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Tuesday March 19, 2013, could prove to be a day that will live in infamy for the global financial system, with the epicenter in Cyprus. Lawmakers rejected, at least for now, a bailout plan that would have directly confiscated depositor money from every Cypriot savings account, as requested by the IMF. The rejection may not stand for long when the real prospect of national bankruptcy makes the politicians very nervous for their very livelihoods. More importantly though is the precedent set just in the attempt of seizure of depositor money. Up until now the massive bailouts have been managed by printing money and surreptitiously confiscating purchasing power by increasing the monetary base. Now central banks, governments, and the IMF have been emboldened to the point where they feel they can simply demand confiscating money directly. Most people don't notice when their money inexorably loses value, and even if they do, very few understand why. But everyone pays attention when their money is directly confiscated.

Before the gritty details, a bit of background on Cyprus and its banking problems: The Cyprus case is cartoonish. The size of the Cypriot banking sector is eight times the size of the island's economy. The government is in debt and can't pay its bonds, which makes the enormous banking sector that invested in government debt in need of a bailout itself. (The banking/government crony partnership is always exposed in these cases, as banks always go bankrupt when governments do.) So the IMF thought up the idea of just taking for itself a percentage of Cypriot savings accounts at progressive rates debated by Cyprus' parliament in exchange for a bailout. By the way, the IMF has not ruled out looting the savings accounts of taxpayers in other countries requesting a bailout in the future.

The logical conclusion to reach in the Cyprus case is that a banking sector that is eight times the size of the country's GDP has been way too coddled by government deals for way too long and may be just a bit too enormous. Therefore, it really should be shrunk. The best way to shrink a sector dramatically is to stop coddling it and let the weak parts of it go bankrupt and go away. But instead, the IMF has come up with a plan to put a whale of a banking sector on life support by simply confiscating money from innocent Cypriots (and others with Cypriot bank accounts), and just handing it to the banking sector while paying lip service to the "need to shrink the banking sector." The dissonance and inherent contradictions here are simply astounding. Talk about having your cake and eating it, too.

One of two things will happen from here. Either Cyprus will bite down hard and go through bankruptcy, or they'll balk, re-vote, and go with the depositor confiscation and IMF bailout. After this initial rejection, the ECB has promised to continue feeding Cyprus ATM's, at least for now. If they don't, there will definitely be a national bank run as the island faces bankruptcy and depositors will lose their money anyway. So from here, either Cyprus' government will realize that depositor losses are inevitable and at some point soon authorize this private money to be confiscated by the IMF, or Cyprus will be incredibly brave and face bankruptcy and the ensuing massive losses and rebuild from there.

The former case, assuming the government eventually authorizes the mass confiscation, could look something like this: With a precedent in the Western World of a government simply authorizing direct seizure of people's life savings and refusing to rule out that it could happen again, trust in banks worldwide will be seriously shaken. We will all have second thoughts about keeping our savings in banks. What if one day they just decide to take some of it in the US?

When Cypriots start a serious national bank run, which will happen in either scenario (bankruptcy or confiscation) the runs could spread throughout Europe. If that happens and Americans start getting nervous, this could be the trigger for dollar hyperinflation. Let me explain exactly why.

The chart above shows the amount of bank failures in the United States before and during the Great Depression. 1933 was a record for bank failures at 4,000. Traditionally, 1933 included, bank runs and the resulting bank failures were inherently deflationary, meaning they served to shrink the money supply. Money taken out of the banking system in the form of cash by the public means there is less money for the 10% fractional reserve banking system to lend out, and therefore a shrunken monetary base. For example, if you have $100 in a savings account, $90 can be lent out while you still see $100 on your account statement. If that $90 is lent to another bank, $81 of that $90 can be lent out yet again, and the bank still counts $90 on its balance sheet. So far, the total money supply in the banking system is $100 + $90 + $81 = $271, and it can expand even further asymptotically. If, however, all that money is taken out in a bank run, the money supply shrinks back to $100 and somebody, or a combination of people, loses $171 that they thought they had but never actually existed. Money supply contracts, prices fall, and the dollar goes up in value.

This is what generally happened with bank failures up until June 16, 1933, when the FDIC was formed. It happened briefly in 2008/2009 before the Fed started printing absurd amounts of money and inflating again ($16 trillion according to Forbes). Now, thanks to the FDIC, every bank and depositor has the implicit guarantee that deposits will not be lost (unless they're being confiscated by the IMF). However, much like the Social Security "trust fund" which was spent mostly on wars and does not exist, the FDIC insurance fund is also just smoke and mirrors. According to CBS News, the Federal deposit insurance fund is roughly $53B, while total bank deposits supposedly insured by the FDIC are closer to $10.54 trillion. That's a reserve ratio of half a percent, or, for every $10 "insured" by the FDIC, about a nickel of that is actually covered.

The main purpose of the FDIC is psychological rather than actual insurance. It is there to convince people that it is safe to keep your money in a bank and thereby prevent bank runs and keep the 10% fractional reserve system intact. But if people start to become afraid not that their cash isn't in their accounts, but rather that their cash will be confiscated to pay for some bailout, that psychologically calming effect of the FDIC will disappear in irrelevance. In that case, where does the FDIC get the rest of the money? The answer is that the Fed prints it. They already printed $16 trillion and passed it out to foreign central banks. Why not $10 trillion more and pass it out to American depositors? In that case, the money supply will not shrink and there will be no deflationary effect. Rather, with the cash printed up to help the FDIC save face and the 10% fractional reserve system still intact, the money supply could increase 10-fold in a matter of months when inevitably, after getting their cash, people start putting it back in the banks again. Thus, we get hyperinflation.

Whichever way Cyprus goes in the end, this will eventually be the end game. If Cyprus does indeed choose honest bankruptcy instead, it will likely set a precedent for other weak Eurozone countries to follow. Large European bankruptcies will push interest rates a lot higher, which will put Federal deficits even higher, which will in turn force the Fed to monetize debt faster and faster on this side of the Atlantic, same end of story. There is no way out.

How to protect yourself? A look at past cases of hyperinflation and where wealth was channeled during that time could be informative. Let's use the most famous case of 1920s Weimar Germany. A seminal yet neglected 1930 work by Princeton University economist Frank Graham, "Exchange, Prices, and Production in Hyper-Inflation," can give us valuable clues.

One passage (page 303) is particularly eye-opening about the structure of the hyperinflationary German economy in the mid 1920s. Graham writes:

Of much greater absolute importance…were the outlays, on capital account, of funds which would ordinarily have accrued to the population at large and have been spent, at least in part, on consumable goods. The volume of new industrial building, of renewal, repair, and expansion of equipment in manufacturing, transportation, agriculture, and mercantile life was large, especially when currency depreciation became so rapid as to make outlays on capital almost the sole means of preserving the substance of profits. These investments were for the most part made directly from undistributed profits. Under stable monetary conditions the funds thus employed would have first gone to private individuals who would have exercised their volition as to whether they would invest them or use them for immediate consumption and would in many, and perhaps in the majority of cases, have decided for the latter.

To put this in simpler terms, capital goods industries were booming during the German hyperinflation. The problem was that the profits from that boom never made it out of capital goods into consumer goods because the capital goods owners didn't leave their profits in the banks long enough for them to be loaned out to other people that would use them to consume goods. Instead, these business owners just reinvested the profits directly into their capital goods businesses and exported it out of the country for currency that was actually worth something because otherwise the entire purchasing power of their money would be destroyed. This left a shortage of consumer goods and less money for consumers to spend on things like food, as it was all trapped in capital formation at the top and then exported.

So, in a hyperinflationary economy, the best places to invest in preparation are capital goods, as money will be trapped there, and direct essential consumer goods, as there will be shortages. The sector that combines both of these very nicely is agriculture.

The conservative thing to do would be to go through a list of agriculture futures, pick the ones that are currently the most depressed, and buy the corresponding ETF's. The four agricultural commodities closest to their 52-week lows are sugar, soybeans, coffee and cocoa. The corresponding ETF's to pick up are SGG (sugar), SOYB (soybeans), JO (coffee), and NIB (cocoa). I would not suggest trading any of these on a short term basis, as the current instability of the financial system will certainly lead to unpredictable gyrations while the Fed fights natural deflationary forces in what will be an epic battle. My favorite of these four in any case in terms of potential gains is JO, as coffee has been in a sharp downtrend since May 2011 and is currently the most depressed. For safety, SGG or SOYB are less speculative and less specialized.

On the capital goods side, my favorite safety pick is Caterpillar (CAT). Even if there is no hyperinflation, this is a sound company with a proven growth record. For Caterpillar, revenues are up 55% in two years, and earnings are up double that at 110%. Caterpillar is not only making more money, it's twice as efficient now as compared to two years ago. Other plusses are that its annual dividend has passed $2 a share for the first time in its history and its dividend has gone up consistently with earnings. Last year the company distributed over $1.3B to shareholders, over 23% of earnings. There is room for dividend growth there. P/E is also an unjustifiably anemic 10.5, so there is room for capital growth as well. The final positive is somewhat obscure and also has to do with the prospect of hyperinflation. Caterpillar has a fair amount of debt totaling $40.1B or 69% of market cap. If hyperinflation does play out, that debt will shrink in real terms. Inflation, as we know, benefits debtors at the expense of creditors, or borrowers at the expense of lenders, as well as capital producers at the expense of consumer goods producers. Caterpillar fits into both categories handily.

For a more speculative pick if you have leftover cash to play with (and why not if there will be hyperinflation), I find Terra Tech Corp (TRTC.OB) an intriguing unorthodox bet. Terra Tech is a microcap just starting out that targets urban farmers, or people who want to grow their own food on their roofs and backyards. In a manner of speaking, Terra Tech sells capital goods directly to consumers. In the event of hyperinflation, consumer goods shortages and capital goods booming, Terra Tech and its customers will be in a unique position to ride out the wave. You can browse what they sell here. Terra Tech is currently expanding, acquiring other small businesses in its niche in an attempt it claims will up revenues to over $10M annually, which would be impressive for its tiny $18M size.

Despite its admittedly sparse balance sheet, Terra Tech does have room to expand given that it has zero long term debt. If revenue targets this year come close to that $10M estimate, TRTC could go a long way from its current position of 22 cents. Follow it closely, along with developments in Cyprus.

Source: How Cyprus Could Cause Hyperinflation, And How Agriculture Can Save You