Posts Tagged ‘Zimbabwe’

Can stocks hedge you from price inflation?

Tuesday, September 15th, 2009

Continuing from our previous article, should we buy stocks as a hedge against price inflation? The answer to this question is not so straightforward.

In normal circumstances, some stocks are a good hedge against the garden-variety types of price inflation (or even beat inflation spectacularly) because their earnings power can increase faster than the general rise in prices. But in times of hyperinflation, when the real economy deteriorates, it will be increasingly difficult to find such a business.

First, let’s take a look at the past from this research report,

The 1970s were a period of accelerating inflation and poor equity returns in the US. By December 1980, the federal funds rate stood at 20%, and the ten-year Treasury peaked at 15.3% in September 1981. From December 31, 1968 to December 31, 1981, the S&P 500 returned 1.28 % per annum in nominal terms and -6% in real returns. Put another way, a dollar invested in the US stock market at the end of 1968 twelve years later was worth roughly 45 cents in real terms.


In the US, there is substantial empirical evidence that high inflation is associated with a high equity risk premium and declining stock prices. Bodie (1976) found from 1953-1972 that common stocks were poor hedges against inflation. Cohn and Lessard (1980) also found that stock prices in many industrial countries are negatively related to nominal interest rates and inflation.

It is important to make the distinction between properly anticipated inflation, and unanticipated inflation. If inflation is correctly anticipated and if companies can in fact pass on costs of doing business, then nominal cash flows should be unaffected by a general increase in prices. However, as inflation rises, it tends to become more uncertain and a component of price increases may not be properly anticipated by firms. Blanchard (1993) found that ?an unexpected increase in inflation in year 0 leads to a sharp decrease in stock prices in that year.?

There are a couple of ways to see why price inflation and stock prices are negatively correlated:

  1. In times of high inflation, interest rates are high. Therefore, bonds may prove better value than stocks relatively.
  2. Investors demand higher returns from stocks to compensate against higher price inflation. The lower the price paid for stocks, the higher yield returned by the stocks and thus, the higher the returns on investments.

On the other hand, we have examples in history where hyperinflation do wonders for stock prices. For example, in 2007, Zimbabwe had the world’s best performing stock market- stocks actually rose faster than price inflation:

Zimbabwe Industrial Index up till 2007

Zimbabwe Industrial Index up till 2007

Despite these two seeming contradictory real-life examples, one thing is clear: everything else being equal, unexpected rise in price inflation will lead to compressed valuation of stocks due to a rise in discount rates used to value stocks. In other words, PE ratio can decrease (in the context of rising earnings) even though stock prices can still rise in nominal terms. In the case of the US stock market in the 1970s, this led to negative returns in real terms. But in Zimbabwe’s case, stocks actually had good positive returns in real terms. But make no mistake: as we quoted Marc Faber in our previous article, such positive returns are the result of rising speculative bubbles in the stock market abetted by the printing of money.

If you believe that the (1) US are going the path of Zimbabwe-style money printing and (2) the stock market hit record high due to speculation, does it mean that you should rush to buy any stocks as a hedge?

Here, you have to be careful. The dizzy heights of stock prices in the Zimbabwean stock market have a survivorship bias. With real GDP deteriorating and sky-rocketing unemployment in that country, we are sure many Zimbabwean public companies are dropping dead like flies. That means, there will be many stocks whose prices went to zero. If you happen to hold one of them, you will suffer loss in nominal terms in a hyper-inflationary environment.

Also, stellar stock market performance that are induced by money printing are, at the end of the day, bubbles. Bubbles can easily burst.

Thus, if you are considering holding stocks as a price inflation hedge, you will have to choose the stocks very carefully. The wrong choice will lead to (1) losses in real terms at the very least or (2) a possible wipe-out in the context of a highly dysfunctional economy.

Should you be bullish on stocks?

Sunday, September 13th, 2009

Marc Faber is a well-known contrarian bear. He has such a pessimistic streak in his blood that he is given a nickname of “Dr. Doom.” But many people were surprised that this bear is actually quite ‘bullish’ on stocks. For example, even though he believes that stocks are going to face a major correction soon, he believes that the rally can still have more room to run.

How do you reconcile his bearish temperament and ‘bullishness?’

The trick is to understand that his reason for ‘optimism’ is different from the reason espoused by the “green-shoots-of-recovery” crowd. The basis of his ‘bullishness’ is based on a very pessimistic view of the economy. This Lateline interview sums up his view very well:

As we wrote before in Can we have a booming stock market with economic calamity?,

But as we stressed many times in this journal, it is possible to have economic calamity with booming asset prices, especially stock prices

Based on conventional economic theory, there is no explanation for such a stellar performance for the Zimbabwean stock market when the GDP was collapsing (see Zimbabwe: Best Performing Stock Market in 2007?). A stock analyst using conventional valuation analysis will hard pressed to justify the lofty heights of stock prices.

But followers of the Austrian School of economic thought have an explanation for this illogical phenomena. In a perfect world, every single cent of the printed money will go straight into repayment of debt and thus, wiping out debt obligations, introduce financial stability and not cause price inflation in one swoop. Unfortunately in the real world, the plans of the governments and central banks do not always work out perfectly. In a dysfunctional economy, the massive printing of money can lead to some of them being used for speculations of assets and commodities instead of de-leveraging. As what happened in 2008 (see Who is to blame for surging food and oil prices?), the speculation of the latter can lead to strong price inflation.

In the same way, the current bout of monetary inflation is the cause of the rally in the stock market. In fact, Marc Faber believes that this rally has more room to go beyond the current impending correction. It is possible that the coming correction may not come in the form of tumbling stock prices- stocks may stagnate sideways until the technical overbought condition deflate to a more balanced one.

Today, it is the stock market that gets artificially inflated. Tomorrow, it can be the commodity markets. Now, the question is, should you buy stocks to protect yourself against price inflation? We will look into it in the next article.

Can we have a booming stock market with economic calamity?

Tuesday, July 7th, 2009

After the First World War, the Allies imposed punishing sanctions on the Central Powers. Germany had to pay gigantic war reparations and had their industrial base in the Rhineland occupied by the Allies. Austria-Hungary was broken up into Austria, Hungary and the other states. They also lost millions of their citizens to the newly formed successor states. The former imperial capital, Vienna, was left as a vast city without any hinterland to support it. Without Czech coal and Hungarian food, the Austrian economy was hardly self-sufficient. There was political and economic chaos in Hungary, Austrian and Germany. Hyperinflation and hunger reigned. Life was miserable then.

In the midst of such widespread economic despair, as this book, When Money Dies: The Nightmare of the Weimar Collapse described,

Speculation on the stock exchange has spread to all ranks of the population and shares rise like air balloons to limitless heights … My banker congratulates me on every new rise, but he does not dispel the secret uneasiness which my growing wealth arouses in me … it already amounts to millions.

In other words, the economic was a disaster, but the stock market roared. As we pointed out before in Zimbabwe: Best Performing Stock Market in 2007?, Zimbabwe too had a roaring stock market.

Today, the mainstream often associate economic calamity with collapsing stock markets and price deflation, and booming economy with booming asset prices and price inflation. As we wrote in Are improving consumer sentiments ?good? news?, if the masses’ sense of financial well-being depends on asset prices, then the past 3 months of rising asset prices had done wonders for improving the masses’ confidence. But as we stressed many times in this journal, it is possible to have economic calamity with booming asset prices, especially stock prices. As we wrote before in Harmful effects of inflation,

With inflation, there is less incentive to be productive and more incentive to hoard, speculate and gamble. This in turn will reduce productivity and increase price inflation, which further increase the incentive to be less productive. In addition, as we said before in How to secretly rob the people with monetary inflation?, inflation re-distribute wealth unfairly and exacerbate the divide between the rich and the poor.

As time goes by, the economy will be structurally damaged one step at a time. This process can take many decades to completely play out. Of course, with economic mismanagement, it can be accelerated, as in the case of Zimbabwe.

It is this speculation in asset prices that brought about the ‘booming’ stock market. In times of hyperinflation, the prices of everything (including everyday stuffs) rise in nominal terms, company profits included. Therefore, stock prices have to rise too to accomodate the hyperinflating profits.

Unlike the mainstream, we see any sustained rally in the stock market with a very suspicious eye.

Is this a bear market rally or a turning point?

Sunday, May 17th, 2009

The global stock market has been rallying for the past couple of months already. There have been talks of “green shoots” of economic recovery. There are hopes that China’s stimulus spending will bring out renewed demand for Australian commodities. Already, there are reports of record Chinese demand for commodities (see China on buying spree).

We heard of many retail investors piling into the stock market, not wanting to miss out in the turning point. Since the stock market tends to be a leading indicator of future economic activity, many are seduced by the idea that this rally is predicting a turning point in the global economy. Unfortunately, as with many cliché ideas, this is only half-true. This is an example of a mental pitfall called lazy induction (see Mental pitfall: Lazy Induction).

To be more precise, the stock market anticipates but not predicts turning points. What this means is that economic recoveries are followed from recoveries in the stock market, but a stock market rally does not necessarily indicate an economic recovery. A very good example will be the number of bear market rallies in the chart of the Dow Jones from 1929 at Bear market rally on the works?.

Now, let’s take a read at what Marc Faber says about this rally in his latest market commentrary:

The economic news in the world is hardly getting any better, but the rate of economic contraction has slowed down somewhat as the  governments? stimulus packages begin to have some impact and as some replacement demand is starting to support consumption. However, to talk  already now about a sustainable economic recovery seems premature because whereas some sectors (autos) and regions may be stabilizing, others are still in a steep decline.

The global economy are declining, but the speed of decline is not as fast as the second half of 2008. Therefore, this stock market rally is anticipating that this reduction in speed is a turning point.

The next question to ask is this: will the stock market be lower or higher in 2010? Even Marc Faber admitted not knowing the answer to this question. Indeed, it is certainly possible to see another bout of breathtaking crash that can rival the panic of 2008. There can be many possible triggers for that, including:

  1. Collapse of a major European bank. Many big European banks lent so much money to Eastern Europe that their asset books are even bigger in size than the GDP of some European nations! Meanwhile, many Eastern European economies are in serious trouble, which means there will be many gigantic bad debts floating around. The European Union is an economic union but not a political union. Therefore, the European Central Bank (ECB) does not have the same level of authority and political support as the US Federal Reserve. Individual nations using the Euro as their currency cannot simply print money to bail out their financial system because they have surrendered their economic sovereignty to an intra-national authority. To do that, there can be a situation whereby taxpayers of say, Germany, are asked to bail out the taxpayers of say, Spain. Politically, this is too much to ask. Therefore, if a banking crisis is to hit Europe, the political deadlock can result in another panic in financial markets.
  2. Swine flu
  3. Collapse of Pakistan

At the same time, governments are already embarking in massive money printing (quantitative easing), stimulus and bailouts spree. As we said before in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view,

… while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see ?Bernankeism and hyper-inflation?), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts.

If government pumps so much money into the financial system, it is only a matter of time before asset prices rise again, not because of improving economic outlook but because of the sheer weight of money. The problem will be massive consumer price inflation once the Global Financial Crisis (GFC) is over, which is a problem for the next generation to solve. The outcome will be what we wrote in Zimbabwe: Best Performing Stock Market in 2007?.

In any case, no matter what happens, the peak of economic boom in 2006/2007 is over and will not be back soon. Investors who are expecting that will be disappointed.

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.

Gold and the strong state

Thursday, March 19th, 2009

Have you walked into a shop that specialises in selling paper money from the past and present from all over the world? Indeed, when holding a Riechmark (the German currency from the 1930s) on our hands, we felt a sense of nostalgia from the past. At some point in time, that piece of paper was used as money by another person to buy his/her daily essentials. Or if you want to be a billionaire, you can easily buy one of Zimbabwe’s currency at a price of say, AU$10.

Alas, all these paper money (currency) met their end and became of value only to collectors. Perhaps as an exercise, you may want to immerse yourself in one of those paper money shops and get yourself acquainted with the history of some of these currencies. Who knows, perhaps one day, the currency that you hold in your wallet will find its way into that paper money shop?

As we explained in our previous article, the whole idea of gold is money. The proper way to understand gold is to see it as money that is not currency. The fundamental reason why you accumulate gold is that (as we said before in What should be your fundamental reason for accumulating gold?) you want it as a hedge against loss of confidence in currently legal tender currency. On the other hand, if you have supreme confidence in currencies, then you will have no reason to hold gold.

As one of our readers, Pete, astutely pointed out before, there are many ways for currencies to lose the people’s rejection as money. Hyperinflation is only one of them. To illustrate this point, we have a story…

In 1940, as the German tanks rolled down to France, many French citizens hopped on to their cars to flee Paris. On the way to somewhere, some had to stop by petrol stations to refuel. It turned out that petrol stations did not accept the French currency as payment. After all, who will trust that the French currency will still be money once the Germans took charge? But if you had some gold coins in that situation, then you are in luck. Of course, when the Germans took over, they issued their own occupation currency and gold went underground.

The point we are trying to make is that gold as money is anti-thesis to a strong state. A strong political state may seek to ban gold on pain of death. That was what happened to China during the Mongol occupation of the 13th century. Marco Polo marvelled that the Mongol Khan had mastered the art of alchemy because paper currency issued by the Mongol empire became money on pain of death. It came to the point that gold, silver and other treasures were exchanged for the Khan’s paper money. Thus, Marco Polo remarked that the Khan was the richest person on earth. Thus, from this perspective, we can see that gold is a symbol of resistance against tyranny, subversion against state power and freedom.

But if you look at history, gold wins in the end because the strong state eventually falls (but the catch is, they may not fail within your lifetime). The Mongols, in enforcing their expensive occupation of China, printed money until there was hyperinflation. It was at that time that the Chinese rebelled against the Mongols and eventually drove them out of China. The subsequent Ming Dynasty continued the Mongol’s monetary policy of using paper as money. But by 1455, China had to revert back to commodity money.

Thus, the major risk of holding gold is that you can be up against the strong state (assuming that strong centralised political power will be the future) who may want to ban gold. But yet again, who knows? For example, Zimbabwe, for all the despotism of Robert Mugabe, has not or were powerless to ban gold.

But if the future turns out to be one in which political power is weak, de-centralised and rivalled by non-state power, then gold is a better bet than pieces of paper called the US dollar. This is the thesis of a strategist in the US Army War College (see From the New Middle Ages to a New Dark Age The Decline of the State and U.S. Strategy).

So, in summary, there’s risk in holding gold. But there’s also risk in NOT holding gold. So, what’s the alternative? Hold real asset (farm land, timber land, barrels of oil, food, guns, etc) instead? Well, there’s also risk as well and furthermore real assets serve a different function from gold. We will talk more about holding real assets later.

If you save, government will wage economic war on you

Tuesday, February 17th, 2009

In this economic climate of uncertainty, governments all over the world have to be seen to be doing something. The problem is, by doing ‘something,’ they are actually making the problem worse (see Are government interventions the first steps towards corruption & inefficiencies? and Supplying never-ending drugs till stagflation). In particular, they fear debt deflation because it is the more immediate threat. It is this fear that led Helicopter Ben (i.e. Ben Bernanke) to subscribe to the Zimbabwean school of economic thought (see Bernankeism and hyper-inflation) in the Keynesian belief that forcing people to spend and consume is the way to go. If printing money are the answers to the Global Financial Crisis (GFC), then Zimbabwe will be the richest and most prosperous nation in the world. Indeed, judging by the number of billionaires, in that country, it must be so! When you see Zimbabwe’s central banker praising the central banks of US and UK (see Zimbabwe?s central banker in praise of Fed), you know something is very wrong with the monetary policy of the Federal Reserve.

As we said before in “Government?s contradictory messages,”

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.

Thus, whether you are currently in debt or not, if you intend to save money, the government will be very keen to discourage you from doing so by undermining and debasing the currency in which your savings are based on. As we said in “When real interest rates is below zero, why save money in bank?

 … if we disregard the doctored statistics of the official figures, real interest rates are negative!

That is why governments all over the world are sending so many mixed messages to the effect that an average person do not know whether he/she is meant to spend or to save (see Government?s contradictory messages). A very simple way to resolve this paradox (sarcastically) is to think of it this way: save while everyone else is committing financial suicide by spending willy nilly.

What if you are a saver who simply does not wish to spend, invest, borrow or speculate? If you believe that the government will fight this war against debt deflation by marching our credit-based economy towards a Zimbabwean-style economy (see Recipe for hyperinflation), you will be forced to make very difficult choices. For such a saver, the best case scenario for your savings will be severe price deflation in an environment of zero-interest rates in a properly functioning banking system (while still employed/business earning positive cash-flow). But if you are pessimistic about this best-case scenario happening, then you will be forced to ‘speculate.’

As the government and RBA try to erode your savings by taxing them and pushing down interest rates to below price inflation (even perhaps to zero), what can you do? Good question.

Let’s take a look at the US. Currently, short-term US Treasury bonds are yielding almost nothing. At one point, their yield even became negative! In that case, what will be the difference between a nothing-yielding government bond and gold? As we said before in “Is gold an investment?“, gold is

a boring, inert metal that does not have much pragmatic use and does not pay dividends, income or interests, it is completely unfit for ?investment.?

That probably explains why we are seeing, at least for now, US Treasury bonds and gold moving upwards together. Traditionally, they move in opposite directions. Today, this inverse relationship seems to have decoupled.

Therefore, the risk/reward profile has come to the point that savers who have spare cash may want to consider transforming part of their savings from cash to gold.

P.S. Use the government’s free stimulus cash to buy gold. 😉

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.

When ‘cash’ becomes confetti, inflation/deflation becomes irrelevant

Tuesday, September 23rd, 2008

The financial and economic events of this month is amazing and history will one day judge September 2008 as one of the major turning points.
Today, if you follow the inflation/deflation debate on the Internet forums, blogsphere, etc, you will find this issue to be a highly divisive, polarising and at times, rather emotional debate. No wonder it is a highly confusing time for investors and traders.

For investors, it will be a big mistake to take sides in this debate. You may have certain inclination towards one or the other side of the fence, but do not dig in and get permanently committed to an opinion/idea. From our observations, some people have become too religious and emotionally involved to one side of the debate. They have become so religious that whoever belongs to the other side is regarded as an infidel. Such loss of objectivity will cloud your judgement.

First, for our newer readers, please take a read at What is inflation and deflation? for our definitions of inflation or deflation. They are not the mainstream idea of price rise/falls.

So, will hyper-inflation or severe deflation be the endgame of this financial crisis?

We don’t know which one will be. But our guess is that it is probably the former. But that does not mean we are loyally committed to that position and bet our entire life and wealth on that. After all, life is more subtle than that either black or white. Because we cannot know with certainty what the future will hold until time has passed, it becomes a game of probability for the present.

Now, take a read at Understanding the big picture in the inflation-deflation debate,

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.

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!

At the root of the deflation argument is the fact that we live in a credit-based economy. As long as this credit-based system is in place, any inflationary bubble will be ultimately deflationary. Please note that the word “ultimately” in the previous sentence is bold. The word, “ultimately,” is a very important qualifier. This implies that before the ‘ultimate’ deflation, we can have inflation in the interim.

So, to illustrate the point of this qualifier, let us conduct a thought experiment. For the purpose of argument, let’s assume that the credit mechanism is firmly in place.

Say, the US nationalisation of its financial sector transfers most of these toxic private sector debt into the public debt. Given that the US government already has a huge amount of debt, this means they have to raise even more debt. The only way for the US government to issue more debt is to issue government bonds, which is still borrowed money that has to be returned. We can see why this is still ultimately deflationary because no matter how much the US government borrows, it has to return them eventually (e.g. by raising taxes).

Now, let?s take a step further and say that the US government monetises its debt by selling the newly issued government bonds to the Federal Reserve. That?s in effect printing of money. Even then, some will argue it is still ultimately deflationary because it is still credit i.e. the government has to eventually buy back the bond from Federal Reserve.

Let?s take a step even further. Let?s say the government pays off that expired monetised debt by monetising even more debt. That?s like an individual borrowing from one credit card to pay off another credit card. Imagine what will happen if the government do that! Its debt will grow exponentially, which is hyper-inflationary. Still, it can be argued that it is still ultimately deflationary because all these government debt has to be returned.

At this point, let’s pause and think.

In such hyper-inflationary environment, it’s doubtful whether people will see government legal tender ‘cash’ as money any more. In Zimbabwe, during an auction of a car, ‘cash’ no longer function as money. Instead, petrol vouchers (denominated in litres of petrol) were used as a unit of account for the bids. In Vietnam, the recent high inflation of the Vietnamese currency leads to some instances whereby people no longer uses legal tender ‘cash’ as money in buying/selling land.

The point we are trying to make is that by the time the situation becomes that bad, all talks about inflation or deflation is irrelevant because, ‘cash’ no longer function as money for practical purposes. They become as good as confetti. Who cares about the inflation or deflation in the supply of confetti?

Please note that the purpose of this article is not to make an inflation/deflation forecasts in the prediction sense. Its purpose is to show you how dragging an idea to the extreme can lead to erroneous thinking. In this example, while it is true that deflation will ultimately happen theoretically in the context of a credit-based system, it is pragmatically irrelevant.

Bloomberg: Fed’s Inflation Analysis Ranks With Zimbabwe’s

Tuesday, February 27th, 2007

We applaud Caroline Baum?s article in Bloomberg, Fed’s Inflation Analysis Ranks With Zimbabwe’s:

But excess money creation is the cause of inflation, and it would be better if the Fed could make the public understand that the rise in the price level is not a result of higher commodity prices, aggressive labor union demands for wage increases or greedy businessmen trying to milk the public.

This is the point we are repeatedly trying to hammer into people?s mind (see Cause of inflation: Shanghai bubble case study).