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Stop me if you’ve heard this one before….  The dollar and financial stocks fall, while gold and oil rise.  Damn, you already heard that one somewhere else? 

It’s a familiar refrain that seems to keep repeating, just like an obnoxious Barry Manilow song or that annoying dog commercial that goes “there might be bugs on some of you mugs but there ain’t no bugs on me”.  (Ha - now you’ve got it stuck in your head too!)

The reason that oil and gold continue to trend higher while the dollar and financial stocks continue to trend lower is one and the same - the Federal Reserve. 

The Fed continues to flood the system with cheap and/or free money.  It’s simple supply and demand.  There are more and more dollars but there hasn’t been a corresponding increase in the demand for those dollars.  So the amount of stuff a dollar will purchase continues to fall.

It’s called inflation, and it’s always CAUSED by the same thing - too much money chasing too few goods.  The classic way to explain inflation is that inflation “is always and everywhere a monetary phenomenon” (Milton Friedman) but it’s saying the same thing.

Even though this is nothing new, I’ve found that damn few people actually understand it.  And the more involved they are in the stock market, the less likely they are to understand it.  They blame inflation on rising wages, or rising oil prices, or the rising cost of (insert commodity here). 

They don’t understand that rising prices are CAUSED by too much money.  When the Fed injects billions of dollars into the money supply (without a real demand for the money) prices HAVE to go up. 

Pretend I have a blog that lots of people read (we’re pretending!) and visit everyday.  Now I take the blog posts that I write and post them on 7 other sites as well.  Assuming more people don’t want to read what I have to say, the number of people visiting each site would go down - even though the total number may stay the same.

Ok, maybe that isn’t the best analogy…. Try this one.  8 people are standing around a barrel of oil.  They all need that barrel of oil, and they’ve all got about $5 to use to purchase it.  Guess what the price of that barrel of oil will be?  Yup, about $5.

Now imagine that Uncle Sam gives (or lets them borrow cheaply) each one of them another $5.  There’s still only one barrel of oil, and all of them still need it.  How much will that barrel cost now?

Does that help?  That’s what the Fed is doing with dollars.  Helicopter Ben is doing everything he can to keep the over-leveraged financial institutions afloat, but he’s simply buying time.  Borrowing money to pay off debt never works - it simply delays the inevitable.

As the dollar loses value (because there are more of them in circulation) the amount of “stuff” each dollar can buy MUST go down.  So things like oil and gold go up BECAUSE the dollar is worth less. 

This sometimes isn’t obvious because with commodities like oil and gold (and corn and soybeans and wheat and rice and pork bellies) demand can also fluctuate and cause price movements, but the underlying cause is the same.  Too many dollars in the system.

Anyhoo, the major financial institutions all owe waaay more than they own.  And they’re finding out that as the value of their assets (and the payments they receive from those assets) fall, they suddenly can’t make the payments on their debt anymore.  But then the Fed comes riding in and lets them borrow more money (using the same assets which are falling in value as collateral) and suddenly everything is supposed to be ok…. Brilliant! (Not!)

There was a report by Reuters today saying “Federal Reserve Chairman Ben Bernanke told Freddie Mac chief Richard Syron that his company and Fannie Mae could take advantage of the emergency discount window, according to a source familiar with the conversation.” 

Since it’s pretty obvious to everyone that Fannie Mae and Freddie Mac are insolvent and going under unless someone steps in, this report was a catalyst for a huge rebound in the market today.  Investors were grasping at straws looking for something, anything to save the sinking financial ship.  They grabbed onto this report and stocks reversed course over 200 points and were even briefly into positive territory today.

Then they realized that even if the report was true, it didn’t change a damn thing.  So the market sold off again into the close. After the markets closed, the Fed denied the story - but I won’t be surprised if the Fed takes action over the weekend like they did with Bear Stearns. 

They know the companies are technically bankrupt, and they’ve got to act at some point.  I don’t know what they’ll do, but they won’t stand by while the ship sinks.  They’ll continue to bail water, only to eventually figure out that the water is coming in much faster than they can bail it out.  The ship will still sink, but they can drag out this soap opera for months. 

In my opinion, they should let it sink now so we can start building the new ship.

gk

It was interesting watching the stock market go into a steep sell-off today after the Fed meeting minutes were released.  For some reason, most people are still underestimating the severity of the problems in the economy, and they’re stunned when they see something that doesn’t fit into the Goldilocks scenario they’re anticipating.

Here’s how CNN phrased the dilemma facing the Fed: The Fed lowered its economic growth forecast for the year. At the same time, it raised its projections for inflation and unemployment. The combination of slowing growth and rising prices [emphasis mine] created a difficult situation that made the Fed’s latest decision to cut rates on April 30 a “close call.”

Webster defines “stagflation” as persistent inflation combined with stagnant consumer demand and relatively high unemployment

Notice the similarity between the two preceding paragraphs?  Everyone remembers the stagflation we had in the Carter years.  Carter was a disaster for this country, and it took Reagan to turn things around, but Carter was an economic genius compared to Bush!

At least Carter took steps in the right direction by deregulating the oil and natural gas industries - Bush ain’t done squat except to print more money to try to inflate his way out of the mess he caused by creating cheap credit after 9/11.  

The problem wasn’t so much the easy money policy, it was that they kept the easy money policy in place for far too long.  This created the housing bubble, which led to our current credit crunch as all the mortgage backed security instruments lose value as home owners can’t make payments on houses that are worth less than the mortgage balance.

The “close call” CNN refers to is that the Fed is stuck now.  They want to lower rates to stimulate the economy, but that will just exacerbate the inflation problem which is caused by too many dollars in circulation.   That’s what happens when the Fed tries to manipulate the economy instead of following their mandate to ensure a stable monetary system.

From the website of the Federal Reserve: The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.

The Fed has become too political to do its’ job - which is to provide for a stable currency.  The same easy money policy (which leads to inflation) has caused the value of the dollar to drop by about 50% since Bush took office.  Like it or not, a dollar today will only purchase about half of the “stuff” that it would 7 years ago.  Thanks GW…  NOT!

When you see the price of commodities such as oil, wheat, soybeans, corn, etc. (the “stuff” we use) double and you wonder why, that’s why.  Global demand plays a part, but the major reason is that we are paying for the “stuff” in a global marketplace with inflated dollars that people don’t want.

That concludes your economics lesson for today.  Any questions?

gk

I read a good article today in the NY Times.  Here’s the opening paragraph:

If the United States were any other country, these would surely be days of panic and austerity in Washington. With debts spiraling higher, a trade deficit exceeding $700 billion a year, and its currency plunging for years, the government would be forced to cut spending and jack up interest rates in a frantic bid to attract investment.

Very true, unfortunately the day when we’ll be forced to do just that is coming.  It might be later this year, or it may be 10 or more years away, but no one that I’m aware of has repealed the law of supply and demand.

The article mentions this, saying on page 2: Yes, foreigners have been lending alarming amounts of money to Americans, who have spent extravagantly in excess of their means, economists say. One day, balance will be restored in line with the basic laws of economics — perhaps chaotically, and probably via a substantial fall in the dollar’s value.  (emphasis mine)

If you want to know why the dollar is eventually doomed, read this:  When Americans head to the mall, backed by foreign largesse, they drive there burning gasoline made from oil pumped abroad, notably the Middle East. They drive home carrying electronics and clothing churned out in Chinese and Japanese factories. Making these goods absorbs commodities — energy from Australia and Africa; cotton from Texas and California; iron ore from Brazil and India.

That explains a lot to those unfamiliar with international finance - it even touches (in part) on why commodity prices have risen so drastically in the past few years.

Regardless of when it happens, we will eventually be forced to raise interest rates and borrow less from overseas.  Even if we eventually do that, inflation will still be rampant - it’s the only way the government can pay its’ debts. 

Inflation makes old debt cheaper to pay off, because you’re paying it off with inflated dollars.  Neat scheme (everyone from the Pharaoh’s to the Romans, to us has tried it) but it always fails.  No nation has ever inflated it’s way to prosperity.  And all paper money eventually returns to its’ intrinsic value - zero.

gk

I read an article on Business Week saying that the dollar may be at a bottom.  Huh? 

I read the entire article, but I don’t see anything that suggests we’re going to quit borrowing $1.45 billion per day - and that’s at the national level alone.  Coupled with the American consumers’ ability to live beyond their means, and we continue to spend more than we produce.  Individually, and at the city, county, state, and national levels.

 Why’s that bad?  Because someone is forking over money when you charge something on your Visa card, someone is paying when you take out a second mortgage, someone is paying when you do a no money down deal on a new car….  Where is the money coming from?

Overseas.  We (Americans) are flooding the world markets with debt instruments.  It doesn’t matter if it’s  bonds sold by the US Government, or bonds sold by Citigroup, or bonds sold by AMBAC, someone has to have the money to lend - and that someone is overseas investors.

As long as “helicopter Ben” keeps printing money, and as long as Americans overall refuse to live within their means, the dollar will continue a downward spiral.  There will be days and weeks (like the last couple of weeks) in which the dollar rises, but nothing has changed regarding the long term fundamentals.

These articles where pundits are calling a bottom in the dollar remind me of the financials since last fall.  How many times have we heard that “this is a kitchen sink” quarter?  “All the bad news is out there now” and “this is the end of the writedowns” has been said countless times by the financial press.

Here’s the bottom line:  The financials ain’t done writing off losses, and the dollar ain’t done falling. 

gk

Given the posts I made earlier tonight, I’ve been thinking that instead of just outlining the problems of today (and how much worse it’s going to get) I should talk a bit about what to do with your money to allow you to keep more if it during this downturn - or worse - of the economy.  So shooting from the hip, here are my thoughts.

1) Pay down debt.  If you’re one of the idiots who bought more house than you could afford, or who took out HELOC’s and second mortgages to “access your home equity” this doesn’t apply to you.  You’re toast.  You’re the problem.  For anyone who has a reasonable amount of debt - which I’ll arbitrarily define as totaling no more than 50% of your gross annual pay - I suggest paying it down as fast as possible.

When the shit hits the fan, you need to be able to live as long as possible on your savings.  Just imagine how much money you’d have each month if you didn’t have any payments!  If you’ve got a car payment, sell the freaking car to get rid of the debt and payments.  Buy a cheap car that runs good. Build up a small emergency fund by making minimum payments on everything and saving every dime you can.  You need at least one month’s worth of expenses saved up. 

Then (as Dave Ramsey would say) “act your wage”.  Live on less than you make so you can start paying off the debts.  Stop eating out, stop renting movies, get rid of your cable or satellite service, collect coupons, etc.  Cut your bills to a minimum and get out of debt.

2) Pile up cash.  Continue your frugal budget and save at least 6 months worth of expenses.  This money needs to be in your local FDIC insured bank in a simple savings account.  I don’t care about the interest rate - the object here is to save money, not grow it.  It needs to be easily accessible, so that means no CD’s or other investments.  This is your cushion for the dismal day when you don’t have a job.

That 6 months of expenses you save gives you time to plan, to look for a better job, to avoid despair, if and when you don’t have an income.

3) Fund your retirement.  Save at least 10% (and you’re much better off if you can save 15 or 20%) of your gross pay in an IRA.  Use your 401k at work if you have one.  Most employers have some sort of matching program, so be sure to contribute enough to get the full employer match.  Put the rest into a self funded IRA - you can open an account online with for as little as $50.  I use Scottrade and TD Ameritrade, but there are dozens of others.  Just do it!

I think a Roth IRA is best - taxes WILL be going up over the coming decades.  A Roth IRA is funded with after tax dollars, and the earnings are tax free.  That might not be much difference right now, but it will when tax rates hit 50 and 60%.  (If that seems extreme and alarmist to you, just wait.  I’ll have more to say later!)

If you’re putting in a big pile of money, be sure to spread it out among various large funds.  Be sure to include international funds (to take advantage of the tanking dollar) and I don’t think you can go wrong in the long run by putting a decent chunk (say 10%) into a gold or silver fund.  10 years from now you’ll be glad you did. 

Personally, I’d stay away from Asia, as the tightly regulated economy (and zero transparency in the numbers the governments provide) will eventually drag them down.  The China bubble may be popping now - although most “experts” say that the Chinese government will keep things propped up through the Olympic games later this year.

If you’re just starting out, pick a few good index funds and contribute each month.  You’ll be automatically dollar cost averaging, which in effect allows you to buy at a lower average price.

4)  Invest in staples.  No, not the office supply company (I don’t have an opinion on them) I mean consumer staples - the things everyone needs regardless of the economy or job situation.  This is stuff like food and clothing.  As times get tougher, people will spend as little as possible on everything - but they have to eat. 

Where’s the cheapest place to buy food and clothing?  Wal Mart.  As sales go down at the Gap, Dillards, Kroger, etc, look for them to go up at Wal Mart.  Target might be ok as well, but I think Wal Mart sales will grow faster - so the stock price should rise more over time.  McDonalds and other cheap fast food should also do better than average.

5)  Stuff.  I don’t have time to get into this in the detail it deserves right now, but “stuff” will become more valuable as the dollar is inflated away.  By stuff I mean things like farm land, apartment buildings, and rental property.  We’re nowhere near the bottom yet in the real estate market, so there’s no hurry on this one.  But in a year or two you should be able (if you’ve saved and invested) to pick up valuable property for 50 to 60% off today’s prices.

Look for property in retirement areas, such as Florida, southern California, and Arizona.  Look for farm land in Nebraska and Kansas - possibly areas of Texas and Oklahoma that receive adequate rain.  If it’s in a windy area, so much the better, as you may be able to lease small sections to energy companies for wind turbines.  It may sound crazy right now, but there will be fortunes made in wind energy over the next 20 years.  There’s too much to go into here, but Google “peak oil” sometime.  We’ll need energy, and wind is relatively cheap.

6) Tin foil hat stuff.  I don’t know what the price of gold or silver will be next month or next year.  But in my opinion, we are watching an epic devaluation of the dollar.  Until we stop spending more than we make (at the personal, local, state, and federal levels) the dollar will continue to lose value.  Conversely, things priced in dollars will continue to rise long term.  Things like gold and silver and oil.  It’ll be a bumpy ride, but 20 years from now, all of these will be much higher than they are today.

1/10 oz gold coins on eBay are going for about $100, while 1 oz silver coins are about $20.  Pick one and buy a coin or two every month.  This isn’t something to turn around for a quick profit - this is your insurance against a 1930’s type depression, or (more likely IMHO) hyperinflation like 1930’s Germany, or Argentina in the 1980’s.  We’re inflating the money supply faster than ever, and the law of supply and demand hasn’t been repealed. 

Remind me to talk more about inflation, deflation, and peak oil sometime.  It involves M3 and the huge unfunded Social Security and Medicare mandates - which are the major reasons the dollar will continue down.  Deficit?  You ain’t seen nothing yet!

gk

This is a repost of a thought provoking article I found on The Daily Reckoning.  You can read the original post on their site at: http://www.dailyreckoning.com.au/america-turns-to-foreigners/2008/01/22/

About the only thing I’d add to Mr. Bonner’s excellent insight is that if you think the falling dollar has created some excellent buying opportunities, just wait - you ain’t seen nothing yet.  I don’t have a specific timeframe in mind, but as long as we collectively spend more than we make, the slide of the dollar - and the US - will continue. 

Will we end up like the Greeks and Romans?  Or like the Soviet Union?  Perhaps it doesn’t matter….

Thanks to The Daily Reckoning for permission to repost it here!

gk

America Turns to Foreigners for Money

Posted by Bill Bonner on Jan 22nd, 2008

There is much disagreement among analysts and commentators: will there be a recession… how bad will it be? But one thing that all agree on is that, “inherent U.S. vitality remains enormous,” and that the U.S. economy will “bounce back.”

Oh yeah?

When everyone thinks the same thing, no one is thinking at all. And everyone now seems to think that whatever is ailing the United States, it will pass. We disagree.

The rules don’t change. Instead, the rules determine how circumstances change. And circumstances can change for a very, very long time.

The Athenians have been waiting 2,300 years for their empire to “bounce back.” The Egyptians have been waiting even longer. And the Seleucids? The Mongols? The Incas? The Romans? Rome is a nice city but the Rome of Berlusconi is hardly the Rome of Augustus. The city never bounced back. And the list of empires that never bounced back is as long as the list of empires. Once they are history, they are history.

When you spend more than you can afford, you get poorer. That’s the rule. So, it should come as no surprise that Americans are getting poorer… though they are just beginning to realize it. Now, when they need money…they have to turn to foreigners… to their imperial competitors.

In the last couple of weeks, some of America’s biggest financial firms have turned to Asians for multi-billion-dollar infusions. The Asians - who’ve been following the rules - working… saving - now have trillions to put to work. The Gulf States, too, have trillions in oil revenues. In the Gulf, they’re building new cities. In Asia, they’re building new industries.

And in America?

The foreigners are putting their money to work - buying up key industries.

“For much of the world, the US is now on sale at discount prices,” says the International Herald Tribune . “Last year, foreign investors poured a record $414 billion into securing stakes in US companies, factories and other properties through private deals and purchases of publicly traded stock.”

We hasten to add that we’re not agin’ it. Politicians will rant and rave about the “loss of US capital and industries.” But it’s a little late for complaining. The loss has been going on for a long, long time. As Americans spent more than they had, the foreigners built up credits. Now, they’re cashing them in. What else can they do? And what would you expect? The falling dollar has reduced Americans’ earnings…and it has cut prices on their assets, too. Now, people with money are taking advantage of the situation.

If you have a factory or a business… you might consider selling to the top bidder - probably a foreigner. If you have no business to sell, well, maybe you can shine the foreigners’ shoes.

There’s no denying what it all means… America’s edge in the world is slipping away. Americans are getting poorer - relative to others. This is an adjustment that probably won’t stop anytime soon. The United States will probably never bounce back to the heights it enjoyed in the ’80s and ’90s.

Bill Bonner
The Daily Reckoning Australia