The Great Inflation Illusion: A Historic Perspective
After the 2000 to 2002 decline, I embarked on a journey to study as much as I could about history and systemic risk in the world of money. In the process I learned that most of us, novice and professional alike, know very little about the history of our markets and thus are blindly following the conventional wisdom of "the experts." If we knew history and could get past our own natural biases, I believe we could dramatically increase our probabilities for financial success. With the Dow falling from 10,984 on March 7 to 10,087 on April 15 of this year, this has become much more than an academic discussion. While it is easy to lose the overall direction of the markets in day-to-day moves, its general direction in the next few years is of crucial importance to all.
Most of our current circumstance can be traced to inflation (and possibly deflation) as reflected in the supply of money. In discussing inflation we do well to first start with a simple definition. Webster's defines inflation as follows:
"An increase in the volume of money or credit relative to available goods resulting in a substantial and continuing rise in the general price level."
Deflation on the other hand would reveal the opposite. It is:
"A contraction in the volume of money or credit that results in the decline of the general price level."
So I ask you, "can you or I create money...legally?" If you answered "no", then congratulations, you just passed economics and law 101. The answer, we both know, is that we, as individuals, are not capable of doing this. So where is all this money coming from?
Since I was a child, the amount of money in the United States has grown significantly. According to the Federal Reserves Historical Data on the money supply (as measured by M3), when I was eighteen months old in 1959, the money supply stood at $292 billion. Of course it continued to grow so that by the time I started college in September 1975, it had reached $1,145 billion. Even though I was totally clueless as to what was causing inflation, I nevertheless, began to notice its impact on the world around me. Prices were going up everywhere. Paul Volcker would seek to curb what was the worst inflationary expansion of money and credit ever in US History by raising rates significantly. So by the early eighties the United States, and the rest of the world, was experiencing the highest interest rates in history. While interest rates had climbed to 14 percent on long-term government bonds by September 1981, this would be dwarfed by rates throughout most Latin American countries. In 1981 Chile's short-term bank loans were 47 percent and Brazil's were 49.
But things changed in the early 1980's for the United States. Even though other countries would still faced very high interest rates throughout the 80's, we would start cutting rates and making credit more and more plentiful. By May 1995, when my third son was born, the money supply had climbed to $4,476 billion. But something peculiar was occurring; as we were inflating credit more and more, the prices of goods were deflating. Increasingly, we were shipping our raw resources overseas. The Asian Rim, China, and India were able to produce what we wanted to consume for a fraction of what it would cost to produce these items in the United States. Inflation was showing up; however, now it was showing up in our asset prices instead of our consumption prices. This would go on to produce the fastest growing stock market in history and continue to cause real estate prices to climb.
In the meantime, on the other side of the world, we failed to notice what was happening to Japan, the second largest economy in the world. As our markets were roaring, in 1989 the Japanese markets began a long-term secular bear market. They would watch their stock values decline and their real estate holdings fall sharply from a growing deflation of prices. In fact commercial real estate values fell 90 percent from 1989 to 2003. Since the government cannot make people borrow and spend money, deflation was something that the Japanese government could do nothing to stop. Meanwhile, in America, our money supply, and therefore inflation, continued to grow.
In January of 2000, I breathed a small sigh of relief. The Y2k scare was over, and we were entering a new millennium and a "New Era." The sky was the limit.
What most of us didn't realize is the fact that from August 1982, when the Dow Jones Industrials hit 777, to the January 2000 price of 11,722, the money supply had grown from $2,396 billion to $6,605 billion. Consumer credit had grown from $383 billion to $1,541 billion. And while we only have information back to June 1985, the Federal Reserve (historical data on Real Estate lending from Financial Companies) revealed a growth in real estate lending from $25.8 billion in mid 1985 to $177.1 billion in early 2000. These numbers confront us with the fact that much of our boom in the stock market and otherwise was actually the consequence of a massive inflation of money and credit.
So where do we stand today? Are we facing a deflationary or an inflationary environment? To answer this question, let's look at the growth of money supply since the bubble popped in early 2000, how this increase appears to have affected us, and what we can learn from Japan.
As of March 2005, the money supply stands at $9,532 billion. Stated another way, the same amount of credit has been produced from the time I was age 42 to 47 as was produced from the time I was 18 months old until I was 28. The last 5 years have also seen consumer credit grow from $1,541 billion to $2,122 billion and finance company real estate lending grow from $177.1 billion to $282 billion. Clearly the cutting of interest rates from 6.5% in January 2001 to a low of 1% in June 2003 made it very appealing to borrow money.
On the other side of the world, Japan has lost money for so many years that its institutional investors and banks invest in the bond market versus stock market. The value of the Nikkei closed 72% lower on May 17, 2005 (at 10,825) than its high (of 38,915) in December of 1989. To this day, its people are focused on saving and its businesses are focused on debt reduction rather than expansion and growth.
Cheap money policies have allowed us to continue to borrow. We have taken this money and maintained or increased our rate of consumption and purchased assets. The swell in dollars has created a swell in demand. While consumption prices have stayed low because of globalization, asset prices have inflated greatly. The primary effect of asset inflation can be seen most clearly in real estate prices, yet the stock and commodity markets reveal this as well. As our borrowing capacity begins to tap out, who will keep "inflating" these asset prices? If we are forced to pay down debt and thus have less money to buy assets and consume, is the next major obstacle inflation or deflation? Every investor will witness the answer to these questions. Our history, and that of Japan's, teaches that asset classes and investment strategies work very differently in a long-term deflationary cycle. The real question is whether we, as individuals, will prepare now or be caught off guard at some point in the future.
"Those who cannot remember the past are condemned to repeat it." George Santayana