Inflation, deflation, gold and currencies

[vincecate]

The Fed is buying $100 billion in government debt each month, and the government is deficit spending about $100 billion per month.

This is a print and spend economy far more than house and car economy. A print and spend economy, historically, ends up with inflation or hyperinflation.

The Fed can print trillions of dollars but if it doesn't get into the hands of actual purchasers then the economy will just collapse. And that's what is happening.

Whatever money the Fed gives the government it spends. Getting trillions into actual purchasers is really happening. There is no missing link between making money and getting it into the economy, the government does that.

I don't see how long term mortgages or corporate debt figure into hyperinflation. Nothing I have read indicates that has anything to do with it. The problem is money creation to cover government obligations (deficit and government debt coming due). How do you figure other debt could delay hyperinflation? I can see how the Fed or government buying up private debt can make hyperinflation sooner, but how could private debt delay hyperinflation?

I don't see how you answered this last time. If the government buys up private debt then I think it makes hyperinflation happen sooner. How can private debt slow down the start of hyperinflation?
Assume you buy my "bond sales fail and government prints to cover deficit and debt coming due causes hyperinflation". Then how can extra private debt slow this down? Run through the steps with and without the extra private debt and explain how you can get extra time before hyperinflation by having lots of private debt.

[Higgenbotham]

Whatever money the Fed gives the government it spends. Getting trillions into actual purchasers is really happening. There is no missing link between making money and getting it into the economy, the government does that.

The money is ending up mostly in the hands of the large financial institutions. The large financial institutions are not pushing the money into the broad economy either by making loans or investing in productive activity. They are engaging in financial speculation but increased asset prices mostly benefit the small fraction of the population who own assets and hurts the larger fraction that must buy items that have inflated in price. The only increased government spending that is getting directly into the hands of the people are transfer payments like unemployment checks and food stamps but that can't buy a house or a car.

I don't see how long term mortgages or corporate debt figure into hyperinflation. Nothing I have read indicates that has anything to do with it. The problem is money creation to cover government obligations (deficit and government debt coming due). How do you figure other debt could delay hyperinflation? I can see how the Fed or government buying up private debt can make hyperinflation sooner, but how could private debt delay hyperinflation?

I don't see how you answered this last time. If the government buys up private debt then I think it makes hyperinflation happen sooner. How can private debt slow down the start of hyperinflation?

Assume you buy my "bond sales fail and government prints to cover deficit and debt coming due causes hyperinflation". Then how can extra private debt slow this down? Run through the steps with and without the extra private debt and explain how you can get extra time before hyperinflation by having lots of private debt.

If a small fraction of debt is government debt (~$15 trillion) and a large fraction is private debt (~$105 trillion), if/when interest rates spike, the value of the private debt will collapse faster than the government can offset. Even if the Fed prints money to keep the amount of government debt equal (by converting long term debt to cash) this is more than offset by the loss in value of the private debt because interest rates will spike further as the Fed prints more money. Whoever is holding the private debt will end up impaired or bankrupt unless the Fed treats most of the $120 trillion the same way they would act as buyer of last resort at a failed government bond auction.

[vincecate]

If a small fraction of debt is government debt (~$15 trillion) and a large fraction is private debt (~$105 trillion), if/when interest rates spike, the value of the private debt will collapse faster than the government can offset.

Imagine a 30 year fixed 5% mortgage of $100,000 owned by a local bank on Bob's house. When interest rates spike up to 50%, the market value of that mortgage plunges by about a factor of 10 and the bank is doing poorly. Bob on the other hand is sitting pretty. All he has to do is put $10,000 in the bank and use the 50% interest from that to pay on his $100,000 loan at 5%. So in a very real sense he can effectively pay off his debt with 1/10th the money. Ya Bob! What the bank is losing Bob is winning.

I think it is incorrect to count long term bonds as money. Clearly a 1 day bond is very much like money, but a 30 year bond is not like money. In my example its value goes down by about a factor of 10 relative to money. In full hyperinflation (say 5% per month) the value of 30 year fixed rate bonds will be basically zero. Anyone holding them at that point will not think they are money.

Historically, when people stop rolling over bonds and the government has to print new cash to pay them off as they come due you get hyperinflation. If turning in bonds and getting cash results in hyperinflation, then I think this is strong evidence that bonds are not "money".

I think we should think of bonds as just another asset type, and not "money".

[Higgenbotham]

I think it is incorrect to count long term bonds as money. Clearly a 1 day bond is very much like money, but a 30 year bond is not like money.

I think we should think of bonds as just another asset type, and not "money".

During financial bubbles debt becomes more like money because it is securitized. Many kinds of debt that are maturing within a year are bundled up and treated strictly like cash. I seem to remember where longer term securitized debt can also partially fulfill that role but I'd need to review some things to come up with how exactly that happens. But say someone owns a corporate bond and it is pledged as security for a loan, the loan may be called in if the value of the corporate bond begins to fall.

The general problem is when institutions become insolvent or there is the fear of insolvency due to falling asset prices, that can cause liquidity to suddenly dry up. The question is whether the Fed can step in and smooth it out again.

[Higgenbotham]

I seem to remember where longer term securitized debt can also partially fulfill that role but I'd need to review some things to come up with how exactly that happens.

This has an extra step and I had temporarily forgotten about it. A financial institution creates a separate entity called an SPV. They then take illiquid longer term securities that are on their balance sheet and transfer them to the SPV. The SPV bundles up the securities and creates instruments that are highly liquid which they sell on the market for cash. So while these instruments are not truly cash, they are a lot more like cash than a mortgage that sits on the balance sheet of a local bank that originated it.

In the case of the shorter term securities maturing in under 1 year, those can be pooled into a money market account. A bank can buy a brokerage firm and put the short term stuff into the brokerage money market funds.

[vincecate]

I have not checked but I am rather confident many of the countries that had hyperinflation also had lots of private bonds losing value and that did not protect them from hyperinflation.

Remember, for every loser on private bonds there is also a winner so there is no real reduction in buying power from private bonds dropping in value. In my example above Bob will find it easy to make the payment on his fixed rate loan and have more money for other stuff. Conceptually people could buy back their own loan at the new cheaper price.

Banks could go bankrupt but since deposits are guaranteed by the government that prints money, that will just result in more money printing. I really don't think there is any reasonable case for substantial deflation in a real world fiat money system. Conceptually the central bank could loan out money and burn all interest it collected to gradually reduce the money supply. However, in the US case the central bank turns over any profits to the Federal government which spends them, so in reality that is not going to happen.

[Higgenbotham]

I have not checked but I am rather confident many of the countries that had hyperinflation also had lots of private bonds losing value and that did not protect them from hyperinflation. Remember, for every loser on private bonds there is also a winner so there is no real reduction in buying power from private bonds dropping in value. In my example above bob will find it easy to make the payment on his fixed rate loan and have more money for other stuff. Banks could go bankrupt but since deposits are guaranteed that will just result in more money printing. I really don't think there is any reasonable case for substantial deflation in a fiat money system.

Well, historically speaking, my thought is there are only a few places in history that come close to matching where things are now. I've looked at all of them and come up with the 1340s being the closest. And I do notice that those who take the very long and integrated view tend to favor the deflationary outcome, and they are few and far between. In a boom there are more winners as the debt grows but in a bust there are more losers as the debt shrinks. That's why the majority is always in favor of trying to keep a boom going. There has never been more debt worldwide based on any measure and the worldwide financial system has never been more interwoven. If that same magnitude earthquake had hit Tokyo instead of the coast, I would venture to say the world would have tipped over into deflation that very day. If the same earthquake had hit Tokyo pre 1970 or thereabouts the worldwide impact would have been negligible. I would venture to say the earthquake as it happened will have deflationary effects within 18 months that may not be able to be contained. See FreddyV's last post. History does show similar outcomes for similar magnitude events though. The Great Chicago Fire, the SF earthquake of 1906, and the Chernobyl meltdown were all followed by financial crashes within 18 months. I'm not sure, but I think the early US disasters had after effects that were confined to the US. Inflation as it is happening doesn't make it any more likely that the typical US mortgage holder can make their payment, less in fact. So is the Fed going to pay people's mortgages to prevent deflation? I'm not going to say no to that because it's not a whole lot different than food stamps.

By the way, I measure the instantaneous inflation rate every time MIT updates their BPI and it is slowing markedly in the past few measurements - last one was down to a 1.3% annual rate (just checked the most recent and it is a 6% annual rate). Not a trend yet, but if you're looking for hyperinflation I would be expecting that index to continue going parabolic. That's an example of the approach I'm taking with this - one of looking at things in real time and making a determination as to whether outcomes are inflationary, especially the ones the Fed is trying to influence like house and stock prices.

I'm getting real close to moving to a 90% plus cash position (see Richard's post a few weeks ago - an experienced investor who has recently done the same) but there are a few more things I'd like to see before doing that. It's always a judgement call and very uncertain but I think a deflationary series of crisis events is possibly imminent. That's just preliminary now and to show what I'm really thinking.

[vincecate]

And I do notice that those who take the very long and integrated view tend to favor the deflationary outcome, and they are few and far between.

I don't think it is at all reasonable to look at deflations under gold backed or partially gold backed money and predict the same thing when Bernanke has the money creation ability he has. So many with the "long view" are making a mistake, I think. Imagine the government had a magical machine that could make $100 billion worth of gold every month back in the early 30s, would there have been deflation? I had seen a nice graph showing how there used to be deflation frequently but since 1971 the only touch of it was recently. I found a place you can graph it since 1914 and it amuses me that they picked that date since that is when the fed started. Anyway, going off gold in 1933 and 1971 seem to have put an end to deflation:
http://www.tradingeconomics.com/economi ... Symbol=USD

Not a trend yet, but if you're looking for hyperinflation I would be expecting that index to continue going parabolic. That's an example of the approach I'm taking with this - one of looking at things in real time and making a determination as to whether outcomes are inflationary, especially the ones the Fed is trying to influence like house and stock prices.

As of 1:00 am silver is up over 3% in the last few hours. Bond interest rates are going up fast. BPI still looks parabolic to me (and looks like it leads the CPI to me). Oil and CRB are way high. Lots of things still seem consistent with the bond sales fall off, interest rates go up, dollar value goes down, hyperinflation theory.
http://www.silverseek.com/quotes/24silver.php
http://www.fxstreet.com/rates-charts/bond-yield/
http://bpp.mit.edu/daily-price-indexes/?country=USA
http://quotes.ino.com/chart/index.html? ... &w=&v=dmax

I'm getting real close to moving to a 90% plus cash position (see Richard's post a few weeks ago - an experienced investor who has recently done the same) but there are a few more things I'd like to see before doing that. It's always a judgement call and very uncertain but I think a deflationary series of crisis events is possibly imminent. That's just preliminary now and to show what I'm really thinking.

It certainly feels crashy, but it has for awhile now. But even more so now. I am in silver leaps and S&P puts. Silver has been doing very well. So far I am losing money on the S&P puts, but I still like them. They have made me comfortable to stay in silver even though silver will probably go down in a crash. And silver calls have made so much money that putting some in S&P puts has not hurt too bad. And I really do think the stock market has to crash when interest rates start going up.

[Higgenbotham]

I don't think it is at all reasonable to look at deflations under gold backed or partially gold backed money and predict the same thing when Bernanke has the money creation ability he has. So many with the "long view" are making a mistake, I think. I had seen a nice graph showing how there used to be deflation frequently but since 1971 the only touch of it was recently. I found a place you can graph it since 1914 and it amuses me that they picked that date since that is when the fed started. Anyway, going off gold in 1933 and 1971 seem to have put an end to deflation:
http://www.tradingeconomics.com/economi ... Symbol=USD

In late 2007, I went from an inflationary bias to a deflationary bias for the first time, meaning to more than 50% cash (75%) and haven't changed it since then. Obviously, I thought the Fed had most likely lost its ability to create more inflation at that point, which turned out to be wrong. Markets crashed very hard in 2008 as it seems Fed actions are swinging things to harder and harder extremes. The situation looks even more extreme now. It seems likely to me that there can be a spike in crude, precious metals and interest rates in the next few weeks, maybe temporarily exceeding the 2008 high in crude, while the rest of the markets and economy don't participate and get worse. If we see that and certain other things happen along with it, then it seems very possible a huge deflationary crash could follow. Once that happens, it will probably be bad enough the Fed will be shut down.

[vincecate]

It seems likely to me that there can be a spike in crude, precious metals and interest rates in the next few weeks, maybe temporarily exceeding the 2008 high in crude, while the rest of the markets and economy don't participate and get worse. If we see that and certain other things happen along with it, then it seems very possible a huge deflationary crash could follow. Once that happens, it will probably be bad enough the Fed will be shut down.

I could see oil shooting up and hurting prices of optional things. But higher oil prices feed into higher food prices, so we would have inflation in necessary things and deflation in optional things. This kind of deflation I could see.

The latest Hussman article is good. He notices that the Fed said they would complete QE2 "by the end of the second quarter" which does not mean exactly at the end. He thinks at the rate they are going they will finish the amount they said well before then. He also calculates that as interest rates go up the velocity of money goes up, so the Fed needs to remove an average of around $125 billion for every 0.25% increase in interest rates to prevent inflation. However, it needs to remove much more than this for the first increases.

I don't see how they can possibly stop buying up treasury debt. Who else has an extra $100 billion a month? But on top of halting this $100 billion per month injection they need to withdraw $125 billion for each 0.25% hike? I don't believe it can be done.

The current 3 month treasury rate is 0.01%. This is insane.

Hussman says: "In order to accommodate short-term interest rates of just 0.25% in steady-state, leaving the monetary base unchanged at present levels, a 40% increase in the CPI would be required. I doubt that we'll observe this outcome, but it provides some sense of what I mean when I talk about the Fed pushing monetary policy to its "unstable limits." "

In other words, if the Fed can not take out a bunch of money, we could see a 40% jump in the CPI just from a 0.25% increase in interest rates.

http://www.hussmanfunds.com/wmc/wmc110411.htm
http://finance.yahoo.com/bonds/composite_bond_rates