Time to get worried about Hyperinflation

 

Michael Burry warned about Hyperinflation.   Then the SEC made Burry shut up.  You should never believe anything until it is officially denied.

 QED

 

Fed Bubble Trouble

 I have tried to explain to friends and family why I think there is a real risk of the stock market dropping by a factor of 4 or more.   It is hard to explain in conversation and it is easy for them to dismiss me.   I decided to put down my thoughts here and see if I can make a more plausible case in writing.  

First I will explain a very simplified model to evaluate a reasonable price of major asset classes.  Then show how interest rates and inflation impact these prices.  Then explain how the Fed can blow bubbles and why they eventually pop.   Then how far down things can go after a pop.

The 3 main investment categories,  bonds, real-estate, and stocks can all be viewed as a future stream of income that you are trying to put a current price on.  The bonds pay interest, the real-estate pays rent, and the stocks will eventually pay dividends (or buy back shares, but lets simplify that out for this).   The bonds state what the payments should be, so the question is just will the issuer of the bonds really pay or will they default.  With real-estate you have to have some idea of what future rents will be, what operating costs will be,  and what percentage of the time it will be rented.  With stocks to have to figure out what the profits for the company will be in the future (and the odds of it surviving) and what that comes to per share.  Fundamentally in each case you are putting a price on a stream of payments.  

There is a "net present value" calculation for what a future stream of payments is worth today.  This depends on the interest rate.   So changes in interest rates change the "net present value" of all 3 of the main investment types.  

By changing the interest rate, the Fed can change the present value of things.  If the Fed lowers the interest rate, the current price of these investments goes up.   This makes people feel richer and they also pay more taxes on profits and such, so it is good for the government too.   

The problem is that by making the interest rates artificially low, the Fed is making the prices of investments artificially high.   The right way to think about this is, "The Fed can blow bubbles".

 The reader may be thinking that they don't do a "net present value" calculation, and that is fine.  But even if you are just using your intuition to decide where to put your money, the interest rates change how good the yields, rents, company earnings of your potential investment seem to be.  For simplification, lets pretend that the neural network in your head does some sort of "net present value" evaluation and interest rates are really important.  This fits with what we see experimentally.  

Many investors will think that these artificially low interest rates can last for the next 30 years, but they can't really.   So the "net present value" calculations are all in error.   They assume some low interest rate for the next 30 years to get the high current price of the investment.   But that was a wrong assumption,  the interest rate won't be low for the next 30 years.  There is a saying, garbage in, garbage out.   The calculation is only as good as the input.   At some point investors realize they need to use a different interest rate and reevaluate what the "net present value" is.   When they calculate with a higher interest rate, the current price calculates lower.  If the interest rate is assumed to go up by a lot, the resulting current price can be far lower.   This is when "the bubble pops".

The Fed was created in 1914 and made lots of new money in the 1920s and kept interest rates down and caused the Roaring 20s where stock prices went up.  Then we got the 1929 stock market crash.  Eventually stocks were down by something like a factor of 8.

In the 1970s when interest rates were high the P/E on stocks was low, like 5.  Today the P/E on stocks is high, like 43 because interest rates are really low.   If people realized that interest rates were going back up to 1970s levels then stocks could go down by a factor of 8.

Because the reader was not investing in stocks in the 1920s and 1930s, and probably not even in the 1970s, this seems too far fetched to be a real concern.   But I think the reader should be concerned. 

You may think, why can't the Fed just keep interest rates artificially low forever?  The reason is inflation.   If they are loaning money at 2% and you can buy copper (or anything) and watch it go up at 6% then so many people would do it that it would go up at 20%.   If they keep printing money once the inflation starts, they can get hyperinflation.  

Recently the inflation index graph is curving up.   The last CPI report was 4.2% for the last 12 months.    People will say there are "base effects" because of the dip in the previous graph.  But that dip means that the next report will be even higher.   It does not imply that future reports are lower though.   If the last few months the CPI index was steady, then after we got past the dip we would have lower inflation (12 month change in index).  But the last few months the CPI index has been going up as fast as it was coming out of the dip.  So the "base effects" argument does not really work. 

It seems we are getting the start of inflation.  If we do get inflation, the stock market could come down by a factor of 4 or more.   There huge trouble is a real possibility.

In The Great Crash 1929 by Galbraith on page 108 it has:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." 

I fear this crash will be like the 1929 one and would like to warn my friends that although every previous crash in their investing experience was over after a 30% or 50% drop, this one really may not be.   Do not be eager to jump in.   The bottom can be far further down than you think.

The following graph comes from an interesting paper with many other graphs.  The yield is the Earnings divided by price for the stock market (inverse of P/E ratio).   So if you subtract the CPI and plot it you are showing how much above inflation the stock yields should be.  On average it is 4.9% above inflation.   When it gets too low you get the shaded areas that are bear markets.   The inflation rate has gone up since the end of this graph so the current plot would be even lower.   It really seems a bear market should follow.  Just understanding this graph means that as inflation goes up the P/E for stocks will go down.

Must be serious

Jean-Claude Juncker said, 'When it becomes serious, you have to lie'.  When the Fed says, "this is not QE",  they are lying.   The current situation must be serious.   QED

 

Simulating the Difficulty of Putting the Inflation Genie Back in the Bottle

I have updated my Hyperinflation Simulation so it will pause after some level of inflation and you can adjust the sliders to try to stop the inflation.  So if the first pause is at 10% inflation you might increase taxes and set the second pause to be at 20% inflation and then continue.   This makes it an interactive learning experience, almost a game.  It really is very hard to put the inflation genie back in the bottle.   The above link is the ongoing latest version, here is a link to version as of 11/22/19.   Here is a link to my 2013 post about my simulation.

Most people think that if inflation gets too high the government can just increase taxes or reduce spending to stop it.  In particular the MMT types believe this (increasingly popular among Democrats).  If you believe this you don't see any big problem with printing money.   In fact, some people think there is no need for taxes until the inflation starts.   For more on MMT please see this post.

This simulation shows the error in the MMT way of thinking.  Once inflation gets to where people are fleeing bonds the money supply can increase so fast that taxes can not keep it in check.  If the government is running a deficit the central bank has to be willing to buy bonds when nobody else is, or the government shuts down.   In all cases so far the central banks rather print money and buy bonds than see their government shut down and their jobs and paycheck go away.   Sometimes laws were changed or the head of the bank was changed, but in the end they always seem to buy the government bonds.  The new money from debt monetization can be many times the flow of taxes, so taxes can not compensate for it.  

Another problem is that taxes take awhile to collect.  If we imagine that on average there is a 30 day delay between a taxable event and when the citizen pays the government, then it is as if taxes are on the GNP of 30 days ago.  Normally this does not matter, but in hyperinflation it means the government is collecting far too little taxes and so has to keep printing.

The core of this simulation is using the equation of exchange to calculate price.   It also uses Hussman to estimate the velocity of money.   There is a good explanation for the math of hyperinflation.   I believe this is the most reasonable and educational simulation of hyperinflation on the Internet (also the only one :-)) but that it could be improved.  I wish I had data for debt, quantity of money, inflation rate, interest rate, monetization, price level, etc for a bunch of different hyperinflations. I don't have any real world data to get  delays/anticipations to plug into the model.    How fast things happen in the model probably does not show how fast they happen in the real world.


I would love to have people play with the simulation and suggest better formulas or defaults.  Report any funny behavior.    You can also clone this simulation and adjust all the formulas.  Please comment with a link if you do.

Historically people have noticed the difficulty of "putting the inflation genie back in the bottle".  This hyperinflation simulation shows why it is so hard.  Hyperinflation is best seen as a "debt monetization death spiral".  Once you enter a death spiral it is hard to get out.   I think if people really understood the difficulty they would be far more concerned about preventing inflation from starting.

Keynesian Leaches

There was a time when doctors would prescribe leaches for certain health problems.  When it did not work they often just increased the dose, with more leaches.   Often the leaches would kill the patient.  The Keynesian economists today do a similar thing.  They prescribe money creation.  When that does not work, they prescribe an increased dosage of money creation.   Eventually the patient, the economy, dies.

James Rickards on Japan

"Jim is increasingly convinced that Japan is ground zero for some very serious problems coming in the global economy. "     I think so too.

Shape of graph for BOJ holdings of JGBs

In an article on the BOJ holdings of JGBs they have the above graph.  Note that BOJ is Bank of Japan and JGB is Japanese Government Bonds.  The red curve above is actual data and the blue part is a projection.   I think the projection is wrong.  The red part looks like it is curving up while the blue projection is linear.  If the curve is really an exponential growth curve, and the projection is linear, then after a few years the projection will be way off.  Even with this linear projection they get to owning about 50% of the JGBs within about 2 years.  I don't believe there is any historical case of any country monetizing such a large fraction of such a large debt without very high inflation.  If inflation picks up you can be sure everyone will want to dump their JGBs, since fixed rate bonds lose value fast as inflation picks up.  This will make the BOJ buy even faster.  So I expect the real graph will keep curving up.

All you need to know

People think central banks have "lots of different tools to work with" but really they have one trick, they can make more money.   The details on on how they do the trick, the words, and the smoke, can change, but at the end of the day their only "secret weapon" is making more money.  If the only tool you have is a hammer, you treat every problem as if it were a nail.  If you try to fix your car, or the economy, with a hammer, it probably won't be a happy ending.

Studies of Failed Currencies

Somehow I have been credited with a study of 599 failed currencies, though I have not done such a study.   There have been studies of the history of failed currencies and it seems good to have a post where we can collect such studies into one place.   If anyone knows of other interesting studies  please post them in the comments and I will add them to this list.

1) History of Fiat and Paper Money Failures by Mike Hewitt.

Has a list of 177 current currencies and when they were started. I count only 16 of these as existing prior to 1900.

It has a list of 609 currencies that no longer circulate and says 153 of these died of hyperinflation.

2) Inflation and the Fall of the Roman Empire by Arto Bendiken

Detailed history of Roman inflation.

3) Fiat Currency: Using the Past to See into the Future by Nick Jones at Daily Reckoning.

Looks at Rome, China, France, and Germany. Says China's paper money was called "flying money" was because "because it could just fly from your hands.". To clarify, people would spend hyperinflating paper money as fast as they got it and hold onto silver coins.

4) Fiat Money Inflation in France by Andrew Dickson White

Fantastic book (free online) with detailed history of a French hyperinflation.

5)  5 Failed Currencies And Why They Crashed by Investopedia

Looks at Germany, Argentina, Zimbabwe, Peru, and Chile.

Referenced but not located studies.

1)  " 775 fiat currencies by DollarDaze.org" but the domain dollardaze.org does not work.  Wonder if someone has a copy.

Stock Market Omen

The S&P 500 recovered much more from the Aug drop than the Russel 2000 did. When people start to get nervous they move from smaller "risky" stocks to larger "safer" stocks. This often happens before a big crash.