Monday, October 25, 2010

Economics: Deflation

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To recap, inflation is the increase of the supply of money which leads to the increase of prices in goods; or put another way, inflation is the decrease in the value of money which is reflected in the rise of prices.

Essentially the exact opposite: Deflation is the contraction in the supply of money leading to prices falling; or put another way, deflation is the increase in the value of money which is reflected in the fall of prices.

Deflation is a good thing for the average citizen, particularly helping those who have been responsible and saved their money, because now the money that they've saved is worth more. However, for people holding debts, deflation is a very powerful reminder of those debts, because now it's even harder to repay them. For instance, if you own a house that hasn't been paid off, you may owe $100,000 on the mortgage, but due to deflation perhaps the price of your house falls to $80,000 before it can be sold which leaves you holding $20k in debt. I'm not saying holding $20k in debt is a good thing, but it's an accurate reflection of reality, that house was never worth $100k to begin with, it was a symptom of an over-inflated economy.

Right now our economy is beginning to see symptoms of deflation. People are paying down debt, which is leading to the money-supply evaporating, which leads to the value of our dollar increasing. At the same time, fewer people are taking out loans, so no new money is being created even though the Fed is trying to re-inflate the economy to give it another "boost". Since the first round of inflation hasn't done it's job (banks aren't loaning out new funds, opting instead to keep reserves high to hedge against future defaults; more on our fractional reserve system later), Federal Reserve Chairman Ben Bernanke is looking to do another round of inflation, which he labels "Quantitative Easing", taken from Japan (whom it didn't help either).

This is a rather dangerous game the Fed plays. On the one hand, pushing banks to loan out money in order to devalue our dollar (thereby raising prices) is an insidious way to "help" our economy (and in the process wipe out the middle class and keep the impoverished down), on the other hand if it works then the debt holders become the winner, because now that person who owns the $100,000 house can sell it for $120k and make their profit, however the responsible people who saved and showed diligence with their finances see their money shrink in purchasing power, essentially wiping out their savings a little at a time.

Those aren't even the worst-case scenarios. If banks aren't loaning out their money right now, which is potentially a couple trillion, and the Fed, wait, scratch that, let's put a name to it, and *Ben Bernanke* decides to push in a couple trillion more and banks let that money hit the market, if Ben Bernanke (in some circles known as "Helicopter Ben" from his essay about combating deflation) isn't able to reign in a lot of that cash then the problem will be hyperinflation, and likely the destruction of our dollar.

The cold reality is that the Federal Reserve is highly political, despite the attempts from Chairmen to say otherwise, because the Fed uses inflation to fund our government. Whenever the US Treasury sells foreigners US Treasury Bonds, those bonds are backed by US Dollars which can only be printed up by the Federal Reserve. Imagine a Fed chairman who decided to not print the money, they would get fired, after all it's the President of the United States who nominates the Chairman and the Senate who confirms him. Seeing as how the US is the largest debtor country in the world (probably in the history of the world) then it's easy to understand why we don't want our figurative "house" to drop in value, it means that the money we used/borrowed is of less value than the money we have to repay, the consequences of which are to cut programs and be fiscally responsible. I bet you can't find a lot of Republicans or Democrats who get excited about that idea. However, destroying the dollar through inflation means you get more programs, less responsibility and someone else holds the bag. Pretty evil stuff.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

Monday, October 11, 2010

Economics: Hyperinflation

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If inflation is the creation of new money (which results in higher prices due to the new money devaluing all the other money already in circulation), then what is hyperinflation? Kind of the same thing, but in warp speed and with a couple twists.

Hyperinflation is certainly the rapid rise in the price of consumer goods brought about by overprinting of a fiat currency. However, it not only happens because of the debasing of the currency, but it also happens due to the loss of faith in a currency, so everyone rushes out to spend their money before it's totally worthless, rather than holding dollars people opt for something tangible.

We don't need to look back too far in history to see where hyperinflation has set in and ultimately caused a currency to crash and become utterly void of value. There's so many examples that it's hard to choose, in fact you could probably name the country and they've seen it. Including the United States debasing our own currency during the Revolutionary War. The most recent was Zimbabwe, after a few years of hyperinflation the government abandoned their dollar all together in April of 2009. Inflation ran so rampant that they were printing up denominations in Trillions, can you imagine paying for a Snickers with a trillion dollars?

The hyperinflation in Zimbabwe was the result of massive printing of new money used to pay debts and "buy prosperity". It didn't take long before the market caught on and opted instead to trade in something more valuable like gold and silver. After finally closing shop on the Zimbabwean Dollar their government officially opened itself to foreign currencies to be used. Ultimately these other government run currencies will also eventually disappear, as all government mandated fiat/paper monies do, because the temptation to abuse the printing press is too much for politicians to handle.

I sincerely doubt if our dollar crashes that it will get so bad that we will be digging in the mountains for enough gold to buy bread, but that doesn't mean it will be a cake walk. Hyperinflation is a very real possibility, some are predicting it absolutely will happen, but it's difficult to tell since there are an infinite amount of variables. For instance, China holds the most US debt (coming in 2nd place BTW, is the Federal Reserve), so it's kind of in their interest to not let the US$ fall, or they'll lose money as well, Japan is the 3rd largest holder of our US Treasury Bonds (our debt), as well as many other nations, so if they all decided to sell their debt/Treasury Bonds then it would quickly become worthless and our dollar would entirely crash, so they won't do that, at least not at first.

What if China became convinced that our dollar was going to soon become worthless? They would sell it as quick as they could find a buyer, United States be-damned, because the first to get rid of it ends up hurting the least. As I mentioned last week, the Federal Reserve is getting ready for another round of inflation, who knows if this will trigger the sudden auctioning of our bonds. Another round of inflation will certainly excite our debtors, in a bad way. After all of these bailouts and inflationary practices what we're actually looking at is an enormous US Treasury Bond bubble. EVERYONE is way way way over-invested in US debt. My financial adviser recently showed me a portfolio where 1/3 of the investments were directly in US Treasury Bonds. What happens when the only group of people who will buy those bonds is the Federal Reserve? The bubble pops and we witness the single largest economic collapse in the history of the world.

I know that seems rather hyperbolic, but if you consider the facts then you'll see it's quite easy to justify. 1) The world has never been as connected as it is now, so intertwined that I can invest in China's market place within a matter of minutes. I don't even have to leave my house. 2) Most of the world is tied into our economic system via holding of our debts. Those two things alone set the stage for a systemic collapse, much in the same way that all of wall street saw a systemic collapse of their financial institutions.

The bottom line is that the market is bigger than any government policy or dictatorship. Just ask 1923 Germany, fine, you can't *actually* ask an inanimate object that "lives" in the past, buuut, if you could... Germany's currency was originally backed by gold, which meant you could redeem their goldmark for actual gold, but in 1914 this gold standard was abandoned in order to allow paper inflation to fund the first World War. The war ran longer than anticipated (as it usually does) and since the treaty that cemented their loss of that war demanded reparations they decided to simply print the money, which ultimately caused their hyperinflation and crash of their currency. (It's a bit more complex and interesting, but I'm cutting to the point.)

In fact, war is a common reason why a currency falls, even in our own country we debased the Continental Dollar in order to fund our own revolution. Our founding fathers having seen the destructive nature of paper currency decided to write into the constitution that states could only accept gold and silver for legal tender of debts (Art. 1 Sec. 10) and that only Congress could "coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures" (Art. 1 Sec. 8).

There are no absolutes with regards to ensuring my money today retains at least the same amount of value tomorrow, but there are some pretty good ways to make it difficult to lose its value, and allowing a private entity to print as much as it wants and hand it to whoever it chooses without any oversight whatsoever is probably the worst idea ever, anyone who disagrees is either clinically insane or profiting from it. It's asking the fox to guard the hen house!

Instead of this current monopoly on the dollar that the Federal Reserve has (via mandated US law), perhaps the single best way to ensure that my money retains value is to allow the market to choose. Competition is good, because everyone votes with their money, and if I think someone is ruining a currency then I can choose to use another and be exempt from its downfall. That very concept, that I can choose someone else's currency will drive honesty into business, or that business will be driven out of town. But as of right now, if hyperinflation sets in and we see prices double over the course of a couple weeks, there is no reprieve for US Citizens who don't have the capital to buy valuable assets and commodities like gold and silver, instead we'll see the savings of responsible people fall into nothingness overnight and only be left with political grandstanding by the ones who allowed this to happen in the first place.

While hyperinflation and the destruction of the dollar remains a very real possibility, I would say the biggest and first indicator is likely going to be when oil stops trading exclusively in the dollar. Until then just plan your finances wisely and tie your savings to something that retains its value, I think that there is NO reason to have more than a couple thousand sitting in cash in a bank account.

So, if inflation & hyperinflation is when a currency loses its value, what happens if a currency *gains* in value? Deflation, and it's a good thing.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

Monday, October 4, 2010

Economics: Inflation

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Magic tricks! Have you ever seen a magician perform? You pick a card, shuffle the deck, he closes his eyes and spins around three times yet somehow still is able to pick your card out of the deck. We all know there was no magic, but there was sleight of hand going on, we missed something...

Inflation is commonly thought of as the rise in price of consumer goods as judged by the Consumer Price Index (CPI), this is the sleight of hand at work, because we're led to believe there's no way to prevent this natural phenomenon. Wrong. In fact, inflation is actually the increase in the money supply, so the rise in prices are only the effects of inflation. If my friend had the only 10 dollars in existence, they'd own 100% of the money, but if I suddenly created 990 dollars then theirs would suddenly be worth 1% of what it used to be worth. I just drank their milkshake.

Inflation is the insidious thing that allows governments to fund their ridiculous promises and expand their operations & wars (there's many kinds of "war", Iraq is one kind, "War on drugs", "War on poverty", etc). Rather than directly tax people for all of these programs, the government turns to the central bank (for the United States it's called The Federal Reserve) to print up money which it uses to buy bonds from the US Treasury. Inflation has just occurred.

Another word for inflation, one the government hates to use or see, is debase. Debasing the currency is a far more accurate description. Since money is merely a facilitator of trade, you cannot create wealth by simply creating more money, instead what happens is everyone's worth goes down and only the creators of the new money win.

One of the tricky parts of inflation is that it doesn't show up immediately, and it doesn't show up everywhere. If you want to spot it all you have to do is look to where the government spends it. For example, health care. The government pours in billions of dollars into this single sector, and rather than make it more affordable all it does is make our dollar less valuable in that sector.

So, it's not that prices are rising, it's that your money is just worth less. If only that was where it ended. Now imagine there's a trillion dollars floating around society right now, all the prices are adjusted based on that (it's more complicated as far as proving this out, but that's what it boils down to), now imagine I create another trillion for myself. While it's sitting in my possession all the prices stay the same, because that money is not in the market yet, which means I get to buy everything at the old price.

Discount! Great deal for me!

It gets far, far worse. I don't, of course, spend all that money in the same place, rather spend it in 5 places. Well, they'll essentially get a discount too, when they use that money. Now, those business don't immediately give their employees a raise, right? Instead, there's a slow trickle down to the lower income people, but by the time it's traded the hands of all these banks, businesses and government purchases, inflation has already set in and the lower income people have been paying the higher pricing before ever seeing an increase in their wages. They've just been robbed without a gun, and without notification.

The Fed creates a ton of money, they and the government pick who it is spent on, those are the real "winners", and everyone else loses, all of the time. Until the money isn't worth anything at all...

You have to understand that the Federal Reserve wants to keep prices inflated, so in order to do so they must create new money. Inflation favors the debtor. If I owe you $200 Million, and can create it out of thin air then I can pay my debts back cheaply, rather than work and be productive to earn that money. It hurts the debt holder of course, but that's beside the point I'm sure. So, who can we think of that holds a lot of debt? Right, the US Government has over $13 Trillion, so inflation helps them keep up the gamble, until everyone catches on that their debts are being repaid with devalued currency and they stop buying our US bonds. Uh oh.

With the Bush and Obama bailouts we already see the creation of a couple trillion in new money/inflation, but that doesn't even include the $2 Trillion the Federal Reserve created (without approval from anyone), and they're planning on another round of "quantitative easing" aka QE2, aka INFLATION, so what happens if/when that money eventually hits the market place? Hyperinflation. That's next.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive