January 2009 America will inaugurate its 44th President. The pressures of being the leader of the world's superpower is a huge one but consider this. George Bush would have left behind a legacy of debt and deficits that will constrain his successor. Those planned tax cuts and social programmes will be nothing more than dreams for it will take more than 8 years to undo the damage heaped on the United States economy by spendthrift Bush. In 2001 he inherited a surplus that could have helped pay down the $5 trillion federal debt. So Bush's $3.1 Trillion dollar budget will see military spending increase by 5% at the cost of medicaid, social security,medicare and a host of social programs. As the graph to the left depicts America under Bush has surely lived beyond her means. So as America moves into Recession and probably Stagflation just who is to blame? Without a doubt the economic policy makers in the Bush Administration the policy of spend and print has wreaked havoc on the economy. You can also add to this a weak dollar that the administration has allowed to weaken over the years. On the lips of the Central bank is the worry of inflation and god forbid Deflation and not growth both Greenspan and Bernanke are guilty of being yes men putting political idea logy before commonsense economics and the folly will continue for the foreseeable future.
Some weeks ago I warned about the impending dangers of Inflation, as the Central banks flood the markets with liquidity the real danger is that the Pound and Dollar in your pocket is worth less. Inflation erodes wealth your purchasing power is diminished as prices increase and your wages remain stagnant.
Why is inflation a problem?
Not for the reasons most people think. It may be tempting to say, "because everything is more expensive," but that is not it. Deflation can actually be just as damaging as inflation. The problem with inflation is one of redistribution: inflation makes some people worse off, but it makes others better off. This redistribution is due to three effects:
Price effects. As the average level of prices increase, some prices increase faster than others, so some people are more affected than others. The increase in gasoline prices in the summer of 2000 hurt truckers a lot, but barely affected people who live close to work and drive economy cars. College tuition has risen almost twice as fast as average prices over the past 20 years, which hurts you a lot, but may have little impact on a married couple with no children.
Income effects. Prices for goods and services mean incomes for someone else. So as some prices increase faster than others, some incomes increase faster than others. Oil companies posted record profits in the summer of 2000.
Wealth effects. Inflation redistributes income between borrowers and lenders. Suppose you borrow $100,000 for a 30-year mortgage at 7% interest, giving you a monthly house payment of about $665. During the next 30 years, as prices rise, that $665 buys less and less. So as a borrower, the real value of your house payment declines. Thus a borrower may gain from high inflation. The lender however, receives $665 per month, so the lender loses. If inflation is high enough the $239,400 the lender receives in loan and interest repayment over the next 30 years ($665 x 12 months x 30 years) will be worth LESS in real terms than the $100,000 the borrower receives today. Inflation hurts lenders but benefits borrowers, especially if it is unexpected. So the Wall Street banker is much more worried about inflation than Joe Average with a mortgage and a car payment. The costs of inflation go beyond redistribution, and have negative implications for the economy as a whole. If inflation is low, the effects may be small. But in periods of high inflation, known as hyperinflation, the negative effects will cripple an economy. What are the macro implications for inflation?
Uncertainty. Future prices are unknown, making it difficult to plan investment and consumption decisions. This means that some production will not be undertaken because firms are not certain about profitability.
Shorter time horizons. Due to uncertainty over prices, firms and consumers are less willing to commit to long-term plans, like a 30-year mortgage, or building a new housing development over 10 years. Again, production falls due to uncertainty.
Diverting resources from production. When inflation gets to be very high, firms and consumers spend more time and resources trying to avoid inflation, and less time on productive activities. For example, in Germany in 1923, prices doubled every week. Workers would be paid several times a day, and would immediately rush out and spend their wages. People had to bring wheelbarrows full of money to buy one loaf of bread. All of this results in time and resources being devoted to inflation-related activities instead of the production of goods and services. So inflation not only redistributes income, it also reduces the growth of real GDP which has negative implications for employment and standard of living for everyone.
The Bank of England has set in place a target of 2.1% for UK inflation and will act accordingly o make sure the UK economy stays within these parameters, the ECB also pays attention to inflation and will do what it takes to keep in check the inflation rate. The Federal Reserve on the other hand has deep and widening problems with the US economy and are using interest rates and fiscal stimulus to lessen the blow of the recession in the US. Other counties who have vast holdings of Dollar reserves are also worried about inflation and will dispose of the US currency to lessen the impact.
The Dollar versus Gold? There's no contest
I have been very bullish on Gold for several months and if you check my past blogs you would have seen the price of a ounce of Gold steadily rising, now approaching $1,000 per ounce what is really behind this increase. Well several factors the scarcity of the precious metal, China and India's insatiable appetite for Gold (demand) the world losing confidence in all the currencies issued by central banks but particularly in the dollar. America's huge trade deficit with the world and attitude to do nothing about it. As this decline continues the demand for Gold will increase as more and more Chinese and Indians will hoard gold as a store value of wealth as well as a hedge and safe haven against inflation. The Americans have abandoned the notion of safe money and are suffering from years of easy credit and living beyond one's means, Gordon Brown on the other hand must be kicking himself after disposing of half the UK's gold reserves at about the a third of the present price. There's also the supply problems in South Africa so where next for Gold? How about $1,000 per ounce by year's end you heard it here first.
On closing I keep getting asked what should I do where do I invest? Well I would advise you to seek advice from a qualified financial advisor but I will add the following:
Eliminate your debts- the ones that charge the highest interest
Live within your means
Adopt the discipline of saving - The US and UK are suffering a savings crisis.
Invest wisely
Own the home you live in (if you can)
Think long term
Until next time-stay in touch
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