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In the early days of the American republic, fortune seekers were urged to "Go west young man!" Unfortunately, with the American economy now clearly showing its fragility, the rallying cry for today could be, "Go abroad!"

In the past quarter century, the center of wealth creation has steadily moved away from the United States and towards new foreign competitors, especially the so-called "BRIC" countries of Brazil, Russia, India and China, where economic growth rates have greatly eclipsed the U.S. In recent years, this economic might has translated into much higher returns on their respective stock markets. These movements are creating a wave of real wealth that wise American investors cannot afford to miss.

In the mid 1970's, a transformation began in which the driving force of the American economy shifted from 'producers' to 'consumers'. Today, as measured by the GDP, consumption accounts for some 72 percent of the American economy. It is no wonder then, that as economics is so synonymous with spending, that the recently passed "stimulus package" is skewed heavily (90%) in favor of the consumer (where the votes are) at the expense of producers.

But after a generation of consuming more than it has produced, America has dissipated vast amounts of its wealth.

Unwilling to allow the citizenry to confront the reduced living standards that such dissipation requires, successive American governments have instead produced consumer booms in technology and real estate. Inflated through a combination of deficit spending, borrowing and massive depreciation of the U.S. dollar, the bubbles created by these policies have left future generations of Americans saddled with vast debts and an anemic currency.

But while America has lost much of its wealth, the rest of the world has gained. Since the late 1980's, a wave of economic enterprise has swept across the world. Under the leadership of the Reagan-Thatcher-Gorbachev triumvirate, communism melted, opening the world to free trade, and brought some 2 billion new consumers to the market. It also brought some 2 billion hard-working, low cost producers into direct competition with the developed West.

Today, Western consumers not only buy their clothes, toys and sneakers from BRIC factory workers, but they are also likely to use service workers in those countries to manage help-desk call centers, prepare tax returns and read X-rays. As a result, growth rates in BRIC countries skyrocketed and corporate profits and stock prices followed suit, far outstripping the average performance of U.S. stock markets.

The benefits of the great, new world consumer super boom have flowed mainly, as should be expected, to 'producer' nations. As an example, the S&P 500 Average Index rose by some 14 percent gross in 2006 (Incredibly, some 80 percent of mutual fund managers failed to equal even this return). Further, when deductions were made for management fees, transaction costs, 3 percent inflation and the depreciation of the U.S. dollar, many American investors actually experienced a 'real' net loss in that year. By contrast, the stock markets of BRIC offered far superior yields in appreciating currencies with Brazil up 33%, India 47%, Russia 71% and China 131%!

One major impact of the increased manufacturing power of the BRIC nations, and even smaller countries like Vietnam, is a greatly increased thirst for raw materials. As formerly impoverished populations gain wealth, demand for higher quality food impinges upon the established demand of the 'mature' markets. These two factors have greatly benefitted nations such as Canada, Australia and New Zealand that provide raw materials, energy and food.

As a result, perhaps a more appropriate and meaningful pneumonic device for international investors would be BRIC JACS (Brazil, Russia, India, China, Japan, Australia, Canada and the Smaller nations, such as Singapore, Vietnam and New Zealand).

American investors face a difficult situation. While the American economy has slowed almost to recession and a property debacle and massive de-leveraging still threaten, the economies around the world are still booming. The solution is clear; Americans must "Go abroad", if not with themselves than at least with their wallets. Investment portfolios should be constructed not just of BRICS, but also of the JACS which largely hold them together.. macro-economic mortar so to speak.

_____

© 2008 John Browne

ABOUT THE AUTHOR

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Posted in Guest Commentary, John Browne

The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund's three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds.

If you study just the last three years, my guess is those numbers will be worse. "The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.

[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]

I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse.

The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.

"The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:

1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade, and then return back to the 5-10% range.

2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half." (Financial Research Center)

This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.

The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.

Yet, what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is very small.

Tails You Lose, Heads I Win

I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is "The Hidden Role of Chance in the Markets and in Life." I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let's look at just a few of his thoughts.

Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their seven-figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!

Ergodicity

In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called "survivorship bias." Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.

Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. The exception, of course, would be my clients. (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)

That brings us to the principle of Ergodicity, "...namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term." (Taleb)

Why Investors Fail

While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as they switch from their poorly performing fund to the latest hot fund, just as it turns down.

Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers, and funds that I know. He has put more start-up managers into business than perhaps anyone in the fund management world. He has a gift for finding new talent and deciding if their "ideas" have investment merit.

He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern-recognition software available. They have run price data through every conceivable program, and come away with this conclusion:

Past performance is not indicative of future results.

Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances.

Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonalds that coffee is hot. We don't pay attention.

Chasing the latest hot fund usually means you are now in a fund that is close to reaching its peak, and will soon top out. Generally that is shortly after you invest.

What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis patterns into their systems.

This is consistent with work done by Dr. Gary Hirst, one of my favorite analysts and fund managers. In 1991, he began to look at technical analysis. He spent huge sums on computers and programming, analyzing a variety of technical analysis systems. Let me quote him on the results of his research:

Becoming a Top 20% Investor

Over very long periods of time, the average stock will grow at about 7% a year, which is GDP growth plus dividends plus inflation. This is logical when you think about it. How could all the companies in the country grow faster than the total economy? Some companies will grow faster than others, of course, but the average will be the above. There are numerous studies which demonstrate this. That means roughly 50% of the companies will outperform the average and 50% will lag.

The same is true for investors. By definition, 50% of you will not achieve the average; 10% of you will do really well; and 1% will get rich through investing. You will be the lucky ones who find Microsoft in 1982. You will tell yourself it was your ability. Most of us assign our good fortune to native skill and our losses to bad luck.

But we all try to be in the top 10%. Oh, how we try. The FRC study cited at the beginning shows how most of us look for success, and then get in, only to have gotten in at the top. In fact, trying to be in the top 10% or 20% is statistically one of the ways we find ourselves getting below-average returns over time. We might be successful for a while, but reversion to the mean will catch up.

Here is the very sad truth. The majority of investors in the top 10-20% in any given period are simply lucky. They have come up with heads five times in a row. Their ship came in. There are some good investors who actually do it with sweat and work, but they are not the majority. Want to make someone angry? Tell a manager that his (or her) fabulous track record appears to be random luck or that they simply caught a wave and rode it. Then duck.

By the way, is it luck or skill when an individual goes to work for a start-up company and is given stock in their 401k which grows at 10,000%? How many individuals work for companies where that didn't happen, or their stock options blew up (Enron)? I happen to lean toward Grace, rather than luck or skill, as an explanation; but this is not a theological treatise.

Read The Millionaire Next Door. Most millionaires make their money in business and/or by saving lots of money and living frugally. Very few make it simply by investing skill alone. Odds are that you will not be that person.

But I can tell you how to get in the top 20%. Or better, I will let FRC tell you, because they do it so well:

That's it. You simply have to be only slightly better than average each year to be in the top 20% at the end of the race. It is a whole lot easier to figure out how to do that than chase the top ten funds.

Of course, you could get lucky (or Blessed) and get one of the top ten funds. But recognize it for what it is and thank God (or your luck if you are agnostic) for His blessings.

I should point out that it takes a lot of work to be in the top 50% consistently. But it can be done. I don't see it as much as I would like, but I do see it.

Investing in a stock or a fund should not be like going to Vegas. When you put money with a manager or a fund, you should think as if you are investing in their management company. Ask yourself, "Is this someone I want to be in business with? Do I want him running my company? Does this company have a reasonable business objective? What is their edge that makes me think they will be above average? What is the reason I would think they could discern the difference between randomness and good management?"

When I meet a manager, and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When they tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it.

It's about not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund, that is random. They had a good run or a good idea and it worked. Are they likely to repeat? No.

But being in the top 50% every year for ten years? That is NOT random. That is skill. That type of consistent solid management is what you should be looking for.

By the way, I mentioned at the beginning that past performance was statistically useful for ascertaining relative performance of certain types of funds like bond funds and international funds. In the fixed-income markets (bonds) everyone is dealing with the same instruments. Funds with lower overhead and skilled traders who aggressively watch their trading costs have an edge. That management skill shows up in consistently above-average relative returns.

Likewise, funds which do well in international investments tend to stay in the top brackets. That is because the skill set for international fund management is rare and the learning cost is high. In that world, local knowledge of the markets clearly adds value.

But in the US stock market, everybody knows everything everybody else does. Past performance is a very bad predictor of future results. If a fund does well in one year, it is possibly because they took some extra risks to do so, and eventually those risks will bite them and their investors. Maybe they were lucky and had two of their biggest holdings really go through the roof. Finding those monster winners is a hard thing to do for several years in a row. Plus, the US stock market is very cyclical, so that what goes up one year or even longer in a bubble market will not do well the next.

Investors Behaving Badly

Gavin McQuill of the Financial Research Center sent me his rather brilliant $5,000 report called "Investors Behaving Badly." He was the author and he did a great job. I read it over one weekend, and refer to it again from time to time.

Earlier we looked at a report which showed that over the last decade investors chased the hot mutual funds. The higher the markets went, the less likely it was that they would buy and hold. Investors consistently bought high and sold low. Investors made significantly less than the average mutual fund did.

McQuill focused on six emotions that cause investors to make these mistakes. You should read these and see whether some of them are familiar.

1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.

2. "Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor behavior.

Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.

3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.

4. "Overconfidence - People's tendency to overestimate their abilities relative to individuals possessing greater expertise." Professionals beat amateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.

In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top 10%, and any time we win it is because of our skills and good judgment. It is bad luck when we lose.

Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.

5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.

As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken, "Sir, the facts have changed, and when the facts change, I change. What do you do, sir?"

We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years - maybe even a decade - for the process of reversion to the mean to complete its work.

6. "Representativeness - The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter (www.dailyreckoning.com). He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinean stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.

Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern. McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian. They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.

_____

© 2008 John Mauldin. All Rights Reserved

ABOUT THE AUTHOR

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore.

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Posted in Monetary Commentary, Guest Commentary, John Mauldin

BIG PICTURE - Over the past few months, we have heard numerous times in the media that the Federal Reserve and the other central banks have a choice between economic growth and rising prices (wrongly defined as inflation). In fact, most investors have been brainwashed into believing that policies which stimulate strong economic growth automatically result in higher prices within the economy. For example, in the current situation it is now widely believed that by slashing rates and adding liquidity to the financial system, the Federal Reserve is opting for strong economic growth in the US which in turn is causing the consumer price levels to rise. In other words, most people are being hoodwinked into believing that the prices are rising due to strong growth!

In my view however, the above assessment is totally incorrect. After all, any student of economics will be able to tell you that if the money-supply was constant, strong growth would not lead to higher prices. On the contrary, strong economic growth (increase in the production of goods and services) would result in price declines as the supply of "things" increased in relation to the amount of money available in the economy. Conversely, a weakening economy (decrease in output) would assert upward pressure on prices as the production of goods and services declined in relation to the amount of money available to purchase those "things".

In the current monetary system however, the supply of money is not constant and the central banks of this world are free to create as much inflation (money-supply growth) as they want. There is a catch though - the central banks can only do so as long as they can keep inflationary fears under check by constantly reminding the public of the threat of deflation. Turning over to the current situation, it should not come as a surprise then, that in the past few weeks the media has published various stories comparing the recent downturn in the US to the Japanese deflationary bust or the Great Depression of 1929. In my opinion, this "deflation" propaganda is crucial to further promote the Federal Reserve's agenda of creating even more inflation as a "cure" for the ailing economy. Let there be no doubt that the Federal Reserve is now desperately trying to inflate the system via rate-cuts, pumping of liquidity and bailouts. And it is this monetary inflation and not strong economic growth which is causing commodity and consumer prices to rise. Unfortunately, for the average American, this is occurring at a time when their economy is weakening, incomes are falling and unemployment is rising. In other words, I would argue that the Federal Reserve's inflationary efforts are making things a lot worse for the majority of people.

My intention is not to criticise Mr. Bernanke as I honestly feel that he is simply a cog in the wheel, an insignificant part within the overall system. Rather I sympathise with him since he is now dealing with the mess which Mr. Greenspan created by leaving the Fed Funds Rate at a ridiculous 1% long after the US recession ended earlier this decade. It is my firm belief that Mr. Greenspan's ultra-loose monetary policies in the aftermath of the technology bust largely created the ongoing financial and credit crisis. And now, Mr. Bernanke is left with no choice but to continue with the inflationary program or else there would be a global economic depression. Figure 1 clearly shows that due to Mr. Greenspan's record-low interest-rates, American home prices sky-rocketed between 2001 and 2005. However, they have fallen sharply in the past 3 years and show no sign of bottoming out.

Figure 1: Home prices falling in the US

Source: www.chartoftheday.com

As an investment-manager, it is not my role to pass a moral judgment on the actions of central banks and governments. To be fair, given the level of debt imbedded in the West, central banks have no other option but to inflate. The problem though for the US economy stems from the fact that this newly created money seems to be finding a home in commodities rather than financial assets. It is interesting to note that since the Federal Reserve started slashing interest-rates in August last year, energy, metals and food prices have gone to the moon whereas the US Dollar and American stocks have plummeted. Unfortunately for the US establishment, the "cure" of monetary inflation seems to be going horribly wrong as it is translating into even higher consumer and producer prices. Now, veteran clients and subscribers will recall that I have long maintained that this decade would belong to commodities and the markets are proving me correct.

Over the past few months, the prices of commodities have gone through the roof due to supply and demand imbalances and massive monetary inflation. However, given the turmoil in the markets and loss of confidence, resource stocks have been punished by investors. This development is strange to say the least and it has paved the way for a massive buying opportunity in the most coveted sector of the future. I find it absurd that the investment-community is dumping quality resource stocks at a time when the underlying commodity prices are super strong. At the end of the day, businesses are valued based on their corporate earnings and with sky-high commodity prices, I can assure you that elite resource-producing companies are going to announce fantastic results in the months ahead. Today, top-quality diversified mining companies are selling at 12-13 times earnings (bear-market valuations) and I can only guess this is due to the fact that most people expect commodity-prices to crash in the months ahead. However, if my homework is correct and commodity prices continue to soar in the future, we will see a major re-rating in the valuations of resource-producing stocks. Some of you may remember that during the technology mania at the turn of the millennium, technology companies (even dodgy ones) sold for ridiculously high valuations. Well, we can expect to see the same type of madness in relation to commodity stocks in the future.

_____

© 2008 Puru Saxena

ABOUT THE AUTHOR

Puru Saxena is an investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC, Bloomberg, NDTV Profit and writes for several newspapers and financial journals. He is the editor and publisher of Money Matters - an economic report, which is read by professionals and investors in numerous countries all over the world.

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Posted in Monetary Commentary, Guest Commentary, Puru Saxena

For those holding out hope that the American economy can miraculously avoid a long and deep recession consumer credit is often viewed as the wonder drug that can cure all manner of economic ills. As such, this week's report showing $15 billion growth in consumer credit was widely heralded as proof of America's economic strength and resilience. However, we are now suffering the after effects of too much debt, and our salvation cannot be found in more of the same.

Credit card debt, which now stands at whopping $957 billion nationally (approximately $3,000 for every citizen) has, in recent years taken on a different role in American life. While in the past cards were used primarily to purchase big ticket items, spreading out costs over many months, they are now increasingly used to bridge the gap between cost of living and the diminishing purchasing power of Americans who have been taxed mercilessly by inflation. By buying with available credit instead of unavailable cash, consumers are not simply postponing the pain of higher prices, but compounding it by adding interest to the cost of everyday purchases. In addition, as home equity credit is now unavailable to fund large purchases, many consumers are turning to non-deductible, higher cost credit card debt as the last remaining life line. As such, credit card debt compounds steadily, and for many borrowers, becomes increasingly impossible to pay down.

The statistics tell the tale. According to Equifax, a credit card analysis firm, people have been buying more with their credit cards but paying down less. As a result average balances jumped nearly 9% in 2007 and delinquency rates recently hit a 4-year high of 4.5%.

Also, the reliance on credit cards is preventing some of the markets salutary forces from working. With credit always an option, domestic demand remains strong despite rising prices. Absent the option of putting more costly gasoline on their credit cards, Americans might have actually been forced to cut back on their consumption, taking some of the upward pressure off gas prices.

It should be painfully obvious that expanded consumer credit is not evidence of improvement, but simply, deterioration. Unfortunately, when it comes to understanding the economy, there is little common sense on display. By going even deeper into debt just to make ends meet, American consumers are digging themselves, and our entire economy, into an even greater economic hole and laying the foundation for the next major credit debacle. It's fitting that just as both Treasury Secretary Paulson and JP Morgan CEO Jamie Dimon declared that the worst of the crisis has past, we are on the verge of kicking the whole thing into a much higher gear!

My guess is that many Americas continue to run up massive credit card debt because they have little intention of ever paying it off. Since many who are underwater on the home loans, and behind on the auto and student loans see bankruptcy as a foregone conclusion, they see no downside to pilling on as much debt as possible while the taps remain open.

Those choking on credit card debt may also be taking cheer from the gathering government campaign to bail out over-leveraged homeowners. The sheer numbers of who are afflicted with spiraling monthly payments will make credit card relief a potent political issue for crusading Congressman and Presidential candidates. After all, there are few fundamental differences between those who borrowed too much to buy houses and those who made the same mistake with consumer goods. If the government bails out the former why not the latter? In fact, one reason some homeowners have such large mortgages is that they consolidated their credit card debts into their mortgages each time they refinanced. Why should renters be forced to pay off their credit card debts while homeowners have theirs forgiven?

Soon, as credit card delinquencies rise and losses on pools of securitized credit card debt mount, those supplying the credit will finally get wise to the fact they will never get their money back. As a result the market for such debt will dry up even more quickly than did the market for subprime mortgages. Cards will therefore be much harder to come by and will have much lower limits then they do today. Limited to only the cash in their wallets, Americans will finally be forced to dramatically curtail their spending, and the recession will finally gather serious momentum.

_____

© 2008 Peter Schiff

ABOUT THE AUTHOR

Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkley in 1987. A financial professional for seventeen years he joined Euro Pacific Capital in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, he is a highly recommended broker by many of the nation's financial newsletters and advisory services.

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Posted in Monetary Commentary, Guest Commentary, Peter Schiff

Money serves as a medium of exchange and store of value. Price provides an important clearing mechanism in a society. Here we are going to explore the interesting dynamics between money and price.

In a free market, when the quantity of money is fixed, the fact that the price of an apple is $1 and that of a Parker pen is $2 has tremendous implications. It takes knowledge, ingredients and time to grow an apple while it involves branding, material, and capital to produce a Parker pen. What the market says here is that the total efforts put into producing the pen are worth twice as much as the efforts of growing the apple. There are thousands of valuations communicated through the market by this simple exchange. Over time, with advances in technology, it takes fewer efforts to produce more goods. The same farm that used to grow 10,000 apples can now grow 20,000 in half the time. While the ratio of exchange between apples and pens might still be 2 to 1, since it also takes less to produce a pen, in a world where the quantity of money is fixed the price of both apples and pens should decrease (i.e. 80 cents for an apple, and $1.60 for a pen).

The decrease in the price level of goods represents an economic advance and an increase in the value of money. As the human race progresses and wealth is being accumulated, shouldn't people be able to buy more with less money? Shouldn't people be rewarded for their savings over time with increased purchasing power of their money? Obviously, the exact opposite is taking place in this world. What's going on?

A picture is worth a thousand words and the chart above is no different. There is 1,500% more paper money today than there was in 1970.

Hey, where did all this money come from? Doesn't more money mean more economic progress?

The huge increase in the paper money supply is from borrowing at all levels from consumers, corporations, and government. Every dollar borrowed is a dollar created out of thin air by the banks. The process is legitimized by "the fractional reserve system", as the bank literally prints dollars in its computer and writes a check to you upon your loan approval.

To answer the second part of the question - there is no positive correlation between the money supply growth and real economic growth. As we explained, the world can function and advance with a fixed money stock.

What's wrong with more money? It stimulates consumer spending, creates more interest-income for savings and promotes higher housing and stock prices. More of everything is a good thing!

To that argument, I say: What if the Fed through its ingenuity and generosity, doubles everyone's savings account balance? Does that create progress? By the same token, to combat price increases, did Venezuela fix anything fundamentally by issuing a new currency, "Strong Bolivar", that essentially chops a zero off the old Bolivar? Here are 4 more points to consider:

1. Fairness - Arbitrarily, some are allowed to borrow more than others. Does it make sense for a government to have unlimited borrowing power while it hardly produces anything? And what is so special about a banker in that he can lend to whomever, for however much he wants, with the money that's not even his?

2. Price Distortion - Since new money is not distributed evenly, the prices of various goods and services increase in a cascading fashion, depending on who gets the money first (like a ripple effect). Think of a lottery winner. He is likely to outbid others for the things he wants, thus causing prices of his desired items to go up first. Let us be clear: The random introduction of new money impairs the role of price as a proper clearing mechanism.

3. Bad store of value - With online banking and credit cards, today's money is a great medium of exchange. However, the ever-increasing quantity of paper money makes it a terrible store of value. Remember: Every time someone borrows, new money is brought into existence, diluting the money you and I have meticulously accumulated. Should a retiree rely on the risky stock market to retain his wealth?

4. Moral Hazards - How is it fair that bankers can borrow billions of dollars to spend and invest? And when banks and companies become too indebted but are too big to fail, they are bailed out. How does that serve as an incentive for those who make cars, sew clothes, and plant trees to save?

When unfairness, price distortion, corruption, and loss of true wealth reach the extreme, the result is a loss of confidence in the paper-money system.

I quote John Keynes from 1919:

Paul Volker was right when he said in 2000:

And Bill Gates said at Davos world economic forum in January 2005:

How do you short the dollar? With ECB printing Euros no slower than the Fed printing dollars, it's clear that gold is the only refuge of savings. Gold has raced from $428 to $850 today since Bill spoke in 2005. Is it too late to join gold? The right price for gold today is a long topic that's best be left for another day. However, judging by how oil rocketed from $10 to $100 within the past decade, gold has not nearly reached its potential. We manage a gold fund and have written much about gold and currencies at www.goldmau.com. I invite you to read up.

John Lee
jlee@goldmau.com
1.800.965.6404
www.goldmau.com

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© 2008 John Lee

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Posted in Economic Theory, Guest Commentary, Gold, John Lee