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 all commodities.
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
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
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 necessities.
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 economic recovery…
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
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 economics.
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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