Ceteris Paribus

October 19, 2008

I understand their logic – historic credit growth contraction will lead to deflationary pressures in the economy – but credit growth just barely went negative for the first time recently and was followed by an intense intervention from governments around the world. There is absolutely no evidence yet of any deflation, all the money supply figures are growing. That doesn’t mean it can’t happen, but given the events of the past few days in many capital cities I find it unlikely. The inflationist argument was always dependent on such intervention and now that circumstances have changed in their favor, deflationists must adjust their analysis.

Decreasing paper asset prices do not constitute deflation. These values are based on human perception and are thus are a figment of our imagination, not money. If the price of a stock doubles, the money supply does not increase. Similarly, if the price of the entire stock market is cut in half, the money supply does not decrease. For each buyer there is a seller, no new money, no lost money. Exchange rates can fluctuate because investors cross international boundaries, but if you invest in an internationally priced commodity I’m not sure that matters. It’s the total supply of currency in the world that determines demand for your assets, that doesn’t change as a result of paper asset volatility. If the price of a mortgage is cut in half, the house does not implode. If the price of an energy company is cut in half, the oil doesn’t burn up. You must differentiate between real and imaginary.

Having said that, all this carnage does produce real psychological damage. We know that as fictional assets go up in price people feel wealthy and spend more, so we should assume the reverse will happen on the down side. As paper wealth dissipates people will hoard their remaining capital until some magical number is reached at which comfort and safety become assured. That number will be different for each individual. For example, for some people $100,000 would be more than enough to sleep comfortably at night. For others, it may be $1,000,000. For others, even more. But there is a number at which people will feel safe and psychology will change. Banks are just groups of people and they will behave similarly.

Now that bailouts are the reality and governments have commit to re-capitalizing the banks with infinite dollars until their psychology changes, the only question you should be asking is – then what? When the banks are brimming with cash and resume looking for investments that beat inflation, where will they turn? More dot-com startups? More houses? More planes, trains and automobiles? Unlikely, we already have enough of those. Maybe gigantic leveraged mergers and acquisitions of domestic corporations by foreigners. Maybe the money will be loaned right back to government to spend on massive infrastructure projects. Who knows, but it will be spent. And I believe, given the real supply shortages we face with many resources, once demand returns, supply concerns will return as well.

I am convinced that my strategy will prevail when the dust settles, but nothing is guaranteed. When I discuss these issues with people they are often misled into believing I am fully invested in commodities. I’m not. I hedge just like anybody else and I never take leverage. My hedge is cash. I discovered the number of dollars in my accounts that gives me comfort, and I only invest the surplus above that amount. The reason is as follows – technology. I am an engineer by training and I recognize the impact that computers and micro-processors had on reducing price inflation expectations during the past few decades, and I will never rule out the possibility that sweeping change could emerge once again. Whether it’s abundant free energy from geothermal or a break-through in battery technology or solar panels or nano-technology or something else entirely I have no idea, but you must protect against these sweeping events that render all previous analysis irrelevant.

Economist like to say “Ceteris paribus” meaning “All else being equal”. Unfortunately for investors (fortunately for historians) all else is rarely equal over the long run.