Sunday, June 29, 2008


In 1929, with a $20 bill, you could buy a very nice tailor-made suit, a fine dress shirt and tie, a good pair of shoes and a belt. You could also take the bill to the bank and exchange it for a double-eagle, a $20 coin containing one ounce of gold. The bill stated on its face, “This certifies that there have been deposited in The Treasury of the UNITED STATES OF AMERICA Twenty Dollars in Gold Coin Payable to the Bearer on Demand.” Take a look at today’s $20 bill. It is a Federal Reserve note. You can take it to the bank and exchange it for, well, another $20 Federal Reserve Note. Today, a very nice tailor-made suit, a fine dress shirt and tie, a good pair of shoes and a belt could easily cost you around $900, or about forty-five $20 Federal Reserve Notes. Or you could go to a coin dealer or the U.S. mint and buy a one-ounce gold coin for the same forty five $20 bills. In gold money, the price of a suit and such has stayed roughly the same. But the value of the dollar has shrunk. And it continues to shrink.

In a 2002 address to the Economic Club of New York City Alan Greenspan said something he knew very well when he first became Chairman of the Federal Reserve two decades ago:

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

Do you remember when your father called you aside and tried to explain the value of compound interest? Well, here is a picture that will bring the image back to you. It is an inverse picture of what the government has allowed to happen to the value of your money. Mostly mild increases in prices year over year, but the cumulative picture is startling. In later posts I will show you some other startling, even hair raising, pictures.

Rising price levels might be tolerable if the value of all things in dollar terms rose together and in the same proportions – in other words, if it were just an accounting issue. But folks, that’s not the name of the game. Some things keep up with rising prices and some things don’t. The name of the game is to be in line to benefit first. Be an oil producer, a defense contractor, a bank pumping out CDOs and SIVs, a hedge fund dealing in credit default swaps, or a mortgage broker pushing easy money on someone who can’t afford it. Don’t be the person who is behind the curve, or under it – a retiree or a little old lady on a fixed income or someone down the line who needs to run a trucking company or airline. And don't be someone whose dollars are just sitting in a bank account. Inflation is a zero sum game of redistribution of wealth from those in the back of the line to those in the front.

Unfortunately, when one hears about the decline of the dollar today, it is a reference to the Dollar’s value relative Euros or some other paper currency, not to the value of tailor-made suits or groceries or gold. Euros, Dollars, Yen and the like are all going down in relation to tangible value, so today’s talk about the decline of the dollar merely means that the Dollar is dropping in real value faster than the other currencies. Neither is good.

The mainstream media are only recently beginning to worry about inflation and, generally clueless, they are looking for a cause, seeking to blame greedy oil companies, speculators, etc. All the while they are ignoring the simple fact that all currencies are now fiat (i.e., not redeemable in gold or anything else – backed by no more than the promise of the government that you can use the paper to pay your bills) – and that such a system, in Greenspan’s words, is “inherently subject to excess.” Most MSM reporters implicitly adopt “an increase in prices” as the definition of inflation. So they miss the point – and the culpable party.

Austrian school economists define inflation as an increase in the supply of money and credit. That increase eventually, but not always immediately, results in prices being higher than they otherwise would have been. Tinkering with the supply of money and credit to achieve government policy goals is a very dangerous game that throughout history without exception has been lost.

Lord William Rees-Mogg wrote an interesting article on inflation last week entitled “Inflation: ‘Destroying Governments Since 1789’” giving a concise history of inflation in the West since the French Revolution. Murray Rothbard wrote a simple explanation in his monograph, “What has the Government Done to Our Money? I commend it to your reading. Alan Greenspan also described the problem quite well in his essay, “Gold and Economic Freedom” in Capitalism the Unknown Ideal. It’s tragic that Greenspan did not use his last position and the bully pulpit to bring a renewed education on the topic to the public. His squandered opportunity may very well have been the last clear chance for economic freedom and stable growth to gain a foothold in today’s world.

In any event, you will be totally bumfuzzled if you think of inflation as price increases. The latest inflation was the vast increase in the amount of money and credit that fueled the real estate bubble. The consequential rise in the price of real estate assets provided a phantom base for other credit and a false impression of wealth, both of which fueled a home-equity line of credit (HELOC)/credit card consumer economy based on borrowed money secured by something that wasn’t secure at all.

It’s over. And we are now suffering the consequences.

Why are people only now screaming so loud about higher prices when the price of food and energy have been going up for a few years. It’s because the false impression of wealth has now disappeared, HELOCs are drying up, and credit cards are getting ugly.

Without credit one normally would pay as you go. If fuel prices go up, you drive less or find a cheaper mode of transportation. You fly less or not at all. If the cost of groceries goes up, you try to shop smarter and eat cheaper, cut out the soda and paper towels entirely. And you start to look everywhere for ways to not spend. This will take its toll on prices. The supply/demand curve loses a certain amount of price elasticity without freely available credit. When a seller’s price increases cause people to stop buying, the market is telling him it’s time to stop raising prices. If the supply of money and credit is not there, the rising prices will ultimately stop.

Unless, that is, someone makes money and credit freely available again. Fed Chairman Dr. Ben Bernanke is an academic expert on the mistakes the Fed made following the crash in 1929 that (in his view) prolonged the last great depression. Here is how he proposed in 2002 to address the threat of a deflation:

“The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

Unfortunately, increasing the number of dollars in circulation or credit available to banks will not and is not doing the trick. The Fed has made the money available to the banks, but they are running scared. They are not lending. A massive deflation is now underway in the credit and financial markets. (Read Michael “Mish” Shedlock’s “Is the Inflation Scare Over Yet? Almost everything he writes is well worth reading.) The credit and credit derivatives markets are so huge that they dwarf the capability of the Federal Reserve or United States to control them. The bursting of the real-estate bubble and resulting deflation in those markets has caused credit and real estate asset prices to nosedive. And the financial markets and consumer economy built on home equity lines of credit, credit cards, and misperceptions of wealth are going down with them. If the Federal Reserve makes new injections of money and credit, they could create yet another bubble somewhere else and will likely sustain the continued “elasticity” (increases) in the prices of food and energy.

Each person’s financial situation is unique and it doesn’t work very well for me to offer advice to other people without knowing their circumstances. But here is what I do for myself that I would recommend anyone do.

  • Try to stay out of debt. Anything more than an 80% mortgage and a car loan is a risk; and, these days it is better to have a 50-75% mortgage or none at all. Too many people are now faced with owing the bank lots of money if they want to sell their home.
  • Live frugally and don’t waste money. This is going to be very hard for the X Box/iPod generation. Figure out a process for determining how to decide whether it’s something you want or something you need, and use the process in every purchasing decision you make. And, I can't say it more simply: don't spend more than you can ever hope to pay off.
  • Strive for personal excellence: work hard at your job and be the best at what you do. A rise in unemployment is a strong possibility and you want to be the last person out the door. If you are an entrepreneur, know that investment capital is scarce and investors will put their money behind only the best.
  • Be very aware of where your savings and investments are. In coming posts I will describe how fragile the banking system is and will identify some types of securities that were thought to be safe and liquid but are no longer.
  • Educate yourself two ways. Gather as much knowledge about the economy and the markets as you possibly can – and do not stop, because they change and develop every minute. If you are young, invest in yourself and pursue as much higher education as you can use in your chosen career. Government mismanagement and misfortune cannot take that away from you.

More to come . . .