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April 01, 2008

A MishMash of Thoughts on Inflation, Gold and the Government
by David Petch

The following article was published for the benefit of subscribers on February 16th, 2008.

Inflation as defined by Ludwig von Mises, "Inflation is defined as monetary expansion through introduction of physical fiat currency or issuance of credit".

Printing money has a delayed effect to hit the system; it will be circulating in the system and travel through a series of bubbles. The end game for inflationary cycles results from excessive money chasing commodities. The phenomenon of inverse relationships between bull markets in broad market indices and commodities is well known...commodity prices decline to such low levels that supplies become critical, thereby driving up prices. An example of delays in pricing hitting the consumer lies in examination of Producers Pricing Index (PPI) and the Consumers Pricing Index (CCI). Many companies use futures in order to secure stable prices in any given commodity i.e. Kellogg's purchases x number of futures contracts for corn at x dollars so price stability can be maintained in their products. Many futures contracts are 12 months plus, so any increases in commodity prices are insulated by the above practice for a "certain" period of time. Upon expiration of future contracts companies must go forth and secure another round of futures (a ladder approach) which will ultimately transfer price increases to the consumer.

Monetary inflation always leads to rising prices, which is a symptom, not a cause. There can be a percentage of any commodity price attributed to geopolitical tensions or supply issues, but values are magnified by price increases due to monetary inflation. Historically, gold backed currencies prevented rapid expansion of fiat currency, thereby creating price stability. Removal of gold-backed currencies after August 1971 allowed governments to lose any sort of moral hazard and make promises to be rewarded with the stroke of a key. John Maynard Keynes was a British economist in the early to near mid 20th century who advocated interventionist government policy by using fiscal stimulus and monetary measures to mitigate the ills of economic booms and busts. His policies became engrained in global government ideology to literally make promises for nothing; the latter portion of this sentence is not entirely true, because the promises are paid for at a later date with inflation.

Generally, when issuance of credit is expanding, interest rates rise to keep pace with inflation, as investor's demand more money. At present, there is a collapse in credit, which is being dealt with the issuance of further credit from Central Banks. Interest rates are being lowered in order to try and support the huge credit problem, which is not supportive for the dollar. Other countries around the globe at present are starting to lower their interest rates, which removes any shadows cast on the US dollar. As the US economy continues to under perform and the US FED issues more credit, securitizes more debt, increasing pressure will be placed upon the US dollar. At some point, the US government will be required to raise interest rates in order to support the currency, which will make things internally fall apart.

In the 1990-present Japanese recession, deflation actually occurred which was due in part to the overall nation being savers rather than spenders. With the US as a nation being borrowers rather than savers, a trend for increased inflation is the most probable outcome as the currency continues to expand. Interest rates are the brakes for controlling economies operating under fiat systems, which are set in part by the market. After interest rates peak, there is a gradual decline which will generally mark lows in broad market indices. Commodities such as gold, silver and oil tend to perform inversely to broad market indices. As such, people tend to seek tangible items during periods of inflation.

Periods such as now are witnessing "real negative interest rates", defined as returns on interest rates paid by holding money in cash accounts being lower relative to the true rate of inflation. This results in savers losing their purchasing power compounded year over year, which is why tangible items are sought. Markets function on the basis of psychology, never "As the Crow Flies", so when the above event (shift to tangible assets) occurs, it is a function of market sentiment. This is where Elliott (or NeoWave) Wave can come in handy, if properly executed...for those who are not familiar, Elliott Wave is one of the most complex tools of technical analysis that attempts to predict future market action based upon patterns that represent footprints of human psychology at any particular point in time.

At present "core inflation" excludes food and energy. Other components such as housing have been extensively manipulated, changed in order to try and show the absence of inflation. Psychology of government officials is reflected in the moral accountability of the public and since people are far more concerned with Bread and Circuses news (what Gary Coleman is doing or what Britney keeps in her "special room") it is no wonder why things can be manipulated. In the past when the public demanded honesty and voted with their feet, change came, but until then, the same game of charades persist.

To imagine what inflation is, begin playing a game of Monopoly with the amount of money supplied with the game and then throw in some more from another game. Over the passage of time, people will end up with more money. To imagine deflation, remove some of the money from the game and see how short the game becomes. I view the current global scenario as a financial purgatory if you will...money is being destroyed but created at the same time to mop up any credit that is lost. The US consumer accounts for 72% of the US economy, which quickly will be replaced by the US government. Since the US government can monetize debt, they or foreign companies will end up owning a large percentage of the US. This situation is not going to be an easy one to get out of unless democracy ceases to exist.

Fractional reserve banking has been one of the primary tools in the present credit cycle that allowed unprecedented economic activity. Now that the feed bag has been removed, lending has declined thereby impacting the degree of credit available to the consumer.

Below is a crude formula to depict the total amount of money in circulation at any given point in time:

M_t = M_p + M_c + M_i + ΔM- M_'

Where:
M_t = total money supply of a given currency
M_p = money physically in circulation at present
M_c = money introduced through credit expansion (fractional reserve banking)
M_i = money introduced into an economy through government printing (physical or digital)
ΔM = net sum of money entering and exiting a given currency
M_' = monetary subprime deflator (yes pun of the subprime crisis is intended) (money lost to the system through failed loans, bankruptcies etc).

There is no requirement for inclusion of a monetary inflator, since any money added to the system through price inflation is accounted for through other defined terms. In order for a currency to remain in a rising trend M_t must continue to grow or maintain a stable level. As long as a government can keep liquidity in the banking system and the economy, there will be no decline in the money supply (money in equal's money out). If the M_t=0, then M_p = number of pigs, M_c = number of cows, M_i = number of incoming animals from birth, ΔM = number of other animals, not included, amount of grain in the system plus gold and silver bullion, M_' = number of animals removed from circulation due to death slaughter, grain removed due to consumption etc. This may sound jovial, but lack of a currency for exchange of items between individuals would drive survival back to the barter system.

More and more people are defaulting on their mortgages, resulting in banks literally owning entire subdivisions developed in the past few years. At some point, losses incurred by a bank must work their way to the balance sheets, which could render some institutions insolvent. The consumer in the US accounts for 70% of the economy, which is going to see that torch passed over to the government. This slow reversal is going to result in the gradual transition from a democracy (if one thinks we function in a democracy) to socialism.

As long as governments print money to keep liquidity in the banking system to keep M_t trending higher, there will be no decline in the money supply thereby keeping inflation well and alive. Higher inflation raises the price of oil (and other commodities), which literally pipes inflation to the doorstep of each individual (higher oil prices raise the cost of manufacturing, transportation, packaging etc.).

Ultimately, inflation slows the velocity of money, which can be defined as the amount of capital per unit time circulating through the economy. This can be compared to a health freak that has blood flowing with no resistance. Suppose our healthy friend takes a change in the path of life and starts overeating, smoking and drinking. He "inflates" his body causing thicker arterial walls, which increases the pressure required to "push" the blood. As cholesterol deposits thicken, there are fewer and fewer paths for the blood to travel requiring a greater force.

Take the above thought and transfer it to an inflationary economy. Money has fewer and fewer "paths" to take, because much of it is lost to buying products at inflated products. Due to a lack of options, tangible items become a focal point due to the arterial walls of the economy having a narrower passage.

In the past, a simple bypass or quadruple bypass surgery could save our friend or the economy, but not without a long period or recuperation. At present, the US economy can be deemed "terminal" which will cause cardiac arrest and death.

The US economy will eventually rise like a phoenix out of the ashes, but it will be as a differently run entity. Before the US experiences a rebirth, it first must go through the motions to purge all of the excesses. Over the next 9-12 months, overnight interest rates in the US will bottom and finally the bankers will realize that the only way anyone will lend them anything is if higher interest rates are paid above the perceived rate of inflation. Now here is the clincher...

The USD is likely to continue declining if monetary expansion occurs with low interest rates. Since the US imports over 70% of its energy requirements and almost all manufactured goods, logic dictates that prices for these items would rise sharply. If the US were to stop printing money, then the dollar would eventually stabilize and may even start rising...but there is a catch. Stopping the printing presses in the US would immediately turn the inflationary cycle upside down to pure deflation. Deflation is caused by a decline in the total money supply based upon the simple equation presented earlier. With deflation, by definition, gold should decline in value along with all other assets relative to cash (since it becomes scarce), but its purchasing power will fall less relative to other goods. In the end game, a country could void any prior currencies and make an exchange rate for a new one.

With the coming waves of inflation setting to hit the shores of economies around the globe, ownership of gold and silver bullion is a must, so accumulate while it is still somewhat accessible for purchase.

A major portion of the work I do is technically oriented, but I am starting to write 2-3 editorials per week, such as the above. For further viewing of prior work, simply click on the Archive section of this site. I update the AMEX Gold BUGS Index, AMEX Oil Index, US Dollar Index, 10-Year US Treasury Index, S&P 500 Index as well as commentary on market-related issues and new technical analysis findings. We follow some 60 stocks, with a focus on core positions and stocks that actually make up our personal portfolio. As well, the keeper of the site, Captain Hook writes 3-4 articles per week discussing macro issues, ratio analysis of various markets and an in-depth study of put/call ratios and shorting candidates.

Have a good day.

David Petch
TreasureChests.info

Treasure Chests is a market timing service specializing in value based position trading in the precious metals and equity markets, with an orientation geared to identifying intermediate-term swing trading opportunities. Specific opportunities are identified utilizing a combination of fundamental, technical, and inter-market analysis. This style of investing has proven to be very successful for wealthy and sophisticated investors, as it reduces risk and enhances returns when the methodology is applied effectively. Those interested discovering more about how the strategies described above can enhance your wealth; please visit our web site at http://www.treasurechests.info.

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