"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Wednesday, December 15, 2010

Nicole Foss takes on Gonzalo Lira: Hyperinflation or Deflationary Collapse?

I don't mean to hype this as some type of economic debate smackdown, but I just don't feel confident on either side of the hyperinflation vs. deflation collapse debate.  I just don't. There are just too many variables that are difficult to predict.   And honestly, I can envision both scenarios playing out.  Hopefully, with the upcoming series on Modern Monetary Theory (thanks Jim Slip) I land in one camp or another.  I think it's important to understand how our modern monetary system works in order to make accurate predictions.

That said, Nicole Foss posted an essay today on her Automatic Earth blog in which she makes a compelling case that dispels (in my opinion) many of the hyperinflationistas arguments - particularly the popular Gonzalo Lira who is often cited on ZeroHedge - along with his rabid followers posting creative ideas of what the post fiat monetary armageddon looks like.  I don't mean to make light of it - I share in many of their concerns.    And then there are the hardcore Euro-centric FOFOA fans - and don't get me wrong, I read FOFOA too, but I don't daydream about happily driving a 7 series BMW in a post apocalyptic world because I held onto some gold.  And although I admire European views on quality life, I have my doubts on the Euro.  Things will get ugly for everyone - even the "winners" if that's what one wants to call them.  Maybe I'm just suffering a bout of doom fatigue... and need to take a deep breath, and re-analyze everything.  That things will get ugly is beyond doubt, in my view.  I just happen to be the type that wants to understand as much as I can before confidently re-sounding off the alarm bells.  And so, I will approach these apocalyptic preachings with an open and objective mind.

Nicole Foss is firmly in the deflationista camp.  Things will get ugly, and when they do, it will be breathtaking.  Weimar Germany is not her posterchild example, the South Sea Bubble is.  Her view is focused on the role of credit in a credit based system.  But she also focuses on the "herd mentality" of the markets, and the trends that develop, and ultimately, reverse.  She sees the Euro failing before the US Dollar, and as a result, the US Dollar will get a temporary boost.  Not because the US is any better, but because it is less worse. She also makes a distinction between holding physical dollars and electronic dollars - very similar to the physical/paper gold argument.  If you think about it, what other currencies do US citizens have access to?

In Nicole Foss, I see John Exter's example.  His pyramid is not one of hyperinflation, but of a deflationary collapse.  It makes sense to me, but the only contention I have is the secret weapon of double entry book-keeping.  As this deflationary event transpires - and it has been - the Federal Reserve can credit any account it wants with money.  It can buy whatever it wants... and then thoughts of hyperinflation enter my mind.  But what of the hoards of unemployed people?  If their purchasing power is rendered impotent, aggregate demand suffers, and thus, so too prices....  It's a violent seesaw that whips up and down.  And therein lies my reason for not firmly abiding to any of the two camps.  Fiat collapse, in whatever form, is the one conclusion I feel confident about.  That destination, to me is obvious.   It is the road taken that I am not so sure of.

Here are some portions of her essay:
Naturally the dollar, like all fiat currencies, will eventually die, but I would argue that the time for that is not now. A dollar rally could be measured in years, although not many by any means. My best guess is that we would see perhaps a year or two of dollar rally in a world going increasingly haywire. After that I expect an end to the system of floating currencies, with all manner of attempts at competitive devaluation, currency pegs established and rapidly blown away, and beggar-thy-neighbour policies all round. The risk of currency reissue will rise over time, and be highly locational. I think the risk of reissue in the US is not imminent, but in Europe it should be a much larger concern, especially in peripheral countries... 
In my view, by the time we see a commodity price spike, the value of people's financial assets will already have evaporated, they will already have unloaded hard assets, and the dash for cash will already be in the past. I think at that point we will be well into a state of economic seizure, where credit will have disappeared, unemployment will have spiked, incomes will be very precarious, scarce cash will be being hoarded and it will be exceptionally difficult to connect buyers and sellers. Consequently, I do not see most people being in a position to engage in panic buying.  
Some may be able to do this, but I think the resource grab is more likely to be a phenomenon operating at the level of the state than at the level of the individual, as most individuals will already have lost almost all their purchasing power. In my opinion, states will certainly engage in a resource grab, and will take supplies off the market, either by sending the tanks or the bilateral contract negotiators into resource-rich regions. States know perfectly well that oil is liquid hegemonic power, and they will be trying to secure their supply in whatever way they can...
Her Conclusion:
I do not see this as a transitory problem leading back to business as usual, and I mean NEVER returning to what we would now regard as business as usual, let alone doing so in only a couple of years.  
Deflation and depression are mutually reinforcing. This is a persistent dynamic that should last at least as long as the last depression, and likely longer as every parameter is worse going into depression this time. We have more debt, far more structural dependencies (on cheap energy and cheap credit primarily), looming resource limitations, far higher expectations, a much larger population, a far smaller skill base etc. 
I think we are looking at an economic catastrophe of unprecedented proportions, not a bump in the road that can be quickly consigned to history, if only we face our problems head on. In my view we are going to have to live through deflationary deleveraging, a long and grinding depression, and then quite possibly hyperinflation once the international debt financing model is broken, and with it the power of the bond market to constrain currency printing.  
This could easily take twenty years to play out, and even then the upheaval is very unlikely to be over. The last time a major bubble burst - the South Sea Bubble of the 1720s - the aftermath lasted for several decades and culminated in a series of revolutions. This bubble is much larger, and the aftermath is likely to be proportional to the excesses of the preceding bubble. This is why I call the presentation I travel to deliver A Century of Challenges.  
Moreover, I do not see a return to what we consider to be business as usual at any point, because our business as usual scenario is critically dependent on cheap energy, and the energy subsidy inherent in fossil fuels has been a once in a planet's lifetime deal. We are going to be living on an energy income instead of an energy inheritance, and this will mean living a life none of us in the developed world will recognize.
I highly recommend a read of her essay in its entirety, link HERE.


Jim Slip said...

Misthos, while I wait for your posts regarding modern monetary theory, here are some thoughts I've been having (I am no economist, so feel free to correct me):

If I understand it correctly, the modern-monetary-system seems sound: money creation is done through deficit spending on the part of the government (aka money transfer to the private sector who now has a surplus), and then controlling the money-supply through taxation, bond issuance etc.

But it still seems that the current crisis has more to do with excessive credit creation through fractional-reserve-banking and less with the monetary system itself.

Why wouldn't it be possible to unwind the excessive credit in the system through deficit-spending (thus allowing the private sector to deleverage), and thus maintaining the current monetary system in place?

I agree that international tensions might be a problem, but if China refuses to sell it's products to the USA (or Germany to Greece), then they might as well do that. It will allow for a much needed rebalancing anyway, no?

I know this sounds oversimplified, but I think the basic concept applies.

I just don't think that governments would want to return to the constraints of a gold-standard, not even China or Russia (or any surplus country).

Like I say, I am no economist, so feel free to correct me.

Misthos said...

Money is created by the government, not thru deficit spending, but every time it spends money in general. When the government spends money, it needs to create it. The government doesn't need to wait to collect taxes or sell a bond to have money to spend. There are many reasons for tax collection, and funding, technically, is not one of them, or at least not the most important - sounds crazy, I know.

Remember, the US created the Federal Income tax around the same time it began its third attempt at Central Banking - the current Federal Reserve. That is not a coincidence.

Terms such as deficits, surplus, etc... are not meaningful in the way that they are to you and me when we look at the bills we pay each month. But that doesn't mean the government has no restrictions either - which I will get to in my posts.

Keep in mind, that this applies to the US system. The US has a free floating currency it controls, and it issues debt in that same currency. The individual EU nations do not have this "luxury." They are bound in a similar way that US States are bound. They also don't have a central treasury or tax collecting authority, so they are forced to abide by Maastricht limits on budget deficits and debt to gdp. In a fiat money world, that's a huge handicap, in my opinion.

I sort of agree with your statement:

"But it still seems that the current crisis has more to do with excessive credit creation through fractional-reserve-banking and less with the monetary system itself."

First, there is this theory of endogenous money creation. That is, banks lend money first, then look for reserves later. They literally create credit from nothing. To an extent, fractional reserve lending is a myth.

But I'll add that US Treasury debt needs to exist for another reason: for foreign central banks' reserves - to earn interest on that surplus they accumulate. In the gold standard days, Central Banks sat on gold - today, they sit mostly on the debts of other sovereigns... there are real consequences to that.

But I'm getting ahead of myself...

I'll say one more thing: The problem with MMT is it still needs to "look" sustainable. Over the long run, on paper, I don't believe it ever can.

Market Perception then becomes reality.

Jim Slip said...

OK, so in the free-floating fiat-system money is created whenever the government spends, which transfers money to the private sector (who thus is in surplus while the government is in deficit). Bond issuance is just a way to mop-up cash, aka control inflation (by exchanging bonds for cash).

But also you're saying that it's a way of making the system look legit, aka making it look as if the government has to finance itself through bond issuance (because if people saw through the keyhole they would lose confidence in the system I suppose).

OK, but it still seems that the biggest problem today is excessive credit through private banking which is in a vicious circle of unwinding because prices started falling (yeah, sorry for mentioning fractional reserve; I've read the part that banks lend first and accumulate reserves later, it seems a counter-intuitive but straightforward concept).

Is the national debt really such a big problem (one's debt, another's asset)? All they have to do is find a way to make sure that payments are being made, while also unwinding debt levels a bit (through some rebalancing of trade?).

Though I guess you're right when you say that this would depend on an awful lot of international cooperation.

Still, wouldn't everybody lose by a new era of international friction?

Finally, why on earth did they allow credit to go through the roof like that? Everybody kept saying they learnt the lessons of the Great Depression, but it seems to me that they haven't.

Misthos said...

Jim you bring up great points- and as for your reference to fractional reserve lending - I make the same error as well. It's difficult to discuss the monetary system because there are so many well accepted principles that just aren't correct - yet we still refer to them. It's just that ingrained in us.

I will be posting an intro to MMT soon, and I want to continue this discussion on the comments of that post.

Dave Narby said...

The problem with the deflation scenario is that it requires everybody obeys the rules.

If you aren't either sitting their with your mouth open or ROFLYFAO, you need to ponder that previous sentence.

That said, we could get biflation for awhile (deflation in the things you want and own, inflation in the things you need) before it all goes *poof*.

Misthos said...

Dave -

That's a good one.

But I agree that biflation is a likely outcome. I also see merit in Jim Rickard's view that we have both inflationary and deflationary forces cancelling out each other right now, and ultimately one will prevail.