Part 1> The Injustice of the Correlation Between Ignorance and Pulpit
Part 2> Inflation vs. Deflation
Part 3> Investment Strategy

Part I – The Injustice of the Correlation Between Ignorance and Pulpit

“The fundamentals are strong”
“Debt is irrelevant”
“Whatever you do, don’t touch your 401k”.
“Ride it out”
“Nobody could have seen this coming”

I’m not frustrated about the economy melting down. In my eyes this was absolutely inevitable. I’m frustrated because of the horrible financial advice people are receiving on TV every day. Markets cannot work without good information and it is in short supply.

To prove that the saying “Nobody could have seen this coming” is completely without merit, here is one of the people I’ve been reading for the last few years. This is from 2006.

The older optimist in that video is likely to be on TV these days, calling the bottom and advising retirees that they should be investing in financials. Why he’s still on TV remains a mystery.

Oh, and here are the people in charge of fixing this mess:

Another blind optimist, Larry Kudlow, is watching his show slowing slip from his grasp. Jim Cramer’s ‘Mad Money’ is alive and well but Kudlow & Company has been turned into a generic roundtable of discussion about the economy. A few months ago, if the market was down, Kudlow would devote his show to the evils of the Democratic party (I’m not a Dem nor Repub). The evidence for his incompetence is now so overwhelming that CNBC had to do something. Kudlow wasn’t lying, he was simply unable to grasp reality.

Part II – Inflation vs. Deflation

Even before I knew the details of credit default swaps and commercial paper I knew that we were going into a nasty housing led recession and that the outcome would be either inflation or deflation. It is the only real question at this point. Over the next year stocks will trend down regardless (punctuated by insane rallies if history is any guide).

As I’ve been focusing more on this problem of inflation vs. deflation the issue of timing is key. It’s not a question at this point of which will we see. The outcomes are these:
1) Deflation followed by rapid inflation
2) Deflation followed by more deflation

I’ve always been in the deflation camp but I’m starting to turn. The Fed has a can of starch now. Pushing on a string to prevent deflation is no longer impossible. Bernanke may be ignorant but nobody will argue that he’s not crafty. I’m now more confident that he can destroy our economy using inflation. He referred to the printing press as a “technology”. The man is fiscal technologist.

The following paragraphs are the most important I’ve read in a very long time. Someone at the Council on Foreign Relations turned on a microphone and transcribed a discussion between some of the best minds thinking about these problems.

QUESTIONER: Thank you. I’m Jeffrey Rosen from Lazard. What you suggest for fiscal policy and monetary policy, massive stimulous deficits, low interest rates, implies an inflationary risk in the future. What you described for the asset market, a real estate market, commercial real estate market perhaps, certainly the residential real estate market, suggests an asset deflation risk. And I’m just curious which of the two you think is more serious and whether you think there are implications for what’s happening now, for asset deflation in the future which brings back to mind the Japanese type of scenarios. And if I’m allowed and he’ll take a minute, I’m just curious what Mort’s views are on the impact of all of this on the political season.

STEIL: I think both of them are serious, and the RTC fund I put forward with Mark Fisch in December was meant to address precisely that problem. But the inflation risk is also serious and we know that we can experience the two together in some combination. And the 1970s was a particularly bad period. I think in many senses the next five to 10 years are going to look like the 1970s; in other words we’re going to have at best very sluggish growth, we’re going to have elevated real interest rates, elevated inflation rates, elevated commodity prices. It’s going to be a painful period that’s going to involve both asset depreciation and an element of higher inflation.

ZUCKERMAN: Anybody else want to — ?

SETSER: I guess both of us.

ZUCKERMAN: Go ahead.

SETSER: I would put slightly more emphasis on the risk of asset deflation in large part because I think the process by which loose U.S. monetary policy was producing, super loose monetary policy in places like China and the Gulf that were pegging to the dollar and generating globally loose monetary policy, I think that process is about to go into reverse and that you’ll see a much stronger contractionary element from the global economy from the emerging world which will take some of the inflationary pressure off.

ZUCKERMAN: Nouriel?

ROUBINI: I don’t know. I think like in the cycle of 2001, 2003 in six months we’re going to start worrying about deflation, where suddenly asset deflation, slacking good labor and commodity market means inflation’s going to be the least of the problems the Fed has to worry.

You’re right about one point, if you’re going to essentially monetize all the fiscal deficit, that’s going to be made eventually inflationary. But I think that the way it’s going to be financed is going to be by public debt which is going to increase interest rates, but it’s not going to be monetized. Of the liquidity injection in the short run are satisfying a demand for liquidity that you can take away once the demand for liquidity goes away, so that’s not inflationary. And most of the — what the Fed does with the swap line doesn’t increase the money supplies, that’s the swap of bad assets for good assets.

So if we were to monetize, reduce the fiscal problem, absolutely, we’ll have a massive inflation problem down the line. But even–(inaudible)–said what Bernanke cannot afford essentially is throwing the inflation kind of expectation rise then because if inflation expectation comes out of the bottle then to bring it back you’re going to need a nasty bulk of this inflation, and we have a severe inflation. And even a–(inaudible)–Fed cannot afford to essentially monetize this problem. Then if we’re going to fiscalize it, we’ll have to raise taxes, cut spending, pass them onto the next generation. I think that’s the way that this crisis is going to be resolved, not with inflation.

ZUCKERMAN: I’ll just make a brief comment about the last part of your question. I believe if the election had been held two weeks ago, that McCain would’ve won. He was ahead in all of the key battle ground states as a quota. It’s amazing to me how close the election — the polls are to this moment. And since I don’t believe that the polls accurately reflect where the votes are going to come out and that votes will be much more than the polls indicated in McCain’s favor, it’s still a close election.

I cannot imagine that the impact of this crisis, which is going to make the economy the dominant issue from now until the end, unless there was some enormous gaffe or differential effect of the first debate, I just don’t see how Obama loses. If he does, it will really say something very, very serious about race relations, I have to say, because I think that’s the only issue that would defeat him if it were a generic poll. If it were any other Democrat, I think it would be a walk-away.

Part III – Investment Strategy

I’ve been advising all cash and 5 to 10% gold since the beginning of ’08. I think 5% gold is a good bet until the Fed Funds Rate hits zero, which could happen soon. At that point the Fed will have to get really creative in propping up markets using inflation.

This is almost unknowable. If inflation gets out of hand interest rates go through the roof (thanks to China selling dollars). That kills housing and bad mortgages are the cause of our problems. This is a hard problem because hyperinflation is a real threat but we’re the world’s reserve currency. I’m pretty sure nothing like this has happened in the history of human kind.

For the first time the Fed has the tools to actually fight deflation. Whether or not they will risk it remains to be seen. Bottom line – In my opinion now is a horrible time to buy stocks or housing. This ain’t the bottom. I really hope I’m wrong.