Inflate Or Die

The Good News

Secretary of the Treasury Snow said in early July “With interest rates and tax cuts, the economy is beautifully aligned for a take off”.

After backing off on the creation of new money earlier this year, the Federal Reserve is currently providing new money at the rate of $1.8 trillion annually. These additional funds have added velocity to the turn over of cash; however, even though there appears to be a slight pick up in the cash flow of our economy, most of the new money is going into refinancing mortgages and bringing back the stock market bubble.

For the year the DJIA is up 10%, the S & P is up 11% and the NASDAQ is up 28%. The dollar has come back somewhat. It is being supported by countries like Japan and China who need a stronger dollar to ensure continued exports to America.

Many articles are appearing in the newspapers about “the return of the day trader” as well as the return of the retail investor.

Current Status of Stock Market

There are always two trends in the stock market: the primary trend and the secondary trend. The primary trend of the stock market right now remains down – the stock market is still in bear market posture. The secondary trend of the stock market is up – the market is up for the year. Should the secondary trend continue to improve, the primary trend of the market could turn around into a new bull market thereby placing both the primary and the secondary trend in bull market mode. This possibility is remote in an already overpriced market.

Can you make money in this market? No. The average investor cannot make money for several reasons:

	1.		If the primary trend of the market is down there are going to be huge gyrations in the stock market averages. This whipsaw usually costs an investor dearly.

	2.		Values currently existing in the stock market are mostly nil. Value comes from price earnings ratios that are low and yields that are high. Currently, price earnings ratios and yields on both the DJIA and the Standard & Poor Index of 500 Stocks are equal to past bull market highs, not lows from which a new bull market may be born.

It is important to realize there is a difference between the stock market and the economy. The economy can be improving, pushed along by massive infusions of new money, while the stock market is not improving. The value of a stock’s price should be equal to the discounted cash flow that can be expected on that investment over a period of time. That is classic Dow Theory definition of value in a stock. Cash flow over a period of years at the current value of the stock market is not expected to yield much of a return at all over the next ten years.

The Government Agenda

Central bankers are involved in a life struggle against the primary trend of prices, which is deflationary. The Feds main interest is to create more spending which provides additional tax revenues. Central bankers do not believe in primary trends – they think they can control the primary trend by setting interest rates, and by increasing and contracting the money supply. The whole “raison d’ etre” of a central bank is to control the primary trend. At this point we really need to hope and pray that their “inflate or die” philosophy will work, and if it does, we need to know that the cost has been, and will continue to be, high additional investment risk in the economy due to the inflated values of the stock market, the real estate market, the debt market, and the overvalued dollar.

America is geared up for inflation. We have roughly $38 trillion of individual, corporate and government debt. Interest at 5% means about $2 trillion of our $10 trillion GDP is used to pay interest annually. On November 21, 2002, at the National Economist Club in Washington DC, Federal Reserve Board Governor Ben Bernake (widely thought to be Greenspan’s successor before Greenspan decided he would accept another term) said, “Like gold, US dollars have value only to the extent they are strictly limited in supply. But the US government has a technology called the printing press that allows us to produce as many dollars as we wish at essentially no cost. By increasing the number of dollars in circulation, the US government can reduce the value of the dollar in terms of goods and services, which is equivalent to raising the price, in dollars, of those goods and services. We conclude that under the paper money system, a determined government can always generate higher spending and hence positive inflation”. This is the agenda of our government. We must inflate or die. Controlled inflation is essential or our monetary system and current form of government could collapse. There is no in-between. There is no way to compromise this — it is mathematical reality.

Additional food for thought is provided by a new study directed by Kent Smetters, former deputy secretary of economic policy at the US Treasury, and Jagateesh Gokhale, senior economist at the Cleveland Federal Reserve Bank. The study is an examination of the present value of all expected future revenue of the US Treasury, as compared to the present value of all existing future obligations of the treasury, based upon the current demographics of our population. The present value short fall of funds is $44 trillion, mostly attributable to government pensions, social security, Medicaid and Medicare. To put this into perspective, examine the following:

Existing US Government Debt	$ 6.5 trillion
Current US Government Deficit	$ .5 trillion
Estimated Future Obligations Less Estimated Future Revenues	$ 44 trillion
Total Obligation in Excess of Total Estimated Future Revenues	$ 51 trillion

As former Senator Dirkson from Illinois used to say, “Now we’re talking about real money!” Want more numbers to put into perspective our future liabilities? The current US GDP is about $10 trillion and the current US Federal government budget is about $2 trillion. The only answer: Inflate or Die.

Obviously the numbers do not work out – there is no way these obligations can be met under our current circumstances of a deflating economy, thereby leaving our government only three options:

	1.		Repudiate the obligations. This is unacceptable as it would ruin the credit of the country and keep foreigners from accepting both dollars and dollar backed securities. Both are essential for us to survive this calamity.

	2.		Increase taxes. If that were an option there would not be a $500 billion deficit, as the government would already have increased taxes. Such a tax increase would cause our politicians to be thrown out of office. Looking at the above numbers, one can easily conclude taxes could not be raised high enough anyway to meet our unfunded obligations. The numbers simply do not work out.

	3.		Inflation is the only hope to get America out of this mess. There is no other alternative. Inflate or Die.

Reality Check (The Rest of the News)

There are further indicators leading one to believe that the inflate or die philosophy is an up hill battle.

China is believed to have 170 million unemployed and migrant workers, equal to 20% of their labor force, (the 170 million roughly equal to the entire US labor force). Because the Chinese will work for food, shelter and clothing, like the Japanese after WWII, it will be beyond our lifetime before the cost of labor in China approximates the cost of labor in America. This puts tremendous continuing pressure on our employment and manufacturing base.

For the last several months, corporate insider selling has been four times greater than purchasing of their own stock. In a market that has been going up, why would insiders be net sellers unless the future did not look so bright?

Last week the bond market crashed. Billions of dollars were lost. The bond market dwarfs the stock market. As pointed out above, with $38 trillion in debt, at least $2 trillion annually is needed just to pay interest. With bonds going down, and interest costs therefore going up, the cost of interest is going to increase. An increasing cost of interest causes government expenses to increase. It will lower corporate and individual earnings, thereby further reducing government tax revenue, and potentially causing the already exploding US government deficit to become a mega-explosion.

High unemployment, record bankruptcies, and the lowest corporate profits as a percent of GDP that has existed in 40 years, are reducing cash flow in an economy desperately in need of increasing cash flow. Pricing power is frustrated by the use of the internet, unemployment, and over production.

Conclusion

The economy indicates that we are involved in a huge monetary chess match. The four bubbles — the stock market, debt, real estate prices, and the dollar — are better positioned for a serious crash than they are for a further increase in value. Indeed, the increasing levels of debt, and the increasing manufacturing of money by our government, currently put the prudent investor in a position where they should ask themselves this question: “Am I currently satisfied with my financial position”? If the answer is yes, rather than take the risk of being in a market set up for the volatility that currently exists, investors are better off conservatively positioned. If the investor is not happy with their current situation, the probability of being really unhappy in the future, if one insists upon playing around with this market, is great, indeed.

Maynard Keynes, a twentieth century English economist whose socialistic influence upon our economy we are suffering from today, said, “the market can stay irrational longer than an investor can stay solvent”. This is one of the few statements Lord Keynes ever made with which Market Watch agrees. An investor would be wise to heed those words. Given the current state of the market investors will be better off in short term, high-grade bonds, cash, or “A” rated high yielding stocks with low price earnings ratios.

We are in a deflating economy at a time when we desperately need inflation.

In this huge monetary chess match our hope should be that the dollar is not checkmated in our efforts to inflate to survive.

When there’s doubt, either stay out, or watch out – and position yourself accordingly.

Caveat Emptor!
George Rauch
July 29, 2003

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