In the previous blogs of this series, I have laid down some basic fundamental definitions for things such as assets and liabilities. In the second post in the series, we saw how the banks serve as the inflationary engines of society, but that their activity does not add to the fundamentals level of assets in a society. Instead, banks expand the monetary base by creating and loaning far more money into circulation that they could actually deliver were their depositors to demand it; banks thereby create situations whereby there are far more claims to the amount of real goods in society then there are actual goods which leads to inflation.
As banks create and loan out money the economy booms, but it is an unsustainable growth. It is caused because the market misinterprets the source of the amount of money flowing into their products and services as a genuine increase in demand as opposed to simply a credit induced event. This leads business to expand their operations in an effort to make more profit, but the problem is that they are responding to false/credit induced demand as opposed to genuine demand. Eventually things have to revert back to fundamentals, and that is when the bubble collapses.
Now lets take these tools and bring them to bear on our current situation. The greatest credit expansion that this country has ever seen has just taken place. It started in 1982 and ended last year; over that timeframe, we saw Americans reach a level of indebtedness (350% of GDP) never before seen in history. Over that timeframe, the credit expansion nearly collapsed in on itself a number of times, only to be driven still higher be a central bank dedicated to not letting it happen. This time around, none of the usual remedies seem to be which is exactly what they are trying to do now with their “quantitative easing” policy. Will they succeed in re-inflating the bubble? I don’t know. I suppose it’s possible, but the one thing that I am sure of is that they’re certainly going to diminish the value of the dollar in their attempts.
Roger, a frequent commenter on this blog does not agree with me. He feels that deflation will be the order of the day and that it will continue for sometime. He instead agrees with Dr. Lacy Hunt that long term US Treasuries are the best place to park your money for now. As he puts it:
The way I see it, the argument boils down to whether deflation or inflation will prevail over the course of the next few years. Over the long-term, we all agree inflation will prevail. OK, so let’s focus the discussion on deflation/inflation for the next few years. I think 2-3 years period is reasonable.
…The Great Depression is definitely a deflationary depression.
Why can there be deflation while the FED can print money? Isn’t printing money inflationary? Well, yes if the credit is extended: banks are willing to lend AND borrowers are willing to borrow.
If these 2 conditions are not fulfilled, the condition will look like this: Sam has a printing machine that can print counterfeit bills perfectly and the FED cannot tell. Sam then prints 5T dollars, but Sam buries all the money in his backyard. Is that inflationary? Of course not. Not until Sam spends the money, i.e. money entering the economy.
This is what precisely happens right now. Capital injections by the FED are being hoarded by banks because they are so capital deprived. Roubini estimated the losses from SPM approximately amounts to 3.6T. That is a minimum of 3.6T the FED can print without causing inflation.
If you still argue there will be massive hyperinflation/stagflation coming in the short-term, the signs are just contradicting that:
1. home prices keep falling
2. stocks tank
3. unemployment soaring
4. GDP is turning negative all around the world
5. commodities tank really hard
6. businesses are falling
7. banks are unwilling to lend
8. consumers are unwilling to borrow
9. increasing savings rate
All of those are powerful deflationary forces/signs. None of those signs/forces are likely to reverse in the short-term. They are actually going to get more severe, hence more severe deflation. To ignore these by only pointing to significant money supply increase is just humpty dumpty-ish
At present there is a massive shortage of USD due to debt deflation. At present, US debt to GDP ratio is around 360%. In 1970s, it was around 110%. As this measure corrects to the norm, debt is being deflated (in a sense, a lot of USD are destroyed). This creates massive scarcity of USD, making it more precious. Our monetary system is called credit money system. Credits can be created (inflation) and destroyed (deflation). To understand the concept, please refer to a great paper by Steve Keen, an Australian economics professor, titled “The Roving Cavaliers of Credit”. The link can be found here:
I tend to view the deflation in US right now will be more severe than even the Great Depression and Japan, because the amount of debt being deflated is way larger and it starts with low savings rate (to increase savings rate -> more USD demand).
In essence, Roger acknowledges that an inflated money supply will eventually lead a greater inflation rate, but he feels that the mechanism of inflation, the banking system, is to enfeebled by the loses on their balance sheets. So the inflationary pressure will just build up over time but not be able be realized for some time.
As I’ve previously mentioned, this is a dangerous prediction. In looking at economic systems and history, we have to keep in mind that they are system comprised of intelligent actors who are capable of altering events from their expected course. The real wild card here is Ben Bernanke. He’s clearly demonstrating to us that he has a printing press and he knows how to use it. He is dead set on getting inflation going again by whatever means necessary, and Congress has shown their willingness to allow the Federal Reserve greater and greater latitude in solving this problem.
If Roger is right, and the banks are no longer able to function as the traditional engine of inflation, then I’m sure Ben is prepared to either go around them to offer credit to consumers directly. Such a scenario could take place in a variety of ways, with the most likely being that Fannie Mae and Freddie Mac start offering 4% 40 year mortgages and refinances straight to consumers. Since both of these lending institutions have now been nationalized, relatively few people would need to be involved in that decision. Fannie and Freddie create the money to give to consumers, and the Fed buys the notes. Voila, inflation.
That’s just one scenario that I’m sure is under consideration. Another that has been talked about is the scenario of a “bad bank.” In essence, the government would create a facility where it would take most/all of the troubled assets off of the banks books. Being freed from the burden of all of these bad debts weighing down the balance sheet, banks could once again surely function as the inflationary engines they have always been.
And who can forget the biggest spender of them all? The US Government just announced a budget that projects a $1.75 trillion dollar deficit over the course of the next year. With the Federal Reserve printing money and the government spending it like drunken sailors, I feel fairly confident that we will see the return of inflation. In fact, there’s only one scenario I can think of where this wouldn’t happen, and that would be if foreigners decided they didn’t want to finance our debt anymore.
Since we are not a nation of savers (unlike Japan) all of our debt must be financed abroad. Were they to get nervous as how grossly we mistreat the dollar, they might demand a higher interest rate for buying our debt. Were we to see a return of 1980s style interest rates of 20% or more, then you could make an argument for deflation, but even then I don’t think it would last for long. In the 1980s the United States was a net creditor nation: more people owed us money than we owed them. We can’t tolerate those kinds of interest rates anymore, and I find it doubtful that we escape this scenario without looking at some kind of default by our government.
In any of these scenarios, long term US Treasury bonds are a horrible place to be. If inflation, the 3% annual yield is not nearly enough to keep pace with it given the gross distortions of the money supply. If deflation caused by a buyers strike in the bond market, then bonds will collapse in value as yields have to rise to dramatically higher levels. If a default by the government, bonds become worthless. In any possible scenario, bonds are exactly what Pimco bond manager Bill Gross called them, “The most overvalued asset in the world bar none.”
I understand that Dr. Hunt is bond advisor and that that greatly colors he recommendation, but I feel its terrible irresponsible to be advising people to invest in long term treasures in this environment. I’ll close with an excerpt from Warren Buffet who, in the 2008 Letter to Shareholders of Berkshire Hathaway wrote:
The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.
Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.