"The past does not repeat itself, but it rhymes." - Mark Twain

Series - Part 2 of 7
Part 1: The Current Investment Landscape
Part 2: Germany's Inflation In The 1920s
Part 3: The Dollar vs. Gold - You Should Care
Part 4: U.S. Stocks, Inflation, and Relative Valuations
Part 5: Commodities In Today's World
Part 6: Investing In A "Flat World"
Part 7: Global Real Estate, Inflation, and Relative Valuations

Inflation vs. Deflation: To Be Successful You Must Decide

The purpose of the article is to explore an extreme case of inflation and to look for similarities to our current environment in the hope of making better investment decisions.

The longer you study the global economic landscape in order to build successful investment allocations, the more apparent it becomes that you must first decide whether you believe we will remain in an inflationary environment or if we are on the verge of slipping into a deflationary environment. Why is making a decision on the inflation/deflation issue so important? Because investments that perform well in an inflationary environment are on opposite ends of the spectrum from investments that will prosper in a deflationary environment. For example, in an inflationary environment, you want to own "stuff" such as commodities, real estate, and to a lesser degree stocks. In a deflationary environment, where the money supply is contracting and paper money becomes more valuable, cash and bonds will be very attractive.

If you look at global money supply growth rates, rising oil, gold, silver, healthcare, real estate, and stock prices, it is difficult to argue that we are not experiencing inflation at this time. Therefore, it is prudent to ask the following questions:

• What does an inflationary cycle look like from a historical perspective?

• What investments have protected investors during past inflations?

• What are the investments to avoid during inflation?

• What does the end of an inflationary cycle look like?

Germany's Hyperinflation of 1923

With a background in engineering, I often find it useful to look at economic extremes for educational purposes just as we explore outcomes in calculus when numbers tend to infinity. If we can better understand the extreme economic case, it may help us deal with more moderate economic cases. An extreme case of inflation occurred in Germany in 1923. One does not have to believe that we are headed for hyperinflation in the present day U.S. to see similarities to Germany in 1923. It is also clearly understood that there are significant differences in 1923 Germany and the 2006 U.S. and global economic landscape.

Similarity #1: Both governments went off the gold standard.

When World War I broke out on July 31, 1914, Germany's central bank suspended the right of currency holders to redeem paper notes for gold. After that change, there was no legal limit as to how many notes the government could print. While the U.S. government appears to have made many questionable financial decisions in recent decades, a good place to begin our parallel with Germany is in 1971. In 1971 during difficult economic times, President Nixon closed the "gold window" and took the U.S. dollar off the gold standard. From this point forward, the U.S. dollar was no longer backed by gold. It is now simply an IOU from the U.S. government.

Similarity #2: Both governments allowed the money supply to increase substantially.

It is well documented that as a result of high debt levels incurred during World War I, the German government printed large amounts of money to finance the war. This is not an uncommon occurrence when governments need money for war or in a situation where the people are either unwilling or unable to provide the funds via increased taxes or through the purchase of government bonds. By the end of World War I, the German government had allowed the amount of money in circulation to increase four-fold. The graph of M3 below shows how the U.S. Federal Reserve has allowed the money supply to balloon at eye-popping rates since the mid-1990s.

Similarity #3 - The large increase in the money supply and easy access to credit lead to unproductive speculation and investment.

In Germany, many businessmen left their legitimate occupations and began to speculate in stocks and in goods. The number of bank employees grew from 100,000 in 1913 to 375,000 in 1923. Many capital projects proved to be inefficient or unneeded. The number of middleman and tax regulations grew substantially. In the United States, we saw day trading become a new occupation and now we have seen the number of real estate flippers, agents, and mortgage brokers swell. We all are very aware of the poor allocation of capital that occurred during our recent dot-com bust. Just like Germany, U.S. corporations have been burdened with a well-intentioned Sarbanes-Oxley Act of 2002.

Similarity #4 - Both governments implied external events, not money creation and overspending, were the cause of rising prices.

We can see similarities to Germany in that the U.S. government needed funds to fight the "war on terror" post-9/11. Just as it was in Germany in the 1920s, it would have been politically unpopular to raise taxes after 9/11. It would also have been politically difficult to raise taxes or sell additional bonds to debt laden U.S. consumers. The latter stages of Germany's money printing was justified in the minds of many political leaders and citizens since the perception was that the reparations required from post-war treaties were too harsh. As Americans, we are often told that our current runaway deficits and price inflation are not the result of decades of overspending and money creation, but because of the current "global war on terror" and war in Iraq. In more recent times, we are also told that China or the oil companies are the roots of all our fiscal and currency problems.

Similarity #5 - Both governments told citizens that portions of the large deficits would be covered from external sources.

Just as President Bush promised that oil money from Iraq would pay for the war, German citizens were told that their enemies would pay off the large deficits after a Germany victory in World War I.

Similarity #6 - As the money creation lead to rising asset and consumer prices, the need to print more money seemed to feed on itself. The illusion of prosperity and low unemployment was difficult to reign in.

During the middle stages of Germany's inflation many businesses could not keep products on the shelves and unemployment remained extremely low. In the U.S., dot-com shares were oversubscribed and many condo developments have been sold-out prior to the completion of construction. Our present day America is dependent on continued loan growth to keep elevated real estate prices high and stocks on an upward path. The Federal Reserve knows that prolonged tight monetary policies (higher interest rates and a contraction of the money supply) could deflate the value of real estate and stocks. Our economy has become dependent on the wealth effect from elevated asset values.

Similarity #7 - Real wages declined even as nominal wages increased

This was true in Germany and is evident in the U.S. today. Worker's pay increases have not kept pace with the loss of purchasing power of their currency.

Similarity #8 - Both governments had enormous debts to repay

Germany had large war deficits and was faced with war reparations. The U.S. is currently faced with large budget deficits and enormous future entitlements in the form of Medicare and Social Security. History shows us that governments with large debts to pay often favor an inflationary environment to help reduce the burden of future payments. In the past large amounts of debt have been inflated away in China, Russia, Mexico, Brazil, Argentina, Poland, Greece, and Turkey. This is an important concept. Using the U.S. as an example, assume Social Security estimates your annual retirement benefit to be $22,000 per year when you retire 10 years from now. In an inflationary environment, the government's real debt burden decreases because the $22,000 that they will give you in ten years will be paid back with devalued dollars. On the other hand if we slip into deflation, the government's debt burden in terms of purchasing power would increase, as the $22,000 they give you in ten years will be worth more than $22,000 in today's dollars. This gives you another significant reason to believe that the Federal Reserve will use any means necessary to prevent deflation. When you look at it from the high levels of government debt and entitlements, Ben Bernanke's "printing press" speech given at the National Economists Club in November of 2002 takes on added significance:

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), which allows it to rs 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."

Much like our look at Germany's extreme case of inflation, I feel Bernanke's remarks above are also based on an extreme way to fight deflation. On the other hand, they do give you some insight as to how Bernanke views the Federal Reserve's role in the fight against deflation.

How did the German inflation end?

When people began to lose confidence in the value of paper money, they began to spend it immediately in an effort to avoid losing purchasing power (this is known as an increase in the velocity of money). In the end, farmers stopped selling produce because they would not accept near worthless paper money. Businesses became unable to keep the shelves stocked or were unable to sell at a profit and thus began to close down. Unemployment began to soar. Today, you need to look no further than the recent gains in gold and silver to see that people around the globe have started to lose faith in global paper money.

Who was hurt most in 1923 Germany?

Unfortunately, it was often a conservative and prudent person who did not like to take on debt or speculate in markets. Those who held cash or bonds saw their purchasing power destroyed by the vast increase in the money supply and resulting rapid rise in prices. People on pensions or fixed incomes also were hurt badly.

How about stocks and real estate?

According to The Nightmare German Inflation by Scientific Market Analysis, after the stabilization:

"Heavy new taxes and the urgent need for cash forced most real estate holders to refinance their real estate, often taking on higher levels of debt. Thus, gains were often illusory. Still, those who held real estate throughout managed to preserve capital more effectively than holders of cash or bonds. However, those who sold real estate during the inflation (often through desperate need for cash) fared poorly. Because it brought little income since real estate sold at extremely low real price levels during inflation. During an inflation of the money supply, common stocks are generally considered a desirable hedge to protect against or even to profit from the rise in prices. In practice, it is not so simple. In the U.S., stock prices have been known to fall violently just when inflation was most evident (1946, 1957, 1966, 1969). Market fluctuations--the rise of exciting new speculative stocks, waves of fear or greed--all make it much too easy to buy or to sell at the wrong time or to go into the wrong stocks. Getting down to specifics, we can say that those who bought a well-diversified list of stocks in solid, well-established companies quite early in the inflation and who held on throughout the period and also through the stabilization crisis preserved much or all of their capital. However, there were many pitfalls along the wayside for the greedy, the fearful and the over-clever. Those who did best were investors with a certain unemotional, stolid character, a basic confidence that strong, well-managed companies would come through.

Many very sharp but brief advances and declines in the market led to widespread speculation and many well-intentioned investors often wound up as traders. Naturally most of them did as badly as amateur speculators generally do. Many decided that speculation was the only sensible approach; when the entire economy and financial structure was visibly crumbling, who could wait patiently with confidence in the long-range value of anything?"

Who was able to protect their wealth?

In the end, people who held gold or moved investments into stable currencies early in the cycle. As prices began to rise rapidly, the German government eventually implemented strict foreign exchange controls. After the controls were in place, the black market was the only vehicle to move to gold or foreign currencies.

What might signal the end of somewhat sustainable inflation and a possible move toward hyperinflation?

As stated above, if the velocity of money increases at very rapid rates, it may signal the final loss of confidence in a currency. Since debt and loan growth play a big part in the creation of new money, the relationship between economic growth (GDP), loan growth, and interest rates may also be worth watching. As shown in the charts below, the switch from rising prices to falling prices in Japan came as loan growth began to slow. If economic growth slows and interest rates rise, borrowers become less willing to take on debt. In that environment, the risk-reward profile of additional debt becomes less attractive.

The focus of this series is on how to approach the markets based on what is actually happening in our inflationary world. It will does not focus on serious commentary of current economic policy or make any firm predictions about the future. It is simply an attempt to understand where we are today in a historical context and where we may (emphasis on may) be headed based on a historical context. We can use Mark Twain's wisdom to our advantage, "The past does not repeat itself, but it rhymes."

Coming Soon: Part 3 of 7 - The Dollar vs. Gold: You Should Care