Inside The Economy

My background obviously isn't in finance - I'm actually some weird hybrid between an electrical engineer and a physicist. While I understand a lot of the basics in finance, there are still quite a few gaps in my knowledge, and I'm slowly working towards filling those in.

Last night I was pretty beat, so I crawled into bed and purchased a book about capitalism and the economy. I actually managed to read most of that in a few hours, and decided I'd grab another book as well. Wouldn't you know it, I finished that one as well sometime around midnight, and passed out on the couch.

Both books gave pretty dismal predictions about what may happen in the United States in the next few years. They also gave a brief history of capitalism and some rather interesting insights into what's going on now. Like I said, a lot of this is new to me, so feel free to chime in and correct anything. But here are some of the key take-aways I got while reading both books last night.

A Healthy Economy Involves Saving

Both books alluded this point, which I found really surprising, primarily because both Bush and Obama seem to be encouraging everyone to spend with little to no thought with regards to saving any money. At its core, saving money provides the necessary capital for future investments that will hopefully lead to further improvements in both businesses and the economy in general. Spending money, unless directed explicitly towards the enhancement of the economy, doesn't help the economy. It does however improve the GDP (which in turn may help the United States finance additional debt), which may be part of the reason it's encouraged.

Inflation Is An Expansion Of The Money Supply

While there are a lot of complicated definitions for the word inflation, both authors seemed to prefer its original meaning - inflation is simply an expansion of the money supply. Inflation seems to be the norm these days, primarily because countries fire up the printing press whenever they need to pay the interest on their loans. That process increases the money supply and ends up reducing the purchasing power of the money we all have saved.

Deflation Isn't The Devil

I can't remember any time in my life where we've undergone deflation, but both authors seemed to indicate that it should be a natural part of the capitalistic machinery. In fact, during periods of time when the dollar and other currencies were backed by gold, deflation actually occurred fairly regularly. What that would mean is that if you put $100 in the bank, which at the time may have been able to buy 20 loaves a bread, there may come a time in the future when you can buy 40 loaves. Sounds like a pretty good thing, no?

Interest Rates Should Adjust Naturally

At the heart of Keynesian Economics is this idea that governments should help stabilize the economy. Their prime tool in doing so is the Central Bank's interest rate, something that is currently pegged at historic lows. When the Central Bank doesn't manipulate the rates, often the rate will float with respect to the amount of capital that is saved. When savings are low, interest rates can rise, encouraging people to put their money into banks. When savings are high, interest rates can go lower, encouraging people to spend.

What we have now is an unusual situation. Canadians and Americans have been saving next to nothing these last few years, and yet the low interest rate is encouraging everyone to not only spend, but to take out loans to finance that spending. If you believe the point above, that spending only benefits the economy when it's used to help expand production, then the current rash of spending is only serving to kick the can further down the road.

Chicken Little May Have Been Right

Both books make one point extremely clear - the United States is in for a world of hurt. Right now their debt is sitting at about $10 trillion dollars, which is about 98% of their GDP (their obligations are actually much greater than this, but this is the official number). Every year, the United States has a huge trade surplus, mostly with China. On paper having a surplus looks great, but it's actually a liability, since it effectively means that China and other countries have purchased the United State's debt, and the United States will owe them interest in the future.

The only saving grace the US has right now is that everyone else's currency is pegged to the US dollar. That has allowed the US to act a lot less responsibly than other countries may have been able to get away with, but it's something that will probably change. When the markets starting crashing in 2008, many other countries started looking to possibly peg their currencies on the Euro. Once that starts happening, you can pretty much guarantee that the US dollar will take a pretty substantial nose dove.

I read a paper a while ago speculating that if the US had access to a big credit card, it would have a fundamental credit limit of $14 trillion dollars. The author speculated that once their debt reached that level (which with the current spending, will happen in less than two years), no countries will finance any additional US debt. At that point the US will either have to default on all its loans (which would probably crash the dollar), or it will have to buy a few more printing presses and go to town, which would ultimately lead to such massive inflation that it even has its own name, hyperinflation.

Both scenarios suck.

How To Survive

The second book I read had two main ideas on how to be well positioned in case a crash occurs. First, the author recommends investing in foreign markets (including Canada), and staying the hell away from the US economy. If the US does crash or enter a period of hyperinflation, a person heavily invested in foreign markets could wait until the crash was over and scoop up a lot of great deals.

The second main idea was to re-invest in precious metals such as gold. A lot of people take flack for investing in gold, but right now gold is on its way up, and last time I checked was around $2,400 $1200/ounce. Given that China is actively encouraging its citizens to buy as much gold as possibly, I can't help feeling that it's only going to keep heading north. The only caveat is that there's historical precedent for governments outlawing the possession of gold in rough times, so the author suggests holding some money and even gold in offshore accounts.

In terms of real estate, one of my favourite blogs is Garth Turner's The Greater Fool. Garth's pretty adamant that we're about to experience a pretty big real-estate crash in Canada here, and actively encourages people to get out of their houses while the prices are still high. If you're lucky, you can sell, bank some money, and rebuy when the market bottoms out in a few years.

If not, one of the books I read last night had an interesting idea about pulling money out of a home equity line of credit and putting it into income generating funds. For example, if your house was valued at $500k last year and suddenly lost $200k in value, presumably you could still withdraw the funds from a HELOC based on the previous year's valuation. With the current interest rates of around 0.5%, you could put that money into a low-risk income fund generating around 5% or so and simply bank the difference. If at any point the bank reassesses, you can simply cash out your investments and pay the HELOC back.

The Changing Of The Guard

After reading both books I was left with two main ideas - the period of US dominance is about to end, and the Chinese are about to take over. Not only is the Chinese economy thriving, but they are well positioned to be a major financial super power in the coming years. With China actively encouraging its citizens to buy gold, I can't help but feel there's a currency coup d'etat about to happen. While returning to a gold standard is often considered difficult nowadays, it's not impossible. If the US dollar loses its reserve status and people start switching to alternate currencies, I wouldn't be at all surprised if China switches back to a gold standard and starts its process of world domination.