Investment Ideas for an Inflationary Environment [View article]
To all commenters on this article - - -
Thank-you for all the thoughtful and respectful discussion on the subject of the article. I would add to the comment of gib and say that you have all added to the excellence of SA. This can not be said of all comments I have read over the past months.
Investment Ideas for an Inflationary Environment [View article]
Chris B - - -
Thanks for making some good points.
Let me explain my basic premise: debt is a form of money. When a bank issues a mortgage, it is in effect creating money. This is because, in our fractional reserve system, only a small fraction of the loan is required to actually be held in "real money" by the lender. Thus, for $100 of U.S. Treasury money in reserves, the bank can release much more currency into the economy, say $1000.
Now let's look at the bank's balance sheet. It now shows as assets the $100 reserve plus the $1000 lent. On the liability side it has the $1000 it created. As the loan is repaid the assets change by tracking the unpaid principal value, which is declining over time, and by adding retained interest earnings. On the liability side, the debit of created dollars is diminished as the loan is repaid, exactly equaling the corresponding decreasing asset. In otherwords, the money the bank created with the mortgage disappears as the mortgage is repaid.
A major problem arises when the mortgagee defaults. Now the asset is diminished but the liability is unchanged. If the mortgaged asset can not be sold through foreclosure for a major portion of the outstanding principle, the bank can become insolvent: liabilities exceeding assets.
Now, if the Fed or the Treasury come to the rescue by printing some treasury currency or issuing treasury debt to recapitalize the bank, this money goes into the required bank reserve to recreate a positive net worth. It does not go into circulation except to the extent that the bank now has reserves again and can issue more debt. However, chastened by its close call with death, the bank will now be much more cautious in issuing more debt.
Now, let's recognize that our current financial structure is so complex that this simple example of a mortgage gone bad is too simple by orders of magnitude with so many zeros before the decimal point (of the magnitude multiplier) that I can't estimate the magnitude. In such a complex system, how does the Fed and the Treasury know when it has printed enough dollars to exactly give the recapitalization dollars needed and no more? Answer: The government looks for the flow of credit in the financial markets. Because of new-found risk aversion, lenders are now more concerned with survival than profit. Reserves are accumulated against possible future defaults of other previously issued debt rather than creating new debt. The government does not see the desired increase in credit needed to stimulate the economy, so it prints more money. Eventually (and eventually is sooner rather than later), the flood of money is so great that the risk aversion dam breaks and the flood spreads into the economy.
The knife edge target of just enough money is very difficult (impossible?)to hit. That's why I am starting to line up my high inflation investment ducks.
You ask if creating this over abundance of money is counterproductive. The answer is yes. But, failing to create enough to recapitalize the bank is worse than counterproductive; it is destructive. If this destruction occurs for the entire financial system structure, the result is apocalyptic and we basically start over. We came close to this in the Great Depression. No one wants to go there again, because this time it would be far worse because national debt is so large and could not be serviced in the absence of a functioning economy. It would also be much worse as a personal experience because the subsistance dislocations would be more severe. We have a much smaller percentage of the population in a position to live off the land - the family farm and substantial rural population has become history.
To survive as a society and a nation, inflation is the preferable ogre and I'm quite sure we will go there because the "just enough new money" target is not likely attainable and we can not afford entrenched deflation. Inflation enables a monetization of the national debt, creates a managable (although unpleasant) burden for most segments of our society and avoids the specter of total collapse.
The far side of this has been lived through before. Paul Volker was the high priest who exorcized our last inflationary cycle. Prepare the way, we may need a new high priest in the coming years.
In the meantime, enjoy any benefits you can salvage from deflation because I don't believe that, when we miss the knife edge, we will end up on the deflationary side.
Investment Ideas for an Inflationary Environment [View article]
Derryl - - -
Thanks for your prescient comment. A primary input to the inflation Volker was fighting was the tripling in the price of oil in the 1970's. Today, our service economy is much less sensitive to energy costs. You correctly point out that transportation costs will inflate with higher oil. You didn't mention it but food also has a high energy cost component in production, as well as transportation to markets. However, oil does not have as high an impact now as in the 1970's because a smaller percentage is used in maufacturing, which is a comparatively inelastic demand. Personal consumption has more demand elasticity and today that component of consumption is a larger percentage of oil usage.
This is born out by the small inflationary response to oil going from $60 to nearly $150 in a period of approximately one year.
One other thought, maybe you are too optimistic when you refer to ANOTHER recession if oil spikes again in 2010-2011. There are some more pessimistic outlooks that propose a 2-3 year recession is possible. In that case your next recession would be merely an extension of the current one and many would call that depression.
On Nov 28 12:32 PM derryl wrote:
> If oil spikes again beginning in 2010-2011 there will be another > recession, no matter how far the recovery is advanced by that time. > The US cannot possibly convert off oil to any significant extent > in that timeframe so the US will still be import dependent. > > When Volcker raised interest rates to 20% to kill early 1980s inflation > the result was recession because the cost of an input to ALL prices--the > cost of money--was too high. Oil prices function the same way because > oil fuels virtually 100% of the transportation sector and virtually > all goods are transported. > > Oil and money are inescapable component factors in all prices. When > either of these gets too high they draw too much of an economy's > spending power into their maw and crowd out spending on everything > else. This unbalanced state manifests as a recession. > >
Investment Ideas for an Inflationary Environment [View article]
305589 and patio - - -
You are both correct. An example of decoupling of inflation from oil prices was seen in 2008. Oil prices nearly tripled within a year's time (and other commodities spiked), but inflation was effected very little (about 1% increase) because of simultaneous deflationary pressures (falling real estate values, lack of credit and declining real personal income, to name three).
At other times, most notably the 1970's, massive increases in oil prices fueled a period of double digit inflation.
Investment Ideas for an Inflationary Environment [View article]
ocankhe - - -
My proposition is that no one knows what is the right amount of newly minted dollars to just exactly fix the balance sheets because the value (or loss of value) for these credit instruments is uncertain. That is why I use the analogy of a knife edge. Too little money is printed and we remain under deflationary pressure. Too much money is printed and we have new inflationary pressure. Exactly the right amount will be very difficult (impossible?) to define.
Investment Ideas for an Inflationary Environment [View article]
Thank-you for all the thoughtful and respectful discussion on the subject of the article. I would add to the comment of gib and say that you have all added to the excellence of SA. This can not be said of all comments I have read over the past months.
Investment Ideas for an Inflationary Environment [View article]
An excellent resource is data published by the Economic Cyclic Research Institute (ECRI):
www.businesscycle.com/.../
Steve Hanson (also known as "The Hand") has some excellent posts on Seeking Alpha discussing ECRI data and related items. A recent post is
seekingalpha.com/artic...?
Investment Ideas for an Inflationary Environment [View article]
Thanks for making some good points.
Let me explain my basic premise: debt is a form of money. When a bank issues a mortgage, it is in effect creating money. This is because, in our fractional reserve system, only a small fraction of the loan is required to actually be held in "real money" by the lender. Thus, for $100 of U.S. Treasury money in reserves, the bank can release much more currency into the economy, say $1000.
Now let's look at the bank's balance sheet. It now shows as assets the $100 reserve plus the $1000 lent. On the liability side it has the $1000 it created. As the loan is repaid the assets change by tracking the unpaid principal value, which is declining over time, and by adding retained interest earnings. On the liability side, the debit of created dollars is diminished as the loan is repaid, exactly equaling the corresponding decreasing asset. In otherwords, the money the bank created with the mortgage disappears as the mortgage is repaid.
A major problem arises when the mortgagee defaults. Now the asset is diminished but the liability is unchanged. If the mortgaged asset can not be sold through foreclosure for a major portion of the outstanding principle, the bank can become insolvent: liabilities exceeding assets.
Now, if the Fed or the Treasury come to the rescue by printing some treasury currency or issuing treasury debt to recapitalize the bank, this money goes into the required bank reserve to recreate a positive net worth. It does not go into circulation except to the extent that the bank now has reserves again and can issue more debt. However, chastened by its close call with death, the bank will now be much more cautious in issuing more debt.
Now, let's recognize that our current financial structure is so complex that this simple example of a mortgage gone bad is too simple by orders of magnitude with so many zeros before the decimal point (of the magnitude multiplier) that I can't estimate the magnitude. In such a complex system, how does the Fed and the Treasury know when it has printed enough dollars to exactly give the recapitalization dollars needed and no more? Answer: The government looks for the flow of credit in the financial markets. Because of new-found risk aversion, lenders are now more concerned with survival than profit. Reserves are accumulated against possible future defaults of other previously issued debt rather than creating new debt. The government does not see the desired increase in credit needed to stimulate the economy, so it prints more money. Eventually (and eventually is sooner rather than later), the flood of money is so great that the risk aversion dam breaks and the flood spreads into the economy.
The knife edge target of just enough money is very difficult (impossible?)to hit. That's why I am starting to line up my high inflation investment ducks.
You ask if creating this over abundance of money is counterproductive. The answer is yes. But, failing to create enough to recapitalize the bank is worse than counterproductive; it is destructive. If this destruction occurs for the entire financial system structure, the result is apocalyptic and we basically start over. We came close to this in the Great Depression. No one wants to go there again, because this time it would be far worse because national debt is so large and could not be serviced in the absence of a functioning economy. It would also be much worse as a personal experience because the subsistance dislocations would be more severe. We have a much smaller percentage of the population in a position to live off the land - the family farm and substantial rural population has become history.
To survive as a society and a nation, inflation is the preferable ogre and I'm quite sure we will go there because the "just enough new money" target is not likely attainable and we can not afford entrenched deflation. Inflation enables a monetization of the national debt, creates a managable (although unpleasant) burden for most segments of our society and avoids the specter of total collapse.
The far side of this has been lived through before. Paul Volker was the high priest who exorcized our last inflationary cycle. Prepare the way, we may need a new high priest in the coming years.
In the meantime, enjoy any benefits you can salvage from deflation because I don't believe that, when we miss the knife edge, we will end up on the deflationary side.
Investment Ideas for an Inflationary Environment [View article]
Thanks for your prescient comment. A primary input to the inflation Volker was fighting was the tripling in the price of oil in the 1970's. Today, our service economy is much less sensitive to energy costs. You correctly point out that transportation costs will inflate with higher oil. You didn't mention it but food also has a high energy cost component in production, as well as transportation to markets. However, oil does not have as high an impact now as in the 1970's because a smaller percentage is used in maufacturing, which is a comparatively inelastic demand. Personal consumption has more demand elasticity and today that component of consumption is a larger percentage of oil usage.
This is born out by the small inflationary response to oil going from $60 to nearly $150 in a period of approximately one year.
One other thought, maybe you are too optimistic when you refer to ANOTHER recession if oil spikes again in 2010-2011. There are some more pessimistic outlooks that propose a 2-3 year recession is possible. In that case your next recession would be merely an extension of the current one and many would call that depression.
On Nov 28 12:32 PM derryl wrote:
> If oil spikes again beginning in 2010-2011 there will be another
> recession, no matter how far the recovery is advanced by that time.
> The US cannot possibly convert off oil to any significant extent
> in that timeframe so the US will still be import dependent.
>
> When Volcker raised interest rates to 20% to kill early 1980s inflation
> the result was recession because the cost of an input to ALL prices--the
> cost of money--was too high. Oil prices function the same way because
> oil fuels virtually 100% of the transportation sector and virtually
> all goods are transported.
>
> Oil and money are inescapable component factors in all prices. When
> either of these gets too high they draw too much of an economy's
> spending power into their maw and crowd out spending on everything
> else. This unbalanced state manifests as a recession.
>
>
Investment Ideas for an Inflationary Environment [View article]
You are both correct. An example of decoupling of inflation from oil prices was seen in 2008. Oil prices nearly tripled within a year's time (and other commodities spiked), but inflation was effected very little (about 1% increase) because of simultaneous deflationary pressures (falling real estate values, lack of credit and declining real personal income, to name three).
At other times, most notably the 1970's, massive increases in oil prices fueled a period of double digit inflation.
Investment Ideas for an Inflationary Environment [View article]
Yes, TIPS would be a good holding in an inflationary trend. I am sure readers will be able to add other good vehicles for inflation.
Investment Ideas for an Inflationary Environment [View article]
My proposition is that no one knows what is the right amount of newly minted dollars to just exactly fix the balance sheets because the value (or loss of value) for these credit instruments is uncertain. That is why I use the analogy of a knife edge. Too little money is printed and we remain under deflationary pressure. Too much money is printed and we have new inflationary pressure. Exactly the right amount will be very difficult (impossible?) to define.