San Diego Housing Bubble News and Analysis

I will answer these in my next posts.

a) The credit component could vary from a huge negative number (in a credit collapse) to a moderately positive number (if speculators continue to borrow dollars to invest in assets).
The upper boundary will be somehow restrained by the ability of servicing the debt and by the margin requirements. We are at quite high levels of debt, and most people couldn't afford to take on much more, since their monthly interest would eat up all their income. But if interest rates go down to 1% again or say to 0%, you could service an infinitely large debt. But you also have margin risk, e.g. if the asset you bought drops by the amount of money you put down. So you probably don't want to take credit in the amount of 1000% of your assets, since if prices drop 10%, you are bankrupt. But some people do it anyways.
The lower boundary can be defended by the governments and banks to keep the party going. They will just prevent you from paying back your loan or defaulting on your house, simply by lowering interest rates again and convince you that you can ride it out.

b) The money component will always be positive as long as we are in a fiat money system, and as long as we have a government that likes to spend and citizens that are pleased with it. The government can so easily issue new dollars, e.g. by purchasing their own bonds, that the possibilties are unlimited. They can pay their salaries, their lobbying groups, the military, old, poor, and sick citizens. They can just deficit spend (on and off-balance sheet) as long as nobody complains. They can spend little, when credit and the economy grow by themselves and when people get wary of the rising prices. They can also spend a lot, especially if times are bad or credit is contracting, under the umbrella of helping the economy out. One thing is for sure, they will spend, and it will be paid for by new money. They won't raise taxes to 60% to pay for social-security and medicare, they will just create new dollars every year to pay the recipients.

Add up the two components and you get the total inflation.

Clearly, I believe we are similar to the 1970s, where deficits came home to roost, and where we were on a fiat currency. Something like the 1930s is out of the question since the dollar is not backed by gold anymore.

So overall, the best way to invest is probably cautiously diversified towards continued inflation. Avoid bonds and stay low in cash, but also don't take too much credit to speculate on rising prices. Try to diversify into the hard assets that are historically cheap. Some precious metals for sure, oil and gas companies since they have low P/Es. Avoid historically expensive assets such as stocks and real estate. But they might make sense in other countries, or away from the mainstream speculation.

Next, let's keep monitoring what the government does in the next years. If we get a time like the late 1970s where rates of inflation accelerate, will a Paul Volcker come along to realize the mistakes and cause a recession, or will it turn into a Weimar Republic?
Here are the clues:

- Will the government lower interest rates so that savers will again get screwed? In this case, take your money and run, like most people will probably do next time. Interest rates would have to be 5% higher anyways to compensate me for inflation, and a widening of this gap will want me to hold even less cash. Just short-term liquidity.

- Watch the government's rhetoric regarding prices catching up. The more people realize inflation, the more they anticipate it by buying fixed assets. If the government starts to blame someone else for rising prices and wants to hand out money to alleviate the problem, things are going to get worse fast. Remember, giving the government control will also result in less production, and then prices will rise even more. Like in the Weimar Republic we could quickly go from 10% to 11%, 13%, 17%, 23%, 35%... if the government plays catch-up.

- A falling dollar might also make things worse. Not just because imports get more expensive, but also because a lot of dollars will come back to the U.S. The past acceptance of dollars world-wide as reserve currency has benefited the U.S. greatly. We could expand the money supply, which is essentially free, to get real products from abroad, while foreigners more and more stored our dollars. This has kept price increases low, but if foreigners decide to send all these dollars back in exchange for products, it will work in reverse.

- Also, watch the public. Most people have been so brain-washed by the government that they are really happy the way things are. Just the fact that people allow the government to print money to erode all the productivity that would otherwise lead to much lower prices. Count electronics together with oil and you get a 2% CPI, something most people are still happy about. In reality such a CPI should show -5%. The difference of course the 7%, that the government can pay to everyone in their reach who now doesn't need to work to produce anything. It will only be the citizens who can eventually prevent the government from inflating. No signs of that though.

So in summary, things like gold still have their purpose. Even in the unlikely event that inflation stops and gold drops somewhat, other assets will drop so much more, so you will still be able to buy a lot with it.
And try to bet on inflation in a tax efficient way. IRAs and foreign accounts might be the way to go, but it is getting more and more difficult to avoid the tax paid on phony capital gains.