How Today's "Deflation" Can Turn Into Tomorrow's Hyperinflation

 

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Since the 2008 Credit Crisis, deflation has been the primary worry of mainstream economists and monetary and fiscal policies that utilize various forms of “money printing” have been implemented throughout the world to try to stop it. Unfortunately, money printing combined with deflation can potentially lead to hyperinflation.

Hyperinflation is a little understood and little studied phenomenon. Even inflation itself is only partially understood and traditional university economic programs devote minimal attention to it (just ask someone with an economics degree what courses they took in inflation). Almost no one seems to have made the connection between deflation and hyperinflation, which are intimately related. Hyperinflation in fact could actually be defined as a self-feeding cycle of severe deflation combined with escalating money printing.

Historical analysis shows that hyperinflation is a creature of damaged and dysfunctional economies. It does not come from overheated economies that continue to grow out of control resulting in ever higher inflation rates.  This mythical view may have been created because government stimulus measures the employ money printing in its various guises to deal with   deflation can briefly make the economy fervent because of a declining currency. This creates high export demand since foreigners can buy the country’s goods cheaply and high internal demand because the population becomes desperate to get rid of any currency it holds. This phase does not last however and it takes place just prior to the final hyperinflationary spike. It was seen in Weimar Germany in 1922 because Germany had a developed manufacturing economy and most of the rest of the world wasn’t experiencing currency devaluation.

In many cases in the past, war preceded hyperinflation. This happened in Germany and Eastern Europe after World War I and in Eastern Europe and Japan and East Asia after World War II.  It also occurred in the United States after the Revolutionary War (arguably the first case of hyperinflation in history) and in the South at the end of the Civil War. Demand can collapse after a war and this will cause prices to drop (the U.S. had sharp deflation after World War I for instance). Governments, who were already printing money to support the war effort, then frequently print more to stimulate the economy.  If the economy isn’t brought back to real functionality however, a country’s currency loses its value and an ever-increasing amount of money has to be printed to create the same amount of stimulus.  

Even if there is no war, hyperinflation can exist just because an economy is dysfunctional. This would describe the cases of hyperinflation in South America, post-colonial Africa, and in Eastern Europe during the collapse of communism.  When an economy just can’t create enough demand on its own, the authorities stimulate demand by printing money. This leads to the same cycle of currency devaluation and ever-increasing money printing in an attempt to keep up with the loss of value taking place. In reality, the economy is continually shrinking, even though prices start heading toward the heavens.

While this has happened in a number of countries over time, mainstream economists continually make the claim that inflation can’t exist if there is slack in the economy. Hyperinflationary economies actually have maximum slack, with Zimbabwe in the 2000s being the extreme example. Unemployment reached 94% there, while the inflation rate was climbing to the sextillion percent level (a number so huge it might as well be infinity). Despite this real world example that took place right before their eyes, a number of economists had no trouble looking right into the TV camera and telling the public that inflation can’t exist if there is excess capacity in the economy. If they had been testifying in court, they would have been arrested for perjury.

Since hyperinflation has only occurred in certain countries at certain times, it is important to ask what it the key factor or factors that lead to it. The short answer would be: deflation created by demand destruction, followed by money printing that is taking place because the ability to borrow doesn’t exist or has been exhausted. Since developed countries have better credit and can borrow more, hyperinflation is less likely to occur in them than in more marginal economies – at least until their lending sources dry up.   

Deflation in and of itself does not lead to hyperinflation. It depends on what the root cause of the deflation is. There were deflations in the late 1800s and in the 1920s in the U.S. due to technological innovations and not demand destruction as commonly takes place after wars. Lack of demand was not the cause of falling prices, rising supply was. The exact opposite situation takes place after a destructive war or in an economy in a post-bubble era (as is the case currently in the U.S., the UK, Europe and Japan).  In the latter case, demand needs to be stimulated, in the former it doesn’t.

Countries also don’t print money if they can borrow it. Less developed countries have limited and sometimes no borrowing ability and this means they turn to money printing early on and this makes them more prone to hyperinflation.  Since developed countries can borrow money, they do so for as long they possibly can. This has allowed Japan to get its debt to GDP ratio to an astounding 229%. The U.S. is already over 100% (based on official numbers, the ratio using more realistic numbers is much worse) and rising rapidly.  Despite its twenty years of economic malaise, Japan has managed to support demand by running huge and continuing budget deficits funded by the massive savings of its people (money printing has been relatively minor).  It is not likely any other developed country will be able to accomplish what Japan has done.  Japan also seems to have reached the end of the borrowing road and will have to start revving up the printing presses in the near future.

In contrast to the Japanese, Americans save little and haven’t been able to fund their budget deficits internally for decades —the U.S. relies on foreign sources for this money. When the Credit Crisis arose, foreign lending became inadequate and money printing began in earnest. The Federal Reserve increasing its balance sheet by over $2 trillion is only one example of this. While foreign lending might have continued to fund $400 billion dollar annual budget deficits, it was not adequate to support the $1.42 trillion, $1.29 trillion and$1.30 trillion deficits that occurred in 2009, 2010, and 2011. Trillion dollar deficits are going to with the U.S. for many years into the future and the only way they can be completely funded is by printing more and more money.  The EU isn’t in much better shape either and has been unable to fund its peripheral country debt by borrowing. Its current solution is to print money through massive credit expansion.

Claims that money printing won’t be harmful in the 2010s because inflationary policies were utilized during the 1930s Great Depression and they worked well back then are moreover completely misleading. The debt level of the U.S. government, businesses and consumers were minimal at that time compared to what exists today. Huge amounts of untapped borrowing capacity existed then, but this is no longer true. Consumer credit expanded so much in the intervening years that during one month of the Credit Crisis it dropped more than the entire amount outstanding at the end of World War II. An apt analogy might be one drink of alcohol won’t be harmful. If you haven’t had anything to drink yet it isn’t likely it will be. If you have already had twenty glasses, it might cause fatal alcohol poisoning. The global financial system now risks being poisoned by money printing.

The monetary authorities worry about deflation and attempts to handle it with money printing are nothing new. The current actions are disturbingly similar to what took place in Weimar Germany in the early 1920s. They handled their deflation problem with money printing as well. As prices rose, instead of facing reality, the economics establishment acted in concert to deny the obvious. Deflation was cited as the biggest danger to the economy until it became laughable. When inflation exploded, the usual scapegoats — foreigners, speculators and minorities — were blamed by the government. Unless human behavior has changed in the last 100 years, the same scenario is likely to play itself out again in the 2010s.


Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Will You Become an Inflation Victim? Take this Simple Quiz

The 'Helicopter Economics Investing Guide' is meant to help educate the public on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the offical blog of the New York Investing meetup.


Recently, San Francisco Fed President John Williams assured the public that there won’t be runaway inflation in the United States. His remarks follow a long litany of comments from  Federal Reserve officials that inflation is under control, inflation is low, and other variations of there simply is no inflation.  People who know inflation history, and this includes very few people alive today, are getting little comfort from these remarks. Central bank officials have repeatedly assured the public that there is no inflation in the past despite inflation obviously existing. One of the most vocal and sustained denials took place in Weimar, Germany in the 1920s. The central bank, the treasury department and top economists all agreed that inflation wasn’t a problem. It eventually reached 100 trillion percent.

Americans just have to open their eyes to see that inflation exists. Gasoline prices have risen from a $1.60 a gallon at the bottom of the Credit Crisis to almost $4.00 today. A number of food commodities, including sugar and coffee are having sustained price rises, and food prices in the supermarket are noticeably higher. I have a friend who records all of his family’s food purchases in Quicken and even though they are eating the same foods in the same quantity, the amount they are spending has gone up 10% in the last year.  Prices of clothing are also rising because commodity cotton prices broke a 150-year high recently. Copper, which has the widest of uses of all metals, has also hit an all-time high earlier this year.

Yet, the Fed tells the public not to worry as it continues one program of money printing after another. Even though this has always resulted in inflation in the past (the basic laws of arithmetic would have to be violated if it didn’t), they claim things are different this time. The continually fall back on the argument that there is a lot of slack in the economy and since U.S. unemployment is around 9%, wages can’t rise and this prevents inflation. Unfortunately, real world observations of past major inflations indicate how absurd this line of reasoning is. Unemployment in Weimar, Germany rose to 23% as their inflation rate reached the trillion percent level. Slack in the German economy was nothing however compared to Zimbabwe in the early 2000s. Unemployment there reached 94% and literally nobody in the entire country had a job. The inflation rate in Zimbabwe is estimated to have been at the sextillion percent level (a number so huge it might as well be infinity).

Before inflation really gets out of control, take the  following quiz to find out how well-informed you are about inflation investments and how your portfolio will be affected by it.

QUIZ

ANSWER TRUE OR FALSE

1. Safe investments like money market accounts, CDs and government bonds are just as good during high inflation as other times.
2. TIPS (Treasury Inflation Protected Securities) will at the very least maintain my capital during inflation.
3. Buy and hold in the stock market is an effective wealth building strategy during high inflation.
4. The higher the inflation rate, the better residential real estate is as an inflation hedge.
5. The U.S. dollar is the strongest currency in the world and will remain so during a period of high inflation.
6. If I have 5% of my portfolio in gold, my assets are protected from high inflation.
7. Of all possible inflation hedges, gold will provide the biggest return during high inflation.
8. When inflation is taking off, commodity prices will rise at the same rate as inflation.
9. When a government imposes wage and price controls, you can assume the inflation rate will come down and stay down.  
10.  Speculators are the cause of high prices during inflation.

WHICH INVESTMENT WOULD YOU RATHER OWN DURING HIGH INFLATION?

11. The U.S. dollar or the Australian dollar
12. A U.S. treasury bond or a collectible Pez dispenser.
13. A house in the Chicago suburbs or a 100-acre farm in Iowa
14. A 5-year CD or a copper mining stock
15.  Utility stocks or commodity oil
16. Municipal bonds or Thai grade B rice
17. TIPS or a set of silverware
18. Long positions in U.S. treasuries or short positions in U.S. treasuries
19. A money market account or a gold ETF (exchange traded fund)
20. British stocks or an antique map of England

HOW TO GRADE YOUR QUIZ

The answers to questions 1 through 10 are all false. The correct answers for questions 11 through 20 are the second choice. If you scored between 0 and 5, don’t be critical the next time you see a homeless person looking for food in a public garbage can. If you scored between 6 and 10, you will probably remain in your home, but won’t be able to heat it that much and your cupboards won’t be well stocked. If you scored between 11 and 15, you will get through a period of high inflation relatively unscathed. If you scored between 16 and 20, go to a neighborhood of high-priced homes (assuming you don’t already live in one), find someone who scored under 5 on the quiz and tell him that you will be living in his house in the future.

Explanations for questions 1 through 10: People who own liquid investment, such as money market accounts, CDs and bonds will lose money during inflation. In the worst cases, they will lose everything. TIPS are not an effective protection because their returns are based on official inflation rates and the U.S. government has been underreporting inflation since 1983. Stock prices tend to go sideways during inflationary periods and can be highly volatile. Residential real estate is a very poor investment during inflation because it can become extremely cash flow negative because of rising taxes and maintenance costs. The U.S. dollar has not been the strongest currency in decades and it went down against every major currency between 2000 and 2010. It is good to hold gold during high inflation, but 5% isn’t enough. Gold does not produce the highest inflationary returns, silver and many other investments can outperform it. It does produce the most reliable returns however. Commodity prices actually rise much faster than the overall inflation rate (examples were cited in the beginning of the article). Wage and price controls almost always fail. The only work if government money printing is permanently halted at the same time that they are imposed. Speculators don’t cause high prices, but along with foreigners, they are universally blamed for inflation. Central bank money printing is the cause of high prices.

Explanations for questions 11 through 20:  In general, tangible investments are preferred to liquid investments during inflation, so if the choice is between a money market account, CD, or bond versus a commodity or commodity related stock, the commodity is the best investment. Antiques and collectibles are also better investments that liquid investments. Of all the public currencies in the world, the Australian dollar most closely tracks price changes in gold, so it is the top choice during inflation. Farmland is the best real estate investment during inflation. Interest rates go up during inflation, so the way to make money in bonds is to short them, not own them.

Disclosure: Author does not own any specific investments cited in this article, but does hold some U.S dollars.

Daryl Montgomery
Author: Inflation Investing – A Guide for the 2010s
http://www.amazon.com/Inflation-Investing-Guide-2010s-ebook/dp/B0051GU06W/ref=sr_1_4?s=books&ie=UTF8&qid=1306940501&sr=1-4

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security

 

The Curious Case of Copper and Its Compatriots

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


While traders are scratching their heads about how the stock market can continue to go up while the economic news continues to get worse, they also should be puzzled over the sharp rise in copper and other industrial metals in recent weeks. These metals move with building and manufacturing activity and a rise in their prices is not just an indication of an improving economy, but is also an indication of inflation - not the deflation that the Fed and its friends have been worrying about lately.

The base metals, copper, aluminum, nickel, zinc and lead, all bottomed in early June. They mounted lackluster rallies into the middle of July. Their rallies went into overdrive after Fed Chair Bernanke testified before congress that it might be years before the U.S. economy fully recovers. Stocks also mounted a significant rally on this gloomy news, which followed a host of economic reports with falling numbers that came in below expectations. Leading indicators had also turned down and were pointing toward an impending recession. Stocks and industrial metals should have tanked, but instead rallied strongly on the news. Only a lot of liquidity flowing into the financial system at that point could make something like this happen.

When trying to analyze the metals markets, the first place to look is China, the primary driver of demand. In June, China imported 212,000 metric tons (tonnes) of copper, 67,000 tonnes less than in May and a drop of 44% year over year. Moreover, projections came out for Chinese demand growth to ease for the industrial metals in the second half of the year. Then the HSBC Purchasing Managers Index for July came in below 50, indicating a decline in Chinese manufacturing. So far, none of this news has stopped the rally.

So if the news from China is bearish, the next place to look is the U.S. dollar. All commodities are priced in dollars and are affected by swings in the currency. The U.S. dollar peaked in early June at the same time that the industrial commodities bottomed. It has since lost about 10% of its value. However, much of this loss took place before Bernanke's congressional testimony and much of the base metal rally took place after. The metals rally has also been too big to be accounted for by the drop in the dollar alone. From the June low to the high of August 4th, Copper (JJC) rose 25%, Nickel (JJN) 24%, Aluminum (JJU) 23% and Lead (LD) 46%.

So we are left with a picture of strongly rallying stocks, even more strongly rallying industrial metals and lots of evidence of an economy falling apart. Has this situation ever existed before?  Indeed it has plenty of times in world financial history. This is what happens when there's massive inflation. It ruins the economy, but makes the prices of assets go up because people want to get rid of their currency. Yet the economic elites are currently worried about deflation and not inflation. Well, that's also happened before as well. In 1920s Weimar Germany, economists even managed to prove definitively that deflation existed and that inflation was not a worry, so it was OK for the government to print all the money it wanted to. Of course, after inflation reached a trillion percent, many people became skeptical.

Disclosure: No Positions

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Fed Will Leave Rates at Zero Until Inflation Shows Up

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


The Federal Reserve left the fed funds rate in the zero to 0.25% range at its April meeting. This is the 16th month that the Fed has maintained rates at an all-time low. While the Fed was a bit more upbeat about the economy than it has been at recent meetings, it still pledged to keep rates near zero "for an extended period of time".

When it comes to the Fed and other government representatives, investors would be best off by paying attention to what they do and not to what they say. The Fed was certainly more upbeat in its statement from the April meeting than it was in previous meetings. It noted that "economic activity has continued to strengthen and that the labor market is beginning to improve","growth in household spending has picked up recently" and  "business spending on equipment and software has risen significantly". You would think happy days were here again and short-term rates will be 5% before you know it. Well maybe not, it turns out.

While strong economic growth leads to inflation, apparantly there is no risk of that (inflation that is) as far as the Fed is concerned. The Fed went on to say that "with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time". So the Fed seems to be talking out of both sides of its mouth. Either growth is not sustainable in the long-run and it thinks this will keep inflation subdued or the Fed has pumped so much money into the financial system that this is creating economic expansion (at least for the moment) and inflation will follow.

The first scenario was seen in Japan during the last two decades, especially after its two-year recession in the early 1990s. The economy was supposedly recovering nicely without inflation for a few years. Instead, it gradually fell into the abyss and a deflationary spiral. In the second case, uncontrollable inflation is possible - and this can take place with a great deal of resource slack. Rapidly declining and eventual collapse of resource utilization is the marker of hyperinflation. Fed chair Bernanke should tell Zimbabwe that it couldn't have possibly had the second highest inflation rate in world history, sextillion percent, because it had an unemployment rate of 94%. Weimar Germany, with a mere 100 trillion percent inflation rate, had unemployment that reached almost 25%.

The Fed statement also had two telling comments that provide significant insight in the Fed's thinking. These were, "financial market conditions remain supportive of economic growth" and "bank lending continues to contract". Taken together these indicate that the financial conditions that are supportive are the Fed's low interest rates and the high prices of stocks - the paper economy. While the paper economy is going great, as indeed it was before the Credit Crisis and during every other bubble in history, the real economy is struggling. It can't function well without adequate credit from banks. In other words, the Fed's positive view of the economy is based on economic make believe.

If the Fed really believed the economy was improving, it would be raising rates or at least getting ready to do so and not say it was maintaining its ZIRP (zero interest rate policy) for a long time. As I have documented in previous articles, there is usually a two to three year lag from the end of a recession until the Fed starts raising rates. If we assume optimistically that the recession ended in July 2009, that would take us until at least July 2011 before rates went up. Any rate rise before that date would indicate significant inflation risk and a rate rise after July 2012 would indicate a serious deflation problem.  In either case, the Fed's response will be too little, too late.

Disclosure: None Relevant

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Inflation Denial Won't Keep Prices Low

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Denial is one of the most destructive forms of behavior for investors. While the markets can operate on false scenarios for a significant period of time, reality always wins in the end. When it does, the situation can get quite ugly and all the profits gained from a belief in an unsupportable viewpoint can evaporate over night. At the moment, there is a lot of denial about inflation and investors should be paying attention to this.

The case for inflation is based on common sense and the laws of simple arithmetic. A country cannot create money at a faster rate than its economy is growing. If this occurs, the currency is devalued and it then takes more units of currency to purchase any given item (which is the same as saying prices go up).  There is a time lag between these two events however, sometimes many years, so people frequently don't connect them. Indeed, governments who engage in this behavior frequently go to great lengths to insure the public doesn't make the connection and realize that inflation is caused by government actions. Invariably throughout history, speculators and foreigners are blamed for rising prices. Think about whether or not you've heard any talk about speculators lately. There will be a lot more of that in the future.

When it comes to inflation, governments not only try to act like magicians and dazzle you with one hand while picking your pocket with the other, but they also engage in strong and persistent denial of its existence. Any number of fanciful, but easily debunked, arguments will be produced to show inflation doesn't and even can't exist. In Weimar Germany in the early 1920s, the economic establishment engaged in an across the board denial that inflation existed and there were even 'proofs' created to show that there was really deflation. Inflation eventually reached the hundred trillion percent level there.

So what is happening in the U.S. today? At the March 16th FOMC meeting, the Fed stated "With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.” The implication is of course inflation can't exist if there is substantial resource slack. By the rules of logic, if we can find a single example that contradicts this, we cannot rely on this statement. There are of course many, many such examples. The most recent and perhaps extreme is what just took place in Zimbabwe. The unemployment rate there reached 94% (yes that's unemployment) and the economy essentially experienced a total collapse. According to U.S. Fed, there should have been massive deflation in Zimbabwe, instead of the second worse case of hyperinflation in world history. How could this have happened? Zimbabwe printed a lot of money. The U.S. has also been engaged in significant excess money printing during the last two years.

The evidence of inflation is also not likely to show up first in U.S. government reports. The government has a vested interest in making sure that it doesn't. This is part of managing inflation expectations, which the Fed also mentioned in its statement. The last thing the government wants is for people to be aware of coming inflation and they will manipulate the official numbers and the news as much as necessary to keep this from happening. Investors who want to know what is really going on with inflation need to look elsewhere for the facts. The most recent ISM (Institute of Supply Management) reports indicated very strong inflation pressures in the system, particularly in the manufacturing sector. This story got buried in the media though and was covered up with glowing claims for economic recovery.

Investors should also watch the markets for what they are saying about inflation. There are three important indicators - interest rates, oil and gold. U.S. treasury interest rates have been bubbling up for awhile now. The market is having trouble absorbing the huge supply of bonds that the U.S. has to sell in order to fund the budget deficit. Long-term interest rates have broken a 30-year downtrend line and look like they will be heading higher for many years to come. Oil just broke above a nine-month trading range and is now heading higher as well. Nothing has more of an impact in leading to higher consumer inflation than does rising oil prices (which are set internationally and are out of the Fed's control). Gold has risen from a low just above $250 in 2001 to its recent high in December above 1200. It is in a seasonally weak period at the moment, but should be hitting new all-time highs in the fall.

Inflation provides an object lesson of how investors need to approach the markets. The media is filled with information on financial topics, and much of that information is misinformation. It is necessary to cut out or ignore the irrelevant to make good investing decisions. The best way to do this is think for yourself, believe your own experience, and watch what the markets are actually doing.

Disclosure: Long oil.

NEXT: An Analysis of Retail Sales Media Coverage

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Interest Rate Rally Portends Inflation in 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


U.S. treasuries closed out 2009 with their biggest loss since 1978. It was the first loss since 1999 and only the fourth loss in 31 years. Interest rates at the long end of the curve are now almost double what they were at the height of the Credit Crisis. It was quite a turnaround from the end of 2008, when bonds managed to rally and survive the market slaughter that took down almost every asset class. 2009 witnessed a complete turnaround when treasuries went down and almost every other asset class went up. The rally in bonds in 2008 and the severe drop in interest rates was used as a key piece of evidence for those who argued the deflation would be a problem. They ignored that inflation-sensitive gold and farmland were the other two assets that had gone up in price that year (gold was up again in 2009 with a 25% gain - it's ninth straight annual gain; final figures for farmland are not yet available).

Very short-term interest rates are still close to zero in the U.S. As long as Fed Funds stay at that level, 3-month T-bills will not be much higher. Long-term rates themselves were kept down by the Fed purchasing 10-year treasuries as part of its quantitative easing program. This ended on October 31st. Once the Fed was no longer propping up the government bond market, December became one of the worst months for treasuries in a long time.  The case for deflation, although  questionable from the start, collapsed right along with treasury prices. Deflationary environments are characterized by low short-term rates and low long-term rates, as was the case in Japan starting in late 1990s and the U.S. during the 1930s Depression. The yield on the 10-year Japanese government bond fell below 1% in 2003, not far above the near zero rates on shorter dated paper. Rising long-term rates indicate inflation and the bigger the spread between them and short-term rates, the higher future inflation is likely to be. That spread is now already wide and widening even further in the U.S.

The problem isn't isolated to one side of the Atlantic either. Rates for 10-year gilts in the UK are already over 4% and are higher than government bond rates with the same maturity in Italy. The UK is engaging in major money printing and its policies are perhaps even more inflationary than those of the U.S. The yield on the 10-year U.S. treasury at the end of 2009 was 3.84%. The 30-year yield was 4.64%. This was not the high for 2009 though. That took place in June when the 10-year yield was around  4.00% and the 30-year yield around 5.00%. It was already clear by then that deflation was not going to happen. Nevertheless, the Federal Reserve, the Treasury and a number of prominent economists continued to maintain otherwise. The same thing happened in Weimar Germany, with the equivalent cast of characters claiming deflation was a problem - not inflation - right up to the point where prices exploded. There is no reason the script should be different this time. It rarely is.

Inflation is devastating for long-term bonds. Their prices have to drop substantially, so yields can go up enough to induce potential purchasers to buy them. These were some of the worst investments during the 1970s (until the final peak in interest rates in 1980, when they became excellent investments). Back then, the average investor's only option to deal with a dropping bond market was to stay away from it. Now we have the ETFs TBT and TMV, which have portfolios that represent leveraged shorts on long-term U.S. treasuries. Long-term treasuries are approaching resistance on the charts, so a pull back should be expected in early 2010. This could prove to be an excellent buying opportunity.

DISCLOSURE: Long gold, farmland, TBT and TMV.

NEXT:

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Common Roots of Hyperinflation

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Rating agency S&P lowered its outlook for Spanish government debt on December 9th. Fitch lowered its long-term debt rating for Greece to BBB+ from A- the day before. In the eurozone, there are concerns about Portugal also being in trouble, although Portugal's debt to GDP ratio is no worse than the United States and a case can be made that the U.S. is actually in much worse shape - the U.S. has a large money printing press however and Portugal does not. No country can compare to Japan however with its debt to GDP ratio currently over 200%. An examination of the CIA Factbook figures for 2008 estimated that only Zimbabwe had a worse debt to GDP ratio than Japan's. Zimbabwe also had the second largest hyperinflation in world history.

The roots of all hyperinflations are governments not being able to fund their operations. Government's first borrow money to do so and this can go on for years or even many decades (the more powerful the government, the longer it can live off of borrowed money). At some point, the credit either starts to run out or the expenditures get so high that the amount that can be borrowed is no longer enough. It is then that governments resort to printing money (not literally done in advanced economies where money is simply created by pressing the enter button on a computer) and this devalues the currency. The devaluation is the result of simple arithmetic. Currency increasing at a faster rate than the size of the economy means each unit of currency is worth less and it takes more money to buy any given good or service than it would have otherwise. The price rises that result are consumer inflation. Many economists do not use this obvious definition of inflation, which is one reason why their inflation predictions are frequently highly inaccurate. Central banks particularly don't like it because it would prevent them from engaging in politically popular, but potentially disastrous monetary policy.

The Credit Crisis has led to a lot of money printing (frequently referred to as quantitative easing) globally and this is taking place after decades of increased borrowing in most countries. While money printing will lead to inflation, it only leads to hyperinflation when it spirals out of control. The preconditions for this are that borrowing power has been maxed out (which is now the case for many countries, but was not true in the 1970s and this is why it was possible to tame inflation back then) and it no longer becomes politically possible to match government expenditures with revenues. In the modern era, this is always a problem during wars since no state is capable of raising enough money through taxes to pay for any major or prolonged military effort (the U.S. accounts for over 40% of global military expenditures by the way). Contemporary democracies also get caught between the need for large outlays for social expenditures and the resistance of rich individuals and corporations to paying the taxes necessary for funding them, so they compromise and give both sides what they want. This problem is by no means brand new. It is essentially what lead to the hyperinflation in Germany in the early 1920s.

Once the preconditions for hyperinflation exist, a major economic shock can then become the precipitating incident. Governments will always assume that the problem is temporary and the economy can be righted quickly through a little money printing. In deep economic shocks like that depression in the 1930s and the Japanese banking crisis in the 1990s, and the Credit Crisis today, this is not the case. The problem will take at least a decade and possibly multiple decades to solve. The possibility for long-term money printing then exists (the U.S. did not engage in this in the 1930s). Zero or close to zero interest rates will mask the damage that is being created. This is what has allowed Japan's government finances to spiral out of control (combined with a huge pool of personal savings of the Japanese people that it could tap into) and is now enabling the U.S. and UK to do the same. At some point though interest rates have to rise and when they do, interest payments on the national debt can equal or exceed the government's tax receipts. The game is up long before that occurs however with a hyperinflationary spiral becoming inevitable. For this reason, it is now no longer possible to solve a future inflationary problem by raising interest rates to high levels as was done in the U.S. at the end of the 1970s. This approach now would be disastrous.

The U.S national debt increased by a $1 trillion in 2008 and $1.9 trillion in 2009. The damaged economy and the after effects of the Credit Crisis are likely to keep the increase elevated for many more years. After that, increased outlays from Social Security and Medicare caused by the Baby Boomers retiring will kick in, so there will be no respite. At some point the whole scheme will fall apart. When interest rates rise well off the zero level, this will be the tipping point that means that an inflationary spiral has started.

Disclosure: Not applicable.

NEXT: Short Bonds When Retail Sales Improve

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Smoking Gun of the Economic Recovery Scam

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

The Economic recovery that is supposedly taking place has been carefully arranged by the U.S. government. Unfortunately, the 'recovery' will be far more evident in the published statistics than in the economy itself. After all, it is a lot easier to change the numbers that to actually fix the economy. Apparently, the hope is that with enough cheer leading, businesses and the public will get on the bandwagon and start spending again. I can picture Bernanke, Geithner and Obama clicking their heels together and trying to wish hard enough to make it so.

The AIG earnings report came in as positive as expected on Friday. How did a company that is beyond bankrupt manage to show positive earnings? The key statement in the report about what happened was "resulting from the adoption of new accounting guidelines". These new guidelines were set by the U.S. government and probably benefited every big bank and brokerage house as well, most of which had surprisingly good earnings - even though their lending operations (the core business of any bank) were continuing to deteriorate during the quarter. So the mystery has been solved. If your earnings are disastrous, just change the accounting rules and like waving a magic wand, suddenly you're earning gobs of money. Happy days are here again!

If you want to know how well this approach works, you can take a look at Enron and GM. Enron's earnings were phony for years and then it imploded overnight. GM changed its accounting in the mid-2000s after the recession and suddenly one quarter it was earning big bucks instead of losing big bucks. To its credit, CNBC News actually reported that the big 'improvement' was merely an accounting gimmick. The stock still rallied strongly on the news (so much for the Efficient Market Hypothesis). Even though the government started pouring money into GM starting in 2007, it still went bankrupt in 2009. Now the government is supporting it to the tune of $4500 per car with the Cash for Clunkers program. Reports out today predict that autos are going to be the next big recovery area of the economy, improving both the industrial production numbers (which fell at a depression level 19% in the first quarter) and retail sales (which went up in May and June because of higher gas prices - they're not adjusted for inflation).

If the government pours huge amounts of money into any industry, the numbers will of course improve. This doesn't indicate economic recovery though, even though it is being sold that way. Will the government keep doing this every quarter? It may have to in order to keep the 'recovery' going. If you want to know how well that approach works, see Weimar Germany and Zimbabwe.

NEXT: Inconsistencies of the Economic 'Recovery'

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Simple Arithmetic of Hyperinflation

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

The U.S. government inflation figures were out last week. According to official statistics, about as reliable as a pronouncement from Pinocchio, CPI fell 1.3% year over year. This was the biggest drop in 59 years. Core CPI was up 1.8% year over year, so no drop there. Core doesn't include energy and food prices, so the fall in oil prices from last year doesn't fully show up in it. The PPI figures had an even bigger annual drop. Mainstream news articles were filled with remarks about how great it is that the Federal Reserve has lowered interest rates to zero and flooded the economy with money to save us from deflation. I have no doubt that they will be very successful in this endeavor.

While there are still a lot of deflationists out there, I think even they could all agree that if a government has so much debt that its tax receipts could only cover interest payments on that debt, massive inflation would necessarily follow. This would happen because the government would need to constantly print a lot of new money to cover its regular expenses. Few outside sources would be willing to lend to that government. While this is an obvious worst case scenario, the inevitably of hyperinflation takes place somewhat before this situation is reached. Finding that exact inflection point depends on a lot of complicated mathematics involving a large number of factors and is subject to significant interpretation. For that reason, it is not possible to say that the U.S. has already reached it.

Examining the national budget figures for 2009, there is now $3.9 trillion in projected spending. Government receipts (mostly taxes) look like they will come in at $2.1 trillion. Only 53% of expenditures are covered. It is the decreasing coverage of government expenditures by tax receipts that led to the hyperinflation in Weimar Germany. The government had to print more and more money to keep itself running. Five years before their hyperinflation peaked, only 69% of the national budget was covered by taxes (yes, 16% more than is currently the case in the U.S.). Falling below 50% coverage seemed to have been the point of no return for the Weimar government.

What about interest payments on the national debt? In 2008, they were only $412 billion. This was during a time of multi-decade low interest rates that were close to zero for short term bills. Interest rates can't go any lower, but have a lot of room to go up. Everything else being equal, if we went back to the interest rates at the end of the 1970s, interest payments on the current debt would use up all tax receipts. Everything else will not be equal however. Every year the national debt is going to increase substantially and the interest rate needed to use up all tax receipts becomes lower and lower with time. Tax receipts need to rise enough to compensate for that. However, this would indicate a rapidly growing economy, that could easily raise interest rates more than enough to overwhelm the benefits of more taxes.

How can the U.S. government deal with this situation other than cutting the budget drastically (don't hold your breath for that one)? Since it is increasing the supply of government debt rapidly, it needs to increase demand even faster for its bonds. But foreign lenders are backing off. So the only solution is to print even more money, so it can buy even more of its own debt. Now that's going to help keep inflation under control!

NEXT: Stock Market Turns Ugly

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

U.S Unemployment Reaches 15%

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

Just because you don't have a job in the U.S. doesn't mean the government considers you unemployed. The monthly Jobs Report was released today and the headline number was an unemployment rate of 8.1%. This is however the rosiest possible interpretation of the U.S. employment picture. While 12.5 million people were counted as unemployed, there were an additional 2.1 million 'marginally attached' workers (also known as discouraged workers) - people who looked for a job within the the last twelve months, but not in the last four weeks. These people are not considered to be unemployed. A much larger 8.6 million workers worked part time last month and are considered fully employed even though they may have worked as little as an hour a week and wanted to work full-time. If you consider the discouraged workers and involuntary part-time workers as unemployed, the U.S. unemployment rate is actually 15.0%.

This 15% is calculated using the government's own numbers. This is more than enough reason to think things might be even worse than what the government is telling us. Every employment report since the Credit Crisis began in the fall of 2007 has had two downward revisions after the initial numbers were released and these have frequently been substantial. As an example, December 2008 jobs losses were initially reported at 524,000. That was revised to 577,000 last month and in the current Jobs Report the losses have now been updated to 681,000. An additional loss of 151,000 jobs for January and December combined showed up in today's report for February employment. You should expect that the January numbers will be revised downward again next month (the numbers are revised for two months). The 651,000 loss reported today will almost certainly be larger in the April and May reports.

Looking inside the figures you would also note that three categories have gained jobs every month since the Credit Crisis began - health care, education, and government. Most education and many health care jobs are of course government related. While it is possible that employment in health care is increasing, considering the poor fiscal condition of state, local and the national government in the U.S., it is quite incredible that more and more people are working in education and directly for the government. Where is the money coming from to pay for these workers and what are they being hired to do?

In the 1930s Great Depression, U.S. unemployment is believed to have peaked around the 25% level (approximately the same rate that was reached because of the hyperinflation in Weimar Germany in the 1920s) . This is just a rough estimate because the data gathering infrastructure that exists today, didn't exist back then. If you see the alternative unemployment numbers reach 20% or so, it would be reasonable to assume that current economic conditions are as approximately bad as they were in the 1930s.

NEXT: Stocks Look for Bottom, Oil Rallies

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Deepening Global Recession Means More Inflation

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

The economic news out this morning corroborates a deepening global recession. GDP in the eurozone fell 1.5% during Q4 2008. This is the third drop in the row and the steepest. Predictions are that Japan's Q4 GDP will fall somewhere around a 10% annual rate. Media coveraged emphasized how the U.S. economy was doing better than those overseas, rather than questioning the absurdity of the U.S. GDP figures. Dire warnings of DEFLATION were mixed in with the reporting.

While it is true that declining economic growth leads to falling demand (an economic argument that discusses only demand and not supply is meaningless) and the current declines are rivaling the Great Depression in the 1930s, this doesn't mean there will be deflation this time around. During the Depression, the U.S. monetary authorities contracted the money supply in the beginning, which is a major reason the Depression lasted so long and became so steep. Currently, the monetary authorities are inflating the money supply at a rate worthy of Weimar Germany in the early 1920's or Brazil in its inflationary heyday. Simple common sense indicates the outcome will be different now than it was in the 1930s.

The truth will be found in the markets. While they can be manipulated in the short term, in the long term they have to move to accurate price levels (unless the government bans trading, which has indeed happened many times in the past). Even though constant efforts are made to suppress the price of inflation-indicator gold, it is nevertheless still rising and could easily hit a new all time high sometime within the next several weeks. It reached 950.00 in futures trading yesterday, just a smidge below the 1000 level. Silver has also been rallying strongly in the last two months. Oil is trying to find a bottom at current levels and expect it to put in a good rally once it does.

Anyone who reads this blog knows the alledged deflation that is taking place is accounted for almost completely by falling oil prices. While the manipulations in the gold market are well documented, oil is probably even more manipulated but in different ways. Right now Light Sweet Crude is in extreme contango (prices for futures months are much higher than the current price). While the current oil contract was trading at $34.45 this morning, April was trading at $42.14 and June was trading at $47.62. Also the price of Brent (an inferior grade of oil) is way above Light Sweet Crude, with Brent trading at $45.90. This is the reverse of the usual price relationship and is somewhat analogous to table wine costing more than a good champagne. Light Sweet Crude may have put in a double bottom yesterday (only time will tell), falling to $33.98, close to the low of $33.16 reached last December 19th. Press coverage on oil seems to have changed this morning, with some talk about how supply is going to be reduced at current prices and how this can support prices even though demand is falling (did someone recently give the reporters a basic lesson in economics?).

Ignore all the talk about deflation coming from the press and well-known deflationists like Noriel Roubini (who is predicting a big decline in consumer prices). Yes, global economies are sinking, but monetary and fiscal stimulation (both of which are inflationary) are being applied at historically high levels. It's only a matter of time before they work their (black) magic. Just remember though that it takes many years before the full impact of inflation shows up.

NEXT:

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Welcome to Hyperinflation

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

Yesterday ZIRP (zero interest rate policy) became a reality in the United States. The Fed cut its overnight funds rate to a range of zero to 0.25 percent. The New York Investing meetup predicted such a possibility in the fall of 2007, when I first said that if things became bad enough the Fed would lower interest rates to zero. In our December 4th meeting two weeks ago, we predicted that 2009 would be the year of ZIRP with the Fed lowering interest rates to around zero and keeping them there. Things apparently have become bad enough.

Yesterday, the Fed bluntly announced that it would print as much money as necessary to deal with the current economic contraction (read depression). And this has allowed the American press to finally acknowledge in its articles that the Fed has been printing money to cope with the credit crisis - something that I have been repeating like an obsessive-compulsive parrot for more than a year. Since this September alone the Fed's balance sheet has more than doubled (that's in only 3 months... think about that) from around $900 billion to more than $2 trillion. With its new programs to buy up worthless mortgage-backed securities that number will be up to $3 trillion. You may safely assume it will go much higher after that.

The authorities and their allies in the mass media assure us that we needn't worry about the obvious (hyper)inflationary implications of the Fed's moves. It is claimed that deflation is the big problem facing us (and War is Peace and Hate is Love, etc. see Orwell's novel 1984 for similar government assertions). The facts, as well as simple common sense, indicate otherwise. The government's own highly manipulated numbers which grossly understate inflation, still indicate prices are going up. The big drop in price increases can be traced to falling oil prices and literally nothing else. Since commodities can only fall to their cost of production, oil is not likely to fall much further and the 'deflation' threat could disappear overnight. The market will then have to deal with a mountain of government printed money instead.

Apparently we needn't worry about that either. While the economic establishment admits that the Fed's actions are potentially dangerous, former Fed Vice Chair Alan Blinder himself said yesterday "If that much money is left in the monetary base, it would be extremely inflationary", it claims the money can be withdrawn as the economy recovers and then everything will be fine. The German authorities said the same thing about their money printing in the early 1920s. But every time they tried to stop it, there was an immediate negative reaction in the economy, so they restarted it again immediately. The U.S. Fed in the 2000s will be no different. Money printing is a form of addiction and addicts will do anything to maintain their high until they hit bottom.

NEXT: The Truth About Deflation - A Crude Analysis

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Inflation Versus Deflation Argument - Part 2

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Inflation can only get out of control if the monetary authorities act irresponsibly by failing to stop rising prices and respond with denial and duplicity instead. In general, the worse the denial the greater the final inflation rate. In no case was this more clearly demonstrated than during the German hyperinflation when prices rose a 100 trillion percent between 1914 and 1923. Toward the end, consumer prices more than doubled every two days.

Eminent financiers, economists, politicians and Wiemar government officials all denied that inflation even existed in Germany, at least right up to the time of its final hyper phase and some of them continued with their denials even in the midst of those explosive price increases. Minister of Finance, Helfferich, assured the public that there was no inflation in Germany because the 'value' of currency in circulation was covered by a greater amount of gold reserves than it had been before prices began rising. Eminent professors, Elser and Wolf, echoed his argument. President of the Reichsbank, Havenstein, categorically denied that the German central bank was creating inflation and was convinced he was following a restrictive monetary policy. The Statistical Bureau of the German Government concluded in a study that there was a shortage of currency in Germany, but a great deal of inflation abroad!

How did these government officials and eminent economic authorities justify their continued assertions that there was no inflation despite rapidly rising consumer prices? They used one of the oldest tricks in the book, simply redefining inflation to be something else. By saying X really isn't X, but X is really Y and Y has certain attributes so X must have those attributes, you could of course prove almost anything. And the Wiemar German experts did just that by defining inflation as an in increase in the real value of currency in circulation (instead of the nominal value, which would essentially be the current definition of money supply) plus credit . While the total face value of currency in Germany was increasing dramatically, the total actual value was declining and this was interpreted as 'proof' that deflation was taking place. The accurate interpretation would have been extreme consumer price increases can take place when real money supply and credit are decreasing.

If instead of defining inflation as a function of real money supply and credit, Wiemar economists had defined it as the change in the value of a nations currency, they would have arrived at the correct conclusions about consumer price inflation. The exchange rate of the German mark essentially went to zero as price increases in Germany approached infinity. Since that time, globalization has only made the importance of currency as the key determinant of inflation even more important.

While the mistakes of the Wiemar German officials and financial experts seem laughable today, almost the exact same arguments about inflation began circulating in the U.S. in 2008. If such absurdities only surface prior to a massive outbreak of inflation, serious trouble was obviously ahead for the U.S. financial system.

NEXT: The Inflation Versus Deflation Argument - Part 3

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

For more about us, please see our web site: http://investing.meetup.com/21