31 March 2015

Deflation, Hyperinflation, Stagflation, and Where We Are Going

This is a repost of a column from four years ago almost to the day.

This is where I make the case most explicitly for the stagflation forecast I made in 2005.

Although I add one parenthetical note and some underlining for emphasis, otherwise I did not have to change a word.  I could have rewritten a few things a little more smoothly but at this point why bother.

I believe that things are playing out pretty much as I had thought with a few notable exceptions on the particulars.    The 'top down' approach to monetary stimulus favored by the Fed and their Banks and their politicians is fostering more inequality and slack aggregate demand while inflating select asset prices, a type of stagflation.  The 'inflation' component of that has not yet set in yet generally, but is certainly visible to anyone who uses incidental things like healthcare, higher education, and food. 

I think that the same dynamic is playing out in Europe and the UK.

It will end involuntarily in a social dislocation, or by a voluntary reform.  Since the oligarchs have apparently not yet been satisfied in their acquisition and looting, they believe that they can keep pushing the envelope for now.

One new area of thought for me now is how China and Russia and a few of their friends will attempt to implement a new regional currency and a global reserve currency with some inclusion or reference to gold, and perhaps silver.  That they are leaning into this area is to be found in their own words and actions.  

What I am struggling with is how they might do this without exposing themselves to currency manipulation and rigging, which is probably a lot easier to accept as a given now than it was in 2011, although it was certainly occurring before all these market rigging scandals broke.   I don't think a market was left untouched.

I suspect it will center around the terms for the exchange and the valuation or peg.  A misstep will open them to the predations of the global hedge funds and the Banks, and the status quo centered on the Dollar. 

One of the more interesting facets of this will be how this new monetary group deals with the bucket shops on the Hudson, that great price setting mechanism without a firm tie to reality.  I believe that recent developments are suggesting that they will make those markets as they are less relevant to the real world, which is precisely both their strength and their weakness. 

Their strength is that they may set price without the necessary reference to real world market supply and demand for surprisingly protracted periods of time.  And this is also their weakness, because with the right push in the right direction it will not take much to displace them since they do not have their feet firmly planted on anything substantial. 

The trick to be to throw them over without undue collateral damage to the real economy, a task that is not without some significant efforts.  If only the Banks would show the same forethought and courtesy when triggering their own financial crises.

16 April 2011
A Review on Where We Stand with Regard to Deflation, Hyperinflation and Stagflation

Well, the good news for everyone is that nothing seems inevitable here, that there is almost always a choice, but it is often wrapped up in a nice looking rationale, with all the compulsion of a necessity, for the good of the people.  Us versus them in a battle for survival and all that. 

And clever leaders on the extremes provide the 'them' to be dehumanized and objectified.  The leftist wishes to murder the bankers, and the fascist the lower classes and outsiders.  The extremes of both end up making life miserable for almost everybody except for a privileged few.

And so I reiterate that in a purely fiat currency, the money supply is indeed fiat, by command.

People like to make arguments about this or that, about how so and so has proved that the Fed does not or cannot do this or that, that banks really create money only by borrowing, that borrowing must precede this or that.

It's mostly based on a fundamental misunderstanding of what money is all about, with a laser beam focus on hair-splitting technical definitions and loquacious arguments more confusing than illuminating, lost in details.  In a simple word, rubbish.

Absent some external standard or compulsion, the only limiting factor on the creation of a fiat currency is the value at exchange of the issuers bonds and notes, and currency which is nothing more than a note of zero duration without coupon.

If I had control of the Fed, unless someone stopped me, I could deliver to you hyperinflation or deflation without all that much difficulty from a technical standpoint. The policy reaction of those who might be in a position to fire or lynch me is another matter.  The Fed not only has the power to influence money creation in the private banking system.  It has the ability to expand its balance sheet and take on existing debt of almost any type at will and at any price it chooses.

But that is the case as long as the Fed has at least one willing partner in the primary dealers, and the Treasury is in agreement. And even that requirement for a primary dealer is not all that much of an issue given the amounts of existing sovereign and private debts of which the Fed might avail itself for the forseeable future.

So at the end of the day, a thinking deflationist is almost reduced to the argument that 'the authorities will not allow it' or 'will choose deflation rather than inflation'  And this is technically correct. However, let us consider my earlier statement about those who might fire or lynch one for making a highly unpopular choice.

It is economic suicide for a net debtor to willingly engage in deflation when they have other options at their disposal, and especially when those decisions involve people outside the system.

That is not to say that the deciders could not opt for economic suicide, but the people designated to suffer and die for that choice and cause might not take kindly to it. Deflation favors the creditors significantly, and those creditors tend to be a minority of domestic elites and foreign entities.   Both the extremes, hyperinflation and deflation, are choices best implemented in autocratic governments.

There are those who observe that Franklin Roosevelt 'saved capitalism' by his actions in the 1930's and I believe they are correct. If one considers the various other outcomes in large developed nations to the Great Depression, whether it be Italy, Germany, Russia, or Spain, the US came out of it fairly intact politically. People conveniently overlook the undercurrent of insurrection and violence that was festering amongst the suffering multitudes, and the growth of domestic fascist and communist organizations.  There were several plots to overthrow the elected government by military means, although the history books tend to overlook them.

So it is really about making the best choice amongst bad choices. This is why governments choose to devalue their currency, either with quantitative easing, or explicitly against some external standard as the US did in 1933. Because when the debt is unpayable, it must be liquidated, and the pain will be distributed in a way that best preserves the status quo.

Hyperinflation and a protracted deflation are both very destructive choices. So therefore no rational government will choose either option.

They *could* have those choices imposed upon them, either by military force, political force, or by economic force. Economic force is almost always the cause of hyperinflation.

So you can see why a 'managed inflation' is the most likely outcome at least in the US. The mechanism has been in place and performing this function for the last 100 years.

The problem or twist this time around comes when the monetary stimulus does not increase jobs and the median wages, because of some inherent and unreformed tendency in the economy to focus money creation and its benefits to a narrow portion of the populace. The result of this is stagflation which although not indefinitely sustainable can be maintained for decades. 

Most third world republics are like this.  A vibrant and resilient middle class is sine qua non for a successful democratic republic, and this has strong implications for the median wage.  The benefits and the risks of growth and productivity must be spread widely amongst the participants.  Oligarchies tend to spread only the risks, keeping most of the benefits to themselves.

This is essentially the reasoning that occurred to me when I looked at the US economy and monetary system in the year 2000.

The one point I remain a little unclear on is how 'hard' the law is regarding the direct monetization of debt issued by the Treasury. I am not an attorney, but I am informed by those familiary with federal statutes that this is a gray area in the existing law but currently prohibited.  But it is easily overcome as I said with the inclusion of one or two amiable primary dealers who will allow the debt issued by Treasury to 'pass through' their hands in the market, on its way to the Fed at a subsidized rate.  For this reason, and for purposes of policy matters, and occasional economic warfare, countries may tolerate TBTF financial institutions with whom they have 'an understanding.' 

I have also come to the conclusion that no one knows the future with any certainty, so we must rely probability and risk management to guide our actions.

So really absent new data the argument is pointless, a matter of uninformed opinions. The dollar will continue to depreciate, (but the DX Index will be highly misleading - Jesse) and gold and silver and harder currencies appreciate (Well that one has gone sideways for now in this metals bear market - Jesse), until the fundamental situation changes and the US economic system is reformed.

I think there are other probable outcomes that involve world government and a currency war, and this also is playing out pretty much as I expected.  Fiat currency can take on the characteristics of a Ponzi scheme, whose survival is only possible by continuing growth until all resistance is overcome.

This is the conclusion I came to in 2000. I admit I was surprised by the Fed's willingness to create a massive housing bubble, and the willingness of the US government to whore out the middle class in their deals with mercantilist nations; their hypocrisy knows no bounds.

So that is the basis of much of my thinking and I wanted to take a moment to share it with you in a compact, highly condensed format.

I remain a little unsettled on the issue of hyperinflation, because there is the possibility that a large bloc of countries could join together to repudiate the dollar. Since so much dollar debt is held in these foreign hands, that is the kind of exogenous force that could trigger a bout of what might be termed hyperinflation. I don't see the dollar going to zero in this, but rather the dollar having a couple of zeros knocked off it, with a new dollar being issued. I have read John Williams case for hyperinflation several times now, and see nothing more compelling in it.

Indeed I think the reissue of the dollar with a few zeros gone is inevitable. It is the timing of that event that is problematic. It could be one year, or it could be fifty years. There is a big difference there for your investment strategy.

“One day you will go the ATM and the dollars will be Blue---not Green ---and you will get a few less than you expected.”

And yes, the government could just get medieval on your asses, and seize all the gold and silver, force you to take the value of the dollar at whatever they say it should be.  (As the MMT crowd has suggested - Jesse)   They could also seize all the farm land, all the means of production, and tell certain groups of people to get on freight trains for resettlement in Nevada. I think we can stipulate that governments can do this, and the people can accept it to varying degrees. If you wish to make this the dominant assumption in your planning then by all means.

For those who simply say "I disagree" or "Go read so and so he has proved this or that" I say that people believe lots of things, and can find data selectively to support almost any outcome they prefer,  But the market is the arbiter here, and the verdict so far is beyond all question. The Fed is doing exactly what they said they would do, so there should be no surprises. And they have more in their bag of tricks.

If there is new data I would certainly adjust my thinking but absent that I now consider this settled to my satisfaction, and wish to turn instead to more thinking on what changes need to occur to prevent the system breaking down, and restoring it to some semblance of reasonable functionality.