Upping the Inflation Dosage

By Peter Schiff

In perhaps one of biggest ironies to ever to come out of Washington, this week Congress simultaneously pilloried major league baseball players for using artificial stimulants to pump up their performance while passing legislation to do just that to the national economy. Am I the only one laughing?

In reality, the current slump in the U.S. economy is simply the come down from years of financial doping in the form of skyrocketing home values and easy credit. Rather than reaching for yet another syringe, Congress should ask Americans to do what it demands of ballplayers: play within their natural means. Unfortunately in the case of the economy, the patient is already so juiced up that further doses may not only fail to stimulate but may result in a trip to the emergency room.

As the widely praised “economic stimulus” bill was signed into law, the only dissent heard was from those saying the plan did not go far enough. Speaking for those unheard voices who disagree with the strategy entirely, I believe the most significant aspect of the plan is that it creates a new and improved method for delivering inflation.

Previously, the government has largely relied on interest rate stimulus to keep the economy humming. In this method, money supply growth, also known as inflation, is channeled through the banking system. The Fed makes cheap credit available to banks, which then lend out the new funds or use them to acquire higher yielding assets. As a result, asset prices, such as stocks, bonds and real estate, have been bid up to bubble levels. However, the inflationary impact on consumer prices occurs with a considerable lag.

Now that rate cuts alone are proving insufficient, mainly because banks are now so over-loaded with questionable collateral and shaky loans that few can consider acquiring more assets or extending additional credit (no matter how cheap such activities can be funded), the Government is opting for a more direct approach. By printing money and mailing it directly to the citizenry, the “stimulus plan” cuts out all of the financial middle men and administers the inflation drug directly to consumers.

If simply printing money could solve financial problems, the Fed could send $10 million to every citizen and we could all retire en masse to Barbados. However, more money chasing a given supply of goods simply pushes up prices and does nothing to improve underlying economics. Since this new money will go directly into consumer spending, without first being filtered thought asset markets, the effects on consumer prices will be far more immediate.

This politically inspired placebo will do nothing to cure what ails our economy. The additional consumer spending will merely exacerbate our imbalances, allow the underlying problems to worsen, and put additional upward pressure on both consumer prices and eventually long-term interest rates as well. The failure of the stimulus plan to cure the economy will cause the Government, and the Wall Street brain trust, to conclude that it was simply too small. Their next solution will be to administer an even stronger dose.

My prediction is that over the course of the next few years, successive doses of even larger stimulus packages will fail to revive the economy. As the recession worsens and the dollar drops through the floor and consumer prices and long–term interest rates shoot thought the roof, politicians and economists will look for scapegoats. Few, if any, will properly attribute the problems to the toxic effects of the stimulus itself.

However, like all drugs, the biggest danger is an overdose. In monetary terms an overdose is hyperinflation, which will surely kill our economy. It is my sincere hope that before we reach that “point of no return,” a correct diagnosis is finally made. When that occurs, the stimulants will be cut off, and the free market will finally be allowed to administer the only cure that works: recession. If that means we lose some speed on our fastball, so be it. Maybe we could use a few months in the minor leagues to get back to basics. While we may not like the economic side effects of stopping cold turkey, it sure beats carrying our money around in wheelbarrows!

For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my new book “Crash Proof: How to Profit from the Coming Economic Collapse.”

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Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkeley in 1987. A financial professional for over twenty years he joined Euro Pacific in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, Peter is a highly recommended broker by many leading financial newsletters and investment advisory services. He is also a contributing commentator for Newsweek International and served as an economic advisor to the 2008 Ron Paul presidential campaign.

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FMM Comment:

The scapegoat referred to WILL be capitalism. Ron Paul addressed the question, "Has Capitalism Failed?" long ago in the U.S. House of Representatives, July 9, 2002.

"Corruption and fraud in the accounting practices of many companies are comingto light. There are those who would have us believe this is an integral part of free-market capitalism. If we did have free-market capitalism, there would be no guarantees that some fraud wouldn't occur. When it did, it would then be dealt with by local law-enforcement authority and not by the politicians in Congress, who had their chance to "prevent" such problems but chose instead to politicize the issue, while using the opportunity to promote more Keynesian useless regulations.

Capitalism should not be condemned, since we haven't had capitalism. A system of capitalism presumes sound money, not fiat money manipulated by a central bank. Capitalism cherishes voluntary contracts and interest rates that are determined by savings, not credit creation by a central bank. It's not capitalism when the system is plagued with incomprehensible rules regarding mergers, acquisitions, and stock sales, along with wage controls, price controls, protectionism, corporate subsidies, international management of trade, complex and punishing corporate taxes, privileged government contracts to the military–industrial complex, and a foreign policy controlled by corporate interests and overseas investments. Add to this centralized federal mismanagement of farming, education, medicine, insurance, banking and welfare. This is not capitalism!

To condemn free-market capitalism because of anything going on today makes no sense. There is no evidence that capitalism exists today. We are deeply involved in an interventionist-planned economy that allows major benefits to accrue to the politically connected of both political spectrums. One may condemn the fraud and the current system, but it must be called by its proper names – Keynesian inflationism, interventionism, and corporatism.

What is not discussed is that the current crop of bankruptcies reveals that the blatant distortions and lies emanating from years of speculative orgy were predictable. "

Capitalism rests its case.

The Mother of All Bubbles

By Peter Schiff

In contrast to the dismal forecasting record of mainstream economists over the last few years, the forecasts that I have made regarding the dollar, oil, commodities, precious metals, global stock markets, inflation, and the U.S. economy have all come to pass. In addition, unlike the top economic oracles on Wall Street and in Washington, I can also point to similar accuracy in predicting the bursting of growing bubbles, first with technology in the late 1990’s, and more recently with real estate. However, my long-standing prediction about the fate of the bond market has fared much worse. I still do believe this prediction was not wrong, but simply premature.

For years I have predicted that the falling dollar, persistent trade deficit, and the lack of domestic savings would combine to send long-term interest rates sharply higher. The effects of these fundamental drivers would undermine the Fed’s efforts to lower short-term rates and compound the problems for the housing market and the U.S. economy. Yet as of today, the yield on the thirty-year Treasury bond still stands below 4.5%, within 40 basis points of a generational low. Either this is the one piece of the puzzle that I somehow got wrong, or other factors are working to temporarily confound fundamental economics and prop up the bond market. As you might imagine, I am confident that it is the latter and consider the U.S. Treasury market to be the mother of all bubbles.

I have often said that the only thing worse than holding U.S. dollars is holding promises to be paid U.S. dollars at some distant point in the future. However, this is precisely what U.S. Treasuries represent. Given all of the inflation that already exists, and all of the additional inflation likely to be created over that time period, why would anyone pay par value for the right to receive $1,000 in thirty years in exchange for a mere 4.5% coupon? Although it looks like the sucker bet of the century, the fools have been lining up to buy. Alan Greeenspan called this a "conundrum." I simply call it mass delusion of the same variety that brought us pets.com, and $800,000 tract homes in the middle of the California desert.

Just like dot coms or real estate, today’s bond prices reflect a fantasy world. In this "Bizarro" reality, the dollar will remain strong, inflation will stay low, economic strength will persist uninterrupted, and Fed policy will be predominantly hawkish for the foreseeable future. But when the fog finally lifts, and investors come to grips with a sagging dollar, recession, gaping budget and current account deficits, and the most accommodative Fed imaginable, bond prices will collapse, sending long-term interest rates skyrocketing higher. Unfortunately, for investors who hitched their wagons to benign government CPI statistics and ignored real world evidence of inflation [rapid money supply growth, surging gold, oil and other commodity prices (wheat and soy beans prices catapulted to record highs this week), the sinking dollar, and actual increases in consumer prices,] the losses will be excruciatingly real.

It is important to remember that for every borrower there has to be a lender. For example, if a homeowner wants to refinance his mortgage, there must be someone willing to loan him the money. Practically everyone on Wall Street is hailing the Fed’s recent rate cuts because they believe it will allow strapped ARM holders to refinance into more affordable mortgages. However, while low rates are great for borrowers, they are lousy for lenders. Why would anyone want to offer a thirty-year mortgage at an artificially depressed interest rate? As soon as the Fed raises rates again, as it clearly intends to do once the crisis ends, all that low yielding mortgage paper will collapse in value. Lenders can surely figure this out and will therefore refuse to volunteer to be the patsy in this plan.

Eventually, the world’s lenders will reach similar conclusions with respect to U.S. Treasuries. No matter how low the Fed funds or discount rates get, private savers around the world will simply refuse to lend given the inherent risks and paltry returns. At some point the sheer absurdity of holding long-term, low-yielding receipts for future payments of depreciating U.S. dollars will be apparent to all. After all, it was not too long ago that investors thought holding subprime mortgages from financially strapped borrowers who could not possibly repay them was also a great idea -- so great in fact that many leveraged themselves to the hilt to buy them. Judging from the extremely poor demand at this week’s $9 billion auction of thirty-year Treasury bonds, the day of reckoning may not be too far off.

For now there are a host of factors temporarily propping up the Treasury bond market, such as unrealistically sanguine inflation expectations, foreign central bank and hedge fund buying, short covering, credit spreads, problems in the mortgage market, recession fears, and flight to what is falsely perceived to represent the ultimately in safety and quality. When these props give way, look out below! As we have learned from previous bubbles they can inflate for a long time before they burst. As this one has been inflating longer then most it has amassed quite a bit of air. When it ultimately finds its pin the popping sound will be deafening.

For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my new book “Crash Proof: How to Profit from the Coming Economic Collapse.”

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Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkeley in 1987. A financial professional for over twenty years he joined Euro Pacific in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, Peter is a highly recommended broker by many leading financial newsletters and investment advisory services. He is also a contributing commentator for Newsweek International and served as an economic advisor to the 2008 Ron Paul presidential campaign.

>> Click here for Mr. Schiff's video interviews.

Another One Bites the Dust

Over the past half-century, the United States has seen its global dominance in dozens of industries slip away. One plum that we have maintained is our gargantuan financial services industry, whose contribution to total GDP more than tripled between 1947 and 2005.

However, the current global financial crisis, manufactured on Wall Street and exported to the entire world, may result in the U.S. losing its financial crown as well.Once upon a time America owned the automobile industry. But after several decades of excessive taxation, onerous government regulation, union extortion, and a crushing lack of foresight and innovation, we no longer dominate an industry that we practically invented.

Just as Detroit no longer claims center stage in the world automobile marketplace, soon New York will lose its position at the center of global capital markets.In the first place, the center of finance tends to go where the money is. Right now all the money is coming from Asia and the Middle East. When the United States was the world’s greatest creditor nation and its largest supplier of capital it made prefect sense for that capital to be allocated here.

But why should the Chinese send their savings to New York only to have it re-invested back in China? Wouldn’t it make more sense for the Chinese to allocate their capital locally rather then out-sourcing the job to us?In the second place, when the strength of the dollar was widely regarded it made sense for global savers to allocate substantial percentages of their savings to U.S. dollar denominated investments.

This preference gave Wall Street a competitive advantage in attracting capital. However, now that confidence in the dollar has evaporated, perhaps permanently, this advantage has been lost. Further, investment in the U.S. was encouraged by America’s respect for private property, low taxes, and minimal government regulation.

However, this advantage has been lost as other nations have strengthened their private property laws, deregulated, and lowered taxes, while we have done the opposite. As a result, thus far this century, the returns on U.S.-based investments have far underperformed those achieved in every other major market.Most importantly, Wall Street’s reputation, once its greatest asset, is also in jeopardy. Just as Detroit lost its reputation for high quality cars, bankrupted dotcoms and worthless subprime debt are creating similar problems for Wall Street.

You can’t expect to keep your customers if you continually sell them shoddy merchandise. Wall Street has spread hundred of billions of dollars in losses around the world and in so doing shattered its reputation with some of its best customers.However, in the last few years Wall Street has not only screwed customers but their own shareholders as well. At one time all of our major investment banks, such as Goldman Sachs, Lehman Brothers, Morgan Stanley, Bear Stearns, Smith Barney, Shearson, E.F. Hutton, Kidder Peabody and Solomon Brothers, were private partnerships.

However, during the 1990’s they all went public (of course many merged first so they no longer exist as independent firms). Goldman Sachs was the last to go public in 1999. The transition allowed Wall Street partners to cash out, transferring future risks to new shareholders. In so doing they were able to capitalize on bubble valuations, yet through lavish bonus compensation packages, still keep the lion’s share of the profits for themselves. In other words they got to have their cake and eat it too.

As a result of this transfer of risks, the business models of America’s leading financial institutions shifted, with profits coming from riskier sources such as proprietary trading and structured finance. To line their own pockets, Wall Street willingly exposed its shareholders to risks that it would never have assumed with its own capital. This moral hazard set the stage for the enormous losses shareholders are now suffering, and are a direct consequence of the phony profits booked in prior years.

However, while shareholders are left holding the bag, Wall Street’s former partners now turned employees have already walked away with huge IPO and stock option windfalls, as well as lavish bonuses paid on phantom profits.The coming crash will plainly expose these conflicts of interest, and the reaction will be severe. In the end, finance and banking, like manufacturing, will be yet another industry lost to foreign competition.

The new financial capitals will likely be in Asia, the Middle East, and Europe. New York will certainly still have a role to play, but much like Detroit, it will be but a shadow of its former self.For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my new book “Crash Proof: How to Profit from the Coming Economic Collapse.”

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Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkeley in 1987. A financial professional for nineteen years he joined Euro Pacific in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, he is a highly recommended broker by many of the nation's financial newsletters and advisory services.