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.

Bill Gross and his PIMCO shop started using a term for our economic future that they term “the New Normal”. I hate this term. It is the same thing as saying “this time its different”. It is never different. The same old story is played over and over. The costumes might change, but the story’s the same. It is a bit arrogant for the PIMCO shop to think they are the first to find this new thing.

Mario Gabelli and Bill Gross were on CNBC this morning at the same time. Mario made the point to Bill that the past 100 years saw a 4-5% annual appreciation in the stock market, so if we average 4-5% per year for the next 100 years, then it really is not so new, but is in fact quite an old average. Bill did not have a good rejoinder to this point. Score one for Gabelli. Gross and Gabelli also agree that a good manager can add a few points of “Alpha” to that average return. So, 7-8% is possible with good portfolio management, in a very low inflation environment.

What is really important, after all, is not the nominal return, but the real, or net of inflation, return. PIMCO is not projecting anything “New” here. In the very long run (hundreds of years), “Real Return” averages 2 to 3 percent. Gross is not saying that will change. What he says will change is nominal return which average 8-10 percent from 1929 to 2005. But this was also a period of higher than historical average inflation due to loose dollar policies in the 1930s and again in the 1970s. If inflation returns to its long run average of 2%, than the “New Normal” of 4 to 5 percent has an embedded 2 to 3% Real Return, which is the old normal. I am not sure why Bill Gross is making such a big deal about it.

“The new normal basically recognizes that we’re in an economy that’s de-levering and that we’ll move to an average level that’s lower than before,” Gross said. “We’re de-levering, loans are going to be less available…homeowners are going to have to put 20 percent down now, as opposed to zero.”

The Federal Reserve is likely to keep rates at the same level for a while, because the economy would need to grow by nominal rates of 4 percent or 5 percent to prevent debt from destroying growth, Gross said. “They (the Fed) have to stay low because the embedded cost of debt (interest payments) in the economy is 6 to 7 percent,” of GNP, said Gross.

This brings up an interesting quandary for many of the Bears who frequent the investing world today. Bill Gross, who many consider to be the world’s leading private sector expert on the future of interest rates and bond prices, says they are staying low and must be kept low in order to achieve his “New Normal”, Excess productive capacity and an emerging market with excess and cheap labor also suggest this future reality. Gross implies a long period of low inflation and low return.

This really undermines the Bear argument for high inflation and / or continued crashing of the markets (which is inherently deflationary; never really understood how the Bears expect high inflation and high deflation simultaneously, which underscores how weak is the Bear argument).

As a member of the “baby boom” generation (like Gross) fast approaching retirement, a low inflation environment, with historical 2 to 3 percent Real Return sounds almost ideal to me. I think I will like Bill Gross’ “New (Old) Normal”.

James Grant penned a commentary in the weekend edition of the Wall Street Journal (September 19, 2009).  James is always worth reading (Grant’s Interest Rate Observer).  He has been a moderately bearish commentator for as long as I have been reading his work (10 years), most often in Barron’s articles.  He has bemoaned the high consumer and national debt and the very low (even negative) personal savings rate in America.  For this, he has called for a weak dollar and higher interest rates for the past decade.

That he flys in the face of his brethren bears is of no small consequence to me.  Normally James Grant’s perspective is closely aligned with so-called other “bond vigilantes” like Bill Gross at PIMCO and perma-bears like Bill Fleckenstein or Peter Schiff.  Those other dollar sellers / interest rate watchers are still looking for a flat to declining economy and dollar and moribund economy.  Grant really is making a departure from his club here, which is good because it is contrary.

He was early to call the stock market decline, as far back as 2005.  But this is news: now he sees it is time to become Bullish, if for the all the wrong reasons in his view.  James Grant is leaving the Bear camp (maybe six months late).   Here is an excerpt from his article.  Click here to read the entire piece from the WSJ.

Though we can’t see into the future, we can observe how people are preparing to meet it. Depleted inventories, bloated jobless rolls and rock-bottom interest rates suggest that people are preparing for to meet it from the inside of a bomb shelter.

The Great Recession destroyed confidence as much as it did jobs and wealth. Here was a slump out of central casting. From the peak, inflation-adjusted gross domestic product has fallen by 3.9%. The meek and mild downturns of 1990-91 and 2001 (each, coincidentally, just eight months long, hardly worth the bother), brought losses to the real GDP of just 1.4% and 0.3%, respectively. The recession that sunk its hooks into the U.S. economy in the fourth quarter of 2007 has set unwanted records in such vital statistical categories as manufacturing and trade inventories (the steepest decline since 1949), capacity utilization (lowest since at least 1967) and industrial production (sharpest fall since 1946)……

…..By rallying, equities and corporate bonds not only anticipate recovery, but they also help to bring it to fruition. By opening their arms wide to such previously unfinanceable businesses as AMR Corp., parent of American Airlines, and Delta Air Lines Inc., the newly confident credit markets are implementing their own stimulus program. “Reflexivity” is the three-dollar word coined by the speculator George Soros to describe the dual effect of market oscillations. Not only does the rise and fall of the averages reflect economic reality, but it also changes it. One year ago, the Wall Street liquidation stopped world commerce in its tracks. Today’s bull markets are helping to revive it.

I promised to be bullish , and I am (for once)—bullish on the prospects for unscripted strength in business activity. So, too, is the Economic Cycle Research Institute, New York, which was founded by the late Geoffrey Moore and can trace its intellectual heritage back to the great business-cycle theorist Wesley c. Mitchell. The institute’s long leading index of the U.S. economy, along with supporting sub-indices, are making 26-year highs and point to the strongest bounce-back since 1983. A second nonconformist, the previously cited Mr. Darda, notes that the last time a recession ravaged the labor market as badly as this one has, the years were 1957-58 —after which, payrolls climbed by a hefty 4.5% in the first year of an ensuing 24-month expansion. Which is not to say, he cautions, that growth this time will match that pace, only that growth is likely to surprise by its strength, not weakness.

And that is my case, too. The world is positioned for disappointment. But, in economic and financial matters, the world rarely gets what it expects. Pigou had humanity’s number. The “error of pessimism” is born the size of a full-grown man—the size of the average adult economist, for example.

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