Steve Saville: Infation - Not a Monetary Phenomenon After All?

Inflation: Not a Monetary Phenomenon After All?

by Steve Saville

Below is an extract from a commentary originally posted at www.speculative-investor.com by Steve Saville on 13th September 2007:


The weekly comments of Dr. John Hussman regularly contain great insights into the world of stock market investing and should, in our opinion, be read by anyone wanting to improve his/her understanding of what drives the stock market. However, almost everything Dr. Hussman writes on the topic of inflation is flawed.

Take his latest commentary, for instance. In this commentary he makes some valid points, such as that the quantity of reserves held by banks no longer determines the amount of lending conducted by the banking system and that the Fed follows, rather than leads, the market at interest-rate turning points. But his argument that "inflation is ultimately always and everywhere a fiscal phenomenon" misses the mark.

According to Dr. Hussman: "Inflation occurs when fiscal policy creates more government liabilities (either money or debt) than people are willing to hold at existing prices." And: "...if the government produces a lot of liabilities in an unproductive economy (as the Germans did in the 1920's, paying striking workers in the Ruhr even though they weren't producing anything), you get high inflation. It would not have mattered had Germany paid workers with bonds instead of money -- bond prices would have declined, raising interest rates, lowering the willingness of people to hold non-interest-bearing currency, and causing a hyperinflation nonetheless. Inflation is first a fiscal phenomenon, tempered by economic activity and credit conditions, and affected only at the margin by "monetary policy"."

Now, Dr. Hussman defines inflation as a rise in the general price level, which is a problem for a start and probably goes a long way towards explaining why most of what he writes on the topic is wrong (if you begin with an incorrect premise and then apply perfect logic then you will certainly arrive at an incorrect conclusion). Inflation is actually an increase in the supply of money, but to avoid writing at cross-purposes we will temporarily adopt his incorrect definition.

Dr. Hussman's assertion, then, is that if the government spends way beyond its means then the result will be inflation (a fall in the purchasing power of the currency) regardless of whether the deficit spending is financed in a way that leads to an increase in the money supply. Furthermore, by stating that inflation is always a fiscal phenomenon he is, in effect, stating that a rise in the supply of money will not cause the currency to lose purchasing power unless it stems from an increase in government deficit-spending.

While we agree that the main contributor to inflation over the long-term is the growth and associated deficit-spending of government, logic and empirical evidence tell us that a) declines in the purchasing power of the currency can only occur when the supply of the currency increases relative to demand for the currency, and b) large and sustained increases in currency supply inevitably lead to declines in the currency's purchasing power. The logical argument is based on the axiom that the law of supply and demand applies to money just like it applies to everything else in the economic world (the price (purchasing power) of money will fall if, and only if, the supply of money increases relative to the demand for money).

Importantly, this logical argument is supported by the historical record. For example, due to increases in money supply being severely limited by virtue of the dollar being a claim on a fixed weight of gold, the dollar did not lose any of its purchasing power during the hundred-year period prior to the establishment of the Fed; but during the 94-year period since the establishment of the Fed the US Dollar has lost more than 95% of its purchasing power in parallel with a massive increase in dollar supply. A substantial chunk of the increase in the supply of dollars is linked to the expansion of the US Government, but it was the increase in the money supply and not the expansion of the government per se that caused the loss of purchasing power. We do acknowledge, though, that the dollar's purchasing power would have held-up better if the increase in its supply had been mostly due to private-sector borrowing (perhaps it would have 'only' lost 80% of its value under this situation as opposed to the 95% it actually lost). The reason is that the private sector would have used the new money more efficiently, meaning that there would have been larger gains in productivity to offset the effects of the money-supply's increase.

Another historical example of how it's the increase in the supply of money and not the increase in the supply of government bonds that ultimately determines the currency's purchasing power was provided by Japan's post-bubble experience. During the 1990s and the first few years of this decade the Japanese Government issued bonds at a much faster pace than the government of any other developed country, and yet the Yen held its purchasing power better than any other currency. This was almost certainly because the supply of Yen increased at a very slow pace.

Japan's experience supports our view that a large increase in government indebtedness will NOT cause the currency to lose purchasing power UNLESS the debt is monetised, that is, unless the issuing of the debt results in the large-scale creation of money 'out of thin air'. Of course, large increases in government debt almost always lead to large increases in the supply of money, which is why Dr. Hussman observes an inverse relationship between the level of government indebtedness and the purchasing power of the currency.

But what about Dr. Hussman's contention that if the German Government had issued bonds in the early 1920s instead of printing money then the end result would still have been hyperinflation? Well, the end result would have been hyperinflation if the government had printed the money it needed to make the interest payments on the bonds. However, had the government chosen not to default indirectly via the printing press then it would have been forced to default directly on its obligations; and in this case the bonds would have become worthless, but the money in which the bonds were denominated would have held its purchasing power.

In summary, there is a huge pile of wrongheaded commentary on the inflation/deflation topic and most of it is based, one way or another, on the falsehood that the laws of supply and demand do not apply to money. Dr. Hussman has contributed to this pile by arguing that the primary cause of falling purchasing power is the increase in the supply of government bonds and not the (usually associated) increase in the supply of money. When people argue that a rising oil price will ripple through the economy and put upward pressure on the general price level they are also guilty of adding to the pile. This is because they are failing to point out that a price rise in one part of the economy (the oil sector, in this case) will have to be offset by price declines elsewhere unless there is an increase in money supply. And then there are the people who argue that under certain circumstances the central bank will be unable to prevent deflation from occurring, regardless of how much money it prints. These people are contributors to the pile as well because they are, in effect, saying that the price of a commodity (money, in this case) can be independent of its supply.

Steve Saville
Hong Kong

Steve Saville: Gold Stocks' Leverage (or lack thereof)

Gold Stocks' Leverage (or lack thereof) by Steve Saville
Below is an extract from a commentary originally posted at www.speculative-investor.com on 29th April 2007. Most people involved in the gold sector would realise that over the past few years gold stocks, as a group, have failed to live-up to their reputation as leveraged plays on the gold price. They provided substantial leverage to gains in the gold price during 2001-2003, but during the most recent 3.5 years of the gold bull market an investment in gold bullion has out-performed an investment in the AMEX Gold BUGS Index (HUI). Given that gold stocks are much riskier than gold bullion, this begs the question: why invest in gold stocks? Before answering the above question we'll take a look at why gold stocks have performed relatively poorly since late-2003 and see if the historical record offers any clues as to what might happen in the future. We think the following chart-based comparison of the yield-spread (the 30-year interest rate divided by the 5-year interest rate), the gold/GYX ratio (gold relative to a basket of industrial metals), and the HUI/gold ratio contains the reasons for the relatively strong performance of the gold sector during 2001-2003 and its relatively weak performance thereafter. The chart shows that as the yield-spread widened (as short-term interest rates fell relative to long-term interest rates), gold trended higher relative to industrial metals and the HUI provided substantial leverage to gains in the gold price. However, the ability of gold stocks to leverage gains in the gold price evaporated when the yield-spread began to contract and gold began to under-perform the industrial metals. The crux of the matter is that during 2001-2003 the financial markets were responding to economic weakness, falling liquidity and aggressive rate-cutting on the parts of central banks. In this environment the yield-spread widened and counter-cyclical gold did well relative to cyclical commodities such as the industrial metals, causing the profit margins of gold miners to expand. However, by late-2003 the markets had begun to discount stronger growth, leading to increased financial market liquidity and strength in cyclical commodities relative to counter-cyclical gold. The rising liquidity tide ended up lifting all boats including the golden boat, but in this environment the profit margins of the major gold producers contracted as the cost of mining gold increased faster than the gold price. As a result, gold stocks performed poorly on a relative basis. It is also worth mentioning that whereas the aboveground supply of gold increases at a slow and steady 1.5-2.0% per year, year-in and year-out regardless of what is happening to the gold price, a gold bull market invariably leads to a rapid increase in the supply of gold shares. As the gold bull market becomes more widely recognised the rate of increase in the supply of gold shares tends to accelerate due, firstly, to the arrival on the scene of many new gold mining companies and, secondly, to most managers of small gold mining companies being embedded with a gene that prevents them from saying "no thanks" when presented with the opportunity to raise money by issuing more shares. In other words, the supply of gold bullion is severely constrained whereas the supply of gold shares can be -- and usually is -- expanded rapidly in response to rising demand. Interestingly, the performance of the gold sector relative to gold bullion during the current bull market is not dissimilar to its performance during the bull market of the 1960s and 1970s (the gold price was fixed at $35/ounce prior to 1971, but the performance of the gold sector of the stock market indicates that a gold bull market actually began in the early-1960s). Specifically, the following chart of the BGMI/gold ratio (the Barrons Gold Mining Index divided by the gold price) shows that relative to gold bullion the major gold stocks peaked in 1968 and then trended lower for the next 12 years. The above chart should give pause to those who believe that a drop in the HUI/gold ratio or the XAU/gold ratio to a particular level automatically means that it's a good time to aggressively buy gold stocks. Today's secular gold bull market is probably going to continue for many more years, but if it follows a similar pattern to the previous secular bull market then the major gold stocks will move much higher in nominal dollar terms over the next several years while moving lower in gold terms. We'll now return to the question: why invest in gold stocks? As we've said numerous times in TSI commentaries over the past few years, we don't think there is a good reason to favour the MAJOR gold stocks over gold bullion. There will be periods when the large-cap gold stocks trend higher relative to the metal, especially those periods when the yield-spread is widening and gold is out-performing industrial commodities. Such periods will offer opportunities to go 'long' these stocks for intermediate-term trades, but we think long-term investors will be better-served by the bullion. In our opinion, the large-cap gold stocks do not offer enough upside potential, relative to gold bullion, to warrant long-term investors taking-on the additional risk inherent in the stocks. However, junior gold stocks in general and exploration-stage gold stocks in particular are a different 'kettle of fish'. Despite their risky nature, there are plenty of stocks at this end of the market that have sufficient upside potential relative to the bullion to enable a good case to be made for accepting the risk (*blogger's emphasis). Of course, speculators in these stocks must be emotionally equipped to handle high volatility and must diversify to mitigate the effect on the portfolio of a big problem with any single stock.
Steve Saville Hong Kong