Part 2 and Part 3. 

I’ve been a follower of economics since I had the opportunity to try to understand America.  I immigrated from Italy as a 10 year old, and everything was “new” to me.  In school I strived to understand cause and effect.  Having studied economics for almost 50 years, this article best describes how I feel about it all.  Enjoy!

Video courtesy of KETV News.

The “We are in the worst economic climate since the Great Depression” wackadoos sure put up a good fight.  But now more folks are finally seeing through their flawed logic. 

From a recent Newsweek article: 

The specter of depression stalks America.  You hear the word repeatedly.  Are we in a depression?  If not, are we headed for one?  The answer to the first question is no; the answer to the second is “almost certainly not.”  The use of “depression” to describe the economy is a case of rhetorical overkill that speaks volumes about today’s widespread pessimism and anxiety.  A short history lesson shows why.

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The infusion of what is called “loose money” is always a stimulating consequence for the economy in the short term.  The analogy I often use is pumping oxygenated blood into your body.

The downside is the Federal Reserve’s ability to create money without limit does create malinvestment of capital.

But the growth of the money supply is, in my opinion, very healthy for the economy.

Long-term, the creation of money out of nothing always causes inflation, which is a problem, especially for those investors whose portfolios are filled with dollar-based investments.  The reason we haven’t seen major waves of inflation despite mass creation of money is because the U.S. and global economy does not have a shortage of goods and services.  This is acting like a sponge soaking up the new money.

Remember the real definition of inflation:  It’s the increase in the supply of money which causes prices to rise when not enough goods and services are available to absorb the new money. 

The difference between today and the Jimmy Carter days of the 1970s was that back then there was a major structural problem with the economy.  Simply put, there weren’t enough factories to produce enough stuff to soak up the money being created. 

If you double the money supply without doubling the amount of goods and services, prices will eventually double.

In our current go-round, the Fed has doubled the money supply but the supply of goods and services has also doubled so it’s nearly a wash.

I say “nearly” because in reality, there is actually a lot more inflation than what the government-published statistics indicate.  In the long-term, inflation is like the tide coming in pushing up the prices of assets, including stock prices.

Investors who are concerned about the money supply growth creating inflation are certainly thinking correctly but they also have to take in to account what is happening with that money. 

“Duh Roland,” you say.  The job of the Federal Reserve is to run the economy.”

True.  The primary function of the Federal Reserve is to oversee the economy but what exactly is “The Economy?”  Conventional dogma (and the politicians in Washington) would have you believe the economy is like a machine which can be controlled and managed. 

I share a slightly opposing viewpoint.  In my opinion, the economy is more like a living environment made up of people and their activities and behaviors.  That means every time the Fed messes around with the economy by manipulating interest rates and the money supply, their monetary policy decisions have consequences that impact you, your family, and everyone you care about.

Not many people alive today remember a time when there was no Federal Reserve.  Prior to its creation the nation got along just fine without it.  In fact, America transformed itself from a tiny colony to the wealthiest nation on the planet in just over 120 years.  

I’m not saying it was an economic utopia; there were still the usual economic concerns but most issues like recessions, inflation, and depressions where confined to regional areas and healed themselves rather efficiently.

It was during this pre-Fed era that America experienced explosive growth in wealth and prosperity unlike any the world had ever seen.  Life was so good that the average worker could get by earning $20 a month and still support a large family at home. 

So what happened?

The Fed is what happened.

From its creation in 1913 to the present, the Fed’s meddling has created more booms and busts than any time in U.S. history.  These boom/bust cycles can offer wonderful opportunities to investors who understand what is going on and are prepared.  For those that aren’t, well, things get a little dicey.

That’s why I’ve long believed any investment decision not based on the consequences of fiscal and monetary policy is likely to be extremely unsafe.

To understand basic monetary policy, visualize the Federal Reserve holding a giant stick.  At one end of this stick is the price of money (interest rates); and at the other end, the quantity of money.

In the 1970s, when I first entered the investment business it was commonly assumed the only way for the Fed to control the economy was by manipulating interest rates.

During the spring of 1978, Jimmy Carter gave a speech telling the public that in an effort to help more Americans own a home, he had instructed the Treasury and the Fed to work together to make more money available at lower interest rates.

The next day, hardly a word of this was mentioned in the media but to me Carter’s new policy translated into future inflation.  So I began telling investors that the Fed had to make a change because Carter’s policy was destroying the economy and the dollar.

A change came in 1979 when Paul Volcker became Fed Chairman who then orchestrated a reversal in monetary policy where the Fed began managing the quantity of money in the long term, non-inflationary way.  The Fed began to shrink the growth of the money supply down from the huge levels seen under the Carter administration.

By early 1981, with the Dow Jones trading between 800 and 1000, it seemed logical that corporate profits would increase as the cost of capital fell so in a letter to my clients in August of 1982, I made the conservative estimate that within the next 10 years the Dow could reach 3000.  The first time the Dow Jones ever traded above 3000 occurred in the summer of 1990 so those investors who were prepared fared quite well.

And that brings me to — where are we headed today?

The mainstream media rarely says anything about this but Ben Bernanke has a far better grip on the economy than Alan Greenspan ever did.  Bernanke’s policies are moving us back in the direction of Paul Volcker’s policies.  Greenspan made the disastrous mistake of managing interest rates versus what Bernanke appears to be doing which is managing the quantity of money and allowing the free market to determine the price of money.

We cover this topic regularly on our weekly radio show. 

A book I highly recommend is THE CREATURE FROM JEKYLL ISLAND by G. Edward Griffin.  The title sounds like a Stephen King novel but it’s actually the story behind the creation of the Federal Reserve System.

You might also want to check out Ed’s lecture that he gave on the topic of his book.