Follow conventional wisdom or not?

By DAVID MOON, Moon Capital Management, LLC
August 2, 2009

Great investors are skeptics. They don’t accept a conclusion simply because it is conventional wisdom. More often than not, successful investors find themselves on the opposite side of conventional wisdom, choosing to zig when others are zagging.

Following the Bay of Pigs fiasco, John Kennedy is said to have remarked, “How could I have been so foolish to have trusted the experts?”

Sometimes, however, conventional wisdom is right.

A few months ago, the inability of lower interest rates to spur economic growth gave rise to a popular fear that the U.S. might enter a phase of deflation. This is a condition in which consumer prices generally stagnate or decline, as does economic growth. The last period of prolonged U.S. deflation occurred during the Great Depression.

I argued that deflation was practically impossible in a country whose currency wasn’t backed by hard assets and whose government had a huge accumulated deficit.

Finally, everyone got the memo.

Money managers, economists, politicians (of both parties), individual investors, my barber, Stephen at the Pilot station – it seems that everybody is talking about the high likelihood of coming increased inflation.

Include former Federal Reserve Board Chairman Alan Greenspan in that group.

In a June 25, 2009 Financial Times (London) op-ed piece, Greenspan noted that there is a 3½-year lag between significant increases in the money supply and a spike in inflation.

The money supply is the total amount of money in circulation at a given time.

Over the past 50 years, the money supply in the U.S. increased at an average annual rate of less than seven percent. It never exceeded 10 percent

In the past eight months, it has increased more than 100 percent.

The U.S. federal debt has increased $1 trillion, to more than $11 trillion in the past 6 months. It will likely increase another $1.6 trillion by the end of September.

Some observers lament that this debt must be paid by increased taxes on someone: the rich, the middle class or future generations.

There is another possibility.

The U.S. could default on a portion of that debt.

No, the U.S. won’t simply walk away from its payments like Argentina or your dead-beat uncle. The U.S. can default on its debt by devaluing its currency via inflation and paying back its obligations with dollars that are worth much less than the borrowers expected.

Today, $100 (U.S.) will buy about 60 loaves of bread. The folks buying 5 and 10-year Treasury bonds might expect that when their bonds mature that $100 will buy a few less loaves, maybe 50 or 55.

If inflation averages six percent over the next 10 years, however, that $100 will only purchase 33 loaves.

From a practical standpoint, that is the equivalent of a partial default on their bond. What is an investor to do?

Conventional wisdom suggests that investors should buy gold during times of inflation.

But you know what they say about conventional wisdom.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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