Vigilant Investor

So much in the U.S. economy has been dislocated thanks to the asinine monetary policy being run by the Fed with full support of conventional economists. By dislocated, we mean our finite wealth resources — our capital stock of savings — has been artificially knocked out of its natural place. From that, we can infer that efficiency of utilization has declined, and resources have been wasted. How you weigh the consequences depends on if you are considering from the U.S. perspective or a global perspective.

Now, first time readers of Vigilant Investor may be asking, why is this important? Why should I care? The answer is simple: if the assumptions upon which your investment valuations are based are faulty, it implies that eventually once the market sorts that information out, their will be a correction.

Some might respond, but are the markets not supposed to be efficient? After all, is that not what we are told by modern asset allocation theory, from Wall Street, to Main Street, all the way to mainstream consumer magazines, and on to “Saint” John Bogel of the index heavy Vanguard Fund family?

To that we would respond, at best markets can be efficient only on average, keeping in mind that “average” does not mean “always”, although much of the retail investment industry acts as if the averages apply to everyone and all circumstances. We have come to often refer to this as “What, Me Worry? Syndrome”.

Of course, we are not alone: Warren Buffet once observed that working with someone who believes in the efficient market theory (and it is a theory only) is like playing Bridge with a partner who refuses to look at his cards. He also once quipped that were the markets truly efficient, he’d be nothing but a beggar with a tin cup, having made himself tremendously rich by capitalizing on market inefficiency.

In more real terms, we can point to the lunacy that took place in the late 1990s with the dot com era and the tech bubble. Clearly, were the markets truly efficient, such bubble oriented insanity would not take place. We can also point to the vast amount of Wall Street corruption that took place — and still does. Among many of Wall Street’s “finest”, during the last bubble, analysts were rewarded handsomely for recommending garbage stocks of companies that would generate massive investment banking fees for the firm. Today, investment banking information still manages to consistently breach the “Chinese Wall” that is supposed to prevent inside information from trickling out to those players on Wall Street who are best connected.

But we digress; we are here to talk about dislocations. Let it suffice to say, dislocations are often not identified until it is too late for some. The rebalancing can be either painful or profitable, depending upon your position. Vigilant investors learn to accept this.

So, back to the point about the Federal Reserve creating such dislocations with its monetary policy of the last thirty-plus-years and especially since the bubble pop in 2000. Basically, the Fed has bloated the money supply and at all too rapid pace since the mid 1990s:

The last figures we have for M3 — the broadest indicator of money supply — are from this past March given the Federal Reserve inexplicably decided to end tracking it. Those increases then were annualized at over 8%. This in the face of official CPI (inflation) coming in at less than 3%. If we extrapolate from the trend in the graph above, M3 Money Stock will have tripled by mid 2008 from 1995, and have increased well over six-times its 1980s level.

Now, Milton Friedman correctly observed long ago that inflation is and always will be a monetary phenomenon. Translated, that simply means that our esteemed bankers who we allow to print dollars at their leisure are the ones responsible for destroying its purchasing power. This is a simple concept to grasp, even if the finer details can get complex: Money is just like a commodity. The more you print of it, the less it is worth. Simply, if you, reader, were to have the only $100 in the world, were I to counterfeit-print another $100, the total in circulation would be $200, and your purchasing power would be cut in half. Assuming apples originally cost $1.00 a piece and the apple supply was the same, fairly quickly after my counterfeiting, the price of apples would climb to $2.00. Moreover, my purchasing power in my freshly minted dollars comes entirely at the expense of your purchasing power that had been stored in your dollars.

Is that criminal? You bet it is. Unless, of course, you happen to be the nation’s central bank - - For the Federal Reserve and the banking system, the exact same deal is perfecly legal! In fact, you can use the Fed’s own numbers to see that prior to the Fed’s creation, inflation was non-existent in the U.S. except at times of war, such as the War of 1812 and the Civil War. You can track the equivalent purchasing power of $100 for the one-hundred years prior to the Fed, and you’d find two dips during the aforementioned wars, and then, in short order, restored purchasing power back to $100.

However, once the Fed is charged with the stewardship of the U.S. dollar in 1913, all hell breaks loose. You immediately have wild money expansion to cover our allies after World War I leading to the boom and bubble in the 1920s, and then the crash and the depression.

Let’s put the real numbers in perspective: $100 of purchasing power on the day the Fed was created now buys only about $3.00 worth of goods:

$100 of purchasing power in 1950 buys today only about $13.00 worth of goods. Moreover, both of those figures would be much worse were it not for the dramatic rigging of the official CPI figure by the U.S. government since the 1970s. (It’s so bad that were we to use the 1970 method for calculating CPI, Social Security payments would be about 70% higher than they actually are. And, therein lies one political motivation for the rigging!)

But in the face of all this history — and reality! — , mainstream economists and Wall Street analysts always point to core CPI as an indicator to tell us that the Fed is right on track. After all, inflation is only around 3% “officially”, so what’s the worry? It would appear, we are told, that the Fed has figured out how to keep the inflation Genie in the bottle, even in the face of massively expanding money supply. In other words, all the old rules are different today!

But what about stratospheric gas and oil prices, you ask? Or rising commodity prices that go into the manufacturing of final goods? Well, we are also told that because wages are not climbing, we needn’t worry about commodity prices going up since they comprise only a relatively small portion of production vs. wages.

Voila! There you have it! Fed has tamed inflation, so don’t worry about 8.4% money supply increases!

Well…Not so fast!

Apart from the fact that the CPI itself is unreliable, the context in which that figure is being interpreted is completely off base. A clean bill of health determination for the U.S. economy fails to acknowledge the reality that CPI has been largely aided and abetted by the massive and ever climbing U.S. trade deficit. Most notable is the reality of global labor arbitrage, where U.S. based producers are finding U.S. labor non-competitive vs. foreign labor. We are told, this is a good thing as it will forever benefit U.S. consumers and the U.S. economy.

From here, allow me to quote Gerard Jackson, the BrookesNews economics editor (our clarifications in [bold brackets]):

” According to [conventional economic] analysis it is the entry of hundreds of millions of workers from China, Russia and India into the world market place [that will prevent labor, and by inference, price inflation in the United States]. This rapid expansion of the international labour force makes any notion of emerging labour shortages look absurd. Should domestic demand outstrip the labour supply, firms will be able to depress wage pressure by using foreign labour and so avert inflation.What advocates of this view do not grasp is that this policy is not averting inflation but is actually exporting it: a fact that could have grave consequences for other countries. By using artificially low interest rates to flood the economy with ‘cheap’ credit the Fed triggered the boom. It’s this monetary expansion in the form of credit that is generating labour shortages and causing bottlenecks to develop.This process also causes nominal incomes to rise, the effect of which is to increase the demand for imports. So rather than complementing America’s capital structure and adding indirectly to its labour market these imports are really the product of a highly inflationary policy. To put it bluntly: this ‘income effect’ is really a symptom of a failed monetary policy.By raising Americans’ demand for imports the monetary expansion distorts the pattern of production of the exporting countries. In response to increased demand from the US these countries redirect a great deal of their capital to satisfying American consumers. When the Fed eventually applies the monetary brakes, demand falls off and these exporting countries find themselves with idle capacity and rising unemployment.

But the process doesn’t stop there. Most trade between countries takes place because of price differences. Now inflation disarranges prices and by doing so it distorts, as I have just explained, the pattern of production. But the same thing also happens in the US. By artificially increasing demand for exports by distorting price differences the, US can unintentionally make domestic firms uncompetitive, forcing them to either close down or move abroad.

When this happens advocates of free trade cheerfully tell us that we are merely witnessing “comparative advantage” in operation, and that this is a benign process that will eventually benefit us all by making the world a more productive and wealthier place. But they are wrong. This is not comparative advantage at work, but forces driven by inflation that have warped the structure of capital and prices.

We would add, also, that it has vented the capital stores of savings in the U.S. out of the hands of U.S. savers and entrepreneurs, and placed them into the hands of foreign nations. Those nations, in turn, have invested that capital into hard assets for manufacturing, which initially returned to the U.S. in the form of cheaper goods. That hid the fact that the Fed was printing money at a crazy pace, but only temporarily. Not only has the process created an emerging middle class in these regions, the entire production apparatus of these economies are now competing on a global scale for finite energy and commodity resources. In other words, all that printing of money has finally caught up to us, and gas prices are merely the tip of the ice berg.

Moreover, in the face of a debt riddle, savings short U.S. consumer, one wonders what will happen to this unnatural, Fed induced, massive dislocation once the U.S. consumer finally is forced to stop spending.

Jackson concludes:

Free trade cannot work smoothly in the absence of sound monetary policies. It is unsound monetary — meaning inflationary — policies that cause financial crises, frenzied speculation, volatile exchange rates, etc. And who gets the blame for these economic fiascos? Capitalism.”

So true!

We could write an entire book on this subject, and how other areas of the economy are precariously balanced thanks to “official policy”. Why, there is the Federal Deficit; the housing bubble; etc. But tying those subjects, friends, is the daily purpose of Vigilant Investor, and why you should come back each day to get an additional piece of the puzzle.

In the meantime, act prudently and make sure that you or your advisors are taking into account how the great global unwinding might affect your portfolio. Those who are Thoroughly Vigilant have considered where the dominos might fall, and are taking evasive action to avoid being sucked into whatever vortexes might be created as it all unfolds.

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