Inflation Could Cure Our Economic Ills 19 comments
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Contracting credit should be an aspect of the business cycle. As the economy grows, credit booms, investments are made and price levels rise.
Eventually, we reach a point where prudent lending standards prevent further credit expansion, borrowing stagnates and economic growth either moderates or declines. During the decline, certain borrowers will experience hardship and default on their loans. If during the expansion, debt levels remained moderate and loan standards prudent, defaults will be limited and economic damage contained.
Our current crisis is much different. As the credit bubble expanded earlier this decade, household debt grew from 60% of GDP to 97% of GDP. Similarly, household debt as a percentage of disposable income (measured as income after taxes) grew from 89% to 127%.
Normally high debt levels would force prudent lending standards as the risk of loss is elevated. Instead, the credit bubble was inflated as investor demand for extra yield and the belief that asset prices only increase caused many lenders to loosen underwriting standards and create subpar loans.
As many homeowners find themselves with negative equity, the rationale for owning a home shifts and their choice is to walk away. Normally, we see economic stress cause people to lose a home they would rather keep. Currently, we have seen people willingly walk away from homes prior to a true downturn in the economy.
This has caught many lenders off guard and has led to tightening of credit to nearly all clients. Thus today's borrowers suffer for yesterday's mistakes.
With the access to credit eliminated and debt levels high, individuals find few options to expand consumption. If consumer spending drops, economic growth also drops. So what are the alternatives? Since the economy is dependent upon borrowed money to grow, we must rely on the one entity with the ability to borrow and spend - the federal government.
While I rarely advocate increasing deficits, the current economic picture requires extreme measures. With individuals and companies locked out of the credit markets, the risks are massive.
As we have seen in the last 6 weeks, financial markets are awakening to these risks and the results have been brutal. With the focus on the Treasury's most recent band aid, the Dow Jones Industrial Average [Dow] has dropped below 10,000 while volatility continues to soar.
Buying bad assets may help eliminate uncertainty, but it does not guarantee that credit markets unclog and lending continues. Instead, we need more drastic actions to stem asset deflation.
Looking at our country, our needs are numerous. Our infrastructure has fallen into disrepair and needs updating. An expansion of both education and healthcare services would be easily justified to the American people. Tax incentives for research and development would increase employment and innovation. Combined, the federal government would be using its borrowing capacity as a way to reinflate the economy, raise asset prices and increase our standard of living.
Normally, I would never advocate inflation to cure our economic ills. These are not ordinary times. Given the size of the problems and the effect it is having, failing to take an inflationary path will lead to, at best, a deep recession and increase the possibility of a severe depression that will affect the entire country and thus, the world.
If I am correct about the need and intent of the government to inflate the economy, the investment implications are many. In an inflationary environment, Treasury bonds will suffer. Currently, the 2 year Treasury pays 1.45% and the 10 year Treasury pays 3.49%.
The initial steps of an orchestrated increase in inflation will be led by a Federal Reserve [Fed] interest rate reduction. When it occurs, you should expect Treasury yields to decline further. At that moment, I would exit these positions as increasing inflation will erode the value of the bonds.
The largest beneficiary of increased inflation will be hard assets and related companies. Gold offers the purest exposure, but all commodities should do well. Equities that either supply commodity producers, i.e. -fertilizer companies such as Potash Corp. (POT), or that currently possess abundant commodity reserves, i.e. - oil companies such as XTO (XTO) should see their shares perform well. Real estate should begin to bottom and then eventually outperform.
As the Presidential election is near, keep a close look at the economic plans presented by the candidates. It is my belief that in order to prevent another Great Depression, greater and more painful than the one in our past because so much more wealth is at stake and the population of our country has increased, our government must spend on infrastructure, healthcare and education. Constructing a portfolio focused on these areas should yield excellent results.
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This article has 19 comments:
No need for further comments as ozzy covered all the salient points.
End Keynesianism, End the FED, resume the gold standard. We'll rebuild with whatever is left over after that.
It feels strange, because it almost feels as though a few at the top knew America was fast becoming bankrupt but instead of standing up and doing what was right, squeezed another couple of rounds of wealth on top of it. This 'meaness' resembles 1873 hardship created from railroad stock, government and banking corruption then 1929, although today seems similar to 1929 with the excess leverage. Worst of both worlds perhaps. As stated in the past, the citizenship will learn the who's who of the corrupt in Washington and clean house. Four years of pain, voter revolution in 2012 and beginning of the next Bull market in 2013 has been my forecast for several months now.
The problem is that people like you believe the government should be involved in healthcare and even more involved in education. Government does not allocate capital efficiently. It mostly transfers wealth from those who create it to those who do not.
All people are endowed with inalienable rights from our Creator. The equality in that comment does not mean that equality of outcome should be pursued. That is the pursuit of the lowest common denominator. That is the result of socialism (where the elite still gets the best treatment).
Take education, which you site. We have massive bureaucracies on both the federal and state levels in a unionized monopoly. (Why does a monopoly need a union anyway?) We get an inferior product/service at high cost. In NJ, spending in the classroom would increase by more than $1 billion if 65% of each education dollar was spent in the classroom. The money is feeds worthless bureaucrats. Test scores in developed countries show this.
If we truly wanted to help kids, and especially kids from low income families, we would inject competition. Vouchers and charter/magnet schools would work.
Look at socialized medicine systems. Where do people under socialized medical systems go if they can afford it when they need care? The US.
The subprime debacle has government interference in free markets as its root cause. This would not have happened without the Community Reinvestment Act and the GSEs (Fannie and Freddie).
As Ozzy43 notes, the result will be the ultimate destruction of the USD and American capitalism.
Mr. Hannon, if you've written this article without the benefit of having studied Murray N. Rothbard's book "America's Great Depression," shame on you for being irresponsible (or perhaps ignorant of the existence of that important volume). If you've written this article after having studied Murray N. Rothbard's book "America's Great Depression," shame on you for being dangerous.
And THAT is exactly the problem!!! TOO DAMN MUCH TAXATION!! Cut the legs out from under the government -- it needs massive shrinkage. We need to cut it to the core, and return the bulk of THEIR OWN money to the people!!
The overhead of the "big government" we have is far too high: it prevents the consumer-investor from being nimble, and constrains disposable income to a much smaller percentage of gross than it should be! This amounts to a high hurdle that the consumer (who is 2/3 of GDP) must jump over *before* being able to do discretionary spending. Since we are spoiled and have gotten used to "things"...we have borrowed (excessively) in order to have them. Meanwhile the government burns our money.
IT MUST STOP. We want and need back what IS OURS.
It worked so well for Zimbabwe we should try it here.
Everybody, google "Derivatives" right now.
It is the derivatives that have the Big Boyz soiling themselves.
There are a few things you need to understand. They have ZERO underlying real assets. They have a notional "value" of HUNDREDS OF TRILLIONS OF DOLLARS or more than the annual GDP of the entire freaking planet. They had absolutely NO regulation and are transparent as MUD.
Nobody knows how much or who holds the liability. This is the "counter party risk" every one keeps yacking about. ALL the financial institutions have a mountain of this toxic crap swept under the carpet. This is what has them hoarding cash and eying each other with mistrust.
The harsh reality is this: Either the institutions and investors who took the risk go bankrupt or the whole world does.
Lest you think I exagerate, think Iceland or ponder the fact that some European governments have guaranteed bank deposits that in some cases exceed three times their annual GDP.
The $700 billion bailout is essentially an attempt to bail out the ocean with a soup spoon.
The government will and is doing what Sean suggests. Expect deflation in the short-run and inflation in the long-run. Real assets, including real estate, will probably provide a hedge against the inflation from a falling dollar. Also, bank accounts with foreign banks in their currencies, be careful which currency you chose, may also be wise in the long-run as the U.S. dollar will lose value and its status as the reserve currency.
Paper money is just that. Paper.
Inflation just makes everyone poorer. Worst possible outcome.
Why would anyone buy them with inflation running wild?
Like Cramer you seem to understand the "game" but not the underlying reality. Eventually you have to have real goods materialize, not just make numbers jump around. People are beginning to understand that. That's why each new financial "innovation" is shrugged off quicker and quicker.
On Oct 07 04:37 PM Mr. B wrote:
> Your recommendations are insane. Let's reflate and turn the US into
> a banana republic. You recommend concentrating more economic power
> with the government with your Keynesian philosophy.
>
> The problem is that people like you believe the government should
> be involved in healthcare and even more involved in education. Government
> does not allocate capital efficiently. It mostly transfers wealth
> from those who create it to those who do not.
>
> All people are endowed with inalienable rights from our Creator.
> The equality in that comment does not mean that equality of outcome
> should be pursued. That is the pursuit of the lowest common denominator.
> That is the result of socialism (where the elite still gets the best
> treatment).
>
> Take education, which you site. We have massive bureaucracies on
> both the federal and state levels in a unionized monopoly. (Why does
> a monopoly need a union anyway?) We get an inferior product/service
> at high cost. In NJ, spending in the classroom would increase by
> more than $1 billion if 65% of each education dollar was spent in
> the classroom. The money is feeds worthless bureaucrats. Test scores
> in developed countries show this.
>
> If we truly wanted to help kids, and especially kids from low income
> families, we would inject competition. Vouchers and charter/magnet
> schools would work.
>
> Look at socialized medicine systems. Where do people under socialized
> medical systems go if they can afford it when they need care? The
> US.
>
> The subprime debacle has government interference in free markets
> as its root cause. This would not have happened without the Community
> Reinvestment Act and the GSEs (Fannie and Freddie).
>
> As Ozzy43 notes, the result will be the ultimate destruction of the
> USD and American capitalism.
>
>