Hyperinflation Article I - How Does Fiat Currency End — Part I: Deflation

將會post Mike Maloney 於2010年寫關於hyperinflation的三篇文章。剖釋了他對hyperinflation的了解，起因，歷史上相同或近似事件及大家應該怎儲備。

July 14, 2010

How Does Fiat Currency End — Part I: Deflation

wealthcycles.com

Fire and Ice

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

—Robert Frost

Hyperinflation or deflation: how does the dollar end? As a financial historian, I have studied hundreds, if not thousands, of fiat currency systems going back to when they first appeared in 11^th century China. Ultimately, every single one has failed. And just like every other fiat currency ever created, the dollar will fail as well—but under what circumstances will the grisly demise occur? And what practical lessons can we learn from the history of past currency failures and economic crises that will enable us to protect ourselves and our families today?

If you have had a chance to read my two-part article, Where Do Dollars Come From, you should have a decent understanding of fiat currencies and their inherent flaws. InWhere Do Dollars Come From, Part II, I explain how the fiat currency affects you and your personal wealth. In a nutshell, fiat currencies result in instigation and prolonging of wars, amplify boom/bust cycles, and steal wealth through the invisible tax known as inflation. 

Fiat currencies are the drug that enables the horrifically unbalanced national budgets, severe trade deficits, and massive currency creation that are disrupting the global economic system today.  But the façade, propagated by world governments and central banks, that all is well with our global economic engine, is beginning to crack. The illusion will crumble around us. There will be an enormous transfer of wealth, from those holding stocks, bonds, currency, or real estate, to those holding the world’s only “real money,” gold and silver. This economic earthquake won’t be pretty; many individuals and institutions will be destroyed financially. But those with a solid grasp of wealth cycles and the foresight to invest accordingly will reap enormous benefits.

But what exactly will happen when the illusion shatters? Will the fiat currency system end in fire, with a massive hyperinflation, or in an icy, deflationary death spiral? This question has been the subject of intense debate, especially after the massive bailouts of 2008 and record-setting deficit spending of 2009.

Over the past couple of decades, the Fed has exercised its considerable powers to ensure that the  currency supply was steadily and continuously inflated through debt and deficit spending, as the dollar did exactly what it was designed to do—lose value.

But I think that fiscal strategy of constant, steady, moderate inflation has just about played itself out, simply because it is impossible to sustain moderate inflation indefinitely. America buys stuff from the rest of the world and pays for it by selling off pieces of itself. Eventually, our foreign creditors will stop lending to us and will rush for the exit in a mad dash to sell dollars, which will cause a collapse of the dollar’s value.  

If Federal Reserve Chairman Ben Bernanke is to achieve his goal of bringing America’s enormous real estate and stock bubbles in for a soft landing, big inflation--much higher than “normal” U.S. inflation of 2% to 6%--will be required.  In this scenario, with the creation of massive amounts of new currency—a process under way right now—the value of many asset classes, such as real estate or stocks, will appear to be rising. In reality, they will be crashing. 

The return (profit) from any asset is its nominal return (what CNBC says the asset is worth) minus the rate of inflation. If the rate of inflation is greater than the nominal return, the asset is actually losing value. Big inflation will silently erode the real value of assets such as real estate or stocks, even if their nominal prices go up!

But I don’t expect mild inflation, or even big inflation, to be the thing that finally breaks the dollar. I think the endgame for the dollar will be a deflationary economic collapse a la the Great Depression, followed by a knee-jerk inflationary reaction from the Federal Reserve Bank that will culminate in a spectacularly destructive hyperinflation.

But don’t despair. The enormous transfer of wealth that will occur as a result of the bursting of the fiat currency bubble represents an enormous opportunity—the greatest opportunity we are likely to see in our lifetimes. The important thing is that we understand the cycle and how to position ourselves so that we and our families are able to take advantage of this life-changing opportunity.

The Icy Plunge: What is Deflation?

Deflation is a contraction of the currency supply, which causes prices to fall and the value of currency to rise. When prices fall, a boom becomes a bust, and suddenly a recession becomes a depression.  Fed Chairman Ben Bernanke, a scholar of the Great Depression, knows the dangers that deflation poses to a debt-based economy. If you read my article, Where Dollars Come From, Part I , you know how a debt-based monetary system is dependent on constant expansion by borrowing.

Deflations are Bernanke’s biggest nightmare, because they can be backbreaking for nations that are overly indebted. Debt, which is generally fixed, becomes crushing when prices (and your salary) go down. For overly-indebted nations (read: the United States and other developed nations) deflation can be excruciating. Here’s why: If you make $1,000 dollars a year, you can spend $400 on rent, $100 on food, $400 to pay your debt, and still have $100 to boot—things aren’t too bad. But if wages fall 53% (as they did during the largest, most widespread deflation of the 20th century, the Great Depression) your $1,000 income will drop to $470. But your $400 debt payment (credit card bills, car payments, student loans) is still a $400 payment. And all of a sudden, you can scarcely pay for food and a roof over your head, let alone keep up with your loan payments.

In the 1930s, millions of people in the United States lived through that very scenario.

The Great Depression 

The beginnings of the Great Depression actually took place in 1914, when the Federal Reserve opened its doors.  Before the creation of the Fed, banks were required to keep larger reserves of cash, credit was more difficult to get, and all U.S. Treasury Notes in circulation were 100% backed by gold. But the Federal Reserve threw all fiscal sanity out the window just in time to help the U.S. government do some massive deficit spending as it jumped into the fray of World War I.

"At its peak, in June 1920, the stock of money was roughly double its September 1913 level and more than double the level of November 1914, when the Federal Reserve Banks opened for business…. And, of course, the [Federal Reserve] Board also took the position that the expansion in the stock of money was a result, not a cause, of rising prices.”

Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States 1867-1960

In the postwar 1920s, easy credit fueled a punch-drunk United States to borrow massive amounts of currency. With easy money readily available, speculation was inevitable. The Dow Jones Industrial Average tripled between 1925 and 1929, as the country indebted itself on the euphoric belief that stocks would rise forever. 

The Fed’s binge of currency creation and loose fiscal policies created a stock bubble of massive proportions. On Black Tuesday, October 29, 1929, the optimism of the roaring 1920s came crashing down as stocks were sold in a mass panic.

As optimism shattered, people paid down their bank loans to reduce their debt, violently contracting the money supply.

Because the vast majority of our currency supply is borrowed into existence, paying down debt removes the currency from the bank’s balance sheets. Voila, the currency supply is reduced in the amount of the paid-off debt.

With fewer dollars chasing the same amount of goods and services, prices fell, suddenly and dramatically.

This is where the term “deflationary death spiral” comes from. Falling asset prices trigger a fall in profits, resulting in bankruptcies and a tendency among the public to hoard money. Because prices are falling, people believe prices will be lower in the future, so they delay purchases until later. Businesses, who are seeing fewer sales, lose confidence, and the money supply contracts even more—creating a feedback loop.

The Fed’s reaction to the crash and the ensuing deflation was to intervene in the free market via Open Market Operations.

Open Market Operations are one of the most powerful and the most frequently used monetary policy tools given to the Fed under the Federal Reserve Act of 1913,  and the Great Depression was Fed’s first major experiment in wielding this tool. The experiment ended in abject failure. Through Open Market Operations, in an attempt to manipulate short-term interest rates and ease the country’s suffering, the Fed sold U.S. securities to private banks. The securities sales sucked up excess cash, leaving even less to lend, and contracted the money supply even further, ravaging America’s economy.  Activist government responses such as this one prevented the free market from healing itself, turning a bad recession into the Great Depression.

“For the first time, laissez-faire was boldly thrown overboard and every governmental weapon thrown into the breach…The guilt for the Great Depression must, at long last, be lifted from the shoulders of the free market economy, and placed where it belongs: at the doors of politicians, bureaucrats, and the mass of  ‘enlightened’ economists. And in any other depression, past or future, the story will be the same.”

Murray N. Rothbard, America’s Great Depression

The chart above shows real economic output per person over the same years as the Dow Jones Industrial Average chart above. While stock prices were falling off a cliff, real economic output plummeted, leading to peak unemployment of 25%. The Fed’s first big experiment in fiscal manipulation resulted in the biggest worldwide collapse in economic output of the 20^th century.

"The terrible depression that followed was a direct result of bungling by the Federal Reserve System…. We never would have had the Great Depression if there hadn't been a Fed."

Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States 1867-1960

The Rise and Fall of the U.S. Dollar

Many of the same type of government and Fed interventions that inadvertently turned a recession into the worst depression in history are being repeated today. 

The crash of 2008 began with a dangerously inflated real estate bubble that had its origins in 1970s social engineering and anti-poverty programs. Then, in the wake of the dot-com crash of 2000, the Fed, then led by Alan Greenspan, pumped up the money supply and suppressed interest rates, resulting in cheap credit for home buyers.

The inevitable correction began in 2007, as real estate became dangerously overvalued, and many consumers overextended themselves, borrowing to buy homes via new zero-down-payment loans, interest-only teasers and Adjustable Rate Mortgages. As real estate prices skyrocketed, home owners began using their homes as personal ATMs, borrowing as much as possible against their equity to fund lavish remodels, to buy cars and luxury items, or to buy and “flip” houses for profit. 

As adjustable mortgages ballooned to unsustainably high payments, and unworthy creditors began defaulting, the real estate market crashed, sending home prices plunging 33 percent over the course of the next three years. Homeowners watched their equity vanish overnight; soon they owed tens or hundreds of thousands more than their homes were worth.

Banks, stuck with bad loans on overvalued properties, foreclosed on millions of homeowners, many of whom were forced into bankruptcy.

New home construction came to a screeching halt, with a domino effect on related sectors of the economy. Unemployment shot to double digits for the first time in a generation. The specter of depression—a massive deflation of the economy—began to seem terrifyingly real to the government and financial establishment.

In 2008 and 2009, newly installed Fed Chair Ben Bernanke, with the support of the Bush administration and later the Obama administration, began throwing money at the problem, spending billions to bail out failing financial institutions and purportedly motivate banks to ease up on struggling mortgage holders. Still shocked from the crash, banks remained leery of lending or refinancing troubled loans, and the waves of foreclosures continued... and continue today. (See my article “The Greatest Crash in History” for more about continuing mortgage resets.)

Even as the crash continues to play out in residential and now commercial real estate, the securitized debt bubble, as in credit card debt, continues to grow. Since expansion of our currency supply depends upon debt, Bernanke and the Fed are in terror of what will happen when the debt bubble pops.

As I explained in “The Greatest Crash in History”,” when you buy something with a credit card, the currency supply is expanding. When your credit card bill is paid off, the currency supply contracts. But what happens when millions of consumers, traumatized by high unemployment and economic instability, stop using their credit cards and start socking their money away for a rainy day instead?

Bernanke and the Fed are like the ostrich with its head in the sand. Maybe if they just act like they don’t see that huge debt bubble on the horizon, and simply continue to keep interest rates low and credit easy, the bubble won’t pop. In fact, the credit bubble cannot be sustained forever, and when it bursts, consumer spending will come to a screeching halt, more businesses will crumble, more people will be laid off, and more banks will fail.

The Incredible Growing Money Base

Thanks to continual government and Fed tinkering in the free market via fiscal policy and currency creation, the U.S. base money supply (money that has been borrowed into existence by the Fed and the U.S. Treasury) has been constantly expanding since 1950, as illustrated in the chart below.

In September 2008 (the large red arrow), in the aftershocks of the real estate crash, every major investment bank in the United States was teetering on insolvency. Without government help, many would have failed. In order to prop up these institutions, the Federal Reserve essentially printed money to backstop them. But why?

Bernanke believed that the failure of these enormous financial institutions would lead to a dramatic loss in confidence. A loss in confidence would reduce people’s willingness to extend credit to anyone. With credit markets essentially frozen, Bernanke suspected the U.S. economy might be on the edge of a second Great Depression. But even more urgent was Bernanke’s fear that frozen credit would eliminate the constant borrowing needed to maintain the United States’ debt-based currency system (see my two-part article, “Where Do Dollars Come From”). If consumers and businesses were to stop borrowing, our currency supply would implode, and the whole charade that is the U.S. economy would crumble.

The chart above shows the base money supply in red—currency created through borrowing by the Fed and U.S. Treasury, as seen in the previous  chart—but also, in blue, all the money borrowed into existence by consumers.

Keep in mind that when we take out a loan from a bank, the bank does not actually loan us any of the currency that was on deposit at the bank. Instead, the second the pen hits the paper on that mortgage, loan document, or credit card receipt that we are signing, the bank is allowed to create brand new dollars in the amount of the loan as a book entry. In other words, the borrower createsnew currency with a signature, and the brand new currency becomes a part of the money supply.  Over 80% of our currency is created this way.

The total of base money in circulation plus the money created by consumer borrowing is called M3. As the chart shows, the M3 money supply peaked in 2009, then began an abrupt drop. That dip in the graph indicates that net borrowing actually fell, as consumers and businesses began to pay down their debt instead of spending and borrowing—a logical and natural response to an economic crisis such as the 2008 real estate crash.

But that drop in borrowing is also symptomatic of deflation. Our deflation-phobic government went into red alert mode, kicking new currency creation into overdrive in an effort to compensate.

Some observers claim that we are due for an inflationary period, as base money has more than doubled during the past year. But remember, the base money supply only accounts for the amount of currency in circulation and ignores the much larger component of the overall money supply—credit.  While the expansion of the base money supply has been dramatic and without historic precedent, as the Fed and Treasury have swamped the economy with new currency, base money only represents approximately 14% of the total money supply (M3). The slowdown in consumer borrowing has more than offset the increase in base money; in fact, the overall money supply is declining. The prices of many commodities also are falling, another indication that a contraction is under way. Despite the Fed’s desperate attempts to hide its head in the sand, deflation has already begun.

Inflating Our Way Out of Deflation

If the crisis that began in 2007 has taught us anything, it is that all of the world’s governments would rather try to inflate their way out of a recession than endure the painful, short-term pain that would result in a real recovery. Rather than tolerate the short-term pain of deflation, the world’s governments would rather inject their economies with more toxic debt—leading to bubbles.

Here’s the way I see the endgame. Ultimately the debt bubble will burst—and the more swollen it becomes, the more calamitous the ultimate implosion will be. In a perfect world, the powers that be would allow the correction to run its course. Bloated and inefficient financial institutions would be destroyed; healthy, entrepreneurial enterprise would spring up. Painful as it would be for many people in the short-term, the long-term result would be a healthy economy functioning efficiently under the direction of the free markets.

But the lessons of history and our knowledge of the political will of our leaders tell us the end won’t be that easy. When deflation of the currency supply takes hold, the government will do everything in its power to stop it. As the currency supply contracts, the Fed will fuel the fire by printing more currency, pushing the value of existing currency ever lower, until hyperinflation occurs.The world will be consumed in a conflagration of hyperinflation before the end comes.

But there are ways to be prepared, even for the flames of hyperinflation. In part 2 of this article, I’ll discuss how hyperinflation occurs, how it impacts our society, and what steps all of us can take today, not only to secure our wealth and protect our families, but to profit from what I believe will be the greatest transfer of wealth in human history.