‘BUILDING AN INFLATION HEDGE,’ from Reuters via fidelity.com. LINE THEE DUCKS UP NOW!!!

To many economists, inflation will be the unavoidable result of federal deficits and the economic recovery.

They posit that the Federal Reserve will have no choice but to pay off the $12-trillion the Federal government already owes and the additional $6-trillion it’s expected to borrow over the next five years. It will do that by pumping more and more money into the economy by creating the cash it needs to buy more and more Treasury securities. That’s called monetizing the debt, and that will make dollars worth less. Ergo: Inflation.

At the same time, the Treasury will have to raise interest rates to keep attracting foreign buyers to their bill, bond, and note auctions. Those higher interest rates will get built into the prices of every business that relies on credit to exist — or relies on businesses that rely on credit. Ergo: Inflation.

That is not a foregone conclusion. Fed Chairman Ben S. Bernanke has told Congress the Fed “will not monetize the debt.” Some analysts believe it will be impossible for the government to pay off its debts with cheap money, because such a large amount of spending is already indexed to inflation. Programs with cost-of-living adjustments, like Social Security, would simply see their costs increase as inflation rose. That would compound the inflationary effect without reducing the debt.

So, even if Bernanke and his colleagues are dead set against creating $18-trillion super-cheap U.S. dollars, the average investor would be smart to prepare for at least a little bit of inflation and the rising interest rates that go along with it. Here’s how.

Don’t assume that we can’t have runaway inflation along with the recession’s continuing job market weakness and suppressed salaries. That is exactly what happened in the 1970s: High unemployment and runaway prices. The decade ended in 1980, during which unemployment was 7.5 percent, the prime rate hit 20 percent and the Consumer Price Index rose 14 percent.

Be aware that interest rates and prices don’t move in lock-step. Interest rates could well rise much faster and more precipitously than prices. That could be a big problem for investors who think Treasury Inflation Protected Securities (TIPS) offer total protection. They do protect the value of investors money in times of consumer price inflation, but they don’t offer much protection against runaway interest rates.

Don’t rush into gold. While the price of gold and other precious metals typically protects against inflation, it’s already been bid up considerably by investors wanting gold as a hedge against economic uncertainty and the prospects of that cheaper dollar. In 2005, gold was hovering below $450 an ounce. Last week it topped $1,200. That’s means it’s already got a 23 percent annual inflation rate built into the price. Gold bubbles may sound like a nice concept in jewelry, not so nice in your investment portfolio.

Be very careful about long-term bonds. Nobody gets as slammed in a rising price/rising rate environment as people who have money tied up in long-term bonds. The value of their bonds crashes as market rates rise. “You don’t want to have money in long-term bonds,” warns David Hultstrom, a money manager in Woodstock, Georgia. He suggests that investors keep the fixed-income portion of their portfolios in short-term bonds, including TIPS.

Think of conservative measures. Here’s an inflation hedge: owning your own home. This is even better: pay for it with a long-term, fixed-rate mortgage. “that is an outstanding inflation hedge, since future payments will be made with cheaper dollars,” says Hultstrom. Another conservative way of preparing for rising interest rates is by buying your bonds and bank certificates of deposit over time and not all at once. Investment pros call this building a ladder. If, for example, you had $25,000 to invest in CDs, you could split it into five different amounts and buy five different CDs — putting $5,000 each into a one-year, a two-year, a three-year, a four-year and a five-year CD. As each matured, you could roll it over into a 5-year CD. That would give you the higher rates of the longer term CD. The added bonus — that one-fifth of your money would become available for reinvestment every year — would protect you from having too much of your money locked into fixed-rate investments as interest rates rose.

Fill in with alternative investments. Don’t go overboard hedging against inflation, but some other investments that typically do well in inflationary times are international stock and bond funds that are not hedged for currency risk, real estate investment trusts, and most commodities.

‘WAKE UP GENTLEMAN,’ from Simon Johnson at baselinescenario .com. Endorsing Paul Volcker’s position on the reforms needed in the banking system, NOW….

“Wake Up, Gentlemen”

Posted: 15 Dec 2009 03:06 AM PST

The guiding myth underpinning the reconstruction of our dangerous banking system is: Financial innovation as-we-know-it is valuable and must be preserved.  Anyone opposed to this approach is a populist, with or without a pitchfork.

Single-handedly, Paul Volcker has exploded this myth.  Responding to a Wall Street insiders‘ Future of Finance “report“, he was quoted in the WSJ yesterday as saying: “Wake up gentlemen.  I can only say that your response is inadequate.”

Volcker has three  main points, with which we whole-heartedly agree:

“[Financial engineering] moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”

“I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy”

and most important:

3. “I am probably going to win in the end”.

Volcker wants tough constraints on banks and their activities, separating the payments system – which must be protected and therefore tightly regulated – from other “extraneous” functions, which includes trading and managing money.

This is entirely reasonable – although we can surely argue about details, including whether a very large “regulated” bank would be able to escape the limits placed on its behavior and whether a very large “trading” bank could (without running the payments system) still cause massive damage.

But how can Mr. Volcker possibly prevail?  Even President Obama was reduced, yesterday, to asking the banks nicely to lend more to small business – against which Jamie Dimon will presumably respond that such firms either (a) are not creditworthy (so give us a subsidy if you want such loans) or (b) don’t want to borrow (so give them a subsidy).  (Some of the bankers, it seems, didn’t even try hard to attend – they just called it in.)

The reason for Volcker’s confidence in his victory is simple – he is moving the consensus.  It’s not radicals against reasonable bankers.  It’s the dean of American banking, with a bigger and better reputation than any other economic policymaker alive – and with a lot of people at his back – saying, very simply: Enough.

He says it plainly, he increasingly says it publicly, and he now says it often.  He waited, on the sidelines, for his moment.  And this is it.

Paul Volcker wants to stop the financial system before it blows up again.  And when he persuades you – and people like you – he will win.  You can help – tell everyone you know to read what Paul Volcker is saying and to pass it on.

By Simon Johnson

‘THE INCOMPARABLE ECONOMIST,’ Paul Krugman remembers Paul Samuelson.

The incomparable economist

I’ve written a brief Samuelson appreciation for Vox EU. I’m cross-posting it here, below the fold.

There have been hedgehogs; there have been foxes; and then there was Paul Samuelson.

I’m referring, of course, to Isaiah Berlin’s famous distinction among thinkers – foxes who know many things, and hedgehogs who know one big thing. What distinguished Paul Samuelson as an economic thinker, making him like nobody else, past or present, was the fact that he knew – and taught us – many big things. No economist has ever had so many seminal ideas.

With a little help from Google Scholar, I’ve compiled a list of some of Samuelson’s big ideas. I say “some” because I’m sure it’s not complete. But anyway, here are eight – eight! – seminal insights, each of which gave rise to a vast and continuing research literature:

1. Revealed preference: There was a revolution in consumer theory in the 1930s, as economists realized that there was much more to consumer choice than diminishing marginal utility. But it was Samuelson who taught us how much can be inferred from the simple proposition that what people choose must be something they prefer to something else they could have afforded but don’t choose.

2. Welfare economics: What does it mean to say that one economic outcome is better than another? This was a blurry concept before Samuelson came in, with much confusion about how to think about income distribution. Samuelson taught us how to use the concept of redistribution by an ethical observer to make sense of the concept of social welfare – and thereby also taught us the limits of that concept in the real world, where there is no such observer and redistribution usually doesn’t happen.

3. Gains from trade: What does it mean to say that international trade is beneficial? What are the limits of that proposition? The starting point is Samuelson’s analysis of the gains from trade, which drew on both revealed preference and his welfare analysis. And everything since, from the distortions analysis of Bhagwati and Johnson, to the generalized comparative advantage concepts of Deardorff, has been based on that insight.

4. Public goods: Why must some goods and services be provided by the government? What makes some, but only some, goods suitable for private markets? It all goes back to Samuelson’s 1954 “Pure theory of public expenditure”.

5. Factor-proportions trade theory: Every time we talk about resources and comparative advantage, every time we worry about the effect of trade on income distribution, we’re harking back to Samuelson’s work in the 1940s and 1950s: he took the vague, confusing ideas of Ohlin and Heckscher, and turned them into a sharp-edged model that defined most trade theory for a generation, and remains a key part of the modern synthesis.

6. Exchange rates and the balance of payments: A bit of personal storytelling: Most people who work in international trade tend to lose the thread when the discussion turns to exchange rates and the balance of payments; as I’ve sometimes put it, the real trade people regard international macro as voodoo, while the international macro people regard real trade as boring and irrelevant (and when I’m in a sour mood, I suggest that both are right). But I was saved from all that when I read Dornbusch, Fischer and Samuelson 1977 on Ricardian trade, which among other things showed how trade and macro, exchange rates and the balance of payments, the possibility of gains from trade but also the possibility of unemployment, all fit together.

What I learned later was that Samuelson grasped these issues much earlier, although the neatness of the DFS formulation surely helped get them across. Here’s what he wrote in his 1964 paper “Theoretical notes on trade problems”: “With employment less than full and Net National Product suboptimal, all the debunked mercantilist arguments turn out to be valid.” And he went on to mention the appendix to the latest edition of his Economics, “pointing out the genuine problems for free-trade apologetics raised by overvaluation”. The solution, of course, was to end the overvaluation rather than restrict trade; Samuelson understood that good macroeconomic policies are a prerequisite for good microeconomic policies. More on that in a minute.

7. Overlapping generations: Samuelson’s 1958 overlapping-generations model of borrowing and lending is the ur-framework for thinking about everything from Social Security to household debt. It’s hard to imagine macro without it.

8. Random-walk finance: Samuelson’s demonstration that forward-looking investors imply randomly fluctuation prices is the starting point for much of modern finance.

As I said, I’m sure there’s more. But notice that any one of these ideas, all by itself, would have been considered enough to make Samuelson a great economist. Nobody, but nobody, has done this much.

So how did he do it? By being smarter than anyone else, of course. But there were also, I’d suggest, two aspects of Samuelson’s intellectual makeup that empowered his intellectual quest.

The first was his playfulness. Read Samuelson’s work, and what you get is the sense of a man who, rather than sitting down to write Very Serious Papers, was having fun with ideas. Sometimes the playfulness boiled over into inspired silliness. Look at footnote #9 in his overlapping-generations paper, where he writes: “Surely, no sentence beginning with the word ‘surely’ can validly contain a question mark at its end? However, one paradox is enough for one article …” It seems clear to me that Samuelson’s playfulness liberated his imagination, and fueled his creativity.

And yet Samuelson was at the same time always grounded in reality. No ivory-tower academic he: he remained deeply interested in events and policy, he played the markets, he never let his theories override his sense of the way things actually were.

Which brings me, finally, to Samuelson’s great contribution to economic policymaking: the Keynesian synthesis. Samuelson was, intellectually, a Depression baby: he came of intellectual age in an environment of mass unemployment. His textbook brought Keynesian thinking to a broad audience. And he never forgot that markets can malfunction terribly. How, then, could economic theory on the virtues of markets be of any real-world use?

Samuelson’s answer was that good macro policies come first. Monetary and fiscal policy had to be employed to assure more or less full employment (and as I’ve pointed out elsewhere, Samuelson appreciated the limits of monetary policy in a way that seems incredibly prescient today). Exchange rates had to be adjusted to assure competitiveness. Only then could the virtues of markets come into play.

It was a lesson that too many economists forgot, as they immersed themselves in the lovely math of perfect markets. But Samuelson’s realism – his understanding that markets are great things, but need to be supported by government activism — has never seemed more relevant than it does now.

So let us praise Paul Anthony Samuelson, the incomparable economist. There has never been, and will never be, anyone to match him.