A Look at the Coming Week - May 18, 2009
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After six months of flooding our financial system with trillions of dollars, it may be time to step back and speculate on the impact of such drastic measures. Has it helped or has it hurt? Are we setting the stage for recovery or could we slip even further? Will we have inflation or deflation?
Traditional Keynesian economics (named for the mid-twentieth century economist, John Maynard Keynes) tells us that the solution to a recession is to pump cheap money and lots of it into the money supply. Ostensibly the idea is cheap money that is plentiful will stimulate more borrowing which in turn causes more spending which nips the recession in the bud. As an example, if the interest rate on a mortgage drops to low levels such as 4.5%, experts will argue that more and more people will recognize that as a terrific opportunity, which will in turn increase home sales and stabilize prices.
As banks lend more money, then more money is created. That is correct. Money begets money. The more money borrowed, the more money created and the more we can spend as the spiral rises ever upward to the heavens. Conversely, the past year has shown us that money can, in fact, be de-created as less money is borrowed.
Naturally, economists are in unison when they clamor for more money to be pumped into the financial system. This brings a possibility of some real problems. It could bring deflation or it could bring inflation both of which are nasty beasts. Inflation makes money worth-less and deflation makes existing loans constrictive.
On Friday, government reports showed the most rapid decline in consumer prices since the days of Ike (Ike is President Dwight D. Eisenhower for you young readers!) in the mid 1950's. This means our dollar is worth more as prices drop. Shoppers love deflation. A person on a fixed income, who has only a certain amount of dollars to spend, will welcome the advent of cheaper goods.
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Savers like deflation too. While they may lament only getting 2% in a certificate of deposit, if consumer prices drop 2%, then the effective yield on savings is actually 4%. Wages are helped too. Real (the word "real" in economics always means adjusted for inflation) wages have not grown in America since 1999. If prices drop then a person whose boss doesn't give a raise this year will, in effect, get a raise. In other words, if prices drop 2%, the worker effectively gets a 2% raise.
Certainly it would seem that this is good but politicians get cold chills thinking that prices could continue to drop. Since government is a "credit drunk" and does not believe in saving, this scenario is bad. And, since government dictates policy, you can bet that deflation is an enemy and inflation is our friend. Here is why.
If you have a mortgage of 6% interest and consumer prices drop 2% then you effectively have an 8% loan. Remember for a moment that the Chinese are our number one creditor. We sell them bonds in exchange for cash to finance our free-wheeling spending habits. If Ben Bernanke and Tim Geithner sell China a bond paying 4% and prices drop 2% then they are effectively paying out 6% and the Chinese start to look awfully smart! I would argue that the Chinese government with all their savings, cash and gold are much smarter than we are. The Bible says the borrower is servant to the lender! Enough said.
The other thing the Obama administration is concerned about is the feeding frenzy that can occur in an environment of falling prices. If one wants to purchase a new home but senses that prices will be lower next year, then they will wait. This drives down prices and also stops the economy dead in its tracks. Lower prices lead to lower wages which leads to less spending which leads to weaker corporate profits which lead to less tax revenues and ad infinitum.
In other words, we are the instant society generation. The government believes that instant gratification is simply not fast enough! We cannot afford to be patient. We cannot afford cheaper prices. We cannot afford to save and we certainly cannot afford to do the right thing.
Enter inflation. The government loves inflation. First of all, it stops the downward spiral of prices. Then it pumps more money into the money supply which stimulates demand. Then it allows the government to pay China (and all other debts) with cheaper money.
The policy makers have assured us that they can prevent inflation. It is hard to imagine right now since that would be a policy issue. When things are good, no one wants to leave the party early and certainly no one wants to be the one to stop the party. For that reason, we may see a return to the high inflationary times of the early 1980's.
The signs are in place. We have flooded the system with more printed money than we have ever seen. Many countries are doing the same. Eventually there could be more dollars chasing too few goods which can touch off hyper inflation, a condition where interest rates skyrocket and money loses value at an alarming rate.
We can only hope that this will not happen but the smart money thinks it will. Many of the biggest money managers are now loading up on gold and gold mining stocks. Gold has traditionally been the only safe haven when inflation strikes. Commodities and other tangibles also escalate in price as goods are stockpiled. China is currently stockpiling ore and copper. They are betting that their dollars will be worth less in the future so they are locking in gains by buying up cheap commodities. They have gotten things right for some time. I suspect that they may be right again! Inflation or deflation? The jury is still out but the verdict should be forthcoming in the next few months.
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Thanks for reading another Vance Advance!
Working for your wealth and peace of mind,
The Vance Capital Management Team |
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