What Effect Will Hyperinflation Have? 51 comments
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Hyperinflation is a devastating phenomenon. It wipes out the middle class by destroying the value of cash, savings, bonds and other paper instruments. But, how does it affect stock markets? With the Federal government just having added $5.2 trillion in Fannie/Freddie liabilities of which about $600 billion will likely default, the Federal Reserve having now polluted its balance sheet by some $700 billion worth of toxic mortgage bonds with a 41.6% default rate ($291 billion in likely defaults), an $85 billion bailout for AIG, and, now, the Administration asking for some $700 billion more to bail out financial firms, it seems clear that the winds of hyperinflation are upon us. What will be the comparative effect of hyperinflation upon index funds, like DIA, QQQ, and SPY, versus bonds and cash?
Hyperinflation is not a particularly uncommon episode in human history. It has occurred in the following countries in the following countries, in the last 150 years. Weimar Republic of Germany 1920 – 23 (1/466 billionth of starting value), Zimbabwe 2003 - Now (6 quadrillionth of the starting value and continuing to fall), Former Soviet Union 1993 – 2002 (1/14th of starting value), Argentina 1975 – 1983 (1/1,000th of starting value), Austria 1921 – 23 (about ¼ of starting value), Bolivia 1984 - 86 (1/1,000 of starting value); Bosnia-Herzegovina 1992 – 93 (1/100,000th of starting value), Brazil 1960 – 94 (1 trillionth of starting value), Chile 1971 – 73 (1/3rd of starting value), China 1947 – 55 (1/10,000th of starting value), Greece 1943 – 53 (1/50 trillionth of starting value), Hungary 1945 – 46 (100 quintillionth of the starting value), Hungary 1922 – 23 (1/4 of starting value), Israel 1976 – 86 (1/16th of starting value), Japan 1934 – 51 (1/362nd of starting value), Poland 1990 – 94 (1/10,000th of starting value), U.S.A. (Confederate States of America) 1861 – 65 (1/90th of starting value, and then, by the end of the Civil War, the Confederate Dollar depreciated to zero). It also happened in the ancient Roman Empire, when the silver and gold coinage of that day was progressively debased with base metals, in order to fund wars, giveaways to the Plebeians, and various other adventures. There are many additional examples that I have not bothered to cover here.
The most studied hyperinflation episode was the early 1920s, in the Weimar Republic of Germany. At the end of the First World War, the mark to dollar ratio was trading at 9:1. By July 1921 the ratio had risen to 77:1, and prices more than doubled again by January 1922, as the ratio of marks to the dollar climbed to 192:1. By the time that the Weimar government introduced the Rentenmark in November 1923, which replaced the deflated mark, the exchange rate had risen to 4.2 trillion marks to the dollar.
Germany’s economic situation in the early 1920s, except for being a defeated combatant in World War I, is frighteningly similar to our own economic situation, today. We can trace the road to hyperinflation, step by step, and compare Germany’s path to the path that is now being travelled by the U.S. Germany abandoned the gold standard in 1914. America abandoned the gold standard, 60 years later, in 1974. Back in 1914, the German government did not expect World War I to last very long, and the war wasn’t properly budgeted, and, instead, it was financed by deficit spending. Similarly, in 2003, the Iraq War was not expected to last very long, and was financed by deficit spending. However, in comparison to the size of the German economy in 1914 and the U.S. economy in 2003, the Iraq War is a somewhat cheaper war.
After WWI, Germany suffered a severe current account deficit, just like the current account deficit we now have in the USA. About 1/3rd of their deficit was generated by the need to pay gold to European allied governments as war “reparations”. But, the rest was due to economic mismanagement, and 2/3rd of the German current account deficit was composed of non-war related spending. Back then, other than for war reparations, America was Germany’s biggest creditor, with American financial institutions, particularly J.P. Morgan, Jr., arranging for consortium loans to the Weimar government, its businesses and industries. News accounts, from that time, indicate that the Weimar German government, like the American government now, was far more concerned with avoiding recession, lowering the unemployment rate, and stimulating business activity than it was about inflation.
German economists in the 1920s thought, just as American economists think now, that a cheaper currency helps stimulate export activity and industrial production. Germany needed exports to buy raw materials, just as the U.S. needs them, now, to buy oil and Asian made consumer goods. Back then, however, the United States was a net creditor nation. It played that role in relation to Germany, similar to the role played by Asian nations, including China and Japan, toward the USA, except that, instead of exporting consumer goods, the 1920s USA exported mostly raw materials to Germany. United States financial firms, in the early 1920s had great faith in Germany, and were buying German government bonds, and supplying loans to facilitate purchase of American commodities. These loans offset the German trade imbalance, just as Chinese Treasury bill and bond buying now offsets the U.S. current account deficit.
When financiers like JP Morgan, Jr., however, finally decided that Germany was no longer a good credit risk, they cut off funds. After that, everything fell apart very quickly. By 1923, you needed a trillion marks to buy one dollar. The German financial class managed, to some extent, to avoid some of the losses, by purchasing large quantities of gold and other hard assets. The German middle class, however, lost everything. This led to a deep resentment of Jews, who dominated the German financial industry, and, later, it gave birth to the Nazi movement and the murder of millions of innocent Jewish people.
German Wholesale Price Index
Source: http://www.usagold.com/GermanNightmare.html
All factories, houses and buildings were still standing, before, during and after 1920s German hyperinflation, just as they will be in 2011 America. Germany in the roaring 20’s was still a potentially rich nation, just as America will be in 2011. But, the stored work product of a generation, represented by the symbols of stored wealth, in the form of cash, savings, stocks, bonds and other paper instruments, became essentially worthless, almost overnight. The same may happen here.
For America, like 1920s Germany, the hyperinflationary trigger will not come from within the nation. It will come from outside. Eventually, China, Japan, and/or some other nation, will see the endlessly increasing American deficit spending as a threat to the viability of the U.S. dollar. In response, they will reduce their purchases of treasury bills. This will bring America to her knees. Indeed, there is already talk, in China, about the danger of keeping Chinese foreign reserves predominantly in the form of U.S. dollar denominated treasury bills and bonds. The Chinese are talking about diversifying away from the U.S. dollar. This will happen, eventually, no matter what we do. It is not a matter of “if”, but, rather, of when.
The joint mismanagement of the American economy by sequential administrations, both Democratic and Republican, have insured that we are now totally dependent upon the whims of the Asian governments. When it finally happens, dollar denominated paper will begin to lose value very quickly. The U.S.A., with a hollowed out economy, is no longer producing much of anything but agricultural products, some sophisticated technological products, a lot of internal services and housing. The need for imports, using a deflated dollar, will swing the country into a hyperinflationary downward spiral.
It will not happen overnight, but it will happen. The situation is so far advanced, at this point, that no matter what we do, there is probably no way around it. The new plan, from this Administration, to buy toxic mortgage instruments from the irresponsible financial firms who caused the credit crisis is not going to stop it, and may very well be the straw that breaks the “camel’s back.”
At minimum, the U.S. dollar will depreciate by the amount by which the Federal balance sheet is corrupted by the toxic mortgage paper. Most frightening is the prospect of giving Hank Paulson, the prior Chairman of Goldman Sachs, one of the key creators of the toxic mortgage instruments that have caused the credit crisis, unlimited discretion in doling out $700 billion in bailouts, without any possibility of judicial review. Doing that assures that the money is used in the most inefficient and nepotistic manner. It will bring us deeper into hyperinflation.
We can rationally expect that the US dollar will lose about 75% of its value, within 2-3 years. Cash in the form of government and/or corporate bonds, money in CDs and other bank accounts, will be hit the hardest. General index fund type of investments, such as DIA, SPY, QQQ, and the like will also be very bad investments. Stocks, in general, do not do well in a highly inflationary environment. However, if the Weimar experience is any guide, stocks will do much better than bonds or cash. Financial and retail stocks, however, will be the worst investments of all equities sectors. The best investments, in contrast, will be gold, silver, shares of companies whose assets consist of modern plant & equipment, productive lands, and other hard assets that will retain value.
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So I see a very bleak future, and am looking for advice as to what to do with my savings. Suggestions?
"With the Federal government just having added $5.2 trillion in Fannie/Freddie liabilities of which about $600 billion will likely default..."
Leaving $4.6 trillion in performing assets for which the government will be paid guaranty premiums of how much? At 28 basis points, it's $13B/year. Of course, the other $600B will add $1.5B per year until they default. Let's assume they default -- oh I don't know -- now. Of that $600 billion, the government then holds underlying assets worth what - $300 billion? $400 billion?
Taking my neighborhood as exemplary, the government's immediate losses are then $200B. Think of that as the cost of the investment. Think of the $13B per year from the guaranty fees on the performing assets as the return on the investment - 6.5%. Not too bad of a risk-adjusted tax-free return. Certainly not as bad as you seem to want to think.
"...the Federal Reserve having now polluted its balance sheet by some $700 billion worth of toxic mortgage bonds with a 41.6% default rate ($291 billion in likely defaults)..."
Again, assuming your numbers are correct, this causes a loss of less than $100B IF the borrowing entities default. They won't. See the Treasury plan below.
"...an $85 billion bailout for AIG..."
The best investment I've seen anybody make in a long time. The government gets paid LIBOR+8.5% for two years on the unpaid balance, providing a huge incentive for the company to liquidate assets, plus warrants to own a vast majority of the company. The terms of this are incredibly onerous, but the company had absolutely no choice - it was either this or outright bankruptcy. Do you actually think the government will LOSE money on this one?
"...and, now, the Administration asking for some $700 billion more to bail out financial firms..."
Do you realize you're double-counting here? The bad collateral you say the Fed now holds is part of this. But let's not worry about facts. This is the part where the government is most likely to lose money; that's why there is still so much up in the air, and why the political debates are ongoing.
So counting it up you appear to have one valid cost to the government. Which leads you to...
"...it seems clear that the winds of hyperinflation are upon us."
I tell you what - I'll lend you $100,000 at 25% interest. You can should jump at the offer, right? You can take those dollars, put them in gold, or euros, or whatever, and in a year or two, after your supposed hyperinflation takes over, you can convert a fraction back to dollars to repay me with.
Hyperinflation. Stop being ridiculous.
So, the article does not propose that we will have hyperinflation of the same extent as Weimar Germany. Weimar Germany is simply the most studied example of hyperinflation. I consider rates of 20-30% per year to be hyperinflation.
I don't see the dollar at 1 trillionth of its present value by 2011. But, I do think that a 75% devaluation is very reasonable, given the circumstances. Weimar Germany is used as a model, in this article, not for the numbers, but, rather, for the type of behavior leading to high inflation.
China, while definitely destined to eat our lunch, is not going to be rebuilding the world. They, instead, produce cheap toys and Nike knockoffs. They sell us all that crap we like to buy. In a true meltdown, if it happens, no one is going to be running out to buy the latest Ipod (or anything else). Business will suck for everyone, though I do admit they would be a lot better off than the U.S.
glta.
Another difficulty is that if we do hit hyperinflation with super expensive gasoline, will workers be able to get to work? Cities, like citizens, won't be able to afford to run mass transit.
We are in scary times.
If your hard assets are gold, jewels, whatever, you sell bit by bit at whatever price you can get in order to feed the family, keep the lights on, etc. There may not be that many buyers because only the truly wealthy will have cash to spend on anything but necessities. So, more likely you barter whatever you have that someone else might need, for something that you need.... but it will have to be local because shipping fees will be skyhigh.
If you have hard assets in the form of oil stocks, gold ETFs, Swiss Francs ETFs whatever, you end up having to sell those off to make ends meet. Most affluent people, unless you are super wealthy, in which case you escape the country, can hold out for about 3 years. This is usually the point at which a government issues new currency.
HONG KONG (MarketWatch) -- Chinese regulators have asked domestic banks to stop lending to U.S. financial institutions in the interbank money markets to prevent possible losses during the financial crisis, the South China Morning Post reported Thursday. The China Banking Regulatory Commission's ban on interbank lending of all currencies applied to U.S. banks, but not to lenders from other countries, the report added, citing a source
There is nothing left to debate, the US is broke, now they want to fund a 700billion bailout, but who will lend it to them? And if they can't borrow it they will print it, and hyperinflation has begun, however expect more failed attempts by paulson and company to protect there wealthy friends from being hurt to bad, while telling the rest of us to eat cake...
When can we sign the papers?...I'm free tomorrow around 2 pm.
I'll take MY share of the "corporate welfare" - WHOOPS - I meant, "bailout" - WHOOPS - I meant, "campaign fund payoffs" - WHOOPS - I meant, "economic recovery package," in gold & silver, and politely sit on the sideline. We'll see who's worth MORE, come 2011. I got a '21 Morgan dollar says, it'll be ME...
Some one wanted to know what kind of investments were safe in this financial atmosphere. Here they are, Guns, ammunition, fuel, dry and canned food. If you're smart you'll think about a few acres of land in the country, seeds, hand farming tools, maybe a mule, solar panels, wood stove, a few books about survival and self sufficiency, a power generator. What ever you do, ditch you're toilet paper assets, turn them into cash, leave the city, and teach yourself how to live off of the land. Yeah I know this sounds stupid to all you city folk driving around in leased BMW's living in mcmansions, but like old hank Jr sang, I 've got a shotgun a rifle and a four wheel drive, I can skin a deer, run a trout line, a country boy can survive. Get serious though, you can't eat C notes, 401k's and certificates of deposit. When the dollar dies and you're stuck in the city, you're going to starve to death, or freeze in the dark.