I don't know of any subject that is more universally misunderstood and misreported than inflation. Virtually every day we see the market commentators and economists on CNBC marveling at how the US economy continues to show strong growth with minimal signs of inflation. The current situation can be likened to an elephant hiding behind a matchstick, where inflation is the elephant and the matchstick is the CPI. For some reason most financial reporters seem incapable of seeing the elephant.

The elephant is, of course, the surging money supply growth rate. Like the bubbles before it, today's stock market phenomenon is fueled by an over-abundance of cheap money. The fact that this money has not caused US consumer prices to rise substantially can be put down to the following:

• Commodity prices are at multi-decade lows due to a massive depreciation of many currencies versus the US dollar and the decade-long recession in Japan
  
  
• Countries throughout the Asian region have been attempting to use their depreciated currencies to export their way out of recession and have flooded the US market with cheap (in US dollar terms) imports
  
  
• Robust productivity increases in the US have offset increases in the cost of labour
  
  

It is incredible that, even with the above factors at work, the US CPI is still increasing. All things being equal, the cost of living in the US should have plummeted during the past 2 years. All things are not equal, however, and the fact that the US CPI has risen in the face of these price-depressing influences is testament to the high level of money supply growth, that is, the high level of inflation.

It is even more incredible that Fed Chairman Greenspan, a man who surely does understand the true definition of inflation and must therefore recognise the current situation for what it is, chooses to pursue policies that add more air to the bubble. Greenspan has studied the boom of the 1920s and its aftermath. However, having now permitted a bubble to form his over-riding goal is 'crash avoidance'. When a crash does inevitably occur despite his best efforts, his over-riding goal will then be to avoid the mistakes made by the Fed during the early 1930s when the US money supply contracted by 30%. Whereas the Fed of the early 1930s was limited in its ability to create new money by a legal requirement to exchange dollars for gold at the rate of $20.67 per ounce, today's Fed has no such restraints. The US dollar will be depreciated to whatever extent is necessary to support asset prices and prevent a debt crisis.

Outside the US the other major central banks are engaged in a giant game of 'one down-manship' as they attempt to remove any barriers to weaker currencies. The Swiss, traditionally the makers of the hardest of the soft currencies, have reduced their official interest rates to Japanese levels and removed the legal link between the Franc and gold. The Euro, the ultimate fiat currency ('ultimate' in the sense that it not only has no link to the physical world, but does not even exist outside the memory banks of computers), is a symbol of the worldwide drive to de-value. In Europe it appears that meaningful structural reforms that would reduce the punitively high levels of taxes on business, reduce the cost of employment and free up the now heavily regulated labour markets, are out of the question. Instead, the current thinking is to use a relatively cheap currency to gain a competitive advantage in the export markets and thus stimulate economic growth. In Japan, a strong Yen relative to the US dollar would cripple the economy by removing corporate Japan's only profitable market. Any increase in the Yen/Dollar exchange rate is therefore likely to be met with Bank of Japan intervention.

Since the link between gold and the US dollar was severed in 1971, we have not seen deflation in this world (or, as far as I know, any other world). Based on the current actions of central banks, and assuming no return to sound money (money convertible into gold or silver), the chances of anything greater than a deflationary blip occurring in the future are somewhere between nil and zero.

Trying to figure out the best fiat currency to hold is like trying to figure out if it is better to be eaten by a shark or by a crocodile. The ability of governments to reduce the value of their currencies should not be under-estimated. Luckily, we have another option. Gold, throughout the ages, has proven itself time and time again to be the ultimate hedge against currency depreciation.

Talk of potential IMF gold sales has dominated the gold market in recent months. Various heads of state and monetary officials have publicly speculated that the amount to be sold will be 5 to 10 million ounces, with the proceeds to be invested in government debt and the interest income on this 'investment' used to reduce the debt of third world countries.

The true reason for the sale of the IMF gold is clearly not to help poor countries reduce their debt, since the amount of interest income would be insignificant in comparison with the amount of currently outstanding debt. However, speculation on the real reasons behind the sale is of academic interest only. The important point is that the proposed sale of 10 million ounces of gold is nothing more than 'noise'. The reason that gold remains firmly entrenched in a bear market is that stocks are perceived to offer high, relatively risk-free returns. Whilst confidence remains in the ability of the US stock market to continually deliver robust capital gains, investment demand for gold will not significantly increase. This confidence was momentarily shattered in 1998 when world equity markets 'corrected', leading to a brief rally in the gold price. However, equities were brought back to life by the aggressive worldwide lowering of interest rates initiated by the US Federal Reserve. The next time the US stock market corrects disconcertingly an accommodative monetary policy may not be sufficient to restore confidence in financial assets. When investors in the 15 trillion dollar US stock market and other equity markets throughout the world seek alternative places to put their money, the investment demand for precious metals will surge. At this time gold will enter a new bull market, irrespective of how much gold the IMF sells.

The latter stage of the bull market in US equities that began in 1982 has been characterised by extraordinary increases in the prices of internet stocks. Short sellers of internet stocks have been crucified as the prices of companies with no earnings and minimal revenues have leapt several hundred, or even several thousand, percent.

The type of speculation we have seen in the internet stocks occurs at the end of major bull markets when the expectations of making the 'killing of a lifetime' completely outweigh the fear losing money. The internet stock boom has also been driven to extremes by a Federal Reserve whose charter now appears to be to provide whatever level of liquidity is necessary to sustain the bull market. However, the internet stock boom should not be dismissed as just one more mass gambling spree in the final stages of a roaring bull market.

The internet is, without doubt, one of the greatest inventions of all time. It is set apart from other great innovations, such as the automobile, the telephone and the computer, by the speed and geographical spread of its impact. Whereas automobiles and computers are still unaffordable to a large part of the world's population, the internet, in its infancy, is already reaching people in some of the poorest countries. As an example, I recently traveled through India and was amazed at how easy it was to get an internet connection at cyber clubs located in almost every town. The majority of Indians cannot afford to buy a PC, but they can afford to pay 1 rupee per minute to access the internet. Western companies have, for many years, been trying to find a way to open the door to the potentially enormous markets presented by China and India. The internet may provide the key.

When the internet stocks eventually crash, the drop in their share prices will be spectacular. With minimal short interest in these stocks there will be no 'short cover' buying on the way down to moderate the fall. However, when this crash does occur (perhaps following one last surge to the upside) it will not be the end of the internet stock boom, it will be the end of the beginning. There will still be fortunes to be made in the internet stocks for decades to come, although individual stock selection will be critical (the indiscriminate buying of anything with a 'dot com' in its name will no longer be an effective strategy).

In conclusion, the unquestioned financial wisdom of the moment is that gold, as an investment, is dead. We are told ad nauseam that there is no inflation and that stocks, if bought with a long term perspective, still represent the best investment choice. However, the unquestioned wisdom of one investment cycle is always seriously questioned at the beginning of the next cycle, before being totally discarded. In this writer's opinion, the next cycle will be characterised by a resurgence of gold and gold stocks, and a continuation of the internet stock boom (although starting from much lower levels and with a far greater emphasis on stock selection).

Milhouse
Hong Kong
7 May 1999

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