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Ben Bernanke,
Chairman of the US Federal Reserve, faces a Sisyphean task because US banks
are experiencing debt deflation and, because lending is now at much lower
levels, monetary deflation is encumbering the domestic US
economy as existing debts continue to be serviced. Government deficit
spending can only offset lower consumer spending to a degree, and the
mushrooming debt of the US
government raises the question of whether the US
can repay or roll over its debt obligations, given that tax receipts are
likely to fall. Despite deflationary pressure, the value of the US
dollar is in a downtrend pointing to higher prices for imported goods and
energy. Devaluing the US dollar will reduce the value of debts in real
terms, thus it can make debt levels sustainable, but higher prices will exacerbate
debt defaults, worsening the condition of US banks. Mr.
Bernanke’s dilemma is how to salvage the balance sheets of US banks
without sparking high inflation or unleashing hyperinflation.
Where the US
dollar is concerned, opinions on hyperinflation range from the view that
hyperinflation of the world reserve currency is impossible in principle
(because, for example, the values of other currencies are linked to that of
the US dollar), to the view that hyperinflation of the US dollar has already
happened and that all that remains are the consequences. The two most
widely accepted theories of hyperinflation are the monetary model, where a
positive feedback cycle is caused by a disproportionate increase in the
velocity of money as a consequence of increasing the money supply too
quickly, and the confidence model, where the monetary authority issuing a
given currency is perceived to be insolvent or no longer legitimate.
The view that
hyperinflation is the inevitable result of a central bank issuing too much
money or of a government taking on too much debt, while correct, both states
the obvious and presupposes that some previously known or predictable limit
is reached. The ability to service debt is one such measure, but the
value of a debt in real terms depends on the value of the currency. In
practice, hyperinflation is recognized only after the inexorable death spiral
of a currency has begun. Detecting it in advance is another matter entirely.
Mathematical
models of hyperinflation, such as predicting years between redenomination
based on inflation rates or applying the quantity theory of money, describe
what is happening but not why. Using the monetary model alone makes it
difficult to explain apparent counterexamples where high levels of sovereign
debt compared to a nation’s gross domestic product (GDP) or
monetization did not result in hyperinflation.
The confidence
model seems to suggest that hyperinflation can be explained by crowd
psychology where hyperinflation is analogous to a market mania or is an
example of mass hysteria. The idea that hyperinflation is only a crisis
of confidence, i.e., that it is a psychological phenomenon, not only lacks
predictive value but implies that hyperinflation can be prevented by
manipulating public opinion regardless of mathematical realities.
When a
nation’s bond market collapses, so does its currency. The view
that hyperinflation is fundamentally caused by failed bond issues suggests
that what is of interest are the reasons why a nation’s bond market
breaks down, along with indications of developing bond market distress.
One fact that is
clear in every historical example of hyperinflation is the rejection of the
currency of a given country either by other countries or by its own
citizens. The simplest explanation of hyperinflation is that when the
credibility of a government, or of its central bank, breaks down, the
recognition of this fact is expressed as a race to shed the currency and to
divest of the government’s bonds. One way to evaluate the
possibility of hyperinflation is therefore to gauge the transparency,
completeness and veracity of government and central bank statements regarding
their balance sheets, budgets and bond issues. Incomplete or inaccurate
information and propaganda contrary to empirical evidence are proverbial red
flags signaling that credibility may be lacking and that confidence is
therefore misplaced.
Between Scylla
and Charybdis
Growth in the US
monetary base has been cited as evidence of incipient hyperinflation but,
while a distortion in the US
financial system is apparent, the currency in question is not in circulation
and the effect is that of re-inflation since US
banks have suffered massive losses linked to the US
mortgage market.
The growth in the
US
monetary base by over $1 trillion since 2008 represents currency held within
the banking system on reserve, which increases the ability of US banks to
absorb further losses.
While more than
doubling the US dollar monetary base in less than 2 years is viewed by some
as printing too much money, high inflation or hyperinflation have yet to
strike. Although money has shifted out of the broad US economy and into
the banking system, the excess liquidity exists in the form of bank reserves
and, despite the fact that inflation is always and everywhere a monetary phenomenon, if
bank reserves are considered separately from interest rates and lending
activity they have little direct impact on prices in the broad US
economy. In fact, the widest measure of the US
money supply is contracting and the broad US
economy is in the grip of debt and monetary deflation.
In terms of
monetary policy, Mr. Bernanke faces an impossible choice. With interest
rates near 0% and with unprecedented government debt and deficit spending
beyond sustainable levels there is a clear risk of high inflation or
hyperinflation if inflationary forces are not counterbalanced with a heavy
hand. In theory, high inflation or hyperinflation could be prevented by
restricting the flow of money and credit to consumers and businesses.
Such a policy would exert deflationary pressure on the US dollar within the
domestic US
economy since principal and interest payments on existing debt would drain
money from circulation. While preventing inflation temporarily, such a
policy would not succeed in the long run because, in addition to offsetting
inflation, deflation depresses economic activity and results in debt
defaults. Concurrent government borrowing and central bank QE to
recapitalize banks and sustain government deficit spending (in a Keynesian
attempt to compensate for declining consumer and business borrowing), would cause
the value of the US dollar to decline against other currencies thus the
prices of imported goods would rise. The resulting combination of
rising prices for imported goods (energy in particular) and a scarcity of
money in the domestic US economy is a formula for business failures and debt
defaults that would ultimately worsen the condition of the US economy and US
banks regardless of lower prices for domestic goods and services.
Structural
Decay
In a
mathematically perfect world, growth in the money supply with a constant
interest rate and level of lending is a simple exponential function. In
theory, this is not problematic but in practice monetary expansion (and the
associated debt) tends to grow faster than population or sustainable economic
activity and even periodic deflationary episodes are insufficient to maintain
a stable currency value.
The tendency to
create currency in excess of what is required to support sustainable economic
activity causes unsustainable booms where debt rises out of proportion to the
ability to service or eventually repay, meaning that total debt in the
economy grows faster than the GDP. The result is that for every boom
artificially created by monetary expansion there is a corresponding episode
of debt and monetary deflation. Nonetheless, the overall pattern of
monetary expansion remains clear.
From a policy
standpoint, restraining debt issuance by private, profit-oriented banks to
sustainable levels is impossible in practice because sustainable growth in
GDP is an unknown when the interest rates and reserve ratios that moderate
lending activity are set. In fact, the goals of the US Federal Reserve,
“to
promote … stable prices and moderate long-term interest rates”
require the money supply to expand faster than sustainable economic activity:
Sometimes,
however, upward pressures on prices are developing as output and employment
are softening—especially when an adverse supply shock, such as a spike
in energy prices, has occurred. Then, an attempt to restrain inflation
pressures would compound the weakness in the economy, or an attempt to
reverse employment losses would aggravate inflation. In such
circumstances, those responsible for monetary policy face a dilemma and must
decide whether to focus on defusing price pressures or on cushioning the loss
of employment and output. Adding to the difficulty is the possibility
that an expectation of increasing inflation might get built into decisions
about prices and wages, thereby adding to inflation inertia and making it
more difficult to achieve price stability.
Deflation is
anathema because debt defaults harm lenders and governments have no mechanism
to tax gains in the value of currency, thus monetary policy always errs
toward inflation and over time the result approximates an exponential
function. Among the results is the long term devaluation of the
currency, which can also be expressed as an exponential function, i.e., exponential
decay.
Exponential decay
occurs when a quantity, such as the value of a unit of currency, decreases at
a rate proportional to its own value. The decay can be expressed as a
differential equation where a quantity N decays at a constant
rate (a positive number)
(lambda) within a given interval of time t.
Central banks
implicitly manage the exponential decay in value of their respective
currencies while they focus on interest rates, reserve ratios and inflation
targets. Although the exponential decay in the value of the US dollar
since 1913 has been distorted by episodes of deflation and variations in
monetary policy, the overall pattern continues to reflect the structural
reality of exponential decay.
The combination
of fiat currency, where currency is created arbitrarily, and central banking,
where money and credit are centrally controlled and where there is an
inescapable inflationary bias, suggests that all such regimes have a limited
lifespan, but this does not allow a hyperinflationary outcome to be
predicted. For example, if US citizens had been asked in 1913, when the
Federal Reserve was established, if they would use the Federal
Reserve’s legal tender knowing that $1 would be roughly $0.05 in less
than 100 years they would certainly have responded in the negative, but
Federal Reserve Notes have not been rejected by the American people.
Similarly, there is no necessary or obvious point where the US dollar will be
rejected as it continues to decline in value for the same structural
reasons. The logical outcome is an eventual redenomination.
Patterns
of Hyperinflation
From the
perspective of sovereign debt, the commonly understood process of
hyperinflation is that if a government responds to declining foreign appetite
for its debt with monetization (or in a historical context direct currency
debasement) rather than immediate budget cuts, its currency looses value, at
first in proportion to the dilution of the money supply and then more quickly
as foreign bond holders and the nation’s own citizens seek shelter from
inflation in other asset classes. The cost of the government’s
future obligations then tends to rise in nominal terms, creating an apparent
need for larger bond issues while bond yields rise, i.e., the cost of
borrowing increases since monetization signals greater risk to
investors. Exacerbating the problem, tax receipts tend to lag behind as
domestic price inflation sets in. Further monetization is the path of
least resistance. Although officials certainly believe that
monetization is only a temporary measure both confidence in and the
credibility of the government fail. Insolvency is eventually recognized
as a reality and the nation’s currency then collapses entirely.
Economists assume
that consumers and businesses respond predictably based on economic
incentives and disincentives, but this presupposes that the value of money is
stable (at least over the short term). If users of a currency find that
it looses value such that savings and wages are perceptibly eroded before
they can be utilized at fair value, the rational course of action is to shed
the currency as quickly as possible. This sparks a competition to shed
currency in favor of real goods and, once the process begins, the rational
course of action is to participate in the proverbial rush to the exits.
Interestingly, a panic is not required to explain this phenomenon.
In the context of
a national economy, the cycle of hyperinflation is driven not precisely by
the supply of money but by its velocity because the competition to shed
currency concentrates purchasing activity in successively shorter time
periods. Within a given interval, more consumers and businesses seek to
buy a limited supply of available goods using all available currency,
including savings, thus demand is pulled forward while the velocity of money
accelerates. If monetary authorities respond by increasing the money
supply, the process feeds on itself.
In terms of the quantity theory of money, which is that
the money supply has a direct, positive relationship to prices, the
equilibrium of prices with the number of items purchased and the money supply
with the velocity of money is maintained (where M is the money
supply, V is the velocity of money, P is the
average price level, and Q is the number of items purchased
over a given interval).
The relation
holds true even as the value of a currency approaches zero while prices
approach infinity. However, while there is no theoretical limit to the
money supply, the supply of goods is limited in various ways and shortages of
goods spur prices higher, exacerbating the problem.
The competition
to shed currency first interacts with prices then with the availability of
currency and with the supply of goods. Rising prices result in rising
demand for larger amounts and denominations of currency producing a genuine
shortage, but increasing the money supply only intensifies the competition to
shed currency, like pouring gasoline on a fire.
Crisis
of Credibility
A gradual decline
in the value of a currency is generally accepted by consumers and businesses
because it has little immediate impact and can have short-term benefits, such
as making money more accessible and stimulating economic activity and
growth. However, when debt increases disproportionately, a deflationary
bust is inevitable and if it is postponed by further credit expansion
systemic instability results.
In 1949 Ludwig
von Mises pointed out in Human Action (Chapter XX, section 8) that
“there is no means of avoiding the final collapse of a boom brought
about by credit expansion. The alternative is only whether the crisis
should come sooner as the result of a voluntary abandonment of further credit
expansion, or later as a final and total catastrophe of the currency system
involved.”
Among other
things, excessive monetary inflation means that the US dollar cannot function
as a store of value. Mounting evidence points to systemic instability,
a lower US dollar and ultimately to a hyperinflationary outcome:
- US federal government
debt of $12.3 trillion, unfunded liabilities of $63 trillion,
deficit spending of $1.35
trillion for fiscal 2010, and the Obama administration’s $3.83 trillion budget all set new
records, while federal income tax revenues are expected to fall for a second consecutive
year.
- It has been
reported that to reduce the cost of borrowing, the maturity of debt
issued by the US Department of the Treasury has shifted from the long
end of the spectrum toward short term debt. At the same time,
episodic flights to the perceived safety of the US dollar by global
investors favor short-term Treasuries. This situation creates an
escalating risk that the US Treasury will be unable to roll over short
term debt and that it will resort to monetization.
- 7 US states are worse off than the financially troubled
European nations of Greece,
Ireland, Portugal
and Spain resulting
in warnings of a US credit rating downgrade possibly
indicating an eventual sovereign default.
- Unemployment in the US,
where more than 2/3 of GDP is consumer spending, should be viewed as a leading, rather than a trailing indicator,
thus the perception of recovery based on slowing unemployment is
premature. Reported unemployment data seem to exhibit unusually pronounced
disparities between initial claims and later revisions and seasonally
adjusted numbers.
- The widely
reported recovery of the US economy is anemic at best
since most of the reported forth quarter 2009 GDP growth is not
sustainable and preliminary government economic data remains subject to
revision by the US
Bureau of Economic Analysis (BEA).
- The imminent
retirement of the so-called baby boomer generation comes with a combined
Social Security and Medicare price tag of more than $60
trillion.
- US bank failures and balance
sheet deterioration together with the inability of banks to mark assets to market due to a growing commercial real estate
problem and ongoing residential mortgage loan problems
suggest that the financial crisis that began in 2008 is not over.
- The suspension of the US Financial Accounting Standards
Board’s mark to market rule means that
the value of mortgage loan portfolios and mortgage-backed securities
(MBS) reported by banks are incorrect, which obfuscates leverage and
risk while magnifying apparent profits.
- Toxic assets
still cripple bank balance sheets since the US Department of the
Treasury has been unable to successfully carry out its Public-Private Investment Program
(PPIP) making taxpayer money available to select investors that can use
the money to buy toxic mortgage-backed securities, retaining any profits
while putting little of their own money at risk.
- The largest
US Banks remain the largest holders of financial derivatives, e.g.,
credit default swaps (CDSs), which suggests that they may hold
liabilities far in excess of amounts that can be paid or that can be
bailed out if significant losses occur. The CDS market, which is
the single largest class of financial derivatives, represents over $600 trillion dollars, a roughly
10x multiple of world GDP.
- The Federal
Reserve’s plans to phase out some of its emergency programs,
adding up to roughly $2 trillion currently, leaves other emergency
measures in place. The Term
Asset-backed Securities Loan Facility (TALF) is set to expire on June 30,
2010 for loans backed by new-issue commercial mortgage-backed securities
and on March 31 for loans backed by all other types of collateral but
existing loans will not be retired for some time.
- Downward
pressure on the US dollar caused by the Federal Reserve’s near 0%
interest rates and ongoing QE has caused a US dollar carry trade affecting
asset prices in global markets. While the value of the US dollar
has rallied in response to episodic flights to perceived safety in US
Treasuries reflecting comparative weakness in the Euro and other
currencies, the overall downtrend is persistent, thus the prices of
imported goods can be expected to rise.
Rather than a
crisis of confidence, hyperinflation results from a crisis of
credibility. Hyperinflation results when the social, legal and
political structures that create the value of paper money break down.
When a government borrows excessively and its promises to repay are contradicted
by mathematical realities, the value of its currency cannot be
maintained. If a government so lacks credibility that it cannot issue
bonds because there are no buyers other than its own central bank, the value
of its currency declines faster than money is printed to cover its
obligations. Perhaps the most important indicator of impending
hyperinflation is whether the statements of a government or of its central
bank, e.g., with respect to the government’s budget or the central bank’s
balance sheet, are evidence based or ideological. If they are not
evidence based, the credibility of the government or central bank, and its
currency, will weaken and eventually fail.
Ordinarily,
supply and demand factors govern the value of money and the prices of goods,
but money has another, deeper level of value apart from its role as a medium
of exchange and unit of account. When money is not redeemable, it is,
in effect, a contract and, as such, it can instantly become more worthless
than the paper it is printed on if the agreement that gives it value is null
and void.
In 1999,
referring to the sale of British gold reserves, Alan Greenspan, then Chairman
of the US Federal Reserve, said that “Fiat money paper in extremis is
accepted by nobody.” The reason for this is that there are two
fundamental kinds of value. De jure value exists because of, and
is dependent upon, social, political and legal arrangements between human
beings. In extremis, agreements are often broken and
unenforceable. The value of fiat currency and of government bonds are
examples of de jure value. Ultimately, de jure value
actually exists only in the minds of human beings and does not exist in an
absolute sense, in the real world, independent of human belief. De
facto value, on the other hand, exists in reality, independent of human
thought, e.g., lumber or farmland. The value of real, tangible things
of value ultimately devolves to biological survival and to material standards
of living. Possessing a physical asset that supports survival does not
require human belief in order to have biological value.
When social,
political and legal arrangements are strong, reliable and endure over
generations de jure value may be preferable for any number of
reasons. However, when social, political and legal arrangements prove
to be unstable, or fail, de facto value trumps de jure value in
every case.
When the balance
sheets of US banks are maintained by suspending accounting rules and when
banks hold financial derivatives liabilities greater than world GDP, both the
stability and credibility of the banks is questionable. When US
economic data consistently seems to reflect a Pollyanna bias and the US
federal budget contains unrealistic projections of GDP growth and tax revenues,
while public debt and government liabilities (which now include unlimited
bailouts for government sponsored entities Fannie Mae and Freddie Mac) are
obviously unworkable and the US government’s own central bank is
already a major buyer of US Treasuries, the federal government’s
credibility is questionable. When private financial losses and toxic
financial assets are transferred to taxpayers while profits and bonuses
abound on Wall Street thanks to accounting rule changes in the midst of the
worst economic contraction since the Great Depression, the credibility and
competency of the US Treasury and Congress, with respect to the finances of
the nation, is questionable. When the US Federal Reserve defies the US
Congress, resists independent auditing, engages in ongoing QE and is the
lender of last resort for banks that under normal conditions would be
insolvent, its credibility is questionable. When the Chairman of the
Federal Reserve, who failed to detect the largest asset price bubble in the
history of the world and who has been consistently wrong in his assessment of
the US economy is reappointed following the worst financial and economic
disaster in generations, both his credibility and that of the Obama
administration are questionable. The plethora of red flags spewing from
Wall Street, from the Federal Reserve and from the federal government point
to a breakdown of de jure value that is already in progress, thus to a
hyperinflationary outcome for the US dollar.
Ron Hera
Hera Research
Visit his website
Send him mail
Ron Hera is the
founder of Hera Research, LLC, and the principal
author of the Hera Research Monthly newsletter. Hera Research provides deeply
researched analysis to help investors profit from changing economic and
market conditions
About Hera
Research
Hera Research,
LLC, provides deeply researched analysis to help investors profit from
changing economic and market conditions. Hera Research focuses on
relationships between macroeconomics, government, banking, and financial
markets in order to identify and analyze investment opportunities with
extraordinary upside potential. Hera Research is currently researching mining
and metals including precious metals, oil and energy including green energy,
agriculture, and other natural resources. The Hera
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extraordinary value and upside potential.
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