The Most Important Issue in Financial Planning: Part II

“If Americans ever allow banks to control the issue of their currency, first by inflation and then by deflation, the banks will deprive the people of all property until their children will wake up homeless”- Thomas Jefferson

(Ed. Note: Hmmm. Might want to paste that quote on the fridge.)


As I stated in my prior post on this topic, I believe that the question of whether we face inflation or deflation going forward is the most important question for advisors and investors out there. Why? The assets classes that do well in one environment struggle in the other and vice versa. Get this question right and your portfolio is set up for success. Get it wrong and the portfolio is likely to fail to meet its objectives. Split the baby and the portfolio is likely to have a mixed or muddled performance. Let's take a look.

The case for inflation going forward has multiple parts. The first is the need to finance existing and future federal obligations, including the national debt. The Congressional Budget Office (CBO) forecasts that the national debt held by the public to GDP ratio will hit 70% in 2012 and 82% by 2019. That is their base-case projection assuming entitlements evolve in line with EXISTING laws and that discretionary spending grows at the rate of inflation. Those sanguine assumption appears to be in direct conflict with the announced aims of the Obama administration regarding health care, not to mention any other programmatic expansions.

The publicly held national debt is absolutely dwarfed by the current and unfunded liabilities of the federal government. If we total the publicly held national debt, plus federal employee and veterans' benefits, insurance, leases and estimated scheduled benefits under Social Security and Medicare, as of September 2008 these unfunded mandates total $56.5 trillion. That's four times the size of our GDP.

Look at the following chart from the White House's Office of Management and Budget (whitehousegove.org/omb):




Starting in the early 80s, the national debt as a percentage of GDP has been on an inexorable climb upward, interrupted only by the mildly declining rate in the Clinton years, and re-accelerated under Bush and now Obama. If the nation's books are in such disarray, what price will we need to pay to attract the capital to finance these debts. If higher interests rates are in store those must percolate throughout the economy and effect the financing decisions of all entities withing it, labor and capital combined.

A second argument for inflation is the sheer magnitude of money supply growth. The financial crisis has brought about an amazing response from the Federal Reserve. See below.



A central bank is best at creating liquidity and in response to the current crisis that is exactly what the Fed (and every other central bank) has been doing. If you believe that inflation is brought about by too much money chasing too few goods then the chart above will scare the bejeezus out of you. Once into the system, how does a central bank control where the money goes?


Per the April 29, 2009 statement of the Federal Open Market Committee, the Federal Reserve plans to purchase up to $1.25 trillion of agency mortgage-backed securities, $200 billion of agency debt, and $300 billion of Treasury securities. That $1.75 trillion in purchases is awfully close to the $1.8 trillion deficit that is projected for the budget in 2009. Look at the explosion from September 2008 until end of March 2009. All kind and manner of securities, once held in the private sector, have been purchased by the Federal Reserve.



TALF, CPLF, ABCP, CPDF. A veritable alphabet soup of programs has been created by the Fed and Treasury in the last year to inject money into the system while provide a place to park assets held in the private sector that could not otherwise be exchanged for acceptable prices. At what cost does our central bank become the only financier for these dubious instruments?

The flooding of money into the system. The need to finance an ever growing national debt. The monetization of large swaths of the credit markets. All are argued to be inflationary pressures underneath the system that are only being held in check for now by the vast amount of wealth destruction engendered by the housing and stock market collapses.

How will this play out in the coming months as we work our way through this crisis? That is the question facing advisors and investors and one which likely holds the key for acceptable returns going forward.