Deflationists and inflationists
have been arguing for years. Each side has data to back up its claims, and
the public doesn't see a clear winner. One of those data points is what historically
occurs when an overburden of debt finally blows up, an event that's almost
certainly dead ahead for us. Deflationists will point to periods in history
where deflation resulted. But there's more to the argument, says Jim Puplava of Financial Sense. He emphatically states, "The outcome depends on whether or not
the economy is operating under a fiat currency system, because there's never
been a deflationary depression when one's been in place."
When I saw this claim, I wanted to hear more,
because deflationary forces seem strong at the moment. And which way this
goes has direct and significant implications for investments, including gold.
Here's my interview with Jim.
Jeff Clark: For those who don't know you, Jim, tell us what you
do.
Jim Puplava: Basically I head up three companies. We have our
own independent broker-dealer; we have a money management firm; and we have a
media company which produces the Financial Sense News Hour online. I
head up those three companies and am the CEO.
Jeff: It's been four years since the financial crisis, and we're still
debating inflation vs. deflation. I found your claim quite compelling, so
tell us what you found in your research.
Jim: Well, why don't we begin with the financial crisis that transpired
between 2007 and 2009, something every investor remembers? Now the
deflationists would argue that in a crisis as big as that, the resulting
downturn in the economy is always deflationary. But if we look at that
period, the money supply continued to expand. In my opinion, inflation is
associated with monetary policy.
Jeff: We should probably define the terms we're using.
Jim: This is one of the problems we have when talking about deflation. You
will often hear, for example, that "housing prices fell by 30%" or
the "stock market fell by 40%," supposedly meaning it was
deflationary. But that is a specious argument at best, because if we call the
crash in real estate and the stock market deflation, then what would the
deflationists argue now that housing is starting to turn around? What would
they call the S&P going from 666 to 1,373? It's up over 100%... is that
deflation?
Let's take the popular definition of inflation
– rising prices, which is really a symptom of inflation. During the
financial crisis, there were only three months where the CPI was negative.
Prior to 2008, the last time you saw a negative CPI was in 1954, when
Eisenhower was president! So despite all the claims about deflation, all you
would have to do is look at a graph of M1 and M2 and see that the money
supply actually expanded during this period.
Investors may not recall that in the middle of the
2007-2009 crisis, Bloomberg sued through the
Freedom of Information Act and got access to the Fed’s records of exactly
what they did. We found out that they either guaranteed, expanded, or
backstopped somewhere around $8 to $9 trillion. That can only be done in a
fiat money system – something you can't do with a gold-backed system.
Jeff: Like during the Great Depression.
Jim: Even before that. Step back to 1920-1921… If you look at the
statistics during that period of time when we were on an actual gold
standard, you saw a huge contraction of GDP and in the price of goods. Here
are the actual numbers: between the summer of 1920 and 1921, nominal GDP fell
by 23.9%; wholesale prices as measured by the PPI dropped by 40.8%; and the
CPI fell by 8.3%. It lasted for roughly two years.
I have yet to see anything like this in Japan. I
have yet to see anything like this in the United States – despite the
credit crisis and all the fallout we've had.
Furthermore, even in the gold standard we had during
the '20s and '30s, we had inflation. President Roosevelt devalued the dollar
by 60% in March of 1933, and when he repriced gold
from $20 to $35, he stopped deflation dead in its tracks. By the end of the
month we were experiencing inflation. We were running single-digit inflation
rates the very month he did that in 1933, all the way up to 1937, when FDR
and the Federal Reserve reversed course. So as a result of the devaluation we
got large doses of inflation.
Jeff: So your point is that even though we had a gold standard during the
Great Depression, the government found a way to cause currency dilution, AKA
inflation.
Jim: That's right.
Jeff: You brought up Japan; I assume you're using it as an example instead
of the smaller countries because it's a major economy?
Jim: Yes, exactly. Even though the US dollar is the world's reserve
currency, we have three major currencies where most trade is conducted
– the dollar, euro, and Japanese yen. Argentina's economy is
insignificant in terms of global GDP, for example, and they're constantly
printing money, so a lot of people don't like to refer to small countries
like these.
I'd like to address Japan, though, because of its
unique situation. And I think a graph will best make the point. The following
is Japan's CPI, year over year, going back to 1982. There were brief periods
of deflation, about 1% or 2%, and you can see that most of this occurred
between 2000 and 2004 and in the credit crisis following 2009 to 2010.
In that period of falling prices, the CPI was only
down 1-2%. If we take a look at Japan's monetary base, however, there was
only one period where it actually contracted, and that was between 2005 and
2010. But the period that the deflationists like to talk about – 1989
going forward – Japan's monetary base expanded every year.
Government spending expanded viscerally.
Jeff: And now their debt is among the highest in the world.
Jim: Japanese debt today is roughly 208% of GDP, one of the highest debt
ratios in the developed world. But there's something else that makes Japan
unique…
If a government expands its spending in order to
rectify weakness in the economy, there are couple ways governments can
finance that. They can print money – which is what the Fed has been
doing – or they can finance it through the bond market with existing
savings. One of the very measures that allows Japan
to escape a rather severe deflation compared to what we experienced in the
early 1920s following World War I or in the '30s during the Great Depression
was the Japanese savings rate. Going back to when the crisis began in Japan,
the savings rate was 18%. In other words, Japan has been able to finance its deficits
internally. Ninety percent of their debt has been financed and held by
domestic savings. If the Fed or US politicians financed government spending
with existing savings – in other words, took the savings of Americans
and financed the deficit – that would not be inflationary. Inflation
comes when we get debt monetization, and fortunately for Japan, they were
able to finance 90% of their debt expansion internally through domestic
savings.
The second factor that contributes to what happened
to Japan was the carry trade. As a leading export nation, Japan exported a
lot of its money to the rest of the world, and it gave rise to the carry
trade, in which we were able to borrow in Japan at some of the lowest
interest rates in the world. So if Japan instituted capital controls, where
the excess reserves of the monetary base were not allowed to leave the
country, that money would have been confined within Japan itself, and then
you would have had more money chasing fewer goods and services.
Jeff: What about Japan's demographics?
Jim: Yes, this is going to play very heavily on Japan. As their population
has aged, the savings rate has declined from 18% to roughly 2%. If we look at
total Japanese debt, 67% of that debt is rolling over in the next five years.
More alarming is the fact that they have 900 trillion yen in sovereign debt
outstanding, and the bulk of that is set to mature in the next two and a half
years. And more importantly, the majority of this debt is now starting to be
sold. A large percentage of this sovereign debt, as I've pointed out, is
owned by Japan's own citizens, and for the first time in nine years, Japan's
Government Pension Investment Fund, which is the world's largest pension
fund, sold 443.2-billion of Japanese government bonds in its fiscal 2009-2010
year, as rising benefit payouts to pension reserves required a liquidation of
debt. This is a major concern in our opinion for Japan, because as the Japan
Investment Fund owns 12% of the country's outstanding domestic bonds, they
are going to be selling an additional couple of hundred billion over the next
two years.
So as Japan goes forward, there are only two things
they can do to finance that debt. One, they could go into the world bond
market, though they could be subject to bond vigilantes where the interest
rate spread could be high; or two, monetize it. Because their debt to GDP
ratio is 208% and still rising, the only way they're going to be able to keep
interest rates down in that country is to monetize that debt in the same way
our Fed is doing it through its monetary base and Operation Twist.
My point here, Jeff, is that the same demographics
that will force inflation on Japan are the same demographics that are going
to force inflation in the United States.
Jeff: Especially when you look at our unfunded liabilities…
Jim: Precisely. Lawrence Kotlikoff, author of The
Clash of Generations and former senior economist on President Bush's
Council of Economic Advisors, has a new book out, and he says US government
liabilities are growing close to $11 trillion a year. At the end of last
year, it stood at $222 trillion. And by the way, these numbers come from the
Treasury and CBO [Congressional Budget Office]. These aren't numbers I'm
making up, so I rest my case with the deflationists. History has shown
deflation can end overnight.
Jeff: So you're saying history shows that when debt blows up in a fiat
currency system, inflation has always been the result.
Jim: Exactly. That's the case even in severe downturns. Look at what
occurred in Japan between 1989 and 1991… their stock market lost 70% of
its value and real estate prices fell 40-50%. Yet you would be hard pressed
to find deflation of more than 1% or 2% for brief periods of time.
Jeff: Let me challenge you on a couple points. Some will point to the
"lost decade" in Japan as deflationary and say that the
government's stimulus efforts didn't work.
Jim: During the Lost Decade of 1990-1999,
inflation rates in Japan were 3% to 4%. One of the few times where they
allowed the monetary base to shrink significantly was the period between 2005
and 2009, and the result was 1% to 2% deflation.
Jeff: I can hear some deflationists say, "Gee, if the CPI only goes up
3% when debt blows up, I'll take that."
Jim: They'll take that, but if you look at the dire warnings deflationists
give, we have seen nothing of that sort in any major economy. Even in our
economy, if we look at the credit crisis of 2007-2009, which had its
origination here in the US, the monetary base didn't contract – it
expanded. What people have to understand is that when money is created,
central banks can't control it. And what happens with that money is that it
finds an outlet. It has to go somewhere – it can go into housing, it
can go into commodities, it can go into stocks. The big warning the
deflationists will give is that the world is going to collapse and that we're
going to see a repeat of the Great Depression. I would challenge them to
prove that, because if we're on a fiat currency, inflation has always been
the result.
Jeff: Another challenge: we're in deflation now because the economy is
going nowhere, stocks are going nowhere, even commodities are going
nowhere…
Jim: This is one chapter in a long book that has to play out. What we've got
right now is the private sector deleveraging and the public sector leveraging
up, and these two forces are fighting against each other and the result right
now is stagflation.
Jeff: How long does this stagflation continue?
Jim: I think this stagflationary economy
continues for the next couple years. Martin Armstrong, former head of
Princeton Economics, also believes that will be the critical period when the
fertilizer hits the fan. Of course a lot can change and accelerate that
– the outcome of the November elections, for example. I've taken a look
at the president's budget... According to the CBO, he will expand spending by
$700 billion over the next four years, assuming he is reelected, and that's
assuming his economic assumptions are correct. In other words, we can raise
taxes by half a trillion dollars and it doesn't impact the economy, even
though the CBO and the Fed acknowledge this would subtract 4% from GDP. So
there are some wild cards out there that are unpredictable. The results of
the November election could favor a postponement, or we could get an
acceleration of that time frame.
And let me make a prediction: Right now the world is
focused on Europe, and we're seeing all the fallout from that. I think the
next crisis jumps from Europe to Japan, and then eventually from Japan to the
United States. Right now the US has the "best-looking house in a bad
neighborhood." A lot of gold investors have been disappointed with the
price of gold or gold stocks, but they have no further to look than what's happened
to the dollar. The US has been a big beneficiary of the flight of capital
escaping Europe, so we've seen commodity prices go down. This fall in
commodity prices has led to a lower CPI, and as a result we're also
experiencing lower import prices, so the United States continues to be the
beneficiary of the crisis. We will continue to be a beneficiary of this,
however, only as long as we maintain some form of credibility in the bond
market, the idea being that the US will eventually get its own financial
house in order and will bring its deficits under manageable conditions.
Jeff: Are you saying we won't have a negative CPI again?
Jim: I'm saying that if we did, it won't stay there long because we're
operating under a fiat currency, giving the government essentially free rein
to print as much money as it wants.
Jeff: If you're right, then when the crisis moves to Japan, gold and
commodities could still be weak because investors would still go to
Treasuries.
Jim: We're in a period of a rising dollar, and that dollar is competing
directly against gold. I also think it will depend on whether or not the US
gets hit with the fiscal cliff in January and the economy weakens. If that
happens, I think the Fed could embark on another massive round of
quantitative easing, which would change the picture for the gold market.
Right now, though, the Fed doesn't have to do anything.
One of the reasons I think gold investors got
disappointed last fall is that the Fed didn't embark on quantitative easing.
Instead it announced Operation Twist, which was really not expanding the
monetary base, and the result was interest rates came down from 2.5% to 1.5%.
So it wasn't necessary for the Fed to do QE. The market was doing the Fed's
job for it.
Jeff: Is it your premise that this money finds its way into the economy and
leads to inflation, meaning higher prices?
Jim: Absolutely. Our unfunded liabilities are simply too big. I had to
laugh when the president gave a speech last week talking about this tax on
the wealthy, which was going to generate, according to the CBO, $65 billion
in tax revenue. The government is spending $10.4 billion per day, so
that revenue would basically run the government for a little over a week.
Jeff: The extent of our unfunded liabilities would imply much higher price
inflation, which in turn would lead to much higher gold prices.
Jim: Absolutely. I'm very bullish on gold. I think we're just going
through a long consolidation period. Right now gold is competing with falling
commodity prices and a rising dollar.
Jeff: What's your view on silver in this context? In spite of it being a
monetary metal, silver could stay flat in this stagflation since it has a lot
of industrial uses
Jim: I think silver can remain weak, but once again, that could change
abruptly. Let's say politicians don't resolve this fiscal cliff we're
approaching and we get a fiasco like we did in August of 2011, where the Fed
could change its policy and resort to another round of QE. If you listen to
the Bernanke's recent testimony on Capitol Hill, Senator Schumer from New
York basically said "Look, Congress is in an election year, we're
unlikely to resolve this. So get to work, Mr. Bernanke. You're the only game
in town." If Bernanke listened to him, then the Fed would have to take action,
especially if we saw economic activity sharply decelerate or unemployment
begin to spike.
Jeff: Another question I want to ask you. You've interviewed a lot of
people over the years…
Jim: Probably in the thousands.
Jeff: Of all the people you've interviewed over, say, the past year, what
have you heard that strikes you as particularly insightful or crucial that investors should be aware of?
Jim: I think if there's anything that I have learned in this market from
the people I've interviewed and from our experience managing a gold
portfolio, Jeff, is that you have to look at your portfolio in several tiers.
I have personally, as well as for clients, set up a core position in gold.
That is never going to change. It's there because I believe it's a store of
value, as insurance against the unexpected. Then we have what we call a
trading portion of gold and silver. Last year around late April early May, we
trimmed our silver position in half and instituted a put on silver and gold,
including our gold equities. Because so much of the market today evolves around momentum trading and leveraged hedge
funds, money moves in and out of a sector. It's like a hive of bees looking
for a place to land. When they land on that sector – boom!
–prices skyrocket like you've never seen. And then all of a sudden that
trade plays out, something changes, and the money moves out of the sector.
The point is, we no longer live in a "buy and
hold" world.
So the thing I would share with your readers is to
keep your core position and know why you own it – it's there because
it's a store of value, for insurance. And if you want to increase that
position over what you feel you're comfortable with, we recommend trading it.
Jeff: So I guess the question is, how long do we have to wait until the
bees come back to the gold beehive?
Jim: Well, it could be this fall, or it could be another year. A lot of
your readers will remember this, but the gold price spent two years
consolidating in the mid-1970s, falling from $200 to $100. So when I see the
price of gold go up from $1,000 to $1,900, it's not unrealistic to expect
there to be a period of consolidation as money goes elsewhere.
What I would suggest gold investors do if they're
getting impatient is look at dividend yields. There are many high-quality
mining stocks today that you can buy at seven, eight, ten times earnings,
something we never have seen in this bull market, and you can receive a
dividend yield that is higher than a 30-year Treasury bond. So while they're
waiting patiently for this to unfold, they're getting compensated.
Jeff: It seems incongruous to bring this up in a weak market, but do you
see a future mania in the gold sector?
Jim: Oh, very much so. And let me throw out another couple predictions.
There are three phases to a bull market: The first phase is where the market
starts to take off, and that's the smart money. They come in and drive it.
Then the second phase of the bull market is where institutional money starts
to come in and participate. I think that's where we were over the past couple
years – just look at the plethora of new gold
funds and resource funds. Then you get a corrective phase, which is what
we're going through now. Then the third phase is when the public comes in. If
we look at the stock market boom that began in August of 1982, the public did
not invest in that stock market until 1995. Ninety percent of the money that
came into the stock market entered between 1995 and 2000. So that final phase
will occur when it finally catches on universally, when Larry Lawnmower and
John Q Public are watching Maria Bartiromo talk about the next gold IPO. That is still ahead
of us.
Furthermore, at that point I don't think you're going
to be able to get the physical stuff. There likely won't be enough production
to meet worldwide demand, and at that point I think it's going to be easier
to open your laptop and type in the ticker symbol for a gold stock than it is
to go out and try to find bullion.
Jeff: Which implies higher prices for both gold and gold
stocks.
Jim: Yes, higher prices in my opinion. So what I would tell your readers
right now is to maintain their core positions and know why they hold them. If
they want to add to their positions, especially in the equity space, take a
look at some of the larger or mid-tier producers that are not only paying
dividends but increasing them. Look at a company like Newmont; they've
increased the dividend by over 100%. So at least your money is not just
sitting idle – you're earning income while you're waiting for this
process to unfold.
Jeff: Good advice, Jim. Thanks for sharing your insights.
Jim: You're welcome, Jeff. Thanks for having me.
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