"By a continuing process of
inflation, government can confiscate, secretly and unobserved, an important
part of the wealth of their citizens.
- John Maynard Keynes, Economic
Consequences of Peace
"Unemployed men took one or two
rucksacks and went from peasant to peasant. They even took the train to favorable
locations to get foodstuffs illegally which they sold afterwards in the town at
three or fourfold the prices they had paid themselves. First the peasants were
happy about the great amount of paper money which rained into their houses for
their eggs and butter… However, when they came to town with their full
briefcases to buy goods, they discovered to their chagrin that, whereas they
had only asked for a fivefold price for their produce, the prices for scythe,
hammer and cauldron, which they wanted to buy, had risen by a factor of 50."
- Stefan Zweig, The World of Yesterday, 1944.
The
beginning of the end of the Weimar Republic was some 89 years ago this week.
There is a stream of opinion that the US is headed for the same type of end.
How else can it be, given that we owe some $75-80 trillion dollars in the
coming years, over 5 times current GDP and growing every year? Remember the
good old days of about 5-6 years ago (if memory serves me correctly) when it
was only $50 trillion? With a nod to Bernanke's helicopter speech, where he
detailed how the Fed could prevent deflation, I ask the opposite question, "Can
'it' (hyperinflation) really happen here?" I write this on a plane flying to
NYC, with a tighter deadline than normal, so let's see how far we can get. More
on where I'm heading at the end of the letter.
But
first, let me quickly call to your attention a speaking engagement that I'm
doing November 9 in Atlanta. It is for Hedge Funds Care, and it's a wonderful
event for a children's charity. If you can make it, I hope to see you there.
You can learn more and register at
http://www.hedgefundscare.org/event.asp?eventID=74.
I
was inspired for this week's letter by a piece by Art Cashin (whom I will get
to have dinner with Monday). His daily letter always begins with an anecdote
from history. Yesterday it was about Weimar, told in his own inimitable style.
So without any edits, class will commence, with Professor Cashin at the chalk
board.
An Encore Presentation
By Art Cashin
Originally, on this day (-2) in
1922, the German Central Bank and the German Treasury took an inevitable step
in a process which had begun with their previous effort to "jump
start" a stagnant economy. Many months earlier they had decided that what
was needed was easier money. Their initial efforts brought little response.
So, using the governmental "more is better" theory they simply
created more and more money.
But economic stagnation
continued and so did the money growth. They kept making money more available.
No reaction. Then, suddenly prices began to explode unbelievably (but,
perversely, not business activity).
So, on this day government
officials decided to bring figures in line with market realities. They
devalued the mark. The new value would be 2 billion marks to a dollar. At the
start of World War I the exchange rate had been a mere 4.2 marks to the dollar.
In simple terms you needed 4.2 marks in order to get one dollar. Now it was 2
billion marks to get one dollar. And thirteen months from this date (late
November 1923) you would need 4.2 trillion marks to get one dollar. In ten
years the amount of money had increased a trillion fold.
Numbers like billions and
trillions tend to numb the mind. They are too large to grasp in any "real"
sense. Thirty years ago an older member of the NYSE (there were some then)
gave me a graphic and memorable (at least for me) example. "Young man," he
said, "would you like a million dollars?" "I sure would, sir!" I replied
anxiously. "Then just put aside $500 every week for the next 40 years." I
have never forgotten that a million dollars is enough to pay you $500 per week
for 40 years (and that's without benefit of interest). To get a billion dollars
you would have to set aside $500,000 dollars per week for 40 years. And
a…..trillion that would require $500 million every week for 40 years. Even
with these examples, the enormity is difficult to grasp.
Let's take a different tack. To
understand the incomprehensible scope of the German inflation maybe it's best
to start with something basic….like a loaf of bread. (To keep things simple
we'll substitute dollars and cents in place of marks and pfennigs. You'll get
the picture.) In the middle of 1914, just before the war, a one pound loaf of
bread cost 13 cents. Two years later it was 19 cents. Two years more and it
sold for 22 cents. By 1919 it was 26 cents. [Double in value, or a "mere" 12%
compound inflation –JM.] Now the fun begins.
In 1920, a loaf of bread soared
to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50.
At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went
for $1200. By September it was $2 million. A month later it was $670 million
(wide spread rioting broke out). The next month it hit $3 billion. By mid
month it was $100 billion. Then it all collapsed [as if a roughly 8 billion
times rise in cost wasn't already collapse! Hint of irony here. – JM]
Let's go back to "marks". In
1913, the total currency of Germany was a grand total of 6 billion marks. In
November of 1923 that loaf of bread we just talked about cost 428 billion
marks. A kilo of fresh butter cost 6000 billion marks (as you will note that
kilo of butter cost 1000 times more than the entire money supply of the nation
just 10 years earlier).
In 1913 Germany had a solid,
prosperous, advanced culture and population. Like much of Europe it was a
monarchy (under the Kaiser). Then, following the assassination of the Archduke
Franz Ferdinand in Sarajevo in 1914, the world moved toward war. Each side was
convinced the other would not dare go to war. So, in a global game of chicken
they stumbled into the Great War.
[Side note: So convinced were
the bond markets that war was not possible that bonds were still selling at
normal prices. War was simply inconceivable. Bad call. - JM]
The German General Staff thought
the war would be short and sweet and that they could finance the costs with the
post war reparations that they, as victors, would exact. The war was long.
The flower of their manhood was killed or injured. They lost and, thus, it was
they who had to pay reparations rather than receive them.
Things did not go badly
instantly. Yes, the deficit soared but much of it was borne by foreign and
domestic bond buyers. As had been noted by scholars….."The foreign and
domestic public willingly purchased new debt issues when it believed that the
government could run future surpluses to offset contemporaneous deficits." In
layman's English that means foreign bond buyers said – "Hey this is a
great nation and this is probably just a speed bump in the economy." (Can you
imagine such a thing happening again?)
When things began to
disintegrate, no one dared to take away the punchbowl. They feared shutting
off the monetary heroin would lead to riots, civil war, and, worst of all
communism. So, realizing that what they were doing was destructive, they kept
doing it out of fear that stopping would be even more destructive.
If it is difficult to grasp the
enormity of the numbers in this tale of hyper-inflation, it is far more
difficult to grasp how it destroyed a culture, a nation and, almost, the world.
People's savings were suddenly
worthless. Pensions were meaningless. If you had a 400 mark monthly pension,
you went from comfortable to penniless in a matter of months. People demanded
to be paid daily so they would not have their wages devalued by a few days
passing. Ultimately, they demanded their pay twice daily just to cover changes
in trolley fare. People heated their homes by burning money instead of coal.
(It was more plentiful and cheaper to get.)
The middle class was destroyed.
It was an age of renters, not of home ownership, so thousands became homeless.
But the cultural collapse may
have had other more pernicious effects.
Some sociologists note that it
was still an era of arranged marriages. Families scrimped and saved for years
to build a dowry so that their daughter might marry well. Suddenly, the dowry
was worthless – wiped out. And with it was gone all hope of marriage.
Girls who had stayed prim and proper awaiting some future Prince Charming now
had no hope at all. Social morality began to collapse. The roar of the
roaring twenties began to rumble.
All hope and belief in systems,
governmental or otherwise, collapsed. With its culture and its economy
disintegrating, Germany saw a guy named Hitler begin a ten year effort to come
to power by trading on the chaos and street rioting. And then came World War
II.
That soul-wrenching and
disastrous experience with inflation is seared into the German psyche. It is
why the populace is reluctant to endorse the bailout. It is also why all the
German proposals have each country taking care of its own banks. (It gives
them more control.) The French plans tend to socialize the bailout. There's
more disagreement in these plans than the headlines would indicate.
To celebrate have a Jagermeister
or two at the Pre Fuhrer Lounge and try to explain that for over half a century
America's trauma has been depression-era unemployment while Germany's trauma
has been runaway inflation. But drink fast, prices change radically after
happy hour.
We
spent a whole chapter writing about inflation and hyperinflation in
Endgame, which I think highlights the
topic rather well (
http://www.amazon.com/endgame).
Let me quote a few paragraphs.
"We know that the world is
drowning in too much debt, and it is unlikely that households and governments
everywhere will be able to pay down that debt. Doing so in some cases is
impossible, and in other cases it will condemn people to many hard years of
labor in order to be debt-free. Inflation, by comparison, appears to be the
easy way out for many policy makers.
"Companies and households
typically deal with excessive debt by defaulting; countries overwhelmingly
usually deal with excessive debt by inflating it away. While debt is fixed,
prices and wages can go up, making the total debt burden smaller. People can't
increase prices and wages through inflation, but governments can create inflation
and they've been pretty good at it over the years. Inflation, debt
monetization and currency debasement are not new. They have been used for the
past few thousand years as means to get rid of debt. In fact, they work pretty
well.
"The average person thinks that
inflation comes from 'money printing.' There is some truth to this, and indeed
the most vivid images of hyperinflation are of printed German Reichmarks being
burnt for heat in the 1920s or Hungarian Pengos being swept up in the streets in
1945.
"You don't even have to go that
far back to see hyperinflation and how brilliantly it works at eliminating
debt. Let's look at the example of Brazil, which is one of the world's most
recent examples of hyperinflation. This happened within our lifetimes. In the
late 1980s and 1990s it very successfully got rid of most of its debt.
"Today Brazil has very little
debt as it has all been inflated away. Its economy is booming, people trust
the central bank and the country is a success story. Much like the United
States had high inflation in the 1970s and then got a diligent central banker
like Paul Volcker, in Brazil a new government came in, beat inflation, produced
strong real GDP growth and set the stage for one of the greatest economic success
stories of the past two decades. Indeed the same could be said of other
countries like Turkey that had hyperinflation, devaluation, and then found
monetary and fiscal rectitude.
"In 1993 Brazilian inflation was
roughly 2,000%. Only four years later, in 1997 it was 7%. Almost as if by
magic, the debt disappeared. Imagine if the US increased its money supply
which is currently $900 billion by a factor of 10,000 times as Brazil's did
between 1991 and 1996. We would have 9 quadrillion USD on the Fed's balance
sheet. That is a lot of zeros. It would also mean that our current debt of
thirteen trillion would be chump change. A critic of this strategy for getting
rid of our debt could point out that no one would lend to us again if we did
that. Hardly. Investors, sadly, have very short memories. Markets always
forgive default and inflation. Just look at Brazil, Bolivia, and Russia today.
Foreigners are delighted to invest in these countries.
"The endgame is not complicated
under inflation/hyperinflation. Deflation is not inevitable. Money printing
and monetization of government debt works when real growth fails. It has
worked in countless emerging market economies (Zimbabwe, Ukraine, Tajikistan,
Taiwan, Brazil, etc.). We could even use it in the US to get rid of all our
debts. It would take a few years, and then we could get a new central banker
like Volker to kill inflation. We could then be a real success story like
Brazil.
"
Honestly,
recommending hyperinflation is tongue in cheek. But now even serious economists are recommending
inflation as a solution. Given the powerful deflationary forces in the world,
inflation will stay low in the near term. This gives some comfort to
mainstream economists who think we can create inflation to solve the debt
problem in the short run. The International Monetary Fund's top economist,
Olivier Blanchard, has argued that central banks should target a higher
inflation rate than they do at present in order to avoid the possibility of
deflation. Economists like Paul Krugman, a Nobel Prize winner, and Olivier
Blanchard argue that central banks should raise their inflation targets to as
high as 4%. Paul McCulley argues that central banks should be 'responsibly
irresponsible.'
"Peter
Bernholz wrote the bible on inflation and hyperinflation, called
Monetary Regimes and Inflation: History,
Economic and Political Relationships. He writes about 29 periods of
hyperinflation. What causes such a spectacular increase in prices? Bernholz
has explained the process very elegantly.
"Bernholz argues that
governments have a bias towards inflation. The evidence doesn't disagree with
him. The only thing that limits a government's desire for inflation is an
independent central bank. After looking at inflation across all countries and
analyzing all hyperinflationary episodes, the lessons are the following:
1. Metallic standards like gold
or silver standard show no, or a much smaller, inflationary tendency than
discretionary paper money standards
2. Paper money standards with
central banks independent of political authorities are less inflation-based
than those with dependent central banks.
3. Currencies based on
discretionary paper standards and bound by a regime of a fixed exchange rate
to currencies, which either enjoy a metallic standard or, with a discretionary
paper money standard, an independent central bank, show also a smaller tendency
towards inflation, whether their central banks are independent or not.
"Bernholz examined twelve of the
twenty-nine hyperinflationary episodes where significant data existed. Every
hyperinflation looked the same. 'Hyperinflations are always caused by public
budget deficits which are largely financed by money creation.' But even more
interestingly, Bernholz identified the level at which hyperinflations can
start. He concluded that 'the figures demonstrate clearly that deficits
amounting to 40 percent or more of expenditures cannot be maintained. They
lead to high inflation and hyperinflations….' Interestingly, even lower levels
of government deficits can cause inflation. For example, 20% deficits were
behind all but four cases of hyperinflation.
"Stay with us here, because this
is an important point. Most analysts quote government deficits as a percentage
of GDP. They'll say, 'The US has a government deficit of 10% of GDP.' While
this measure makes some sense, it doesn't tell you how big the deficit is
relative to expenditures.
The deficit may be 10% the size of the US
economy, but currently the US deficit is over 30% of all government spending. That
is a big difference."
I
am confronted all the time on the road by investors who want to know my basis
for stating that we will not see hyperinflation in the US. I am good friends
with many who believe it is the only way the US can end up, given the size of
the current off-balance-sheet debacle. "End of America" Porter Stansberry, Doug
Casey and David Galland (see below), Peter Schiff, Bill Bonner, and a host of
gold bugs see no other way out. They look at history as written by Bernholz and
see the proverbial writing on the wall. It is totally decipherable by them. I
remain very unconvinced.
The
US Federal Reserve system is different from most central banks, whether it is independent
or not. It is composed of 12 separate regional banks, each of which has its own
board, which appoints its regional president. The regions each get a certain number
of rotating votes in the FOMC meetings, along with the appointed Fed governors.
But they all get to participate in FOMC meetings and offer opinions. And the
presidents certainly talk with each other. The last two meetings have seen the
unusual circumstance of three dissenting votes.
These
regional boards comprise local business leaders, some academics, and community
leaders. They have to go back and work and live in their communities. They
don't get to retire to an ivory tower and tenure, like many Fed governors. They
see the real world, or at least their parts of it, and the boards have become
very diverse over time.
Hyperinflation
requires a central bank to willingly commit economic suicide. Typically, that
happens at the behest of an authoritarian government. Under our current system,
I can't see that happening. The hue and cry would be very loud and long and early.
If you think Fisher et al. are vocal today, think about their response to
really aggressive printing. I am not talking about something on the order of
QE2, a BB gun as compared to a bazooka. I am talking about real printing.
It
is not just a few vocal regional Fed presidents, of whom Fisher is the most
eloquent. Even Bernanke has been talking about the limits of monetary policy
and the need for the fiscal house to be put in order.
If
Bernanke and his fellow Keynesians could whip up 4-5% inflation for a few
years, would they do it? I think so, although they would publicly demur. But
that is a far cry from 10% and even further from the 50% that would be needed
to really ignite hyperinflation. I doubt they have the stomach for that, even
in the face of a serious recession. The memories of the '70s are still part of
our genetic make-up.
But
could they print a whole lot more than one can imagine now, without unleashing
the inflation demon? The simple answer is yes, and for that rationale we go
back to the '30s and Irving Fisher, who gave us the
classic equation of the link between money supply and inflation and the
velocity of money (how fast money moves through an economy).
Inflation is a combination of
the money supply AND the velocity of money. In short, if the velocity of money
is falling, the Fed can print a great deal of money (expanding its balance
sheet) without bringing about inflation. Remember the above instance, where
workers wanted to get paid twice a day? That was a case of both rising money
supply and rising velocity of money, a deadly combination. I have written
several e-letters about the velocity of money, if you want more in-depth
analysis. If this is something you do not understand, I suggest you take the
time; otherwise you will not get the background of the argument. Here are a couple
links to letters where I explain the velocity of money:
http://www.johnmauldin.com/frontlinethoughts/the-implications-of-velocity-mwo031210
http://www.johnmauldin.com/frontlinethoughts/the-velocity-factor-mwo120508
When
do we see a seriously falling velocity of money? At the end of debt
supercycles, where deleveraging is the order of the day. Which is where we are
today in the US. Look at the graph below (from my friend Lacy Hunt at
Hoisington Asset Management). Notice that the late '70s saw a rising money
supply and rising velocity of money. And voila, we got inflation in the US.
Notice that now velocity is falling and, as Lacy points out, the velocity is
mean reverting over very long periods of time, so we can expect it to go lower.
Also remember that the US government (at the federal level) has yet to really
begin to get its fiscal house in order. (Although state and local government
have combined to cut deficits $200 billion a year through a combination of
spending cuts and tax increases, or over 1% of GDP, which has been a serious
headwind with more cuts and tax increases to come.)
What could change my mind? If the (how to say this politely?) ill-conceived (stronger
words come to mind) proposal by Financial Services Committee ranking member
Barney Frank (D-Mass) were to see the light of day, I would get very concerned.
According to Bloomberg and
The Hill,
Frank plans to submit a bill that would remove the votes of the five regional
Federal Reserve presidents from the 12-member Federal Open Markets Committee (FOMC),
which sets interest rates, and replace them with five appointees that would be
nominated by the President and confirmed by the Senate.
Frank says "he is concerned that the process is
undemocratic because the regional Fed presidents are not elected or appointed
by elected representatives, and he believes that regional Fed presidents are
overly likely to focus on guarding against inflation at the expense of more
adequately tackling the country's unemployment crisis."
(US News and World Report)
Basically, he wants the Fed to be subservient to
the politicians. Under his proposal, the FOMC could lose what independence it
has in a short time. This is part of a strain of thought that suggests that the
decisions that affect all of us should be made by a few elite people who purport
to understand what is going on, which coincidentally are government insiders
and the academics who foster their agendas.
How did Weimar and other
hyperinflation incidents occur? When power was in the hands of a few
well-intentioned elites who did not understand the long-term consequences, or
were acting in self-interest without transparency or any check on their
decisions. The Fed is designed to be a system of checks and balances, with no
one president getting to appoint all the governors (they have 14-year terms), in
order to try to remove the process as much as possible from political
interference. That does not mean they will make the right decisions, but in
this I agree with the alarmists: history suggests that without some constraint
(gold standards as an example) hyperinflations may occur.
A repeat of the '70s? That is within
the realm of possibility, but it's certainly not a base-case scenario. Hyperinflation
under our current system? I just don't see it.
I
am asked that question all the time. My answer is that it illustrates the power
of "It Won't Happen." As in "if it can't happen it won't happen." That number
will never be paid, either in terms of current buying power or actual numbers
or actual benefits. It can't be. The money is not and will not be there.
The
far more interesting question is what will happen when we reach the point of
"won't happen." Will that be something we recognize before it happens and act
proactively to avoid a cataclysmic event? Will we wait until the bond market
jerks our chain about the fiscal crisis, which is massively stagflationary?
Yes, the Fed can print to some degree, but not dealing with the crisis will ultimately
force a huge restructuring of spending and taxes which, if not caught early
enough, will propel us into a certain Second Great Depression. Which is why I
think we will deal with it proactively in 2013, because to not do so would be
folly of the worst sort. The consequences are unimaginable for the US and for
the world. Think Greece, and then go downhill. All over the world.
I
think more and more political leaders are beginning to understand that point.
They are not happy about it. But I remain hopeful that in 2013 we can actually
deal with the deficit and the debt in an orderly manner. If we do not, God help
us all.
source: John Hussman, Phd.
)
