Wednesday, January 28, 2009

Whither Hyperinflation

It seems there are two sorts of people out there right now: those who say that no matter how much money the government throws at every problem it will never result in hyperinflation, and those that say that hyperinflation is now an inevitability regardless of what actions are taken from here on out. It is likely futile to attempt to reconcile the two groups, but we have decided to present some facts, as well as some statistical data culled by Morgan Stanley.

Before that though, we do want to point out the amusing fact that the general media rarely will touch the question of hyperinflation, just like the whole question of are we in a recession or depression - usually the subject is brought up unsolicited. A tangential and rhetorical question is why everyone in this society is so terrified to discuss the real issues that face the economy, and most just opt to skirt around the periphery?

What is hyperinflation and can it occur to the U.S.? The classical, Philip Cagan definition assumes monthly inflation higher than 50%, and the most recent examples include post World War I Europe (Austria, Russia, Poland, Hungary and Germany, of which the latter recorded over 3,000,000% monthly inflation), as well as Argentina (89-90), Peru ('90), Ukraine ('91-94) and Zimbabwe (past several years).

Hyperinflation is caused by uncurbed money supply growth, usually mandated by central banks which are forced to meet excessive fiscal deficits or finance untenable expenditure programs (sound familiar?), and traditionally occurs in a context of adverse economic and political shocks. Ultimately, it has a psychological manifestation - a loss of confidence in the value of money, a flight into real assets and hard currencies, increase in bartering, a shrinkage in financial intermediation initially and the banking system overall, subsequently.

Empirically, hyperinflationary periods are marked by high correlations of money supply growth and inflation rates as seen below.

The correlation can also be seen in episodes of high, but not quite hyper, inflation as were the historical cases of the UK and Mexico:

While in low-inflation environments, the money growth correlation is weaker, there is obviously a high statistical inference with higher money growth rates always resulting in above normal inflation rates.

So where are we now? According to Haver analytics we are rapidly approaching a point of no return, if we haven't passed it already. Concerted efforts by the Fed, Treasury, the ECB and the BOE have resulted in an explosion of money growth. The critical question is has this wholesale pumping of M1 funneled into downstream monetary aggregates (M2, "M3", etc) and the general public.

Clearly M1 levels are gaining momentum and we have yet to feel the impact of the $825 billion + stimulus package. Furthermore, the government seems hell bent on breaking the dam of money supply at all costs by forcing banks to increase lending, reducing taxes, and generally encouraging currency transfers to the end public. How will the government finance all this increase in money supply: options include central bank loans to the government, buying of government bonds at auction, purchases of government bonds in the open market and additional lending to banks against government collateral.

With an increase in monetary supply flooding the consumer now being only a question of time, the psychological element of public confidence will have to be carefully monitored: a surge in inflation would open up a vicious cycle of a loss of confidence by the public and force a reduction in deposits and cash holdings, resulting in purchases of real assets (commodities, select currencies and real estate). At that point the velocity of money and inflation would rise and the central bank would have to keep printing even more money to finance government spending.

Morgan Stanley attributes a low probability to a hyperinflationary outcome as a result of current monetary and fiscal policy, and assigns to it a mere black swan risk, but regardless believes that "buying some insurance against the event of high inflation or even hyperinflation makes sense and is relatively cheap currently."

Our belief is that the worst case outcome is not a fat tail, and is a question not of if but rather when. The ironic situation that the U.S. and the entire Developed world has put itself into is that due to the measures taken at fixing the broken financial system, which one could argue were precipitated by the collapse of Lehman, or alternatively, taking a cue from Soros' book, began when the massive credit bubble started some time after Bretton Woods, the outcome of the current period of financial instability, will be a world of even greater financial distress marked by hyperinflation in most western countries.

As we have argued before, and as evidenced by today's FOMC statement, the Fed is now toothless in its monetary policy (0% rate floor, when it should ostensibly be negative, in order to maintain an appropriate rate of economic expansion and inflation) and, by purchasing treasuries is now commencing its involvement in pseudo-fiscal adjustments. This adds more ice to the slippery slope of M3 exploding in our faces, at a time when the central bank is still fighting to prevent the consequences of 10%+ unemployment and an effective shut down in consumption from impaling U.S. GDP. (there is, of course, the export component of GDP, but I think we are in for a slew of negative surprises on that front as well very very soon).

For monetary policy sticklers, we have provided the most recent version of the Fed's H8 report where one can see the rather violent increase in the M3 proxy (either total assets or total liabilities, opinions differ). It is a safe bet that the total amount will only continue increasing in the coming months.

What can investors do to protect themselves from eventual (hyper) inflation? As specified above, "hard assets" are a safe bet. TIPS, shorting treasuries, purchasing currencies of those countries that are not expected to have huge deficits and/or untenable leverage, commodities (we still like our "risk free" profit idea, although the contango now has collapsed, so if you did it at the time, props to you), others? While the alleged pessimism that we sometimes exhibit may be too much for some readers, we only try to present both sides of the coin, and to help as many people preserve capital. Over the next 2-3 years, this will be a very difficult task, absent amusing days like today when the market is up 3% on patently horrendous news.
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Anonymous said...

"Impaling US GDP" or imploding? (Second paragraph above the chart)

Tyler Durden said...

both work

Philidor said...

To better understand your own personal exposure to hyperinflation, see my blog at Old Junkyard Dogs.