Inflation and Democracy By Les Nemethy, CEO, Euro-Phoenix Financial Advisors Ltd., former World Banker

According to macro analyst Octavio Costa, the United States (and for that matter most of the world) are facing three macro extremes simultaneously:
  • The debt problem of the post-World War II era of the 1940’s.
  • The highly inflationary environment of the 1970’s.
  • Bubble equity valuations, as in the 1990’s before the dotcom bubble.
Each of these problems would be formidable in isolation. The fact that we are facing them simultaneously greatly limits the room for maneuver for central bankers and economic planners.

Ray Dalio, a macro investor and founder of a leading US hedge fund, Bridgewater Associates, believes we are in the final phases of an 80-year economic down cycle—the aforementioned trifecta being fairly typical symptoms. The stresses induced by these difficulties lead to polarization and civil strife. He believes there is a 30% chance of a civil war type event in the US over the next five years as the down cycle reaches new lows.

Charlie Munger, close associate of Warren Buffet, stated in a recent interview that inflation is the graveyard of democracies, contributing to the collapse of multiple countries and civilizations, from the Roman Empire to the Weimar Republic. Inflation eats away at savings, reduces purchasing power, leading to dissatisfaction and civil strife. Munger’s scenario is that the US dollar will inflate to become effectively worthless within 100 years, which may pose a threat to the very foundations of democracy in the US and elsewhere.

My own view is that given the current macro situation, the dilution of the US dollar may be much faster:
  • The USD has effectively lost 97% of its value since “temporarily” coming off the gold standard in 1971.
  • The US Fed is already widely regarded as responding late to the threat of inflation, perhaps even losing control of the situation, yet is prevented from raising interest rates dramatically because of uncertainties surrounding Ukraine, Covid, and global debt levels (at 360% of Global GDP), that increases sensitivity to interest rate hikes.
  • Labour markets are tight, and inflation is becoming embedded in expectations, meaning that it will be stubborn to combat, possibly even with a tendency to accelerate.
Given the background, what are the options for the Fed? And what are the options for investors? In a nutshell:

The Fed has no good options. The trifecta, caused by years of poor fiscal and monetary governance, has diminished room for maneuver. If the Fed were to apply the monetary brakes (e.g. dramatically raise interest rates) in a fragile and decelerating economy, with record debt levels and uncertainties on Ukraine and Covid, a major recession or depression would be the result. Taking inflation back to 2% would require raising interest rates to levels that would completely throttle the economy.

In today’s circumstances, just preventing an acceleration of inflation would already be a not bad result. The inflation would have a monumental societal cost on retirees and savers in general, but perhaps falls short of Weimar inflation levels that destroyed democracy. Allowing negative real interest rates for 5-7 years would have the enormous benefit of allowing the world to inflate away its debt (assuming profligate spending is stopped), as in the late 1940’s.

As for investors, I believe gold to be the best hedge. Bitcoin is highly correlated to the Nasdaq, and inversely to the VIX (e.g. volatility or risk index); it does not provide the type of counter-cyclical hedge provided by gold.

It is not an accident that Central Banks the world over hold vast amounts of gold. The German Central Bank has recently stated that it would not rule out the revaluation of gold to deal with high debt levels.

Other than gold, resource and mining shares also provide a hedge. Global resource companies (excluding energy) represent a mere 2.5% of the global value of publically listed equities. As the world wakes up to the threat of inflation and seeks refuge in tangibles, there will be a rotation into commodities and mining shares. In my opinion, this process has barely begun.

There is an increasing sense that as we reach the bottom of this 80 year cycle, there will be increasing turbulence that will result in a great economic reset. The head of the IMF has warned of such a reset. It is too early to predict what will happen in the reset, but it could involve the US dollar losing its currency reserve status, changes in the Bretton Wood organizations (IMF, World Bank, etc.) and a more pivotal role for gold, as fiat currencies will strive to regain credibility. Above all, moving into first more positive phase of the next debt cycle will require excellence in leadership.

This article is for educational purposes only. It should not be construed as investment advice. Investors should perform their own due diligence and consult their financial advisors.

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