Mad Money Machine

Where Do We Run When the Dark Clouds Come?

A tag cloud is a visual depiction that identifies the frequently-used words of an information collection. A tag cloud for 2008 might include: Sub-prime. Meltdown. Credit-crisis. Foreclosure. Term-auction. Dollar-collapse. Asset-devaluation. Inflation. Deflation. Stagflation. Recession. Depression. It would be strikingly different from that of just one year ago. Back then we were talking earnings, iPhones, and efficient frontiers. Back then we were rationalizing a 130% exposure to equities. Back then we were calculating our 4% safe withdrawal rates. Back then it was sunny skies ahead. Today our tag cloud is dark indeed. Where do we run when the dark clouds come?

Meltdown CreditCrisis Foreclosure TermAuction DollarCollapse AssetDevaluation Inflation Deflation Stagflation Recession Depression SubPrime

I asked at the end of last year whether it might be time to dynamically adjust our risk capacity. We had been properly focused on the long term. We understood that over any span of 20 years an investment in stocks had not just performed well but had performed pretty darn well. We understood that taking risks meant expecting returns. We understood that proper investing meant first understanding our capacity for risk and then carefully matching that risk with a portfolio of equity and fixed income index funds.

Should We Run?

But late last year we saw cumulonimbus on the radar. A monster of a stormcloud threatening to bring down home prices, their mortgage lenders, their insurers, their investors, and just about anything else in its path. Storm warnings advised those holding stocks and bonds to be prepared for tough times ahead. We did not know if the big red blob was headed our way or if it was going to veer off to the north or to the south. It was time to reassess our capacity for risk. Could we truly accept devastation in the short term? Nope. Stand here and take a pounding? Nope. It was time to turn tail and run. That meant shifting our asset allocation. But what to buy? And what to sell?

Ah selling. Mark Hebner of Index Funds Advisors has a saying that there are only two reasons to sell. The first is when you need the money and the second is when you lose faith in capitalism. Is it now time to sell? Do we need the money? We might argue that yeah, we need our money. Rather than losing the value of our stored wealth to someone else, wouldn’t we rather have it? So the answer to the first question then is, yes, we need our money.

But that is distorting words and bending them to suit our desires isn’t it? We don’t need our money in the sense that we need it to buy food. We need our money in the sense that we need it to avoiding losing it. Maybe we need a better definition of the word need. Rather than getting all Clintonian about word meanings, let’s scrap question one and instead let’s have a look at the second question; Have we lost our faith in capitalism?

Now we’re not asking whether we have lost our faith in God or our faith in family or our faith in the goodwill of all the great people that make up this wonderful nation in which we live. No, we are asking whether we have lost faith, even temporarily, in the privately operated market economy we call capitalism. Most importantly, we want to know if we can still make capital with our capital. In order to figure this out, we need to understand the nature of money. For some reason, they don’t teach us about money in government schools. Perhaps it is because the dumber we are about money, the more easily it can be slipped from our possession by those who might have taught us about it.

The Meaning of Money

I am frustrated that I didn’t know the true meaning of money until recently. Even though I took a tour of the Bureau of Engraving and Printing last year and they showed how they print Federal Reserve Notes, they didn’t explain what money is. Only by joining the r3VOLution did I get my first glimpse into the true nature of money. Why didn’t somebody long ago grab me by the collar and shake me and tell me what money is? If I would have known a year ago what I know now about money I might have listened to Jim Rogers more closely and bought some commodities. I might have listened to Peter Schiff and bought some gold at $300. I might have listened to Warren Buffet and bought more foreign investments. Brazilian reals. Swiss francs. Even dollars – Australian dollars that is. Folks have been trying to explain money to me for years. I did not have ears to listen. I do now.

I just finished reading a book published in 2006 called Empire of Debt: The Rise of an Epic Financial Crisis by Bill Bonner and Addison Wiggin, they of the DailyReckoning.com web site. When their book was released, we were in the midst of a most glorious stock prosperity. I remember coming across the book but thinking, "Why waste my time with some doom-and-gloomsters when I can be shoveling cash into the coal fire of hot stock gains?" Now that I have ears to hear, I am open to the message of this book. And the message is this: The US economy is built upon a house of cards that doesn’t stop with a deck of just 52 but is expanding geometrically, piling layer upon layer, reaching far and wide, and that someday – the authors don’t know the date – we are going to be playing a game of 52 Pickup, but with a much larger mess on the floor.

The US economy, nay the economy of most of the globe, is now built upon an exponentially expanding supply of fiat currency. Talk about a Mad Money Machine! A growing supply that is shrinking its own demand. We are aware that generally when one has more of something, that thing becomes worth less. That is indeed the nature, they tell us, of fiat currencies. And not only do they continually become worth less, but indeed they become worthless. Yes, the expected value of a fiat currency is zero. Backed by the full faith and credit. Got faith?

I admit I am coming to my limited understanding about all of this a bit late. When asset prices were rising day after day, who needed an understanding? Buy high and sell higher was the rule. A monkey could make money in stocks.

We now know that the puffy white cloud we saw miles away became a roaring thunderhead once it got on top of us. We know we gotta get to shelter. But where do we go? Over here we have the quicksand of the falling dollar. Over there we have the credit crisis. Cash is not safe; it is losing its value to inflation. Similarly, US bonds are not safe with the risk of rising interest rates. Foreign stocks are not safe; they’re coupled to the US. And now that the smart folks have figured out where to be, namely, commodities, can they be considered safe after their enormous gains recently?

Armed with an understanding of the impact of the glut of dollars, I cringe when I hear people talking about rising oil prices or the rising cost of commodities and how that might create inflationary pressures. Create inflationary pressures? These high prices ARE inflation. And they are not caused by growing demand. They are caused by growing supply… of dollars!

Taxing Inflation

And another thing… How good of the government to tax us on their own inflation! We swap out of dollars into something that holds its value, like say an American Eagle gold coin. The dollar falls and falls. Later, we swap back into dollars so that we can swap again for a car or something. But guess what? The government wants us to give them something like 30% to 40% of the difference between up there where the dollar started and down there where it ended. Don’t look at it as buying gold at $850 and then selling it at $950. Instead, consider it as swapping out of dollars at 1/850 oz. gold and swapping back in at 1/950 oz. gold. Oh yeah, and when swapping dollars for a car, they take taxes again! If we could swap directly gold for a car, perhaps we would get taxed only once?

Where to Run? 

But I’m looking for a place to stay dry while the storm passes, remember. Peter Schiff in Crash Proof: How to Profit From the Coming Economic Collapse says buy gold, foreign assets, and keep some cash to buy the crash. James Turk in The Coming Collapse of the Dollar and How to Profit from It says to buy gold metal and miners, short the financials, and buy some selective exporters. Maybe it’s not a bad idea to listen to these ideas and incorporate some of them into our portfolios.

So how will America get out of this debt? You think there isn’t an answer don’t you? You think that we will just sink until we’re all once again living in caves. You’d be wrong. There is a way American can pay off these debts! In fact, there are three ways. Quoting now from Empire of Debt:

When people cannot pay their debts, they do not pay them. But the debts do not cease to exist. They are merely "paid" by someone else–the creditor. In the case of America’s debts to foreign nations, this can be achieved in three ways: the currency in which the debt is denominated can be devalued against other currencies; the currency can be made less valuable through inflation; or the debt can be repudiated. One of these things–or all of them–is likely to happen.

So there is a way to reduce if not eliminate America’s debt. Reduce the value of $9 Trillion to about $9 Million and hand over a check for the $9 Trillion. More precisely, just print $9 Trillion and pay off the debt to the foreigners with that. Never mind that by adding 9 trillion in dollars makes all of the already existing dollars worth far less.

A Loaf of Bread for a Quarter

We used to be able to buy a loaf of bread for a quarter. Yes, 25 cents. A quarter dollar. But if hyperinflation were to happen, it could take $50 or $500 or $5000 or worse to buy a loaf of bread. But it would still take only one silver quarter. You see, a true silver quarter contains about $3.5 worth of silver at today’s prices. Even after hyperinflation where the value of the dollar drops terrifically, the silver quarter relative to the loaf of bread will stay basically the same.

It is hard to recommend buying silver or gold after the recent parabolic run up. Just like it was hard to buy Google at $450 the first time through that price point. I don’t know which way it will go. But this seems certain: the US dollar will get weaker. Maybe not today, maybe not next month or even the rest of 2008. But with government spending the way it is and people not saving the way they don’t, the US economy is on track for some serious mean reversion compared to the rest of the planet. Folks, we need to get really serious about preparing for some hard times. Dark clouds are here. But hey, if we’re wrong and we only get peace and prosperity, if it turns out to be only a passing shower before the azure blue skies, then what have we lost? A little upside?

Here’s hoping that all your umbrellas are beach umbrellas and that our tag cloud for the future is full of cheery words.

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