December 2, 2011
Off To The Races
“Of all contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money.”
–Daniel Webster
A Basic Guiding Principle
The developed world has become so heavily indebted there appear to be only two ways out. One option is outright default. Debts are simply written down – or completely off. Outright default can be straightforward, swift, brutal, and cleansing.
The other option is another form of default. It’s called inflation. The printing/devaluation by the government of the currency it pays its debts back in. Default via the inflation mechanism can be long and drawn out — like a Band-Aid being pulled off slowly. It can also be surreptitious. Often the population either does not notice, or just gets used to (like a frog being boiled slowly in pot of water) the deliberate, steady erosion of the purchasing power of the currency their savings are denominated in. That is until inflation hits its final (you pick) Wiemaresque/Zimbabwean/Argentinian 2000’s/Brazilian 1990’s/U.S. 1970’s/etc., etc., phase.
Outright default by countries can cause a large-scale deflationary contraction of the money supply – potentially leading to a stronger currency since there is less of it to go around. Those whose savings are denominated in the currency tend to be rewarded – and those who are forced to pay back their debts with stronger money tend to be punished.
Default by inflation (government money printing) often goes hand in hand with anexpanding money supply. This generally leads to a weaker currency since there is more of it in circulation. Savers are typically punished. Debtors generally benefit since inflation dilutes the value of the currency they must pay their debt back in.
So, operating under the basic guiding principle that debtors are punished by a stronger currency and benefit from a debased currency – take a look at the chart below of the U.S. National Debt. Then ask yourself where you think U.S. monetary policy is really headed. Towards a truly stronger Dollar (relative to itself not other currencies) – or a Dollar far more debased?
And That’s Why…
I believe many developed nations are so hopelessly indebted they will default via inflation. It’s my opinion they fully intend to debase their currencies despite the political rhetoric. An outright default and its corresponding deflationary monetary contraction tends to get politicians unelected (cutting entitlements has a habit of causing the same thing) – and makes it much harder to pay back the national debt with a currency truly worth more. Nobody wants to be Herbert Hoover. Politicians are inclined instead to cite FDR (who’s policies I believe dragged out the Great Depression). And in an outright/non-inflationary default – where would the money come from to bail out big-banks making bad investment decisions?
Blink
That said, recently it seemed governments and central banks were about to drop the money-printing ball. European nations struggled to sell their bonds/finance their debt. Germany could not even get bids for 35% of their 10-year bonds offered for sale.[1] Yet European governments and central banks seemingly dithered as major financial institutions approached the brink. A deflationary collapse seemed increasingly likely.
And that’s why the November 30th move by the Fed, ECB, and central banks of Canada, Switzerland, Japan and the U.K. to lower the cost of emergency dollar loans to banks outside the U.S.[2] was, in my opinion, monumental. While I believe in no way will it resolve the European banking fiasco (far from it) – I see it as a major “blink” moment. I’ve always believed governments and central banks would continue to print to make debt repayment easier – and to bail out large banks. That said, we seem to have approached a critical juncture. When push came to shove the Fed and other central banks stepped in. They showed the hand I’ve always thought they were playing. They were not going to allow a European (and correlated U.S.) banking disaster to occur.
Thus, I believe the first steps in the next round of large-scale global central bank money printing has begun. Germany is becoming increasingly isolated and I believe could very well be forced to cave on the Euro-money-printing issue. I also see an ever-increasing likelihood of large-scale IMF intervention/money printing on the horizon (with U.S. contributions of course out of thin air).
Seemingly off to the races. We plan accordingly – and carefully.
As always, I maintain my positive outlook. That outlook is based on my belief a bear market in one thing is often a bull market in another.
As we enter this critical time – now, more than ever – I believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.
Sincerely,
Stephan R. Ernharth, JD
Vice President
Ernharth Group
www.ernharth.com
Go to www.ernharth.com/economic-
[1]Bloomberg, “German Auction ‘Disaster’ Stirs Crisis Concern” November 23, 2011
[2] Bloomberg, “Fed Dollar-Funding Cut Shows Limits of Action on Europe” December 1, 2011
