THE GLOOM, BOOM & DOOM REPORT

ISSN 1017-1371 A PUBLICATION OF MARC FABER LIMITED NOVEMBER 10, 2005

From Asset Inflation to Consumer Price Inflation

INTRODUCTION
While the US Undersecretary of State, Karen Hughes, was on a visit to the Middle East that was supposed to boost the image of the United States in the region, but about which Robert Pape, a University of Chicago political scientist who has conducted extensive research into the motives and background of suicide terrorists (he is the author of Dying to Win: The Strategic Logic of Suicide Terrorism) and who has recently briefed the Pentagon, commented, If you set out to help bin Laden, you could not have done it better than Hughes, I was on a lengthy trip to South Africa, Europe, Canada, Australia, and Vietnam. Everywhere I went, I was struck by how much prices have risen, certainly in US dollar terms, compared to, say, two or three years ago an observation shared by just about everybody I spoke to while travelling. Part of the reason why countries such as Australia, South Africa, and Canada have become expensive is the strength of these countries currencies against the US dollar, but at the same time these countries have all experienced domestic price increases. This led me to think again about inflation, which I believe is going to meaningfully determine investment returns in the years to come. I therefore propose to discuss here the outlook for consumer price inflation and interest rates in rather simplistic terms. Robert Blumen, a regular contributor to the Mises Institutes website and a follower of the Austrian School of economics, will then provide a more theoretical analysis of the phenomenon of inflation in a piece entitled Debt and Delusion. Roberts analysis draws heavily on Peter Warburtons excellent book, Debt and Delusion: Central Bank Follies that Threaten Economic Disaster (The Penguin Press, 1999), which we highly recommend to our readers. I shall then follow up with some investment conclusions and round up this report with a piece by Peter Haenseler about Russian real estate investment opportunities. China, today, we find a similar deflationary boom. Prices of a large number of consumer goods are declining rapidly, which is boosting real incomes spent on these goods and leading to a rapid expansion of these markets in terms of physical units. In their China Investment Strategy Weekly Bulletin of October 6, 2005, Yan Wang, senior editor, and David Abramson, managing editor, of Bank Credit Analyst Research (www. BCAresearch.com) include two figures that depict the process of a deflationary boom better than I could possibly explain. Figure 1 shows that since 2002, car prices have declined by 80%, while output has risen from 2 million units to 5 million units annually. Similarly, we can see from Figure 2 that the sharp decline in cellular phone prices has lifted the number of cellular phone users from less than 50 million in 2000 to over 350 million currently. Deflation in these sectors of the economy has enabled more and more people to purchase these goods and has dramatically expanded their markets in terms of units sold. So, what is wrong with deflation? Maybe Mr. Greenspan and Mr. Bernanke can explain this to us. As far as I am concerned, deflation in this particular instance is beneficial to real economic growth, leads to a deflationary boom, and is nothing other than an increase in the purchasing power of money. I concede, however, that measured against Chinese property prices, which have increased considerably, there has been a loss of purchasing power of money. But what is important to notice here is that deflation isnt necessarily bad, and that

SOME MISCONCEPTIONS ABOUT INFLATION AND DEFLATION

There are numerous misconceptions about inflation and deflation. The most common misconception is that whereas a moderate dose of inflation shouldnt be a cause for concern, deflation should be avoided at all costs, as it is considered most disruptive to the economic system (Mr. Bernankes dogma). The notion that deflation is an economic calamity might arise from the blackand-white images of unemployed workers lined up at soup kitchens, taken during the deflationary Great Depression of the 1930s, with which we are all familiar. But what investors tend to overlook is that the entire 19th-century economic expansion in the US at that time the emerging market of the world occurred amidst deflation. Real per capita incomes were doubling every 40 years or so, not so much as a result of wages increases but because of declining prices for consumer goods, which were brought about by huge productivity gains and declining transportation costs following the construction first of canals and later of railroads across the continent. In

Figure 1 Chinas Deflationary Boom: Motor Vehicles, 20022005

Source: www.BCAresearch.com

Figure 2 Chinas Deflationary Boom: Cellular Phones, 19992005

Source: www.BCAresearch.com

both inflation and deflation can coexist in different sectors of the economy. So, when Fed officials talk about rising inflationary pressures, it is a meaningless statement. Inflationary pressures have manifested themselves ever since the Federal Reserve Board was founded in 1913, and are reflected in the colossal loss of purchasing power of money since then. At times, this loss of purchasing power came about as a result of rapidly rising consumer prices (the 1970s); at other times, it was a result of rapidly rising asset
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prices (from the 1980s to the present day). To be fair, this loss of purchasing power of paper money hasnt occurred only in the US; to a larger or smaller extent depending on the rate of money creation it has occurred in every country that has a central bank! Therefore, to target inflation as a monetary policy is the ultimate economic sophism, since inflation is nothing other than an increase in the supply of money. In fact, the best way to visualise this loss of paper moneys purchasing power as a result of the

process of printing money is to compare the price of gold, whose incremental supply is limited, with the value of the paper money issued by a country. In an environment where the value of paper money is stable, the price of gold should remain more or less constant. But in an environment where paper money is losing its purchasing power, the price of gold will move up. A country whose paper money has had the largest loss of purchasing power will see the gold price increase the most (for example, Zimbabwe dollars in the last few years, Latin American currencies in the 1980s, etc). Figure 3, courtesy of www. Thechartstore.com, shows the price of gold in US dollars since 1800. We can see that, with the exception of the American Civil War, gold prices held steady between 1800 and 1933. Thereafter, the value of paper money began to erode considerably as a result of money growth exceeding the supply of gold by a wide margin. Now, I am not arguing that comparing the price of gold in a country with the value of its paper money is a perfect way to measure the paper moneys increase or decrease in purchasing power. In an economy, paper money will always gain in value against some items that decline in price (such as transportation costs up until recently, and communication cost currently, as both have fallen in price) and lose in value against some other items such as health-care and education costs, and home prices. (These sectors are inflated, but the amount of paper money that needs to be spent to buy one ounce of gold provides an approximate indication at least in terms of purchasing power of a countrys paper money stability over longer periods of time.) I also concede that at times the price of gold can over- or undershoot its equilibrium price as a result of speculative excesses (as in the late 1970s) or total neglect (the late 1990s) on the part of investors (see Figure 3). One way to target inflation with monetary policies would obviously be to try and keep the gold price as steady as possible over longer periods of time (but not by
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Figure 3

Gold in US$, 18002005

Source: www.Thechartstore.com

intervening in the gold market itself). The second misconception about inflation arises from the belief that when asset prices decline, the economy will experience a recession. While this was certainly true of the Great Depression in the early 1930s and to some extent of Japan post1989 and of Hong Kong post-1997, the causes of asset deflation must be taken into account as well as the alternatives, which might have far worse consequences. In all three cases just mentioned, the asset deflation was preceded by a huge asset inflation, which was fuelled by the monetary authorities and driven by excessive money supply and credit growth, and extremely lax lending standards. That these asset bubbles had to burst at some point was inevitable. Moreover, since consumption was driven during the boom at least to some extent by these asset inflations, their end
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also had some negative implications for consumption. But if we look at the asset deflations that occurred in the 19th century, and in the 1973/ 1974 and 1981/1982 recessionary periods during which some assets such as equities and regional housing markets declined in value, it isnt the deflating assets that led to the recession but the other way around. The downturn in the business cycle led on these occasions to declining asset values. Only when highly expansionary monetary policies boosted asset values excessively as a percentage of the economy, as was the case in the US (1929), Japan (1989), and Hong Kong (1997), did their subsequent downturn lead to recessionary periods. (Ways to measure asset prices as a percentage of the economy would be to look at stock market capitalisation or home values as a percentage of GDP.) Faced with asset deflation, the monetary authorities can try to

support asset prices by massively increasing the quantity of money and cutting interest rates to artificially low levels (as the Fed did post-2000). Thus, if sufficient money printing had been implemented in the US (post-1929), in Japan (post-1989), and in Hong Kong (post-1997), I suppose that the asset deflation in nominal terms could have been largely avoided and asset prices in nominal terms might even have continued to appreciate (as they did in Latin America in the 1980s). However, in real terms, the asset deflation would still have taken place, as the excessive money printing would at some point have led to rising consumer prices and interest rates, and to a weakening or collapsing currency. US money printing in the 1970s left the Dow Jones, in 1982, at about the same level, in US dollar terms, as it had been in the mid-1960s. But in Swiss Franc terms (then the strong
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currency), the Dow had declined by almost 70% between 1971 and 1978 (see Figure 4). Moreover, despite a rapidly expanding money supply, two vicious recessions in 1974 and 1981/1982 still took place. It is likely, therefore, that excessive money printing in the case of the US post-1929, Japan post-1989, and Hong Kong after 1997 would sooner or later have led to consumer price increases that would have exceeded asset price increases and, therefore, as was the case in the US in the 1970s, asset prices would have deflated in real terms. (Between 1964 and 1982, the Dow Jones lost 70% of its value in real terms.) Moreover, another possibility following an asset bubble but not very likely if extraordinary monetary policy measures la Bernanke are implemented would be that, despite all the money printing, both asset prices and consumer prices still

decline (liquidity trap). In such a case, consumer prices decline far less than asset prices and squeeze households who relied on the asset inflation to boost their consumption. (The affordability of consumption becomes a problem.) In fact, it should be obvious to anyone except central bank officials that if money printing was to ensure eternal prosperity, a gold standard under which money printing is extremely limited would ensure continuous depression. But under both the gold standard of the 19th century and the central banking system as we have it today, periods of expansion have always given way to periods of recession no matter how much money was printed. In addition, it is likely that the central banking system has led to more pronounced business cycles, with more extreme boom times being followed by more severe downturns. In this respect, the next recession

whenever it comes will be very revealing for students of economics and, in particular, monetary policies. (It will be interesting to see whether Mr. Bernanke will pass this test with summa cum laude.) Should the next recession only be mild, shallow, and brief, I will admit that I have been too harsh in my criticism of Mr. Greenspans expansionary US monetary policies since he became Fed chairman, and especially as far as the last couple of years are concerned. However, should the next real recession be as vicious and persistent as I believe it will be, then the futility of money printing in order to prevent an economic downturn brought about by the bursting of an asset bubble that has been allowed by the monetary authorities to blow out of all proportion because of ultraexpansionary monetary and credit policies will be very vividly exposed.

Figure 4

Dow Jones Industrials in Swiss Francs, 19702005

Values divided by four for scaling purposes

Source: www.Thechartstore.com

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A ROADMAP TO FINANCIAL RUIN!

For as long as the Fed perceives the economy to be healthy, it is almost a certainty that it will continue to increase the Fed fund rate in baby steps to between 4.25% and 4.50%, and possibly even higher. Some observers believe that in order to gain credibility, Mr. Bernanke will increase rates more aggressively than Mr. Greenspan intended. However, the economy is most likely far less healthy than what Fed officials believe. Plunging consumer confidence and especially the Consumer Optimism Indexs expectations seem to confirm this point (see Figure 5). (The Consumer Optimism Index, compiled by Ed Yardeni, is the average of the Consumer Sentiment and Consumer Confidence indexes.) Note the close correlation between the Consumer Optimism Index and stock prices in the past, which would under normal circumstances suggest a significant downside risk for equities in the near term. But here is my point: the market participants may be beginning to anticipate that the Fed will shortly (in the next three to six months) wake up to the fact that the economy isnt as healthy as it thought. And once the Fed notices, home prices will decline (as is indicated by the sharp drop in the shares of homebuilding companies), and consumer spending will stall or even decline moderately. Mr. Bernanke, whose principal concern is deflation, will immediately cut interest rates again and move to an expansionary monetary policy. Depending on the Feds view on the impending threat of asset deflation and its negative consequences for the economy, the money-printing press could, in this phase two of our roadmap to the next severe recession, possibly run at full speed. This renewed monetary easing is likely to stabilise asset prices. This is what the stock market may now already be discounting by not selling off and following the Consumer Optimism Index on the downside. However, in phase two of our
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Figure 5

Consumer Optimism Index and Stock Prices, 19962005

Source: Ed Yardeni, www.yardeni.com

roadmap to ruin, two new trends will likely become more persistent. From Figure 6, courtesy of Barry Bannister of Legg Mason, we can see that, in the past, upturns in commodity prices have always led to upturns in the Consumer Price Index, while downturns in commodity prices have always led to declining consumer prices except for the period post-Second World War when, after 1980, declining commodity prices only led to a deceleration of consumer price increases (disinflation, as opposed to deflation). Why was the pattern of declining commodity prices bringing down consumer prices broken after 1980? Very rapid money supply growth and unprecedented budget deficits in peacetime led to rapid debt growth, which prevented consumer prices from deflating. From Figure 7, we can see that following Paul Volkers monetary squeeze of 1979/ 1980, money supply growth exploded in the period 19821986. I would argue that if money supply hadnt exploded at the time, it is likely that we might have experienced for the first time since the Second World War declining consumer prices for several years in a row. (This would certainly have been the case under a gold standard.) Note that whereas in 1983 most economists, including Milton Friedman, expected consumer

price inflation to reaccelerate based on the rapidly expanding money supply it didnt happen, as inflation had moved away from consumer price increases to asset inflation (bonds, stocks, and real estate). There were at the time two main reasons for the moderation in consumer price inflation. First, as can be seen from Figure 6, commodity prices tumbled after 1980, which certainly removed some inflationary pressures for consumer goods prices. In addition, as a result of rapidly growing US consumption, Asian manufactured goods began to flood the US market and pressured at least manufactured goods prices. This trend has continued, as Chinese imports began to increase very rapidly in the 1990s. Rising imports of lowcost Chinese goods then led to import price deflation and contained wage increases in the developed world. The trend to declining wages in real terms gained momentum in the last few years as more and more high-value services became tradable and allowed their outsourcing to countries such as India. We can therefore say that, in the 1980s and 1990s, the developed world enjoyed the tailwind of declining commodity prices and the outsourcing of production and services to low-cost countries, which, despite easy monetary policies, didnt
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Figure 6

PPI All Commodities Index and US Consumer Price Inflation (Y/Y% Change), 17932004

Source: Barry Bannister, Legg Mason

Figure 7

Money Supply M2 in 1982 Dollars (Y/Y% Change), 19602000

Source: The Business Picture

lead to rising consumer price inflation. (Other factors contributing to disinflation were the peace dividend, privatisations, and aggressive cost-cutting measures by the corporate sector and not to be forgotten declining interest rates, which reduced the financing costs of companies.) But the next time the Fed embarks on a massive liquiditycreating exercise (such as the one Mr. Greenspan implemented following the Nasdaq collapse in 2000), these favourable conditions may no longer be in place. For one thing, it is evident that the commodity cycle has turned up (see Figure 6). And while I dont rule out a meaningful correction for industrial commodity prices, it would seem to me that the dynamics of demand and supply as a result of the growing need for commodities from countries such as India and China, which are in the process of industrialising at breakneck speed, are so vast that, in the absence of a global deflationary depression, the demand will structurally exceed supplies especially for energy for years to come. Therefore, my view would be that we are at the beginning of a long-term upward wave in commodity prices that could last for another 15 to 20 years. (Commodity cycles, also called Kondratieff cycles see Figure 6, tend to last between 45 and 60 years from peak to peak.) Also, one should consider that whereas industrial commodity prices look stretched and vulnerable at present, many soft commodities such as cotton and agricultural commodities have not yet participated in the commodity cycle upturn. Their future rise could cushion at least to some extent any medium-term decline in industrial commodity prices. So, whereas declining commodity prices provided expansionary monetary policies with a tailwind between 1980 and 2000, from here on their price increase could become a strong headwind. (In September the CPI increased by 4.7%.) As far as the benefits from lowcost imports and the outsourcing of
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services are concerned, it is debatable whether import prices will continue to deflate. I have no doubt that China and India are both at the beginning of huge market share gains in the production of goods and the provision of high-value services, which will keep some pressure on prices and wages in the Western world. In fact, it wouldnt surprise me if, one day, Chinese exports were to make up 2530% of the worlds total exports, up from around 12% currently, and if research facilities in India were to account for a huge chunk of global R&D spending and any imaginable tradable services. But therein lies precisely the threat to higher global inflation rates, for two reasons. If both India and China are so successful at gaining global market share in export markets and in tradable services, their demand for natural resources especially energy could increase possibly far more than even the commodity bulls anticipate and pressure prices to far higher levels than we expect. Moreover, if both China and India not to mention a host of other countries such as Russia, other former Soviet Union states, and Vietnam are so successful at hollowing out the economies of the Western world and especially the US, what will the governments of these economically threatened countries do? They will try to force these new competitors on the block to revalue their currencies in order to make them less competitive. Should this fail, however, or succeed only partially, the central bankers of the Western world will print money and debase their own currencies (competitive devaluation). This will be particularly tempting for Mr. Bernanke, who believes that budget and current account deficits dont matter, as well as for US policymakers, since 90% of Americans dont have a passport and so wouldnt even notice that the dollar was losing value against foreign currencies. Moreover, since the foreign indebtedness of the US is denominated in US dollars, at first sight the easy monetary policies by
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the Fed which are designed to lower the value of the dollar against its principal economic competitor and geopolitical arch-rival, China, which owns a big chunk of the American debt in the form of foreign exchange reserves, would seem to punish China most. (The Japanese would also be punished, but, feeling threatened by China, they would go along with any economic policy that could hurt China.) As we have seen above in our roadmap to the next severe recession, the Fed will, in phase one, continue to increase short-term rates in baby steps. In phase two, when the Fed realises that the economy is weaker than expected, it will reverse its tightening bias, cut rates, and ease massively. Along the way, it will blame the undervalued Chinese currency, which gives China an unfair competitive advantage for the soft patch in the US economy. However, as I have tried to explain above, a policy where the Fed eases in the upward phase of the long-term commodity cycle, and with the US recording such large current account deficits and a staggering negative net asset balance that requires foreigners to acquire at least US$2 billion of US debts every day, could backfire very badly. For one, it is far from certain that the coming soft patch in the economy whenever it comes and however severe it turns out to be will be accompanied by moderating upward pressures on consumer prices and wages. Commodity prices may possibly remain firm or ease only moderately, or some import price inflation may become visible. It is also conceivable that wages for employees in the service sector whose services are not tradable will rise more rapidly than in the past in order not to let wage increases fall behind the rate of consumer price inflation. (The vast majority of service jobs, such as those in the hospitality industry, retail, fast food, health and beauty care, government, and so on, are not tradable and, therefore, are immune from being outsourced to foreign countries.)

Moreover, since Mr. Bernankes main concern will be deflation of asset prices in particular, homes it is likely that the money-printing press will be turned on at full throttle. In any event, I suspect that once monetary policies reverse from a modest tightening bias, such as we have had over the past year or so, to an easing bias, the dollar and the bond market will begin to weaken in earnest. In fact, the weakening bond market may have already begun to discount this coming easing bias and its inflationary implications. In addition, I simply cannot believe that foreign creditors will forever accumulate US dollars when they realise that there is no will at all among US policy-makers to redress what are, in the long run, unsustainable external imbalances. Whether it is at that point of phase two of our roadmap to the next serious recession that the dollar will collapse against gold or foreign currencies is debatable, but some crisis of confidence in the dollar is almost a certainty. The weakness of the dollar, even at a time of a soft economy, will likely lead to some upward pressure on US interest rates. This could force the Fed to ease more than it originally intended in order to support the asset markets. At this stage, dollar weakness, rising commodity prices, and rising import prices could lift the rate of consumer price increases and the yield on longterm bonds above the rate of asset and wage inflation (declining asset prices and wages in real terms). If that were to occur, the economy wouldnt benefit from the easier monetary policies at all. Moderate stagflation would follow. In this situation of poor or no economic growth but modest inflation, the Fed will likely opt for an all-out assault to revitalise growth with its monetary tools and massively monetise with extraordinary measures. This would occur in phase three of our roadmap to ruin. Asset prices would then rise in dollar terms, but decline in terms of gold or if there still existed any hard currencies. In phase three, I wouldnt rule out that the Dow Jones could rise
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to 36,000 (see James Glassman, Dow 36,000, New York, 1999) or 40,000 (see David Elias, Dow 40,000, New York, 1999), or 100,000 (see Charles W. Kadlec, Dow 100,000: Fact or Fiction, New York, 1999). As an aside, I bought all three of these books to add to my financial curiosities collection. (Note that they were all published in 1999.) However, in gold terms, the Dow no matter how high it will rise in dollar terms (even to 100 million) will most likely decline to a Dow/ gold ratio of around 10. (See Figure 8, which shows how many ounces of gold are required to buy one Dow Jones Industrial.) So, if the Dow were to rise to 36,000 as a result of massive money printing, the price of gold would rise to $3,600 in order to achieve a Dow/gold ratio of 10. I might add that at present the Dow/ gold ratio is still very high by historical standards and could, in an extreme crisis of confidence, decline to around 1, as was the case in the 1930s and in 1980 (see Figure 8). With the Dow at 36,000, this would mean an ounce of gold would sell for $36,000 as well! In this third phase of our roadmap to economic and financial ruin, consumer price inflation and interest rates will be extremely high (hyperinflation). The economy, however, will slump, as wage increases will badly lag behind the rate of asset and consumer price inflation. In phase three, wealth inequity will reach extremes and lead to a breakdown of American societys social fabric. At the beginning of phase three, foreign exchange controls will be imposed and the ownership of gold will be declared illegal. Also, oil and gold companies could at this point be appropriated and nationalised. (If not, we can be sure that an excess profit tax will be imposed.) In this phase all dollar bills below $100 in face value will have been retired and will be sought after as curiosities and collectors items. Phase three will be an age of penniless billionaires. (There are currently more than 300 billionaires in the US, compared to fewer than 10 in 1980.) The likelihood of a major war breaking
8 The Gloom, Boom & Doom Report

Figure 8

Dow/Gold Ratio, 19002004

Source: www.sharelynx.com

out will be highest during this phase. Religious and racial intolerance will become dangerous, as the government will need to blame a minority for the Schlamassel (mess) it has created. Now, I know that some readers will be questioning my sanity. However, what I am describing is already well under way. I am grateful to Barrons for having published recently a figure that shows the loss of purchasing power of the US dollar in the last 100 years (see Figure 9). The figure is actually the reciprocal pattern displayed by the price of gold in Figure 3. As the price of gold rises, the value of the dollar declines. Barrons explains that the log scale in Figure 9 of the purchasing power of the dollar begins with an index value of 100 at the passage of the Mint Act of 1792. The solid lines present periods when the dollar was convertible into a quantity of gold, and the fluctuations represent changes in the purchasing power of gold. (Note that the purchasing power of gold increased in the deflationary periods, or commodity downward waves, of 18141845, 18641895, and 19211942 a subject Fred Sheehan discussed in a report entitled Gold and Flations (see GBD report of April 20, 2005, entitled The Performance of Gold during Inflation and Deflation). Barrons continues:

[T]he dotted lines present periods when the dollar was not pegged to gold, during and after the War of 1812, the Civil War, World War I and World War II. There was limited convertibility from 1945 to 1971, but the dollar lost purchasing power during the period. The link between the U.S. currency and gold was cut in 1971 and the loss of purchasing power accelerated. By 2004, the dollar had lost more than 92% of its original purchasing power. (Emphasis added) What is interesting about Figure 9 is that for as long as there was no Federal Reserve, the dollar maintained its purchasing power (18001913). But once the Federal Reserve Board came into existence, and especially after the link between the US dollar and gold was cut in 1971, the dollars value began to slide in earnest. My point is simply this: the last time around it took 100 years for the dollar to lose 92% of its purchasing power. But with Mr. Bernanke at the Fed, it wont take another 100 years for the same to happen again! From here on, events will unfold at a rapid pace. This is a high-confidence prediction. As a commentator recently remarked, Mr. Bernanke was moved from the Board of Governors at the Fed to become the Chairman of the White House
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Figure 9

The US Dollars Purchasing Power, 18002004

Source: Barrons

Council of Economic Advisors four months ago, bringing him inside the White House for a while so that the President could become comfortable with him before his appointment as the Chairman of the Federal Reserve Board was made. Correct. The President had to be absolutely sure that Mr. Bernanke was really serious about the Feds power to print money and, in emergencies, to drop dollar bills from a helicopter in order to finance this administrations ill-fated military follies and alarmingly rising debts which are fuelling asset inflation and financing excessive US

consumption. So much for the Feds independence! Following Neros first devaluation of the denarius in AD 54, when he reduced the coins silver content from 100% to 94%, it took almost 200 years for the denarius to lose around 70% of its value. In AD 244, under Gordian, the denarius still had a silver content of 28%. (Without machines that can print paper money, there are some physical limitations on how fast new coins with a lower and lower silver content can be issued and distributed throughout an empire. With

electronic money, this constraint doesnt exist.) However, during the following 24 years the rate of depreciation of the denarius accelerated, and by AD 268, under Claudius Gothicus, the denarius had a silver content of just 0.02% (a 99.9% loss of value in 24 years)! I might add that the deflationists will tell you that the purchasing power of money will increase. But if you look at Figure 9, how likely is this? In my opinion, at least in this instance, the trend of the dollars and other paper moneys diminishing purchasing power will, for now, remain by far your best friend. At the end of phase three, the system will break down. A major financial reform will become unavoidable. A gold standard will be reintroduced. A deflationary stabilisation crisis will follow in phase four of our road to financial fiasco. Large segments of the population will be totally impoverished. Smart hedge fund managers will all have sold their businesses to banks and will have left the US to live in the Caribbean, Brazil, Singapore, or Thailand, while members of the Federal Reserve Board will either be in jail or defending themselves from class action suits in costly litigations in courts of law. In the meantime, as John Law once fled France to settle in England in a luxurious home (which was later burned down), Ben Bernanke will flee the US in a hurry; unlike Mr. Law, however, he wont even be able to afford to buy a shed with his billions of worthless dollars. * * *

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Debt and Delusion

Robert Blumen, robert@RobertBlumen.com Burned by the last serious outbreak of inflation in the 1970s, central banks have rededicated their efforts to the conquest of this pestilence. They have practised responsible stewardship over their national monetary systems ever since. Due in no small part to the benign inflationary environment that has followed their victory, stocks and bonds have outperformed historical averages. This reflects a high degree of confidence in future monetary stability and prosperity. Or so is the consensus view of recent financial history. This view is an occult mirror of reality, according to an undeservedly obscure work of financial economics, Peter Warburtons Debt and Delusion: Central Bank Follies that Threaten Economic Disaster. First published in 1999, the book rapidly went out of print. It has since become a cult classic among financial contrarians and has recently become available again in a second edition. I first came across the book owing to its popularity in Austrian financialeconomic circles. Although not written from a strictly Austrian point of view, the argument echoes the Austrian Schools view of creditgenerated business cycles in many key aspects. My purpose in writing about the book is to present Warburtons thesis and to interpret it through an Austrian lens. create out of nothing the money with which to purchase the bonds. This is often referred to as printing money, although in modern times the money is usually created electronically rather than through the manufacture of paper notes. After suffering one episode of runaway prices, public opinion had turned against inflation by the early 1980s. The political parties associated with the inflationary period had been voted out of office in the US and the UK. Chairman Volker had been appointed to head the Federal Reserve, a post from which he embarked upon a painful campaign of raising interest rates sufficiently to slow money supply growth. Warburtons story begins in the aftermath of Volkers triumph. The dilemma facing governments at the time was how to enable governments to continue spending beyond their means without suffering inflationary consequences. In this climate, a new outbreak of inflation would have contained the seeds of its own demise, for the following reason. For lenders to earn a real rate of return, nominal interest rates must exceed the rate at which the currency is losing value. Having recently been burned by inflation, bond buyers would have resisted any signs of rising prices by demanding higher bond yields. Such a marketdriven rise of interest rates would have given the central bank little choice but to follow with rate increases of its own to slow down money growth, or else risk a total destruction of the currency through accelerating inflation. Central bankers offered a way out of this dilemma, the centrepiece of which was a change in the method of financing government debt. Deficit finance bonds would henceforth be sold to private investors through financial markets. This would place the bonds in the hands of investment funds, rather than on the books of commercial banks, as would have been the case had they returned to the old style of monetisation. The subsequent explosion in the size and breadth of bond markets is illustrated by a few snapshots of gross issuances: less than US$1 trillion in 1970; US$23 trillion by 1997; and nearly US$43 trillion by 2003. A second part of the central bankers program was to rein in government deficits so as to reduce the need for borrowing. This advice has been widely ignored. Borrowing to fund government deficits exploded under Reagan, continued to soar in spite of the phony surpluses of the Clinton years, and has reached stupefying levels under George W. Bush. It is the interaction between this explosion of debt and what Warburton calls the capital markets revolution that has produced a new and deceptive manifestation of inflation.

THE INTEREST RATE ANOMALY

Scarcity requires that when a good is demanded in increasing quantity, the prices paid by increasingly eager buyers will be successively higher. Sellers who value a good the least are the first in line to sell. As buyers continue to search out a greater quantity of the good, potential sellers who place an increasingly greater valuation on the good must be recruited to supply it. Now think about credit as demand for savings. Economists of the Austrian School have advocated a banking system based on 100% gold reserves for demand deposits. Credit transactions under this system would be based on loans, with credit expansion by banks strictly prohibited. Under such a system, if increasing volumes of credit were demanded, borrowing would have to take place at ever-higher interest rates because savings are necessarily scarce; a higher interest rate is necessary to draw more marginal savers into parting with their present consumption opportunities.
November 2005

THE DEMISE OF INFLATION

During the developed worlds flirtation with hyperinflation in the 1970s, wage and price increases were driven by a rapid expansion of the money supply created by central banks to fund government deficits. The upward spiral was finally stopped when Fed Chairman Volker raised short-term interest rates enough to slow down monetary growth. The mechanism of the last major bout of inflation was the sale of government debt to commercial banks. In this process, called monetisation, banks or the Fed
10 The Gloom, Boom & Doom Report

While there is no limit to the amount of credit that can be created, there is an inherent limit to the amount of lending that can occur: the point where savers cannot be enticed to part with any more present goods at any rate of interest. The reason that the pool of savings cannot expand indefinitely is because people only have so much income or assets that they can save, and everyone must engage in some consumption in the present. Yet, as the fire hose of government bond issuances has flooded international capital markets with debt, interest rates havent risen much, are now lower than in the 1970s (a time of less borrowing), and in 2004 reached generational lows. It is dubious to maintain that the gargantuan volumes of bond purchases in recent years could have been funded out of savings when the US personal savings rate has also dropped to long-term lows. Bernanke has attributed the situation to a savings glut, blaming high-savings nations for saving too much and spending too little. While the purchase of government bonds by Asian central banks is part of the story, as Richard Duncan has written, even the largest purchasing nations dont have enough domestic savings to fund their purchases of dollar-denominated debt and must print money to make up the difference. Until Greenspan uttered the word conundrum, this anomaly hadnt attracted much attention or investigation. Indeed, most analysts now find this state of affairs to be utterly normal, requiring hardly any explanation at all. An alleged quote attributed to Vice President Dick Cheney deficits dont matter perfectly summarises the prevailing attitude. Notes Warburton, the incongruity of the massive accumulation of government and corporate debt with a low inflation environment no longer provokes much curiosity, even among professionals; and a stratospheric stock market has become accepted as the normal state of affairs, requiring no special explanation.
November 2005

Warburton wryly noted: Periodic bouts of price inflation, the tell-tale signs of a longstanding debt addiction, have all but vanished. The central banks, as financial physicians, seem to have effected a cure Few have bothered to ask how the central banks have accomplished this feat, one which has proved elusive for more than 20 years. As long as inflation is absent, who really cares exactly what the central banks have been up to. The solution to this puzzling anomaly is to identify the source of demand for government bonds. For this, we must examine what the central banks have been up to.

FINANCIAL ASSETS AND PRICE INFLATION

Debt and Delusion argues that the institutional changes described above have confined the price adjustments resulting from monetary expansion to the financial system. The character of the 1980s and 1990s inflation differed from that of the 1970s. In recent decades, price changes following money quantity changes have been in stocks and bond prices, rather than wages and consumption goods prices. Economists have long known of a general correspondence between changes in the quantity of money and its purchasing power. A nave quantity theory of money would have all prices moving by the same proportion in response to a change in the quantity of money. How can inflation sometimes affect financial assets and other times mostly consumer prices? The monetary framework of the Austrian economist Ludwig von Mises can explain this. Mises accepted a general relationship between money quantity and money prices, but he argued that the introduction of new money into a community wont affect all prices uniformly. Relative as well as general price changes will result. The particulars of magnitude and goods depend on where the new money

enters the economic system, and what the initial recipients spend it on. The initial recipients of newly created money, Mises noted, find themselves with a surplus of cash relative to their needs for immediate spending. They are in a position to increase their demand for the goods or assets that they wish to purchase, which will bid up those prices first. The sellers of those goods then receive the money second-hand, putting them in a position to demand more of some other goods, affecting those prices, and so forth. In essence, variations in the value of money always start from a given point and gradually spread out from this point through the whole community. In this way, monetary expansion will affect some prices more than others, changing relative prices as well as the general level of prices. With financial assets absorbing most of the impact of new money, the outbreak of inflation into wages and consumption goods that proved so unpopular in the 1970s has been (at least for a time) repressed. Newly created money was injected into capital markets, where it was initially spent on the purchase of government bonds. The low yields in government bonds have made low-yielding corporate bonds more attractive and equities with low dividend yields in competition with bonds an increasingly good buy. The inflationary price adjustments have leaked out of government bonds into other financial assets. But, over time, wouldnt the second or third recipients of the money spend it on cars or food, causing the inflation to leak out of financial markets into consumption goods? Eventually, when inflation is perceived for what it is, real interest rates will rise and financial assets deflate. While this must happen eventually, the game can be continued as long as inflation is contained within the financial sphere. The greater part of Debt and Delusion deals with the myriad mechanisms of this containment. They are interest rate arbitrage, gearing through financial derivatives,
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[Marc: Word(s) missing here]

the attraction of private savings from banks into capital markets, and management of public opinion about inflation. More will be said about each one of these below.

INTEREST RATE ARBITRAGE

The rate at which commercial banks can borrow from the Fed for shortterm loans is fixed by the Fed itself. Under the current monetary and banking framework, interest rates dont have to rise with increased loan demand to reflect the actual scarcity of savings. To fix the interest rate below the market-clearing level, the Fed must create whatever amount of money borrowers wish to borrow. Were they not to do this, instead allowing borrowing to be constrained by saving, the market-driven rate rises that would occur would choke off the boom in financial assets and deflate the leverage pyramid. Austrians dont see the interest rate as being set by the bond market, but by time preference, of which the bond market is only one expression. The productive structure of the economy, consisting of different capital investment projects at different stages of completion, is a more important expression of the time preference market and is (or should be) larger than the financial markets. Without central bank price fixing, argues Austrian economist Murray Rothbard, bond yields of different maturities would tend to be the same. Deviations could arise in one direction or another for some duration, but if, for example, fiveyear bonds consistently yielded more than one-year bonds, that would imply the existence of different rates of return not just for different bonds but also within the productive structure of the economy, something that couldnt persist permanently. Empirical research by Paul Kasriel suggests that the long and short bond yields tended to be more nearly equal prior to the existence of the Fed than afterwards. As long as a rate differential between short-term and long-term bonds remains, an essentially risk-free
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carry trade will persist no matter how much arbitrage occurs. Debt and Delusion locates the source of financial inflation in the ability of large bond buyers to borrow volumes of newly created money from the Fed at a fixed price. Because the interest rate doesnt rise to meet increasing quantities of borrowing, this arrangement generates volumes of synthetic demand for the government bond markets at longer maturities. Enough bonds are purchased to maintain their prices above, and their yields below, true market-clearing levels. Warburton terms this the illusion of an unlimited savings pool and notes that this illusion has grown more and more powerful and is matched by a new confidence among prospective bond issuers. Within Austrian economics, entrepreneurial activity is the activity of insightful actors who perceive profit opportunities that others have missed and who are willing to risk their capital to test their ideas. The continuing rearrangement of productive activity by entrepreneurs aligns production with consumer preferences. A crucial element of entrepreneurship, according to Austrians, is private property, which is put at risk when capital is allocated. Under central banking, financial markets are not real markets in the economic sense, although they are similar enough in appearance to fool a lot of people. In this environment, the term arbitrage is a misnomer because borrowing and lending is no longer a market-driven price adjustment process. The carry trade merely recycles debt from the central bank to government borrowing.

Derivatives are used to secure the control of a more expensive asset from a much smaller commitment of capital. The use of derivatives by hedge funds and the proprietary trading desks of large banks in relation to government bond markets represents itself as a grossly inflated demand for the underlying bonds. This acts as an artificial support mechanism for both bond and equity markets, keeping yields lower and asset values higher than would otherwise be the case. This synthetic source of demand is critically dependent on the downward progression of bond yields and on the slope of the yield curve. While there is a sense in which all demand for financial assets are [sic] contingent on their expected performance, this is especially true of geared and unhedged derivatives positions. Warburton explains how these leveraged contracts are used to generate a synthetic source of demand for financial securities. A hedge fund wishing to purchase $100 million of stock can put up $8 million and borrow the remaining amount from an investment bank. Then: It is possible to use unrealized gains in financial assets (including derivative contracts) as collateral for further purchases. The persistent upward trend in underlying asset prices has amplified these unrealized gains and has enabled and encouraged the progressive doubling-up of long positions, particularly in government bond futures. It is easy to envisage how the cumulative actions of a small minority of market participants over a number of years can mature into a significant underlying demand for bonds. While financial commentators are apt to attribute a falling US Treasury bond yield to a lowering of inflation expectations or a new credibility that the federal budget will be balanced, the true
November 2005

GEARING
A second mechanism of financial asset inflation is the use of derivatives to create additional purchasing power. The important feature of these contracts is the ability of one side to control a position whose value is that of a large volume of an underlying commodity for a much smaller amount of money.

explanation may lie in progressive gearing. The initial injection of new money into the bond market explains why the effects of inflation would show up there first. The continued containment of inflation within the financial sector as money is spent and then re-spent on financial securities is created by the leveraging available through derivatives. The funding of these derivatives is complex, but again it ultimately relies on borrowing at fixed low yields from the central bank. The process circulates the newly created purchasing power again and again back into the financial sector, rather than allowing it to leak out into wages or consumption goods.

their expectations of rising prices, their lowered demand for cash pushes up the prices now rather than later. The more people anticipate future price increases, the faster will those increases occur Deflationary price expectations, then, will lower prices, and inflationary expectations will raise them. Recent history would also suggest that people attribute more importance to the recent price changes of consumption goods in forming expectations about the future trends in the prices of consumption goods. Similarly, more importance is placed on price trends in financial assets in forming opinions about the future price trends in financial assets. Our publisher, Marc Faber, has observed that moves in asset price tend to attract little interest from the mass of investors until a trend has been in place for several years. The beneficiaries of the arrangement will do everything within their power to keep the game going as long as possible, including lying about the extent of actual inflation. To the extent that any monetary inflation at all has leaked out of financial assets into consumption goods, the distortions in the measurement of the US Consumer Price Index (CPI) have been introduced in order to create a false consensus that there is no inflation. A variety of questionable price adjustment stratagems have been instituted in the CPI computation: the exclusion of food and energy, the use of lower qualityadjusted prices, seasonal adjustments, and the replacement of home prices with rental rates. The index incorporates only consumption goods, when most of the price increases are showing up in financial assets. So successful has been the management of expectations that, until quite recently, inflation has disappeared from public discussion. Most of the public didnt view a succession of all-time highs in the stock market, or five years of annual 30% housing price gains in coastal

THE MANAGEMENT OF EXPECTATIONS

Mises investigations showed that the purchasing power of money depends on the supply and demand for money itself. The greatest determinant of the demand for money is public expectations of future prices. If prices have been stable, people will expect them to remain stable and money demand will remain about the same. If prices have been falling slowly for many years, people will expect them to continue to fall. In spite of accelerating money supply growth, if people dont believe that prices will rise in the future, inflation expectations can remain low while the growth of money supply proceeds. Rothbard has noted: suppose that people anticipate a large increase in the money supply and hence a large future increase in prices People now know in their hearts that prices will rise substantially in the near future. As a result, they decide to buy now to buy the car, the house or the washing machine instead of waiting for a year or two when they know full well that prices will be higher. In response to inflationary expectations, then, people will draw down their cash balances But as people act on
November 2005

cities, as in any way relevant to consumption prices. Growth in the money supply attracted no analytical attention from the mainstream financial media until gasoline prices moved to uncomfortable levels. Some prominent supply-side economists even advanced the ludicrous idea that the US economy was experiencing a deflation during the 1990s stock market bubble, and called upon the Fed to inflate even more. The successful management of inflation expectations has forestalled the eventual rejection of cash in favour of tangible goods that ultimately results from excessive money printing. The impressive reduction of inflation, writes Warburton, is a dangerous illusion; it has been obtained largely by substituting one set of serious problems for another. In the end, the public, intoxicated with the gains from stock market inflation, had adopted a dont ask, dont tell policy toward central banks.

THE CORRUPTION OF SAVINGS

A peculiar feature of the social psychology of financial asset prices is their self-reinforcing character. The upward trend in stock and bond prices has served to enhance the respectability of capital markets and their perceived safety as repositories of capital, which in turn has aided their cause of attracting even more of the meagre available savings from the private sector. Warburton documents a longterm trend of investment funds essentially chasing price inflation: shifting their cash out of low-yielding bank accounts, CDs, and money funds into bonds of longer maturities and, eventually, equities. Some commentators reason that inflation must now be quite low because the credit markets are patrolled by bond vigilantes, astute traders ever alert to punish central banks for their inflationary indiscretions, ready to dispense rough justice in the form of higher interest rates. This analysis assumes that
The Gloom, Boom & Doom Report 13

inflation is reflected primarily in consumption goods, and that bond yields are free to move on their own to convey meaningful information about changes in the value of the monetary unit, more or less the reverse of reality. The funnelling of inflation into bonds as described above provides a floor under bond prices and hence a ceiling on bond yields. The bond vigilantes have gone on an extended vacation. Another popular argument is that a stock market that is expensive measured by P/E ratios is cheap, or at least fairly valued, because low interest rates justify higher multiples. Stocks appear to be cheap in a dividend discount model that uses the current bond yields to discount future earnings. This view fails to take into account that the bond bull market is a symptom of high inflation, not low inflation. Inflated prices for bonds might make stocks look relatively cheap in comparison to bonds, but in the absolute sense both are inflated.

measures total stock market capitalisation to replacement cost) reached all-time highs in the late 1990s and are still above long-term average values. The financialisation of the economy the expansion of the financial sector relative to agriculture, manufacturing, and consumer retailing is but one example of these distortions. The run-up in commodities prices over the past few years is no doubt at least in part a symptom of the liquidity gone mad. The securitisation of US home mortgages and the resulting financialisation of housing is a third. The increasing domination of the stock market capitalisation and economic activity by financial institutions is noted by the New York Times: in recent years, financial services companies have quietly come to dominate the S&P 500. Right now, these companies make up 20.4% of the index, up from 12.8% 10 years ago. The current weight of financial services is almost double that of industrial company stocks and more than triple that of energy shares. It is also worth noting that the current weight of financial services companies in the S&P is significantly understated because the 82 financial stocks in the index do not include General Electric, General Motors or Ford Motor. All of these companies have big financial operations that have contributed significantly to their earnings in recent years. Financial companies now generate about 30% of the profits, after taxes, of United States companies, [financial economist Andrew] Smithers said. That is up

from 7% in 1982. In addition, profit margins at financial companies in the first quarter of 2004 stood at 32.6% of all corporate output, around 11% higher than their average since 1929 [Smithers] said. The economic purpose of capital markets is to provide a nexus between savers and borrowers for the financing of productive investment. Entrepreneurs are essential in forecasting the best uses of available savings and bearing the risk in an uncertain world. But a society cannot prosper by printing ever-increasing quantities of paper tickets representing claims for real goods, and drawing more of the population into trading these tickets back and forth among themselves. We cannot all make a living flipping real estate: someone must produce the goods that are consumed. As Mises wrote, The endeavors to expand the quantity of money in circulation either in order to increase the governments capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation. Warburton calls the recent period an excursion into the realm of financial fantasy. The fantasy is that central bankers have found a way to inflate without any negative consequences. While the effects of money supply growth can be confined to stocks and bonds, inflation is hidden in plain sight. The adjustment of relative prices between financial assets and consumption goods cannot be postponed indefinitely. The unwinding will not be easy or painless. Surely central bank follies now threaten economic disaster. * * *

CONCLUSIONS
But what does it matter if stock and bond prices rise relative to consumption goods? As economist Paul Krugman once wrote, Its paper gains today, paper losses tomorrow; who cares? The problem with financial inflation (not grasped by Krugman) is that investment decisions by entrepreneurs are based on relative prices. When relative prices are disrupted, as by financial inflation, the entire productive structure of the economy is distorted. The movement of real savings into real investment is stymied. Various measures of the size of financial assets, such as the stock market capitalisation to GDP ratio, and Tobins Q ratio (which

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The Gloom, Boom & Doom Report

November 2005

INVESTMENT IMPLICATIONS
It is likely that we are nearing the end of phase one of our roadmap to financial ruin. Further short-term rate increases in the next three to six months should cool down the housing market sufficiently and lead to lower stock prices. Once asset prices decline and negatively affect household wealth, the economy will be sufficiently weak to induce the Fed to move into phase two. The moneyprinting press will move into high gear. So, whereas some bond market strength might still occur in the next three months or so, bond prices will thereafter become very vulnerable as interest rates will begin to rise in earnest. It should be clear that the market participants will push up longterm interest rates, while the Fed will flood the market with liquidity and create artificially low short-term interest rates in order to support the asset markets (prevent deflation). I wish to stress an important point. While I would be very careful in playing a bond market rally, as the market may begin to discount phase two relatively soon, there is the possibility of such a rally sometime in the near future, for the following reason. When the asset markets begin to weaken and their weakness becomes obvious through poor economic statistics (consumption flat to down, GDP growth slowing down to a trifle, industrial commodity prices selling off), the deflationists will scream, Hurrah! Deflation is coming! Lets buy long-term US treasuries! But, as explained above, this will be just a temporary phenomenon before high-powered money drives the dollar down, and commodity prices as well as consumer prices higher, in phase two of the road to disaster. Given the views expressed above, I still recommend from a longerterm perspective avoiding bonds, although they may experience a rebound as Mr. Bernanke may push short-term rates up for a tad longer than Mr. Greenspan might have done, out of a wish to gain some respectability. The long-term bond market could greet such further Fed fund increases by Mr. Bernanke
November 2005

initially with some relief and may rally; however, its unlikely to be to new highs. In the tightening cycle of phase one, its unlikely that equities and commodities will perform well. In particular, we would, as advised in recent reports, avoid sub-prime lenders and home-building shares (see Figure 10).

So far, oil and copper prices have held up well. But, as explained in the past, the declining growth of foreign official dollar reserves (FRODOR) tends to lead to slower global economic growth, and so to slower growth in demand for oil and other industrial commodities (see Figure 11). Therefore, at least in phase one of our roadmap, commodity prices should

Figure 10 KB Home (KBH), 20002005 Still Significant Downside Risk

Source: www.decisionpoint.com

Figure 11 Foreign Official Dollar Reserves and Crude Oil Demand (yearly percent change), 19872005

Source: Ed Yardeni, www.yardeni.com

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Figure 12 Taiwan Stock Prices and Taiwan Stock Exchange Dividend Yield, 19982005

Taiwan: Stock Price Index

Source: www.BCAresearch.com

Figure 13 Volatility Index (VIX), 20032005

Source: www.decisionpoint.com

still come under pressure. Diminishing rates of growth in FRODOR are also negative for emerging markets, some of which (Eastern Europe, India) are extremely over-extended. For now, we would avoid the emerging market asset class. Still, a buying opportunity may emerge in Taiwan. My friends at the Bank Credit Analyst showed recently how high dividend yields in Taiwan were compared to domestic interest rates (see Figure 12). After the recent poor performance (the Taiwan Stock
16 The Gloom, Boom & Doom Report

Exchange Index is down 13% year to date), the downside seems to be limited. Individual investors could slowly accumulate the Taiwan Exchange Traded Fund (EWT). We are hoping for a gold correction, which might take gold prices down to the US$430$440 range and provide for a better entry point. However, in view of our forecast of a decline in the Dow/gold ratio to about 10 or less, the risk for investors clearly lies in not owning any gold and other precious metals

(see Figure 8). Still, given the Refco fiasco, it is important to make preparations for where and how to hold gold and ones other assets. We recommend holding gold and some other assets in accounts outside the US, and owning physical gold deposited in a safe deposit box. Diversification not only in terms of asset classes, but also in terms of custody, remains important for the prudent investor, especially as we move into phases two and three of our roadmap to financial ruin. For as long as the Fed fund rate is expected to rise, the US dollar is likely to have limited downside risk. Declining rates of growth of FRODOR (see Figure 11) are also supportive of the US dollar. Still, we would use current US dollar strength to diversify in terms of currency exposures. The US dollar is a doomed currency in the longer term, along with all other paper currencies. However, among all the bad paper currencies, we continue to like the Singapore dollar and the Malaysian Ringgit best. For Japan, inflation would be a boon for the property and stock market. We continue to recommend an overweight exposure to Japanese stocks and have little doubt that they will outperform the US over the next five years. Near term, however, some caution is in order, as bullish sentiment seems to be on the high side. I suspect that a correction of 10% or so is now likely. As recommended in recent reports, we believe that volatility will increase. Buy the VIX futures contract (see Figure 13). (Note that the VIX can only be bought through a futures account.) Our preferred asset class remains real estate in emerging economies. Properties in emerging economies offer a decent rental yield and capital protection in a more inflationary environment. My friend Peter Haenseler, with whom I have personally invested some funds, is the founder and CEO of PH Investment AG (PHI). PHI offers through its funds in Guernsey and Cayman Islands the possibility of investing in real estate projects in Russia. Peter has kindly provided the comments below on Russian real estate opportunities.
November 2005

Russian Real Estate: Tapping the Potential

Peter Haenseler, PH Investment AG Moscow Office: Mali Kharitonievsky 9/13, Building 4, Office 22, Moscow 107078 Tel: +7-095-234 1881; Fax: +7-095-234 1991 Zurich Office: Grossmnsterplatz 1, 8001 Zurich Tel: +41-43-888 6699; Fax: +41-43-888 6690 E-mail: ph@phinvestment.com; Website: www.phinvestement.com Peter Haenseler is the founder and CEO of PH Investment AG (PHI), which offers through its funds in Guernsey and Cayman Islands the possibility of investing in real estate projects in Russia. PHI funds invest in Class A office developments, elite residential projects, and shopping centres. The PHI group not only advises its funds on which projects to invest in, but also manages the process from the acquisition of the land rights, to development, design, construction, and exit from the respective projects. PHI currently runs two offices in Russia (Moscow [20 people] and Krasnodar [five people]), and an office in Zurich, which handles investor relations. Peter Haenseler has been active in the Russian real estate market for ten years and has a track record with only profit-making projects including the period of the Russian crises of 1998/1999.

MACROECONOMIC STATUS
By now most of the investment community has recognised that Russia is a market that should not be disregarded in the asset allocation of a sophisticated investor. After the crises of 1998, Russia proved that it was able to get out of the slump on its own. President Putin was elected by his people for a second term and enjoys an approval rate of around 75% a figure most other democratically elected leaders can only dream of. It is also true that the soaring oil price has helped Russia a lot. But I cant think of any Western nation that would have had the discipline to save most of this windfall profit in a stabilisation fund that is growing steadily. It was and still is tempting to use this money to subsidise the pension funds in Russia or for some other purpose. However, Mr. Putin is aware that spending these billions wouldnt help the country, because the structures are not yet efficient enough; the money would just be frittered away. Furthermore, Russia is one of the few countries in the world to have a budget surplus; it has proved wrong the many critics and so-called experts who claimed that the reforms had failed. A study by the World Bank (published on February 24 of this year) pointed out that the oil boom indeed helped the recovery and

growth of the economy, and that it could have been even better if it had been implemented more rigorously. However, the decisive force behind the growth was the achievement of successful reforms implemented by the Putin administration.

PUBLIC PERCEPTION
In the past year, Russia had an image problem with the West due to the Yukos affair. The West maintained that the Kremlin would nationalise private property again and didnt believe that the Yukos affair would remain a special case, as the Russian government was arguing. The consequence of the Yukos affair was, however, that major Russian companies started to pay their fair share in taxes definitely a good outcome for Russia and its growing economy. Needless to say, the Western media didnt report this very important fact to the public. Why? Most probably because this consequence proves that the media frenzy regarding Yukos was wrong. Figure 14 shows effective tax rates for the years 2002 and 2004 of selected Russian companies. On the other hand, it is indeed true that the Russian government intends to regain control of a strategic share of its natural resources industry. However, the government didnt proceed as predicted by the Western media. Gazprom, a publicly

held private company that is (still) majority owned by the Russian government, acquired the oil giant Sibneft from Mr. Abramovich for a market price. This is a clear indication that Yukos had been a unique case. The Western media, however, didnt come to this conclusion again because it would have proved that they were wrong. I spend every working week in Russia, where I have been doing business for the past ten years. The publics perception of Russia doesnt correspond with the reality at all. The Yukos affair mentioned above shows that clearly. If you live and work in a country, the day-to-day experience of running a business there is a good measure of whether that society is being steered in the right direction. Russia still has to overcome a mountain of problems in the next two decades and it should be allowed that time. Russia was looted for 70 years by the corrupt dictatorship of a powerful few. The system had about as much to do with communism as a cow with a jazz piano player. The progress the country has made in the last decade is impressive by anyones measure. The business environment is liberal and simple (if you discount the paperwork problems you have with the government). The Russians are extremely good business people and negotiators. The younger people

November 2005

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Figure 14 Effective Tax Rates of Selected Russian Companies, 2002 and 2004

modern office stock hasnt been able to catch up with the demand. The largest city in Europe has produced only about 700,000 sq. m. in the past year. Moscow has a total of about 4 million sq. m. of modern office stock, Paris around 32 million! One can ask, why arent the Russians producing much more office stock, like the Chinese are doing?

WHY THE REAL ESTATE BUSINESS IN RUSSIA IS DIFFICULT

Why did the real estate market not create the desperately needed space in the course of the last decade? The problem isnt the technical knowhow. Russians are skilled engineers; during the Soviet period they showed the world that they were able to run an impressive space program with a fraction of the budget of the United States. The problem lies with the Soviet heritage in certain fields of business. For example, in order to build a modern office building, over 200 permits are required (see Figure 16)! Most people dont have the nerve, the know-how, and the stamina to cope with such barriers. Furthermore, building office space is less profitable in the short run than building cheap apartment buildings. The majority of players build cheap apartment buildings with high shortterm returns; only a few developers are focusing on office space. Its not difficult to find investors who will put their money into a completed, fully leased building in Moscow. There are even Western funds who want to place money in finished projects. The problem is that there arent enough investment-grade buildings to buy. Such assets have to be developed first. There arent a lot of players in the market and until we started not a single Western player who offered to investors a Western-style product.

Sources: Company reports; Hermitage Capital Mgmt estimates

today have a bright future and lots of opportunities. Today, if you work hard and diligently, in return you will have a good life period. That is the reality. Statistics normally dont show in a persuasive way how much (human) energy a country has. In my opinion, energetic people are the main driver of an economy. But there is maybe one figure that impresses: the retail turnover serves as an indicator of the real purchasing power of the middle class, not of the rich happy few. Without a real existing middle class, no economy can achieve a high retail turnover. For example, a chain of doit-yourself shops cannot sell a million toilet seats to 200,000 rich people. Three years ago, the retail turnover in the city of Moscow reached about 40% of the turnover of Paris. Today, Moscows retail turnover is higher than that of Paris! This isnt a bubble; its people going shopping.

WHY RUSSIAN REAL ESTATE IS EXCITING

Whenever investors visit us in Moscow for the first time, they are flabbergasted by the gap between what they had expected and what
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they are confronted with. Moscow is by far the largest city in Europe, currently having 15.35 million inhabitants. Every day, the Moscow metro transports 9.3 million people (Paris transports 3 million and London 2.5 million). The energy level you feel in Moscow is hard to find anywhere else in Europe. The average income today in Moscow is on the same level as in Prague, the capital of an EU member! Peoples opinion before they visit Moscow is tainted by the Western mass media, who report on the billionaires and the problems but never on the millions of hardworking people who have been creating a modern and efficient workplace! Moscow is also the city in Europe with the highest potential for real estate development. The shortage of modern office space is unique: on average, European cities have a modern office stock of 2,900 sq. m. per 1,000 inhabitants; Moscow has the lowest rate of 270 sq. m. (see Figure 15)! With 5.1%, Moscow also has by far the lowest vacancy rate and it is expected to decline by another 1.6% within the next 12 months. For the last ten years, the production of

PHIS STRATEGY AND MANAGEMENT

Every good investment starts with research. PHI is the only Western fund which conducts its research with
November 2005

Figure 15 Modern Office Stock per 1,000 Inhabitants (in m as per Q2 2005)

Sources: CB Richard Ellis, Jones Lang LaSalle, H1 2005; PHI

Figure 16 Approximate Number of Building Permits Required in Moscow City

Source: PHI

its own team independent from agents and brokers. The PHI database contains over 6,000 completed and planned projects; this detailed information helps in reading the market and its tendencies. On this foundation, and through its widespread network, PHI is able to conduct independent project searches. The result is that PHI is able to get to the projects at an earlier development stage and, therefore, for a lower price. Control is everything in development projects. PHI therefore develops projects on its own or in a joint venture with a local partner. Control isnt a matter of reading biweekly or monthly reports; its about having your own people full-time on the site. This is what we at PHI do. Otherwise, development can be a very expensive adventure and not only in Russia. During the development phase, PHI begins working on the marketing campaign for the project, whereby our marketing team coordinates the production and design of the marketing materials and manages the agents with whom PHI works. In my opinion, a fund that takes on the role of a passive investor by just supervising processes and reading reports wont be able to work successfully in the Russian market. It wont be able to react as quickly, and to be as flexible in its strategies, as such a young and, therefore, volatile environment requires. In this respect, I feel that PHI has a definite advantage in terms of capitalising on opportunities as they arise.

November 2005

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THE GLOOM, BOOM & DOOM REPORT

Marc Faber, 2005
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