We take up today’s Markets and Money where Dan left off yesterday…
That is, how does it all end? In massive hyperinflation? Or massive deflation?
Before we attempt an answer, here’s another question to ponder:
Does it have to be one or the other? Or, more accurately, doesn’t one lead to the other? If so, the question is more about timing the change in direction of monetary flows rather than betting outright on the big H or big D.
This is a topic that readers of the Sound Money. Sound Investments newsletter hear about often. It’s a pet theme because in today’s screwed up monetary world, analysing the big picture flows is crucial.
We like to quote from the excellent The Great Reflation, by Tony Boeckh, published in late 2009. From 1968 to 2002, he was chairman and editor-in-chief of BCA publications, and publisher of the highly respected Bank Credit Analyst.
The bloke knows what he is talking about.
One of the book’s most powerful statements is: “…inflation and deflation are two sides of the same coin with the difference being in the timing. Too much inflation always ends in deflation, and deflation paves the way for the next inflation so long as the central bank is able to reflate.”
That seems a pretty accurate assessment. The credit inflation of 2003–2007 led to deflation in 2008, followed by a reflationary effort in 2009/10. We are still experiencing the ‘benefits’ of this inflation.
Underpinning this big picture dynamic is the US dollar, in it’s duel (and completely incompatible) role as the world’s reserve monetary asset and currency of the American people.
The system is without external discipline – it has no mechanism to promote rebalancing. As Boeckh says:
“The debtor keeps spending and borrowing, and the creditor keeps building industrial capacity, lending, and experiencing asset inflation. This goes on until a crisis puts an end to it. At that point, the debtor has too much debt and the creditor has inflated asset prices and excess productive capacity. Both create deflation…”
Obviously, the debtor is the US and the creditor is China. But we’re still in the inflationary part of the cycle and no one is really thinking about deflation at this point.
Just take a look at the Dow Jones Industrial Index. Day after day it rises. It’s relentless. US blue chips are now viewed as an inflation hedge. Value is a secondary concern.
More ominously, soaring commodity prices, especially for food staples, are causing social unrest in poorer countries all around the world.
This is what happens when the world’s central banker (Ben Bernanke) starts experimenting with monetary policy. In a muffled speech given overnight to the National Press Club in Washington, Bernanke could be heard through the sand his head was firmly stuck in saying monetary policy was working because equity prices had risen.
And later, he had this to say on the effect of higher food prices on emerging market economies:
“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy because emerging markets have all the tools they need to address excess demand in those countries.”
In other words, Bernanke is not concerned about maintaining the US dollar’s role as a stable global reserve currency. Let’s face it.. He never has been.
Only now he’s saying it more forcibly. It’s also a warning to China.
He’s tugging the levers with only the domestic US economy in mind. The external value of the US dollar is not a concern. Pumping up the stock market by monetising government debt is.
The market knows this, hence the asset price inflation we are seeing just about everywhere. Some are even speculating about hyperinflation.
Now hyperinflation is a different beast to inflation. It represents the disintegration of a currency’s value. This occurs when governments, with the help of the central bank, print money to fund their expenditure.
The US is already on this path. The Fed is monetising debt at a rate of knots.
But could it really lead to hyperinflation? The probability is low. Hyperinflation in advanced, productive economies is very rare, and usually associated with war and its aftermath, or revolution.
In a study on hyperinflation, Peter Bernholz nominates only two developed economies to suffer that fate – revolutionary France and post WWI Germany, in the famous Weimar inflation.
Bernholz shows in a study of 12 hyperinflations that all were caused by government deficits of at least 20 per cent of GDP. The US is currently around 10 per cent. Irresponsible and stupid, yes.
But there can be do doubt the US is on the path to hyperinflation. It is a process that starts with high and rising inflation. Out of nowhere, it goes parabolic, as confidence in the currency vanishes.
Most hyperinflations occur over many years of budget and currency neglect. So the US is on the path, but not close yet. The question for investors is whether we’ll have another bout of deflation before the authorities really lose their heads (as opposed to just putting them in the sand).
The other point to consider is what would US hyperinflation mean given it is also the world’s reserve currency? International reserve assets total around $9.2 trillion. US treasury bonds represent a large portion of this sum.
In a hyperinflation (or even a large inflation) the real value of these assets would plummet. Here’s the question – If the US Treasury market suffers a major fall in price (because of rising yields), isn’t that deflationary?
The US treasury market is the largest asset market in the world. A fall in price would represent the loss of massive wealth, which is deflationary. But a fall in price against what? After all, it’s the world’s reserve asset and meant to be the benchmark for value.
Well, precious metals would be an obvious choice, and perhaps the only one. The US dollar falling against other currencies would prove deflationary for those countries, especially for those that have built their economic success around mercantilist trade policies.
Fortunately, such a dire scenario is some way off. But it’s still something you must think about and prepare for because we’re heading that way.
In the meantime, enjoy the current reflationary effort and see it for what it is – a last ditch effort by the world’s hegemon to delay its day of reckoning.
We’ll leave the last word to Tony Boeckh, who is far smarter than we are.
“When the acts of borrowing and speculating push market values far beyond what is historically normal, it is time to look for the exists. Even though you may be a year or two early, the money made at the end by taking large balance sheet risk is never kept, except by luck.”
For Markets and Money