Is this the beginning of the end for the dollar?

The US runs a trade deficit and normally the rest of the world increases their Treasury holdings every month. However, last month the Foreign treasury holdings went down $17 billion.

Part of the usual hyperinflation situation is that people stop rolling over bonds and get their cash as the bonds come due, and the central bank ramps up cash production. So I have been expecting this.  Some people like Pettis and Mish have claimed that mathematically the world has to keep buying Treasuries, but I don't think that is true at all. If the world stops buying, then the Fed will buy more Treasuries with newly made money. The more the Fed makes money the less people will want to hold US debt. The less people want to hold US debt, the more the Fed will have to buy with newly made money so that the US government can continue to cover their expenses. This is the kind of positive feedback loop that drives hyperinflation till the currency is destroyed.

So I will be watching the Treasury report this week with great interest.  A new report comes out on the 15th or 16th. If Foreign holdings drop again, I think it will be very significant news. I think they will drop.

Gold price and US debt

As the debt limit and debt have gone up, so has the price of gold.  When the debt doubled gold went up by about a factor of 4.   They are raising the debt limit by $2.4 trillion from $14.3 trillion, or about 17%. So one reasonable guess is that gold will go up by 1.17^2 or 1.3689.   So from $1,650 that would get to $2,259. 

Fed Funding Gov Deficit

Many people understand that a government can not just print and spend money for most of its expenses or you get hyperinflation like Zimbabwe did when they tried it.   In fact, many people think Zimbabwe was stupid to even try that.

Many people realize that the Fed creating money and handing it to the US government for bonds is uncomfortably close to Zimbabwe's situation.  So many are expecting that this Quantitative Easing will stop.  However, there is a puzzle as to who else would put $100 billion a month into US government debt.

One popular theory is that banks will borrow money at 0.25% from the Fed and buy US government bonds at higher rates like 1.5% for 5 year bonds.  So the theory goes that the banks are funding the government, not the Fed.   This is foolish as it is really still newly created money from the Fed that is funding the government. 

People think that Zimbabwe just printed money and spent it.  But Zimbabwe had a central bank that financed the government just like the US.   At some point it became clear that the "loans to the government" were just an accounting fiction and what was really going on was they were printing money and spending it.   The same will become clear in the US.   At some point in the future people will think the US was stupid to try it.

Is Debt Situation Like After WWII?

There is an interesting paper that claims the way debt was brought under control after WWII was "financial repression".   The idea is that government debt levels after WWII were about what they are now and the way they were brought under control was by government controlling private finance and inflation.  The expectation is that austerity and hyperinflation are less acceptable choices,  so we should expect governments to use financial repression to flece their populations.

This basic theory is bogus.  The main reason governments were able to cope with such high debt levels back then is that the high spending levels generating the high debt were due to the war.  Back then more than 3/4ths of the government budget was for the war so it was easy to cut government spending in half once the war was over.  Once the spending problem was solved the debt level was not a killer.

Today there is no equivalent way to cut government spending in half like there was after WWII.   Today most of the budget is mandatory spending.  So even though the US debt level is comparable to after WWII, the US debt level now is a far more difficult and dangerous situation than it was back then.

Investors after WWII understood a history of hundreds of years of gold and silver money.   They did not have much understanding of paper money and inflation.  Back then many could be fooled into owning government debt that paid an interest rate lower than the inflation rate.  After the high inflation of the 1970s investors understand inflation better.  Today, with the Internet, word would get around very fast.  There is just no way that same trick used in "financial repression" could work for 30 years now like it did back then.

FredGraph does not go back before 1947 for government receipts and expenditures.   But here is 1947 to 1950:

The government had expenses of less than $40 billion and income of over that.  If the US government today had budget surplus then the debt situation would be comparable.  However, it has a huge deficit and no credible plan to get it under control, so the situation is very different.

We are all deflationists now

There is a big inflation vs deflation debate.  But really both sides believe in deflation.   Deflationists believe in deflation when measuring prices in  paper money.  The inflationists believe in deflation when measuring prices in terms of gold coins.

The meaning of the historical record is not obvious.  In the early 1930s the US was sort of on paper money and sort of 40%  gold backed.  So do you count the deflation in this time as deflation in terms of gold or deflation in terms of fiat money?   I think there is a big clue.  The way they ended deflation was by getting off the gold standard and making it illegal for people to own gold. 

If you look at house prices measured in ounces of gold they are down by about a factor of 4.  That is some deflation.

Flawed excuse to print money

Many economists claim there is a tradeoff between unemployment and inflation.  Hussman shows this is a totally flawed interpretation of some old data.  The original data showed that under a gold standard when labor was in short supply wages went up.  Economists have warped this into a claim that they have to print money or there will be unemployment.    Read Hussman and learn just how bad economists are today.

Gold Safe Haven, Not Dollar

In previous crisis people have rushed into dollars and the dollar became stronger.  This time the dollar is not getting stronger but gold is.  Some point, well before hyperinflation, I expect gold to be more of a safe haven than the dollar.   I think we have reached that point.  It may also be that the trouble in OPEC countries risks weakening the support the dollar gets from oil being priced in dollars.  And clearly it can also be both.

We are starting to get clear signs of price inflation and I expect we will get more.  As signs of inflation go up interest rates will go up too.  Rising interest rates are bad for bonds, stocks, and real estate.   Commodities, gold, and silver may be the only safe havens.

Abandon All Hope

After the US voters showed a clear interest in government having some fiscal restraint congress can only find $74 billion to cut out of a budget of $3,800 billion.  For this and other reasons things are going to get really bad. These cuts will probably really end up smaller.

Over the last two months the 2011 deficit estimate has gone from $1.267 trillion to $1.4 trillion and then $1.645 trillion. So the best estimate of the size of the deficit has gone up $378 billion in the last 2 months when they have been promising cuts.    Every 1% increase in interest rates adds around $140 billion per year in interest payments on the debt.  Interest rates are going up.  These $74 billion cuts are nothing, the deficit will keep going up.

The printing of money is out of control and there is no longer any reason to hope that it will be controlled.  The US has past its Havenstein Moment.  At this point hyperinflation is nearly certain.  As they say when a hurricane is coming, "PREPARATIONS TO PROTECT LIFE AND PROPERTY SHOULD BE RUSHED TO COMPLETION."

Commodities Already Priced in Gold

 If you think in terms of gold coins, there is no commodity inflation since 2002.  However, in paper money prices have jumped up.  In effect the world commodities are already priced in gold.

The last people to switch to the new money will get the worst deal.

Note that 17.5% interest compounded annually for 10 years will result in something being 5 times the original size.  This kind of inflation in commodities will eventually feed through to everything else.

This is not what a recovery looks like.

This graph of food stamp participation is not what a recovery looks like.  

Hussman + Mish => Hyperinflation

Today's Hussman article has a very good explanation of how money velocity, interest rates, quantity of money, and prices relate to each other.  It also shows the fix the Fed is in. When interest rates go up people won't be so casual and slow with their money, so the velocity of money will go up. If other things stay the same, this would cause prices to go up.  He calculates that if treasury bills get to 4%, and the Fed does not take out money, prices will be more than double.  So he figures the Fed must withdraw lots of money.  To do this the Fed must sell the debt it recently bought to get the money supply back down where it used to be.

Mish recently noted that if the Fed sold (or marked to market) the debt they bought over the last few years after interest rates go up they would have a huge loss.   To a good approximation a 30 year bond is worth half as much if the market interest rate doubles.  Mish says the Fed can just hold the debt till maturity so it won't take a loss. The Hussman article show the flaw in this thinking, the Fed must sell to withdraw money when interest rates go up or there will be huge inflation.

Like other banks, the Fed currently operates on mark to fantasy accounting.  They will not really be able to sell their assets for anywhere near what they paid, so they can not withdraw all the money they created when they bought these.  The other problem is that the Fed is monetizing about $100 billion per month and the Federal deficit is about $100 billion per month.  If the Fed stops buying debt and starts selling, how can they find enough buyers?  So I don't believe they will actually sell any, there is no real exit strategy.

If you put Hussman and Mish together, neither of which is a hyperinflationist, you get close to the hyperinflationist case. I highly recommend reading both of these articles and thinking about the implications of the two together.

The Bernanke Stock Jump

On Aug 27, 2010 Bernanke gave a speech at Jackson Hole and since then the market is up around 20%.  I suspect the speech resulted in the stock market jump.  However, there is no meat in the speech to justify such a jump.  It did make it seem that Bernanke was not going to start an "exit strategy" but instead thought he needed to add more money.  Since Bernanke has no skill in predicting the future nobody should trust any forecasting he does. 

In particular Bernanke thought he could hold down interest rates but bond yields are going up since then. At this point bonds are about the worst investment you can make so they should go down and interest rates up for some time.  During the history of the Fed messing with interest rates, stocks tend to move the opposite direction interest rates are moving so we should expect stocks to go down.