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.

Electronic Dollars Pegged to Paper Dollars

There are people, like Bernanke, who talk as if electronic dollars are different than paper dollars.  These are really both part of base money but for this post let's think of them as two different types of dollars.

Dollars in a bank's reserve account at the Fed are "electronic dollars" and green dollars on paper are "paper dollars".  Now the Fed maintains a 1 to 1 peg between these two things.  If a bank gives them a paper dollar the Fed will credit them an electronic dollar.  If a bank has an electronic dollar it can turn it in and get a paper dollar.
 
Since there is a 1 to 1 peg between electronic dollars and paper dollars, it is really the banks and their users that determine what fraction of the base money is paper money and what fraction is electronic money.  It is not really up to the Fed.

If the Fed makes lots of new electronic dollars, and people still want the same ratio of electronic dollars to paper dollars, it will result in lots of new paper dollars as well.  They might not have to print the new paper dollars the same day they made the electronic dollars, but after things equalize they will.

Since the Fed can make both electronic dollars and paper dollars, it can theoretically always maintain the peg between electronic dollars and paper dollars at 1 to 1.

However, imagine that many people holding government bonds no longer roll them over and want to get paid in paper dollars.   There could suddenly be $1 trillion of electronic dollars turned in for paper dollars.  I am sure the Fed does not have enough $20 and $100 bills around to cover this.  It would probably take a long time to print a trillion dollars in $20s or $100s.   So what would the Fed do?  It would probably make a $1,000 bill and maybe even a $10,000 bill.

In the Caribbean many people won't take a $100 US bill now because the risk of counterfeit is too great.   I doubt that a $1,000 bill or $10,000 bill would go over well.

Bernake Lies on Camera