Hyper Connectedness and Hyperinflation

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

With 40 yr highs in official measures goods and service prices, it should not be surprising that inflation expectations are marking similar highs.

Although it is caused by increases in money supply, inflation's effect on prices can be shaped by buyer psychology. The greater the belief that money will be worth less tomorrow, then the more consumers will buy today in attempt to get ahead of that devaluation. Prices squirt higher as result.

That is why it is often said that once inflationary psychology takes hold, the toothpaste is out of the tube.

This time around, I wonder whether inflation expectations may be worse than in the past due to the amplifying effect of our increased connectedness. We know that networked individuals are more tightly coupled, meaning that they respond similarly to stimuli and disturbances. 

If the echo chambers of social networks, et al tell individuals that inflation is rocketing, might this exacerbate expectations and the 'buy today' behavior that serves as a coping mechanism?

Weimar Germany. Venezuela. Could hyper connectedness breed hyperinflation? 

Crack-Up Boom

"It's just money. It's made up--pieces of paper with pictures on it so we don't have to kill each other just to get something to eat."
--John Tuld (Margin Call)

Ludwig von Mises coined (!) the term 'crack up boom' to refer to people swapping out of money and into real goods out of fear that purchasing power was being destroyed by ever increasing monetary creation--either through expansion of bank credit or through monetization of debt. 

As supply of money ever increases, demand for money (i.e., desire to hold cash rather than spend it) collapses. People buy stuff even if they don't need it because anything tangible is better than holding cash which is deemed worthless.

Mises witnessed this phenomenon first-hand during the marquee hyperinflation of the 20th century in 1920s Weimar Germany. He saw children playing house with piles of worthless currency, and men pushing around infamous 'wheelbarrow wallets.'

Ron Paul wonders whether we're on the verge of another crack-up boom. Trillion$ in new money have been created with no end in sight. Inflation measures are printing multi-decade highs. Asset prices have followed suit.

He thinks that re-kindling the spirit of liberty would stop progress of a crack-up boom. Why? Because liberty-minded people do not tolerate massive government spending nor central bank intervention in financial (and social) affairs).

That's a worthy cause to pursue.

Inflation and Stocks

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

Some believe that if Big Inflation cometh, stocks will get creamed. Surging prices will drive folks to spend less. Simple ECON 101.

Lower demand for goods and services should be bad for stocks.

A counterargument is that Big Inflation occurs when people get nervous about the value of their dollars sitting idle, so they put them to work today assuming that they can buy more today (i.e., goods, services, AND stocks) than tomorrow. The psychology feeds on itself, creating, in its ugliest form a reinforcing cycle of higher prices and money printing that feeds it.

Although producers are hurt on the input side with higher costs, they can offset them at least partially by raising prices, thereby preserving profit margins to some degree. To the extent that producers own tangible assets, these are also likely to appreciate in value as inflationary pressures rise--giving a boost to book value at least in nominal terms.

In this scenario, stocks are likely to rise. Perhaps not to a degree that completely compensates for purchasing power decline, but at least to serve as a partial hedge that preserves wealth (note Kyle Bass estimates perhaps 85% coverage).

Historical analysis supports this thesis. Weimar Germany, Venezuela, Zimbabwe. Equities tended to rocket in the local currency--even if they didn't keep pace with exchange against more stable currencies (and gold).

One thing seems increasingly clear. In Big Inflation environments, stocks are likely to be a better place to be than cash.

It also seems that, in the current market environment where the CPI is starting to print some big numbers, stocks seem unfazed--like they want to go higher.

position in gold

Policy Uncertainty and Inflation Expectations

"Remember, sometimes when you're blind, and times seem darkest, you can often see more clearly."
--David Sloan (Kickboxer 2)

Article suggests a negative relationship between policy uncertainty and inflation expectations. The greater the policy uncertainty, the lower the expectations of inflation.

This is not necessarily intuitive. I suppose the argument goes like this. When people have trouble predicting what will happen in the institutional/regulatory environment, they will hoard cash and pull back on purchases (kind of like the 'wait and see' approach to investment advanced by researchers). Expectations of price increases therefore decline.

But we've seen the opposite as well, haven't we? In unstable policy environments, people can get nervous about holding onto cash because it might degrade in the future. Dumping cash on the market causes expectations of prices to explode higher. A reinforcing cycle commences where Big Inflation motivates even bigger inflation expectations.

The relationship between policy uncertainty and inflation expectations is moderated, it seems. What are those moderating variables?

Money Spigot

Rain on my face
It hasn't stopped
Raining for days
My world is a flood
Slowly I become
One with the mud
--Jars of Clay

Credit creation is inherently deflationary. Credit money supply increases upon the creation of debt but it contracts when debt is repaid or defaulted on.

In past cycles central banks have countered the deflationary phases with lower interest rates that spark even more credit creation. But each cycle requires lower rates than before, and marginal bang for the credit buck gradually declines.

With lower interest rates waning in their effectiveness and approaching the 'zero bound,' central banks are now turning toward monetization. This involves printing money out of thin air to buy stocks, bonds, and other financial assets to prop up prices in the face of deflationary decline. Why must central banks do this? Well, the system has become so levered up from past credit creation that even small declines in prices threatens to render balance sheets insolvent.

The next logical step involves simply printing money and sending it to people directly. This is the endgame. Flooding the entire economic system--not just the narrow financial system--with freshly minted cash.

This is how all currencies collapse. First excess borrowing and debt. And then opening the money spigot to keep the system solvent, which morphs into a hyper-inflationary endgame.

Inflation and Purchasing Power

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

While inflation carries many meanings, a popular contemporary definition is loss of monetary purchasing power. Stated differently, as inflation goes up, the value of the dollars in your wallet goes down.

The same is true with streams of dollars coming your way in the form of income. Picking up on our previous pension example, suppose that you are 65 and begin drawing a pension income of $1,000 per month (amounting to $12,000/yr). Let's also assume that inflation amounts to 2% annually. That's the Federal Reserve's current inflation 'target,' btw. (Think about that for a second. The Fed is saying that it wants to destroy your purchasing power by 2% each year.)

What happens to your fixed income pension over time in this environment? A 2% decline in purchasing power after one year may not seem like much, but the losses compound annually. After 10 years, that $12,000 in annual income spends like it was only $9,800 in today's dollars (an 18% decrease). At the ripe old age of 85, the purchasing power of your pension would have deteriorated to about $8,000--a 33% decline.

If inflation goes higher, then your pension's purchasing power declines more rapidly. A 4% annual inflation rate turns $12,000 into $5,300 after 20 yrs. At 6% inflation, your annual pension would be worth about $3,500 twenty years later--that's a 70% decrease.

Don't think higher inflation rates can happen? In the 1970's the US saw prolonged inflation rates well above 5%. Other countries (recent example Venezuela) have experienced 'hyperinflation' where inflation rates increase by over 100% annually.

This pension example may seem arcane, but lessons here readily transfer to a mainstream asset class: fixed income. Like pensions, most bonds and CDs pay a preset level of income to their owners on a routine schedule. Inflation erodes the value of these income streams just as it does to pension payouts.

The message should be clear. Inflation, even at 'low' rates, can whittle away at the purchasing power of an income stream. How can individuals protect against the wealth-destroying forces of inflation? If you're still working, you can endeavor to be more productive so that you earn more and outpace the eroding effects of inflation on your paycheck. Retirees, of course, can't employ this approach because by definition they are no longer working.

Another way to hedge against inflation is to invest in asset classes that generate returns deemed to keep up with inflation. Asset allocations that favor stocks and some alternative assets such as gold have historically been decent inflation hedges. Retirees or prospective retirees who have built sizable investment portfolios can offset risk that inflation poses to fixed income pension benefits.

A third way to manage inflation risk presented to some prospective retirees is the lump sum pension buyout. If a decent lump sum offer is made by the pension plan, then it might make sense to take the offer and then invest the proceeds in a manner that hedges against inflation.

Personally, I suspect that inflation rates are likely to increase in the years ahead--perhaps substantially. As I consider the pros and cons of accepting the lump sum buyout recently offered by my former employer's pension plan, my inflation outlook constitutes a 'pro.'

position in gold

Monetization, Pure and Simple

The deception, with tact
Just what are you trying to say?
--The Fixx

When it wants to employ 'monetary policy' to stimulate economic activity, the Federal Reserve can choose from three primary approaches. All three involve the creation money out of thin air (i.e., 'money printing'). However, the dynamics differ depending on the approach employed.

The most popular approach to date has been to lower the interest rate charged to banks that want to borrow funds from the Fed. All else equal, the lower the cost of borrowing money, the more money that will be borrowed. Presumably, banks would then use those borrowed funds to engage in lending, investing, and other activities that would stimulate the economy. The funds that the Fed lends are sourced out of thin air. The catch, however, is that this form of money, sometimes referred to as 'credit money,' is not free and clear. It is not like receiving a $100 bill as a gift. Instead, it is like taking out a $100 loan. The loan is a liability. You can spend the $100, but you must pay it back in the future--with interest at the rate specified by the Fed. As such, credit money created is subsequently 'destroyed' when the loan is paid back. Credit money can therefore be seen as temporary in nature. When credit contracts, so does the supply of credit money.

A second approach is to simply send checks directly to the people. This is the 'helicopter money' idea famously elaborated by former Fed chair Ben Bernanke. To date, the Fed has rarely used this approach, although central banks elsewhere have engaged in goodly amounts of helicopter money--often to the visible detriment of the monetary system (e.g., Weimar Germany, Zimbabwe, Venezuela). A recent example on a small scale here in the US was the 'tax rebate' checks sent to people in attempts to stimulate the economy during the 2008 credit collapse (a collapse which, by definition, destroyed lots of credit money discussed above). Imagine this on a larger scale, e.g., $50,000 checks sent to every US citizen every month, to get a sense of big league helicopter money.

The third approach, one that has gained recent popularity, is monetization. Monetization is where the Fed creates money out of thin air to buy assets. The Fed's three 'quantitative easing' programs (QE1, QE2, QE3) programs were large-scale monetization schemes. From 2008-2015, the Fed bought nearly $4 trillion of Treasury, agency, and other debt from bond dealers. The Fed put those assets on its balance sheet. In exchange, bond dealers got $4 trillion of freshly minted cash. How might this stimulate economic activity? The thought was that, in addition to the direct effect of putting money in bond dealers' pockets (which could be used for investment or consumption purposes), interest rates would also be pulled down by the bond buying (when bond prices go up, bond yields come down). Lower rates, as noted above, should stimulate borrowing all else equal.

Other central banks followed the Fed's lead and established their own flavors of QE-style monetization. Currently, the Bank of Japan and European Central Bank operate QE programs that dwarf the $4 trillion Fed project.

Last week, the Fed announced that, after a four year respite, it will once again buy assets. This time the focus will be on shorter duration Treasuries. The central bank adamantly denies that this is QE, but this is a semantic smokescreen.

Bond buying, whatever the duration and for whatever reason, is monetization, pure and simple.

Treaty of Versailles

"You offer terms. I ask none."
--Balian of Ibelin (Kingdom of Heaven)

Yesterday marked the 100th anniversary of the Treaty of Versailles. Although conventional wisdom is that the treaty marked the end of war and the institution of peace, the reality is that it motivated a period of unprecedented statism and war.

The Treaty of Versailles was actually a collection of treaties signed by individual countries in a series of settlements. In January, 1919, delegates from Britain, France, Italy, and the US convened in Paris for a preliminary conference to decide amongst themselves the terms to offer Germany. Germany was not summoned to Paris until May, and it was not permitted to negotiate terms. Because this violated precedent for resolving post-war differences, the fact that treaty terms were dictated was bound to breed contempt in Germany.

Germany signed the treaty forced on them on June 28, 1919.

The several clauses of the treaty, heavily influenced btw by British economist John Maynard Keynes, intensified the bad taste in German mouths. The military clause disarmed Germany. However, German disarmament was supposed to be part of a general European disarmament sponsored by the League of Nations. But the Allies did not fulfill their promise to disarm, and this broken promise infuriated German public opinion.

The reparations clause, upon Keynes's recommendation, did not fix the amount of reparations that Germany was to pay for wartime damages. Instead, Germany was forced to sign a blank check, which permitted the country to complain that its citizens had been condemned to indefinite slave labor. Moreover, the reparation sums demanded by Britain and France subsequently indebted Germany to the point of the Weimar hyperinflation and country's economic collapse in the early 1920s.

The reparations clause also included Article 231. Article 231 required that Germany accept sole responsibility for starting the war. This was folly, of course, because all major European powers shared responsibility for starting the war. Sadly the charade of Article 231 has been perpetuated in most history books.

The territories clause caused Germany to lose 13% of its land and 10% of its population. Alsace-Loraine went to France, territory in the east (along with Russian and Austro-Hungarian land) went to recreate Poland, the Polish Corridor to the sea cut off East Prussia from the Germany, the Austro Hungarian empire was shattered to create the new nation of Czechoslovakia, and the unification of Germany and Austria was prohibited. Not only did these moves deny the people in these territories the right to self determination--a self-determination that was promised by the Allies prior to the treaty conference--but it festered ill feelings inside Germany about surrounding locales that had been created by force rather than by freedom.

The German people thought the treaty unfair, and they wanted someone to oppose it. The platform for Hitler's rise to power was built on the Treaty of Versailles.

The scope of the treaty also facilitated land deals in Italy, Asia, and the Middle East--all motivated by imperialistic impulses of the Allies. These deals were forced, and violated principles of self-determination for the peoples involved. Negative outcomes subsequently followed, including Italy's fascism and proclivity to side with the Axis in WWII, extremism in the Middle East, communism in Russian, China, Korea, and Vietnam, and militarism in Japan.

It is difficult for the reasoned mind not to conclude that many if not most of the major social and economic problems faced by the world today were set in motion one hundred years ago from yesterday.

Wheelbarrow Effect

Well we barely make the airport
For the last plane out
As we taxied down the runway
I could hear the people shout
--Don Henley

Venezuela is currently experiencing the wheelbarrow effect. This is when hyperinflation hits the point where it no longer makes sense to count currency, in this case the bolivar, being used in transactions. That would take too long. Instead, it is easier to just weigh it--often by the wheelbarrow full.

That could never happen here, right? Only in third world countries and banana republics.

Sure. Just ask the Germans about Weimar.

Inflation Heat

The shadow's high
On the darker side
Behind the doors
It's a wilder ride
--Glenn Frey

Stock futes flipped over this morning after CPI numbers printed higher than expected. Not exactly 'hot' though, as the core CPI came at at 2.1 vs 1.9 exp.

In the scheme of things, measured CPI still looks tame. However, market participants may be waking up to the reality that the Fed Funds Rate has been below the core CPI for about 10 years--by far the longest period in history.

Central banks who, by their easy monetary policies and negative real rates, have been trying to stoke inflation should be careful for what they wish. Once released, the inflation genie is difficult to get back in the bottle.

Hyperinflation Nightmare

Oh, see the fire's sweeping
Our very street today
Burns like a red coal carpet
Mad bull's lost its way
--Rolling Stones

Hyperinflation seems to be a distant thing on people's minds. Yet, gargantuan money supply increases over the past decade place us on the path.

History, famously in Weimar Germany and most recently in Venezuela suggests that hyperinflation lays dormant for a long time before it quickly kicks in. And once it does kick in, hyperinflation is virtually impossible to stop.

Pray that we will be spared this nightmare.

What Hyperinflation Looks Like

Better get yourself together
And hold on to what you've got
Once the music hits your system
There's no way you're gonna stop
--Miami Sound Machiine

Venezuela provides an example of what hyperinflation looks like. Prices rising at double, triple, and even quadruple digits rates.

Hyperbolic currency exchange rates.

Empty grocery store shelves and associated consequences.

Good thing the Venezuelan situation could never happen.here.

Communism and Fascism

And the parting on the left
Is now parting on the right
And the beards have all grown longer overnight
--The Whoe

Socialism is a form of economic organizing in which control of the means of production rests with the state. Rather than consumers ultimately dictating what gets produced and for whom (as in capitalism), bureaucratic planning boards make production and distribution decisions.

While the concepts of socialism have a long history that can be traced back to Greek philosophers, political frameworks for putting socialism in motion are more recent. Of the several frameworks proposed over the past two hundred-plus years, primarily by Europeans, two of them have popularly evolved.

The earlier form, communism, is credited to German born Karl Marx, although many of his concepts were drawn from developers in France and England. Communism espouses equitable distribution of resources in the name of the 'common good.' In its ideal form, property rights and class differences are non-existent, and individuals are supposed to produce according to their ability and consume according to their need. Of course, the strong arm of the state is necessary to confer such equity.

Communism as a political means for socialistic economizing became the rage among European academics and politicians in the mid to late 1800s--particularly in Germany. By the turn of the Twentieth Century, Germany had implemented several social welfare programs patterned on the Marxian ideal.

The devastating effects of World War I and its epilogue soured sentiment for communism among the German people--particularly the part about sharing wealth with comrades worldwide. Political activists, among them an ambitious Adolf Hitler, sensed opportunity in advancing a different brand of socialism--one with a reach that stopped at German borders. The idea was for government to concentrate resource control and distribution among various verticals that were controlled by the state. The proceeds would be shared inside Germany only.

Hitler's National Socialist (i.e., NAZI) Party became the template for similar movements in other countries. National socialism is also known as fascism.

One would think that, because they are both grounded in socialism, that communists and fascists would get along nicely. Historically, however, this has not been the case. In 1930s Germany, communists and fascists fought a bitter battle for power that was ultimately won by Hitler's Nazis. Surviving communists fled and took up residence elsewhere. Subsequently, World War II pitted Germany and it fascist neighbor Italy against the communists heavyweight Soviet Union.

While that war has long since ended, the battle between the two dominant brands of socialism continues, as is currently being demonstrated by street riots pitting fascists against their 'antifa' adversaries.

Easy to Create, Hard to Stop

Oh, a storm is threatening
My very life today
If I don't get some shelter
Oh yeah, I'm gonna fade away
--The Rolling Stones

Great point made by Fleck last nite. Monetary policymakers currently base their actions on the belief that inflation is hard to create and easy to stop.

This is a false belief, as Fleck observes. Properly defined, inflation is easy to create and hard to stop. Witness the gargantuan growth in global money supply under the tenure of central bankers.

When inflation spills over into the prices of goods and services in a big way, the toothpaste is out of the tube. Witness Weimar, Zimbabwe, et al.

People continue to ignore the insane nature of policies currently being put forth by central bankers. These bankers seem determined to ignite a cataclysm that cannot be stopped.

Venezuela

You see it in the headlines
You hear it every day
They say they're gonna stop it
But it doesn't go away
--Glenn Frey

The latest socialist state to collapse is Venezuela. The handiwork of former president Hugo Chavez is now coming home to roost big time. As is always the case in socialist states, economic resources have been grossly misallocated. Production and distribution have withered.

To compensate for hard times, bureaucrats have inflated the currency. Rather than increasing prosperity, this action has only led to hyperinflation.

Shelves are bare. The bolivar is next to worthless.

Socialism strikes again.

Crack Up

There's a room where the light won't find you
Holding hands while
The wall come tumbling down
When they do, I'll be right behind you
--Tears for Fears

Several excellent points made in this interview with David Stockman, including:

Many people who opposed the bailouts of 2008/2009 seem to have no problem with suppressing interest rates for extended periods of time. These people do not appear to realize that extended interest rate suppression policies are essentially prolonged bail out programs favoring one group (foolhardy borrowers and lenders) at the expense of another (savers).

The collapse of the US shale oil patch is just another example of the boom/bust pattern put in motion by central bank easy money policies.

Extreme move by central banks like NIRP are a sign that we are entering the 'crack up' phase. CBs have painted themselves into a corner that they know no way out of. They are now stepping on the gas out of desperation.

Expect huge market volatility following periods of calm and complacency. The discounting mechanism has been broken and market participants are reactive--meaning little warning will precede sharp declines.

Whatever drives the 'weight of disbelief' in central bank omnipotence is what will kick volatility into high gear. While they can win a few rounds, central banks are certain to lose the ultimate confidence game in the end.

Greece's new found pushback against EU-imposed measures designed to keep holders of Greek bonds whole constitutes an important inflection point. Previous can-kicking exercises are wearing out. The new Greek government is now speaking the unspeakable: We're broke. We can't pay out debt back. If this message resonates, then the 'weight of disbelief' increases dramatically.

Political blowback from profoundly stupid and unsustainable fiscal and monetary policies is likely to increase. In previous episodes of blowback led to world war.

Homeward Gold

Take that look of worry
I'm an ordinary man
They don't tell me nothing
So I find out all I can
--Phil Collins

Based on recent NY Fed data, ZeroHedge reports that gold once again appears to by flying out of Fed vaults toward its rightful owners in Europe. In addition to the Netherlands, it appears that Germany wants more of its gold back.

Seems a natural action given Germany's position in pending QE actions by the ECB (summarized nicely by John Hussman here).

Am beginning to wonder whether this massive bond buying program sanctioned by the ECB will be the straw the breaks the flawed EU's back.

If I were Germany, I'd want my gold back too ahead of such prospective craziness.

position in gold

Policymakers NEED Inflation

"The mother of all evils is speculation--leveraged debt."
--Gordon Gekko (Wall Street: Money Never Sleeps)

This missive is exactly right. The Fed and other central banks NEED inflation. Properly defined, inflation is expansion of money and credit supply. A system gets leveraged as credit inflates.

With current leverage in the system, it takes only a small decline in asset prices to turn balance sheets upside down. Because our incomes cannot support current level of debt service, we must resort to ever more borrowing to make ends meet.

This is why the Fed keeps pushing out the date for raising rates. Still grasping some principles from ECON 101, the Fed knows that raising rates (raising the price of debt) reduces quantity of debt demanded.

No credit expansion->not enough debt service->not enough stimulated demand->falling prices->upside down balance sheets->insolvency.

So the ponzi continues until credit can no longer be created at ZIRP or NIRP. Then comes pure money printing a la Weimar.

A most laughable claim is that the Fed is an inflation fighter. In reality, the Fed is an inflation factory.

Zimbabwe Vision

Well, we barely made the airport for last plane out
As we taxied down the runway we could hear the people shout
They said, "Don't come back here Yankee!"
But if I ever do, I'll bring more money
'Cause all she wants to do is dance
--Don Henley

Patrick Barron suggests that the US is heading toward a Zimbabwe moment. We're printing dollars to cover obligations that cannot be covered out of income. The effect of this money printing is delayed because the USD is the world's reserve currency, and central banks worldwide have been purchasing money of these dollars in the name of beggar thy neighbor mercantilist policy.

I would also add that the transmission mechanisms for much of this inflation, QE money laundering and the credit creation ponzis, have largely confined the new money to the financial system where it has thus far inflated only financial security prices.

This Cantillon effect cannot last forever. When dollars make their way into everyday markets for goods and services, it is likely that price increases for goods and services will be quick and steep.

No US in WWI

"You've been given a great gift, George--a chance to see what the world would be like without you."
--Clarence Oddbody (It's a Wonderful Life)

David Stockman suggests many unpleasantries that would not have occurred had the US stayed out of WWI. German hyperinflation (Weimar) and Hitler's subsequent rise to power. The US boom/bust of the 1920s/1930s. WWII. The Holocaust. Atomic bombs dropped on Japan. The Cold War. US empire-building.

I would add domestic policies birthed during the period including Great Depression. Social Security. Oppressive government regulation. Fannie Mae. Various Federal Reserve actions.

In the classic film It's a Wonderful Life, George Bailey is allowed to see how different life would be had he not been born. We have been given a similar gift, reason, that we can apply to historical events and gain insight into the negative consequences of past acts of aggression.

Our challenge is to use this gift, and to apply what we learn.