Here's a video I put up on youTube explaining why i think deflation is likely:
Tuesday, November 20, 2007
Monday, November 19, 2007
Big Question #2: Fed Rates
In my previous post "Big Question #1: Deflation or Hyperinflation", I settled on deflation as the more likely scenario.
The next question, of course, is the Fed rate. If we expect deflation, then we might want to short the stock market. However, what do we use for sweep? Short term government debt, or long term government debt?
Short term is "safer" in that it's less speculative. During the Great Depression the Fed jacked its rate up to 15% -- the reason is that even though we experienced deflation, the dollar fell in value relative to other currencies, so the Fed was obligated to "prop up" its value by increasing the interest rate. Because of this, those that held long-term government debt gained less during deflation than those that owned short-term government debt -- the short term owners renewed at the higher interest rate. Of course, both gained overall from the deflation.
However, there are other deflationary crashes where the short term government debt pays a 0% interest rate, such as Japan's recent deflationary crash. In this case, owning long term government debt can cause a huge gain (Jim Shepherd estimates a 200% increase in the long term bond's value in this case).
So: will the U.S. have a 0% rate (in which case you want to own long term bonds) or a high rate (in which case you want to own short term debt)?
The prudent bear fund is betting on long term bonds, which I agree with. I think that the funds rate is related to the amount of deflation that occurs. The Great Depression was deflationary, but the deflation experienced was comparatively mild to what we're about to go through next. As the previous post explained, a 50:1 ratio of debt to debt-money could easily initiate a historic deflation, much larger than Japan's deflation. Therefore, I'm placing my bets on long term debt rather than short term.
However, unlike the other posts, I need to warn you that I'm less of an expert on this topic. Therefore, you may consider a 50/50 combination of long term and short term debt. Also, do some research and leave me a good comment with a link :)
Either way you go, you'll gain from the deflation. In fact, shorting the market coupled with deflation can produced exponential gains. And if you're right about the long term / short term question, then you may experience additional multiplication of your gains.
The next question, of course, is the Fed rate. If we expect deflation, then we might want to short the stock market. However, what do we use for sweep? Short term government debt, or long term government debt?
Short term is "safer" in that it's less speculative. During the Great Depression the Fed jacked its rate up to 15% -- the reason is that even though we experienced deflation, the dollar fell in value relative to other currencies, so the Fed was obligated to "prop up" its value by increasing the interest rate. Because of this, those that held long-term government debt gained less during deflation than those that owned short-term government debt -- the short term owners renewed at the higher interest rate. Of course, both gained overall from the deflation.
However, there are other deflationary crashes where the short term government debt pays a 0% interest rate, such as Japan's recent deflationary crash. In this case, owning long term government debt can cause a huge gain (Jim Shepherd estimates a 200% increase in the long term bond's value in this case).
So: will the U.S. have a 0% rate (in which case you want to own long term bonds) or a high rate (in which case you want to own short term debt)?
The prudent bear fund is betting on long term bonds, which I agree with. I think that the funds rate is related to the amount of deflation that occurs. The Great Depression was deflationary, but the deflation experienced was comparatively mild to what we're about to go through next. As the previous post explained, a 50:1 ratio of debt to debt-money could easily initiate a historic deflation, much larger than Japan's deflation. Therefore, I'm placing my bets on long term debt rather than short term.
However, unlike the other posts, I need to warn you that I'm less of an expert on this topic. Therefore, you may consider a 50/50 combination of long term and short term debt. Also, do some research and leave me a good comment with a link :)
Either way you go, you'll gain from the deflation. In fact, shorting the market coupled with deflation can produced exponential gains. And if you're right about the long term / short term question, then you may experience additional multiplication of your gains.
Sunday, November 18, 2007
Big Question #1: Deflation or Hyperinflation?
Deflation versus hyperinflation is probably the most important question for those who expect an upcoming bust, be it quick or gradual. Clearly, in the case of hyperinflation, we will not have a crash but rather a bust, since the nominal value of stocks would skyrocket while at the same time the economy tanking -- which means you better own gold. Deflation requires the opposite strategy, which is the hording of cash coupled with shorting the stock market.
What causes hyperinflation?
Hyperinflation is a process that can only occur with fiat money (including debt-backed). When I say "hyperinflation", I am not talking about rapid inflation such as 5% per month. In my opinion, that is still normal inflation because hyperinflation is a completely different dynamic from inflation.
Rapid inflation is simply a rapid increase in the supply of money -- with fiat money, the government prints more very quickly, and with debt-money, they monetize the debt while banks issue loans, etc. Hyperinflation, however, is exactly the same dynamic as a "run on the bank": trust is lost in the issuer. Hyperinflation can be triggered by rapid inflation or a destruction of the GDP of the issuing nation -- either of these equates to a "tax on cash" that can become so great that nobody wants the money any more, and there's a panic to sell your cash for commodities or foreign currencies. This process occurs exponentially fast, and occurs precisely because there's no commodity backing for the currency -- there's no real value to the currency.
To summarize, hyperinflation is a panic out of a troubled currency. This is very different from normal inflation.
What causes deflation?
Deflation (in the rapid sense, i.e. supply related) only occurs with debt-money, and not with traditional fiat-money. It is a common misconception that the U.S. has traditional fiat money -- it does not. People who claim that the U.S. government is just "printing money" are pretty close to the truth, but not 100%.
The government doesn't print money directly, but rather borrows money at interest from a central bank that prints the money. Private banks can also borrow in this manner. This borrowing/printing causes inflation. However, when the debt is paid back to the central bank, it ceases to exist as money, which reduces money supply causing deflation.
The inflationary process is exponential because bank's use their borrowed debt-money as reserve for the money they lend out. This means that a bank that borrows from the central bank and then issues a loan to a citizen is only the beginning of the inflationary cycle. This same debt-money can be re-deposited and re-loaned over and over. There are certain reserve requirements, but in the end the total amount of money that the banking system can create is limited only by the amount that the public can borrow.
Notice that I say "money created", but really I mean "I.O.U dollars" created -- that is, debt rather than deb-money is created. During an inflationary period, in the world of commerce, these I.O.U. dollars are generally treated the same as dollars themselves.
Right now estimates are 50:1 -- 1 unit of debt-money (federal reserve note) for every $50 worth of I.O.U's for debt-money. That's a lot of inflation! However, the deflationary spiral can quickly unravel this process through a cycle of debt liquidation:
What causes hyperinflation?
Hyperinflation is a process that can only occur with fiat money (including debt-backed). When I say "hyperinflation", I am not talking about rapid inflation such as 5% per month. In my opinion, that is still normal inflation because hyperinflation is a completely different dynamic from inflation.
Rapid inflation is simply a rapid increase in the supply of money -- with fiat money, the government prints more very quickly, and with debt-money, they monetize the debt while banks issue loans, etc. Hyperinflation, however, is exactly the same dynamic as a "run on the bank": trust is lost in the issuer. Hyperinflation can be triggered by rapid inflation or a destruction of the GDP of the issuing nation -- either of these equates to a "tax on cash" that can become so great that nobody wants the money any more, and there's a panic to sell your cash for commodities or foreign currencies. This process occurs exponentially fast, and occurs precisely because there's no commodity backing for the currency -- there's no real value to the currency.
To summarize, hyperinflation is a panic out of a troubled currency. This is very different from normal inflation.
What causes deflation?
Deflation (in the rapid sense, i.e. supply related) only occurs with debt-money, and not with traditional fiat-money. It is a common misconception that the U.S. has traditional fiat money -- it does not. People who claim that the U.S. government is just "printing money" are pretty close to the truth, but not 100%.
The government doesn't print money directly, but rather borrows money at interest from a central bank that prints the money. Private banks can also borrow in this manner. This borrowing/printing causes inflation. However, when the debt is paid back to the central bank, it ceases to exist as money, which reduces money supply causing deflation.
The inflationary process is exponential because bank's use their borrowed debt-money as reserve for the money they lend out. This means that a bank that borrows from the central bank and then issues a loan to a citizen is only the beginning of the inflationary cycle. This same debt-money can be re-deposited and re-loaned over and over. There are certain reserve requirements, but in the end the total amount of money that the banking system can create is limited only by the amount that the public can borrow.
Notice that I say "money created", but really I mean "I.O.U dollars" created -- that is, debt rather than deb-money is created. During an inflationary period, in the world of commerce, these I.O.U. dollars are generally treated the same as dollars themselves.
Right now estimates are 50:1 -- 1 unit of debt-money (federal reserve note) for every $50 worth of I.O.U's for debt-money. That's a lot of inflation! However, the deflationary spiral can quickly unravel this process through a cycle of debt liquidation:
- Defaults on loans cause a reduction in money supply (debt used "as" money is eliminated), and therefore deflation
- Decreasing optimism due to defaults causes less money to be loaned out, slowing or stopping inflation
- Trust is lost in ability of debtors to pay, interest rates skyrocket and value of existing debt (in dollar terms) decreases, causing deflation
- Decreasing purchasing (due to decrease in credit) decreases money velocity, causing deflation
- People who are still able pay back their loans do so because of interest rate increases, and their debt cease to exist as money (deflation)
- Deflation causes money value to rise, making it harder to pay back loans
- Goto 1
Will inflation continue?
It should be clear that inflation (under central banking) requires people to take on more and more debt. Now, however, it is obvious that credit is tightening, and that there's no-one left to borrow to continue inflation: the worst borrowers (sub-prime) have already been lent to (and many have already defaulted), and everyone in the U.S. is piled with debt to the ceiling.
Deflation Short Term, Hyperinflation Long Term
Every paper currency in history eventually hyperinflates, so we already know what to expect long-long term. However, for the short term, the 50:1 ratio of debt to debt-money means that a deflationary cycle could increase the value of dollars by many, many times. This is a problem for the government since governments benefit from and, indeed, almost require inflation, because it reduces the real value of their outstanding debt (also, they make billions in revenue from the inflation tax).
But isn't the Dollar Over-Valued?
It has been mentioned that the dollar is overvalued, which is probably true. However, even if foreigners reduce their demand for dollars by half or more, the deflationary spiral would probably increase the value of dollars much faster than any changes in demand could affect it. In fact, if deflation starts, people will be scambling for dollars to repay loans, so it's likely that the demand for dollars will actually increase.
Wednesday, November 14, 2007
Inflation/Deflation Caused by Credit Cycles
Inflation and deflation are primarily driven by credit cycles. This is why boom and bust occur so strongly under central banking (unlike gold backed money, central banking can leverage much, much more).
Remember, dollars = debt. That’s the whole point of central banking. Every time someone takes out a loan, the supply of money increases, and the supply of debt increases even more.
Almost all dollar inflation is a directly result of overly leveraged banks. Right now, 95% of all the dollars in the system were created as bank credit. Gov’t issued dollars are only about 5% of the total money supply.
That means that as loans default or get paid off, the money supply shrinks (deflation). Currently, the ARMs that default are directly shrinking the money supply, but they are not enough to counter the new money being created when banks borrow from the central bank (inflation), lend out this debt-money, which gets re-deposited and re-lent (expanding about 100 times throughout the whole process!).
There are other things that cause deflation or inflation (changes in GDP) but they’re very slow and ultimately insignificant compared to changes in supply. When it comes to inflation and deflation, supply is the most important consideration.
But no, inflation is not “rising prices”, it’s “rising prices” that’s an effect of inflation. There are a lot of other effects of inflation under central banking, such as increased indebtedness. Haven’t you noticed that as inflation has raged, indebtedness has risen perfectly in sync with it? That’s because all the new money created required someone to take out a loan first. Inflation is often fueled by speculation, when people leverage their investments.
It’s ironic then, and rather terribly perfect, that right when inflation gets the worst and people really worry about it the most is when they should be worried about deflation, since once credit reaches a critical extreme it can quickly cycle in the opposite direction (loans defaulting decreases money supply, which increases value of money, which causes other loans to be harder to pay off, which causes more defaults, etc.). This is why we had such extreme deflation after 1929.
A correct understanding of money can save you a lot of money.
Remember, dollars = debt. That’s the whole point of central banking. Every time someone takes out a loan, the supply of money increases, and the supply of debt increases even more.
Almost all dollar inflation is a directly result of overly leveraged banks. Right now, 95% of all the dollars in the system were created as bank credit. Gov’t issued dollars are only about 5% of the total money supply.
That means that as loans default or get paid off, the money supply shrinks (deflation). Currently, the ARMs that default are directly shrinking the money supply, but they are not enough to counter the new money being created when banks borrow from the central bank (inflation), lend out this debt-money, which gets re-deposited and re-lent (expanding about 100 times throughout the whole process!).
There are other things that cause deflation or inflation (changes in GDP) but they’re very slow and ultimately insignificant compared to changes in supply. When it comes to inflation and deflation, supply is the most important consideration.
But no, inflation is not “rising prices”, it’s “rising prices” that’s an effect of inflation. There are a lot of other effects of inflation under central banking, such as increased indebtedness. Haven’t you noticed that as inflation has raged, indebtedness has risen perfectly in sync with it? That’s because all the new money created required someone to take out a loan first. Inflation is often fueled by speculation, when people leverage their investments.
It’s ironic then, and rather terribly perfect, that right when inflation gets the worst and people really worry about it the most is when they should be worried about deflation, since once credit reaches a critical extreme it can quickly cycle in the opposite direction (loans defaulting decreases money supply, which increases value of money, which causes other loans to be harder to pay off, which causes more defaults, etc.). This is why we had such extreme deflation after 1929.
A correct understanding of money can save you a lot of money.
Tuesday, November 13, 2007
Money 101: What is Money?
To understand money, you need to understand that there are five main types of money, each which evolved from the latter:
1. Commodity money
A physical thing (that cannot be duplicated) is the money, such as precious metals, silk, spices, deer skins, etc. Of these things, gold has great historical usage as money (since ancient times) because:
- It is a cannot be duplicated
- It is infinitely divisible
- It does not corrode or spoil over time; is not easily destroyed
- Aesthetic value
- Commodity money automatically creates price stability through the forces of the free market (supply and demand). As a test of this, you should check out how much you could buy (relative to technology/living conditions at the time) with an ounce of gold at any point in history and compare it to today – it's trade value is largely unchanged throughout the centuries. Alan Greespan has been quoted as saying “Gold is the ultimate form of payment in this world.”
2. Receipt money
This is a piece of paper that is a receipt for commodity money, and is used as if it were the commodity money itself: i.e. it's 100% backed by commodity money. Back in the early 1900s, the US Dollar was receipt money for gold, which meant that it was used “as” gold. You could exchange your dollars for a fixed amount of gold, and vice versa.
3. Fractional money
This is the same thing as receipt money, except that the issuing bank does not have enough commodity money to back the receipts. Fractional money is a classic banking scandal that has occurred again and again and again throughout history. Here's how it works:
- People deposit their commodity money into a bank
- People exchange largely with the receipts for this commodity money rather than the commodity money itself
- The bank realizes that it can just print new receipts for commodity money that it doesn't have, and either loan it out (and collect interest in commodity money), or just spend it directly. [This is what causes the inflation – because there are now more receipts for commodities (that don't exist!) chasing few other goods – it's just a supply and demand equation, econ 101]
- When people finally realize that the bank has done this (trust is lost), then they rush to exchange their receipt for the commodity money – but alas, there are too many receipts out there, and not enough commodity money – so either (a) only a fraction of the people get their commodity money back or (b) each person only gets a fraction of their commodity money back[this is where deflation occurs, because suddenly those who have kept their commodity money have vastly more purchasing power – again, supply and demand]
4. Fiat money
This is just like infinitely fractional money: they remove all commodity backing – therefore, the only backing is by fiat (latin for “let it be done”), which means by force. Under this scenario, the government can then print as much “money” as they wish, increasing the supply and therefore causing inflation. If trust is lost, however, there is no commodity backing, so rather than a deflation like in (3), the value of the fiat money quickly dives towards to zero (hyperinflation). This has occurred many times throughout history, such as Germany after WWI and, more recently, Argentina.
5. Debt-Money (Fiat with Central Banking)
I'm hesitant to put this as a fifth type of money, becase it's really not. Once you have fiat money, the government can design any financial system that they wish. However, it's important to understand debt-backed currencies since they're so different from traditional fiat money.
Traditional fiat money can be printed at will by a government. However, under central banking, a specific bank (in the case of the US, it's the Federal Reserve) colludes with government and is given the sole role of printing their fiat money. The government actually borrows money from this monopoly, but rather than borrowing deposit money they borrow newly printed money (or its electronic equivalent, a new checking account). Banks are also allowed to borrow newly printed money from this central bank. However, for every new unit of currency printed, a debt obligation (bond) is held by the central bank for the same amount of dollars plus interest.
Think about this for a moment. Every dollar ever printed has a interest bearing bond backing it up at the Fed. However, there arn't enough dollars to ever pay back all the bonds because the Fed only printed enough for the principle. Therefore, the amount of debt in the system is always larger than the actual Federal Reserve Notes (dollars). Such a system quickly causes an explosion of increasing indebtedness.
We are a nation that is deeply financially indebted to the Fed and its colluding member banks, and already our entire income tax just goes to pay the interest on the money they printed! If you would like more information on this system, please watch the excellent video "debt money": http://www.youtube.com/watch?v=cy-fD78zyvI
Also, vote Ron Paul for President since he's the only candidate who is against this system of theft.
Nov 2007 Portfolio Update
Last week, the DOW fell from its 14K peak down to nearly 13K. Today (Tuesday) it finally rallied back to 13,300.
I remain confident in my investments. Previously I was 1/3 in short-term U.S. treasury debt but I've quickly moved my position almost entirely into the Prudent Bear Fund (one of the few good managed short funds available). Luckily I caught most of the fall, gaining about 9%. Today the upward rally ate about 3.5% of that gain.
Regardless, I'm going to taking this rally as a way to stengthin my position by going even more short. I've assume more shares of prudent bear and am almost 100% in that single fund. Since the fund is 70% short (and uses US treasury bonds for sweep), it should profit greatly during a deflationary crash despite its long position on precious metals mining stocks.
Actually...even though I'm bearish on gold for the next few years, it truely is the ideal hedge in case for some reason the Fed changes its policies an hyperinflation sets in. And when the crash is over, precious metals will probably be the best place to be. Additionally, gold is appreciating so much right now that it keeps the fund perfoming well even in this pre-crash era.
According to Jim Shepherd (http://www.jasmts.com/), in the advent of a 30-50% crash, a successful short fund should be able to gain over 200% in value (3x principle). But remember -- this is in nominal terms -- coupled with deflation, the real value gain could be enormous. The name of the game in deflation is to be sure your debtor doesn't default, which is why you must use safe government debt for sweep.
Of course, I am not planning to use any extra leverage. I assume there will be a story of some guy who did a bunch of fully leveraged shorts and became a multi-millionare overnight, but this crash is far too devious for that. Really, it is so long, long overdue that timing it has become almost impossible.
I remain confident in my investments. Previously I was 1/3 in short-term U.S. treasury debt but I've quickly moved my position almost entirely into the Prudent Bear Fund (one of the few good managed short funds available). Luckily I caught most of the fall, gaining about 9%. Today the upward rally ate about 3.5% of that gain.
Regardless, I'm going to taking this rally as a way to stengthin my position by going even more short. I've assume more shares of prudent bear and am almost 100% in that single fund. Since the fund is 70% short (and uses US treasury bonds for sweep), it should profit greatly during a deflationary crash despite its long position on precious metals mining stocks.
Actually...even though I'm bearish on gold for the next few years, it truely is the ideal hedge in case for some reason the Fed changes its policies an hyperinflation sets in. And when the crash is over, precious metals will probably be the best place to be. Additionally, gold is appreciating so much right now that it keeps the fund perfoming well even in this pre-crash era.
According to Jim Shepherd (http://www.jasmts.com/), in the advent of a 30-50% crash, a successful short fund should be able to gain over 200% in value (3x principle). But remember -- this is in nominal terms -- coupled with deflation, the real value gain could be enormous. The name of the game in deflation is to be sure your debtor doesn't default, which is why you must use safe government debt for sweep.
Of course, I am not planning to use any extra leverage. I assume there will be a story of some guy who did a bunch of fully leveraged shorts and became a multi-millionare overnight, but this crash is far too devious for that. Really, it is so long, long overdue that timing it has become almost impossible.
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