October 9, 2007, marked the day when the Dow Jones reached a peak at 14,198.83. On October 10, 2008, the Dow reached as low as 7,882.51 which is a decline of about 45%. These are tough and humbling times to be an investor or simply someone trying to save for retirement or a down payment on a house.
A 45% decline in the Dow over 1 year does not happen often. When we take a longer term look at investing, we can appreciate that we'll have years when we won't have gains, but at the same time, we'll have years when our gains will be terrific and we'll have years when our gains will be average. But ultimately, the goal of investing is to have gains and not lose them, and that makes years like this tough.
America and the world have seen massive wealth destruction both in real estate and business/stock wealth over the past 12 months, especially over the past month and a half.
This kind of wealth destruction is normally deflationary like what happened in the early 1930s: Falling prices for goods and services, falling house prices, falling stock prices, falling commodity prices.
Deflation:
Deflation is the opposite of inflation. Therefore, under the usual contemporary definition of inflation, 'deflation' means a decrease in the general price level.
Deflation is considered a problem in a modern economy because of the potential of a deflationary spiral and its association with the Great Depression, although not all episodes of deflation correspond to periods of poor economic growth historically.
I'm mentioning this because the topic of whether we will have a deflationary recession/depression or inflationary recession/depression will have very big consequences on our investment strategies.
It is and has been my belief that we are likely to be getting a more inflationary recession/depression over the next few years. So, as we are seeing the signs of deflation happening, commodities falling, house prices falling and stocks falling, we can take a look at what our Fed Chairman had to say about this.
He has provided us with his take on deflation and how it affected America in the great depression of the 1930's. He does not want America to have deflation and has provided us with his views on how to prevent deflation if it was to occur from a speech he gave in November of 2002 known as his "Helicopter Speech." Here are some samples from that speech that bear reading now as this credit crisis and wealth destruction occurs.
The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. (ME: That's inflationary) We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).
Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, (Me: At 1.5% now and may very well go to 0% as he suggested) the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. (Me: Buying $700 billion of toxic mortgage backed securities and now taking equity stakes in banks directly) Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. ( ME: AIG) Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
(Emphasis with underline and bold all mine.)
Our Fed and Central banks around the world are doing all they can to both alleviate the credit crunch and perhaps, without saying it, inflate away some of the debts outstanding via their actions.
So what's it going to be: Inflation or deflation?
Let's look at where we are now. Inflation in September showed year over year CPI increase in the US at 4.94%. This is down from 5.6% in July. If you have been holding anything yielding less than 4.94%, you have lost purchasing power. The hidden tax of inflation has eaten into your wealth.
US Treasuries maturing 3 years or less are all currently yielding less than 3%. It's no wonder Warren Buffett is selling his treasuries and buying stocks in great American businesses as per his recent Op-Ed in the NY Times. The world's greatest investor is not interested in negative rates of return, especially given the actions of the Treasury and Fed to print money and flood the system with ever more dollars that will likely lead to higher inflation.
In Warren's Op Ed to the NY Times, he states, and I think this is important, "Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."
So what is an investor to do to protect his or her wealth in an inflationary recession/depression when real rates of return are negative? Here is a starting point.
1. Invest in business that have strong franchises and can earn high returns on capital or don't need to invest in a lot of capital each year just to stay in business. These businesses should be able to pass off the higher costs of production to their consumers and still make high returns on capital. Many of these businesses pay dividends whose rates are now far higher than money market and treasury yields.
2. Consider having silver or silver mining shares in your portfolio. Or, own physical silver, if you can find any as there is a big shortage at retailers currently. Precious metals have always been considered a hedge against inflation, so it only makes sense that under current conditions, one has some precious metals in their estate, even if it's just 2% - as much as 15%.
One of the most interesting things about silver that makes it so compelling now is the price in relation to gold. About 160,000 tons of gold have been mined in the history of the world of which nearly all of it is still around today. That's close to 5 billion ounces of gold out there. It's been estimated that there have been 44 billion ounces of silver mined in the history of the world. Modern industry has used up a lot of silver through its various uses and some has been lost to simple abrasion. So, it's been estimated that there may be only about 25 billion ounces of silver left in the world. That includes all silverware, jewelry, medals and of course, coin and bullion. Also, industry uses more silver than gets mined every year so the above ground supply can continue to shrink.
So, 5 billion ounces of gold in the world and perhaps as much as 25 billion ounces of silver make the ratio of gold to silver 1 to 5. Yet as I write, gold is 782.90 an ounce and silver is 9.35 an ounce making gold over 83 times more than silver! This means that silver is either drastically undervalued to gold or gold is simply way overvalued. I think the price of silver is drastically undervalued Vs gold and that is why I own shares of iShares Silver Trust (SLV) and for more speculation, shares of Silver Standard Resources (SSRI).
Source for this info about silver came from here and other sources I've read over the years in either books or articles.
Disclosure: Long SSRI and SLV.
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This article has 33 comments:
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User 282433
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2 Comments
Oct 20 08:28 AMJP Morgan can loan "your" SLV silver to any hedge fund it wants. Odds favor, it would be to someone wanting to short it (borrow it from good ole JP Morgan and sell it). Since it's now common/accepted knowledge that hedge funds can drop like flies and bury themselves...there is simply no guarantee your silver "backing" will be in Morgan's vaults in a world of ever-escalating silver prices.
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User 282433
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2 Comments
Oct 20 08:32 AM-
brewtul
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9 Comments
Oct 20 10:08 AM-
sickofthehype
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236 Comments
Oct 20 10:43 AMInflation will be HUGE, so look out above...
Real estate will once again be a good thing to own in the near future.
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ozzy43
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60 Comments
Oct 20 10:53 AMI agree with brewtul - near term deflation then long term (probably hyper)inflation, thanks to both the feds and the Fed. The history of fiat currencies is pretty stark in this regard - we have centuries of history to rely upon for clear lessons. Just look at any chart of *real* inflation (i.e. increase in money supply) noting 1933 and 1971 and what happens to money supply afterward. A good primer:
www.chrismartenson.com...
Sections 6 to 10 are relevant to this discussion, but all are worth watching and thinking about.
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JasonC
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367 Comments
Oct 20 11:25 AMInflation indexed treasuries currently yield 3% real, 2-3 times a year ago. They are within 1-1.5% of unadjusted treasuries. Anyone who thinks there will be strong inflation ahead is clearly disagreeing with the market consensus, and can buy those. The risk is practically non-existent.
Better investments for those who believe deflation is much more likely are high quality bonds trading at distressed levels, (up to 15% for banks the government has made clear it will not allow to fail e.g.), loan participation closed end funds at double digit discounts to net asset value (with senior creditor positions, and profitable over the last year despite the turmoil), AAA senior tranches of private MBS on prime credits, yielding 6-7% above treasuries, etc.
It is outright crazy that these assets are being dumped at prices this attractive, while central banks make unlimited credit available at 1-3% rates. Nobody has the stones to step in an arb the spread. All the usual players who did such things in the past blew out, or had their short term financing costs spike, or banks pull their credit lines, forcing them to dump.
There is no fundamental reason for those spreads. It is a pure capital panic. Since the authorities are simply not going to allow that panic to cause systemic collapse, it is objectively entirely safe to buy all these classes of assets.
Those worried that interest rates will go higher in the medium term can hedge credit positions by owning TIPS as mentioned above, or use floating rate securities - some are available on financials that will yield twice the short rate forever with an 8% floor (because they are selling at half issuance price), and they are going begging.
These inducements to save, or to take on credit risk, are the highest in my lifetime and likely the highest any of us will ever see. Everyone brave enough to act on them is going to make a killing.
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derryl
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134 Comments
Oct 20 11:32 AMIn fact the "normal" way money enters the economy is via private commercial bank loans, not via Fed money. When a bank makes a loan to a business or a consumer or an investor the bank is not lending out someone else's savings. The bank is creating new financial credit which is new "money". That's what "banks" do. Various kinds of "mutual funds"--including guaranteed investment certificates sold by banks--invest people's savings, but "banks" as formally defined create the money in the first place.
Prior to 1913 many private banks issued their own money. In 1913 both the US and Canada passed their Bank Acts (England passed its own in 1914; other countries in other years). Federal governments have the Constitutional obligation to provide their nation with appropriate institutions for the creation and administration of money and financial credit. On the one hand the Bank Acts prohibited banks from issuing their own money (e.g. Bank of Nova Scotia dollars in Canada). On the other hand they formally gave chartered banks authority to issue and administer credit denominated in the national currency (US dollars, Canadian dollars, British pounds). The US Federal Reserve Act created the Fed in 1913, but Canada's Central Bank wasn't created until 1936. Britain's central bank, the Bank of England, was created in 1694 and was nationalized in 1964.
If central bank injections were the "normal" way money enters our economies, how did money get into the US and Cdn economies prior to the establishment of our central banks?
It is a simple fact of financial economics that bank loans are the creation of new money. When the loan principal is repaid, that money ceases to exist. In a modern economy only about 2% or less of the money supply in any currency exists as the coins and paper currrency that we carry in our wallets. Almost all "money" exists as numbers in bank accounts.
To make a "loan" of $1000, the bank adds $1000 to the credit balance in your bank account which you can then withdraw in cash or debit or write checks on. The bank also adds $1000 + interest to your "debt" account--you have to give the money back. The bank circulates money to borrowers, and the borrowers circulate the money into the economy. Eventually the borrower has to withdraw $1000 from the economy to repay the loan principal. You deposit the money in your account to restore your credit balance to at least $1000 and when the principal is repaid the bank reduces your account credit balance by $1000 and writes off your debt principal balance to $0 and the "money" no longer exists as either a credit or debt.
It began its life as numbers added to your bank account credit balance; it ends its life as numbers deleted from your bank account debt balance. This is not controversial. Any financial economics textbook will confirm that this is the mechanics of "normal" money creation and circulation into an economy.
You will note that the $1000 bank loan simultaneously created 2 things: $1000 of "credit-money&quo... and $1000 + interest of "debt-money"... If it's a one year demand loan at 8% interest then after one year you have to give the bank $1080 of money to payout your principal + interest. To repay your principal + interest you have to withdraw $80 more OUT of your economy than the $1000 you put INTO the economy.
The $1000 you circulated into the economy may well have generated more than $1000 of new "economic" wealth, but it didn't generate any new "money". Only the federal government and banks can create new money. Anyone else who creates money is called a "counterfeiter&qu... The real, physical industrial economy creates all the "real" economic wealth. But only banks can create the "money" that the economy needs to enable its productive and consumptive processes. Economic activity does not "make money". It makes goods and services. Only banks (and to a very minor extent government mints and printers) "make money".
Every country in the world that uses this system of bank-money is getting increasingly in debt for the simple arithmetic reason that banks always add more monetary debt into the system than they add monetary money. The world has become much richer in terms of real economic goods and services. All of these things--houses, cars, furnishings, food, etc.--have been built and everyone who contributed to building them has been paid. So why are we getting further in debt? "Really" we are much richer economically. "Monetarily" we are deep in debt.
This is a simple consequence of the arithmetic flaw in our system of money creation as bank loans with interest. Debt adds up fast. Every new loan adds more new interest obligation into the system without adding any new money to pay that interest, so borrowing new money to pay old interest just makes the problem worse.
Let's grossly simplify the situation for clarity. Let's say that Americans need $1 trillion per year of money to enable all the economic production, investment and consumption transactions they want to do in a year. On January 1 US banks add a total of $1 trillion of new credits to Americans' collective bank balances. At 8% interest the banks also add $1 trillion and $80 billion to Americans' collective debt balances. On December 31 when the loans are due Americans find themselves collectively $80 billion short of money to pay the interest. That's because the money to pay the interest was never created so it doesn't exist. When they repaid their collective $1 trillion principal their banks collectively wrote their principal debt balances down to $0 and that principal money ceased to exist. But the debt balance of $80 billion remains. ALL of the money is gone but $80 billion of monetary DEBT remains. And American industry cannot create the $80 billion by counterfeiting it. The only way to make new money is to get new bank loans. Or the government could print and spend/circulate $80 billion into the economy to allow the debt balance to be liquidated, but this is not the practice.
On January 1 of the following year Americans again collectively borrow a new $1 trillion for the coming year with a new $80 billion interest obligation. Let's assume the banks have carried forward the $80 billion interest debt from Year 1. Really, this is all they can do, because the money to pay that $80 billion does not exist because the banks haven't created it yet. The banks could force American businesses and consumers into a total of $80 billion of bankruptcies to write off the unrepayable debt and balance the banks' credit and debt accounts, and in fact this does periodically happen. But you see that destroying real economic wealth by forcing bankruptcies in the interest of balancing the national accounting system is, well, stupid.
So Americans start Year 2 with no money and $80 billion in debt, even though everyone working in the real economy has been paid and all of the year's economic output has been purchased (in this simplified economic picture) and people are enjoying the new economic wealth they created during the year. By the end of Year 2 when Americans repay Year 2's $1 trillion principal, they find themselves with no money and now $160 billion of accumulated debt. Actually it's worse, because in fact the unpaid $80 billion interest from Year 1 is charged to Americans' debt account as a new loan at a new 8% interest, so total debt increases with compound interest obligations.
You can do the arithmetic from here through Year X. Unrepayable monetary debts mount at a logarithmic rate. Americans are "economically&quo... very wealthy and quite secure, but Americans are "financially"... in deeply disturbing monetary debt.
Is this an appropriate way to operate a country's financial system? Bankers are generally very good at micromanaging the country's financial credit by screening borrowers. But the banking SYSTEM of debt-money at interest has a fatal arithmetic flaw: there is never enough money to pay all the principal + interest, unless you bankrupt people who don't need to be bankrupted as an excuse to write debt off bank balance sheets.
Congress enabled this system with the 1913 Bank Act when legislators were ignorant of how money works. Congress can fix this problem with new legislation based on understanding how money works. This is certainly not the only financial problem America is currently experiencing, but this is the cause of unnecessary financial insecurity in the midst of economic wealth.
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v8hemihead
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4 Comments
Oct 20 01:24 PMDump a whole bunch of something on the market, it's value ( the price you can get for it) drops. Keep on a printing boys . . .
The $ is toast.
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GoldWize
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8 Comments
My Website
Oct 20 02:39 PM-Money supply increase
-inflation pressure increases
-SEC valuation modification: we can't properly value equities
-leading to more uncertainty
-investors run to hedge their cash
-worldwide increase in the price of gold.
Gold Long, Inflation Long.
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v8hemihead
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4 Comments
Oct 20 07:03 PMderrly's synopsis makes sense. So who holds all the debt? Whoever it is would have a vested interest in not seeing the US economy go bust if they ever expect to get anything out of that debt. I see countries propping up the $ - England, the EU, the Swiss, etc. Will they will want to hold that dollar denominated debt long term? Will anyone want to buy debt from anyone as fiscally irresponsible as uncle sam? Will they prop the $ up until they can cash in their treasury certificates and spend the money? Will they be able to spend the money anywhere but the US? Will prices of real estate and any other hard asset be on a shot for the moon? Isn't this called inflation?
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Greg Pinelli
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574 Comments
Oct 20 09:21 PMFor everyone else who'se sober let me state and restate...deflation will NEVER happen...It means loss of political control and President Obama will personally come to your homes and give you lunch money and free mortage payments before he allows that to happen.
Deflation only works when it's laid on people with integrity..like those in the 1920s who endured the burden of the 1930s..and then fought a war! How could the entitled, weenie grabbing, whining mommy boys and daddy girls of the last 2 generations possibly handle that?? We'll inflate because the morons who weekend to Las Vegas will still have the illusion they matter.......
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NOWHEREMAN
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1499 Comments
Oct 20 10:14 PMNot that you need edification but there is a site with a writeup on "Deflation scare" which you may be interested in just to send others to if gor no other reason:
murkywaters.com
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NOWHEREMAN
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1499 Comments
Oct 20 10:16 PM-
NOWHEREMAN
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1499 Comments
Oct 20 10:17 PM-
http://www.directcommunications...
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78 Comments
My Website
Oct 20 10:36 PM-
NOWHEREMAN
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1499 Comments
Oct 21 01:08 AM-
EE
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89 Comments
Oct 21 10:58 AM-
xsuddensam
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242 Comments
Oct 21 11:14 AMYou're beating a dead horse. The need to buy un-needed things has been culturally embedded in the American psyche. Maybe you can convince some wayward hippies from the sixties to ride bikes and grow vegetables but you're not going to get Mr. & Mrs. Bling, nor their kids, to change their ways.
As long as we are going to go broke bailing out the financial system, it would only be fair to give us another stimulus check. Today, $600 would buy me about a half bag of pre-1964 U.S. silver coins. Now, that would certainly stimulate me.
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xsuddensam
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242 Comments
Oct 21 11:19 AMSorry.
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deuxsous
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77 Comments
My Website
Oct 21 11:59 AMJohn Hussman addressed both the issue of Treasury real rates (TIPS) and commodity inflation/dollar strength in his weekly letter yesterday...and he also discussed Buffett's NYT op-ed piece at length:
www.hussmanfunds.com/w...
I think he's on the right track,,,as he ususally is.
Tom
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User 30121
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339 Comments
Oct 21 12:08 PMThe rationale I see in SOME of these posts makes me realize that my brain is STILL good and functional after all these years.
ashizashiz: You scare me, man! You need some oxygen, and get off the weed!
EE: You are spot on!
xsuddensam: Your posts are a joy to read, usually because they are so on target!
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Right in San Francisco
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195 Comments
My Website
Oct 21 12:25 PM-
David Roskoph
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115 Comments
My Website
Oct 21 12:31 PM- 3 trillion lost (so far) in real estate
- 1 trillion lost in everything else.
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11.0 trillion lost
Fiat so far 2.5 trillion
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Net deflation 8.5 trillion
The only way we could have inflation woud be an imbecillic attempt to reinflate the deflating assets and postpone the reset for a few more years. That would look a lot like Weimar Germany circa 1923.
Deflation is not going away and the dollar will reach parity with the Euro within 18 months.
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carey_jim
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547 Comments
Oct 21 01:17 PMFor instance, theoretically, you could put fifty percent of your savings in non-callable bonds and fifty percent in blue chip stocks and survive any inflation or deflation for obvious reasons.
But hyperinflation (even inflation of 20 to 30 percent a year) or serious deflation can send an economy (and any economic or financial model) into a chaotic state where people lose confidence in all investment vehicles except mattresses and hoard their money to to point of not consuming anything but necessities.
If economies become chaotic then money, and people that can afford it, tend to flow into more secure economies abroad and social disruption, revolution, food riots, etc. make life impossible.
I'm not predicting economic chaos for America which would be similar to crying "fire" in a crowded theater.
But I do smell smoke and I notice that quite a few people going to get popcorn :)
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derryl
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134 Comments
Oct 21 01:59 PMYou find arithmetic "indecipherable&q... If you doubt that money is created as bank debt look it up in any financial economics textbook, like I did over 25 years ago long after I had moved out of mommy's basement. The consequences of creating money as debt at interest (ever-increasing debt) are arithmetic problems, not political or policy or economic problems. Until you understand what money is and where it comes from you cannot understand the sources of our financial problems and you cannot begin to figure out solutions that can realistically hope to correct the problems. Fiscal and monetary Bandaids have no hope of closing the ever-widening hole of unrepayable debt that is caused by creating money at interest.
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xsuddensam
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242 Comments
Oct 21 02:24 PMI read the Hussman article and it did not assuage my concerns over the economy, growing unemployment, and the government's monetary & fiscal policies. He does not address the very real possibility of crippling consumer loan defaults and more importantly, commercial real estate mortgage defaults. Nor does he address the trillions of dollars of credit default swaps.
In light of the fact that Treasury and the Fed are, for the most part, just throwing money at the current problems, I'm spooked by what appears to be desperate actions by desperate men.
Hussman appears to be just another stock market tout who, as he readily admits, is covering his ass with put options.
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xsuddensam
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242 Comments
Oct 21 03:09 PMLooks like Ashizashiz's post got the hook; must have been his English ;-)
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Joseph Wechter
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2 Comments
My Website
Oct 21 11:50 PM