Hyperinflation is very poorly understood by modern economists. My research has shown that this is likely due to the lack of evidence showing direct connections between economic environments and consistency in prior cases of hyperinflation. The widely held belief is that government debt and deficits (aka, "money printing") lead to hyperinflation. But my research shows that hyperinflation is not merely the result of "money printing" or an expansion of the money supply and in fact tends to occur around very specific and severe exogenous economic circumstances which lead to an increase in the money supply ultimately leading to hyperinflation. Hyperinflation is not merely high inflation or a collapse in confidence, but is actually due to severe exogenous shocks with very real and provable transmission mechanisms. Historically, these events tend to be:
- Collapse in production.
- Rampant government corruption.
- Loss of a war.
- Regime change or regime collapse.
- Ceding of monetary sovereignty generally via a pegged currency or foreign denominated debt.
Not seeing any of this in Japan ... or the U.S.!
Money and Credit:
First and foremost is the apparent misunderstanding of the differences between money and credit. At times, they may appear to have the same characteristics. At other times they act completely opposite from one another. As an economy is expanding, an increase in the total amount of credit would appear to have the same effect as an increase in physical dollars because credit is widely accepted as an equal to money. In a sense, they are the same. They are both "fiduciary media" (in English they are both a representation of something else, rather than having intrinsic value themselves). But when the economy is contracting, the prospect of default is thrown into the equation. When this happens, money increases in value relative to credit. Money is more valuable than credit because in the event of default, the physical dollar holders are king. Yes, the U.S. Treasury could default on its obligations. Holders of Treasury Bonds would get a big, fat zero, while holders of physical currency would still have a claim. In effect, they act similar to a preferred share as opposed to common stock. They are a step above in terms of priority.
It is often said that we live with a "fiat currency" or with "paper money." This is not entirely accurate. A very small portion of our total supply of money and credit is in the form of physical currency. It depends on how you count it, but regardless, it is under 10% of the total. This is what differentiates our monetary system with that of Zimbabwe or Weimar Germany circa 1920's. Their economies were based on nearly 100% physical currency because nobody would accept the promises of government in order to issue credit.
The vast majority of our money supply is in the form of electronic credit. Electronic credit can be destroyed, while physical notes issued by a central bank cannot. This is why deflation is possible in a credit based monetary system, but not in a paper based monetary system.
There are hundreds of trillions of dollars floating around the world in credit. Much of that is an insurance contract on top of another insurance contract, on top of a securitized mortgage, on top of an asset. The total value of all the aggregate claims on the asset vastly outnumber the value of the asset itself. That is what this crisis is about at its very heart. Picture an inverse pyramid with assets occupying the bottom bit, securitized mortgages in the middle, and credit derivatives at the top. A stable economy would have a right-side-up pyramid with assets occupying the bottom, etc.
Our problem now, is not that the assets are going to go to zero. It's the value of the much larger derivatives and mortgages that back the assets going to zero. Their values were derived from faulty computer models that grossly underestimated risk in the underlying asset, but more importantly in the ability for a counterparty to make good on their promise in the event of a default. The counterparties, like AIG (NYSE:AIG) or Citi (NYSE:C), issued 30 or 40 times more in insurance than there were in assets to back them up. Their models told them that the possibility of all the different assets declining at the same time was negligible, therefore justifying such enormous leverage. Now that the assets have fallen by at least 20-30%, the holders of the securities that were tied to them want to be paid for their insurance. Only there's nothing to pay them with. So the people that hold these contracts are trying to get rid of them as fast as they can, and for whatever price, because they fear that if the counterparty goes belly-up, they'll get nothing. If they can sell, they take the loss. If not, they keep the asset off their balance sheet in what's known as a SIV (Special Investment Vehicle) until they can be sold. While they are kept off the balance sheet, they are still considered to be worth 100% of their original value.
The total amount of these assets is far greater than the equity banks have and their sum represents future losses that eventually need to be realized. No, the value of these assets is not completely nil - because the value of the underlying assets are not nil. But for all intents and purposes, it might as well be zero because it dwarfs their tangible equity.
That was a very long-winded explanation of what the difference is between "money" and "credit" but it is essential to understand this difference. Not only if you want to be an econo-nerd like myself, but in order to understand the very essence of our economy, banking or investing. Any other information is essentially useless unless you can wrap your mind around this concept.
So the next time you hear that the Federal Reserve is "printing money," please do not automatically assume that they are printing physical notes. They are creating electronic reserves (credit) to support the balance sheets of the big banks. There is absolutely nothing inflationary about this. The banks are simply taking it and using it to cancel out their derivative losses or are hoarding it in order to prepare for future losses. Previously, banks would have used the electronic reserves to go out and make 10x that amount in loans to consumers or businesses (in reality the order was the other way around - loans first, then reserves). That is not the case anymore, and until the bad assets are completely liquidated, it will not be the case again.
Thus far, we have a total of $9.7 Trillion dollars in total government/central bank assistance in the United States. An amount equal to that and more has been provided by their counterparts around the world. More is promised. But the fact remains that the minimal inflationary impact these actions have are negligible in comparison to the amount of "problem assets" being devalued around the world. Much of it is just in guarantees - that is, more insurance. The Federal Reserve will offer to swap good assets for bad. All this does is cancel out debt from somewhere else. It's like moving money from one pocket to another. The act of putting money in your right pocket does not make you any richer.
No matter how much credit is issued, it cannot make up for the massive contraction elsewhere. The net result will be deflation - even though it will be less than it would be without any interventions. Japan has discovered this over the last two decades - and they had huge demand for their exports, whereas the current situation is global. America discovered this in the 30's - and they had a far smaller debt burden than now. We will discover the same.
Will the U.S. Dollar Collapse?:
Closely tied to the belief in imminent hyperinflation and a skyrocketing gold price is the misplaced belief that the United States dollar is on the brink of collapse. Essentially, they are one and the same. Many of my arguments against hyperinflation are the same against a dollar collapse. But there is even more evidence stacked against such an occurrence.
Ultimately, the dollar will end up at zero - but that is not going to happen any time soon, and I would argue is likely decades away. Until then, the massive amounts of deleveraging will increase our appetite for dollars to pay back debt. There is too much credit in the system, and as we rid ourselves of it slowly, we need to acquire dollars. A large portion of the credit derivatives I mentioned above are denominated in dollars even though the underlying asset may be priced in another currency. This is a theoretical short position on the dollar. A "carry trade" in other words. It must be unwound, just like the yen carry trade.
This is what is meant when we call the U.S. dollar the world's "reserve currency." Most people hear the word "reserve" and automatically conclude that because many other countries hold the dollar as their primary currency in their foreign exchange "reserves," that is what is meant by "reserve currency." It is not. Total foreign exchange reserves of dollars are far smaller than total foreign credit contracts denominated in U.S. dollars (reserves worldwide are "only" ~4.6 Trillion). It is the reserve currency because it is the default currency for international trade and commerce in general. In order for that to change, 100's of trillions in contracts would need to be re-written. Not practical.
As such, demand for U.S. Dollars will persist.
Additionally, the U.S. dollar is not alone in its state of affairs with an over-indebted government and central bank getting itself in all sorts of trouble. In fact, nearly every other currency has the same issues facing it. And even though the numbers aren't quite as dire elsewhere, they are far more likely to collapse than the U.S. dollar due to the reserve status. Fair? No. But neither is life.
In summary, there are many multiples more debt than capital in the world economy. Debt is being liquidated and will continue to do so until it reaches a sustainable level relative to capital. The process of this debt liquidation puts a higher value on dollars relative to debt, thus ensuring an oversupply of dollars is impossible.
A credit based economy requires an ever increasing amount of debt in order to support itself. Since the 1970s, all of the recessions we have seen involved a slowdown in credit expansion - never an outright contraction. In order for a hyperinflation to occur, we not only need to get back to a level of credit expansion equal to that of 2006/2007, we would need to exceed that level and continue even further. Let's review the facts:
- Banks cannot lend because their balance sheets are loaded with tens of trillions in impaired paper assets
- The government and Federal Reserve only control a small portion of the total supply of money and credit
- The interventions we have seen are not inflationary because for every dollar of credit provided or guaranteed, another is wiped out
- Social aversion to conspicuous consumption and "living beyond one's means" is catching fire
- An aging boomer generation needs to sell their assets to a smaller, more risk averse younger generation
- Emerging markets like China are in a position of overcapacity and are too small to offset a worldwide contraction
Taking the above information into account, we can only conclude one thing:
Hyperinflation is impossible.
Money Printing - One Overtly Abused Term Today!:
I never stop seeing the term "money printing" all over the place. It has to be the most abused term in all of economics and finance. The madness must end! So let's try to make this so simple that a 6 year old could understand it.
- Banks create most of the money in our system. Loans create deposits and deposits are, by far, the most dominant form of money in the economy. So, if you want to say someone "prints money" you would be most accurate saying that banks print money.
- The government is a user of bank money. When the government taxes Paul they take Paul's bank money and redistribute it to Peter when they spend.
- If the government runs a budget deficit (taxes less than it spends) then Paul buys a bond from the government and the government gives Paul's bank deposit (which he used to buy the bond with) to Peter. Paul gets a bond which the government created in much the same way that a private corporation creates a bond when they issue corporate debt. If you want to say these entities "print" financial assets then fine. Corporations print stocks and bonds every day and you don't hear the world exploding with hyperinflation rants because of it ...
- When the Fed performs quantitative easing they perform open market operations (just like they have for decades) which involve a clean asset swap where the bank essentially exchanges reserves for Treasury Bonds. The private sector loses a financial asset (the t-bond) and gains another (the reserves or deposits). The result is no change in private sector net financial assets. QE is a lot like changing your savings account into a checking account and then claiming you have more "money". No, the composition of your savings changed, but you don't have more savings.
- Cash notes like the ones you have in your wallet are created by the US Treasury and are issued to the Federal Reserve upon demand by member banks. This cash is literally "printed" by the Treasury, but serves primarily as a way for banks to service their customers. In other words, if you have a bank account you can exchange your bank deposit for cash from the ATM or the bank teller. Cash is preceded by the dominant form of money, bank money. But it doesn't get printed off the presses and fired into the economy as some would have us believe.
See, there's no "money printing" in any of this unless you want to distort the role of cash in the economy or refer to lending and security issuance as money printing. Yes, QE alters the composition of private financial assets, but that's about it. No real "money printing" there either. So, next time someone goes off on a "money printing" rant just point them in the direction of these 5 easy to understand steps.Disclosure:
I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.