There is a simple fact that all Goldbugs miss: and that is the American economy, and most all others in the world, have just experienced a massive asset DEFLATION (still underway in some segments like commercial real estate). This deflation in America was about $15T over the past two years according to New York University's Nouriel Roubini (from $40T to $25T). That asset deflation was completely psychological. One day American assets of all types were worth one value in dollars and just a little bit later, were worth quite a bit less. There was no massive physical destruction of assets as in a war (counter to the weak Weimar argument for hyperinfaltion), only economic.

The basis for my opinions on monetary reflation are derived from Hyman Minsky's work. PIMCO's Paul McCulley has written on "The Minsky Solution" many times the past two years. In early January, I featured one of McCulley's articles in a post: http://wealth-ed.com/2009/01/reflation-economics-or-the-minsky-solution/

To deflate assets requires the value of the currency those assets are denominated in to increase as the quantity decreases (this might be counterintuivitive for most). In essence, $15T of dollars were destroyed or disappeared (not physically, but notionally with debt paper markdowns). Less dollar supply at a given demand = higher price / value. Central bankers everywhere understand this dynamic. So, in a coordinated way to restore stability to global assets, currencies are being expanded to replace those notionally destroyed through markdowns during 2008 (the paper that underpinned all those assets, CDOs, RMBS, etc).

The most intelligent dissertation I have seen on repairing a deflation was printed in Barrons last February. Ray Dalio, a rare Barrons contributor, was interviewed. I reference this interview on this blog: http://wealth-ed.com/2009/02/fixing-a-deflation-a-most-intelligent-analysis/

To recap what Dalio said, then, and most presciently: this CB driven monetary expansion is NOT inflationary to the extent that aggregate asset values are being returned to 2007 levels. "How can this be?", say all the skeptics at this point.  My answer: by definition, the reduction of the value of $40T national assets to $25T assets is DEFLATIONARY. In America, $15T of the global reserve "currency" (almost all of it electronic bookkeeping and not "paper") can be created to replace the "paper" that was lost in 2008, with mostly positive effects. There is no deleterious effect so long as the re-creation of the lost currency is done slowly enough as to not be disruptive to global currency flows (currency destruction in 2008 was disruptive enough, don't we all agree?)

$80 Oil and $3 copper is probably in the area of "fair value" vs. the dollar given a mid 2007 USD reference. But $1100 Gold? Unlikely. Gold is now trading on speculative fear of inflation, not the reality of inflation itself. So far, the dollar has not even been expanded (reflated) sufficiently to move asset values back to mid-2007 (check local house prices). Monetary expansion is definitely not inflationary, in America, at this point in time. For gold to be worth $1100, let alone $1500, then global central banks must be unable to stop the expansion that has started in an effort to stabilize asset values. Maybe that is a reasonable speculation, and maybe not (and I own a prudent number of gold shares as a hedge, just in case it is). But like many others, as a more significant inflation hedge, I would rather take my chances with commodities that have fundamental industrial value, and not merely the psychic value of gold.  As is pointed out, gold is worth nothing unto itself. And worse, gold is not consumed, so supply forever increases. This ever-increasing supply dynamic is NOT the hallmark of a good investment.

Nirav at "LivingOffDividends" just gave me some more grist for my opinion mill.  I hope he doesn't mind being my debatee in the Socratic tradition. 

"LOD" is somewhat Goldbuggish, which is not a scathing criticism.  LOD does a great job of exploring various classes of investing and living life.  The overall theme and site moniker is an outstanding recommendation.   But, while I think gold is a terrific financial asset and has its place in just about any portfolio, one must be careful to advise that people flee to gold because of the prospect of inflation / deflation or everything in between.  Gold has lost people a lot of money over the ages.  It is a store of wealth, but not much of an investment as it does not grow, or help a business grow.  It just sits there like a pretty lump.

Here is the LivingOffDividends post and my rebuttal:

Insurance Company Buys $400 Million in Gold

I just can’t let this one pass without a challenge. Sure, money supply has exploded at the Federal level. But it has done so by deliberate effort to replace the value of assets destroyed by the financial crisis and real estate panic. I think a healthy way to look at this is as a transfer of the financial bubble from weak hands to strong hands that can absorb and dissipate the bubble. By the way, this is the same financial bubble that has been traveling through the American economy since the early 1980s, if not before. The private sector seems to be unable to deal with the hot potatoe, so it had to end up in public hands at this point. But as you say, the wealth will gradually be transferred by the Feds back to the private sector over the next 5-10 years.

Once money is created, it cannot be destroyed. It is similar to Einstein’s Theory of Relativity and the Conservation of Energy. That theory everyone knows as E=M*C squared. Mass can be transmuted to energy, but it always will exist in one or another form. Money (wealth)  is not only preserved over all of time once created, but can be  increased by the productive enterprise of humans.  Once created, it can be transferred and transmuted into different forms of assets, but it cannot be destroyed (call this “Brian’s Theory of Monetary Conservancy”).

Consider the history of great civilizations that have risen and fallen.  The political structure of those civilizations has ceased and political power has disappeared in the Greek Empire, the Roman Empire (Italy), the Spanish Empire, the British Empire and the Chinese Dynasties.  But the wealth created by those political systems has lived on and been passed down over the generations.  Even World Wars have proven unable to destroy wealth, as inconceivable as this seems.

I wrote about this idea on my blog back on May 4th. http://wealth-ed.com/2009/05/04/gmo-and-the-persistence-of-stock-market-returns/

I quoted one of the true financial experts of our time, Jeremy Grantham regarding the phenomenon of indestructible wealth:

“The Great Depression is far and away the most striking period on the chart (see linked article for charts). Real GDP fell by 25% from 1929 to 1933, in what was easily the worst economic event to hit the U.S. since the Civil War. But that fall, as extraordinary as it was, was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually (by 1945) got back onto its previous growth trend as if the Depression had never happened.”

So, while it is very interesting that a life insurance company has decided to buy some gold to diversify its assets (I am sure a very small percent of its total managed assets), there is nothing about this that should indicate anything significant about gold for the future. Gold is just another class of asset. That is all. It has no special place as compared to other real assets, and it may be less important or significant than assets which have some productive use, like copper or oil.

I also refute the assertion that gold has a use as an asset offering protection when an economy is “weakening”. Gold has some short term panic value, as it did last fall. But if it didn’t shoot to $2500 an ounce during the worst financial crisis since 1930, then it probably is not even good as an insurance policy during a crisis.

The statement: “CEO Zore believes that the price of gold could double “or even rise fivefold” if the economy continues to weaken.”, just tells me that Mr. Zore should not be running a major insurance company. That statement is shear stupidity and shows a lack of financial understanding. Gold might increase by five-fold if the dollar weakens to 20% of its current value. But that is the only way this scenario will play out. For the dollar to weaken in that way, the economy would have to be going strong. We just saw that the dollar STRENGTHENS as a global safety trade when the economy tanks.

Yes, gold will appreciate while the dollar depreciates.  It is a fiat currency alternative. That is a given. But while people have been watching gold trade between $900 and $1000 the past 3 months, oil has gone from $30 to $70. So which asset has more potential to protect against inflation while providing investment opportunities?

A response to a post by my good blog friend, Nirav:

Nirav, this is the problem with professors having opinions. Some people may want to think those opinions are more meaningful or well-informed because a given professor happens to be employed by a school like Stanford, or NYU (Roubini). But, such professors opinions about the future are no better than yours or mine. Professors should teach, and not opine.

The first thing wrong with Taylor’s opinion is his lack of command of basic financial math. A 100% change in nominal GDP over 10 years (and the resultant 50% cut in debt to GNP ratio) does not require a 10% annual inflation, but a 7.2% inflation, according to the Rule of 72, something any college finance or economics professor should know. I fully expect a 6-7% inflation within 2 years and think the Fed and Treasury are actually trying to orchestrate that.

The second thing wrong with the Professor’s opinion is the statement that a “permanent 60% tax increase would be required” to balance the budget. That statement is inconsistent with the 10% inflation conclusion. I think taxes could be left unchanged, or only increased to the degree Obama proposes, along with spending decreases, and inflation will do the rest. Not only will inflation cheapen the debt over time, it also will increase the number of dollars in which the debt is paid off. Anyone who owned a home in the 1970s remembers what a good deal inflation was at that time, so long as the mortgage was fixed. You could buy a $40K home, watch it appreciate to $80K with inflation, but pay off the debt as though it were still $40K. To the degree the Feds fix our interest costs (by issuing 30 year bonds which they should be doing in a big way right now), we will all benefit from the repayment in debt with ever cheaper dollars.

Inflation is the only way out of this box. I think the 1970s scenario is not only likely to occur, but welcome. It helped us resolve our Johnson era “guns and butter” Great Society debt of the 1960s, which in its time, was every bit as problematic as where we are today.

I would go on to say that as a responsible investor, it is important to try and anticipate the future, and not wait for it to run you over.  If inflation is in our future, as I think it most surely is, then a prudent investment strategy will take that into account.  The way to not only beat, but prosper from inflation is to own hard (real) assets, or stocks thereof. 

Oil, natural gas, industrial metals, precious metals, timberland, ag commodities, all the equipment suppliers to those industries (Joy Global, Deere, Cat, Monsanto, Nabors, Transocean, Dow Chemical, Dupont), and even real estate or REITs in the near future (once RE stops deflating) will all benefit from a long period of moderate inflation.  The Fed has demonstrated in the past its ability to prevent hyper-inflation, so that should not be a great worry.  Ben Bernanke knows the economics playbook very well.  So, rather than nashing teeth over the course of easy money and tax deficits, instead, put those actions to your own advantage.

Here is his post:

How to Reduce a Trillion Dollar Deficit

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

As we begin to move towards economic recovery, it begs the question "what next?"  It is unlikely America will have a strong economy, as measured in 4+% GNP growth, for many years to come.  We have oceans of debt to pay off.  Even if the Feds are able to transfer the enormous debt hole from the private to the public sector to assist the economic recovery (and save the banking system), that debt still must be paid back in some form. 

There is a high liklihood that the public debt will be paid back through several different means: higher taxes, limited spending and most significantly dollar devaluation (aka inflation) over a long period of time.  Higher taxes and limited government spending will put a cap on American economic growth and will ensure a very slow economic recovery or even stagnation.  An extended period of 1-3% GNP  growth can be expected.  But with a weakening dollar, it is possible that rate of growth will not keep pace with inflation of 5-7%.  So, real GNP will be negative for several years undermining domestic investment returns.  All this is very remiscent of the late 1970s.

But there was a way to make decent, and maybe even excellent, real investment returns in the 1970s.  It was by investing away from America in hard or real assets like commodities and in the growth of non-dollar economies like Japan. 

In the 2000s, the new Japans are the BRIC nations: large, motivated and politically willing.  Today's post is on investing in three of those four.  Brazil, India and especially China meet my requirements for foreign market investing.  But Russia, I do not trust.  Its political system has shown contempt for foreign investment.  It very much resembles the politics of the USSR, with a newly energized "politburo" that controls the economy and stifles free enterprise (though we here in America are catching up fast on this front).  So, I will focus my non-dollar investments in BIC, not BRIC. 

As of today, I am selling all of my long term international mutual fund investment in Fidelity Diversified International (FDIVX) and will gradually move those dollars in equal amounts to IFN (India Fund), EWZ (Brazil ETF) and FXI (China ETF).  I will dollar cost average in because all three markets / funds have just experienced a very strong surge from the bottom of the market crash and may correct. 

My goal will be to move my portfolio to 20% in non-dollar market investments.  Beyond the country ETFs, I also will buy strategic investments in Canada, Australia and non-China Asia.  I will have another 35% of my total portfolio invested in commodities and energy.  This position is already in place with most of the commodity portfolio in Canadian Royalty Trusts (Canroys).  I am also adding FXC and BHP to provide more industrial metals exposure along with additional precious metals exposure, adding to VGPMX and GGN by buying gold miners like AEM and AUY.   The balance of my portfolio will be in domestic stock and bond funds, especially high yield bonds which can keep up with the devaluing of inflation.  In this way, my portfolio will have less than 50% US dollar exposure to protect against inflation and a decade long weak economy.

Today's Barrons runs a great story on this same subject. 

The [most important factor in the coming commodity boom is the] growth of the middle class in the rapidly developing economies; large-scale infrastructure investments in many developing nations; and the emergence in these regions of a huge new consumer cohort, which has developed out of the poverty of the past.  The size of this low-income cohort dwarfs anything the global marketplace has ever seen. Approximately one billion people, one- seventh of the world's population, are moving out of poverty and entering the market as consumers. If these billion consumers were a nation, they would have the third-largest population in the world and the 10th-largest gross domestic product.

China lacks the raw materials it needs to manufacture steel. This has turned it into the world's largest importer of iron ore. It has been accounting for 40% or more of the international iron-ore trade in recent years.  China's need for steel will continue long into the future. Remember that the U.S. took 35 years to finish its Interstate highway system. It took 16 years for Japan to build its New Trunk Line railway. Even with China spending a reported 9% of its GDP on infrastructure, it will take decades to bring its roads, ports, airports, power-generation capacity and other infrastructure systems up to speed.

Read the entire story here:

Commodities' Coming Rebound