Shedlock vs. Schiff: Rumble in the Economic Jungle

By: Fake Ben | Mon, Feb 18, 2008
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While Democrats struggle to line up behind one candidate or the other, there is a lesser known, yet more important fight going on over your wealth. This is the rumble in the economic jungle, and its outcome could determine if you end up being a pauper or a king. We could have massive inflation, and any cash and U.S. treasuries you hold could end up being nearly worthless. Or deflation could set in, and stocks, commodities, and housing could come crashing down.

In one corner is the mighty Mike "Mish" Shedlock of the blog Global Economic Trend Analysis ( If you haven't already visited his blog, I highly encourage you to do so. Mish updates his blog almost daily, with running commentary on the latest financial and economic news. He has a great sense of humor, and his intellect cuts right to the point.

Mish's point is deflation is inevitable. There is no escaping a contraction in money and credit supply. The financial tsunami hitting our country will overwhelm the Fed and the federal government. He is firmly on the side of the deflationistas.

In the other corner, representing the inflationistas, is Peter Schiff. Peter Schiff, of Euro Pacific Capital, Inc., is famous. He is often on CNBC, and he even has a profile on Wikipedia, the ultimate modern indication that you have arrived (

Schiff argues: "In perhaps one of biggest ironies to ever to come out of Washington, this week Congress simultaneously pilloried major league baseball players for using artificial stimulants to pump up their performance while passing legislation to do just that to the national economy…Those in the deflation camp believe that money supply will collapse as a natural consequence of the implosion of the biggest credit bubble in U.S. history. As loans go bad, assets, which collateralize these loans, will be sold at fire sale prices to satisfy creditors." He continues to say that "the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing." In other words, every time the stock market threatens to go down, the Fed will create more money, sending it into the financial system either via the banks or working with the Treasury Department to send it to whatever special interest is now deemed to be deserving of new money by Paulson, Pelosi, and Reid.

Mish retorts that "Schiff makes a false assumption that the Fed can replace credit out of thin air. The Fed is simply not in control of credit at all. The Fed can encourage borrowing but it cannot force it. The second failure by Schiff pertains to monetary printing. There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise. Think of the consequences for housing and commercial real estate. Schiff ignores the consequences of interest rates on existing debt, much of which is variable rate. Furthermore, think about what rising rates would do to future expansion plans of businesses."

Readers, I promise you this. Unlike politicians, I will not wrap my self-interest in a deceitful web of hope, belief, and inspiration. There is no inspiration here. Just pure and utter self-interest in trying to find out how to protect my wealth from the government. I'm writing in the hopes that some of you will share your thoughts with me, so that I can better understand these issues.

So will Schiff be correct? Will gold and oil go through the roof? With food prices continue to skyrocket? Or is Mish correct? Will housing continue to fall and drag down commodities and stocks (interestingly, although Mish is a deflationista, he recommends gold as well)?

While I have been a bull on oil and gold for many years, I have recently begun to question whether the commodity run might be coming to an end. To be honest, I'm not sure. It has been many years since I have been so confused.

On one hand, oil put in a double top at $100, the dollar put in a double bottom at 1.49 to the Euro, and gold seems to be topping around $930. The banking sector is in chaos, with one credit problem following another: subprime, CDOs, monoline insurers, CLOs, auction-bonds, credit card delinquencies, car loan delinquencies, student loan delinquencies, and CDSs. The only reason the entire banking system has not collapsed is because the Fed has loaned massive amounts of money directly to the banks. According to Fed reports, the total non-borrowed reserves in the banking system are now negative, meaning the banks have been wiped out and are just being propped up by the government! Yes. That is correct. If the Fed hadn't stepped in, the entire U.S. banking system would have defaulted.

Figure 1: A broken banking system, caused by the Fed, solved by government spending?

On the other hand, oil has surprisingly spiked back above $95, the dollar has turned back down from 1.45 to nearly 1.47 to the Euro, and gold is staying firmly above $900. The Fed has also lowered interest rates dramatically, and Bernanke has indicated he will continue to do so. Fed Funds futures indicate a rate cut of between 50 and 75 basis points on or before March 18th. Furthermore, the federal government is all about liquidity injections. The budget deficit is already on pace to double this year, and that's before the $160 billion stimulus bill, and the numerous other government handouts that are being prepared. Some proposals would give money to homebuilders (helping the CEOs who made big bonuses setting this whole thing up!) and guarantee loans to subprime borrowers (some of whom are just real estate speculators who never had to put a dime down and now own houses). Obama wants $210 billion for a government jobs program. He also wants to provide health insurance for every American (can you imagine the cost?). Hillary wants much of the same. McCain wants to continue our costly war in Iraq. But can you blame the politicians? They are just responding to the American people, who want something done quickly! They don't want to spend less and save more. They want help from the government to keep their lifestyles in place. No wonder there are reports that the Chinese are participating less in the auctions of our long-term government bonds. The government is threatening to set off massive inflation, yet long-term interest rates hardly compensate for the risk.

Schiff writes: "In reality, the current slump in the U.S. economy is simply the come down from years of financial doping in the form of skyrocketing home values and easy credit. Rather than reaching for yet another syringe, Congress should ask Americans to do what it demands of ballplayers: play within their natural means. Unfortunately in the case of the economy, the patient is already so juiced up that further doses may not only fail to stimulate but may result in a trip to the emergency room. As the widely praised 'economic stimulus' bill was signed into law, the only dissent heard was from those saying the plan did not go far enough. Speaking for those unheard voices who disagree with the strategy entirely, I believe the most significant aspect of the plan is that it creates a new and improved method for delivering inflation."

So who will win the rumble in the economic jungle? Quien es mas macho? Shedlock or Schiff? At this point, it's hard to say.

As for me and my self interest, I continue to hold a lot of cash, waiting for a clearer indication of the market's direction.

I do, however, have a yen for Yen, which I have been buying. The Japanese economy continues to show strength and even some signs of mild inflation (which is good for them since they have suffered so many years of deflation). I think the carry trade will unwind if their economy continues to do well and the U.S. Fed continues to lower interest rates - all of which will favor the Yen over the dollar.

I'm also short the U.S. long bond, which I call my Pelosi/Obama Protection Plan.

Other than that, I have a short-term short position in oil, but I'll close out my position if oil goes above $98.

Here is why I'm bearish on oil:

1) The price has rocketed from around $86 to $96 in less than two weeks, based on Nigerian supply news (valid) and Chavez threats (an untenable bluff).
2) Winter is almost over, and supplies are building.
3) Heating oil supplies are ample.
4) Gasoline prices have remained low, crack spreads are low, and therefore demand from refineries is likely to be moderate.
5) The U.S. and probably world economy is slowing. Demand for the last several years has been surprisingly subdued. It continues to be so.
6) There appears to be more spare capacity than a year ago.

Here's why I could be wrong:

1) Rest-of-the-world growth could surprise on the upside.
2) Energy shortages worldwide (from China to Chile to Nicaragua to Brazil to South Africa ) could lead to more oil-driven electricity generation.
3) Tensions from Venezuela and Nigeria could be indicative of upcoming resources wars.
4) New production might be harder to come by and not meet demand.
5) Our friends at the Fed could continue to shower the world with money, igniting a rush out of the banking system and into commodities (why keep my money captive in a faltering U.S. banking system if (a) risks of losses or freezes are high; (b) rates are artificially kept low to mask the sins of bank loses that I had nothing to do with; and (c) commodity prices continue to accelerate?).

Overall, my portfolio position remains confused. While this position is unsatisfactory, sometimes doing nothing is the best course of action. I'm closely watching the dollar (especially the 1.49 line), gold (especially at $930 on the upside and $895 on the downside), oil (at $97 on the upside), and stocks (1310 on the downside for the S&P500). If any of these lines are crossed, then I think new trends are in place that could last a while. Until then, the rumble in the economic jungle continues!



Fake Ben

Author: Fake Ben

Fake Ben Bernanke

FakeBen is a blog to monitor the Fed and its actions and encourage community participation. At FakeBen, we believe that the Fed policy of the last two decades has created a credit bubble as large as that created in the 1920s. This bubble will lead to either inflation, a recession, or both.

We believe that the Fed's policy of lowering interest rates to encourage more credit creation is misguided, will eventually lead to 0% interest rates, and will not solve the long-term problem, which is too much credit relative to GDP.

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