Search results matching tag 'Hyperinflation'

Things That Make You Go Hmmm…

JohnMauldin — Tue, 15 Nov 2011 07:41:00 GMT

What do the “Big Fitz,” the largest ship ever to sail the Great Lakes, and the Eurozone have in common? Hint: the former sank without a trace. Or, as Grant Williams so eloquently puts it, in his Things That Make You Go Hmmm… for Nov. 13 (this week’s Outside the Box), “One can’t help but think … that this week may well have brought us to the wall at the end of the road down which Europe has been kicking the can for quite some time now.”

Grant inspects the SS Europe from bow to stern and concludes: “The smoke has pretty much cleared now and those in charge of the SS Europe are left with a stark choice – print money or allow the break-up of the Eurozone and the end of the common currency known as the Euro. At this point it really IS that simple.”

So come on along as Grant takes us on an eye-opening and at times jaw-dropping ride – there are some real insights here. From his perch in Singapore he sees the same problems I do, just from the other side of the globe. And that perspective is worth your time.

As you read this, I am on my way to Capitol Hill to meet with a member of the Super-Committee. If there is anything I can report, you will get it this weekend. I hope I can bring good news at some point. Then it’s back to the UBS Wealth Management Conference in time to hear Ken Rogoff (and Alan Greenspan) on a panel. I am looking forward to that. Tomorrow night in my own bed again. And be looking for a special note from me on Thursday.

Your trying to figure out how we get out of this mess analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm...

Grant Williams | Nov. 13, 2011

“Common responsibility for the European currency will also engender a common decision-making instance for the European economy. It is unthinkable to have a European central bank but not a common leadership for the European economy. If there is no counterweight to the ECB in European economy policy, then we will be left with the incomplete construction which we have today… However even if the building is not finished it is still true that monetary union is part of a supranational constitution… It is our task for the future to work with the appropriate means for the transfer of traditional elements of national sovereignty to the European level.”
– Italian President Carlo Ciampi, Frankfurter Allgemeine Zeitung, February 8, 2000

“The euro is Europe’s key to the 21^stcentury. The era of solo national fiscal and economic policy is over.”
– German Chancellor Gerhard Schröder, December 31, 1998

“No amount of synthesized growth can evaporate global debt. Trying to sell creditors, debtors and taxpayers on the idea that it can be done is a futile and dangerious proposition. Time is not a variable. There is debt that is owed and only money or assets-in-kind can satisfy it.”
– Paul Brodsky / Lee Quanitance

Big Fitz sounds like the name of a Heavyweight Champ - or the affectionate nickname given to the regular in a neighbourhood bar whom everybody knows. Big Fitz doesn’t ordinarily sound like the name of a boat.

In the mid-1970s though, the only Big Fitz anybody spoke about in Duluth, Minnesota was the Great Lakes freighter that carried taconite from Duluth to the iron works in the then-thriving Detroit, Michigan and Toledo, Ohio.

When she was launched in 1958, the SS Edmund Fitzgerald was the largest boat on the Great Lakes. 729 feet long with a 75ft beam and a 25 foot draft, she could carry 26,000 DWT in her 33’ 4”deep hold. Powered by a Coal fired Westinghouse Electric Corporation steam turbine 2 cylinder, she had a top speed of 14 knots and carried a crew of 29.

For 17 years, the floating workhorse ploughed back and forth across Lake Superior, setting seasonal haul records six times and became a firm favourite with boatwatchers (yes, they do exist) due to her size and her record-breaking exploits. Besides her affectionate soubriquet, the SS Edmund Fitzgerald was also known as The Titanic Of The Great Lakes.

On November 9, 1975, Big Fitz was loaded with 26,116 tons of taconite iron ore pellets in Superior, Wisconsin and embarked on what would tragically turn out to be her final voyage - a routine crossing of Lake Superior, bound for a steel mill in Detroit, Michigan.

The next day, November 10th, Big Fitz found herself caught in the midst of a massive winter storm, with 35 ft waves and hurricane force winds. Captain Ernest McSorely, a 44-year veteran, made contact with the Avafor, a nearby ship, and reported that he had encountered “one of the worst seas he had ever been in”.

A couple of hours later, with Big Fitz roughly 17 miles from the relative safety of Whitefish Bay at the northeastern tip of Michigan’s Upper Peninsula, another ship made contact and was told that the Titanic of The Great Lakes was holding her own.

Then something strange happened.

(History Channel): ...minutes afterward, the Fitzgerald disappeared from radar screens. A subsequent investigation showed that the sinking of the Fitzgerald occurred very suddenly; no distress signal was sent and the condition of the lifeboats suggested that little or no attempt was made to abandon the ship.

Subsequently, many theories on what caused the SS Edmund Fitzgerald to capsize and sink 530 feet to the lake bed almost instantly were put forward.

(History Channel): One possible reason for the wreck is that the Fitzgerald was carrying too much cargo. This made the ship sit low in the water and made it more vulnerable to being overwhelmed by a sudden large wave. The official report also cited the possibility that the hatches to the cargo area may have been faulty, leading to a sudden shift of the cargo that capsized the boat.

Either way, it didn’t matter. Big Fitz sank - quickly. So quickly in fact that nobody was saved and all 29 crew members perished in the icy waters of Lake Superior. Big Fitz had been battling the odds for several hours and things had looked bleak but she was managing to stay above water until, suddenly, without warning, she didn’t.

This week’s anniversary of the tragic sinking of Big Fitz got me thinking about the Euro - another behemoth currently navigating some extremely choppy waters but managing to keep herself above water. Holding her own, if you will.

The odds have been stacked heavily against the common currency for some time now and yet, despite a clearly unsustainable level of debt, several countries who should never have been allowed through the doors of the Eurozone, rapidly slowing growth and a group of basket-case politicians who have redefined the meaning of ineptitude, if you had shorted the Euro on January 7th of this year, you would now be staring at a loss of roughly 6% on your investment (chart, below).

SOURCE: BLOOMBERG

To have sat and read the headlines these past 10 months and yet to be losing money on a short Euro position would have doubtless sent even the most stoic of investors in search of a stiff drink or some heavy counselling - but that’s the way these things go sometimes. Things stay afloat against all the odds - until, suddenly, they don’t.

One can’t help but think, however, that this week may well have brought us to the wall at the end of the road down which Europe has been kicking the can for quite some time now.

With the long-expected demise last week of the Papandreou government and now the swift fall of Silvio Berlusconi’s administration in Italy, events in Europe picked up speed as they move rapidly towards the kind of definitive end that we have needed for some time now, but that the prevaricating of the various bureaucrats in Brussels and beyond have denied us.

The smoke has pretty much cleared now and those in charge of the SS Europe are left with a stark choice - print money or allow the break-up of the Eurozone and the end of the common currency known as the Euro. At this point it really IS that simple.

The impediment to a EuroTARP or QEU program remains Germany. That’s pretty much it. Sure, the Dutch and the Finns and even the Austrians all pay lip service to a hard line on monetary easing, but, as oneby- one the formerly ‘strong’ countries get dragged into the maelstrom of the peripherals leaving a new country exposed on the outer fringes of the ‘core’, it becomes more and more obvious that somehow, some way, Germany has to find a way of justifying an action that is anathema to the citizens of Europe’s powerhouse economy. The blowout in the spread between Austrian and German 10yr bonds this week highlights that perfectly (chart, below).

SOURCE: BLOOMBERG

Weimar hyperinflation is still a very vivid memory for many Germans and, as Adam Fergusson explained in his seminal work ‘When Money Dies, the reasons why Germany is so set against the idea of money-printing are clear:

Over most of Germany the lead was beginning to disappear overnight from roofs. Petrol was syphoned from the tanks of motor cars. Barter was already a usual form of exchange; but now commodities such as brass and fuel were becoming the currency of ordinary purchase and payment. A cinema seat cost a lump of coal. With a bottle of paraffin one might buy a shirt; with that shirt, the potatoes needed by one’s family. Herr von der Osten kept a girl friend in the provincial Capital, for whose room in 1922 he had paid half a pound of butter a month: by the summer of 1923 it was costing him a whole pound. ‘The Middle Ages came back,’ Erna von Pustau said.

Communities printed their own money, based on goods, on a certain amount of potatoes, or rye, for instance. Shoe factories paid their workers in bonds for shoes which they could exchange at the bakery for bread or the meat market for meat.

Those with foreign currency, becoming easily the most acceptable paper medium, had the greatest scope for finding bargains. The power of the dollar, in particular, far exceeded its nominal rate of exchange. Finding himself with a single dollar bill early in 1923, von der Osten got hold of six friends and went to Berlin one evening determined to blow the lot; but early the next morning, long after dinner, and many nightclubs later, they still had change in their pockets. There were stories of Americans in the greatest difficulties in Berlin because no-one had enough marks to change a five-dollar bill: of others who ran up accounts (to be paid off later in depreciated currency) on the strength of even bigger foreign notes which, after meals or services had been obtained, could not be changed; and of foreign students who bought up whole rows of houses out of their allowances.

There were stories of shoppers who found that thieves had stolen the baskets and suitcases in which they carried their money, leaving the money itself behind on the ground; and of life supported by selling every day or so a single tiny link from a long gold crucifix chain. There were stories (many of them, as the summer wore on and as exchange rates altered several times a day) of restaurant meals which cost more when the bills came than when they were ordered. A 5,000-mark cup of coffee would cost 8,000 marks by the time it was drunk.

Stories like these still live and breathe in Germany so it is no surprise that the language of Mrs. Merkel and Messrs. Schauble, Wiedmann et al have been defiant whenever the subject of money-printing has arisen. But this week, as the Eurozone threatened to spiral out of control, it became abundantly clear that the Euro has reached the point of no-return.

The ECB now has to either become the lender of last resort that Europe so desperately needs (and trample over Germany’s sensitivities in the process), or the Euro must fall. There is no other choice.

On Thursday, Italy’s 10-year bond yield spiked to 7.5%. Presumably the only thing that stopped it shooting higher still was aggressive buying on the part of the SMP (we shall hopefully find out on Monday when the weekly totals are updated on the ECB website), but whatever the reason for the sudden and sharp retracement to 6.5% on Friday (surely it wasn’t due to the news that Massimo Monti had been touted as Prime Minister in Berlusconi’s stead? Surely?), you can be certain the bond market has not finished with Italy just yet.

SOURCE: BLOOMBERG

BUT..... Italy is running a primary surplus. The only thing sending her over the edge is the simple fact that the Italian government cannot borrow at low-enough rates. At 4% (where rates were a year ago), they can gradually begin to adjust their debt ratios and still finance their borrowing - it will not be easy, but they, unlike their spendthrift cousins in the Aegean, have one of the highest savings rates in the OECD (although, as you can see from the chart, below, that savings rate has been eaten into rapidly over the past five years).

SOURCE: BLOOMBERG

But what of that other ‘Big Fitz’, the Euro?

Any attempt to make a significant change to either the treaties that surround the common currency or the constituent members of the union would require a hellacious amount of maneuvering in order to pull them off and, like the notion of Greece (or any weakened EU member) ever being allowed to leave the Euro, the idea of either a fiscal union, the ECB becoming the lender of last resort or, God forbid, Germany exiting, stage left, was strictly verboten - at least until this week:

(UK Daily Telegraph): German and French officials have discussed plans for a radical overhaul of the European Union that would involve setting up a more integrated and potentially smaller eurozone, EU sources say.

“France and Germany have had intense consultations on this issue over the last months, at all levels,” a senior EU official in Brussels told Reuters, speaking on condition of anonymity because of the sensitivity of the discussions.

“We need to move very cautiously, but the truth is that we need to establish exactly the list of those who don’t want to be part of the club and those who simply cannot be part,” the official said.

French President Nicolas Sarkozy gave some flavour of his thinking during an address to students in the eastern French city of Strasbourg on Tuesday, when he said a two-speed Europe - the eurozone moving ahead more rapidly than all 27 countries in the EU - was the only model for the future.

Pretty conclusive.

Naturally, any such plan was immediately denied by ‘a spokesman’:

A French finance ministry spokesman denied there was any project in the works to reduce the currency bloc’s membership.

“There have been no conversations between French and German authorities at any level on decreasing the size of the eurozone,” the spokesman said.

But this time it really WAS different as the Germans, too, were talking about the possibility of exits from the Eurozone:

One senior German government official said it was a case of pruning the eurozone to make it stronger.

“You’ll still call it the euro, but it will be fewer countries,” he said, without identifying those that would have to drop out.

“We won’t be able to speak with one voice and make the tough decisions in the eurozone as it is today. You can’t have one country, one vote,” he said, referring to rules that have made decisionmaking complex and slow, exacerbating the crisis.

If you listen very carefully, you can hear the subtle changes that make it pretty clear that German officials are now trying to find a way to make ‘temporary’ money-printing palatable to the German electorate. The tabling of possible exits from the Eurozone was the first flare sent up, next was the discussion of a breakaway union featuring the‘strong’ countries, but immediately, Frau Merkel dropped the hammer with this stark warning to her constituents (delivered at just the right degree of arm’s length, of course):

(Businessweek): Germany will resist any attempt to reduce the euro region to its strongest members to increase its stability, the parliamentary finance spokesman for Chancellor Angela Merkel’s Christian Democratic Union said.

“Such a shrinking process would be deadly for Germany because we would end up in a mini-euro zone with all the effects you can see in Switzerland,” Michael Meister, who is also a CDU deputy floor leader, said today in a phone interview in Berlin. “It would be a deadly development for an export country like Germany. It can’t be in our interest at all and if it’s not in our interest, we should do everything to keep it from happening.”

Once more, with feeling:

It would be a deadly development for an export country like Germany. It can’t be in our interest at all and if it’s not in our interest, we should do everything to keep it from happening.”

SOURCE: BLOOMBERG

There it is.

That is the first step in a move to persuade the German people that a EuroTARP or some form of QEU will be‘manageable’ and will not cause the runaway inflation of which Germans are terrified. It will probably be proposed as a program designed to alleviate the pressure facing the likes of Italy, Spain and Portugal and its architects will point to the (relatively) benign US CPI numbers in the wake of repeated Quantitative Easing as testament to the fact that money printing doesn’t necessarily lead to hyperinflation - although, very quietly, US CPI has almost quadrupled since the beginning of QE2 and its trajectory remains solidly bottom-left to top-right.

SOURCE: ST LOUIS FED

They WON’T mention the US’adjusted monetary base (chart above), nor will they bring up UK CPI (chart, below) which is moving ever faster away from its target rate of 2% - currently standing at a breathtaking 5.2% - and will assure the citizens of Germany that there will be a cap on inflation past which the ECB WILL NOT go - either that or it will be a program that will be wound back after, say, two years by which time everything will be on the mend again.

SOURCE: BLOOMBERG

Mach dir keine Sorgen. Wir haben alles unter Kontrolle.

Don’t worry. We’ve got it all under control.

Of course, this assumes that the vagaries of a vastly expanded money supply can be controlled once released into the wild and, as Weimar Germany, the Zimbabwe of Gideon Gono, Eduardo Duhalde’s Argentina and, to a lesser extent, even the America of Paul Volcker in the 1980s bear witness, once this particular beast is unleashed it can take some pretty drastic tranquilizers to get it back in the cage again.

No matter for now though, as Europe’s problems are both immediate and pressing. The Eurocrats will eschew the potential pitfalls of runaway inflation in favour of the short-term fix of money-printing. Lots and lots of money-printing.

In addition to Frau Merkel’s Michael Meister‘s dire warning, other headlines this week have been very carefully laying the groundwork for a speech I dare say we’ll be seeing soon about how, much as it is against the original concept of the Euro, a temporary bout of Quantitative Easing is necessary to save Europe and the Euro from destruction. We will be in ‘desperate times’, will require ‘bold action’ and can have‘confidence’ in the ability of Europe’s leaders to ensure there is no inflationary impact from any monetization. The gang is definitely all here...:

(NY Times): Europe’s economic outlook received a fresh dose of gloom Thursday, when the European Commission warned that the Continent’s economies were stalled and faced the risk of a double-dip recession.

“The recovery in the European Union has now come to a standstill, and there is a risk of a new recession,” Olli Rehn, the European commissioner for economic and monetary affairs, told reporters in Brussels.

“This forecast is in fact the last wake-up call,” he added.

(UK Daily Telegraph): Barack Obama, the US President, tonight urged Europe to provide “strong” assurances that countries like Italy will be able to finance their debt.

“We are not going to see massive growth out of Europe until the problem is resolved and that will have a dampening effect on the overall global economy.”

Speaking at the Asia Pacific Economic Cooperation (APEC) summit, Mr Obama said: “It’s not going to be addressed over night. So it is important that Europe as a whole stands behind its Eurozone members.”

(UK Daily Telegraph): Europe must “move quickly” to control its spreading debt crisis, because the volatility it is causing is the “central challenge” to global growth, US Treasury Secretary Timothy Geithner said.

“We are all directly affected by the crisis in Europe, but the economies gathered here are in a better position than most to take steps to strengthen growth in the face of these pressures from Europe.”

Mr Geithner added that the basic framework for the European recovery was good.

“But we need to see it put in place with the speed that markets require and with the force that restores confidence,” he said. “They’re moving ahead. We just need to see them move a little more quickly and with a little more force behind it.”

(Todayonline): The global economy could suffer a “lost decade” unless nations act together to counter threats to growth, International Monetary Fund managing director Christine Lagarde warned yesterday.

Speaking at a financial forum, Ms Lagarde said: “There are clearly clouds on the horizon ... particularly in the advanced economies and particularly so in the European Union and the United States.” Said Ms Lagarde:“If we do not act, and act together, we could enter a downward spiral of uncertainty, financial instability and a collapse in global demand. Ultimately, we could face a lost decade of low growth and high unemployment.”

Let’s see.... is that everybody pulling in the same direction? US President? Check. US Treasury Secretary? Check. EU commissioner for monetary & economic affairs? Check. Head of the IMF? Check. German and French heads of state? Check. Anybody else?

(Reuters): “I refuse to even speculate about so-called two-speed Europe,” Czech Finance Minister Miroslav Kalousek said in response to Reuters questions on the matter.

“That would go against the Czech Republic’s interests.”

Czechs? Check. Hell, they’re not even IN the Eurozone yet.

I guess that just leaves the big dog, China:

(Brecorder): Chinese President Hu Jintao warned on Saturday that the global economy recovery was under threat and called for efforts to boost growth and liberalize trade.

“The global economic recovery is fraught with greater instability and uncertainty,” Hu said during a speech in Honolulu ahead of a summit of Asia-Pacific leaders.

Referring to Europe’s sovereign debt crisis, he said the world must remain committed to “ensuring strong growth in order to add momentum to the economic development of the Asia-Pacific and beyond.”

So there we have it. A carefully crafted scenario which will give Germany the ability to stand astride the world stage by giving up its objections to money-printing (temporarily, you understand) in the interests of the global good; the all-new Committee To Save The World.

Judging by the Daily Telegraph story on page 20 of this week’s Things That Make You Go Hmmm..... this cunning plan comes not a moment too soon (can you say ‘Ponzi’?):

(UK Daily Telegraph): Europe’s€1 trillion (£854bn) rescue fund has been forced to buy its own debt as outside investors become increasingly concerned about the worsening eurozone sovereign debt crisis.

The European Financial Stability Facility (EFSF) last week announced it had successfully sold a €3bn 10-year bond in support of Ireland.

However, The Sunday Telegraph can reveal that target was only met after the EFSF resorted to buying up several hundred million euros worth of the bonds.

Sources said the EFSF had spent more than €100m buying up its own bonds to help it achieve its funding target after the banks leading the deal were only able to find about €2.7bn of outside demand for the debt.

Speechless.

SOURCE: BLOOMBERG

But before we finish for today, we return to our own ‘Big Fitz’ of the currency markets - the Euro - as it struggles to stay afloat against all the odds. So far, it has been managing quite nicely, although the technical picture has been deteriorating rather dramatically (see chart, above). Once the now-inevitable European money-printing begins, it’s hard to make a case for a strong Euro -particularly in light of weakening economic data across the core of the region- from the French trade balance (which showed a €6.303 billion deficit in September - the seventh largest single-month deficit in French history and a staggering 46% m-o-m decline), to a plunge in French exports that matched the lows seen in 2008-9, to Germany’s Industrial output (which fell almost 3% in September) and Industrial Orders (which fell 3.6% m-o-m) and on to the rise in unemployment in Germany - the first such increase for 28 months.

Mario Draghi’s rate cut is just the beginning. Interest rates in the EU are heading below 1% in a hurry if the recent data are anything to go by and, once QEU or the EuroTARP commence, Europe’s Big Fitz , which has stayed afloat for so long against all the odds, will likely sink - suddenly and without warning.

You have been... oh, wait...

Can “It” Happen Here?

JohnMauldin — Sat, 15 Oct 2011 19:11:00 GMT

Can “It” Happen Here?
How Could This All Happen?
Currencies, Culture, and Chaos
What Causes Hyperinflation?
A Very Frank Idea
But What About the $70 Trillion in Off-Balance-Sheet Debt?
New York, London, South Africa, and the Future

"Bankruptcies of governments have, on the whole, done less harm to mankind than their ability to raise loans."

- R.H. Tawney, Religion and the Rise of Capitalism, 1926

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

- John Maynard Keynes, Economic Consequences of Peace

"Unemployed men took one or two rucksacks and went from peasant to peasant. They even took the train to favorable locations to get foodstuffs illegally which they sold afterwards in the town at three or fourfold the prices they had paid themselves. First the peasants were happy about the great amount of paper money which rained into their houses for their eggs and butter… However, when they came to town with their full briefcases to buy goods, they discovered to their chagrin that, whereas they had only asked for a fivefold price for their produce, the prices for scythe, hammer and cauldron, which they wanted to buy, had risen by a factor of 50."

- Stefan Zweig, The World of Yesterday, 1944.

The beginning of the end of the Weimar Republic was some 89 years ago this week. There is a stream of opinion that the US is headed for the same type of end. How else can it be, given that we owe some $75-80 trillion dollars in the coming years, over 5 times current GDP and growing every year? Remember the good old days of about 5-6 years ago (if memory serves me correctly) when it was only $50 trillion? With a nod to Bernanke's helicopter speech, where he detailed how the Fed could prevent deflation, I ask the opposite question, "Can‘it' (hyperinflation) really happen here?" I write this on a plane flying to NYC, with a tighter deadline than normal, so let's see how far we can get. More on where I'm heading at the end of the letter.

But first, let me quickly call to your attention a speaking engagement that I'm doing November 9 in Atlanta. It is for Hedge Funds Care, and it's a wonderful event for a children's charity. If you can make it, I hope to see you there. You can learn more and register at http://www.hedgefundscare.org/event.asp?eventID=74.

Can "It" Happen Here?

I was inspired for this week's letter by a piece by Art Cashin (whom I will get to have dinner with Monday). His daily letter always begins with an anecdote from history. Yesterday it was about Weimar, told in his own inimitable style. So without any edits, class will commence, with Professor Cashin at the chalk board.

An Encore Presentation

By Art Cashin

Originally, on this day (-2) in 1922, the German Central Bank and the German Treasury took an inevitable step in a process which had begun with their previous effort to "jump start" a stagnant economy. Many months earlier they had decided that what was needed was easier money. Their initial efforts brought little response. So, using the governmental "more is better" theory they simply created more and more money.

But economic stagnation continued and so did the money growth. They kept making money more available. No reaction. Then, suddenly prices began to explode unbelievably (but, perversely, not business activity).

So, on this day government officials decided to bring figures in line with market realities. They devalued the mark. The new value would be 2 billion marks to a dollar. At the start of World War I the exchange rate had been a mere 4.2 marks to the dollar. In simple terms you needed 4.2 marks in order to get one dollar. Now it was 2 billion marks to get one dollar. And thirteen months from this date (late November 1923) you would need 4.2 trillion marks to get one dollar. In ten years the amount of money had increased a trillion fold.

Numbers like billions and trillions tend to numb the mind. They are too large to grasp in any "real" sense. Thirty years ago an older member of the NYSE (there were some then) gave me a graphic and memorable (at least for me) example. "Young man," he said, "would you like a million dollars?" "I sure would, sir!" I replied anxiously. "Then just put aside $500 every week for the next 40 years." I have never forgotten that a million dollars is enough to pay you $500 per week for 40 years (and that's without benefit of interest). To get a billion dollars you would have to set aside $500,000 dollars per week for 40 years. And a…..trillion that would require $500 million every week for 40 years. Even with these examples, the enormity is difficult to grasp.

Let's take a different tack. To understand the incomprehensible scope of the German inflation maybe it's best to start with something basic….like a loaf of bread. (To keep things simple we'll substitute dollars and cents in place of marks and pfennigs. You'll get the picture.) In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents. Two years later it was 19 cents. Two years more and it sold for 22 cents. By 1919 it was 26 cents. [Double in value, or a "mere" 12% compound inflation –JM.] Now the fun begins.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50. At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went for $1200. By September it was $2 million. A month later it was $670 million (wide spread rioting broke out). The next month it hit $3 billion. By mid month it was $100 billion. Then it all collapsed [as if a roughly 8 billion times rise in cost wasn't already collapse! Hint of irony here. – JM]

Let's go back to "marks". In 1913, the total currency of Germany was a grand total of 6 billion marks. In November of 1923 that loaf of bread we just talked about cost 428 billion marks. A kilo of fresh butter cost 6000 billion marks (as you will note that kilo of butter cost 1000 times more than the entire money supply of the nation just 10 years earlier).

How Could This All Happen?

In 1913 Germany had a solid, prosperous, advanced culture and population. Like much of Europe it was a monarchy (under the Kaiser). Then, following the assassination of the Archduke Franz Ferdinand in Sarajevo in 1914, the world moved toward war. Each side was convinced the other would not dare go to war. So, in a global game of chicken they stumbled into the Great War.

[Side note: So convinced were the bond markets that war was not possible that bonds were still selling at normal prices. War was simply inconceivable. Bad call. - JM]

The German General Staff thought the war would be short and sweet and that they could finance the costs with the post war reparations that they, as victors, would exact. The war was long. The flower of their manhood was killed or injured. They lost and, thus, it was they who had to pay reparations rather than receive them.

Things did not go badly instantly. Yes, the deficit soared but much of it was borne by foreign and domestic bond buyers. As had been noted by scholars….."The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits." In layman's English that means foreign bond buyers said – "Hey this is a great nation and this is probably just a speed bump in the economy." (Can you imagine such a thing happening again?)

When things began to disintegrate, no one dared to take away the punchbowl. They feared shutting off the monetary heroin would lead to riots, civil war, and, worst of all communism. So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.

Currencies, Culture and Chaos

If it is difficult to grasp the enormity of the numbers in this tale of hyper-inflation, it is far more difficult to grasp how it destroyed a culture, a nation and, almost, the world.

People's savings were suddenly worthless. Pensions were meaningless. If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months. People demanded to be paid daily so they would not have their wages devalued by a few days passing. Ultimately, they demanded their pay twice daily just to cover changes in trolley fare. People heated their homes by burning money instead of coal. (It was more plentiful and cheaper to get.)

The middle class was destroyed. It was an age of renters, not of home ownership, so thousands became homeless.

But the cultural collapse may have had other more pernicious effects.

Some sociologists note that it was still an era of arranged marriages. Families scrimped and saved for years to build a dowry so that their daughter might marry well. Suddenly, the dowry was worthless – wiped out. And with it was gone all hope of marriage. Girls who had stayed prim and proper awaiting some future Prince Charming now had no hope at all. Social morality began to collapse. The roar of the roaring twenties began to rumble.

All hope and belief in systems, governmental or otherwise, collapsed. With its culture and its economy disintegrating, Germany saw a guy named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting. And then came World War II.

That soul-wrenching and disastrous experience with inflation is seared into the German psyche. It is why the populace is reluctant to endorse the bailout. It is also why all the German proposals have each country taking care of its own banks. (It gives them more control.) The French plans tend to socialize the bailout. There's more disagreement in these plans than the headlines would indicate.

To celebrate have a Jagermeister or two at the Pre Fuhrer Lounge and try to explain that for over half a century America's trauma has been depression-era unemployment while Germany's trauma has been runaway inflation. But drink fast, prices change radically after happy hour.

What Causes Hyperinflation?

We spent a whole chapter writing about inflation and hyperinflation in Endgame, which I think highlights the topic rather well (http://www.amazon.com/endgame). Let me quote a few paragraphs.

"We know that the world is drowning in too much debt, and it is unlikely that households and governments everywhere will be able to pay down that debt. Doing so in some cases is impossible, and in other cases it will condemn people to many hard years of labor in order to be debt-free. Inflation, by comparison, appears to be the easy way out for many policy makers.

"Companies and households typically deal with excessive debt by defaulting; countries overwhelmingly usually deal with excessive debt by inflating it away. While debt is fixed, prices and wages can go up, making the total debt burden smaller. People can't increase prices and wages through inflation, but governments can create inflation and they've been pretty good at it over the years. Inflation, debt monetization and currency debasement are not new. They have been used for the past few thousand years as means to get rid of debt. In fact, they work pretty well.

"The average person thinks that inflation comes from ‘money printing.' There is some truth to this, and indeed the most vivid images of hyperinflation are of printed German Reichmarks being burnt for heat in the 1920s or Hungarian Pengos being swept up in the streets in 1945.

"You don't even have to go that far back to see hyperinflation and how brilliantly it works at eliminating debt. Let's look at the example of Brazil, which is one of the world's most recent examples of hyperinflation. This happened within our lifetimes. In the late 1980s and 1990s it very successfully got rid of most of its debt.

"Today Brazil has very little debt as it has all been inflated away. Its economy is booming, people trust the central bank and the country is a success story. Much like the United States had high inflation in the 1970s and then got a diligent central banker like Paul Volcker, in Brazil a new government came in, beat inflation, produced strong real GDP growth and set the stage for one of the greatest economic success stories of the past two decades. Indeed the same could be said of other countries like Turkey that had hyperinflation, devaluation, and then found monetary and fiscal rectitude.

"In 1993 Brazilian inflation was roughly 2,000%. Only four years later, in 1997 it was 7%. Almost as if by magic, the debt disappeared. Imagine if the US increased its money supply which is currently $900 billion by a factor of 10,000 times as Brazil's did between 1991 and 1996. We would have 9 quadrillion USD on the Fed's balance sheet. That is a lot of zeros. It would also mean that our current debt of thirteen trillion would be chump change. A critic of this strategy for getting rid of our debt could point out that no one would lend to us again if we did that. Hardly. Investors, sadly, have very short memories. Markets always forgive default and inflation. Just look at Brazil, Bolivia, and Russia today. Foreigners are delighted to invest in these countries.

"The endgame is not complicated under inflation/hyperinflation. Deflation is not inevitable. Money printing and monetization of government debt works when real growth fails. It has worked in countless emerging market economies (Zimbabwe, Ukraine, Tajikistan, Taiwan, Brazil, etc.). We could even use it in the US to get rid of all our debts. It would take a few years, and then we could get a new central banker like Volker to kill inflation. We could then be a real success story like Brazil.

"Honestly, recommending hyperinflation is tongue in cheek. But now even serious economists are recommending inflation as a solution. Given the powerful deflationary forces in the world, inflation will stay low in the near term. This gives some comfort to mainstream economists who think we can create inflation to solve the debt problem in the short run. The International Monetary Fund's top economist, Olivier Blanchard, has argued that central banks should target a higher inflation rate than they do at present in order to avoid the possibility of deflation. Economists like Paul Krugman, a Nobel Prize winner, and Olivier Blanchard argue that central banks should raise their inflation targets to as high as 4%. Paul McCulley argues that central banks should be ‘responsibly irresponsible.'

"Peter Bernholz wrote the bible on inflation and hyperinflation, called Monetary Regimes and Inflation: History, Economic and Political Relationships. He writes about 29 periods of hyperinflation. What causes such a spectacular increase in prices? Bernholz has explained the process very elegantly.

"Bernholz argues that governments have a bias towards inflation. The evidence doesn't disagree with him. The only thing that limits a government's desire for inflation is an independent central bank. After looking at inflation across all countries and analyzing all hyperinflationary episodes, the lessons are the following:

1. Metallic standards like gold or silver standard show no, or a much smaller, inflationary tendency than discretionary paper money standards

2. Paper money standards with central banks independent of political authorities are less inflation-based than those with dependent central banks.

3. Currencies based on discretionary paper standards and bound by a regime of a fixed exchange rate to currencies, which either enjoy a metallic standard or, with a discretionary paper money standard, an independent central bank, show also a smaller tendency towards inflation, whether their central banks are independent or not.

"Bernholz examined twelve of the twenty-nine hyperinflationary episodes where significant data existed. Every hyperinflation looked the same. ‘Hyperinflations are always caused by public budget deficits which are largely financed by money creation.' But even more interestingly, Bernholz identified the level at which hyperinflations can start. He concluded that ‘the figures demonstrate clearly that deficits amounting to 40 percent or more of expenditures cannot be maintained. They lead to high inflation and hyperinflations….' Interestingly, even lower levels of government deficits can cause inflation. For example, 20% deficits were behind all but four cases of hyperinflation.

"Stay with us here, because this is an important point. Most analysts quote government deficits as a percentage of GDP. They'll say, ‘The US has a government deficit of 10% of GDP.' While this measure makes some sense, it doesn't tell you how big the deficit is relative to expenditures. The deficit may be 10% the size of the US economy, but currently the US deficit is over 30% of all government spending. That is a big difference."

A Very Frank Idea

I am confronted all the time on the road by investors who want to know my basis for stating that we will not see hyperinflation in the US. I am good friends with many who believe it is the only way the US can end up, given the size of the current off-balance-sheet debacle. "End of America" Porter Stansberry, Doug Casey and David Galland (see below), Peter Schiff, Bill Bonner, and a host of gold bugs see no other way out. They look at history as written by Bernholz and see the proverbial writing on the wall. It is totally decipherable by them. I remain very unconvinced.

The US Federal Reserve system is different from most central banks, whether it is independent or not. It is composed of 12 separate regional banks, each of which has its own board, which appoints its regional president. The regions each get a certain number of rotating votes in the FOMC meetings, along with the appointed Fed governors. But they all get to participate in FOMC meetings and offer opinions. And the presidents certainly talk with each other. The last two meetings have seen the unusual circumstance of three dissenting votes.

These regional boards comprise local business leaders, some academics, and community leaders. They have to go back and work and live in their communities. They don't get to retire to an ivory tower and tenure, like many Fed governors. They see the real world, or at least their parts of it, and the boards have become very diverse over time.

Hyperinflation requires a central bank to willingly commit economic suicide. Typically, that happens at the behest of an authoritarian government. Under our current system, I can't see that happening. The hue and cry would be very loud and long and early. If you think Fisher et al. are vocal today, think about their response to really aggressive printing. I am not talking about something on the order of QE2, a BB gun as compared to a bazooka. I am talking about real printing.

It is not just a few vocal regional Fed presidents, of whom Fisher is the most eloquent. Even Bernanke has been talking about the limits of monetary policy and the need for the fiscal house to be put in order.

If Bernanke and his fellow Keynesians could whip up 4-5% inflation for a few years, would they do it? I think so, although they would publicly demur. But that is a far cry from 10% and even further from the 50% that would be needed to really ignite hyperinflation. I doubt they have the stomach for that, even in the face of a serious recession. The memories of the '70s are still part of our genetic make-up.

But could they print a whole lot more than one can imagine now, without unleashing the inflation demon? The simple answer is yes, and for that rationale we go back to the '30s and Irving Fisher, who gave us the classic equation of the link between money supply and inflation and the velocity of money (how fast money moves through an economy).

Inflation is a combination of the money supply AND the velocity of money. In short, if the velocity of money is falling, the Fed can print a great deal of money (expanding its balance sheet) without bringing about inflation. Remember the above instance, where workers wanted to get paid twice a day? That was a case of both rising money supply and rising velocity of money, a deadly combination. I have written several e-letters about the velocity of money, if you want more in-depth analysis. If this is something you do not understand, I suggest you take the time; otherwise you will not get the background of the argument. Here are a couple links to letters where I explain the velocity of money:

http://www.johnmauldin.com/frontlinethoughts/the-implications-of-velocity-mwo031210

http://www.johnmauldin.com/frontlinethoughts/the-velocity-factor-mwo120508

When do we see a seriously falling velocity of money? At the end of debt supercycles, where deleveraging is the order of the day. Which is where we are today in the US. Look at the graph below (from my friend Lacy Hunt at Hoisington Asset Management). Notice that the late '70s saw a rising money supply and rising velocity of money. And voila, we got inflation in the US. Notice that now velocity is falling and, as Lacy points out, the velocity is mean reverting over very long periods of time, so we can expect it to go lower. Also remember that the US government (at the federal level) has yet to really begin to get its fiscal house in order. (Although state and local government have combined to cut deficits $200 billion a year through a combination of spending cuts and tax increases, or over 1% of GDP, which has been a serious headwind with more cuts and tax increases to come.)

What could change my mind? If the (how to say this politely?) ill-conceived (stronger words come to mind) proposal by Financial Services Committee ranking member Barney Frank (D-Mass) were to see the light of day, I would get very concerned. According to Bloomberg and The Hill,Frank plans to submit a bill that would remove the votes of the five regional Federal Reserve presidents from the 12-member Federal Open Markets Committee (FOMC), which sets interest rates, and replace them with five appointees that would be nominated by the President and confirmed by the Senate.

Frank says "he is concerned that the process is undemocratic because the regional Fed presidents are not elected or appointed by elected representatives, and he believes that regional Fed presidents are overly likely to focus on guarding against inflation at the expense of more adequately tackling the country's unemployment crisis." (US News and World Report)

Basically, he wants the Fed to be subservient to the politicians. Under his proposal, the FOMC could lose what independence it has in a short time. This is part of a strain of thought that suggests that the decisions that affect all of us should be made by a few elite people who purport to understand what is going on, which coincidentally are government insiders and the academics who foster their agendas.

How did Weimar and other hyperinflation incidents occur? When power was in the hands of a few well-intentioned elites who did not understand the long-term consequences, or were acting in self-interest without transparency or any check on their decisions. The Fed is designed to be a system of checks and balances, with no one president getting to appoint all the governors (they have 14-year terms), in order to try to remove the process as much as possible from political interference. That does not mean they will make the right decisions, but in this I agree with the alarmists: history suggests that without some constraint (gold standards as an example) hyperinflations may occur.

A repeat of the '70s? That is within the realm of possibility, but it's certainly not a base-case scenario. Hyperinflation under our current system? I just don't see it.

But What About the $70 trillion in Off-Balance-Sheet Debt?

I am asked that question all the time. My answer is that it illustrates the power of "It Won't Happen." As in "if it can't happen it won't happen." That number will never be paid, either in terms of current buying power or actual numbers or actual benefits. It can't be. The money is not and will not be there.

The far more interesting question is what will happen when we reach the point of "won't happen." Will that be something we recognize before it happens and act proactively to avoid a cataclysmic event? Will we wait until the bond market jerks our chain about the fiscal crisis, which is massively stagflationary? Yes, the Fed can print to some degree, but not dealing with the crisis will ultimately force a huge restructuring of spending and taxes which, if not caught early enough, will propel us into a certain Second Great Depression. Which is why I think we will deal with it proactively in 2013, because to not do so would be folly of the worst sort. The consequences are unimaginable for the US and for the world. Think Greece, and then go downhill. All over the world.

I think more and more political leaders are beginning to understand that point. They are not happy about it. But I remain hopeful that in 2013 we can actually deal with the deficit and the debt in an orderly manner. If we do not, God help us all.

New York, London, South Africa, and the Future

Monday I will be on Yahoo! Finance in the morning, Bloomberg Radio at 9:45, and Fox Business TV at 1:15, with meetings all day (and time for reading sandwiched in between). Then Monday night dinner with a special group of people: Art Cashin, Barry Habib, Barry Ritholtz, Dennis Gartman, Vince Farrell, and Doug Kass if he can shake free. Think we'll talk investments and economics? Then on to Philly that night, where I speak the following morning for a group hosted by my partner Steve Blumenthal of CMG. Then back to NYC, a quick 3 PM TV gig with Canadian TV BBN, and off to JFK and London. The next month is crazy with travel. I am in London (actually Richmond) Wednesday for a 12-hour layover, where I can have a few meetings. One night in South Africa. Back home Saturday and then Monday to New Orleans and then somewhere else, etc.

But that is then. Tonight and this weekend is pure pleasure. Tiffani and I have a private dinner with Ray Kurzweil in about 10 minutes (now in car). I must admit I am a huge Ray Kurzweil groupie. Then some of the best futurists in the world will be speaking in rapid order for the next two days at the Singularity Summit, and lucky me, I get to meet them! Plus 750 attendees, who will all have their own stories, opinions, and insights. Sunday night with David Galland, head honcho of Casey Research and fellow futurist and sci-fi junkie, who is also attending the conference. He told me to read Daniel Suarez's two books, Daemon and Freedom. They are an adrenaline rush. Must-reads, if you want to get a feeling for what it is going to be like to have change hit you seemingly all at once. I am not a fan of his dystopian vision, but it makes for gripping fiction, and the technology descriptions make the ride doubly enjoyable. Read them. Oh, and really good friend David Brin will also be there. We will celebrate our recent birthdays. And he has just finished a brilliant book that I got to read the first draft of, even before he finished. Love it! Will let you know when it is out.

And now I'm back in the room, finally getting ready to hit the send button. What a week. It was good to be with old friends Ed Easterling and David Rosenberg last night, as well as money maven Cliff Draughn, who flew in from Savannah just to be here. (Thanks Cliffie!)

I feel like I am drinking life through a fire hose, but I would not want it any other way. I am now writing a book (The Millennium Wave) about how fast change is going to happen (and that will be the topic of my speech on Sunday), but I am struggling to keep up even now! The great British Prime Minister Lord Salisbury is said to have remarked to Her Majesty Queen Victoria, "Change, change, why do we need more change? Aren't things bad enough already?" But the changes coming are something not even a conservative English lord can hold back, so better to learn to surf the inevitable.

Have a great week. Other than sleeping three nights in four on airplanes (what idiot designed this schedule? I would fire him if I only could!) I am going to have a good one.

Your ready for some future thinking analyst,

John Mauldin

John@FrontlineThoughts.com

John Williams: Hyperinflation and Double-Dip Recession Ahead

DougCasey — Wed, 04 May 2011 22:02:00 GMT

An interview with Karen Roche of The Gold Report

Economic recovery? What economic recovery? Contrary to popular media reports, government economic reporting specialist and ShadowStats Editor John Williams reads between the government-economic-data lines. "The U.S. is really in the worst condition of any major economy or country in the world," he says. In this exclusive interview with The Gold Report, John concludes the nation is in the midst of a multiple-dip recession and headed for hyperinflation.

The Gold Report: Standard & Poor's (S&P) has given a warning to the U.S. government that it may downgrade its rating by 2013 if nothing is done to address the debt and deficit. What's the real impact of this announcement?

John Williams: S&P is noting the U.S. government's long-range fiscal problems. Generally, you'll find that the accounting for unfunded liabilities for Social Security, Medicare and other programs on a net-present-value (NPV) basis indicates total federal debt and obligations of about $75 trillion. That's 15 times the gross domestic product (GDP). The debt and obligations are increasing at a pace of about $5 trillion a year, which is neither sustainable nor containable. If the U.S. was a corporation on a parallel basis, it would be headed into bankruptcy rather quickly.

There's good reason for fear about the debt, but it would be a tremendous shock if either S&P or Moody's Investor Service actually downgraded the U.S. sovereign-debt rating. The AAA rating on U.S. Treasuries is the benchmark for AAA, the highest rating, meaning the lowest risk of default. With U.S. Treasuries denominated in U.S. dollars and the benchmark AAA security, how can you downgrade your benchmark security? That's a very awkward situation for rating agencies. As long as the U.S. dollar retains its reserve currency status and is able to issue debt in U.S. dollars, you'll continue to see a triple-A rating for U.S. Treasuries. Having the U.S. Treasuries denominated in U.S. dollars means the government always can print the money it needs to pay off the securities, which means no default.

TGR: With the U.S. Treasury rated AAA, everything else is rated against that. But what if another AAA-rated entity is about to default?

JW: That's the problem that rating agencies will have if they start playing around with the U.S. rating. But there's virtually no risk of the U.S. defaulting on its debt as long as the debt's denominated in dollars. Let's say the U.S. wants to sell debt to Japan, but Japan doesn't like the way the U.S. is running fiscal operations. It can say, "We don't trust the U.S. dollar. We'll lend you money, but we'll lend it in yen." Then, the U.S. has a real problem because it no longer has the ability to print the currency needed to pay off the debt. And if you're looking at U.S. debt denominated in yen, most likely you would have a very different and much lower rating.

TGR: Is there a possibility that people would not buy U.S. debt unless it's in their currency?

JW: It is possible lenders would not buy the Treasuries unless denominated in a strong and stable currency. As the USD loses its value and becomes less attractive, people will increasingly dump dollar-denominated assets and move into currencies they consider safer. And you'll see other things; OPEC might decide it no longer wants to have oil denominated in U.S. dollars. There's been some talk about moving it to some kind of basket of currencies—something other than the U.S. dollar, possibly including gold. This would be devastating to the U.S. consumer. You'd get a double whammy from an inflation standpoint on oil prices in the U.S. because the dollar would be shrinking in value against that basket of currencies.

TGR: Different countries are starting to discuss the creation of an alternative to the USD as reserve currency. How rapidly could an alternative currency appear?

JW: That would involve a consensus of major global trading countries; but just how that would break remains to be seen. Let's say OPEC decides it no longer wants to accept dollars for oil. Instead, it wants to be paid in yen. It's done. It's not a matter of creating a new currency—it's a matter of how things get shifted around.

TGR: What other commodities or monetary issues would that create?

JW: Again, the dollar's weakness is doubly inflationary. It is the biggest factor behind the ongoing rise in oil prices. Let's say you're a Japanese oil purchaser. Oil, effectively, is purchased at a discount in a yen-based environment due to the dollar's weakness. Usually, the market doesn't let such advantages last very long. As the dollar weakens, you see upside pressure on oil prices. If, hypothetically, you're pricing oil in yen, there's no reason for anybody to hold the USD. The dollar would sell off more rapidly against the yen and oil inflation would be even higher in a dollar-denominated environment.

TGR: You've mentioned that hyperinflation will happen as soon as 2014. If that is true, wouldn't OPEC want to shift off dollar pricing as quickly as possible?

JW: From a purely financial standpoint, that would make sense. Other factors are at play, though, including political, military and unstable times in both North Africa and the Middle East. Those who are able to get out of dollars, I think, will do so rapidly and as smoothly as possible.

TGR: And how will they do that?

JW: They will sell their dollar-denominated assets. They will convert dollars to other currencies. They will buy gold. Generally, they will dump whatever they hold in dollars and sell the dollar-denominated assets they don't want. There's a market for them; it's just a matter of pricing. As the pressure mounts to get out of the USD, the pricing of dollar-denominated assets will fall, which in turn would intensify that selling. The dollar selling will intensify domestic U.S. inflation, which is one factor that picks up and feeds off itself and will help to trigger the hyperinflation.

TGR: The U.S., even in recession, is still the largest consuming economy. If the U.S. continues in, or goes into a deeper, recession, doesn't that impact the rest of the world?

JW: If the U.S. is in a severe recession, it will have a significant negative economic impact on the global economy. That doesn't necessarily affect the relative values of other currencies to the USD. If you look at the dollar against the stronger currencies, a wide variety of factors are in effect—including relative economic strength. The U.S. is probably going to have an economy as bad as any major country will have, with higher relative inflation. The weaker the relative economy and the stronger the relative inflation, the weaker will be the dollar. Relative to fiscal stability, the worse the fiscal circumstance in the U.S., the weaker is the dollar. Relative to trade balance, the bigger the trade deficit is, the weaker the currency. As to interest rates, the lower the relative interest rates in the U.S., the weaker will be the dollar.

Part of the weakness in the dollar now is due to the way the world views what's happening in Washington and the ability of the government to control itself. That's a factor that may have forced S&P to make a comment. So, even having a weaker economy in Europe would not necessarily lead to relative dollar strength.

TGR: If the U.S. experiences a continued, or even greater, recession, doesn't that impact spill over into Canada?

JW: The Canadian economy is closely tied to the U.S. economy, and bad times here will be reflected in bad times in Canada. However, I'm not looking for a hyperinflation in Canada. Its currency will tend to remain relatively stronger than the U.S. dollar. Canada is more fiscally sound; it generally has a better trade picture and has a lot of natural resources. Keep in mind that economic times tend to get addressed by private industry's creativity and, thus, new markets can be developed. For instance, you're already seeing significant shifts of lumber sales to China instead of to the U.S.

TGR: What about the effect on other countries?

JW: The world economy is going to have a difficult time. You do have ups and downs in the domestic, as well as the global, economy. People survive that. They find ways of getting around problems if a market is cut off or suffers. I view most of the factors in Canada, Australia and Switzerland as being much stronger than in the U.S. Even when you look at the euro and the pound, they're generally stronger than in the U.S. Japan is dealing with the financial impacts of the earthquake. There's going to be a lot of rebuilding there. But, generally, it's a more stable economy with better fiscal and trade pictures. I would look for the yen to continue to be stronger. Shy of any short-term gyrations, the U.S. is really in the worst condition of any major economy and any major country in the world and, therefore, in a weaker currency circumstance.

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Hyperinflation… and Then What?

John Williams believes things will get much worse before they get better for the U.S. economy – and so do the other 34 economists and investment pros that gathered at the just-concluded Casey Research Summit “The Next Few Years.” But all is not lost; there are many ways savvy investors can protect their assets from the coming hailstorm, and even make handsome gains amidst the crisis.

Hear what to expect and how to prepare for it – including specific investment advice and stock picks – from renowned experts like investing legend James G. Rickards, risk analyst Chris Whalen, Rich Dad advisor Mike Maloney, and many others. Details here.

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TGR: Then why are media analysts talking about the U.S. being in a recovery?

JW: You're not getting a fair analysis. There's nothing new about that. No one in the popular media predicted the recession that was clearly coming upon us, and the downturn wasn't even recognized until well after the average guy on Main Street knew things were getting bad. We have some particularly poor-quality economic reporting right now. The economy has not been as strong as it advertised. Yes, there has been some upside bouncing in certain areas, but it's largely tied to short-lived stimulus factors.

Let's look at payroll numbers and the way those are estimated. In normal economic times, seasonal factors and seasonal adjustments are stable and meaningful. What's happened is that the downturn has been so severe and protracted it has completely skewed the seasonal-adjustment process. It's no longer meaningful, nor are estimates of monthly changes in many series. The markets are flying blind—it's unprecedented, in terms of modern reporting.

Are we really seeing a surge in retail sales? If so, you should be seeing growth in consumer income or consumer borrowing—but we're not seeing that. The consumer is strapped. An average consumer's income cannot keep up with inflation. The recent credit crisis also constrained consumer credit. Without significant growth in credit or a big pick-up in consumer income, there's no way the consumer can sustain positive economic growth or personal consumption, which is more than 70% of the GDP. So, you haven't started to see a shift in the underlying fundamentals that would support stronger economic activity. That's why you're not going to have a recovery; in fact, it's beginning to turn down again as shown in the housing sales volume numbers, which are down 75% from where it was in normal times.

TGR: But we were in a housing boom. Doesn't that make those numbers reasonable?

JW: Housing starts have never been this low. Right now, they are running around 500,000 a year. We're at the lowest levels since World War II—down 75% from 2006—and it's getting worse. I mean the bottom bouncing has turned down again. We're already seeing a second dip in the housing industry. There's been no recovery there.

In March, all the gain in retail sales was in inflation. Retail sales are turning down. You're going to see a weaker GDP number for Q111. The GDP number is probably the most valueless of the major series put out; but, as the press will have to report, growth will drop from 3.1% in Q410 to something like 1.7% in Q111.

TGR: You've stated that the most significant factors driving the inflation rate are currency- and commodity-price distortions—not economic recovery. Why is that distinction important?

JW: The popular media have stated that the only time you have to worry about inflation is when you have a strong economy, and that a strong economy drives inflation. There's such a thing as healthy inflation when it comes from a strong economy. I would much rather be in an economy that's overheating with too much demand and prices that rise. That's a relatively healthy inflation. Today, the weak dollar has spiked oil prices. Higher oil prices are driving gasoline prices higher—the average person is paying a lot more per gallon of gas. For those who can't make ends meet, they cut back in other areas. The inflation of Q410, which is now running at an annualized pace of 6%, was mostly tied to the prices of gasoline and food.

You also have higher food prices. It's not due to stronger food or gasoline demand—it's due to monetary distortions. Unemployment is still high, even if you believe the numbers. I'll contend the economy really isn't recovering. At the same time, you're seeing a big increase in inflation that's killing the average guy.

TGR: Why isn't there more pressure on the U.S. government to reduce the debt deficit?

JW: When you get into areas like debt and deficit, it's a little difficult to understand. The average person, though, should be feeling enough financial pain that political pressure will tend to mount before the 2012 election; but whether or not the average person will take political action remains to be seen. I don't think you have until 2012 before this gets out of control and there's hyperinflation. It could go past that to 2014, but we're seeing all sorts of things happening now that are accelerating the inflation process.

TGR: Like the dollar at an all-time low.

JW: If you compare the U.S. dollar against the stronger currencies, such as the Australian dollar, Canadian dollar and Swiss franc, you're looking at historic lows. You're not far from historic lows in the broader dollar measure.

TGR: In your April 19 newsletter, you stated, "Though not yet commonly recognized, there is both an intensifying double-dip recession and a rapidly escalating inflation problem. Until such time as financial market expectations catch up with the underlying reality, reporting generally will continue to show higher-than-expected inflation and weaker-than-expected economic results." What do you mean by "until such time as financial market expectations catch up with the underlying reality?"

JW: A lot of people look closely at and follow the consensus of economists, which is looking at (or at least still touting) an economic recovery with contained inflation. I'm contending that the underlying reality is a weaker economy and rising inflation. I think the expectation of rising inflation is beginning to sink in. Given another month or two, I think you'll find all of a sudden the economists making projections will start lowering their economic forecasts. Instead of looking at half-percent growth in industrial production, they'll be expecting it to be flat; if it comes in flat, it will be a consensus—and the markets will be pleased it wasn't worse in consensus. But the consensus outlook will have shifted toward a more negative economic outlook.

TGR: Do you think economists will shift their outlooks before we get into hyperinflation or a depression?

JW: In terms of economists who have to answer to Wall Street, work for the government or hold an office like the Federal Reserve chairman, by and large, they'll err on the side of being overly optimistic. People prefer good news to bad news. If Fed Chairman Ben Bernanke said we were headed into a deeper recession, it would rattle the market. People on Wall Street want to have a happy sales pitch. What results may have little to do with underlying reality.

TGR: In your April 15 newsletter, you mentioned that a signal of an unfolding double-dip recession is based on the annual contraction of the M3, which was the Fed's broadest measure of money supply until it ceased publishing it in 2006. Recent estimates show that the annual contraction of M3 went down from 4.3 in February to 3.6 in March. Is this good news?

JW: No. It doesn't have any particular significance as a signal for the economy. You do have recessions that start without M3 going negative year over year. In the last several decades, every time the M3 went negative, there followed a recession—or an intensifying downturn—if a recession was already underway. If you tighten up liquidity, you tend to tighten up business conditions. Again, though, you've had recessions without those signals. When it goes positive, it does not signal an upturn in the economy. It doesn't make any difference if it continues negative for a year or two, or if it's negative for three months. The point is—when it turns negative, that's the signal for the recession.

We had a signal back in December 2009, which would have indicated a downturn sometime in roughly Q310. We already were in a recession at that point. According to the National Bureau of Economic Research, the defining authority in timing of the U.S. business cycle, the last recession ended in June 2009. So, this current recession will be recognized as a double-dip recession. The Bureau doesn't change its timing periods.

I'll contend that we're really seeing reintensification of the downturn that began in 2007. Although it's not obvious in the headline numbers of the popular media, you'll find that September/October 2010 is when the housing market started to turn down again. That is beginning to intensify. We'll see how the retail sales look when they're revised. When all the dust settles, I think you'll see that the economy did start to turn down again in latter 2010. Somewhere in that timeframe, they’ll start counting the second or next leg of a multiple-dip recession.

TGR: Does M3 have anything to do with calculating potential inflation or hyperinflation?

JW: It does; but when you start looking at the inflation picture, you also have to consider that we are dealing with the world's reserve currency and the volume of dollars both outside and inside the U.S. system. Right now, M3 is estimated at somewhat shy of $14 trillion. You have another $7 trillion outside the U.S., which is available for overnight liquidation and dumping into the U.S. markets. It's not easy to measure how much is out there, but that has to be taken into account to assess the money supply related to inflation. Again, that's where the Fed chairman's policies come into play.

Efforts have been afoot to weaken the U.S. dollar. Usually with the weakening of the U.S. dollar, you see increased repatriation of dollars from outside the system. If everyone is happy holding the dollars, the flows can be static; but when they start shifting and the dollars are repatriated, you begin to have currency problems. That's when you have the money supply and the inflation problems we're beginning to see.

TGR: This has been very informative, John. Thank you for your time.

[Is it too late to prepare for what’s coming? Not if you listen to the all-star cast of the just-concluded Casey Research Summit. From the right allocation of gold, silver and cash in your portfolio, to the top stocks and sectors that will weather the coming economic storm, to easy-to-execute offshore solutions for guarding your wealth – you’ll hear it all, in 20 hours of audio recordings on CD straight from the summit. Order now, while supply lasts!]

Walter J. "John" Williams has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his AB in economics, cum laude, from Dartmouth College in 1971 and earned his MBA from Dartmouth's Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. John, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor's Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all of the government's statistical agencies. Despite a number of changes to the system since those days, John says that government reporting has deteriorated sharply in the last decade or so. His analyses and commentaries, which are available on his ShadowStats website have been featured widely in the popular domestic and international media.

Inflation and Hyperinflation

JohnMauldin — Sat, 12 Mar 2011 14:47:00 GMT

In This Issue:

Inflation and Hyperinflation
A Dose of Inflation
The Characteristics of Hyperinflations
The Problems of Inflation
Hyperinflation in the United States?
Europe, New York, La Jolla, Korea, and Recent Media Links

Bankruptcies of governments have, on the whole, done less harm to mankind than their ability to raise loans.

—R. H. Tawney, Religion and the Rise of Capitalism, 1926

By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

—John Maynard Keynes, Economic Consequences of Peace

Unemployed men took one or two rucksacks and went from peasant to peasant. They even took the train to favorable locations to get foodstuffs illegally which they sold afterwards in the town at three or fourfold the prices they had paid themselves. First the peasants were happy about the great amount of paper money which rained into their houses for their eggs and butter. . . . However, when they came to town with their full briefcases to buy goods, they discovered to their chagrin that, whereas they had only asked for a fivefold price for their produce, the prices for scythe, hammer and cauldron, which they wanted to buy, had risen by a factor of 50.

—Stefan Zweig, The World of Yesterday, 1941

I have had a lot of questions about my thoughts on inflation and hyperinflation of late, especially in the new “Ask Mauldin” section on www.johnmauldin.com. Unfortunately, the answer is not short and simple. The good news is that my new book has an entire chapter on inflation and hyperinflation, and today, as I fly to La Jolla (more below), I give you that chapter as this week’s letter. The letter will print a little long, as there are a lot of charts. Hopefully it will encourage you to want to read the rest of the book!

Please note, my co-author (Jonathon Tepper) and I have different views on the subject, for different countries. In some, we consider high (or worse) inflation a serious prospect. In others the opposite is true. There is no one size fits all. And of course our best estimates today are based solely on the facts as we know them – if the facts change, so will our opinions. When we wrote this chapter late last year, it was not obvious that the Fed would purchase 100% of the US debt. We currently assume that will stop. If it does not, then the lessons of this chapter are more important than we would like them to be. Inflation and hyperinflation are choices made by humans. That means there is an element of uncertainty, when logic would dictate there should not be. And also, we start off the chapter a little tongue in cheek (we are NOT really recommending inflation as an answer to debt!).

Endgame got up to #2 on Amazon yesterday (#1 non-fiction). Thanks to all you faithful readers who bought the book, whether there or at your local bookstores. Maybe this weekend, those of you who procrastinated will help us get to #1! And if you are going to buy some extra books for clients, family, or friends go ahead and do it now! No more procrastination! Go to www.Amazon.com/endgame and get clicking!

I just bought the book myself (really!) on Kindle. I need it on my IPad for reference. It works great! And we are #1 on Kindle! OK, I will only be this aggressive for another month or so, then it’s back into regular e-letter mode, but cut me some slack – books are a big deal for my generation. And I think this one adds some important insights to the national conversations that must be had around the world. Now, let’s jump into the chapter on inflation.

Inflation and Hyperinflation

In the previous chapter, we looked at deflation. Now let’s look at the opposite: inflation and even hyperinflation. Hyperinflation is an extreme case of inflation and a nightmare for anyone living it.

We know that the world is drowning in too much debt, and it is unlikely that households and governments everywhere will be able to pay down that debt. Doing so in some cases is impossible, and in other cases it will condemn people to many hard years of labor to be debt-free. Inflation, by comparison, appears to be the easy way out for many policy makers.

Companies and households typically deal with excessive debt by defaulting; countries overwhelmingly usually deal with excessive debt by inflating it away. While debt is fixed, prices and wages can go up, making the total debt burden smaller. People can’t increase prices and wages through inflation, but governments can create inflation, and they’ve been pretty good at it over the years. Inflation, debt monetization, and currency debasement are not new. They have been used for the past few thousand years as means to get rid of debt. In fact, they work pretty well.

The average person thinks that inflation comes from printing money. There is some truth to this, and indeed the most vivid images of hyperinflation are of printed German reichsmarks being burned for heat in the 1920s or Hungarian pengös being swept up in the streets in 1945.

You don’t even have to go that far back to see hyperinflation and how brilliantly it works at eliminating debt. Let’s look at the example of Brazil, which is one of the world’s most recent examples of hyperinflation. This happened within our lifetimes. In the late 1980s and 1990s, it very successfully got rid of most of its debt.

Today, Brazil has very little debt, as it has all been inflated away. Its economy is booming, people trust the central bank, and the country is a success story. Much like the United States had high inflation in the 1970s and then got a diligent central banker like Paul Volcker, in Brazil a new government came in, beat inflation, produced strong real GDP growth, and set the stage for one of the greatest economic success stories of the past two decades. Indeed, the same could be said of other countries like Turkey that had hyperinflation, devaluation, and then found monetary and fiscal rectitude.

In 1993, Brazilian inflation was roughly 2,000 percent. Only four years later, in 1997 it was 7 percent. Almost as if by magic, the debt disappeared. Imagine if the United States increased its money supply, which is currently $900 billion, by a factor of 10,000 times, as Brazil did between 1991 and 1996. We would have 9 quadrillion U.S. dollars on the Fed’s balance sheet. That is a lot of zeros. It would also mean that our current debt of 13 trillion would be chump change. A critic of this strategy for getting rid of our debt could point out that no one would lend to us again if we did that. Hardly. Investors, sadly, have very short memories. Markets always forgive default and inflation. Just look at Brazil, Bolivia, and Russia today. Foreigners are delighted to invest in these countries.

Endgame is not complicated under inflation and hyperinflation. Deflation is not inevitable. Money printing and monetization of government debt work when real growth fails. It has worked in countless emerging market economies (Zimbabwe, Ukraine, Tajikistan, Taiwan, Brazil, etc.). We could even use it in the United States to get rid of all our debts. It would take a few years, and then we could get a new central banker like Volcker to kill inflation. We could then be a real success story like Brazil.

Honestly, recommending hyperinflation is tongue in cheek. But now even serious economists are recommending inflation as a solution. Given the powerful deflationary forces in the world, inflation will stay low in the near term. This gives some comfort to mainstream economists who think we can create inflation to solve the debt problem in the short run. The International Monetary Fund’s top economist, Olivier Blanchard, has argued that central banks should target a higher inflation rate than they do at present to avoid the possibility of deflation. Economists like Paul Krugman, a Nobel Prize winner, and Blanchard argue that central banks should raise their inflation targets to as high as 4 percent. Paul McCulley argues that central banks should be “responsibly irresponsible.” There are, however, problems with inflation as a policy tool.

In this chapter, we’ll examine inflation and hyperinflation, what they are, how they’re different, and how hyperinflation ends. As a quick aside, that is why we expect the current attempts by the Fed at quantitative easing 2 to be probably ineffective: $600 billion is not all that much in the grand scheme of things. Now, if they start talking $6 trillion, that would get our attention.

A Dose of Inflation

In the previous chapter, we discussed why the current crisis presents the real risk of deflation if monetary velocity falls and does not rise. However, there are many reasons to believe that we will not see deflation. The major mistake that deflationists now make is their focus on spare capacity. Central bankers and most economists assume that because of the huge deleveraging we’re seeing, governments can print money and borrow like crazy without provoking inflation because of slack in productive capacity created by the recession.

The severity of the recession means that they are wrong. During a normal downturn, production slows, but spare capacity isn’t destroyed, and it is able to create extra supply when demand returns. A severe credit squeeze, though, does lasting structural damage, as the evaporation of bank lending destroys firms’ longer-term ability to produce at given levels. People who think inflation isn’t possible point to high unemployment in the United States, the United Kingdom, and Europe. But as we’ve shown earlier in this book, many of the unemployed in the developed world are unskilled or will be unemployed long enough that their skills will be totally rusty and, hence, they will be unemployable. The slack, in other word is imaginary.

According to a major study by Athanasios Orphanides, now central banker in Cyprus, the “ex-post revisions of the output gap are of the same order of magnitude as the output gap itself, that these ex post revisions are highly persistent and that real-time estimates tend to be severely biased around business cycle turning points, when the cost of policy induced errors due to incorrect measurement is at its greatest. . . . The bulk of the problem is due to the pervasive unreliability of end-of-sample estimates of the trend in output.”

The English translation is: Economists and central bankers are very, very bad at estimating output gaps. No surprise there!

The output gap is often subject to considerable measurement error, and it is often revised because of revisions to real GDP and to estimates of the economy’s underlying rate of productivity growth. So output gap estimates and capacity utilization estimates are almost worthless in real time. Not only are they worthless but also revisions turn out to be bigger even than the output gap itself. (As we’ve written before, anyone can make mistakes, but it takes an expert with a computer to really foul things up.)

Even Federal Reserve governors understand the problem. As Charles Plosser of the Philadelphia Federal Reserve has noted, “The data uncertainties are not just theoretical curiosities. They have caused actual problems when policy has been based on mis-measured gaps, resulting in unnecessary economic instability. A particularly poignant example is the Great Inflation of the 1970s in the U.S. [emphasis added].”

I have written before that when you become a Federal Reserve Bank governor, you are taken into a back room and are given a DNA transplant that makes you viscerally and at all times opposed to deflation. Modern central bankers are much happier with inflation. They’re pretty good at producing it, in fact.

Figure 8.1 shows U.S. inflation historically, going back to the late 1600s. (How economic historians know what prices were centuries ago always amazes us, but that is the story for another fascinating book.) As you can see from Figure 8.1, when the United States and the rest of the world used a gold standard, periods of inflation alternated with periods of deflation. On average, the price level didn’t go anywhere. One year’s inflation was usually canceled out by the next year’s deflation. But if you look to the right on the chart, you see that suddenly we don’t get deflation anymore. After the Bretton Woods Agreement in 1948, when the world moved to a dollar standard only nominally backed by gold,

and then after 1971, when the United States no longer made the dollar exchangeable for gold, something happened: We only got inflation. Figure 8.1 shows that inflation is the norm in a world of paper currencies. Central banks and governments have an inflationary bias. They can regulate monetary policy much more easily when interest rates are positive, so they prefer always to have some inflation in the system. In fact, there are very, very few examples of deflation after 1948 or 1971.

In the previous chapter, we looked at the elements of deflation. Deflation can happen right after banking crises and property busts. It happened, for example, after the Japanese bubble burst and as the Japanese banks started going bust. It also happened after the housing bubble burst in Hong Kong in 1997, the banking bust in Ireland in 2008, and the Baltics after their housing bust in 2008. These examples are the only examples we know of deflation after 1971. Almost all of these cases happened because the countries had given up control of their monetary policy. Hong Kong, Ireland, and the Baltics did not control their own money supply. They operated pegs that fixed their exchange rate to the U.S. dollar or the euro (in Ireland’s case, it was in fact already inside the euro). Japan is the one and only case of deflation in a country that is not pegged to another currency or in a currency union.

As Reinhart and Rogoff have shown us, the typical pattern is for banking crises to lead to sovereign defaults and for sovereign defaults to lead to inflation.

BANKING CRISIS (leads to) DEFAULT (which leads to) INFLATION

The simple explanation is that banking crises unleash powerful deflationary forces of deleveraging and falling monetary velocity. In this environment, people, corporations, and eventually governments are unable to pay their debts and default. Government defaults typically lead foreigners to sell the local currency, and you get a currency devaluation. A devaluation makes prices for imported goods more expensive and leads to inflation. At the same time, governments and central banks fight the downturn with more expansive monetary policies, which leads to higher inflation.

The previous paragraph is a highly simplified (or if you’re an economist, it is a highly stylized) version of what typically happens. But it is accurate. Figure 8.2, by Reinhart and Rogoff, captures very well how inflation typically follows external defaults, which typically follow banking crises.

It is easy to see why this is the case. Every week, you can read a very respectable professor recommending monetizing deficits and having a free lunch. If only the world worked that way. The following was written by Ricardo Caballero, a brilliant professor at MIT:

“What we need is a fiscal expansion (e.g. a temporary and large cut of sales taxes) that does not raise public debt in equal amount. This can be done with a ‘helicopter drop’ targeted at the Treasury. That is, a monetary gift from the Fed to the Treasury.

“Critics may argue that this is simply voodoo accounting, as it is still the case that the consolidated balance sheet of the government, which includes the Fed, has incurred a liability. But this argument misses the point that the economy is in liquidity-trap range, and once this happens the system becomes willing to absorb unlimited amounts of money. In this context, by changing the composition of the liabilities of the consolidated public sector in the direction of money, the government gets a sort of ‘free lunch.’”

Of course, in Professor Caballero’s defense, he argues that we should have a mechanism to drain this liquidity from the system, but realistically, would the Treasury or the Fed have the wisdom to do it? Inflation doesn’t work as a policy response for many reasons. The reason inflation only makes things worse is probably best shown by looking at extreme examples, where the ravages of inflation are clearest and most evident. We will look at hyperinflations, which is a lot of fun for the reader, but not much fun if you’ve lived through hyperinflation.

The Characteristics of Hyperinflations

Just as Reinhart and Rogoff wrote the book on banking and debt crises, there is one book that is the bible on hyperinflations. Professor Peter Bernholz, from the University of Basel, has written Monetary Regimes and Inflation, which provides an overview of every inflationary episode that has ever happened, and he explains the origins and characteristics of hyperinflation. It is well worth your time if you are interested in the mechanics of hyperinflation.

As Professor Bernholz points out, you can get inflationary episodes without printing money. Under the Greeks and Romans, rulers often made gold and silver coins smaller or put bad coins into circulation to debase their currency. However, true hyperinflation only happens with paper currencies.5 As you can see from Table 8.1, almost all hyperinflations have happened in the twentieth century. (Note: he wrote the book before the episode in Zimbabwe.) The only hyperinflation prior to the twentieth century was during the French Revolution, when the French monetary regime, too, was based on the paper money standard. We don’t have very long-term inflation data for most countries, but as you can see in the case of the United Kingdom, where we have

historical data, inflation was relatively stable for about 600 years. It was only after the United Kingdom moved toward paper money that inflation has really taken off. Unfortunately, this is true of every country with a paper currency (see Figure 8.3). Interestingly, after countries abandoned the gold standard, there are more cases of hyperinflation than deflation. Figure 8.3 shows inflation, but we need to distinguish between inflation and hyperinflation. Many countries have high inflation, but hyperinflation is a very special case in which money grows greater than 50 percent from one month to the next. When money starts growing that quickly, the numbers become truly astronomical. To give you a sense of just how crazy inflation can get once it gets going, Figure 8.4 shows inflation in Weimar Germany. You can see that toward the end of 1923, inflation was growing at 16 million percent per year.

What kinds of prices does 16 million percent inflation give you? The highest-value banknote issued by the Weimar government’s Reichsbank had a face value of 100 trillion marks (100,000,000,000,000; 100 billion on the log scale).6 At the height of the inflation, one U.S. dollar was worth 4 trillion German marks. One of the firms printing these notes submitted an invoice for the work to the Reichsbank for 32,776,899,763,734,490,417.05 (3.28 x 10¹⁹, or 33 quintillion) marks.

What causes such a spectacular increase in prices? Bernholz has explained the process very elegantly. He argues that governments have a bias toward inflation. The evidence doesn’t disagree with him. The only thing that limits a government’s desire for inflation is an independent central bank. After looking at inflation across all countries and analyzing all hyperinflationary episodes, the lessons are the following:

*Metallic standards like gold or silver show no or a much smaller inflationary tendency than discretionary paper money standards.

*Paper money standards with central banks independent of political authorities are less inflation-based than those with dependent central banks.

*Currencies based on discretionary paper standards and bound by a regime of a fixed exchange rate to currencies, which either enjoy a metallic standard or, with a discretionary paper money standard, an independent central bank, show also a smaller tendency toward inflation, whether their central banks are independent or not.

Bernholz examined 12 of the 29 hyperinflationary episodes where significant data exist. Every hyperinflation looked the same. “Hyperinflations are always caused by public budget deficits which are largely financed by money creation.” But even more interestingly, Bernholz identified the level at which hyperinflations can start. He concluded that “the figures demonstrate clearly that deficits amounting to 40 percent or more of expenditures cannot be maintained. They lead to high inflation and hyperinflations. . . .” Interestingly, even lower levels of government deficits can cause inflation. For example, 20 percent deficits were behind all but four cases of hyperinflation.

Stay with us here, because this is an important point. Most analysts quote government deficits as a percentage of GDP. They’ll say, “The United States has a government deficit of 10 percent of GDP.” While this measure makes some sense, it doesn’t tell you how big the deficit is relative to expenditures. The deficit may be 10 percent of the size of the U.S. economy; currently the U.S. deficit is over 30 percent of all government spending. That is a big difference.

Figure 8.5 shows the level of deficits relative to expenditures before hyperinflationary periods.

Interestingly, currently Japan and the United States are not far from levels that have preceded hyperinflations. The big difference between Japan or the United States and countries that have experienced hyperinflations is that the central banks are not monetizing most of the deficit. If they were to do that, then we would be one step away from paying quadrillions of dollars for a stamp or a sandwich (see Figure 8.6). It is extremely important to note Bernholz’s conclusion. Hyperinflations are not caused by aggressive central banks. They are caused by

irresponsible and profligate legislatures that spend far beyond their means and by accommodative central banks that lend a helping hand to governments.

What are the implications for the present day? Fiscal liabilities are the real threat that will lead to higher inflation, if central banks continue to monetize government liabilities. In the case of a monetization, governments with independently authorized central banks disavow the overly convenient slippery slope option of paying their bills by printing new currency. A government must pay down its liabilities with currency already in circulation or else finance deficits by issuing new bonds and selling them to the public or to their central bank to acquire the necessary money. For the bonds to end up in the central bank, it must conduct an open market purchase. This action increases the monetary base through the money creation process. This process of financing government spending is called monetizing the debt. Monetizing debt is thus a two-step process where the government issues debt to finance its spending and the central bank purchases the debt from the public. The public is left with an increased supply of base money.

Although now with quantitative easing (QE2), some would argue that the United States is on such a path. Mohamed El-Erian writes:

“The unfortunate conclusion is that QE2 will be of limited success in sustaining high growth and job creation in the US, and will complicate life for many other countries. With domestic outcomes again falling short of policy expectations, it is just a matter of time until the Fed will be expected to do even more. And this means Wednesday’s QE2 announcement is unlikely to be the end of unusual Fed policy activism.”

Do we think the Fed will abandon its responsibility to control inflation and resort to total monetization of U.S. debt? No. But in the attempt to get mild inflation, it is possible the controlled fire they hope to kindle could get out of control, forcing them to act to take back the excess reserves and bring about a recession, as did Volcker. Let’s hope it does not come to that.

If inflation is the cure for too much debt, as we suggested earlier in our tongue-in-cheek example of Brazil, why is it that high inflation and eventually hyperinflation made things worse? Governments have to spend money all year round, but typically they collect tax revenues at the end of the year. So the value of the government’s revenue in real terms is constantly diminished until the money is spent. Indeed, plugging a hole with inflation merely makes the hole bigger. Digging yourself deeper in an inflationary situation is what economists call the Tanzi effect, after the economist who discovered it.

Hyperinflations are all very similar. At first, bad money drives out the good. Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them. This is called Gresham’s law: Bad money drives out good money.

In modern hyperinflations where gold coins don’t exist, people begin to barter and exchange goods and services to avoid having to use devalued paper. Then, if they can get their hands on a foreign currency that is perceived to be hard and unlikely to lose its value, like dollars or deutschmarks, they will start to use the foreign currency. At first, they’ll use the foreign currency as a unit of account to settle wages and price negotiations, then as a means of exchange, and finally as a store of value. Once enough people use the hard currency, Gresham’s law reverses itself and hyperinflations come full circle. The good foreign money drives out the bad, and the inflating currency becomes totally worthless. This is called Their’s law.

This happened in Argentina. If you are buying a home, you literally come to the closing with large bags of physical U.S. dollars. One side counts the cash while the other checks the paperwork.

The consequences to this pattern are dreadful. Hyperinflation completely destroys the purchasing power of private and public savings. No one wants to hold paper money, so it leads to excessive consumption and the hoarding of real assets. Investors face uncertainty and refuse to invest, unemployment skyrockets, and savings flee the country. The best-performing stock market in 2008 was Zimbabwe, which offered people a way to hedge their currency risks, even as their economy plummeted.

The Problems of Inflation

It’s tempting to think that highly indebted countries can inflate their way out of their fiscal problems. Inflation would erode the real value of debt. Debts are fixed, while workers, companies, and governments could earn higher income as wages and prices could be indexed to inflation. The main drawback of high inflation or hyperinflation is that most people become poorer through reduced real income. If we look at the real incomes, we can see that periods of high inflation, for example in the late seventies and in the last few years, have led to negative real wages. On the other hand, periods of disinflation and deflation have led to periods of positive real wage growth. Simply put, prices go up faster than wages, so the things you need to buy tend to go up faster in price than your salary (see Figure 8.7).

There are three main problems with trying to use inflation to get rid of the value of real debt. Investors would recognize even a stealth inflation policy and quickly push up yields. Many governments around the world have tied pensions and salaries to inflation measures, so increases in government spending would rise with inflation. Nearly half of federal outlays are linked to inflation, so higher inflation means higher deficits. Social Security, which represents about 25 percent of federal spending outlays, is officially indexed, and Medicare and Medicaid are unofficially indexed. Indeed, over the period 2009 to 2020, the Congressional Budget Office (CBO) estimates that these three programs will account for 72 percent of the growth in total federal outlays and about the same share of the growth in debt. If anything, CBO’s assumptions may be conservative, as they are required under current law to assume a sharp cutback in physician reimbursement payments under the Medicare program. Those cuts have been delayed every year since 2003. Any increase in inflation will erode the value of existing debt, but it will make deficits much larger going forward and even possibly increase the real burden of debt as a percentage of GDP. The CBO estimates that if inflation is 1 percentage point higher over the next decade than the rate CBO has projected, budget deficits during those years would be roughly $700 billion larger.

Hyperinflation in the United States?

Congress likes spending more than a drunken sailor on shore leave, and the Federal Reserve sees the answer to any problem as providing more liquidity. Given this unfortunate dynamic, what is the likelihood that the United States will suffer from higher inflation and hyperinflation? Who better to answer the question than the world’s foremost expert on hyperinflation? Given all the fiscal problems and the monetary response, Bernholz sees many potential problems, but he currently sees no danger in the United States:

“But does this mean that inflation may evolve into a hyperinflation in the United States? I believe not. Though it is true that budget deficits with government expenditures covered by 40 percent or more through credits have historically led to hyperinflation, it has been stressed in Monetary Regimes and Inflation that it is not only the size of these credits but also their composition that is important. This is noted in the book, thus:

“‘It will be demonstrated by looking at 12 hyperinflations that they have all been caused by the financing of huge budget deficits through money creation” [emphasis added]. This expresses the fact that only credit extended directly or indirectly by the monetary authorities to the government leads to the creation of money, that is, an increase of the monetary base. This is not true for borrowings taken up in the capital markets if they are not resold to the Fed. Looking from this perspective at the U.S. deficit, by far not all of the credits borrowed by the government were financed by the Fed.

‘According to preliminary and rough estimates, not 40 percent but “only” about 13 percent of U.S. expenditures are presently financed this way. Moreover, in discussing this problem it has to be taken into account that about two-thirds of dollar bills are estimated to circulate abroad. This—together with the fact that incredibly huge holdings of dollar assets are owned especially by the central banks of China, India, and the Gulf States—may pose other and later dangers. But these dangers will be, except for a return of the dollar bills and a purchase of foreign-owned dollar assets by the Fed, of a different nature. Inflation may rise more or less strongly during the next years, but there is presently no danger of a hyperinflation in the United States.’”

Bernholz is likely being far too generous to the Fed and Congress. He is not counting more than $700 billion worth of mortgage bonds by Fannie and Freddie that the Fed bought with money it printed. Arguably, if other central banks had not been dumping their mortgage-backed securities, the Fed would have monetized 100 percent of the U.S. deficit through Treasury purchases. Interestingly, the only country in the world that currently fits the bill for hyperinflation is the United Kingdom, where 100 percent of the budget deficit was monetized by the central bank. Unsurprisingly, ever since, inflation in the United Kingdom has consistently overshot the Bank of England’s own forecasts. Apparently, they don’t see a connection.

While it is unlikely that the United States, Japan, or any other country will soon enter hyperinflation, the situation could change in the future if any of the central banks were to lose their independence or continue to coordinate their actions with their treasuries. Central banks have lost a lot of independence through quantitative easing. They may say they are keeping an arm’s length from the legislature and the Treasury, but few are fooled. Central banks in the United Kingdom, Europe, and the United States are now effectively working alongside the Treasury to pump money into the economy, so far with limited results due to the massive deleveraging in the private sector. They may continue to try this on a greater scale, and the larger the scale, the greater the need for coordination and the less the independence. If we go into a downturn, we hope central banks will be wise enough not to monetize government debt in any fiscal crisis. Sadly, they probably will. The Federal Reserve has made spectacular mistakes over the past few decades. Under Alan Greenspan, the Fed’s only solution to any problem was to provide more liquidity. To a man who only has a hammer, everything looks like a nail. Under Bernanke, the Federal Reserve effectively monetized government debt and monetized mortgage bonds held by quasi-government entities like Fannie Mae and Freddie Mac.

If we go into another downturn, will the Fed use its hammer again and provide more liquidity by monetizing even greater quantities of government liabilities? We hope not. Debt deflation is a terrible thing, but hyperinflation is even worse. We must remain vigilant that central banks maintain their independence.

+++++++++++++++++++

What are we predicting for the US and your country? That’s all in the following chapters. Go to www.amazon.com to get your own personal guidebook to the coming few years.

Europe, New York, La Jolla, Korea, and Recent Media Links

I did a lot of TV last week, which of course got rescheduled as the week progressed. Two short (5-minute) interviews, with Liz Claman on Fox and Dylan Ratigan on MSNBC. Very different questions. I like the challenges. They are at http://www.foxbusiness.com/on-air/closing-bell/index.html#/v/4578867/steps-to-getting-the-us-fiscal-house-in-order/?playlist_id=87063 and http://www.msnbc.msn.com/id/31510813/#41995013.

Next Saturday I am off to Europe. We are working on a book “launch” party with my co-author, Jonathan Tepper, in London on Monday Happy Hour in the City area. Drop me a note for details. And I will be on CNBC Squawkbox as guest host in London (I love that gig; lots of fun, smart anchors!). Then Malta, Milan (a public speech), and Zurich and home.

I am on my way to La Jolla for my good friend Jon Sundt’s birthday party tonight (his 50^th!) which will be a hoot. Keb’ Mo’, for you blues guys, will be the entertainment (lots of his stuff on YouTube). I love it. Jon has had a very impressive run for only 50 years, and I want to honor his life. Not just his work life, but his efforts in drug education for our kids, and as a great father, are an inspiration. To many more years of partnership, my friend!

It looks like I will be going to Korea in mid-May. I look forward to going for the first time to the country from which I have two adopted children. My twin daughters are a true joy in my life. And I will be in NYC April 4-6 (that is the plan for now!) doing media for the book and some research.

Have a great week.

Your happy so far with the book launch analyst,

John Mauldin

Global Bear Rally Of 2009 Will End With Japan

JohnMauldin — Mon, 04 Jan 2010 21:52:00 GMT

Let me welcome you to a new year of Outside the Box. I doubt we will have trouble finding interesting commentary this year, as there are many things that could happen that demand our attention. We start with a short column by Ambrose Evans-Pritchard of the London Telegraph giving us a quick run down of the problems faced around the globe. He thinks the #1 problem is Japan, and I more or less agree. I have written about Japan many times in the past few years. In my speeches I refer to Japan as a bug in search of a windshield. I am not so sure about the timing, however, as the economic and fiscal insanity that is Japan may be able to go on for longer than many think possible. But to me it is not a question of whether there will be a crisis, but when there will be one. This year? 2011? 2012? I doubt Japan makes it to the middle of the decade with a very serious and sad day of reckoning.

The downside to the continuation of running massive deficits is that when the break does come, it will be all the more painful and difficult to deal with as the debt mounts. If there is an upside, it is for the rest of the world to see what can happen to a developed country like Japan when massive deficits are allowed to pile up one after another. It will be a morality play writ large upon the walls, which cannot be dismissed.

But as Ambrose points out, it is not just Japan. There are problems all over the developed world. He does end on the encouraging note that at some point we hit bottom and will find the buying opportunity of our lives.

This is a little darker than most of the cheery forecasts of late, but we need to think of the world at large and how we are all connected.

This Friday I write my annual forecast letter. It will be more upbeat than last year's. Until then, have a great week.

John Mauldin, Editor
Outside the Box

Global bear rally of 2009 will end as Japan's hyperinflation rips economy to pieces

By Ambrose Evans-Pritchard

The contraction of M3 money in the US and Europe over the last six months will slowly puncture economic recovery as 2010 unfolds, with the time-honoured lag of a year or so. Ben Bernanke will be caught off guard, just as he was in mid-2008 when the Fed drove straight through a red warning light with talk of imminent rate rises – the final error that triggered the implosion of Lehman, AIG, and the Western banking system.

As the great bear rally of 2009 runs into the greater Chinese Wall of excess global capacity, it will become clear that we are in the grip of a 21st Century Depression – more akin to Japan's Lost Decade than the 1840s or 1930s, but nothing like the normal cycles of the post-War era. The surplus regions (China, Japan, Germania, Gulf ) have not increased demand enough to compensate for belt-tightening in the deficit bloc (Anglo-sphere, Club Med, East Europe), and fiscal adrenalin is already fading in Europe. The vast East-West imbalances that caused the credit crisis are no better a year later, and perhaps worse. Household debt as a share of GDP sits near record levels in two-fifths of the world economy. Our long purge has barely begun. That is the elephant in the global tent.

We will be reminded too that the West's fiscal blitz – while vital to halt a self-feeding crash last year – has merely shifted the debt burden onto sovereign shoulders, where it may do more harm in the end if handled with the sort of insouciance now on display in Britain.

Yields on AAA German, French, US, and Canadian bonds will slither back down for a while in a fresh deflation scare. Exit strategies will go back into the deep freeze. Far from ending QE, the Fed will step up bond purchases. Bernanke will get religion again and ram down 10-year Treasury yields, quietly targeting 2.5pc. The funds will try to play the liquidity game yet again, piling into crude, gold, and Russian equities, but this time returns will be meagre. They will learn to respect secular deflation.

Weak sovereigns will buckle. The shocker will be Japan, our Weimar-in-waiting. This is the year when Tokyo finds it can no longer borrow at 1pc from a captive bond market, and when it must foot the bill for all those fiscal packages that seemed such a good idea at the time. Every auction of JGBs will be a news event as the public debt punches above 225pc of GDP. Finance Minister Hirohisa Fujii will become as familiar as a rock star.

Once the dam breaks, debt service costs will tear the budget to pieces. The Bank of Japan will pull the emergency lever on QE. The country will flip from deflation to incipient hyperinflation. The yen will fall out of bed, outdoing China's yuan in the beggar-thy-neighbour race to the bottom. By then China too will be in a quandary. Wild credit growth can mask the weakness of its mercantilist export model for a while, but only at the price of an asset bubble. Beijing must hit the brakes this year, or store up serious trouble. It will make as big a hash of this as Western central banks did in 2007-2008.

The European Central Bank will stick to its Wagnerian course, standing aloof as ugly loan books set off wave two of Europe's banking woes. The Bundesbank will veto proper QE until it is too late, deeming it an implicit German bail-out for Club Med.

More hedge funds will join the EMU divergence play, betting that the North-South split has gone beyond the point of no return for a currency union. This will enrage the Eurogroup. Brussels will dust down its paper exploring the legal basis for capital controls. Italy's Giulio Tremonti will suggest using EU terror legislation against "speculators".

Wage cuts will prove a self-defeating policy for Club Med, trapping them in textbook debt-deflation. The victims will start to notice this. Articles will appear in the Greek, Spanish, and Portuguese press airing doubts about EMU. Eurosceptic professors will be ungagged. Heresy will spread into mainstream parties.

Greece's Prime Minister Papandréou will balk at EMU immolation . The Hellenic Socialists will call Europe's bluff, extracting loans that gain time but solve nothing. Berlin will climb down and pay, but only once: thereafter, Zum Teufel. [which roughly means your on your own or the devil with you. Not quite sure that's polite German.]

In the end, the Euro's fate will be decided by strikes, street protest, and car bombs as the primacy of politics returns. I doubt that 2010 will see the denouement, but the mood music will be bad enough to knock the euro off its stilts.

The dollar rally will gather pace. America's economy – though sick – will shine within the even sicker OECD club. The British will need the shock of a gilts crisis to shatter their complacency. In time, the Dunkirk spirit will rise again. Mervyn King's pre-emptive QE and timely devaluation will bear fruit this year, sparing us the worst.

By mid to late 2010, we will have lanced the biggest boils of the global system. Only then, amid fear and investor revulsion, will we touch bottom. That will be the buying opportunity of our lives.

Catching Argentinian Disease

JohnMauldin — Sat, 31 Oct 2009 02:47:00 GMT

Catching Argentinian Disease?
The Ascent of Money
The Independence of the Fed Threatened
A Few Quick Thoughts on the Dollar, GDP, and the Recession
Uruguay, Philadelphia, Orlando, and then...

I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security.

This week, we will look at the Argentinian experience and ask ourselves whether "it" - hyperinflation - can happen here.

The Ascent of Money

I will be quoting from Niall Ferguson's recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already.

If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn't happen more often.

In his introduction Ferguson writes, "The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp."

As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an "Aha!" Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com)

As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all.

Catching Argentinian Disease

At the beginning of the 20^th century, Argentina was the seventh richest nation on earth. It's very name means "silver." "As rich as an Argentine" was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that "There was so much gold you could barely walk through the corridors."

Argentina had actually defaulted on its debt in the late 19^th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press.

My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more.

Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!)

Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar?

Let's look at some quotes from Ferguson (emphasis mine):

"The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement... To understand Argentina's economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon...

"To put it simply, there was no significant group with an interest in price stability...

"Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy."

Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money.

In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it's not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices.

As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today's thought process is about what happens if they don't.

Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow?

Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy.

In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed.

I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason.

For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter.

The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part.

I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don't have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.

I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it.

The Independence of the Fed Threatened

The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok:

"It's now official. The proposed legislation to reform America's financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America's central bank.

"The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

"The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board.

"The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

"In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis."

This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement.

(Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.)

All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my "optimistic" scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching.

A Few Quick Thoughts on the Dollar, GDP, and the Recession

Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here.

And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%:

"Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more."

John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report)

And David Rosenberg writes: "Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go -- and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

"Only 29% of those polled believe the economy has hit bottom -- imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally -- not the onset of a new bull market) has not swayed their view (or ours for that matter)."

Uruguay, Philadelphia, Orlando, and then...

I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile.

My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living.

One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices.

Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary.

Your ready to be in his own bed analyst,

John Mauldin

To Stimulate Or Not To Stimulate The US Economy

RichardSchwartz — Thu, 05 Mar 2009 19:29:00 GMT

ANTI-Stimulus Protest Demonstrations; Say What?

That’s a big global fear surrounding this global economic slump. History shows economic debacles like this breed unrest, anger, frustration among those losing their jobs, etc. and thus protest demonstrations. If one watches www.worldfocus.com or any other news global news show, you’ll see violent protests happening globally. In Eastern Europe as one example. In China too and especially. China’s government’s big fear, knowing it’s own history, is protests which bring down the government there. Making the upturn in global protests there and elsewhere important for all investors to track.

Yesterday’s Investor’s Business Daily (IBD) newspaper had a front page article reporting that anti-stimulus demonstrations have occurred in 35 American cities. Yes, these are small demonstrations so far, 100 or 200 people and organized by interest groups, but maybe they will grow in size after IBD gave them face time, i.e. publicity -- I hadn’t even heard about these protests at all until yesterday -- and also gave them such a nationalistic and catchy name: “Nationwide Tea Parties.” I read where these events are being organized by those groups who sarcastically say we should: “Legalize Capitalism!” Or who believe: “The best government, governs least.” And those who sardonically and exaggeratedly say: “No to socialism!” And are epitomized by one protestor’s sign which read: “Your mortgage is not my problem!”

Obviously US government stimulus spending to try to keep this weakened economy from getting worse is anathema to those who believe in the strict Austrian school of economics. That economic school says things just get screwed up terribly whenever the government gets involved. And who knows, maybe doing nothing, to try to shorten this downturn, was indeed the right move. But as I see it it’s too late now; we’re already committed. I’ve given up opining on what were the right and wrong roads to follow but let me also report there are a lot of other angry people in America today, those that say they are tired of lavish retreats and concerts, tired of private jets, tried of companies paying out huge bonuses with or without government money. Regular readers know I’ve been angry and pounding the table for many years about these excesses. So maybe we do or will have class warfare, that is if these anti-stimulus demonstrations get larger and cause more of a divide among all kinds of angry Americans.

Schwartz View: But as I see it, we’re now committed to this “bail out” path, we got committed a year ago when we bailed out the first company, Bear Stearns or whoever came first. This far along this path I can’t foresee us stopping now. Plus it only makes common sense for any government to try to stimulate the economy when the two other major sources of normal demand, consumer spending and business investment, are in total hunker down mode. The even bigger picture, as I see things from up on the mountaintop looking down at the valley and what’s happening, is that these demonstrations by those who say your problem is not my problem, are the last desperate efforts by those who still believe in the “me first” path America has been on for roughly three decades now. As I see it, the results of the recent US presidential election announced that the majority of Americans want big change in America, a change which returns the America Dream to the average working person once again and returns us to a more level playing field. And that means, even though there is some opposition, that America has now crossed the Rubicon, so to speak. Meaning we’ve just begun a 10-year or so cycle which puts public interest over private interest. History shows we do swing back and forth from longer periods, or about 20 years, of letting capitalism run unchecked and America showing strong economic growth as a result to shorter periods of about 10 years or so where we put the unfortunate and forgotten Americans first, which yes, also means slower economic growth as a result. (Please read Arthur Schlesinger Jr.’s THE CYCLES OF AMERICAN HISTORY if you’d like more on this repetitive cycle.) All signs that I can detect today tell me that America is going to level the playing field, get rid of the excesses, the corruption and scamming of the system, in general just the overall greed which always naturally arises from allowing capitalism unchecked to run for too darn long. Again, I’m just observing what I see happening not opining whether it’s right or not. As for investment implications, for now stay hunkered down, practice extreme patience and proper money management while out waiting this Papa Bear market.

To subscribe to my daily letter PRINCIPLES OF THE STOCK MARKET or to receive a week’s worth of FREE letters, please email me at RichardStk@oaol.com.

Good trading, speculating and investing!

Monday Weekly Strategy

RichardSchwartz — Mon, 22 Dec 2008 14:37:00 GMT

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Monday, December 22^nd, 2008: So here it is, last letter ‘till Monday, January 5^th, as Lucy & I fly off to the white sand, warm blue waters of the Caribbean, maybe on a last hurrah (if the economy keeps sliding). I’m taking Cycles of American History & Rethinking the Great Depression books. Our routine is: Go to the beach, play backgammon, read & go out to dinner. Day after day. Warm our bones & work on new tans.

THE BIG PICTURE

Friday I saw John Bogle, who has been on Wall Street for 50 years and who created the first index fund, the Vanguard 500 Index Fund back in 1975, say investment bankers and bankers generally owe the country a huge apology (which I doubt we ever get). Their imprudent speculations and greed for massive fees from too complex speculations led to today’s financial sector problems, problems which have now fed out to the real economy hurting innocent, hard working, everyday Americans. Mr. Bogle says greed has even spread out to our whole economy, that we’ve morphed into in a “me first” society and it’s something we have to seriously take a look at. Thus capitalism, allowing markets to work unfettered of regulation and based on trust and trusting, has now been “deeply discredited.” Even the underpinnings of capitalism have changed radically. We’re no longer an ownership society whereby individual stockholders used to select and then hold 92% of all common shares; institutions 8%. Now institutions control 75% of shares through huge sums entrusted to them by others and have not invested prudently. Again, because of the incredible fees they got for investing. Mr. Bogle says they sure wouldn’t manage their own monies so recklessly. These institutions were supposed to be wiser than individuals but, again, it’s not their money. Supporting Mr. Bogle’s view is the revelation that 29 of the 30 largest losers in the Bernie Madoff Ponzi scheme scandal were institutions whereby just one of these fund of fund companies was paid $160 million in 2007 alone for recommending the Madoff “hedge fund.” In other words, where was the fiduciary responsibility, the prudency, the probity expected when we entrust institutions to manage 75% of our investments? Schwartz View: Regular readers know I’ve been distressed and pounding the table about a number of these societal issues for years. About capitalism running amuck, culminating its 30-year trend toward widening the gap between it and its counterpart, democracy, with President Bush’s skewed one way Texas twang policy saying the be all and end all is that “bidness is bidness” and thus stifling regulation. And about society becoming so uncivilized, we ended up booing our own hometown, beloved sports teams! So while no one wants to live through what may come next in the economy, I have to say America has finally woken up, albeit after the nightmare it usually takes to precipitate major change, and that we are now started down a long and arduous path, but one finally pointed in the right direction again. As one example, we’ve even started to SAVE once again; amazing! So, for myself, I guess sort of a contrary indicator in recent years, I’m becoming more optimistic and bullish on our future. Finally! “Go America Go!”

THE ECONOMY

It became apparent that the US economy was suddenly falling-off-a-cliff right after Lehman Brothers became the one firm chosen NOT to be bailed out by the Federal Reserve and US Treasury Department. (Looked back upon as a colossal mistake in strategy I’ve read.) Lehman’s bankruptcy rippled out far and wide and led directly to losses in some money market funds, a “breaking of the buck,” and thus then to a total loss of confidence. Now, by all accounts, the economy is in total free fall. This sudden screeching halt in US business activity has caused the same in our global trading partners and most everywhere I look is now in corresponding economic free fall. You extrapolate it for yourselves from here. One view I’m pondering is that many times sharp declines lead to the second leg of a V-move, back up, and we’re overdue. Maybe stocks, with their recent unwillingness to keep going lower on bad news, means Mr. Market (the consensus of large investors) sees some end out there to the economic free fall. Still, we’d have to see some economic revival to expect a sustained V snapback in stocks. For now, I see 2009 providing a steady stream of bad news every time we look up. Just like in the second year of the last Papa Bear bear market, back in 1974, a continuing stream of bad news back then ultimately overwhelmed all attempts to rally until the final months of that year. Schwartz View: The consensus I’m hearing is that this sudden, fall-off-the-cliff global economic contraction is NOT going to lead to a repeat of the depression-spawned 1930s starting with its four-year long period of contraction followed by its anemic recovery, a.k.a. the Great Depression. I hate to follow any consensus especially when this one’s been so wrong for so long. But my own history look backs and studies by Federal Reserve Bank Chairman Ben Bernanke, an expert on what went wrong in the 1930s, turning a recession into a depression, show that we raised taxes, cut spending and blocked global trade, just the wrong policies. So I sure don’t expect any exact repeat of those failed policies. Leading me to think out of the box and that maybe today’s Fed policy of battling a deflationary depression is also implementing incorrect strategy. How about worrying against runaway inflation spawning from all the money the US and now the world has and is still throwing at this economic slump? Just the problems we worried about in the early 1930s but didn’t occur. You know the old saying, people fight the wrong war, the old war, because that’s what’s still fresh in their minds. Thus, summing up, maybe we can’t expect much creativeness from the Fed pointing in the less obvious direction of battling inflation since they are entrusted with getting us through hard times. They will naturally, after learning certain lessons from the 1930s well, not break much new ground. One reason being that if their policies didn’t work, they would be heavily criticized for experimenting. Thus while everyone pooh-poohs an inflation problem, I still worry about one. Seems like the consensus, which may be correct, among the minority expecting and talking about an inflation problem, doesn’t expect one until 2010 at the earliest. Keeps me thinking about that quote I printed here back on Friday, December 5^th, from Sir John Templeton: “It’s impossible to produce a superior performance unless you do something different from the majority.”

THE STOCK MARKET

Maybe we’ve started off on a new, lasting stock market rally as many now say. Maybe the November 20^th closing low and November 21^st intraday low did end this bear market or at least this phase of it and start us up and on a new mini bull market. But I don’t think we can determine that from these final days of stock market trading this year. This jig jag, saw-tooth modest rally we’ve had in December – the Dow remains down -2.8% this month, but up +13.6% from its closing low on November 20^th – still looks like just a time killer rally to me after stocks fell -6% in September, -14% in October and another -5% in November. So while I’m off on my annual winter beach vacation, I’m leaving my managed portfolios hedged with a slight long bias, still with my modest overall about 20% or less market exposure which I’ve carried since late last year. You remember late last year? At least as a lesson learned for the future, if for no other reason. After the stock market rallied back from its original car wreck in July, in what amounted to a head fake, false move, dead cat bounce and pretty obvious sucker’s rally, and a failed break out to new highs by the Dow and S&P (while the rest of the stock market refused to confirm).

Anyway, last week I ended the letter by noting that psychologically we should rally since bad news couldn’t drive prices down in recent days. Technically we had what could prove to be two months of base building everywhere I looked on the charts (but bases which could easily prove false). Fundamentally we even finally had low enough market valuations, like P/E ratios, to support a rally as well. But how about a catalyst? Well, let me offer up: (1) much lower gasoline prices which keeps our wallets and purses fuller and healthier, and (2) the good feelings anyone watching our president-elect making non-partisan, non-political, non-ideological selections for his cabinet, should feel. There may be a wellspring of good feeling, a sort of honeymoon psychological effect on investors, business, consumers and most all of us as we hope our new president can perform miracles. Schwartz View: Unfortunately no one man is going to remake America overnight. So, while keeping an open mind and watching all unfolding developments, for now I’ll back history which says this “worst financial crisis since the Great Depression” has to lead to an extended Papa Bear market, one which lasts at least a couple of years. Not just for one year, where we stand today.

PORTFOLIO STRATEGY

I hate to follow or even agree with some of what I’m hearing about going forward strategy, especially if such is espoused by those who were so wrong all this year. I’m speaking specifically about Bob Doll, now at BlackRock as their “Trillion Dollar” fund manager. I don’t want to pick on anyone but since he’s been leading the charge forward as stock markets collapse and getting all the face time doing such, I guess I have to. I start off very skeptical because my belief is that these big money managers are not going to get on TV and recommend anything before they and their clients get first crack at their thinking, ideas and recommendations and position themselves accordingly. I already wrote awhile back many old stock market books talk extensively about how big money always used to try to sucker the little investors. The age old technical Wall Street term “distribution” implied big guys needed little guys to unload their big positions on to when they foresaw a bear market ahead and thus put on a bullish face. It took much time to unload huge positions these large investors stockpiled so much frenzied excitement about the stock market had to be built up as big money sold. What better way today than Bob Doll coming on CNBC ubiquitously and always saying we are now in a bottoming process. He said that back in March and those who followed him are much the worst after the October panic crash. Anyway, that’s all secondary, although supporting, my main point. My main point is that Mr. Doll now says next year is going to be a good one for those taking on risk, not for those playing it safe. Again sounds good to me, at least at first blush. We all know what goes down the most generally can bounce tremendously when psychology changes. But do we really want to buy really risky investments in just the early part of the second year of a big, bad bear market? I say no. Bear markets of this size and scope historically have taken a lot longer than one year to work through.

Net, net, probably Mr. Doll will be proven correct about taking on risk, if one doesn’t factor in any time period. I’d guess risky asset classes will move fast when this bear market ultimately does end but do I really believe its going to end soon? No. And if we do have a 2009 mini bull market, say because stocks have fallen so much, then I’m not going to count on Bob and other institutional investors to tell me and us exactly when to get back out. No, starting off next year next week, I’d suggest still playing our cards close to the vest. Yes, play modestly for a continuing rally but look at it for now as just a bear market rally.

Happy Holidays & Happy New Year!

Richard

Re-Regulation Begins a Multi-Decade Road

RichardSchwartz — Mon, 06 Oct 2008 14:39:00 GMT

THE BIG PICTURE

Today’s Big Picture view revolves around the probable coming re-regulation of the financial markets. History shows regulation of markets is similar to a grandfather’s clock pendulum swinging back and forth although not as regular. A brief look back to the start of the 20^th century, shows free markets and a first age of globalization, with the introduction of the telegraph and telephone, steamships and railways, at a peak. Millions even migrated without passports while trade flourished meaning free markets were in charge.

· Governments Take Charge. Then, in August 1914, with World War I, that age ended abruptly. WWI left people disillusioned and looking for something better and many turned to socialism and communism. The Russian Revolution in 1917 drew followers and essentially sought to end capitalism for good, making private property illegal. Socialists and other government controlled economic systems were winning the battle of ideas, governments were in charge, free markets were in retreat. In less than 30 years, one third of humanity, including Eastern Europe, China and the Soviet Union, would be living under socialism or communism. Capitalism looked to be doomed except for in America. The 1920s in America was still a boom time, Americans buying cars, buying illegal gin, buying stock. Radio was the Internet of the 1920s. It was a classic bubble. Finally the 1929 stock market crash started Americans on the way to despair, a complete economic collapse "with no ability to earn, repay, spend, consume." Everything spiraled downward while about half the banks in the US closed. America turned toward government for help and thus re-regulation with President Roosevelt’s numerous new government regulatory agencies. Around the globe, governments gained power … over free markets. In Italy, Spain and Germany fascism took charge. World War II then arrived and even afterwards people all around the globe still blamed capitalism for causing the depression. The whole world kept moving towards more regulated economies. England even went socialistic as Winston Churchill, the great war leader, was beaten by the socialists! Most of the world operated under this sort of government planning process for the next 30 years.

· Free Markets Regain Control. But in the 1970s free markets began a resurgence. Margaret Thatcher came to power in England with free market thoughts as did Ronald Regan here in the US. with his Reganomics. Both cut back on government regulations, giving markets more ascendancy and free markets again starting coming to the forefront. England started privatizing its economy while President Regan cut taxes and let free markets regain control as epitomized by breaking the air controllers strike. Thus capitalism got a free hand which lasted for aboutt 30 years, even through the dot.com boom and bust. But after last year’s incredible debacle with investment banks, money center banks, insurance companies, etc. losing billions after irresponsibly leveraging up their investments 20 or 30 times, it’s apparent to most everyone that, just like in the 1930s, we can’t afford to have any similar financial market collapse spawning from totally free markets to happen again any time soon.

Schwartz View: So after reviewing the history of the 20th century and seeing how over long periods, market regulation swings back and forth, I have to figure we’ve just started a long term swing back on the way to re-regulation. For more on this topic, I recommend you watch Commanding Heights, the Battle for the World Economy, by Daniel Yergin and Joseph Stanislaw which was turned into a DVD and a PBS prouction, a wonderful esplanation of the battle for economic minds in the 20th century. Filled in some missing pieces for me and should for you all as well.

Once a Century Day of Reckoning Starting?

RichardSchwartz — Mon, 09 Jun 2008 13:44:00 GMT

THE BIG PICTURE

Ok, here’s a Big Picture of where America and we Americans stand today. A fairly downbeat Big Picture so buckle your seatbelts. America has been on the verge of a major comeuppance for many, many years. But its been postponed and postponed. Because the US dollar is the world’s reserve currency we’ve been able to play by different rules than the rest of the world but now we’ve pushed that special benefit to the limit and beyond. But each time we’ve come close to going into a major economic recession, which almost by definition means a near term cleansing out and thus longer term strengthening of the economy, we get “bailed out,” so to speak, by the Federal Reserve or by our much deteriorated if not totally corrupted political system, i.e., by the sitting president and his staff or by Congress. Our economic problems which terribly need to be resolved, just get more and more money thrown at them (which just makes them worse and more deeply entrenched) say by President Bush’s multiple tax cuts upon taking office in 2000 or by the Fed dropping interest rates rapidly or through the floor or both. For example, former Fed Chairman Alan Greenspan numerous, back to back to back interest rate cuts in 2001 and 2002 and current Fed Chairman Ben Bernanke’s dramatic rate cuts since September. So our economy has been artificially pumped up and stimulated by what I call, financial “steroids.” time and time again for many years now. But now this use of steroids just isn’t working. Now all the money the Fed is pumping into the system to mitigate the credit crunch and crisis is just causing a big bubble in gasoline (and heating fuel prices) in America which at $4.00+ a gallon is now being felt widely. I say $4.00 is the tipping point and things are going to get worse quickly now because of the four following examples over the past weekend. First, Lucy let her Honda get down to a quarter of a tank for the first time in a long time. She called the dollar cost to fill it up

“eye-opening” numerous times as we drove off and away. I could hear the wheels turning in her head. Second, a real estate owner told me he was feeling this recession with a massive increase in real estate taxes, etc. and that he never felt any previous economic downturns in his life. Knowing me I probably blurted out it was just beginning, but I hope not. Third, awhile after my Sunday early morning bird walk, while reading the paper and drinking my coffee I heard the morning manager of Stewart’s, the local all purpose convenience store, tell another customer, a bit desperately, she couldn’t afford to drive to work now. And lastly, when I called to wish my brother-in-law Happy Birthday, my sister, retired but who was a bank trust officer in Buffalo for many years, says she’s never seen anything like this looming downturn. All in all, I expect $4 gas or out of control oil prices in general, is what the stock market discounted roughly six months back, it’s normal advance foresight time frame, when it really collapsed back in January, it’s first leg down in this bear market.

Now, Price Inflation. This commodity inflation, this cost of living inflation or price inflation, is starting to work its way through the economy in food prices as well. Watching the free marketplace work, in effect dramatically weeding out, killing off cattle herds because it costs too much to feed the cattle, that’s going to reverberate into higher hamburger and steak prices down the road. Plus Chinese wage demands will now work their way into much US clothing prices as well during this cycle. And if the US dollar keeps dropping, as it will because the US balance sheet is in such terrible shape, all prices will rise even faster. I’d go so far as to say commodity guru Jim Rogers’ and Peter Schiff’s predictions of hyperinflation are becoming a distinct possibility. All this rising inflation as the economy sinks and US wages stagnate or go lower and jobs shrink. So it’s not a pretty picture. And it’s possibly worse than a normal recession because we’ve put off this day of reckoning for so, so long. For example, in Trader Vic Sperandeo’s two early 1990s books, Trader Vic – Methods of a Wall Street Trader and Trader Vic II – Principles of Professional Speculation, he predicted a day of reckoning right then or very soon. And related to us a little history of how the US government operates, trying to paper over our problems by lowering rates, cutting taxes and whatever else they can think up to throw more money at our problems. This works and works and works … until it doesn’t work anymore. So far no one really has been able to predict when the day of reckoning will arrive. In the late 1980s/early 1990s was a flash point for trouble but we muddled through. Then another flash point around the dot.com bust from 2000 to 2002. But lower taxes and lower interest rates got us through. But now, 2008 -- 10 is the next flash point. Who knows? This time may indeed by the real thing. It sure looks it. Why? Obviously because the extremely important financial sector, the very area which has been driving the stock market higher by soaking up all the Fed and other government liquidity and manipulating it to make things look better and better on paper, has now imploded and gone bust. As Peter Schiff writes in his 2007 book, Crash Proof and Robert Prechter Jr. wrote in his 2002 book Conquer The Crash manipulating financial paper/assets/capital around to make it seem like we’re getting wealthier is a lot different than when America did grow wealthy by actual manufacturing, producing things people need and thus were willing to pay for. In the 1950s and 1960s we were the manufacturing colossus we lived on some of our profit and saved the rest. That’s how you build wealth. This disparity is one of Mr. Schiff’s key theses. Also one of Mr. Prechter’s major theses as well, just illustrated differently. Mr. Prechter, a chartist, says the US economy performed its best in the 2^nd leg up of this long term business cycle, say from the 1950s through the 1970s which shows this 3^rd leg up is nearing a major top. Schwartz View: So it’s all coming together now, seemingly. All the wrong paths we’ve followed for years coming home to roost now. That’s my guesstimate anyway. So, is this latest market decline really the beginning of America’s day of reckoning whereby the rest of the world finally loses confidence in America, waking up to the deception of the dollar as the world’s reserve currency, as Mr. Schiff describes it? Does the US dollar really head down as the world unloads our Treasury bonds, thus forcing up long term interest rates, which in turn ratchets up the already gigundo squeeze on America and us individual Americans and make the situation even worse? No one really knows for sure as Mr. Prechter reports these true economic disasters only occur about once a century! Like in the 1930s in the just departed 20^th century and once in the 19^th century as well. Why would this once in a century event be beginning now? As bad as things now look, maybe somehow we’ll get bailed out and the day of reckoning postponed once again. But since I began this stock market letter, 18 years ago in September 1990, I’ve watched things get worse and worse, not on the surface where we had a great stock market run in the 1990s, but under the surface, as democracy got pushed back and back, as labor unions lost power, as corporate statesmen became extinct, as much needed government regulation somehow morphed into a swear word and became despised, as liberalism or helping the unfortunate became obsolete behavior and as capitalism ran away unchecked, benefiting from fiscal and monetary stimulus over and over again whenever the economy lapsed into the normal down wave of a business cycle leaving us today with just a shell of the old wealth producing US economy. Yep, all looming economic crises and recessions have been pushed to the back burner by our dysfunctional political system which now listens only to corporations through their lobbying efforts. A system which even business if fed up with. Social Security, Medicare & Medicaid, pensions, health care, energy, the environment, a big wow! when I write them all down, all these long term vital issues have been avoided because of capitalism gone wild, because doing anything about them would “… hurt the economy and be bad for business … .” The same mantra Congress just used as its reason last week to kill a critical climate bill! Just awful action. Politicians should know there’s more to the economy than keeping the steroid sham going year after year, there’s more than keeping the business lobbyists happy near term and there’s more than their next election result. The US economy needs to be cleansed out from time to time and thus made fundamentally stronger for the longer term and more competitive in today’s new global economy. We still have the strongest, most fundamentally sound economic, financial and social system going from all I can tell. And the country has more than just our economy to worry about and strengthen for the longer run. We also need to re-strengthen our democracy once again after the loss of common man representation that’s taken place over the last 30 to 40 years. Actually, it’s no one’s fault, this push into Supercapitalism as Robert Reich terms it in his latest book of the same name, what has happened in America over the last few decades. But now it’s time to look at and push the flip side of the coin, to reawake democracy which is vital to American life as well. We need to regain representation for little towns and smaller groups, non-profits, etc., etc., all those groups who can’t get their sides of the story heard any more today as corporate lobbyists dominate. Again, I don’t blame anyone for what’s evolved. That’s capitalism, if left “unfettered” as even Republican presumptive presidential nominee Senator John McCain has described today’s economy, it will go to an extreme … as it now has. * For the record, one can get all five books I’ve just mentioned above from www.Amazon.com or elsewhere. And I recommend them all.