Inside The Economy

Last modified on October 3rd, 2013

My background obviously isn’t in finance – I’m actually some weird hybrid between an electrical engineer and a physicist. While I understand a lot of the basics in finance, there are still quite a few gaps in my knowledge, and I’m slowly working towards filling those in.

Last night I was pretty beat, so I crawled into bed and purchased a book about capitalism and the economy. I actually managed to read most of that in a few hours, and decided I’d grab another book as well. Wouldn’t you know it, I finished that one as well sometime around midnight, and passed out on the couch.

Both books gave pretty dismal predictions about what may happen in the United States in the next few years. They also gave a brief history of capitalism and some rather interesting insights into what’s going on now. Like I said, a lot of this is new to me, so feel free to chime in and correct anything. But here are some of the key take-aways I got while reading both books last night.

A Healthy Economy Involves Saving

Both books alluded this point, which I found really surprising, primarily because both Bush and Obama seem to be encouraging everyone to spend with little to no thought with regards to saving any money. At its core, saving money provides the necessary capital for future investments that will hopefully lead to further improvements in both businesses and the economy in general. Spending money, unless directed explicitly towards the enhancement of the economy, doesn’t help the economy. It does however improve the GDP (which in turn may help the United States finance additional debt), which may be part of the reason it’s encouraged.

Inflation Is An Expansion Of The Money Supply

While there are a lot of complicated definitions for the word inflation, both authors seemed to prefer its original meaning – inflation is simply an expansion of the money supply. Inflation seems to be the norm these days, primarily because countries fire up the printing press whenever they need to pay the interest on their loans. That process increases the money supply and ends up reducing the purchasing power of the money we all have saved.

Deflation Isn’t The Devil

I can’t remember any time in my life where we’ve undergone deflation, but both authors seemed to indicate that it should be a natural part of the capitalistic machinery. In fact, during periods of time when the dollar and other currencies were backed by gold, deflation actually occurred fairly regularly. What that would mean is that if you put $100 in the bank, which at the time may have been able to buy 20 loaves a bread, there may come a time in the future when you can buy 40 loaves. Sounds like a pretty good thing, no?

Interest Rates Should Adjust Naturally

At the heart of Keynesian Economics is this idea that governments should help stabilize the economy. Their prime tool in doing so is the Central Bank’s interest rate, something that is currently pegged at historic lows. When the Central Bank doesn’t manipulate the rates, often the rate will float with respect to the amount of capital that is saved. When savings are low, interest rates can rise, encouraging people to put their money into banks. When savings are high, interest rates can go lower, encouraging people to spend.

What we have now is an unusual situation. Canadians and Americans have been saving next to nothing these last few years, and yet the low interest rate is encouraging everyone to not only spend, but to take out loans to finance that spending. If you believe the point above, that spending only benefits the economy when it’s used to help expand production, then the current rash of spending is only serving to kick the can further down the road.

Chicken Little May Have Been Right

Both books make one point extremely clear – the United States is in for a world of hurt. Right now their debt is sitting at about $10 trillion dollars, which is about 98% of their GDP (their obligations are actually much greater than this, but this is the official number). Every year, the United States has a huge trade surplus, mostly with China. On paper having a surplus looks great, but it’s actually a liability, since it effectively means that China and other countries have purchased the United State’s debt, and the United States will owe them interest in the future.

The only saving grace the US has right now is that everyone else’s currency is pegged to the US dollar. That has allowed the US to act a lot less responsibly than other countries may have been able to get away with, but it’s something that will probably change. When the markets starting crashing in 2008, many other countries started looking to possibly peg their currencies on the Euro. Once that starts happening, you can pretty much guarantee that the US dollar will take a pretty substantial nose dove.

I read a paper a while ago speculating that if the US had access to a big credit card, it would have a fundamental credit limit of $14 trillion dollars. The author speculated that once their debt reached that level (which with the current spending, will happen in less than two years), no countries will finance any additional US debt. At that point the US will either have to default on all its loans (which would probably crash the dollar), or it will have to buy a few more printing presses and go to town, which would ultimately lead to such massive inflation that it even has its own name, hyperinflation.

Both scenarios suck.

How To Survive

The second book I read had two main ideas on how to be well positioned in case a crash occurs. First, the author recommends investing in foreign markets (including Canada), and staying the hell away from the US economy. If the US does crash or enter a period of hyperinflation, a person heavily invested in foreign markets could wait until the crash was over and scoop up a lot of great deals.

The second main idea was to re-invest in precious metals such as gold. A lot of people take flack for investing in gold, but right now gold is on its way up, and last time I checked was around $2,400 $1200/ounce. Given that China is actively encouraging its citizens to buy as much gold as possibly, I can’t help feeling that it’s only going to keep heading north. The only caveat is that there’s historical precedent for governments outlawing the possession of gold in rough times, so the author suggests holding some money and even gold in offshore accounts.

In terms of real estate, one of my favourite blogs is Garth Turner’s The Greater Fool. Garth’s pretty adamant that we’re about to experience a pretty big real-estate crash in Canada here, and actively encourages people to get out of their houses while the prices are still high. If you’re lucky, you can sell, bank some money, and rebuy when the market bottoms out in a few years.

If not, one of the books I read last night had an interesting idea about pulling money out of a home equity line of credit and putting it into income generating funds. For example, if your house was valued at $500k last year and suddenly lost $200k in value, presumably you could still withdraw the funds from a HELOC based on the previous year’s valuation. With the current interest rates of around 0.5%, you could put that money into a low-risk income fund generating around 5% or so and simply bank the difference. If at any point the bank reassesses, you can simply cash out your investments and pay the HELOC back.

The Changing Of The Guard

After reading both books I was left with two main ideas – the period of US dominance is about to end, and the Chinese are about to take over. Not only is the Chinese economy thriving, but they are well positioned to be a major financial super power in the coming years. With China actively encouraging its citizens to buy gold, I can’t help but feel there’s a currency coup d’etat about to happen. While returning to a gold standard is often considered difficult nowadays, it’s not impossible. If the US dollar loses its reserve status and people start switching to alternate currencies, I wouldn’t be at all surprised if China switches back to a gold standard and starts its process of world domination.

30 responses to “Inside The Economy”

  1. Duncan says:

    I’m glad to see you’ve taken an interest in finance and economics. It’s a fascinating field that’s constantly changing.

    I think Gold is acting as more of a store of value. As people lose faith in Fiat currencies and don’t want to risk capital by investing in the stock markets, they turn to Gold. Cash turns to trash with inflation so gold is the safe haven and the new Bank for parking capital.

    The biggest opportunities lie in resource stocks right now. I believe we’re about to enter another major commodities boom. Many resources and metals have gone up recently yet the mining companies that extract them have not seen the same movement. It’s a rare situation where the commodity rises before the stocks that represent them that I believe presents a tremendous opportunity for investors.

    Demand from China plus an inflationary western economy are all bullish for commodities. I see huge moves coming in uranium, silver and platinum. Oil and coal will also be much higher in the coming 6-8 months from the fundamentals I’ve seen.

  2. Duane Storey says:

    Dude, you gotta learn how to press enter with WordPress! If you want a paragraph break you gotta press enter twice! I fixed it for you.

    But good comment, thanks!

  3. Duncan says:

    Haha, got it thanks. And now for a practice run.

    Begin paragraph 2.

    End.

  4. Alex Curylo says:

    “It does however improve the GDP (which in turn may help the United States finance additional debt), which may be part of the reason it’s encouraged.”

    Yes. A fiat currency is effectively collateralized by consumption, you may recall me observing. If people stop trading pieces of paper for things, it becomes rather more obvious in short order that they’re just pieces of paper. And foreigners would have no reason to hold them. And, for the US as for most countries, the consequences would be … distressing.

    ” inflation is simply an expansion of the money supply.”

    That is the monetarist view which is correct. There are other theories such as demand-pull and cost-push, but they are incorrect; the price level effects they describe lead to relative values changing or consumption declining.

    “Deflation Isn’t The Devil”

    Oh yes indeed it is with a fiat currency. See above about consumption being the real store of a fiat currency’s value; then consider that when a commodity-back currency deflates, that just means the backing commodity becomes more valuable, so at some point people start trading currency for goods again. When a fiat currency deflates, nobody buys anything that it’s not actually necessary to consume immediately, and the value of the currency plunges to zero, as there is no backing commodity whose intrinsic value would stop the plunge. That is actually a worse situation than hyperinflation, as real savings rates cannot go negative. (OK, in the middle of the 2008 crisis, they actually did at some central banks, yes — but that was a momentary crisis situation. If that was a policy held long enough for people to react to it sanely, it would *immediately* destroy the currency.)

    “The only caveat is that there’s historical precedent for governments outlawing the possession of gold in rough times”

    And I am just about as completely certain as certain can be exactly that will happen in the coming tribulations and the goldbugs are going to find themselves incredibly discomfited, yes. What I am doing, mind you, is keeping my Free Miner cert up to date and staking out some placer properties…

    “Garth’s pretty adamant that we’re about to experience a pretty big real-estate crash in Canada here, and actively encourages people to get out of their houses while the prices are still high.”

    Garth is correct as far as he goes …

    “If you’re lucky, you can sell, bank some money, and rebuy when the market bottoms out in a few years.”

    The rebuying is the trick. Unless you have enough cash to purchase outright, qualifying for mortgages is going to be insanely difficult after a big crash, because your mortgage won’t be guaranteed by expected future gains like it is now. We’re talking on the order of you’ll have to have fantastic credit to get away with less than 60% down. This is why I am not selling either my condo (paid off) or the townhouse ($340K @ 1.9%, i.e. basically free), because I am not confident that I will be able to reenter the market later, and the parents and I both need places to live and if their current value plunges 60% as is probably a reasonably prudent expectation, well hey I’m ok with that. If it plunges more, then I think there’ll be worse problems than my net worth having disappeared.

    “I wouldn’t be at all surprised if China switches back to a gold standard and starts its process of world domination.”

    Take a look at China’s population pyramid.

    http://www.china-europe-usa.com/level_4_data/hum/011_7a.htm

    ‘Bout 2030, when the kids born today are entering the workforce, there’s going to be some pretty serious social dislocation there. Whatever progress China makes in the meantime, world domination is almost certainly off the table by then. But we shall see!

  5. Alex Curylo says:

    “I see huge moves coming in uranium,”

    Well, my underperforming Cameco stock certainly hopes you’re correct on that one…

  6. Duane Storey says:

    “When a fiat currency deflates, nobody buys anything that it’s not actually necessary to consume immediately, and the value of the currency plunges to zero”

    I’m not sure I understand that. If I could suddenly buy two iPods with the same money that used to be able to buy one, you don’t think I’d go out and buy stuff? I’m not disagreeing, I just don’t really understand how a fiat system can function in one direction but not the other. How does the currency plunge to zero? If inflation devalues a currency relative to the economy, doesn’t deflation naturally increase it?

    “This is why I am not selling either my condo (paid off) or the townhouse ($340K @ 1.9%, i.e. basically free), because I am not confident that I will be able to reenter the market later, and the parents and I both need places to live and if their current value plunges 60% as is probably a reasonably prudent expectation, well hey I’m ok with that”

    Well, I don’t own any real estate, so I can’t really comment. That said, guys like Garth suggest people like you sell, lock that money away in a reasonable fixed income investment that gives you 5% or so, and simply live off of free rent until you can buy again.

    That said, most of the people Garth talks about on his blog are guys with 5%/35yr mortgages, and so they are facing having negative equity.

  7. Alex Curylo says:

    ” If I could suddenly buy two iPods with the same money that used to be able to buy one, you don’t think I’d go out and buy stuff? ”

    No, because the same money will buy even more stuff if you keep waiting. A good real world example is the Sports Junkies style consignment stores; how often do you see any piece of equipment get sold before it reaches its floor price? Now imagine its real deflation and not artificial deflation, and there is no floor price to put a time limit on your waiting. How much gets sold? Not too bloody much, to most people.

    “How does the currency plunge to zero? ”

    I hope you didn’t spend too much time trying to puzzle that one out 🙂

    What I was meaning to say was that *interest rates* plunge to zero, and then we enter what’s called the “liquidity trap”, where there is no incentive to invest because there is no return on an investment. When nobody invests anything, we’re back to Dark Ages level subsistence farming in short order. Possibly extremely short order. That was why I went on to say “that is actually a worse situation than hyperinflation”, because it is. Just got tripped over my keyboard getting there.

    guys like Garth suggest people like you sell, lock that money away in a reasonable fixed income investment that gives you 5% or so, and simply live off of free rent until you can buy again.

    And if the economy does indeed unfold in close proximity to Garth’s predictions, that is indeed a wise course of action yes. If there’s another credit crisis, or a currency crisis, or any number of other not discountable occurrences, then not so much. BP preferred shares were a “reasonable fixed income investment”, up to last month…

  8. Duncan says:

    Many people define inflation or deflation by rising or falling prices. In fact, we need to be clear about what we’re measuring prices in terms of.

    If we’re measuring against the purchasing power of one ounce of gold, we are by definition already in a deflationary environment.

    If we’re measuring prices relative to a fiat currency, then we’re in an inflationary environment relative to the purchasing power of that currency.

    The idea that continually falling prices will prevent consumption on optional goods is flawed. Technology proves this to be incorrect every day. I bought the iPad knowing full well there’d be a cheaper and more powerful model coming in a year or so. Putting the money I would have spent on this iPad away and investing it into something that produces a gain would be far wiser. If I continued this logic, I’d never buy an iPad because there would always be a cheaper model if I waited. Reality is not linear, nor is it always rational.

  9. Alex Curylo says:

    The idea that continually falling prices will prevent consumption on optional goods is flawed. Technology proves this to be incorrect every day.

    Technological goods are special because of the high present value of their consumption; the rate of return on their employment outweighs the deflation of their inherent value. Very few asset sectors have comparable utility.

  10. Duane Storey says:

    Hmm, well what asset sectors are we talking about? I mean, people will still buy food because they have to eat. They’ll still pay for energy because they need a warm place to live. They’ll still pay for shelter since they need a roof over their head. I can’t imagine people foregoing seeing a movie because it’ll be cheaper next month.

    I can see maybe holding out on an automobile, or big ticket items. But I’m having a hard time seeing it for smaller items.

  11. Duane Storey says:

    Actually, ignore that. I just remembered what the word asset means. But my point is I expect people would still spend routinely.

  12. Duncan says:

    In the US, if prices fall too rapidly in several sectors the government will increase the velocity of money. They will inflate faster than prices can deflate, causing prices to shoot through the roof. There’s no limit to how much money the Fed can pump into the economy. They could mail everyone million dollar bills if they wanted.

    For these reasons, deflation is going to happen in a massive way relative to Gold. In terms of US dollars, inflation will always be the more powerful force under the central banking system. There’s no way to reset back to zero with a currency backed by nothing.

    Deflation therefore is not the real threat if measured in US dollars. Inflation however, is pretty much impossible to control at this point unless they’re willing to cut spending, raise interest rates to double digits, and raise taxes. This of course would cause every sector would collapse in tandem and enter a deflationary spiral.

  13. Alex Curylo says:

    “Actually, ignore that. I just remembered what the word asset means.”

    Indeed.

    “But my point is I expect people would still spend routinely.”

    Yes, people continue to consume products. But nobody invests in the assets that are necessary to produce those products. In some period possibly measured in decades (the gradual decay of Communist countries’ economies is a good model for that) but more likely than you’d think to be measured in years, your industrial infrastructure ceases functioning and what you’re left with for a sustainable asset base is composed of livestock, thus my references to Dark Ages subsistence farming.

    Mind you, there would be a certain schadenfreude in seeing the hardcore environmentalist types trying to survive in the 100% renewable and sustainable economy they claim to want…

  14. Duncan says:

    To add to the above, the central banks always cover deflationary busts with bouts of inflation. It’s a constant cycle created by Keynesian economic theory and the advent of the central banking system.

  15. Duane Storey says:

    The more I read about Keynesian economics, the more flawed it seems to me. I actually tend to agree mostly with the Austrian school of thought as I’m reading comparisons.

  16. Duane Storey says:

    I wonder if that’s because they want to keep the illusion of the GDP increasing? If prices fall, naturally the GDP would fall, so it’s in their interests to keep the GDP looking like it’s climbing, which I would think inflation would help with.

  17. Duncan says:

    Keynesian economics sounds wonderful in theory, and has been adopted by Governments around the world. Derivitives were also devised by some of the most intelligent minds and embraced world wide. Look how well they turned out!

    A great life lesson the world is learning at this time is the analogy of the black swan. Google it for more info. Basically, life is unpredicatbly. Probablilty is not always relevant. Events do not happen in a linear manner for then most part. This is where mathematics can let us down.

  18. Duncan says:

    Duane,
    The government sets income tax rates, sales taxes and most other revenue generating areas based on a percentage of a dollar value. Lower prices domestically translates into lower revenues for their coffers. Raising taxes is an option, but it’s also political suicide. Hence, their silent partner and secret weapon-inflation. How else could an essentially bankrupt country maintain aircraft carriers on every corner of the earth and sustain superpower military dominance?!

  19. Alex Curylo says:

    “Deflation therefore is not the real threat if measured in US dollars.”

    How you measure the dollar supply is the trick here. If you accept that credit and derivative instruments count as currency — and if you don’t, it’s hard to see how you can come up with any financial model that makes a lick of sense — then why yes reducing their magnitude counts as deflation, no matter how much “quantitative easing” you throw into the system to try to hide what’s happening.

    “This of course would cause every sector would collapse in tandem and enter a deflationary spiral.”

    Indeed. And getting out of one of those, with a currency lacking intrinsic value, is quite likely to turn out to be impossible.

  20. Duane Storey says:

    But conceivably everything the government is spending money on at home has been reduced as well in deflation? I guess the only thing that doesn’t reduce really is foreign debt, which in the case of the US is substantial.

  21. Duane Storey says:

    And yah, I agree. There are many problems with mathematical models, and almost all scientists agree they are at best approximations.

    You can never prove anything in science, you can only set out to disprove it – that’s a fundamental aspect of science that a lot of people ignore. Theories and models exist today not because they are true, but only because no one has been able to prove them false. That’s why many of the major scientific breakthroughs are still classified as theories, for example Einstein’s Theory of Relativity.

  22. Duncan says:

    “But conceivably everything the government is spending money on at home has been reduced as well in deflation? I guess the only thing that doesn’t reduce really is foreign debt, which in the case of the US is substantial.”

    Yes, but try explaining this to the public and to employees by asking them to take home a smaller pay cheque. Paying down the debt becomes much more difficult now as well since it takes far greater amounts of foreign currency to finance US debt.

  23. Alex Curylo says:

    Well, Keynesian theory is elegant. It would probably work fine if those applying it were completely omniscient of foresight, and completely insulated from political demands.

    Unfortunately, we live in this thing called “the real world”.

  24. Duncan says:

    The problem as of late is that politicians and investment bankers took science as fact and proven. They’ve learned a very expensive and hard lesson on the reality.

  25. Duncan says:

    I think our Global economic model has simply been a long, drawn out experiment based on several theories. We’re now starting to see the long term effects of these theories for the first time.
    Out of the dust will rise several new theories though. And so it goes. At the end of the day, everything we do as a modern way of life is just our perception of reality. And as they say, perception is reality.

  26. Duncan says:

    Okay, now I’m getting philosophical. It’s time for bed! I’ve been up since 5am.

  27. Mark says:

    Duane, if you want to read about the social, rather than economic side of the argument, check out an excellent book by Richard Wilkinson (& KP) called “The Spirit Level – Why equality is better for everyone”.

    Rather than being gloomy about inflation and exchange rates etc., it covers a wide variety of issues & is a must read (although it seems extremely pro-socialist – hence the title).

  28. Jen says:

    “That said, guys like Garth suggest people like you sell, lock that money away in a reasonable fixed income investment that gives you 5% or so, and simply live off of free rent until you can buy again. ”

    I find Garth’s rants entertaining, but he’s admitted (more than once) on his blog that he owns real estate that he isn’t planning on selling.

    I understand his rants generally apply to those who over-extended themselves, but when he says “everyone” should sell and rent… well I have troubles trusting a guy who doesn’t take his own advice.

  29. Duane Storey says:

    It’s likely I’m putting words in his mouth. He may not be saying that to everyone, but that seems to be his general gist most of the time.

  30. Jen says:

    I doubt you are – from reading his blog, it’s the impression I get as well.

    And while it’s not really financial advice or education, I get a hefty dose of financial (and life) inspiration from reading Warren Buffet’s annual shareholder reports. I’m actually considering buying a few shares of Berkshire-Hathaway so I can go to one of the AGMs in person.

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