of time has never happened in the U.S. since the Fed was created almost 100 years ago.  The government debt to GDP ratio is close to 100%.  There are unfunded liabilities for Medicare and Social Security that are estimated to exceed $100 trillion, a ridiculous number.  The government is running deficits over $1 trillion per year now.  There really isn't much to be optimistic about.

So will we see catastrophe?  I suppose it depends on your definition.  There will be very hard times ahead. However, I think it is unlikely that we will see a total collapse.  I think to prepare for a total collapse is futile, unless you are willing to go all out.  By all out, I mean that you would be living on a farm, out in the country.  Even with that, how would you survive if everything turned to chaos?  What do you do when you need new shoes?  Do you have any medications that you take?  I hope you don't need to go anywhere, because there won't be any gasoline to start your car.

While anything is possible, I don't think a total collapse scenario is likely.  A more realistic view is that we will see hard times ahead, maybe some chaos, but not a complete breakdown of the division of labor.  The biggest fault of most libertarians is that they underestimate the power of the free market.  It is hard to believe since libertarians are the most staunch defenders of the free market.

While we live in unique times as far as the size of the government, we have a competing force.  We also live in a unique time where technology has never been so great.  We have the internet, cell phones, and all of the other latest electronic wonders.  Communication is easier than ever.  The government can't stop it.  Americans will not easily give up their high standard of living so that we can have more war and more government programs.  Americans will give up some of their standard of living, but there is a breaking point and we are about to hit it if we haven't already.

While we will certainly see some tough times ahead (the Austrian business cycle theory ensures that), the long-term outlook should be positive.  Don't underestimate the power of the free market.  Don't underestimate human nature and people's desire to live freely.  The free market can beat back the government.  People are starting to resist more.  It is just a matter of time before the tide of big government is turned back.

Sunday, November 21, 2010

Monetary Base and QE2



It seems that the Fed has not started QE2.  What is taking it so long?  Here is a chart of the latest adjusted monetary base, which should go up with "quantitative easing".  There is no monetary inflation yet, at least in the last 6 months.  Once the Fed starts with QE2, assuming it does, it will be interesting to see what happens to excess reserves.  It will also be interesting to see what happens to interest rates.

Thursday, November 18, 2010

Robert Murphy on QE

Robert Murphy has written another great article, this time on the Fed and quantitative easing.  In the latter half of the article, he describes a black swan scenario where price inflation all of a sudden gets out of hand. I want to focus on one particular part of his article.  It is something that I've written about before.

Towards the end of the article, Murphy states,
"The problem is that Bernanke is sitting on huge piles of US government debt, which have just gotten decimated in the bond market. For example, if Bernanke in 2010 had created $1 billion of new reserves by buying $1 billion in additional Treasury debt, those securities would now be worth (say) only $650 million. So even if Bernanke sells them all back into private hands, he will only be able to eliminate 65 percent of the new reserves he had earlier created. Open market operations will not allow him to drain the system."


This is what I discussed in the past with mortgage backed securities.  If the Fed bought all of these mortgage backed securities back in 2008 to bail out the banks and the Fed paid the original value of these things, what happens when the Fed tries to sell them?  After all, a lot of these mortgages have gone bad.  We hear about the horrible housing market and all of the short sales and foreclosures.  So let's say that all of these mortgage backed securities are only worth half of what the Fed actually paid for them.  If high price inflation becomes a problem and the Fed tries to sell these assets, they will only be able to sell them for half of what they paid.


Just for example, let's say the Fed paid $1 trillion for mortgage backed securities.  Now the Fed sells these and can only get half or $500 billion for them.  What happened to the other $500 billion?  That money is already in the system.  The Fed can't soak it up.  It has no exit plan.  All it can do at that point is prevent future monetary inflation.


The only other possibility is forcing the banks to buy them back for the original value.  But why would the Fed do this when one of its main unstated purposes is to prop up banks?  Also, this would severely weaken the banks and could cause banks to fail.  Then the FDIC would have to bail out depositors and the Fed would have to bail out the FDIC.  This would defeat the original purpose of trying to soak up the excess money in the system.  Therefore, this is an unlikely scenario.


I don't think the Fed would intentionally cause hyperinflation.  The bankers would be destroying themselves.  The fear that I do have is that they somewhat unintentionally destroy the dollar.  They think they can pull back at any time, just as Volcker did in the late 70's and early 80's.  But based on the discussion above, it may be impossible for the Fed to soak up all of the excess money once price inflation becomes bad.  If Bernanke and the Fed really do have an exit strategy, I sure would like to hear what it is.

Wednesday, November 17, 2010

Bush is Back

George W. Bush has been back in the news lately with the release of his book.  He basically admits to allowing torture and he is as arrogant as ever.  He is also as incoherent as he has ever been.  The guy can't admit any mistakes and of course he still thinks he made the right decision in invading and occupying Iraq.

This is something that ruffles a lot of feathers, but Bush and Obama are a lot more alike than most would care to admit.  They are both arrogant and full of themselves.  They both surround themselves with horrible people.  Can you think of two more sleazy people than Karl Rove and Rahm Emmanuel?  These people are pretty much the scum of the earth.  This only shows that Hayek was correct in his assessment that the worst rise to the top in politics.  The presidency is the top and we continue to see the worst.

Ultimately, politics is not our answer to having a more free society.  The game has been rigged for a long time.  The Republicans and Democrats are in on it together.  There was not much of a choice between Bush and Kerry or between Obama and McCain.  Either way, we get an establishment politician that will continue with more war and more welfare.

If you want to help in bringing a more liberty-oriented society, the best thing you can do is to educate yourself and educate others.  Many libertarians neglect the first part.  They are not well versed in libertarianism.  How can you educate others on the benefits of liberty if you yourself cannot explain your position to others?  We should all seek to better ourselves at all times and we should always work on making our position more understandable for others.

We don't need to elect a libertarian to the presidency to move in a libertarian direction.  You should remember this when investing too.  We could have a total socialist in office, but it doesn't mean that you should move out of the country or bet on a horrible economy for the rest of your life.  A libertarian revolution could be happening right under your nose, but you just don't see it because you are watching the mainstream media talking heads and looking at the fools in Washington DC.  We should not underestimate how much the politicians can wreck the economy, but we also shouldn't underestimate how much the free market can overcome.

Tuesday, November 16, 2010

Shorting Bonds and QE2

Bonds are an interesting investment right now.  There is definitely a tug of war going on, particularly with U.S. government bonds.  On the one hand, bonds should be doing poorly with interest rates rising because of all of the money printing.  Bond buyers should be asking for higher rates to compensate the risk of inflation.  On the other hand, bonds should being doing well (which they generally have been) because the Fed is buying them.  Who wants to compete against the Federal Reserve, with the deepest pockets in the world?  If the Fed announced that it would be buying shares of Microsoft, I would expect the stock price of Microsoft to skyrocket.

The relationship of interest rates and inflation can be a bit confusing.  It is like wondering if someone wearing a jacket is hot or cold.  He might be wearing a jacket because he's cold or he might be hot because he's wearing a jacket.  The cause and effect are not always clear.  It is much the same with interest rates and inflation.

Ultimately, artificially low interest rates and money printing usually translate into price inflation.  But even that is not a guarantee.  Japan has had low rates for a couple of decades with little price inflation (although it hasn't really been deflationary as many will claim).

There is no doubt that the Fed's policy is inflationary and will probably translate into higher prices in the future.  Unless Helicopter Ben isn't really who he says he is, then I would expect the money creation to continue as long as there is high unemployment with a weak economy.  I think the only way he will pull back is if there is a threat of really massive inflation.

In the long run, shorting bonds will probably be a good speculation.  It is a speculation though because nothing is a sure thing and we also don't know the timing of it.  I would not short bonds in the next 6 months.  Bernanke and the Fed will be implementing QE2, which means they will be buying government bonds.  I would not compete against them.  There is no guarantee that their purchases will drive down rates as intended, but I also wouldn't fight it.  We should look for higher price inflation before we start considering a short play.

When it is time, there are easy ways to bet against bonds.  If you aren't into options, you can purchase a double inverse ETF of longer term government bonds (symbol: TBT).  As interest rates go up, the fund will also go up.

Again, it might be an interesting speculative play in the future, but I would be patient and not bet against the Fed right now.

Monday, November 15, 2010

Currency Wars

Robert Murphy has an article on the Mises Institute website today called Currency Wars.  Murphy is one of the best, if not the best, economists that I know of.  He understands Austrian economics as well as anyone (he wrote a study guide for Human Action), but he also knows how to write and speak in language that almost anyone can understand.

He correctly points out that when a government/central bank inflates its currency, it can have a beneficial effect for exporters of that country.  Of course, as good economists, we have to look at the unseen consequences and see that it makes things more expensive for everyone.

Since Bernanke announced QE2, there has been criticism from foreign governments.  Some, like China, should be concerned because of the large amount of U.S. bonds that the country owns.  The more the Fed inflates, the more worthless the bonds will become.  The problem is, many foreign governments are criticizing Fed policy because they think they too will have to engage in inflation.  It is because they say it will hurt their exporting business.

Once again, these foreign politicians are not looking at the benefits of Fed inflation.  It's true that it may hurt exporters in their country, but it will also help importers with cheaper goods.  Whether the Fed's policy hurts or helps another countries citizens on net, it doesn't mean the other countries should partake in the same destructive policy.  They will only be further hurting their own citizens by making things more expensive and misallocating resources.

This whole subject reminds me of the discussions about Japan in the past.  People would be in a panic because Japan (although it wasn't literally the country but mostly private businesses) was selling cheap cars and electronics to Americans.  They thought if the Japanese government subsidized this at all, that it was hurting the U.S.  They never stopped to think that the Japanese government was subsidizing Americans at the expense of Japanese citizens.

My response was that if the Japanese (government or companies) started giving away free televisions and cars to Americans, would this be bad for Americans?  I'll take inexpensive products all day long.  Better yet, I'll take them free if someone else wants to build them and transport them to me without accepting payment.

Ignorance in economics runs rampant throughout the world.  It is hard to believe, but Americans are actually better educated in economics than the average person elsewhere.  This is a generalization of course, but just look at the situations in other countries.  You don't see tea parties in most other places or at least not on the scale you see in the U.S.  There are Keynesians throughout the world and it seems that the U.S. is actually the best hope sometimes.

The U.S. government is the biggest empire ever and the Fed is doing horrible things, but I'll still place my bets on the American people.  More people are becoming educated in economics and monetary policy, especially with the internet.  The Fed will cause a lot of problems in the near future, beyond what has already happened, but its days may be numbered.

Saturday, November 13, 2010

Velocity of Money

Velocity, or demand for money, is a topic that is not understood real well.  When it comes to price inflation, the focus tends to be on the money supply.  While the money supply is extremely important and it has an effect on velocity, it is really only one half of the equation.

Velocity is the speed at which money changes hands.  It is also called the demand for money.  If the demand for money is high, then people are holding onto their money and spending less.  Another way of saying this is that the velocity is low.  Money is changing hands at a slow pace.  If people are spending money and it is changing hands quickly, then velocity is high and the demand for money is low.

After the fall of 2008, velocity slowed down.  People spent less money, paid down debt, and were cautious with their money because of fear of unemployment and a bad economy.

If there is an increase in the supply of money, this should raise the general price level.  If velocity slows down, this has a counter effect.  Low velocity is deflationary on prices.  The opposite is also true.  An increase in velocity acts as an inflationary effect on prices.

This is important to understand because prices will not always move with the money supply.  The money supply could increase and yet we might not see prices rise because people are scared and holding onto their money.  You can have more money in the system, but prices won't rise unless people are using the money to bid up prices.

By the same token, price inflation could also increase faster than monetary inflation.  That is a real threat that we have to worry about.  The Fed will not intentionally cause hyperinflation.  The Fed members and other bankers would essentially be destroying their own game.  Hyperinflation would be bad for almost everyone, including bankers and politicians.  The threat though is that the Fed tries to produce mild price inflation, as it is trying now, but gets carried away and can't stop the massive price inflation.  The Fed could slam on the monetary brakes, but if the general public views the U.S. dollar as risky to hold onto, then velocity could go up very quickly.  People might start spending money like crazy, knowing that it will be worth less every day that it is held.

If the general public thinks that the Fed will not stop and that high inflation will continue, then a hyperinflation of prices could occur.  This is not a prediction as I think the Fed will pull back eventually and the general public will realize it and we will have a deep recession or depression.  But it is good to know what it possible and runaway price inflation is possible because of velocity.  It all depends upon the attitudes of those holding the currency (which also includes foreigners).  So while we should pay close attention to the money supply and bank reserves, we should also pay attention to the views of the market and whether people are spending their money in fear of future inflation.

Velocity is almost impossible to measure, but we should at least try to get a sense of what the general thoughts and attitudes are of those holding U.S. dollars.

Thursday, November 11, 2010

Adjusted Monetary Base and QE2

It will be important over the next 8 months to watch the monetary base and the excess reserves held by commercial banks.  Although there are other factors, these two charts will give us a good idea of how much new money is being injected into the economy.  The more money that enters, the higher prices will go.

Again, this isn't the only factor.  Velocity, or the demand for money, plays a huge role (more on that in the future), but the supply of new dollars in the economy will have a major impact on consumer prices.

We need to watch what Bernanke and the Fed do, not just what they say.

For the adjusted monetary base, go here:
http://research.stlouisfed.org/publications/usfd/page3.pdf

For the excess reserves, go here:
http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=EXCRESNS&s[1][range]=1yr

Wednesday, November 10, 2010

What Does QE2 Do?

Charles Goyette is the author of the lead story on LewRockwell.com today.  Goyette is the author of a great book called The Dollar Meltdown.  If I had to advise someone on what to do with their money, I would tell them to put a large portion, say 80%, in a permanent portfolio as outlined by Harry Browne in his book Fail Safe Investing.  With the remainder of your money, put it in the investments recommended by Goyette in his book.

Now let's talk some more about QE2.  The Fed is planning to buy $600 billion worth of bonds over the next 8 months, plus up to another $300 billion that it collects from its current assets.  We can forget about the $300 billion because it is really neutral as far as the money supply.  It is the $600 billion we need to focus on.

Does this new money run up the national debt?  No, not directly.  If the Fed didn't create this new money, would the debt go down?  No, at least not in the short-term.  So what does this money creation mean?

Basically, the Fed is buying government bonds from brokers.  The brokers buy the bonds from the government and the Fed buys the bonds from the brokers.  The Fed is basically handing over newly created money to the government, with a commission going to the brokers.  The government is handing over bonds (promises to pay) to the Fed.  The Fed's balance sheet goes up.  The money that goes to the government did not exist before.  This increases the money supply.

If the Fed did not do this, the government would have a couple of choices.  It could balance its budget (yeah right) or it could sell its bonds to others.  Other purchasers of bonds could be individual investors, the Chinese government, the Japanese government, or mutual funds (which would be bought by individual investors) just to name some of the most common.  Since the Fed has also gotten into the bond buying business, the Fed will bid up the prices of bonds compared to what they would have been.  In other words, this lowers the interest rates on the bonds.

That is what QE2 does.  It is monetizing debt and by doing so, it is increasing the money supply and it is lowering interest rates.  The only catch is that because it is increasing the money supply, it is also increasing the risk of the value of the bonds (being paid back in depreciated dollars) which serves as a reason for rates to increase.  It basically causes a tug of war with interest rates.

We'll talk more about what could happen with interest rates and bonds.  Although it is a tug of war and the Fed has a lot of power to keep rates low, it is unlikely that they will stay low for a long time, especially if the banks start lending out this money and we see massive price inflation.

Tuesday, November 9, 2010

Hedges Against Price Inflation

With the Fed's announcement of QE2 (more money creation out of thin air), it is becoming more likely that we will see high price inflation in the somewhat near future.  While a lot will depend on action by the banks, it wouldn't surprise me to see the CPI rising at 15% or more in the next year or two.  I know that CPI isn't accurate when it comes to reading inflation (monetary or price), but it is still useful to look at it to see trends.

The most important thing you can do is to have a portion of your investments, say 25% or maybe a little more in this environment, in assets that will do especially well in inflation.  I don't like TIPS (bonds indexed to the CPI) because they are dependent on the government's reading of inflation and they also are not a good hedge because they don't go up in real terms.

Investments appropriate to hedge against inflation are precious metals and other commodities.  Gold and silver are the best metals, but I favor gold because it is less volatile.  Oil and food are important because we use these things in our daily lives.  Although traditional stocks may go up during inflationary times, they are not as reliable and will probably go down in real terms (inflation adjusted).  There are a wide variety of ETFs and mutual funds to invest in to get exposure to commodities.

While I will expand on these at a later time, there is something else you can do as a minor hedge against price inflation and you can't really lose money on it.  It is something I've talked about before, but it is worth repeating.  If prices are going to be higher a year from now, why not buy things now instead of a year from now when prices are higher?  If you have storage space where you live, there are a lot of things that you can buy now and store for later.  I don't recommend buying a house or car (unless you really need one and can afford one), but there are always things you know you will need.  Here is a sample list of things that you can buy now and store for later.  I'm sure you can add many things to this list:

Toilet Paper
Paper Towels
Kleenex
Laundry Detergent
Dishwashing Soap
Shampoo
Bar Soap
Toothpaste
Canned Food
Canned Soda
Bottled Water

Use the first in, first out method.  These are just a few things in a long list.  You will not become rich using this method, but you might save a few bucks down the road.  What do you think the chances are of these things being less expensive a year from now?  If you have the space, why not start buying in bulk? If you see a sale at the store, buy some extra.  If you buy $500 worth of stuff today and prices go up by 20%, then you will save $100.  If you wait for sales, you will save even more.

Again, this method won't make you rich, but it is something easy you can do if you have the storage space.  If you have any extra money, it is better to buy cheaper goods now than to have it in a savings account earning less than one percent interest.

Monday, November 8, 2010

Reactions to the Fed Plan Continue

As news of the Fed's announcement last week to buy $600 billion in U.S. government bonds is ingested, we have seen a lot of reaction to this plan throughout the planet.  Today, there is a story of one of the Fed governors, Kevin Warsh, who is now questioning the Fed plan.  Of course, he voted for the program, so it doesn't mean much now.  There was only one Fed official, Thomas Hoenig, who voted against the measure.

In other news, Obama is in India right now and he spoke about the Fed plan.  When asked about international worry, he said that the Fed program would jump start the American economy and that that benefits other countries.  There is no polite way to say this, but Obama is an idiot when it comes to economics.  He has absolutely no clue and he has surrounded himself with Marxists and Keynesians, if there is a difference.  He believes that the government is the answer to all of our problems and he has no concept of how the free market works.

Meanwhile, criticism is growing from the international community.  Politicians from other countries are warning of consequences of the Fed plan.  Some of these warnings are accurate and well-founded.  Others are pure politics.  It's not to say that the accurate ones aren't playing politics, but at least they are right in what they are saying.

It is amazing how powerful the internet is.  It is also amazing how much of an affect Ron Paul has had, along with the other libertarians of the world.  There is a lot of criticism of the Fed that wouldn't have existed 10 years ago.  There are a lot of people warning about the possible consequences of QE2 and how it may trigger inflation (QE2 itself is inflation, but we'll cut them a break and assume they mean price inflation).

Tomorrow, I'll discuss some easy ways to hedge against possible price inflation.  While there is no guarantee, it seems that much higher prices are looking more and more likely in our future.

Saturday, November 6, 2010

Excess Reserves

During the fall of 2008, the big banks were bailed out.  They were bailed out by Bush, Congress, and the Federal Reserve.  The Fed more than doubled the monetary base in a short period of time.  This was a unique event in modern American history.

The massive increase in monetary inflation did not translate into massive price inflation.  The money that was created by the Fed went to the banks.  The banks have held this money as excess reserves.  Normally, the banks are only required to hold about 10% of deposits in reserve.  The other 90% is lent out.  If a bank dips below the 10% requirement, it borrows money at the overnight rate.  This is the Fed funds rate that is talked about so often.  Because most banks don't have to borrow to meet their reserve requirement these days, the Fed funds rate is near zero.  The Fed says it is holding the rate near zero, but it is really the excess reserves held by banks that is keeping the rate near zero.  With massive excess reserves, most banks don't have to worry about falling below the reserve requirement right now.

Since this money created out of thin air has been parked at the banks, it has not resulted in massive price inflation.  The money is not being lent out or spent.  It is also preventing the fractional reserve process from taking place.  In normal times, somebody would deposit, let's say, $1,000.  Knowing that only a small number of people show up at any given time to withdraw money from their account, the bank would lend up to 90% of deposits.  In this case, the bank would lend out $900.  This $900 might end up in another bank and this bank would lend out 90% of $900 or $810.  This process keeps going.  This is fractional reserve banking.  It keeps going unless a lot of people start showing up at the bank to redeem their money.  This is a run on the bank.  The FDIC was created in the 1930s to protect people's money.  This has prevented runs on banks (for the record, I'm not saying this is a good thing).  The fractional reserve process can also be reversed if banks stop lending money.

Two years ago, the Fed did something unusual, besides the massive increase in the monetary base.  The Fed bought mortgage backed securities instead of U.S. government bonds.  All or most of these mortgage backed securities were probably high risk loans.  Due to the popping of the housing bubble, there are a lot of bad loans that people can't or won't pay.  The Fed bought these for more than what they were worth.  This money went directly to the banks that used the money to increase their reserves.  The banks are probably scared to lend out this money because of what potentially lies ahead.

The next round of quantitative easing (QE2) involves the Fed buying $600 billion in U.S. government bonds.  This is a different scenario than buying mortgage backed securities.  However, this money could still end up parked at the banks.  Even if this newly created money went into the hands of average Americans, they will deposit it at a bank.  If the bank keeps this money on deposit and doesn't lend any of it out, excess reserves can still go up more.  This would again prohibit the process of fractional reserve lending.  It would prevent a quick jump in prices.

This is a possibility, but it is also just as possible that this newly created money won't sit at the banks.  This is what we need to watch.  If the excess reserves don't increase with what is supposed to be an increase in the monetary base coming up, then we should expect high price inflation within a relatively short period of time, say a year.

Thursday, November 4, 2010

A Day After the Fed Announcement

After the market had a chance to digest the Fed announcement of buying an additional $600 billion in bonds, the dollar went down.  The major things that go up with dollar weakness were up big.  Oil was up.  Stocks were up.  Gold was up over $40 per ounce.  Silver was up really big.

There is some negative reaction from China, Brazil and other places.  Some, like politicians in Brazil, see it as a currency war.  If you are in another country, why should you care if the U.S. wants to destroy its own currency?  The only way it will affect you is by the U.S. having less to trade.  China has a reason to care though.  The Chinese government owns hundreds of billions of dollars of U.S. government bonds.  The Chinese are going to be paid back in depreciated dollars if they are paid back at all.

We'll continue to watch the adjusted monetary base and the excess reserves held by banks.  If this additional inflation finds its way into the economy, we could see massive price inflation in the near future.  It is really time to pay attention.  The Fed is wrecking the dollar and it will have severe consequences.

I don't think Bernanke is dumb enough to drive us into hyperinflation, but we can't be 100% certain because the man is already doing stupid things.  He swore to Milton Friedman that the Fed would never let another great depression happen again.  He thinks the reason the Great Depression was so bad is because the Fed didn't print enough.  If he really believes this, then he truly is a moron.

Be ready for prices to skyrocket.  Grocery bills will go up.  A trip to the gas station will be more expensive.  Shopping for clothes won't be much fun when you see the price tags.  Don't expect your wages to go up though.  If they go up, it will only be nominally.  They will not keep up with price inflation.  High price inflation is almost inevitable at this point the way Bernanke is running the show.  It probably isn't a question of if, but when.

Wednesday, November 3, 2010

Election and Fed Results

There have been two significant events this week.  First, the election results are in.  It turned out about as well as a libertarian could hope for, at least realistically in today's world.  The Republicans will have a majority in the House and the Democrats maintain a slim majority in the Senate.  It is being seen as, not a win by Republicans, but as a repudiation of the Democrats.  A majority of people don't like Obamacare, along with all of the big spending, and that is why the Democrats lost so badly.

I was disappointed to see that leftist California voted down an amendment to legalize marijuana.  Here is a state that is electing socialists all over the place and yet they can't get a majority to vote on legalizing a drug that is one of the least harmful of illegal drugs.  It makes you wonder what hope there is.  It just means that libertarians have to work harder to educate others on individual freedom and how it is beneficial to nearly everyone.

The second important topic is the Federal Reserve.  An announcement came out today that the Fed will likely purchase long-term government bonds.  It will do this for the next 8 months, buying $75 billion per month.  This totals $600 billion.  It will also continue to rollover money collected from expiring bonds.  The Fed did include language that it would monitor the economy and make adjustments when necessary.

This announcement is about what the market had already priced in to this point.  The stock market did not make any really dramatic moves for an announcement this big.  The dollar fell, but not dramatically.  It will be more interesting to see how the market reacts over the next couple of days.

We'll continue to monitor this whole thing and there will be many more posts on this topic.  We will have to keep an eye on excess reserves, to see what the banks do with this money.  Will it sit as excess reserves, similar to what happened with the last major increase in the monetary base two years ago?  Will the banks lend this newly created money out and spark high price inflation?  This is a significant amount of money being created out of thin air and it will only make things worse.  We will just have to see how it takes form.

Tuesday, November 2, 2010

Election Day

If voting changed anything, they'd make it illegal.
~Emma Goldman

Voting is good and bad for freedom.  In a completely free society, voting would be a non-issue.  The only relevant voting would be in your private life.  You might be voting with your friends on where to go to dinner.  Voting for government politicians wouldn't matter because either there would be no government or the government would have virtually no power over your life, so it wouldn't matter who was elected.

In our current society, voting is a cover for politicians.  It makes people feel like they are in control.  In most cases, they aren't.  People think that as long as there are elections, they are free.  This isn't true.  You can live in a very oppressive society while retaining the right to vote.  India is an economic mess and they are considered a democracy.  Of course, democracy is part of the problem.  Democracy can mean that the majority oppresses the minority.  The ironic thing is, democracy usually leads to the majority oppressing themselves, while the minority live well.  But the minority makes the majority think they are in control.

There is a positive aspect of voting.  As Murray Rothbard wrote in 1978,


"Until or unless the United States changes from free elections to dictatorship, the question of armed revolution is, at the very least, totally irrelevant to the American scene."


The only way for the U.S. or any other country/area to achieve freedom is by changing the hearts and minds of the people.  A violent revolution will achieve nothing, but not just because violence is not the answer.  In order to achieve liberty, the majority of the people need to understand and advocate liberty.  And if you get to a point where most of the people are liberty oriented, then the only thing that is necessary is for the people to withdraw their consent.  This holds true whether voting is allowed or it is a dictatorship.  But withdrawing consent is even easier where voting is permitted.


Things have changed a lot in the last couple of years.  With the Ron Paul presidential campaign in 2007/2008, with the power of the internet, and with the horrible government policies, there has been a shift in the general attitude of the American people.  There is a lot of work to do in educating others on the benefits of liberty, but we can see progress and there is much hope for the future.  It is not because we will elect the "right" people, but because people will simply turn away from government and look for other ways to solve their problems.

Monday, November 1, 2010

Fed to Create $500 Billion

That is not exactly the headline from the media, but it's close enough.  The headline is "Fed Likely to Announce $500 Billion of Purchases, Survey Shows".  The bet is that the Fed will create inflation of half a trillion dollars.  This is huge, especially when it is added on top of the over 1 trillion dollars created 2 years ago.

The Fed and the economy are in trouble at this point, no matter what is done.  The best case scenario is for the Fed to stop creating money out of thin air and to start withdrawing its earlier money creation.  Of course, this would put some banks in jeopardy of failing, which then causes a problem for the FDIC which is bankrupt and would depend on a bailout from the Fed.  It is one big circular mess.  And the Fed won't do this anyway because it is politically incorrect and goes against the Keynsianism of the establishment.

Instead, the Fed will continue to accommodate Congress and the big banks.  In the process, it will continue to weaken the dollar and set the stage for massive price inflation in the United States.  Assuming the headlines are correct and the Fed injects another half trillion dollars, the question will be what happens with the money.  Most of the previous money created is now sitting as excess reserves with the banks.  The banks are not lending this out because of fear.  They need to make sure they stay solvent.

So what will happen with this new money?  Will it add to the excess reserves or will it find its way out into the economy?  Either way, trouble lies ahead.  If it stays as excess reserves, we will continue to see a weak economy that resembles something like Japan.  If the banks decide to lend out the money, then we will be looking at high price inflation in the near future, along with more bubbles.

The Fed is in trouble.  It is trying to do the politically correct thing.  It is putting the dollar at risk.  It is lowering our standard of living.  It is misallocating capital on a grand scale.  Eventually, it will have to choose between a depression or a complete collapse of the currency.  Hopefully it will choose depression.