The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (13 page)

The decline in foreign investment in the United States would not have as much of an impact if there hadn’t been so much inflow of foreign capital into our economy earlier. On the way in, that extra money helped pump up our bubbles, and on the way out, the drop in foreign investment will help pop the bubbles as well.

The combination of rising inflation and rising interest rates will pop the huge dollar and government debt bubbles, and will pull down what is left of the already falling real estate, stock, private debt, and consumer spending bubbles. With all our bubbles fully popped, the global Aftershock will begin.

Even if that is not something you can currently let yourself believe is possible, you must at least admit that rising inflation and rising interest rates will certainly not be good for any economic recovery. And once you let yourself see the bubbles, you will realize that, under these conditions, these bubbles cannot last.

Frankly, even without rising future inflation and rising interest rates, these bubbles cannot last. Why? Because they are bubbles! Bubbles don’t last forever. What goes up must eventually come down because their rise was not driven by real productivity growth and other fundamental economic drivers. It was driven by speculation and a whole lot of borrowed and printed money.

Despite these facts, CW will try to deny, ignore, and happy-talk our way through an increasingly obvious falling bubble economy. But ask yourself this: How many CW-type analysts and economists predicted or anticipated our current economic situation? This is how CW tries to ignore the change. But, of course, that doesn’t stop the reality of the current and future economy.

This enormous resistance by so many sophisticated economists and financial analysts to changing their CW economic outlook, even in the face of overwhelming evidence, is highly unusual in U.S. history. Although there has certainly been cheerleading in the past and blatant ignoring of reality by economists and financial analysts, this current period stands out as an extreme level of resistance to facing facts. CW has become blind as a bat, while insisting its eyes are wide open.

Key to the CW position that nothing too bad will happen next is their belief that inflation poses no threat. Some CW analysts (and even some bears) have gone so far as to say that future
deflation
, not inflation, is the real problem.

Vital to the CW argument against our analysis is the wrong idea that instead of inflation, we are about to enter into a period of deflation. The idea that deflation is the real threat, not inflation, is the last refuge of the deniers. They want to deny that printing money is a problem. They want to be able to print all the money we need without any consequences, without inflation. So, instead, they say they are worried about deflation.

Let’s start with a definition of inflation and then dissect the deflation arguments one at a time. As Nobel Prize–winning economist Milton Friedman famously stated:

“Inflation is always and everywhere a monetary phenomenon.”

By using the word
monetary
, Friedman meant that inflation is a direct result of increasing the money supply. Increase the money supply, relative to the size of the economy, and you get inflation; decrease the money supply and you get deflation.

A lot of people think that falling prices equals deflation. That is not true. Prices can fall when there is a change in supply and demand: falling demand and/or rising supply naturally reduces prices. That is not deflation. Deflation is caused by a contracting money supply and inflation is caused by expanding the money supply faster than the economy grows. We have a massively expanding money supply, and we are going to get significant future inflation, not deflation. Making matters more confusing, there is a difference between a change in the “nominal” price, which is the price paid, and a change in the “real” price, which is the price adjusted for inflation. The nominal price can rise due to inflation, while the real price can fall due to falling demand or rising supply. The fact that some asset values (in real dollars, adjusted for inflation) will fall due to popping bubbles does not mean we have deflation. What we have is falling bubbles.

Another argument we’ve heard for deflation is based on demographics. Some have said that as the Baby Boom generation reaches retirement, more people will be saving what money they have, which will make dollars scarcer and therefore more valuable. The problem with this is that, in the twenty-first century, when people save their money, they don’t put it under their mattresses. They invest it. It circulates in the economy just like it always has. Even if there were some truth to this idea, there’s no way that a little extra penny pinching by the Baby Boomers could offset the massive money printing by the Fed that we’ve seen so far and will continue to see. Also, remember that we have had no periods of deflation in the United States since the end of the Great Depression when the government began to print more money. Inflation helped pull us out of the Depression. We simply cannot have significant deflation now or in the future when we are massively printing money.

Another common argument for deflation is that when debts cannot be repaid, the resulting write-offs and bankruptcies will effectively decrease the money supply. This argument seems to come from the fact that money is created as debt. But the argument goes one step too far in assuming that when debt is destroyed, that reduces the money supply. A simple thought experiment will show why this is untrue: If you lend me money and I can’t repay you, the debt may be wiped out, but the money went wherever I spent it. It’s still in circulation. Destroying the debt does not destroy the money.

A similar argument is that, when we talk about the increase in the money supply, we’re not considering that credit effectively functions as money. So if the amount of credit goes down in a struggling economy, the money supply is effectively decreased, too. But decreasing credit doesn’t cancel out any money already in the system—it just slows the rate of new money being introduced in the economy, which doesn’t matter much if the economy has already been flooded with money. Whenever a purchase is made using credit (say, when you buy a TV with your credit card), sooner or later it ends up in a bank account somewhere. Once it’s in a deposit account, it makes no difference where it came from. It’s in the economy for good.

There are two reasons why this will not happen. The first problem with this solution is that the economy is showing no signs of growing under its own steam. (Remember, there is no “natural” growth rate; the bubbles have been the growth engine, and without the bubbles, not much growth happens). Pulling money out of a no-growth economy would just make the recession far worse not better, so that won’t work. The second problem is that even if the economy did recover somehow, not only would a contraction of the money supply jeopardize those gains, but the only way the Fed can pull that money out of the economy is by selling $1 to $2 trillion worth of government bonds. Not exactly a winning scenario in an already precarious public debt situation. If they tried to do this by selling the bonds, interest rates would rise. Higher interest rates would have a negative impact on stocks, bonds, real estate, and other assets, which would hurt the economy. So the Fed won’t pull the money out to spare us inflation later.

As the economy continues to struggle and markets fall, the Fed will do even
more
money printing, and this will result in even
more
inflation than anyone would expect. The Fed will do even more money printing in the future in order to cover the costs of . . .

• Market stabilization
  . Like the first rounds of quantitative easing that began in 2009, the next rounds will largely come from a need to prop up declining markets and a fragile banking system.
  
• Stabilizing foreign currency markets
  . The Fed can prop up the market and banking system only to a limited degree, especially as this goes on for a longer period of time. Foreign investors will still get nervous. Hence, the Fed will also need to print money to support the dollar in the foreign exchange markets.
  
• Government spending deficit
  . Long term, once the Aftershock hits, the Fed will have a very heavy burden of financing the government. We already fund about 40 percent of our spending with debt, and it will be much higher when the Aftershock occurs. The money to buy this debt will increasingly come from the Fed.
  

Keep in mind that this represents only the base money introduced by the Fed. Any loans created from these reserves will have a
multiplier effect
on that figure. So while we will not have inflation on the level of Zimbabwe or the Weimar Republic, we will certainly have very high inflation, and it will certainly have a very big impact on the future economy.

Because inflation will truly devastate the stock, bond, and real estate markets, people want to say it won’t happen. If you own a stock, such as Bank of America, you desperately want to believe the problem is deflation, not inflation; otherwise, your investment is about to be wiped off the planet. For that reason, a lot of people want to believe we will have deflation, not inflation.

Maybe you believe it, too. If so, ask yourself this: If the Fed’s buying massive amounts of government bonds with printed money doesn’t create inflation, why don’t we do more of it? Most economists agree that if we eliminated all taxes tomorrow, including corporate and Social Security taxes, while maintaining all federal government spending, that we would boost the economy right out of the current slump and into a period of enormous growth. All we have to do is borrow that money instead of taxing it. How do we borrow it? By selling bonds to the Federal Reserve. That’s exactly what we did in the past with QE1 and QE2. With the Fed buying the bonds, it won’t stress the bond markets. They just buy whatever it takes to fund the government each year. No more. No less.

Since the deflationists strongly assert that massive Federal Reserve purchases of government bonds (as they have done in the past few years with QE1 and QE2) won’t create inflation, then what’s the downside? We can just print all the money we want, whenever we want. We can quit paying taxes. In fact, why should anyone work at all? We can all just print money whenever we need it, just like the government. No taxes and lots of shopping would be a great boost to the economy, right?

But we all know in our gut that this is a fraud. We instinctively know that endless money printing is impossible and would eventually create problems. There really is no such thing as money from heaven, and having the Fed buy our government bonds with printed money is
not
money from heaven. It is the fuel for inflation.

Inflation doesn’t start immediately, but that doesn’t mean it doesn’t happen. Inflation doesn’t start at a high level, but that doesn’t mean it won’t get higher later. That’s where we are today—we are far enough along that inflation has started, but it has not gotten to a high level yet. Ask anybody who’s lived through an inflationary environment, and they will tell you that low inflation now is no protection from higher inflation later. Low inflation is simply the beginning of high inflation when you are printing massive amounts of money.

Let’s also be clear that we have not had deflation in any way since the financial crisis. We have never had a negative Consumer Price Index (CPI), which would be a good indicator of deflation. We have always had a positive CPI. And most honest observers would say that the CPI significantly underestimates the true rate of inflation most consumers are facing.