Yogi Berra Was Right

The debate among the "hard money" types about the near future cannot be settled. It is like Yogi Berra said, "It is difficult to make predictions, especially about the future." 

How can one predict with certainty how a future president or Federal Reserve Chairman will act? 

Peter Schiff thinks that they will print money, and then print some more, and then some more. He may be right. Mish Shedlock thinks that they will not do so because this would be stupid and it may not even be possible. John Mauldin thinks that there will be a crisis, but good ol’ American knowhow will prevail. I have no idea and this is the reason I have been talking about the impossibility of making investments. The reason I do not think that Schiff is right is that I cannot see the "powers that be" doing something so against their own self interest as hyperinflation. My thinking is to combine all these viewpoints. Yes, there will be inflation, but it will not be hyperinflation. Yes, there will be a partial repudiation, not of the US debts, but the Social Security and Medicare promises—especially Medicare. There is really no choice. 

Here is an argument between Mauldin and Schiff at the Cambridge House conference I attended in February. I saw it live and it was a lot of fun! 

LIFO vs. FIFO

Join me deep in the weeds of accounting! The last time I went this deep in the weeds the beloved editor of the Prophecy Podcast blog commented that the post was mind-numblingly boring. This is even more deep into things as it discusses a rather obscure part of accounting. Yes, accounting. Ugh.

I had a discussion about this over coffee at the Cambridge House Conference I attended. The two other coffee drinkers were talking about the conference and I mentioned how inflation affected the profit and loss of a business. Since they are expecting inflation, what I said was shocking to them. 

LIFO and FIFO are two different accounting methods used for allocating inventory to the profit and loss for the business. (Sorry to have to slog through this.) 

Here is how Wikipedia describes the two accounting methods. 

FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in the U.S.

I am expecting moderate inflation in the 10 to 20% range for a couple of years. Others are expecting deflation; others are expecting hyperinflation. But for discussion purposes let’s talk about how a 33% inflation rate would affect a business. 

Let’s say that there is a retail business with an inventory of $750,000 in widgets. This is a C Corp that pays 35% in taxes. (Yes, I am aware that the rate varies.) The corporation pays any wages that are due to shareholders. The corporation is able to keep the same number of widgets as before with great effort through the year, but now has $1,000,000 in inventory. But in terms of cash flow, the business is in the same situation it was before. What is the taxable income of the Corporation? If you said zero you would be right, if the corporation is using the LIFO accounting method. But if the FIFO method is being used, then the taxable income is $250,000. 

At 35% this is a tax of is $87,500. Where is this money supposed to come from? The business has barely managed to break even with the heavy inflation rate of 33%. This is why many corporations now use the LIFO method. 

So what is the big deal? Obama, in his never-ending search for new taxes, is proposing to abolish LIFO accounting. While this is an old proposal, it will continue to be offered until it is passed. Under normal circumstances this will just be a modest increase in taxes for most businesses. But for those with inventory that has a volatile price surge history, like say the lumber that I sell, it can be a major tax increase in a year. To be fair it can also result in a tax decrease if prices drop. A smaller inflation rate would be survivable for a business, but for many businesses it would be the proverbial straw that broke the camel's back. With hyperinflation and FIFO accounting every retail business in the US would close. 

Coming soon to a business near you. I can see a business surviving with high inflation and forced to FIFO accounting and the resultant tax for a year, maybe two, but then businesses will start closing. A tax on the phantom income due to inflation has the potential to close retail stores—remember that Safeway is a retail store. 

This is what was shocking to my coffee companions. The effect of this stealth tax could be extremely destructive and it is not on anyone's radar right now. It should be.

CORPORATE TAX RATES

TAXABLE INCOME	RATE
Up to $50,000	15%
$50,001 – $75,000	25%
$75,001 – $100,000	34%
$100,001 – $335,000	39%
$335,001 – $10 million	34%
Over $10 million – $15 million	35%
Over $15 million – $18,333,333	38%
Over $18,333,333	35%
ALTERNATIVE MINIMUM TAX*	20%

* The corporate AMT exemption of $40,000 is phased out with alternative minimum taxable income between $150,000 and $310,000. 

This chart is the technicalities of Sub C Corporation Taxes.   

Is the Gold Still in Fort Knox?

I never wear such a hat as it is well known that such hats make it easier for the government to track you. Get out your aluminum foil hat. At least that is what I thought about the possibility of Fort Knox being empty before one presentation at the Cambridge House seminars. I had only heard the goofy version of this, that Fort Knox and the gold at the Federal Reserve in New York was missing.

No, the gold is there all right, but the real question is "How much of it is pledged or lent to banks?" This is how it works. The Fed leases gold to a "gold bank" for a modest fee. The gold bank issues certificates can be redeemed for gold. The gold bank then buys bonds, often government bonds in the country that lent the gold to the bank in the first place. This has a great effect from the government perspective. They receive a fee and get to sell their bonds. From the bank's perspective they get a great spread on the difference between what they pay the central bank and the interest they receive from the bonds they buy—a win/win for both parties. Since most money center banks, the big ones, are bankrupt if they marked their assets to the price the market would give them for these assets, this allows them to replenish their capital on the sly. In fact a lot of the various oddness in the financial markets is explained by the banks’ desperate need for capital.

Pay No attention to the Banker behind the curtain. Are the banks doing this? Yes, the Austrian central bank released that they had lent a considerable amount of their gold out. How many other central banks did this? We do not know.

So is everything fine? Sure, as long as the paper gold is not ever returned to the central bank or the Federal Reserve. But if gold goes higher, and the banks are forced to return the gold and draw out the paper gold from circulation, these banks will go bust. In that case what will happen to the paper gold, the ETF? It will be worthless. If you buy gold, do not buy ETF's.

Can we be certain that this is a big a problem as I think it is? No. But there was one new interesting data point that became common knowledge. Germany has its gold stored mostly at the Bank of England, France, and the Federal Reserve. This is a legacy of the Cold War where it was feared that the Soviet Union might steal it in war. There was considerable buzz about German gold in Germany. So it was announced that all the gold would be returned—over 7 years. 

Will the German Bundesbank still love the Fed after 7 years? 7 Years.

7 Years!

7 Years?

Why not 7 months? I have no idea what is going on, but something is wrong. The probability that the gold is being double counted to drive down the price just went up—by a lot.

Here is a presentation similar to the one I saw at the Cambridge House seminars. I have my doubts about the extent of the problem, and we do risk being stuck in tinfoil hat territory, but there is no doubt that this gold lending is happening.

John Mauldin is Guardedly Optimistic

John Mauldin Is Guardedly Optimistic. Mauldin tries to justify this by quoting Lenin, who said:

 "There are decades where nothing happens, and there are weeks when decades occur."

We are in such a period. But Mauldin thinks it is a transition into something better.  "If something cannot be sustained, it will change," he said. Mauldin then quotes economist Laurence Kotlikoff who estimates that the US has 200 trillion in unfunded liabilities. (I have talked about this previously.) Mauldin comments, "We can't pay that amount. What happens when we realize this?" He thinks that when this becomes evident change will occur.  "Expenses cannot rise faster than income," he says.  He thinks that, "It is the end of the world, yet I am excited" because things will have to change for the better. 

2020 will be great, after the world economy goes through this transition period. What will be the characteristics of this transition? Here is what he thinks (note that what I put in quotes is not his exact words, but it is close. When I put something in parentheses, it is me speaking.):

Pension and health care are the reason for the troubles due to demographics. Sweden tied benefits to GDP, it is necessary, not heartless. (This means that a certain percentage of the economy is devoted to helping people. This is something I have long advocated.) Eventually everyone will do the same. (I hope he is right.) 

Peak oil is false; energy prices will go up, but no catastrophe. (I agree.) 

Japan is a bug in search of a windshield. (What a great line!) 

In Europe, France is the new Greece—then the US.

In China the demographics are awful—they have more people leaving the workforce than entering it. Japan and Europe have this problem as well. 

"Of course austerity does not work, that is why it is called austerity." (My question would be, "What choice did Greece have?")

"Government has made promises they cannot keep." 

Krugman is not an economist. (Ha.)

Adapt to change, not fight it. We don't have enough money to protect people from change.

Social Security is welfare.

Invest in things that central banks can't print—gold, technology, and corn, for example. 

Alas, his presentation was not well rehearsed for the time he was allotted, so the speech ended somewhat abruptly, but Mauldin does make you somewhat more hopeful. What he calls optimistic is what I have been calling guardedly pessimistic. No, I do not think the crisis I have been predicting to happen in 3 to 7 years is The Powers That Bethe Apocalypse, nor Ragnarök, but it will be very bad.  I am guardedly pessimistic because I do not think the "powers that be" will act against their own best interests. No, the "powers that be" do not meet in secret conclaves and decided the future. They each act in their own best interests, and since they all have the same interests it can appear there is collusion. (The TV drama, The Man, I will post tomorrow assumes that there is a conspiracy. It is a great "drama," but quite wrong-headed.)  

Here is Mauldin's presentation. 

What is Money?

Money makes the world go around. You would think this question has an easy answer. It doesn't. The Federal Reserve has many different definitions. Here is one definition from the Federal Reserve:

The money supply is commonly defined to be a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, U.S. currency and balances held in checking accounts and savings accounts are included in many measures of the money supply. 

Here is an example of recent money supply calculations based on two different definitions of Money from the Fed. If you can figure it out, you are a smarter person than I. Or maybe you have more time than I do! Or you could read the Wiki entry on the money supply. I did until I had a bad case of EGO—eyes glazed over. 

So after much reading and thought I decided to present my own amateur musings. Hopefully you will conclude that I am a talented amateur. 

Some people actually think that money grows on trees-more on this next week. The primary category of "money" is wealth that can be accessed immediately—currency, savings accounts, checking accounts, and here is where I probably disagree with many…short-term treasury bills. 

Secondary "money" would be financial assets that are highly liquid and have a small transaction cost: stocks, CD's at a bank, gold, silver, and other semi-monetary metals, or medium-term debt from the government.   

Tertiary "money" would be real estate, corporate bonds, and long-term government debt. These have either high transaction costs or interest rate risk, or both. In my view anything in an IRA or a 401K would be in this category. 

Quaternary "money" would be things like collectables and derivatives.   

So what is money? How about real estate with a line of credit on it? You just pick up a phone and voilà, the money is in your checking account and you can spend it. Is this "money"? Or what about Apple stock? One call to your broker and it is in your account and it can be spent. Apple has been volatile lately, but the transaction costs on stock sales keeps dropping. Is an investment in Apple stock money? 

Before I answer these questions, you probably have another question. "Why does this matter?" It matters because we all like to plan for the future; I hope you do anyway. So among the hard money types the question of the moment is “Are we headed for deflation?” Mish Shedlock would be in this school. Or, are we headed toward hyperinflation? Peter Schiff is in that school. John Mauldin speaking at the Cambridge House seminars I attended offered a third way. 

This would be just as true with a picture of Bush.Who is right? If you define money as in my first definition, we are in an inflationary period. Hooray for Peter Schiff. If you use the second definition we seem to be in a neutral period. Hooray for John Mauldin. If you use definition three then we are in a deflationary period. Hooray for Mish Shedlock. (Even Peter Schiff thinks real estate is grossly over-valued, and sorry Peter, but this is deflationary.) If you include the fourth definition of money, then it changes nothing but does manage to intensify the alternatives. 

We cannot trust the definition of money. We cannot trust the price increases announced by the government CPI, Consumer Price Index. If we use the same method that kept Jimmy Carter from being reelected, our inflation rate is 5 to 7%. Remember that Nixon was horrified and instituted wage and price controls when inflation was at 4%. Even if inflation was the 2% the government insists that it is, a 22-year-old college graduate just now entering the work force, good luck by-the-way, would have 90% of whatever he saves today stolen from him over his 45 year working life. Yes, inflation is "only" 2%! We cannot trust the government announced unemployment rate. 

We are screwed. This is not the word I wanted to use but this is a family-oriented blog. 

What is money? I have no idea. Yogi Berra was right. “It is difficult to make predictions, especially about the future.” Liza Minnelli and Joel Grey were right too. 

I have decided to conclude with an analogy. Imagine you are in a plane in a blinding hailstorm. The plane's navigation systems fail, just as our financial system is mostly failing today. After the financial plane crash you might be eaten by dinosaurs! Co-pilot Schiff says we will crash and die and we will all go to inflationary hell. Co-pilot Shedlock thinks we will crash, and the plane will be a total loss and we will go to deflationary purgatory. Co-pilot Mauldin thinks we will crash, but we will repair the plane and fly again to heaven. I might wish that Mauldin is right, but I would not rely on it. I plan to talk about Mauldin and his theories on Tuesday. 

I remain guardedly pessimistic. 

In the meantime, here is an interview with another opinion, this time by co-pilot Gary Schilling. He thinks that everything is A-OK and that there is no reason to worry, the plane will have a safe, but bumpy landing. I think in the short run he is right, the government will spend money and sell bonds until it doesn't, then the plane will hit the ground. 

Are you wearing your financial seat belt? 

Thanks to Eric Anderson at Universe of Lies for pointing out this video.