Everyone is wrong, again (except
the gold bulls)
May 12, 2009
Here are excerpts from commentaries
recently posted at www.speculative-investor.com
on 10th May 2009.
One of our readers sent us
a very interesting article from itulip.com entitled "Everyone
is wrong, again -- 1981 in Reverse Part II: Nine Signs of Inflation".
The article is an explanation by Peter Warburton (the author
of the book "Debt
and Delusion") of why generalised 'price inflation'
is likely to become an issue by early next year, with comments
by itulip's editor (Eric Janszen) interspersed. We don't agree
with every aspect of this article, but we do concur with its
gist and conclusions. Unfortunately, we can't provide a link
because it is in the subscriber area of the itulip web site,
but what we can (and will) do is discuss some of the article's
main points and tie them in with our own views.
One of the points made by Mr. Warburton is that global supply
of goods and services has been damaged at least as severely as
their global demand, but before exploring this point it is appropriate
to address one of the many critical flaws in the Keynesian theoretical
framework. The Keynesians generally view the economy in terms
of aggregate supply, aggregate demand, and the so-called "output
gap" that stems from an excess of aggregate supply (or potential
supply) relative to demand. Right now they perceive a large economy-wide
"output gap" caused by "excess capacity",
and on this basis conclude that there will not be generalised
price increases for many years to come almost regardless of what
happens to the supply of money. In a nutshell, they believe that
it will take years of increasing "aggregate demand"
to use up the "excess capacity" and reduce the "output
gap" to a level where businesses will be able to raise prices.
The central error in the Keynesian line of thinking summarised
above is that it assumes the economy to be an amorphous blob.
This assumption over-simplifies the real-world situation to the
point of making the resultant analysis totally worthless. The
real-world situation is that the inflation-fueled boom of 2003-2007
led to many ill-conceived investments, including the establishment
of new production facilities and service businesses that were
not supported by sustainable consumption trends, in SOME segments
of the economy. These investments looked feasible for a while,
but only because the cost of capital had been artificially suppressed.
Now that the cost of capital has risen to a more realistic level
the mal-investments of the boom period are in the process of
being liquidated, meaning that the associated capacity is in
the process of being eliminated. At the same time, there are
other segments of the economy in which there was minimal mal-investment
in new productive capacity during the boom.
What we therefore have are sectors of the economy where an increase
in demand is likely to result in an almost immediate increase
in prices (the sectors where there was minimal mal-investment
during the boom), and other sectors where it will take some time
before increases in demand result in higher prices. However,
even in the latter cases the lead time from rising demand to
rising prices will likely be a lot shorter than many economists
currently believe, the reason being that a rapid capacity contraction
is in progress. For example, in the mining sector there have
already been large reductions in capacity and plans for the development
of new production have been shelved. Furthermore, additional
large reductions in capacity are likely over the coming months
unless the recent up-trend in prices continues. This should mean
that supply will barely be sufficient to satisfy demand by early
next year, even in the likely case that the global depression
persists. The food-production sector of the economy, on the other
hand, never had much in the way of "excess capacity"
to begin with and is therefore likely to experience rising prices
We'll now return to Mr. Warburton's point that global supply
of goods and services has been damaged at least as severely as
their global demand. He notes that the credit crisis has had
a greater impact on the supply capability of the global economy
than on its consumers. In particular: that business expenditures,
rather than consumers' expenditures, have been scaled back to
the greatest extent thus far.
He goes on to say that as businesses go bust and expansion plans
are curtailed due to the increasing cost of capital and the reduced
availability of credit, supply will continue to fall. As a result,
the demand stimulus that governments are attempting to engineer
by increasing their own spending and by creating incentives for
additional private-sector spending will encounter inflationary
tendencies at lower levels of activity than before. At the same
time, there is a high probability that the money supply will
continue ramping upward at a fast pace due to the massive monetisation
of government debt that will be made necessary by the massive
planned increase in government spending.
Falling supplies of goods and services combined with rising money
supply is the ideal recipe for an increase in the general price
level. This "ideal recipe" is what we were talking
about in the 27th April Weekly Update, when we wrote: "...economic
weakness will not prevent a currency from losing its purchasing
power in response to substantial growth in its supply. In fact,
it's the other way round. The less stuff that gets produced by
the economy the greater will be the eventual decline in the currency's
purchasing power stemming from monetary inflation. Or, to put
it another way, real economic growth puts downward, not upward,
pressure on the general price level, so during periods when the
economy is weak there will be greater potential for increasing
currency supply to bring about higher prices (after the usual
'confusing' lag, of course)."
Other 'building blocks of generalised price inflation' mentioned
by Mr. Warburton include:
- While governments may avoid
an openly protectionist agenda, global trade is likely to suffer
because increases in government spending will be targeted to
benefit the locals and to not 'leak out' into the global economy.
This will tend to put upward pressure on goods and services prices
at the expense of asset prices.
- The public sector is notoriously
less efficient than the private sector, so as the public sector
becomes more involved in the provision of goods and services
the effects of inflation will become more apparent in the prices
of everyday items.
- With the unemployment rate
likely to remain in double digits for a long time there will
be no political mandate to "fight inflation" until
after the inflation threat has become substantial and blatantly
obvious to all.
Mr. Warburton's view is that
evidence of an inflation problem won't begin to emerge for at
least another 6 months. This is also our view. Our expectation
is that another DEFLATION scare will occur between now and when
the effects of inflation bubble to the surface, so there should
be no urgency to purchase inflation hedges. On the other hand,
inflation hedges will be a lot more expensive by the time an
inflation problem becomes obvious to all. Consequently, it would
be a good idea to scale into such positions over the coming 6
We continue to believe that gold will be the best hedge against
the problems to come. This is not because gold is always a good
hedge against monetary inflation, because it isn't. For example,
there have been many times when gold has fared poorly in response
to rapid money-supply growth. It is, instead, more appropriate
to think of gold as a hedge against government stupidity and
the negative economic effects of that stupidity, and rarely in
history have the governments of 'free' and developed countries
acted as stupidly as they are today. As a result of the way governments
are acting and have committed to act in the future, economic
and monetary conditions over the next few years are likely to
come together to create the ideal environment for gold-related
investments. Specifically, we are likely to get the combination
of rapid money-supply growth, economic weakness, a strong desire
by the public to increase its savings in terms of something stable,
low financial-market liquidity (liquidity and money are different
things), and, eventually, rising goods and services prices.
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