Inflation, Deflation, or Bust

Inflation, Deflation, or Bust
by Bill Bonner
The Daily Reckoning
London, England
Friday, June 30, 2006

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• Omens that the end is near…sellers get skunked…

• The worldwide tragedy of dirty water…and how you can ride the "blue gold" profit boom…

• The older you get, the more dead people you know…remarkable emphasis on the future…and more!

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"Lightning Strike Destroys 10,000 Square Foot Mansion," says a headline from Winter Park, Florida.

"Was there ever a more distinct omen from the gods of the end of the housing bubble than this?" asks our correspondent, Bryon King.

And here comes our colleague Steve Sjuggerud, writing from Florida after raking through the ashes, studying entrails and consulting the stars:

"According to my research, the boom in housing is finally running out of gas. Let me explain…

"This is a change for me. I'd been bullish on housing for quite a while. For example, in the November 2002 issue of True Wealth, I recommended buying homebuilding stocks. Here's what I said:

"I expect a real estate bubble to take hold, for a few reasons. First, 'bubble money' requires easy credit, and plenty of it. It is there in the mortgage market, and more is coming. Second, because of the huge differential in real estate rental yields (7%) versus the other options (paying 2%), huge piles of money will flow into real estate. It's actually already happening, as huge pension funds are earmarking big dollars to put into real estate.

"So we've got individuals trading up. And we've got big investors (and HUGE investors) making a rational investment decision. We've got buyers coming from every direction, and not much out there to derail them. Put simply, there are no investment alternatives right now, other than your mattress.

"The only thing holding prices back is disbelief. Disbelief is actually what happens in the middle stages of all bull markets - disbelief that prices can go higher. Indeed, if it weren't for disbelief, prices would already be higher.

"We got it right in 2002. In the May 2003 issue, I reiterated my bullish stance, and recommended another homebuilding stock. I said:

"A downturn is not around the corner. Demand is unsatiated…Quoting the head honcho of this month's recommendation in a conference call he had with analysts this month: it is 'difficult to supply enough homes for the demand we're seeing.'

"But that was then, this is now.

"Most of the indicators that looked so attractive in 2002-03, when I was calling for higher home prices, have now reversed in mid-2006. So I think the rise in single-family home prices is over. Plan accordingly."

Steve was looking at the building stocks - clearly in a bear market. He also mentioned "affordability." Houses aren't as cheap as they used to be; fewer people can buy them.

He might also have noticed that sellers are getting "skunked" at their open houses. That's a new term for what happens when you open up the doors and find no one there. "A year ago," explained a real estate agent from Rhode Island to a Bloomberg reporter, "we would hold an open house and get 30-40 people passing through. Now, we may not get anyone."

It is "the first U.S. housing decline since 1999," says Bloomberg. Sales in the Northeast lead the decline, down 4.2%. In the Midwest they're down 3.8%. The West is down 0.7%. The South down 0.4%.

Where does this housing decline lead? More below…

[Ed. Note: Both Byron King and Steve Sjuggerud will be shedding more light on the housing market conundrum at this year's Agora Financial Wealth Symposium in Vancouver, British Columbia, July 25-28. If you haven't secured your spot for this meeting of some of the finest minds in the investment world, act fast! Spaces are filling up…

The Agora Financial Wealth Symposium, July 25-28, 2006

More news from The Rude Awakening…

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Chris Mayer, reporting from Gaithersburg, Maryland:

"We see things a little differently…Oil may be undervalued, but NOT relative to drinking water. In fact, the truth is exactly the opposite. For most of the world, clean drinking water is a far more precious commodity than oil."

For the rest of this story, and for more market insights, see today's issue of The Rude Awakening:

Blue Gold

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Further thoughts from London…

*** "Dirty water is a worldwide tragedy. Clean water is a worldwide investment opportunity," says The Rude Awakening's Eric Fry.

"Half of all hospital beds in the world are occupied by someone suffering from a water-related illness. In the developing nations, 80% of all diseases stem from consumption of and exposure to, unsafe water.

"There is no shortage of water on this big orb of ours, but there is an acute shortage of clean water…and the human toll is alarming.

"Contaminated water is deadlier than any other evil on Earth; deadlier than AIDS; deadlier than cancer; deadlier than contagious diseases; deadlier even than world wars. During the Second World War, one soldier died every five seconds. Today, one human being dies every 3.5 seconds from drinking contaminated water."

Interestingly, the country bearing the brunt of the clean water shortage is China.

Chris Mayer reports:

"China has about as much water as Canada, but a population 40 times as large. On a per capita basis, China's water reserves are only about one-quarter of the global average. Worse, the distribution of people and water creates its own logistical obstacles. Nearly half of China's population resides in the northeastern provinces, where only 14% of the water resources are located.

"These facts provide endless challenges for the Chinese. Water shortages and widespread pollution are serious threats to China's booming economy. It costs billions each year in lost output. The World Bank says environmental damage and health problems cost the Chinese economy more than $54 billion a year - or almost 20% of its GDP. That's why China is drastically stepping up its commitment to water management, particularly wastewater treatment and recycling. In 2005, the Chinese government pledged a US$30 billion 5-year package to overhaul its wastewater sector. Municipalities there are now required to treat between 40% and 60% of their wastewater.

"In an attempt to avert crisis, China plans to build hundreds of new water-treatment plants. But for now, bottled water is the preferred choice - even among the Chinese, at least among those who can afford it. When I was in China, bottled water was nearly everywhere. As the Monitor points out, consumption of bottled water nearly quadrupled between 1997 and 2002."

[Ed. Note: China's market for water-systems infrastructure will grow at nearly twice the global rate - with as much as $250 billion in new spending, just between now and the end of 2008.

While a lot of water-industry infrastructure companies will make a fortune replacing or providing that equipment, the one Chris Mayer has pegged for you in his new special report could crush all the rest on total shareholder performance over the months ahead…

How To Ride the "Blue Gold" Profit Boom

*** From opposite sides of the Atlantic come two of the most remarkably loopy (to us, and probably only to us) initiatives of recent history. One is to be funded by theft - that is, from tax money. The other finds its footing in money that was honestly won in the investment markets. Both take our breath away.

In the United States of America, the two richest men on the planet have announced plans to join forces - which is to say, to put their money together - for the avowed purpose, among others, of holding down the world's population. They intend to give millions, if not billions, to worthy organizations such as Planned Parenthood, whose goal is to curtail the number of people. While, in the Federal Republic of Germany, Frau Merkel has just announced a plan to spend $30 billion or so to try to bring forth more of them. Buffett and Gates figure there are too many people. Merkel thinks there are not enough.

As to whether we would be better off with fewer or more, we have no opinion. We can think of one or two people we could happily do without, but we hardly thought it was our place to choose.

The older you get, the more dead people you know. We can think of quite a few. They died in Vietnam, in bar fights, of diseases and accidents. Among the quick at least, they no longer exist. Of course, each downside death came with a little upside; the living got a little more light…more air to breathe…a little more wealth…a little more elbow room. But we can't think of a single dead man we liked so little as to make the bargain worthwhile. We miss every one of them.

It is hard for our modest minds to grasp the thinking behind either the "more the merrier" or 'the fewer the fitter" factions. Does Warren Buffett have trouble finding an empty parking place? When he goes to his favorite restaurants in Omaha, does he have to wait in line for a table? What exactly leads him to think that there are too many of us on the planet, and exactly which ones, present or future, does he plan to eliminate?

We have the same questions, upside down, for Ms. Merkel. Is she lonely on public transport? When and how does it occur to her that the Fatherland needs more mommas and poppas?

Yes, we know. We are being simpleminded. Neither the German chief of state nor the two top slots on the Forbes list imagine making any immediate change in population. Instead, they are thinking ahead, you will say, merely trying to avoid a future problem. After all, a child born this year won't be taking a seat on the subway for at least a few years. It will be more than two decades before he is likely to contribute to Social Security. In theory, a baby boom in Germany will help keep the country's retirement plans solvent. And in theory, one less person in Africa is one less mouth to feed.

But what kind of deranged theories are these? Who would have a child just so he could be enslaved to the nation's social welfare system, working half his time like a serf to pay for the benefits the older generation voted for?

People grow food. People produce wealth. The next man is just as likely to be able to support himself as the last one. If you believe in progress, he'll be able to do more easily.

Back before global warming came along and stole the headlines, population control was much more in style. Paul Ehrlich wrote a book, The Population Bomb, in which he predicted a worldwide famine by 1975. All he was doing was extrapolating existing trends into the future. But patterns persist, trends don't. Who had heard of biotech or computer chips in the '60s? Who could have foreseen the breakthroughs that would multiply output faster than humans could couple? Who now knows what will happen next?

This emphasis on the future only makes the whole thing even more remarkable. Saying you don't like having so many people around you is merely anti-social; to spend billions in anticipation of what your grandchildren will want - when even the present generation cannot agree - is madness.

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The Daily Reckoning PRESENTS: The Fed has raised rates - yet again - to "tame inflation." However, Bill Bonner argues that in this mock battle against inflation, another enemy will rear its ugly head: deflation. And when push comes to shove, the Fed will fall over…

INFLATION, DEFLATION, OR BUST!
by Bill Bonner

At 7:15 p.m. London time came the news we already knew: the Fed raised rates an 18th time - to 5.25%. Inflation will be tamed! Deflation, be damned!

Concerning the U.S. economy, and by implication the entire world, there are two major currents of thought. There are, on the one hand, those who believe in the perfection of man and those who don't. The first group thinks the science of central banking has made amazing strides. In the 1980s, the Volcker Fed learned that it could tame inflation. Then, 20 years later, the Greenspan Fed found that it could avoid deflation, too.

Central bankers now have at their command whole armies of statisticians, number crunchers, and economists. When their forward listening posts hear the sounds of oncoming inflation, for example, the feds set the range on their heavy artillery and begin firing away. On the other hand, if it is deflation on the march they know what to do - blow up the dikes! Open the sluices and floodgates! Flood the paddies and lowlands with liquidity!

In the view of the first group, the Fed has finally got the hang of it, and the latest GDP figure, 5.6% growth in the first quarter, proves it. The experts have become so good at fighting both inflation and deflation that neither poses any further real danger. The U.S. economy is impregnable, a citadel of growth that will continue expanding forever and ever, amen.

Nay, say the naysayers; it doesn't work that way. An increase in firepower doesn't eliminate war; it just makes it more costly. At the heart of the Fed is a heart…a living, heaving, squeezing, juice-pumping human heart. And like all human hearts, it is sometimes good, some times bad, but always subject to influence. And the influence to which a central bankers heart is subject is not one easily brushed aside. What can a man do but bend a little when the president of the United States of America leans on him? And when his cronies and future employers on Wall Street come into the bar and ask for more liquidity, can he really say no?

A poll, released just yesterday, tells us that Americans now oppose more rate increases by a margin of three to one. What is more amazing is that they have any opinion at all. The going rate of short-term credit is hardly a matter for public debate. It is, or should be, what it is: a natural equilibrium worked out between borrowers and lenders themselves. Instead, voters expect to find it on the next ballot, along with grumpy resolutions proposing to skip winter this year and round off pi to the nearest whole number.

'Liquidity' is an economist's word for more cash and credit. 'Inflation' is the word used to describe what happens to a currency when too much liquidity is made available. Central banks can control the quantity of the money they emit, and by extension, its quality. What they cannot do is increase the quantity and the quality at the same time. Given a hard choice, they almost always give way to quantity and let the quality go to hell. The supply of currency increases; it is "inflated." Sooner or later, inflation of the money supply leads to the kind of inflation that voters recognize, an increase in consumer prices.

This second group, more skeptical than the first, and long gold, believes the Fed is neither as competent nor as determined to fight inflation as it pretends. It expects neither sorrow on the part of the Fed for all the inflation it has wrought, nor pity on all the poor householders who live on fixed budgets and low savings. The Fed may want to fight inflation, they say, but its hands are tied. The federal checkbook is overdrawn by some $500 billion this year. In addition, the U.S. Treasury has a trillion-dollar mountain of short-term debt it must refinance in the months ahead. And then, there are the voters themselves, faced with rising interest rates, falling house values and $2.7 trillion worth of adjustable rate mortgages that will be reset in the next 24 months. It's no wonder they want lower rates. Under these conditions, consumer price inflation should increase steadily, and the price of gold should climb.

Today's little reflection suggests that both groups - optimists and pessimists - are wrong. We begin and end by pointing out the obvious. The world may have too many dollars, but it also has too few. Central bankers' vaults, drug runners' pockets, and Wal-Mart's cash registers may be full of them, but there is another side of the ledger, too. Average Americans already are having trouble finding enough dollars to pay their bills. When the going gets tough, they may have even more trouble finding that elusive dollar.

According to the latest report from Charles Gave and Anatole Kaletsky, consumers did not cut spending in order to balance their household books. That is why spending has been so robust. It is up at a 5.1% annual rate in the first quarter. Cutting back expenses and saving money may have been the prudent thing to do, but it would not have been as much fun. And why bother? You save for a rainy day. But if the Fed is really as good as it thinks it is, you can throw away the umbrellas.

Instead of cutting back, they borrowed more - in dollars. These extra borrowings create what could be viewed as a massive short position in the U.S. currency. People must need more dollars than ever before, in order to service past loans as well as maintain their current living standards. Gave/Kal write:

"The bottom line is that oil consumers around the world have decided to postpone as much as they could the moment of reckoning which the increase in oil prices should have triggered. They have decided to borrow dollars (or yens?) to buy oil. As a result, a number of countries are now not only short oil, but are increasingly short the dollar. This means that, slowly but surely, we are building a corner on the U.S. dollar similar to the one we built in the period from 1978 to 1980, or from 1995-97…"

Their conclusion: buy assets with cash flow denominated in U.S. dollars.

Consumers edged themselves into more debt rather than face up to declining spending power. Now they're in worse shape than ever. They have no room to maneuver. Unlike the Japanese, they cannot hunker down and wait out a recession; they have bills to pay! So has the Fed edged itself into a tight spot of its own. Armed to the teeth to fight inflation or deflation, it cannot fire a shot.

Over the horizon are the forces of inflation. Bernanke trains his guns on a 2% core rate as if he were Patton aiming at Metz. That there is no real enemy in front of him, no one bothers to mention. If inflation were a problem, speculators haven't noticed - they recently sold off commodities to buy the dollar! Nor is inflation given any support from wages; for most people, wages are going nowhere. Even gold, that ancient hedge against inflation, acts as if there were nothing to worry about; it rises no faster than base metal.

But what would the Fed do if inflation really were attacking? In the late '70s, Paul Volcker had to set the price of credit at 15% in order to bring stop inflation's advance, causing the worst recession since the 1930s. Members of Congress called for his resignation. Members of the public burned him in effigy. And that was before the country went on its borrowing binge. A 15% fed funds rate today is not impossible, but it would bankrupt 10 million people, and Ben Bernanke would have to flee for his life.

That is why real consumer price inflation, when it comes, will get little fight from the Fed.

While the Fed engages in mock battle with inflation, its real enemy takes the field hardly noticed. Here is where we part company with economists, kibitzers, and commentators on both sides of the argument. The naysayers argue that the Fed's inability to fight inflation guarantees a higher gold price. As Dan Denning puts it, "The fed has one way and one way only of coping with high consumer and government debt levels: it has to inflate." That may be, but it is not the fight against inflation that is likely to be lost first. When push comes to shove, the Fed will fall over. Just as it is unable to fight inflation, it is unable to fight deflation, too. It has spiked its own guns.

Welcome to cruel irony. Welcome to sweet revenge. Welcome to Tokyo!

The risk of consumer price inflation is more consumer price inflation. People see the value of their currency dropping and rush to get rid of it. Prices rise even more. In the most spectacular case in modern history, in Weimar Germany, inflation got to such levels that employees insisted on being paid twice a day, and a man mailed his landlord his rent in the morning. By the time the letter arrived in the next day, the rent money was worth less than the stamp on the envelope.

But it is not consumer price inflation that the U.S. economy most has to fear, it is inflation in a more agreeable form: asset price inflation. Houses, in particular, have gone up. And the risk from this kind of inflation is different; the risk is not more inflation, it is less inflation - or deflation. House prices have already begun to go down. Meanwhile, high energy costs are draining cash away from American consumers and toward strange and unfriendly places: Russia, Venezuela, and Saudi Arabia. The price of gasoline averaged $2.34 per gallon in the first quarter of this year. Now, it is $2.84. The demand for dollars is increasing, even as their intrinsic value goes down. But Bernanke still believes he is fighting the first kind of inflation, not the second. He trains his cannon on consumer price inflation, and makes noise. Kapow! Kaboom!

But out on the vast plain of Middle America, the flowers begin to wilt. Where will the money come from to pay the mortgage? How will the tank be filled? And by the time Ben Bernanke has his helicopters gassed up and loaded with twenties, it may be too late. The nation may already be in deflation's grip - like Japan in the '90s or America in the '30s - with declining property prices squeezing the juice out of consumer spending. If prices for houses fall, who will borrow to buy another one? How can the feds push their debt when the nation finally goes on the wagon? Why will people spend now, when they can get a better deal next month? Won't they finally get out their umbrellas when they see the clouds forming overhead?

A pullback by American consumers, caused by declining house prices, would put the whole world into the dryer. Liquidity would disappear. Even the hint of declining liquidity, given out a few weeks ago by central bankers themselves, caused cracked lips and parched throats. Commodities fell 20% or more. Gold lost $100. Emerging markets shook and quavered. Imagine what a real deflation would do! When the debt-soaked U.S. householder dries out, the whole world goes into a slump. Chinese factories would go quiet. The demand for raw materials would collapse. Unemployment would increase. Wage progress, feeble as it is, would go negative. Even the debt pushers would have to look for other work. Refinancings could turn brown and curl up like an old leaf. Defaults and bankruptcies would soar. Gold, the ultimate safe haven, may be the only thing to go up. As for the dollar, it might fall in the currency markets, but still be in demand at home. Instead of finding themselves with too many dollars, Americans would find they had not enough.

Bill Bonner
The Daily Reckoning

Editor's Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin's follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is - an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount - just click on the link below:

The Most Feared Book in Washington!

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