Saturday, March 21, 2009

Hyperinflation Is Impossible: Addendum

I received quite a bit of feedback to my last article, "Hyperinflation Is Impossible." Most of it was in agreement, some of it was not and gave good counter-arguments, and a small portion was hateful. One person went as far as accusing me of working for the US Government and issuing propaganda. I got a kick out of that one. That never surprises me though. It is a fairly divisive issue. I've seen the arguments from both sides hashed out for years. Long before the crisis even started, folks who knew it was coming were arguing over which shape it would take. With estimates of over 45% of the world's wealth disappearing in 18 months, it should be obvious which ones were in the right. But strongly held opinions die hard, I suppose.

Today, I'll try to dissect most of the counter-arguments that I didn't in the original article. I'll likely miss some of them, but will try to pick out the most important and less ridiculous.

For the record, I don't really think anything is impossible. But I don't walk around trying to protect myself from being hit by lightning. I don't wear a helmet when driving my car. And I rarely bother tagging my baggage at the airport. There are some things that are worth preparing yourself for. Others are such low probability events that preparing yourself for them can actually be counter-productive. This is how I feel about any talk of an imminent hyperinflation threat. As I mentioned in the article, the US Dollar will likely fall victim to collapse at some point. But there are too many factors conspiring in it's favour during this specific crisis. When the stars align again against the dollar (like they were in the 70's) I'll get bearish. But that could be decades away.

For the most part, I feel that those who were disagreeing with me on this matter are massively underestimating the role of changing behavours toward consumption and debt. Areas where the Fed may succeed in expanding the total supply of money and credit, it will be rejected by frugal consumers. Indeed, had the Fed been doing what it is doing now 10 years ago, we would have seen massive inflation. And it could be argued that we did see massive inflation over the last few decades from the actions of the Fed during the early 90's and early 00's recessions. Most monetary aggregates rose by over 10% yearly. And if you insist on using prices as your definition for inflation, how about these factoids:

Stock prices averaged an 18% return plus dividends over 12 years ('88-'00)
Real Estate prices averaged a 10% return in most regions over 15 years ('91-'06)
Commodity prices averaged a 15% return over 7 years ('01-'08)

As Mike Shedlock and others often point out, if one were to substitute home prices for the absurd "Owners Equivalent Rent" portion of the CPI, we would have seen numbers in excess of 10% for over a decade (and negative now). Hyperinflation is most often described as inflation that is "out of control." I would argue that we were dangerously close to that.

The point of this detour and talking about the last few decades of inflation is that it occurred while the Fed and other CBs were doing far less than they are now to encourage it. Why? Attitudes. People were willing (even if they weren't able) to take on the debt that was being offered to them in order to create demand for all of the above. It was the same story for the banks. They weren't exactly able to lend either. So they created all sorts of accounting tricks to make themselves able. The underlying driver of the inflation was not really the Fed's encouragement (although that did help), but rather banks' desire to lend, and people's desire to borrow.

In reality, the Fed wasn't the main driver of the problem then. And now that those desires have done 180's, the Fed certainly cannot be the the driver of a return to that problem. I'll give a few quick examples of these attitude changes on the part of consumers, before getting to my mailbag.

First, is today's poll from Canada's Globe and Mail. The question asked was: "Do you think you will resume your old spending habits once the economy rebounds? Yes or No" As of now, over 60% of respondents have answered "No."

Second, is the title "Austerity Tide Hits Florida Beaches." Understand the dynamic at work here.

Lastly, read this entire article from somewhere in Missouri: "The New Economy of Frugality." You think once these people learn how to cook for themselves, they'll automatically go back to eating at Red Lobster twice a week? You think they'll plow over their gardens when the economy recovers and replace it with energy-sucking swimming pools? Neither do I.

Ok, and now to some reader responses.

First comes from Steven Saville of the Speculative Investor. I've read Steve for years and respect his work very much. Let's see what he has to say:

...there's not a lot I disagree with in the article you linked. First, I'm not expecting the dollar to tank against other fiat currencies (on a long-term basis I'm actually more bearish on the euro than the US$). Second, I believe that private sector credit will either contract or remain stagnant over the next few years. Third, I have argued against the "hyperinflation is imminent" view (I don't think there's a realistic possibility of hyperinflation occurring within the next few years, although it will ultimately occur). Fourth, I disagree with the de-coupling theory put forward by Peter Schiff et al. Fifth, I don't think the moonshot in the monetary base has near-term inflationary implications.

Regarding gold, I've noted at TSI in the past that it is not a good hedge against monetary inflation or the so-called (but poorly named) "price inflation". It is a hedge against a loss of confidence in the official currency and in the purveyors of the official currency. Sufficient monetary inflation will eventually lead to such a loss of confidence, but it can take a long time.

The best long-term measure of confidence in the US$ is, IMO, the Dow/Gold ratio. Gold was extremely over-valued relative to the Dow in 1980, indicating that confidence was at a low ebb. At that point one of two things had to happen: a total monetary breakdown or a secular trend reversal. Obviously, it was the latter. Another secular trend reversal occurred in 2000 (the confidence peak).

Despite the areas of agreement, my view is that an inflation problem is building because the private sector debt bubble is in the process of being replaced by a public sector debt bubble. Note that even though the private sector has been retrenching, total credit in the US economy is still expanding and M2, which doesn't include bank reserves, is 10% higher than it was a year ago.

Cheers,
Steve

Thanks Steve. Some good points were raised here by Saville. Indeed, there's little we disagree about. He brings up the expansion of M2 as a potential warning sign that inflationary pressures could be building. As most of my regular readers have noticed, I don't rely much on government statistics as support for any arguments. They are way down on the list when it comes to importance. But let's have a look at the M2 measurement of the Money Supply. Wikipedia defines M2 as "M1 + most savings accounts, money market accounts, retail money market mutual funds,and small denomination time deposits (certificates of deposit of under $100,000)"

In my opinion, a rising M2 could be explained by a number of things. First off, notice the inclusion of money market mutual funds. What are these? Again from Wiki: "A money market fund is a kind of mutual fund (technically, a regulated investment company). Investors receive shares in this company, which buys securities (for example, commercial paper). There are rules on what kind of securities may be held and rules about diversification. Thus, investors have risk on the assets, but not on the bank." My question is this: how much are all of the money market funds really worth if they were marked to market? And what would M2 look like if this were the case? I would guess quite a bit different than the 10%

And second, because M2 includes M1 and all savings accounts, I question whether an increase in this metric tells us anything about inflation. Because of the current consumer retrenchment, we know that debt is being paid back and people are desperately trying to boost their savings. If they are selling their assets (stocks, real estate, etc) and putting the proceeds in their savings accounts, we are only seeing a shift in asset allocation, not necessarily a growth in the total amount of money and credit.

The next point raised by Saville was that he believed a growth in public debt was going to replace the private debt bubble that is currently imploding. I don't disagree that public debt will grow. But will it grow enough to create net inflation? I highly doubt it. Consider that total US public debt currently "only" accounts for 1/4th-1/5th (depending on whose numbers you trust) of the total US debt burden (and this does not factor in the many trillions in possibly worthless credit derivatives). So in order for an increase in public debt to adequately negate the deflationary effects of a crashing private debt, it would need to increase at a rate many times greater than the decrease in private debt - and do so for years on end.

This is possible. But would likely take many years to transpire.

Reader Mike Monchalin writes,

Yes, I understand how the US debt/credit system is deflationary and different from Weimer/Zimbabwe's paper based system. But isn't it possible that paper could be printed in the U.S? Everything that the fed has done so far has been within the debt/credit realm.

Now, the Federal reserve has said it will buy as much as $1.15 trillion in bonds to lower borrowing costs. Could this be the beginning of monetization?

I understand the scope of debt is incomprehensible. But why can't monetization occur on the same incomprehensible level?


Good question. There is currently about $800 Billion in physical notes issued by the Federal Reserve. If I understand the question correctly, you're asking why the Fed can't just start multiplying this number like crazy a la Zimbabwe and just mail it out indiscriminately to US citizens? Of course they could (I've learned to never underestimate the stupidity of central banks). But again, we run into the problem of what people would use the money for. Would they use it to buy skidoos? Or would they go directly to the bank and use it to pay off their mortgage or credit card? I think they'd do the latter. Considering 50% of Americans are one month's wages away from financial ruin, I don't see how one could think otherwise.

Reader JLak at the Generational Dynamics forums writes,

This subject demands a more quantitative treatment. Unfortunately I don't have one to offer, but I can suggest some rational questions to ask. First, the quadrillion dollars or so in derivatives has a centroid (zero-value point) about a certain economic indicator, probably home prices equal to 2007 levels or so. As we approach that point, the risk will evaporate. What is this point? Secondly, with the takeovers, the Fed/Treasury is the counterparty in much of the paper trade, so there is no risk. How much of the derivative market does this represent? Thirdly, every trade has two sides. The Fed/Treasury now holds most of the downside risk. How much upside risk do the banks hold? Fourth, the risk models may have been updated, but in banking, that just means more insurance and higher interest rates. What is the interest rate at which the banks would start lending out their massive excess reserves?

Macroeconomics is more mathematics than narrative sociology. There is a very definite point at which hyperinflation will occur and a very definite point where deflation will occur. Social trends are good to consider, but the fundamentals do matter in economics just as in bridge building.

I disagree with this wholeheartedly. To be sure, we are taught that economics is a mathematical study in most colleges and universities. But this is false. And it is false for the same reasons that Neoclassical models suggesting home prices would never fall were false: because you cannot model human action. In order to make a quantitative statement that "hyperinflation will occur under these specific conditions," but "inflation will occur under those conditions," we need to make literally dozens of assumptions all along the way. How will people react to the increase of A? How will banks react to a decrease in B? All we can do is see what they have done in the past and assume they will do the same in the future.

Think about it. If there was a way to actually determine this, why hasn't the Fed managed to create inflation and prevent deflation from taking hold already? How many interventions are we at now? It's got to be over 20. I've lost count. But each and every one was brought forth with the promises of some economist that his proposed solution would work. None of them have. Why? Because you can't model human action! People are acting in ways they haven't acted for 80 years. The economists with these models either don't have reliable statistics going back this far, or they do and simply don't like the results it gives them. So they make assumptions, which are usually total garbage. Garbage in, garbage out.

I realize that it is frustrating to never be able to predict anything with 100% accuracy. For most economists to admit this, it would require them to admit that most of their qualifications are useless. Much like the astronomers who were put out of work once Galileo had proven that the earth was not the center of the universe.

Neoclassical economists have been trying for over 150 years to base the study of economics on mathematics. It has failed miserably. All along, Austrian economists (whose roots were predominately philosophical) have told them they were fools because their models were ridiculous. (So have Marxists - but they're wrong for other reasons).

I also received a number of questions regarding Wednesday's announcement by the Fed that they are going to be buying 1.2 trillion in securities, some of which will be US Treasuries. Has the monetization begun?

Let me direct you to Kevin Depew, who answered similar questions like this:

So this desperate move by the Fed, the final bullet so to speak, this is clearly hyperinflationary, right?

Not by a long shot.

Here's the thing: When the Treasury issues debt, it takes liquidity out of the market as cash is swapped for Treasury bonds, bills and notes. When the Federal Reserve buys those Treasuries from the dealers, it is injecting liquidity back into the market. But, because the Fed's announcement will cover less than a third of Treasury issuance this year, all that is taking place is that the Fed is desperately trying to at least reduce the amount of liquidity the Treasury is sucking out of the market.

But wait - there are other, more complicating factors at work.

Household net worth has declined by roughly 20% since peaking in 2007, according to the Fed's own figures. Household "wealth" fell by $5.1 trillion in the fourth quarter alone. Combined with rapidly increasing household savings, the Fed, by moving to artificially suppress interest rates, is inadvertently quashing the very risk appetites it desperately needs to motivate in order to kickstart its own ongoing Ponzi scheme.


I don't think I could have put that better myself. These suppressed interest rates are contributing to the lack of willingness of banks to lend. If you were a bank manager, would you make a home loan to somebody for a measly 4% when home prices are expected to decline at least through 2010? I wouldn't. In fact, it would have to be a pretty good business plan for me to consider lending money to ANYONE at 4% right now.

In conclusion, the Fed can do whatever it wants. But if there is no desire for people to do anything with the new credit (or money), it will not have the initial inflationary implications on people's decision making. In order for people to get paranoid to the point that they will buy goods as fast as they can and get rid of their money (hyperinflation), they need to see prices rising first. Otherwise, they will hoard the cash and wait for lower prices. That is, the velocity of money is too low for inflation to take root. They certainly will not be in any rush to take out loans to buy things that are falling in price.

The Fed has been promising that their interventions would be successful in preventing deflation for 19 months now. They had philosophized about it for years prior. And it has failed because the assumptions behind that philosophy are faulty. The same philosophy has failed for 20 years in Japan. The same philosophy failed 80 years ago in the Depression. It will fail again.

I tried to tackle as many of the arguments that made sense as I could. I realize that deflation is not exactly a sexy process. There's not much money to be made on any investment in such a situation. Therefore, it is much easier to wish for hyperinflation so we can all buy gold and get rich quick. If life were only that easy...

My investment stance remains the same. Cash held in various forms and banks, a little bit of gold, and short positions on stocks if you want to take risk. After a few years, one can start picking up cash producing assets (dividend stocks, arable land, rental buildings, small businesses, etc).

Leaning too heavily toward a continuation of the inflation trend could prove disastrous for one's financial well-being.


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13 comments:

RRB said...

Matt,

If I understand you correctly, your hypothesis is that a natural damper on the growth of the money supply in a credit based economy is the growing and sustained reluctance of the population to take on additional debt, which in turn limits the number of new $$ created by the Fed.

What about the fact that the largest customer of the Fed - the US government - is willing to borrow and spend all the money that the Fed can lend? With government participation in the economy getting to be such a high % of the GDP, can't government spending itself increase velocity of money?

This is where I am stuck - appreciate your inputs.

- R

RRB said...

Alternately, here's a question: is there any natural limit on the amount of money the Fed can lend the US government?

What are the implications of the Fed writing off money owed to it by the US government?

I don't know if these questions are naieve, but I don't know the answers.

fish10 said...

Ultimately nothing ends deflation like a big war.

The Great 'Deflation' of the 1930's finally ended with the start of WW2.

Why? Because the government pays for stuff that it blows up! Sounds silly, it isn't. It buys hugely expensive ships, missles, planes and hires lots of soldiers.

However the products are not cars and shoes which someone has to buy, they are used to fight a war and then left to rust somewhere.

Meanwhile all that money is chasing a smaller pot of goods (since pruduction has been diverted to war production)

All great inflations happen duing or right after major wars

Matt Stiles said...

RRB - As I mentioned, government can replace the private sector, but it will take a long time for it to do so. In the meantime, deflation will reign supreme.

There are no limits to the amount of debt, but one would think the American people and then congress will eventually say "enough is enough." Riots, tax holidays, etc.

Fish - It seems to follow that war and inflation would go hand in hand. I guess it kind of depends where the war is and who's winning, doesn't it? I can't imagine people would rush out to buy houses when they could be blown up or taken over by the enemy. The 30 years after the US Civil war were deflationary (average of 2% per year). WWII saw prices of some things rise, but not hyperinflationary by any stretch. Stocks took until '55 to reach their '29 peak again. Real estate took until '49. But WWII (for the US) came more than a decade after the start of the crisis. By then, prices had nowhere to go but up, and behaviours were sufficiently changed. Time and price is the usual cure for deflation. So was it the war, or was it simply 'time' for the deflation to end?

Fish10 said...

Matt my scenario of inflation was for the winning side! :) Of course the losing side experiences infinite inlfation as it's currency becomes worthless.

Inflation and war are frequent bed-fellows. look at the great depression....

Inflation rates were negative 10% and negative 5% for 1932 and 1933 and despite Roosevelts New Deal (which I agree with BTW) continued at near zero with some negative years until 1942 when they suddenly shot up by 11% in one year. 6% the following year. 15% in 1947. 8% in 1948.

Inflation then settled to low single digits until late in the Vietnam War when they shot up again and stayed high for several years during Reagan's cold war spending.

Like you I dont accept recent inflation numbers as legitimate and think we have had several years of severe inflation (oil, housing, commodities etc all doubled or more and yet the 'official numbers' were low).

Now we are unwinding and are in deflation.

IMO eventaully the Central banks WILL win out and will devalue money enough to stem deflation and turn it around, but I think we still have a ways to go.

Namke von Federlein said...

@Fish10

I have been working for 8 years to try and prevent the US civil war from breaking out in Detroit on August 14th, 2009. I would take a long, hot summer rather personally right now. I only tagged it as a warning. And I am really, really not happy today.

A war economy is not an option for the USA. I won't go into the details.

It would seem (just my opinion) that the epicenter of the credit crisis has not only been tagged - it has been put into the position that the Fed was before they pulled off the AIG make. Do you really, really want all that publicity? Do you really, really want someone to open your books? Or do you really, really want to carve 500 trillion off fictional b******t before everybody loses their temper?

Hey Matt - guess what they might have said? Just my opinion - not a fact.

I was going to make a post on my blog calling this 'The Sleepless Weekend'. After the Fed's latest 1.2 trillion cash grab - I mean - wow. It's not their money. They aren't even a part of their country! (generally called the USA).

And the whole world is holding its breath waiting for the crash of the USD. The whole world is hoping that suddenly, as if by magic, somebody somewhere does the math - and then does the right thing. I hope so, too.

After all, I could be having lunch with you tomorrow on commercially scheduled flights. So could old Osamara and his band of merry makers. It's a very small world.

Anyway - I really hope that the next issue of Rolling Stone takes it to the next level. Find that man of wealth and taste? After all, he lives somewhere. And so do the friends who owe him money.

Just think about it - Retention fees for people who don't even work at AIG anymore being considered 'sacred contracts'? Pension plans aren't sacred, union contracts aren't sacred. But the AIG contracts are needed to retain (how poetic, huh) the best talent - even if some of them don't work there anymore??? Who are they paying off, exactly? After all, only the Devil himself says - a deal is a deal no mercy. Everybody else pays cash - out of their bonus.

I could hide out under there
I just made you say underwear
(Barenaked Ladies band)

I'm just hoping that Monday (tomorrow) will be remembered as White Monday. As opposed to Black Friday.

But - hey - time for a joke. It's your move...

mannfm11 said...

As usual you wrote a good post here Matt. I have been debating deflation for this entire decade and there is stuff I have written all over the net. I just wrote a long comment that the computer lost for me so I will try to write again.

First of all, hyperinflation isn't impossible because the fed or the government could go broke, but the Fed is far from printing money. It is merely using powers banks have to create credit out of thin air. The Fed must also be concerneed with losses, so this is why they at least appear to insist they are getting AAA stuff.

But, what they are doing is merely transferring assets in exchange for collateral. The bank still has the same liability, the money they created when they bought or acquired the loans or bonds to be purchased by the Fed. Thus the bank has been made the middle man in a transaction where the Fed now holds the asset and the bank holds a deposit with the Fed that they owe to their customer.

The printing happens when the bank acquires a new asset. So, lets say the Fed comes to market with $100 billion in Fed notes and bonds a month after they bought $100 billion. The banks would merely use their fed credit to buy this stuff. If the bank had a good way to cover itself out of attracting deposits or government checks, it could merely create the money to buy the bonds, but being that the Fed is the destination of the money to buy the bonds, this is highly unlikely.

What I think is going to shock people is how deflationary this is. For one, the Fed is buying the performing assets out of the bank, not the junk. They are going to offer leveraged loans to finance the stuff to investors who make between a 5% and 20% downpayment. These downpayments, if they are used to buy bank assets, will come right out of the money supply never to be seen again until the bank makes a new loan.

The recent growth of the money supply as evidenced in m-2 is most likely due to companies drawing their credit lines while they could, maybe money market accounts needing bigger lines of credit to keep themselves liquid or companies having to use bank financing because the environment hasn't been good for issuing bonds. If the third reason happens to be the case, we will see a huge decline in M-2 once junk bonds become more marketable. I am assuming this will happen, because it appears the Fed is going to push for it to happen.

The question is who is going to get in debt in this environment other than someone who has been living on credit and is out of work and borrowed up? I see people are attempting to catch falling knives in the housing market, but it appears the bulk of sales are to speculators that are buying REOs at a fraction of their prices 2 years back. I don't think there is a bottom in houses that will seem reasonable to most folks, meaning that unless there is a hard turn upward in the economy, they are going lower than most people think. This won't make any difference if they owners find out they can't rent the homes or cashflow stays below rent price.

Another thing is I don't believe capital is loaned on a supply and demand basis, but on a risk and return basis. If the government is going to not only become the buyer of last resort, but the buyer of any resort, they are quite likely going to end up with a big loser, as long term rates will go their own direction and most likely the world will take out the missing return out of the dollar. This will serve to drive down units demanded, not raise them.

Bearded Spock said...

Thanks for the link, RG. It is an interesting argument, but it only takes into account the monetary policies that are inflationary. Fiscal policies also effect inflation, particularly government spending.

Futronomics gets the China issue exactly backwards. It's not demand from Chines consumers that will drive up prices and cause price inflation. It is the decreased willingness of the Chinese to invest their trade surpluses in U.S. Treasuries.

With a significantly smaller market for U.S. government debt and no appetite to reduce spending in Washington, U.S. fiscal deficits will be financed by selling treasuries to the Federal Reserve. This amounts to conjuring money out of thin air. As money is a commodity like any other, an increased supply will make each unit of money less valuable. This is how monetary inflation results in price inflation.

Compounding the risk is that every dollar created by the fed is multiplied into about ten dollars through the magic of fractional reserve banking.

Bernanke's zero percent Fed Funds rate and Quantitative easing was bad enough, but when the government and the Fed are forced to "print" money just to meet payroll, capitol will start fleeing all dollar denominated assets, further destroying economic output and therefor tax revenue. This in turn will force the government to print the difference again and the whole cycle repeats until either dollar value reaches zero or government spending does.

The fiscal time-bomb of social security and medicaid alone guarantee that there will be no significant cuts in government spending.

abs said...

Bearded Spock -

I have to disagree with you on many levels. Your argument is the one we've been hearing from many of the 'pundits'. The problem is that although your comments might be valid in normal times, we are not in normal times now. The size of the US Government's spending plans and the quantity of new dollars being produced by the Fed does not come close to compensating for the destruction of wealth worldwide or replacing the valuations of risky assets held by financial institutions. Also, you are assuming (incorrectly) that every dollar spent (or created) will result in a 10x increase due to reserve banking or a multiplier on GDP due to the velocity of money in the economy. Unfortunately, it is all too convenient to ignore that attitudes towards debt have shifted dramatically as has spending. As a result, the velocity of money has been hovering around 1 resulting in no multiplier effect and secondly, corporates and households whose liabilities are now greater than their assets (call it a balance sheet recession if you like) are unwilling to incur new debt and are trying to paying down current liabilities. The result? Long term lower rates of borrowing and lending relative to what we've seen over the last decade or two. The magnitude of these issues and the feedback loop ramifications of the same will likely result in these processes and pressures continuing for a very long time (years to decades).

The problem for most people is that the shear magnitude of these dynamics are very difficult to wrap one's head around and I think this is a big reason for so much misunderstanding.

Anonymous said...

Dear Matt,

Thank you for article! It's excellent, and I learned a lot.

However, I don't understand the below part: "They (the Fed Reserve) are creating electronics reserves (credit) to support the balance sheets of the big banks".

Why buying treasuries from a bank or a third party will support bank's balance sheet? My understanding is that this is a simple exchange between two different asset items on the balance sheet.

Would you please elaborate more on it? or recommend some resources to help me better understand this issue?

Thanks A Lot
Jacky

Jon said...

Matt, great points about the ongoing facade of distinguishing "consumer price inflation" from asset and commodity price inflation in recent years.

Steve Keen provides a (very) detailed explanation of the impotence of the Fed in creating monetary inflation by demonstrating how money is endogenously created by the financial system - only in response, of course, to the willingness of borrowers to take on additional debt. URL is below:

http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

John Britely said...

I enjoyed your article but I'm not totally convinced. I think that government spending will replace private spending sooner than you think.

Second, we can have some really severe reductions in purchasing power even if it doesn't meet your definition of hyperinflation. The price of things like derivatives and luxury goods will fall while the price of food and fuel could rise. Incomes may be flat with higher unemployment. Thus, it might feel like the 1970's even if M2 is not increasing. What is your definition?

Vincent Cate said...

I have a post, "FAQ for Hyperinflation Skeptics" that people might be interested in:

http://howfiatdies.blogspot.com/2012/10/faq-for-hyperinflation-skeptics.html


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