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.

Noah:
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.


Noah:
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.

Noah:
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.

Wednesday, August 27, 2014

Regression toward the mean / Pendulum swings back


Hussman has a very interesting graph.




We are currently at extremes never reached before.   We should expect regression toward the mean or for the pendulum to swing back past the mean.   We should not expect to stay at the current extreme levels for low interest rates or for high monetary base to NGDP ratio for a long time.

So how do we return to normal levels?   With  US deficit spending levels, and Yellen as Fed Chair, I don't think there is any real chance of reducing the monetary base.   Over a long enough time, the real GNP might grow by a factor of 2 and bring us back to normal levels of monetary base to NGDP, but I don't think we have that much time before something happens.  So what will happen?   The easy way is for prices to go up so that NGDP goes up.   That is what I expect.   Prices going up.

Prices going up by a factor of 2 or 3 gets us near the mean for the above data.  However, after such extremes, I think we should expect a pendulum swinging to extremes at the other end of the graph.   So prices should go up well over a factor of 3 and we should have high interest rates.

Monday, August 25, 2014

Kuroda Warns JGBs will drop in value this fiscal year


In Jackson Hole, Kuroda said:
Mr. Kuroda vowed to maintain Japan’s aggressive monetary-policy easing until the country reaches its 2% inflation target, which he said could happen as early as this fiscal year.
Mr. Kuroda said that once inflation starts moving higher, 10-year government bond rates around 0.5% will not be sustainable.
If interest rates are going up then bond prices are going down.

I think Japan is primed for hyperinflation and just needs some kind of spark to light the positive feedback loop.  Bonds dropping could be the thing to get the ball rolling.  People don''t like to hold bonds that are dropping in value.  The more people who sell the more they will drop in value.  So we could set off the feedback loop.  In fact, just the central bank chief saying bonds will be dropping might even be enough of a trigger.

Saturday, August 16, 2014

Positive Feedback Theory of Hyperinflation


I contend that Hyperinflation is a set of Positive Feedback loops.   There are many different ways to describe these loops.  One is that after a government has a large debt and a large deficit that it can get into a loop where the more people stop rolling over their bonds the more the central bank has to make new money and buy bonds, so the government has cash to operate.  But the more new money it makes the more inflation there is and the less anyone wants to hold bonds.    So the phenomenon can feed on itself and grow.  There are more loops, but this gives you one way of explaining one part of hyperinflation.

In comments on the previous post Tom said this was circular reasoning.  A good example of circular reasoning is:

       "The Bible is the Word of God because God tells us it is... in the Bible."

In the above the reasoning is circular.  If the Bible is the word of God, then in the Bible God tells you so.   But if it was not the word of God, then God did not say it was.  It is not a good logical argument.

In a positive feedback phenomenon there is a feedback loop made up of real things.   It is not just circular reasoning.   You can watch and measure what is going on in the real world.  You can see how one part pushes another, and that pushes so that it comes back around magnifying the phenomenon.

I think it will help readers to understand my examples of positive feedback loops below, and their common characteristics, before looking at hyperinflation:

Avalanche

A bunch of snow can be sitting on a steep mountain so that it is almost ready to slide.  If something, say a little rabbit, then causes some of it to move, then that can cause more, which causes more, etc.  A small trigger can set off a chain reaction that causes a huge amount of snow to slide down the mountain.

Forest Fire

If there is a high enough density of burnable material in the forest, then a single ignition can set of a chain reaction where a whole forest burns down.

Earthquake

There are two plates of earth touching each other.  But they are slowly pushing past each other.  For many years the ground just slightly flexes under the strain.  However, at some point part of the ground rips.  After the first part rips the strain is too much for the next part and it also rips. This chain reaction continues down the fault line often for miles.


Volcano

Water is mixed in the lava but under such pressure that it does not turn into steam even though it is very hot.  However, if some of the lava on top breaks through the earth dam around the lava and spills out then there is less pressure on the lava below.   If there is enough less pressure that the water turns to steam it can throw off the top of the lava.  This then reduces the pressure on the lava further below which then also releases steam.  This chain reaction can continue till huge quantities of lava are thrown into the air as volcanic ash.

Hurricane Formation

The faster the wind goes the more heat is transferred from the ocean to the air. 
The more heat there is in the air, the faster the wind blows.  So you get a positive feedback loop leading to really strong winds.

Ice Age

The more snow the more sunlight is reflected back into space and the colder it gets.  The colder it gets the more snow accumulates.   You can get a positive feedback loop where much of the Earth ends up covered with snow.

Not only is there a feedback loop as the snow advances, there is also one as it recedes.   The warmer it gets the less land is covered with snow.  The less land covered with snow, the warmer it gets.   So the snow marches forward as far as it can and then it marches backward.

Domino Avalanche

Set up dominoes so that the first one will knock over 2 others, and each of those will knock over 2 more, etc.   So with each time increment there will be twice as many dominoes falling.   One little push can then cause many dominoes to fall over.

Landslide

This is much like an avalanche but earth instead of snow.   There is a bunch of earth on a slope and once some of it starts to break more and more follows till there is lots of earth sliding down.

Earth Dam Failure

If a little bit of water goes over or through an earth dam it can erode a bit of the dam.  This makes for a bigger path for water and so water flows faster.  This then removes earth faster and so water flows faster and faster.   With this positive feedback loop, an earth dam can be quickly destroyed.  

Snowball

With the right hill and snow you can start a small snowball rolling down the hill and it will grow and grow and grow.

Common Characteristics for these and Hyperinflation

In each case there is some set up condition.  Something that has to be in place for a growing chain reaction to be possible.   Under the right conditions, a small thing can set off a large chain reaction.  Once the chain reaction starts it is very hard to stop it.  Eventually it will burn itself out and stop on its own.   Under the "proper conditions", we say there is a risk of this chain reaction.  Even if the reaction has not yet happened, an expert can still see that there is a risk of it happening.

Because a small input can move things to another state, the initial state can be viewed as unstable.   We also tend to see positive feedback loops as causing destruction.

The natural positive feedback loops above, except for the Ice Age, have some form of stored energy which is used up in powering the chain reaction.  This can be potential energy, chemical energy, or heat energy.  I think the equivalent in hyperinflation is the value of the money being used up.

The best prediction you can give for most of these is "a high risk" and not an exact date.   Earthquakes, volcanoes, forest fires, avalanches, etc. are things where an expert can tell when there is a danger, but still not be able to say  exactly when the trigger will be.    I think it is the same with hyperinflation.

It would make as much sense to accuse each of these real world phenomenon of circular reasoning as it does to claim this of my explanation of hyperinflation.

Now on to Hyperinflation

Once you understand the above examples of positive feedback loops you should then read the different ways of explaining the positive feedback loops in hyperinflation

Tuesday, August 12, 2014

Lack of avalanche does not prove lack of risk of avalanche

Hyperinflation is like an avalanche, forest fire,  earthquake, or volcano eruption. Conditions for a chain reaction build up and then things happen fast. But the build up time can be very long. It is not really possible to predict exactly when the chain reaction will start. The best you can do is say that conditions for the chain reaction are such that there is a high risk. Certain types of things can transition from stable to destruction very quickly with very little provocation.

If conditions are right, a small rabbit jumping across the snow could set off a  huge avalanche.   Conditions in Japan are such that some small event could trigger hyperinflation at any time.   Maybe China sinking a Japanese boat or a pension fund getting out of JGBs.  We don't know what the equivalent of the rabbit will be for Japanese hyperinflation, but we can tell Japan has the setup for this type of chain reaction.  

Again and again there are blog posts where people say the fact that Japan or the USA has not had hyperinflation so far proves that the theories saying there is a risk of hyperinflation are wrong.   This is just not true.  That an  avalanche has not happened yet is in no way proof that there is no risk of avalanche.  Such logic is flawed.   It ignores the fast moving chain reaction that is fundamental to the nature of the problem.   The same is true for hyperinflation.  That it has not happened yet does not in any way prove that there is not a high risk of hyperinflation.  Many countries went from normal inflation to hyperinflation rather quickly.

I have yet to have any really strong logical attack on my hyperinflation explained or hyperinflation faq posts.   More than 100 times I have tried to engage other bloggers posting about hyperinflation.

The lack of any serious intellectual challenge to my "positive feedback theory of hyperinflation" is more of a confirmation of my theory than the lack of hyperinflation in Japan or the USA is any sort of refutation.  

Cnningham's Law says, "the best way to get the right answer on the Internet is not to ask a question, it's to post the wrong answer.".     If I was wrong, I really think someone would have been able to point this out by now.

The xkcd Duty Calls sort of sums this up:


I think it is safe to say there is nothing obviously wrong with my theory of hyperinflation. 

Dear reader, if you think there is anyone that could refute my theory of hyperinflation please send them a link to this post.