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In a recent article, I wrote about Mike
“Mish” Shedlock of the blog Global Economic Trend Analysis (http://globaleconomicanalysis.blogspot.com)
and Peter Schiff, of Euro Pacific Capital, Inc. (http://www.europac.net/). I
separated them into the camps of the deflationistas (Shedlock) and the
inflationistas (Schiff).
Peter
Schiff wrote me to make a very important point. “Remember,” he
wrote, “I too forecast a massive deflation, with both asset and
consumer prices falling in terms of gold. However, these will clearly not be
the case in terms of U.S. paper dollars. While asset prices may indeed fall,
consumer goods prices will rise.”
Mish,
who is one of the best writers in the blogosphere, has always been careful to
specify how he defines deflation. He calls it a contraction of money supply
and credit. He does NOT define deflation as a fall in prices (for example, he
believes oil prices may go up because of Peak Oil).
What
I like about both these writers is their clarity, well-thought out visions,
and continual updates.
In
retrospect, it was probably unfair to characterize their differences as a
Rumble in the Jungle, because they share many similarities. They both have
been long-time critics of the insane, rapid, and excessive credit creation in
the United States. They both are critics of current Fed policy (Schiff thinks
the Fed should be raising interest rates to encourage savings, discourage
more debt assumption, and defend the dollar). And they both see the collapse
of the credit bubble as inevitable.
The
difference between them, according to my understanding, is that Mish believes
the government will ultimately be powerless to create more money supply and
credit, and the dollar’s fall should be limited. Schiff, on the other
hand, talks more about the weakness of fiat money. There is nothing backing
the dollar and therefore nothing preventing the government from creating more
and more dollars. As a result, Schiff focuses on the implications of a
weakening U.S. dollar.
Mish
sees more of Japanese-style deflationary collapse, where it is likely that
prices will go down. He claims that the government will do many things to
stave off deflation, but he believes they will not be able to overcome
certain constraints. He believes there are many forces outside of the
government’s control: people consuming less, taking on less debt, and
walking away from their homes and bad loans. Job losses will lead to lower
wages. In addition, our society is in the process of creating “zombie”
banks, which will be unable to expand their balance sheets. “The
Fed,” he claims, “cannot create jobs and the Fed clearly cannot
prop up home prices.” Interestingly, Mish recommends gold, but he
believes the Euro is overvalued (at 1.52, he said it was “riding on the
fumes of sentiment”). Mish has made many amazing calls and he has been
a true leader in forecasting the credit crisis. His clients at Sitka Pacific
Capital Management are no doubt pleased. However, he has made one error to
date (he might be ultimately proven correct), which is his belief that the
U.S. dollar would hold up.
Schiff
recommends foreign currencies, gold, commodities, and other means of actively
defending one’s savings and purchasing power against the coming crash
[you can learn more about Schiff’s recommendation in his book
“Crash Proof: How to Profit from the Coming Economic Collapse.”
http://www.europac.net/report/index_crashproof.asp]. Schiff has generally
been correct, and it is almost a certainty that his readers and clients have
profited enormously from his advice.
My
own take is that the economy will slow. The result is likely to be a
government that “changes the rules of the game.” The government
will alter what the Fed can do, how money is created, and what the government
itself does. Part of this rule changing is likely to involve government
bailouts of Freddie, Fannie, a large number of banks, and individual debt
holders (see Barney Frank’s and Hillary Clinton’s latest
proposals). Rule changing may also include more government infrastructure
spending (Obama), tax breaks (Obama, Clinton, and McCain), and Fed
monetization of debt. I also expect the Fed to eventually lower the reserve
requirements for banks.
More
liquidity, however, will not solve the essential problem. The problem, as I
will write about in a subsequent article, is that banking reserves have been
shrinking while credit and money supply have been growing. In the 10-year
period from July 1996 to July 2006, while the M2 money aggregate increased by
83%, total banking system reserves decreased by 17%. While the Fed would
justify this trend as a result of innovations in banking, to me it signals
that real wealth is not being created. The Fed is printing money to create
the illusion of wealth, and they are mortgaging our future by allowing more
of our banking reserves to be destroyed through excessive consumption and not
enough savings. The Fed and politicians are unwilling to accept a recession
that would bring spending back in line. They are trying to keep the system
moving forward by leveraging our future through a worsening proportion of
banking reserves to GDP and to money supply. While short term bursts via
liquidity injections and interest rate cuts help prop up the system, they
only make the ratios of financial health worse. The Fed always claims its
emergency measures are temporary, but it never seems to be able to remove
them because the system has become more leveraged and more sick and therefore
needs more assistance.
For
many decades, the U.S. benefited by issuing dollars and sending them abroad.
We manufactured a fiat currency, while other countries sent us goods. The
result was that we had less inflation (because of a cost of money that was
artificially low), a greater sense of productivity, and a high standard of living.
Today, around 70% of the entire world’s reserves are in U.S. dollars.
This amounts to trillions and trillions of dollars residing outside the U.S.
Now, the process of massive dollar creation is reserving itself and having
the opposite effect. The U.S. will suffer from this unwinding, while the rest
of the world will benefit from no longer having to subsidize our consumption.
For
many years, sensible people who argued against increasing levels of leverage
were shocked and awed as the markets rallied higher in response to Fed
incentives to create more and more leverage. The bull market became a
self-fulfilling prophesy. Now, however, the grand illusion has been revealed
to be, well, an illusion. Any move by the Fed now will only spark inflation.
So it's either the stock market or the dollar (the same choice as the Great
Depression, interestingly --- when they chose to sacrifice the markets).
We'll see if sacrificing the dollar works any better this time around.
Throughout
the world people are losing faith in the dollar (there are even reports of
Chinese peasants not wanting to hold dollars). Meanwhile, our people and
government cannot show restraint and continue to spend and incur debt in the
face of a slowing economy and deteriorating personal, banking, and
governmental balance sheets. We are addicted to spending. We are addicted to
debt. The mantra is not: “We need to live within our means.” The
mantra is “We need hope and more creativity from Washington.” The
mantra is not “Let’s cut back because the government is broke and
cannot afford Social Security and Medicare.” The mantra is “A
country as rich as ours should provide healthcare for all its
citizens.” [Note: Mish would argue that the culture of America is
already changing towards reduced spending and increased savings and there is
nothing the Fed can do about it now]. Already, in the first four months of
this fiscal year, the run-rate of our budget deficit has doubled.
We
have so much faith in the dollar, we think of macroeconomic choices as
either-or. Either we raise rates and the economy slows, or we lower rates and
the economy expands. We are not seeing the complexity and the true nature of
what is happening. We can lower rates, but risk destroying confidence in the
dollar and eroding our country’s good credit (and therefore ability to
borrow). We think that lowering rates will jump-start our economy, whereas it
could lead to investors fleeing to other safer havens. Lowering rates further
and engaging in bailouts could create a sense that the game is rigged and
therefore should be avoided. When Argentina devalued their currency, it led
to a currency decline AND an economic decline.
In
his most recent article, Schiff writes: “Bernanke also seems to think
that if the economy does somehow slip into recession, that inflation will
subside as a consequence. This is pure nonsense, as diminished demand here at
home will be offset by enhanced demand abroad. As a weak dollar forces
Americans to cut back on their consumption, strengthening foreign currencies
will give foreigners added purchasing power to consume more. Therefore fewer
foreign made products will be imported while more domestic made, or in most
cases grown, products will be exported. The result will be reduced domestic
supply putting additional upward pressure on prices.”
It
has been so long since we have seen inflation and a prolonged decline in our
currency that we do not realize the old playbook will not work. If we lower
rates, we risk destroying our currency and impoverishing ourselves.
Foreigners will buy more of our agricultural products, coal, lumber, and
clothes, and we will have less purchasing power to import the same products.
Foreigners will buy up our real estate and assets. We will have to sell our
foreign holdings. While politicians may blame the foreigners, WE are the ones
creating this situation.
So,
while the rest of the country becomes poorer as a result of misguided Fed
policies, it is not too late to protect your own wealth, by buying gold,
commodities, foreign currencies, and other inflation hedges.
In
the last article, I wrote: “I’m closely watching the dollar
(especially the 1.49 line), gold (especially at $930 on the upside and $895
on the downside), oil (at $97 on the upside), and stocks (1310 on the
downside for the S&P500). If any of these lines are crossed, then I think
new trends are in place that could last a while.” Well, all those lines
have been crossed. As I write, the dollar is at 1.56, gold is at $935, oil is
above $101. As Schiff predicted, a slowing economy is not leading to
Bernanke’s predicted disinflation. Could it be any more clear?
Stagflation is here, and Peter Schiff has the vision that predicted and
continues to explain what is happening in the markets. Mish’s vision is
similarly compelling. It will be interesting to see if Mish is correct, and
the dollar turns around, or whether dangerous creativity continues to come
out of Washington and the world’s reserve currency continues to
implode.
Fake Ben
Bernanke
FakeBen.com
FakeBen is a blog to
monitor the Fed and its actions and encourage community participation. At
FakeBen, we believe that the Fed policy of the last two decades has created a
credit bubble as large as that created in the 1920s. This bubble will lead to
either inflation, a recession, or both.
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