Today's Market WrapUp 11.17.2003 Mon Tue Wed Thu Fri Puplava Archive
Good
and Bad Inflation
BY
JAMES J. PUPLAVA, CFP
Inflation
has and will always be a monetary phenomenon. This is to say that
inflation is the direct consequence of government policies. Spending
more than it takes in, governments often resort to policies of inflating
the currency. What a government can’t politically extract in the form
of taxes it extracts through inflating the money supply. This, in effect,
is another form of taxation. The government is taking what is not
lawfully its own by expanding the supply of dollars in the economy.
Unlike citizens who have to work for wages or investors who earn returns
from their investments, the government contributes nothing for the
dollars it creates. It is simply adding dollars to its account through
fiat means, which depreciates the value of the national currency.
The consequences of these actions are that the value of the currency declines and in this case, the value of the U.S. dollar. When a government or central bank creates additional money through fiat means, it creates inflation. The real definition of inflation is an increase in the supply of money beyond any increase in specie. 1 By its very definition, it attributes the real cause of inflation to its root source which is expansion of the supply of money and credit through artificial means. Its real cause is an act of fraudulent intervention into the financial and economic system distorting values, investments, and in the process, the distribution pattern of wealth and income within the economy.
An understanding of the real cause of inflation is crucial to an understanding of fixing it once it reappears. Most economists and analysts misdiagnose inflation. The standard definition of inflation today adopted by economists, analysts on Wall Street and the mainstream press is that inflation is an increase in prices. The modern definition of inflation as simply rising prices looks more at the symptoms of inflation and not the cause.
Prices are rising, but why?
By focusing more on the symptoms of inflation (rising prices) rather than its root cause (expanding money supply and credit) shifts attention away from government. Government decisions or central bank decisions to expand the supply of money and credit is what causes inflation in the first place. The fact that prices are rising is simply the way that expanding money and credit surfaces in the economy. By creating more money and credit than can be produced or gained from productive resources or through savings, the government has interjected an artificial source of demand in the economy. There is now more money and credit floating around the economic system than there is the capacity to produce goods or services. Since the additional money did not result from producing additional goods or increased savings, its source is artificial. The additional dollars created through fiat means creates additional demand in the economy beyond its ability to produce, so the prices of goods or services rise as a result.
So-called "Good" Inflation
When a government or a central bank begins inflating, it can’t always control the outcome or flow of fiat dollars. Those fiat dollars can go into goods and services driving up their prices or it can go into investment assets such as stocks, bonds, real estate or other currencies inflating their values. This is what is mistakenly referred to as “good inflation,” since it manifests itself through rising asset prices. This is what we saw throughout the 1990s when the prices of stocks and bonds rose beyond the value of companies to earn profits. The above average returns from stocks during this period were viewed favorably as a bull market. In reality, it was a bull market in paper and credit. Rising stock and bond prices were the avenue in which this additional money and credit found an outlet. The result was rising prices for most paper assets such as stocks, bonds, and the dollar.
The
general public was unwittingly happy with this form of inflation because
they were at first the beneficiaries of this asset inflation. The price
of paper assets rose in value making everyone feel that they were
wealthier. But this was artificial wealth. It wasn’t wealth created
through the means of production or through savings. It was inflated
wealth created through too much money chasing too few goods or assets
(stocks and bonds) driving up their price.
Corporate earnings actually peaked in 1997. Yet stock prices rose at high double-digit rates as shown in the graphs below reflecting Fed policies of adding additional reserves to the financial system in response to the Asian crisis in 1997, Long Term Capital Management and Russia’s debt default in 1998, and Y2K in 1999.
By creating illusionary profits through excess money creation, the normal economic forces of the free market were distorted. During periods of inflation (inflation defined as a period of excess money creation) as we experienced throughout the mid-90's, investors were rewarded through the ownership of common stocks. The shares of both efficient and profitable companies as a well as inefficient and unprofitable companies rose in price. However, anything that is created artificially can not long endure. The increase in stock prices throughout 1995-2000 was all artificial. It had more to do with the supply of additional money and liquidity in the financial system than it did real wealth created from the production of goods and savings.
The distortions that were created through excess money creation manifested itself through not only higher than normal asset prices, but also through a change of behavior of the citizenry. Thrift was discouraged, above-normal consumption was encouraged and borrowing to consume became the standard. There was a tinsel town atmosphere of prosperity that was unreal and unsustainable. Fed inflation polices penalized thrift, encouraged debt, and stimulated consumption beyond the economy's capacity to produce. The result is that savings went to zero, debt rose to more than 100% of disposable income, and the nation’s trade deficit ballooned to a record level. These distortions can be viewed in the graphs of debt, the savings rate and the trade deficit below:
Boom
to Bust
Eventually the artificial boom led to a bust. Booms that are created unnaturally through the creation of fiat dollars always end in a bust. This is an irrefutable law of all fiat currencies and can be viewed throughout all of recorded history. The first thing that gave was stock prices. In the next three years stock prices fell by double digits each year resulting in nearly $8 trillion in losses for investors. Instead of allowing the economy and the markets to cleanse itself from all of the distortions and malinvestments of the boom, the Greenspan Fed embarked on a policy of reinflation. This can be viewed by the current graph of the money supply. M3 grew from a low of $6.6 trillion in January of 2000 to $8.8 today. The result of this excess supply of money was that additional asset bubbles were created in the bond market, mortgage market, real estate market, and in consumption. The rise in real estate prices was once again viewed favorably as good inflation since the value of real estate rose.
And Bubbles Everywhere
As repeatedly annunciated through press releases following FOMC meetings and Fed research papers, the Fed was concerned over the possibility of asset deflation or the bursting of bubbles it had artificially created through its own polices. Money supply growth expanded at double-digit rates as the Fed expanded liquidity in the financial system in an effort to keep asset prices from deflating. We now had multiple bubbles taking place in not only bonds, mortgages, and real estate, but another mini-bubble was developing again in the stock market as the price of profitable and unprofitable companies rose sharply. In the most recent rally it was the shares of unprofitable companies with balance sheet problems that rose the sharpest. Rather than looking at the various asset bubbles and their cause, attention was directed at the rise in asset prices. The inflation that was occurring in real estate was viewed more in terms of a bull market than its inflationary cause. This once again stems from the distorted definition of inflation as rising prices without examining its cause. This definition doesn’t apply to assets. Rising asset prices are always viewed as favorable regardless of their cause. In this case rising real estate prices, rising debt levels as a result of refinancing, and above-normal consumption financed through debt was viewed favorably as a sign of economic recovery rather than the distortion created through excess money and credit.
Things Are More Costly
The
only problem with this policy is that much of this new money is now
starting to show up in rising goods inflation and rising service costs.
The government reported Friday that producer prices rose 0.8% in
October, an annualized rate of 10%! In addition to rising goods and
service prices the cost of raw materials from energy, copper, sugar,
cotton, cattle to gold and silver are rising at a fast clip. The CRB
just broke out to a multi-year high. When
the government begins inflating, the general public is usually caught
unaware. Up until now all they have seen is rising asset prices in
either stocks and bonds or real estate. The rise in prices is considered
transient and only temporary. The Fed, worried about asset deflation,
has conditioned the markets into thinking that asset deflation is a
major concern so any price rise should be viewed as favorable.
When the public believes that asset prices rises are only temporary, they begin to hoard money. The consequences are that demand for money increases by the general public and the velocity of money declines. The result is that prices increase less than the rate of increase in the quantity of money. The government benefits from these actions since it creates additional dollars without any initial demand created for goods and services. Prices rise less slowly at first.
When John Q Wakes Up
However, at some future point the public wakes up to the fact that it has been fooled. When the public wakes up to the fact that government policies are creating inflation and that prices of essential goods and services will rise, they step up their purchase of goods. At this point, the demand for money falls and as a consequence the price of goods begins to rise faster than the supply of money. This sets the stage for goods inflation to start showing up in rapidly rising prices as we are now seeing in commodities. The public begins to wake up to the fact that it has been scammed by government. The preference to own real assets begins as the public looks at owning other forms of money. A flight from money takes place as individuals seek to invest in real goods or anything that is tangible that can hold its value. When this scramble begins, the stage for hyperinflation is at hand. Unless the central bank takes steps immediately to stem the flight out of paper fiat money and maintain confidence in the currency, all is lost. For confidence lost is confidence that is not quickly regained.
We are not there yet, but the tide is quickly turning against the Fed’s inflation polices. Already a cycle of rate hikes have begun first in Australia and then in Great Britain. The Fed has indicated that it is a long way from beginning the next rate hiking cycle, but Fed notes from FOMC meeting reveal it is now considering how it will unwind its polices of keeping interest rates artificially low. Just how it will do so without creating severe market dislocations remains a major policy concern. How do you detoxify an economy and financial market that has grown addicted to cheap money and credit?
It is time for investors to take steps to protect their portfolios and purchasing power. The unwinding of Fed inflation policies and the slowing down of the money supply indicate that in fact this process has already begun. It is one more reason why smart money has been buying gold and silver. The rise in the price of both precious metals is serving a warning that financial disruptions and a collapse in confidence in fiat paper will shortly be upon us. The surprise going forward could be how quickly goods inflation could be upon us and equally how quickly the Fed responds by raising rates. There is a game of chicken going on in the financial markets between bond investors and the Fed. It is a question of time to see who flinches first -- the bond markets or the Fed. You have to protect yourself from the melee that may unfold, which means you have to own silver and gold.
Today’s Markets
Major stock indexes fell on Monday for the third consecutive session. There were a number of reasons as to why stocks fell from increased terrorist threats to increased mutual fund and other financial scandals, which are a common weekly occurrence. Today’s drop in U.S. stock prices follows on the heels of steep declines in the Japanese and European markets. Markets were also concerned over Friday’s sharp increase in the rate of producer goods inflation.
Tomorrow, the government will report the CPI numbers for October. Gold prices have been signaling trouble, rising close to $400 an ounce. The Fed can not afford to see gold prices rise, because it will mean the end of confidence in its inflation schemes, so large vested interests attacked gold today driving down its price. The Fed hopes money will go into the bond market driving down yields, which is what it did. The price of Treasury bonds rose as equity markets fell. However, even a late round of buying in the futures pit failed to stem the day’s losses. Large buying in futures managed to only to trim the day’s losses.
In the U.S. markets, technology and Internet shares were among the biggest losers. Falling shares outnumbered gainers by 22-10 on the Big Board and the NASDAQ. Volume came in at 1.3 billion on the NYSE and 1.8 billion on the NASDAQ.
JP
© 2003 Jim
Puplava
November 17, 2003
Chart
courtesy: www.stockcharts.com
and Bloomberg
[1]
Rothbard, Murray, Man, Economy, and State, p. 878.
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