Deflation Vs. Hyperinflation

from FOFOA blog, this is hands down the best explanation of the two phenomenon, deflation and hyperinflation:


Chapter 84 – Bond salesmen's propaganda that "a dollar is a dollar" should be rewritten to say "a dollar is 3¢"

Since most ordinary people, bankers, and company presidents have never studied currency theory, they swallow it hook, line, and sinker when the bond salesmen tell them, "a dollar is a dollar." That piece of propaganda should be rewritten to say "a dollar is 3¢." The nominal dollar is officially worth no more than 14¢ of its 1940 value, unofficially only 3¢.

If computed in 1940 constant dollars, not more than $1,380 exists of the US $46,000 per capita gross public and private debt. More than $44,628 has been destroyed by inflation. But sadly, the owners of this debt do not want to hear about it. They do not wish to know that bonds are issued by governments with the sole purpose of debasement.

To my knowledge, no government in history has paid its debts in currency equal to the purchasing power of the currency lent to them. The people always lose their money on bonds.

It angers me. Bond salesmen should be thrown into the East River.

-The above was written in 1985 by Dr. Franz Pick, in the book "The Triumph of Gold" sent to me by one of my readers. The photos are from Time Magazine.

The whole point of the deflation versus hyperinflation debate is about the denouement, the final outcome of this 100-year dollar experiment. It is about the ultimate end, and the debate has been going on ever since the 70s when the dollar was separated from gold and it became clear that there would be an end. The debate is about determining the best stance someone should take who has plenty of net worth. And I do mean PLENTY. People of modest net worth, like me, can of course participate in the debate. But then it can become confusing at times when we think about shortages or supply disruptions of necessities like food. Of course you need to look out for life's necessities first and foremost. But beyond that, there is real value to be gained by truly understanding this debate.

I want to apologize in advance for the length of this post, but I have to be thorough if I want to have any chance of winning Rick Ackerman over to the hyperinflation/Freegold side. And I think there is a chance. While deflation and inflation are practically polar opposites, deflation and hyperinflation look almost identical on the surface, with the main difference being the wheelbarrows of worthless cash. As I wrote in 2009 in The Waterfall Effect:

There is a quote I like that comes from Le Metropole Cafe. It goes, "we will have deflation in everything we own, and inflation in everything we use". This is partly true. It is true during the run up to the rubber band snapping. It is true until we hit the waterfall. At that point I have my own version of the quote. "We will have hyperDEflation in everything measured against real money, GOLD, and we will have hyperINflation in everything measured against paper dollars."

My latest post on this subject was called Big Gap in Understanding Weakens Deflationist Argument in response to Rick Ackerman's "Big Gap in Logic Weakens Hyperinflation Argument". Rick also received responses from Jim Willie and Gonzalo Lira. Last week, with regard to Lira and Willie, Rick reported to his readers in "Rick's Picks":

I’ve concluded there is little to gain arguing on the one hand with a guy who turns rabid whenever someone contradicts him, even in a friendly way; and on the other, with a preening narcissist who comes to argumentation in the same state of sexual arousal that Jeffrey Dahmer must have experienced hovering over the fresh corpses of teenage boys. These guys are bad news, as lacking in civility and manners as buzzards in a scrum, and you’d do well to avoid them both. You might try tuning instead to the hyperinflation arguments of Steve Saville, Peter Schiff and a few others who seem less concerned with trouncing, slicing and dicing opponents than with presenting facts that might better prepare you for the financial crisis ahead. The very best of them, in my opinion, is FOFOA blogspot, where the essays are erudite, the discussion elevated and the arguments as knowledgeable as any you will find on the web.

I would first like to thank Rick Ackerman, and to also acknowledge his perspicacity in this particular regard. And because he has demonstrated such a discerning acumen in his preference for hyperinflationists (among other things), I will try, once again, to help him see the way. As our own Blondie likes to say (and I paraphrase for clarity), "you don't own your baggage, it owns you." Here is Rick's baggage, in his own words:

My instincts concerning deflation were hard-wired in 1976 after reading C.V. Myers’ The Coming Deflation. The title was premature, as we now know, but the book’s core idea was as timeless and immutable as the Law of Gravity. Myers stated, with elegant simplicity, that “Ultimately, every penny of every debt must be paid — if not by the borrower, then by the lender.” Inflationists and deflationists implicitly agree on this point — we are all ruinists at heart, as our readers will long since have surmised, and we differ only on the question of who, borrower or lender, will take the hit. As Myers made clear, however, someone will have to pay. If you understand this, then you understand why the dreadnought of real estate deflation, for one, will remain with us even if 30 million terminally afflicted homeowners leave their house keys in the mailbox. To repeat: We do not make debt disappear by walking away from it; someone will have to take the hit.

Rick repeats what he calls "C.V. Myers' dictum" quite often in his deflation-oriented posts: “Ultimately, every penny of every debt must be paid — if not by the borrower, then by the lender.” I'm going to go out on a limb here and say that this dictum is Rick's baggage, his foundational deflation premise, in a nutshell. And it leads him to his "bottom line" or his analytical conclusion:

Rick's Picks Commenter SD1: To my knowledge, no bank has ever made provisions in their lending criteria. So to anyone subscribing to the hyperinflation theory, all I can say is there is nothing I, and millions of other North Americans, would love more than to take $250,000 of worthless, hyperinflated money that we worked a few days to make, to pay off a mortgage that would otherwise have taken twenty-five to thirty years to repay.

Rick Ackerman:That’s the bottom line, as far as I’m concerned.

In this post I will explain the flaw in Myers' dictum. I will go into great detail as to why the missing component in the dictum is the essential (and inevitable) one. I will show how this one flaw in Rick's premise sends his otherwise excellent analysis careening 180 degrees in the wrong direction (with regard to the subject of this post). And I will explain the proper frame of reference from which to view what I am describing. How's that for a kick-off?

First Myers' dictum. “Ultimately, every penny of every debt must be paid — if not by the borrower, then by the lender.” Rick: "Inflationists and deflationists implicitly agree on this point — we are all ruinists at heart, as our readers will long since have surmised, and we differ only on the question of who, borrower or lender, will take the hit." Me: Yes, someone will pay. But there is a third option that is missing from Myers' dictum. "The hit" can be socialized:

"Human nature has followed this path for thousands of years. You know the old joke about outrunning the bear? Well, these lenders will influence our financial policy as such. They will try to get their debt securities liquefied first, spend the fiat and in this process outrun you and I. Leaving anyone they can beat to the mercy of the hyperinflation bear eating their remaining fiat assets…"

"…hyperinflation is the process of saving debt at all costs, even buying it outright for cash… because policy will allow the printing of cash, if necessary, to cover every last bit of debt and dumping it on your front lawn!"

(The quotes are from FOA on Hyperinflation and FOA on Currency Styling, Currency Management, Dollar Hyperinflation and End Game Scenarios respectively.)

As many of you know, I came to this debate, with no baggage and no hard opinion, in 2008. And in the "doom and gloom internet community" where I arrived there was definitely an equal helping of both deflation and inflation/hyperinflation talk. Most of it I found less than convincing (on both sides). The "deflation side" is actually bigger than you might think. Most of the peak this or peak that crowd, the majority of the survivalist community, and the Great American Collapse people are all expecting a sort of grand deflation, whether they understand the arguments or not.

If you want to think of a grand deflation as a deflating—or grand contraction—of economic activity that was previously "energized" by massive trade deficits, massive credit expansion, and the massive structural malinvestment that flows from those easy money expansions, well then I too am expecting a sort of grand deflation, in many of the same ways they are. But one thing I have learned from the writer that made the most sense to me, the writer that I found most convincing from within my "past baggage" vacuum, is that "deflationists" as a group still have a big gap in understanding.

Rick became a deflationist in the 1970s by his own account. And he certainly wasn't alone. I wasn't even aware of the existence of such a debate in the 1970s let alone 2007, so I can hardly add the wide perspective necessary in this debate from my own personal experience. What I can do, instead, is to share with you this excerpt from the one that spoke convincingly to me, the one that informed my developing view in 2008.

One point I hope you'll find curious in this excerpt is that deflationists have always fixated on residential real estate. This is one of Rick Ackerman's, almost obsessive, objections to the hyperinflation case, and it clearly has roots in his kind. This was written in 2001, just as the housing bubble was developing. My notes in [brackets]:

Somewhere in the 1970s era I was exposed to the thinking of several different deflationists. It seemed that all of their conclusions came to the same end: that dollar deflation would rule the day, no matter what. Mind you now,,,,,, most of them were split on the finer points of the issue, but for all of them; [de]flation would have its day even if prices would rise somewhat. Deflation was always the final outcome.

One of the central themes in these thoughts was concerning how this coming deflation would impact plain old residential real estate. You see, most of these guys advocated selling excess residential property because it was, sooner or later, going down for the count. Mostly because the mortgage markets would be destroyed in the deflation and nobody could buy [prices would collapse to the cash price].

-- Note: The reader has to understand that these discussions were directed towards people and investors that had plenty of net worth. And I do mean Plenty! The argument wasn't about how to survive; rather how to balance a truly conservative estate portfolio. --

As time has passed we can see several major flaws in their thinking. Flaws that cost them a bunch of credibility, if not personal money. [I want to jump in here with a quick quote from Gary North written in 2002:

"I remember in 1975 hearing C. V. Myers tell attendees at a gold conference, 'If you get this one wrong, you'll lose everything.' He was predicting deflation. He got it wrong. He didn't lose everything."

And now back to FOA] One point, that I have touched on here several times, was in understanding just how much ourselves and our economic structure would and did evolve into accepting fiat money use. Even though it was, "god forbid", separated from gold.

In one area alone, the bond markets, investors reacted far differently than deflationists thought they would. Twenty ++ years ago [again, this was written in 2001], it was expected that just gross increases in money printing alone would be enough to crash the bond markets. Not talking about price inflation here, but money inflation and that should have started a deflationary fall in our credit markets. It almost happened, several times, but never followed through. It seemed that the market function had evolved to accept fiat inflation as a prerequisite to modern economic function. In a like comparison to today's thinking; investors assumed that as long as we had an expanding economic stance [nominal GDP growth, credibility inflation and financial product appreciation], sourced by inflating fiat supply, price inflation would not impact long bond credibility. We saw confirmation of this over many years. We saw that our credit markets, especially long bonds, were used in spite of the price inflation threat. Indeed, there was a ready [highly liquid] market demand for bond purchases.

In hind sight, long term holders of bonds did do very well if their position was part of a balanced holding and they didn't need to sell at bad times. Even now, dollar bonds have gained as rates are pushed lower.

Back to the thought:

This whole IMF dollar system has always been based on an expanding fiat theory that swells [nominal] GDP over time. Investors that bet on deflation coming along, after each of our bouts of inflation, were badly burned as deflation was overcome. Economic function returned, essentially because price inflation could not rout the overall market for long credit.

The flaw in all of this was in the reserve structure of our Dollar IMF money system. The fact that the world had to walk, lock step, with our money policy meant that their goods production would almost always be cheaper than ours; keeping local US price inflation under control. In other words; local US-based price inflation could not get out of hand as long as the rest of the world was willing to use their economic production to control it by selling [products cheaper than we could produce them] into our expanding fiat system.

In this, the dollar [and its securities, and their derivatives] could be inflated without end while our credit markets functioned in a non-inflationary environment.

But there is an end.

A money system like this has a definite timeline and that point is reached when the world can move away from keeping price inflation low in the US. That point is reached when Another money system comes along to challenge the dollar and, in the process, offer these other goods-producing countries a chance to buy some "lifestyle" for themselves.

At first, the show is dull as investors keep right on buying into the dollar argument above: that an expanding fiat base builds non-inflationary [nominal] growth [in both GDP and securities]. This is one reason traders still buy US long credit, not to mention chasing rising dollar exchange rates; they expect more of the last several decades of economic theory to keep right on going. It won't.

The dollar faction saw its match early in the 90s as the Euro was taking shape. To counter this threat, as I have outlined here in several ways, they promoted derivative hedges as a way of insuring dollar dominance. These hedges, including gold derivatives, only served to leverage the entire dollar / IMF system beyond its ability to serve as a real fiat money system, today. [See (my title): Is the Fed selling Hyperinflation Insurance Backed Only by Hyperinflation?]

I mean; that our whole dollar landscape has now become just a trading asset arena: it's now evolving away from any meaningful currency use to trade for real goods. It can head in no other direction because our local economic structure, the USA economic base, cannot possibly service even a tiny fraction of the buying power currently held in dollars worldwide.

So what does this have to do with Real estate?

Take a look at any broad section of the US; Northeast, SouthWest, etc.. If any of the deflationists were correct, their reasoning back in the late 70s and early 80s should have produced at least an average fall in Residential real estate. Can any of you find an "average" of property today, that is lower than early 80s prices?

Of course I'm not talking about the spikes in Hawaii, New York, Denver or San Francisco; those are just blips on an ever rising inflation scale. Even if they fall some from here, it isn't part of a deflationary act playing out. Average home prices will rise all across this country no matter what the future economy holds. A super inflationary stance by the Fed means that even unemployed workers can buy a house and pay for it! Watch how this all comes about. The Dow will not be much different when seen ten years from now; a drop to 5,000 then off again, is a real possibility! [Note: The Dow dropped from 11,000 in 2001 down to 7000 and back up to 12,000 in 2011. Again, FOA wrote this ten years ago in 2001]

The same is true for anything perceived as something real: "even silver" (grin).

The difference is in the drastic ups and downs derivatives will place on all asset markets. My point is that we are on an "end time run" in fiat dollar production that will soon produce a spike in real price inflation that crushes hedge vehicles. One item alone, physical gold, because it is the main wealth asset behind the next currency system [See: RPG #1], will outrun everything by a wide margin. No matter the derivative's hold on it!

As the Euro builds a base [which is happening right now in 2011 – see this, this, this, this, this and this], it will drive an inflationary recognition into our credit markets, then freezing up our derivative markets. That perception will fuel a complete failure of our bond markets and force the Fed to buy up any and all credit; paying in full. [Paying full price for deflating assets? Oh my, would the Fed ever do that? The deflationists never saw it coming!] If needed, Bush and congress will see to it that enough money is printed so we are paid in cash for everything! Don't laugh, this is where we are headed.

[I must insert here the rest of the famous FOA quote from above. I affectionately call it "the front-lawn dump" and it was coined by FOA a full 18 months before Bernanke's famous "Helicopter drop" speech:

"My friend, debt is the very essence of fiat. As debt defaults, fiat is destroyed. This is where all these deflationists get their direction. Not seeing that hyperinflation is the process of saving debt at all costs, even buying it outright for cash. Deflation is impossible in today's dollar terms because policy will allow the printing of cash, if necessary, to cover every last bit of debt and dumping it on your front lawn! (smile) Worthless dollars, of course, but no deflation in dollar terms!"

Okay, now back to the original excerpt…] In the meantime, whether or not our economy is growing, stalling or failing, will have little or no impact on price inflation.

You see, living with real serious price inflation goes something like this:

---- "Honey, I talked to Fred again, he can't sell his house! Poor guy, he has had it up for two years now and has to raise his asking price again. No takers, yet. The last couple was just about to close but took a month too long; they almost got the cash together, too. He backed out to raise the asking price, again. Oh well, that's not so bad, we had to jump ours up three times before selling." ----

Inflation runs crazy when a money system is forced to "print out". We will "print out" our dollar, too. Getting there just takes time and an alternative system to cause it.

Now I do realize that it takes a certain talent to distill deep wisdom from a 10-year-old internet forum post. And I can almost hear some of you out there screaming, "but but but… house prices DID collapse… d… d… DEFLATION!" Wrong. Sorry. Residential real estate will ultimately crash to its non-leveraged cash price as credit disappears, just like the deflationists think. But that ultimate cash price, once reached, may actually be higher than today's leveraged prices and be outrunning the availability of cash needed to clear the market! And all the while real estate will keep crashing in real terms (gold).

There is always a shortage of cash during a full-bore, in-your-face hyperinflation, which is why the printer has to keep adding zeros. His press simply cannot keep up with prices at established denominations. It is also why the first to touch the new cash (the "elite") have a very valuable advantage. Hyperinflation is a grand competition for lifestyle retention in the face of forced austerity, just like a race! Here, look at this from the excerpt:

"Honey, I talked to Fred again, he can't sell his house! Poor guy, he has had it up for two years now and has to raise his asking price again. No takers, yet. The last couple was just about to close but took a month too long; they almost got the cash together, too. He backed out to raise the asking price, again. Oh well, that's not so bad, we had to jump ours up three times before selling."

I'll bet the deflationists were thinking in terms of deposit+loan=price, rather than cash. Wrong paradigm. Sorry. When the hyperinflation hits in a reference point purely-symbolic fiat currency paradigm, the market will try to clear for the rising symbolic cash price while the hard currency price (denominated in gold) continues to drop like a stone. Deflationists do have one thing right. Real estate is not a very good investment when preparing for what's coming. That doesn't mean home loan debt won't be hyperinflated away though. It most likely will be. And if you are lucky enough to catch the bottom in the reference point gold paradigm during the crisis, bless you. But it's still a poor investment choice right now, even at 5% down, compared to putting that same cash into physical gold. More on this in a moment.

The point of sharing this FOA excerpt was that deflationists, like other groups that have established encampments cluttered with old baggage, tend to miss what is actually unfolding. And for that, you might want to start with my post The Debtors and the Savers. Understanding the balance necessary to keep the peace between these two groups is fundamental to understanding the political will behind the inevitability of both Freegold and dollar hyperinflation.

Rick seems to have a number of hang-ups when it comes to both gold and hyperinflation. His biggest is obviously real estate and the modern home mortgage. He simply cannot seem to fathom how a system designed and managed by The Power Elites could ever deliver a "windfall" to overleveraged, underwater homeowners or shady, uncouth gold bugs. And, frankly, if you don't make the effort to understand what is actually unfolding, there's a good chance it won't.

To the deflationist, "a dollar is a dollar" just like it is to ordinary people, bankers, company presidents and bond salesmen in the quote at the top. And even though the dollar has already lost almost 99% of its original gold purchasing power, Rick believes The Power Elite will make sure it stays strong until you have worked off every last dollar you owe. Because someone has to pay! (He's right about that.) And it's not going to be "them". (He's mostly right about that too.)

The dollar has a long, storied past. To believe "a dollar is a dollar" is to simply ignore its history. Of course I'm not implying that deflationists are unaware of this chart:


But I am saying that they think the collapse of the dollar's financial system will strengthen the dollar itself and make prices fall in the end. This is a funny notion when you take the totality of the dollar's journey into consideration.

The dollar was once worth 1.555 grams of gold. Then it was reduced to .888 grams of gold. Today it is able to purchase .02 grams of gold, but only at the margin. Notice that I said "able to purchase" instead of "is worth," and I also added "at the margin." That's because the dollar is not worth .02 grams of gold today. Around 60 years into its 100-year life, not unlike the human retirement age, the dollar retired to become a purely symbolic, completely worthless token. And in the big scheme of things, this "retirement from value" is not such a bad thing. Someone emailed me a question the other day and this was my reply:

Hello Mark,

I don’t see much wrong with your grasp of the subject, other than those worthless tokens are actually a good thing. What sets us apart from those monkeys is our ability to divide labor in a way that resists the second law of thermodynamics and allows us to organize our environment.

This division of labor requires us to use a medium of exchange in order to avoid the double coincidence of wants.

The question then becomes, what is better as a medium of exchange? Should it be something of value? Or is it more beneficial to the anti-entropic process for it to be something purely symbolic and worthless?

If you answered “something of value” I would ask, Why? Is it because you want to hoard that thing in the case that you produce more than you consume? And what is the net effect on man’s battle against entropy if the circulation of that valuable medium slows due to hoarding? Conversely, with a worthless medium, why not just exchange it for that same valuable thing if, in fact, you do produce more than you consume? Seems simple enough to me.

Sincerely,
FOFOA

You see, this is where we are today. We are using, as a medium of exchange, a purely symbolic, completely worthless token. The logical action, then, is to exchange surplus worthless tokens for something of value. Yet still today, most everyone hoards up purely symbolic, completely worthless tokens in the form of the debt of more tokens to be worked off and paid by someone else. In fact, globally, this debt far exceeds the ability for it to ever be paid (worked off by future labor), at least not at today's dollar purchasing power of .02 grams of gold. And yet it will be paid by someone, just as the deflationists promise! So the question then becomes, how can an impossible debt be paid?

Answer: if it cannot be worked off by future labor, it will be worked off by past labor, the net surplus of which was erroneously stored in debt and dollars. The icing on the cake is that it is also the past labor of "someone else," if the profits can be capitalized and the losses socialized. Precisely the process we have witnessed over the past three years, for those with eyes to see.

Rick Ackerman's somewhat-myopic focus is on home mortgages as the lynch pin that will keep this worthless, symbolic token valuable while you toil on the chain-gang working off your debt of worthless tokens. So let's take a look at the larger picture to gauge the strength of this pin and the stress it must endure.

Total US mortgage debt is a little over $14 trillion. That number includes you and your neighbors. Of that $14 trillion, about $6 trillion sits on the balance sheets of banks and $9 trillion has been packaged and sold to savers like pension funds. Of that $9 trillion held by savers, about $5 trillion is guaranteed by the US government.

So here's Rick's lynchpin that's going to keep all of you indebted homeowners honest: $14 trillion - $5 trillion guaranteed = $9 trillion. And that $9 trillion lynchpin is so powerful because it is held by politically connected and powerful banksters and pension funds, or so they say. Now in a minute I'll tell you why these two groups would rather have all that debt printed and the cash handed to them than to watch even 20% of you default on your mortgages. But first, let's step back and take a wider look at what might be exerting shear stress on this supposed lynch pin.

Total worthless token debt in the US, both public and private, is around $55 trillion, four times as big as that backed by physical real estate. If we add in the government's unfunded liabilities (which definitely apply shear stress to the dollar's lynch pin), that number comes in around $168 trillion. And that is simply the promises to deliver worthless, purely symbolic tokens, at some time in the foreseeable future, emanating from within the United States. Meanwhile the US produces enough "goods and services" (loosely defined) every year to be purchased by 14 trillion of these purely symbolic tokens at their present level of purchasing power. And with a trade deficit of around $500 billion per year, it appears the US is consuming roughly 103.5% of what it produces every year, in real terms.

So in real terms, that is, in terms of the dollar's purchasing power as it stands today, it would take, let's see… $168T/($14T produced - $14.5T consumed)= x years… hmm… somehow it's going to take us negative 336 years to deliver those promised dollars at today's purchasing power. Remember I said this debt would be "worked off" in the past, without the use of a time machine I might add? Well here you go—past surplus labor foolishly stored in dollars and dollar financial instruments and their derivatives will be tendered. Of course the deflationists want you to know that we will be forced to reduce our consumption to below our production in order to pay those off. And once again, they are correct, though not in the way they think.

Reducing consumption means reducing your standard of living. Some call it austerity. But with forced austerity also comes the competition to avoid reducing your standard of living. And herein lies the inevitability of US dollar hyperinflation.

You see, those Power Elites that Rick thinks are going to support the dollar and its $169 trillion burden (excluding derivatives) simply to make sure you'll work off your $9 trillion dollar mortgage at today's purchasing power are the same ones that will resist personal austerity measures the most. And as all good deflationists know, you simply cannot resist the irresistible without breaking something. And what they will ultimately break in their competition to maintain lifestyle is the value of the dollar, which will actually break quite easily due to the mountainous (think: landslide) shear stress applied to it right now.

Now let's go back to those "banksters" that, along with the politically powerful pension funds, are part of the Power Elite that are going to keep the dollar strong enough so that your mortgage isn't hyperinflated away. Remember, this is roughly $6 trillion, or 3.5% of the dollar's debt problem, that is still sitting on the balance sheet of banks, yet gradually being absorbed and/or guaranteed by the Fed and/or the US government.

This is simple logic: Do you think they'd rather offload that debt onto the Fed's book in exchange for full cash value? Or would they prefer to hold onto those notes while you struggle to pay them off in symbolic tokens over the next 25 years? How about this: Is it better for the health of the bank to take possession of the houses (and then have to sell them) that roughly 20% of the troubled homeowners are walking away from? A 2009 jingle mail study showed that close to a fifth of troubled mortgages in the U.S. involved borrowers who were strategically defaulting. That represents roughly a 10% hit to the asset side of the banks' balance sheets. Yet the banks' liabilities (deposits created when the loans were originated) remain, fully insured by the FDIC which has no money.

Through the magic of commercial bank double-entry bookkeeping, the banks' balance sheets are actually not exposed to decreases in the purchasing power, or present value of purely symbolic, completely worthless token dollars. They are, however, exposed to decreases in the value of their assets and to the risk of default that flows from deflation. Deposits are nominal liabilities that remain when assets deflate. So supporting deflation would be, to a bank, like suffering a masochism fetish.

Rick thinks the banks will defend their assets by keeping the dollar strong. But that only keeps their liabilities that much harder to meet while the effects of deflation tend to shrink their assets making it even harder still. Ignoring the dollar for a moment, and the flaw in Myers' dictum, what happens to a bank's balance sheet if all of the loans are defaulted at the same time? Or if the asset value of all of their collateral collapsed at the same time? It would have precisely the same impact. So would a mixture of the two. The banks have and are experiencing precisely this type of squeeze. How has their "guardian angel" the Fed responded so far?

Rick Ackerman's view of the banks' incentive or preference to prevent (as if they had that control) hyperinflation is exactly bass ackward. A bank's balance sheet becomes severely damaged in deflation, yet it is made whole through hyperinflation.

As for the pension funds, they hold this debt not for its value to maturity, but for its appreciation in a falling interest-rate environment and its liquidity in trade. Pension funds get in trouble when they cannot perform nominally. They hold nominal assets and make nominal promises (like 8% returns) which simply cannot be met in a deflation. However, as disastrous as hyperinflation is for pensioners (the funds' clients), it is a Godsend for the politically-connected pension managers who were being crushed by deflation.

So once again, the incentive or preference of those who hold the note on your mortgage to prevent (as if they had that control) hyperinflation is simply not there. In fact, as I will show in a minute, there will be ample incentive for these politically connected Power Elite Giants to actually encourage the kind of printing that will take an Icelandic-style currency collapse into full-blown Zimbabwe-style wheelbarrow hyperinflation. More on this in a moment.


What you see is the result of the perspective you choose

A small-minded ant's only interaction with Giants may be getting stepped on or sprayed with deadly poison. So from the ant's limited perspective, this activity of killing ants is what Giants live for, what motivates them, and what they spend their time scheming and planning for. Don't limit yourself to the ant's perspective. If you want to find the tasty morsels left by Giants, you've got to start thinking like a Giant. You can read more about ants in my post Life in the Ant Farm.

In his latest of several posts on this subject, Rick Ackerman presented two responses that he found "of particular interest." The second one is so ldo that I won't spend much time on it. It is a comment that explains the old truism, "you can't eat your gold." That's right, gold is not at its highest and best use being spent (circulated) as a currency during a hunger crisis. Instead, if you are one with PLENTY of net worth, gold is the very best way to shuttle your wealth THROUGH a crisis to the other side. If you are forced to deploy this wealth for food during a crisis, then you apparently planned poorly.

And with a little understanding of how a monetary collapse actually unfolds, flipping the switch on illusions and revealing reality, you'll find that the actual crisis itself will be relatively short-lived. My best guess is 6 months maximum—for the worst of it—beginning when the normal distribution of food abruptly stops. So transporting your wealth to the other side should be of great importance to those with significant savings. But if you are one of the ants that cannot distinguish between a monetary collapse and the myriad other problems with our civilization (i.e. you think that when the money collapses everything else goes to permanent sh-t as well—it doesn't by the way, look at history), then you probably think we'll be in a Mad Max wasteland for a generation or more after the dollar finally goes the way of the peso.

In that case, you should probably buy yourself a Texas ranch, a lot of guns, and a few friends to help you shoot those guns, like the Circle K Cowboys. The way I see it, the monetary collapse is going to reverse and ultimately correct many of those myriad other problems because reality will be uncovered and freed to exert its more balanced supply and demand dynamic.

But that's enough on the Texas Rancher's Thunderdome wasteland. The first of the two responses that Rick found "of particular interest" was an email he received from Charles Hugh Smith, the man "Of Two Minds" who is bothered by the "conviction" (or what he perceives as single-mindedness) of others, particularly hyperinflationists. He said as much in the email:

What bothers me is the widespread conviction that hyperinflation is “guaranteed.”

Smith is truly a man of two minds. He likes to stay uncommitted and agile, to trade against the crowd:

I certainly wouldn’t want to debate anyone because my arguments are those of a trader, basically, not an economist. Maybe we will get hyperinflation, I don’t claim to know… This smells like a one-sided trade to me, even if it is more of a meme than a trade.

I am up on a hill with a wide view of the valley. In this post I am attempting to share the framework in which you, too, can see what I see rolling in. It is a tsunami called currency collapse coming in, following a violent financial and economic earthquake, which in our case will end in probably the most devastating hyperinflation the world has ever seen. And the more people that come to see what I see rolling in; the more people that join me safely on higher ground with a view of the valley below, the more the man of two minds likes his contrarian position in the valley below. Did you see that newish video out of Japan? The one I have in mind?

In order to share my view with you, I am going to patiently work my way through Smith's email, correcting errors and explaining the flaws in his perspective as I go:

As we’ve both said, the other issue is, how do the Elites benefit from hyperinflation?

I think we can safely define Charles Smith's "Elites" by his own words as the Financial (Wall Street) Elites, the politically powerful (including politically connected corporations and unions/union pension funds), the "banksters robbing us blind" and "CONgress" along with all the politicians running this country into the ground; basically everyone running the Dollar International Monetary and Financial System (the $IMFS). And he asks how do "they" benefit from hyperinflation? Well, they will benefit, in the same way that those closest to the printer benefit tremendously in all hyperinflations. But more importantly, Smith's core perspective on "the Elites" is wrong. He makes the same mistake Karl Marx made, which I explained in my post The Debtors and the Savers. [I know, this is the second time I've linked this post. It is intentional. I'll probably do it one more time as well.]

What I described in that post last July is the essential foundation to the framework for understanding why US dollar hyperinflation and Freegold are, simply, unavoidable, or to use Smith's word, "guaranteed." I have been accused of overconfidence in my views. But I specifically and actively limit the scope of this blog to only these two topics. I'm certainly not a know-it-all. I only describe the things that can be clearly seen, and how to ascend to that perspective.

Was the Japanese guy shooting that video up on a hill overconfident about his view of the tsunami rolling in while those still down in their houses had a more rational, balanced opinion? Perhaps they were of two minds; on the one hand, there had just been a Richter scale 9 earthquake and they lived in a tsunami warning zone. On the other hand, they were not exactly ocean-front properties and it would have to be a pretty big tsunami to bring the ocean over that levee. Surely they would hear it coming giving them plenty of time to escape. It's all about perspective. With the proper perspective you can see things more clearly.

In The Debtors and the Savers I wrote:

Today we have many fine, intelligent and exacting analysts all looking at the same economic data and coming up with vastly different analyses of the present global financial crisis. What sets them all apart from each other is not intelligence, or math skills, or even popularity. What sets them apart is the foundational premises on which they operate.

And a false premise can skew a brilliant analysis 180 degrees in the wrong direction. Few analysts fully disclose their premises. But Karl Marx did, and in this we can find the one, key flaw that sent his analysis off in a disastrous direction.

Marx writes, "The history of all hitherto existing society is the history of class struggle." He got this part right! What he got wrong was his delineation of the classes.

Marx's classes were:

1. Labour (the proletariat or workers) - anyone who earns their livelihood by selling their labor and being paid a wage for their labor time. They have little choice but to work for capital, since they typically have no independent way to survive.

2. Capital (the bourgeoisie or capitalists) - anyone who gets their income not from labor as much as from the surplus value they appropriate from the workers who create wealth. The income of the capitalists, therefore, is based on their exploitation of the workers.

Simply put, Marx says it's the rich versus the poor. According to Marx the rich exploit the poor to get themselves a "labor-free income", which spawns a class struggle.

This is an attractive perspective because it requires only a cursory, superficial judgment to place someone into one of the two camps, the rich or the poor. If someone is driving a Bentley we immediately know which group they are in, right?

[…]

As I said, Marx got one thing right. History does bear out the dramatic story of centuries of class struggle. But if we eliminate his one small flawed premise, we can see it all much more clearly.

The two classes are not the Labour and the Capital, the rich and the poor, the proletariat and the bourgeoisie, or the workers and the elite. The two classes are the Debtors and the Savers. "The easy money camp" and "the hard money camp". History reveals the story of these two groups, over and over and over again. Always one is in power, and always the other one desires the power.

1. Debtors - "The easy money camp" likes to spend (and redistribute) money it did not earn, either by borrowing it, taxing the savers for it, or printing it. They like easy money because it is always and everywhere constantly inflating, easing the repayment of their debts.

2. Savers - "The hard money camp" likes to live within their means and save any excess for the future. They prefer hard money (or in some cases "harder" money) because it protects their savings and forces the debtors to work off their debts.

1789, the French Revolution, "the hard money camp" had been in power since 1720 when John Law's easy money collapsed, and starting in 1789 "the easy money camp" killed "the hard money camp" and took back the power. This is the way "the easy money camp", the Debtors, usually take power... by revolting against the hard repayment of their spending habits…

Obviously I don't want to reprint the whole article here, which is why I linked it three times. So please go read it.

But here's the fatal flaw in this Marxian paradigm; many of we, the modern proletariat, are savers who would prefer hard money like gold to protect our savings. It is we, the savers, that are punished by the current easy money system. That's why I delineated the groups as the Debtors and the Savers, otherwise known as "the easy money camp" and "the hard money camp."

And with the proper view of who Smith's Elite CONspirators really represent—the easy money camp, the debtors, the hungry collective—the answer to his question begins to develop. It is the opposing camp, the savers, that will be most-punished by hyperinflation and it is Smith's Elite that will profit the most during the race to spend.

If you can start to think of the administrators of the $IMFS, the "banksters", politicians and Western Capitalists in charge of the system as being firmly entrenched in the Debtor camp, you are well on your way to a very rewarding enlightenment. I realize this is counterintuitive, and counter also to much of the baggage that accumulates while reading other "hard money" writers on the Internet, which is why I spend so much time on it. But once it clicks, you'll be like, "OMG! WTF was I thinking?" I have conversed via email with many extremely intelligent people that have had this momentous "click", so I am tempted to consider that I may be on to something.

So call me overconfident if that makes you feel better, but I'm not going to be wishy-washy about what I can see. I'm certainly not of two minds on this.

How will "the Elite" profit from hyperinflation? By being the first to spend the bills with new zeros added and thereby outrunning the rest of us in the race to spend and winning the competition to retain standard of living. Hyperinflation is the end result of the dollar-debt timeline, there is no other way it can end. Only the severity is a variable to be considered.

Rick Ackerman and other deflationists agree with me that the unsustainable, unstable mountain of debt must and will collapse. And they view "the Elite" as the capitalist creditors and the rest of us poor working saps as the proletariat debtors. Therefore they believe that when the debt mountain collapses, their version of "the Elite" will not print Zimbabwe-style because, even though they just took a tremendous haircut on their bonds, they want to be sure that the super-saps among us, the proletariat that are still working, will continue to service the remainder with dollars of today's purchasing power.

This is a bass-ackward view in my opinion. The hungry collective provides ample political backing and sufficient naiveté for "the [Western] Elite" to print the full face value of their bonds and dump that worthless paper on the public's front lawn. Furthermore, deflationists like Ackerman as well as practically all mainstream economists provide plenty of cover in the form of plausible deniability that hyperinflation would be the inevitable result.

But the story runs deeper still. The reason I have been putting "the Elite" in quotes or referring to them as "Smith's Elite" is because, not only does he have the delineation wrong, but he is myopically focused on only one quarter of the bigger picture.

Some of you, I know, like to think in terms of grand conspiratorial conflicts, a "Clash of the Titans" (Clash of the Elites if you will), or something like that. Well I can probably help you with that view in this "Debtors v. Savers" paradigm.

We have the West which is roughly only 25% of the world's population, and then we have the rest of the world. And oh yes, they have their own "Elite". You'd probably guess that "the West" represents "the debtors" in this paradigm. But you'd be wrong to assume that the rest of the world is taking "the hard money camp" stance.

It is true, we are at the end of one of the longest-running "easy money camp" regimes. And these things usually swing back to the other side. But history has taught the world that while easy money regimes end in financial collapse, hard money regimes usually end in bloodshed. And it's usually the blood of the hard money campers that is shed. (See: the French Revolution.)

So the rest of the world has taken a different stance this time. It has been "in the works" for several decades.

Q: **Who does BIS really represent?

A: "old world, gold economy, as viewed thru modern eyes" or "way to move from US$ without war".

Those are the words of ANOTHER from my post "The Gold Man" (not Goldman) at the BIS. The BIS truly represents "the rest of the world" from a monetary perspective. It is the "trade union" of their Central Banks. All is not as it seems on the surface.

So how do you view an "old world gold economy" through modern eyes? And how do you move there peacefully with the easy money camp? It's quite simple actually. You let nature take its course, you support that natural course however long it takes (rather than pathologically fighting nature like the dollar system does with its obsessive-compulsive drive to control), and you don't deprive the easy money camp of their precious fiat. It's Freegold. It is about allowing meritocracy to rise like a Phoenix from the ashes of the dollar's inevitable collapse. It's not about a transfer of wealth. It is about a re-born meritocracy. The transfer of wealth that will take place is what blinds most people from seeing its inevitable approach.

More from Charles Hugh Smith via Rick's Picks:

As we’ve both said, the other issue is, how do the Elites benefit from hyperinflation? The only answer I’ve ever received is “they’ve already bought gold.” Yeah, right. As I noted, there’s $7T in gold, total, half of which is owned by central banks, and there’s $160T in financial wealth to protect in the world. Even if gold went to $10K/oz there would be no more than $35 T in gold in private hands, and by that time, the gold in Fort Knox (or in the PBoChina vaults, etc.) would be enough to establish a gold-backed currency. Meanwhile, the Financial Elites would have lost all their financial wealth. Have they really transferred all their wealth out of all financial instruments and totally into gold and land? If so, then [who] owns the $160T in financial wealth?

First of all, it is unclear exactly how much gold there is, but it's probably over $8T by now, and only about 18% of it is owned by central banks, not anywhere near half. That leaves $6.6T in private hands, at today's price.

Smith exposes his ant-like perspective in this paragraph when he implies the Giants that own the lion's share of $160T in financial products should have already crashed the value of those financial products and exploded gold in the stampede from one to the other, if a collapse of the dollar was really on the horizon. On the contrary, you have to think like a Giant to see the best way to move your Giant wealth from one system to the next. True Giants do not panic out like ants, nor like ants imagine that Giants would. True Giants know that if they panicked out, with the weight they carry, they would end up transferring much LESS wealth into the new system.

Viewed from the Giant's perspective, you can see that most all of that dollar value, that $160T will vanish in a flash. And when that happens, the market for paper promises of gold delivery will also collapse and vanish as physical gold gaps up (in my estimation) 40x. That's right, $160T vanishes, and $6.6T worth of gold—in private hands—gaps up to $264T.

Oooh. Now I'll bet I've got the deflationists screaming! "You can't turn $160T into $264T in a flash during a deflationary collapse!" Au contraire, mon frère. What you see is the result of the perspective you choose. Reader "Reven" recently asked this same question, to which I replied:

It is a fallacy to compare a snapshot of gold with a snapshot of "global asset values" because it ignores the time dimension in which gold flows. Even if you are correct about everything in the world (other than gold) being worth [$160T] in 2011 constant dollars, the value of all the gold can be multiples of that amount. It is theoretically unlimited, unlike paper wealth which is self-limiting by its own objective metrics and economic ties. Paper wealth is limited to the upside but unlimited to the downside. Gold is the inverse of paper, unlimited to the upside, limited to the downside. It's not the total stock of gold that matters, but the flow from those that already hold it.

Here are a few snippets from my post How Can We Possibly Calculate the Future Value of Gold?

1. the storage of purchasing power is size-unlimited in a solid medium with potentially infinite confidence and one that does not infringe upon anything else, and

2. the storage of purchasing power in a flawed medium with a mathematical limit (like debt) is constrained roughly to the aggregate purchase price of everything in the world at any point in time, with a decent margin of error.

[...]

This transfer of wealth that is coming is not a direct and equal transfer. It is not like pouring one pitcher into another. It is more like flipping a switch on the virtual matrix. Turning off the monetary plane that hovers over the physical plane and claims to tell you how much "stored purchasing power" everyone has. When you turn it off, all that purchasing power disappears in a flash. And then what lies beneath is exposed in daylight, the real physical world. No real capital is destroyed, only the myth is destroyed. But true capital is exposed and revalued.

And as I said earlier, true capital as a storage for purchasing power has no limit whatsoever to its total size relative to normal prices. This is because it uses the time dimension with unequalled confidence. Absolute confidence allows it to stretch as far out into time as it wants. And this confidence is a self-reinforcing, self-sustaining feedback loop in the same way that a faulty store of purchasing power is self-limiting by its intrinsic lack of infinite durability.

[...]

Commodities and paper investments are limited to the upside by economic forces and future earnings metrics respectively. Yet they are unlimited to the downside for the same reasons. Gold, on the other hand, has none of the upside limitations that everything else has. It will only find its point of equilibrium when enough "stock" is reassigned to "flow" to meet demand.

[...]

Lastly, understand that currency flows through assets, not into them. In fact, a limited amount of dollars can flow through the same gold many times, over and over, driving it higher and higher with each pass, as long as new gold stock is not coaxed out of hiding. And the interesting thing in this process is that, as I said above, it actually causes the opposite of the expected supply/demand reaction. With each pass-through of the dollar more "flow gold" is moved into "stock gold", not the other way around like commodities and paper.

This is the feedback loop. It is confirmation to the gold investor that his gold is a good investment. And it also says something very distinct about the alternatives. Namely that they are failing. And with this confirmation, it is from existing gold holders that less supply comes. This is not true of any other investment class because they all have objective metrics for valuation or economically limiting forces. All except gold.

[...]

So, cutting to the chase once again, the biggest fallacy in your model is using "Total above ground gold" as your point of comparison. It's not the stock that matters, it's the flow.

Now, if you have a supercomputer you can try to run this unimaginably complex flow algorithm. But be careful with your assumptions. One wrong assumption can throw the whole thing off by orders of magnitude.

Back to Smith. Here's that same paragraph again. Let's see if we can answer his questions a little more concisely now that we have a new perspective:

As we’ve both said, the other issue is, how do the Elites benefit from hyperinflation? The only answer I’ve ever received is “they’ve already bought gold.” Yeah, right. As I noted, there’s $7T in gold, total, half of which is owned by central banks, and there’s $160T in financial wealth to protect in the world. Even if gold went to $10K/oz there would be no more than $35 T in gold in private hands, and by that time, the gold in Fort Knox (or in the PBoChina vaults, etc.) would be enough to establish a gold-backed currency. Meanwhile, the Financial Elites would have lost all their financial wealth. Have they really transferred all their wealth out of all financial instruments and totally into gold and land? If so, then owns the $160T in financial wealth?

Yes, they've bought the gold and it's still priced at around $6.6T, at least that portion that is in private ownership. No, there will be no gold-backed currency because we aren't going back to "hard money" because "your Elites" wouldn't like that. No, they won't lose all their wealth; they will gain wealth. Here are the steps as viewed, not by ants, but by Gi-ants:

Step 1: Buy up as much physical gold as you can over a couple decades without running the price and without panicking out of your paper, while the Western investor is caught up in all manner of paper including paper gold.

Step 2: Wait patiently for the inevitable financial collapse. As Rick Ackerman himself wrote, "financial collapse is not just likely, but inevitable."

Step 3: When the collapse comes, sell that $XXXT in "financial wealth" to the printer for fresh cash at full face value in the name of "saving the system" and "survival of the country and the Western way of life."

Step 4: Spend the new cash.

Step 5: Adjust your balance sheet from the old paradigm where it used to read $160T paper/$6.6T gold to the new paradigm where it now reads $0 paper/$264T gold. A net gain of $97.4T.

Now I must explain here that I don't view this as a nefarious plan, plot or con. It is simply the way you deal with the inevitable collapse of the global reserve currency at the end of its financial timeline. And if you are a Gi-ant, it's the clearest way to transfer your wealth through the crisis and into the future. You don't do it with a high-yielding bond Con and a sustained deflation. LOL Gimme a break!

And if you think Congress will prevent the Fed from doing what it did in 2008… and 2009, 2010 and 2011… guess again. The USG will face a real, existential shut down this time. Nothing like the charade that happens every few years when it's time to renew the budget or raise the debt ceiling. This will be the real deal. Congress will DEMAND that the Fed print "for the good of the country" (and for their own paychecks).

Back to Smith:

This explanation — that the wealthy have already transferred their financial assets into gold and land and thus they don’t care if all money, bonds, mortgages, derivatives, insurance policies, etc. all go to zero and is wiped off the books as an asset—makes no sense because it doesn’t explain who is the bag holder to all this “fiat-based” wealth. If the wealthy don’t own all these financial assets, who does? Who did they sell it all to? Yet we know that the Financial Elites own all this financial wealth and thus it will not be in their self-interest to see it wiped out. Only debtors, i.e. Central States, want to see hyperinflation to wipe out their debt. But who considers all that sovereign debt an interest-paying asset? The Financial Elites, that’s who, along with politically powerful union pension funds, banks, etc.

Yes, I know I have already addressed everything in this paragraph. But I wanted to show you how silly it starts to read once you have a different perspective. Moving on:

Everyone seems to forget that debt is an asset to the guy on the other side of the trade. The debtor would love hyperinflation but the owner of the debt will resist hyperinflation with every fiber of his being — and that includes the Financial Elite who own the debt.

Okay, here Smith moves into the first of his two strongest complaints about hyperinflationists. Remember up at the beginning of this post I wrote that in 2008 I didn't find many of the arguments convincing on either side of the debate? That is, until I read FOA? Well, clearly Mr. Smith has not read much of my blog, not that I'd expect he had, because his two complaints are completely backward in their reasoning.

Those two complaints are that he views hyperinflationists as i) not considering that debt is an asset to someone else, and ii) that hyperinflationists don't understand that hyperinflation is a POLITICAL event and not a mechanical or "deterministic" event. Once again I had to LOL when I read this backward view.

I think it's time for me to post links to my three part series again, in which I DRIVE HOME these two topics… and how they inevitably end in hyperinflation, not deflation:

Just Another Hyperinflation Post - Part 1
Just Another Hyperinflation Post - Part 2
Just Another Hyperinflation Post - Part 3

If you haven't yet read them, you should probably start with the post I made just prior to those, Credibility Inflation, in order to understand what is actually deflating in our hyperinflation.

Basically, regarding Smith's paragraph above, "the guy on the other side of the trade," if he is well-connected enough to be considered "the Financial Elite who own the debt" would prefer to be relieved of that "asset" at full face value as long as he's getting that cash first. Remember, hyperinflation is a race, not against the bear (you can't outrun the bear) but against your neighbor.

Next:

This is basically a “politics of experience” analysis, and very few are equipped to understand such an analysis, as it’s outside their econometric comfort zone. They prefer a deterministic financial analysis that there are “laws” of economics which lead to hyperinflation, etc. Meanwhile, for me, there are only political choices, a narrow band of which lead to hyperinflation and a bunch of others which do not. This kind of analysis doesn’t lend itself to refutation or confirmation by financial models of the sort being bandied about — it’s a behavioral analysis and a political one.

I have yet to see how banks and the Financial Elites would benefit from hyperinflation. Without getting too fancy, it’s obvious that holders of debt, those collecting interest on debt assets, would be wiped out by hyperinflation. Thus as a simple matter of self-interest, we can deduce they will not favor policies that lead to hyperinflation. If the owners of debt (Treasuries, mortgages, corporate debt, commercial paper, etc.) were politically powerless, then we could expect them to be steamrolled by those who would benefit from hyperinflation. But they are not politically powerless — it’s the debtors who are powerless, except for the Central State, and it’s beholden to the Financial Elites who have captured the political and regulatory classes that govern the State.

This is the introduction of Smith's "it's about politics, and hyperinflationists don't get that" argument, which he refined in his next post on his own blog titled "Con of the Decade" or something like that. (By the way, this came out after Smith's blog post, but if there's any truth to it, it pretty much demolishes Smith's con idea and ensures—or insures—hyperinflation.) In that post Charles Hugh Smith pretty much threw down the gauntlet on this issue in the opening paragraph:

I described The Con of the Decade last July (2010). The Con makes me a heretic in the cult religion of Hyperinflation. I consider myself an agnostic about the destruction of the U.S. dollar and hyperinflation (basically the same thing), but my idea that hyperinflation is fundamentally a political process makes me a heretic. I skimmed a few of the dozens of comments posted on Rick's Picks and Zero Hedge after they posted one of my expositions on this dynamic, and didn't see even one comment in favor of this perspective.

Now I'm not sure if this is technically a straw man fallacy if Smith has never read FOA or FOFOA. Perhaps not. In any case, here are a few quotes from my hyperinflation posts:

What is a deflationist? It is one who looks very closely at the present structure of everything, the laws, the rules, the regulations, what is supposed to happen, who should fail, etc… but ignores the political (collective) will that backs it all up. The same political will that always changes the rules to suit its needs as surely as the sun rises. And it is this political will that makes dollar hyperinflation a certainty this time around.

[…]

As FOA warned 12 years ago, these bailouts were always baked into the cake. They are a mandatory function of the political will that backs the entire system. This is the main element that all of the deflationists miss.

[…]

The political will (which is the same as the collective will in my lexicon) always does whatever will lessen the immediate pain, even if it will most certainly cause greater pain later. This is the part that is as reliable as the sun rising.

[…]

Because we have a purely symbolic currency, a dollar-denominated deflation is impossible... because of the political will I mentioned above!

[…]

But this is also where the political (collective) will comes into play. It will NOT let that savers' balloon deflate. The Fed is helpless against the debtors' balloon and the credit/debt feedback loop, but it is most certainly NOT helpless against the savers' balloon.

The Fed has the power to keep the savers' balloon 100% full if it wants to, and the political will to fully back that action.

[…]

This is an excellent description of what the deflationists see, and also why they don't see the rest of the big picture. They view the monetary world as a machine rather than a human ecology. They underestimate the will of the "politicians and bureaucrats who are playing God." And they also underestimate the power of fear and monetary velocity.

I think you get the picture. But if you really want to get to the heart of this subject and see where Smith and the deflationists (notice I'm not calling Smith a deflationist here) go wrong on cause and effect with regard to hyperinflation and political will, you should read noteworthy deflationist Mish Shedlock's comment under my "Part 3" where he defended his post saying:

"I explicitly said hyperinflation is a political event… The amazing thing is I was agreeing with you…"

And my responding comment where I wrote:

"…Velocity can have the same exact effect as printing. Would you agree with this statement? Fear is the spark that ignites it. And then the government will need to fund itself in this hyperinflationary environment. This will entail THE massive printing that always follows immediately after hyperinflation starts. ***THIS IS THE POLITICAL EVENT THAT I AM TALKING ABOUT*** Not the priming beforehand. That's already done. We are already in the summer of 1922…

…It is this LATER political event that is 100% guaranteed. That our government will debase its currency TO ANY DEGREE to ease its own fiscal pain. And as for the cause, the prime, it's already there. Has been for at least 10 or 12 years now…"

And then Mish's follow-up where he writes:

"…I agree with FOFOA about what starts hyperinflation. I wish I would have made that perfectly clear in my post.

I disagree with him in regards to whether or not "politics" or as FOFOA calls it (loss of faith) makes the US more vulnerable.

It was a very gentle disagreement."

I didn't call Smith a deflationist because I don't know if he is. I haven't read enough of his blog to know if he's ever categorized himself. Usually deflationists are happy to categorize themselves as such, as in the case of Mish and Ackerman. But Smith appears to be a simple skeptic, a man of two minds, as he wrote in closing of that email to Rick Ackerman:

Maybe we will experience hyperinflation after all. I am a skeptic, not a true believer, but I am certainly open to it as a possibility. I think all the financial arguments are somewhat akin to biblical debates about how many angels can dance on the head of a pin. They are fundamentally deterministic and apolitical, while the actual process of setting policies that lead to hyperinflation is entirely political.

I have no econometric arguments against hyperinflation, I only have political ones. But since politics sets policy, then hyperinflation is necessarily a political choice. So a political analysis will trump an econometric one in my view.

But I could be wrong. As a basically poor person, I don’t have much of a stake in either outcome.

If Charles Hugh Smith happens to be reading this post, and I hope he is, I would like to point out that my hyperinflation arguments cover the gamut. And thanks to Rick Ackerman, I now have kudos from both camps, deflation and (hyper)inflation:

Deflation camp: "The very best of them, in my opinion, is FOFOA blogspot, where the essays are erudite, the discussion elevated and the arguments as knowledgeable as any you will find on the web."

[Hyper]Inflation camp: "FOFOA is probably one of the very best analyst in the whole world. The more I read from him, the more I am convinced of his vast superiority over most experts and analysts, probably of the Schiff-Turk caliber… This is one of the very best contributions in the inflation-deflation debate. It is long and detailed, but the topic is extraordinarily complex."

I really despise self-promoting in this way and risking coming across as if I think too highly of myself. The truth is quite the opposite, and I only post these so that skeptics like Smith will at least consider my arguments rather than dismissing them outright. I know my posts are long, and I know that some people think I'm just a crazy gold bug, which I am not. So there has to be a good reason for a skeptic to make that commitment of time and energy. And if he's read this far in my longest post ever, then at least that's something!

Now before I wrap this treatise up, there was one thing I said I would come back to that I haven't yet. And that is, if hyperinflation is guaranteed, why aren't all these hyperinflationists snatching up real estate left and right on the leverage that's still available? I, for one, don't have a mortgage. I don't even have any debt because I don't have an income, other than donations from this blog, to cover the carrying cost. And back when I was following Peter Schiff he was a proud renter too. Perhaps he still is, I don't know. There are literally dozens of answers to this question, almost all of them extremely personal. But the bottom line is that real estate will continue to fall in real terms even more than having an LTV of 95% hyperinflated away would cover.

Even if you accept that hyperinflation is 100% certain, real estate is still a poor investment choice to carry your wealth through. Gold is so much better that real estate shouldn't even be considered an investment choice (choice, as in a new investment) beyond your primary residence. Even with 10x or even 20x presumed leverage in a near-term debt wipeout, unleveraged gold is still a much better choice. And in addition to it being the lesser choice, leveraged real estate also carries a non-zero political risk in hyperinflation. I'm giving this an extremely low probability in today's world, but under any kind of conservative and personal "one percent doctrine" it must be factored heavily into the equation that includes expected leverage and the carrying costs on an unknowable timetable. This is an excerpt from an email I received a while ago:

Today I read a short little book titled Fiat Money Inflation in France by Andrew White (published 1912). My general impression is that there is no law so insane that it can't be enacted during a hyperinflation. As you may know, they even passed a law such that debts increased along with the issuance of further currency, so that for every so many additional assignats printed, one's debts increased by 25%. Thus they took away the one silver lining of currency debasement for the middle class. What a nightmare. I liked this bit:

"All this vast chapter in financial folly is sometimes referred to as if it resulted from the direct action of men utterly unskilled in finance. This is a grave error. That wild schemers and dreamers took a leading part in setting the fiat money system going is true; that speculation and interested financiers made it worse is also true; but the men who had charge of French finance during the Reign of Terror and who made these experiments, which seem to us so monstrous, in order to rescue themselves and their country from the flow which was sweeping everything to financial ruin, were universally recognized as among the most skillful and honest financiers in Europe. Cambon, especially, ranked then and ranks now as among the most expert in any period. The disastrous results of all his courage and ability in the attempt to stand against the deluge of paper money show how powerless are the most skillful masters of finance to stem the tide of fiat money calamity when one it is fairly under headway; and how useless are all enactments which they can devise against the underlying laws of nature."

Okay, last thought on the real estate home front, and then I'll let it go. I have a question for Rick and his commenter SD1 from the top of the post. Remember they wrote:

Rick's Picks Commenter SD1: To my knowledge, no bank has ever made provisions in their lending criteria. So to anyone subscribing to the hyperinflation theory, all I can say is there is nothing I, and millions of other North Americans, would love more than to take $250,000 of worthless, hyperinflated money that we worked a few days to make, to pay off a mortgage that would otherwise have taken twenty-five to thirty years to repay.

Rick Ackerman:That’s the bottom line, as far as I’m concerned.

How close to the business end of the printing press are these millions of North Americans? You guys seem to assume that, during hyperinflation, millions of American mortgage payers will have access to this river of cash early enough to benefit overall. By the time they get their hands on it they may be struggling to meet other skyrocketing expense like property taxes and, uh, food. Wages won't keep up. Most people simply won't be able to keep up. And most of those who do will find that their wealth relative to those closest to the printing press will be declining. Like I said this is about outrunning the next guy, not the bear.

This is why I wrote, "if you don't make the effort to understand what is actually unfolding, there's a good chance [hyperinflation] won't [deliver any windfall in your direction]." If you really want "to pay off a mortgage that would otherwise have taken twenty-five to thirty years to repay," then you'd be best equipped to do so by buying some physical gold right now!


Inevitability

Here is Rick's premise once again: “Ultimately, every penny of every debt must be paid — if not by the borrower, then by the lender.” If the borrowers can't pay, at least not in full, and certainly not in real terms (today's purchasing power), and the politically connected lenders won't take the hit, that only leaves the third option which C.V. Myers missed and Rick can't seem to fathom.

How do I know hyperinflation is inevitable? I know that they will do the "front lawn dump" not only because they said they would do it, and then did it, and they continue doing it, but because it makes absolutely no logical sense, from their perspective, to NOT do it in the face of a crushing deflationary collapse like both Rick and I see as inevitable. It will be judged an infinitely better option than immediate total economic collapse. And besides, 75% of the world has been waiting patiently, for a long time, to get off the dollar standard. And it has prepared for this very, inevitable, eventuality. So it won't be fought from abroad.

This is very important: Once hyperinflation commences it is characterized by a running shortage of cash, even though it appears like the opposite to the outside observer. The currency collapses in value against economic goods because the debt and the credit collapsed. There is no credit, only cash, and there is a shortage of cash for everyone, including the Elite and the government. So they, the Elite/government, print and print for their own survival while saying it is for yours.

And for those of you that think they won't do it because they'll be afraid it will end the dollar, end the Fed, or end fiat currency altogether, guess again. Not a chance! After it's all said and done, Bernanke will say some sweet things like his cuddly Zimbabwe counterpart did in this 2009 interview:

Gideon Gono: "I've been condemned by traditional economists who said that printing money is responsible for inflation. Out of the necessity to exist, to ensure my people survive, I had to find myself printing money. I found myself doing extraordinary things that aren't in the textbooks…

"There are certain things, policies with the benefit of hindsight, where we could've managed our affairs better… We are [only] human…

"Only a fool does not change course when it is necessary. Because economics is not an exact science, you want to be able to be relevant. The only constant is change and adaptation…

"It's a free market, a business which must be allowed to succeed or fail…

"What keeps me bright and looking forward to every day is that it can't be any worse. And those who have studied the history of economies know that we are down, but that the only thing that can happen is we will move up. That is a certainty…

"I am modestly credited with the survival strategy of my country. The issue is if you want to break Zimbabwe and want it to fall, just deal with one man. You deal with Gideon Gono…

"I'm a normal guy: I miss going to the supermarket. One would like more freedom…

"If you raise the interest rate you'll be friends of people who have access to money. If you lower the interest rate, you'll be the darling of borrowers, but pensioners will curse you to hell. It's never about popularity. At all times you are definitely hurting some people in the economy…

"It's impossible to be directing the course of an entire economy and divorce yourself from politics. Politics are important because the turnaround of the economy hinges on political stability, but I can't tell when that will happen…

"I have been in the trenches during every moment of survival for my country. Any central bank governor is of necessity. When things go bad, we governors are the fall guys. No other governor in the world has had to deal with the kind of inflation levels that I deal with, no other governor has to come up with the gymnastics and strategy for the survival of his country. But let me say that in my bank resides the cutting edge of the country. I'm privileged to be the leader of that team."

Zimbabwe still has a Central Bank, and Dr. Gideon Gono still has a job as its governor. It will likely be no different for Bernanke and the Fed. Extreme times call for extreme measures. And that's how it will be spun. They will print for survival and they will say it was for the survival of America. The dollar will end this thing without reserve currency status, more like the peso. But at least we'll have Freegold!

In our time and for the first time in the modern US dollar history, the US will embark into a classic hyperinflation for the sake of retaining its own lessened dollar for trade use. As destructive as that might be to players in this financial house, it is better than immediate total economic failure. It will evolve in a form much like the course of any other third world country, if its currency too was suddenly deprived of world reserve status. We will, like people the world over, learn to live with it and live in it. Truly, our dollar and economy will not go away, but its function, use and value will change dramatically.

Thank you
FOA/ your Trail Guide

Happy Easter!

Sincerely,
FOFOA



Something filled up
My heart with nothing
Someone told me not to cry

But now that I'm older
My heart is colder
And I can see that it's a lie



Children, wake up
Hold your mistake up
Before they turn the summer into dust

If the children don't grow up
Our bodies get bigger but our hearts get torn up
We're just a million little gods causing rainstorms
Turning every good thing to rust

I guess we'll just have to adjust

With my lightning bolts a-glowin'
I can see where I am going to be
When the reaper, he reaches and touches my hand

With my lightning bolts a-glowin'
I can see where I am going
With my lightning bolts a-glowin'
I can see where I am go-going

You better look out below!

Black Swan Events and How to Hedge Them

from Zero Hedge:

With all the hoopla over Egypt some have forgotten that this is merely a geopolitical event (one of those that absolutely nobody, with a few exceptions, was talking about less a month ago, so in many ways this is a mainstream media black swan which once again exposes the entire punditry for the pseudo-sophist hacks they are), and that the actual mines embedded within the financial system continue to float just below the surface. Below we present the five key fat tail concerns that keep SocGen strategist Dylan Grice up at night, which happen to be: i) long-term deflation, ii) a bond market blow-up, iii) a Chinese hard-landing, iv) an inflation pick-up, and v) an Emerging Markets bubble. Far more importantly, Grice provides the most comprehensive basket of trades to put on as a hedge against all five of these, while also pocketing a premium associated with simple market beta in a world in which the Central Banks continue to successfully defy gravity and economic cycles. For all those who continue to trade as brainless lemmings, seeking comfort in numbers, no matter how wrong the "numbers" of the groupthink herd are, we urge you to establish at least some of the recommended trades in advance of what will inevitably be a greater crash than anything the markets experienced during the depths of the 2008 near-cataclysm.
But before we get into the meat of the piece, we were delighted to find that Zero Hedge is not the only entity that believes that providing traditional annual forward looking forecasts is nothing more than an exercise in vanity (and more often than usual, error).

At this time of the year we’re supposed to give our predictions for what’s in store for the year ahead. The problem is I don’t have any. Not because making forecasts is difficult. It isn’t. It’s just pointless. Instead, I suggest getting in touch with our inner Kevin Keegan, the hapless former England football manager who, facing the sack after a bad run of results famously lamented “I know what’s around the corner, I just don’t know where the corner is.” The more people construct portfolios on the assumption that they can see the future, the greater the opportunity for those building portfolios which are robust to the reality that we can’t.

That said, no matter how ridiculous the act of Oracular vanity ends up being, those who charge an arm and a leg for their "financial services" continue to do it, only to be among the first carted out head first when reality is imposed upon them and their blind belief that this time is different and the crowd is actually right. Few are willing to accept and recognize the humility that they really know little if anything about how a non-linear, chaotic system evolves. Which is once again why we believe that Grice is among the best strategists out there: in his attempt to hedge the stupidity of the crowd, he has coined a term that may well be the term that defines 21st century finance and economics: instead of foresight, Grice believes the far more correct term to explain the process of prognostication should be one based on foreblindness.

In financial markets, craziness creates opportunity. It affects only prices, not values. And one of the craziest afflictions I know of is our faith in our ability to see the future. Indeed, there isn't even an appropriate opposite to the word "foresight"  in the English language. So I'?m going to make one up. And rather than build a portfolio based on the pretense we have foresight, let's explore some ideas for building one that is robust to our foreblindness.

This is the kind of insight that one will never find from a TBTF "strategist"... And one wonders where all those softdollars go.
So now that we know that unlike the traditional cadre of sell side idiots who are always wrong in the long-run, Grice actually admits that he has no clue what will happen, which is precisely the reason to listen far more carefully to what he has to say.
Let's dig in:

Here are some things I think are true:

• developed economy governments are insolvent
• Japan is the highest risk developed market (DM) to an inflation crisis (though it might be Greece)
• there is too much debt around
• China?s economic model is biased towards misallocating resources
• every country which has industrialized has experienced nasty bumps on the way
• China and the US are in the early stages of an arms race
• demographic trends suggest more conflict in the oil rich regions of the world
• bottlenecks are developing in key commodity markets
• the only thing central banks are good at is blowing the bubbles that cause the crashes which are used to justify their existence
• market prices only reflect fair value by accident and in passing
• most people don't think these things are important
• they might be right.

Here are some things I know are true:

• perceived uncertainty causes emotional discomfort which isn't conducive to good decision making
• all the above situations have the potential to cause significant asset price volatility
• I have no idea when.

What to do? To my mind, the ideal is not to make huge bets on particular events happening because failure of the expected event to materialize will materially endanger your capital. Instead, the ideal is purchase insurance at a price which won't materially pressure the returns from your core portfolio of investments if the event fail to materialize, but will protect capital from significant impairment if it does.

Is such an ideal attainable? By evaluating insurance and using the same valuation discipline you'd apply to anything else, I think it is. So what follows is not a list of recommendations here, or even any suggestions. Everyone should do their own homework. What follows is an illustration of why I think the macro research we've been doing is relevant and can be used to lower portfolio risk. The insurable risks I'm most worried about at the moment are:

• long-term deflation
• a bond market blow-up
• a Chinese hard-landing
• an inflation pick-up
• an EM bubble

The first thing you?'ll notice is that these aren't all consistent with one another. It's difficult to get a Chinese hard landing and an EM bubble at the same time, for example. But internal consistency is overrated. It's only relevant for point-in-time forecasts, and the assumption underlying this entire exercise is that I haven't a clue if/when any of what follows is going to happen. At the risk of repetition, I'm interested in the possibility of building a profitable portfolio which is robust to my ignorance.

Let's take a look at the five fat tails in detail:
Long-term deflation
Not surprisingly, Grice gives the least amount of weight to the one thing most troubling to such economic disgraces as Ben Bernanke and Paul Krugman. Yet it should not be avoided. After all there are many deflationists out there, who believe that the Fed, which has now clearly telegraphed it is all in on reflating (or after the Fed, the monetary collapse deluge) may actually succumb to what has been ailing Japan for two decades.

According to economists the primary risk faced by economies is that a huge deleveraging spiral becomes self-fulfilling: deleveraging reduces demand, which lowers prices, which further lowers demand, and so on. The idea was first developed by Irvine Fisher in the 1930s to describe the great depression, and has been used to explain the ?First Great Depression? of the 1870s and Japan since the early 1990s.

Paul Krugman says everything has changed because we?re in a liquidity trap. The fear of prolonged deflation is what keeps poor old Ben Bernanke awake at night. And maybe that's the clue. At our London conference this year, James Montier said that Bernanke  as the worst economist of all time. Now, I'm not sure I agree with James on this one because I can't make up my mind, sometimes I think it's the Bernanke, other times I think it's the Krugman. But usually I think nearly all economists to be the joint worst economists of all time. So I have a lot of sympathy with the idea that if the consensus macroeconomic opinion is worried about something, it probably isn't worth worrying about. In fact, if they worry about deflation, I'm going to worry about inflation.

We couldn't have said it better ourselves.
So how does one trade deflation insurance?

More importantly though, deflation insurance is expensive. The following chart shows the price of 5y 0% US CPI floors to be trading for just under 200bps. The way these floors work is that they provide the owner of the contract with the right to payments equal to the rate of deflation. Since the floors in the chart have a five-year maturity, they entitle the owner to five annual payments. For example, if inflation was -1% in year one, the owner would receive 100bps of the notional value of the contract. If inflation was -1% in year two, he'd receive another 100bps. And if the rate of deflation remained at -1% for years three, four and five, he'd receive 100bp cash flow for each of those annual payments so that over the life of the contract he'd have received a total cash flow of 500bps. So if you're worried by the prospect of CPI deflation, this is the product for you.

And skeptical though I am of the debt deflation hypothesis, Western demographics worry me. Although we don?t know what aging economies look like, we know that the glimpse into the future provided by Japan isn't encouraging. So I do take the scenario seriously and would be happy to put the hedge on at the right price. The problem is, I don't think the price is right. I think this insurance should be sold, not bought.

Chinese Hard Landing
While Grice is obviously far less worried about a systemic deflation scenario arising out of events in the US, what may happen in China is obviously a far riskier proposition, and one that could generate deflation out of the proverbial "Hard Landing." Luckily there is an instrument with some wonderfully convex properties to hedge this...

Albert calls China a ‘freak economy.’ Certainly, running with an investment to GDP ratio of over 50% doesn't seem normal. Neither does keeping interest rates at 5% when the economy is growing by 15% in nominal terms each year. Such lax monetary conditions have helped land prices rise by 800% in the last seven years, according to NBER economists. And when you come to think of it, more recent examples of real estate inflation fueled by negative real interest rates: Ireland, Spain, the US didn't end too well. Jim Chanos says China is a shortseller's dream and that there's not one company he's looked at that passes the accounting sniff test. And if Jim Chanos, who built a very successful business around spotting accounting gimmickry says something like that, my guess is he's right.

Taking a step back though, as far as I?m aware all industrialized countries have experienced financial crashes. It seems a part of the maturing process. Why should China be any different? A credit crisis wouldn't necessarily mean the end of the China story any more than the panic of 1873 meant the end of America's, (though US demographic prospects were considerably more favorable at the end of the 18th century than China's are today). For the record, I think the Chinese have a bright future. My son is learning Mandarin. But when I look at the numbers I can't help but think there's going to be a crash and that it's going to be  quite unpleasant. It's just that my guess as to when it's going to happen is as good as Kevin Keegan's.

What happens if and when the inevitable crash happens? One word - Australia. Another word(s): 10x-20x payout.

When it does happen though, the Australian economy will be toast and its government bond yields will collapse. During the panic of 2008, AUD 10y swap rates fell around 3% to 4.40%.

The panic of 2008 was a "good crisis" for Australia though. A Chinese crash would be more serious.

And you can get pretty attractive odds on AUD rates collapsing. The following chart shows the payout available using AUD receiver swaptions prices with a three-year maturity, based on the 10y swap rate. Effectively, these are put options that pay out when rates fall below the strike price. The prices I've used here are from Bloomberg based on the swaptions striking at about 5.5% (i.e. 100bp below the current rate of 6.50%). What's interesting is that at current prices, if Australian swaps were to break their 2008 lows, you'd be making about 10x your premium (for the record, these swaptions are priced at about 120bps, or 40bps per year over three years, which is about the same as the annualized revenue you'd get if you sold the CPI floors discussed above). If swap rates fell by 300bps as they did during the panic of 2008 the rate would fall to 3.5% and you'd make nearly 15x your premium. To repeat the point I made earlier, this isn't a recommendation. It's just a starting point (my guess is that you'd find more attractive payouts as you went further out of the money with the strike price, and that  capital structures of Australian banks, property companies and levered resource stocks would be worth looking into too).

Asset Bubbles
Grice provides one of the best and most succinct explanations of bubble mentality we have read to date:

For reasons I won't go into now, but which are probably obvious from what I just wrote about China, I think EM is riskier than it seems. I'm not even sure I feel comfortable valuing EMs yet. So should EMs bubble up, the risk for investors sharing my concern is that they'll be faced with quite a nasty dilemma: do they buy something they don't feel sure is cheap because everyone else is and they're scared of underperforming, or do they stick to their principles and prepare themselves to take on the business and career risk of underperforming their competitors, seeing clients withdraw their funds, and possibly finding themselves out of work?

And the sad reality is that ultimately nearly everyone gets hurt during a bubble. Sceptics get hurt as it inflates, believers get hurt when it bursts. George Soros says when he sees bubbles he buys them. He?'s been pretty good at selling them at the right time too. But most of us aren't so clever.

Regardless of the psychology behind each and every bubble, the good thing is that there is a good way to hedge this risk outright.

One way to hedge the inflation of a bubble, rather than its bursting, is to buy out of the money call options on the equity indices. Calls are usually cheaper than puts ? I think because fear is a more powerful emotion than greed and the tails in equity markets tend to be on the downside. But the following chart shows that that difference (or skew, the difference in implied volatilities between puts and calls) is close to unprecedented highs, at around 4.5 vol points (the chart shows skew for the S&P500 though other equity indices show a similar picture).

In other words, the upside is close to unprecedentedly cheap relative to the downside. If you could get two year call options 30-35% out of the money for 130bps per year you?'d be getting good value (of course you could make this zero cost, or even ve cost by selling puts to fund the purchase, and you could do it in such a way that your downside risk would be similar to that of holding stock, but I'm no derivatives strategist- as usual, if you want to talk about this stuff to people who know more than I do, speak to your SG derivatives salesman, or ask me and I?'ll put you in touch).

Hyperinflation
A topic near and dear to many. Luckily, once again, one which can be hedged proximally in a form that generates massive returns should it transpire there where it most needed: no, not the US. Japan. In fact, if Grice is right about Japan, his proposed trade takes the returns generated by Paulson in shorting subprime... And magnifies them by about a million.

Historically, bankrupt governments have used inflation to alleviate their indebtedness. I doubt things will ultimately be different this time. And as regular readers know, I think Japan is the country closest to the edge. All DM governments have the same problems: they've made promises to their electorates which they're unlikely to be able to keep. But while there's time for European and US governments to fix the problem, for Japan I think it's already too late. John Mauldin says the Japanese government debt position is a “bug in search of a windshield”. I agree with him.

I've already written too much this week, so I don't want to rehash all the stuff I've already written on Japan and which regular readers will be familiar with. But if you chart past episodes of extreme inflations with how stock markets behaved during the episodes, you invariably find something similar to what happened to Israel in the 1980s.

In Steven Drobny's excellent “Hedge Funds Off the Record” (which I consider a must read - almost every interview oozes with profound risk-management wisdom), Steve Leitner talks about buying out of the money call options to hedge against such a hyperinflation. Buying 40,000 strike Nikkei calls with a ten- year maturity, with a payout in a strong currency can be done for around 40bps per year. And to give you an idea of how explosive that asymmetry might be, if Japan was to follow the Israeli experience from here, the Nikkei- currently 10,500 would trade at around 60,000,000 (sixty million). So putting even one-tenth of your notional into that kind of hedge would cost 4bp per year (for reference, the Nikkei currently offers in excess of a 2% annual yield, while some JREITS offer in excess of 4% - I'd argue that 40bp is a bearable burden, and 4bps certainly is).

Bond Market Blow-up
When a few weeks ago we presented Sean Corrigan's chart which we dubbed the Great Regime Change, few put two and two together, and realized the vast trading implications of this chart. And they are profound. As Grice rightfully observes, they stand at the base of nothing less than the hedge against that most critical of fat-tail events: a bond market blow up, one which is getting increasingly more probable with every single $X0 billion UST bond auctions (the bulk of which is now monetized directly by the Fed).

One obvious way to hedge against a bond market blow-up is to use the swaptions market as we did in the Australian market to hedge a Chinese crash, only this time buying payer swaps, which are effectively call options on rates. But I thought I'd show you something I think is a bit more interesting: the correlation between the S&P500 and bond yields.

Bonds represent poor value in my opinion, with little margin of safety to protect against the very real risk that governments try to inflate away their debts. But one good reason to continue holding them is that they protect risk asset positions during the '?tails'?. The following chart shows that over the last ten years the correlation has been volatile, but positive: when equities have fallen so have bond yields, offsetting losses in the equity portfolio as bonds benefit during "risk-off" events.

When inflation expectations were (probably) around zero (before the 1960s) the correlation between bonds and equities was zero too. But look what happened during the 1960s when inflation expectations broke (this was during the Vietnam war, as the Bretton-Woods system was coming under pressure and as the bear market in bonds was getting into full swing). The chart shows that the correlation went negative. When bond yields rose equities fell because government bonds were reflecting the same tensions that were pulling down equity valuations (fear of ever-higher inflation).

As the bond bear market reached its climax in the early 1980s, the correlation remained negative. But as the worm turned, and central banks across the developed world made new and credible commitments to stop printing money, a bond market rally was born. And as inflation expectations began to fall, what was good for the bond market was good for the equity market. Now, falling yields coincided with rising equity prices and so the correlation remained negative. But during the last ten years, inflation expectations have been roughly stable and, if anything, slightly biased towards the deflationary side. So what?s been good for bonds hasn't been good for equities, and the correlation between yields and equity prices has been positive to reflect that.

The point is this: if governments are insolvent, and the government bond market becomes a source of risk once again (as opposed to the nonsensical "risk-free" description it has somehow obtained in recent years) what's bad for the bond market will be bad for risk assets too. As yields rise, risk assets will fall. The correlation will go negative. Bonds will provide less protection against the tail events than they have done in recent years because they will be a source of the tail event.

For all those who figured this out based on the Corrigan chart, congratulations. This could well be the holy grail of the biggest black swan insurance trade of all. For those who haven't quite grasped it, here is some more from Grice:

This correlation is tradeable. Any bank with a derivatives operation must have an implicit correlation exposure between products they've sold options on. So for derivatives houses, correlation is a by-product in much the same way that molybdenum is a by-product of copper miners. and correlations like this trade in the IDM market. And sometimes that means you can get it for a very good price. I recently heard of a correlation trade between the S&P500 and the US 10y swap rate done at 40 correlation points, which seems a decent enough price to me (of course, selling at 50 points would give you even more margin of safety), although current pricing is at around 30 I believe. Pricing can be volatile though and waiting to sell in the 40-50 range seems sensible to me. It would hedge risk positions against a regime in which government bonds were seen as the source of risk, rather than the reliever of it.

Finalizing the Black Swan Insurance basket.

Let's add it all up and see how much it would cost to insure our portfolio. If we were to sell the 5y US CPI floors for 200bps (40bps annualized); buy the 3yr AUD receiver swaption for 120bps (-40bps annualized); buy 2yr 30% S&P500 calls for around 130bps (-65bps annualized) and bought one tenth of our notional on NKY calls for 40bps (-4bps annualised) the net upfront cost would be 90bps (200bps-120bps-130bps-40bps). If we wanted to hedge the risk of bond market turbulence with a correlation product, this would cost nothing upfront because it would be done on a swap basis with the bank. On a roughly annualized basis our cost would be 69bps each year.

Of course, we'd have a maturity mismatch because our hedges would have different time horizons. So we'd have to adjust them from year to year. We'd also be more vulnerable to deflation because we don't think the deflationary hedges offer value. So our portfolio wouldn't quite be bullet-proof because it would be tilted towards inflationary outcomes. But we'd have insurance against deflation with the Australian receiver swaption. And since the correlation swap hedges us against any bond market blow-up which also blows up the equity market, we can feel more comfortable allocating some capital towards bonds we think might offer good value (not that there are many, I'd say maybe about 20-30% in Australian and New Zealand bonds).

I'd put 10% in gold. I'll explain more in another note but for now, although I've said I'm not a fan of plain commodities as investment vehicles because buying commodities was equivalent to selling human ingenuity, I exclude gold from that logic. I prefer to see buying gold as buying into the stupidity of governments, policy-makers and economists, and I'm comfortable doing that.

With the exception of Japan (which we'd be hedged against anyway) I'm not so worried about "traditional" CPI inflation any time soon. At the moment, I think the first signpost on the way to that kind of crisis will be via the bond market, which the correlation swap should protect us against. That and my gold holdings would make me comfortable allocating 20%-25% cash. I still think risk assets are generally overvalued and cash is the simplest insurance "option", whose relative value rises proportionate to the decline in other assets. So let's say I'm 20% in cash,10% in gold, and 20% in mainly Australian and New Zealand government bonds. That leaves just under 50% of my capital for me to put into the equity market (the 69bps per year for my insurance bucket to be precise).

Which equities? I've always thought investing in index funds to be crazy, but nearly everyone does it and it's a part of the craziness we can use to our advantage. The EMH says that market prices are always broadly efficient because all market participants respond to all available information. But around 10% of the market is explicitly passive and probably another 50% is benchmarked and therefore implicitly passive. In other words, the overriding variable for the majority of equity investors is a company's weight in the index! Intuitively therefore, the prices can't fairly reflect fundamental value, which means that at any point in time, there will be lots of stocks which are mispriced.

The following chart shows two lines. The red line shows the cumulative return to buying stocks in the cheapest decile, while shorting stocks in the most expensive decile (I define value as the discount relative to the estimated intrinsic value - a methodology I've been meaning to write up in detail for several months now but which I will definitely do within the next few weeks). Using a monthly rebalance, the annualized return is 750bps. This shows that there is meaningful alpha in identifying and owning those stocks trading at a discount to intrinsic value. The black line shows the relative outperformance of the top decile against our wider stock universe. (In passing, note that this value strategy underperformed in the late 1990s during the tech bubble, and remember that this is the reason our hypothetical portfolio has out of the money call options.)

The relative outperformance of this long-only basket has been 330bps. If I expect a stock market return of 5% per year over the coming years, that 330bps outperformance is highly significant. It means we only need to put 60% of our capital into that basket of stocks to generate the same incremental return as a market portfolio would generate. So owning 50% isn't as cautious as it sounds.

The bottom line, and the reason why we think this is a great basket trade, is that it makes money in a normal environment while at the same time, providing great positional hedges to those 5 events which sooner or later are bound to happen.

In the sort of world in which everything is normally distributed, well behaved, and in which our insurance expires worthless (i.e. the sort of world most economists forecast), we'd still be making decent returns. And while there's no such thing as a truly bullet proof portfolio, we'd have done so with far less embedded risk. Because if any of the scenarios I've explored here come to pass we'd be in a much better position to take advantage of the distressed selling of others.

That said, and as Dylan would be the first to acknowledge, if and when everyone is positioned with precisely this hedge on their books, it will be something totally different that will cause the next great financial wipeout. But until then, those who step in first, will benefit from appreciating prices precisely on their hedges. At that point it will be up to the principal to decide whether to take profits or to hold off until the bitter end. The problem, however, at least the way we see it, is that should any of these five black swans occur, any currency that one generates as a result of a successful trade, no matter the P&I, will probably not be all that useful for the world that materializes at T+1.