Notes – Horizon Kinetics 2014 Compendium, Skepticism About Indexation

For the last two years, Murray Stahl and Steve Bregman of Horizon Kinetics have published a “Compendium Compilation” of their various research pieces and market commentaries throughout the year. I recently requested copies of the 2014 and 2015 compendiums and just completed reading through the 2014 compendium.

The Scourge of Indexation

The single biggest trend that Stahl and Bregman have been criticizing for years is the rise and dominance of indexation as passively-managed ETFs as the practical consequence of widespread adoption of the Efficient Market Hypothesis. I collected comments from several different essays and stitched them together into a meta-commentary on the phenomenon:

We are reliably informed by many academicians that growth, value, momentum, yield and volatility are fundamental attributes for portfolios and, as such, are the determinants of performance. Numerous studies assert this as true. However, the studies were all done on the opportunity set of stocks, not actually on funds organized upon the findings of the research. In other words, these studies predate the implementation of the conclusions of the studies.

The efficient markets hypothesis is subject to no serious scholarly challenge. Indexation is by far the largest investment strategy and it is growing in acceptance by the day.

One could argue convincingly that markets are efficient if the market place is made up of a multiplicity of active managers gathering information and, by their trading, expressing that information in the prices of securities. However, as we saw in the Facts and Figures section, if the majority of the dominant investors, who are also the marginal buyers and sellers, are now passive, and if this dominance is growing, how can one be sure that the efficient market model remains a valid assumption?

What does it mean when one — that is, the investment ecosphere — creates multi-trillion-dollar managers that are valuation indifferent?

You cannot merely have trillions of dollars invested in indexes and assume that everything will be the same as it was before they were investing in indexes.

For 40 years, indexation worked because of four trends. There was a strong fiscal stimulus to promote the demand in most countries. Companies engaged in cost-cutting and eliminated marginal products and divisions, thereby increasing margins. Corporate tax rates have been declining for 40 years, and interest rates have been declining for decades. Companies, however, cannot count on those four benefits anymore.

We are going to replace poor judgment with no judgment whatsoever.

…an unintended consequence of the indexation movement is the creation of quasi-permanent holding companies for [S&P 500 and other major index stocks]

To my mind, the rise of indexation represents something of a corporate governance crisis in this country and any other where passive index funds account for a substantial proportion of the total shares outstanding in the market place (for purposes of this argument, I’ll peg that number at 20% which just so happens to be how much are currently owned by passive funds according to a recent New Yorker piece). Looked at in very simple terms, that is 20% of the shares of the average public company that have no active agency behind them, that is, there is nobody scrutinizing the operations of the company and the efficacy and honesty of its management by or on behalf of the shareholder whose capital is at risk. Given how many individual and even institutional shareholders are already “actively disengaged” from their duty to provide capitalist oversight of the companies they own, this is a troubling context to invest in if you believe that sound corporate governance is a key ingredient for above average investment returns and safety of capital at risk.

It reminds me strongly of one of the quotes from my recent review of Panic, “Underpinning the ideology of modern finance is the notion that the insight, judgment and even diligence of the entrepreneur are irrelevant for investing in public securities markets. These markets, we are told, are special, too powerful and too perfect to allow any entrepreneur’s judgment to matter.”

This indexation phenomenon has gone beyond influencing the markets to the point that it is “making” them, an inevitable consequence of gamification:

BlackRock… has issued a call for reform… [their] paper calls for the standardization of features of newly issued bonds. For example, an issuer would not be free to issue bonds with any features it wanted; it would have to issue them in certain standard packages, which are defined in the paper. BlackRock’s proposed change is an example of how indexation as a business is beginning to reflect the market as it impinges upon the index providers’ business needs.

Bonds have different characteristics because they represent different kinds of risks with different kinds of borrowers and lenders. While it’s possible to standardize anything for most applications, this is decidedly a “new era” where the standardization process is not being driven by the desire to reduce costs and confusion for borrowers and lenders per se, but rather it is being driven by the desire to efficiently index such media whose performance can then be captured in an ETF. It’s an important difference considering the fact that risk can not be standardized away just so that an investor can more easily allocate his funds.

In time, these indexes just end up playing themselves, as Stahl warns:

It is important to keep track of how the indexes are going to be tilted because that has two sets of implications. First, it has implications for the businesses of the index orchestrators, but second, it has implications for the entire marketplace. Whichever way a given sector gets tilted, either positively or negatively, the amount of money involved is so huge that it is going to be either the best-performing sector or the worst-performing sector.

Some Other Strange Side Effects Of Indexation

I captured a few other anecdotes related to indexation and EMH that I thought were memorable. One concerned the changes occurring in the utility industry. Stahl shared numerous statistics demonstrating the rapid rate of increase in solar power production, explained the different economics of solar (especially once installed) compared to gas, coal or nuclear powered generation and then surveyed the effect that the reach for yield and the indexation of the utility industry have created “priced to perfection” conditions in the publicly traded utilities firms. He concluded:

The asset allocation to yield-oriented stocks relies upon historical data regarding stability of dividends, which date back decades. The allocators treat this data as if they are immutable, scientific constants… They are completely unaware that a dividend quality constant is about to manifest a certain degree of inconstancy… This is an important phenomenon happening in the world of utilities, and people should remain very cognizant of it.

He also commented on the role volatility plays in the EMH:

In theory [institutions] are all fleeing volatility, but in reality are they merely fleeing volatility or, said another way, is volatility merely wherever they are going to be?

Connected to that idea is the degree of correlation which many investments are experiencing:

One can sell all of one’s investments and replace them with gaming stocks, and still have a correlation of 0.9726 with the S&P 500. It is an incredible statistic when you think about it.

Why should a presumably rational investor buy the more volatile Russell 2000 Index for a long period of time only to see it fail to outperform, or even underperform, the less volatile S&P 500 index?

And he brought further scrutiny on the idea of boiling down the predictive performance of a stock to one or two variables, such as volatility:

Companies possess many characteristics so it is difficult to assign causative factors to any one of them without knowing the other characteristics in that factor universe.

Miscellaneous Ideas

I also enjoyed Stahl’s commentary on including land in one’s diversified portfolio (again, these comments are stitched together from various essays):

Land held its value during the Great Depression.

Comparing and contrasting land with gold, it is clear that there were many periods when gold did not appreciate.

Government regulations sometimes affect the value of gold, but it is hard to envision government regulations that would affect the vast panoply of land resources in the world in some uniform way. Therefore, land is worth considering as a portfolio asset.

Land is not a hedge against political instability, which gold is because gold is mobile. Land is not mobile so it is only a hedge against inflation, not against political instability. Sometimes political instability and inflation come together.

He shared a contrarian view on eliminating an equity from consideration simply because it carries a high earnings multiple:

We cannot merely assert that if a company trades at 57x earnings, we will dismiss it as an investment. That would be an escape from reality… a Google at 15x earnings would be preposterously valued.

As long as it is possible to create companies at this scale of revenue, then not a few companies will trade at high P/Es. it looks like it is going to be a permanent part of the investment landscape.

Google’s valuation at the time it went public was around 57x earnings, and it’s market cap exploded from there. An interesting question is why it wasn’t valued even more highly given its realized potential?

Stahl observed a dichotomy between bond market interest rates and duration:

The interest rate is more or less engineered by the Federal Reserve, but the weighted average life reflects the risk preferences of bond investors.

Finally, I really liked this “bubble” related quote he shared from G.K. Chesterton:

There are no rules of architecture for a castle in the clouds.

Four Views On Gold And Gold Miners

1.) Atyant Capital, “What is gold saying?”:

Gold stocks lead gold and gold leads currencies and currency moves correlate with stocks and bonds. Gold stocks have been declining for two or so years now. This is in part due to unavailability of capital and credit for gold mining projects, but in our assessment, not the whole story. We believe gold stocks are also correctly forecasting lower gold prices.

Long term readers know my gold pricing model puts fair value at $1100 per ounce (Alpha Magazine Aug 24, 2011). So at $1700-$1800, gold was about 60% overvalued, floating on a sea of credit. Gold declining now tells me the sea of credit is receding here and now. This should translate to a higher US Dollar and pressure on asset prices globally.

2.) Value Restoration Project, “Gold miners – Back in the Abyss – An Update“:

Gold mining stocks remain cheap by almost any objective measure.

One way to look at mining stocks is to compare them to the price of gold itself.

Comparing miners to the price of gold itself, show miners are cheaper today than they have been in decades.

[…]

Today, gold appears undervalued relative to the growth in the monetary base that has occurred up to now, and in light of the monetary expansion the Fed and other central banks are currently undertaking, gold appears more undervalued. The Fed’s current quantitative easing program probably won’t be curtailed until households stop deleveraging and the government can handle the rising interest expense on its expanding debt.

Yet, in the face of all this, many gold mining stocks are now selling at valuations that suggest the market has priced in a decline in the price of gold back to 2007 levels, before the Fed began expanding its balance sheet during the financial crisis. Many gold mining stocks are now selling near or below their book value, which is the market’s way of saying that these businesses won’t be able to add shareholder value in the coming years by mining gold and silver. If the price of gold were to decline below $700 or so, it would certainly be the case that most mining companies wouldn’t be able to profitably sell gold. Yet such a decline in gold is the main implied assumption being priced in by the market today, and this has sent valuations of gold mining stocks to their lowest levels since the current bull market began.

3.) Robert Blumen, “What is the key for the price formation of gold?“:

The gold price is set by investor preferences, which cannot be measured directly. But I think that we understand the main factors in the world that influence investor preferences in relation to gold. These factors are the growth rate of money supply, the volume and quality of debt, political uncertainty, confiscation risk, and the attractiveness (or lack thereof) of other possible assets. As individuals filter these events through their own thoughts they form their preferences. But that’s not something that’s measurable.

I suspect that the reason for the emphasis on quantities is that they that can be measured. Measurement is the basis of all science. And if we want our analysis to be rigorous and objective, so the thinking goes, we had better start with numbers and do a very fine job at measuring those numbers accurately. If you are an analyst you have to write a report for your clients, after all they have paid for it, so they have to come up with things that can be measured and the quantity is the only thing that can be measured so they write about quantities.

And in the end this is the problem for gold price analysts, you’re talking about a market in which it’s difficult to really quantify what’s going on. I think that looking at some broad statistical relationships over a period of history, like gold price to money supply, to debt, things like that, might give some idea about where the price is going. Or maybe not, maybe you run into the problem I mentioned about synchronous correlations that are not predictive.

Part of the problem is that statistics work better the more data you have. But we really don’t have a lot of data about how the gold price behaves in relation to other things. The unbacked global floating exchange rate system has never been tried before our time. How many complete bull and bear cycles has the gold/fiat market gone through? My guess is that when we look back we will see that we are now still within the first cycle. Our sample size is one.

[…]

I do think we will have a bubble in gold, although it may take the form of a collapse of the monetary and a return to some form of gold as money in which case, the bubble will not end, it would simply transition over to the new system in which gold would go from being a non-money asset to money.

I have been following this market since the late 90s. I remember reading that gold was in a bubble at every price above 320 dollars. I very much like the writings of William Fleckenstein, an American investment writer. He has pointed out how often you read in the financial media that gold is already in a bubble, a point he quite rightly disputes. Fleckenstein has pointed out that the people who say this did not identify the equity bubble, did not believe that we had a housing bubble, nor have they identified the current genuine bubble, which in the bond market. But now these same people are so good at spotting bubbles that they can tell you that gold is in one.

Most of them did not identify gold as something which was worth buying at the bottom, have never owned a single ounce of gold, have missed the entire move up over the last dozen years, and now that they’re completely out of the market, they smugly tell us for our own good that gold is in a bubble and we should sell.

So, I don’t know that we need to listen to those people and take them very seriously.

4.) Me:

I don’t know what the intrinsic value of gold is. I don’t think gold mines are good businesses (on the whole) because they combine rapidly depleting assets with high capital intensitivity and they are constantly acquiring other businesses (mines) sold by liars and dreamers and schemers. And I don’t think this will end well, whatever the case may be. So, I am happy to own a little gold and wait and see what happens.

I wonder what the short interest is on gold miners?

The Best Interview On Gold, The Gold Market And Investment Implications I’ve Ever Read

In “What is the key for the price formation of gold?” at GoldSwitzerland.com, SF-based software developer Robert Blumen covers a lot of fascinating and, to my eyes, original ground in an interview with the site’s host.

This has got to be the best interview on the subject of gold in general, the functioning of the gold market and the implications for investors that I’ve ever come across. Blumen not only covers these specific subjects related to gold, but also discusses the Chinese economy, the US economy and the state of monetary and fiscal affairs and even the attitudes of value investors, demonstrating thoughtful familiarity with all he touches. Blumen is well-versed in Austrian economic philosophy and applies this theory to the various practical considerations resulting in surprising new perspectives on common themes.

It’s a long interview and it will only fully reward those determined to dive all the way in. Here’s an excerpt:

There are two different kinds of commodities and we need to understand the price formation process differently for each one. The first one I’m going to call, a consumption commodity and the other type I’m going to call an asset.

A consumption commodity is something that in order to derive the economic value from it, it must be destroyed. This is a case not only for industrial commodities, but also for consumer products. Wheat and cattle, you eat; coal, you burn; and so on. Metals are not destroyed but they’re buried or chemically bonded with other elements making it more difficult to bring them back to the market. Once you turn copper into a pipe and you incorporate it hull of a ship, it’s very costly to bring it back to the market.

People produce these things in order to consume them. For consumption goods, stockpiles are not large. There are, I know, some stockpiles copper and oil, but measured in terms of consumption rates, they consist of days, weeks or a few months.

Now for one moment I ask you to forget about the stockpiles. Then, the only supply that could come to the market would be recent production. And that would be sold to buyers who want to destroy it. Without stockpiles, supply is exactly production and demand is exactly consumption. Under those conditions, the market price regulates the flow of production into consumption.

Now, let’s add the stockpiles back to the picture. With stockpiles, it is possible for consumption to exceed production, for a short time, by drawing down stock piles. Due to the small size of the stocks, this situation is necessarily temporary because stocks will be depleted, or, before that happens, people will see that the stocks are being drawn down and would start to bid the price back up to bring consumption back in line with production.

Now let’s look at assets. An asset is a good that people buy it in order to hold on to it. The value from an asset comes from holding it, not from destroying it. The simplest asset market is one in which there is a fixed quantity that never changes. But it can still be an asset even when there is some production and some consumption. They key to differentiating between consumption and asset is to look at the stock to production ratio. If stocks are quite large in relation to production, then that shows that most of the supply is held. If stocks are small, then supply is consumed.

Let me give you some examples: corporate shares, land, real property. Gold is primarily an asset. It is true that a small amount of gold is produced and a very small amount of gold is destroyed in industrial uses. But the stock to annual production ratio is in the 50 to 100:1 range. Nearly all the gold in the world that has ever been produced since the beginning of time is held in some form.

Even in the case of jewelry, which people purchase for ornamental reasons, gold is still held. It could come back to the market. Every year people sell jewelry off and it gets melted and turned into a different piece of jewelry or coins or bars, depending on where the demand is. James Turk has also pointed out that a lot of what is called jewelry is an investment because in some parts of the world there’s a cultural preference for people to hold savings in coins or bars but in other areas by custom people prefer to hold their portable wealth as bracelets or necklaces. Investment grade jewelry differs from ornamental jewelry in that it has a very small artistic value-added on top of the bullion value of the item.

So, now that I’ve laid out this background, the price of a good in a consumption market goes where it needs to go in order to bring consumption in line with production. In an asset market, consumption and production do not constrain the price. The bidding process is about who has the greatest economic motivation to hold each unit of the good. The pricing process is primarily an auction over the existing stocks of the asset. Whoever values the asset the most will end up owning it, and those who value it less will own something else instead. And that, in in my view, is the way to understand gold price formation.

Many of the people who follow and write about this market look at it as if it were a consumption market and they look at mine supply and industrial fabrication as the drivers of the price as if it were tin, or coal, or wheat. People who look at gold as if it were a consumption market are looking at it the wrong way. But now you can see where the error comes from. In many financial firms gold is in the commodities department, so a commodities analyst gets assigned to write the gold report. If the same guy wrote the report about tin and copper, he might think that gold is just the same as tin and copper. And he starts by looking at mine supply and industrial off-take.

I wonder if more equity analysts or bond analysts were active in the gold area, if they would be more likely to look at it the same way they look at those assets.

Notes – Dying Of Money

Dying of Money

by Jens O. Parsson, published 1974, 2011

The collapse of a monetary regime

The following note outline was rescued from my personal document archive. The outline consists of a summary of Jen O. Parsson’s classic tale of monetary woe, Dying Of Money. Parrson catalogued two mass inflation events in modern Western history– the German post-war hyperinflation and the US monetary boom of the 1960s and 70s which culminated in the abrogation of the gold-exchange mechanism by Nixon in 1971; both are instructive for different reasons.

Dying Of Money

1. Prologue: The German Inflation of 1914-1923
   1. The Ascent
      1. “Disastrous prosperity”
         1. old mark had been worth 23 US cents; written off at 1T old marks to one new mark at end of inflation
         2. all the marks in the world in summer of 1922 (190 billion) were not enough to buy a newspaper or tram ticket in November 1923
         3. first 90% of Reichsmark’s real value had been lost before the middle of 1922
         4. inflation cycle: gestation of 8 years, collapse of 1 year
      2. The beginning
         1. summer of 1914, Germany leaves gold standard, runs up debt, prints money in anticipation of WWI
         2. war financed through issuance of new debt (war loans) paid for with newly printed currency
         3. domestic prices slightly more than doubled by the end of the war in 1918, even though money supply increased more than 9x
         4. 1919, Germany sees violent price increases of 17x prewar level
         5. other nations, including WWI victors, stop spending and suffer recession 1920-1921; Germany continues printing and experiences a boom while prices stabilize for fifteen months between 1920 and 1921, money supply doubles again
      3. Benefits of the inflationary boom
         1. Exports thriving
         2. Hordes of foreign tourists
         3. New fortunes minted overnight
         4. Berlin becomes one of the brightest capitals in the world
         5. Great mansions of the new rich in abundance
         6. City life took on a wanton, careless manner
         7. Frugality absent as no one took time to search for real value
      4. Losers of the inflationary boom
         1. Crime rate soared
         2. Unionized workers kept up with inflation while non-unionized fell behind
         3. Salaried and white-color workers lose purchasing power even as unemployment virtually disappears
         4. Total production rose
      5. Paradoxical wealth and poverty
         1. much employment in “spurious and unproductive” pursuits
         2. paperwork and paperworkers abounded
         3. government employment grew, heavy restraints against layoffs and discharges kept redundant employees on payroll
         4. incessant labor disputes and collective bargaining consumed time and effort
         5. business failures and bankruptcies were few
         6. almost any kind of business could make money
      6. Speculative fever
         1. speculation became one of the largest activities
         2. fever to buy and sell paper titles to wealth was enormous
         3. volumes on Berlin Bourse were so high that, even with bloated back-office staff, Bourse was closed several days a week to work off the backlog
         4. capital goods and industrial construction industry experience a boom, many new factories built all while neighboring countries continued using old equipment
         5. M&A, takeovers and proxy fights in vogue
         6. massive conglomerations of non-integrated businesses took place; these businesses and the “kings of inflation” disappeared after the collapse
   2. The Descent
      1. Price increases catch-up with money printing
         1. From July 1921, prices double in next four months and increase 10x through summer of 1922
         2. consumers put on “buyer’s strikes” that are fruitless
         3. interest rates soar as lenders attempt to anticipate inflation
         4. businessmen transact in gold or constant-value clauses or foreign currency
         5. government’s budget deficits close to balance; nonetheless, government is only able to refinance existing debt through money printing
      2. Final moments
         1. July 1922, prices rise 10x in four months, 200x in 11 months
         2. near end in 1923, prices nearly quadrupling each week
         3. prices raced so far ahead of printing that the total real value of all Reichsmarks in the world was smaller than ever
      3. The end of the inflation
         1. August 1923, government of Wilhelm Cuno falls; October 1923, Gustav Streseman made chancellor, given dictatorial powers, hires Dr. Hjalmar Schacht as commissioner of new Rentenmark (“investment mark”)
         2. Rentenmark placed in circulation beside mark with the avowal that Rentenmark’s would not be inflated
         3. Germans believed it, and Rentenmarks supply was held constant
         4. November 15, 1923: final exchange rate, 1T mark: 1 Rentenmark
         5. Government budget balanced by finance minister Dr. Hans Luther
      4. The fallout of the collapse
         1. Schacht orders end of credit from Reichsbank April 7, 1924; credit squeeze ensues; price increases halt
         2. Savings destroyed
         3. Inflationary boom businesses go bankrupt
         4. Credit nearly impossible to get
         5. Unemployment temporarily skyrockets
         6. Govt spending slashed, govt workers dismissed, taxes raised
         7. Working hours increase, wages cut
         8. Millions of voters join Communist and Nazi parties in the “inflation Reichstag” of May 1924
      5. Economic recovery
         1. New elections in December 1924 erase extremist party gains
         2. business recovery based upon foreign loans due to German credit tightening; world depression of 1929 knocks debtor Germany down
   3. Gains and Losses
      1. Debtors: winners
         1. every contract or debt fixed in marks was paid off in worthless marks
         2. Germany’s total prewar mortgage indebtedness, equal to 40 billion marks or 1/6th of total German wealth, worth less than one American cent after the inflation
         3. Savers and owners of mark wealth (bank accounts, savings, insurance, bonds, notes) lose out big
         4. those who borrowed up until the last minute to buy assets turned out to be winners
      2. German Govt: winner
         1. Largest debtor
         2. Entirely relieved of crushing war debt, representing cost of war, reconstruction, reparations and deficit-financed boom
         3. beware being a creditor when the government is a huge debtor
      3. Farmers: winners
         1. always had food
         2. farms were constant values
         3. mortgages were forgiven outright
      4. Foreign owners of marks and other losers
         1. Germany made a profit of 15 billion gold marks, or 40% of annual national product, on sale of paper marks to foreigners, after deduction of reparation payments
         2. Trustees, forced by law to own fixed obligations, lost
         3. Wealthy Germans invested in marks lost
         4. Great charitable institutions wiped out
         5. Banks and insurance companies were weakened but not destroyed (they are both lenders and borrowers)
         6. Sound business survived, but in a weakened state, boom businesses wiped out
      5. Industrial stocks
         1. height of the boom, astronomical P/E ratios
         2. dividends cancelled
         3. stock prices increase 4x from February 1920-November 1921
         4. Stock market crash of December 1, 1921, in the middle of inflation
            1. prices fell by 25% and hovered for 6 mos while other prices were soaring
         5. real value of stocks decline because their prices lagged behind the price of tangible goods
            1. Entire stock of Mercedes-Benz valued at price of 327 cars
         6. near end of 1923, stocks skyrocket again as investors realize that stocks have value even when bonds do not and have a claim to underlying real value
   4. Roots of the inflation
      1. Prices contained by faith
         1. Germans and foreign investors, until 1922 and the brink of collapse, absorbed the Reichsmark
         2. faith was in the idea that an economic giant like Germany could not fail
         3. willingness to save marks kept them from being dumped immediately back into the markets
         4. realization that Germany would not back the money was the moment the dam let loose
      2. Balance of payments
         1. More cheap Reichs flowed out than hard money came in
         2. This despite constantly rising exports and constantly falling imports
         3. payment deficit actually muted price increases by keeping Reichs outside of German markets
         4. Reversal of payments deficits marked the proximity of the end
         5. in collapsing stages, Germany ran a huge payments surplus
      3. Foreign exchange rate
         1. unlike era after WWII, free and uncontrolled “float” of forex
         2. German mark almost always falling and almost always had a lower forex value than its purchasing power within Germany
         3. Thus, forex rate proved a quicker and more sensitive measure of inflation than internal prices
         4. German exports were abnormally competitive on world markets due to forex vs. internal purchasing power discrepancies
         5. Germany lost 10 billion gold marks, or 25% of a year’s national product, on underpriced exports due to inflation
   5. The Great Prosperity of 1920-1921
      1. March 1920-December 1921
         1. prices stable
         2. businesses and stock market booming
         3. exchange rate of mark against $ and other currencies rose for a time, was momentarily strongest in the world
         4. ROW enduring severe recession; Germany envy of the world
      2. Reign of finance minister Matthias Erzberger, June 1919
         1. Raised taxes on capital; real tax yield of 1920 highest of any year from beginning of war to end of inflation
         2. tight money induced for an extended period in late 1919; only time money supply stopped rising for more than a month or so
         3. March 1920, price level was 17x prices of 1914, roughly equal to increases in money supply, new equilibrium reached
         4. Price increases halted for nearly a year, real burden of war debt had been cut by 5/6ths as a result of price increases of 1919
         5. March 12, 1920, Erzeberger exits govt, disgraced after a libel suit, and his pro-inflationary rivals take over
         6. March 1920 is the month prices stop rising, but with Erzeberger’s exit, the boom prosperity begins
            1. prices remain passive
            2. exchange value of Reichsmark rises
            3. stock market rises 3x before crashing in December 1921
            4. Reichsbank doubles over next year into summer of 1921 when price increases catch up
   6. The Lessons
      1. Unrealized depreciation
         1. built upon faith in the German economy to recover
         2. built upon faith in German government to make good on debts
      2. Booms
         1. built upon increasing rates of inflation
      3. Hitler and extremists thrive in wild, inflationary conditions
         1. Hitler’s putsch was in the last and worst month of the inflation
         2. totally eclipsed when economic conditions improved
         3. took power through elections during another economic period of trouble
         4. middle class voters wiped out in the inflation moved to the extremes in polling, bolstering Hitler and others
2. ACT ONE: The Rise of the great American Inflation
   1. The War
      1. Dollar lost 70% of its value from 1939-1973, prices rose 3.5x
      2. Seven years of WWII, Federal debt increased to $269B
         1. 1/4th greater than the annual gross product of the country at that time
         2. money supply grew by 3.5x between 1939 and 1947
         3. June of 1946, prices had increased by less than half from 1939
            1. price controls
            2. new money was absorbed by the issuance of war debt rather than bidding for consumer goods
            3. many saved money during the war for “safety” rather than spent it
            4. low money velocity resulted
         4. real value of dollar at the end of the war was 2/3rd what it had been at start of war
         5. government stopped inflating, allowed price increases to reach new equilibrium
      3. Prices controls end 1946
         1. prices double from levels in 1939 in two years
      4. Money supply held stable 1947-1950; prices remain stable as well
         1. economic recession 1949
      5. Comparisons: German war inflation vs. US war inflation
         1. American war debt of $269B, about 1.25x annual national product; Germany 153B marks, about 1.5x annual national product
         2. American monetary inflation, 3.5x; German 25x
         3. American price inflation 2x; German 17x
         4. Ratio of monetary to price increases about the same, 60%
   2. Grappling with Stability
      1. Korean War, 1950
         1. Federal budget did not run a deficit fighting the war
         2. money supply increases by 16%; prices increased 13%
      2. Eisenhower administration
         1. money supply increased 1% per year on average from 1953-1962; wholesale prices never varied +/-1% from 1958-1964
         2. “monetary oscillations”
            1. 1953-1954, money growth <1%, recession
            2. 1954-1956, money growth 3.9%pa, boom and price inflation
            3. 1957, money supply contracts, followed by recession
            4. 1958-1959, inflation
            5. 1959-1960, contraction
            6. 1961, inflation
            7. 1962, contraction
   3. The Great Prosperity of 1962-1968
      1. intense monetary inflation beginning 1962
         1. 4.6% per annum for 43 months (through April 1966)
         2. 7.2% per annum for 27 months (January 1967-April 1969)
         3. total inflation over seven years was 38%, interrupted only by the 9month period of no expansion in 1966, accompanied by stock market collapse and economic recession by no effect on prices
         4. combined with an investment tax credit of 7% for businesses to spend on new capital assets, leading to exaggerated investment boom
         5. prices did not keep up, leading to “unrealized price inflation”, despite rising at nearly 5% per annum for the seven year period
   4. The Inflationary Syndrome
      1. economic effects from 1962-1968
         1. gross national product increased $360B, or 7% per annum, compared to 4.8% per annum during Eisenhower years of 1955-1960
         2. unemployment continually decreased
         3. stock market was almost constantly rising for more than 6 years
      2. speculative effects
         1. high stock market volumes, huge capital gains appreciation, large paper profit generation
         2. conglomeration and merger of big business
         3. most wage growth in the speculative class of paper-pushers
         4. overinvestment in capital goods
         5. IBM, Xerox (back-office service/goods companies) were the investment darlings of the era
         6. overproduction and stimulation of the growth of educational and legal industries
      3. foreign exchange and the balance of international payments
         1. current account deficits are a symptom of inflation
            1. when there is excess money in one country it flows out to other countries
            2. the currency in the inflationary country is overpriced relative to world markets, so it goes out and buys imports
         2. current account deficits reduce price inflation in the inflationary country because the currency bids up prices in foreign rather than domestic markets
         3. dollars held by foreigners returning to the US at the point that the current account turns to a surplus, would result in price inflation in the US
3. INTERLUDE: The General Theory of Inflation
   1. Prices
      1. prices in aggregate are determined by total amount of money availble for spending in a given period of time, in relation to total supply of all values available for purchase with money in that period of time
      2. money supply defined as that which people use to buy things of value with, but which is not a thing of value itself (dollars, coins, checking account deposits)
      3. money available per unit of time, aka money velocity, also a factor, but it is hard to measure or determine
      4. price level = money quantity x money velocity / supply of all real values
      5. this is the quantity theory of money
   2. Real Values
      1. in an inflation, there are many “spurious values” which disguise and conceal the inflation of prices of real values
      2. real wealth consists of land, resources, productive plant, durable goods and people
      3. paper wealth is not real wealth; money wealth is debt, including money contracts such as bonds, mortgages, debentures, notes, loans, deposits, life insurance and pension obligations
      4. debt does not represent the direct ownership of any real assets but rather subdivision of interests in real assets with the direct owners of the assets
         1. for ex, a man is not part of the total supply of real capital as he can not be bought and sold
         2. however, if this man borrows money, he subdivides ownership of his future productive power and adds himself to the supply of capital assets
         3. if he borrowed from a bank which borrowed from a depositor, further subdivision has occurred
         4. government debt represents a “lien” on the part of the productivity of all citizens
      5. this multiplication and stratification of paper wealth can be increased to many times the size of the real existing wealth
      6. paper wealth structure is all built on faith– issuance of new paper wealth does not result in an increase in real values by itself
   3. Government Debt
      1. issuance of government debt increases supply of paper wealth, meaning it is price deflationary
      2. when Fed wants to tighten money, sells govt debt into market, reducing prices
      3. large issues of government debt could not be marketed without a large increase in the supply of money because they’d drive interest rates upward– precisely what govts don’t want; therefore, they’re almost always accompanied by money printing
      4. government surplus is price inflationary; if it is used to pay down debt, it reduces the supply of outstanding values and raises prices
      5. when faith in government debt fails, price inflationary effects will be amplified
   4. Interest
      1. lenders accepted negative real rates only because they didn’t realize what they were doing
      2. “the announced intention of Keynesian economics was to effect [the holder of money’s] extinction”
      3. the rich tend to be net debtors in an inflation
      4. inflation is paid for by the lower classes and the creditors
      5. an attack on interest results in a flight from debt to equity, from money wealth to equity/real values
   5. The Economics of Disaster
      1. occurs when the holders of money wealth revolt
      2. duller the holders of money are, the longer price inflation can be kept at bay by govt, though the greater will be the eventual breaking of the price dam
      3. desertion of money resembles a panic, sudden and unexpected
      4. people’s ability to discern real and spurious values suddenly becomes acute
      5. people flee paper assets and goods and services for known value like food and land
      6. no government causes collapse, “when at least it sees the choice, it has no choice”
4. THE LAST ACTS: The American Prognosis
   1. Act Two, Scene One: President Nixon Begins

1. Treasury reduces expenditures and attempts to balance budget, July 1969- June 1970
2. Fed drops inflation rate in May of 1969 from 8%, 1yr later approx 3.8%
3. Stock market prices fall by 14% within two months of May 1969, another year later down 31 percent; interest rates rise into spring 1970 credit crunch
4. Approaching two year mark to next election, government begins pumping money again
   1. August 1970, budget deficit plunges to new peacetime lows
   2. money inflation of 6.5%
   3. interest rates plunge, stock market soars

• Act Two, Scene Two: Price Controls and Other Follies
  1. worst inflation since the end of WW2 and before 1967
  2. economic boom into Nixon’s re-election in 1972
  3. boom quickly wears off
     1. stock market falls
     2. interest rates rise to surpass peaks of 1970
     3. price inflation worse than ever, around 4%
     4. cheap dollar floods world markets
  4. Nixon announces Phase I of price controls, August 15, 1971
     1. detaches dollar from gold
     2. 10% import surcharge
     3. excise taxes on automobiles removed
     4. wage and price controls
• Self-Defense
  1. No sure safety, safety will change fluidly through an inflation
  2. Best hope is to lose as little as possible
  3. fixed money wealth/debt is the absolute worst investment in an inflation
  4. foreign money can be safe refuge only if the foreign government inflates less wildly than the domestic government
  5. the author shits on gold, but with no reason other than an arbitrary one because he is a Keynesian– gold may be overvalued during and even before and inflation but so long as people continue to think it is money, it can hold some value
  6. real estate provides a shelter for REAL value (usability/livability/productivity of land) but could be harmed in terms of investment value in an inflation
     1. real estate held in high esteem by inflationary prosperity (luxury dwellings, overblown commercial developments) may lose more real value than other investments as they started out overpriced in the inflation
  7. farmland is a special category of real estate
     1. produces what people must have, inflation or no
     2. farmers thrive and farmland excels in dying throes of every inflation
     3. less prosperous in early stages of an inflation
  8. hoarding of useful goods is a possibility, but has large storage, distribution and opportunity costs prior to an inflation
• Self-Defense Continued: The Stock Market
  1. stock shares are pieces of paper, but they are claims on real assets and real wealth
  2. stock market is incredibly liquid
  3. common stocks provide returns in first madness of an inflation, then fall into disrepute in middle stages of an inflation
  4. a booming stock market is not necessarily part of an economically healthy nation
     1. the opposite is truer: booming stock market is a signal of inflation
     2. falling stock market is a sign of returning to reality
  5. the stock market as a whole rises due to inflation and nothing more
  6. the stock market declines on a weakening of inflation
  7. general business conditions and price inflation operate on a lag; when money is first printed it has nowhere to “work” and goes into investment markets
     1. markets rise while business is still bad
     2. later, as money moves out of the market and into businesses, the market falls
     3. when business is worst, stock markets rise; when business is best, stock markets fall
     4. rising stock market signals nothing but fresh money inflation– it is the earliest and most sensitive signal
  8. stocks bought at any price above their real-value bottom are not a hedge against loss but a guaranteed loss
  9. conversely, stocks bought at real-value bottoms have a good chance of holding their values through an inflation
  10. American stock market’s deflated bottom in 1970 was 43% higher than deflated bottom in 1962, just as money supply in 1970 was about 43% higher than in 1962
  11. as other prices outpace stock market rises (or even stock market decreases), fear can take over that the businesses will not be worth anything; but faith will pay off with real value nearly the same at the end of an inflation
  12. stock markets can enjoy inflated gains if there are laws in place forbidding the inflationary money to bid up prices elsewhere or in foreign markets
  13. the stock market represents real value, but not every stock does
  14. inflationary times tend to reward the most valueless stocks; use a “post-inflationary eye” to have a look around at what might actually survive the inflation in terms of real value
  15. “Attempting to make profits from the stock market, or even to make sense of it, without completely understanding the universal determinant of inflation was like being at sea among uncharted rocks and shoals without so much as a tide table.”
• A World of Nations
  1. Virtually all of the entire growth of Federal debt after 1967, $55B, was involuntarily financed and acquired by foreigners
  2. by 1973, foreigners’ holdings of liquid dollar debt had risen to $90B from $31B in 1966
  3. America exported inflation; other nations imported it– this is the balance of payments deficit
  4. natural consequence of an inflation, surplus money must flow outward looking for “cheap” items to buy abroad
  5. 100% beneficial to the deficit country
     1. import real value from abroad while exporting worthless paper
     2. price inflation domestically is partially contained
  6. central bankers began a game of printing up new local currency to exchange with the inflowing dollars, sending the dollars back to the US where they would be recycled and re-exported
  7. exchange rates operate on a time lag
     1. first, the internal price level is too low, so the new currency flows out to the rest of the world
     2. then, the internal price level rises, drawing in currency from the rest of the world
  8. the best defense against another country’s inflation, is inflation