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America’s Leading Export: Inflation

November 30, 2010
Daily Reckoning

Daily Reckoning

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“Depending on how bad a crisis gets, gold ranges from being between the best answer and the only answer.”

Inflation is on everyone’s lips these days…everyone in Asia, that is. Because Fed Chairman, Ben Bernanke is so busy pumping up the US money supply to battle a perceived deflationary threat here at home, he is putting pressure on overseas economies to print money at the same pace, in order to prevent their currencies from appreciating against the dollar and, thereby, become less “competitive.” The mechanics of all this are a bit complicated, but suffice it to say that the US is “exporting inflation.”

This important topic hit the front page of yesterday’s The Wall Street Journal’s Money & Investing section. The paper posted official inflation rates for the biggest emerging market economies in Asia.

India leads the pack with an 8.6% official inflation rate. At that pace, prices would double in India in less than nine years. Indonesia is at 5.8%, China at 4.4% and South Korea at 4.1%. These are on the high side and increasing. Folks worry that central banks in these countries will tighten up their loose monetary policies to try to rein in inflation.

In so doing, these people worry economic growth will slow or even reverse. And that would have a wide impact on the world’s stock markets, as most of the growth that companies enjoyed in the last year came from Asian markets. After all, those rising commodity prices that delight commodity investors are due in good part to the demand from places like Asia.

China is already at work trying to contain price increases. It has implemented price controls, which never work. It has also tried to boost the reserve requirements of its banks, essentially forcing them to hold more in reserve and lend less.

This kind of tinkering and meddling creates its own problems and almost always ends badly. I should send a copy of Henry Hazlitt’s Economics in One Lesson to the world’s central bankers and policymakers – if only they’d read it.

I was in Baltimore last week recording an interview with my publisher, Addison Wiggin. We talked about this book, because Agora Financial has acquired the rights to it. We think it is an important book, so we are reprinting it. (You’ll hear more soon.)

Anyway, Hazlitt’s book is full of good principles and prescient predictions. The one key lesson he hammers home is to think not only of the immediate impact of any act or policy on one group, but to reason out the longer-term consequences for all groups.

For instance, the policy of encouraging homeownership seems a good one. But Hazlitt points out the problems of government-guaranteed mortgages. He wrote this passage in 1946, which is startling for its prescience. This describes exactly what happened in the big housing bubble that popped in the financial crisis:

“Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize bad risks and to defray the losses. They encourage people to ‘buy’ houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily over-stimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages) and may mislead the building industry into an eventually costly overexpansion.”

Remember, this was written in 1946!

If only more policymakers and central bankers had read and understood this passage, we could have avoided a lot of pain and losses.

This is also a pretty good way to think as an investor. For example, Hazlitt writes about inflation. He makes some good points that most people overlook. Inflation, he tells us, doesn’t mean that all prices rise at the same time. Inflation is really a process, as the newly printed money courses its way through the economy.

“The process of inflation is certain to affect the fortunes of one group differently from those of another… It may indeed bring benefits for a short time to favored groups, but only at the expense of others. And in the long run, it brings ruinous consequences to the whole community. Even a relatively mild inflation distorts the structure of production. It leads to the overexpansion of some industries at the expense of others… When the inflation collapses, or is brought to a halt, the misdirected capital investment – whether in the form of machines, factories or office buildings – cannot yield an adequate return and loses the greater part of its value.”

This brings us to the inflation worries in Asia. Most of the time, you’ll hear commentators talking about economies “overheating” as if it is the duty of central banks to cool things down. But really, the damage is already done. Inflation distorts markets. It leads to people making investments they might not otherwise have made.

So the only choice is continuing the inflation to its ultimate flameout, or stopping it earlier. Either way, the “misdirected capital” – as Hazlitt dubs it – loses the greater part of its value. Anyone who owned, say, a homebuilder stock over the last five years knows this all too well.

Where is the misdirected capital in Asia? That’s what you want to avoid.

It’s hard to say, or investing would be easy. But it seems fair to say that real estate is one to be careful about. The building spree in Chinese cities has surely been abetted by lose money and an approving nod from the powers in Beijing.

The whole region, but China in particular, has had a great boom in heavy industry. Producers of cement and steel are concerns, in my view.

But the process of inflation also creates areas of neglect.

The great commodity boom we’ve enjoyed in the last decade came about in part because the industry has been starved for capital for a long time. Investors were drawn first to the telecom, media and Internet darlings of the 1990s…then to the miracles of subprime loans and financing in the 2000s. As a result, the resource sector received very little new investment. The last financial crisis also tightened the spigot on investing in resources. A whole raft of projects suffered delay, or even cancellation.

This, too, doesn’t fall evenly on all commodities. Some have been harder hit than others. Just this past weekend, I read a good piece in Barron’s on the titanium miners. From the piece:

“Titanium miners have painted themselves into a corner, as a lack of investment during the downturn has made it difficult to keep pace with booming emerging-market demand now. Higher prices are likely to result.”

It goes on to cite some titanium plays. Iluka Resources – trading under the ticker ILU in Australia – is the second largest miner, after Rio Tinto. Its stock is up 112% this year. South Africa’s Exxaro Resources is up 25% and Kenmare Resources is up 21%. The latter has a mine ramping up in Mozambique.

We’ve seen other commodities enjoy tight supply: uranium, iron ore, hard coking coal and rare earths. Each of these has gone up in price in the last year. No doubt there are some distortions in these markets, too. But new supply is not so easily forthcoming, leaving a window for investors to make some good money.

Another commodity that should be good no matter how Asia’s inflation story plays out is gold. The strength of gold reflects concerns of the creditworthiness of the issuers of paper money. As a result, gold is near 52-week highs. Yet the stocks of gold miners have lagged the metal. Gold miners should put up some great numbers in the next few quarters, though, sending their shares higher.

Hang onto your gold stocks.

Finally, if you read only one economics book in your life, Hazlitt’s is the one I recommend. I tell people that this book changed my life because it changed many of my ideas on economic questions and set me on a path that I still follow today.

You’ll find Hazlitt’s book is also a doorway to other thinkers, should you decide to go deeper. His final section, “Notes on Books,” contains many excellent recommendations.

I found Hazlitt back in 1996 while browsing bookstore shelves. I had been studying finance and the great investors – Ben Graham, Warren Buffett, Peter Lynch, Phil Fisher and others – for several years. But I felt I wanted to get a better grounding in broader economic principles. I was looking for one readable book that had a good summary.

Hazlitt’s book is the one I found.

Regards,

Chris Mayer

for The Daily Reckoning

America’s Leading Export: Inflation originally appeared in the Daily Reckoning.


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