Jan 9 2009 11:26AM
Keynesian Economics Works - Sometimes!
Washington has plunged full bore into Keynesian economics, based on the principle that government can increase spending to alleviate economic downturns, while ignoring the fact that Keynes said that we should decrease government spending to cool the economy.
The government is creating money and spending it or giving it away at a rate unprecedented in my long lifetime. But the problem is that the end result is not anticipated.
Let me tell you what I think will happen in 2009:
First, we will continue to plunge into a major deflation period which will be characterized as a “recession,” and later in the year as a “depression.” Deflation and inflation are always monetary phenomena.
Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s.
The government is creating money at a rate unprecedented in all of American History, with deflation and depression, driving their decisions, as politicians hate deflation. That is why they have been inflating the currency at varying rates for decades.
Now the Treasury and the Federal Reserve are pouring money into the economy at an unprecedented rate. Inflation is a monetary phenomenon caused by creating too much currency, and we are doing this like crazy.
But another factor is not very well understood, and that is that creating money isn’t necessarily inflationary at the moment of creation, because the money that has just been created is just sitting there. The banks have gotten the bailouts that improved their balance sheets and preserved their survival. But the money just sits there. The velocity of money is what really counts.
A dollar changing hands and paying for economic activity through the loan process at a high rate is inflationary. A dollar just sitting there is not. The banks have repaired their balance sheets and are just sitting on their cash.
Until they start lending again and people begin to put the money to work, it will not be inflationary. When the banks start lending money again and people start using it, and the velocity of money increases, then it will be inflationary. So this final element must eventually materialize.
Based on Keynesian economics, the government is suggesting “a little bit of hair of the dog that bit us,” which is an old English expression that says if you have a hangover, a little more liquor will help. Actually it only makes alcoholism worse.
Debt got us into this mess; people borrowing money they couldn’t afford to buy houses they couldn’t afford; credit-card debt is growing like crazy. People are borrowing to go to college who should perhaps be in a trade school, but they accumulate debt before they drop out. Consumers were borrowing against their houses in the bubble so they could buy more things.
In the meantime, we old stick-in-the-muds who refrain from debt have reduced our spending to less than we could earn. Debt caused the problem, and now the government is suggesting that their effort to create literally trillions of dollars is designed to give us more money to borrow and encourage us to spend it.
I remember on 9/11 when President Bush announced that “we should continue to borrow and spend or the terrorists have won.” Although he did most everything else right as far as terrorism is concerned, that was sheer madness.
Keynesian economics says “create the money, let people borrow it and spend. Consumer spending will trigger an active economy.” That’s true when you’re fighting deflation and recession. But the government, as usual, is engaging in overkill, and the amounts of money they are creating will not be just sitting there lifeless forever. Eventually the banks will lend, because if they don’t lend, they don’t make any money, and bankers are in the business of making money. So they can’t sit on their money forever out of fear. Fear will fade, and bankers will get back to their real business. When that happens, we are headed for the classic hyper-inflation.
I expect as much as a year of deflation while the government continues to pump money into the banks and tries to encourage them to loan it into circulation because that is the way government gets the money into people’s hands and gets them spending.
Our whole sick economy is based on borrowing and spending. I’m sorry, I won’t do that, and I won’t recommend that my subscribers do that.
“But,” I hear you say, “If everyone just stopped borrowing and buying and just saved their money, it would create a depression.”
That’s probably true, but everyone won’t do it. My subscribers, as numerous as they are, are a very small percentage of the population. So they will control their spending, reduce their debt, and prepare for the next opportunity. That opportunity will be inflation. Inflation will create opportunity for the savvy saver and investor.
In the Meantime: Invest for Deflation?
I’m in untrodden territory. I know exactly how to invest in inflation. I’ve been planning for inflation, off and on, for almost 32 years.
But now this is a deflationary period, which will soon bloom into a runaway inflation. So how should you invest in the interim?
Inflation and deflation are monetary phenomena. Inflation is caused by increasing the supply of fiat currency, and consumer prices respond to the dilution of the currency.
But what should you do now when you are faced with the opposite – deflation? Deflation means that either the amount of currency has shrunk, or as in the present, the velocity of money is down, with banks sitting on money without putting it into circulation. That is about the same as reducing the money supply.
While the government is now trying to inflate the currency to fight deflation, we are fighting the financial consequences of falling prices. So what should you do with your money?
During deflation, prices will inevitably fall. That means the value of currency will increase. Whereas with inflation the last thing you want is an inflating currency steadily losing value, with deflation, the exact opposite is true.
One of your best investments for a little while will be cash. The first thing you can do is get out of debt and put your money short-term into dollar-denominated investments, because this deflation will be a short-term phenomenon.
Where is a safe place for your money? I suggest a money-market fund or a savings and loan, as they are less damaged than the commercial banks and the banking system. Keep a close eye on it because this deflationary period is transitory. We know it will morph into inflation once money starts circulating in the economy. Your most profitable bet might be to buy inflation hedges now while they are cheap and wait patiently, perhaps as much as a year. At the very least you would be in cash, getting ready.
The traditional inflation hedge has always been precious metals. They have been moving recently.
Silver, which has been as low as $9.20 per ounce, is now around $11.40 and will go much higher in anticipation of the coming inflation.
Perhaps the safest way to invest in gold and silver now, with the real shortage of bullion and a wait as long as three months to get your metal from the dealer, is to invest in the Central Fund of Canada, Ltd. (CEF) listed on the American Stock Exchange. When you buy shares of CEF, unlike most mutual funds, they don’t buy stock, they buy gold and silver bullion – one ounce of gold for every 50 ounces of silver.
I have been following them closely; they have been buying the appropriate bullion. That way you will be covered by both gold and silver.
When everything else in the world was crashing (stocks, real estate, etc.), gold held up pretty well. It is down maybe five or six percent when the stock market is down 40 or 50 percent.
Silver is due for an explosive up-move. If you have some, hang onto it. Any additional money should be put it into CEF.
The current deflation with falling gas prices and falling prices at the supermarket is a transitory event. Consistent with my strategy to make long-term calls, you can invest for the future. This means inflation hedges. Concentrate on CEF.
If you have $10,000 lying around, I would keep at least $4,000 in cash. I would pay off all my debts as fast as possible, leaving your cash available to be moved into inflation hedges when inflation is reborn.
That is the best strategy for this transitory period, while planning for the future boom in inflation hedges.
By Howard Ruff
The Ruff Times
Howard J. Ruff, the legendary author and financial advisor, has re-edited and re-issued his 1978 mega best seller, How to Prosper During the Coming Bad Years, still the biggest-selling financial book in history, with 2.6 million copies in print. He is founder and editor of The Ruff Times financial newsletter. This article is from The Ruff Times of January 9, 2009.
The newsletter is much more comprehensive and deals with a broad spectrum of middle-class financial issues and includes an Investment Menu from which you can build your portfolio. (You can learn about it here). The Ruff Times has served more than 600,000 subscribers – more than any financial-advisory newsletter in the world. His updated and revised book, How to Prosper During the Coming Bad Years in the 21st Century, is in book stores or at www.rufftimes.com. You can get it free when you subscribe to The Ruff Times, or if you buy the book at your favorite bookstore, you can deduct $10 from the subscription price.