As we look at the recent monetary, fiscal and legislative policies designed to address the "economic crisis," the popular conclusion points to hyper inflation. After all, massive increases in the Federal Reserve's balance sheet is inflationary, right? Add to this the historical surge in federal government spending and almost incomprehensible deficits intended to stimulate economic activity, and the arguments in favor of inflation appear to make sense...on the surface.
While I would rather face inflation, we face some serious issues that may steer us into deflation. In the past year, the Fed's balance sheet, as measured by the monetary base, has nearly doubled from $826 billion in March 2008 to $1.64 trillion, with larger increases on deck. The historical increases in the monetary base have not led to economic growth or creating new credit. Why? The simple answer is money supply. While M-0 (what comes off the printing presses) is sky rocketing, M-2 (what makes its way into the economy) has barely moved. In short, banks are soaking up every dollar they can to rebuild their balance sheets. Over the past year, while total reserves increased by $736 billion, only 1.9 percent was available for loans. Hence, for the first quarter of 2009, bank loans fell 5.4 percent.
While most recessions come from excess manufacturing inventory, this one is the result of excess credit. Economic activity cannot move forward unless credit expansion follows reserves expansion. Because this isn't happening, we may have witnessed the end of a 70 year credit expansion cycle that started after World War II. Over a 25 year period, we've gone from societal debt of 150 percent of Gross Domestic Product to 350 percent of GDP. As only policy makers can do, they will make matters worse by increasing regulation on the very banks that are already reluctant to lend money.
Another factor to consider in the inflation vs. deflation debate is U.S. Government Debt, predicted to be 72 percent of GDP in four years. History shows us that massive increases in government debt weaken the private sector and slow an economic recovery. Some economists argue that by weakening the private economy, government borrowing is not an inflationary threat. In looking at Japan from 1988 to 2008, their government debt to GDP ratio grew from 50 percent to 170 percent. Did government spending lead to prosperity? No, Japan is in the midst of its worst recession since the end of World War II, with declining GDP much worse than ours. Incidentally, Japan's increase in debt was a result of bailouts for banks, insurance companies, manufacturers and FDR style works projects. If a government spends $1, it must raise $1 in taxes. The $1 raised in taxes comes from individuals and business who would otherwise have put the money to use in the private sector, purchasing goods, services or taking risks through business investment or expansion.
So where does all this lead us for making portfolio decisions? For the short term, deflation is still a significant threat. Looking three to five years down the road, I hope we do have inflation because if we don't, our problems will have gotten worse. Trying to outsmart the economy by making big short term bets on inflation with your portfolio may prove disappointing. A good way to hedge your bet would be buying U.S. Treasury Inflation-Protected Securities (TIPS). You can do this online at treasurydirect.gov. I prefer using the iShares Barclays TIPS Bond (symbol TIP). You'll have the liquidity of a stock, no phantom income tax concerns and a current yield around 4.8 percent.
Whether all the new dollars continue to sit in banks or make it out into the broader economy, inflation will eventually take a bite out of every investor. Our best hope is for government to limit spending and regulation so that exploding productivity can muzzle the monster before it gets out of control.
Andrew Brown is a Certified Financial PlannerTM and a Fee-Only Registered Investment Advisor.