A Bad Assumption

Although many factors helped bring about the worst financial crisis this century, perhaps the most underappreciated was the widespread reliance on bad assumptions.

Many people took it for granted that what had happened many years ago was, well, ancient history; they figured that with all of the regulatory and other backstops in place, any problems that might crop up would be dealt with by authorities in one way or another; they bet the ranch on the view that low-probability events were not worth worrying about.

Even now, mainstream commentators appear to be ruling out developments that don't quite fit with mainstream economic thinking. But as Jordan Roy-Byrne notes in a post at Minyanville, "Hyperinflation Is Fiscal, Not Monetary Phenomenon,"  "too many analysts believe there has to be some economic demand or some consumption to stimulate inflation or hyperinflation."

I disagree with the views put forth by John Mauldin, Mike Shedlock, and now Jim Rickards, who all focus on velocity and/or bank lending as important causes of hyperinflation.

The reality is that hyperinflation is first and foremost set in motion and driven by a deteriorating fiscal situation. In fact, significant economic weakness and deflation is a precursor to hyperinflation. Too many analysts believe that there has to be some economic demand or some consumption to stimulate inflation or hyperinflation. Printing money to try to stimulate your economy or excessive credit growth is what leads to inflation. Printing money because you're broke and can’t service your debts is what leads to hyperinflation.

Recently Rickards wrote about how a change in velocity can trigger hyperinflation or severe inflation.

At Mises.org, Henry Hazlitt educates us on velocity:

For example, it is frequently said that the value of the dollar depends not merely on the quantity of dollars but on their “velocity of circulation.” Increased “velocity of circulation,” however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall (or, to put it the other way round, of the belief that the price of goods is going to rise). It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on “velocity of circulation” is just another example of the error of substituting dubious mechanical for real psychological reasons.

Indeed! The focus on velocity may have led you astray over the past 10 or 15 years. Take a look at this chart of velocity from Lacy Hunt of Hoisington Investment Management.

As you can see, velocity actually increased during a time of disinflation and has been muted throughout most of the bull market in commodities. Moreover, despite the sharp drop in credit growth and bank lending in the West during recent years, gold and commodities have powered higher. We know gold has made all-time highs against every currency. Yet, take a look at this chart.

Priced in euros and pounds, commodities have rallied back to their 2008 high! Priced against a basket of currencies (example: US$), commodities are 9% below their 2008 peak. Not bad considering the crash in 2008 and ensuing deflationary environment.

Why are gold and commodities performing so well if we're in a deflationary environment? The greater the deflation and the worse the economy gets, the greater the worry about sovereign bankruptcy, which will come via default or hyperinflation.

Certain government bonds are rallying because they're safe havens relative to other government bonds.

The point is, precious metals are outperforming commodities to a lesser extent even without a rise in bank lending, a rise in credit growth, and a rise in velocity. As I already explained, deflationary forces and a weak economy ultimately exacerbate the ability of various governments to service their ongoing and growing debt burdens.

Hyperinflation is a fiscal phenomenon borne out of a bankrupt state that can’t service its debts. Monetization is a trigger while a rise in consumption and velocity is a psychological effect, as Hazlitt notes. After all, if massive inflation is coming, what's the first thing you want to do? You’ll position yourself in hard assets well ahead of thinking “I need to spend now because this money will be worthless later.”

Comments

[Dave L]

"Why are gold and commodities performing so well if we're in a deflationary environment?"

Because those prices are now being set more by demand conditions in the major emerging market economies, not in the old industrialized world. It's not a harbinger of hyper-inflation.

[Dave]

Is our government run by the banks? If so, why would the banks allow the government to make their assets worthless? Perhaps our huge amount of personal debt is saving us from hyperinflation. Hyperinflation has happened only in economies with relatively low amounts of personal debt.

[BmoreHon]

Deflation may be a prerequisite for hyper-inflation, but there is no guarantee that it will play out in this instance. Sure it could happen, but you're putting the cart before the horse. We are far from that scenario, judging from the ever-dropping treasury yields, not to mention the declining money stock and total credit outstanding.

Still looking at commodities prices (which are heavily manipulated with massive leverage) for clues about inflation/deflation? Mish would not approve.

[kevinearick]

The Bad Assumption

OK, so, let’s zoom back out to the big picture. The corporation has evolved slowly over several thousand years, employing government as its foil, in a mega half-cycle of demographic acceleration sub-cycles, to get to this point, where the current is now in the process of reversing polarity. Within those sub-cycles, communities develop, the corporation issues credit to preferred behavior, the corporation locks up the economy with “standards / certification” of behavior, collateral / RE values plummet, the corporate controllers scoop up the collateral for next to nothing, and the system is re-booted accordingly, for a repeat performance. But the controllers cannot re-boot the system this time around, because there is no room to accelerate the reproduction of 7 billion people.

On the other side of the fulcrum, labor starts from scratch with each generation. Within labor, the premium is in acceleration to adaptation, which starts in the birth cohort. Within the corporation, maintaining control is the premium, which is the same old feudal process, while folks in the middle build out circuits between the voltage potential, with increasing diversity in each round. Now that viral corporate growth has hit the planetary wall, that $500T in promises is due, immediately, because the ongoing assumption fails. The real problem is not the money or electronic monetary expansion. The problem is the behavior, the expectation that tomorrow will look like yesterday, because it has for a few thousand years, which is a blink of an eye in planetary time.

The bulldozer of evolution is pushing the global economy off the cliff accordingly, and the people in front of the bulldozer blade, the controllers and their allocation managers in the hubs, thought they were smart because everyone else was going off the cliff first, everyone that refused to release their non-performing assets that is. They are all tied together by behavior, however, and the more that go ever the cliff, the more weight on the remainder. Greed operates throughout the biological system, and the outcome is always the same; it’s a virus, the plague in extreme cases.

When all else fails, distribute credit randomly (although it would be better to deliver it directly to those who were denied credit over the last 40 years, and specifically to the engineers in that sub-population.)

[sharonsj]

I don't know about hyperinflation, but we have had inflation for the past two years despite what the government claims about the CPI. I see inflation in everything I need to buy from food to utilities. Today I discovered the price of sugar went up 15%--that's on top of the 35% rise six months ago.

The only prices I see going down are clothing. But that's because most of it is overpriced, especially the designers. I found a Ralph Lauren linen skirt in a thrift shop with all the tags still attached. This skirt (which didn't even have a lining), originally sold for $170. I found it in the clearance bin for 85 cents. Is it any wonder so many stores are going under?

[Rocky]

Less than 10 years after the German mark collapsed, the first concentration camp opened in Dachau. If the experts in Washington and New York get it wrong, Katy bar the door. Things will get very ugly, very fast. See William Shirer "The Rise and Fall of the Third Reich" pp. 59-62 ("A House Divided").

[spectator]

Another good pointer in the great unknowable inflation/deflation debate. Have to give round one to the deflationistas. And likely the next couple of rounds as well.

I suspect from now on inflation is tied to global demand, not US demand, which may never come back to be the force it once was. The dollar carry trade will fuel the mother of all wage price spirals on a global scale. The US will be caught in this tempest, with faith in it's currency failing at the worst possible time. But don't worry, such low probability events are not worth worrying about.