Posts Tagged ‘hyperinflation’

When will serious inflation catch up with us?

Thursday, July 31st, 2008

Recently, one of our readers asked us this question:

If, as you have reported, our money supply is still increasing at over 20% per annum, what is this likely to lead to in terms of price inflation in the years ahead? I suspect that it will somehow catch up with us one way or another, and the result will not be pretty. But this is just a generalised gut feeling, which is not as useful as a more particularised and detailed understanding would be for positioning oneself for the inevitable. Part of a clearer vision would be, of course, a better sense of the likely timeframes involved. How long before the ugly bits start to catch up with us, and how long will it be likely to last? What will be the signs of imminent danger? Or do we already have plenty of them now, as we speak?

First, for those who are new to this publication, we would highly recommend that you read Cause of inflation: Shanghai bubble case study before continuing reading the rest of this article. The reason is because mainstream economics and the Austrian School of economic thought have different definitions for inflation. To make our language more precise, we will refer to the former’s definition simply as price rise and the latter’s definition as monetary inflation. If you have time, you may want to read our guide, What is inflation and deflation?.

Next, the point of this article is about recognising the signs of inflation- we are not airing our opinion on what will happen in the future in this article. Our opinion for that can be found in Inflation or deflation first? instead.

Here are two considerations to think about when considering the future effects of monetary inflation:

  1. One troubling aspect when discussing the economic phenomenon of price rise is the indices used to measure it. As we argued before in How much can we trust the price indices (e.g. CPI)?, the whole idea of measuring general price levels is logically invalid. For instance, as we said in that article,

    … the world is experiencing unprecedented asset price inflation. In Australia, it is the housing price bubble. Since the Reserve Bank of Australia (RBA) does not have the mandate to prick asset price bubbles, then can we give them such a mandate by merely redefining houses as consumer durable goods and include them in the basket of goods in the price index calculation?

    That is, if we include houses as part of the basket of goods in the CPI, Australia will be suffering from severe inflation for the past 10 years! One way for governments to deny the severity of price rises is to fudge the figures and the composition of goods and services, which is what the US government is arguably doing right now.

  2. Also, as we said before in Introduction to the famous Quantity Theory of Money, according to the Austrian School of economic thought,

    Monetary inflation (or ?printing? money or increasing the money supply) results in the distortion of the relative price levels. That is, when money is ?printed,? prices will be affected in varying degrees for different things with different time lags (see How to secretly rob the people with monetary inflation?).

    Monetary inflation takes time to work itself out to the rest of the economy. Sometimes, the effect is not immediate. For example, for the past 10 years, monetary inflation did not result in visible price rises. In fact, thanks to the rise of Chinese manufacturing, we have price falls of manufactured goods, while at the same time, the price of houses sky-rockted (see The Bubble Economy). But lately, we see the rise in the prices of commodities, food and oil. To add to the difficulty, the effect affects prices of different things with different time-lags. Some goods and services are are susceptible to monetary inflation than others.

    Next, monetary inflation may not affect the price levels of of everything to the same degree. For example, the past rise in house prices was probably not going to be accompanied by as great rises in the price of funeral services.

In view of these two considerations, you can see why it is not easy to give a straight answer to our reader’s question. But before hyperinflation can develop, there will be plenty of warning signs. An exponential increase in the supply of money is one sign. The conditions that we described in What is a crack-up boom? is another. Governments turning towards populism and fiddling with the laws is another (see Recipe for hyperinflation). In other words, while you cannot know the precise time-frames of such development, you will have plenty of time to prepare for it as long as you keep your eyes and ears wide open. In addition, the initial stages of inflation¬†are akin to a silent killer that is slowly doing its destructive work. But as it move towards the finale (i.e. hyperinflation), you will see the acceleration of developments.

Thus, we would encourage you to acquaint yourself with history in order to help you recognize the signs. We will be watching and listening too. You will get to see what we see and hear what we hear both in this publication and on our sister site: Contrarian Investors’ News.

Why should central banks be independent from the government?

Wednesday, July 16th, 2008

Yesterday, one of our readers asked us this question:

Why is it important to keep central banks independent from the government? Wouldn’t it be better if the board of directors of a central bank are selected by the people, and therefore held accountable to the people for decisions, mistakes, and misjudgements?

At what point did central banks become concerned about targeting inflation? Before they existed, inflation was close to 0%, so surely they wouldn’t have been created with inflation targeting in mind?

The more I read, the more I feel that your ideal of a 100% reserve banking system with no central bank is the best way to control inflation (and to allow the people to understand the true cost of government projects [wars, etc] that is currently paid for through inflation). But why didn’t this work in the first place?

To answer these questions, we will turn back to history. As we explained before in A brief history of money and its breakdown- Part 2,

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury.

Under an international gold standard, there was an automatic market mechanism to keep government from inflating the money supply and to keep each country’s balance of payment in equilibrium. Hence, the world enjoyed the benefits of only one monetary medium, which facilitated trade, investment and travel. Prices were also kept in check (see What is inflation and deflation?). During that time, there were periods of price rises (e.g. during war) followed by periods of price falls (e.g. when war ends), with relatively stable prices in between.

Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ‘afford’ to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today. You can read the rest of the monetary breakdown story at A brief history of money and its breakdown- Part 2.

Now, you know how the US is able to ‘afford’ to fight extended wars in Iraq and Afghanistan with expensive professional armies today.¬† A gold standard will make this truly unaffordable.

Today, the central banks of the US and Australia follows an inflation targeting policy. That is, monetary policy is set ensure that there is a consistent price rise within a target range. How did inflation targeting develop? Well, it is another long story. You can read about it straight from the RBA at Inflation Targeting: A Decade of Australian Experience.

Next, we come to the most important part: why should central banks be independent from the government?

First, we have to understand the basics. What is the purpose of money? In essence, money functions as (1) a medium of exchange, (2) unit of account and (3) a store of value. To perform these functions, money has to fulfil certain properties as described in Properties of good money and its integrity cannot be tampered with.

Now, consider the situation that we described in Recipe for hyperinflation:

… 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.

Under the gold standard, gold is money that is under the control of the free market. No one or institution ‘owns’ or control the money. But today, the central bank is the only institution that has the authority to create money out of thin air. As we said in Recipe for hyperinflation,

Look at any piece of paper money today and you will find the words of a government decree (e.g. ?This Australian note is legal tender throughout Australia and its Territories?) and perhaps a signature or two.

In Australia, the signature belongs to the RBA governor.

What if we give the government (which already has executive power) the power to create money? This will give the government a deeper concentration of power! If you believe the old adage that power corrupts and absolute power absolutely corrupts, then you will not want such a deep concentration of power. As we said before in Have we escaped from the dangers of inflation?,

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.

That is why today, central banks are independent of the government, with complex and elaborate rules of money and credit creation (the exception will be Zimbabwe under Robert Mugabe). Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation). Your belief in whether you will see hyperinflation in your lifetime will depend on your faith on the government to maintain the integrity of money.

Next, what if we let the people vote for the board of directors who control the central banks? If shareholders have trouble keeping the directors of their company honest and accountable, then it will be the same for the central bank.

How do we all pay for the bailout of Fannie Mae and Freddie Mac?

Monday, July 14th, 2008

Last week, the US Federal Deposit Insurance Corporation (FDIC) took over IndyMac, an insolvent US$32 billion Californian mortgage bank. As if this is not bad enough, two of the America’s largest government-insured mortgage lender, Freddie Mac and Fannie Mae, were losing the market’s confidence in their solvency status. The level of confidence was so low that both the Treasury and Federal Reserve had to step in over the weekend to announce their plan to prop them up. This look to be reminiscent echo of the Bear Stearns bailout in March this year (see New tricks required to bail out financial system).

For those who do not yet already know, Freddie Mac and Fannie Mae are US government-sponsored enterprises (GSE) in which their bonds are insured by the US government. That is, if the US home-owners default on their mortgage debt, the US government will ‘insure’ the shortfall between what they are obliged to pay to their investors and lenders and what they collect from the impaired mortgage debt payments. Now, they can be regarded as insolvent. As we explained before in Banking for dummies,

… the banking business is a balancing act of managing a portfolio of assets and liabilities.

This means that Freddie Mac and Fannie Mae, thanks to the rising debt default of American mortgages, is failing to do a proper job in the balancing act. As we explained with an example in De-leveraging in the real economy- mortgages, with falling house prices and rising debt defaults,

… if house price goes down by more than 10%, then the home ?owners? will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

Make no mistake about it: this development is highly serious. To give you a sense a scale of the problem, consider this (as reported in this news article- Federal Reserve to rescue US mortgage giants):

  1. Both of them owns around US$5 trillion worth of mortgage bonds, which is almost half of all mortgages in the US.
  2. US$ 5 trillion is the GDP of Japan, the world’s second largest economy.
  3. As at June 2007, foreigners hold US$1.3 trillion long term debts issued by all GSE (which includes Freddie Mac and Fannie Mae). This was 21.4 percent of the total debt. China and Japan holds US$376 billion and US$229 billion of these debts respectively.
  4. The rest of them are held by mum and dads, state and local governments, banks, insurance companies, pension funds, retirement funds, money markets, managed funds and so on.

As you can see, if Freddie Mac and Fannie Mae fail, it will not not just affect the US. Financial assets all over the world will be affected. It could be your superannuation and pension funds holding the bag of worms!

We believe the de-leveraging process still has to continue (see Is the credit crisis the end of the beginning?), it will only be a matter of time before Freddie Mac and Fannie Mae will really become insolvent. If a US government-insured bond becomes defaults on its debt, it will be as good as a default by the US government on its debt. If that ever happens, you can be sure this will descend into an extremely ugly global US dollar crisis. Therefore, both of them are too big to fail.

The only way out of this is, as we explained before in Recipe for hyperinflation,

… once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.

New tricks required to bail out financial system

Thursday, April 10th, 2008

As we all know, last month, the Fed engineered a bailout of Bear Stearns over the weekend. It’s no secret that the Fed had to invoke an obscure law passed in the 1930s to save Bear Stearns. Some news media claimed that this law had not been invoked since the Great Depression, which is not true but is certainly attention grabbing. The truth is that, it was last used in the 1960s.

You may have recalled that we said in Recipe for hyperinflation,

Such scheme of arrangements is just a tiny fraction of ?rules? that ?govern? the vast power associated with the authority to create money. Now, imagine that those above-mentioned ?rules? are being relaxed such that the government can order the central bank to bail out everyone and every business that is financially insolvent by giving them freshly printed money. Overnight, this will solve the problem of bad debts and we will not have any credit crisis to worry about. Everyone will be happy right?


The main point is, once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

Let’s review a sample of how some of these ‘rules’ had been rolled-back and relaxed:

  1. Most of the time, banks lend to and borrow from each other to cover their daily shortfall or surplus cash. But banks can also borrow directly from the Fed through the discount window. But the Fed would prefer that they do not do so by keeping the discount rate higher than the Fed Fund Rate as a disincentive. It used to be ‘humiliating’ for banks to have to go to the Fed to beg for money. But today, due to the credit crisis, staying solvent is more important than to stay ‘dignified.’ Furthermore, the Fed helped by auctioning more money (fiat money that is created from thin air) to the banks.
  2. The Fed used to only accept Treasuries as a collateral for loans. Now, it has come to the point of accepting AAA mortgage bonds (other central banks are guilty of this too). Congratulations to the Fed for getting involved into the landlord business!
  3. The Fed cannot lend to non-banks such as Bear Stearns. But last month, it had to invoke an old law to be able to lend to Bear Stearns. As this news article said, Fed Invokes Little-Used Authority to Aid Bear Stearns (Update4),

    Bernanke took advantage of little-used parts of Fed law, added in the 1930s and last utilized in the 1960s, that allow it to lend to corporations and private partnerships with a special board vote. The Fed chief probably sought to stave off a deeper blow to the financial system from a Bear Stearns collapse…

  4. The US government embarked on an economic ‘stimulus’ plan by sending newly printed money (nicely called a ‘tax rebate’) to Americans (see Watch the US government).

In the weeks and months to come, we will get to see more ‘ingenious’ plans and actions by the Fed to ‘solve’ the worsening credit crunch problem. They will try every new, weird and unprecedented tricks not found in the book to achieve that aim. As this Wall Street Journal article, Fed Weighs Its Options in Easing Credit Crunch said,

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.

Among the options: Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed’s name rather than the Treasury’s; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.

As long as the Fed keeps on trying to ‘solve’ the problem, we will not rule out hyperinflation.