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April 18, 2008

Pick Your Poison Now
by Kurt Kasun

The "true grit" of the American investor was on display today as earnings from JP Morgan and Coca-Cola buttressed earnings from Intel, and the tech sector lead all of the indexes higher in today's commendable rally as a result. Never mind endlessly exploding oil prices, a beige book report which confirms the further deterioration of the economy across much of the nation, and a housing report that shows that new starts have plunged to the lowest level in 17 years. Interestingly, perma-bulls are celebrating the low housing starts as a sign that this will now enable housing prices to quickly regain their footing with less supply being added to the market. Just shake off these abysmal economic indicators they proudly pronounce. These are the same guys who say that "the bad news is already priced in" and will be coming into the media spotlight to proclaim one tempting "bottom" buying opportunity after another. Eventually they will be right but I am not sure whether it will take months or years.

If you want blind optimism then you shouldn't read my columns; turn instead to continual list of Paula Abduls that are presented on the popular financial media shows. Simon Cowell might be good for ratings on "American Idol" but his type is generally not warmly received on financial TV. More pathetic than the cheery financial pundits are the more seriously-regarded economic types who believe that the solution for our economic mess generally lies with simply strengthening the US dollar. Those aligned with the "Economic Right" have largely adopted this mantra. You can read about this in every edition of Forbes magazine, hear about it from the right-leaning economic commentators on TV, and as recently as this week, read about it in Wall Street Journal editorials.

In one such editorial titled "Enough With the Interest Rate Cuts," was written by Dr. Martin Feldstein. While not specifically mentioning the dollar in the article, a weakening dollar is the result of lowering interest rates and is therefore the implied culprit of our worsening economic situation. First of all, trying to use manipulative measures to strengthen the US dollar in order to strengthen the US economy is backwards--it is like saying, in order to win a basketball game, "hey, all you need to do is to get the operator of the scoreboard to add a few points to your score...then you will be winning."

The way to address the concerns associated with lower interests rates, as Feldstein properly points out--a reduction in real incomes, exacerbated political instability, higher commodity prices, higher inflation and cost of living, and an inability to address the dysfunctional state of the credit market, to lower mortgage rates, and to stimulate aggregate demand--is to focus on the real culprit-years and years of excess money creation. A strong dollar is the result of a strong economy, not the cause of one. Interest rates will adjust upward when the economic conditions warrant. Sadly, we could be waiting a long time for this.

The truth of the matter is that the time to worry about inflation and higher commodity prices is over-we should be praying for inflation. In my commentary "Debt, Demographics & Debasement are Destiny" I chronicle how the events of the past century have created a growing gap between credit/debt creation and real wealth creation. The resulting reckoning is now leading us down a path of economic misery after an unprecedented consumption binge and welcomed period of asset inflation. With the massively complex existing debt overhang, further interest rate cuts risks plunging us into a deflationary depression. The alternative will certainly bring about the harmful inflationary effects Feldstein warns us in his editorial, but they are not nearly as bad as deflation. I address the inflation versus deflation debate in my commentary "Changes Are Coming and Resistance is Futile (Part 1):"

A Legg Mason report issued back in 2003 titled, "War, Legacy Debts, and Social Costs as Catalysts For a US Inflation Cycle" correctly responds:

"Debt may seem to be a catalyst for deflation, but when most of the debt is backed by government guarantees (actual or implicit), and the government owns the printing press, debt may warrant an inflationary response. It is a question of timing and national choice." We will choose inflation in large doses and the Fed will accommodate. The days for responsible government with controlled spending and honest money have long since passed. We are simply too indebted to pay the bill. The result would be a wholesale slaughter of defaults. At this point, we will absolutely have a deflationary depression if the Fed does not act aggressively. I have been surprised that the Fed has appeared slow to grasp this, but I am now confident that they are on the brink of massive monetary accommodation...

The sooner these economists come to terms that a multi-year decline in the American standard of living is inevitable (after years of borrowing from the future, pander to political constituencies, and living the high-life) and the fact that there is no mathematically possible way to pay all of the future unfunded trillions of dollars of liability debt (Medicare and Social Security) and that pain and suffering is unavoidable, the sooner they will abandon all pretense of "responsible" government actions. The time for that has long since passed. Dr. Feldstein's editorial ran in Tuesday's Wall Street Journal. Amazingly, John Makin, a visiting scholar at the American Enterprise Institute wrote a brilliant editorial the day before which Dr. Feldstein, a member of the Wall Street Journal's board of contributors, either did not read or chose to ignore in writing his piece the day after. Makin's editorial, "The Inflation Solution to the Housing Mess" argues for what I call "intentional inflation." Both Feldstein and Makin come from the "Economic Right" but promote starkly different solutions. Makin insightfully recognizes:

The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street...While there is a substantial risk that inflation may rise for a time - this would be the policy goal - monetization is more easily reversible than nationalization of the mortgage market. Meanwhile, Fed officials concerned about inflation should rethink their view that it is impossible to identify an asset bubble before it bursts. The post-bubble period has yielded some very unattractive policy alternatives. They clearly underscore the rationale for having the Fed target asset prices - in a world where asset markets affect the real economy more than the real economy affects asset markets.

To this I say Halleluiah...Makin is one of the first economist (within the "respected" mainstream community) to realize the severity of the crisis, what caused it, and how to best to adapt/survive. By logical extension it lists the perils associated with Dr. Feldstein's policy prescriptions.

At some point the political demands of the US citizenry will lead us to inflation over deflation. Some believe that members of the US government have already chosen this path of stealth inflation years ago. I am not so sure. I think ignorance and incompetence may have prevailed over cunningly duplicitous policy. If we choose "intentional inflation" now, at least we will be able to at least partially influence our economic future, painful as it will certainly be. If we delay the inevitability of choosing inflation, we may lose total control of our economic destiny. Think of it as a "controlled burn" required to prevent a much larger forest fire, or, in this case, hyper-inflation.

As the painful process of de-leveraging, aka the "Great Unwind," accelerates, calls for containing inflation and concerns over lowering interest rates will eventually become distant memories. As an investor, it will be increasingly important to own hard assets because they will retain their value and require more and more units of currency (the dollar) to purchase them. US stocks, however, will not fare so well. In addition to the harmful effects of rising input costs on non-commodity companies, higher inflation also tends to lower the price-to-earnings multiple investors are willing to pay for them. You should therefore prepare your portfolio for a massive rotation out of non-commodity companies and into commodities and commodity-based companies.

Kurt Kasun
GlobalMacro

A contributing writer to GreenFaucet.com, Kurt Kasun writes a high-end investment timing service, GlobalMacro, which is focused on identifying opportunities that produce returns in excess of market with reasonable risk. He is strategically located in Washington, D.C., a key to maintaining contacts and relationships which help Kurt understand global policy and economic factors as they emerge. His investment approach has always been macro in nature largely due to his undergraduate studies at the U.S. Military Academy at West Point (B. S. National Security, Public Affairs, 1989) and his graduate studies at George Mason University (M.A. International Commerce and Policy, 2006).