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The Fed's 20-Year Misguided Monetary Adventure

The Fed has run a misguided monetary policy for the last twenty years. The error of its ways is finally being revealed, and there is NOTHING the Fed can do to stop it. Gold will continue to go up in price, food stuffs will continue to go up in price, housing will continue to collapse, and stocks will go down. Investors who do not understand what is contained in this article risk losing (in inflation-adjusted terms) a very large amount of their wealth.

Why?

Stagflation. Plain and simple.

For decades economists have struggled to explain stagflation. How can inflation accelerate if the economy is slowing? The economists at the Fed think of monetary policy within the context of a two-dimensional Phillips Curve. When the economy grows, so does inflation. When the economy contracts, disinflation occurs.

Exhibit 1. The Outdated Phillips Curve

Unfortunately, out here in reality, the Phillips Curve does not exist. It never did. It is absolutely the wrong model to explain our economy. Yet, it is the basis of Fed policy and a central premise behind the Fed's dual mandate.

The problem with the Phillips Curve is that it does not take into account the difference between credit creation and money creation.

Credit and money creation are related, but they are not the same. Credit is debt. Money is cash. Economists agree that creating excessive amounts of money is bad, because it leads to inflation. However, large credit growth is encouraged. The Fed thinks of it as is a sign of a healthy economy. Credit creation drives up asset prices. Houses increase in value, stock portfolios go up in price, and yet consumer inflation is moderate. We feel really, really rich. Times are good.

Listen to how Greenspan (in his 2004 Congressional testimony) talked positively about credit spreads tightening and mortgage debt growing: "Narrowing credit risk spreads and a considerable rally in equity prices have reduced financing costs and increased household wealth, which should provide substantial support for spending by businesses and households... Home mortgage debt increased about 13 percent last year, while consumer credit expanded much more slowly. Even though the ratio of overall household debt to income continued to increase, as it has for more than a half-century, the rise in home and equity prices enabled the ratio of household net worth to disposable income to recover to a little above its long-term average. The low level of interest rates and large volume of mortgage refinancing activity helped reduce households' debt-service and financial-obligation ratios a bit."

In his testimony, Greenspan focuses on the positives and ignores the consequences of excessive credit creation. As it has done for the last 20 years, the Fed also continues to ignore the consequences. From 1985 onwards, there was MASSIVE credit growth in the U.S. This growth got particularly out of control in the late 90s and over the last 5 years. With the U.S. so out of control, credit growth spread to other parts of the globe.

Exhibit 3. Massive Credit Growth Starting in the 1980s

Over time, massive credit growth causes asset prices to become overpriced relative to consumer prices, commodity prices, and wages. That is the situation we are in now. Few can afford houses at their current prices. And many companies cannot generate enough earnings to support their debt levels and stock prices. Asset prices simply cannot be justified relative to consumer prices.

Exhibit 2. The Simple Stagflation Model

When asset prices become too inflated, the market kicks in. Asset prices turn down. The market wants to realign asset prices to consumer prices.

The Fed doesn't want asset prices to come down because asset prices lead to bankruptcies, especially among banks which are highly leveraged. The Fed tries to encourage more credit creation. But the market is saturated with credit, and banks have to cut back their lending. So the Fed has to create actual money to replace the credit that is being destroyed. This money creation creates consumer price inflation.

Stagflation is born.

Exhibit 4. A Real Life Example of the Stagflation Model

For those who believe in the Phillips curve, stagflation is very confusing. However, looking at money and credit separately, we can see the situation clearly. Ironically, as excessive credit was being created, it was not inflationary. As it is being destroyed, it becomes inflationary!

Whatever the Fed does, it cannot fool the market. The market wants to re-align prices, and it will go on doing so until housing becomes affordable. That is why gold is skyrocketing, and why it is likely to continue to skyrocket.

If that isn't clear, here is another way of looking at the problem. Right now, most investments I look at are highly priced relative to their potential return. I look at lots of businesses people are starting, and they just don't make sense to me as an investor. The sellers are saying, well, I paid X and now prices are going up, so I need X PLUS 10 to make up for inflation. However, the buyers are saying, I need a minimum return that is greater than inflation, so I need you to sell the business at X MINUS 10.

As a result, less and less business is getting done. Buyers and sellers cannot agree on a price. Business is slowing down, and investment is simply not happening.

Airlines are rationalizing supply. Banks are cutting back. Retailers are slowing their rates of growth. Margins are contracting in many industries. The market is saying: at these high asset prices, we don't need any more investment.

Meanwhile, commodity prices are going up, so investors are saying: I'll just invest in commodities. Why do I need to invest in companies? Why invest in production?

You'd think that higher prices would mean higher production. But they don't. That is the true conundrum of stagflation. Look at oil companies starting to peak in their earnings. Their input costs are going up as fast as their output costs. Margins are tightening, as end users (consumers) are having trouble stomaching the higher prices. Again, the market is clearly saying that we do NOT need more production.

How can this be? How can the market be telling companies to cut back production if prices are rising? This situation is in no way explained by the Phillips Curve model. However, if we look at it from the new model, it makes complete sense. The market is asking for less investment and less value to assets. It does not need more asset creation. It is asking for higher consumer prices, so it is encouraging the market to produce less and drive up prices. This is the key point. Because the market wants lower asset prices relative to consumer prices, it actually favors lower production and therefore higher consumer prices as the asset economy contracts. What most people don't realize is that the price increases are coming from production cuts as much as demand increases. Now try that one on for size! Now that is stagflation.

For decades, no one has understood it. But it is plain and simple.

Of course, at a certain point, consumer prices rise so much that the world is in balance again. But by then, everyone has lost faith in assets and consumer prices overshoot. That's the time to start buying houses and financial stocks and other stocks. However, looking at affordability measures, that time seems to be several years off at least.

Please, don't lose your wealth. This time is not different. It's just the same as it always was: when excessive credit creation occurs, asset prices begin to fall relative to consumer prices.

The future is that consumer prices/wages/commodity prices will increase in value relative to asset prices (stocks, housing). As a result, a great way to protect your wealth continues to be gold.

 

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