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New Era Nonsense

Our weekly commentaries provide Euro Pacific Capital's latest thinking on developments in the global marketplace. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital.
Peter Schiff
Monday, January 1, 2001
Article actually written some time in 1999.

There is a general misconception on the part of many mainstream economists that the apparent exceptional performance of the U.S. economy is evidence of a “new era,” where strong productivity gains allow the economy to grow faster without causing inflation, enabling interest rates to remain low and the economic expansion to continue for an extended period. This naïve hypothesis results from a fundamental lack of understanding of inflation..

Contrary to popular belief inflation is not rising prices but an expansion of the money supply, which results in higher, though not necessarily rising prices. As the Federal Reserve creates more dollars, the purchasing power of each dollar diminishes, causing prices to rise to compensate for the dollar’s diminished value. On the other hand, as the economy becomes more productive, the purchasing power of each dollar increases. If the Federal Reserve inflates (creates dollars) faster than the economy expands production prices will rise. Alternatively, if production accelerates at about the same rate as inflation (money supply growth) then prices will remain stable. However, the latter is not indicative of an absence of inflation but of rising productivity. Had there been no inflation prices would have fallen to reflect that increase. By inflating (creating dollars) the Federal Reserve prevents prices from falling, thus transferring productivity gains from the consuming public to government, whose agencies are able to spend the newly created dollars into circulation. Inflation, therefore, transfers purchasing power from the private to the public sector without the need for politically unpopular tax increases..

In a growing free market economy the natural tendency for prices is to decline. Improvements in productivity have always put downward pressure on prices. However, during most of the twentieth century the Federal Reserve created so much inflation (printed money) that prices actually rose despite productivity gains. During the past several years, even though the Federal Reserve created more inflation than at any time in its history, consumer prices increases have been relatively modest. Many economists mistakenly attribute this phenomenon to a “new era.” However, a closer examination of the facts reveals a more realistic explanation. .

Foreigners irrationally regard the dollar as a “safe haven” and during the past several years a variety of temporary factors, including the Asian economic crisis, the Latin American crises, the Russian crises, European monetary convergence, the weakness in gold, the yen carry trade, and Y2K fears, have caused excessive foreign demand for U.S. dollars. In exchange for dollars foreigners supplied Americans with vast quantities of consumer goods, as evidenced by America’s ever widening merchandise trade deficit. The excess dollars created by the Federal Reserve (inflation) were exported and therefore not available to Americans to bid up domestic consumer prices. Instead, foreigners used them to bid up prices for U.S. assets, mainly bonds, resulting in lower consumer prices and interest rates for Americans..

In reality, what has been mistaken for a “new era” is merely nothing more than an abnormally long lag between inflation (expanding money supply) and rising prices. The fact that prices for consumer goods have been rising relatively slowly is not so much the result of increasing American productivity, but rather of increasing imports. Americans have not been producing that much more but merely have been importing a lot more. Foreign demand for dollars has been allowing Americans to live beyond their means for years, but the recent increase in that demand has allowed Americans to elevate that propensity to an art form..

As the temporary factors causing increased foreign demand for dollars have begun to subside foreign demand for U.S. treasuries has been falling, causing interest rates to rise and the dollar to fall. In time the cross-border flows will reverse, as foreigners spend their excess dollars on U.S. goods instead of on U.S. bonds. The result will be paper dollars flowing into the United States and real goods flowing out. Domestic money supply will swell and prices for consumer goods will soar as import prices rise and Americans compete with foreigners for a dwindling supply of U.S. manufactured goods..

Soaring consumer prices and rising interest rates will herald the end of the “new era” and ultimately prick the stock market bubble. As stock prices collapse to reflect more realistic valuations, the resulting bear market will further diminish foreign demand for U.S. assets, accelerating capital outflows, putting further downward pressure on the dollar and upward pressure on interest rates. As over-leveraged Americans see their asset values dwindle (falling stock and real estate prices), and their debt burdens swell as a result of floating rate debt, bankruptcies will soar, real consumer spending will slow dramatically, and there will be wide spread layoffs within the over-developed service sector..

The resulting recession will be severe, with a negative savings rate leaving the typical American family ill prepared for economic bad times. The Federal Budget surplus will quickly become a deficit putting further upward pressure on interest rates. Exacerbating this situation will be the fact that the 6 trillion dollar national debt is financed with short term paper, the average maturity being about 4 years. This will cause the cost of servicing that debt to rise sharply further increasing the budget deficit, forcing the federal government to either cut spending or raise taxes during the recession prolonging the economic downturn. The Federal Reserve, forced to remove excess dollars from circulation and raise interest rates, will be equally powerless to combat the recession, leaving Allan Greenspan and other similarly delusional economists, portfolio managers, private investors, and on-line traders with little to do but mourn the passing of the short-lived “new era.”.

Otherwise intelligent portfolio managers have used the “new era” as justification for abandoning traditional methods of stock valuation and security analysis in favor of momentum “investing,” where stocks are purchased simply because their share prices are rising. Furthermore, since portfolio managers are consistently being evaluated on their short-term performance relative to some benchmark index, they are forced to buy the overvalued momentum stocks that dominate those indices, even if they realize that such stocks are bad investments. They do not dare buy any “value” stocks for fear that doing so would further increase their risk of underperformance. Indeed, value-oriented funds have been suffering net redemptions, putting further price pressure on such stocks, as individual investors move money out of these funds in favor of better performing indexed or momentum funds. The perverse result of this process is that overvalued “momentum” stock keep getting more expensive, while undervalued “value stocks” keep getting cheaper. Eventually the bubble in “momentum” stocks will bust, their share prices will collapse, and portfolio managers will once again seek traditional value..

Until that happens prudent investors with long time horizons can pick up some incredible bargains. One country where such bargains abound is New Zealand. In a bear market since 1987, The New Zealand stock market is a value-investor's paradise.

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Investing in foreign securities involves risks, such as currency fluctuation, political risk, economic changes, and market risks. Precious metals and commodities in general are volatile, speculative, and high-risk investments. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. International investing may not be suitable for all investors.

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Our investment strategies are based partially on Peter Schiff's personal economic forecasts which may not occur. His views are outside of the mainstream of current economic thought. Investors should carefully consider these facts before implementing our strategy.