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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