Without thinking, investors are following the path of least resistance, which is to return to the past and jump right back into paper assets such as stocks and bonds. This is clear when examining each bear market rally. Investors recently have gone back into tech stocks, especially Internet shares where manifestations of a manic bubble are apparent. They are helped in part by a giant spin machine that recycles every piece of bad news on the economy, corporate earnings and geopolitics in a favorable light. Authorities are trying to keep the sheep corralled on one side of the road and prevent them from seeing the greener pastures that lie yonder.

The movement in the markets right now is pure feelings and emotion. Investors are reacting to contagion, the idea that there will finally be a second-half recovery. The crowd in this case also includes Wall Street and fund managers who are falling prey to their own suggestions and hopes. The danger of the herd moving en masse is that it becomes susceptible to suggestion–which the authorities are only too happy to provide–and the Pollyanna belief in an eventual recovery. Moving en masse, the vast herd of investors are responding to their favorite cue: rising asset prices. The financial authorities are helping by providing the stimulus that comes from direct intervention and constant credit.

Credit Creators Hold The Strings

The point to understand is this: as long as authorities have the ability to create oceans of money, we will always have an inflationary trend or bubble that surfaces somewhere. When the stock market bubble burst, the money went into real estate and bonds creating bubbles in both asset classes. Now we have a trend where the dollar is depreciating rapidly, interest rates are at record lows, debt is climbing at all levels of society and the value of paper assets such as stocks and bonds are rising. This is unprecedented. For more than three decades now the world financial system has been operating without an anchor. No paper currency is linked or backed by gold. There has been no escape for investors, but to flee from one paper asset or currency to another. That is unless they understand what money is and isn’t.

Money in our present fiat system is simply credit. It isn’t issued by government. It is created by central banks. In the U.S., that means the Fed. At one time there was a limit to the amount of money that could be created, but today there are no limits.

The Fed, in the words of Ben Bernanke, has a wonderful invention that allows the Fed to create or destroy as much money as it chooses without restrictions or without limits.

Money in our present system is debt money. It is created out of thin air and distributed through the banking and financial system without limit.

 

The more authorities expand credit, the more credit will be required to sustain it. When money is created out of nothing and lent out at interest, there will never be enough money to repay all of that credit unless more credit is created. This point is demonstrated by viewing the charts on the left that show federal and household as well as the collective debt of the United States.

At some point, as history teaches us, all fiat currencies come to an end. In effect, they default. The U.S. did this on August 15, 1971. President Nixon defaulted on all gold payment obligations of the dollar to the rest of the world. Since that time we have been operating on a credit-based IOU system. The current system of money is backed by nothing more then the full faith and credit of our nation's Treasury. However all debt-based systems have limits. So far defaults have been postponed through the endless issuance of credit. There is a limit to debt. Money doesn’t grow on trees and the sky is not the limit. An eventual day of reckoning is approaching.

A Dismal Picture Ahead

Until that day of reckoning, the Fed will continue the pumping process and the dollar will continue to depreciate. Under the current environment of low savings and investment, low productivity and dismal profits, the economy will continue to weaken outside of housing. Housing is a special asset in its own unique bubble thanks to record low mortgage rates and inflating asset prices. Businesses will continue to downsize to achieve earnings objectives. That means unemployment will rise. As things worsen economically, the government will spend more money then it takes in and the Fed will pump more credit into the system. Gradually inflation will rear its ugly head. It is already starting to surface in the price of things we need; while deflation impacts the prices of the things we want downward. The price of housing is still soaring and the costs of services and energy is rising. Currently the money supply continues to expand at a rate faster than economic growth. Essentially, the Fed is monetizing debt by forcing interest rates down and the dollar continues to shrivel in purchasing power.

As things worsen economically, there will be a louder cry for even more government intervention. Since the 1930s more Americans have become increasingly dependent on government for part of their sustenance. The entitlement system has become engrained in the fabric of our economic life. Many Americans now identify their own interests with preservation and expansion of the entitlement system. In a recent political survey more Americans would prefer that the government expand entitlements and benefits rather than cut taxes. The very debt pyramid that you see in the charts above is directly attributable to these forces of redistribution. So expect the cry to get louder as the election gets closer. Politicians will make even larger promises–promises that can’t be paid for economically without incurring more debt, printing more money and raising more taxes.

Living on Dependent Means

This predilection for spending may soon come face to face with a harsh reality. America is living beyond its means and has become far too dependent on foreign capital. The U.S. has had to rely more on foreign capital since it became a debtor nation under President Reagan. Foreign capital finances our trade deficit and part of our budget deficit. As the Fed continues to hyperinflate and as the government continues to amass large quantities of debt, the credit worthiness of the United States may come into question. The loss in the dollar is eroding the value of foreign investments here in the U.S. Many are beginning to question the rise in debt levels and the erosion of the dollar's value. At some future point, foreign money may start exiting our system. The magnitude of our debt is staggering and may exceed our ability to repay it. If foreign investors ever doubt our solvency, an all-out capital flight will follow rapidly.

Blinded by a malfunctioning economic philosophy (Keynesianism) that has led us down this path, our politicians only know how to do one thing: spend money. In order to pay for more consumption, they will print, borrow, and tax. Although the Bush Administration has cut taxes, it is also increasing spending. Spending on the military and expanding entitlements under both Clinton and Bush has increased substantially over the last four years. The government's budget has gone from $1.8 trillion to $2.3 trillion, an increase in spending of $500 billion in just four short years.

This process continues under the headship of both parties. It doesn’t matter who controls the White House or Congress. Tax, print and spend has become embedded in our economic life. Government spending and government deficits will continue to expand and consume not only all of our own savings, but also the majority of the world’s saving as well. It will continue until the world says, "No!"

We are living well beyond our means and very few politicians have the courage to speak frankly to the American people. Instead, all they do is promise even more entitlements with money we don’t have. We are living in an era of big government and that government is going to get even bigger. All the government knows how to do is grow and perpetuate itself. This means more debt, more spending and further depreciation of the dollar. The world–and especially the United States–is awash in debt with the unlikelihood that this debt will ever get repaid. For investors investing in paper assets at this time could be extremely damaging to their economic health. For more than two decades, the government has transferred inflation to the financial system as it gave us two decades of appreciating paper assets. Now interest rates are at record lows and stock prices are at extreme valuation levels despite three years of declining asset prices. These paper assets now represent certificates of confiscation subject to asset deflation or depreciation.

The Day of Reckoning is at Hand

The world financial system is unraveling. After decades of credit expansion and currency debasement, inflation is about to revisit us and interest rates are set to rise. We will be facing inflation because inflation is strictly a monetary phenomenon. As long as central banks and governments can print money and supply the economy with an endless stream of credit, inflation will surface somewhere. Inflation will find its way in either asset classes or in the real economy in the form of higher wages and consumer prices. In the last two decades inflation has found an outlet in paper assets. That trend is changing and I believe that commodities are due to become "The Next Big Thing.”

We are at an inflexion point in history. It is a time when the investment tides change ever so subtlety that few investors notice it. It has been over two decades since the last bull market in commodities ended. It has been a long, long time since gold was at $800, silver at $50 or oil was at $40 dollars a barrel. During those two decades American investors became accustomed to declining interest rates, lower rates of inflation, declining commodity prices, a strong dollar and American preeminence around the globe. That was not the case when I began my career in the investment business in the late 1970s. American power–militarily and economically–was in decline. Stocks had been in a bear market since the late 60’s and inflation was seen everywhere in the real economy and especially in hard assets. Taxes and inflation were considered a scourge and not a blessing as they are viewed today. Now there is a greater call by the public to raise taxes to pay for more entitlements; while Wall Street calls for the Fed to inflate so that asset prices may levitate again.

A Catalyst for Change

We now have in place the major catalyst for a new investment theme to emerge. While central bankers reinflate the supply of money into the financial system, the markets will determine the ultimate destination. What isn’t apparent at the moment is that the investment game is about to change dramatically. Asset bubbles always lead to displacement of one asset class by another. The credit excesses that fueled the bubble created the opportunity to profit and speculate in the asset class that was inflated. As bubbles deflate, other bubbles replace them. Smart investors take profits out of inflating bubbles and redirect those profits into other assets that are cheaper. In this case the money has gone into real estate, which at this time is another asset inflating bubble that has yet to burst. In respect to real estate, it is not uncommon for prices to rise long after stock market bubbles deflate. This happened in the U.S. during the early 1930s, in Japan after the Nikkei’s fall in 1990 and now again in the U.S. after bursting the tech bubble in 2000.

What is clear from viewing the present circumstances in the U.S. is that the Fed–in order to ward off post-bubble deflation–will continue to flood the economy and financial markets with money. As to whether this money creation will lead to either deflation or inflation, I believe we will see both. Lower cost production coming from China will continue to exert deflationary pressures on manufacturing. In addition there will also be deflationary pressures coming from collapsing credit. Anything associated with credit, housing, autos, and other luxury goods or the things that “you want” will go down. As asset bubbles deflate, investors no longer have the means to buy what they want so the price of those items will deflate. There is also the possibility that government will inflict punitive taxes on luxury goods in a soak-the-rich-scheme. This happened in the last recession in the U.S. where a 10 percent surcharge tax was added to the price of luxury autos, yachts and airplanes. It nearly destroyed the boating and small aircraft industry in the U.S. (For further details and explanation of my deflation/inflation argument, please see the last four chapters of my Storm series. Another suggestion is to read Marc Faber’s new book “Tomorrow’s Gold“ for a more detailed explanation as to why both deflation and inflation can coexist at the same time.)

Even today’s prominent deflationist, Robert Prechter, acknowledges that inflation or hyperinflation may emerge in place of deflation. Two of Prechter’s barometers of coming inflation would be a declining dollar and a rise in the price of gold over $400 per ounce.

For the next theme to emerge and become prominently visible as well as obvious to all, the public must gradually lose confidence in paper. It has already begun with the shift to real estate as more investors feel secure with something tangible rather then the intangible and fleeting wealth of the stock market. As the value of the dollar continues to depreciate and as the Fed prints more money, public confidence will gradually begin to dissipate. A loss of confidence in the dollar has already begun in the international markets. Foreign investors who are financing our monster trade and current account deficit have already begun to diversify out of dollars. Central bankers have been the main force keeping the dollar from collapsing in an effort to keep their own currency from appreciating against the dollar.