Food, Clothing, Shelter and Medicine

A few years back, when someone recommended that I buy real-estate, I would ignore them. I believed that real-estate was in a bubble, and all these people investing in property would get their just desserts. This has been a big cause of debate in my family, especially with my in-laws. When we were thinking of buying our house, I was not convinced that it was a good idea.

Flash-forward 6 months.

I now have a more nuanced take on all of this. I think investing in the RIGHT property WITHOUT debt is always a good idea. Let me explain what is investable real-estate. An investable property is one that immediately begins to generate income for you.

This test immediately eliminates:

1. Any property that is an empty piece of land (unless it is agricultural land).
2. Any real-estate like an apartment that a builder is yet to build (say will be done in 3 years, but builder wants a deposit now)

As long as you can immediately rent it out, it is just like keeping money in the bank (which earns interest). It is possible that the rate of return with real-estate is lower than a bank, but I believe it is a safer investment than a bank. This is because real-estate is a better hedge against inflation as long as you buy it WITHOUT using any debt.

Why is real estate a good hedge against inflation?

1. If inflation runs high, the value of your savings in your bank (the principal) will be reduced. Not so with real-estate, where prices will likely rise with inflation.
2. Usually, when inflation runs high, interest rates on loans rise - but not necessary that the rates on savings accounts will rise by the same amount. However, you can be guaranteed that your rent will also rise. Note that in case of inflation, consumption of goods actually falls. But essential commodities like food, clothing, shelter and medicine continue to hold their value.

That's all fine and dandy, but what happens if the rental income falls? There are two scenarios to consider:

1. There is a global decrease in rents: Rents fall across the country, or across the world. In this case, not to worry, because your other expenses will fall accordingly (there will be deflation, not just in rents, but everywhere). You'll still earn enough from rent to maintain your standard of living.
2. There is a local decrease in rents: It is no longer a desirable area, etc. Well - when you're looking for a good investment, you have to make sure that such local factors do not exist, and that it will remain desirable for many decades to come.

Basically, in uncertain times, you always hold investments that generate a rate of return, and are guaranteed to maintain that rate in the face of inflation or deflaton. Investments in food, clothing, shelter and medicine fall in that category.

Of course, this is me being conservative. There are good investments in things like transportation (that help food to get from one place or another), energy (which is also basic commodity), and even technology (because technology helps optimize all complex systems like transportation, energy, etc).

But if you buy real-estate, remember two rules

1. Location, Location, Location: Buy at a desirable location.
2. Buy something that can generate rent immediately.

I would pay lesser attention to the price that you pay for the apartment as LONG as you do not use debt.

Does Gold have intrinsic value?

Just today at lunch, somebody mentioned - "what's the point of gold - it has no intrinsic value". My relatives say the same thing - "What's the point of keeping gold? You can't use it for anything". Or, "Gold just has psychological value - it gives you a feeling of being rich".

To all the folks who say that Gold only has psychological value, I propose the following thought experiment:

1. Open your wallet
2. Pull out a dollar bill, any dollar bill in your wallet
3. Think about whether that piece of paper has any intrinsic value

What value does it have? It takes a few cents to print it. It has no intrinsic value. It's value is mostly because there is a large number of people who are willing to accept it as currency and give you something of value in return.

Let me repeat that: The pieces of paper currency work because of a shared faith by a large number of people who are willing to accept it in return for something of value. The US Dollar, like gold, has no intrinsic value.

Similarly, Gold also works because there is a shared faith by a large number of people that it can be used as currency - like the US Dollar.

In fact, one would argue that a rational person should have more faith in Gold than the US Dollar. The US Government can destroy the value of the US Dollar by printing more dollars (in fact, this has been happening at a rapid pace in the last few years). Gold's supply is harder to control - you cannot generate gold in unlimited quantities. Gold tends to hold its value better.

In fact, the market seems to be acknowledging this reality - that the US Government will eventually destroy the value of the US Dollar, and Gold is a better store of value.

But the core point I wanted to make is: Gold has just as much intrinsic value as any piece of paper currency. People who buy gold, do so to keep their savings in gold instead of keeping savings in US Dollar.

Also remember, however, that Gold has stood the test of time (has been used as currency for the last 2,000 years). The paper currency has only been around for less than 200 years.

The current recession: How will it end?

Some say the world will end in fire

Some say in ice.

From what I've tasted of desire

I hold with those who favor fire

- Robert Frost, American Poet

90% of surveyed economists think that we'll be out of the recession in a year. I am not so sure.

To see where the economy is headed, you need to paint a picture of how the US economy should ideally look. Here's what I think: Ideally, America should have little external debt and about 10% average savings.

Now check how far we are from this ideal situation. The answer is - very far - we have a huge amount of debt which is slated to approach 100% of GDP in a few years, and savings are increasing, but are not near 10%.

OK - so how do we get from current situation to ideal? There are five ways to get to the ideal situation, and all of them involve a lot of pain. America has gotten itself into a situation where it has very little (except its land) to help with the crisis. Here're the five options:

1. Reduce consumption, save more and pay down the debt
2. Increase productivity, work more and pay down the debt
3. Sell some of the riches in the US (like publicly owned land, etc) and pay down debt
4. We could default on the debt. This looks like the most likely outcome to me.
5. We could tax the hell out of the US population in an attempt to pay down the debt.

#1 is in progress - the problem is that reducing consumption causes economic depression and deflation. This will get us to a very painful point, with high unemployment. It also takes a long time to do. Also, as long as China and other nations are willing to loan us money, there is no pressure to reduce consumption drastically. Remember that in the 1970s, Jimmy Carter asked the nation to cut down oil consumption by setting their thermostat 2 degrees lower - and we all know what happened - he did not get reelected.

#2 is infeasible. Remember, US is already one of the most productive nations. To be more productive requires significant changes, improvements in the education system, getting rid of entrenched monopolies like the teachers' union, doctors, drug companies, etc - which takes a very long time (a generation) to accomplish.

#3 is doable. In fact, I think it will happen - with China buying shares of US companies, as well as part of the very rich US real-estate. Warren Buffett referred to exactly this issue back in 2003 with his story about Thriftville and Squanderville. China knows that the US is trying to inflate away their currency - they'd rather buy hard assets in the US and elsewhere while they can. See this New York Times article which explains how they are already doing this. However, I don't think it will be enough to pay down all the debt. For one, there will be political pressure to not sell too much of the hard assets, and secondly, the magnitude of the US debt is huge.

#4 will happen, because #3 will not be enough. When we default, the world will cease to loan us any more money, and we will not be able to rely on loans to buy oil, automobiles and other imports. Suddenly, the quality of life will plummet because imports will become prohibitively expensive.

Note that the US not only has external debt - but also internal debt. It owes money to retirees, the money in US banks, etc - when the US defaults on its debt, it will be impossible to meet Medicare commitments, banks will fail, etc. People will lose their income precisely when the cost of living will shoot up. It will not be pretty.

#5 will also happen, before #4 happens. The government will tax the hell out of the US population. This will make it harder for people to pay mortgages (since their take-home pay will go down). It will cause a wave of defaults, which will depress real-estate prices. Since direct taxation is not politically viable - the US will introduce taxation through inflation. In fact, the US has had a hidden tax of 7% for about 25 years now - see my previous post on the Great Deception. This hidden tax will increase significantly - see Warren Buffett's comments on this topic here.

In short, I think a combination of #3, #4 and #5 will happen by 2012. This will be very painful for everybody in the US. In the next few years, inflation will shoot up, China will buy hard assets in the US and eventually we will default on the debt. The cost of living will shoot up, the quality of life will fall.

Gerald Celente, a US forecaster who predicted the financial collapse and previous crashes (like 2001 crash and 1987 crash), predicts very dire things for the US. From his wikipedia page:

On November 14, 2008, Celente appeared on Fox Business Network and predicted economic depression, tax rebellions, food riots, and more concern for buying food than Christmas presents by 2012 in the United States. Celente also predicted in this interview that governments across the country will be squeezing the little guy for every last dime wherever they can.

I hope it doesn't happen, but I can see the possibility of this happening. I certainly see the possibility of higher taxation and higher food prices.

Now, everytime I bring this up with my family, I get the answer - surely the US will think of an answer. I can't think of any other option than the five I outlined above. If you think of another option - leave a comment, so that I can modify my analysis accordingly.

The Great Deception

For the past decade, the government has said that we're experiencing low inflation in the range of 2-4%. I think this is the biggest scam this country has ever seen. The government has used various tricks to under-report inflation and to hide the fact that the US has been printing money to finance its deficits, and it does so by penalizing all American savers and retirees.

I think we're already experiencing significant inflation (because of extra dollars being printed), and the government is under-reporting CPI (see the end of this article for a graph with real inflation numbers).

This has been going on for quite a while - for about 25 years now, the government has penalized savers and retirees by inflating the currency away - the only reason the middle class hasn't noticed it yet is because stocks and real-estate have continued to out-perform inflation and have made the American middle-class seem richer. But that game is now coming to an end.

You don't have to listen to me say it - I'll quote Bill Gross of PIMCO, which is the largest bond fund in the world. Bill Gross is one of the most successful mutual fund managers (read his biography here). You can read his original analysis on this topic here.

Bill mentions three tricks used by the government to under-report inflation (some of these tricks have been in use since 1983!).

Imputed Rent

Starting 1983, during the Reagan era, the government does not count your mortgage payment towards CPI. It tracks the rent that you would get were you to put the house up for rent - and that's your supposed "expenditure on housing". As I write this (June 2009), rental market has softened enough to bring down rents by 25% in my area. However, I have not had similar luck with my mortgage payment :-). This is 40% of the CPI, and leads to significant under-reporting of inflation.

In Bill Gross's words:

It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

Hedonistic Improvements

Let's say 10 years ago, a particular textbook costed $100. Let's say, today, the same textbook has a new edition that costs $200. The government does not look at this as 100% inflation. They look to see if the new edition has more pictures, more examples, more exercises - and if so, they presume that the textbook "adds more value" to you. The government puts a cost on this "added value", and then calculates inflation.

This is worst when it comes to technology. Let's say a laptop needed to run Windows and Office reasonably well costed $1000 10 years ago. Let's say a laptop to run the latest version of Windows and Office costs $1200 today. The government does not look at it as 20% inflation. If the speed of the processor has doubled, it assumes you're getting twice the value from that laptop! According to the government, you've experienced deflation.

Product Substitutions

Prior to 1990s, the basket of goods used to calculate CPI was fixed. So if the basket had one pound of chicken in it, the cost of that one pound of chicken would be calculated month over month. However, today, the government evaluates how the american consumer reacts to the price of chicken going up - if the consumer cuts back and starts consuming only half-a-pound of chicken a month - then the basket is updated to have only half-pound of chicken.

The problem with this approach is that while the cost of living as measured by a changing basket does not go up much, the quality of life has gone down. Some analysts actually call this methodology as not measuring "cost of living" as much as "cost of survival" :-)

Conclusion

So what's the true rate of inflation? Some analysts say that it is 7% higher than whatever the CPI says. Here's a chart showing true inflation rates using pre-1983 methodology (click on the link). For the up-to-date chart, click on http://www.shadowstats.com/.

Inflation or Deflation in the US?

A few weeks ago, I mentioned in passing to my father-in-law that I was worried that inflation would punish the savers in the US. He replied that economists are more worried about deflation right now.

After having read and thought about it, I think the answer is the US is going to be: inflation. The rest of the world, may go through deflation.

There are two factors at work. Globally, I think deflation is a concern - especially as the economic downturn forces reduced consumption as well as a drastic change in consumption patterns. For instance, it is safe to say that the price of SUVs will go down drastically :-). So will the price of large houses.

Within the US, however, there is the looming chance of inflation for imported goods. What I tell my father-in-law (and others) is:

In the US, I is for imported, and I is for inflation. D is for domestic and D is for deflation.

In other words, prices of imported goods will go up drastically (including oil), and prices of domestic goods (including real-estate) will deflate.

Inflation will happen simply because the US is printing dollars. In fact, it has been doing so for quite some time - for more than 15-20 years, and this is what I have previously called the great deception. The savers and retirees in the US have been penalized unfairly with this hidden inflation that has typically run in the range of 7%, and which is not captured in the CPI. The only reason the US population hasn't noticed it yet is because of the increased value of their stock portfolios and later the increased value of their real-estate.

But this deception is now coming to an end.

And when it does, imported goods like oil, automobiles and other imported goods will become expensive. To pay for basic necessities like oil, the US population will be forced to liquidate assets that are higher up the value chain. Things higher up the value chain (software, large houses, vacation homes, etc) will become cheaper as the Americans will liquidate those to pay for basic necessities.

At the same time, this reduced US consumption and deleveraging will force deflation in all export-oriented economies (China included).

So how do you make money in this scenario? That is the topic of another post.

Don't borrow money if you have cash in the bank

We recently signed the deal to buy a house. This has been a major topic of argument in our house for many years now, and I thought this would put an end to the disagreements.

Little did I know.

The raging issue in our house now is - how big a loan should we take?

I prefer to pay as much down as we can - while my wife and her father disagree with me. I have always felt uncomfortable owing someone money - to the extent that it's one of the principles of my life - never owe money if you can help it. My wife's father thinks I'm being "old-fashioned". Our discussions typically end with him trying to convince me that times have changed - how his grandfather also did not believe in loans (his family had many businesses) but everybody takes a loan now, to run their businesses. Just today, my wife's brother was mentioning how a Harvard MBA grad in their family was dead against paying down more than the minimum on a loan.

And it especially seems to make sense in the USA, where we don't have to pay tax on the interest.

So let's pay closer attention to my principle: Never take a loan if you have cash in the bank. If you don't have the money - sure, you should take the loan. But you should pay down as much as you can.

Here's why: When you take a loan from someone (and you had the money in the bank anyway) - you are betting that you will make more money with your savings than the interest payment. However, the guy giving you money is also betting the same thing - that his loan to you will give him more returns than he would have gotten otherwise. This is a win/lose transaction. One of you is going to lose. Each party in the transaction believes the other person will lose. How sure are you that you will be the winner? (sidebar: this is also the reason I don't believe in trading options or short-selling).

To which my wife's father would probably reply: banks are not making such an evaluation. They are virtually handing out the money because the federal reserve has lowered interest rates. But the bank is not the lender here. You need to look at the lender at the end of the chain. When you borrow money from Bank of America, Bank of America borrows money from the Federal Reserve. The Fed borrows money from the Treasury. The Treasury borrows from the Chinese Government.

So really, you're borrowing money from the Chinese Government. And you can bet that the Chinese Government is not a fool. The Chinese Government is a big player is these markets. You're entering into a win/lose transaction with the chinese government. How sure are you now that you'll make money on the market with your savings?

We haven't seen the bottom yet

A lot of mainstream media has been touting that we're on the way to recovery. In my house, when I present the contrarian view (that we haven't hit bottom yet), family members disbelieve me. This already feels like the worst recession in even my parents' (and my wife's parents') lives so - really, how much worse can it get?

The answer is not to compare it to previous recessions, but to work through fundamentals.

The US savings rate is very low by historical standards. A few years ago it was actually negative, and even now it is running at 4%. Moreover, the US has prior debt to pay off. The only way it can do so is to drastically reduce consumption.

The question everybody should be asking is: What will the world look like if the US decides to tighten its belt and pay off all its debt. To do that, it must consume less and produce more. Producing more will take time - but what it can do immediately is start consuming less.

70% of the US economy relies on consumer spending - and if that falls, the US economy will fall.

It is useful to think of nations like individuals. What if the US were a person? What if this person - call him Mr. U - lived on credit, and consumed a lot and racked up a lot of debt? Eventually, Mr. U would have to cut down on consumption, live frugally until he had built up enough saving. That's exactly what needs to happen in the US.

We're not there yet.