Some time ago, Gonzalo Lira wrote a couple of interesting pieces on hyperinflation, and I promised to respond to them. This has taken me a while, as there is much material to go through, many arguments to pick apart, areas of agreement and disagreement, differences in definitions and matters of timing. The first article, How Hyperinflation Will Happen, is a long, thoughtful and detailed piece that I found interesting. There are many aspects I fundamentally disagree with, however, some for reasons of substance and others for reasons of timing.
Essentially the central proposition is that the US dollar is in danger of imminent demise due to a widespread loss of confidence, and that treasuries will be dumped en masse within a year, leading to hyperinflation, by which Mr Lira means price spikes. I do not see a loss of confidence in the dollar going forward, at least not soon. We have seen a long slide in the value of the dollar coincident with the rally in stocks. This is a reflection of a resurgence of confidence in being invested rather than being liquid, but this confidence is fragile and subject to rapid reversal.
I regard the extremely bearish sentiment regarding the dollar specifically as typical of a bottom. Trends take time to become established as received wisdom, and by the time they come to be generally accepted, they are much closer to an end than a beginning. When everyone is bearish, and has acted upon that sentiment, who is left to carry the trend any further in that direction? Market insiders will be taking the other side of the bet, as they always do at turning points. This is how they make their money – by recognizing and feeding off the sentiment of the herd.
When the market rally tops, I expect people to begin chasing liquidity in earnest – too late for many, as liquidity will get much harder to come by. Only a small minority will be able to cash out at the top. I fully expect the dollar to surge in relation to other currencies when this happens, on a knee-jerk flight to safety into the reserve currency as the least-worst option. At that time, I would not expect the US to have difficulties selling treasuries, because I think they will be regarded as the safest option in a horribly unsafe world. This is not rational, as the US is far past the point of no return on repaying its debt, but rationality is not the point, as herding impulses are never rational.
I would also expect the purchasing power of the remaining dollars (i.e. physical cash, of which there is actually very little) to increase substantially in relation to available goods and services domestically, as dollars will be both scarce and essential once credit virtually ceases to exist. Central authorities cannot print cash to alter this situation, as this would trigger an enormous increase in the risk premium charged by the bond market. Hence, cash will remain scarce, and people will hoard what little there is, compounding the effect of deflation through a fall in the velocity of money. In this regard, my view is diametrically opposed to Mr Lira’s.
I see far more imminent problems ahead for the euro than for the US dollar. I expect the shift from optimism to pessimism, that will define the end of the stock market rally, to lead to a rapid resurgence of fear over sovereign debt default risk in Europe. This can only exacerbate the widening regional disparities, and I think it will widen them to breaking point, for the eurozone and perhaps later for the EU itself.
As I have said before, the austerity measures coming for the whole European periphery are going to be severe enough to amount to political suicide for domestic politicians to implement. I think peripheral countries will choose to leave the euro, however high the cost of doing so, as the cost of staying in the eurozone could be even higher. If this does in fact happen, I think we would see an Argentine scenario, where savings are converted into the local currency (which would probably fall even compared with a falling euro), while debts remain in euros. These unpayable debts would then be defaulted on somewhat later. The level of uncertainty would almost certainly lead to massive capital flight from Europe, to America’s temporary benefit.
Naturally the dollar, like all fiat currencies, will eventually die, but I would argue that the time for that is not now. A dollar rally could be measured in years, although not many by any means. My best guess is that we would see perhaps a year or two of dollar rally in a world going increasingly haywire. After that I expect an end to the system of floating currencies, with all manner of attempts at competitive devaluation, currency pegs established and rapidly blown away, and beggar-thy-neighbour policies all round. The risk of currency reissue will rise over time, and be highly locational. I think the risk of reissue in the US is not imminent, but in Europe it should be a much larger concern, especially in peripheral countries.
I agree with this passage from Mr Lira’s article:
But this Fed policy—call it “money-printing”, call it “liquidity injections”, call it “asset price stabilization”—has been overwhelmed by the credit contraction. Just as the Federal government has been unable to fill in the fall in aggregate demand by way of stimulus, the Fed has expanded its balance sheet from some $900 billion in the Fall of ’08, to about $2.3 trillion today—but that additional $1.4 trillion has been no match for the loss of credit. At best, the Fed has been able to alleviate the worst effects of the deflation—it certainly has not turned the deflationary environment into anything resembling inflation.
Yields are low, unemployment up, CPI numbers are down (and under some metrics, negative)—in short, everything screams “deflation”.
This has been occurring under the most favourable of circumstances – a major rally during which people are prepared to suspend disbelief and give central authorities the benefit of the doubt. In all this time, and with all its efforts, the Fed has only been able to slow deflation. Once we turn the corner, confidence (and therefore liquidity) will evaporate again, and the headwind against the Fed will get very much stronger.
If they could not stop deflation under favourable circumstances, their odds of doing so under unfavourable ones must be extremely low. Periods of intense pessimism are not kind to central authorities. Everything they do is too little and too late. Every time they try and fail they look more desperate, which only acts to confirm people’s pessimism in a self-reinforcing spiral. Deflation has a massive psychological component, which the Fed has no tools to fight.
The second major proposition Mr Lira makes is that commodity prices will spike as a consequence of a meltdown in the treasury market:
At the time of the panic, commodities will be perceived as the only sure store of value, if Treasuries are suddenly anathema to the market—just as Treasuries were perceived as the only sure store of value, once so many of the MBS’s and CMBS’s went sour in 2007 and 2008.
It won’t be commodity ETF’s, or derivatives—those will be dismissed (rightfully) as being even less safe than Treasuries. Unlike before the Fall of ’08, this go-around, people will pay attention to counterparty risk. So the run on commodities will be for actual, feel-it-’cause-it’s-there commodities.
As I do not think such a treasury meltdown is imminent, I do not think such knock-on consequences are imminent either. In contrast, I think we are already seeing evidence of a top in commodities, which typically peak on fear of scarcity. I regard the sentiment indicators as strong evidence of such fear, and am therefore looking for a reversal, roughly coincident with a stock market top and a dollar bottom.
We have already seen significant speculative gains in commodities, similar to 2008, and I think that speculation will go into reverse, probably quite sharply. I would then expect a demand collapse to carry prices further to the downside. As I see a speculative reversal followed by a demand collapse setting up a supply collapse, I can see Mr Lira’s scenario possibly playing out in the future, quite possibly coincident with a bond market dislocation as he suggests. It is difficult to predict the timing for such an event, but I see it as being much further in the future than he does.
Because of my objection to the timing, I disagree with Mr Lira’s next assertion:
People—regular Main Street people—will be crazy to buy up commodities (heating oil, food, gasoline, whatever) and buy them now while they are still more-or-less affordable, rather than later, when that $15 gallon of gas shoots to $30 per gallon.
If everyone decides at roughly the same time to exchange one good—currency—for another good—commodities—what happens to the relative price of one and the relative value of the other? Easy: One soars, the other collapses.
When people freak out and begin panic-buying basic commodities, their ordinary financial assets—equities, bonds, etc.—will collapse: Everyone will be rushing to get cash, so as to turn around and buy commodities.
This sell-off of assets in pursuit of commodities will be self-reinforcing: There won’t be anything to stop it. As it spills over into the everyday economy, regular people will panic and start unloading hard assets—durable goods, cars and trucks, houses—in order to get commodities, principally heating oil, gas and foodstuffs. In other words, real-world assets will not appreciate or even hold their value, when the hyperinflation comes.
In my view, by the time we see a commodity price spike, the value of people’s financial assets will already have evaporated, they will already have unloaded hard assets, and the dash for cash will already be in the past. I think at that point we will be well into a state of economic seizure, where credit will have disappeared, unemployment will have spiked, incomes will be very precarious, scarce cash will be being hoarded and it will be exceptionally difficult to connect buyers and sellers. Consequently, I do not see most people being in a position to engage in panic buying.
Some many be able to do this, but I think the resource grab is more likely to be a phenomenon operating at the level of the state than at the level of the individual, as most individuals will already have lost almost all their purchasing power. In my opinion, states will certainly engage in a resource grab, and will take supplies off the market, either by sending the tanks or the bilateral contract negotiators into resource-rich regions. States know perfectly well that oil is liquid hegemonic power, and they will be trying to secure their supply in whatever way they can.
I agree with Mr Lira that almost everything will be very much less affordable than it is now, and that this will happen quickly. I do not agree that prices will rise in nominal terms, or that this is in any way a requirement of a drastic fall in affordability. I expect prices to fall in nominal terms, but for purchasing power to fall much more quickly as credit evaporates. Thus as prices fall in nominal terms, affordability decreases, and the essentials end up being the least affordable of all. They will receive relative price support as a much larger percentage of a much smaller money supply ends up chasing them, hence any fall in their prices should be much smaller than for other goods and services. Thus I agree with Mr Lira that the essentials will be drastically less affordable, but I do not think nominal prices need to rise for this to happen.
When we see the inevitable price spike in the future, once demand collapse has led to supply collapse, we could easily see price increases in nominal terms. Against a backdrop of monetary contraction, this would mean prices were going through the roof in real terms (ie adjusted for changes in the money supply). Being able to obtain essentials will be a huge problem, and I fully expect ordinary people to be priced out of the market for many things at that point.
Their survival may then depend on rationing and bare-minimum level handouts. I think the problem will begin before this though, as a collapse in purchasing power prevents people buying essentials for lack of money long before essentials actually become scarce.
The next point of contention between my view and Mr Lira’s is his discussion of Japan’s fortunes:
That’s right: The parallels with Japan are remarkably similar—except for one key difference. Japanese sovereign debt is infinitely more stable than America’s, because in Japan, the people are savers—they own the Japanese debt. In America, the people are broke, and the Nervous Nelly banks own the debt. That’s why Japanese sovereign debt is solid, whereas American Treasuries are soap-bubble-fragile.
In my view, we are looking at a Japanese scenario in some ways, but on more of an Argentine timeline. Japan has been mired in a long and drawn out deflation, because they had an enormous pile of money to burn through before having to address their banking problems and also because they had an export-oriented economy at a time when they could exploit the largest consumer boom in global history. We are not so fortunate. We find ourselves in a huge debt hole, and as the economic seizure will be global, we will not be able to export our way out of anything, even if we still had yesterday’s productive capacity, which is in any case long gone thanks to global wage arbitrage.
I do not regard Japanese sovereign debt as solid. In fact I think Japan is very close to the final day of reckoning where the problems of the past must finally be faced head on. I see a banking collapse in their near future, compounded by their extreme dependence on imported resources, which they will not be able to afford if their export markets die for lack of consumers with purchasing power.
The main point of contention I have with Mr Lira centres around the longer-term prospects for the USA:
Instead, after a spell of hyperinflation, America will end up pretty much like it is today—only with a bad hangover. Actually, a hyperinflationist spell might be a good thing: It would finally clean out all the bad debts in the economy, the crap that the Fed and the Federal government refused to clean out when they had the chance in 2007–’09. It would break down and reset asset prices to more realistic levels—no more $12 million one-bedroom co-ops on the UES.
And all in all, a hyperinflationist catastrophe might in the long run be better for the health of the U.S. economy and the morale of the American people, as opposed to a long drawn-out stagnation. Ask the Japanese if they would have preferred a couple-three really bad years, instead of Two Lost Decades, and the answer won’t be surprising.
I do not see this as a transitory problem leading back to business as usual, and I mean NEVER returning to what we would now regard as business as usual, let alone doing so in only a couple of years.
Deflation and depression are mutually reinforcing. This is a persistent dynamic that should last at least as long as the last depression, and likely longer as every parameter is worse going into depression this time. We have more debt, far more structural dependencies (on cheap energy and cheap credit primarily), looming resource limitations, far higher expectations, a much larger population, a far smaller skill base etc.
I think we are looking at an economic catastrophe of unprecedented proportions, not a bump in the road that can be quickly consigned to history, if only we face our problems head on. In my view we are going to have to live through deflationary deleveraging, a long and grinding depression, and then quite possibly hyperinflation once the international debt financing model is broken, and with it the power of the bond market to constrain currency printing.
This could easily take twenty years to play out, and even then the upheaval is very unlikely to be over. The last time a major bubble burst – the South Sea Bubble of the 1720s – the aftermath lasted for several decades and culminated in a series of revolutions. This bubble is much larger, and the aftermath is likely to be proportional to the excesses of the preceding bubble. This is why I call the presentation I travel to deliver A Century of Challenges.
Moreover, I do not see a return to what we consider to be business as usual at any point, because our business as usual scenario is critically dependent on cheap energy, and the energy subsidy inherent in fossil fuels has been a once in a planet’s lifetime deal. We are going to be living on an energy income instead of an energy inheritance, and this will mean living a life none of us in the developed world will recognize.