The War Is On!

In the war between inflation and deflation, Friday was a bloody day.

It began with a shot from the Labor Department; unemployment registered its biggest increase since 1986 - from 5% to 5.5%. Then, all Hell broke loose.

Immediately, investors figured that there was no way the Bernanke Fed could follow through on its half-promise to give up the fight against deflation and begin fighting inflation, alongside the European Central Bank. Central banks do not increase rates when unemployment is rising. At least, that’s the ways it’s gone for a long time.

The Fed, we remind new readers, has a "dual mandate." It is supposed to do two contradictory and incompatible things at once - protect the dollar (guard against inflation)...and maintain full employment (guard against deflation). The two are mortal enemies. Generally, lower rates help stimulate employment; but higher rates are the way to protect the dollar. Of course, in the period known as the Great Moderation, it didn’t matter. The feds could stimulate employment all they wanted and not worry about inflation. The dollar was being protected - by the Chinese, who were exporting cheaper and cheaper goods to the US.

Now, the inflation rate in China is 8.5%...labor costs are rising...energy and raw materials prices are soaring; the poor Chinese have no choice. They’re exporting price increases...not price cuts. All of a sudden, the war is on!

Yesterday, amid the smoke and dust of the battle, in rode the ‘crude oil vigilantes’, guns blazing. The news from the Labor Department seems to have set them off, but they seemed to be itching for a fight anyway. Soon, they had driven up the price of oil more in one day than ever before. A barrel of crude rose $11. . To put that in perspective, that’s about the whole price of oil 10 years ago. At the end of the day, the oil price was at a new record high -- at $139. As we’ve been saying, there is no clear winner in the battle between inflation and deflation. There is just a clear loser - the US householder. He gets blasted no matter which way he goes. Higher unemployment means lower earnings. And a higher oil price means higher consumer prices. And don’t forget the falling housing market. His earnings and his major asset go down; his cost of living goes up. Heck, even Ed McMahon says the bank is trying to take his house - and he’s got a lot of company. Aretha Franklin and Michael Jackson too are said to be facing foreclosure.

Lately, most of the news has been about inflation. The threat of recession was thought to be past. The oil price has been setting records...and we’re getting more and more consumer inflation-sighting reports from all over the world.

"Inflation is biggest threat to global economy," a Bloomberg poll of business executives discovered.

But last week, according to the Wall Street Journal, "recession fears [were] reignited."

Adding to deflation’s firepower last week was an announcement by the European Central Bank on Thursday. Unlike the Fed, the ECB only has one job - to protect the euro. And when the inflation numbers in Europe came out higher than hoped - remember, inflation is now a globalized phenomenon - Jean Claude Trichet, head of the ECB, stepped forward to tell the world to get ready for higher rates. This, of course, had the effect you’d expect - the dollar fell, which puts additional pressure on the Bernanke forces, who had hoped to be able to talk the dollar up.

Of course, everyone knows you can’t fight inflation and fight deflation at the same time. And everyone knows that when push comes to shove, the Fed will throw its weight in inflation’s direction. That is, when its back is to the wall, the Fed will lash out at deflation...and let the dollar go whither it wants - down.

How much difference it makes is open to question. Because, when the shooting really starts, the Fed’s policy changes often get lost in the fog of war. Even as the Fed was being pushed towards the wall...so close it could scratch its back on the aluminum siding...investors sold off stocks. You might have thought that the prospect of lower rates would be good for stocks. But now, with the crude oil vigilantes in the saddle, investors know that being soft on inflation is no guarantee of lower rates and a growing economy. Instead, they’ve come to see that higher oil prices...and higher prices generally...shoot so many holes in consumers’ budgets, the economy goes into decline anyway.

*** Stocks sold off on Friday, sending the Dow reeling by 394 points. The banks were hit hard. You’ll recall that everyone thought the banks had seen the worst back in March, after Bear Stearns collapsed. Investors expected the banks to lead the following rally.

But once a bubble pops, the hot air goes elsewhere. Instead of going into the financial sector, now it’s going into prices for oil and commodities. Not only did oil hit a record on Friday, by the way, so did corn - at $6.50 a bushel.

The banks have been almost cut in half since last year’s high. You’ll recall that they were "adding value" by "allocating capital more efficiently" than their predecessors. Well, for some reason, they don’t seem to be allocating capital very efficiently anymore. All the value they added to their own shares, ever since the merger and acquisition boom of the late ‘90s, has now been wiped out.

Aren’t there some good bargains in the financial sector, thanks to the collapse of share prices? Yes, almost certainly...just as there were some good buys on the Nasdaq after the collapse of the dot.coms...and good buys in tulip bulbs after the blowup of the bubble in the 17th century. But don’t expect to see the whole sector reflate anytime soon. Now, it’s on to the NEXT bubble...

*** It looks to us as though the next bubble is in oil and commodities.

As we pointed out on Friday, markets work. And now they’re working their magic on the oil market. High prices discourage consumption...and encourage new production - which is just what we’re seeing.

The weekend news brings more details.

For example, Brazil has a huge new oil find. Trouble is, it’s offshore and six miles down. It will cost $240 billion to get the oil to market, say current estimates - making it the most expensive oil deposit ever exploited.

Meanwhile, there’s the huge Bakken field in the US. It’s huge too. But it’s deep, and in a thin layer of dolomite, which makes it hard (expensive) to bring out.

As we reported last week, the bubbles in natural resources and food coincide with an even bigger bubble - the mother of all bubbles - in human population. Yes, there are more of us every minute. And as near as we can make out, we are now growing as Malthus predicted -- faster than supplies of oil, food and water. The really big question is: which bubble will pop first?

This is not the first time that question was posed. Malthus himself posed it and answered it -- incorrectly, as it turned out. Then, Paul Ehrlich put the question to himself in the 1970s; again, he came up with the wrong answer. Both thought millions of people were destined to starve, since it seemed to them a mathematical certainty that supplies could not rise fast enough to keep up with population increases.

Now, most free market economists believe the matter settled. ‘Seek and ye shall find,’ they say, adding a caveat, as long as you have a properly functioning capitalist economy.

We’re not so sure...more to come...

*** It was an odd week. We were on the train from Munich to Zurich, when we noticed a group of fully grown men in what looked like Boy Scout outfits, including shorts and knee socks. Then, three of these men crowded into the tiny toilet and closed the door. Time passed; we forgot about them. Then, a half hour later, they marched out.

*** Zurich is a marvelous city. Clean, prosperous...pretty. Unfortunately, it was a soccer weekend...the beginning of an important European soccer championship...somehow involving the city of Zurich. There were huge TV screens set up around town...and temporary stands selling hotdogs, beer, won tons, pasta - practically anything you could want.

Late at night, the soccer fans were still going strong...singing, drinking, falling into the lake. The Swiss had to call in extra policemen from Germany to help control them.

"It is very un-Swiss," said a friend. "Zurich is a small town - only about 600,000 people...with a single main industry, banking. There are plenty of restaurants, but people usually go to bed early. It is a very quiet place."

But Zurich has a rich history...

We went to dinner at a famous restaurant, the Kronehalle. On the walls were original works by Chagall, Picasso and others.

"Zurich has quite an intellectual history," Elizabeth reported, studying a guidebook. "In the early 20th century, this was the place where the Dada Movement was born. Apparently, Tristan Tzara, the founder, was here. And Lenin lived here...and James Joyce...and Picasso and others...philosophers...artists...revolutionaries. Switzerland, then as now, was neutral. So, they must have felt safer or freer here."

"The key to understanding the Swiss is to realize that the place is very hard to conquer and rule," said another friend. "The Romans...or the Holy Roman emperors...or Francois Premier...or the Bourbons or the Hapsburgs could invade. But they couldn’t really control Switzerland’s remote valleys. It was too easy for the Swiss to ambush a foreign army in the mountain passes. So the Swiss acquired a very independent attitude and a reputation for being very warlike. Later, since they were also very poor, the Swiss hired themselves out as mercenaries. Then, no country wanted to attack Switzerland, because their Swiss mercenaries wouldn’t allow it.

"The Swiss have never been part of an empire...and never had any real imperial ambitions themselves. Switzerland is not even a nation-state. It is a collection, a confederation, of cantons. The German-speaking cantons don’t really like the French-speaking cantons. And the Italian-speaking cantons don’t like anyone. So, it’s very hard to get any cooperation for national-level policies. We don’t even know who our president is...because we don’t vote for him directly; it’s a post that rotates among different cantonal representatives.

"Now, there is a lot of pressure for us to join Europe. But I think it would be a big mistake...we’d lose our independence."

*** European Union bureaucrats are forever telling people what to do. You’d think the Europeans themselves wouldn’t put up with it. But in Europe as in America, TV and popular democracy have lobotomized the whole race. They’ll go along with anything.

The latest EU directive forces fortune tellers and astrologers to warn the public that they are "For Entertainment Purposes Only"...and that their métier is "not experimentally proven."

Which just goes to show what cementheads EU functionaries are. Everyone knows perfectly well that fortune telling is a hit or miss business. Astrology and religion too. You hardly need to warn people away from them.

But there are dozens of expensive preoccupations where a warning might be valuable - where people believe there is some "experimental proof" even though there is none at all. Central banking, for example. Psychiatry. Marriage counseling. Fund management. Stock broking. Economics. City management. Drinking 8 glasses of water. Elliott Wave theory. Global warming. Unemployment, inflation, productivity - and all the numbers put out by the Labor Department. Political science. The War on Terror. Image advertising. Higher education. Colonoscopy.

P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.

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The War Is On!

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The War Is On!