Reflation. It is a very provocative concept. We all know what is meant by the term Inflation. It is almost intuitive because we have lived with it all of our lives. Those of us over 40 have a special affection with that word as we experienced the 1970s and some of the worst that inflation can bring.

But few of us have a good idea what is meant by the term reflation. Whether we should embrace or fear it. My way of looking at reflation is to “fill the hole” left by the deflation caused by housing, stock market and other financial asset price contraction. All that asset value had to go somewhere. The assets underlying value didn’t just disappear, though much of the derivative paper might have.  Assets were revalued by a mass panic of the entire American and global population. But this was a psychological phenomonon, and so it can be reversed.  It is quite possible for assets to regain their previous value with some encouragement.  That encouragement comes in the form of reflation and what it encourages: the ”animal spirits” of the market place.  Until we find asset price recovery through the process of reflation, diminished values will wreak havoc on the economy through slashed consumption, falling corporate and tax revenues, declining profits and higher unemployment.

Reflation is made possible by the expansion of the monetary supply, offsetting money supply reduction that occurs from asset price contraction. But it is an indirect offset. If my house was worth $600,000 in 2007 and is now worth $400,000 in July 2009, to reflate the economy the government doesn’t just send me a check for $200,000 (though a case can be made for doing just this ala “Helicopter Ben”). Rather, monetary expansion trickles through the economy: first to bolster the banking system where it originates from programs like TARP and TALF, then through Federal “stimulus programs” that eventually (belatedly?) result in a “Cash for Clunkers” program, and finally to home owners through firming home prices and higher wages with economic expansion and increasing demand; all from the proverbial “thawing” of a frozen credit system enabled by backstopping the banking system.

But reflation comes with a price, and it is political, not numerical. Because reflation originates within the Federal government (the Federal Reserve Banking system and the Treasury), the only entity which can legally create money from nothing, it comes with plenty of strings attached. Those strings will be pulled by the majority political power, Democrats at this point in time. The party in power will seek to use economic reflation policy to achieve social policy and, in the case of liberals, a redistribution of wealth. Whether one agrees or disagrees with a specific policy or program,  it is beside the point. The point: because there are strings attached, reflation through fiscal policy or monetary means there are conditions that are inefficient and carry plenty of future baggage (entitlements).

Bill Gross wrote about our economic reflation policies and what it means for our economic future. In his eyes, the future is none too optimistic. Bill Gross suggests we are doomed to many years, perhaps decades, of below trend economic growth, his “new normal”. Those of us less than 70 years old, who did not experience life during the 1930s and 40s, will probably need to recalibrate our expectations.

I personally take exception to the characterization of 3% Nominal GDP growth, as Bill Gross forecasts, as being a “New Normal”.  Such a growth rate is an aberration and would mean perpetual recession. It is actually an old normal at a time of zero or negative inflation, like right now when Nominal GDP equals Real GDP.  Rather, 3% “real” growth in a mature economy like the American, is an “old normal”; more like the economy of the 1950s, 60s, 70s and 80s, on average. In fact, the Real GDP expanded by an average of 3.45% between 1951 and 2004. It is important to look at “REAL” data as it strips out the effect of inflation, which was pronounced during the latter half of that range.

In Bill Gross’ words:

Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.

Gross goes on to make the point that we can’t expect to see 5% Nominal GDP growth as we did in old normal times.  But his point doesn’t make much sense as it was actually much higher on average in the past 50 years.  Even at face value, his statement begs the question “what part of that nominal GDP  will be inflation?”

I expect we will actually see moderate inflation once reflation has been achieved.  It is the natural result of successfully reflating the economy and having it run at productive capacity and full employment all while running a Federal fiscal deficit to fnance reflation policy. Because full employment (around 95% of the workage population) is a Federal policy goal, and because the Feds have the means to control reflation (monetary expansion), I expect this goal to be successfully met.  So, we can therefore expect moderate inflation once stability is achieved.

Bill Gross concludes his August 2009 newsletter by making the case for 3% Nominal GDP for the forseeable future:

A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

Yes, I suppose a 3% Nominal GDP would have the effects described if it were possible.  But the PIMCO scenario is highly unlikely and Gross’ reasoning is flawed in many ways.  If we are  indeed in a period of lower interest rates, then P/Es will not contract but will likely expand.  P/Es run inverse to the Treasury Yield Curve, the infamous Greenspan “Treasury discount model”.    So, low interest rates should result in higher stock prices once stability returns to the economy.  However, I believe we will see higher interest rates once the economy is reflated and the economy stabilized.  This will result in attenuated economic growth of around 2-3% Real GDP, plus an inflation rate of 5% which will cause Nominal GDP to run above 7% as opposed to the 3% forecast by Bill Gross.  American Nominal GDP ran between 7 to 13% during the late 1970s, a period of anemic economic growth (real), large fiscal deficits and moderate to high inflation.  Even in 1981, during a severe recession, nominal GDP grew by 4.4% due to the high embedded inflation.

Like Gross, I do worry that the “strings attached” to reflation policy will “substantially change the character of the American capitalistic model”.  But political pressure from the right should counter the most extreme of what the left has to offer.  We already see evidence of this in respect to nationalized medicine and “cap and trade”.  So, even this concern of Gross’ is overblown.  Another threat comes from foreign interests who might not want to help America reflate by continuing to buy Treasury bond issues that support monetary expansion / quantitative easing.  But I think these foreign entities (China, India, Oil Nations, etc) see that it is their own self-interest to reflate the American economy and rekindle its consumer sentiments.

I think Mr. Gross has fallen prey to his shifted paradigm of a “New Normal”. His position does not take into account the resultant moderate inflation that must naturally  follows a reflationary policy.  We can expect inflation in 2012 and after of perhaps 5 to 7%. This will result in a Real GDP that is negative if we sutract inflation from the Nominal GDP forecast of 3% suggested by Mr. Gross. Zero or negative Real GDP is not consistent with full employment and will not be tolerated by our political process.  So it cannot happen for an extended period of time invalidating the PIMCO argument. I suggest the PIMCO triumverate re-examine their assumptions.

Bill Gross August 2009 Investment Newsletter

Today’s big news (at least in some corners of the investment world) is US Congressman Issa’s claim that Fed Chairman Ben Bernanke has “covered up” the facts regarding the Bank of America acquisition of Merrill Lynch and Mr. Bernanke’s supposed threats to BOA CEO Ken Lewis. Mr. Issa is an otherwise, insignificant Republican Congressman from Califronia, who, according to his webpage, has great admiration for President Ronald Reagan. But I promise you, President Reagan would want nothing to do with this idiot, and would quickly distance himself from his fellow state politician.

This whole Bank of America situation should be much ado about nothing. Whatever happened between the Federal Reserve, the US Treasury and the banking industry in the last few months of 2008 was done in desparation to keep the entire planet above water. Had the American banking industry collapsed at that time, there would have been a domino effect that would have collapsed the financial system worldwide. All large banks lend to each other on a global basis, and if a few of the “money center” banks like Citi and BOA had gone bankrupt in the middle of the crisis, all banks would have likely ended in the same situation. This would have magnified the recession several times over into a crisis that would have easily eclipsed the Great Depression.

For those new to this story: Fed Reserve Chairman Ben Bernanke and Hank Paulson, then-Secretary of the US Treasury, first convinced Ken Lewis to acquire Merrill Lynch, which was in very bad shape. Serial acquirer Mr. Lewis reportedly had coveted M-L for many years and was happy to oblige, with government assistance. But once the bean counters at BOA looked under the covers, M-L was in much worse shape than they had suspected. At this point, in early December 2008, Mr. Lewis wanted to pull out of the deal fearing for his reputation and the impact on BOA shareholders. Had Lewis done so at that point in time, the very fragile banking system may have collapsed, as it started to in September when the Treasury and bank regulators allowed Lehman to go bankrupt following the bankruptcies earlier of Bear Stearns, Fannie Mae, Freddie Mac and AIG.

And here is where the controversy begins. Mr. Lewis needed some amount of encouragement to keep his end of the bargain. Bernanke and Paulson helped him understand the danger to the entire global economic system if he abandoned the deal at that point in time. Mr. Lewis was not happy about the situation, but agreed to go through with the merger, because he came to understand the ramifications of pulling out, according to his own Congressional testimony a few weeks ago.

This should be “end of story”. We all know how dangerous the banking system was last Fall. The Fed and Treasury did what it took to stabilize the system at great risk to personal reputation, and reportedly 24/7 effort over more than a couple months. If some subtle arm twisting took place to help Mr. Lewis understand the significance of his decision, then so be it. What a small price to pay for saving the global economy. We aren’t talking water-boarding or horse heads here.

Then, along comes Rep. Issa and his over-reaching desire for political gain (apparently, that is the only motive that makes any sense). He is the Republican minority leader on the House Oversight Committee. Today, he decided to make hay of the misplaced concerns in Congress that Bernanke and Paulson overstepped their authority and coerced Mr. Lewis into making the acquisition, something Mr. Lewis has already denied under oath in his Congressional testimony.

Mr. Issa apparently thinks his personal political gain is more important than the stability of the world’s economy and the millions of unemployed. His accusations of “cover up” intentionally bring up comparsions to Watergate. Why else would he use such a volatile term? He obviously is trying hard to embarrass the President who has backed Bernanke. Some of the Republican “hard right” are not happy that Bernanke has saved the banking system preferring instead “to let the free market fix the problem”. Yeh, right.

So, I ask the question? Can a Congressman be impeached? And if so, how can I help impeach Mr. Issa? He is a disgrace to our country and to the Republican party and should be ashamed of himself for breaching protocol and making on his own as only the minority leader of this committee, his accusations regarding the Fed Chairman.

Just six months ago, at the bottom of the financial crisis during the darkest days of October and November 2008, it was unclear whether the American banking industry would survive.  Fannie Mae, Freddie Mac and AIG had already been effectively nationalized (more than 80% of stock owned by the Feds) and Citigroup, Bank of America, Morgan Stanley and others appeared to be on the doorstep of investor-owned demise. 

Now, in May 2009, the world seems a much better place for bankers and the rest of us that use bank money.   I for one, don’t think banks will lead the market higher, but they need to at least regain their health and participate in the economy for growth to happen.  It seems they are on their way.  BAC, one of the sickest of the surviving banks, successfully sold over 1 billion shares after hours on Tuesday to close the gap on its capital needs according to the government “Stress Test”. 

Dick Bove, who has been a lone voice for the survival of the banking industry, sees a very bright future for BAC, at least as compared to now.  He came public Monday with a statement that he expects BAC earnings to normalize around $4 per share, even after dilution, within the next 2-3 years.  Applying a 10-12 multiple to earnings, this implies a $40-48 future share price as compared to the $12 today. See his comments towards the end of the embedded news clip.

A great way to play the banks over the next few years is UYG, the leveraged ETF of the financial index.  UYG is today comprised mainly of the superior banks such as JP Morgan, Goldman Sachs and Wells Fargo, but BAC also has a place on this index.  Barrons posted an article on options trading strategies for BAC stock that might provide some ideas to capitalize on the return of the banks:

http://online.barrons.com/article/SB124265990717130781.html

There have been plenty of times recently, where Warren Buffett and I have been at odds. He doesn’t know this, of course, but I have debated Warren long and hard in the comfort of my living room on the one-way medium of my TV.

I have no issue with Buffett’s investing style or results. In fact, I do everything I can to mimick his style and his picks. My disagreements with Warren are political in nature. He was an unabashed supporter of Barak Obama for the past two years. I had great reservations about our then “President-to-be” based on what I perceived was a commitment to an ideology that was unfriendly to our economic system. Those reservations are being borne out. Warren Buffett wrong, at least on the narrow (but very important) point of Obama’s capability of caring for our economy in a time of crisis.

Today, I am vindicated. He came out this morning on a series of interviews on CNBC and indirectly criticized the Administration and the Congress for a lack of focus and cooperation on the most important issue of our time: the Financial Crisis and resultant Depression.

Listening to Warren is more interesting than reading me. So I will use the rest of this post to link the most interesting of his interview segments. There was almost three hours of segments done by Buffett, so if you like hearing what he has to say, you can go to CNBC.com and view them all.

Warren says that no one is immune from the effects of a financial meltdown. Even the wealthy and powerful are frightened at a time like this.

Warren says: “The banks should get back to banking”. I have been beating this drum for months now. We need to reinstate “Glass-Steagall” or something similar, that regulates the banks and separates them from riskier investing businesses. Getting rid of mark-to-market would be a good short term fix.

Warren also talks about what he did wrong the past few months, the mistakes he made. Buffett is always straight up about his errors and that it is part of being an investor. If he can make mistakes, we all should expect and accept them.