Economists and the economy
July 2, 2004
The Wall Street Journal released its Semiannual Economic
Forecasting Survey for the second half of 2004 yesterday. In summary,
economists see better times ahead and are not concerned that rising
interest rates or inflation are going to crash the party. They expect
economic growth to increase and unemployment to decrease.
Sixty percent of those surveyed see inflationary pressures
dissipating during the balance of the year. More than half blame
the increase in inflation on higher energy and commodity prices,
yet only four percent believe that weakness in the dollar had anything
to do with the inflation. They are the only ones that realize both
energy and commodity prices are up (in US dollars) predominantly
as a result of the decline in the dollar. It makes you wonder about
the other ninety-six percent.
When the dollar declines on foreign currency markets
anything the US imports, or anything that is priced on world markets,
such as oil, copper, nickel, gold, etc., increases in dollar-terms.
Not only is it intuitive that commodity prices increase when the
dollar declines, it is possible to show statistically that the decline
in the dollar has played the leading role in the increase of almost
If inflation is increasing as a result of higher energy
and commodity prices then the underlying reason for the increase
in inflation has really been due to weakness in the dollar.
Let’s be clear about what inflation really is.
Nowadays inflation is defined as a general increase in prices, and
it’s typically measured by the increase in prices of a basket
of consumer goods; hence the Consumer Price Index. But if you still
have an old dictionary handy, you’ll see that inflation used
to be defined as an increase in the supply of money. Prices rise
as a result of an increase in the money supply, but by changing
the official definition of the word, economists have confused the
issue and managed to confuse the majority of people, including themselves.
At its root, inflation is an increase in the supply
of money. As the amount of dollars increase the value of every existing
dollar decreases so that an increase in the supply of dollars causes
a general increase in prices of goods.
The broadest measure of money supply in the United
States is M3. M3 has increased by an average of 7.93% per year since
2000. Had all else been equal, we should have seen an almost eight
percent annual increase in prices. Yet the average increase in the
CPI (Consumer Price Index) has been only 2.1% since 2000; why has
it not been closer to eight?
The application of hedonic calculations (yes, hedonic
is an official economic term: it’s when the intrinsic quality
of an item is taken into account when evaluating its price) to the
CPI has rendered the Index dubious at best. I would suggest you
check your monthly grocery bill and estimate by how much it has
increased since 2000. According to the increase in money supply
the same groceries you bought in 2000 should cost you about thirty-six
percent more now, and according to the CPI they should cost less
than nine percent more. I suspect you’ll find the truth somewhere
in between, but much closer to thirty-six percent than two percent.
Other than a decrease in money supply, circumstances
within the economy could cause a general decrease in prices. Let’s
take the reversal of the wealth effect as an example.
During the Nineties US consumers went on a spending
binge and bought all they could. When they couldn’t buy any
more they borrowed money and bought some more because they felt
wealthy: they were making money in the stock market, in the bond
market and in real estate. This is called the wealth effect.
I mentioned (in previous columns) the detrimental
impact higher interest rates and a lower dollar would have on the
US economy. If I’m right, then US consumers will, during the
next five to ten years, lose money in the stock market, lose money
in the bond market and even perhaps on their homes. This is not
going to make them feel wealthy and therefore is unlikely to stimulate
the kind of consumerism that we have seen during the past two decades.
And a decline in consumption can put downward pressure on prices.
So how do we reconcile a decline in prices from a
lack of consumer demand with an increase in prices as a result of
monetary inflation? Will we see inflation (of prices) or deflation?
I think we’ll see both.
The increase in energy and commodity prices will put
upward pressure on just about everything. So we’ll see increases
in gasoline prices (already happened -- check), increases in food
prices (check), and, basically, increases in the prices of most
But as discretionary spending subsides, the decline
in consumer demand will put downward pressure on the prices of those
things that are not necessities. Therefore we’ll see a decline
in prices of big-ticket items and capital goods, like automobiles
(check). First there was 2.9% financing, then zero percent financing,
then zero percent financing or a cash rebate. Now you can get zero
percent financing and a cash rebate, and yet Ford has just announced
that its June vehicle sales fell almost eight percent because of
a double-digit decline in passenger vehicle sales. So much for the
I wrote an article about the economic recovery on
January 30 (The Greater Depression), I suggest you read it if haven’t
yet done so. Compare that with the Wall Street Journal’s Survey
that says all is well, that inflation is going away during the next
six months, that the economy is not only going to continue to expand
but actually expand more rapidly, that the dollar is in good shape
and stocks are a safe bet.
Fifty-three percent of the economists polled expect
stocks to remain where they are or move up slightly and forty-five
percent expect stocks to move up significantly. Only two percent
expect stock prices to decline. It was interesting to note that
fifty-eight percent of the economists had more than fifty percent
of their savings in the stock market and seventy-six of those said
that their stocks were up from a year ago. I wonder if any of them
own gold stocks, because the NYSE Composite Index is only up 2.5%
over the past twelve months.
I think I’ll stick to my junior exploration
stocks. If I had to make a bet, I’d say that the guys who
run the companies I own know more about their businesses that the
economists who were polled by the Wall Street Journal know about
I started selling gold and related stocks in
March (March 19, 2004: Are we ready for a correction?). The market
has become a lot more rational since then and I have started accumulating
fairly aggressively. Fortunately I raised a lot of cash between
March and April, enough to allow me to be a serious buyer for the
next two to three months. Visit my website at www.paulvaneeden.com
and subscribe to my newsletter to find out what I am buying.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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