Dr. Marc Faber
Author, The Gloom, Boom & Doom Report
"Inflation / Deflation"
Transcription of Audio Interview, July 2, 2005
Editor's Note: We have edited the interview in this transcription for clarity and readability. The original real audio interview may be heard on our Ask The Expert page.
JIM PUPLAVA: My special guest this week is Dr. Marc Faber. He’s no stranger to FSO listeners and he is also the editor of the Gloom, Boom & Doom Report, one of the best investment newsletters around, and also the author of a book called Tomorrow’s Gold.
Marc, I remember when I got into this business in 1979, and between 1980 and 81, Wall Street, investors and the Fed were concerned about inflation. We had gold at $800, oil at $40, the Dow at around 800 and interest rates at 15%. Today, we do have rising oil, but the Dow is over 10,000, PEs on the Nasdaq are close to 40, T-bill rates are in the 3% range, and everybody is worried about deflation. Is this a contrary indicator?
DR. MARC FABER: Well, we can talk about whether this is a contrary indicator later on, but first, I think we should define what inflation is really, because normally people will associate inflation with rising consumer prices. In other words, when the price of food goes up, the price of clothing goes up, items that you buy everyday increase in price, then the housewives are obviously not very happy and they will go and tell the central bank to do something about this inflation. And so, usually, the central bank will then tighten monetary policies.
I think it’s important to understand that inflation is basically an increase in the quantity of money in an economy. And when the quantity of money goes up at a faster rate than the production of that said economy, then obviously it leads to some price increases. Now again, we would have to define exactly what money is, because we could have an increase basically in the quantity of money, and it would not necessarily be reflected very much in money supply figures. It could be reflected in debt growth, for instance, which would not be captured entirely by money supply figures. But in any event, when this quantity of money goes up it can then manifest itself in many ways. In the 1960s we had high wage inflation, real wages were rising very rapidly and that gave unions � because there was some tightness in the labor market � tremendous power. And maybe you remember those days of Walter Reuther and of Jimmy Hoffa, these people � these union leaders � had tremendous power.
And then inflation migrated into commodities in the 70s, and along with an increase in commodity prices, we had high consumer price inflation until about 1980, and after 1980 inflation migrated to asset prices. In other words, after 1980 we had diminishing rate of increase in consumer prices � they were still going up, mind you, but at diminishing rates of growth � and we had very high asset inflation, stocks and bonds rallied and in the last 5 years, especially since 2000, we had this huge increase in housing. So it’s important to understand that basically there has always been, in the last 25-30 years, some inflation in the system. In fact, I would say that, whereas in 1913 when the Federal Reserve Board was founded, the price level in the US was no higher than it had been in 1800 � and during that period, 1800-1930s, there had been tremendous growth, the entire industrialization of the United States, all the inventions and so forth, and this was accompanied by price stability � since 1930, paper money has lost over 95% of its purchasing power. Anyone listening to this radio show will know how more expensive goods are today � and services � compared to, say, 30 or 40 years ago when I was still studying and going to school. So, we have this inflation that has shifted in 1980 into asset prices, and now the big question is, since commodity prices seem to have bottomed out in the period 1999-2001, and since � as you point out � the yields on bonds are as low as they are, I think there is a real threat that inflation will migrate back into consumer prices. And I would say, whereas in 1980 bonds were considered certificates of confiscation and nobody dared to buy bonds, and bond yields went to 15.8% in September 1981, today, it seems to me, there is an enormous complacency about bond yields. When people buy 30-year bonds at the yield slightly in excess of 4%, you would have to be extremely confident that for the next 30 years inflation will never again be above 4%, which I kind of doubt. I think eventually the Fed will have to print money and that this will lead to more inflation.
JIM PUPLAVA: You know, Marc, you bring up a point that I think is very important in understanding this debate. And I would like to discuss the real economy versus the financial economy. In the real economy: that’s where goods are made; goods are traded; that’s where doctors heal people; companies manufacture widgets. Then we have the financial economy where paper is traded and credit is created. I wonder if we might speak about that for a moment?
DR. FABER: What is interesting in today’s world, and possibly unique � and I pointed this out before � is we have the breakdown of the socialist-communist ideology and of policies of isolation in India. We have new technologies and this has allowed the industrialization of these formerly communist countries at a much faster pace than ever before in history. And it has had a huge impact on the world in two ways. On the one hand, they are coming into the global economy, these 3 billion people, as producers of goods and as providers of services. And so on these sectors of the global economy they have frequently a deflationary impact, because: their wage levels are lower; their working hours are longer; they don’t have the whole regulatory costs we have in the Western world; they don’t have the product liability costs we have in the Western world; and so forth and so on. So basically, on the manufacturing sector the entry of China, and in the service sector the entry of India, into the global economy has a deflationary impact. At the same time, they have, on the real economy, an inflationary impact as their standards-of-living are improving, and as their industrial production is growing very rapidly. Trendwise, industrial production in China is growing at around 12-15% per annum, and per capita incomes in China have doubled every 10-12 years for the last 25 years. That has never happened anywhere in history. Before that, you double your per capita income at this pace and that means more demand for certain goods, in particular in the case of China, for commodities. But it’s not just China, it’s also Vietnam and it’s also India, that require more commodities, in particular also more energy. So on the real economy this globalization � basically the end of communism, the end of policies of isolation � has a huge impact. The impact is felt in some sectors through deflation, or price declines, in other sectors, in particular commodities, through price increases.
At the same time, as you know, we had essentially a steady debt-to-GDP ratio between 1950 and 1980, and since 1980, debt as a percentage of the economy in the United States � but also in other countries � has gone from 120% to now over 300%, and that has created a huge kind of financial economy. The financial economy is gigantic in terms of GDP. It’s much larger than GDP in the United States and, in fact, if you look at the earnings of the S&P500, whereas in the 1950s and 1960s corporate profits were still derived 50% from the manufacturing sector, and only about 10-15% from the financial sector, today, more than 50% of S&P earnings � if you add the financial subsidiaries of industrial companies such as GE Capital and GM Acceptance Corp, etc., � are derived from the financial sector, and only 10% from the manufacturing sector. So in the US we have a kind of very bizarre economy where the manufacturing sector has contracted as percentage of the economy and we have what I would call the asset sector of the economy that has been grossly inflated: the financial markets and the housing market. About, I would say, a third of employment creation since the recovery in 2001 is real estate related, in other words: construction; real estate brokers; real estate financing; and so forth. It’s kind of an asset bubble economy in the United States that hasn’t recovered after 2001 because of real economic activity, which would be a rise in capital spending and strong industrial production. So we have this � as you point out � these two economies. One is in fantasy land: the asset inflation economy; real estate; equities; and bonds. And the rest of the economy, which really produces goods�namely the manufacturing sector�is kind of neglected and not doing particularly well.
JIM PUPLAVA: You bring up a point a friend of mine, Bob Prechter, brings up. In fact, he’s got a graph of the 3 million manufacturing jobs that have been lost and continue to be lost because � when you look at the monthly job numbers � manufacturing continues to shed jobs, while, as you say, real estate and construction are adding jobs. But getting back to this real economy, Marc, where the financial economy is much larger than the real economy, it seems to me that in the financial economy, it’s an economy of speculation, asset bubbles, it’s commerce, it’s financial instruments. I would say it’s almost easier to move a billion dollars from New York to Tokyo than a truck load of lettuce and grapes from California to Arizona. There seems to be a real divide here between the real economy and the financial economy.
DR. FABER: Yes, we are in an extreme casino society and it can become bigger. But one thing is sure: one day it will end badly when this whole financial bubble and asset bubble is deflated very badly. What the catalyst to that will be I don’t know. The Federal Reserve and other central banks of the world will of course do whatever is possible to keep this bubble alive, simply because to deflate the bubble would be economically extremely � and I repeat, extremely � costly. So the moment the Fed sees a crisis � whether it’s the S&L crisis in 1990, or the Tequila crisis in 1994, or LTCM, or they sometimes totally misjudge events, like Y2K � they just print money like there is no tomorrow. And the next time the economy cools down, presumably because the housing market no longer goes up � it doesn’t need to collapse, just no longer going up � or because of an implosion in China, or a slowdown in China, or whatever may happen, you can be sure the Fed will be there to print money, and the other centrals banks the same.
The first great example in history of printing money in order to boost economic activity was undertaken by John Law in 1719. It was called the Mississippi Scheme and it is interesting to read about it because what the central banks are doing today is exactly what he did at that time, namely, to print money and try to stabilize asset values � in that particular case of his Mississippi company. But of course, it totally failed and the whole scheme eventually collapsed and the crisis ensued. And that will be the end result. But how do we get to the end result? Robert Prechter says that we will get deflation. Yes, I am sure he will be right, but before deflation we can get maybe a wisp of deflation, then massive money printing, and first hyperinflation, or very high inflation rates, and then deflation. But I doubt we will go just from where we are today into serious deflation. I think first, the central banks, led by helicopter commander Mr. Bernanke, will drop dollar bills onto US households. They may have to retrieve all the helicopters that are in Iraq to do the job, but they’ll do it.
JIM PUPLAVA: You know, Marc, you bring up a point that I think some of the deflationists really miss. That is, if a central bank is willing to print sufficient amounts of money and make it unlimited then deflation can be avoided temporarily, however with certain costs.
DR. FABER: Of course. It’s like the Nasdaq bubble was deflating and it looked for awhile in 2001 that we might have some consumer price deflation. So Mr. Greenspan created artificially low interest rates � he pushed the Fed Fund rate to 1%, in an extreme case he could push it down to 0, theoretically � and in an extreme case, where deflation really becomes a threat, the government could send to each household a check of $100,000. That would be the ultimate monetization of the system. It can be done, but at what cost? The cost is obviously that if you have one country that inflates badly � in other words prints money badly � and other countries don’t do the same, then the currency collapses. Then you can get deflation through the exchange mechanism. Say, in Latin America we had very high domestic inflation rates in the 1980s, but the exchange rate totally collapsed. So in dollar terms, the dollar was strong against the Latin American currencies, but in dollar terms the price level was deflating. In fact, I would mention that the Latin American experiment of the 1980s has some similarities with what is happening in the US today. Because what happened then is that they had an economic boom based on the petrodollars flowing to Latin America in the late 70s � these were petrodollars that were recycled through the American banking system to Latin American countries in the form of loans � and when the petrodollars no longer came after 1980, they experienced a crisis. So what did they do? They created budget deficits and started to print money, and that led in some cases to inflation rates of up to 900% per year, in Brazil and in Argentina and other Latin American countries. But the exchange rate totally collapsed with the result that by 1988 you could have bought the entire Argentine stock market for $750 million US dollars. And Brazil was no higher in 1991 than it had been in the early 1970s, simply because the currency had totally collapsed. In local currencies the market had gone up a lot, but not in US dollars, and that’s why at that time one termed Brazil “the land of the eternal future,� because nothing ever worked. But then they tightened monetary policy, and reformed, and then it took off. But that is an example where they never really had deflation in local currencies. They had a terrific deflation vis-�-vis the dollar, and the deflation manifested itself through the exchange rate mechanism.
JIM PUPLAVA: Marc, why don’t we discuss, for example, how this inflation can manifest itself, because - as we started this conversation and you talked about some people think of inflation in terms of rising prices, not in expanding money supply, as we have today, and expanding credit � I would argue that America’s trade deficits are a form of inflation, in the sense that: you have over-stimulated demand spilling over into the trading side; we have hyperinflating stock prices with volatility; hyperinflating real estate prices; and low interest rates; and a Nasdaq that is still selling at 40 times earnings. Aren’t these in many ways, parts of the financial economy, and manifestations of asset inflation? And at the same time, the trade deficit is where real goods inflation is being channeled?
DR. FABER: I think you are making a very important point: we always have to look at causes and effects. If you inflate your price level in a country then obviously over time you become less competitive and that is then reflected in the trade deficit. Now, in the case of the US what has happened, if you compare, let’s say, the US to China, China pegged its currency to the US dollar in 1994 and they had a modest trade surplus with the United States until about 5-6 years ago, and since then it has exploded. Now, Ms Rice, who has the tendency to lecture the Chinese about economic matters, and the Russians about democracy, blames the Chinese for this trade deficit by saying, “well, the Chinese have an undervalued currency.� But basically, who is to say the Chinese currency is undervalued? I could argue the US dollar is overvalued. And why did this all come about? Simply because, in the US, the price level over the last 10 years or so has been inflating, whereas in China, we have unit costs going down very sharply, because China is becoming very productive and wages are not rising much, and so the imbalance between China and the US has been growing. But it has been especially, as you have pointed out, growing as a result of the expansionary monetary policies after the year 2000, because that’s precisely the period when the trade deficit in the US, and the current account deficit, exploded. Before that, the US had a trade and current account deficit, but not to the extent of what we have today, which is now roughly 6% of GDP on the trade account, and on the current account also around 6% of GDP.
I’d just like to mention one more point, that it is true that the US has a big trade deficit with China. In other words, China has a big trade surplus with the United States running right now at an annual rate $174 billion. But last year, China had a trade surplus of only $32 billion overall. In other words, it’s not that China has a totally unfair trade policy. They have a trade deficit with numerous other countries, among them Latin American countries, Asian countries, and so forth. So they’re importing goods, but they’re just not importing a lot of products from the US simply because the US doesn’t have a lot of very internationally competitive products. You don’t see any American cars around the world. You see some that are, yes, manufactured in Europe, like Opal cars and Ford cars, some of them are manufactured in the US. But really, [of] the American cars [manufactured] in the US, you see just very few around the world. And as a hedge fund manager observed to me, he said, “You don’t even see a lot of American cars in America.�
JIM PUPLAVA: Especially California.
DR. FABER: The problem with asset inflation � and I have observed this also in Hong Kong, and in Tokyo � is the asset inflation leads to a boom, say, in stocks or in real estate, and it really distracts the attention of people from actually producing something, because the manufacturer says to himself, “why should I be so stupid and work my butt off for a year, and make a profit of a million US dollars when my friend, he buys a piece of land or a few homes, financed on credit, and makes a few million by just speculating on real estate.� And so the whole system...An asset bubble is actually very bad for an economy.
And I’d like to mention one more symptom of an asset bubble and this will become more and more apparent in the United States, and in my opinion will also lead to some social problems eventually. This is it leads to a tremendous rise in wealth inequality. The rich run away. They do very well in periods of asset inflation, whereas the middle class and the poor people are basically relatively impoverished � relatively impoverished � and I can tell everywhere I go in the world, I see the same. The middle class and the poor people are lagging way behind, and the rich � admittedly, it takes more money to be rich, but the rich they have a huge increase in wealth. And this is borne out by the statistics about income development over the last 25 years in the United States, and also about the ownership of assets � about the composition: the 10% of the richest of the population have done very well. In fact, the 1% richest have done the best. The 10% have done very well, and the 50% below average � or below the median income or median assets � they haven’t done very well.
JIM PUPLAVA: Let’s talk about something that is impacting the middle class and the poor as you just mentioned. One of them is wages have not kept up with inflation, and number two, I think inflation is grossly understated. So if you take, for example, cost of living increases � rents that are indexed to the CPI, cost of living at a company, or union contracts that go back to CPI � because of hedonics, geometric weighting, substitutions, seasonal adjustments, I think the CPI in the United States is grossly understated.
DR. FABER: I think the CPI in the US is a total fraud. I think that in general the rate of inflation for the average person is 5% per annum [if] he’s very lucky: his insurance premiums have gone up; his property taxes have gone up; his heating bills have gone up; petrol has gone up; building costs have gone up � you name it, basically � healthcare. This is evidence that healthcare expenditures have gone up on average by about 7-8% per annum for the last ten years or so, and healthcare in the US is 15% of GDP, but only accounts for 8%, or 7%, of the CPI. So if the CPI is a grossly doctored measure of inflation � and I can assure you my cost of living is not rising 2.9% or 3.3% per annum as the CPI would suggest � it is going up much more than that.
JIM PUPLAVA: If we take a look at where we are today � where sometimes you’ll see deflation in certain sectors, declining prices, and rising prices elsewhere, as long as the central bank can print money. You had an analogy that you wrote about in one of your newsletters, and you talked about this bowl that gets replenished with water and that water spills over somewhere. Why don’t you give that analogy because it certainly explains a lot of the asset bubbles that we are starting to see? Following the Nasdaq, we saw money printing, credit creation on a gigantic scale, and it showed up in lower bond prices, mortgage refinance, consumption in the United States and real estate.
DR. FABER: Yes, and it also shows up because of the pegged currency in an investment boom in China, which then basically lowers the cost of manufactured goods, because of overcapacities. So essentially, what I want to say is: you have at the Federal Reserve � and you look at the financial system and the Federal Reserve � when there is a problem they just replenish the water level of this fountain, or of this lake, and then it overflows. And whereas the Fed controls the quantity of money that comes into the system � more or less, they don’t control it 100%, but more or less � what they certainly don’t control is where water, or the money, then flows to. It can flow, as I mention, in the 60s into wages, in the 70s into commodities, and consumer prices in the 80s, notably into Japanese stocks and real estate, and then in the 1990s into the Nasdaq, and now more recently into the real estate market � that is uncontrolled � and if the door is open, or the system, then the money can one day also flow out of that door, which leads to weakening currency. Now, weakening currency we have to define. Weakening against what? It can weaken against asset prices: money has lost its purchasing power in the last 5 years compared to real estate and compared to commodities. The US dollar has weakened against the Euro. It has strengthened recently, but it may weaken again against some other currencies in the future, that we will all see. So in this environment we have to, as investors, always think where this over liquidity � surplus liquidity � will flow to. I happen to think that people are very complacent about CPI inflation today, in other words, consumer prices. And, whereas people were worried about consumer price inflation in 1980 � when, as you say, gold was at $850 and when interest rates on long term bonds were over 15% in 1981 � today, people are very complacent about the CPI inflation, and therefore they have bid up bond prices to an extremely high level, in my opinion. Now, I’m not saying that bonds cannot go up somewhat more. I also hold some bonds. But I think that if you look at long cycles � and long price cycles are called Kondratieff, they last 45-60 years � then I think we had the last peak of price cycle in 1980. We had more than 20 years of declining commodity prices, declining interest rates. Somewhere in this period where we are now, interest rates will start to rise and consumer price inflation will start to accelerate.
JIM PUPLAVA: Inflation, which is what I believe we have today, at first � when central banks stimulate, or print money � it stimulates something: sometimes production; sometimes employment; sometimes assets; it annihilates thrift; it destroys, in my opinion, moral and intellectual values; it creates the wealth disparity you just talked about, because people with the means to invest can benefit from inflation � if you’re just struggling to get by you don’t have that means � but the first signs of inflation show up in the housing market. You wrote a piece back in the Summer of 2003 and you talked about a gentleman who was a part of the war reparations committee in Germany, Bresciani-Turroni, and I wonder if you might bring up some of those points of how these inflations develop and eventually lead, in some cases, to hyperinflation.
DR. FABER: Basically, Germany after the First World War was faced with very high reparation payments with which they had difficulties. Their reparation payments were so huge that they then embarked on printing money in order to meet these payments and that then led to very high inflation rates in Germany � to the hyperinflation � and to the impoverishment of the poor and the middle class, because there is relatively little investment activity in these asset inflationary times. The rich people move their assets outside the country where the high inflation takes place, and carry out their investments elsewhere, by and large. And so employment doesn’t do particularly well in these very high inflationary times, and wages always lag behind the rate of inflation.
And I would say � if I kind of observed the last 50 years � my grandparents and my parents had really rising standards of living over the course of their lives. But I would say, since the mid-80s or so, I doubt people in the Western world have really had significantly rising standards of living, or significant increases in real incomes. In some cases prices of goods have come down, like TV sets and radios and fax machines and PCs and so forth. But you also have to see that the basket of goods that is today necessary just to live a middle class life has also increased dramatically. When I was a child, one family had one TV set. Now a family has 3 or 4 TV sets, because each member wants to watch a different program; and each member of the family must have a mobile phone and calls around the whole world all the time; and family members have different computers; and so forth and so on. So, just to live what I consider a normal lifestyle � I’m not mentioning a luxurious lifestyle � already costs a lot of money. And also, I see how insurance premiums have gone up, what a family has to pay for insurance for health care, and so forth and so on. So overall, we have had inflation. It hasn’t manifested itself so much in consumer price increases because, as we discussed, the Consumer Price Index has been doctored and kept artificially low; but also because the inflation has been more in assets. Let’s say in 1980, it may have taken you this many hours to buy one Dow Jones Industrial and to buy a house. Today, it takes you many more hours to buy the Dow Jones � many more hours of work to buy the Dow Jones, and many more hours of work to buy the house � unless you are in this lucky one percent of the top of the population, which has been riding this asset inflationary cycle very well.
And I have to say, I’m not mentioning this because I have any grudge. I have also benefited from the Fed replenishing the water lake, and the buckets of financial markets, all the time, because I am involved in the financial services industry. But something doesn’t add up when I compare my compensation � and especially the compensation of some of my friends who are hedge fund managers, who undoubtedly are smart � to say, the compensation of an engineer who is also smart, or a chemist, or a scientist, it doesn’t add up that they earn that much more. Maybe they are smarter, but not that much smarter.
JIM PUPLAVA: Richard Duncan has a thesis in terms of what’s going on with inflation, deflation, and the central banks. Ben Bernanke gave his, I guess, infamous speech back in 2002 where he talked about this wonderful invention the Fed has, called a printing press. He went over to Japan and gave that same speech. Now, as Richard Duncan posits, between January 2003 and the first quarter of 2004, Japan printed and bought $320 billion of US Treasuries. And one of the things the Fed talked about in their speeches on avoiding deflation is that they could create a fiscal stimulus � let’s say, through tax cuts, which the US got, we got 3 tax cuts � and then monetize those tax cuts to create money. Now, the Fed has only monetized slightly � I think it was over $52 billion last year � but other central banks have been buying our debt, and in many ways doing what the Fed might have had to do if had these other banks not bought our debt.
DR. FABER: This is always cause and effect. Basically, some will argue interest rates are so low in the US because the Asians are buying US debts with their reserve accumulation, and are therefore keeping interest rates in the US artificially low. I’m sure this argument has some validity. But equally, let’s say, if foreigners wouldn’t buy US debts, what would then happen? What would they buy with the currency they earn through their trade and current account surpluses with the United States? They could let their currencies float upward. That is a possibility. Now, that would mean the price level in Asia would increase and that wages in Asia would increase relative to the ones in the United States � even [though] wages may be not increased in local currency � but through the exchange rate mechanism. And say China has officially a GDP of $1.3 trillion and the US has a GDP of $11.7 trillion. It doesn’t reflect the reality. The Chinese GDP, adjusted for the price difference between China and the US, is probably already about 60% of the US economy, and the second largest economy in the world. But that aside, what China could do is let its currency appreciate by, say, 100% � so we go from $1 equals 8.28RMB to $1 equals, say, 4RMB � this would immediately double in nominal terms Chinese GDP in dollar terms. And the US GDP relative to the Chinese GDP would diminish. It would still be larger but it would diminish. And so their economies in dollar terms would have become larger and the US smaller. So in other words, relative to Asia, the US would have a diminishing standard of living. But the way they have acted, namely, to support the dollar has � basically, and that I agree � allowed the US consumption boom to go on.
And the big question is: what will ever come and disturb this kind of arrangement, where the Asian central banks are still buying US dollars? Because maybe one day they decide, “Well, there is a risk of buying just US dollars.� To some extent they have already voted with their feet, in the sense that they have started to accumulate assets. And as you know some Chinese companies have bid for US companies. Some have raised some concerns in the United States, in the case of China National Offshore Oil Company wanting to acquire Unocal. I don’t think it should be an issue simply because, although Unocal is listed as headquartered in the US, over 70% of its assets are in Asia. So I don’t see why anybody in the US should be concerned about this, the assets are not in the US, and it’s basically a smart move on the part of the Chinese. And it’s very clear the Chinese don’t want to just hold USD cash and agency bonds and treasury bonds, but they want to invest their reserves � and that is a top priority � in the procurement, and for the security of, resources, that they need for their economic growth. So, that is where we stand basically today. But if I look at the US economy and I look at the Asian economies there is no doubt in my mind that the standard of living in the US will, relative to Asia, decline over time. And possibly, one day, decline very meaningfully, because in the US what you have is an asset bubble. In Asia we have basically an investment bubble: we have excessive capital spending in China and we have excess capacity. But if a disaster happens, at least we have built the roads, the bridges, the subways, and we have built the factories, and we have bought the machinery to produce goods. And in India, we have employment gains in high tech industries whereas in the US we have layoffs in high tech industries � IBM is laying off people in America and hiring in India, no wonder if you get wages in India that are 80% lower than in the US. So I think it is inevitable that, in due course, in the Western world, your children and my children will not have the enjoyment of rising standards of living, because a wealth creation that is purely based on inflating real estate prices and stock prices, isn’t going to work in the long run.
JIM PUPLAVA: I want to come back to part of the problem for this � and this gets back once again to the deflation-inflation debate. Deflationists would argue the end result of money credit is deflation. If that is true then, how do you get hyperinflations in Germany, Austria, Hungary, Poland and Russia during the 20’s � let’s say Germany, Hungary, China, Greece after World War II � and then more recently, Latin America, Turkey, and Russia, and perhaps Indonesia?
DR. FABER: Basically, the deflationists are right. But the question is: at what stage are they right? I mean, in Germany after the hyperinflation period, 1919-1923, there was a stabilization crisis, and deflation for a while during the stabilization crisis, because new money was introduced and the supply of money was then controlled, and so asset prices suddenly collapsed. They didn’t stay down very long. But the key to understand is that if you print money � and you have a central bank that is keen to print money � deflation is a most unusual experience. And I would argue in Japan we had deflation � that is true, between 1990 and recently, real estate prices went down, stock prices went down and also consumer prices went down � but in general this period of deflation in Japan was beneficial for the average household. The reason being, that it became affordable for the average household to buy goods and to rent an apartment and to buy equities. In other words, in this period of deflation in Japan we had a kind of deflationary boom, in the sense that someone who had $1000 in 1990, today, with the same $1000, can buy a much larger basket of goods. I cannot say that of the $1000 you have in the US. You cannot buy with $1000 today in the US a much larger basket of goods than you could buy in 1990, because real estate prices are much higher, stock prices are much higher, and consumer prices � if you measure them properly � are much higher than in 1990. But the deflation can have, in some countries like Japan, if it’s not a totally deflationary collapse, actually a beneficial impact on the typical household.
The problem of this high inflation we have in asset prices in the US and on the high inflation we had in Latin America, and in the Weimar hyperinflation in Germany, is that it impoverished the typical household, because they were not able to capitalize on the speculative earnings: through the financial markets; through the exchange markets; through the real estate markets; and so forth. And this book by Bresciani-Turroni, The Economics of Inflation, is a very, very good study of what happens socially, economically, to prices, to the exchange rate, to stock prices, in hyperinflation countries. And I strongly recommend to your listeners to actually study this book and buy it. It’s not easy to get it but it’s an outstanding book. And the consequences of high inflation rates, I am really concerned, if Mr Greenspan and Mr Bernanke really lead the US into high inflation rates, the end result for the United States will be a total disaster. It would be much better to take a recession now, to push interest rates up, to control the speculation and the real estate speculation � one could also control it through increasing margin requirements, in other words you can only borrow this much against the house, that could be implemented easily � and to bring the country to sanity again this way.
JIM PUPLAVA: After reading Bresciani-Turroni, which I picked up from your newsletter, it almost led me to some of the conclusions: this seems to be the path the US is headed towards, and especially, if you read speeches made by Mr. Bernanke � in terms of helicopter money and what could be done to avoid a deflation here in the United States � it speaks right to Weimar.
DR. FABER: Yes, I would actually argue that if you had a high period of inflation such as we had for the last half century since the 1950s � first in consumer prices and then especially in asset prices � then some deflation may be necessary to redress some of the imbalances that have been created. But of course, deflation, if you think of it, is disastrous for the rich people, because it means stock prices go down, it means real estate prices go down, so the rich class benefits the least. And as I mentioned in Japan: the rich got hit. I mean, if you look at the pattern in Japan and if you go, today, to Japan you would think that Tokyo is a boom town: you would never think that the stock market is down 70% from the highs in 1989; and you wouldn’t think that property prices are down 70% from the highs in 1989. But a normal family, their wages are the same as in 89, 90. Maybe their wages have actually even increased by 1 or 2% per annum, but they can now rent an apartment 50% cheaper than at the time; they can join a golf club for 80% less than in 1990; and they can buy consumer goods cheaper, because of cheap imports from China and so forth. So, actually, the typical Japanese household isn’t complaining about this deflation, and it’s cash money, and that you have to see.
We also have to look at money as a store of value. Let’s say you have an income of $100 and you put $10 aside, when you’re 20 years old. The $10 put aside when you’re 20 years old, ideally maintained their purchasing power, so that when you retire at 60 you can actually buy something with the $10. But what the central bank in America, and other countries, has done is to actually erode the purchasing power of your $10. But in Japan, 1990 to today, the $10 has become worth more, simply because of the price decline. But I think this store-of-value of money is a very important consideration when you think, “why do people actually rush into real estate?� They rush into real estate because it’s almost a panic of people seeing real estate prices go up and they say to themselves, “if I don’t buy a property today, I won’t be able to afford it 3 or 4 years from now.� So actually, the central bank in America, the Fed notably, has actually created a kind of inducement of normal people who are honest, who have savings on deposit, to liquidate their savings and to rush into assets because they are afraid that their money on deposit is not going to be eroded in terms of value by rising consumer prices, but eroded in value by rising real estate prices.
JIM PUPLAVA: Another argument too, that is made in terms of inflation and deflation � and I think it’s one worth noting today � is that major inflations accompany war. And I would argue that right now the world is not at peace but at war that could grow larger. And if you take a look at what the US is spending � on budget, off budget � for homeland security, the deficits are much bigger. We’ve got a possibility that, perhaps Japan could rearm. But it seems to me, as you look around the globe, the dangers of war are increasing not decreasing.
DR. FABER: I would say, first of all, if you impoverish a society through inflation, they take extraordinary measures, and they fall prey to dictators, basically, � I’d just like to point out that Hitler was democratically elected; a lot of villains of this world were democratically elected � and so the country becomes more belligerent. But where I would be very concerned is... we economists, we have business cycle theories and there are numerous theories but some are more accepted than others. Historians, they have war cycle theories because war occurs in certain cycles. There are peace grown generations and war torn generations and so forth; and if you are born in a war torn generation you are less likely to start a new war if you’ve really seen the horrors of war, whereas if you’ve never seen war, at some point you become more belligerent. And one of the war cycle theories say that when commodity shortages occur, then prices go up. Then obviously some countries become concerned about securing the supplies of resources.
And all I can say is the demand for oil in Asia will double from 21 million barrels to 40 million barrels in say 10-12 years, because we start from a very low per capita consumption level. And on the supply side we have, today, a supply of around 84 million barrels/day. We don’t know how much more oil can be produced. There are lots of people and studies that would point out that, actually, oil production will begin to diminish. My impression is that: the world will go to World War Three one day over oil, because China needs oil, the US needs oil, Japan needs oil, every country needs oil, including also India; and that these rising commodity prices will lead in the next few years to a rise in geopolitical tensions. And nobody can tell me there are fewer geopolitical tensions today than there were during the Cold War. In fact, the Cold War was a beautiful equilibrium because no dared to really do anything, and now the Cold War is over, and a lot of countries are up for grabs: the US is establishing bases in the Middle East, Central Asia; the Chinese also want to expand into Central Asia, because if you look at the map, China borders Kazakhstan, Tajikistan, Kirgizstan, and that border is several thousand miles long; and the Russians also have strategic interests in Central Asia.
I think that if I look at the financial markets today � and the low volatility we have � and then I look at the rising geopolitical tensions, I’m surprised by the low volatility and the complacency that exists concerning financial assets, because I think at any time something could really start to go bad. I think Iran may not have bad intentions, but maybe they do, and I would understand if Israel would perceive the intentions of the Iranians as being bad. Whether they are bad or not we don’t know, but it is not totally unlikely that the US or Israel will one day go and bomb Iran. I don’t think the US, after their brilliant and glorious military exploit in Iraq, will dare to invade Iran, but I think bombing is quite likely at some point.
JIM PUPLAVA: Marc � if we were to sort of bring this to a conclusion � if we take what happened to the US after 2000, 2001 and the current thinking at the Fed, if we take the last recession the Nasdaq bubble was deflating and at the same time the amount of money and credit began to expand and we gave birth to new multiple bubbles, is it possible � if we see a situation now, where the Fed is raising interest rates � something happens? The US goes into a recession; perhaps real estate prices start to deflate and then they bring on the Bernanke helicopter money; and then we get to a stage where foreign central banks say “you know, there’s too much risk in the US dollar�; and the real consequence of our money inflating give way to a hyperinflation, before we eventually get to that deflation people talk about?
DR. FABER: Exactly the sequence of events, I’m not sure. Some sectors of the economy may already be in recession in the US. As you know the Index of Leading Indicators has been down for several months now, and the manufacturing sector doesn’t seem to do particularly well. But maybe we go into a situation where real estate prices suddenly start to go down or where something happens, then, yes, I suppose, the modern day John Laws � namely Mr Greenspan and Mr Bernanke, or whoever comes, encouraged, of course by the government, that you have to see �will print money like there is no tomorrow. This is my view. I strongly think that Robert Prechter will be right one day. The question is: at what stage of the inflationary cycle will he be right? Because the debt level was already very high in the mid-80s and early 1990s and it’s gone on and become bigger and bigger. The only thing I want to mention is that, of course today, to make the economy grow by $1 you need about $4 of additional debt, and one day all the money creation doesn’t go into the real economic activity we discussed earlier, which is the production of goods, capital spending. All this increased money goes into increased speculation, and hot air and asset inflation. And then you get a bad economy, with high inflation rates. That’s what all the hyperinflating countries have simultaneously: a recession in the real economy; and very high inflation rates, which as I mentioned impoverish essentially large portions of the population except for the rich that have moved their money overseas, or in other assets, where they could make speculative gains. I mean we have a democracy in the US and if one day there are more poor than rich people, then obviously it will lead to some meaningful political change.
JIM PUPLAVA: It’s amazing because when you study history � if you take a look at history here in the US, and especially in times of difficulty like the great depression � government demands or increases its power: for example, in Germany, where you saw this hyperinflation, a period of stabilization, but then once again you got the inflation and then you got Adolf Hitler. In times of crises governments tend to demand more power and interfere with the economy. And Marc, what are the possibilities that the same thing could repeat here in the US?
DR. FABER: I would say usually it goes hand in hand in hyperinflating countries you then get dictators that become populists, who promise things to the poor people and so forth. Usually they fail to deliver, but they promise a lot and they take actions that are beneficial to their reputation and keeps them in power. Although these actions may occasionally be totally wrong. That is a real threat and my feeling is that the US, with this administration has moved a step away from democracy (that’s kind of an observation from overseas); that they have handed power over to a very small group of people � the Defense Secretary, and the President and his entourage � and this group of people is behaving in many ways totally undemocratically, and disregards international laws. Now, I’m not saying that the problem [is] with torture � let’s say, if your child was kidnapped and you caught one of the kidnappers and he wouldn’t tell you where they’re hiding your son, I can understand you would maybe use torture to get him to tell you where the son is. So I’m not even objecting to that entirely, because the terrorists also commit crimes and presumably also torture people, and war is a horrible game, and ideally you avoid war at all costs; but when war is out then torture usually becomes the order of the day, essentially in all countries, everywhere in the world. But I think in other cases the US has disregarded international law and this is reflected in their relative unpopularity, and it’s made the Chinese actually look suddenly very acceptable. Ten years ago nobody really trusted the Chinese. In Africa, or in Latin America, they had very few friends, and today the Chinese are on very friendly terms essentially with all African countries. They have very good friends in Latin America. Of course that gives rise to further geopolitical tensions. They’re on good terms with Mr. Chavez of Venezuela, and with Mr. Castro of Cuba. You can imagine how the US State Department is pleased with this. And so you have a situation where, I think, eventually tensions will rise and where governments will have larger defense budgets, and where they will print money, and we will go into an unpleasant, high inflationary environment. To what extent this high inflationary environment will be reflected by continuously rising asset prices and a depreciating currency, maybe not against the Euro, but maybe against gold, or against the Asian currencies, or against other commodities, or oil. It’s interesting that oil at $60 hasn’t yet had an impact on demand, but demand is still rising. Maybe oil needs to go � I don’t know where � to get it to a level where it really cripples demand.
JIM PUPLAVA: I had Bob Prechter on my show a couple of weeks ago and Bob and I agree and disagree. I believe we get hyperinflation first, then deflation. Bob believes we get deflation first, then hyperinflation. I’m leaning towards hyperinflation first. Given what you see and what you’ve experienced, Marc, how would you be investing right now, the way you see thing around the globe?
DR. FABER: I’d just like to make one comment about your debate with Robert. I think he could be right � to get deflation first � but I don’t it would be a deflation of more than, let’s say, 3-5% and then you would have massive money printing and then hyperinflation. But he’s talking about a deflation that brings the Dow Jones down to 1000, home prices crashing and so forth. That I don’t see right away, and I think he is very courageous in his forecast there. But the way I would invest today � to be entirely frank, I don’t know what the world will look in 10 years time � you have to be diversified. The people that will survive the best are those that do not have high leverage, because if you have no leverage you will not lose your possessions if there was deflation, and this is an important consideration.
I’m an international citizen. I’m a Swiss, but I live in Asia � I have an office in Hong Kong and a house in Thailand. If I was an American, I would certainly have assets outside the US and have these assets also held outside the US, not just buy foreign stocks with an account in America. I would have assets, and one can do that legally, there is no law that says you cannot have, as an American, an account overseas. It is possible to do that and so I would diversify a) the location of my assets; secondly, real estate in the US, and the UK, and Australia, and in Western Europe is relatively expensive. But even in the US, in some places, real estate is less expensive than in other places � let’s say in the Midwest, real estate prices have also gone up but it is not yet a huge bubble � and so in some places you could still buy probably some real estate for the amount of money you want to have in real estate.
I would also maybe own some equities, and I would own some bonds. But as I said, I’m not generally bullish about bonds in the long run. I think bonds maybe OK for another six months or so, but I worry that the bond market has been strong during a time the Federal Reserve has been tightening. In other words, the Fed pushed up short term rates from 1% to 3% � the Fed Fund rate � and bonds have rallied. The day they will cut the Fed Fund rate�when they see economic weakness developing�the bond market and the dollar will sell off. The bond market, I know what it will sell off against, it will just go down. The dollar sell off, I’m less sure if it will be against the Euro, or Asian currencies, or gold. I think for sure it will sell off against gold and silver. Whether it will sell off against the other currencies will also depend on the actions of the central bank in the respective countries, because theoretically the whole world could print money at the same rate and then the exchange rate wouldn’t move very much against each other. That is a possibility. So I would certainly also diversify some money into gold, and I would probably own some energy shares, oil and uranium. I think oil could sell off in the near future somewhat, but if I look at the world in 10 years time, I rather think that we will have significantly higher oil prices in 10 years time than we have today. The danger of owning oil and mining companies is one day when the price of oil is sky high, the government � say, if there was a war � will declare an excess profit tax. That they can do, so the shareholders may not benefit from the full price increase. So these markets you may want to play rather through the commodity markets and ideally, again, through an account overseas.
then concerning real estate in Asia, when I look at the prices of say
property prices in Malaysia, in Thailand, in Indonesia, in the
Philippines, and also China, of course, they are much, much lower than
in the Western world, than in Western Europe, and the
JIM PUPLAVA: Well, Marc, as we come to a conclusion here, I wonder if you might give out your website and tell people about your newsletter. I have to give you a compliment: it is the one newsletter that as soon as I get it, I have a great time reading it, because you always come up with original ideas. I don’t know how you do it every month but you manage to do so.
DR. FABER: That is very kind of you to mention that. I actually travel a lot and I always come back here to Chiangmai for about a week to ten days to write the newsletter, because here I have the time to do it. It’s very difficult to write and then go to meetings, and then write again, so I really focus for a few days only on the newsletter. And I admit it’s difficult every month to find new ideas, and new angles. The world has been blessed with information � we have essentially free information flow, through the internet you get any kind of information you wish, we have TV and so forth and so on � but it is always the interpretation of the information that is most important. And of course different people have different views and I always have to continuously reexamine my views and so forth. I was fortunate this year at Christmas I said also in a Barron’s interview that the only undervalued asset was the US dollar, and so far the dollar has rallied against the Euro, and I said the most contrarian investment vehicle would be US dollar zero-coupon bonds because, remember at Christmas, people were very bearish about bonds and said sell bonds and buy equities. Now I’m not so sure anymore about the US dollar, and where Bill Gross and the deflationists may be right about the bond market still rallying somewhat, I’d rather be out too soon than too late, and think that, at this level of interest rates, when I look at the next 10-20 years, for sure, interest rates will be at some point much higher than they are now. That I have no doubt.
Whether we get this deflation � la Robert Prechter first, I also doubt it, maybe a brief period of mild deflation in some sectors of the economy and then again heavy, heavy money printing because that’s what central banks have always been doing and I don’t think they’ll change their tactics: it’s easier for a democracy to print money than to take the pain. And it’s easier for a drug addict to keep on taking drugs and for an alcoholic to keep on drinking than to stop it. It takes a tremendous amount of will in a society to take the pain of bringing inflation down and to bring back the country onto the path of totally non-inflationary growth. And as I said in my earlier part of the conversation, in the US it is true you have low CPI inflation, but that is because of Chinese production. On the other hand, you have this very high asset inflation and I would say in 1980, US families were income rich and asset poor: the Dow Jones was around 800-1000 and home prices were low as a percentage of disposable income. Today, you have high asset prices and relatively low incomes. You have very high Dow Jones compared to the income level of households and you have very home prices compared to the income, of say, your son, if he starts to work and he wants to buy a house. He will pay a very high price for that house compared to his income. He will have to borrow at least 90-100% to buy a house.
JIM PUPLAVA: Well, Marc, I want to give out your website for our listeners. It’s always refreshing to go there and highly recommend that they get a copy and subscribe to your newsletter. The website is www.gloomboomdoom.com, and that’s the name of Marc’s newsletter as well. And also if you’re in a bookstore, I highly recommend getting Tomorrow’s Gold, also written by Marc. Great book!
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