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By Daniel R. Amerman, CFA
DanielAmerman.com
The week of May 3rd to 6th
has rocked the financial world. Stock
markets fell around the globe with an almost 2% one-day drop in equity values
across 23 developed nations (per the MSCI gauge), and a 5.2% fall in three days. The S&P 500 hit a two-month low in the
US. The euro plunged against the dollar
for two straight days, reaching a 14-month low. The financial crisis claimed
three lives in Greece, as a result of fires set during the nation’s paralyzing
general strike, even while German newspapers roiled with anger over the
European Central Bank’s inflationary rule changes intended to help finance the
Greek bailout. Meanwhile, Australia
considers exorbitant mining tax hikes, to keep those global gold profiteers
(aka investors) from reaping too many of the benefits of the gold that
rightfully belongs to all Australians.
The world is changing rapidly, but it
is not descending into unpredictable chaos. Instead, as we will review in this article, three
separate but intertwined economic themes that will dominate the 2010s are
emerging into the headlines. Investment
values have been falling around the world, and this is likely to continue as
pervasive asset deflation in
purchasing power terms takes hold. Global monetary
inflation will simultaneously be another powerful force, for plunging asset
values do not prop up the purchasing power of currencies. The third global force is likely to be rising tax rates, with particular
effects on many precious metals investment strategies.
Investors who do not understand these
three broad forces are likely to see little more than chaos, and they face an
oncoming series of negative surprises that will systematically destroy much of
their net worth. Through anticipating
these forces however, and understanding how they intertwine, informed investors
gain an opportunity to not only protect what they have, but to turn that understanding
into substantially increased wealth.
As fears of the Greek “contagion”
spread this week, the repercussions swiftly became global. The losses were
worst in Europe with Madrid's key stock index falling 5.4% in a day, even as
Lisbon's index fell 4.2% and Paris fell 3.6%. The DJIA in the US fell 2%,
closing below 11,000. Shanghai's benchmark index fell 2.1%, Hong Kong’s key
index fell 2%, and Australia fell 1.9%.
In all, about $1.1 trillion of global stockholder paper wealth was
destroyed in a day, according to Bloomberg.
We do live in an interlinked world.
While Greece is in the headlines at the
moment, it is not the heart of the crisis.
For Greece is only a comparatively minor example of a common global
theme: governments having made a series
of politically popular promises over the years that they simply can’t pay for. When we consider the much greater problems
with the larger nations – a mere $1.1 trillion in equity losses may end up
looking like pocket change when compared to eventual total investors losses.
To see the problems stemming from
impossible government promises, but on a fantastic scale -- you need to look no
further than the United States. As I
cover in my article “Bailout Lies Threaten Your Savings", the United
States long ago passed the point where it was credible to believe it could pay
for its promises. When we add up
expected Social Security and Medicare shortfalls, cashing out pension and
retirement investments, and the guarantees of the bailout and stimulus package,
the total shortfall comes in close to $100 trillion. There are about 111
million US households, but not all of them can help pay. When we adjust out below-poverty-line
households and average retiree households over the coming years, there will be
about 79 million “able-to-pay” households.
Divide the total shortfall by “able-to-pay” households and the shortfall
works out to about $1.25 million dollars
per household. That is, $1.25
million per household over and above current household tax payments and other
expenditures.
Thus, Greece’s current crisis could be
described as a mere rounding error in comparison to what is coming fast and
hard at the United States.
When they talk about the contagion
spreading, most people look to countries like Portugal and Spain. However, if we want to see a crisis in Europe
that dwarfs Greece, then consider Britain.
According to yesterday's New York
Times, government spending in the UK over the last 13 years has risen at a
rate that’s 41% higher than the rate of inflation. About 25% of British government spending is
currently borrowed money (comparatively, US federal deficits ran about 40% of
spending last year). Mervyn King, the
governor of the Bank of England, is quoted (secondhand) as saying that he
expects that whichever party wins the current election will later be out of
power for a generation, because the austerity measures needed to meet Britain's
problems will be so painful.
The reason to believe why global asset
deflation will dominate world markets over the coming decade comes down to a
little bit of radical common sense. This
common sense is that every nation only has one economy. Therefore, paralyzing economic problems with
impossible government promises will necessarily have to travel through to the private
economies of those nations. Economic
devastation and political turmoil do not lead to ever increasing corporate
profits, as is assumed with long term investment models. Mathematically, most of today’s global equity
valuations are based upon assumed growth in corporate earnings. A world in which that growth does not occur is
a world in which equity values effectively collapse in purchasing power terms
on a global basis.
Investor pain went well beyond just
falling equity prices. The euro fell roughly 3% against the dollar in the first
half of the week, because of fears of the inflationary effects of the Greek
bailout. So for a Spanish investor
wanting to buy an asset priced in US dollars, the one-two combination of
Spanish stocks falling 5% and the euro falling 3% means they lost about 8% of
the purchasing power of their assets in a matter of days. Likewise, a US
investor in Spanish equities would've lost about 8% of their investment value
in dollar terms.
The reason for the plunge in the euro
was not just the damage to the European economy, nor the costs of the Greek bailout,
but the method the European Central Bank is using to help finance the bailout. The ECB has announced that it will change its
policy and make loans based upon accepting Greek government debt as collateral,
despite the Greek government bonds having a “junk” credit rating. In other
words, a private commercial bank can purchase Greek government bonds, and fund
that purchase through borrowing from the European Central Bank. The ECB, in its own equivalent to the Federal
Reserve's actions in the United States, has the ability to effectively create euros
out of thin air to fund that loan and thereby the purchase of the bonds. While this is still one step short of outright
direct monetization, such as the ECB directly creating euros to buy Greek bonds,
the line is getting very thin indeed, and the direct purchase pressure is growing.
While the euro can likely handle a
roughly hundred billion dollar bailout, the problem is that this sets a
precedent for future bailouts. While on the surface it may appear less painful
than the alternatives, the chosen solution places in peril the value of every
euro held in every nation. The Germans
in particular are keenly aware of this, and German newspapers have been furious
about what has happened. To cite a
couple of examples, the Die Welt says:
“they (the ECB) have also sacrificed the
credibility of almost all EU institutions from the European commission on down
to the central bank. These are the true costs of rescuing Greece." The Handelsblatt
takes it a step further and says “if you take a closer look at the situation
you can see that European politicians sealed the fate of their currency union
over the weekend.”
To understand why the European Central
Bank is taking these unprecedented actions – look to the streets of Athens. The citizens of Greece are less than grateful
for the bailout and the accompanying austerity measures. They don't really understand or care about central
bank actions; what the average Greek sees is broken government promises, and
rapidly approaching personal impoverishment compared to the lifestyle they
believe to be their natural right. So general strikes paralyze the country and
the fatalities begin, as three people die in the firebombing of a Greek bank.
When it comes to government spending
and promises bankrupting a state, however, Greece has nothing on California. Just as the California economy dwarfs that of
Greece, so does the incredible size of California's rapidly growing budgetary
crisis, particularly when you take into account what happens when their pension
crisis intersects with widespread global asset deflation.
When we consider the long-term value of
the US dollar, think about those tragic deaths in Athens. Consider the anger that might be unleashed in
the cities of California and elsewhere, if millions of people see broken
promises and steady impoverishment as their future. Think then about whether
our politicians will force severe austerity measures on the population when
there are riots in the streets -- or whether they will elect to quietly debase
the currency in a manner that few understand, let alone protest.
So will the future be (a) global
deflation, or (b) global inflation?
Unfortunately the answer is (c) both of
the above.
Asset deflation is a decline in the
purchasing power of your assets.
Monetary inflation is a decline in the purchasing power of your
money. The simplistic view is that your investment
assets losing value somehow protects the value of your money. In other words, many people believe that if
markets and real estate are falling, at least you don’t have to worry about the
value of what is in your savings account.
This was more or less true back in the days of gold-backed currencies – such
as the US gold certificates at the beginning (but not the end) of the Great
Depression. This “protection” is
non-existent however, for a nation with a symbolic or fiat currency. Instead, when a nation is in trouble, it is
the norm for the value of its investment assets to simultaneously decline with
the value of its currency. On a global
scale, this could mean an environment of simultaneous asset deflation and
monetary inflation that could last a decade or more.
As an illustration, the real danger to
your savings is not the Dow Jones index dropping to 6,000. The danger is that the DJIA rises to 30,000,
with triumphant newspaper headlines every step of the way – but the purchasing
power of the dollar simultaneously falls to ten cents. Thus, a future Dow 30,000 will only buy what a
Dow 3,000 would today. So you have
experienced a plunge in the purchasing power of your savings that has been
masked by the destruction of the value of your money. Meanwhile, the government is increasing your
losses through collecting whopping taxes on the (economically non-existent)
profits generated by the increase of the Dow to 30,000. It is this relationship between asset
deflation, monetary inflation and inflation taxes that is the central danger
facing long-term investors around the world.
When viewed from the simplistic perspective
of newspaper headlines, it may look like you tripled your money in the
illustration above. In fact, however, you
lost more than two thirds of the value of your investments. Let me suggest that any methodology that is
unable to distinguish between tripling your money and losing two thirds of your
money, is profoundly dangerous for your net worth.
(I have written extensively about these
issues in other articles, with my Puncturing Deflation Myths series being a
good start, as well as the video / text article “Can Theory & Jargon
Destroy Your Net Worth?”)
Meanwhile, in Australia it appears as
if another global trend for the 2010s could be getting started, and this trend is
one that could be devastating for many precious metals investors around the
world. As reported in the Sydney Morning Herald, the “Henry tax
review” study is recommending a 40% tax on mining company profits. Prime
Minister Kevin Rudd appears to be embracing the recommendations as forming the
basis for a long term tax blueprint.
This huge mining tax is not yet law,
and may never become law, its support from the current ruling party
notwithstanding. Nonetheless, the talking
points involved, and the way it is being presented by both politicians and the
media are quite educational, and should be carefully noted by precious metals-oriented
investors.
Prime Minister Rudd is phrasing the
debate in terms of the profits from gold that rightfully belong to Australia are
unfairly going overseas to foreigners. The
proposed tax law changes call for reducing the domestic tax burden for
Australian businesses overall, with that reduction in domestic tax burden being
paid for by effectively increasing the taxes on foreigners. This is powerful,
powerful stuff from a political perspective, and variations on this theme can
be expected to play out on a global basis over the years to come, particularly
if we assume that gold continues to rapidly rise in price. (And yes, Australian citizens who've been
buying mining stocks to protect themselves from the fiscal actions of their own
government will be equally hurt -- but playing it as Australians versus
foreigners is the more potent political argument.)
Another level of concern is that once
grabs get going, they happen at more than one level. Specifically, as reported
in The Australian, the government of
South Australia is considering doubling its mining tax from 3.5% to 7%. After all, the national government is looking
at raising mining taxes, and raising mining taxes “worked” for the government
of Western Australia, so why shouldn't it work for South Australia too? It
should also never be forgotten that the greater the profits that flow into a
business, the more incentive there is for company management to find a way to
cheat outside shareholders. Level after level, the more powerful the incentives
–the more likely the action.
This is a danger which I have been
warning about for years in my educational materials. Too many people have been
acting as if “history was over” and people could invest as safely around the
globe as they could in their own nation. History has not ended, but rather history
is that nations act in their own self interests, and that they change the “rules”
at will. Small investors who can't vote,
or investors who are only a minority of voters in their own country, can have little
or no power to affect how those rules are changed. When gold soars in value, even as the global power
order restructures, there are a wide variety of ways in which both nations and
mining companies can cheat foreign investors out of what they thought would be a
fair share of the profits. Indeed the incentives are so great for this behavior
that it should be considered not a remote possibility but quite probable, and
the higher the price of gold goes, the more likely it is that this will happen.
Rules change. And they usually change in favor of those
people who have the power, while hurting those people who don't have the power.
The greater the incentive for changing the rules, the more likely the rules
will be changed. These basic
relationships should be core to any long-term investment strategy in a time of
turmoil.
Expropriation of the wealth of foreign
investors -- which is another name for the recommendations of the Henry tax
review -- is a very real danger. However
this is not the greatest tax danger for gold investors globally. No tax law changes are needed for gold
investors around the world to be dealt devastating blows to their net worth in
an environment of high inflation, through high inflation taxes as described in
my many other writings on the subject.
However bleak the situation is, don't assume
that your savings are necessarily doomed -- because they don’t have to be. The outcome for your personal financial
situation will come down to the decisions which you personally make. What is going on today will make many people panic.
However, I believe that the best way to
preserve your personal assets, and even improve your situation, is not to panic,
but to get very calm and make some coolly rational decisions. With the best
place to start being conducting a personal inventory of not just your
investment capital, but of something even more important: your intellectual capital.
Do you have the knowledge you need?
Do you know how to protect what you
have built from asset deflation? Here's the bonus net worth question: do you
know how to profit from asset deflation?
Do you know how to protect the value of
your assets from monetary inflation? Do
you know how to profit from monetary inflation on an after-tax and after-inflation
basis?
Do you know how to protect yourself
from governmental confiscation of your net worth through inflation taxes?
Do you understand how simultaneous
asset deflation and monetary inflation work?
Do you know enough to protect what you have in a world where the value
of assets is falling simultaneously with the value of money, even as taxes rise?
Being frank in your self-assessment is likely
the single most important thing you can do to preserve what you have in this
crisis. Because monetary crises are times when a very rapid redistribution of
wealth occurs. And the way that
redistribution can work is that the wealth is taken from the people with many
assets but little knowledge of monetary crisis, and redistributed to other
people who have more education (albeit an education in unconventional financial
techniques).
Since the year 2000, I have been a
student of simultaneous asset deflation and monetary inflation, and how they can
interact in an environment of inflation taxes. The reason I've been a student is that none of
today's headlines as covered in this article were unpredictable even 10 years
ago. The demographic crises, the
investment crises, and the debt crises have all been building in plain sight
for a very long time.
When I started my studies, I was
already the author of two books on investment finance, with 2 degrees in
finance, as well as a former investment banker.
Over those 10 years, I had to relearn much of what I had been taught in
the previous 20 years of my financial schooling and career. Because most of
what passes for the conventional financial wisdom, is implicitly based on the
assumption that we already know the future, and it is a rosy future of never
ending economic growth and ever increasing corporate profits. The paradigms
that we have all been taught about investing collapse in an environment where
the value of money and the value of investments are simultaneously falling over
the long term.
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Gold is a particularly interesting example, as it can be described as either the unconventional alternative to
conventional investing, or perhaps more accurately, the most conventional of
the unconventional investments. Gold
operating as one of the most effective of all the inflation hedges is quite
commonly accepted. However, as I explore
in my new “Gold Out Of The Box” materials, inflation-oriented buy-and-hold gold
strategies are crippled by inflation taxes. The government’s effective confiscation
of wealth through taxing the investor on the destruction of the value of the
government’s own currency can be expected to outweigh gold gains in
inflation-adjusted terms over most long-term holding periods. So the gold investor loses a chunk of their
after-tax and after-inflation net worth if gold rises to $5,000 an ounce, loses
a bigger chunk if gold rises to $10,000, and takes a devastating blow if gold
rises to $20,000 an ounce.
Making things more interesting still,
is that gold can in fact be a superb investment during times of simultaneous
asset deflation and monetary inflation.
Indeed, in a time of economic meltdown, an asset deflation based gold
strategy can be the single best way to generate spectacular returns that turn
crisis into potential multigenerational wealth. Gold becomes the best investment in the
world for crisis. But gold asset
deflation strategies are quite different in the execution from gold monetary
inflation strategies.
The difference between the two types of
gold strategies? Intellectual
capital. Which is acquired through
education.
As Greece leads the way into our new
financial world, the time for taking action that will build your knowledge– is
today.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will
redistribute real wealth to you, and the higher the rate of inflation – the
more your after-inflation net worth grows?
Do you know how to achieve these gains on a long-term and tax-advantaged
basis? Do you know how to potentially
triple your after-tax and after-inflation returns through Reversing The
Inflation Tax? So that instead
of paying real taxes on illusionary income, you are paying illusionary taxes on
real increases in net worth? These are
among the many topics covered in the free “Turning Inflation Into
Wealth” Mini-Course. Starting simple,
this course delivers a series of 10-15 minute readings, with each
reading building on the knowledge and information contained in previous
readings. More information on the course
is available at DanielAmerman.com or InflationIntoWealth.com .
Contact Information:
Daniel R. Amerman, CFA
Website: http://danielamerman.com/
E-mail: mail@the-great-retirement-experiment.com
This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.
Copyright 2010 by Daniel Amerman