Inflation, Interest Rates and Financial Armageddon! What could be more fun? Your thoughts get aired (and questions get answered) as we dip into the mailbag...

"Actions are sometimes performed in a masterly and most cunning way, while the direction of the actions is deranged and dependent on various morbid impressions – it’s like a dream."
– Fyodor Dostoyevsky, Crime and Punishment

Last week’s musings on organized crime and double-digit interest rates brought forth an outpouring of intelligent responses. Many thanks to all of you who shared your thoughts, questions and stories.

As usual, we can only hope to reprint a small fraction of your worthy replies – but we appreciate every single one. So let’s dig into a few...

When double digit inflation didn't work, Nixon simply froze prices and wages. Then the next guy in the House had to deal with it.
– TD Reader TJO

Actually, that little ruse worked pretty good for ol’ Tricky Dick...

The overriding goal of the Nixon White House was to win reelection in 1972. To that end, White House staffers leaned hard on Arthur Burns, the chairman of the Federal Reserve at the time, to make sure that easy money would lead to full employment in time for voting day. Nixon’s goons even planted fictitious stories and rumors in the press – a “shot across the Fed Chairman’s bow” one White House aide called it – in order to pressure Burns into playing ball.

Nixon announced price controls in the fall of 1971 because he knew the monetary juice was coming, courtesy of Fed Chairman Burns. His logic was that things would look pretty good come election day, what with wages rising on an easy money tide and raw materials prices held in check.

And Nixon was right. 1972 turned out to be a good year, helping him win in a landslide. Of course, 1973 then turned out to be a horrible year, with worse still to come... but so what? It was all about the election. Politicians love robbing Peter to pay Paul, especially when Paul doesn’t even know ‘til years down the road.

I wonder if Von Mises was writing at a time when he could imagine a global economy . . . since we're not going to be returning to a barter system anytime in the near future, what happens if ALL the national currencies are going through the same issues? Wouldn't investors resort to the most stable, least impacted, most important of all the bad choices out there?

...If the US was alone in this financial crisis, the Austrian school sounds like it would be a perfect road map. But with all of Europe. China, Japan, Russia, not to mention the 2nd and 3rd world countries affected equally – if not worse, isn't the real question something like: which sinking ship has the most seaworthy life boats?
– TD Reader Thea M.

Well, we’ve actually had a global economy for centuries. Think back to the far-flung British Empire, or the great Taipans of old who opened up new trading routes between East and West.

Your point is well taken though. This crisis is global, not just America-centric. All countries, and all currencies, stand to be deeply affected. And no currency whose intrinsic value is ultimately determined by politicians and a printing press could be considered truly safe. (Though some are certainly far more “seaworthy” than others.)

So where do you go? What do you do? I’ve actually done a lot of thinking on that very subject. In fact, I think I have a pretty strong sense of what the next world reserve currency is going to look like... that is to say, what will wind up replacing the dollar as the lynchpin of the global economic system in the 21st century.

I can’t dive into that subject right now for two reasons. One, because it would take a heck of a lot of explaining and background detail... and two, because I plan on exploring this idea extensively at the upcoming Taipan Global Opportunities Summit, “Finding Wealth in the Post-Dollar World.”

At the summit, I will lay out my carefully researched case, piece by piece, for what the “next” world reserve currency will be... and why... and how to approach the numerous trading and investing opportunities that will be created by this massive sea change.

It’s a pretty damn big topic. I hope you can make it to the Intercontinental (on Chicago’s “Magnificent Mile”) on August 13th and 14th. If you do make it out, you’ll hear from not just me of course, but all the other members of the Taipan brain trust.

At the last Taipan conference in San Francisco, one of the conference sponsors – who has probably been to dozens if not hundreds of these things – said it was maybe one of the best he’s ever been to. Anyway, enough shameless plugging... if we see you we see you. You can find more details on the Taipan Global Opportunity Summit here.

My name is mark s___ and after being a commodities trader for 19 years, I gave it all up and moved to Jamaica 4 years ago. I started an organic fruit farm knowing that in the depression that was coming, food and energy will be the two constants that will befuddle and remain irritatingly strong.

Ever since I heard the sentence "we have reached a new paradigm" back in '98, I knew it was over. There is nothing new in the heavens or the earth and mans greed is the constant that keeps the cycle moving.

Although I have heard of Von Mises and read numerous writings and referrals to him during my trading days, the quote in your letter staggered me. There it is - in a nutshell - what I have been feeling and trying to express all these years - in a nutshell. Make no mistake - you are 100% correct - we are well down the path. Can you believe they sell us this [quantitative] easing as legitimate?

...Along the lines of your double digit interest rates argument is gold. I am the biggest gold bug there is- but the closet feels awful crowded lately. I started buying at 323$ and added on big to 400$. I talked blue in the face to every trader friend and relative - I became a broken record - but now... It’s everywhere... I mean everywhere. It makes me truly feel the elevator is about to fall the next deflationary floor. This will be the one that makes people realize their standard of living is at stake. The dollar will then fall exactly according to the little outline you laid out - but first this deflationary plug must be pulled which will empty the drain.

I read your article many times over today - the relevance wasn't in the journey - but in the certainty of the destination. Thank you for the clarity.

– TD Reader Mark S.

Wholly agree on the “crowded closet” analogy with gold. Last week I talked a little about “the mountain and the valley.” On our way to the mountain, we must first pass through the fog-covered valley. Investors can focus on the mountain and just hang on tight, but traders, who are much more active in the valley, want to be aware of the profit opportunity not just with big trends, but with big countertrends too.

In the raging gold bull market of the 1970s, for example, I believe there was at least one 50% correction that took place well after the gold bull market started, but well before it peaked at the ultimate 1980 highs.

We are going to have some volatile times ahead of us, particularly because of the yin-yang nature of the whole inflation/deflation dilemma. Ironically, it could well be the icy-fear grip of new a deflationary death spiral... the new threat of killer deflation staring us in the face... that leads the Federal Reserve to “go nuclear” in its money printing efforts.

Then, too, it’s possible that we skip straight to inflation – a wholly feasible event based on a rapid “loss of faith” scenario leading to mass dumping of U.S. Treasuries. The time frames remain unknown, and events move fast. But that’s why it’s a great time to be a trader – and why I find myself immersed in hundreds of charts and the content equivalent of seven or eight newspapers every single day...

All you say seems to make sense, but please explain why "Stagflation" cannot take place. I lived thru that: the value of the dollar going down, down, down; interest rates going up, up, up; wage's in number of dollars going up, but never enough to keep up; and prices going up, up, up.
But you are correct, it will kill the patient, eventually! Not at the beginning.

– TD Reader James M.

Oh, it can certainly take place. Let me be clear, I’m not ruling out stagflation by any stretch here.

In fact, the Fed’s need to hold down interest rates could actually wind up creating stagflation... fueling it, making it even stronger.

It works like this. As the government borrows even more and the Fed prints even more, people start to lose faith in the currency. This, in turn, creates inflation – especially in the price of things like energy, raw materials and imported goods. But at the same time, it’s possible that wages can stay low, or not rise fast enough, because the economy is weak and workers have very little pricing power. That is a recipe for stagflation.

The thing is, if the Federal Reserve is forced to hold down interest rates – in order to keep them from killing the economy – that just makes the stagflation scenario even worse. The dollar gets cheaper... the price of raw materials and real goods gets more expensive... and a debt-burdened populace finds it even harder to make ends meet.

So, yes. It could easily be stagflation city before all is said and done... and the Fed’s emergency actions to hold down interest rates could make that all the more true.

One item you forgot to mention is the law of supply and demand. Not even the government or the central bankers have repealed that law. How do you sell dollar denominated debt when the expectation is for a decreased value of the dollar from inflation? You have to raise the return to create the demand for that debt. How do you do that except for increased interest rates? Government and central bankers can only manipulate market forces for a limited period of time before market forces (Supply and demand) prevail.

– TD Reader J. Neil M.

Actually, Ben Bernanke really has repealed the laws of supply and demand! He bragged about it in a speech in 2002 called “Deflation: Making Sure ‘It’ Doesn’t Happen Here.”

You can read the speech yourself right off the Federal Reserve’s Web site. Or, to avoid wading through all that text, here’s the “money” quote: “Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

I know I know, that’s not really what you meant. You’re saying that if the Fed prints out trillions of dollars nobody wants, then the reality of supply and demand will kick in and the value of the dollar goes to hell. And this is true.

But that’s why it’s important to understand we are talking about the ultimate endgame here. If things get bad enough to threaten debt-fueled implosion, the Fed will only have two choices, one of which isn’t really a choice:

• Let interest rates rise high enough to precipitate total economic collapse.
• Keep interest rates from rising by purchasing all the bonds being sold (with printed dollars).

So if China and Japan hypothetically got together and said, “Hey guys, we’ve decided to jointly dump $1 trillion worth of Treasuries on the market,” then the Fed could do one of two things. They could shrug and let skyrocketing long-term rates crush the U.S. economy like a snail shell under a truck tire... or they could trade out that $1 trillion worth of abandoned debt for $1 trillion worth of cash in one big monopoly swap. Hyperinflation might be the result, but it would be a “least bad alternative” in comparison to violent economic death for the U.S. economy.

...The Fed is theoretically independent. It’s conceivable that if confronted with that choice, it would opt for saving the dollar (i.e., by refusing to print more of them). In that event, interest rates could easily reach double digits.

While I wouldn’t bet on the Fed making that choice, it may not be as unlikely as it first appears. The Fed must recognize that by continuing to monetize the debt it runs the risk of a dollar collapse, which in turn could have a disastrous impact on the economy. In short, by trying to save the economy, the Fed could end up losing both the dollar and the economy.

The basic instinct of all organisms is self-preservation. If the Fed’s policies bring about hyperinflation, it’s probably finished as an institution. If it ruins the economy but preserves the dollar, it can always argue that given the no-win situation it faced it made the right choice.

– TD Reader David S.

A very intriguing point – albeit one that hinges on the word “theoretically.”

How independent is the Fed really and truly? And not just in government terms, but private sector terms. Ben Bernanke has many high-powered friends in the academic world... friends who manage tens of billions of dollars for Ivy League institutions like Harvard, Princeton and Yale. The canyons of Wall Street are also far better served by inflationary policies than deflationary ones.

The dirty little secret behind most forms of public service is that the real payoff comes when you go back to the private world. This is true for the Fed too. Were the Fed to deliberately embrace a deflationary policy, it would in effect save itself by shooting its friends. That might make sense from an institutional point of view, but not from the perspective of the men and women looking for private sector paydays once their government stint is done.

Then, too, there is the question of Congress. Remember, we are talking about real “end game” type stuff here. Were the Fed seen as sacrificing the American economy for the sake of its own reputation – and if the economy were experiencing deflationary death throes in result – Congress would go stark raving nuts. It wouldn’t be hard at all to imagine a wave of populist rhetoric drowning the Fed’s independence in result. Then we could enjoy the privilege of Nancy Pelosi and Barney Frank setting our monetary policy.

Well dang. We’re running way over (in terms of length) and still haven’t dug into the organized crime responses. Looks like we’ll have to save those for next week... for those of you in the states, Happy Independence Day (a few days early) and enjoy the long holiday weekend!

Other Related Topics: Gold Investments , Interest rates , Justice Litle , Macro Trader , Mafia

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