I get a lot of emails and questions from readers and friends about whether I think the US Dollar could collapse and start a bout of terrible hyperinflation. The questions are usually stemmed from watching an interview on TV with extremely biased energy/gold analysts. People who have every reason to sell you on hyperinflationary doom in order to make themselves a quick buck. I have no respect for these people, so I will not publish their names. They know who they are. I call them the "opportunistic hyperinflationists."
But there is another group of "inflationists" who I do respect greatly. Guys like Peter Schiff, Jim Rogers, Doug Casey and Jim Puplava. These guys have spent years, if not decades, railing against the growing debt bubble and warning that it would end badly. A large faction of the Austrian School of Economics (of which I consider myself a student) had been doing the same. They are the "ideological hyperinflationists."
However, this group of economists/pundits/analysts have been terribly wrong in predicting how this debt bubble would unfold. And I am certain that they will continue to be wrong as it continues and reaches it's ultimate conclusion. Typically, these folks have a fundamental dislike of our current system of currency. The feel it is immoral, illegal by the US constitution and is doomed to failure as all paper currencies have been since the beginning of civilization. I agree with them on all counts. But as a function of their dislike for paper money, they have been enchanted by its most obvious replacement: gold. They carry it around with them and flash it at interviews. They become walking salesmen for the return to a gold standard. And they point to a rising price of gold as proof that they have been right all along.
They haven't and aren't.
Their arguments are usually the same. That in order for the massive amounts of debt to be repaid, the Federal Reserve and other central banks are going to have to resort to monetizing that debt via the "printing press." Their claims are well documented. Even the Chairman of the Federal Reserve has promised to do this, should it prove necessary, earning him the nickname "Helicopter Ben" (after promising to drop money from helicopters to prevent deflation). And it appears he has already started. We can see it in their own figures. By now, I'm sure all of my readers are familiar with the Monetary Base "Hockey Stick" graph below that shows how the Fed has essentially doubled the monetary base in just a few short months. This, claim the inflationists, is visual evidence that hyperinflation is already occurring and will inevitably start showing up in everyday prices:
Another common claim by these folks is that inflation is running at far higher levels than what is reported by the very flawed CPI measurement. For proof of this claim, they'll point to John Williams' "Shadowstats" counting of inflation in charts like the one below. It shows that if we only counted inflation like we did pre-Clinton Administration, inflation would be much higher than we're told.
In this article, I will explain why these arguments are wrong.
Money and CreditFirst and foremost is the apparent misunderstanding of the differences between money and credit. At times, they may appear to have the same characteristics. At other times they act completely opposite from one another. As an economy is expanding, an increase in the total amount of credit would appear to have the same effect as an increase in physical dollars because credit is widely accepted as an equal to money. In a sense, they
are the same. They are both "fiduciary media" (in english they are both a
representation of something else, rather than having intrinsic value themselves). But when the economy is contracting, the prospect of default is thrown into the equation. When this happens, money increases in value relative to credit. Money is more valuable than credit because in the event of default, the physical dollar holders are king. Yes, the US treasury could default on it's obligations. Holders of treasury bonds would get a big, fat zero, while holders of physical currency would still have a claim. In effect, they act similar to a preferred share as opposed to common stock. They are a step above in terms of priority.
It is often said that we live with a "fiat currency" or with "paper money." This is not entirely accurate. A very small portion of our total supply of money and credit is in the form of physical currency. It depends on how you count it, but regardless, it is under 10% of the total. This is what differentiates our monetary system with that of Zimbabwe or Weimar Germany circa 1920's. Their economies were based on nearly 100% physical currency because nobody would accept the promises of government in order to issue credit.
The vast majority of our money supply is in the form of electronic credit. Electronic credit can be destroyed, while physical notes issued by a central bank cannot. This is why deflation is possible in a credit based monetary system, but not in a paper based monetary system.
There are hundreds of trillions of dollars floating around the world in credit. Much of that is an insurance contract on top of another insurance contract, on top of a securitized mortgage, on top of an asset. The total value of all the aggregate claims on the asset vastly outnumber the value of the asset itself. That is what this crisis is about at it's very heart. Picture an inverse pyramid with assets occupying the bottom bit, securitized mortgages in the middle, and credit derivatives at the top. A stable economy would have a right-side-up pyramid with assets occupying the bottom, etc.
Our problem now, is not that the assets are going to go to zero. It's the value of the much larger derivatives and mortgages that back the assets going to zero. Their values were derived from faulty computer models that grossly underestimated risk in the underlying asset, but more importantly in the ability for a counterparty to make good on their promise in the event of a default. The counterparties, like AIG or Citi, issued 30 or 40 times more in insurance than there were in assets to back them up. Their models told them that the possibility of all the different assets declining at the same time was negligible, therefore justifying such enormous leverage. Now that the assets have fallen by at least 20-30%, the holders of the securities that were tied to them want to be paid for their insurance. Only there's nothing to pay them with. So the people that hold these contracts are trying to get rid of them as fast as they can, and for whatever price, because they fear that if the counterparty goes belly-up, they'll get nothing. If they can sell, they take the loss. If not, they keep the asset off their balance sheet in what's known as a SIV (Special Investment Vehicle) until they can be sold. While they are kept off the balance sheet, they are still considered to be worth 100% of their original value.
The total amount of these assets is far greater than the equity banks have and their sum represents future losses that eventually need to be realized. No, the value of these assets is not completely nil - because the value of the underlying assets are not nil. But for all intents and purposes, it might as well be zero because it dwarfs their tangible equity.
That was a very long-winded explanation of what the difference is between "money" and "credit" but it is essential to understand this difference. Not only if you want to be an econo-weenie like myself, but in order to understand the very essence of our economy, banking or investing. Any other information is essentially useless unless you can wrap your mind around this concept.
So the next time you hear that the Federal Reserve is "printing money," please do not automatically assume that they are printing physical notes. They are creating electronic reserves (credit) to support the balance sheets of the big banks. There is absolutely nothing inflationary about this. The banks are simply taking it and using it to cancel out their derivative losses or are hoarding it in order to prepare for future losses. Previously, banks would have used the electronic reserves to go out and make 10x that amount in loans to consumers or businesses (in reality the order was the other way around - loans first, then reserves). That is not the case anymore, and until the bad assets are completely liquidated, it will not be the case again.
Thus far, we have a total of $9.7 Trillion dollars in total government/central bank assistance in the United States. An amount equal to that and more has been provided by their counterparts around the world. More is promised. But the fact remains that the minimal inflationary impact these actions have are negligible in comparison to the amount of "problem assets" being devalued around the world. Much of it is just in guarantees - that is, more insurance. The Federal Reserve will offer to swap good assets for bad. All this does is cancel out debt from somewhere else. It's like moving money from one pocket to another. The act of putting money in your right pocket does not make you any richer.
All in all, the central banks are not nearly as powerful as they'd have you believe. The amount of the total money supply that is controlled by them is minimal. They won't tell you that. They'd prefer you to think that just by them moving their lips they can affect the entire economy's decision making processes. It simply ain't so.
This begs the question: why is gold going up? Who knows. It has a mind of it's own. But if it really only moved due to inflation concerns, it wouldn't have declined 75% over two inflationary decades (80's, 90's) would it? If inflationary concerns were real, we would see TIP yields rising along with the gold price. They're not. We'd also be seeing other typical inflation hedges rising - like property prices. That is obviously not the case. A better explanation is that gold is rising because of increased instability. People want to own a little bit "just in case." As they should. But an even better explanation is that it is going up because it is going up. Pure speculation.
No matter how much credit is issued, it cannot make up for the massive contraction elsewhere. The net result will be deflation - even though it will be less than it would be without any interventions. Japan has discovered this over the last two decades - and they had huge demand for their exports, whereas the current situation is global. America discovered this in the 30's - and they had a far smaller debt burden than now. We will discover the same.
Will the US Dollar Collapse?Closely tied to the belief in imminent hyperinflation and a skyrocketing gold price is the misplaced belief that the US Dollar is on the brink of collapse. Essentially, they are one and the same. Many of my arguments against hyperinflation are the same against a dollar collapse. But there is even more evidence stacked against such an occurrence.
Ultimately, the Dollar will end up at zero - but that is not going to happen any time soon, and I would argue is likely decades away. Until then, the massive amounts of deleveraging will increase our appetite for dollars to pay back debt. There is too much credit in the system, and as we rid ourselves of it slowly, we need to acquire dollars. A large portion of the credit derivatives I mentioned above are denominated in dollars even though the underlying asset may be priced in another currency. This is a theoretical short position on the dollar. A "carry trade" in other words. It must be unwound, just like the Yen carry trade.
This is what is meant when we call the US Dollar the world's "reserve currency." Most people hear the word "reserve" and automatically conclude that because many other countries hold the dollar as their primary currency in their foreign exchange "reserves,"
that is what is meant by "reserve currency." It is not. Total foreign exchange reserves of dollars are far smaller than total foreign credit contracts denominated in US Dollars (reserves worldwide are "only" ~4.6 Trillion). It is the reserve currency because it is the default currency for international trade and commerce in general. In order for that to change, 100's of trillions in contracts would need to be re-written. Not practical.
As such, demand for US Dollars will persist.
Additionally, the US Dollar is not alone in its state of affairs with an overindebted government and central bank getting itself in all sorts of trouble. In fact, nearly every other currency has the same issues facing it. And even though the numbers aren't quite as dire elsewhere, they are far more likely to collapse than the US Dollar due to the reserve status. Fair? No. But neither is life.
In summary, there are many multiples more debt than capital in the world economy. Debt is being liquidated and will continue to do so until it reaches a sustainable level relative to capital. The process of this debt liquidation puts a higher value on dollars relative to debt, thus ensuring an oversupply of dollars is impossible.
Attitudes Toward DebtThe previous section was devoted to why banks
cannot lend. But lets forget all that for now. Lets pretend that by some sort of accounting trick, they are allowed to forget about all of their trillions of bad assets and after gifts from the government/central banks, they are willing and able to start making loans again.
In a recent article, John Xenakis of
Generational Dynamics wrote:
As I wrote last month, something that's constantly freaking me out these days is all the talk of greedy bankers. The reason it's freaking me out is because the rhetoric is identical to what I used to hear when I was growing up in the 1950s.
My parents and my teachers often talked about the Great Depression. They talked about how greedy people were in the 1920s. They said that people were so greedy that even if they were rich, they'd borrow more and more money so that they could make even more money.
My teachers often referred to the greatest evil of them all: margin. A greedy investor could buy stocks and pay only 10% of the purchase price. The 10% was called "margin," and the other 90% was borrowed. My teachers emphasized how evil this was, that some greedy rich person would pay only 10% of the price of a share of stock in order to make more money.
I can almost still hear one of my teachers saying: "Thank God! They've made it illegal to buy stocks on margin like that! Those greedy investors will have to pay for the stocks they buy, so we'll never have a Great Depression again!" My teachers must be turning in their graves to see what's been happening in recent years.
Xenakis describes the social revulsion of risk-taking and the attitudes toward debt that lasted all the way into the 50s after the Great Depression. As he mentions, the social backlash against "greedy bankers" and those who put themselves in incredible amounts of debt is frighteningly familiar. How much compassion does the average American have for a person who got in over their heads and is now in
dire straits? How willing will people be to take on even more debt than they already have, while risking their social standing to do so?
This is a perception change that has gone from one extreme and is only still on its way to the other. Through the 90's and 00's, anyone who
didn't live above their means were the ones marginalized. Renting was for the poor. Anyone who was remotely successful was a home or condo owner and had a nice, shiny new car to go along with it. I shouldn't need to explain this. We all know it too well. Our measurement of success was determined by our ability to portray it, and that ability was provided more by easy credit than it was by actual underlying success.
My, how times change. As I wrote recently in "
Say Goodbye to Conspicuous Consumption," this paradigm has ended. There might be a few stragglers that haven't got the memo yet, but the game is up. And it's not going to return for many decades.
People see the massive government bailouts. Those that were responsible know that they are bailing out the irresponsible. The amount of acrimony this will provide toward the former will be more than sufficient to ensure they are kept in check. The same social pressures that essentially "forced" people into living beyond their means (or lose a wife, be cut out of a social circle, etc) will now be pressuring people to stay out of debt and live
below their means.
This is the uphill battle the central banks are facing when trying to "get credit moving again."
But that's not all. There is another massive headwind working against any possible reinflation attempts: massive looming supply from a larger "baby boom" generation. They have only just begun retiring (the first ones hit retirement in 2007 - the same year this crisis started - coincidence?). As they retire, they will be liquidating their assets to a far less numerous generation. Coupled with the already excessive supply in housing, autos and other big ticket assets, the only possible solution to a problem of oversupply/falling demand is lower prices. This construct is amplified in Europe.
And now lets think about that younger generation. They will be bearing the brunt of this crisis. They will grow up with few job opportunities, a punitive tax code and a seemingly endless public debt burden. Who will they blame? How will their consumer behaviour be affected by their experiences as a child? Seeing one or more parent lose their job. Having to screen calls for their parents in order to avoid the collection agencies. Seeing the repo man give notice to your parents of their foreclosure. How will these children behave in reaction to their experiences with their parents' excessive debt loads?
Do you really think that this younger generation is going to make the same mistakes they've witnessed their parents make? Will they just pick up where we left off and continue consuming at the same rate we did?
I think not.
Will Chinese Demand Not Be Inflationary? One would think that the stories of Asian decoupling would have gone away by now. Their markets have crashed just as massively or more as any western markets. The "China Miracle" is no exception. There's reports of 20+ million unemployed migrant workers, and that doesn't include the regular city dwellers who have been put out of work. Mass factory closings are to blame. Chinese imports from Japan, Taiwan, and Korea have been cut in half. Electricity consumption (typically a good proxy for economic growth) has fallen off a cliff. Cargo loadings at their major ports have fallen drastically. Entire fleets of freighters sit idle in the harbours. There is 14 years worth of office building supply in Shanghai - and that is only if buildings are filled at similar rates to the last few years. It is the equivalent of all the office space in Manhattan.
How the jobless Chinese are all of a sudden going to start spending money at a rate sufficient enough to stoke the fires of inflation is beyond me. But suppose they
do turn around and start slowly transforming into a consumerist society. What impact would that have? Consider that taken together, the economies of China, India and Brazil are 1/5th the total size of US and EU economies put together (~7 Trillion compared to ~34 Trillion). Consumption makes up for a far smaller portion of the emerging markets as of now. So for every 1% drop in consumption in the west, emerging markets would need to increase their consumption by approximately 8% (doing rudimentary math from the CIA World Factbook Data). And they would have to increase it by far more than that in order to have an inflationary impact.
This is not going to happen. It is so far beyond reality that discussing it further is a waste of time. The fact is, emerging economies are not nearly relevant enough in the scope of the world economy to create a large enough demand for credit to compensate for the falling demand in the west.
Another common argument I hear is that China could one day press the sell button on its 1.4 trillion in US treasuries, thus pushing interest rates up and increasing inflationary expectations.
China would not do this. The very act of selling US treasuries requires that they buy something else with the proceeds. The gold market is way too small. Any other currency is too risky and not strategic enough to justify the cost of switching. So they would have to buy their own currency. This would massively push up the value of the Yuan, further choking their exports. It would be suicidal. Sure, they'll try to jawbone rates higher by rumbling about distaste for US policies. But they won't act.
ConclusionA credit based economy requires an ever increasing amount of debt in order to support itself. Since the 70s, all of the recessions we have seen involved a slowdown in credit expansion - never an outright contraction. In order for a hyperinflation to occur, we not only need to get back to a level of credit expansion equal to that of 2006/2007, we would need to to exceed that level and continue even further. Let's review the facts:
- Banks cannot lend because their balance sheets are loaded with tens of trillions in impaired paper assets
- The government and Federal Reserve only control a small portion of the total supply of money and credit
- The interventions we have seen are not inflationary because for every dollar of credit provided or guaranteed, another is wiped out
- Social aversion to conspicuous consumption and "living beyond one's means" is catching fire
- An aging boomer generation needs to sell their assets to a smaller, more risk averse younger generation
- Emerging markets like China are in a position of overcapacity and are too small to offset a worldwide contraction
Taking the above information into account, we can only conclude one thing:
Hyperinflation is impossible.(edit: please read
the addendum to see my response to some common arguments)
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