Saturday, November 8, 2014

Greenspan on Inflation and Gold

Interesting recent interview with Greenspan.  Some parts:

But the fact the fiat currency expansion got very tarnished with -- you know, in 1775, we printed a whole bushel full of continentals. And one of the fascinating things about that period is the fact, for the first year or two, there was very little evidence that that had any effect on prices, meaning that that paper currency circulated with the same value as specie.

And there is an extraordinary -- there's an extraordinary lag which exists between actions of that type and consequences. Now, eventually the continental was not worth a continental. But it took a long while. And I think that we're looking at very similar things now. This, again, is a human propensity.

The Continental currency had hyperinflation.   It is interesting that Greenspan says, "I think that we're looking at very similar things now".   He is directly talking about the long delay between printing money and high inflation, but it sure seems like he is hinting at high inflation this time too.

Greenspan also thinks gold is a good investment:

Tett: Do you think that gold is currently a good investment?

Greenspan: Yes... Remember what we're looking at. Gold is a currency. It is still, by all evidence, a premier currency. No fiat currency, including the dollar, can match it.

First Exchange Rate Drops Then Hyperinflation

In Weimar Germany the exchange rate adjusted well before inflation started.

In Zimbabwe the exchange rate collapsed 72% on November 14 1997.  After that inflation really started picking up.

I believe the normal case for hyperinflation is that the exchange rate drops first and then the inflation picks up after.  The exchange rate reacts quickly while the huge number of prices that make up inflation indexes take longer to adjust.

I expect that Japan will see the Yen exchange rate drop much more before they start getting high inflation.

Wednesday, November 5, 2014

2.6% in 11 days

From Oct 20 to Oct 31 the Central Bank of Japan increased their balance sheet and the base money supply by 2.6%.   The last day of this period was their big announcement that they would be making 80 trillion yen per year.   I wonder if the current 10 day period will be even higher, since all of these days will be after the big announcement.  Will be very interesting to see the next report.

I don't expect the demand for Yen is going up as fast as the supply.  In fact, with all this printing I would expect the demand to go down.

Saturday, November 1, 2014

Impending Shortage of JGB Fools

As a central bank drives up bond prices investors can make money holding bonds, even at low interest rates.  However, at some point the prices get so high and interest rates so low that you really need a greater fool to buy them.  Currently the interest on 10 year JGBs is less than 0.5% per year.  The Yen was down more than 3% for part of the day yesterday and closed down 2.7%.   It takes 6 years of interest at 0.5% to make up for a 3% loss in the currency.  However, there will be many more losses over the next 6 years, so investors will never catch up.  At this time there is no greater fool than someone holding 10 year JGBs, except someone holding 30 year JGBs.  There will soon be an acute shortage of these JGB fools. 

The normal method to get more people to hold bonds in a currency is for the central bank to let interest rates go up.  This past week Russia let interest rates go up to try to make holding their bonds more attractive to the market.

However, Japan is in such a bad situation that this normal method will not work.  The government is spending about twice what they get in taxes, a problem almost impossible to fix.    The yearly taxes were 47 trillion Yen and the central bank is now monetizing at a rate of 80 trillion per year.   The total Japanese government debt is over 1 quadrillion yen (1000 trillion yen).  Money printing is much more than taxes and more than the deficit.  The central bank is effectively funding the deficit and about that much again buying up bonds from the rest of the market, which on net is reducing bond holdings.   Even the pension funds are now getting out of JGBs.  The Japanese government debt is so high that if interest rates go up to about 4.7%, just paying the interest on the debt will use up all the money collected from taxes.  Rates in Japan were this high in 1991.  If people don't want to buy JGBs now, they won't want to buy them when all of government taxes just cover the interest on the debt.  This is not an attractive situation to bond holders.   Half this rate would mean half of taxes just to pay interest, twice this rate would mean interest twice taxes.  Neither of these is attractive to bond investors either.    The normal method of raising interest rates to improve demand for bonds will not work for JGBs.  There is no interest rate that increases demand so the central bank is not forced to monetize even more than the total deficit at this point.  This is a big problem, the central bank is effectively forced to print money with no way out.

When the central bank of Japan announced the increased rate of monetization they claimed it was because they are worried that lower oil prices are pushing Japan toward deflation, so they want to push harder toward inflation.   I think the real reason is nobody else is buying JGBs and people are selling, so the central bank needs to buy even faster.  Also, when they announced the first huge printing it was to double the money supply in 2 years.  This had the implication that they would stop.  Now they are saying they are printing at a rate of 80 trillion yen per year, which does not imply any ending.

At this point the Japanese Central Bank is really funding Japan's government deficit, with no way to stop.   I think the market is starting to realize this and that is why people are starting to flee JGBs.     Soon, if not already, there will be a death spiral where the more the central bank monetizes, the less people want to hold JGBs and the less people hold JGBs the more the central bank is forced to monetize.  The only alternative is for the central bank to let the government fail, which never happens.    This death spiral has many characteristics in common with positive feedback loops in nature, which tend to end in destruction.  In this positive feedback loop, which also include higher velocity of money and loss of confidence, the end is  the destruction of the currency.   

Keynesians live in fear of a deflationary spiral, which in practice almost never happens and when it does is usually slight.  They are now acting like anything less than 2% inflation is deflation, just so they have some real world examples to panic about. However, they can't seem to imagine or understand a high inflation death spiral, which happens rather often to fiat money and is a much greater danger.  They need to study up on the theory of hyperinflation death spirals.

Mark my words, there will soon be a horrible shortage of JGB fools.

Monday, October 20, 2014

BIS Fears Bond Panic

In a BIS report by Guy Debelle there are warnings of the risk of a bond panic.  A few interesting parts extracted below:

When volatility returns, for a number of reasons, including those I have already mentioned, it may well rise quite rapidly.

But if we look back at previous market sell-offs, when market-making capacity was larger, we see that they were often quite violent too.

There are a few other reasons to suspect that the sell-off, particularly in fixed income, could be relatively violent when it comes.

But there are probably a sizeable number of investors who are presuming they can exit their positions ahead of any sell-off. History tells us that this is generally not a successful strategy.  The exits tend to get jammed unexpectedly and rapidly.

Another reason to suspect that the sell-off might be violent is the starting point, namely zero nominal interest rates. That is a point we haven’t started from before (with the possible exception of Japan).

So there is a fair chance that volatility will feed on itself. One should always be careful of looking for too much rationality in trying to understand market dynamics. Given the lack of rational arguments for the current state of affairs, trying to rationally explain how it will unwind is also going to be difficult. 
So in conclusion, there are a number of anomalies present in financial markets in terms of pricing and volatility. There are also some misplaced perceptions amongst market participants about the degree of liquidity present in some market segments. That strikes me as a dangerous combination and unlikely to be resolved smoothly.
I also think a bond panic will feed on itself.  I think the end result will be that the central bank makes lots of new money and buys up lots of bonds, and the value of the currency goes down.

Saturday, October 4, 2014

Noah says Japan Will Monetize Debt

Noah Smith wrote Japan's Debt Trap where he concludes that Japan will monetize their debt.   On this point I believe he is correct, Japan will monetize their debt.  However, he says a few other things I do not agree with.

But if inflation strikes, it could rise high enough to hurt growth, and therefore tax revenue, severely. That would mean game over -- Japan’s government would be forced to default (or to hyperinflate, which amounts to a messier version of the same thing).
Defaulting would not really help because much of the debt is owed to their retired voters.  The government would still end up having to take care of these people, so it would not save that much.  After defaulting the government would still be spending nearly twice what they get in taxes but now the central bank would be the only bond buyer for sure.  With the central bank clearly monetizing their deficit, they would get hyperinflation even after defaulting.  Default in Japan would not avoid hyperinflation.  Yes, hyperinflation amounts to a messier version of default.

But I’m not worried. In the end, a sovereign default is just an accounting exercise -- marking down the assets of some Japanese people and marking up the assets of others.

He should be worried.  Hyperinflation destroys an economy.  It is not just an accounting exercise.    I suspect he need to read my CMMT article.

The fact is, no one really knows what causes high-inflation episodes to begin.
I really think  I understand and can explain how high inflation episodes work.  In fact, I have a model with which I can simulate how high inflation quickly begins.  It is true that predicting the exact start time of a positive feedback phenomenon is not really possible.  However, we can tell Japan has a high risk of a hyperinflation chain reaction at any time now.

Saturday, September 27, 2014

Lenin and planned hyperinflation

Gary North quotes Keynes and someone who says they got some notes from someone who interviewed Lenin.    Part of it is:

Hundreds of thousands of rouble notes are being issued daily by our treasury. This is done, not in order to fill the coffers of the State with practically worthless paper, but with the deliberate intention of destroying the value of money as a means of payment. There is no justification for the existence of money in the Bolshevik state, where the necessities of life shall be paid for by work alone.
 Assuming this quote is correct, my bet is that after the currency was "practically worthless paper" Lenin was trying to pretend that it was planned so that it looks like central planning works.   If he admitted that he did not want his money to be worthless it would seem central planning was a failure.  Lenin needed to seem in control.

In another quote Keynes says:

In the latter stages of the war all the belligerent governments practiced, from necessity or incompetence, what a Bolshevist might have done from design.
The "might have done from design" seems to indicate Keynes had some skepticism about the claim that Lenin did it on purpose.

This is the only case of hyperinflation I have found where there is any claim that the hyperinflation was intentional.  I just don't buy it.  I suspect this case was just like all the others,  the market reacting after  government had too much debt and deficit and out of control money printing.

Saturday, September 13, 2014

Central Banks Jump The Shark

There was an episode of Happy Days where Fonzie jumped over a shark on water skis.  Since then the idiom Jumping the Shark has come to mean when the creators of a show have run out of good ideas.

Japan's central bank has made negative interest rates and also Europe’s central bank has made negative interest rates.   This means they have run out of good ideas.   These central banks have jumped the shark.   From here on the quality will go downhill.   It will not be fun any more.

Wednesday, September 10, 2014

Japanese Yen Heading For Hyperinflation

The Yen is down more than 4% in the last month against the dollar.

The 10 year Japanese Government Bonds (JGBs) pay 0.54%.   So losing 4% in value is about like losing 8 years worth of Interest.   If you can lose 8 years worth of reward in one month, the risk and the rewards are way out of whack.

The demand for JGBs is very low.  Many of the buyers are really just front running the central bank.   The central bank has driven some rates below zero.  Investors and traders are happy to hold bonds while interest rates are going down because the value of the bonds goes up.  With interest rates below zero, it is time to get out. 

In the Aug 31 report from the Central Bank of Japan, they had increased their balance sheet by 1.1% in the previous 10 day period.   This is printing money at hyperinflationary rates.

I think Japan is falling into the grip of the positive feedback loops of hyperinflation.  It does not make sense for investors to roll over JGBs.   As people don't roll them over, the central bank becomes more and more the only buyer.  But it is buying with newly made money which makes holding bonds an even worse investment.  The more new money, the less people will want to hold JGBs or the Yen.   But the less people hold, the more the central bank will make money to buy JGBs.   Seems like the death spiral is starting to circle for the Yen.

A big part of the last month change is really that the US dollar has gone up.  So one could argue that it is not the Yen going down but really the dollar up. 

Right now Great Britian may be losing part of their tax base to independence.  If Scotland leaves, Northern Ireland may follow.   The Euro has gone even more crazy with printing money.  So maybe it is that the Pound, Euro, and Yen are all going down and not that the dollar is really going up.

If an expert saw water coming through a gopher hole in an earth dam he could tell you for sure that the dam was going to fail very soon.  Once the positive feedback loop for dam failure starts, it is just a matter of time.  I wish I was such an expert that I could tell you for sure that the positive feedback loops for Yen hyperinflation have started, I really think so,  but I can't tell you for sure.

Full disclosure:  Author is short Yen.

Wednesday, September 3, 2014

Krugman's Missing Model

For years Krugman has been posting asking if anyone has a model of how a country that prints its own money can get into trouble from high government debt and deficit.  Here is one quote, but there are many many others:
I find it quite remarkable that nobody has managed to produce a coherent model to justify the seemingly simple story that anyone, even a country that borrows in its own currency, can suddenly turn into Greece. Again, show me the model!
I have the model he is looking for!   Of course when you print your own money the exact failure mode from too much debt and deficit is a bit different but no less dangerous or bad.

First let me quote Wikipedia about economic models, "In economics, a model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using mathematical techniques."  Also, "A model establishes an argumentative framework for applying logic and mathematics that can be independently discussed and tested and that can be applied in various instances."

In my model of hyperinflation there are positive feedback loops.   It is very similar to an avalanche, earthquake, volcano, or forest fire.  Conditions build up that make a chain reaction possible.  It is hard to predict when the chain reaction will start because some small thing triggers the chain reaction.  After starting, the chain reaction happens relatively quickly and with impressive power.   Once started, it is very hard to stop.  Eventually it burns itself out.

There are many different ways to explain the positive feedback loops in hyperinflation.   Different economic theories explain it differently.  There are many good ways to think about hyperinflation.   Here is just one sample from that link:

There can be a feedback loop where the more the central bank makes money and buys bonds the less people want to hold bonds, but the less people hold bonds the more the central bank has to monetize so the government has cash to operate.  This results in a flood of new money and inflation.  The inflation causes the velocity of money to go up.  Governments almost always try to fight inflation with price controls.  The resulting shortages make the real GNP go down.   Using the equation of exchange view of hyperinflation, we can see that if the money supply is going up fast, the velocity of money is going up fast, and GNP is going down, that prices will go up very fast.  Hyperinflation is a triple whammy of inflation.  Of course, the more inflation goes up, the more value bonds lose, so the less anyone wants to hold bonds...

I also have an online simulation showing how hyperinflation works.   It shows how hyperinflation emerges mechanically from macroeconomic processes gone wrong.  This shows 5 different feedback loops with reasonable formulas can quickly go from normal inflation to high inflation.   It uses things like "money supply", "inflation rate", "velocity of money", "interest rate", "GNP", etc.   I think my model is closer to the reality of hyperinflation than any other I have seen.  All the details of the model are well specified so that the computer can run the simulation.   Anyone can easily change the inputs or even the formulas and see how it would change the results.   They are invited to publish their version of the formulas for further argument/discussion.   It is a good model for learning and thinking about how inflation spirals out of control in a country that can print its own money.  This is the model Krugman has been searching for.

I have been unsuccessful in contacting Krugman.  If you know how to contact him, please let him know I have the model he is looking for.