Inflation
It's Not Just a Good Idea, It's the Law
George J. Paulos
The law in question is the Federal Reserve Act of 1913. By giving a small cartel of bankers the exclusive right to create unlimited money and credit, the Act virtually guaranteed long term price inflation. Since 1913, the US dollar has lost almost 95% of its purchasing power. This loss in purchasing power is a direct result of a massive increase in the supply of money that has occurred since the founding of the Fed.
Historically, spokespeople for the Federal Reserve always maintained an illusion that the Fed was dedicated to fighting the forces of inflation using its power to set short-term interest rates. Nowadays, there is not even a pretense of fighting inflation. Fed governors have now declared deflation, a fall in the money supply and general price levels, to be public enemy number one. Recently, Fed governor Bernanke stunned the world by admitting that the central bank could and would use the power of the mythical money printing press to create inflation if necessary. Fed Chairman Greenspan publicly lamented that "an unwelcome fall in inflation" would be disastrous to the economy. What is an "unwelcome fall in inflation" anyways? Heck, I would gladly welcome some deflationary relief against sharply rising energy, food, insurance, housing, and medical costs. Why is to my advantage to pay more for everything that I buy?
To be fair, Messrs. Greenspan and Bernanke actually have something to worry about. The massive increase in "money" that I mentioned at the beginning of this essay was a little misleading. The Fed actually creates relatively little money in the sense of the dollar bills that you hold in your wallet. That is true fiat currency. Created from a printing press and backed by nothing, these bills at least have some tangible reality and carry no hidden obligations or interest liabilities. Most of what we call money that is carried in bank accounts, money market funds, brokerage accounts, etc. are actually just credits. There are few, if any, actual bills backing any if this "money." Money today is almost entirely a balance sheet entry. The money that you and I hold in our various accounts is actually just somebody else's debt. These debts are packaged as securities and traded as money. They come in the form of Treasury bills, commercial paper, repurchase agreements, and a menagerie of other exotic debt securities that people and institutions accept as payment in lieu of actual cash. Since these are all just debts, they possess the two fundamental characteristics of debt: interest payments and maturity. All issuers of these securities are obligated to pay interest and to reimburse the creditor full face value at maturity. So what happens if some of the issuers of these debt securities default on their obligations? Big Trouble.
The quirky design of the Federal Reserve System makes it rather inefficient at creating and distributing cash-type money, but in coordination with member banks it is fabulously efficient at creating debt. This is called "fractional reserve banking" and it allows your local bank to create gobs of new money via lending, all mediated and facilitated by the Fed. Fractional reserve banking is something like a pyramid scheme (remember Mr. Ponzi?). As long as only a few people try to cash in, the system works fine. But like all pyramid schemes, it needs a constant flow of new funds to keep the game going. Since almost all of the money in existence carries a compound interest rate, the supply of new money or debt must increase by at least as much as the interest expense to support the system. This is where the inflation comes from. Don't believe me? Look at the chart of M3 broad money supply.
Since 1960, there has hardly been a single year when this broad measure of money materially declined. This is a good thing because it allowed the money game to continue and the country to prosper and grow. Should the money supply start to decline, there would not be enough money to pay interest expense so debts would start to default at an increasing rate. Since debt is also money, disappearing debt will further shrink the money supply in a vicious circle. This is what Greenspan and Bernanke are so worried about. They MUST keep inflation above a minimum level to ensure the proper functioning of the monetary system. It's not their fault; they did not design the system.
Eagle eyes looking at the above money supply chart may see a little "hook" at the end of the graph. Is that a downturn in the most recent money supply data? Let's zoom in and see.
Yes, it's true. M3 money supply has been contracting since Sept 2003. All of the other money measures M1, MZM, and M2 are also contracting. What's worse is that money velocity is falling also, making the existing money stock less potent. If this trend continues there will almost certainly be trouble in the US economy. This is because the US is incredibly indebted at all levels. Personal, corporate, municipal, state, and federal debt are at record levels and growing at an increasing rate. Increasing debt requires increasing money to service the debt. If insufficient money is available for debt service, much debt will default and the economy will spiral downward.
Why is the money supply falling? It seems that nobody really knows for sure but there are probably a number of causes relating to overcapacity, global competition, trade deficits, bubbles bursting, etc. Maybe the country just can't take on any more debt.
What is the Fed to do? Unfortunately, they have already exhausted almost all of the tools at their disposal to "reinflate" the system. They have reduced interest rates to near record low levels in an effort to entice even more borrowing. But as we have seen, more borrowing only increases the strain on the system and the Fed is near the end of its effectiveness using its conventional policy tools. They have threatened to go "unconventional" using untried and aggressive tactics but this will only further weaken an already battered US dollar and may destabilize financial markets. The Fed is in a box and there is little left for them to do except to jawbone the economy into recovery.
It seems that we are near an endgame of some sort. There are people who think that it will end in hyperinflation and those who argue for deflation. It's possible that we may experience both simultaneously in different markets. The debt situation can only be resolved by either depreciating the currency (inflation) or liquidating the debt (deflation). Investors must prepare for either scenario. This is why many thoughtful advisors are stressing the need for some precious metals and hard assets as part of a sound portfolio. These are the few asset classes that will weather this storm.
George J. Paulos
Editor/Publisher
Alternatives for Financial Freedom
gpaulos@freebuck.com
www.freebuck.com
Copyright 2004 George J. Paulos, All rights reserved.
The information contained herein is deemed reliable but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The author/publisher may or may not have a position in the securities and/or options relating thereto, & may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein. The author/publisher of this letter is not a qualified financial advisor & is not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.
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