BIG MONEY AND MOTHER NATURE

by Byron King
for Whiskey & Gunpowder
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THE ANNOUNCEMENTS WERE REMARKABLE for many reasons, not the least of which was their coincidence in time. Last week, Anadarko Petroleum Corp., a large, independent oil company, announced a $21 billion deal to take over two other oil and gas firms, Kerr-McGee Corp. and Western Gas Resources Inc. And then this week began with Phelps Dodge Corp., a large mining concern, announcing a $40 billion deal to take over two Canadian mining companies, Inco Ltd. and Falconbridge Ltd. Welcome to the world in which big money meets Mother Nature.

The Anadarko Deal

Here is the background on the Anadarko deal. Anadarko is proposing to pay $16.4 billion for Kerr-McGee and $4.7 billion for Western Gas. Anadarko will finance the entire acquisition with debt. Upon completion of the deal, Anadarko will more than double its annual sales. In 2005, Anadarko, which has 3,300 employees, reported $7.1 billion in sales. Revenue for Kerr-McGee last year totaled $5.93 billion, and Western Gas Resources booked $3.96 billion in 2005 sales. Together, the three companies will ring the cash register for annual revenue of $17 billion.

“We are creating a combined company with industry-leading positions in the deep-water Gulf of Mexico and the Rockies, two of the fastest-growing oil- and natural gas-producing regions in North America,” said Jim Hackett, chairman, president, and CEO of Anadarko. Despite the recent weakening in natural gas prices, Anadarko managers are looking to the longer term. They are confident that natural gas prices will regain any lost ground and remain high, due to increasing demand and flattening output across North America. Also, in all likelihood, Anadarko wants to keep itself from falling prey to other potential buyers who may covet Anadarko’s own assets and personnel. (Shell Oil Co. has been mentioned as a possible suitor.) Hold that thought while we look at another takeover proposal.

The Phelps Dodge Deal

Here is the raw data on the Phelps Dodge deal. Phelps Dodge, one of the world’s largest copper producer, is proposing to acquire Inco, one of the largest nickel mining companies in the world. In turn, Inco will sweeten an existing offer to acquire Falconbridge, another nickel mining concern already in play, and thus complete a problematic merger.

By acquiring Inco and Falconbridge, Phelps Dodge will create a diversified mining superpower whose presence will reshape the industry in a world of booming commodity prices. If this deal closes successfully, it will create the fifth-largest mining firm in the world, behind BHP Billiton, Rio Tinto, Anglo American and Brazil-based CVRD, with a market capitalization of $40 billion.

The underlying assumption behind the Phelps Dodge deal has to be that worldwide demand for basic materials will remain strong, particularly from the factories of China. Otherwise, Phelps Dodge would be acquiring assets at a post-run-up premium price and risk getting caught at or near the top of a traditional commodity cycle.

The other side of this coin is that worldwide, the basic commodity mining business has suffered from over two decades of low investment in the infrastructure needed to bring ore to the surface and process it into a useable end product. Thus, real ore deposits with real mines and processing facilities sitting on top of them are a relatively scarce item. These big holes in the ground can and do command a premium.

According to a company press release, Phelps Dodge is proposing to pay $80 (Canadian) per share for every share of Inco. Of that amount, $17.50 will be paid in cash and the rest in Phelps Dodge stock. Inco will in turn increase its offer for Falconbridge by about C$5 a share, to about C$62 per share. Phelps Dodge has announced that it will commence a US$5 billion stock repurchase program as part of the transaction. Thus, in the end, the Inco offer will be even more valuable to Falconbridge shareholders as a result of the increased value of its stock due to the Phelps Dodge bid.

Phelps Dodge officials believe that the combined entity can save about $900 million annually as a result of the three-way combination. For example, both Inco and Falconbridge operate massive nickel mines near Sudbury, Ontario. But despite the proximity of their operations, the arrangement of their mines often verged on being silly. Ore from Inco’s operations, literally a stone’s throw from Falconbridge’s sites, was routinely moved long distances by rail to Inco operations, and vice versa.

Execution Risk

Corporate mergers and large-scale asset sales are relatively routine. But three-way deals, such as we are seeing here, are uncommon, and it is an almost astonishing coincidence that we see a simultaneous confluence of events in two natural resource sectors. It makes one wonder what is driving this phase of a business cycle in the natural resource industries. Hold that thought, too.

Buying two companies at once adds what investment bankers call “execution risk” to any transaction. Imagine the difficulty involved in merging just two corporate cultures, two sets of management, two groups of employees, and two different asset bases. Now consider the difficulty entailed when there are three distinct sets of players involved in a transaction. (And in the case of the Phelps Dodge acquisition, the joinder of the three firms spans two nations.) Aside from the financial angles, the Phelps Dodge deal for Inco and Falconbridge requires governmental approvals from authorities in the U.S., Canada, and Europe, along with Phelps Dodge and Inco shareholder approval. The transaction is expected to close in September.

Just in terms of employees, Phelps Dodge has about 13,500 on the payroll, and the proposed acquisitions will swell the ranks with 12,000 more from Inco and 14,500 from Falconbridge. Combining the three mining companies “will vault [Phelps Dodge] into super-major status within the global mining industry,” and make it easier to raise capital and develop giant projects, said Phelps Dodge chairman and CEO Steven Whisler on Monday, June 26. “Our key driver in this transaction,” said Mr. Whisler, “is the potential for significant synergies.” Ah yes, those wonderful “synergies.”

Synergies or not, the transactions present world-class financial challenges, because in both instances, management proposes vastly to increase company debt in an environment of rising interest rates. Phelps Dodge has lined up $22 billion in financing for the deal and the related share buyback program. Simply to enable Inco to acquire Falconbridge, Phelps Dodge has agreed to buy as much as $3 billion of convertible subordinated notes issued by Inco. This cash infusion would, in turn, provide Inco with the cash it requires to buy out the Falconbridge common shares and, as one spokesman put it, to “satisfy related dissent rights, as needed.”

$22 billion is, of course, a lot of money. But Phelps Dodge is focusing, according to Mr. Whisler, on the “extremely strong cash flow [estimated at $10 billion before interest, taxes, depreciation, and amortization], which will enable us to reduce debt quickly and fund growth projects.” Let’s hope that Mr. Whisler is not whistling Dixie.

Speaking of debt, Anadarko is proposing to fund its acquisition of Kerr-McGee and Western Gas by taking on debt greater than its market value. The acquisitions will cost Anadarko $23.3 billion, including assumed debt. To pay for it, Anadarko secured a $24 billion acquisition facility from UBS, Credit Suisse, and Citigroup that it proposes to pay down using proceeds from asset sales, free cash flow, and the sale of new stock over the next 18-24 months.

Because the offer for Kerr-McGee and Western Gas is all in cash, the Anadarko shareholders do not have a vote on the matter. Thus, there is no possibility of what is called a “fiduciary out” for the company (i.e., the company cannot back out by saying the shareholders voted this down.) The proposed takeover price for the two target firms is at something of a rich premium, as well. Pre-announcement, Kerr-McGee was selling for 15 times earnings. Western Gas was selling for 21 times earnings. Anadarko, by contrast, was selling at 9 times earnings, and its market capitalization dropped by $1.7 billion on the first day of trading after the takeover announcement.

Execution Benefit

For every risk, however, there are potential benefits. According to a summary provided by Anadarko, the company expects ultimately to recover 3.8 billion barrels of oil equivalent from Kerr-McGee and Western Gas at a price of less than $12 per barrel. It would certainly be difficult to find that amount of hydrocarbon the old-fashioned way, by going out in the field, acquiring acreage, and drilling wells. By way of comparison, crude futures are currently trading above $70 per barrel.

In a series of press releases, Anadarko stated:

“Opportunities to gain access to such large, high-margin resource opportunities at such economic full-cycle costs are rare…The core assets being acquired strongly complement Anadarko’s existing properties, providing the scale and focus needed to deliver more robust, predictable, and efficient growth…Kerr-McGee’s outstanding deep-water holdings (in the Gulf of Mexico) and skill sets will elevate Anadarko into the top echelon of deep-water operators.

“Similarly, Kerr-McGee’s long-lived natural gas resource plays in Colorado and Utah, along with Western Gas Resources’ [holdings] in Wyoming, will combine with Anadarko’s assets to make us one of the largest producers in several of the most prolific basins in the Rockies.”

“There Is Nothing Left to Drill”

About a year or so ago, no less a scholar of natural resources than T. Boone Pickens said of the United States oil and gas situation, “There is nothing left to drill.” Boone was, of course, being facetious. There is always “something” left to drill.

But Boone was making an important point, summing up in just a few words the notion that exploration for natural resources in the ground is always an issue that involves many variables. Among other things, exploration involves access to new areas, the quality of the prospect, the costs of drilling and production, and the return on investment. By these criteria, the U.S. environment for significant new natural resource discoveries, and future extraction, is distinctly unfavorable.

From a geological standpoint, there is not enough room between the dry holes of the American oil range to find any new deposits of oil or gas of significant size. Similarly, the most significant of the hard rock deposits of North America have been explored and fairly well defined. It is safe to say that there are few important mineral districts left to uncover in the U.S., and perhaps slightly less in Canada. Add to this the dramatically increased cost of exploration and production. Fuel costs have soared, as well as the costs for most of the basic equipment used in oil and mineral extraction. The cost of tubular goods and rock bits, for example, has skyrocketed in the past three years. And people are measuring waiting times for drilling rigs with a monthly calendar.

Sure, there is a lot of oil and gas left out there for the driller’s bit (if you can wait long enough for a delivery of drill bits), and there are significant numbers of mineralized anomalies in the Earth’s crust. But the deposits that the extraction companies will encounter will be smaller, further afield, and more expensive to develop and produce.

The Anadarko and Phelps Dodge plays certainly illustrate another point, one for which T. Boone Pickens is equally famous: that you can still “drill for reserves on Wall Street.” It was Boone who put my former employer Gulf Oil Co. into play back in 1983. The takeover that resulted, by so-called “white knight” Chevron, which swooped in to rescue Gulf from the hands of Boone, was among the first of the big takeovers within the traditional Western oil industry. So I have a certain bias when it comes to seeing oil and gas companies being taken over.

The Anadarko and Phelps Dodge deals will certainly make money for the investment bankers. This will be very good for the economies of Park Avenue, Long Island, and suburban Connecticut. And the takeover deals reward patient shareholders with a significant gain, especially the patient shareholders who took the risk of buying the variety of takeover stocks in the few days before the deal was announced (ahem!). A lot of people will sell their shares, and eventually, the tax collectors of the world will do well by this deal.

The parachute makers of the world (also known as “employment attorneys”) are probably working overtime sewing golden thread into the linings of the respective harnesses for many of the senior managers of the acquired companies. Everyone knows you cannot be too careful these days. So while the current environment in takeover land is all smiles, chuckles, camaraderie, and glowing optimism, I am sure that a good many senior employees are inspecting their ejection seats like a Blue Angels pilot just before a big air show.

To their credit, the Anadarko managers went out of their way to state that they are pleased with the potential to “acquire” the geological and other technical staff of Kerr-McGee and Western Gas. That is, Anadarko appears to want the human resource base of its takeover targets, as well as the oil and gas in the ground. Similarly, the Phelps Dodge managers have stated that layoffs of Canadian technical and production staff will be minimal.

This degree of solicitousness toward the employees is rather unusual. We used to say that the definition of an “optimist” was the geologist or engineer who brought lunch to work (as if he would be there to eat it by noon). It may truly be a reflection of management beginning to realize the severity of the shortage of human skills in the natural resource sector, after more than two decades of layoffs and declining enrollments in related earth science and engineering education programs.

The historical problem with mining and energy company takeovers is that ofttimes when one company buys another, a lot of the exploration and production people from the “other” outfit get laid off. This occurred as recently as last year when Chevron took over Unocal. And as a rule, with the merger of exploration and production departments, there tends to be less diversity of thought in the oil patch and among the rock-kickers. Fewer drilling prospects get generated in the oil and gas arena, and there is less creativity in following the mineral trend lines out in hard rock country. Considering the rising world demand for resources, and the shrunken talent pool, sooner or later it was going to become evident.

Companies that are the principal in big takeover plays almost always say something along the lines of, “Our larger size will allow us better to compete in the aggressive business climate of the modern petroleum industry.” This always a good line, and not unexpected considering the money that is in play. But it is not as if a smaller, well-managed company cannot partner up or obtain the financing it needs to pursue high-cost, risky ventures.

So the Anadarko and Phelps Dodge deals will play themselves out. We shall see what happens. Inquiring minds want to know how, when one company takes over two others, will the world be a better place? Will the combined company shoot more seismic or less? Will the combined firms drill more feet of core in the hard rocks, and drill more or fewer oil wells out in the oil patch, than the combination of the separate entities? Will the new larger entity discover and produce more stuff out of the ground than otherwise?

More on the Business Side

And now for just a few final words on the economic rationale behind the Anadarko and Phelps Dodge deals. Commentator Jim Cramer noted that “Neither deal should have ever been able to get done. But both deals reflect the playbook…that says all of these stocks must be sold because of the Fed.”

That is, the Fed has been steadily raising interest rates, causing the yield curve to turn inverted. There was, in consequence, a sell-off of natural resource stocks as people who had previously purchased shares on margin had to unload them at distressed prices. Deals that were otherwise uneconomical became possible. What this interesting coincidence of takeovers also says is that many companies involved in basic industrial activity -- mining, oil and gas, infrastructure, and basic manufacturing -- are relatively cheap. At Agora Financial, we have been saying this for a long time.

Until we meet again,
Byron W. King

Byron W. King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades. However, in the process of seeking more excitement than a man can safely obtain from flaring over-pressurized gas whipping out of a 21,000-foot well, Byron also served for many years in both the active and reserve components of the United States Navy.
While in the sea service, Byron logged more flight time in tactical jet aircraft than George W. Bush, as well as 127 more carrier landings than the recently-re-elected commander in chief. Among other assignments, Byron has served as a field historian with the Navy.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geologic history, and blends its significance into the more recent, man-made kind of tale.

Flationed Out

by Mike "Mish" Shedlock
Illinois, U.S.A.



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I HAVE BEEN pondering the word "stagflation." Nearly everyone but me seems to think we are in it or headed for it. What exactly does stagflation mean anyway?

Let's take a look at two definitions and a comment:

1. "Sluggish economic growth coupled with a high rate of inflation and unemployment" (American Heritage Dictionary)

2. "A condition of slow economic growth and relatively high unemployment -- a time of stagnation -- accompanied by a rise in prices, or inflation" (Investopedia.com)

3. "Investopedia commentary: "Stagflation occurs when the economy isn't growing, but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries...For these countries, stagnation increased the inflationary effects."

From above context, stagflation seems to be based on rising prices (instead of an expansion of credit), and furthermore, the term seems to imply that rising prices are bad only in context of the "stag."

An Austrian View of "Flation"

Inflation -- Expansion of money and credit

Deflation -- Contraction of money and credit

Disinflation -- Expansion of money and credit, but at a declining pace

Hyperinflation -- Rapid rise in inflation accompanied by a complete loss of confidence in currency

In Austrian terms, I find little use for such a term. Where exactly does it fit in?

Several days ago, I sent an article that called for "stagflation" to a good friend of mine who posts under the name "Trotsky" on Kitco. We had not discussed that term before, but knowing his Austrian leanings, his answer did not surprise me at all. It is as follows (note: He does not capitalize his sentences):

"what immediately comes to mind is that the term was coined with a Keynesian mind-set -- as if it were a new phenomenon that sort of 'just happens' without a sensible explanation at hand. at the time of the 1970s K summer, economists had been conditioned to associate economic downturns with deflation -- the inflationary recession of the early 1920s was long forgotten. when suddenly recession coincided with the effects of the concurrent inflationary monetary policy becoming highly visible, something happened that wasn't supposed to happen. so they thought it required a new term -- 'stagflation,' equaling recession cum inflation, the supposedly 'unnatural' state of affairs. Obviously, once you define inflation correctly (expansion of the fiat money supply), such a term makes no sense. especially considering that the Keynesian (as well as monetarist, i might add) recipe for 'combating economic downturns' consists of deficit spending cum monetization, i.e., printing lots of money, as a matter of course! perversely, application of this recipe leads only to bigger failures (proven by EVERY major application of it, including, IMO, the most recent one, which only created yet another surge in malinvestment, namely the housing bubble).

"the only reason why at times the inflation seemingly 'works' and at other times doesn't is that the initial conditions, as defined by the K seasons vary. IMO, there are two aspects that play a role -- the state of the pool of real funding (if it is shrinking, no amount of monetary pumping can even create the illusion of a new boom -- that's Japan from '89 onward) and the size of the private sector debt extant at the conclusion of the last boom.

"note that the term 'boom' is actually a negative term, or should be. during the boom, which is itself a result of lax monetary policy, capital is malinvested and the economy's production structure damaged/distorted. the bust is the economy's attempt at RECTIFYING the mistakes of the boom by liquidating malinvested capital and redirecting those resources to their optimal use (usually, that entails the realization that assumptions about future demand were simply wrong, as they are based on the illusion created by the credit expansion).

"anyway, the rarer condition of deflation as we understand it in the context of the fiat system is simply a credit contraction so massive that it overwhelms the countervailing attempts of the central bank to inflate. one must not forget the credit was largely created from thin air -- in a deflation, it simply goes back there.

"in any event, ultimately, 'stagflation' does not describe anything really...even though we know what it is meant to describe. simply put, it's the type of bust where the usual inflationary policy is noticed by everybody because prices and wages start to rise everywhere (because the 'debtberg' is still able to expand further)."

An Austrian Debate

Actually, I think the origin is probably far simpler. Someone wanted to talk about "stagnation" and accidentally said "stagflation" or perhaps said "stagflation" purposely trying to be cute. In any case, the word stuck, but as Trotsky pointed out, the word makes no real sense from an Austrian point of view. Yet it is only from the Austrian point of view that I wish to debate anyone on inflation.

That last sentence is key, and it has caused a lot of frustration recently. In addition, I keep responding to the same questions over and over again from e-mail and replies to blogs, many from people that do not know (or refuse to accept) what inflation is. In other cases, people are just now finding my blog and just happen to be asking a question I have addressed elsewhere a dozen times. Here are some of the typical questions:

"Mish, doesn't the rise in the price of oil prove you are wrong?"

"Mish, you still haven't explained how we can have a falling U.S. dollar and deflation"

"Mish, the U.S. is not Japan"

"Mish, how is your favorable view of gold consistent with deflation?"

"Mish, isn't it about time for you to throw in the towel?"

"Mish, inflation is our past, present, and future"

And so on and so forth, with no one adding anything to the debate.

One of the problems I face is that people want to be a part of the debate, even though they refuse to accept the terms of the debate. Austrians in general would accept the "Flation" list above (or something reasonably close); others do not. Unless one can agree on definitions, however, there can be no meaningful debate. People keep telling me I am wrong when they do not agree to the terms of the debate.

Following are three people whom I believe do agree with those "Flation" terms as defined above:

1. Marc Faber

2. Steve Saville

3. Robert Blumen

Note that I said they agree with those definitions. All of them disagree with my position. Taking the other side of a debate with Faber is dangerous, but we agree on far more things than we disagree on. Faber also admits deflation is possible (even if unlikely). Most inflationists will not even grant that.

Anyway, I want to thank Robert Blumen for his piece "Must Bernanke Choose Deflation?" simply because he not only agrees with the terms of debate, but he also made a serious effort to understand what I am saying. Hardly anyone else has bothered to try. If you are new to this discussion, not only do I ask you to read Blumen's article, but to click on all the embedded links in his post and read those too. Unless you do that, you cannot understand what I am saying or why.

Blumen disagrees with my position, but there is nothing wrong with that. Should unanimous opinion ever form on something economically related, I confidently predict we would all be wrong, and probably sooner, rather than later.

Questions Answered

I will reply later to his rebuttal, but for now, I want to address some of those questions above.

Q: "Mish, doesn't the dramatic rise in the price of oil prove you are wrong?"

A: No, the price of oil could be rising for many reasons, and perhaps much of that price is related to Peak Oil, dwindling supplies, and geopolitical concerns, rather than directly to monetary expansion. One cannot know for sure what causes any price increase, and that is a key reason why attempting to define inflation by looking at prices is dead wrong. It simply cannot be done. At any rate, prices rise and fall for many reasons, so one simply cannot look at prices to decide if there is inflation. My views on deflation are forward looking, and in response to an expected credit collapse in housing. For now, I freely admit there is inflation, as credit and money supply are still expanding, but note that it is possible for oil prices to keep rising, perhaps dramatically, even during deflation on account of Peak Oil.

Q: "Mish, you still haven't explained how we can have a falling U.S. dollar and deflation"

A: I have not explained how, because a falling dollar is not part of the equation. Inflation is an expansion of money and credit. Rest assured, there was inflation when the U.S. dollar index hit an all-time high of 120. Rest assured the U.S. dollar can sink even in a contraction of money and credit. I am not saying the dollar will fall -- I am saying it could fall. More than likely, the dollar will hold its own. If it falls, I have many reasons why it is unlikely to crash (anytime soon). For starters, it has already collapsed in just a few short years. Everyone thought the euro was trash a few short years ago, and now everyone seems to be a euro bull. That said, I do think the dollar could crash much later on down the road, after debt is wiped clean. A dollar crash will probably occur after everyone gives up on it. In the meantime, I expect savings will rise, and in a worldwide economic debacle, there will be safety in U.S. Treasuries. Note too that many other fiat currencies look just as bad from where we are now. Ideas about hyperinflation with a housing bust and loss of jobs and a worldwide economic bust seem rather silly to me. You are free to disagree, of course. For a more complete discussion of the U.S. dollar, please consider "Is the U.S. Dollar Toast?"

Q: "Mish, the U.S. is not Japan, and besides, Japan really did not have deflation anyway"

A: I never said the U.S. was Japan. And yes, there are big differences. In fact, I have outlined many of those differences between the Japan and the U.S. Some factors, such as demographics, favor the U.S. for avoiding deflation versus Japan. Other factors, most notably consumer debt, are a bigger problem here. Even though we are not Japan, I expect the deflation experience here will be quite similar. Part of that was addressed in "Inflation: What the Heck Is It?" And as for "Japan being a nation of savers" and the U.S. being not: That fact will actually make the snapback to the mean all the more vicious for over-expanded retail stores of all kinds. The U.S. was once a nation of savers, and will likely be again.

Q: "Mish, how is your favorable view of gold consistent with deflation?"

A: This question is really simple. If one views gold as money, it will be hoarded in deflationary times. Housing and equities will both plunge relative to gold, even if gold just manages to stay flat against the U.S. dollar value. That is the key idea. I believe that gold will more than hold its own, but there are no guarantees.

Q: "Mish, isn't it about time for you to throw in the deflation towel?"

A: On the verge of victory? No chance. One of the conditions required for my deflation scenario to unfold was a housing bust: a loss of jobs and income, and rising bankruptcies. Housing is just starting to bust, and eventually that will affect jobs and income. The scenario is just now finally starting to play out.

Q: "Mish, inflation is our past, present, and future"

A: Spoken like a person that has not studied history. Yes, three-quarters of the time, those believing in inflation will be correct. K Cycles are long cycles, lasting up to 80 years in length. By the time a deflationary winter is upon us, most people have known nothing but inflation all their lives. That is why no one sees deflation as a possibility. Memories of 1930 are long, long gone. Note too that length makes timing it a problem. In a 60-80 year cycle, pinpointing the start is not that easy to do. If housing is the "bubble of last resort," as I believe it to be, we can be in a world of hurt over the next seven years or more.

Those questions and similar ones keep coming up again and again and again. I thought I would address them all in one place, and of course, everyone is free to disagree with my conclusions. That said, one cannot have a rational discussion unless one agrees to definitions, and I choose to accept Austrian monetary definitions. In that regard, stagflation is simply not the answer to the "Flation" debate. It has little to do with "Flation" at all, from my point of view.

Mish Addendum: I started writing the above last Thursday. No sooner do I finish writing the article, but right before posting it, a good friend of mine going by the name "Chispas" on Silicon Investor sent me a link to a Forbes article on the topic.

What are they doing reading my mind? Or can it be vice versa? Regardless, let's briefly consider "If It's Not Stagflation...":

"It's not stagflation, but no one can seem to agree on the new term for an economy in which growth is slowing while inflation is rising, such as it is today.

"Could it be 'fearflation,' a term that means it's all just fear, rather than actual inflation that's driving the current economy? Maybe it's 'bubblenomics,' as the U.S. seems to be stuck in a bubble of higher prices, growing unemployment, high housing prices, and a falling dollar. Then again, it could be 'transflation,' the cycle of high gas prices leading to higher inflation. Or how about 'moderflation,' a slowing down accompanied by inflation?...

"Of course, if Bernanke is to be believed, it's not inflation we need to fear, but expectations of inflation...

"So maybe we should describe the current economy as 'Fedflation.'"

Eleven terms were submitted to Forbes to describe the current economy. Click on the above link to see them. YES, I agree with Forbes that it's NOT stagflation (at least someone agrees with me), but NO, we do not need another term for it. With that thought in mind, I changed the title of this article from "Stagflation Anyone?" to the current title selected, because, quite frankly, I am "Flationed Out."

Regards,
Mike Shedlock ~ "Mish"

Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish is currently doing economic and investment research for a number of clients. In addition, Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs / Mishedlo and one of the more popular boards on Silicon Investor as well, Mish's Global Economic Trend Analysis. You can see more of Mish's writing on his blog also entitled Mish's Global Economic Trend Analysis. While he is not writing about stocks or the economy Mish spends a great deal of time on photography, one of his other passions. Mish has over 80 magazine and book cover credits, for magazines such as Country Magazine, Wisconsin Trails, the Chicago Tribune Sunday Supplement, Browntrout Calendars, and numerous other publications. Some of his Wisconsin and gardening images can be seen at www.michaelshedlock.com.

SAILING WITHOUT AN ANCHOR!

by Puru Saxena
Editor, Money Matters
June 16, 2006

RECENT HISTORY – Up until the early 1970’s, our planet followed the Bretton Woods agreement of international monetary management. This system sought to secure the advantages of the gold standard without its disadvantages. The US dollar was linked to gold at the rate of $35 per ounce of gold and other nations pegged their currencies to the US dollar. At this fixed rate of US$35 per ounce, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, which was itself convertible into gold. The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world's key currency, most international transactions were denominated in dollars.

During the 1960’s, the US accumulated massive deficits and when the French demanded gold in exchange for US dollars, the US refused to redeem its dollars in gold. On 15 August 1971, US President Nixon shut the “gold window”, thereby removing gold from the monetary system. The result was inevitable – currencies started floating against each other and without gold as the anchor, nations gave up on their monetary discipline. A fabulous new era of “endless prosperity” had arrived! Central banks became obsessed with monetary inflation, world-trade benefited and the world’s foreign exchange reserves exploded. Figure 1 captures this development in all its glory. In 1971, the non-gold reserves of all countries were worth US$100 billion and today these have grown to roughly $4.3 trillion – an alarming 43-fold increase in 35 years!

Figure 1: Explosion in global non-gold reserves!

Source: www.yardeni.com

As the amount of money within the financial system increased due to the absence of gold, prices within the economy started rising. Once currencies were no longer linked to gold, the global economy became a ship without an anchor, floating from one “boom and bust” cycle to another! Rampant monetary inflation fuelled by the growth of credit turned the capital markets into one giant casino as punters worldwide (often loaded with credit) searched for the next opportunity to make a fortune.

In the 1970’s, this excessive liquidity churned out by the central banks found a home in commodities as the price of raw materials went crazy. During the 1980’s, investors piled into Japanese assets as stocks and real-estate soared. And in the 1990’s, when we were ushering in the new millennium, our world fell in love with the technology, media and telecom sector. Each of these booms was accompanied by rapid credit growth, heavy speculation based on unrealistic expectations and unfortunately they all met their common fate – the eventual bust!

Since the “tech wreck” in 2000, this excessive capital floating around the system has found a refuge in real-estate. Today, the public’s money is predominantly in property and everyone is convinced that the current boom will last forever. “What me worry? Nah, real-estate always goes up!” seems to be the common argument. Allow me to share a secret – no asset-class goes up in a straight line and property investors may be in for a rude shock if interest-rates continue to rise, which in my view is inevitable.

History has shown that rising interest-rates have always been bad news for stocks, bonds and highly-leveraged properties. Will this time be different? I guess we’ll find out!

THE FUTURE – I must admit that I don’t have a crystal ball, but wait, neither does anybody else. In the business of investing, we’re always dealing with change and all we have in our arsenal are probabilities based on the ongoing developments around us. At present, I’m most certain about the following mega-trends, which are likely to intensify over the coming decade –

· Transfer of wealth from the West to the emerging world

· Transfer of capital from financial to tangible assets

I base my above forecasts on the fact that due to globalization and the opening up of China and India, 2.3 billion people have now entered the workforce and these people are hungry for success and a better quality of life. After having lived in dismal poverty for decades, the middle-class in these developing countries has now “tasted blood” and it is determined to catch-up with the West.

To be perfectly honest, China is much more developed and its infrastructure far superior than India’s. In fact, I would argue that China probably has the best roads in the world. I might as well add that the same can’t be said of its drivers!

Last week, I traveled to Suzhou (2-hour drive from Shanghai) for a meeting with an extremely successful Chinese businessman. Mr. Wong is the new breed of entrepreneurs and represents modern, capitalist China. He established his manufacturing business 10-years ago and today his annual turnover is US$240 million. Mr. Wong is in the process of building another factory; he has just bought a luxurious Mercedes and his children study in exclusive schools in England! Moreover, I was amazed to learn that one of Mr. Wong’s friends had just built a 5-star luxury hotel in Suzhou by paying US$30 million upfront in cash! Welcome to communist China

Let’s face it, the 21^st century will belong to China. Shanghai is a phenomenal city with countless skyscrapers, huge shopping malls, great restaurants and an energetic population. Even a small town like Suzhou is home to massive factories, modern buildings and its people have an incredible work ethic. You really have to visit China to see what’s going on in the world’s fastest growing economy! For sure, its vast majority is still poor and the wealth divide is getting bigger but I am very excited about China’s future. If my assessment is correct, the world’s oldest civilization has a bright future.

© 2006 Puru Saxena
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