A friend emailed me a wideranging article from the National Inflation Association and asked whether I believe the currency situation to be as serious and imminent as the author contends. Click here to read the article. I found the subject interesting enough to offer my response as the basis for this week’s blog entry.
The article from the National Inflation Association (NIA) makes a number of interesting arguments. While I agree with the conclusion that we could potentially face hyperinflation, I see it as just one of a few possible outcomes. I wrote a blog entry titled “The Danger of Hyperinflation” on December 23, 2010. My views have not changed. Let me comment on the specific points in the NIA article.
I concur that the United States has already sunk below a AAA credit rating, but disagree that we should be accorded junk status. Barring a possible temporary disruption caused by an inability to increase the debt ceiling, the U.S. will continue to pay its debts for years to come. For the foreseeable future, we are capable of printing our way out of our problems. While that action precipitates its own deleterious consequences, hyperinflation need not be one of them in the near term.
I do not agree that “the credit ratings agencies have absolutely no credibility left and will be out of business in a few years.” They certainly deserve condemnation for their role in the recent financial crisis. Because of very obvious conflicts of interest, they may have been complicit in the deceptions foisted on the investing public. That notwithstanding, they have largely escaped anything worse than moral outrage, and they have been forced under the microscope of public scrutiny to clean up their acts. They are still widely used and are unlikely to fail unless successful suits are brought that could wipe them out.
I do agree that Treasury Security Tim Geithner has lost credibility. He is a government spokesman with a vested agenda to maintain public confidence in the U.S. as a creditworthy borrower. There is, in fact, no realistic chance that the U.S. will ever satisfy its long-term financial promises in dollars worth anything resembling their current value. That eventuality, however, could be far short of hyperinflation as last experienced in a major industrial country in the Germany of the 1920s, where the currency became essentially worthless.
The article clearly gets into the realm of hyperbole when it contends “There is no chance of the U.S. ever balancing its budget, without eliminating the so-called untouchable entitlement programs like Social Security, Medicare, and Medicaid.” These programs have been looming problems for years, despite the fact that we’re only a bit more than a decade removed from our last balanced budget. Serious modification is certainly necessary, but “elimination” is not required and won’t happen. Furthermore, the magnitude of the long-term problem with these programs has been recognized for years, and hyperinflation has yet to occur. In spite of our profligate money creation, we have still been able to borrow at extremely low rates. So far our creditors have chosen not to concentrate on future payment problems. While there is no certainty that those future concerns will factor into their present considerations, with each year that passes, the risk increases.
The article makes a sound point that a current major defense against U.S. default is our status as the world’s reserve currency. It is also true that, as the author points out, the world is diversifying away from the dollar. Diversifying away from and abandoning the dollar as the reserve currency, however, are two very different things. There is obviously a growing global impatience with U.S. monetary policy, but there is no readily available substitute for the U.S. dollar. The euro, the yen, the yuan, a basket of currencies or a new gold-backed currency all have been discussed, but each has major drawbacks, and a transition would not be easy or rapid.
The author opines that, “China is likely to begin selling their U.S. dollar reserves and accumulating real assets like gold and silver with this money. The biggest ever rally in precious metals is just around the corner, which means the U.S. dollar’s purchasing power is about to plummet.” The article’s forecast could be spot-on. On the other hand, even if the premise is correct, the predicted conclusions need not follow. China has frequently voiced its concern with the stability of the U.S. dollar. It has been on a concerted program of buying real assets such as strategic real estate and other resources around the world. They may continue to concentrate on that type of asset purchase rather than on precious metals. There have already been huge rallies in gold and silver. While that doesn’t rule out a continuation of such rallies, one always has to question the extent to which future expectations have already been taken into account by current prices. While a continuation of the rallies in precious metals could well be accompanied by further drops in the dollar’s purchasing power, that isn’t a necessary consequence. Purchasing power is more closely related to the dollar’s value relative to other currencies, rather than to the precious metals. Without doubt, one of the Fed’s goals has been to decrease the value of the dollar relative to other currencies. Recently they have been eminently successful. It is unlikely, however, that the other central banks of the world will simply let our Fed devalue the dollar and gain economic advantage. At some point, currency wars are likely and competitive devaluations could become a fact of life. Such actions would promote inflation but would also destabilize world commerce, which could in turn lead to recession, which would tend to offset inflation. What condition would dominate and to what degree would be subject to innumerable unpredictable details and political decisions.
The article argues that both the Paul Ryan budget and the Barack Obama budget “…are simply being used to distract Americans from the real issue, the Federal Reserve’s monetization of our debt…” I agree that neither budget sufficiently addresses our debt and deficit problems, leaving us with massive deficits even a decade or more from now. They are just different degrees of bad.
The article offers the opinion that the Fed will likely soon stop paying interest on excess reserves banks have parked at the Fed, in an effort to push this colossal monetary reserve out into the economy. The author suggests that this massive infusion of new money could “…cause a run on the dollar, with the world rushing to dump their U.S. dollar reserves for just about any real asset they can get for them.” First, the Fed’s terminating interest payments on excess reserves will only mildly increase the willingness of banks to lend those funds into the economy. The credit worthiness of interested borrowers is still a major hurdle. Such a Fed action will have no effect on demand for the funds. Even at historically low interest rates, there is very little demand for already abundant funds. The suggested run on the dollar will not occur simply because of an increase in money supply. There must be an increase in demand and in turn an increase in the turnover velocity of the money in the economy. These will occur only if the stimulus-fueled economic recovery continues to grow in the absence of the current level of Fed pump priming.
The article suggests a growing danger from accelerating inflationary readings over the past few months. Much of the CPI surge is related to the jump in oil prices, the demand for which could fall markedly unless the recovery becomes self-sustaining. The author attributes the oil price rise to the Fed’s loose monetary policies. Such policies are certainly contributors to inflationary growth. It’s overly simplistic, however, not to recognize worries about the instability in the Middle East and Northern Africa as additional significant factors. The price increases for oil and gas, while inflationary, contribute to self-correction. As energy prices rise, use will decline, which will in turn slow economic growth, which will dampen inflationary tendencies.
The author assumes that the Fed will pump even more money into the economy to maintain consumption as gas and food prices rise. With political attitudes having turned increasingly intolerant of unfettered monetary stimulation, that assumption becomes less likely.
With respect to the potential for spiraling food price inflation, you know far better than I what happens in the agricultural cycle when prices rise. It won’t take long before lots more supply hits the market.
My devil’s advocate response to the article’s contentions and urgency is not to deny the possibility that they could be right. I still believe hyperinflation to be unlikely, however, especially in the near term. The debt excesses throughout most of the world are ultimately an ongoing deflationary force. They won’t be quickly resolved. Most of the developed world is still suffering from extreme weakness in residential and commercial real estate. Add to that the worst unemployment situation in this country since the Great Depression of the 1930s, and it will be very difficult for inflation to take hold. Strong inflationary and strong deflationary factors may interact violently to create all sorts of economic dislocations with unpredictable outcomes.
Carmen Reinhart and Ken Rogoff have written a magnificent analysis of 800 years of financial crises and their aftermath – This Time Is Different: Eight Centuries of Financial Folly. Examining hundreds of financial crises throughout the world, of which our recent crisis is the most current, the authors identify several common themes. Inflation is the most common path back to stability, although hyperinflation is rare. Such a process, however, usually unfolds over many years typically encompassing a few recessionary episodes. While inflation may be the normal longer-term outlook, the path to that result is littered with hurdles which may include deflationary periods. Investments that may benefit from inflation normally are very different from those that benefit from deflation. The risk of losing money is especially severe during such unpredictable periods. Flexibility and preservation of capital are critically important until economic stability is restored and values are again historically attractive.