SAlpha: It's Either Inflation or Deflation - Not Much in Between
posted on: March 26, 2008 | about stocks: DIA / QQQQ / SPY Jim Bradley
For the Fed to play this balancing act, some entities have to fail (and be bought up cheap) so that the capital they hold is transferred to the remaining economic entities. The buyer is bailed out of losses by early failures of the sellers. The game is "last man standing".
Here's why:
If X lends to Y and Y doesn't pay, then if the Fed bails out X, puchasing power is X plus Y. That's inflationary if the credit expansion is big enough (and real estate is a big market). Since a large percentage of the financial entities are likely insolvent, if the Fed doesn't bail some of them out, we could have a deflationary collapse.
But the Fed cannot afford to bail out very many financial entities because that would causes the "X plus Y" purchasing power problem noted above.
The practical effect is the necessity of having a number of failures with a "guarantee" (however accomplished) of the remaining institutions. It is happenening now and likely will continue. The so-called orderly liquidation.
As a result, an investor needs to store savings where it will not lose from these inflation or deflation effects and where the investment provides a hedge against systemic risk (a huge inflationary or deflationary event). In addition, if the Fed is successful, the economy will continue to oscillate between inflation and deflation. Investment policy should take that into account as well.
Why will policy oscillate? Because the Fed cannot afford to have inflation or deflation for too long as it would ruin their power over the currency. However, the Fed cannot (or does not) keep policy level either. When gold was removed as the ultimate form of payment, insiders became able to game the political system or buy it off. That means crises and bailouts.
It also means an investor needs to be prepared to inflation during deflation and vice versa.
If things get out of hand, the system ultimately relies on the solvency of the Federal Government (as opposed to liquidity management by the Federal Reserve) to achieve a sustainable bailout. If a Federal Government bailout isn't successful because the finances of the Federal Government are in question, the choice becomes binary: bite the bullet and go into mega-deflation ... or monetize and suffer unbelievable hyperinflation.
If the market senses inflation, it will begin to shed the currency which brings inflation to the present. That is why the Fed will frequently tighten hard to front-run inflationary expectations when the Federal Government is vulnerable - that is what the Fed is doing now.
However, with 516 trillion in notional value of derivatives, a mere 1% "shock" might be too much, so the Fed is careful to prop up the settlement system. Even so, the correction is probably not over: The magnitude of the losses disclosed so far are too little in comparison to the boom.
I suggest regularly storing a percentage of savings in physical cash (safe deposit box, or other safe storage), gold (include small denomination coins because one ounce is expensive and less liquid), and other storeable assets (in case gold is again outlawed), in conjunction with regular investment goals of buying stocks and bonds in the U.S. and worldwide. The recent (and, in my view, not over) correction in commodities should provide opportunity.
There is an interesting offshoot of the anticipated economic situation. I imagine it could or likely will occur in the next twenty years, perhaps sooner: a world currency with a world bank, a "necessary" result of profligacy of government(s) with the unwillingness of the authorities (or the populations) to answer the binary choice of hyperinflation or deflation. No question the "global bank" solution is even worse, but it likely will be attempted. Preparation for that event might be an interesting speculative play.
The recommendations here are not "prepare for the unlikely worst". In my view, what is happening now is a significant shift in global finance which will continue indefinitely even if it settles down. The U.S. Government may be close enough to a funding crisis that investors should consider the future tipping point, as no one knows how much forewarning will occur.
Raising taxes won't necessarily solve the Federal Government problems as revenues could still shrink. Deficit spending is going to be less possible if financing becomes more difficult. At the same time, expenditures are due to increase dramatically (and there's no stronger, more politically motivated voter than a voter who is retired and living on government payouts).
The genuine solution is to downsize the U.S. government which ensures national solvency. But that is very unlikely to happen with the current presidential candidates and congress in place.
And for those concerned about foreign threats: The only sustainable plan to overcome foreign threats is to stand back and let economic and technological growth keep us strong. No other system can come close to freedom whose practical implementation is private property and private money ....
Right back where we started.
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