Tuesday, December 30, 2008

Opening Post: Thoughts on Inflation

You know it is coming. May be not next year but it will be here soon enough. So what is wrong with inflation? Many things. I am posting a video of a lecture below called "21 Evils of Inflation". It is a bit on the long side but does a good job explaining the many ways it harms everyone, including you.

What is inflation? In its basic definition, too much money chasing too few goods. There are a couple of components there, one is the amount of money (right now in the US, skyrocketing) and the second one it the velocity (basically, how much turnover there is; this has dropped). Eventually all the money that our government has been printing will find its way into the system. This is when you have to watch out.

Most Americans have not experienced rapid inflation firsthand. One needs to talk to Argentinians, Yugoslavs or Russians to get a first-hand account of what life is like once the rabbit is out of the bag, and the printing presses are in overdrive. Let me tell you, it is not fun. Check out the Argentina link below to get a sense of the complete societal breakdown that a hyperinflation brings. There is also the opinion that the Hungarian hyperinflation right after WWII was induced by the Soviets to destroy the middle class. And, for the history buffs, there is the story of SS General Bernhard Krueger (no, not the Kruegerrand gold coin guy) who was in charge of the Nazi's printing of massive amounts of British currency (and trying to put it into circulation) in order to destabilize Britain's economy: the work was done by people pulled from concentration camps. The book is called "Krueger's Men". Currently, you have the Zimbabwe dictator printing money (the same guy that turned a food exporter into a starving country by confiscating the white-owned farms). Hopefully you get the picture: printing money is rarely a good thing.

The main evils in my book: destruction of the middle class, added layer of risk and uncertainty, stealth or not-so-stealth taxation, distortion of economic information, favoring speculation over production, collapse in capital spending and other productive activities, corruption, crime, black markets, loss of civility and political instability.

What can one do?
I think that one should be concerned with real principal preservation in times of rapid inflation. There are several ways to do that: desirable hard assets (gold, gold coins, gold bullion, silver, oil, gasoline, firewood, firearms, ammo), consumable soft assets (wheat, rice, tobacco, canned food, alcohol, medical supplies), productive land. There is also a very high likelihood that your earnings power will diminish greatly and will take years to recover. There is also a high likelihood that simply obtaining basic necessities (food, transportation, medical care) will not be as easy as it is now.

Think what happens in price control situations.
If fuel prices get capped, fuel will disappear, so you can forget about any food deliveries or transportation in general. Imagine that: no fuel for ambulances and doctors not going to work because their pay buys nothing, or they can't even make the 15-mi commute.
If wheat prices get capped, wheat/flour/bread will disappear. Prices provide valuable information to the participants in the market, which includes producers (duh!). You can expect that there will be 0 acres of wheat planted, and everything will go to the non-capped commodities, if any are left. Now if farmers can't run the tractors because of fuel shortages, guess what is next.
Now mind you, price controls are very popular with the electorate. They always, always fail but it does not stop politicians from imposing them. Read up on Chavez in Venezuela, and how a country can be a major oil exporter at $100 per bbl, and yet have no milk or sugar in the stores. Fascinating stories come from there and Argentina, and, unfortunately, we seem to be following their playbook.

What asset classes am I leaving out?
(1) Stocks. Here and there you read that stocks are a natural hedge. Forget it. You do not know if the companies you invest in will be hit with price controls, or disproportionate inputs inflation, or labor strife, or who knows what other unforeseeable event. On top, the economy will likely crash in hyperinflation, taking many companies down with it. I would even stay out of food and energy stocks: nothing can prevent Congress from declaring a certain industry "strategic", Russia-style, and expropriating it, directly or indirectly.
(2) TIPs. The same entity that prints the money determines the CPI index. Enough said. Moreover, in high inflation, you'd need daily indexing. So forget TIPs.
(3) Cash and fixed income investments. For obvious reasons. Why anyone would hold bonds at this stage is beyond me.
(4) Real estate (ex-productive land). Not an obvious one. Real estate prices move in part with real incomes. Real incomes will crash down. Ditto for rent and investment properties. Rents might even be caped by the localities.
(5) "Objects": art, antiques, books, furniture, clothing, etc. They will have no value in a world where getting food is a challenge.
(6) Other currencies: this is very, very tricky. In "normal" hyperinflations, the transactions are often linked to a "hard" currency, the usually the dollar (Argentina/Lat Am, Russia) or the Deutsche Mark (across former Yugoslavia). Usually the hard currency is widely held and circulated. What can replace the US dollar in the US? Very few people here are accustomed to dealing in foreign currencies. All other major currencies (EUR, JPY, GBP) are likely to be devalued as well due to protectionism and deficit spending in each locale. The Canadian dollar? I do not know if there are enough to provide any utility on a large scale. Moreover, the loonie is too linked to the US. Which leaves barter, which is extraordinarily inefficient.

The video discusses "who wins" since society as a whole loses. The obvious answer is the money creator which can magically print the money to repay its debts. Debtors that are able to rise prices and still sell whatever they have should have a great time. People with insight as to what the printer will do next will win. People with foresight should make out ok. Diligent, responsible people with savings will lose a lot. Low-income people will lose whatever they have.


Further reading:
Overview
Weimar Republic
Argentina


The video from the American University in Bulgaria.

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