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The Daily Reckoning | Thursday, August 12, 2010 The twisted logic behind the "Gimme Gvt. Shelter" investment strategy, isunderstanding inflation...two points the deflationists forgot to notice, Plus, Bill Bonner on what the Fed didn't do and $202 trillion worthless dollars, end to end... Gimme Government Shelter Why Seeking Refuge in Government Debt Won’t Save You Joel Bowman Reporting from Lake Livingston, Texas... Oh, a storm is threat'ning My very life today If I don't get some shelter (Ooh yeah) I'm gonna fade away. - Gimme Shelter, The Rolling Stones Nassim Nicholas Taleb says "every single human being" should bet these assets will decline... Jim Grant says these "certificates of confiscation" represent a "surefire way to lose one's invested money"... And Dr. Marc Faber, not known for mincing words, says they are "for idiots"... Our question this morning, therefore, is why would anyone hold US Treasuries? The obvious answer - keeping in mind that an easy conclusion does not necessarily make for a correct one - can be observed in the "flight to safety" argument. Fears of a deepening global crisis have spurred investors to seek shelter in the perceived safekeeping of US government debt. "Treasuries have rallied amid speculation the global economic recovery is faltering," reported Bloomberg yesterday, "driving yields on two- year notes to a record low of 0.4892 percent today." The trough in two-years, the newswire continued, came a day after the Federal Reserve "reversed plans to exit from monetary stimulus and decided to keep its bond holdings level to support an economic recovery it described as weaker than anticipated." Huh?... So yields are at record lows because the Fed is buying bonds from the Treasury? Isn't that a little bit like loaning a $20 bill from your left pocket to your right? Well, no, it isn't...because the left pocket also has a printing press, and it's not afraid to use it, as Ben Bernanke reiterated yesterday. In the midst of this high-level shell game, therefore, what enduring value will a dollar bill have? And if the dollar's value is suspect, how much more so for those pieces of paper that promise to repay dollars in the future? Treasuries might be a great trade. But the "Gimme Gvt. Shelter" logic appears a tad funky, especially when taking into consideration the fact that government bodies are nothing if not wealth destroyers and that, historically, their preferred method of destruction is to inflate away the value of their respective currencies. In 1970, a year after the Rolling Stones released the greatest rock 'n' roll track of all time, you might have picked up a front-row ticket to see the British invaders for around $20. Adjusted for "official" inflation, that same ticket (or any other $20 item) would today set you back $112.35. That's a 461.8% jump in price. (Adjusted for unofficial inflation - i.e. actual prices - a front-row Stones ticket would cost something like $350). Some safekeeping! Nevertheless, the case is as it is...at least for now. All the same, one is given to wonder just how long the government can continue to churn out record deficits in tandem with vastly expansionist monetary policy before the consequences show up in consumer prices? Could inflation (or, more precisely, the effects of inflation) be, as Mick Jaggar crooned, "just a shot away?" In today's guest essay, Puru Saxena holds a couple of the deflationist camp's vaunted precepts up to the light for closer examination. How do they fair? Take a look for yourself, below... The Daily Reckoning Presents Debunking Deflation Puru Saxena Now that almost every Wall Street economist is looking for the arrival of a Great Deflation, we think investors should begin looking the other way. Keep an eye out for inflation, we say. You will recall that during the bottom of the previous bear-market, most of the pundits were shunning 'risky assets' (stocks and commodities) and they were advocating a heavy exposure to cash and fixed income assets. Back then, the vast majority of strategists and their devotees were erroneously fretting about deflation. According to these folks, deflation was a done deal due to the following reasons: a. Contraction in private-sector debt - When the credit crisis arrived in the summer of 2008 and asset prices collapsed later that year, over- leveraged consumers and businesses started paying off their debt. After all, this act of deleveraging was a logical reaction to the devastation caused by the most vicious bear-market since the 1930s. So, when private-sector debt began to shrink, the proponents of deflation (deflationists) announced the death of inflation. "How could the global economy inflate when the private-sector was tightening its belt?" was their battle cry. Although the deflationists had a point, their assessment was flawed because they totally ignored the borrowing capabilities of the governments. While it is true that from peak to trough, private-sector debt in the US contracted by roughly US$800 billion, this debt reduction was overwhelmed by the US government's debt accumulation efforts. As the chart below shows, over the past two years US federal debt has surged by a whopping US$3 trillion, thereby more than offsetting the deflationary impact of private-sector deleveraging. If you have any doubts whatsoever, you will want to note that total debt in the US is now at a record high! b. Excess capacity - The lack of aggregate demand and the excess capacity prevalent within the economy is another factor often cited by the deflationists. Let us explain: You will recall that in the aftermath of the Lehman Brothers bust, the credit markets froze and the global economy came to a screeching halt. Suddenly, worldwide consumption contracted and the world was left with idle factories, empty buildings and unwanted inventories. Thus, the deflationists argued that with such a lack of aggregate demand and so much spare capacity, we could never experience inflation. Once again, the deflationists failed to understand that over-capacity has been a constant feature in our economic landscape and price increases (which they erroneously describe as inflation) have very little to do with capacity utilization. It is interesting to observe that over the past 42 years, the US economy has never operated at full capacity. Moreover, it is notable that even during the highly inflationary 1970s and the most recent inflationary boom (2003-2007), the US economy operated well below maximum capacity. In case you are wondering, the same holds true for the global economy. Therefore, the idea that inflation cannot occur in the face of excess capacity is ill-conceived and absurd. All the popular deflation myths aside, the reality is that inflation is an increase in the supply of money and debt within an economy. Furthermore, the price increases often described as inflation are simply consequences of monetary inflation - a euphemism for the dilution of the money stock. Look. Whenever any central bank creates new money and whenever any entity (individual, business or government) takes on more debt, the outcome is inflation. As Milton Friedman once said, "Inflation is always and everywhere a monetary phenomenon." Today, under our fiat-money system, governments are willing borrowers and central banks are more than eager lenders (money creators). Under these circumstances, a contraction in the supply of money and debt (deflation) is out of the question. Conversely, given the short- sightedness of the politicians and their perpetual urge to "kick the can down the road," the real risk facing the economy is extreme inflation or even hyperinflation. Given our grim outlook on inflation, we continue to favor hard assets and the fast-growing developing economies in Asia. If our assessment is correct, our preferred sectors (energy, precious metals and industrials) and our favorite stock markets (China, India and Vietnam) are likely to generate superior long-term returns. Regards, Puru Saxena, for The Daily Reckoning Joel's Note: Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription here. Puru is also the founder of Puru Saxena Wealth Management, his Hong Kong based firm, which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs. Bill Bonner Bridging the Fiscal Gap of Unfunded Liabilities Bill Bonner Reckoning from Ouzilly, France... The stock market took a tumble yesterday. The Dow fell 265 points after investors had a chance to ruminate about the Fed's latest action. It wasn't what the Fed did or said that discouraged investors. It was what it didn't say and what it didn't do. It didn't say, for example, that it was going to "crank up the printing presses" and deliver trillions of new dollars to the economy. We didn't think it would. But it also didn't say that the economy was doing well. Au contraire, it gave investors reason to believe that it was worried about the "recovery." (We continue to put the word in quotation marks so dear readers will know there's something fishy about it...) Eventually, the Fed probably will get the printing presses going. But not just because it is desperate to re-start the economy. We are getting used to big numbers. US trade deficits are more than $500 billion per year. US federal budget deficits are more than $1 trillion. And the US official debt is now more than $13 trillion. Then, you add in all the off-budget items and the numbers get bigger and bigger. If the government promises to buy drugs for someone five years from now, for example, that's a financial commitment that it has to own up to. If it were a private company, the expenses would be put on its balance sheet as a liability...a bill that will have to be paid in the future. Typically, a company would put aside money to pay the bill, so it would be "funded" - covered by savings or a special-purpose fund. The US government, however, hasn't saved any money since the Carter Administration. But it's added a heckuva lot of financial commitments since then. Democrats, Republicans - it didn't matter who was in office; the zombies got more money and the financial picture worsened. The last number we saw for the whole enchilada of unfunded federal financial obligations was $115 trillion or thereabouts. So we were shocked when Laurence Kotlikoff, a well-known professor of economics at Boston University, updated the figure to...are you sitting down, dear reader?...$202 trillion. How much is $202 trillion? Well, if you laid out $100 bills, end to end, day after day...you'd be an idiot. Because you'd die long before you got to even a trillion worth. The $202 trillion is the current "fiscal gap" of the federal government. It is the present value of future unfunded obligations. To fund that gap, Kotlikoff refers to an IMF study showing we'd have to double taxes...raising an amount equal to 14% of GDP every year from now on. Every year that the gap is not closed, the additional amount is added to the "principal," making that much more to be paid in the future. "How can the fiscal gap be so enormous?" asks Kotlikoff. "Simple. We have 78 million baby boomers who, when fully retired, will collect benefits from Social Security, Medicare, and Medicaid that, on average, exceed per-capita GDP. The annual costs of these entitlements will total about $4 trillion in today's dollars. Yes, our economy will be bigger in 20 years, but not big enough to handle this size load year after year. "This is what happens when you run a massive Ponzi scheme for six decades straight, taking ever larger resources from the young and giving them to the old while promising the young their eventual turn at passing the generational buck." What to do about it? There are no win-win solutions. "Recovery"..."stimulus"..."grow our way out"...and all the other painless remedies are just claptrap. Nor is the US government going to double all taxes. Congress doesn't have the stomach for it. And it wouldn't help anyway. The economy would collapse even further - leaving possibly less revenue for the feds. No, there is only one real solution. The feds will have to renege on their promises. But how? Will they step up to a microphone and just admit that they have been fools and knaves...and that they are cutting federal spending in half? Will they look the voters in the eye and tell the truth: "I can't give you anything that I haven't taken from you in the first place"? Whatever your party affiliation, we wouldn't advise you to hold your breath waiting for politicians to be straight with voters. No, dear reader, they will use the only tools they have - lies, bombast and subterfuge. One way or another, sooner or later, they will call upon the Fed and the Treasury to bail them out. How? By using quantitative easing - money printing, in other words. The Treasury will borrow the money from the Fed. The bills will be paid. And the dollar will become almost worthless...or perhaps completely worthless. At least, that's what it looks like this morning... And more thoughts... "Things are heating up around here," said Elizabeth last night. She was not talking about the weather. "I guess it is inevitable. The balmy weather. The moonlight. The little boat on the lake. So many young people together. "People were up until 5am last night. I couldn't sleep. I kept hearing them singing. Laughing. Or I heard the crunch of the gravel when someone was walking around. "Of course, I'm glad they're having a good time. But I'm worried too. I don't know what's going on. Some of them are probably having a great time. And some of them are miserable. I suppose that's inevitable too. The two boys got into an argument at the table last night. We couldn't hear it because they were at the other end. But I know they're upset. "You don't see it so much. You keep working. Which is probably a good thing. It gives you a kind of stability. But I think this extended vacation has a de-stabilizing effect on people. They spend a lot of time talking to one another. They get to know each other better...and know things about themselves probably that they didn't know before. They're just teenagers and young adults. The boys are more than a little impressed by Maria's beautiful friends. And the girls seem to be at ease and relaxed in the large family setting. They're treating the boys like little brothers...but the boys would probably like to imagine different roles. "And then, the cook is acting very strange... I don't know what to make of it... "But sometimes when we're here, I feel like we are dancing on top of a huge gasoline tank...and everyone is smoking a cigarette." Regards, Bill Bonner for The Daily Reckoning