Posted on 11/04/2009 10:35:37 AM PST by blam
Four Reasons Hyperinflation Hasn’t Hit The US... Yet
Keith Fitz-Gerald
Nov 04, 2009 11:30 am
This uncertain limbo isn't good now, or ever.
Everything we know about classic economic theory suggests the US economy should be experiencing Zimbabwe-like hyperinflation right now, thanks to the nearly $2.2 trillion the US Federal Reserve has pumped into the system.
But we’re not... yet.
Classic economic theory says that money supply can be used to stimulate the economy and our central bankers seem to agree. That’s why they’ve pumped more than $1 trillion dollars into the economy, engineered countless bailout bonanzas for zombie institutions, put Detroit on life support, and delivered a bunch of financial Band-Aids to the trauma ward -- all in a desperate bid to make Americans feel better about the global financial crisis.
To their way of thinking, the trillions of dollars have been a success. That’s why any meeting of the Group of Eight nations looks more like a mutual affection society with central bankers eager to claim credit and backslap each other in congratulations for having avoided the “Great Depression II.”
But by taking the Federal balance sheet to more than $2 trillion from $928 billion 2008, they’ve created a situation that should have resulted in an epic inflationary spike to accompany the 137% increase in liabilities.
[snip]
(Excerpt) Read more at minyanville.com ...
In the United States, the printed dollar is a tiny percentage of the total "money" in existence. Most of it is created by the fractional reserve banking system. When banks shut off the funding spigot to borrowers, the amount of money in the economy began to collapse. If Congress hadn't printed dollars in that moment (back when Lehman Brothers failed), we would have gone into crippling deflation where a guy who had a $100,000 house would see the value of it fall to $70,000 but his mortgage remain the same, effectively putting him further into debt.
The danger is that Congress will continue to run deficits (the current project is $9.5+ trillion over the coming 10 years). If that happens, the total printed money will exceed the M2 and M3 money levels by far, causing severe inflation. We are not yet to that point, but we can see it on the horizon.
Now, even if the inflation were terrible, it wouldn't be anywhere near what post-war Germany or Zimbabwe experienced because the money is always compared to the overall size of the economy. Our debt as a percentage of GDP would only then be approaching that of Japan. That's a lot of inflation to get there, but still not unprecedented for a G7 country.
I don't have faith in Congress to stop spending money so I think inflation is inevitable. But it's important to understand why we're not there yet to avoid drawing false conclusions.
bookmark
Good post. Thanks.
There is no inflation, hyper or otherwise, because money demand spiked on the market crash. Men now voluntarily hold 15% of their wealth in savings forms, down from 10% at the market peak.
There is also no inflation because there is nothing magical about money among assets, and in the period when money held by US households increased $1 trillion, the value of all assets owned by US households fell $11 trillion.
Money is not wealth. Declining nominal wealth values are very far from inflationary.
Great article, blam! Thanks for posting it.
You're correct that money is not wealth. Your presumptions would have been correct if - and this is where it falls apart in the real world - we were dealing with a debt-free population.
That's simply not the case: A vast majority of Americans have debt on their home and their car. When the debt level is fixed in nominal terms (in this case something we call the U.S. dollar), and the asset value falls in nominal terms, the person has lost real wealth because they now have to pay back nominal debt with harder to acquire nominal currency. By artificially drowning the banking system in replacement liquidity as the money multiplier collapsed, this outcome could have been avoided (and it was).
In other words, if you were debt-free and owned a house, changes in the money supply wouldn't influence your real wealth level one penny. The moment you introduce debt, which is quoted in nominal terms, you have created a legal liability with real world court consequences if you fail to satisfy the debt (foreclosure). At that moment, changes in the nominal value of the artificial currency do have a direct, and powerful, influence on your wealth level. A vast majority of Americans have debt. That's where your analysis fails the real world test.
You must learn to separate academic models from real world application. Economics makes a lot of foolish assumptions, such as the "rational buyer. Everyone knows that a woman walks into a store on 5th Avenue and sees a Hermes bag, rational economic calculus is not factoring into her decision about the acquisition of that bag. She is interested in one thing only: Improving her appeal to the opposite sex and status among other women. This means she's likely to pay more than the bag is actually worth for the "label". The analysis you provided makes the same sort of mistake by ignoring the day-to-day reality of the citizen base.
By increasing the total level of Treasury bills in circulation in an absolute sense, it's a backdoor form of inflation and one of the most widely used ones in history. It seemed pointless to detail that process in the post. Most people intuitively understand that it is Congress that has the power, indirectly through its legislative decisions, to increase or decrease the level of inflation, both through the Treasury Department and manipulation of the debt ceiling, and through the Chairman of the Federal Reserve, whom they can install or remove from office, as well as abolish the institution altogether.
Isn't that exactly what happened?
Thank you for your informative post.
bookmark
Yes. We got a bit of it, but nowhere near what it would have been if the Fed hadn’t drown the system in liquidity. If we had just stepped back and done nothing, you would have seen stocks go down to the 1932 and 1933 levels where they traded for less than the value of the *cash* the companies had in the bank, essentially giving the business away for free.
This wouldn’t have been because people didn’t recognize the assets were cheap. It would have resulted from them being unable to raise the money to buy anything because their own wealth had been decimated and no bank would be able or willing to lend.
But by taking the Federal balance sheet to more than $2 trillion from $928 billion 2008, they’ve created a situation that should have resulted in an epic inflationary spike to accompany the 137% increase in liabilities.
WOW
****In the United States, the printed dollar is a tiny percentage of the total “money” in existence. Most of it is created by the fractional reserve banking system. When banks shut off the funding spigot to borrowers, the amount of money in the economy began to collapse. If Congress hadn’t printed dollars in that moment (back when Lehman Brothers failed), we would have gone into crippling deflation****
I have some questions for you then.
1.) Stupid housing loans mandated to the banks(mainly by democrats in congress) were certainly a part of this collapse of the big lenders. How much a part do you attribute to the bad loans?
2.) Am I wrong in not seeing any real changes so far in legislation and oversight?
3.) If I am correct in my assumption in question 2, is this not a new mechanism for control of the economy and also control of power through politics?
4.) What are the necessary steps to avoid the collapse of the lenders again?(your answer to 2 may answer this question).
1.) The mandated loans were a big part but not nearly as big as one, fatal development: The moment community banks failed to hold on to the loans they originated (forcing them to live with their underwriting results), we had a recipe for disaster. If you are lending your own money, you're going to be more careful than if you're lending a stranger's money. It's human nature.
2.) Nope, you are 100% correct. There have been no meaningful regulation changes or new laws to address the problem. In all sincerity, it could happen again 3 years from now unless something is done.
3.) You could be but I think it's more fundamental than that: People always want to make money and if they can do it with the promise that government will bail them out, they're not going to willingly give up that security blanket (just think of a worthless twenty year old who still depends on mom or dad to pay the bills). I think it's a case of individual human nature, not some grand scheme.
4.) The way to solve it is simple and requires two parts:
Part A.) All derivatives must be placed on an exchange, just like stock options, so that bets include a small insurance premium that goes to the exchange itself. If one of the parties goes bankrupt, this insurance fund pays off the counterparty. It's worked for the stock option market for generations and it will work here. When Lehman melted down, or AIG had problems, the exchange would have simply stepped in and handled the problem without the need for Government involvement.
Part B.) Traders at firms need to be personally liable for transactions of their companies. In the old days, Goldman Sachs, Lehman Brothers, and others were pure partnerships, meaning that if one trader put the whole system at risk, every other employee in the building had their home, car, and bank accounts on the line. This caused people to check their coworkers trades and severely limit what they were willing to wager. We have to tie that downside risk back into the compensation arrangements if we want to solve the problem. After all, if you were a partner at Lehman and saw that the guy at the next desk was wagering 30-1 on soybean futures, you may just call a meeting and shut him down because you don't want to find yourself awake at night worrying about the crop report.
Thank you for your quick reply.
In response to your answer of question three. If you are correct that the situation purely developed because of human nature and was not a well thought out plot for control, now that the mechanism is in place and there are no steps(I like yours by the way) to remedy the problem then human nature would dictate that it will be exploited.
“...in the period when money held by US households increased $1 trillion...”
Is that another way of saying newly printed money acquired?
So you are saying Bush did the right thing by creating TARP.
Yep. That’s the problem and our worthless Congress is doing absolutely nothing to solve it. The incentive system hasn’t changed. The average memory of an investor is about 3 years - give it another year or two and most will completely have forgotten about the pain of watching the Dow go to nearly 6,000.
For all of its faults, TARP had some necessary components. If, for instance, the commercial paper guarantee program hadn’t been put in place, the world as we know it would have ended. The problem is, the government has done such an inept job managing its own budget, no one trusted it (rightful so) to intelligently manage a bailout program.
All in all, TARP (not what came afterward, but the initial liquidity that was provided in the days following the Lehman Bros failure) was a necessary evil. Without it, I firmly believe we’d be in Great Depression II right now because corporations would have had no choice but to immediately hoard every penny they got to cover payroll and the financial system would have gone backwards 200 years overnight.
So you really think the DOW won't go near 6000 again before it really recovers?
I don’t think it matters. You either fit into two camps (or if you manage money, have two operations):
1. Companies that you buy because they are consistently profitable and generate ever-increasing dividends. Think of firms that are boring but mint money like Johnson & Johnson, J.M. Smuckers, Procter & Gamble, General Mills, etc. If you’ve been buying these for 40+ years, and always reinvest your dividends, you are actually *happy* if the Dow goes back down to 6,000 because your dividend reinvestment is going to end up with you owning far, far more shares and a bigger equity percentage of the company.
2. If you trade regularly, volatility is like a Christmas gift because it drives up option premiums. Right now, for example, if you owned 10,000 shares of General Electric you could sell covered call options against your shares. In exchange for letting someone else have the right to buy your stock at $15 per share (the shares are currently at $14.19) any time between now and December - so four weeks away - they will pay you $0.42 per share as an “insurance premium”.
You could accept this transaction, and you would get a deposit in your brokerage account of $4,200 today (10,000 shares x $0.42 per share for 4 week contract = $4,200). That money is yours forever. It was an insurance premium you collected. If the stock stays below $15, the option expires worthless and you still own your shares plus you kept the money. If the stock goes beyond $15, you have to sell the shares to the other investor for $15 regardless of how high it goes. In that case, you’d get the $4,200 plus the $150,000 your shares were worth (premium plus $15 x 10,000 shares = $150,000.)
If the Dow were whipping back and forth, that premium may be at, say $0.80 or even $1.00. For selling the same contract, you could have gotten $8,000 or $10,000. If four weeks go by and you still own the shares, you could write another contract and pocket the money.
This has been an extremely profitable way for some long-term investors to make huge profits on companies they are happy to buy at these prices, anyway. The more volatility, the richer the premium they get. The happier they are.
Even though I’m a long-term investor, I’d love for the Dow to back to 6,000 and the back to 14,000, then back and forth, back and forth, because both of my operation would profit from this. Those are actually the perfect market. It makes the average person emotionally upset but if you know what you’re buying and why you’re buying it, there’s no need to feel that way.
1. If stock prices keep going down unless the companies have sufficient cash flow or cash, they will have to sell shares to raise capital thus your shares will be diluted. Few companies these days are buying back their own stock when money is hard to raise.
2. Yes high volatility can be profitable but, -vix is a double edged sword. If GE goes to 10 and you earn $4200 and lose $50,000 in equity. If you sell more calls and it goes to $5 you make another $3000 or so and lose another $50,000. Remember if the stock goes down 50% you need a 100% gain to break even. What was GE last year, over $40?Your strategy only works if it stops going down or up and stays level, if it goes back up your calls will be exercised and your loses become real. No free lunch, to make money you have to follow or lead the market up or down (trend).
How long did one have to wait from the bottom of the depression to break even? Will your heirs wait this time around?
You’ve assumed a lot that simply isn’t true. The fundamental difference (and what you’re not accounting for) is I’m sitting on top of a collection of businesses that generate torrents of cash every day for me to invest - everything from a sporting good company to a luxury jewelry store. I’m not dealing with a fixed amount of capital; my companies are constantly pouring in new money that I can use to lower our cost basis, all of which started with my first online retailer right out of college.
In regard to your specific points:
1. If the company isn’t generating sufficient cash flow, why the h*ll would anyone own it? That’s not investing, that’s speculating. Of course what you pointed out would be a problem in the event of declining prices. Just look at the firms that had to dilute their equity at ridiculous prices. That didn’t happen with companies such as Coca-Cola, Procter & Gamble, or Johnson & Johnson, which were the examples I provided.
2. As is often forgotten by those who only look at stock charts, even though it took decades for the stock market to reach its former level after the Great Depression, people who held on actually broke even with 5-7 years because of reinvested dividends. One of the biggest problems with the financial media is that investors don’t understand if you own $1,000,000 worth of stock, it crashes to $500,000, but you receive $2,000,000 in cash dividends over a 10 year period, you still earned a very good rate of return despite experiencing a 50% loss in principal on the share value. That doesn’t show up in any charts and there’s no incentive for the media to report it.
All of your presumptions are based upon the idea that someone has a fixed amount of money and needs to cash out within a decade. Neither is the case. In my personal instance, I’m in my mid twenties and just don’t give a damn about volatility. I’m wired differently; it doesn’t have any emotional power over me if I know my underlying thesis was correct. I’m also not dealing with a fixed portfolio, but rather have the backing of a collection of businesses that constantly generate fresh cash for me to deploy. That was purposeful; it’s the entire reason I built the company in the first place because my true love is investing. I get to sit in an office, drink coffee, and read by the fireplace all day.
I was, and remain, entirely serious on the two points I made. I would be ecstatic if the market would collapse back down to 6,000 and then bounce back and forth for a few years.
There are also monetary lags that can be 18 months or longer.
I'm not at all sure that, at this point, we can assume that we're not. The great depression lasted a decade. It's one year after our market crash and the only positive sign that I see is that the market has (somewhat) recovered. The bad debt is still there. The economy is still losing jobs. And to boot, BECAUSE of the bailouts, we have one great big new problem to solve - "too big to fail".
Capitalism doesn't work without failure. I continue to worry about the impact of the bailouts on our economy going forward. While changes such as those you're suggesting can be made, there's no undoing what was done - in the sense that everybody now knows, or at least believes, that the politicians will step in to prevent failure if the circumstances are right.
There will be unintended consequences of this anti capitalist policy. A (not altogether unfounded) growth in populist sentiment against wall street is one of them, for instance.
And we still don't know how much. Isn't it true that if AIG had gone thru bankruptcy, at least the facts about how much "bad debt" they had would be revealed?
Some of the TARP defenders assure us that "we," the taxpayers, will get all the TARP money back eventually, but I'm not so sure. Barney Frank wants to spend it.
bump for l8r
Great posts. Thanks.
I wish it had stayed at 6000 a lot longer. Since the market came back I did manage to make back every penny I lost after it began to drop, but if it had stayed at 6000 for a few more months, I could have made a killing. I'm sure a lot of savvy investors who knew how to work the system made out like bandits after the Dow hit the floor. I suspect that is why the file clerks at Goldman Sacks all got $700,000 bonuses this year.
bookmark
Have you considered an Economics class for homeschoolers?
I’m looking for a good class at a Junior High level.
My girls are taking Latin from an instructor who uses Dimdim.
Neither of us leave our houses, yet she makes 3.00 per student, per class and they get great instruction.
Think about it. Bet you could get a bunch of homeschooling FReeper kids to take it.
This is perhaps the most singularly stupid thing I've ever seen posted bar none.
I think Jasonc is saying that money is not the only form of wealth. For example, the owner of 5,000 acres of land might be "wealthier" than another individual who had $500,000.
bump
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.