The Times They Are a-Changin'

When Bob Dylan wrote the words "The times they are a-changin'," he was of course writing about the cultural mega shifts of the sixties. But these words are more applicable today than most of us realize. However, the application has shifted from the forty+ year culture war to the economy.

Why?

Because the United States' economy is about to undergo huge changes due to three overlapping factors:

• Rising inflation;
• The long term continued decline of the dollar; and,
• Entitlement reform.

What do these changes mean? How will they effect each of us? What personal decisions provide the most protection, the lowest risk and the greatest opportunity?

In ancient time inflation usually involved monarchs shaving coins or dilution the precious metals from which those coins were cast. Nowadays, it's much easier because the United States has delegated management of its money to the Federal Reserve (FED), a privately owned bank. The FED can issue money at will with a few computer key strokes.

What does this mean?

It means that the purchasing power of a dollar today is about the same (actually a bit less) than the purchasing power of a nickel back in 1914. 1914 is about the time the U.S. monetary system was privatized and turned over the FED. The same can be said for the Euro, the Yen, British Pounds and other paper currencies around the world. Interestingly the purchasing power of gold in the past 94 years is virtually unchanged. According to the World Gold Council, no paper currency (FIAT currency) has existed longer than a human lifespan and the Federal Reserve Dollar is already a Methuselah at 94 years. I guess we're lucky life expectancy has been climbing.

Why would the FED allow this to happen?

Because the crushing pressure of debt service on the $40 trillion to $60 trillion in unfunded liabilities of Social Security, Medicare, Pensions, the "on budget" National debt, business debt, consumer debt and other costs such as the Iraq war makes it easier to repay that debt with cheaper inflated dollars. Our national policies and spendthrift politicians are debasing the dollar.

However, that's not the whole story. The dollar is also under inflationary pressure because of rising commodity costs. The people of China, India and Brazil all aspire to the "American lifestyle." Energy, metals, food and transportation are becoming scarcer and therefore more expensive.

The situation is unsustainable, eventually forcing whoever serves as President and in Congress to act. What can they do? There are only four alternatives: raise taxes, cut benefits, borrow more or inflate the currency in cooperation with the FED. At the rate the United States economy is deteriorating borrowing may not be an option much longer. Raising taxes is never a popular alternative. And cutting Medicare and/or Social Security benefits is rightfully called the "third rail" of American politics. It's not good for the proverbial political career to take expected benefits away from the electorate.

Regardless of how bad the situation may become, the questions remain about how best to deal with it personally. Obviously it is impossible to offer specific management or investment advice that means anything to you in this post. But in general three observations can be made and a couple of questions can be suggested for you to consider during your next meeting with your investment advisor.

The initial observation is: Although it's clear that something has got to give in the United States when it comes to entitlement reform, don't bet that reform will solve issues confronting successful people. Generally it's easier for politicians to adopt the "Robin Hood" approach and take from the deep pockets to give to the poor and middle class. If you work in a profession (law, medicine, architecture, investment banking), own your own business, or make more than $150,000 a year your pockets are perceived to be deep. You might plan accordingly to protect your assets, your income stream. Remember the old truism: "There is no limit to the good that do-goodees will do with other people's money.

The second observation is: Inflation in the United States is likely to become worse as time goes on. It is simply irresistible for politicians and bankers to avoid paying the price for their past sins as long as possible by using cheaper dollars to pay off old debt. Additionally, every time the FED encounters a financial crises its knee jerk reaction is to soften the blow by injection huge amounts of money into circulation to maintain liquidity. The broadsest measure of money is known as M3 and it's been growing at an annual rate of about 14%. That number is harder to pin down because in March of 2006 the FED decided to stop reporting M3. I suppose it became something of an embarrassment. In 2008 the FED has continued its practice of bailing out the economy by injecting vast amounts of cash for such worthy efforts as the Bear Stearns, Fanny Mae and Freddie Mac "bailouts." In a couple of years Medicare will begin to experience a huge cash flow crunch and one must wonder at whether even the FED can bail out that entitlement. Then in 2018 Social Security will experience its own cash crises.

The final observation is: The dollar is probably about to stabilize at least in the short term. The dollar will probably reach equilibrium at least relative to the Euro because the the Euro is beset by generally unrecognized structural problems such as unsustainable entitlement and tax policies that are actually worse than those facing the dollar. Asian countries artificially maintain cheap currencies relative to real dollar exchange values to facilitate exports to the United States. If those policies change due to the perceived credit risk of American debt and/or the increased ability of Indians, Brazilians and Chinese to consume their output, then all bets are off and the dollar could go into free fall.

Here are a couple of starter questions that you might want to consider asking when you next meet your investment advisor:

• First, with Medicare set to go cash flow negative in 2011 according to the Trustees Report issued last spring, does it make sense to pour a lot of capital into your business? Since medical care is such a huge part of our economy this applies across the board, but especially if you are in the medical professions?
• Second, with the upward pressure on commodities and downward pressure on the dollar does it make sense to increase the percentage of retirement portfolio invested in commodities, precious metals and companies that provide those, while seeking instruments in other currencies?

One final word of caution: However tempting it might be to give up the day job and invest in commodities, currency or anything else full time, it is strongly advised not to attempt this at home. Investment advisers who do this for a living may cost some management fees, but that is a small price to pay for avoiding undue and unknown risks in areas about which you have too little knowledge to even identify those risks.

Although the situation appears critical, a well prepared and fully informed investor can prosper even in the worst of times. It's time to do your homework, consult with your investment advisor and devise a prudent strategy to preserve your capital! "The times they are a-changin'!"