Looking For The Next Bubble
Inflation is Everywhere

In the last 12 months the price of oil has risen from under $24 to as high $35 a barrel. It is currently at $32.47. The price of soybeans has gone up more dramatically from a low of $5.09 a bushel to today’s price of $8.39. Copper prices have gone parabolic, rising from $73 to $118.70. Platinum prices are also rising sharply. They have jumped from $670 to $834. The CRB Index, made up of 17 different commodities from metals, soft goods, grains, energy and livestock is up even more. Having hit a nadir in October of 2001, the index is up 42%. Commodity prices from energy, metals, and grains have been on an upward track for the last two years.

On Main Street the average Joe is finding it harder and harder to maintain his current standard of living. More Americans are going deeper into debt each month to pay their bills. They are making use of extraordinary low interest rates on home mortgages to extract equity out of their homes to make ends meet. Households are also using credit cards to supplement spending each month as personal income and job growth has not kept pace with the rise in prices. The public is told that inflation rates are extremely low, but each month they must reconcile the difference between what they are told and the higher billing statements they receive each month.

Grocery prices at the supermarkets are up over 50% over the last three years. Service costs from the local dentist and the family doctor to the local plumber are all up double digits. Medical premiums are starting to skyrocket again and the cost of sending junior to college requires more equity extraction and second mortgages to pay for tuition. On a day-to-day basis, the cost of just about everything the family needs keeps going up. Yet, Washington and Wall Street keep telling households that inflation rates remain low. They are low because government statisticians have removed price increases from the cost of most goods by counting quality improvements as price reductions.

There is no inflation on paper, but it visible everywhere you look on the price of things you need. Unions are striking for higher wages and benefits. Supermarket workers in California have been on strike for over 4 months protesting their having to share in the cost of medical care. Employers are finding it difficult to shoulder the burden of healthcare costs and are forced to require employees to share in part of the costs. The financial press keeps talking about low inflation, but employers and employees face rising prices. At this point it is either cut benefits or start raising prices--prices of things that are never counted in the monthly inflation statistics. There is a growing gap between what the average American has to spend each month in order to live and what is reported in the financial press as inflation. When prices get high enough, politicians will start looking for demons to castigate when the real inflation demon is government.

What Causes Inflation?

Ask the average person on the street or query financial professionals and you’ll find very little understanding of where inflation comes from or where it originates. Most individuals define inflation as rising prices. They speak about symptoms rather than cause. If inflation is simply rising prices, then what causes it? You’ll find that inflation is attributed to many sources--none of which are accurate. The common misperceptions by policymakers and the public is that inflation has three principal causes:

1. Cost-push inflation as a result of arbitrary demands of labor unions.

2. Profit-push inflation resulting from the greed of businesses raising prices.

3. Crisis-driven inflation resulting from acts of God or weather.

The general belief that inflation is the result of something other than its true cause makes it hard to understand and resolve. Most people believe that inflation is conspiratorial such as OPEC raising prices, businessmen wanting to make higher profits, or greedy unions looking to enhance worker benefits and pay. Somehow inflation has become an evil caused by greedy individuals and businesses. To most people inflation has become a causeless phenomenon inexplicable and born of ill will.

Let's Get This Straight

Definition
However, there is irrefutable evidence that government is the source of all inflation. An undue increase in the quantity of money is what stands behind a rise in prices. The source of all money or credit is government. Thinking of inflation only in terms of rising prices is similar to looking at the symptoms of a disease rather than the disease itself. A more exact definition of inflation would be an increase in the quantity of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level, an increase in the quantity of money caused by government.

You will notice that this definition doesn’t say anything about cost-push, profit-push, or crisis-push inflation. It simply states that the supply of money expands leading to higher prices. It is the expansion of money and not rising prices that leads to inflation. This also points to the real cause behind inflation as government intervention in the economy and financial system by expanding the supply of money and credit in the system.

Formula
When the government increases the supply of money and credit in the economy, it increases demand for goods leading to higher prices. Higher demand or lower supply is the only conceivable cause of higher prices. It can be demonstrated by the formula below:

          P =  Dc
                 Sc

This theory states that the general level of consumer prices equals the aggregate demand for goods divided by the aggregate supply of consumer goods. Therefore, the resulting rise in consumer prices is a function of a numerator (demand) divided by a denominator (supply). If there is a resulting change in price, it the result of either a rise or fall in demand or a rise or fall in supply.

Government Variables
When the government or actions by the Fed increase the quantity of money in the economy, the demand for consumer goods is increased through the supply of new money being spent and re-spent within the economy. Since there is greater demand than supply, the price of most goods will go up. In the U.S. the rise in prices has not been commensurate with the supply of money and credit in the system because of imported goods. The trade deficit is a function of increased demand being satisfied by increasing imports. If the U.S. economy was self sustaining and self sufficient and able to meet all consumer demand, prices would have risen more substantially. Goods inflation has been somewhat tame only because excess demand in the U.S. has been satisfied through imported goods. Without the ability to import goods, prices would have been driven dramatically higher.

However, goods inflation eventually surfaces because a country with an expanding trade deficit eventually experiences a declining currency which raises the costs of imported goods. The graphs below of the money supply, budget deficit, trade deficit, and declining dollar are interrelated.

www.economagic.com	www.stockcharts.com

They are all attributable to an expansion of money and credit in the economy and financial system. Inflation and higher interest rates are often associated with government deficits. If these deficits are financed by selling bonds to the public or to institutions, there is no increase in the quantity of money. The existing supply of money stock is simply diverted from private to public consumption. Government budget deficits become inflationary when they are financed through new and additional money. This occurs when the Federal Reserve purchases government debt. In effect this is known as monetization. The full inflationary impact of the U.S.’ growing budget deficit has been mitigated by the purchase of government securities by foreign central banks and foreign financial institutions. The Fed hasn’t had to resort to debt monetization because of direct foreign intervention in the currency markets.

Foreign Variables
As shown in the chart below, foreign intervention in the currency markets through direct purchases of U.S. Treasuries has prevented the full inflationary impact of government deficits from materializing. This enables the U.S. government to export its inflation. Japan and China’s central banks purchased $300 billion in U.S. Treasuries last year.

This year that figure could go much higher. Japan’s Ministry of Finance has set aside $575 billion for dollar purchases, while China has allocated $150 billion. The two central banks combined have the ability of buying up to $725 billion in Treasury debt. This could produce a sharp reduction in the outstanding stock of federal government debt in circulation leading to lower interest rates. Intervention of this magnitude could give us a bond rally at a time when everyone is expecting higher interest rates.

In a Nutshell
The point to understand is that the full inflationary impact of excess money and credit in the U.S. has been partially mitigated by foreign intervention. The U.S. consumer increases consumption as a result of taking on more debt. This increase in demand side consumption is made possible through cheap and abundant credit (inflationary). Since the U.S. economy is unable to meet all of consumer demand, excess demand is made up through foreign imports. This also lessens the impact of inflation since foreign goods help meet excess demand, keeping a lid on prices. Foreign goods can also be manufactured at a lower price.

When new money and credit are created, they enter the system through various avenues. The money and credit can actually be spent on domestic goods and services, foreign goods and services or financial assets leading to higher asset prices. Goods inflation and asset inflation are really two different sides of the same coin.

The New Century Inflation in Financial Markets

Unlike the inflationary 70’s when money and credit went into the real economy, since the early 80’s and accelerating into the 90’s, this new century money has been increasingly channeled into financial assets, creating asset inflation. This was visible first in the equity bubble of the late 90’s. New money created by the Fed to fight off a collapsing stock market bubble, recession, and a major terrorist attack led to additional bubbles in the bond market, mortgage and housing market, and finally in excess consumption in this new century. Rising bond, stock and real estate prices are simply another form of inflation that has been created through excess credit and money added to our financial system. All of these related financial bubbles are what is keeping the U.S. economy going. The fact that P/E multiples on the major indexes are now at 96 on the NASDAQ, 23 on the S&P 500, and 21 on the Dow Industrials is another manifestation of inflation. Just as increased demand raises the price of goods, excess demand for securities raises their price. In this case, the price of bonds goes up lowering their yield and the price of stocks goes up leading to higher market multiples.

The U.S. economy has morphed from a manufacturing economy to a service economy and finally to a financial economy consisting of multiple asset bubbles. It has been one reason why job growth in this latest recovery has been so anemic. Money and credit are no longer going into the real economy in the form of new investment in plant and equipment which would create new jobs. Instead credit and money creation is fed into the financial markets leading to multiple asset bubbles in the stock and bond markets and real estate.

There's Only One Way Out

Given this new aspect of America’s economic life and the fact that the Fed and the government have no inclination to live within their means or curtail rampant money creation, new asset bubbles are going to be inevitable. While one asset bubble may deflate as was the case in the NASDAQ and tech stocks from 2000-2002, other asset bubbles in bonds, mortgages, and real estate took its place. The only thing that can force a government to balance its budget or prevent a central bank from issuing endless money is to limit the power to create money. That is possible only when the money unit of a country is backed by gold and silver. With gold and silver backing the monetary unit, the government is totally dependent on the taxpayer for every dime it spends. Tax rates would be far higher in order to support the government’s voracious appetite for spending. It citizens might not be as willing to accept tax rates that border on slavery.

Inflation is nothing more than an extension of tax rates through other means. Inflation then is a hidden tax. Deficits and taxes are really the twin pillars of the welfare state. It gives the appearance that government benefits are free, making government out to be a benevolent Santa Claus.

What We Can Expect

Printing Presses in Overdrive
Since governments are addicted to spending money and central banks exist only to create new money and credit, additional asset bubbles are inevitable. Since the U.S. economy is now a financially-driven economy, we can expect more money and credit to find its way into other asset classes. In a financial economy such as the U.S. where a disproportionate share of capital is invested in the capital markets, additional credit leads to speculative bubbles. Greenspan/Bernanke & Co. have argued that the Fed has unlimited ability to create unlimited amounts of new money (helicopter money) and intervene endlessly in the financial markets to support asset prices of stocks, bonds, or real estate. Therefore as long as this ability isn’t curtailed through constitutional means or through gold and silver backing, the Fed can create sufficient quantities of money to bail out any financial entity be it a bank, hedge fund, or government enterprise such as Fannie and Freddie.

Currency Depreciation
What we’ve seen so far is financial asset inflation in the form of rising stock and bond prices. More recently this asset inflation has spilled over into the housing markets. Looking at the rise in commodity prices and the cost of goods and services, it appears that money and credit are feeding into hard goods. Judging the policy decisions of Asian, European, and especially the U.S. central bank to expand the supply of money and credit, further currency depreciation is inevitable globally.

Asset Bubbles in Natural Resources
What I believe that we will see later this year is that the price of gold and silver will begin to appreciate against most major currencies and not just the U.S. dollar. Therefore if one views the current rate of monetary debasement, I believe the next asset bubbles will take place in the natural resource sector. Commodities and especially the precious metals are only in the beginning stages of a new bull market. The charts of the CRB Index, energy and precious metals are tell tale signs of the coming boom in natural resources. We are close to the second phase of the boom when institutions recognize that they have been fooled.

Higher Interest Rates
The bond and currency markets are waking up to the fact that they have been fooled. A downward adjustment in the exchange rate of the dollar is the next big crisis that will shake the financial markets this year. Already, Pimco’s Bill Gross the manager of the world’s largest fixed income fund has indicated he may no longer be as accommodating. In his recent Investment Outlook “The Last Vigilante” states:

”My point is that at some point on this seeming never ending ascent of debt/GDP, someone will say “no mas”. Maybe it’ll be Pimco and Pimco think-alikes; maybe it’ll be foreign holders of bonds grown tired of currency/inflationary erosion of principal; maybe it’ll be risk takers in high yield/ emerging market/ levered hedge funds scared to death from a future LTCM crisis. Hard to tell, but I’m telling you it’ll will happen, helicopter or no helicopter and with it will come an economic slowdown/recession unseen since at least the early 1980s when Volcker began his vigil. High Noon”. [1]

In addition to shortening maturities anticipating higher interest rates, Pimco has also started a commodity fund.  Want to know where the next bubble is surfacing, look seriously at “things” or commodities. The bubble has only begun to inflate in what looks like a decade-long or longer bull market.

Today’s Markets

We’re off to the start of what could be another losing week for equities with the possibility of high drama this week on Capital Hill. Mr. Greenspan testifies before the House Financial Services Committee on Wednesday and before the Senate Banking Committee on Thursday. Friday the U.S. releases trade deficit figures for the month of December. Experts are forecasting that the trade deficit widened to $40 billion in the month of December.

The financial markets will be dissecting every word the Chairman makes for an elaboration or clue to future Fed intentions. The Fed has indicated that monetary looseness won’t last forever. Just how long it will last is a big question that the financial markets will like answered.

In trading today shares of oil services, integrated oils, gold and biotechnology stocks were the big winners. The shares of the energy sector rose despite downgrades by analysts.

The dollar had meager gains against most currencies. Meanwhile gold futures closed at a 8-session high. The price of gold rose $3.20 to close at $407.40 on ounce on the New York Mercantile Exchange. Silver jumped $.15 to finish at $6.428. Oil prices rose $.35 to close out the session at $32.83.

Volume on the NYSE was 1.3 billion and 1.7 billion on the NASDAQ. Market breath was positive by 18-14 on the Big Board and was negative by 18-14 on the NASDAQ.

Jim Puplava

© 2004 Jim Puplava
February 9, 2004

Artwork courtesy of Antonio Garcia, Ohio State University
Chart Courtesy: www.ino.com www.stockcharts.com
Foreign Assets: The International Bank Credit Analyst, February 2004
[1] Bill Gross, Pimco Investment Outlook, February 2004, p.5