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
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
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
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.
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.
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.
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.
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.
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.
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
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.
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
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.
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
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
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.
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
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
disparities between initial claims and later revisions and seasonally adjusted
- 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
- 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.
Mar 10 2010, 05:13 AM
Filed under: Federal reserve, US dollar, CPI, deflation, debt, inflation, GDP, central banks, money supply, US economy, central bank, M3