The sight of harvesting machines, highly capitalized farmers participating in commodity futures markets are completely foreign to a hyper inflationary scenario. Such a sight belongs to farming under stable relative prices and available credit.
Please, click here to read this article in pdf format: January 8 2013
This is my first letter of 2013. I was not able to write earlier as I was travelling in Argentina. The situation there is complex and fluid. It would seem easy to compare it to that of Venezuela, but that would be a dangerous reductionism. Three things really caught my attention and are related to what we are going through in the developed world:
a) Argentines, just like everyone else in this world, struggle to find acceptable assets to allocate their capital. This is striking because they have no capital markets and it would seem that real estate or the US dollar should be the no-brainer, natural alternatives. Yet, unlike in the past, they are not. However, the reasons for this go beyond the scope of today’s letter.
b) In spite of explicit acknowledgment by the Argentine government that the monetary base will grow at no less than a 40% per year (this is even embedded in the government budget projections), the government still manages to issue its currency. The country is still far from hyperinflation, although with high inflation. There are no definitive metrics given the media repression, but private estimates gauge it at no less than 25%.
c) Just like some analysts today see a bubble in the price of gold, there are analysts in Argentina who see a bubble in the price of the US dollar vs. that of the peso. This is a country that has gone through two hyperinflations and decades of high inflation within a single generation. I was astonished to see how easily the memory of all this was lost. This is so impressive that even Roberto Cachanosky, a leading Austrian voice in the country and who regularly writes at La Nación, had to devote one of his weekly columns to “explain” that the US dollar was not in a bubble.
Why do I bring this up? Because I still can’t find what the difference is between Ben Bernanke, who is telling me that he’s going to monetize US sovereign debt as long as the unemployment rate (as measured by the government) is not below 6.5%, and Mercedes Marcó del Pont who openly says that monetizing debt does not lead to inflation (as measured by the government) and that the Banco Central will monetize all the sovereign debt necessary to boost economic growth. As much as I hate acknowledging this, I am convinced Cristina Fernandez de Kirchner is right when she says that the developed world lacks the moral authority to criticize her policies.
Real estate under high inflation: Context and assumptions
Let’s return now to the topic of the day, namely real estate as an inflation hedge. Today, I want to offer my family’s experience in the case of Argentina’s hyperinflation and their choice of real estate as the hedge against it. The context in which this story takes place is one of high inflation, in which the market knew two things: a) It was a point of no return, and b) It was going to get worse before it would get better.
I think it is clear that none of these points are visible today in the developed world. For instance, gold was sold last week simply because the FOMC minutes suggested that the same Fed that has to buy approx. 90% of the Treasury’s long-term debt issuance to keep rates from rising (without much success one must add), may end the purchases by the end of this year.
The context of the story was also one of increasing financial repression. As I suggested earlier, inflation and financial repression are only two different sides of the same coin. And as inflation spikes, so do interest rates, for the trust in the system collapses. Only with higher rates can central banks sustain a target level of deposits, so that the coerced banking system sources the funds needed to buy sovereign debt. High nominal interest rates and inflation then, go hand in hand.
In such a context, there is no return and the market knows it will get worse. The fear of confiscation sets in. Confiscation can and did take place in two ways: a) Between private citizens/corporations, in which case, we are in the face of explicit wealth transfer from creditors to debtors or landlords to tenants, and b) from private citizens/corporations in favour of the state.
A true story
In 1973, Argentina decided to nationalize bank deposits and to impose a 100% reserve requirement. This measure however was not to last long and by 1976, the banking sector was again allowed to leverage on its deposits. To fight the increasing exodus from the system by depositors, the central bank decided to encourage deposits by paying interest on savings accounts deposits and charging a fine on current account deposits. By 1980, 90% of all deposits were in savings accounts under 90 days and the average lending rate was 35%. This brought about a spiralling quasi-fiscal deficit (i.e. a deficit at the central bank) that led to the hyperinflations of 1985 and 1989 (Read more about this –in Spanish- here)
It was in the context described above that my father first lost his first apartment and later bought a ranch as a hedge against the increasing inflation. The apartment in Buenos Aires was lost to a tenant, in the early 1970s, who took advantage of a new bill favouring tenants over landlords. That apartment was my parents’ first home and they had only vacated it because they were working outside Buenos Aires at the time. It was not their investment property. My father ended up negotiating a ridiculous discount to at least get something back, but he basically lost it all. There is really not much more to say in defense of the investment-in-condos thesis as a hedge against inflation (Remember that if rental contracts at one point, given high inflation, become denominated in a foreign currency or gold, the government will very likely fix the price of these assets (i.e. fx, gold) at an official rate, below the proper market prices. Landlords will receive that official rate and will not be able to challenge it in court).
In 1978, however, my father did purchase a ranch for investment purposes, in beautiful Patagonia. Today, I want to share this experience, vis-à-vis the thesis held by Jim Rogers because my father back then thought like Mr. Rogers today.
The Jim Rogers thesis
Briefly, Jim Roger’s thesis is old and simple: The monetization of sovereign debt means higher commodity prices and owning a farm is a means to both profit from these higher commodity prices and protect one’s capital, invested in land. In Jim’s words, farmers will drive Lamborghinis.
Well, it may be true in the early stages of a hyperinflationary process. But as inflation arrives to stay and the money printing becomes structural, the financial repression that follows challenges the thesis. As well, just like in the first world today newer taxes or higher tax rates are being imposed on those lucky enough to be able to save and invest, back then politicians engaged in demagogy and established new laws to favour debtors and tenants over creditors and landlords. In my experience, under high inflation, the price of agricultural commodities rises in local currency terms because of shortages in production. There are shortages because producing is not profitable. Rising nominal prices therefore are not a signal to encourage production, but precisely the opposite; the reflection of supply shortages because producing is unprofitable. The unprofitability, of course, is caused by the government’s intervention via price controls (wages, foreign exchange), higher taxes, trade restrictions and outright confiscations. To expect that farmers will be able to receive international market prices for their produce under high inflation is naive at best. I know of no nation under high inflation, where its government would have not controlled exports (or their prices) of necessary goods (i.e. food), or forbidden imports of luxury goods.
The case of “Los Maitenes”
My father bought Los Maitenes (the name of the ranch) in 1978 with the simple idea of protecting his capital. He was not a rancher, although he knew the business well from my grandfather (who had managed an estancia for Mr. Bunge in the 1920s). Indeed, it was not a farming property in the sense Jim Rogers means: It is in the mountains and is for the purpose of raising cattle. Growing grains there is not efficient. However, whenever the price of grains rises (in US dollars) and the agricultural frontier shifts to the West, land formerly used for cattle in the Pampas needs to find a replacement and ranches in Patagonia get bid.
To my father’s disappointment, rates and the appreciation of the US dollar continued to outperform ranching. Under high inflation, soon everyone wanted to own (“stock up” would be a better word) products, but not producers. Nobody was interested in producing anything and it was not due to some behavioural problem, as Keynes and its followers always point to. Simply, the distortion in relative prices and the disappearance of credit for working capital (i.e. nobody in the business of “making stuff” could any longer reasonably calculate whether they did so at a profit or at a loss) was too high to bear. My father then became a forced long-term real estate investor. Nobody was interested in buying him out of the ranch. It was far better to keep playing the dangerous game of earning absurd returns in savings accounts deposits, subsidized by the central bank, or to keep your capital in foreign currency, fully liquid. It was a game that would last until 1989, when deposits in savings accounts were confiscated and paid back in bonds. In my view, we can see this same phenomenon playing out further down the road of this ongoing inflationary process, whereby gold would play the role the US dollar played in Argentina.
In the meantime, my family had managed to survive from other income sources until 1981. In that year, their most important source, a concession on a beach resort in Mar del Plata, was finally expropriated under the regime of General Galtieri. The thesis that owning a ranch was the final hedge against inflation and general chaos suddenly became a reality and in January 1982, my father set off to Patagonia. It was a three-day long trip with a trailer (see picture below). In this trailer, we would live the first three months.
Picture 1: A stop on the way to Los Maitenes, January 1982 (I am on the right, next to my mother and sister).
A few months later, war broke with the UK over the Falkland Islands. Living in Patagonia, this meant that everything could be taken from us at any moment, if either the UK or Chile invaded. Fortunately, this scenario did not play out. However, during that first year at the ranch, my father found out that squatters were living in different parts of the property. Once again, even though he managed to negotiate a settlement with some of them, the government expropriated a few hectares from us. I am sure Mr. Rogers did not take into account this sort of inconveniences, but expropriation becomes very real when credit disappears and food shortages follow. As I wrote in my earlier letter,”…thousands of years of Diaspora are screaming to us in the face that the advantage of gold as an easy-to-transport and store asset is not to be underestimated…”
From 1983 on, inflation began to grow exponentially. Soon, it became difficult to know if one was making or losing money. Relative prices in terms of US dollars fluctuated widely and in general, over the long term, everything tended to depreciate versus this currency (just as I expect prices to continue depreciating in terms of gold, if QE remains eternal). Without liquidity and credit, farmers began to barter. The most liquid items were alfalfa hay, flour, wire rolls, gasoline and meat. Contracts could be settled in alfalfa bales, 10-kilo flour bags, fencing wire rolls (1,000 meters per roll), and litres of gasoline or kilos of meat.
Bartering, my father survived those years. He hired men to plant, irrigate and harvest the alfalfa lots in the ranch, on a partnership basis. Whatever alfalfa bales he managed to keep, he used them to further buy cattle or to pay for labour. The cattle were then bartered at the nearest general store to buy groceries. Anything outside the bartering circle became extremely expensive (clothes, fuel, electronics, etc.), as cattle or alfalfa bales had to be first exchanged for currency.
The years of high inflation were years of self-sufficiency. It took us about seven years to build our house, for we had to produce our own bricks (adobe), stucco and wood. Below is a picture worth a thousand words: In it, we see Don Onofre Grandón, carpenter, working a poplar tree just cut down at the property to produce one of the rafters for the roof frame of our house. Circled far in the back, we can see a stock of adobe bricks also produced at the ranch. This picture was taken on January 1989, during the last hyperinflation.
Picture 2: House building under hyperinflation
The picture above is comparable to a painting of the London’s Carpenter’s Company in the late Middle Ages. Any European peasant resuscitated from the Middle Ages would immediately recognize and feel familiar with this scene. This is a typical scene of a farm in times of hyperinflation. And it makes perfect sense: Under the Pax Romana, the owners of villas were rich. When hyperinflation finally destroyed the Roman Empire under Diocletian, owning a villa was a liability, as one could not trade the produce without price controls or safe transportation and was further subject to either looting by barbarians or confiscatory taxation by Rome.
The above picture shows a scene of non-monetary exchange, no access to a Home Depot, no credit, no capital markets nor commodity markets (either spot or futures). The sight of harvesting machines, highly capitalized farmers participating in commodity futures markets are completely foreign to a hyperinflationary scenario. Such a sight belongs to farming under stable relative prices and available credit. Eventually, both came back after the peso collapsed and became convertible to the US dollar, in 1991. It was only after the hyperinflationary episode, when the peso as legal tender was fully repudiated, that farming became again a productive enterprise, when the government had no choice but to become friendlier to open markets and seriously diminish any form of financial repression.
The story I just shared is definitely not what Jim Rogers has in mind. During those years, holding US dollars or taking the risk of financing the government with deposits at the banks far outperformed any productive project. However, at one point (in 1989), even financing the government ended up a losing proposition, and term-deposits were confiscated (see the announcement of the confiscation here)
US dollars (or any other stable foreign fiat currency), in the end, were king. When I extrapolate my personal experience to our current situation, I feel confident that holding physical gold to the end will also be the winning strategy. Hence, my disagreement with Jim Rogers: Farmers will not drive Lamborghinis if inflation spikes.
During those years, the government constantly sought to manipulate the price of the US dollar or to discourage everyone from holding foreign exchange. This too is happening with gold and I expect it will become more pronounced in the years ahead.