Why Does the Fed Fear Deflation More than Inflation

Have you noticed that the Fed Chairman seems to be far more concerned about deflation than inflation? It's reflected in his public comments and in the policies being pursued by the Fed.

In a nutshell, when deflation is caused by corrections of bad investments made during a bubble (like the sub-prime mortgage loans and their related derivatives) it is manifested by bad loans that don't get repaid. Individuals and businesses take bankruptcy or they negotiate more favorable terms. Most of the lenders are banks and they don't get repaid. Never mind that the banks made a lot of those loans with artificial money created by the Fed or the fractional reserve banking system. The banks don't like to write off their loans.

In addition, deflation has the opposite effect of inflation. Whereas inflation is caused by an increase in the money supply, deflation reduces the money supply. The effect is to make it more expensive for banks to secure money with which to make loans.

in case you may have missed it, the Fed is owned by the banks. It's completely separate from the Federal government, despite the implication caused by the name "Federal Reserve Bank".

So it makes sense that the Fed is far more concerned about preventing deflation than about preventing the kind of inflation that is caused by an increase in the money supply and by the fractional reserve banking system.

Just my two cents.

Vern

The Best is Yet to Come

Have you seen the t.v. commercial that expounds on the merits of gold as an investment?

Near the end of the message, the announcer is talking about how much gold prices have increased in the past ten years or so. And then he says,

"And the best is yet to come."

Really?

Do you really want the price of gold to increase? If so, do you really understand that the price of gold is a measure of fear, inflation and political instability?

I first bought some gold back in 1979 when the price was closing in on $700 an ounce. By early 1983, the price was down to near $300 an ounce and it stayed there for nearly twenty years.

Why? The monetary policy of Paul Volcker drove interest rates way up and set off a serious recession. But it took the steam out of the double digit inflation we were experiencing. And it took away a large part of the reason that gold prices were so high. In spite of moderate inflation from 1980 through 2003, gold prices didn't increase -- which demonstrates that gold is not a pure inflation hedge. The price of gold does not correlate closely with inflation because it is also a measure of the degree of political instability. And, of course, the price is affected by large purchases and sales by governments.

Speaking for myself, I'd be happy if the price of gold were to drop from it's current level because that would be an indication that things were back to normal. Over time I do believe that gold will increase to reflect the loss of value in the dollar due to creeping inflation.

As far as the price of gold is concerned, I surely hope the best is not yet to come and that gold won't go up to $5,000 an ounce as some promoters are claiming.

Nonetheless, I will continue to maintain a portion of our net worth in what Lord Keynes called "the barbaric relic" -- just in case things get worse instead of better.

Vern

A Cure for Inflation?

Have you noticed that we talk about an increase in the price of gold, silver and various foreign currencies, instead of talking about a decrease in the value of the U.S. dollar?

As of about 10:30 am (central time) in the U.S., on November 15th, the spot price of gold was $1,338. If you bought some gold at $1,000 an ounce, have you made a profit of $338 (33.8%) or has the value of the dollar decreased by about 25%? If you invested in Euro's at 1.20 per dollar and sold out when the Euro was at 1.40 per dollar, have you made a profit of 16.7% or did the dollar fall by about 14%?

If the increase in the relative value of gold or other currencies versus the dollar is actually a decline in the purchasing value of the dollar, why do we have to pay taxes on the alleged gains in the value of gold, silver or other currencies?

One of the diverse suggestions for a way to curb inflation is to permit people to use gold or silver as a substitute for the dollar, but without eliminating the dollar. This would require that we do not impose a tax on any increase in the value of the competing currency in relation to the dollar. Many people would continue to use dollars to conduct business, but an increasing number would choose either gold or silver to establish the price of various products or services. This would be particularly attractive for transactions (such as loans) that expose one of the parties to a potential loss because of a decline in the value of the currency. But this would also put a lot of pressure on the Federal Reserve to stop inflating the currency.

Of course, that's simply a lot of wishful thinking on my part because there is no way the political and banking establishment would allow us to use any competing substitute for the declining dollar.

Vern

See The Tax Reform Alternative
http://www.offshorepress.com/taxreform2010.html

If I pay Less Will You Pay More?

A scholarly analysis of the IRS penalties versus the excessive fines clause of the Constitution concluded with the statement (in part) that

"When one taxpayer pays less, we all pay more."

This is also an often used comment by various IRS officials. But is it true?

If it is true, it means that the government somehow arrives at some budgeted amount that is somehow divided among all taxpayers. Furthermore, if the full amount that is budgeted isn't collected in the current year, it must somehow be picked up in a later budget year.

And what happens when a lot of taxpayers lose their jobs and end up paying less taxes? Do the rest of us have to somehow make up for that lost tax revenue?

If that's true then every time the government introduces some kind of new targeted tax incentive (aka special interest tax expenditure), all of the taxpayers who are not part of the favored group must have to somehow make up for the shortfall. And what about the fact that roughly 50% of the households in the U.S. don't pay any income taxes at all? Clearly, the other half must make up for the shortfall.

However, it doesn't really work that way.

First of all, this cliche' presumes that the expense side of the budget can't be changed. Is that the way things are in your household or business? If there is a shortage of revenue, don't you make up for the difference by either borrowing (if you can) or by cutting back on expenses if borrowing is not an option? And if the loss in revenue persists (or is expected to persist), you start cutting some expenses, like the cruise you wanted to take or the new car you were going to buy. In extreme cases, you might even downsize by moving to a smaller home and selling some stuff.

With the federal government, there is a lot more opportunity to borrow the funds, which are rarely repaid. The annual deficit is just added to the accumulated national debt which results in having to pay more interest. But the debt isn't repaid -- it is just rolled over from year to year. And if the debt gets to be too much, we pay off some of it with new money courtesy of the Federal Reserve. Of course we try to do that gradually because if we print too much too fast, it would upset all of our trading partners around the world. (Because our money would lose value.)

Back to the question. If I somehow pay less taxes by not working or by getting a cut in pay or by using some sort of obscure tax break, do you have to pay more? The answer is no! There is no connection because the government has an almost unlimited ability to borrow money.

But I can hear a few readers asking, "O.K., if that's true why do they need to collect taxes at all?" And my humble two cents on the question is that they don't have to collect taxes as long as they have the Federal Reserve available to create new money in exchange for new treasury obligations. But doing that would make it obvious that inflation is actually a substitute for taxes.

Vern

Who Suffers from Deflation?

It often seems that the financial media treats deflation as if it were some sort of financial plague.

It's somewhat obvious that everyone is hurt by inflation, right? Oh yeah, I almost forgot. People who owe money to banks or other lenders like inflation because they get to pay off their debts with cheaper money. That must mean that the lenders don't like inflation and logically should like deflation. And debtors should be the ones who get hurt financially during periods of deflation.

But it seems that it's the bankers who scream the loudest about the evils of deflation. Why is that?

Put simply, it's because they have less money to loan at interest rates above what they have to pay for the money.

The banks get money to lend from three main sources. One is from the money that is deposited with them. They can loan up to about 90% of those deposits to borrowers at interest rates above what they have to pay the depositors. The second source of money is from the deposits by the borrowers or from people who have borrowed funds from other banks. But that is probably their most expensive source of funds.

The third source of funds is from the Federal Reserve and it is often the cheapest source of funds. Right now, the Fed is keeping the interest rates they charge member banks as low as possible. In fact, the rate is so cheap that the banks are finding it safer and more profitable to just park that borrowed money in U.S. treasury bonds.

With deflation, it works pretty much in the opposite way.

Fewer people are borrowing money so the banks have less money to lend. The Fed is likely to try to push money into the market with lower interest rates but if people aren't borrowing, it's like pushing on a string.

With deflation, prices are generally declining. Each dollar in circulation has more purchasing power. Although borrowers pay off their debts with more valuable dollars, that's not a profitable thing for them to do. So they try to pay off debts as soon as possible instead of delaying the payments as long as possible. And there is then less money in circulation which reduces the profits for the banks.

The bottom line is that it is the bankers who are hurt the most because of deflation. And the Fed is owned by the bankers. So if I have to place a bet on whether we are more likely to have inflation or deflation, I'll bet on inflation.

But there are some times (like now) when some deflation or at least a lack of inflation is unavoidable. That's because bankruptcies and loan defaults are inherently deflationary. They offset the money that was created when the loans were made and reduce the money in circulation.

But in the long run, those who avoid debt would be better off with deflation.

At least that's the way it seems to me.

Vern

Logic vs. Faith

For a long time I have found it difficult to understand how otherwise intelligent people can honestly believe that any government is able to create prosperity or even security. To a large degree it seems that those who are the most educated (and therefore presumed to be highly intelligent) are the most likely to argue that government is the solution to every problem and the great provider of greater prosperity and justice for all.

I have developed a litmus test with respect to the honesty of politicians based on their promises about what the government can do for their constituents. When a candidate for President claims that he will be able to "fix the economy", I regard him as either a fool or a lier. The government can impose laws and regulations and they can impose taxes or create new money through cooperation with the Federal Reserve. They can create an environment that encourages entrepreneurs but they can't create prosperity. That can only be done by private industry.

More laws and regulations rarely solve more problems than they create. The regulations consume resources to fund the bureaucracy and they restrict or inhibit industry in a variety of ways. They create distortions in the economy and cause industry to divert resources to deal with whatever mandates are imposed. For every useful law or regulation, there are a dozen others that are politically motivated and pander to the goals of various special interest groups. Government benefits for various constituents inevitably lead to an expansion of the intended scope of the program.

The laws and regulations inevitably require more taxes or more "funny money". The progressive income tax provides an incentive for those who are excluded from the tax (the bottom 50% of households) to demand more government benefits at the expense of those who do pay income taxes. It is a simple truth that whatever we tax, we get less of. When we tax income we end up with less income. When we tax assets, the assets always evaporate. When higher taxes become unproductive, the government resorts to the debasement of the currency. In a country with a central bank that simply involves the issuance of government bonds in exchange for newly created money. And that leads to inflation, which diminishes the purchasing power of the currency.

But the advocates of more government and central planning are immune to this kind of logic or common sense. They seem to base their decisions on blind faith that a few people with concentrated power can somehow produce a better result than millions of individuals who are motivated to find solutions for whatever problems they may face. The advocates of bigger government believe that centralized power and planning can force people to do what they would otherwise not do. But force is never a motivator. It does not lead to maximum effort. It only leads to the minimum effort required to avoid punishment.

In a controlled economy, the government pretends to pay the workers and the workers pretend to work. Eventually the entire system begins to fade the way a battery operated appliance does as the battery loses its power. History is full of failed attempts at managing an economy. But the proponents seem to believe that they have the magic missing ingredient to force people to be more productive.

Faith in the flawed concept of economic equality is the cause of untold misery. The advocates of more government operate on faith and blindly ignore the many clear lessons of history and logic.

Just my two cents.

Vern

Do T.I.P.S. Really Make Sense?

One of the solutions that is often offered for those who are concerned about inflation is to invest in Treasury Inflation Protected Securities or TIPS.

But for those who accept the logic of the Austrian School of economics, inflation is caused by an expansion of the money supply by the Fed's purchase of otherwise unmarketable U.S. debt securities.

So if we are concerned about inflation arising from recent legislation that will require a huge amount of deficit spending, does it really make sense to invest in government debt that promises to keep up with the inflation that is caused by that same government?

Also, there is a lot of plausible information to support the view that the inflation index that is managed by the government is about 50% of the real rate of inflation. For more about that subject see Shadow Stats.

What kind of investments do keep up with inflation? Think about a combination of precious metals, commodities, short term debt, a paid off residence, tangible things like guns, ammunition and generators.

Can you make a profit by building up a lot of debt during the current recession and then paying off that debt with cheaper (inflated) dollars? Perhaps, but the lenders are also aware of possible future inflation and will be raising rates in anticipation of future inflation. So the question is, can you outsmart the bankers on the timing of future inflation? And can you invest that borrowed money to make an after tax return in excess of the inflation rate?

Vern

www.vernonjacobs.com

The REAL Rate of Return

A few days ago, I came across an article about "The Law of Zero Return", which is a concept that was partly attributed to me. (See http://members.cox.net/mathmistakes/zeroreturn.htm)

The concept is that the combined impact of inflation and income taxes consumes all of the return from an investment.

But that's not exactly what I said or intended to say.

For any kind of investment there is a rate of return, which can be positive, negative or even zero. For example, a bond issuer may offer to pay interest at the rate of 5% on the face value of the bond. This is sometimes referred to as the investment rate or gross rate of return.

Most investors are also well aware of the concept of the "real rate of return", which is defined by investment professionals as the investment rate of return minus the inflation rate. Generally, the inflation rate is assumed to be the same as the rate of change in the Consumer Price Index. If the investment rate of return is 6% and the inflation rate is 2%, the real rate of return in 4%.

Most investors are also aware of the after tax rate of return. This is defined as the investment rate of return minus the rate of tax as a percentage of the investment. And it varies from one investor to another depending on their own marginal tax bracket. For a taxpayer who is paying the maximum 35% federal income tax plus a 5% state income tax on his/her investment income, the combined income tax is equal to 40% of the investment rate of return. So if the investment rate of return is 6%, the income tax rate on the investment income is 40% times 6%, or 2.4%. Thus, the after tax rate of return is 3.6%.

But few investment advisers like to talk about the after tax real rate of return. Perhaps that's because it is a very depressing concept for any fixed income investor.

If the rate of inflation is 2%, and the after tax rate of return is 3.6%, then the real rate of return after taxes is 1.6% on an investment that is paying a gross return of 6%.

Now here's the "fun" part.

If the rate of inflation increases, what usually happens to the gross rate of return?

It goes up, because the people who have money to lend don't want to get repaid in cheaper dollars.

So, let's assume that the expected rate of inflation increases from 2% to 4% and the gross rate of return increases from 6% to 8%. How will that affect the after tax real rate of return?

The taxpayer is still in the 40% federal and state marginal tax bracket, so his 8% is cut down to 4.8% after taxes. But now the rate of inflation is 4%, so the after tax real rate of return is 0.8% instead of 1.6%.

And if the rate of inflation rises to 8%, the investment rate of return would increase to about 12%. The tax rate would be 4.8%, leaving an after tax rate of return of 7.2%. But now the inflation rate is 8%, so the after tax real rate of return is - 0.8%.

The result is that as the rate of inflation increases, the investment rate of return generally increases by an equal percentage and the after tax real real rate of return will decrease.

Like many other elements in investments and economics, there isn't a perfect correlation between inflation rates and rates of return on fixed income investments. However, I did a study in 1986 of various fixed income rates and the CPI inflation rate from 1940 to 1986 and the correlation was very high. The difference is due to the fact that investment rates are set by investors who add the expected rate of inflation to the interest rate that they require. Thus, the inflation adjustment is based on projections of the rate of inflation by investors. The actual rate of inflation will turn out to be more or less, depending on how the Federal Reserve attempts to deal with the problem.

But whatever the Fed might choose to do, it's not a good idea to wish for higher interest rates because higher rates are usually an indication of increasing rates of inflation in the economy. During periods of low inflation rates, investment rates of return are generally very low. And when investment rates of return are very high (as in the late seventies), the rate of inflation is also high.

Vern

www.offshorepress.com

The Inflation Tax

When I started my first newsletter on legal methods of tax avoidance, my focus was on income taxes. But a few years later, the U.S. economy was experiencing double digit inflation. Somewhere during that period I discovered what I chose to call the "inflation tax".

While I agree with those who argue that inflation is a tax, I don't agree that it is a hidden tax. When inflation rates get into the double digits, everyone is acutely aware of how inflation is hurting their purchasing power.

But there is an aspect of inflation that is hidden and few people are aware of it.

First, let me make it clear that I agree with the economists who argue that inflation is a function of an expansion of the money supply when the Federal Reserve buys government debt by issuing new money. There are other elements in the equation -- such as the so-called multiplier effect and the velocity of money -- but the driving force is new money created by the Fed.

The new money drives up the price of both assets and the price of nearly all products and services.

The assets and products and services aren't worth more. it just requires more dollars to buy something.

With respect to assets like stocks, real estate, natural resources, foreign currencies, collectibles, precious metals and most tangible assets, the increase in the dollar price of those assets is deemed to be a gain by the tax law. If the asset is sold, the increase in the price from when it was acquired and when it was sold is taxable. Under current law the tax might be 15% of the gain, plus state income taxes of up to 10%. Some types of assets like collectibles are taxed at a 28% federal rate and a state tax rate of up to 10%.

Suppose you bought some stocks in a company that produces oil. The stock cost $100 per share. With 6% inflation, it would double in about 12 years assuming that there is no change in the profitability of the company. Although the price has doubled, the original $100 will only buy half as many goods or services. This is like a 50% tax on the stock shares. Then, when the stock is sold, the tax law treats the increase in the dollar price as a gain and subjects that $100 to an income tax of up to 15% federal and up to 10% for some states.

So that's a tax on a tax. And it's what I call the "inflation tax".

Vern