Hera : inflation, debt

QE2 and its Consequences (Part II)

Ron Hera — Mon, 21 Feb 2011 13:59:00 GMT

Investors understand that the Federal Reserve’s ongoing purchase of U.S. Treasuries in the open market, known as quantitative easing two (QE2), injects newly created money into the U.S. financial system and economy, but the actual means by which newly created money monetizes U.S. government debt, stimulates the U.S. economy and flows into the U.S. stock market are involved. Proponents of QE2, namely Ben Shalom Bernanke, Ph.D., Chairman of the Federal Reserve, deny that the Federal Reserve is monetizing U.S. government debt and claim that QE2 promotes price stability, stimulates economic growth and helps to create jobs. Critics charge that QE2 is causing price inflation in the U.S. and abroad, as well as a currency war. Given the amount of debt owed by the U.S. federal government, as well as by U.S. states and municipalities, investors are, understandably, liquidating U.S. Treasuries and other government bonds and buying equities and commodities, thus, supporting the U.S. stock market rally and driving commodity prices higher. The Federal Reserve’s purchase of U.S. Treasuries is amplifying the U.S. stock market rally and absorbing the U.S. federal government’s debt.

Chart courtesy of Josh Staiger (www.multpl.com)

The effect of QE on the U.S. Stock market is, to a large extent, accidental, i.e., an unintended consequence. The primary goal of QE2, which is widely misunderstood, is to rebalance the broad money supply with economic activity and debt levels in the U.S. economy, but the Federal Reserve has little control over the flow of funds from QE2.

The Real Reasons for QE2

Understanding QE2 requires a basic knowledge of fractional reserve banking and economics. In an economic recession, the broad money supply contracts and underlying economic activity declines. In a shrinking economy, borrowers come under increasing pressure as money becomes less available and may default on loans, destroying the financial assets of banks, which are loans, and causing banks to fail, which is deflationary. In effect, carrying debt becomes more expensive when money is scarce. Since bank deposits are leveraged through loans, when banks fail, the effects are similar to an old fashioned run on a bank. In a fractional reserve banking system, banks loan out much more money than they have on deposit and when borrowers default, banks may have insufficient capital to cover their liabilities, i.e., their deposits. When banks fail, money in the financial system—on the books of banks—is literally destroyed leaving less money available. In other words, the money supply mathematically shrinks, which is the literal meaning of the word deflation. Setting aside the fact that a shrinking money supply tends to cause prices to fall, when less money is available in the economy, interest rates, which reflect the cost of borrowing money, tend to rise as a function of supply and demand. Since borrowing is the engine of money creation in a fractional reserve banking system, rising interest rates exacerbate declines in economic activity, which is the reason why the Federal Reserve cuts interest rates during recessions.

If debt levels in the economy are excessive, debt service can drain money from the economy faster than money can be created through new borrowing and a deflationary spiral can result. Specifically, a contracting money supply triggered by bank failures, e.g., linked to excessive leverage and financial speculation on the part of banks, results in an increase in defaults while debt service creates a net drain of money from the economy, leading to more bank failures and to a further contraction of the money supply, and so forth. Setting aside the inherently inflationary, cyclical and ultimately unstable nature of the fractional reserve system, if left unchecked, a deflationary spiral will end in an economic depression.

Normally, bad debts are liquidated in a recession and banks are allowed to fail, but that changed in 2008. To prevent the failure of the largest banks, and to head off a deflationary spiral, the Federal Reserve began injecting newly created money into the U.S. financial system and is continuing to do so via QE2. Banks were bailed out in 2008 and the value of their assets was preserved, at least on paper, thus debt levels were largely maintained while the U.S. economy and money supply contracted. In the absence of sufficient new borrowing to maintain the money supply, debt service began to drain money from the broad U.S. economy, threatening to plunge the U.S. into a depression. Since the U.S. dollar, which is a Federal Reserve bank note, is a debt instrument created through the execution of loan contracts, it is logical, at least from a macroeconomic perspective, to alleviate the excessive debt levels in the economy by creating additional money that has no corresponding debt. Obviously, when the Federal Reserve writes a proverbial check, the funds are not debited against any account but, instead, money is created ex nihilo. This is the ultimate reason for QE2.

QE2 is an attempt to rebalance the broad money supply and, eventually, economic activity levels with debt levels, otherwise there would be many more loan defaults, banks would fail and both the money supply and the U.S. economy would contract further. It would be equally fair to say that QE2 is currency debasement, which will reduce the real value of debt. As a scholar of the Great Depression, Bernanke certainly knows that a new, and perhaps greater, depression has been averted only temporarily and has only been held at bay by the Federal Reserve’s printing press. This is the key to understanding Bernanke’s famous helicopter speech. The problem, of course, is finding an exit from money printing before the currency collapses. It follows that QE2 (or QE3, etc.) cannot and will not stop until the broad money supply, i.e., money circulating in the real economy rather than locked in the financial system, along with the level of economic activity, come approximately back in line with debt levels. As guideposts, self sustaining GDP growth, absent radical government deficit spending, should be apparent and unemployment levels should be coming down steadily before stopping QE2.

Chart courtesy of Karl Denninger

Critics of QE2, although they may be correct regarding its unintended consequences, often do not seem to understand the gravity of the situation in terms of debt levels versus economic activity and the money supply, i.e., they underestimate the risks associated with deflation. With respect to unintended consequences, the Federal Reserve has no way to make newly created money flow into sectors of the economy where they can be effective in achieving specific goals such as job creation. In other words, Bernanke is pushing on a proverbial string. Thus, one valid criticism of QE2 is that money seems to be flowing everywhere except where it most needs to go. Amplifying the rebound of the U.S. stock market into a rally that is not adequately supported by economic fundamentals is merely a byproduct of QE2 and excessive government debt, i.e. investors seeking an exit from U.S. Treasuries and other government bonds. Similarly, the debasement of the U.S. dollar is unavoidable, thus rising prices for imported goods in the U.S., disruptive inflows of U.S. dollars into foreign economies, and rising global commodity prices will persist as long as QE2 continues. By the same token, precious metals prices, i.e., silver, gold, platinum and palladium (each of which has an ISO 4217 currency code), will not only continue to rise but, the longer QE2 continues, the more investment demand for precious metals will grow.

Debt and Systemic Liquidity

Primary Dealers, e.g., Goldman Sachs & Co. and JP Morgan Securities, Inc., purchase Treasuries in the open market and when holders of U.S. Treasuries sell them to the Primary Dealers as a consequence of QE2, they receive cash. Primary Dealers buying Treasuries on behalf of the Federal Reserve sell them to the Federal Reserve in exchange for newly created money, thus money is injected at the level of investors that sell Treasuries to the Primary Dealers.

QE2 effectively destroys Treasuries, i.e., it removes them from the marketplace to the balance sheet of the Federal Reserve, replacing them with cash at a rate of roughly $2.5 billion per day. However, Treasury purchases by the Federal Reserve are not taking place at a rate faster than the U.S. Treasury issues new debt, thus, the effect of QE2 is to slow the rate at which the supply of Treasuries in the market increases. Theoretically, this should hold Treasury yields down, but QE2 has not been entirely effective as a means of keeping the borrowing costs of the U.S. federal government down.

Chart courtesy of Doug Short, Ph.D.

Another effect of QE2 is to distort the distribution of money over the U.S. economy. As the Federal Reserve creates new money, it flows into the financial system and creates the false appearance of a transfer of money from the broad U.S. economy to financial markets, i.e., from so called Main Street to Wall Street. In fact what is happening is that excessive debt levels in the U.S. economy are causing a net drain of money from the broad U.S. economy, versus normal money creation through lending. In other words, monetary deflation over the whole economy is being offset by monetary inflation in financial markets.

Chart courtesy of Shadow Government Statistics

Direct bidders, e.g., domestic funds and depository institutions, Primary Dealers, as well as foreign investors, participate in U.S. Treasury auctions. Some Treasuries are held to maturity at which time investors receive cash, but the money paid by the U.S. Treasury for Treasuries held to maturity is derived from new borrowing. The total of all new Treasuries to be issued in fiscal year 2011 has been estimated to be $2.25 trillion in net debt, which is more than $800 billion more than the U.S. federal budget deficit.

Chart courtesy of Zero Hedge

As a result of QE2, overall systemic liquidity is increased, thus investors have more cash than they would otherwise have, and the cash they have, either literally or in effect, has been newly created. Of course, funds can also flow into the U.S. Treasury and out again as federal government deficit spending, i.e., government debt can be monetized by the Federal Reserve through transactions intermediated by the Primary Dealers and through multiple other parties that purchase new Treasury debt with funds derived from QE2. In any case, QE2 represents an increased but artificial demand for U.S. Treasuries which, directly or indirectly, helps to fund the U.S. federal government’s deficit spending, and deficit spending temporarily, stimulates the economy.

How QE2 Funds the U.S. Government and Inflates the U.S. Stock Market

Without auditing the Federal Reserve and its Primary Dealers, it is not possible to determine the complete flow of funds or the sums of money involved in all transactions resulting from QE2, aside from the announced rate of U.S. Treasury purchases of $75 billion per month. As newly created money, through successive transactions, circulates further from the point of injection, both the flow of funds and causal relationships become less clear. Closer to the point of injection, however, either the data are known or a higher confidence level is possible.

An outsider analysis of the QE2 flow of funds devolves into (1) known transactions, where the exact sums of money involved in particular transactions may or may not be known, followed by (2) deducible transactions, i.e., transactions that must logically occur but where the sums of money involved are unknown, and (3) a variety of transactions that are possible but that may or may not occur (no probabilities are assumed) and where any sums of money that might be involved are also unknown. Given these limitations, there appear to be no less than seven ways that funds created through QE2 can flow into the U.S. stock market assuming the minimal possible number of transactions so as to remain as close as possible to the point of injection.

When the Primary Dealers buy U.S. Treasuries in the open market on behalf of the Federal Reserve, they either use funds from the Federal Reserve or pre-existing money [1a] to make purchases, and then sell the Treasuries they acquire [2a] to the Federal Reserve, receiving newly created money [3a]. Between U.S. Treasury auctions, the Primary Dealers could invest the new funds in the stock market [3b], liquidating these investments or taking profits [6b] only as needed to make further U.S. Treasury purchases from investors.

U.S. Treasuries are sold at auction to a combination of the Federal Reserve’s Primary Dealers [4a], which re-sell Treasuries to domestic investors [4c] and foreign [4d] investors, and to direct bidders to the U.S. Treasury [4b]. As the Primary Dealers purchase Treasuries in the open market their capital is replaced by new money from the Federal Reserve. In theory, Primary Dealers that purchase new Treasuries at auction could, in effect, if not literally, use newly created money to do so [3c and 6c]. Treasuries sold at auction by the U.S. Treasury [4a, 4b] not only cover current U.S. federal government deficit spending but also roll over debt for Treasuries reaching maturity, thus generating profits for investors, i.e., profits from Treasuries reaching maturity represent additional, newly created money in the hands of investors [5a ,5b, 5c].

Newly created money also flows from the U.S. Treasury to the Primary Dealers [5a] and, directly or indirectly (through Primary Dealers), to both domestic [5b] and foreign investors [5c]. Treasuries reaching maturity, i.e., U.S. government debt that is being rolled over, represent an estimated $800 billion or more annually, above and beyond the U.S. federal government’s budget deficit, which is currently $1.5 trillion. Both profits from Treasuries held to maturity and interest payments could flow into the U.S. stock market [5d, 5e, 5f], back into U.S. Treasuries [5a`, 5b`, 5c`], or elsewhere, e.g., into emerging markets, commodities, etc.

When the U.S. federal government spends borrowed money into the U.S. economy [3d], it supports government employee salaries, payments to government contractors, etc. Money spent into the U.S. economy becomes part of the Gross Domestic Product (GDP) and contributes to U.S. economic growth statistics. Pension funds and individual retail investors [3f, 3g] can invest money derived from U.S. federal government deficit spending in the U.S. stock market, in US Treasuries, etc.

Finally, as the U.S. stock market rises, profits flow back to investors [6a, 6b, 6d] which can then be recycled in myriad forms of investment or spending. One can imagine the financial system as a hydraulic system where increasing pressure will affect the whole system but it’s not precisely a closed system thus the pressure falls off with distance from its source. Ideally, increased spending on the part of investors taking profits would create a wealth effect where money would trickle down through the economy and stimulate economic activity. Unfortunately, the majority of U.S. financial assets are held by a relatively small percentage of the population, which makes it difficult to substitute investor trickle down for reduced consumer spending.

Chart courtesy of StockCharts.com	Chart courtesy of StockCharts.com
Chart courtesy of StockCharts.com	Chart courtesy of the Federal Reserve Bank of St. Louis

Since the start of QE2, the rate of increase in some of the major U.S. stock market indices is similar to that of the Federal Reserve’s M1 monetary aggregate over the same interval. The evidence suggests that increased liquidity, flowing from QE2, is amplifying, and perhaps manufacturing, the U.S. stock market rally.

The End of U.S. Dollar as the World Reserve Currency

U.S. federal government deficit spending represents a $1.5 trillion component of U.S. GDP, which is approximately 10%, while U.S economic growth remains anemic and unemployment remains high. At the same time, annual U.S. federal government borrowing represents approximately 3% of world GDP and willingness to lend to the U.S. federal government is waning. It is, therefore, difficult to see how or when QE2 can be stopped without the U.S. economy either stagnating or tipping back into recession, or without the U.S. federal government becoming insolvent pursuant to Treasury auction failures.

Chart courtesy of Shadow Government Statistics

In contrast to poor economic fundamentals, the S&P 500 P/E ratios are above their historical average by approximately 50%, most probably pointing, if not to an imminent correction, to a decoupling of the U.S. stock market from the broad U.S. economy, reinforcing the view that the current stock market rally is artificially enhanced or largely manufactured.

All other things being equal, as long as QE2 continues, the U.S. stock market will most probably remain in an overall rally while the U.S. dollar will continue in an overall decline. Of course, weakness in other currencies can mask the decline of the U.S. dollar and increase exchange rate volatility, but the prices of commodities, as well as precious metals, provide an elucidating standard of comparison.

Chart courtesy of StockCharts.com

In the long term, QE2 is obviously not a sustainable course. Nonetheless, QE2 can continue as long as (1) the United States remains politically stable, (2) the U.S. dollar remains the world reserve currency and (3) the value of the U.S. dollar strengthens, remains flat or decays in a controlled manner, i.e., at a relatively stable, gradual rate. Although Bernanke clearly believes that the risks are contained, the Federal Reserve’s policies are, in fact, debasing the U.S. dollar and have already guaranteed the end of the U.S. dollar as the world reserve currency.

The unintended consequences of QE2 indicate a countdown to the hyperinflationary collapse of the U.S. dollar. In other words, if QE2 is not stopped, the U.S. dollar will eventually fail. The main risk is that (1) a double dip recession in the U.S. that shatters confidence in U.S debt, (2) a rush on the part of domestic or foreign investors to exit U.S. Treasuries, (3) a rapid and widespread rejection of the U.S. dollar abroad, (4) a large, rapid decline in the value the U.S. dollar, regardless of the cause, or (5) runaway price inflation, i.e., cost push inflation, could trigger the collapse of the U.S. dollar. What is important about the risk of a U.S. dollar collapse, is that QE2 escalates all but one of the potential triggers, i.e., QE2 is countering deflation, albeit in a distorted way, thus it is technically preventing a double dip recession, or a depression, in the U.S.

Into the Abyss: The Cycle of Debt Deflation

Ron Hera — Wed, 02 Jun 2010 12:46:00 GMT

One of the most famous quotations of Austrian economist Ludwig von Mises is that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.” In fact, the US economy is in a downward spiral of debt deflation despite the bold actions of the federal government and of the US Federal Reserve taken in response to the financial crisis that began in 2008 and the associated recession. Although the vicious circle of debt deflation is not widely recognized, precisely what von Mises described is happening before our eyes.

A variety of positive economic data has been reported in recent months. Retail sales rose 0.4% in April 2010 as consumer spending rose and the US gross domestic product (GDP) grew at a rate of 3%. In May 2010, home sales rose to a five-month high and consumer confidence rose 17% (from 57.7 to 63.3). Industrial production rose 0.8% and durable goods orders rose 2.9%, more than had been forecast. However, the modest gains reported represent the continuing adaptation of economic activity at dramatically lower levels compared to the pre-recession period and most of the reported gains have been substantially manufactured by massive government deficit spending.

Despite the widely reported green shoots, in May, the unemployment rate rose to 9.9% while paychecks in the private sector shrank to historic lows as a percentage of personal income, and personal bankruptcies rose. Roughly 14% of US mortgages are delinquent or in foreclosure, credit card defaults are rising and consumer spending hit 7 month lows. To make matters worse, the reported increase in consumer credit, in fact, points to a further deterioration because consumers appear to be borrowing to service existing debt. Outside of the federal government, which is borrowing at record levels and expanding as a percentage of GDP, and outside of the bailed out financial sector, debt deflation has continued unabated since 2008.

Money Supply vs. Debt Service

A contraction of the broad money supply is taking place because the influx of money into the US economy, i.e., lending to consumers and non financial businesses, has fallen below the rate at which money is flowing out of general circulation as a function of debt service (interest and principle payments on existing debt), thus a net drain of money from the broad US economy is taking place. As a result, additional borrowing, as consumer spending falls, appears to be servicing existing debt in a pattern that is clearly unsustainable and that signals a further rise in debt defaults in coming months.

^{Chart courtesy of}^{Shadow Government Statistics}

The estimate of the broad money supply (the Federal Reserve’s M3 monetary aggregate) is crashing and the Federal Reserve’s M1 Money Multiplier, a measure of how much new money is created through lending activity, fell off of a cliff in 2008, and remains practically flat-lined.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The contraction of the broad money supply points to a potential slowing of economic activity and indicates that consumers and non financial businesses will be less able to service existing debt. Despite easing somewhat in March 2010, credit card losses are expected to remain near 10% over the next year and mortgage delinquencies, are currently at a record highs, and these dismal predictions implicitly assume a stable or growing money supply.

A tsunami of eventual mortgage defaults seems to be building and loan modifications have been a failure thus far. There have been only a small number of permanent loan modifications (295,348) under the Home Affordable Modification Program (HAMP) in 2009, out of 3.3 million eligible (60 days delinquent) loans and more than half of modified loans default.

^{Chart courtesy of}^{Calculated Risk}

Although it has been reported that American consumers are saving at a rate of 3.4%, the contraction of the broad money supply suggests savings liquidation. Given a contracting money supply, ongoing debt defaults and declining consumer spending, the increase in non-mortgage consumer loans indicates that consumers are borrowing where possible to consolidate debts, cover debt service, or borrowing to continue operating financially as their total debt grows, thus as they approach insolvency.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The increase in non-mortgage consumer loans has not prevented an overall decline in total household debt attributed to ongoing deleveraging by consumers. While deleveraging (paying down debt) has been interpreted as caution on the part of consumers, or as low consumer confidence, the decline in outstanding credit reflects a reduced ability to borrow, i.e., to service additional debt. This suggests that the recovery of the US economy may be illusory and that the economy is likely to contract further in coming months.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

Commercial borrowing has declined more sharply than household debt suggesting that the nominal return to growth estimated at 3% has not been matched by debt financed expansion in the private sector.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The broad US money supply is no longer being maintained or expanded by normal lending activity. If federal government deficit spending ($1.5 trillion annually), debt monetization and emergency actions by the Federal Reserve (totaling an estimated $1.5 trillion since 2008) to recapitalize banks are considered separately, there remains a net drain effect on the broad money supply. The scarcity of money hampers economic activity, i.e., money is less available for investment, and directly exacerbates debt defaults as consumers and businesses experience cash shortfalls, while at the same time being less able to borrow. Since unemployment is a key indicator of recession, then if the US economy were contracting, it would be evident in unemployment statistics.

Structural Unemployment

Unemployment and labor force data suggest that the US labor market is in a structural decline, i.e., millions of jobs have been and are being permanently eliminated, perhaps as a long term consequence of offshoring, outsourcing to other countries and the ongoing deindustrialization of the United States. However, the immediate meaning of the term “structural” has to with the fact that jobs created or sustained during the unprecedented expansion of debt leading to the financial crisis that began in 2008, e.g., a substantial portion of service sector jobs created in the past two decades now appear not to be viable outside of a credit expansion.

Officially, the US unemployment rate rose to 9.9% in April 2010, which represents the percentage of workers claiming unemployment benefits. However, the total number of unemployed or underemployed persons, including so-called “discouraged workers” (Bureau of Labor Statistics U-6), rose to 17.1%. Using the same methods that the BLS had used prior to the Clinton administration, U-6 would be approximately 22%, rather than the official 17.1% statistic.

^{Chart courtesy of}^{Shadow Government Statistics}

With official U-6 unemployment of 17.1% and a workforce of 154.1 million there are roughly 26,197,000 people officially out of work. Using the pre-Clinton U-6 unemployment calculation of approximately 22%, there would be 33.9 million unemployed. If the average US household consists of 2.6 persons and if 33% of the unemployed are sole wage earners, then 55.5 million US citizens currently have no means of financial support (17.9% of the population).

^{Chart courtesy of}^{Calculated Risk}

While it has been reported that the labor force is shrinking, the characterization of workers permanently exiting the workforce by choice may be inaccurate. While a shrinking workforce could reflect demographic changes, the rate of change suggests that tens of millions of Americans are simply unemployed.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

Setting aside the question of whether or not those “not in the workforce” are, in fact, permanently unemployed, the workforce, as a percentage of the total US population, is currently at 1970s levels. Since many more households today depend on two incomes to meet their obligations, compared to the 1970s, a marked drop in the percentage of the population in the workforce points to a decline in the labor market more significant than official unemployment statistics suggest. What is more important, however, is that structural unemployment suggests structural government deficits, e.g., unemployment benefits, welfare, food stamps, etc. Since more than 2/3 of US GDP (roughly 70%) consists of consumer spending, a sustainable recovery from recession seems improbable if unemployment is worsening or if the labor force is in a structural decline, since that would imply unsustainable government deficits, whether or not they are masked by nominal GDP gains thanks to economic stimulus measures.

Government and GDP Growth

The US federal government is a growing portion of GDP, thus reported GDP growth is largely a byproduct of government deficit spending and stimulus measures, i.e., reported GDP growth is unsustainable. Total government spending at the local, state and federal levels accounts for as much as 45% of GDP, thus nominal gains would be expected when government deficit spending increases. According to some measures, reported gains in GDP are a byproduct of relatively new statistical methods and, using earlier methods of calculation, GDP remains negative.

^{Chart courtesy of}^{Shadow Government Statistics}

Government borrowing and spending may have offset declines in the private sector but only to a degree and only temporarily. The resulting growth in US public debt has an eventual mathematical limit: insolvency. Of course, the actual limit to US borrowing remains unknown. The continuing solvency of the US depends on the ability and willingness of governments, banks and investors around the world to lend to the US, which in turn depends on the tolerance of lenders for the US government’s profligacy and money printing by the Federal Reserve, e.g., quantitative easing and exchanging new cash for worthless bank assets. US Treasury bond auctions will fail if lenders conclude that a sufficiently large portion of their investment will be diluted into oblivion by proverbial money printing. In that event, the US dollar will surely plummet, despite deflationary pressures within the domestic US economy, and the cost of foreign goods, e.g., oil, will rise causing high inflation or triggering hyperinflation.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

According to the Bank for International Settlements (BIS), the federal budget deficit increased from 3.1% of GDP in 2007 to 9.2% in 2010. Rather than being the result of one-time expenses, such as temporary stimulus measures, much of the deficit represents permanent increases in government spending, e.g., due to the growing number of federal employees. If increased government spending is removed, GDP appears to be declining significantly.

^{Chart courtesy of}^{Karl Denninger}

Of course, sustainability has more to do with total debt than with deficit spending because a deficit assumes that there is an underlying capacity to service additional debt.

Unsustainable Debt

While asset prices have declined, e.g., real estate and equities, debt levels have remained high due to the federal government’s policy of preserving bank balance sheets, which had ballooned prior to the financial crisis to the point that overall debt in the US economy reached unsustainable levels.

^{Chart courtesy of}^{Karl Denninger}

The absolute debt to GDP ratio of the US economy peaked in 2007 when debt levels exceeded the ability of the economy to service debt from income based on production, even at low interest rates. Although US GDP began to decline prior to the advent of the global financial crisis, debt coverage had been in decline approximately since the 1970s, coincidentally, around the time that the US dollar was decoupled from gold.

^{Chart courtesy of}^{Karl Denninger}

Government deficit spending cannot correct the situation because, for every dollar of new borrowing, the gain in GDP is negligible and some have argued that the US economy has passed the point of “debt saturation.”

^{Chart courtesy of}^{Nathan A. Martin}

In a growing economy, additional debt can result in a net gain in GDP because the money supply grows and economic activity is stimulated by transactions that flow through the economy as a result. The debt saturation hypothesis is that, as debt levels rise, additional debt has less impact on GDP until a point is reached where new debt causes GDP to decline, i.e., the capacity of the economy to service debt has been exceeded and, not only is it impossible for the economy to grow at a rate sufficient to service existing debt (since interest compounds), but economic activity actually declines further as a function of additional debt.

A Downward Spiral

The process of debt deflation is straightforward. New lending at levels that would maintain or expand the broad money supply is impossible for two reasons: (1) asset values and incomes have fallen and millions remain unemployed; and (2) debt levels remain excessive compared to GDP, i.e., real economic activity (outside of the government and financial services industry) cannot service additional debt. The inability to lend, actually the result of prior excess lending, results in a net drain of money from the economy. The drain effect, in turn, leads to further defaults as cash strapped consumers and businesses fail to service existing debt, and as debt defaults impact bank balance sheets, putting a damper on new lending and completing the cycle of debt deflation.

Keynesian economic policies, i.e., government deficit spending, are irrelevant vis-à-vis excessive debt levels in the economy and bailing out banks is not a solution since it cannot stop the deterioration of their balance sheets. The process is self-perpetuating and cannot be stopped by any government or monetary policy because it is not a matter of policy, but rather one of mathematics.

Since the presence of excess debt (beyond what can be supported by a stable GDP, or by sustainable GDP growth) impacts the broad money supply, efforts to preserve bank balance sheets, i.e., to keep otherwise bad loans on the books of banks at full value, will ultimately cause bank balance sheets to deteriorate more than they would have otherwise. The fact that US banks issued trillions in bad loans cannot be corrected by changing accounting rules, nor can the consequences be avoided by government deficit spending or by unlimited bailouts, and the problem cannot be papered over by dropping freshly printed money from helicopters flying over Wall Street. The major problems facing the US economy today—a tsunami or debt defaults, structural unemployment, massive government budget deficits, a contraction of the broad money supply outside of the federal government and the financial system, and a lack of sustainable growth—cannot be addressed as long as excess debt levels are maintained. As von Mises clearly understood, sound economic conditions cannot be restored unless and until the excess debt, which resulted from a boom brought about by credit expansion, is purged from the system. The alternative, and the current policy of the United States, is a downward spiral into a bottomless economic abyss.

Bernanke’s Dilemma: Hyperinflation and the US Dollar

Ron Hera — Wed, 10 Mar 2010 13:13:00 GMT

Ben Bernanke, Chairman of the US Federal Reserve, faces a Sisyphean task because US banks are experiencing debt deflation and, because lending is now at much lower levels, monetary deflation is encumbering the domestic US economy as existing debts continue to be serviced. Government deficit spending can only offset lower consumer spending to a degree, and the mushrooming debt of the US government raises the question of whether the US can repay or roll over its debt obligations, given that tax receipts are likely to fall. Despite deflationary pressure, the value of the US dollar is in a downtrend pointing to higher prices for imported goods and energy. Devaluing the US dollar will reduce the value of debts in real terms, thus it can make debt levels sustainable, but higher prices will exacerbate debt defaults, worsening the condition of US banks. Mr. Bernanke's dilemma is how to salvage the balance sheets of US banks without sparking high inflation or unleashing hyperinflation.

Where the US dollar is concerned, opinions on hyperinflation range from the view that hyperinflation of the world reserve currency is impossible in principle (because, for example, the values of other currencies are linked to that of the US dollar), to the view that hyperinflation of the US dollar has already happened and that all that remains are the consequences. The two most widely accepted theories of hyperinflation are the monetary model, where a positive feedback cycle is caused by a disproportionate increase in the velocity of money as a consequence of increasing the money supply too quickly, and the confidence model, where the monetary authority issuing a given currency is perceived to be insolvent or no longer legitimate.

The view that hyperinflation is the inevitable result of a central bank issuing too much money or of a government taking on too much debt, while correct, both states the obvious and presupposes that some previously known or predictable limit is reached. The ability to service debt is one such measure, but the value of a debt in real terms depends on the value of the currency. In practice, hyperinflation is recognized only after the inexorable death spiral of a currency has begun. Detecting it in advance is another matter entirely.

Mathematical models of hyperinflation, such as predicting years between redenomination based on inflation rates or applying the quantity theory of money, describe what is happening but not why. Using the monetary model alone makes it difficult to explain apparent counterexamples where high levels of sovereign debt compared to a nation's gross domestic product (GDP) or monetization did not result in hyperinflation.

The confidence model seems to suggest that hyperinflation can be explained by crowd psychology where hyperinflation is analogous to a market mania or is an example of mass hysteria. The idea that hyperinflation is only a crisis of confidence, i.e., that it is a psychological phenomenon, not only lacks predictive value but implies that hyperinflation can be prevented by manipulating public opinion regardless of mathematical realities.

When a nation's bond market collapses, so does its currency. The view that hyperinflation is fundamentally caused by failed bond issues suggests that what is of interest are the reasons why a nation's bond market breaks down, along with indications of developing bond market distress.

One fact that is clear in every historical example of hyperinflation is the rejection of the currency of a given country either by other countries or by its own citizens. The simplest explanation of hyperinflation is that when the credibility of a government, or of its central bank, breaks down, the recognition of this fact is expressed as a race to shed the currency and to divest of the government's bonds. One way to evaluate the possibility of hyperinflation is therefore to gauge the transparency, completeness and veracity of government and central bank statements regarding their balance sheets, budgets and bond issues. Incomplete or inaccurate information and propaganda contrary to empirical evidence are proverbial red flags signaling that credibility may be lacking and that confidence is therefore misplaced.

Between Scylla and Charybdis

Growth in the US monetary base has been cited as evidence of incipient hyperinflation but, while a distortion in the US financial system is apparent, the currency in question is not in circulation and the effect is that of re-inflation since US banks have suffered massive losses linked to the US mortgage market.

Chart courtesy of Federal Reserve Bank of St. Louis

The growth in the US monetary base by over $1 trillion since 2008 represents currency held within the banking system on reserve, which increases the ability of US banks to absorb further losses.

Chart courtesy of Federal Reserve Bank of St. Louis

While more than doubling the US dollar monetary base in less than 2 years is viewed by some as printing too much money, high inflation or hyperinflation have yet to strike. Although money has shifted out of the broad US economy and into the banking system, the excess liquidity exists in the form of bank reserves and, despite the fact that inflation is always and everywhere a monetary phenomenon, if bank reserves are considered separately from interest rates and lending activity they have little direct impact on prices in the broad US economy. In fact, the widest measure of the US money supply is contracting and the broad US economy is in the grip of debt and monetary deflation.

Chart courtesy of Shadow Government Statistic

In terms of monetary policy, Mr. Bernanke faces an impossible choice. With interest rates near 0% and with unprecedented government debt and deficit spending beyond sustainable levels there is a clear risk of high inflation or hyperinflation if inflationary forces are not counterbalanced with a heavy hand. In theory, high inflation or hyperinflation could be prevented by restricting the flow of money and credit to consumers and businesses. Such a policy would exert deflationary pressure on the US dollar within the domestic US economy since principal and interest payments on existing debt would drain money from circulation. While preventing inflation temporarily, such a policy would not succeed in the long run because, in addition to offsetting inflation, deflation depresses economic activity and results in debt defaults. Concurrent government borrowing and central bank QE to recapitalize banks and sustain government deficit spending (in a Keynesian attempt to compensate for declining consumer and business borrowing), would cause the value of the US dollar to decline against other currencies thus the prices of imported goods would rise. The resulting combination of rising prices for imported goods (energy in particular) and a scarcity of money in the domestic US economy is a formula for business failures and debt defaults that would ultimately worsen the condition of the US economy and US banks regardless of lower prices for domestic goods and services.

Structural Decay

In a mathematically perfect world, growth in the money supply with a constant interest rate and level of lending is a simple exponential function. In theory, this is not problematic but in practice monetary expansion (and the associated debt) tends to grow faster than population or sustainable economic activity and even periodic deflationary episodes are insufficient to maintain a stable currency value.

Chart courtesy of Wikimedia Commons

The tendency to create currency in excess of what is required to support sustainable economic activity causes unsustainable booms where debt rises out of proportion to the ability to service or eventually repay, meaning that total debt in the economy grows faster than the GDP. The result is that for every boom artificially created by monetary expansion there is a corresponding episode of debt and monetary deflation. Nonetheless, the overall pattern of monetary expansion remains clear.

Chart courtesy of Federal Reserve Bank of St. Louis

From a policy standpoint, restraining debt issuance by private, profit-oriented banks to sustainable levels is impossible in practice because sustainable growth in GDP is an unknown when the interest rates and reserve ratios that moderate lending activity are set. In fact, the goals of the US Federal Reserve, "to promote ... stable prices and moderate long-term interest rates" require the money supply to expand faster than sustainable economic activity:

Sometimes, however, upward pressures on prices are developing as output and employment are softening-especially when an adverse supply shock, such as a spike in energy prices, has occurred. Then, an attempt to restrain inflation pressures would compound the weakness in the economy, or an attempt to reverse employment losses would aggravate inflation. In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output. Adding to the difficulty is the possibility that an expectation of increasing inflation might get built into decisions about prices and wages, thereby adding to inflation inertia and making it more difficult to achieve price stability.

Deflation is anathema because debt defaults harm lenders and governments have no mechanism to tax gains in the value of currency, thus monetary policy always errs toward inflation and over time the result approximates an exponential function. Among the results is the long term devaluation of the currency, which can also be expressed as an exponential function, i.e., exponential decay.

Chart courtesy of Wikimedia Commons

Exponential decay occurs when a quantity, such as the value of a unit of currency, decreases at a rate proportional to its own value. The decay can be expressed as a differential equation where a quantity N decays at a constant rate (a positive number) (lambda) within a given interval of time t.

Central banks implicitly manage the exponential decay in value of their respective currencies while they focus on interest rates, reserve ratios and inflation targets. Although the exponential decay in the value of the US dollar since 1913 has been distorted by episodes of deflation and variations in monetary policy, the overall pattern continues to reflect the structural reality of exponential decay.

Chart courtesy of Federal Reserve Bank of St. Loui

The combination of fiat currency, where currency is created arbitrarily, and central banking, where money and credit are centrally controlled and where there is an inescapable inflationary bias, suggests that all such regimes have a limited lifespan, but this does not allow a hyperinflationary outcome to be predicted. For example, if US citizens had been asked in 1913, when the Federal Reserve was established, if they would use the Federal Reserve's legal tender knowing that $1 would be roughly $0.05 in less than 100 years they would certainly have responded in the negative, but Federal Reserve Notes have not been rejected by the American people. Similarly, there is no necessary or obvious point where the US dollar will be rejected as it continues to decline in value for the same structural reasons. The logical outcome is an eventual redenomination.

Patterns of Hyperinflation

From the perspective of sovereign debt, the commonly understood process of hyperinflation is that if a government responds to declining foreign appetite for its debt with monetization (or in a historical context direct currency debasement) rather than immediate budget cuts, its currency looses value, at first in proportion to the dilution of the money supply and then more quickly as foreign bond holders and the nation's own citizens seek shelter from inflation in other asset classes. The cost of the government's future obligations then tends to rise in nominal terms, creating an apparent need for larger bond issues while bond yields rise, i.e., the cost of borrowing increases since monetization signals greater risk to investors. Exacerbating the problem, tax receipts tend to lag behind as domestic price inflation sets in. Further monetization is the path of least resistance. Although officials certainly believe that monetization is only a temporary measure both confidence in and the credibility of the government fail. Insolvency is eventually recognized as a reality and the nation's currency then collapses entirely.

Economists assume that consumers and businesses respond predictably based on economic incentives and disincentives, but this presupposes that the value of money is stable (at least over the short term). If users of a currency find that it looses value such that savings and wages are perceptibly eroded before they can be utilized at fair value, the rational course of action is to shed the currency as quickly as possible. This sparks a competition to shed currency in favor of real goods and, once the process begins, the rational course of action is to participate in the proverbial rush to the exits. Interestingly, a panic is not required to explain this phenomenon.

In the context of a national economy, the cycle of hyperinflation is driven not precisely by the supply of money but by its velocity because the competition to shed currency concentrates purchasing activity in successively shorter time periods. Within a given interval, more consumers and businesses seek to buy a limited supply of available goods using all available currency, including savings, thus demand is pulled forward while the velocity of money accelerates. If monetary authorities respond by increasing the money supply, the process feeds on itself.

In terms of the quantity theory of money, which is that the money supply has a direct, positive relationship to prices, the equilibrium of prices with the number of items purchased and the money supply with the velocity of money is maintained (where M is the money supply, V is the velocity of money, P is the average price level, and Q is the number of items purchased over a given interval).

The relation holds true even as the value of a currency approaches zero while prices approach infinity. However, while there is no theoretical limit to the money supply, the supply of goods is limited in various ways and shortages of goods spur prices higher, exacerbating the problem.

The competition to shed currency first interacts with prices then with the availability of currency and with the supply of goods. Rising prices result in rising demand for larger amounts and denominations of currency producing a genuine shortage, but increasing the money supply only intensifies the competition to shed currency, like pouring gasoline on a fire.

Crisis of Credibility

A gradual decline in the value of a currency is generally accepted by consumers and businesses because it has little immediate impact and can have short-term benefits, such as making money more accessible and stimulating economic activity and growth. However, when debt increases disproportionately, a deflationary bust is inevitable and if it is postponed by further credit expansion systemic instability results.

Chart courtesy of Karl Denninger

In 1949 Ludwig von Mises pointed out in Human Action (Chapter XX, section 8) that "there is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Among other things, excessive monetary inflation means that the US dollar cannot function as a store of value. Mounting evidence points to systemic instability, a lower US dollar and ultimately to a hyperinflationary outcome:

US federal government debt of $12.3 trillion, unfunded liabilities of $63 trillion, deficit spending of $1.35 trillion for fiscal 2010, and the Obama administration's $3.83 trillion budget all set new records, while federal income tax revenues are expected to fall for a second consecutive year.
It has been reported that to reduce the cost of borrowing, the maturity of debt issued by the US Department of the Treasury has shifted from the long end of the spectrum toward short term debt. At the same time, episodic flights to the perceived safety of the US dollar by global investors favor short-term Treasuries. This situation creates an escalating risk that the US Treasury will be unable to roll over short term debt and that it will resort to monetization.
7 US states are worse off than the financially troubled European nations of Greece, Ireland, Portugal and Spain resulting in warnings of a US credit rating downgrade possibly indicating an eventual sovereign default.
Unemployment in the US, where more than 2/3 of GDP is consumer spending, should be viewed as a leading, rather than a trailing indicator, thus the perception of recovery based on slowing unemployment is premature. Reported unemployment data seem to exhibit unusually pronounced disparities between initial claims and later revisions and seasonally adjusted numbers.
The widely reported recovery of the US economy is anemic at best since most of the reported forth quarter 2009 GDP growth is not sustainable and preliminary government economic data remains subject to revision by the US Bureau of Economic Analysis (BEA).
The imminent retirement of the so-called baby boomer generation comes with a combined Social Security and Medicare price tag of more than $60 trillion.
US bank failures and balance sheet deterioration together with the inability of banks to mark assets to market due to a growing commercial real estate problem and ongoing residential mortgage loan problems suggest that the financial crisis that began in 2008 is not over.
The suspension of the US Financial Accounting Standards Board's mark to market rule means that the value of mortgage loan portfolios and mortgage-backed securities (MBS) reported by banks are incorrect, which obfuscates leverage and risk while magnifying apparent profits.
Toxic assets still cripple bank balance sheets since the US Department of the Treasury has been unable to successfully carry out its Public-Private Investment Program (PPIP) making taxpayer money available to select investors that can use the money to buy toxic mortgage-backed securities, retaining any profits while putting little of their own money at risk.
The largest US Banks remain the largest holders of financial derivatives, e.g., credit default swaps (CDSs), which suggests that they may hold liabilities far in excess of amounts that can be paid or that can be bailed out if significant losses occur. The CDS market, which is the single largest class of financial derivatives, represents over $600 trillion dollars, a roughly 10x multiple of world GDP.
The Federal Reserve's plans to phase out some of its emergency programs, adding up to roughly $2 trillion currently, leaves other emergency measures in place. The Term Asset-backed Securities Loan Facility (TALF) is set to expire on June 30, 2010 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral but existing loans will not be retired for some time.
Downward pressure on the US dollar caused by the Federal Reserve's near 0% interest rates and ongoing QE has caused a US dollar carry trade affecting asset prices in global markets. While the value of the US dollar has rallied in response to episodic flights to perceived safety in US Treasuries reflecting comparative weakness in the Euro and other currencies, the overall downtrend is persistent, thus the prices of imported goods can be expected to rise.

Rather than a crisis of confidence, hyperinflation results from a crisis of credibility. Hyperinflation results when the social, legal and political structures that create the value of paper money break down. When a government borrows excessively and its promises to repay are contradicted by mathematical realities, the value of its currency cannot be maintained. If a government so lacks credibility that it cannot issue bonds because there are no buyers other than its own central bank, the value of its currency declines faster than money is printed to cover its obligations. Perhaps the most important indicator of impending hyperinflation is whether the statements of a government or of its central bank, e.g., with respect to the government's budget or the central bank's balance sheet, are evidence based or ideological. If they are not evidence based, the credibility of the government or central bank, and its currency, will weaken and eventually fail.

Ordinarily, supply and demand factors govern the value of money and the prices of goods, but money has another, deeper level of value apart from its role as a medium of exchange and unit of account. When money is not redeemable, it is, in effect, a contract and, as such, it can instantly become more worthless than the paper it is printed on if the agreement that gives it value is null and void.

In 1999, referring to the sale of British gold reserves, Alan Greenspan, then Chairman of the US Federal Reserve, said that "Fiat money paper in extremis is accepted by nobody." The reason for this is that there are two fundamental kinds of value. De jure value exists because of, and is dependent upon, social, political and legal arrangements between human beings. In extremis, agreements are often broken and unenforceable. The value of fiat currency and of government bonds are examples of de jure value. Ultimately, de jure value actually exists only in the minds of human beings and does not exist in an absolute sense, in the real world, independent of human belief. De facto value, on the other hand, exists in reality, independent of human thought, e.g., lumber or farmland. The value of real, tangible things of value ultimately devolves to biological survival and to material standards of living. Possessing a physical asset that supports survival does not require human belief in order to have biological value.

When social, political and legal arrangements are strong, reliable and endure over generations de jure value may be preferable for any number of reasons. However, when social, political and legal arrangements prove to be unstable, or fail, de facto value trumps de jure value in every case.

When the balance sheets of US banks are maintained by suspending accounting rules and when banks hold financial derivatives liabilities greater than world GDP, both the stability and credibility of the banks are questionable. When US economic data consistently seems to reflect a Pollyanna bias and the US federal budget contains unrealistic projections of GDP growth and tax revenues, while public debt and government liabilities (which now include unlimited bailouts for government sponsored entities Fannie Mae and Freddie Mac) are obviously unworkable and the US government's own central bank is already a major buyer of US Treasuries, the federal government's credibility is questionable. When private financial losses and toxic financial assets are transferred to taxpayers while profits and bonuses abound on Wall Street thanks to accounting rule changes in the midst of the worst economic contraction since the Great Depression, the credibility and competency of the US Treasury and Congress, with respect to the finances of the nation, are questionable. When the US Federal Reserve defies the US Congress, resists independent auditing, engages in ongoing QE and is the lender of last resort for banks that under normal conditions would be insolvent, its credibility is questionable. When the Chairman of the Federal Reserve, who failed to detect the largest asset price bubble in the history of the world and who has been consistently wrong in his assessment of the US economy is reappointed following the worst financial and economic disaster in generations, both his credibility and that of the Obama administration are questionable. The plethora of red flags spewing from Wall Street, from the Federal Reserve and from the federal government point to a breakdown of de jure value that is already in progress, thus to a hyperinflationary outcome for the US dollar.

Faces of Death: The US Dollar in Crisis

Ron Hera — Sun, 11 Oct 2009 08:45:00 GMT

The US economy has been in crisis since 2008 and despite optimistic statements by officials and commentators there are no fundamental signs that the crisis will end in the foreseeable future. Current economic data suggests a number of diverging and unsustainable...(read more)