There Are No Good Choices for the Fed

Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue. I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future. (And I tell you later on when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there is not an easy answer. In fact, the answer is that it could be both. Saturday I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe, but the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it is seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 does not really tell us anything about the future of inflation.

In fact, it is my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003, when Greenspan was holding down rates too long in order to spur the economy, that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that is the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there is a cost.

It is not a matter of pain or no pain; it is a matter of choosing which pain we will face and for how long, and perhaps in what order. As I wrote a few weeks ago, like teenagers, we as an economic polity have made some very bad choices. We are now in a scenario where there are no good choices, just less-bad ones.

In a normal world, the amount of monetary and fiscal stimulus we are witnessing would produce inflation in very short order. That is what has the gold bugs of the world excited. It is their moment. They keep repeating that Milton Friedman taught us that inflation was always and everywhere a matter of too much money being printed. The answer to that is that the statement is mostly true, but not always and not everywhere (think Japan). The reality is somewhat more nuanced. Let's review something I wrote last year about the velocity of money, and this time we are going to go into the concept a little more deeply. This is critical to your understanding of what is facing us.

The Velocity Factor

When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And what about my business? Travel costs are way, way up; and as aggressive as we are on the budget, expenses always seem to rise. Compliance, legal, and accounting costs are through the roof. I wonder how those costs are accounted for in the Consumer Price Index? About the only way to deal with it, as my old partner from the 1970s Don Moore used to say, is to make up the rise in costs with "excess profits," whatever those are.

Is the Money Supply Growing or Not?

But we are not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money, and how it affects the growth of the economy. Let's start with a few charts showing the recent high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast, or just about right, depending upon which monetary measure you use.

First, let's look at the adjusted monetary base, or plain old cash plus bank reserves (remember that fact) held at the Federal Reserve. That is the only part of the money supply the Fed has any real direct control of. Until very recently, there was very little year-over-year growth. The monetary base grew along a rather predictable long-term trend line, with some variance from time to time, but always coming back to the mean.

But in the last few months the monetary base has grown by a staggering amount. And when you see the "J-curve" in the monetary base (which is likely to rise even more!) it does demand an explanation. There are those who suggest this is an indication of a Federal Reserve gone wild and that 2,000-dollar gold and a plummeting dollar are just around the corner. They are looking at that graph and leaping to conclusions. But it is what you don't see that is important.

[click images to enlarge]

Now, let's introduce the concept of the velocity of money. Basically, this is the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy. Stated as an equation, it is Y=MV, where Y is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing Y by M.

Now let's dig a little deeper. Y, or nominal GDP, can actually written as Y=PQ, that is, GDP is the Price paid times the total Quantity of goods sold. Therefore, since Y=MV, the equation can be written as MV=PQ. But the point is that Price (P) is tied to the velocity (V) of money. You can increase the supply of money, and if velocity drops you can still see a drop in the "P," or inflation.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few paragraphs, please. Let's assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc.; and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does NOT increase, that means (in our simple island world) that on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. They fall into actual deflation (very simplistically speaking). So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If the central bank increased the money supply too much, you would have too much money chasing too few goods, and inflation would rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it?

No, because only 20% more goods is produced from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services, which only grew by 20%. They would start to bid up the price of the goods they want, and inflation would set in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon (XOM) down to the local dry cleaners, and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month, and another hundred thousand fail. Productivity over time increases, so that we are producing more "stuff" with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, plus some more for new population, and you have to factor in productivity. If you don't then deflation will appear. But if the money supply grows too much, then you've got inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant. And it was from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts, the first from Stifel Nicolaus Capital Markets.

Here we see the velocity of money for the last 109 years. The left side of the chart shows the velocity of money using both M2 and M3 (measures of the money supply.)

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average for the last 100 years. Lacy Hunt, in a conversation that helped me immensely in writing this letter, explained that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let's look at the first chart.

Y=MV

And then let's go back to our equation, Y=MV. If velocity slows by 30% (which it well has in terms of M3 – and it is down more than 15% in terms of M2) then money supply (M) would have to rise by that percentage just to maintain a static economy. But that assumes you do not have 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, which mean M (money supply) would need to grow about 5% a year, even if V were constant. And that is not particularly stimulative, given that we are in recession. And notice in the chart below that M2 has not been growing that much lately, after shooting up in late 2008 as the Fed flooded the market with liquidity.

Bottom line? Expect money-supply growth well north of what the economy could normally tolerate for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday morning quarterback for many years.

But this is important. The Fed is going to continue to print money as long as they are not confident deflation is no longer a problem. They can't tell us what that number is because they don't know. My guess is if they did tell us the markets would simply throw up, especially the bond market, which would of course make the situation from a deflation-fighting point of view even worse.

Sir, I Have Not Yet Begun to Print

Remember the story of John Paul Jones? An American naval officer during the American Revolution (the French gave him a medal, although the British referred to him as a pirate), he engaged a larger British ship off the coast of Yorkshire. He literally tied his boat to the larger ship and they shot cannons and guns at point blank range. Legend has it that he was asked to surrender, as his ship was sinking. He is supposed to have replied, "Sir, I have not yet begun to fight!"

When faced with the possibility of deflation, I can almost hear Bernanke saying, "Sir, I have not yet begun to print!"

When will they know when enough is enough? When the velocity of money stops falling. When we see two quarters in a row where the velocity of money is rising, then it is time to start investing in inflation hedges.

Now, why is the velocity of money slowing down? Notice the significant real rise in velocity from 1990 through about 1997. Growth in M2 was falling during most of that period, yet the economy was growing. That means that velocity had to have been rising faster than normal. Why? It is financial innovation that spurs above-trend growth in velocity. Primarily because of the financial innovations introduced in the early '90s, like securitizations, CDOs, etc., we saw a significant rise in velocity.

And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. The absence of new innovation and the removal of old innovations (even if they were bad innovations, they did help speed things up) are slowing things down. If the money supply had not risen significantly to offset that slowdown in velocity, the economy would already be in a much deeper recession.

The Fed has more room to print money than most of us realize. How much more? My bet is that we'll find out. Will they print too much at some point? Probably.

There Are No Good Choices

What we are looking at in our near future is not inflation. We are in a period where the Fed is in the process of reflating, or at least attempting to do so. They will eventually be successful (though at what cost to the value of the dollar one can only guess). One can have a theoretical argument about whether that is the right thing to do, or whether the Fed should just leave things alone, let the banks fail, etc. I find that a boring and almost pointless argument.

The people in control don't buy Austrian economics. It makes for nice polemics but is never going to be policy. My friend Ron Paul is not going to be allowed to make monetary policy, although he might get a bill through that actually audits the Fed. I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly.

A mentor of mine once told me that the market would do whatever it could to cause the most pain to the most people. One way to do that would be to allow deflation to develop over the next few quarters, thereby probably really hurting gold and other investments, before inflation and then stagflation become (hopefully) the end of our perilous journey. Which of course would be good for gold. If you can hold on in the meantime.

Is it possible that we can find some Goldilocks end to this crisis? That the Fed can find the right mix, and Congress wakes up and puts some fiscal adults in control? All things are possible, but that is not the way I would bet.

While there are some who are very sure of our near future, I for one am not. There are just too damn many variables. Let me give you one scenario that worries me. Congress shows no discipline and lets the budget run through a few more trillion in the next two years. The Fed has been successful in reflating the economy. The bond markets get very nervous, and longer-term rates start to rise. What little recovery we are seeing (this is after the double-dip recession I think we face) is threatened by higher rates in a period of high unemployment.

Does the Fed monetize the debt and bring on real inflation and further destruction of the dollar? Or allow interest rates to rise and once again push us into recession? (A triple dip?) There will be no good choice. The Fed is faced with a dual mandate, unlike other central banks. They are supposed to maintain price equilibrium and also set policy that will encourage full employment. At that point, they will have to choose one over the other. There are no good choices. I can construct a number of scenarios. All end with the same line: there are no good choices.

Comments

[Steven Hansen:]

"They are supposed to maintain price equilibrium and also set policy that will encourage full employment. At that point, they will have to choose one over the other."

I am thrilled at the opportunity to comment real time on your articles.

The Fed has not approached full employment since 2000, and the meltdown last year demonstrated they were not in control of prices either. This is no Sophie's Choice - they are not deciding between the two.

what the Fed is doing is attacking deflation with all the unconstitutional powers it can muster in the face of a spineless congress. they believe the economy will contract in the face of deflation.

Sep 13 04:41 AM

[Faisal Humayun:]

There is no doube that in the near term one can see deflation. It is also worth mentioning that some sectors can have inflation while other deflation. Example - Equities and Commodities went up post March 2009 while housing prices declined.

Moreover, with the massive debt burden of the U.S., there will be every effort to prevent deflation through massive quantitative easing. This might show itself in the form of inflation in the long term.

I think inflation is not just increase in prices (due to demand supply mismatch)...If the Government wants to debase its currency (to get out of the massive debt burden) then inflation will result.

But for sure a good article with lots of supporting charts and data.

Sep 13 05:18 AM

[markfl:]

The Fed has shown itself prompt in lowering short-term rates over the last decade and tardy in raising them post-recession. Clunkers is illustrative. Even a brief demand spike resulted in attempts to boost production in some car plants. The economy is awash in liquidity (not much of it being lent at the moment, however). Some forecasts call for the possibility (although not high) of 4% GDP before year's end.

This might be seen as a positive sign, but IF strong demand actually occurs, it's by no means clear that production could meet the demand quickly: businesses have become quite lean. Even with brisk growth, pressure on the Fed not to "risk" the recovery would be great, and they could again delay raising rates. So, while the prospect of inflation seems vary distant at the moment, it could resurface next year, and we will see whether history (2002-2003) repeats. I hope it doesn't.

Sep 13 05:53 AM

[LE:]

What do you think is the primary impetus (or impetuses) for the 2nd dip of the double dip that you think we face?

Sep 13 08:44 AM

[axelrod608:]

While one can create equations and play with numbers, economics is not a science. There is zero opportunity in the real world to compare "equals" with differing inputs and measure differences in outcome. No, economics is obsevation and opinion.

What I see happening in its most simplistic form is not inflation or expansion of the money supply. It is rather the quicksand model - new money being created is simply replacing the money lost in the latest crash, and faulty, futile monetary policy is the quicksand that continues swallowing it all. What our nation's "leaders" don't understand is the concept of unsustainability.

ZIRP (zero interest rate policy) is a weapon of middle class destruction. Sure, the big corporations - especially big banks - love it. They can fund their casino junkets with essentially free money. Meanwhile, the inadequately educated middle class is charmed by the credit industry into a lifestyle of make believe wealth with cheap neverending credit. Neverending until the bubble bursts.

You don't have to be a rocket scientist to compare interest rates around the globe and notice something. The economies that are doing the best are where you can get a decent rate of interest on your savings account. Japan has had negligible rates for a couple decades now, and look where they're at.

ZIRP is annhililating the American middle class. Until and unless the Fed or Congress make saving a fiscally prudent policy, the economy will, at best, continue to muddle.

On another front, ZIRP encourages the government to borrow vast sums to fuel its totally out-of-control spending. If it cost serious amounts of interest, the government might be less profligate. Might be. Hard to imagine, isn't it.

Finally, if government spending is not curtailed, there is no "recovery" ahead. Just more pain in more sectors. Saving the banking system from collapse does not keep the empire from collapsing.

Sep 13 09:09 AM

[ron_paulite:]

good article.

is there a typo here? should it be "or deflation" at the end of the sentence?
"You can increase the supply of money, and if velocity drops you can still see a drop in the "P," or inflation."

Sep 13 09:14 AM

[Roger Knights:]

"While there are some who are very sure of our near future, I for one am not. There are just too damn many variables."

The lesson is to stay flexible. (The multitude of variables means that it is easy to make a case for anything, by paying selective attention.)

Sep 13 09:30 AM

[PearlCreek:]

John Maudlin is bearish and in a long-winded confusing way?

I am shocked, just shocked.

Sep 13 09:53 AM

[thesheet:]

I agree with your view that gold is seen as a neutral currency.

I disagree that the price of gold is going only due to forecasted inflation
Gold is also seen as a safe-haven for economic uncertainty and collapse. The idea that Gold is only good for an inflation hedge is, in my opinion a half-truth and simplistic at best.

Various central banks are purchasing more, asking for their stash to be returned from London or indicating they won't be selling their gold reserves. They are probably doing this as a way to diversify out of US dollar(currency neutral), but I think in the back of their minds they are worried about systemic risks associated with the current economic system in general. Derivatives, which were initially meant to reduce risk, was and still are threatening to cause another collapse. Ironic!

I think it will take some other unforeseen event to cause portions of the derivatives market to collapse; so we are safe for now. It is a risk though!

Gold does well during deflationary collapses as well as inflationary episodes. During the 1930's deflation, gold was pegged to US dollar. I proxy to gold would have been Homestake Mining. I can't copy the chart, so here's the webpage. oxburyresearch.com/tag.../

Notice the shares going parabolic? The massive upturn was probably due to gold being seen as a safe haven during economic collapse. The US government made gold illegal to own april 1933. The shares went ballistic because since gold was illegal to own, people went for the blue-chip proxy for gold. Homestake.

( In case you think that homestake only went up when gold was made illegal should note that the chart was beginning its parabolic run before the government made gold illegal to own. Although there could have been insider buying from people who knew about the confiscation ahead of time).

Conclusion: Investing in Gold bullion may not be as bad as it would seem. It would be better to think of gold as a safe-haven as opposed to only as an inflation hedge.

Gold companies do get dragged down with general markets, but during outright deflation their costs go down!
Gold maintains its value, which increases the companies profits so eventually investors realize that gold companies are the only stock investment that will do well during deflation.

thesheet

Sep 13 10:02 AM

[wcrxlp edit...:]

Mr. Mauldin writes: "I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly."

Compared to Congress, the Fed is transparent. Fed data is fairly descriptive of the part of the picture that the Fed is interested in.

To learn what Congress will do is impossible.

Learning what Congress has already done is the deeper mystery. The amount of money taken, directed, re-directed, forgotten and lost by that deliberative body is incalculable.

For portfolio structure and allocation, Laura Frank's Bexley CPI has more useful data than anything the Congressional Budget Office publishes.

I'm curious about what data and information sources Mr. Mauldin uses for figuring out what Congress will do.

Nonetheless, Mr. Mauldin series of articles is very helpful.

Sep 13 10:27 AM

[knight:]

Hey John,

Glad you took up the advice to write on SA. I think you work is great and you explain it in a very commense sense way. Keep up the good work and look forward to reading more of your stuff on SA

Salman

Sep 13 10:30 AM

[Warren B. M...:]

The 'money' that the Fed is 'printing' is not the stuff of quantity theory and therefore of no further economic or monetary consequence. It used to be when we were on the gold standard, but the concept is inapplicable with today's non convertible currency, where lending is in no case reserve constrained. Lending is constrained by capital from time to time, and regulation, but not reserves at the Fed.

With the entire mainstream 'out of paradigm' on this issue there very well could be a substantial buying of gold for that inapplicable reason.

If so, this is the stuff of bubbles, and gold could be the next bubble.

moslereconomics.com

Sep 13 10:49 AM

[Alphameister:]

Truly funny misspelling of the author's name! Intentional?


On Sep 13 09:53 AM PearlCreek wrote:

> John Maudlin is bearish and in a long-winded confusing way?
>
> I am shocked, just shocked.

Sep 13 10:54 AM

[bottoms-up:]

Perhaps "resignation" for some of these morons would be appropriate...

Seriously though, there is no way out for them. I think the drug addict analogy is the best one for the fed's/government's policy... The pump billions into the cash for clunkers program and say, look at the bump in durable goods. The worst is over! Well, let's se how well it plays out sans billions of $$$$ thrown into the mix.

I've heard that the reason that the fed, etc is starting an "exit strategy" is not because things have turned around, it's because they've run out of money and can't go back to Congress because they know the jig will be up on the massive sham they've been running for a year.

People are out of work and broke, the state/local governments are broke and the only final admission missing is that our central government is broke.

Finally, please tell the millions of people who are unemployed or underemployed that the fed and U.S. Government have deployed a "no pain policy." Believe me, there is plenty of pain out there, but the likes of CNN, CNBC and Bloomberg don't want to dampen the rosy scenarios of the current powers that be, so the misery is hidden from view.

Sep 13 11:03 AM

[Alphameister:]

John,

Kudos to you for the best article on this subject that has appeared in Seeking Alpha.

Years ago, I reviewed Friedman's classic "Monetary History of the United States" and argued that the depression-era anomalies that did not fit his analysis proved to be well explained when accounting for velocity and using inflation-adjusted money (real money) instead of the nominal money supply to forecast economic trends.

Re your description of the country as a teen-ager run wild, I agreed completely in a recent comment that "As a country, we have the big heart of an adolescent, utopian liberal.....and the weak mind to go with it."

And finally, I agree that the best future the country can expect in the next ten years is to cycle around a base stagflation. There is more than enough fear of the consequences of hyper-inflation to make that scenario very unlikely. Meanwhile, "moderate" levels of inflation (destined to be interpreted at 3% to 5% for the foreseeable future) will gradually ameliorate the debt burdens without totally losing credibility with international creditors (who will increasingly demand inflation-protected treasuries). As for a sustained return to economic growth at rates of 3% or better, I'm inclined to doubt that it will happen in my lifetime given current political trends.

Sep 13 11:09 AM

[DaveW:]

The market/pundits/bloggers will find one to attribute it too, after the fact... Sentiment cycles play a big role in volatile markets.


On Sep 13 08:44 AM LE wrote:

> What do you think is the primary impetus (or impetuses) for the 2nd
> dip of the double dip that you think we face?

Sep 13 11:13 AM

[bottoms-up:]

You forgot to note that money both real and imagined has a multiplier effect or velocity in the economy.

For example, you use $100.00, but lets say you put $100.00 of credit on the line. The same thing happens. Let say that you have $100.00 in cash and I have $100.00 in credit (that is backed only by my good looks - LOL). Same effect, but we both compete on the playing field for the same goods or resources.

You make excellent points with the velocity of money, but I've seen zero about the abuse of credit in these scenarios as both an inflationary and destructive force in economies. I think a documented argument could be made that the fall in housing prices and other goods is a result of a credit correction, not deflation.

There are two factors in an economy that can create inflation: The central bank printing money and the abuse of credit lines. If you give every man, woman, child, dog and cat in the United States a credit card with a $20,000.00 credit line, guess what happens? Consumer spending jumps and so do prices... Home loans... same thing... They gave $$$million dollar loans without even checking to see if the applicant was really employed... It inflates prices and this fake money is thrown into the "velocity of money" with everything else.

We also have the "velocity of debt," that seems to be off the radar screen; it moves faster than the "velocity of money."

Anyhow, as you withdraw abused credit from the economy and the asset values reach reasonable levels based on the market, sure things will go down lower than they are now.

It's not "deflation," it's a "correction."

When the central governments can no longer pump the balloon any longer, than the laws of gravity will kick in, market forces will return and normalcy will again rule the day. (I guess I should say, until the lessons are lost on the next generation...)

Sep 13 11:22 AM

[Boxed Merlot:]

On Sep 13 10:27 AM wcrxlp editorial collective wrote:

> Mr. Mauldin writes: "I am much more interested in learning what the
> Fed and Congress will actually do and then shaping my portfolio accordingly."

> I'm curious about what data and information sources Mr. Mauldin uses
> for figuring out what Congress will do.

> Nonetheless, Mr. Mauldin series of articles is very helpful.


I agree that in terms of US$ valuations, Congressional (in)activity / expectations and policy implementations are crucial. Their previous track record does reveal considerable information, and short of a mass “come to Jesus” conversion by the current majority, US$ velocity will continue its deceleration with more and more being parked in the garage of gold / silver/ commodities to wait until the darkness has passed. That’s one of the problems with the US$ relationship to gold and silver, they represent very slow (if any) monetary velocity in the current climate of government acquisition of the major financial / industrial and healing arts / pharma sectors of the US economy. IMO

Sep 13 11:33 AM

[Aaron Ashcraft:]

ZIRP is necessary to provide a cushion for the banking system until reserves are recreated: otherwise, banks are broke! ZIRP is also GOOD for the middle class because it enables average wage earners to borrow money at low interest rates.
While it is true that savings interest rates are low, most Americans have little savings, anyway; it isn't going to hurt them to have a couple of years of 1.5% interest on their savings, if the banks can get healthy again in the interim. People also can buy utility stocks and receive a 5% dividend, even in today's market - so middle class Americans have an opportunity to earn a decent return on their savings.


On Sep 13 09:09 AM axelrod608 wrote:

" ZIRP is annhililating the American middle class. "

Sep 13 11:38 AM

[bottoms-up:]

I gave you a thumbs-up on your full comment. I received my undergraduate degree in economics many years ago from UCLA, then I went on into another field...

I feel that's important to note what goes in economics: What goes in is what comes out. In other words, if economists are fed a bunch of garbage statistics from the U.S. Government, OECD, IMF, all with a strong agenda for a quick recovery, what comes out is just that. Believe me, I don't think you'll find another time in the history of the world when there was more false and misleading statistics being thrown into the mix on a daily basis then you'll find in the past year.

The other factor is that economist are first and foremost people. They conform to their workplaces, have families to feed, etc., etc.... Do you think that an economist for Citi is going to go on Bloomberg Monday and say, well, we are really screwed and people who hold C are idiots? It may or may not be the truth, but no economist is going to come out and do something like that.

Same thing with all of these "undershots" so things will be "better than expected." Really now...

Sorry to go on about this, but I do feel the need to defend the profession from time to time.


On Sep 13 09:09 AM axelrod608 wrote:

> While one can create equations and play with numbers, economics is
> not a science. There is zero opportunity in the real world to compare
> "equals" with differing inputs and measure differences in outcome.
> No, economics is obsevation and opinion. SNIP/////

Sep 13 11:41 AM

[Aaron Ashcraft:]

John:
As an avid reader, thank you for another insightful explanation of a complicated subject. Friedman's work has been very valuable; however, his assumption of stable money velocity clearly limited the value of his theories about money supply and inflation. The coming 10 years will be incredibly interesting, and will provide incredible opportunities for investors who are careful to keep collars on their investments (e.g., trailing stops/call and put options).

Sep 13 11:50 AM

[Gem Hudson:]

Playing with funny money cost you plenty. Because what couldn't buy you much should not be selling as high from its low. Buying stocks from more than a carry trade are selling more paper for paper and paper money from that of print money is the gold price for an ounce that is rising up to a fallen dollar but stuffing the bank vaults with nothing more than their paper money are buying paper for paper and paper money is worth nothing. The price for an ounce of gold goes up.

Dow to gold ratio betray the dow jone average but pure gold in refiner fire is all that worldly dross that is burnt out.

Sep 13 11:55 AM

[TAS:]

Well reasoned commentary.

Thanks for joining the Seeking Alpha stable!

Sep 13 11:59 AM

[One Eyed Guide:]

John,

Great to see you posting on SA. Maybe a few more people will be converted to reality based investing before the market crushes their investments as it moves to fair valuation in a deleveraging world.

One of the reasons there are "no good choices" is that some things are still off limits, at least as far as admitting in public that they need to be done. Just one example is that every economic theory will show that that today the dollar is overvalued against at least some currencies yet there is no outcry that the dollar should be devalued, in fact, the outcry is that devaluation is bad. Why? Auguements are too convoluted to cover here. In any case, the government appears determined to achieve devaluation without admitting what it is doing.

Gold is interesting because the government should let it run to help achieve the dollar devaluation but seems to be moderating gold prices to moderate global financial concerns. If gold is a neutral currency then it should be possible to rearrange the relative valuations versus gold with minimal change in the price of gold in dollars.

We'll see.

Sep 13 12:22 PM

[tjfxh:]

I think that gold is more than a neutral currency. It seems to me that gold has the most real "moneyness," hence, it is not only a hedge against impending inflation but also currency depreciation. In deflationary times, the CB's will reflate and depreciate currency, thereby driving gold's real moneyness. Gold is also a hedge against social and political instability, which are rising domestically and globally.

The Fed's dual mandate of price equilibrium (monetary stability) and full employment (NAIRU) is inherently contradictory. There are three forms of "inflation." The first is monetary (money + credit) inflation. The second is price (asset + goods) inflation. And the third is wage inflation. The latter two are related to the former as dependent variables. When price deflation threatens, the Fed's action to reflate monetarily leads to asset inflation first, then price inflation and then wage inflation (or else political instability). What this means is that government intrusion in the marketplace eventually manifests are imbalances among vital sectors, destabilizing not only the economic system but the social and therefore political system as well. The Fed is in the course of blowing more bubbles, and this is not going to end well either economically or politically. This "uncertainty" (I'd say certainty) is also driving the flight to safety and pushing gold. (The Fed is not alone in this, and this is a global phenomenon.)

In modern economies, society is dependent on employment for survival. Agricultural economies were threatened primarily by natural causes such as droughts and plagues, against which they hedge with stored surplus. Modern industrial economies have rendered workers almost totally dependent on employment and savings for survival. Capitalism favors capital accumulation and protection (and rent) over labor, so the employment mandate is secondary.

Saving reduces velocity, so saving has been discouraged in the US (decentivized by low rates and easy credit), where national prosperity is defined as growth measured by GDP increase regardless of the GINI coefficient (distribution). Moreover, wages have been flat for decades due to the goal of capital accumulation, with the resultant lowering the bargaining power of labor. Now real unemployment is around 20%, with a million or more foreclosures impending.

Because of worker dependence on employment, it is incumbent on government to provide for survival in times of economic contraction. Therefore, socially ( and politically) unemployment becomes the top priority economically, or the government is replaced.

Larry Summers recent statement that high
unemployment will continue (is acceptable) for several years is ominous socially (and politically for Democrats). On the other hand, the GOP champions free market capitalism, which places monetary stability over unemployment, so a shift in government seems to be no solution. And the country is already gunning up, and discourse is turning ugly. This does not bode well.

So I don't think that the run up in gold is entirely speculative or based on the expectation of impending inflation. A significant number of people are hedging against the possibility of disaster and even governments are hedging against dollar depreciation. Until the "uncertain" situation changes (without sparking inflation), gold has a bright futures, although increasing volatility comes with increasing interest.

Sep 13 12:27 PM

[Glen L.:]

"What we are looking at in our near future is not inflation. We are in a period where the Fed is in the process of reflating, or at least attempting to do so. They will eventually be successful (though at what cost to the value of the dollar one can only guess). One can have a theoretical argument about whether that is the right thing to do, or whether the Fed should just leave things alone, let the banks fail, etc. I find that a boring and almost pointless argument.

The people in control don't buy Austrian economics. It makes for nice polemics but is never going to be policy. My friend Ron Paul is not going to be allowed to make monetary policy, although he might get a bill through that actually audits the Fed. I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly."

With those two paragraphs, I lost all respect for John Maudin. To me, the goal of ending the Fed and the very concept of monetary "policy" -- i.e., government interference in free markets in support of crony fascicapitalism -- is the ONLY argument worth making. This ridiculously long article to explain the simple concepts of inflation, deflation, and velocity of money is what is boring. Give me the inspiring words of the free market Austrians any time; every other school of economics is a false school. As Peter Schiff said, there is only economics, which the Austrians teach; we don't talk about "Chinese physics", do we?

Yes, the Fed is between a rock and a hard place of its own creation. Every possible exit scenario is bad. Maudin wants more Fed transparency so he has a chance of knowing how to protect his money. So do I, but the logical conclusion, i.e. ending the Fed itself, "bores" him. What a disappointment.

Sep 13 12:28 PM

[Mike from NYC:]

I agree with your statements. Once all the stimulus money is expended we'll really see how bad things truly are. So far, the only bump in the economy, the 'real' economy, not that fantasy 'Wall Street' economy, is from stimulus spending. When states and local governments spend all their bonus money and see how pitiful their tax receipts truly are there are going to be huge layoffs or higher taxes, or both.

This is the dawning of the age of the new Amerikan Ekonomy, something which America has ignored far too long.


On Sep 13 11:03 AM bottoms-up wrote:

> Perhaps "resignation" for some of these morons would be appropriate...
>
>
> Seriously though, there is no way out for them. I think the drug
> addict analogy is the best one for the fed's/government's policy...
> The pump billions into the cash for clunkers program and say, look
> at the bump in durable goods. The worst is over! Well, let's se
> how well it plays out sans billions of $$$$ thrown into the mix.
>
>
> I've heard that the reason that the fed, etc is starting an "exit
> strategy" is not because things have turned around, it's because
> they've run out of money and can't go back to Congress because they
> know the jig will be up on the massive sham they've been running
> for a year.
>
> People are out of work and broke, the state/local governments are
> broke and the only final admission missing is that our central government
> is broke.
>
> Finally, please tell the millions of people who are unemployed or
> underemployed that the fed and U.S. Government have deployed a "no
> pain policy." Believe me, there is plenty of pain out there, but
> the likes of CNN, CNBC and Bloomberg don't want to dampen the rosy
> scenarios of the current powers that be, so the misery is hidden
> from view.

Sep 13 12:47 PM

[John Lounsbury:]

John - - -

Welcome to SA. I hope you find the comment stream feedback useful. I have. I actually cited this article in my SA post today on the same subject (deflation and monetary flows), but didn't know yours would be here, so the hyperlink is to Thoughts from the Front Line.

I read carefully what you write each week in your e-mail newsletter and often receive inspiration to tackle a new topic. This time we got on the same topic independently with not radically different results.

Look forward to reading your work here.

Sep 13 01:35 PM

[HEARTSFORLOVE:]

Forrest Gump once said that i don't read newspapers cos i can see what's going on by watching the street.

Ignore all government reports. Travel costs especially air travel have shot up and house prices have shot down. Most retail goods are costing less with massive ongoing sales and closures. While food is still edging up. Life is not so simplistic that everything will go up or down in value in a block. We are already in a major stagflation cycle.
And even if we were in a major deflationary cycle Gold and Silver would still go up if there is not enough investment return from property ,,, currencies,,, or business activity. World wide.
First is the series of foreclosure waves and then tenants start defaulting on their rents because their credit is shot anyway, which will sap property values even further. This will boost gold and silver more.. Then the government with its excess of "we will take care of your every need attitude 'will lose more of its tax base as it continues to tax sap private enterprises and finally assertively go after property taxes as a major revenue base.
This is all inevitable unless folks don't realize the government is meant to guide and not govern our lives. And oh yes we don't have a government by the way we have a bunch of well spoken eloquent charmers who are over powered or in bed with the lobbyists who redirect national policy at the end of the day.

Yep Things can be very simple if just look around on the street. And i am already experiencing a full fledged deflationary lifestyle.

Sep 13 01:57 PM

[ed233:]

I read your article not completely because I found it confusing. A lot of people assume inflation as too many dollars chasing too few goods. And I assume given that situation there would be inflation as a result of that circumstance. However in the USA unemployment is approaching all time levels and those that are employed are saving more which restricts money from going into the system. Velocity is nothing more than the multiplier effect. For example, if you reduced unemployment say by 10 percentage points that means you have a greater number of spenders entering the market place. Let's say for example purposes it represents a 10 billion payroll. The multiplier effect can be approximately 9 times. That means that 9 times ten billion is really injected into the economy and therefore you can see the exponential effect of this type of injection. However, there are also two other types of inflation. One is monetary inflation caused by a decrease in the value of a currency and another caused by supply inflation. The latter two have not been adequately explored but they are very important because they have application for these times. LOL Looking after your money.

Sep 13 02:01 PM

[ECHealthIns...:]

The fact that interest rates have been so low for so long and no longer impact the economy, and coupled with the money supply would indicate that our future is going to be very painful. I think the most complicated graph or chart will not be able to show the full-scale economic catastrophe that is looming nor its exact impact. Remember the housing market bubble, in the beginning everyone bet against it, and they got burned and when it finally crashed no one was even betting against it anymore (some were of course but very few). In conclusion, though I imagine that our financial future will be painful, I am neither certain of when nor how, or even what. So even though shorting the market or investing in forex etc. sound great as a long term strategy, I would not recommend it for the near term. The general consensus in the country seems to be that the recession is coming to an end and their incorrect exuberance will drive the market higher for an uncertain period of time before the inevitable crash.

Sep 13 02:15 PM

[seasaw:]

Successful investing does not require the ability to predict whether we have inflation or deflation in our future (instead, the best way to successfully invest is to take advantage of mispricings - buy assets that are undevalued and sell assets that are overvalued and don't risk going broke by using excessive leverage). No one in history has been able to consistently predict the amount of inflation (or deflation) in a given time frame. Mr. Mauldin himself provides no specific information as to how much inflation or deflation will incur at a specific time.



That said, the likely result is that at some point, and I don't know when, we will

feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future

Sep 13 03:08 PM

[seasaw:]

That said, it is not too difficult to see that we will likely return to inflation sometime in the future (when I don't know, but certainly in less than 10 years). Governments tend to inflate the currency and our government's plan appears to be consistent with this. Although some analogize to Japan, Japan is not analogous because it has had a declining popullation (and is a a small country with a conformist culture).

Sep 13 03:15 PM

[Charles Cas...:]

Such a great article. I agree there are "too many damn variables" right now to assess which ones drive the economy's direction in coming years, e.g. stagflation or inflation?? A general assessment, however, would indicate to me that the M2 / M3 V is prepared to revert back to the mean soon, which is supported by the fact that the banks cannot hold onto all of the additional money printed and issued by the Fed forever. Banks must start lending again for the velocity to mean revert, and until that happens we'll be misled into believing our economy has stabilized. What happens at that point is most likely the Fed raising rates to control the inflation (selling off US Treasuries to reign in the money supply) and costing many more quarters of rising unemployment on top of what we currently have. My only caveat to that assessment is the impact of upcoming fiscal policy decisions in Washington - namely the effects of Healthcare "Reform" and this Cap N' Trade nonsense. Maybe there's an argument to be made that implementing these policies now will create sufficient headwinds to inflation growth... but what a silly argument that is to make when the Fed should decide that, not Congress.

Sep 13 04:18 PM

[derryl:]

Excellent article, Mr. Mauldin.

I agree that we will see Mr. Bernanke saying, "I have not yet begun to print!", in order to offset the credit contraction deflation the US is experiencing. There was a good article in the Sept.2 Financial Post by Penn Bullock titled, "Did Friedman do it?",

network.nationalpost.c...

in which Mr. Bullock makes the case that Bernanke is a disciple of Friedman and will use Friedman's monetarist measures to prevent deflation and to reflate. Unlike author Bullock I am not an anti-monetarist. Really, we have gone too far down the fractional reserve debt-money road to just 'turn, and be healed' as the Austrians advocate. So the way forward is monetarist. But I would add some caveats.

bottoms-up makes a crucial point in his comment above regarding the "velocity of debt", which he accurately states is faster than the velocity of money due to the fact money is created as debt at interest. So the debt + interest to be repaid always exceeds the amount of money that was originally created as the loan. What we have reached is what Michael Hudson michaelhudson.com calls "terminal debt" where the velocity of debt expansion reaches the vertical phase of its exponential growth curve.

In other comments I have been trying to make the case that in a monetary system like ours what always happens over time is that all the money ends up owned by the investor class of the population while all the debt ends up with the consumer class. The consumers run out of credit and have no spending power to fuel the real economy, and the investors don't spend their money on consumption. So you reach an impasse or standoff between the people who have the money and the people who want to consume, and your financial system and economy collapse.

The financial system collapses because banks who lent to the consumers of houses and other durable assets find those borrowers laid off work due to the collapse of consumption money circulating through the economy. So those asset values plummet leaving the banks insolvent. Declining spending induces businesses to cut costs, especially labor, which further reduces spending power as you wind into a deflationary spiral that crushes your real economy.

Without the fast and extraordinary measures that have been undertaken by central banks and governments the world would now be at September 1931 instead of September 2009, near the beginning of a deflationary depression that the free market was unable to get out of. It took the enormous public spending of WWII to get the world's economies started up again, to put spendable money into the hands of all those millions newly employed at the war effort.

The market could not solve the money/debt impasse. It took a market externality--government spending--to restart the economy.

The reason for that is clear. The investor class who owns a great portion of the money, and these people do not owe the money they have to any bank, is a small portion of the population and cannot by themselves spend enough money to demand anywhere near full employment of labor and capital. The vast majority of the population is cash-starved and income deficient so they can't spend either. So the economy contracts and there is no way to get it going again without some external source of new money coming in.

You don't need to go to war to get out of deflation. What you need to do is get money, that is not burdened by an obligation to repay it, into the hands of people who will spend the money. That is, more "credit" will not stop this deflationary death spiral because credit is debt and we have already passed the point of terminal debt.

In his FP article, Penn Bullock writes, "Friedman suggested that countries could escape the liquidity trap by handing out money to consumers, and he laid out his argument in a tale about a helicopter unloading cash on a town." As we all know, Mr. Bernanke has quoted Friedman's idea of dropping money from helicopters, hence "Helicopter Ben". This is not a joke or an exaggeration. The monetarist solution to the liquidity trap, or what I call the impasse or standoff, is to give people free money.

Mr. Mauldin notes that Japan's program of QE failed to prevent a 2 decades long and counting deflation. I would argue that that is because Japan failed to put the newly created money into the right set of hands.

Certainly it is necessary to first prevent your banking system from imploding, but you don't actually have to give banks new capital to do that. All you have to do is refrain from enforcing regulations regarding asset/capital ratios and insolvency during the period of reflation. TARP and "mark to fantasy" are versions of relaxed enforcement.

What you really need to do to reflate is to give money directly to the people who have excessive debts or no jobs and have lost their financial capacity to pay their debts and consume. As I have argued in previous comments, the only politically viable and equitable way of doing this would be a program of 'stimulus checks' given to everyone over 18 with a SS number. No means testing or other politicking. Everybody gets the checks.

I suggested that checks of $1000 given every month for a year would cost about $2.5 trillion, which is in line with other easing programs currently being administered. This money would not be created as debt. It would be 'naked QE', where Treasury sells zero interest bonds to the Fed and the Fed credits Treasury's account to cover the checks, with no redemption date on the bonds.

At first this would not be inflationary at all, especially if one condition was that recipients first use the money to payout their present consumer debt (e.g. credit cards, car loans, student loans, etc.) and the underwater portion of their mortgages. Money is created as loans and that amount of money ceases to exist when the loan is repaid. So if half of the first year's $2.5 trillion went to paying down debt, $1.25 trillion would cease to exist and only $1.25 trillion would be spendable money. Of that amount many people would save some so only a few hundred billion would actually be spent and contribute to reflating the economy. (A quicker alternative, if you wanted to get more spending happening more quickly, would be to issue time limited spending coupons that are accepted as money by retailers and redeemable by them at their bank for real dollars, kind of what like Arnie is doing in California with his IOUs.)

This is clearly not enough to overcome the approximately $12 trillion of asset wealth Americans lost last year, and their spending reductions due to the negative wealth effect. So the program could be continued until some real inflation started to appear again.

This money is not issued to the people as 'loans' so they don't have to pay it back, ever. If inflation started to get out of control due to a quickening of velocity, then the Treasury could tax some of the new money back out of the economy and redeem some of the bonds it sold the Fed. In previous comments I have linked to Warren Mosler's, "Soft Currency Economics" for a more thorough description of how fiat money should be administered. I notice Warren made a comment above, and a link to his website.

Simon Johnson has been writing about how big finance has captured the US political process, and I agree this is the case. Normally it is bankers who create and distribute new money, and they would not want to be left out of this 'stimulus check' loop. So the QE stimulus could be administered through the banking system. It would be the check recipient's bank account that receives the checks directly, and it would be up to the banker to ensure that the money is first used to payout the recipient's consumer credit and underwater mtg principal. Banks would be paid fees to administer this program. The bankers are kept in the loop. The Fed is kept in the loop. No changes to the current system are required. Just the new 'naked QE' bonds, which would never leave the Fed unless Treasury redeemed them.

Our monetary system is "monetarist". Banks create our money as debt. The Federal Reserve tries to control changes in money supply. This is "monetarist". There are inherent problems with this system, as I laid out above and as Friedman and Bernanke clearly understand. Unless we want to abandon this system and try another one, the solutions to our current terminal debt problem are monetarist: either a deflationary depression from which there is no natural escape, or giving people free money. As Mr. Mauldin writes, "There are no good choices."

Sep 13 04:58 PM

[tripleblack:]

I enjoyed this article, which shed some light in a few dark corners of my understanding of money supplies. Thanks Mr. Mauldin.

Sep 13 04:58 PM

[Laurence Hunt:]

Mr. Mauldin has borrowed from Buffett well in describing a simple island economy.

Re: deflation. Obviously money supply is increasing. The free market still decides where the new money ends up (and how it gets there). Obviously new money used to recapitalize banks can simply sit on the balance sheet to assure minimum capital requirements get met. I'm not a banker, so I don't know the subtleties as to what banks do with cash on the balance sheet, but it obviously has to get managed conservatively. Recapitalization funds thus aren't particularly inflationary. What they accomplish of course is keeping failed enterprises in business (banks). They also assure that fiscal instruments on which the bank would otherwise have defaulted are made good. Thus the simple facts of banks staying in business vs. failing keeps much more money in circulation (velocity of money).

Now, what does observation tell us about where "excess" money supply ends up? Well, we are paying less for items digital and electronic. We are paying less for items manufactured overseas (compared to when they were made here, but not compared to last year when they were made over there). We are paying less for real estate because few of us have available funds to purchase it even at reduced prices (demand destruction meets over-supply).

What costs more? Well, goods made in China are gradually running up in price. The funds we transfer overseas to fund offshore manufacturing are increasing prices of goods and services where the new manufacturing money ends up (mostly Asia). The Chinese (for the most part) can't buy our real estate, health services, local infrastructure - because these items are local to us. So that economy is determined locally vs. globally.

What do we pay more for here? Things that we need vs want, and that are produced locally... energy (excluding natural gas for a while, but just wait!), services of all kinds - including health care, insurance, repair and maintenance of whatever we need to keep working, transportation, postage and parcel delivery, etc., etc.

We are more or less seeing "deflation" in discretionary items, and inflation in necessary items.

The underlying trend is inflationary, but capital destruction impacts our ability to borrow and spend..... on things we want vs. need (for the most part)....

So... inflation in the cost of the local and necessary; deflation in the cost of outsourced manufacturing and services and in discretionary items of all kinds, particularly those discretionary items for which we typically borrow (I count bigger houses than we need and business over-expansion as discretionary)....

Sep 13 06:16 PM

[jse17:]

Ole John is a poor man's Gary Shilling. Their moment in the sun is exceedingly short and blessedly infrequent! This viewpoint plays well to the Birther class et al and the next catastrophic land mine always lies within the next step or two!

Chronic despondency sells newsletter subscriptions and admission tickets for Save Your Portfolio meetings in exotic settings!



On Sep 13 09:53 AM PearlCreek wrote:

> John Maudlin is bearish and in a long-winded confusing way?
>
> I am shocked, just shocked.

Sep 13 06:51 PM

[so2c:]

The logic is flawed in that it assumes Fed has the ability and capability to supply the money in a normal way, whatever that means.

I don't believe print money out of air can be properly described "supply the money"? by common sense. Of course, who care common sense these days.

Sep 13 07:43 PM

[John Bowman:]

I have this feeling that the Fed examines their tidy M1, M2, M3 and velocity charts daily and decide on which method they are going to utilize to "save" the economy from itself.

Meanwhile, in the real world the numerous variables assert themselves and result in unexplained phenomena to them.

Greenspan once described the low mortgage rates a few years ago as a conundrum, and just months before the housing bubble collapsed, Bernanke was optimistic about that sector of the economy. And his decision to try to reflate housing prices has been like trying to win the last war.

I guess reality is a bit too complex to analyze to these very powerful people. Living in an ivory tower with neat formulas is a lot easier.

Sep 13 07:45 PM

[rennert:]

The economy is going to tank along deeper and deeper until grandma gets a decent return on her CD's. No one in her Elder Clubs is buying anything but food. And that keeps going up in price as well as her doctor bills and her vet bills. The elders watch their little nest egg with fear full eyes and they are not going to spend.

Sep 13 07:51 PM

[Econ Base:]

>>>Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.<<<<<

yes, but only if you are trying to time entry/exit points. Best is to stay the course once a portfolio is built with your comfort level.

portfolioforlife.blogs...

Sep 13 08:23 PM

[William Ram...:]

Very fine article. Thank you. I had some questions please:
1) Do you know where I might find a list of core economics books worth reading, or perhaps a books similar to Bertrand Russell’s, History of Western Philosophy, but in the area of economics?
2) If the government increases M but V is lower, then why would the value of the USD fall? There would be more US dollars, but since they are circulating less, then would not there still be the same supply/demand relationship?
3) Is the fall of the USD recently due to increasing M or other reasons, for example, lower US interest rates, or higher returns in non-USD assets?
4) Is the recent rise of gold negatively correlated with the fall of the USD, or is gold rising against any other currencies also?
Thank you

Sep 13 08:59 PM

[PANAMA JACK:]

We are at a point in time that we can only believe what affects us.
All the ellected officials feed us the info that they feel we should here, but is it the truth?
Fact is the economy is in a slump, bad one at that.
This is not a (v) shaped recovery no matter how much papper they
print.
Soon or latter the piper needs to be paid!

Sep 13 09:07 PM

[Nyetnichevo:]

Lots of intelligent verbiage to reach no conclusion except confusion.

Sep 13 10:45 PM

[AlphaKing:]

I believe that they must start sounding more hawkish, at least, if they are not going to play it. It is true the fed is normally several months too late when raising rates, and keeping up with inflation pressures.

In order to compensate for their tardiness they can start talking more hawkish. Those who are worried about inflation will then at least have more confidence that they will not let inflation run rampid. As long as they keep up with the short term t-bill rates, and do what they have been doing by properly injecting capital where needed, we will be good in the medium-long run.

Sep 13 11:00 PM

[AlphaKing:]

Also, regarding the money supply, there is nothing to really focus on with it. All of the real factors to be considered regarding the money supply are disguised in the M3.

M1 & M2 money supply mask what lies in the M3. Since, we cannot actually read and track the M3 anymore, only M1 & 2, there is really no point to analyzing the money supply, because most of the inflationary pressures are hidden in the M3, or what M3 was composed of, government and bank debts. So without the M3 you will not be able to see how big the worlds greatest ponzi scheme really is.

Sep 13 11:10 PM

[Econ 101:]

HAVE YOU SEEN THR Rolling Stone article????

www.rollingstone.com/p...

Sep 13 11:30 PM

[JoeSixPack:]

Interesting article, and good that you brought velocity and gold into it. My question is how much velocity do we get from $1 Quadrillion of derivatives and off the balace sheet entities.

Sep 14 12:25 AM

[Dykes:]

Mauldin has been perennially wrong over many years, and has a dismal track record. He is the instigator years ago of the concept of the "muddle through economy." Some muddle! So we can say that he did not foresee the current debacle though it was staring him in the face, unlike a few other less vague commentators such as Peter Schiff, Ron Paul, or Jim Sinclair. How does this now qualify him to prognosticate, which one can see he is wisely deisiting from doing?

Now we have a new vagueness, which is that he doesn't "know" whether there will be inflation or deflation. Brilliant illumination! Still steering the middle course.

John is an establishment man and he doesn't want to rock the boat, as it could hurt his credentials in La La land amongst the status quo.

Sep 14 04:54 AM

[Plant the s...:]

Mark,
Concur on the timing of Inflation risk resurfacing? I am hoping for a U recovery rather than a V, since that will give them time to respond and not see it slide into a W as they realize inflation is out of control.

On Sep 13 05:53 AM markfl wrote:

> The Fed has shown itself prompt in lowering short-term rates over
> the last decade and tardy in raising them post-recession. Clunkers
> is illustrative. Even a brief demand spike resulted in attempts to
> boost production in some car plants. The economy is awash in liquidity
> (not much of it being lent at the moment, however). Some forecasts
> call for the possibility (although not high) of 4% GDP before year's
> end.
>
> This might be seen as a positive sign, but IF strong demand actually
> occurs, it's by no means clear that production could meet the demand
> quickly: businesses have become quite lean. Even with brisk growth,
> pressure on the Fed not to "risk" the recovery would be great, and
> they could again delay raising rates. So, while the prospect of inflation
> seems vary distant at the moment, it could resurface next year, and
> we will see whether history (2002-2003) repeats. I hope it doesn't.

Sep 14 05:33 PM

[JCC:]

I am a long time reader of Charles Mauldin, and find that his work and writing are generally excellent. Furthermore his record have pretty good.

That aside, in recent correspondence with Lakshman Achuthan he indicated that there was a chance of a double dip, but that during the last two recoveries the Fed waited quite a while before pulling back. He indicated that we should keep an eye on the ECRI WLI (weekly leading index), and if it backs off sharply then buckle up. For now though things look to get better. Look at the chart in ECRI and you will see that it is moving up.

Sep 14 08:49 PM

[MarkitWacha:]

You're right about the crash, but I think that the next crash won't have waves of people crowding into the Treasury market. It will be a dollar mini-collapse, so the Treasury market should be a safe place to short, near- and long-term.


On Sep 13 02:15 PM ECHealthInsurance wrote:

> The fact that interest rates have been so low for so long and no
> longer impact the economy, and coupled with the money supply would
> indicate that our future is going to be very painful. I think the
> most complicated graph or chart will not be able to show the full-scale
> economic catastrophe that is looming nor its exact impact. Remember
> the housing market bubble, in the beginning everyone bet against
> it, and they got burned and when it finally crashed no one was even
> betting against it anymore (some were of course but very few). In
> conclusion, though I imagine that our financial future will be painful,
> I am neither certain of when nor how, or even what. So even though
> shorting the market or investing in forex etc. sound great as a long
> term strategy, I would not recommend it for the near term. The general
> consensus in the country seems to be that the recession is coming
> to an end and their incorrect exuberance will drive the market higher
> for an uncertain period of time before the inevitable crash.

Sep 15 09:32 AM

[carey_jim:]

The American and world economy are too large and complex to understand well and to predict future direction and behavior with confidence.

First, there are many non-economic factors such as commodity wars, government interventions, social disturbances, new inventions or stagnation of inventions, epidemics, large changes in weather patterns, ecological disasters, population explosions, revolutions and simple, but unpredictable system breakdowns. That is to say, economic history is driven by "black swan" events.

Second, economics itself is not a hard science. We have to contend with Keynesianism, neo-Keynesiansim, Monetarism, Classical Economics, Institutionalism, Austrian School economics and even various strains of socialism which we Americans have all ignored, royally, so to speak. And there are many more schools which I haven't mentioned.

History is replete with successful finance ministers whose advice to the king suddenly took a turn for the worse, starting with the disasters of the physiocrats Law, Colbert and Quesnay and continuing down into our own times with our own recent finance minister Alan Randy Greenspan.

Our destinies as financial planners force us to try to make sense out of this mess but we should look to the weatherman for advice about humility: "The rain in Spain falls mainly in the plane." (I think she's got it, I think she's got it.)

Sep 16 01:18 PM

[AlphaKing:]

The recent FOMC statement proves my previous comment on this post. They are sounding too laxed, and more dovish than they need to be. A little hawkishness at the moment would be a positive thing, signaling they have greater faith in short term economic recovery and are prepared for inflation. Instead, they will continue to monetize debt and let inflationary pressures build up greater than needed. This is now worrying investors as they are afraid they will "drop the ball" too quickly, and may be a little late in raising rates as they usually are.

Sep 25 01:59 AM