Posts Tagged ‘hyperinflation’

Is there any benefit for Aussies to invest in gold?

Tuesday, November 16th, 2010

Recently, one of our readers who bought How to buy and invest in physical gold and silver bullion wrote to us,

I live in Perth so am looking to buy bullion from the mint, just down the road, literally, however I?m concerned about how the fluctuating US dollar affects my investment. Surely during hyperinflation of the US dollar gold will obviously go up, but also the Aussie dollar will strengthen significantly at the same time. If the Aussie dollar goes up more than the gold price, I actually loose money in Aussie dollars for which i use to pay my gold (If I use us money trading account…i will loose money when i finally exchange us to aus $$ if the exchange rate is super high)…is this a realistic situation or in a case of hyperinflation, is gold likely to spiral upwards whereas the Aussie dollar marginally increase in relation to the US$…….i.e will the spiralling gold price and hyperinflation in the states cause equivalent hyperinflation worldwide and therefore maintain the “approx” AU/US $$ exchange rate.? I can see gold skyrocketing but if the Aussie dollar also sky rockets also…this is of no benefit is it>>> or is it???

our dollar is very strong at the moment and predicted to get stronger, hence, i will loose money by investing in gold or silver, but i have no trust in the US financial system. Is there a way i can hedge myself against a strengthening Aussie dollar??

I realise u don’t have a crystal ball…I’m not holding you to anything i just want your opinion.

As we can all see, currently there?s a correlation between Australian dollars (AUD) and gold price. Hence, from the point of view of Australian investors of gold, a rising gold price (in USD) does not benefit them. We see that correlation working out in 2007 and today. Today, even though gold prices had hit a record high in USD terms, it is still below the record high in AUD terms- gold hit a record high of around AU$1500 in 2009 when the AUD was very ?weak?.

To answer our reader?s question, we have two points to make:

Back to the basics?

First, let?s revisit the basics. As we wrote in How to buy and invest in physical gold and silver bullion, when we invest in gold, we are not so much into ?making? money. We are doing so to hedge and protect our existing wealth. In other words, gold is not so much of an investment. Instead, it is more of an insurance policy. Therefore, we wouldn?t be so concerned if our ?investment? in gold is not turning out well in terms of AUD. However, what we are more concerned is the possibility of an AUD currency crisis. We have written about that in Will there be an AUD currency crisis?. We are not saying it will happen. Instead, we are suggesting that there?s a possibility that it may happen and by ?investing? in gold, we are hedging ourselves against that.

USD the reserve currency

Regarding the mess in the US financial system, it would be quite an entertaining spectacle if the US is just an inconsequential banana republic like Zimbabwe (which incidentally fell into hyperinflation- a object lesson for the US to learn). In that case, the case for ?investing? in gold will be much weaker.

Unfortunately, the US is not an inconsequential banana republic. It is a superpower whose currency is the world reserve currency. As we wrote in How to buy and invest in physical gold and silver bullion,

The United States, with ?helicopter? Ben Bernanke at the helm of the Federal Reserve, is committed to money printing to solve America?s economic woes. To the extent that the US dollar is the world reserve currency, it will affect the rest of the world.

Because it is the world?s reserve currency, China ?saved? most of the fruits of its hard work in the form of that reserve currency (a cool US$2 trillion worth). Same thing for Japan. Ditto for many other countries.

By printing money, the US is devaluing the world?s reserve currency. But the world cannot afford to have its reserve currency devalued towards the value of confetti. As we wrote in Why did the foreigners bail out cash-starved financial institutions?,

China?s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

So, what is the solution to the devaluation of the reserve currency? As we wrote in What if the US fall into hyperinflation?,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

That?s why there?s a threat of a currency war between the US and China right now. The US is accusing the Chinese of manipulating their currency while the Chinese are pissed off with the US for exporting their inflation to China. As the US prints and devalue its reserve currency, China will be hard pressed to devalue theirs too (in the form of a currency peg). If China let their yuan soar in value, their exports will collapse, which will severely affect their economy and social stability. Japan is in the same situation too. A strong yen (relative to the USD) is very bad for their economy too. That’s why Japan recently cut their already super-low interest rates and there’s talk of more money printing on the Japanese’s part.

Now, look at Australia. Let?s imagine that the AUD reaches US$1.20 and is threatening to march forward to $1.40 and beyond. If the AUD gets too strong, it will hurt the Australian economy. In such a situation, Australia will be hard pressed to devalue its currency too (e.g. by cutting interest rates, direct intervention). Or maybe impose capital controls.

In other words, the world is in a situation where there?s a competitive devaluation of currencies. In the recent G-20 summit, countries are pledging not to engage in that. Well, if you doubt their words, then you will sleep better to have your own reserve currency in the form of gold.

In any case, it?s going to be very rough ride in the forex markets. If you are forex speculator, this is heaven. If not, then it is going to suck.

Unemployment in Weimar Germany

Thursday, October 15th, 2009

Since the powerfully rally several months ago, there are many economic indicators that seems to point to an economic recovery (there are also indicators that point to worsening economic conditions). In Australia, we have the ‘honour’ of being the first Western developed country to be on the road to recovery, with unemployment rate actually falling. The Reserve Bank of Australia (RBA), in the belief that emergency threat of deflation is over, decided to raise interest rates (and indicated that more rate rise will follow).

For the bears (particularly for those who are in the deflation camp), this is a very trying time. Some of them even seem to be throwing in the towel (e.g. Gerald Minack).

But is it really blue skies ahead?

Our view is that, when governments print copious amount of money, mirage of prosperity can appear. In fact, money printing, in addition to doing wonders for stock prices (see Should you be bullish on stocks?), can also do wonders for the unemployment rate. Let’s take a look at this book, The Economics Of Inflation- A Study Of Currency Depreciation In Post War Germany, written by Costantino Bresciani ? Turroni, an economist who lived through the German Hyperinflation of the 1920s,

In the summer of 1922 unemployment practically disappeared. It appears that?in spite of the gaps caused by the war in the ranks of the working population?the total number of individuals occupied in industry, agriculture, commerce, public services, etc., was greater in 1922 than before the war.

Next, we will show you the graph of the unemployment rate:

German unemployment rate 1913-1922

German unemployment rate 1913-1922

As we can see, in the midst of hyperinflation in Weimar Germany, as the standards of living of workers collapsed (as the German mark depreciate against the US dollar), the German economy had made great ‘strides’ in the area of unemployment!

So, don’t be surprised if the US economy’s unemployment numbers actually improved in the months to come. This need not necessarily be a sign of prosperity. Instead, it can be a sign of inflation.

What should the ‘evil’ savers do?

Sunday, June 14th, 2009

In our previous article, What goes in the mind of the Rudd government as it extends FHOG?, Rebecca asked the following question:

I was wondering, can you guys make any suggestions on what potential first home owners OUGHT to be doing INSTEAD OF leaping upon the FHOG [free cash (of around $14k to $21k) that Australian government gives to first home buyers]? This reader may, uh, be personally invested in the answer to such a question 😉 but I bet a lot of others are in the same boat: people who’ve been saving saving saving only to have the cheese moved $21,000 ahead again (thanks KRudd!), and now face the possibility of having their hard-saved future deposit decimated by inflation because it’s still liquid rather than sunk into bricks and mortar?

Assuming stable employment (easier said than done, but run with me here), isn’t the property market almost a safe bet now just because Kevvie’s obviously bailout-happy and presumably knows he’s not going to be very popular if he lets all the first home owners he made go under, so is likely to keep on bailing?  Does the traditional advice that a person save a good deposit apply any more when the only way to save your money is to have it invested in property or some other format that’s not going to get devalued should inflation occur? What else can one do to escape being a victim in this whole mess simply through being on the poor end of the spectrum and trying to do the right thing and be responsible?

Basically, as Rebecca asked, let’s say these 3 conditions are satisfied:

  1. Assuming you have a guaranteed stable job (if we read Rebecca correctly, other people are not in this envious situation).
  2. The government will succeed in enticing people to go deeper and deeper into debt to bid up property prices higher and higher.
  3. If those who are enticed into debt default, the government will bail them out.

Wouldn’t this result in property price rising further and immune to a price crash? If that’s the case, should savers gouge themselves in debt instead because the government is committed to moral hazard?

[Note: some parts of what follows are a bit of sarcasm and humour- so, don’t take them too literally.]

Sure, it can be very cheap and easy for the government to engineer further property price inflation. The FHOG is an example of that. The government needed to fork out a relatively small outlay to result in a much larger increase in borrowing, which helps to inflate property prices even more. To see why, imagine a borrower has a $1000 deposit. At 90% LVR, he can buy a house that cost $10,000. Let’s say the government give the borrower another $1000. At the same LVR, this borrower can now pay $20,000. Thanks to the powers of leverage, a $1000 outlay from the government result in an increase of $9000 in debt.

Sure, in the event that the sh*t hit the fan for the Australian economy, the government can bail out defaulting sub-prime borrowers willy nilly and prevent a property price crash. They can print copious amount of money (until Australia runs out of paper), invoke emergency powers to prevent repossessions, confiscate the wealth of savers to bail out irresponsible defaulters, nationalise banks, and so on.

The problem is, if the sh*t hit the fan for the Australian economy AND the Australian government engage in such extreme moral hazard, Australia will become a big banana republic and the Australian dollar will have less value than toilet paper. Foreigners lend a lot of money to Australia and they will readily punish any extreme moral hazards. In that case, all Australians will lose big time, especially savers. And also, a property is not recommended in such an environment because:

  1. One cannot carve out a tiny fraction of his property in exchange for food.
  2. There are much better hedge against hyperinflation than property- gold and silver. The reason is because credit will be scarce in a hyperinflationary environment because lending money is a losers’ business. If credit is scarce, what do you think will happen to property prices in real terms?
  3. As lenders raise interest rates to match the rate of hyperinflation AND one loses his job, one is essentially stuffed (unless the government bails him out).

So, if you believe Australia is going towards that route (it may not be as extreme as the scenario that we painted, but you get the idea) and you want to protect your savings, you may want to diversify part of your savings away from Australian dollars (as well as any assets denominated in Australian dollars). Ideally, such diversification should transfer your wealth to foreign countries, where the foreign government is in a position to respond with a “stuff you” to any Australian government’s demands for information about your foreign assets. For example, you may want to consider foreign currencies (preferably in foreign banks out of reach of the Australian government), physical gold and silver (stored overseas or buried in some secret treasure island guarded by dragons), foreign assets and so on. Lastly, if the masses and government persecute the evil savers the same way the Nazis persecute the Jews, be prepared to migrate.

Please note that we are not trying to be unpatriotic here. Our point is that, if politicians resort to extreme stupidity, they can easily turn a nation into a banana republic in record time. Just ask how Robert Mugabe did it by turning the bread basket of Africa into a starving and improvished nation.

How well will stocks do in times of high inflation?

Tuesday, April 28th, 2009

As we all know, governments all over the world are engaging in expensive and wasteful bailouts, stimulus and printing of money. Naturally, this resulted in many investors being worried about the long-run impact on price inflation. Already, contrarians like Marc Faber, Warren Buffett and Jimmy Rogers are making the high inflation call.

Investors are scrambling for ways to hedge against high inflation. One of the asset class being considered to do that job is stocks. Indeed, Zimbabwe is a great example of the world’s ‘best performing’ stock market in the midst of hyperinflation (see Zimbabwe: Best Performing Stock Market in 2007?). In a hyper-inflationary economy, earnings can soar in nominal terms through the sheer force of price inflation. Therefore, stock prices will definitely rise in nominal terms.

So, should you rush out to buy any stocks if you are worried about hyperinflation in the future? Before you do so, take note of these points:

  1. A hyper-inflationary economy is in deep trouble. Unemployment can be very high (e.g. the stagflation of the 1970s, 90% unemployment rate in Zimbabwe), many businesses will fail and there will be social problems. You will likely witness depleted store shelves as there will be shortages of goods. Therefore, in such economic environment, not all businesses will survive. This means that many stock prices are going to be zero. You will not want to buy into one of them.
  2. Our theory is that in hyper-inflationary times, while stock prices can go up tremendously in nominal terms, their price-earning (PE) ratios will decline. The reason is not so much due to earnings growth expectation. Instead, it will be due to higher discount rate applied by the market. Remember back in Quantitaive demonstration of the effects of price inflation on your investment, we showed you how high inflation can easily make a mockery of your investment returns if you apply a discount rate that turns out to be far below the inflation rate. Historically, the rate of inflation for hyper-inflations increases exponentially. This may translate to higher and higher inflation expectations, which result in higher and higher discount rates, which in turn imply lower and lower PE ratios.

Zimbabwe’s experience shows that in nominal terms, stocks are great investments. But in real terms, their performances are very restrained.

Anyone has any stories to share about hyperinflation?

Thursday, December 4th, 2008

Back in Zimbabwe?s central banker in praise of Fed, one of our readers, Temjin asked,

Lol Praised by Zim?s RB, such a honor. But is Gono really really serious about his monetary policy will work in the very end?

We scanned through the Reserve Bank of Zimbabwe’s First Quarter Monetary Policy Statement for 2008 and saw this:

Our economy is and has been in trouble for over ten years and our extraordinary interventions by whatever name have helped to keep the wheels of this economy moving.

Of course, in the short-term such interventions are without doubt inflationary but in the medium to long-term they trigger and propel economic growth and development that everyone craves for.

It is amazing to see how low the depth of human delusion can go. The disturbing thing is that the US is treading the very same path that Zimbabwe took years ago. As Marc Faber said here,

… central banks have become asylums for economists that have turned insane. And in their insanity, they became money printers. And so you have to be your own central bank. You cannot trust the central banks of our governments anymore…

As we said before in Supplying never-ending drugs till stagflation,

Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.? That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

Finally, Temjin asked,

Ed, can you paint us a scenario on the final ?breakdown? of a hyperinflation? What will happen afterward? Out of paper/ink to print? 😀 People resort to violence/anarchy? Full acceptance of bartering?

For this, we will do something different today- we will turn to you, our readers to share your stories about hyperinflation at our forum. Your stories can be first-hand or second-hand. If not, you can also share stories that you learn from TV, movies, books, newspapers and magazines, etc (e.g. what is happening in Zimbabwe today). We believe that stories are more effective than dry economic theories at helping all of us to understand the true meaning of hyperinflation.

We remembered that one of our readers, Sergey Stadnik, had a story at Harmful effects of inflation:

I lived in Russia during the hyperinflation of late 80s-early90s. It was exactly as you say: people and businesses were not interested in producing goods. The only path to success was speculating.

Perhaps you have more stories to share? Or you have questions about hyperinflation? Our forum is open for questions and sharing here.

What does an Obama Administration mean for investors?

Thursday, November 6th, 2008

Now that the initial euphoria of the Obama election victory is over, it is time to get back to reality. No doubt, although Obama’s victory is very meaningful for the aspirations and dreams of millions of African-Americans, the truth is that nothing has changed fundamentally. America’s economy (and by extension, the global economy), is still in a mess. On the geo-political and foreign policy front, there are still a lot left to be desired. Although we admire Obama for his victory against all odds, we would not like to be in his shoes because the tasks ahead is colossal. After 2 terms of mismanagement under the previous administration, we doubt Obama could undo all the damages very quickly.

As investors, we will leave the politics aside and look at what the implications of an Obama Administration for investors:

Political ideology

We are not well versed in American politics here, so please correct us if we are wrong. The Republican Party is often ideologically associated (whether rightly or wrongly, it doesn’t matter) with smaller governments and free markets. The Democrats are perceived to be leaning more towards socialism ideologically.

We vaguely remembered George Bush said something like this regarding his initial thoughts on the $700 billion bailout plan,

My first reaction is to let the market be free, but on second thoughts…

We cynically believe that this talk was probably scripted. What does this mean for investors? At the very least, we expect more government interventions and bolder economic ‘stimulus.’


While many political analysts may not describe the Obama’s victory as a landslide, it is very clear that he has the mandate of the American people to change America. Now, we have:

  1. A very charismatic Democrat president, …
  2. … whose race is rallying point for the unity of the American people,…
  3. … who has the mandate of the people and…
  4. … whose party controls both houses of Congress.

These three factors imply a greater concentration of power for the US government than before. Compared to the previous administration, we believe that government interventions will be bolder and will be done quicker and more decisively.


Is this a good thing? If you belong to the libertarian camp, then this is bad news. As we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money. Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

The American people have spoken and got what they want.

On the other hand, if Obama can use his charisma, mandate and authority to sell the message that America’s economic woes require tough medicine, then this is a good thing. But if not, it will be as we we warned in Recipe for hyperinflation,

There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilisation.

This is not to say that if hyper-inflation ever happen, it will arrive soon. Such development can take many years to unravel.

Government’s contradictory messages

Wednesday, October 22nd, 2008

Back in Can China save Australia?, we mentioned about SBS’s Insight program, Greed. As we read the transcript of that program, we cannot help but realise that while the government officials are busy trying to deal with this crisis, they are sending out contradictory messages as a side effect.

For example, take a read at this:

JENNY BROCKIE:  But what sort of possibilities are we talking about here? I mean unemployment going up to 10%, 20% in the event of this taking hold in Australia? What could happen?

LINDSAY TANNER:  Definitely not. None of us can see into the future and the international crisis is obviously so unprecedented that it’s very hard to make predictions, but the fundamentals in Australia are very strong. We’re better off than virtually anybody else in the world to deal with these problems and we remain optimistic that we will be able to ride through this buffeting in reasonable shape.

On one hand, Lindsay Tanner ruled out the possibility of Australia’s unemployment going north of 10%. Yet, on the other hand, he said that no one knows the future and make predictions. If you notice, by saying “Definitely not,” he is already making a prediction!

Incidentally, in Jobless rate may double as China slows, JPMorgan Australia’s chief economist Stephen Walters said that

“We now expect the jobless rate to more than double to 9% in late 2010, from the current 4.3%,” Mr Walters said. “Softer growth in one of Australia’s leading export destinations means Australia’s export volumes will be lower, as will be the terms of trade.

“That said, on our forecasts, there will be 1 million unemployed Australians by the second half of 2010.”

The current way of measuring the employment rate includes those who are under-employed (see Nearly 600,000 Australians under-employed). When the economy slows down, it is those kinds of jobs that will be shed first, especially jobs in businesses that depend on discretionary spending (e.g. retailing). Therefore, a figure of 1 million unemployed people is not so unthinkable after all.

The next contradictory message from the government is on spending:

JENNY BROCKIE:   OK, there are quite a few things in what you’ve said that I’d like to pick you up on because we live in very contradictory times at the moment. You’re saying we should be thinking about thrift. You’ve just released a $10.4 billion package and you’re telling people to go out and spend. I mean, should Siobhan keep spending, keep getting into debt? What’s the message the Government is sending at the moment?

We believe that the government’s $10 billion stimulus package is a misguided Keynesian policy that will not solve the problem.

Firstly, as we said before in Will Australia?s own pump-priming work?, it is far too little to combat the deflationary force.

Secondly, even if it is big enough to induce the masses to spend, it is the wrong medicine. If such policies are carried out to the extreme, the outcome will be hyperinflation (see Bernankeism and hyper-inflation). As we explained in Supplying never-ending drugs till stagflation,

Students of the Austrian School of economic thought will understand that indiscriminate ?printing? of money will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.?

Without the liquidation of mal-investments and restoration of the structural imbalances that is brought about by deflation, applying bigger and bigger stimulus packages will only function in similar ways to drugs- more and more for less and less effect. The reason why Keynesian reflationary pump-priming worked during the Great Depression was that it was applied after the cleansing effects of the deflation had done its work. But today, in reaction to the financial crisis, governments all over the world are doing so before the purge of fire. As a result, the much-needed economic correction that the economy had to have will not happen.

Is this the beginning of the loss of confidence in fiat money?

Sunday, September 21st, 2008

Events from the past week are tumultuous. It started from the nationalisation of Freddie and Fannie (we were mulling about the implication of nationalisation 2 months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?). Then came the bankruptcy of Lehman Brothers and takeover of Merrill Lynch. Then we have the nationalisation of AIG. Gold prices surged by more than US$100 in two days (it had declined since), which was the most rapid surge in 26 years. At the same time, the Dow plunged by more than 400 points. It looked as if there was a panic from stocks straight to gold, which meant even cash was distrusted.

Then we have another massive rally in stocks for the past two days when there was hope that the US government, in conjunction with the Federal Reserve are doing something to solve the root of the rot in the financial system. Reports come out that they are planning to use taxpayers’ money to buy up bad assets at sale price. As always the case, the devil is in the details. At this point in time, there is no definitive figure on the cost. Make no mistake about this: this is no trivial task. As this New York Times article reported, Ben Bernanke warned the Congressional leaders,

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program ?Good Morning America,? the congressional leaders were told ?that we?re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.?

Mr. Schumer added, ?History was sort of hanging over it, like this was a moment.?

When Mr. Schumer described the meeting as ?somber,? Mr. Dodd cut in. ?Somber doesn?t begin to justify the words,? he said. ?We have never heard language like this.?

By now, it should be clear that this global financial disaster has the potential of even surpassing the Great Depression of the 1930s!

Is this crisis a surprise? If you listen to the mainstream economic schools of thought, central bankers, mainstream financial media, captains of the financial industry and so on, it looked as if this looming financial disaster is something that no one can see coming. The common underlying excuse (that was un-said, un-written but implied) goes something like this: “No one could ever foresee this! It’s impossible! Only hindsight can tell!”

Now, we would like to make it clear that this is completely false. Please note that we are not accusing individuals of lying. Instead, our point is that this excuse is a sign of collective mass delusion. If you look at the 6000 years worth of the history of human civilisation, you will find that humanity is repeatedly capable of mass delusions. Always, only the minority could see through the lie. In this case, students and practitioners of the non-mainstream Austrian School of economic thought SAW IT COMING. Some of them sounded the alarm as early as 2004! To press our point further, let’s us show you the chronicle of our warnings in this blog since 2006…

  1. In May 2008, when the world was in denial about the precarious state of the global financial system, Satyajit Das warned that the credit crisis was just the end of the beginning (see Is the credit crisis the end of the beginning?).
  2. Back in November 2007, if you look at the list of major US financial institutions that was compiled by Nouriel Roubini at How solvent are some of the major US financial institutions?, only half of them are left standing. Interestingly, Merrill Lynch was the safest among the insolvents and today, it failed to live. If Merrill Lynch was insolvent, what about the remaining ones today (i.e. Goldman Sachs, Morgan Stanley, Citigroup)?
  3. In June 2007, in Epic, unprecedented inflation, we warned that

    How much longer will the roaring global economy fly? We do not know the answer, for this boom may last longer than what we anticipated. However, please note that in the entire history of humanity, all bubbles (and we repeat, ALL) burst in the end. Thus, a global painful hangover will ensue?the greater the boom, the more painful the eventual bust. This is the theme that we had repeated many times.

    Thus, do not be surprised if a second Great Depression were to strike.

  4. In the same month, the Bank for International Settlements (BIS) warned that the world was in danger of another Great Depression (see Bank for International Settlements warns of another Great Depression).
  5. Back in January 2007, in Spectre of deflation, we wrote that

    But we smell danger.

    It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

  6. In the same month, Trichet, the president of EU central bank warned of a coming asset re-pricing (see Prepare for asset repricing, warns Trichet).
  7. Back in November 2006, in How will asset-driven ?growth? eventually harm the economy?, when the global economy was still booming in apparent ‘prosperity’, we quoted the late Ludwig von Mises (the in which the Mises Institute of the libertarian Austrian School of economic thought is named after) and warned that

    That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

    This is the reason why we believe a recession is on its way.

  8. In October 2006, we quoted the late Dr. Kurt Richebächer (an Austrian School economist) and questioned in The Bubble Economy,
  9. These are some of the serious questions we would like to ask:

    1. As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
    2. Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?

Other contrarians who sounded the alarm long ago (and we quoted often) include Marc Faber, Jimmy Rogers, Robert Shiller, Peter Bernstein, Nouriel Roubini and our local Aussie economist, Professor Steve Keen.

Our readers should, by now, appreciate the colossal magnitude of this financial crisis. When you listen the media, the phrase “since the Great Depression” is often mentioned. Make no mistake about this, this has the potential to be worse than the Great Depression (note: we are NOT predicting that it will happen).

The world’s stock market is rallying in the hope that the US government’s plan to nationalise the financial industry will be successful in stopping the core of the rot. New legislations has to be rushed through Congress by the end of next week to change the rules to make the plan legal. As in everything done in haste, we believe there will not be enough thought put into them to understand the long-term ramifications. It is probable that once the changes are in place, they will not be revisited again.

As we warned in Recipe for hyperinflation,

There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilisation.

Understanding the big picture in the inflation-deflation debate

Sunday, August 24th, 2008

Right now, there are just too much confusion over the inflation-deflation debate. In fact, this debate is so polarising that many of our readers are thoroughly confused and bewildered by the many millions of conflicting reports, chatter and opinions on the blogs, forums and media. As one of our readers said in Will deflation win?,

I’m getting more and more conflict signals from bases put forward by those who argue for inflation and those who argue for deflation.

So, which will win? Inflation or deflation? Today, we will attempt again to explain the big picture so that you can understand what is going on. As we said before in Failure to understand Black Swan leads to fallacious thinking,

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

First, let’s take a brief look at the history of money at A brief history of money and its breakdown- Part 1. As that article explained, humanity started off with bartering, which was highly inefficient. Eventually, for whatever reason, the free market chose gold and silver as money. It is interesting to note that gold and silver was the coincidental choice across almost every ancient civilization. In any case, regardless of your view on gold, the point is that in most of the 6000 years worth history of human civilization, money always existed in the form of a physical commodity. That is not to say that monetary inflation cannot happen- ancient Rome debased their own silver coins by diluting the silver with some other less precious metals.

If you think about it, it was un-intuitive for money not to be in the form of a commodity. In one of the movies about Marco Polo, it showed a scene whereby Marco Polo was astonished to see his Chinese slave exchanging goods for pieces of paper:

He ask, “What are you doing??!!!?”

His slave replied, “I am buying something.”

“But money is gold and silver! How can a piece of paper be money?!?!”

If you lived back then, it was obvious why money should not be pieces of paper backed by nothing. Firstly, such money is vulnerable to forgery. Secondly, it can be re-produced at almost no cost. Thirdly, as we said before in Recipe for hyperinflation, the integrity of such money depends on the integrity of the authority that issues it:

To illustrate this point further, imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Basically, it WAS obvious why paper money, especially the ones backed by nothing but ‘confidence’ and made legal tender by government decree, is not a good form money. Such money is called “fiat money.” The free market, if left to its own devices, will never favour it. But that did not stop ancient governments from dabbling with fiat money. The ancient Chinese was probably the first to try that (see Ancient Chinese fiat paper money) and failed. Today, the entire world is back to using fiat money again (see A brief history of money and its breakdown- Part 2). History shows that there were many attempts to make fiat money work and all of them failed. In other words, excluding the current one, the failure rate of fiat money is 100%.

To make fiat money work even for a time, some kinds of rules or ‘mechanism’ are needed to maintain its integrity (if it can really be achieved indefinitely). As we said before in Recipe for hyperinflation,

Therefore, some kinds of ?rules? are necessary to fetter and curb such vast power. Without these ?rules,? it is impossible to maintain the integrity of money. If money loses its integrity, the financial system and economy will break down and we will be reduced to primitive bartering.

That is why an independent central bank is part of this complex system of ‘mechanism’ (see Why should central banks be independent from the government?).

What are the ‘mechanisms’ that are used?

  1. Commodity backing– Technically, if a paper money is backed by a commodity (i.e. the paper can be redeemed for a commodity), it is not a fiat money. Today’s fiat money was originally warehouse receipts for gold. If too much warehouse receipts are issued than there are gold in the vault, then the issuer has essentially committed fraud and runs the risk of legal/economic repercussions.
  2. Self-expiry– In ancient China, during the Song Dynasty, paper money had a limited life-span, after which it would become no longer be legal tender. As this article from Financial Sense explained,

    The S’ung dynasty was the first to issue true paper money in 1023, and it did so at first cautiously, issuing small amounts, used in a limited area, and good for a specific time period. The notes would be redeemed after three year’s service, to be replaced by new notes for a 3% service charge, a neat way for the government to make money.

    The abuses started immediately. Though the notes were valued at a certain exchange rate for gold, silver, or silk, in practice convertibility was never allowed. Then, the notes were not retired as they printed many more of them. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

    The idea is that at any one time, certain amount of self-expiry money will be retired from circulation and thus, ‘protect’ the integrity of the money. Today, if you look at Zimbabwe’s currency, you will find an expiry date on it.

  3. Credit-system– This is the system used in today’s money (see Are we heading for a deflationary type of recession?). The basic idea is that money is created in the context of credit, which must be returned plus interest.

So, the world’s fiat money system works under the ‘mechanism’ of credit. Because money has to be returned, it acts, in theory, as a check against abuse and rampant monetary inflation. But as we all know from the sub-prime crisis and credit crunch, it got abused to the extreme in practice.

The fact that the global financial system is facing acute deflation threat shows that this credit-system ‘mechanism’ is working to protect the integrity of fiat money! From that perspective, we can see why the US dollar is appreciating in the context of deflation. But at the same time, if the integrity of money is to be protected, then all these years of credit abuse will come home to roost in a colossal economic pain for the masses.

The issue is, do the masses want to avoid great financial pain or does it want to maintain the integrity of fiat money? Reality dictates that it can only choose one but not both. If they choose the former, the only way to do that will be to repeal the credit-system ‘mechanism,’ which will mean the loss of integrity for the current fiat monetary system. Such loss of integirty will manifest itself in the form of hyperinflation.

In summary, whether you believe the end game is deflation or inflation will depend on your faith in human nature.

Will deflation win?

Thursday, August 21st, 2008

In just a few months ago, the talk in town was price inflation. Oil, food and commodity prices were rising, as we wrote Who is to blame for surging food and oil prices?. Today, the talk is different. US house prices have never stop falling. Gold, oil and base metals are falling. There is even talk about the end of the commodity boom, the end of the commodity “super-cycle.” Economic slowdown and recessions are the expectations of the market.

Long time readers of this publication should never be surprised to see this is happening. As we said back in March last year in Inflation or deflation first?,

If you have been with us long enough, you may have heard us mulling over both the threats of inflation and deflation on the global economy (see Spectre of deflation and Have we escaped from the dangers of inflation?). You may be wondering whether we are contradicting ourselves. How can both threats exist simultaneously? Since one is a general rising of prices and the other is the opposite, are they not mutually exclusive?

At this current phase of the financial crisis, we are experiencing deflation. It is reported that the US M3 money supply is currently “collapsing.” A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on. The angelic type of deflation is caused by rising output and production, which is clearly not the case in the debt-addicted Western economies but more true for China with its government-forced savings.

When the US money supply shrinks, it increases in value relative to the other currencies as the US dollar gets repatriated back to make up for the dwindling supply of cash back in the US. That’s why we are witnessing a rally in the US dollar and a fall in commodity prices as there is a mad scramble to liquidate whatever assets to raise cash.

With the current legal powers, the US Federal Reserve is quite powerless to stop deflation (see Are we heading for a deflationary type of recession?). It can cut interest rates, but it cannot force people to borrow. Even at 2% Fed fund rate, the shrinking M3 money supply is proof that monetary policy is still tight (see What makes monetary policy ?loose? or ?tight??). Will the Fed continue to cut interest rates? It had already tried but failed a few months, which resulted in skyrocketing oil and gold prices. We doubt Ben Bernanke is going to try it again.

Meanwhile, the US Treasury is preparing open up the bottomless coffers of the US government to nationalise Freedie Mac and Fannie Mae, who are essentially insolvent. The question is, with the US budget deficit already in the red (plus the massive current account deficits), where is the money going to come from to do that? If a savings-less individual spend more than he/she earns, that individual is basically bankrupt. But for governments, it is a completely different story. They can make up for the shortfall by borrowing from the public by selling newly issued government bonds. As a last resort, it can sell the bonds to the Federal Reserve, which is called “monetising debt” or printing money.

Will it get that bad? It can if the deflation threatens to shock and awe the entire nation into a Greater Depression. By then, as we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Therefore, as we advised before in Recipe for hyperinflation,

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation.