Overview
The week of May 3rd to 6th has rocked the financial world. Stock markets fell around the globe with an almost 2% one-day drop in equity values across 23 developed nations (per the MSCI gauge), and a 5.2% fall in three days. The S&P 500 hit a two-month low in the US. The euro plunged against the dollar for two straight days, reaching a 14-month low. The financial crisis claimed three lives in Greece, as a result of fires set during the nation's paralyzing general strike, even while German newspapers roiled with anger over the European Central Bank's inflationary rule changes intended to help finance the Greek bailout. Meanwhile, Australia considers exorbitant mining tax hikes, to keep those global gold profiteers (aka investors) from reaping too many of the benefits of the gold that rightfully belongs to all Australians.
The world is changing rapidly, but it is not descending into unpredictable chaos. Instead, as we will review in this article, three separate but intertwined economic themes that will dominate the 2010s are emerging into the headlines. Investment values have been falling around the world, and this is likely to continue as pervasive asset deflation in purchasing power terms takes hold. Global monetary inflation will simultaneously be another powerful force, for plunging asset values do not prop up the purchasing power of currencies. The third global force is likely to be rising tax rates, with particular effects on many precious metals investment strategies.
Investors who do not understand these three broad forces are likely to see little more than chaos, and they face an oncoming series of negative surprises that will systematically destroy much of their net worth. Through anticipating these forces however, and understanding how they intertwine, informed investors gain an opportunity to not only protect what they have, but to turn that understanding into substantially increased wealth.
Global Asset Deflation
As fears of the Greek "contagion" spread this week, the repercussions swiftly became global. The losses were worst in Europe with Madrid's key stock index falling 5.4% in a day, even as Lisbon's index fell 4.2% and Paris fell 3.6%. The DJIA in the US fell 2%, closing below 11,000. Shanghai's benchmark index fell 2.1%, Hong Kong's key index fell 2%, and Australia fell 1.9%. In all, about $1.1 trillion of global stockholder paper wealth was destroyed in a day, according to Bloomberg. We do live in an interlinked world.
While Greece is in the headlines at the moment, it is not the heart of the crisis. For Greece is only a comparatively minor example of a common global theme: governments having made a series of politically popular promises over the years that they simply can't pay for. When we consider the much greater problems with the larger nations - a mere $1.1 trillion in equity losses may end up looking like pocket change when compared to eventual total investors losses.
To see the problems stemming from impossible government promises, but on a fantastic scale -- you need to look no further than the United States. As I cover in my article "Bailout Lies Threaten Your Savings", the United States long ago passed the point where it was credible to believe it could pay for its promises. When we add up expected Social Security and Medicare shortfalls, cashing out pension and retirement investments, and the guarantees of the bailout and stimulus package, the total shortfall comes in close to $100 trillion. There are about 111 million US households, but not all of them can help pay. When we adjust out below-poverty-line households and average retiree households over the coming years, there will be about 79 million "able-to-pay" households. Divide the total shortfall by "able-to-pay" households and the shortfall works out to about $1.25 million dollars per household. That is, $1.25 million per household over and above current household tax payments and other expenditures.
Thus, Greece's current crisis could be described as a mere rounding error in comparison to what is coming fast and hard at the United States.
When they talk about the contagion spreading, most people look to countries like Portugal and Spain. However, if we want to see a crisis in Europe that dwarfs Greece, then consider Britain. According to yesterday's New York Times, government spending in the UK over the last 13 years has risen at a rate that's 41% higher than the rate of inflation. About 25% of British government spending is currently borrowed money (comparatively, US federal deficits ran about 40% of spending last year). Mervyn King, the governor of the Bank of England, is quoted (secondhand) as saying that he expects that whichever party wins the current election will later be out of power for a generation, because the austerity measures needed to meet Britain's problems will be so painful.
The reason to believe why global asset deflation will dominate world markets over the coming decade comes down to a little bit of radical common sense. This common sense is that every nation only has one economy. Therefore, paralyzing economic problems with impossible government promises will necessarily have to travel through to the private economies of those nations. Economic devastation and political turmoil do not lead to ever increasing corporate profits, as is assumed with long term investment models. Mathematically, most of today's global equity valuations are based upon assumed growth in corporate earnings. A world in which that growth does not occur is a world in which equity values effectively collapse in purchasing power terms on a global basis.
Global Monetary Inflation
Investor pain went well beyond just falling equity prices. The euro fell roughly 3% against the dollar in the first half of the week, because of fears of the inflationary effects of the Greek bailout. So for a Spanish investor wanting to buy an asset priced in US dollars, the one-two combination of Spanish stocks falling 5% and the euro falling 3% means they lost about 8% of the purchasing power of their assets in a matter of days. Likewise, a US investor in Spanish equities would've lost about 8% of their investment value in dollar terms.
The reason for the plunge in the euro was not just the damage to the European economy, nor the costs of the Greek bailout, but the method the European Central Bank is using to help finance the bailout. The ECB has announced that it will change its policy and make loans based upon accepting Greek government debt as collateral, despite the Greek government bonds having a "junk" credit rating. In other words, a private commercial bank can purchase Greek government bonds, and fund that purchase through borrowing from the European Central Bank. The ECB, in its own equivalent to the Federal Reserve's actions in the United States, has the ability to effectively create euros out of thin air to fund that loan and thereby the purchase of the bonds. While this is still one step short of outright direct monetization, such as the ECB directly creating euros to buy Greek bonds, the line is getting very thin indeed, and the direct purchase pressure is growing.
While the euro can likely handle a roughly hundred billion dollar bailout, the problem is that this sets a precedent for future bailouts. While on the surface it may appear less painful than the alternatives, the chosen solution places in peril the value of every euro held in every nation. The Germans in particular are keenly aware of this, and German newspapers have been furious about what has happened. To cite a couple of examples, the Die Welt says: "they (the ECB) have also sacrificed the credibility of almost all EU institutions from the European commission on down to the central bank. These are the true costs of rescuing Greece." The Handelsblatt takes it a step further and says "if you take a closer look at the situation you can see that European politicians sealed the fate of their currency union over the weekend."
To understand why the European Central Bank is taking these unprecedented actions - look to the streets of Athens. The citizens of Greece are less than grateful for the bailout and the accompanying austerity measures. They don't really understand or care about central bank actions; what the average Greek sees is broken government promises, and rapidly approaching personal impoverishment compared to the lifestyle they believe to be their natural right. So general strikes paralyze the country and the fatalities begin, as three people die in the firebombing of a Greek bank.
When it comes to government spending and promises bankrupting a state, however, Greece has nothing on California. Just as the California economy dwarfs that of Greece, so does the incredible size of California's rapidly growing budgetary crisis, particularly when you take into account what happens when their pension crisis intersects with widespread global asset deflation.
When we consider the long-term value of the US dollar, think about those tragic deaths in Athens. Consider the anger that might be unleashed in the cities of California and elsewhere, if millions of people see broken promises and steady impoverishment as their future. Think then about whether our politicians will force severe austerity measures on the population when there are riots in the streets -- or whether they will elect to quietly debase the currency in a manner that few understand, let alone protest.
Simultaneous Inflation & Deflation
So will the future be (a) global deflation, or (b) global inflation?
Unfortunately the answer is (c) both of the above.
Asset deflation is a decline in the purchasing power of your assets. Monetary inflation is a decline in the purchasing power of your money. The simplistic view is that your investment assets losing value somehow protects the value of your money. In other words, many people believe that if markets and real estate are falling, at least you don't have to worry about the value of what is in your savings account. This was more or less true back in the days of gold-backed currencies - such as the US gold certificates at the beginning (but not the end) of the Great Depression. This "protection" is non-existent however, for a nation with a symbolic or fiat currency. Instead, when a nation is in trouble, it is the norm for the value of its investment assets to simultaneously decline with the value of its currency. On a global scale, this could mean an environment of simultaneous asset deflation and monetary inflation that could last a decade or more.
As an illustration, the real danger to your savings is not the Dow Jones index dropping to 6,000. The danger is that the DJIA rises to 30,000, with triumphant newspaper headlines every step of the way - but the purchasing power of the dollar simultaneously falls to ten cents. Thus, a future Dow 30,000 will only buy what a Dow 3,000 would today. So you have experienced a plunge in the purchasing power of your savings that has been masked by the destruction of the value of your money. Meanwhile, the government is increasing your losses through collecting whopping taxes on the (economically non-existent) profits generated by the increase of the Dow to 30,000. It is this relationship between asset deflation, monetary inflation and inflation taxes that is the central danger facing long-term investors around the world.
When viewed from the simplistic perspective of newspaper headlines, it may look like you tripled your money in the illustration above. In fact, however, you lost more than two thirds of the value of your investments. Let me suggest that any methodology that is unable to distinguish between tripling your money and losing two thirds of your money, is profoundly dangerous for your net worth.
(I have written extensively about these issues in other articles, with my Puncturing Deflation Myths series being a good start, as well as the video / text article "Can Theory & Jargon Destroy Your Net Worth?")
Australia's Gold Tax Grab
Meanwhile, in Australia it appears as if another global trend for the 2010s could be getting started, and this trend is one that could be devastating for many precious metals investors around the world. As reported in the Sydney Morning Herald, the "Henry tax review" study is recommending a 40% tax on mining company profits. Prime Minister Kevin Rudd appears to be embracing the recommendations as forming the basis for a long term tax blueprint.
This huge mining tax is not yet law, and may never become law, its support from the current ruling party notwithstanding. Nonetheless, the talking points involved, and the way it is being presented by both politicians and the media are quite educational, and should be carefully noted by precious metals-oriented investors.
Prime Minister Rudd is phrasing the debate in terms of the profits from gold that rightfully belong to Australia are unfairly going overseas to foreigners. The proposed tax law changes call for reducing the domestic tax burden for Australian businesses overall, with that reduction in domestic tax burden being paid for by effectively increasing the taxes on foreigners. This is powerful, powerful stuff from a political perspective, and variations on this theme can be expected to play out on a global basis over the years to come, particularly if we assume that gold continues to rapidly rise in price. (And yes, Australian citizens who've been buying mining stocks to protect themselves from the fiscal actions of their own government will be equally hurt -- but playing it as Australians versus foreigners is the more potent political argument.)
Another level of concern is that once grabs get going, they happen at more than one level. Specifically, as reported in The Australian, the government of South Australia is considering doubling its mining tax from 3.5% to 7%. After all, the national government is looking at raising mining taxes, and raising mining taxes "worked" for the government of Western Australia, so why shouldn't it work for South Australia too? It should also never be forgotten that the greater the profits that flow into a business, the more incentive there is for company management to find a way to cheat outside shareholders. Level after level, the more powerful the incentives -the more likely the action.
This is a danger which I have been warning about for years in my educational materials. Too many people have been acting as if "history was over" and people could invest as safely around the globe as they could in their own nation. History has not ended, but rather history is that nations act in their own self interests, and that they change the "rules" at will. Small investors who can't vote, or investors who are only a minority of voters in their own country, can have little or no power to affect how those rules are changed. When gold soars in value, even as the global power order restructures, there are a wide variety of ways in which both nations and mining companies can cheat foreign investors out of what they thought would be a fair share of the profits. Indeed the incentives are so great for this behavior that it should be considered not a remote possibility but quite probable, and the higher the price of gold goes, the more likely it is that this will happen.
Rules change. And they usually change in favor of those people who have the power, while hurting those people who don't have the power. The greater the incentive for changing the rules, the more likely the rules will be changed. These basic relationships should be core to any long-term investment strategy in a time of turmoil.
Expropriation of the wealth of foreign investors -- which is another name for the recommendations of the Henry tax review -- is a very real danger. However this is not the greatest tax danger for gold investors globally. No tax law changes are needed for gold investors around the world to be dealt devastating blows to their net worth in an environment of high inflation, through high inflation taxes as described in my many other writings on the subject.
Intellectual Capital In A Time Of Rapid Change
However bleak the situation is, don't assume that your savings are necessarily doomed -- because they don't have to be. The outcome for your personal financial situation will come down to the decisions which you personally make. What is going on today will make many people panic. However, I believe that the best way to preserve your personal assets, and even improve your situation, is not to panic, but to get very calm and make some coolly rational decisions. With the best place to start being conducting a personal inventory of not just your investment capital, but of something even more important: your intellectual capital.
Do you have the knowledge you need?
Do you know how to protect what you have built from asset deflation? Here's the bonus net worth question: do you know how to profit from asset deflation?
Do you know how to protect the value of your assets from monetary inflation? Do you know how to profit from monetary inflation on an after-tax and after-inflation basis?
Do you know how to protect yourself from governmental confiscation of your net worth through inflation taxes?
Do you understand how simultaneous asset deflation and monetary inflation work? Do you know enough to protect what you have in a world where the value of assets is falling simultaneously with the value of money, even as taxes rise?
Being frank in your self-assessment is likely the single most important thing you can do to preserve what you have in this crisis. Because monetary crises are times when a very rapid redistribution of wealth occurs. And the way that redistribution can work is that the wealth is taken from the people with many assets but little knowledge of monetary crisis, and redistributed to other people who have more education (albeit an education in unconventional financial techniques).
Since the year 2000, I have been a student of simultaneous asset deflation and monetary inflation, and how they can interact in an environment of inflation taxes. The reason I've been a student is that none of today's headlines as covered in this article were unpredictable even 10 years ago. The demographic crises, the investment crises, and the debt crises have all been building in plain sight for a very long time.
When I started my studies, I was already the author of two books on investment finance, with 2 degrees in finance, as well as a former investment banker. Over those 10 years, I had to relearn much of what I had been taught in the previous 20 years of my financial schooling and career. Because most of what passes for the conventional financial wisdom, is implicitly based on the assumption that we already know the future, and it is a rosy future of never ending economic growth and ever increasing corporate profits. The paradigms that we have all been taught about investing collapse in an environment where the value of money and the value of investments are simultaneously falling over the long term.
Gold Out Of The Box
Gold is a particularly interesting example, as it can be described as either the unconventional alternative to conventional investing, or perhaps more accurately, the most conventional of the unconventional investments. Gold operating as one of the most effective of all the inflation hedges is quite commonly accepted. However, as I explore in my new "Gold Out Of The Box" materials, inflation-oriented buy-and-hold gold strategies are crippled by inflation taxes. The government's effective confiscation of wealth through taxing the investor on the destruction of the value of the government's own currency can be expected to outweigh gold gains in inflation-adjusted terms over most long-term holding periods. So the gold investor loses a chunk of their after-tax and after-inflation net worth if gold rises to $5,000 an ounce, loses a bigger chunk if gold rises to $10,000, and takes a devastating blow if gold rises to $20,000 an ounce.
Making things more interesting still, is that gold can in fact be a superb investment during times of simultaneous asset deflation and monetary inflation. Indeed, in a time of economic meltdown, an asset deflation based gold strategy can be the single best way to generate spectacular returns that turn crisis into potential multigenerational wealth. Gold becomes the best investment in the world for crisis. But gold asset deflation strategies are quite different in the execution from gold monetary inflation strategies.
The difference between the two types of gold strategies? Intellectual capital. Which is acquired through education.
As Greece leads the way into our new financial world, the time for taking action that will build your knowledge is today.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com.
