The missing Bond Vigilantes are now Currency Vigilantes

The central banks are so aggressive on buying bonds that they are effectively controlling the price of the bonds.   Because of this investors are not shorting bonds but instead shorting the currency.   As the central banks print like crazy to control interest rates on bonds they devalue the currency.   So while there are not many Bond Vigilantes, there are Currency Vigilantes.  

Japan to be First Currency Domino

The Japanese Yen has lost about 20% of its value compared to the dollar in the last 6 months.  The 10 year Japanese Government Bonds (JGBs) are paying 0.61% per year as of Apr 14.  This is the ultimate in return-free-risk.  You lose about as much each week on the Yen going down as you gain in interest for the whole year.   After 10 years you get a total of 6.27%.  But if you bought these 6 months ago and the yen did not drop any more in the next 9.5 years, you would still be down 14% in real terms.   The Japanese central bank has announced they will double the monetary base over the next 2 years.   The Yen will  drop further in value, much more than 6.27% over the next 9.5 years, I promise.  :-)  It is foolish to buy or hold JGBs at this point.  As investors realize this they will want to get out of JGBs.  But the faster they get out, the faster the central bank will have to print money. The faster the central bank prints money, the faster investors will want to get out of JGBs.   We have probably already entered the death spiral and just don't realize it yet.   This is explained in my Hyperinflation FAQ and shown in my Hyperinflation Simulation.  Japan seems about to have hyperinflation. 

After Japan gets hyperinflation, the myth that advanced Democratic countries don't get hyperinflation will be destroyed.  After people realize that the Dollar, Pound, and Euro (*) are not safe from hyperinflation, people will want to get out of bonds in these countries as well.  There will be huge monetization in these countries and then hyperinflation.   Once these 4 currencies have fallen, others will too, since these make up about 95% of the central bank reserves backing other currencies.  Faith in paper money in general will be shattered.   Japan will be the first Domino to fall, but not the last.

I think that this hyperinflation will happen far faster than others. In other hyperinflations people did not understand what was going on, sometimes for years.  When prices are shooting up people will be interested in hyperinflation. With blogs, youtube, facebook, etc. it will not be long before people understand.    Once people understand, the currency dies. So instead of taking 3 years, it might go from start to finish in only 3 months.

The big question is how soon does hyperinflation start in Japan.  Given the Yen's drop on the international markets, the Japanese prices seen for imports are already going up much faster than the 26% per year that counts as hyperinflation.   My guess is the bond panic will be obvious within a few months and the rapid price increases come soon after.  The central bank is aiming for 2% inflation per year, but I bet they get more than 2% per month, which is 26% per year and counts as hyperinflation.  The high inflation in imports and the higher prices exports can fetch will both drive up local prices in Yen.   I think Japan will get a month with 2% inflation within the next 6 months.    Things could just snap some weekend.

We live in interesting times.

(*) The Euro is different than a normal single country currency, so hyperinflation may be more or less likely than normal.

Simulating Hyperinflation

I have a model for simulating the mechanics of how hyperinflation works.  You can see how a simple set of reasonable formulas and a starting situation similar to the US today can cause hyperinflation.    You can play with the simulation here.    Below is an earlier image of the model.  The key point is that hyperinflation emerges mechanically from macroeconomic processes gone wrong.

The key equation behind the model is the equation of exchange, that relates the money supply, the velocity of money, the real GNP, and the price level.  This formula is used to calculate the "Price Level" in my model.

The overall behaviour of the model is correct.  With too much debt and deficit the inflation rate gets out of control.  I think it is a great way to understand the feedback issues in hyperinflation.  There are at least 5 feedback loops you can see in this model.  You can see how the velocity of money affects the price level but the price level changes mean changes in the inflation rate, which affects the velocity of money.  Also how the nominal GNP going up will cause government spending to go up, which increases the money supply (if input for "spending to taxes" is more than 1), which increase inflation, which increases nominal GNP.    Or how bond holders are looking at the inflation rate but their decision not to roll over bonds results in an increase in the money supply, a higher price level, and more inflation.  Also, hyperinflation lowers the real GNP,  which makes inflation worse.  The spending relative to taxes gets worse as hyperinflation progresses, which contributes to inflation.  So these 5 hyperinflation feedback loops are very visible in the diagram and in the results of the simulation.

Note that nowhere in the model is there a "now the people in control vote for hyperinflation" node.  Not a single "war starts now".  No "debt in foreign currencies".  Noplace do I have "people vote themselves money from the public till".  Nothing about "crazy dictator takes over" etc.   No "demand for money goes down" or "confidence in money drops".  Many of the common explanations for hyperinflation are just not to be found in this model.  There are many different ways to get to the starting conditions of a government with high debt and deficit but how you get there does not matter for the simulation of what happens next.  Once the conditions are right, hyperinflation can just happen.

One could argue about the details of the formulas at different nodes, and I am open to suggestions for better formulas.  If you put your mouse over a node you will see an equals sign, if you click that you can see the formula for that node.  Because there are 5 different feedback loops in this model, changing a formula so much that you break one loop will still not prevent hyperinflation, just delay it.   In the real world the velocity of money does depend on the interest rate and the inflation rate.  My function has the velocity vary linearly with these.  In the real world  hyperinflation makes the real GNP go down.  I have it go down for a bit and then bottom out. My function for people deciding to roll over bonds uses the inflation rate and the interest rate.   If bonds are a bad deal people don't want them.  Again, the details of when a bond panic happens are not the point of this simulation.   But a key part of hyperinflation is a central bank printing money when the government does not have money for the deficit or the bonds coming due.     

The model has a few assumptions, of course.  It assumes that if the government is running a deficit that any bonds not being privately bought are bought by the central bank.  I think this is just an accounting identity.  If the central bank makes the money and the government is spending more money than it is taking in then it must be that the central bank is giving money to the government.  In this view the central bank printing is sort of a dependant variable.  In real hyperinflation this is what happens, the central bank must print to support the government.   It simplifies the model to do it this way.

Another way I like to think about it is as if the central bank was part of the government and all money from taxes or bond sales was burned and all money for spending and bond redemptions was printed.  A government could theoretically do this.  It makes it very clear that changes in the money supply come from the difference between taxes and spending and changes in bond holdings.

The point of the model is that when a government has a large debt and deficit they can lose control of the money supply.  They just have to print money if not enough people are buying bonds.  But as they do this the money supply goes up,  the velocity of money goes up, the real GNP goes down, fewer people want to hold bonds, and the inflation rate goes up really really fast. This model can show this dynamic.  Kind of fun.

In the simulation you can set inputs on the right and then click run on the top.   A window will pop up showing a graph.  There are tabs on it to see other graphs.  One of the tabs is "Big Table" and it has a big table with values for many of the nodes in the simulation.    In the top right you can click "duplicate insight" and make your own copy of the simulation where you can change any formulas or anything you want.

At some point people are in a hurry to get out of bonds.  You can see that in these results.  These results are for "spending to taxes" at 1.339, "yearly interest rate %" at 3.12.

First the money supply:

Then the price level, notice how it is up by around a factor of 10 when the money supply was only up by around a factor of 3:

Then yearly inflation factor (1 means no inflation).  In this simulation this is really the inflation so far that year, not the inflation rate at that moment:

Velocity of money:

Bond redemptions.  They go up and then reach as short term bonds are finished and then bonds are redeemed as they come due. 

If the interest rate drops fast enough then it can make the velocity of money drop  fast enough that there is no inflation even when the money supply is increasing fast.  This can only go on for awhile as eventually you get to 0 interest rate. 

There is nothing in this simulation for "bank created money".  This type of money does not seem significant during hyperinflation as banks do shorter and shorter term loans as inflation gets higher and higher.  However, this type of money does help explain the deflation that often comes before hyperinflation.

Please note that no attempt has yet been made to match the timing of the real world.  In the model, when there is more money the prices go up the next day, then the velocity the day after that, etc.   In the real world there are "long and variable delays" (Friedman) between when money is created and when it impacts prices.  Conditions that result in hyperinflation in less  than 1 year in this model could take many years to get to hyperinflation in the real world.

If someone has historical data for hyperinflations that includes money supply,
velocity of money, bond holdings, and price level I would be very appreciative of a copy or pointers to this.  If this model were made to match several historical hyperinflations then it could be useful for predicting timing on future hyperinflations.   If anyone else wants to start with my model and do this you have my blessing.   

For more on hyperinflation please see my Hyperinflation FAQ.

I would also like to put in a plug for insightmaker.com.  I think Insight Maker is a really nice tool for this sort of thing.   Do try it out.  You can "duplicate this insight" and have a copy of my simulation to play with.  Change formulas and all.  I would love to have people try to improve the simulation and then post on their blog what they did to improve the simulation.  Please post a link in the comments here if you do that.  If you don't think hyperinflation is a problem please try to correct the formulas till you don't get hyperinflation and then post about what changes you made.

There are some academic models of hyperinflation.  For example, Modeling Hyperinflation Phenomenon: A Bayesian Aproach,  The Hyperinflation Model of Money Demand Revisited , or A Model of Hyperinflation.   These also references other papers.  I think my model is far closer to modeling reality than the other stuff I have seen.   The quantities in my model are based on real things in the real world, like taxes, bond redemptions, money supply, velocity of money, etc.   Other models are based on more abstract things like "demand for money",  "negative inflation elasticity", or "crisis of confidence". 

Vulnerable to an Adverse Feedback Loop

There is a new paper that studies the issues for countries with high debt loads and the math of how this makes countries "vulnerable to an adverse feedback loop" when debt gets over 80% of GNP.    It is an academic paper and does have a bunch of math, so not for everyone, but I think it is a very good paper.

Krugman thinks the paper should have made a bigger distinction between countries that print their own money and those that don't.  I think the paper well understands that some countries print money.

Abstract from the paper:


Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe. We analyze the recent experience of advanced economies using both econometric methods and case studies and conclude that countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for the U.S. to maintain a sustainable budget course.  A potential fiscal crunch also puts fundamental limits on what monetary policy is able to achieve. In simulations of the Federal Reserve’s balance sheet, we find that under our baseline assumptions, in 2017-18 the Fed will be running sizable income losses on its portfolio net of operating and other expenses and therefore for a time will be unable to make remittances to the U.S. Treasury. Under alternative scenarios that allow for an emergence of fiscal concerns, the Fed’s net losses would be more substantial.

Excess Reserves is like Government Debt

Bernanke came up with a new trick, of paying interest on excess reserves, and it has people fooled so far.

The central bank is created by the government, it operates under rules and laws created and changed by the government,  the leaders are appointed by the government, it is given governmental regulatory powers over banks, and at least in the US case the profits go to the government.  For the rest of this article, try to think of the Federal Reserve as just part of the government.  So if a bank gives their money to the Fed and earns interest or gives it to the Treasury and earns interest, just think of it as giving it to the government and earning interest.

The bank excess reserves at the Fed used to be tiny amounts, not earning interest, just part of the money supply.   In Oct 2008 the Federal Reserve started paying interest on excess reserves and the size has shot up since then.   People understand that this money "just sitting in the banks and not lent out" is not inflationary.   It has let the Fed print lots of money without causing lots of inflation, so far.

The Fed has put out $2 trillion in new money and sucked in $2 trillion at about the same time by paying interest on excess reserves.  The net result is little inflation, so far.

I think the best way to think of excess reserves is as part of the national debt.  Since it is owed by a government agency to something outside government, and earns interest, it really is like a government debt.  Paying interest on excess reserves keeps some money off the street, just like short term government debt, and so reduces inflationary pressure. 

When excess reserves did not pay any interest it was correct to count them as part of the money supply, which does not pay interest.  When they are paying interest they are like government debt and should be counted as such.

If you imagine a big black box around both the Treasury and the Fed, what goes on outside the box, how much money is out of circulation,  the interest earned, lack of inflationary pressure, is no different if when money is loaned into the box it is recorded in the Treasury as bonds or in the Fed as excess reserves.

The monetary base has a big strange jump up when they start paying interest on excess reserves.

However, if we subtract excess reserves from the monetary base then it does not look like anything peculiar is going on.  This could help explain why there has been little price inflation so far.

If we add excess reserves to the national debt it is then growing even faster and is even less sustainable.   

I view this as a clever trick to let the government print almost $2 trillion  that does not seem inflationary, so far, but also does not make people worry about a larger national debt.  It is like they are hiding a $2 trillion debt right out in the open.  It is an amazing magic trick, but it is just a trick.  It does not make anything better.

The near term inflationary pressure is really lower than one would expect from just looking at the monetary base.   However, the hyperinflation risk is higher than one would think from just looking at the official debt and deficit numbers.   As far as the size of the potential money flood in hyperinflation, it is like the short term US debt is $2 trillion higher than people think.  The threshold for hyperinflation has been found to be debt/GDP of 80%.  If we include the excess reserves as part of the debt then the US debt/GDP went from 70% to nearly 110% just since this crisis started.  The upward trend is very steep.

You might think that internal government debt should not be counted.  The following graph just has public debt plus excess reserves.

Next it is interesting to plot gold and the debt including excess reserves, with the price of gold scaled.

Now for some wild speculation.  Paulson and Bernanke had a secret meeting the month before the Fed started paying interest on excess reserves.   At that time Paulson was telling congressmen that if they did not do what he wanted there would be martial law. I can imagine Paulson telling Bernanke that the government needed more money and also needed the Fed to help fight inflation, so the Fed should pay interest on excess reserves to suck back off the street some of the extra money the government would be spending.   Paulson probably understood that it was a trick to hide government debt.  Bernanke might have been in on the trick or he might have been conned.

Comparing Roman and US Inflation

Zerohedge has a good article on Roman hyperinflation.  I recommend reading it all.  Below is an image from the article comparing US inflation to Roman with a "You Are Here".

Nuclear and Monetary Meltdowns

The central planners at the government and central bank think they can print some money and control the inflation rate like a thermostat on a room.  You want things a bit hotter you turn it up a bit, a bit colder you turn it down a bit.  The reality is it is like a Nuclear Reactor.  If you do things wrong there are feedback loops such that events spiral out of control.   Hyperinflation is how it spirals out of control.  Most people don't really understand hyperinflation, so when it comes most people are surprised.   Having people in government and central banks who do not understand hyperinflation controlling your fiscal and monetary policy is like having people who do not under understand nuclear reactors controlling a nuclear power plant.  Things are just bound to end badly.

I saw this analogy in a video.

Modern video of Hyperinflation

In 2011 Belarus got hyperinflation. In this video someone uses a bag of cash to buy some beer. This youtube video of piles of cash from just over a year ago makes hyperinflation more real than a black and white picture of a wheelbarrow full of cash from 90 years ago.

I suspect that credit cards will be used more and more if the US heads into hyperinflation.  Counting lots of paper money looks too painful.  If there was very much of this I think a supermarket would put a bill counter on one "cash line" and make anyone using lots of paper money go into that slow line.  

Good article on hyperinflation

There is a good post on hyperinflation on seekingalpha.  Well worth reading.

Interest Rates and Jobs

Some people believe if interest rates are artificially held down by the central bank printing money and buying bonds that more jobs will be created.   They argue that low interest rates drive up asset prices, which makes people feel rich, so they spend more.   It also causes inflation which can make real wages go down, so employers are earning more profits and can afford to hire more workers.  Also, low interest rates make it easier to build a factory and start a business that creates more jobs.

There are counterarguments to the above but I am going to skip over that and look at something that people often overlook.   Imagine a robot costs $500,000 and the employee he can replace costs $25,000 per year.   If interest rates are 5% then a $500,000 loan costs you $25,000 per year in interest, plus some principle.  At 5% it is easier to have the employee.  But if interest rates are 2% then you are better off to eliminate the job and get the robot.   Artificially holding down interest rates distorts the market toward more robots and less jobs.

The Fed has now said they will keep interest rates down until unemployment gets to 6.5%.   This is just like,  “the beatings will continue until morale improves”.