All of the industrial world's central banks and public treasuries currently are engaged in an impossible exercise — trying to reinflate an artificially created boom through zero interest rates and deficit spending. The reality is that the current financial crisis was caused by central-bank money expansion, so it cannot be cured by further money expansion. It is as if a doctor is continuing to bleed a patient who is already bleeding to death.

The monetary-induced boom destroys capital, but this destruction is masked by a monetary illusion. This illusion cannot be discovered by normal financial due diligence; it can only be grasped by understanding proper economic theory, which is called Austrian School economic theory, also known as "reality economics." In order to avoid unprofitable investments, you need to understand how a central-bank-induced boom proceeds from the euphoria of new-era/new-paradigm illusions to the despair that all is lost. You must understand that the boom is the problem and that the bust is the solution. So, "fear the boom, not the bust."

Like others before it in the modern era, this recent boom-bust cycle was caused by expansion of credit, which expanded the money supply out of thin air due to fractional-reserve banking.
Overall, prices rise and wealth is redistributed from those who produce it to those who consume it. Central-bank money expansion initiates this boom-bust cycle, whereby capital is malinvested in longer-term production processes for which there is insufficient real capital for profitable completion. Later, higher prices and higher real interest rates bring the artificially initiated boom to an end, but not before real capital, real vendible goods, have been invested in enterprises that will never turn a profit.

Money expansion ultimately destroys capital and leads to lower production in the future. Because the entire process was a monetary illusion of wealth creation, when in reality it was capital destruction through malinvestment, the coming of the bust should be celebrated, for it is the beginning of the process of reestablishing the structure of production to reflect the true preferences of the consumer.The sooner the boom ends, the better. The boom destroys capital; the bust replenishes capital through savings. The economy needs savings, which are the foundation of production. The current fad, promoted by all central banks worldwide, is exactly the opposite. Central banks want everyone to believe that it is spending that drives the economy, not savings. This is called "Shop-Until-You-Drop Economics," and it is inherently flawed and unsustainable, as I will further demonstrate.

Governments destroy sound money because sound money forces every economic actor, including government itself, to practice fiscal discipline. But central-bank-created fiat money allows government to avoid the hard choices that are part and parcel of an economy ruled by scarcity and uncertainty, and it opens the floodgates for (temporarily) unlimited deficit spending by politicians.

Fiat money allows politicians to buy the votes of special-interest groups through money production, while avoiding the unpopular necessity of taxing the people or borrowing honestly in credit markets, which crowds out private investors. So expansion of fiat money is in government's self-interest but not the peoples' self-interest, although this fact is hidden and propagandized away — for example, by blaming the credit crisis on "greedy bankers."

Furthermore, we all receive or expect to receive expropriated property in some form — governments buy us off with retirement benefits and free healthcare services, for example. Under sound money, the people are the masters and government is their servant. But under fiat money, government is the master and the people are the servants. This is why Ludwig von Mises said that sound money is as important to human liberty as bills of rights and constitutions.

Because monetary expansion masks the true nature of the economy, it is advisable to rely upon an understanding of Austrian economic theory to guide our investment decisions. Austrian economic theory tells us that new money will go somewhere, creating bubbles that cannot be sustained. Examples are the dotcom bubble of the late 1990s and the housing bubble of the first decade of the new millennium. Today's zero interest rates probably are inducing a stock-market and bond-market bubble right now.

Bubbles will appear also in commodities. The prices of corn, wheat, soybeans, iron ore, and oil have risen tremendously in the last year at the same time that production has risen. This phenomenon is possible only due to an increase in the supply of money. There is a high probability of another bubble in farmland prices in America, so it is probably the same in Europe. High commodity prices and low interest rates drive up the capital value of farmland. But this is a mirage. When the bubble bursts and interest rates rise, the capital value of farmland will fall.
This has happened several times in my banking career. The last one in the 1980s was vicious — bankers in Iowa were murdered because they were forced to repossess family farms that were used as collateral for farmland purchases. Other bankers were driven from their professions after death threats. I witnessed this phenomenon firsthand.

A banker from Wisconsin, a prime American agricultural state, recently told me that a land bubble probably already exists — but it is hard to tell. Exactly. It is hard to tell, because the standard risk-analysis methods make farm loans appear to be sound — for now: crop prices are high and interest rates are low. This is the perfect storm for a bubble in farmland prices.
But what about the higher bank capital requirements of Basel III? Won't more capital protect us from bad loans? It is true that higher capital requirements will slow bank lending. If banks cannot raise capital, their only option is to reduce assets in order to meet the new, higher capital-to-assets ratios. But keep two things in mind: (1) more capital will not prevent malinvestment via the boom-and-bust business cycle; and (2) governments want the money supply to expand, and they will continue to make it happen.

A South Dakota banker recently told me, "We don't know what to do with our excess liquidity." But bankers will find something to do with their excess liquidity. They will make loans in the latest hot market, whether it is housing, farmland, direct lending to cities and municipalities (which is a new trend in the United States), or something else that is not on our radar screen right now.
At his latest testimony before the Senate Banking Committee, Fed chairman Ben Bernanke was questioned by a Democratic senator about why bankers weren't utilizing their excess reserves to support new lending. The Fed chairman reassured the senator that in time they would. Where this will be, we don't know; but beware the latest "can't-miss" loan bubble.
Remember, five years ago housing was seen as a very safe investment. It was assumed that the prices of homes never went down, or if they did, it wasn't for very long. But Austrian economics tells us that it is foolish to rely upon past experience to predict the future. Just because housing has always been a safe investment does not guarantee that it will be in the future.

Remember that the purpose of monetary expansion is to make it possible for government to steal resources from the legitimate owners and to take a greater share of new wealth generation (through the silent tax of inflation). So, it is very difficult to invest safely in such an environment, because government will expropriate resources. Your challenge is to avoid investments that appear to be sound under normal financial analysis but are more likely to suffer losses due to the distorted economic environment in which you must operate. So, here are some guidelines.

 

1. Avoid those industries that are most capital intensive, because in an inflationary environment government taxes phony profits. Much capital investment was expended years ago at lower replacement prices, but the tax man does not recognize replacement cost, only historical cost. So capital-intensive industries report higher profits due to low, historical depreciation expense. In effect, they are being taxed on their capital and cannot retain enough earnings to replace their worn-out plant and equipment. America's so-called Rust Belt of the '70s and '80s can be attributed to the inflation that was begun in the '60s. Now it is coming back.
   
2. Be very careful investing in the expansion of industries that are most removed temporally, meaning further away in time, from generating revenue. Two examples are mining and wineries. Unless new mines or wineries can be opened or expanded and new equipment can be employed in a very short period of time, which is unlikely, the boom will be over. This is the classic example of malinvestment in higher order goods — further away temporally from final, consumer goods — that cannot be sustained due to lack of real capital from real savings (not paper capital from the monetary printing press).
   
3. Avoid industries that depend upon increased money creation or some form of government coercion for their existence. This includes governments, who are spending beyond their ability to pay with revenues from taxes. Taxes can be raised only so high before they begin to destroy the very basis of government's existence, i.e., the private wealth creators. So, governments will attempt to pay off their debt with debased money.
   This has pernicious effects for the investor. Government bonds will fall in price, as interest rates rise, and some governmental bodies may default — for example, the state governments of California and Illinois. Governments are not productive enterprises; they depend entirely upon taxing away the wealth of others. They will eventually run out of other people's money. I would recommend that you avoid them.
   
4. Avoid investments that catch the eye of government and environmentalists, such as natural-resource exploration companies. Also avoid investments that governments might tax, regulate, or confiscate. Third-world countries are notorious for allowing investments into their territory only to confiscate them later, such as Venezuela's oil industry or Cuba's sugar industry.
   
5. Do not base investment decisions on tax credits, subsidies, and the like — for example, sugar, milk, wind power, solar power, etc. America's most grievous program along these lines is ethanol production, which is supported by all three types of government interventions. It is subsidized; there are trade barriers to the importation of competing ethanol products, such as sugar-cane-based ethanol; and its use is mandated. (The reduced demand for gasoline in recession-America has created an ethanol glut. By law the refineries must mix a certain total amount of ethanol with gasoline per year. Currently the maximum ethanol blend is 10 percent ethanol, 90 percent gasoline. But at the 10 percent blend, American refineries will not use the mandated amount of ethanol. Congress recently stopped a bill that would require that refineries change the ratio to 15 percent ethanol, 85 percent gasoline.) So, America is facing an ethanol glut.
   America has had these gluts before, and they usually end in price collapse. For example, dairy-industry subsidies created a cheese mountain in the 1980s. The government bought milk at subsidized support prices and stored it in government warehouses in the form of cheese. Eventually, the warehouses were full and the government gave away cheese "wheels" to city governments to distribute to the poor. This program became the subject of ridicule in America.
   
6. Do not rely upon government oversight agencies or private rating agencies to protect you from what later becomes "obvious" malinvestment. New agencies armed with new regulations and enforced by new bureaucrats are fruitless attempts to prevent the evils caused by monetary expansion.
   
    
   Malinvestment is inevitable and impossible to identify even by an army of regulators. The regulators will be blinded by money expansion too. A lower interest rate appears to regulators and entrepreneurs alike to be a fact of the market when it is not; it is artificial. Furthermore, early entrants into a market may make money if they get out early. This leads to the illusion that the market is in equilibrium when it is not. And, don't forget that government wants more credit expansion, so even honest, professional regulators will be under pressure to issue rosy reports of the markets they regulate.