Answer to Jay's Question

This is an answer to the previous post from Jay in the previous post.

Jay,

Interesting argument.

The question of Hyperinflation

Hyperinflation happens by circumstance, not by plan. It is a sign that the government has lost control of its financial resources. Also in a world economy no government can control their currency absolutely outside of their borders. Even the power of the US is dependent upon international consensus. Therefore to indicate in a major banking crisis that the US can control the value of the US dollar is not possible if enough countries decide to get rid of their US dollars.

Hyperinflation is not a political popular option; however inflation is a very popular political option. Why the difference?

Since politicians are in the job to get reelected, inflation is a good policy to follow because this provides additional money to the government in the form of printing money to gain price stability. Therefore in today’s situation whereas the US dollar is overvalued, the drop in prices by world wide deflation is countered by expanding the monetary base. This expansion of the monetary base is really a hidden tax on American’s.

Prices relative to incomes should be much cheaper; however this hidden tax gives the government a hidden revenue base.

Hyperinflation is avoided at all costs. This is because the amount of chaos it produces can easily destroy the political system of a country and destabilize the country. This would certainly not be the goal of any politician seeking reelection. The current political power structure would be in very serious jeopardy. Therefore when a country goes into hyperinflation it is definitely not by choice, but by circumstance.

I would also like to point out that even though hyperinflation is really bad, it is much better than having your banking system destroyed through massive defaults. I prefer to think of it as the lesser of two evils. Both totally screw up your country; hyperinflation screws it up slightly less.

I would hate to think what would happen to the US if we hyperinflated. Just think, in Germany they got a brand new political system complete with Adolf Hitler.

Democracy and Debt

Since we live in a Democracy in order to get and stay elected there is a huge pressure on politicians to overspend. This is due to the fact that the voting franchise is all encompassing and paying off groups of voters with through the accumulation of debt is a very popular tactic. This is true of both Republicans and Democrats.

The voting population does not want an increase in taxes, or to cut existing services and government goodies in which are given and not earned. Therefore all Democracies accumulate debt until the debt load becomes too unstable.

Too many financial promises are made, and when the country can no longer service its debts, the promises are still there. They just do not go away. The only option is a destruction of the countries currency as payments must be made on the government goodies promised, but which its society can no longer afford.

Therefore governments come up with all kinds of ways to pay for the promises and to keep their voters happy. One very popular way is to lower lending requirements on mortgages. This provides more tax money, increases GDP (through debt), and makes everyone feel rich. In these periods government increase spending.

The party only stops when the debt load can no longer be substance. However the country now goes into deficit spending to keep the people working and to stabilize the banking system. As a large unemployed population is a recipe for political unrest the government is very motivated to keep people employed in some way. Government spending goes on a binge, increasing when it should be decreasing.

This uncontrolled spending, the return of currency from foreign banks in the form of bonds and other securities denominated in sovereign currency leads to a sharp increase in the money supply in general circulation in the country.

Inflation is the plan, hyperinflation is what happens when government spending

Raising the Interest Rate as a fight Against Inflation

This technique does not work as well as it did 20 years ago due to derivatives and the securitization of debt into bonds. Now the banking system can get around almost all rules the government may implement just by selling the debt. (This is of course assuming there are buyers for the debt).

Therefore as long as foreign banks continue to want US debt, then the international interest rate set by the bond market bypasses the federal funds rate. The short term rate set by the Fed just is not considered as supply and demand is really at work here. This is why you can get an inverted yield curve.

Dr. Greenspan has spoken on this issue before and he has publicly exposed doubts about any real effects of adjusting the federal funds rate. In a time before derivatives this would have been more effective as debt holders would have been inside the country.

Repudiating the Debt

Do countries have a tough time getting loans after going through hyperinflation.

No, they do not, not at all in fact.

The world is full of countries which have repudiated, meaning that they tell the creditors that past debts shall never be repaid. This is a common occurrence. A typical strategy is that the country in question just invents a new currency, and just like new, all their old debts go away.

Does this hamper their ability to obtain new debt?

No, it may raise interest rates for a limited time, sometimes very limited. However a countries ability to borrow does seem to be endless. Just do a study of all the countries that have gone through hyperinflation, when the country stabilized, generally under another political system, borrowing at very reasonable interest rate occurs very quickly.

Argentina is a good example of this. This country suffered though chromic hyperinflation for years, and then very quickly interest rates on sovereign debt went down very quickly once the banking system stabilized in 1991. The country then went back into hyperinflation in 2001. Here is some historical data

Argentina’s Money Supply













Argentina’s Inflation Rate
1989 5,103%
1990 1,344%
1991 84%
1992 17.5%
1993 7.4%
1994 4.2%
1995 3.4%
1996 0.2%












Argentina’s Interest Rate














http://www.latin-focus.com/latinfocus/countries/argentina/arginter.htm

Argentina’s GDP
1991 10.5%
1992 10.3%
1993 6.3%
1994 5.8%
1995 -2.8%
1996 5.5%









http://www.blx.com/portal/inicio/paginasInfoLatam.aspx?PAG_ID=21&CAT_ID=5


The Question of Dr. Bernanke and Fed Policy

I do not think Dr. Bernanke is an idiot. He is very well studied on the mechanics of the Great Depression and his book can be found at Borders Books in Downtown Washington DC.

Dr. Bernanke thesis is that we did not inflate enough to prevent event the very few years of mild deflation we experienced during the 1930’s during the depression. He also believes that a country can grow their way out of a debt crisis. Given the right circumstances I do not disagree with him on this point if the growth is not dependent on the accumulation of debt and adds to the real economic base of the country.

I do no feel that this economic recovery fits that mold as just building houses with debt, and they increasing the value of the houses by flooding the market with debt doesn’t in any way really add to the economic base of the country.

If the country had increased the debt with jobs in manufacturing, engineering, and other real economy and wealth building functions that create an income stream I would expect the US to be in better shape than a society based on the expansion of credit. Of course if the money for manufacturing didn’t get allocated correctly, then massive oversupply would ensue.

Can Dr. Bernanke fight hyperinflation, I doubt it. Just like every other country that faces hyperinflation the government has too many promises to keep, and too much money abroad. In our case the shear amount of money abroad and the speed of transition for foreign banks to get rid of US currency is far faster than any government in the history of the human race could deal with effetely.

Dr. Bernanke does not make decisions on military, social security, or any of the other goodies that the government is giving to its people through the assumption of debt. He could not limit or get rid of these programs. I don’t think the President could either. So we are really stuck at our current spending level.

How would Dr. Bernanke even be able to deal with the collapse of the negative trade balance? It’s not like you can run a massive negative trade balance for ever. At some time your currency devalues due to it proliferation all over the world. A sharp decrease in the purchasing power of currency is hyperinflation.

If foreign banks stop buying our mortgages, then this US money coming into their countries through debt payments and a negative trade balance will no longer be trapped in a lending loop, it will now be free to devalue on the international currency market. There is no way out side of war that the US could stop this. This is precisely why we have this international lending loop whereas our money keeps coming back to the US in the form of credit.

In many ways I feel sorry for Dr. Bernanke. He will go down as the Chairman of the Federal Reserve when the world goes off the US dollar. I cannot imagine what history shall show him as, but it will certainly not be positive.

Paul Volker

I think the Fed chairman before Greenspan needs some attention.

In 1971 the US effetely went off the gold standard. Then the US dramatically increased the money supply through the 1970’s. This action reduced the purchasing power of the dollar.

US Money Supply M3 in billions
Year Supply (Billions) Percent Increase
1960 $303.4
1965 $450.5 48.5%
1970 $618.3 37.2%
1975 $1076.8 74.2%
1980 $1826.4 69.6%
1985 $3026.5 65.7%
1990 $4091.7 35.2%
http://www.federalreserve.gov/releases/H6/hist/h6hist1.txt

It is very easy to see that after the US went off the gold standard that the supply of money almost doubles in its creation from a high 30’s to high 40’s in before the US left the gold standard to high 60’s and mid 70’s after we left the gold standard. It is also very easy to see that in the 1980’s the money supply still gaining at an alarming rate.

From 1979 to 1987 Dr. Volker served as Chairman to the Federal Reserve and is credited with ending the 1980’s inflation crisis by raising the federal funds rate and therefore constricting the money supply. Dr. Volker increased the federal funds rate well over 17% in the 1980 and over 19% in 1981. The federal funds rate has over 10% in 1984 then declines between 6% and 7% by the end of his term.

The creation of M3 in the money supply starts out at about mid 70’s to mid 60’s when Dr. Volker increased the federal funds rate and then falls to mid 30% when the federal funds rate is relaxed.

The question you should really be asking is why did the money supply grow so fast after the US left the gold standard. Obviously Vietnam pumped money into the US economy, but without a huge negative trade balance, the money borrowed and created stayed in the country, causing inflation in everything.

During this time financial derivatives where not really in wide use, therefore international holding of US consumer debt was not nearly so widespread. I could be therefore argued that raising the federal funds rate was effective in the 1980’s as most of the holders of consumer debt (i.e. mortgages, car loans, credit cards) were inside the country.

At this period of time the securitization of debt into bonds easily defeats loan requirements and interest rates on credit are now far removed from the federal funds rate for the same reason. Once the debt left the country the Feds ability to manipulate it downward was dramatically decreased.

I could only see direct intervention by the government to limit the expansion of credit through the limits on selling debt. This would put the fed back in power.

CPI and PPI
I agree with your analysis of how CPI and PPI would and did work in the 1970 through the 1980’s under a high rate of money creation and a localized banking system with debt unable to be sold enmass.

Let’s expand the money supply to 2005 and we see this chart.

Us Money Supply M3 in billions
Year Supply (Billions) Percent Increase
1960 $303.4
1965 $450.5 48.5%
1970 $618.3 37.2%
1975 $1076.8 74.2%
1980 $1826.4 69.6%
1985 $3026.5 65.7%
1990 $4091.7 35.2%1995 $4397.4 7.5%
2000 $6630.5 50.8%
2005 $9480.6 43.0%

M1 is one measure of the money supply that includes all coins, currency held by the public, traveler's checks, checking account balances, NOW accounts, automatic transfer service accounts, and balances in credit unions.

M2 is one measure of the money supply that includes all coins, currency held by the public, traveler's checks, checking account balances, NOW accounts, automatic transfer service accounts, and balances in credit unions.

M3 is one measure of the money supply that includes M2, plus large time deposits, repos of maturity greater than one day at commercial banks, and institutional money market accounts.

It looks like money creation is limited between 40 and 50 percent. However with the advance of derivatives money is now much harder to define. According to Aubie Baltin PhD. Writes “It appears that there is $1.971 trillion of money market mutual funds buried in M2 and these accounts have check writing privileges, so it is 'real' money. In other words M1 should actually be $3.3 trillion. It is being reported as $1.3 trillion (June 2004)."

So how does all of this debt in the form of bonds affect the money supply which is not classically defined under M1, M2, or M3?

Certainly when a person takes out a HELOC loans and purchases something this adds to the money supply. However this money is transported via a negative trade balance to another bank outside of the country.

When US bonds are sold by foreign banks, does this affect the purchasing power of money?

It certainly gives the buyer of the bond cash stream of US money. If the bond is bought at a discount then this effetely lowers the purchasing power of money. If the bond is bought at a premium this effetely raises the value of money. Therefore securities held internationally in terms of debt do in fact adjust the buying power of the US dollar in terms of those countries desire to hold onto that debt.

At this time the money paid on this debt is transported out of the US and to the foreign countries, where it is mostly sent back to the US in the form of mortgages. This held excess US currency out of our money supply by trapping it in MBS and ABS. HOLC money was sucked up by a comparable negative trade balance. This money also came back to the country in the form of MBS and ABS.

Therefore I would argue that the money supply is really much higher than the Federal Reserve is recording it to be since effective money substitutes are now everywhere thanks to new check writing rules and derivatives.

So how does this relate to CPI and PPI.

I would agree that as the purchasing power of the dollar falls then prices go up and people are layed off, reducing the base of people who can purchase goods. Therefore this creates oversupply and prices are forced down. As prices rise due to the money supply more and more jobs are lost. I do not disagree with this analysis.

What I expect to happen during the process is that the other countries with huge asset bubbles, I think this is a large percentage of all US trading partners, will experience the deflation of their asset bubbles at about the same time as the US for similar reasons. The bubbles are falling under their own excessive weight.

As these countries go into a banking crisis they shall start to bail out their banks by printing money. I would say borrow money, but who could you really borrow from. Even if you did borrow money, it is really just that country monetizing their debt in order to extend credit at this stage, and this would just add to the supply of money in their country.

This will effetely cut off effective borrowing. Not that countries won’t borrow from each other, just that the borrowing is really monetizing the debt instead using money from savings. This will cause a situation whereas money is created in both economies, the lender and the borrowing economy, increasing the money supply in both countries.

In this period I also expect democratic governments to increase spending on public works, military and social programs. In no way will the governments reign in current spending.

As the US dollar is the most widely used currency on the planet I would also expect to see foreign banks dumping US assets as they shift away from a US dollar standard to a basket of currencies. This will flood the international market with US securities, discounting them, and devaluing the purchasing power of the US dollar.

As the US dollar is highly overvalued in purchasing power I would expect to see the US dollar fall faster than other currencies. This will in effect make it cheaper to produce things in the US again and rebuild our manufacturing base.

The US negative trade balance with the world will also stop as countries start selling things to other countries. This will eliminate the negative trade balance and give the US a positive trade balance eventually.

The US government has expanded its spending with GDP growth induced through the assumption of debt. This spending will not be reduced, but increase during the crisis.

Government spending will now inject US currency into the US economy and into the US currency general circulation within the country. US dollars will be returning through the foreign banks divulging themselves of US securities.

Therefore even though I agree with your argument for CPI and PPI, I think that the international banking system and our own government spending will bring too many dollars into the country, bring with it hyperinflation.

Until the US gets a firm hold on its spending, gets rid of many social programs, public works and such, then the US is in serious danger of chronic hyperinflation for years to come.

Chromatic Dispersion