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Sunday, October 16, 2011

Can "It" Happen Here?

I would urge readers to see John Mauldin's latest column Can "It" Happen Here. If you aren't subscribed you will have to enter your email address to read the full thing.

There are several very important points in that article.

The first is about Barney Frank's bill to New-Yorkify/DCify the Fed. That's covered in enough detail to be self-explanatory. It would be a disaster of the greatest magnitude - in fact what Barney Frank thinks is democratic would be the destruction of the democratic process. The regional bankers are voicing worries because employment and trade in their regional economies are dependent on a somewhat stable currency. They are representing the full-employment agenda. But Barney isn't the brightest bulb in the DC closet, so he probably really believes in the justification suggested to a somewhat feeble mind by his own wealth constituents who are not exactly the average American.

The second is that incidents of hyper-inflation have historically been prompted not just by printing money but by printing money and big government deficit spending of that money. This is important, because US expenditures funded by deficits were 36% of net expenditures for fiscal year 2011, and Obama's proposed "jobs" bill would be doomed to make fiscal year 2012's ratios worse. This is so close to the historical danger line for hyperinflation episodes that it must be taken very seriously.

The third is that 2013 is probably the line. That's seriously true.

Hyperinflation occurs when the people who do most of the bottom-line trading, selling and servicing in any economy are forced to exit the monetary system. They usually do this by barter. The result is vicious, and it sets up a self-reinforcing cycle that can't easily be contained by CB activity. Instead, to correct it, central banks are forced to inflict nothing less severe than an acute recession on the hyperinflating economy, and in severe cases it has to be a depression. China is in a state of near hyperinflation, which is why it has to be so carefully watched.

The early symptoms of impending hyperinflation are difficult to diagnose. Money velocity slows because common individuals can't buy necessary commodities and services. Eventually barter networks emerge, and they probably already have in the US among many service businesses. As these networks emerge, demand for money in the real economy drops, and those who have money either have to bid up commodities or dump their money into equities. And then, if the deficit spending continues, the whole thing topples. But the earliest marker is always going to be when the average participant in an economy becomes less and less able to buy the basic goods and services with money.

Devaluation benefits the banks,MNC's and the government.
My guess is that is the road that will be taken.
A vivid portrait of the social & psychological effects of hyperinflation was provided by Sebastian Haffner, who grew up in Germany between the wars:

"By the end of 1922, prices had already risen to somewhere between 10 and 100X the pre-war peacetime level, and a dollar could purchase 500 marks. It was inconvenient to work with the large numbers, but life went on much as before.

But the mark now went on the rampage…the dollar shot to 20,000 marks, rested there for a short time, jumped to 40,000, paused again, and then, with small periodic fluctuations, coursed through the ten thousands and then the hundred thousands…Then suddenly, looking around we discovered that this phenomenon had devastated the fabric of our daily lives.

Anyone who had savings in a bank, bonds, or gilts, saw their value disappear overnight. Soon it did not matter whether it ws a penny put away for a rainy day or a vast fortune. everything was obliterated…the cost of living had begun to spiral out of control. ..A pound of potatoes which yesterday had cost fifty thousand marks now cost a hundred thousand. The salary of sixty-five thousand marks brought home the previous Friday was no longer sufficient to buy a packet of cigarettes on Tuesday.

The only people who were able to survive financially were those that bought stocks. (And, of course, were shrewd or lucky enough to buy the right stocks and to sell them at the right times.)

Every minor official, every employee, every shift-worker became a shareholder. Day-to-day purchases were paid for by selling shares. On wage days there was a general stampede to the banks, and share prices shot up like rockets…Sometimes some shares collapsed and thousands of people hurtled towards the abyss. In every shop, every factory, every school, share tips were whispered in one’s ear.

The old and unworldy had the worst of it. Many were driven to begging, many to suicide. The young and quick-witted did well. Overnight they became free, rich, and independent. It was a situation in which mental inertia and reliance on past experience was punished by starvation and death, but rapid appraisal of new situations and speed of reaction was rewarded with sudden, vast riches. The twenty-one-year-old bank director appeared on the scene, and also the sixth-former who earned his living from the stock-market tips of his slighty older friends. He wore Oscar Wilde ties, organized champagne parties, and supported his embarrassed father."

Haffner believes that the great inflation–particularly by the way it destroyed the balance between generations and empowered the inexperienced young–helped pave the way for Naziism.

"In August 1923 the dollar-to-mark ratio reached a million, and soon thereafter the number was much higher. Trade was shutting down, and complete social chaos threatened. Various self-appointed saviors appeared: Hausser, in Berlin…Hitler, in Munich, who at the time was just one among many rabble-rousers…Lamberty, in Thuringia, who emphasized folk-dancing, singing, and frolicking."
I've been reading Mauldin for a year or so. He seems to be a beacon of sanity among so many nattering nabobs of gold buggery -
Porter Stansberry, Doug Casey, David Galland, Peter Schiff, Bill Bonner, etc. Along with Paul Krugman and assorted champions of Keynes.

I hope he's correct that we can set the ship right by the bringing the deficit down on a smooth curve and get some confidence back into the system. Less government spending coupled with more economic activity will gradually reduce the deficit and allow time for the debt to be marked down and worked through. At least that's the way I'm reading it.
Man I hate reading that stuff. It is the one thing that makes me physically queasy in my stomach.
...incidents of hyper-inflation have historically been prompted not just by printing money but by printing money and big government deficit spending of that money.

That's a good point, M_O_M. Makes sense--it's not just creating money, it's creating money and then using it in ways that disrupt production of goods.

But complex economies with respected tax enforcement also do not hyperinflate without an alternate currency. That's what makes it possible for most transactions to abandon the local currency. The Reichsmark fell to gold; the various pesos fell to the dollar; the Yugo dinar fell to the Deutschmark, the Zim dollar fell to the Rand. The U.S. tax code takes a dim view of conducting business in any medium other than dollars, which puts constraints on what might defeat the dollar.

Let's assume for the moment that the IRS maintains its fearsome reputation. A hyperinflation then requires something money-like that is either accepted as payment for taxes (by law nothing but dollars will suffice), or is given favorable tax treatment.

Maybe I should pay more attention to my airline miles accounts...
It is really pathetic that at this tine in modern history we have the greatest collection of fools and idiots running the western world.

We are doomed ... there is no doubt.

What is scarier is that there are many tough vulture counties out there waiting to feast on the corps of a dying Western (formerly democratic) capitalist West.
Neil - when things break down they break down, and actually real economy impacts are worsened when the compensations that take place are obstructed.

To some extent we are seeing aspects of this around the world. For example, many have written of the empty cities in China - but few note that those buildings have been sold. The cities themselves may be mostly unpopulated, but Chinese with wealth bought the dwellings because they have little in the way of a workable money market system.

To a large extent, the more bubbly aspects of the Chinese property rush were induced by the lack of an alternate store of money. The system will break down in China only to the extent that Chinese stop being able to raise money with those buildings as collateral.
David - exactly. On a short-term scale, the response to printing money is to divert money into some sort of hard asset. But as Germany discovered, the end is not controllable.

History - in which I believe rather than in theory - tells us of numerous examples of such. What history doesn't tell us is exactly where the line is, or how to back away from the line.

The Fed's relatively modest intervention last year produced near-term effects similar to these. But the only cure for the hangover in such situations appears to be the hair of the dog, and ultimately the economic liver fails.

The key metric I'm interested in is whether cash savings become worthless. That's the distinguishing mark of a hyperinflation. I'm aware of the current wealthy Chinese practice of borrowing against commodities (though your particular example is new to me), but that's not the same thing as the rural population's savings accounts. Or, in the U.S., the Baby Boom's lifetime savings. If those become worthless while remaining nominally unchanged, the social fabric is shredded.

I have no time to do the academic work on this, but I am not aware of a hyperinflation except where there was a pre-existing practice of using dual currencies. Now that I think about it, we can add one of the early instances--the Roman denarii was used in parallel with the gold aureus, prior to their hyperinflation. Without the alternate currency, you get commodity inflation or equity bubble and then severe deflation. Savings hold their value, if you can avoid spending them.

Perhaps I'm missing something, but I think hyperinflation in the U.S. will be difficult without drastic changes in the tax codes (except for a caveat about customer incentive scrip). I'm not sure about China--I think they do still have a dual-currency structure, which is vulnerable to mismanagement.
The key metric I'm interested in is whether cash savings become worthless.

Don't put all your eggs in one basket.

Cash isn't the eggs, it's the basket.
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