Have we escaped from the dangers of inflation?

February 25th, 2007

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Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the financial system. The growth of money supply of major economies is estimated around or above 10% per annum, with China having the dubious ?honour? of being near the top at 18% (see Why is China printing so much money?). The top ?honour? goes to Russia, with their M2 money supply rising a whopping 48.8% from the beginning of 2006 to beginning of 2007 (see the figures at the Russia Central Bank web site here).

With all these flood of fiat money inundating the global financial system, we look at all these skyrocketing financial asset prices with a yawn. Price bubbles of all sorts are found everywhere in the world?from Chinese stocks, junk bonds to private equity booms. Back here in Australia, it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade. The logic is simple: central banks around the world are hard at work ?printing? money. These monies first go to the financial system, creating price bubbles. The bubbles then attract speculators, gamblers and punters into the asset markets the way bees get attracted to honey. Soon, word get round to the masses and they want a slice of the action too.

Let us tell you a ?secret:? do you know that Zimbabwe?s stock market is now booming too? Do you know why? The reason is not because Zimbabwe is getting richer, but because its currency is becoming worthless with hyperinflation (see Zimbabwe: Living with hyperinflation). As we said back in October last year in Divergent sentiment, ?you can make the Dow Jones climb as high as you want as long as you print enough money.? That is what is happening in Zimbabwe.

As we said before in Example of inevitable effect of monetary inflation, we are very sure that as all these liquidity work its way to the rest of the real economy, it will only be a matter of time before price inflation will show its ugly head. Yet we are simply amazed with Wall Street?s obliviousness to this danger and Ben Bernanke?s incredibly sugar-coated words in his recent economic report to Congress. Can we rely on the Chinese to forever keep the price of importable things down to save us from inflation? We very much doubt so?they have their own inflation problem to handle (see Cause of inflation: Shanghai bubble case study).

The root of the hell of price inflation is fiat currency. Make no mistake about this: in all of human history since the beginning of time, there has never been a time when fiat currencies did not become worthless eventually. For example, the ancient Chinese, during the Song Dynasty (960-1279), had tried it before, even using self-expiring fiat money in an attempt to prevent inflation. The Mongols? use of fiat money to fund their occupation of China was eventually ended by the subsequent Ming Dynasty (1368-1644). Today?s current fiat money experiment only began in 1971 (see A brief history of money and its breakdown- Part 2). How much longer can it last? We do not know but we hazard a guess that it is very much possible for us to see that day in our lifetime.

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

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