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Mark's Market Blog

1-19-11: Inflation

By Mark Lawrence

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Last week, I called for a drop in market prices. Didn't happen. Yet. It will. Perhaps starting today, perhaps in a couple weeks. Soon. However, Bernanke and his helicopter are still ruling the air.

S&P 500 August 12 2010 to January 19 2011

Harold Camping says the Bible has recently revealed that the Rapture will occur on May 21, 2011. (Yes, I'm deeply troubled by writing a sentence with an active verb referring to an inanimate subject, but it's a quote, what can I do?). You may have seen the myriad billboards. Time to sell all your assets and get serious about your bucket list: take that trip to Thailand, Nepal, New Zealand, Paris. Jump out of a perfectly good airplane. Call your high school sweetheart and see how may times she's been divorced and if she now regrets dumping your rear end. The world will be ending in 4 months. We're talking biblical calamities: oceans turning to blood, plague and insects covering the earth, earthquakes and volcanoes, this is the real thing. Forget the Mayans, they were off by an entire year. I presume most of my readers, like me, will not be swept up to heaven on the 21st, but will be "left behind" to deal with the harsh alternative. My personal belief: John needed some sunscreen and one-a-day vitamins. 2000 years ago, wandering around in the desert at age 87 was a bit more than the human body could handle.

Portugal and Spain had major bond sales, and both "succeeded," in the sense that they sold the required bonds. They're paying interest rates that are higher than they can live with in the long run. The sale succeeded because the European Central Bank and China collaborated to make sure it worked, so it's all a big fix.

Ireland continues to guarantee the external debt of their banks, even though in the worst case this will crush their economy for at least a decade. This guarantee will almost certainly result in the current government being replaced in the next couple months, likely by some more sensible people. The EU bailout of Ireland is now being compared to the Treaty of Versailles, which required Germany to pay so many reparations for WW I that it lead to WW II.

Brazil is worried about food and energy inflation spreading through the rest of their economy, and just raised their interest rates.

India is having inflation in their food prices of 20% to 70%. The Indian government is doing all the usual stupid things about this, like passing laws about how much you can charge for food and dropping all taxes on foods.

China is also experiencing inflation on both real estate and food, running at 10% to 25%, depending on whose numbers you believe. Their government is also passing laws about pricing and telling banks to stop lending. China's government has successfully convinced their people that Bernanke is to blame for their inflation. Basically money supply growth and inflation are out of control in China, and this will not end well for them.

In the US and Europe, inflation in stock prices, oil, and foods is also heating up. In the US, the difference between the 30 year bond rate and the 90 day rate is approaching an all time high, indicating that investors think inflation is back.

From where is this inflation coming? I think there are a few different answers to this question, not one simple answer. Milton Friedman, one of the gods of economics, famously said "Inflation is always and everywhere a monetary phenomenon." That is, inflation is from too many dollars chasing too few goods. I suppose that's true as far as it goes, but it's not very prescriptive: Bernanke has loaned several trillion dollars to the banks in the last couple of years, which sounds incredibly inflationary, but the banks aren't lending and the money supply isn't expanding much. So the idea that inflation is coming from an expanding money supply is hard to support.

Because of Bernanke's actions, the value of the dollar compared to other currencies in the world has dropped. OPEC prices their oil in dollars, but they buy things from all over the world, so when the dollar drops they like to raise the price of oil to keep their purchasing power up - you wouldn't want them to have to pay more for their new Mercedes, right? A substantial part of world inflation is from an increase in oil prices, which drives up transportation, fertilizer, farm costs, and food prices.

In Europe, many banks are almost certainly technically bankrupt. The ECB is buying up bonds and printing money like mad, and in defiance of the Maastrict treaty, some governments are also printing money. Ireland is reported to have printed up $50 billion worth of Euros in the last couple of weeks and handed it out to their banks, a clear violation of the treaty, but tolerated in these fearful times.

Banks are sitting on lots of money, so they invest part of it in stocks. This is driving stock markets up, and is helping to raise real estate prices in many parts of the world, unfortunately not including my own neighborhood. The result is asset inflation.

In many parts of Asia, hundreds of millions of people are getting jobs and moving into what they consider the middle class. These people immediately wish to eat more and better food, and this is helping drive food inflation in many parts of the world. First because they're simply spending more money on food; second because they want to eat more meat, and it takes ten thousand to twenty thousand calories of grains to make one thousand calories of meat, so the desire to eat more meat raises grain prices quickly.

Finally, the Chinese government has made in implicit deal with their people: let the communists continue to run things, and they will provide a continuously growing economy that employs more and more people at higher and higher wages. China is now employing a couple hundred million people in construction, a field where you can hire unskilled labor quickly and easily and put them to work. These people are building cities that no one lives in (at least five that I know of); airports where no planes land; roads that lead to no where; gigantic apartment complexes where no one lives; and huge world-class shopping malls where no one shops. Lord Maynard Keynes, our other god of economics, famously said during the Great Depression that it would be an improvement to pay people to dig holes. More or less, this is exactly what the Chinese government has been doing for the better part of a decade. Here's the problem: these people work, earn wages, and want to buy food, motorbikes, clothes, improved housing. But for all practical purposes they don't actually produce anything: a city where no one lives is not really different from a hole in the ground. When you pay someone who doesn't produce anything useful, you add money to your economy without adding goods, and that's highly inflationary.

Here in the US, we have our own way of paying people to dig holes, it's called unemployment insurance. However, the longest you can qualify is 99 weeks. It's now been a bit over 100 weeks since the Great Recession started, and in the next couple of months something like four million Americans, the "99ers," will have their unemployment benefits stop. If paying them to do nothing is inflationary, then stopping those payments is deflationary. This, I believe, is why Bernanke is running QE2 and adding a trillion dollars to the economy: to compensate for four million Americans losing $80 billion in unemployment benefits. Janet Yellin, vice chairman of the Federal Reserve, has said that she expects QE2 to generate 3 million new jobs. Personally, I find this statement a stunning disconnect from reality, and indicative that either she's completely incompetent or a huge politically motivated liar.

So, why is the world experiencing inflation? Raising incomes in the 3rd world generate more demand for food and oil; recession and banking crises in the US and the EU mean money is being printed; OPEC driving the price of oil up is extremely inflationary; Chinese hordes building empty cities mean even more demand with no commensurate production. What will change? In the short run, nothing: food and energy inflation is the new reality, get used to it. Many people in many countries are going to be priced completely out of the food market: as Jim Rogers said over a year ago, the time is coming quickly, perhaps this very summer, when there are parts of the world where food is not available at any price. In the long run, I fear for the stability of the Chinese and Indian governments. In a world where half of the people don't have a stable government, the likelihood of seriously bad things happening only increases. My prediction: inflation will be the story of this year. Governments will not agree to take their medicine, so inflation will continue to grow. This will be a problem in the US and Europe, but it will bring social unrest and possibly new governments in the third world.

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