Inflation, deflation, gold and currencies

[Higgenbotham]

Money has been, and continues to be, sucked out of the private economy and used to buy U.S. government debt.

I agree this can not continue forever, but short of a crisis like the bank runs followed by bank failures in Europe and the United States during the 1930s this can continue for a while longer.

I agree that it definitely can continue for a while longer and will continue for awhile longer. My guess is that it will continue as the Euro implodes and as the US stock market crashes.

Beyond that, it is problematic, partly for the exact reason you mention, that money is being "sucked out of the private economy and used to buy US government debt." I stated a few posts back that part of the problem with QE to date and why it can make the US vulnerable to a hyperinflation is that it is damaging the private sector to the point that profits can be reduced to nil, and therefore the private corporations and wage earners income taxes could go down too much to keep the deflationary spiral within containable limits.

[Reality Check]

The US Treasury conducts an auction and there are not enough bidders. Against its mandate and as a "temporary" emergency measure, the Federal Reserve steps in and buys the bonds to prevent a failed auction and gives newly created cash to the US government as a book entry.

Both the U.S. Fed and the European Central Bank have proven there are many, many ways to avoid this happening. In fact the reason they can avoid this is one of the major reasons that the U.S. private economy did not already "take the debt bubble hit" and start to recover.

An extreme example of this is the relationship between Greek banks, Greek government debt and the European Central Bank. Twice now, the most recent event being just last month, the ECB used bankrupt Greek Banks to buy new worthless Greek government bonds using loans from the ECB secured by ... nothing but the new worthless Greek government bonds. The ECB buying the bonds directly would have violated the ECB charter, but this obvious money laundering operation is well known to investors - and has not caused the type of reaction you predict.

These zombie banks no longer make free market loans to private businesses in Greece ( and other parts of Europe ) based on sound banking decisions. They only loan money ( aka invest in bonds ) with the permission of the European government.

Something very similar has been going on between U.S. banks and the U.S. Fed since 2007.

What you're describing here is different because there is something greater than Greece to hold Greece up. But when the US bond market collapses, there will be nothing greater than the US to support it.

If Greece were isolated, receiving no support from any other country, and on their own currency, using a Greek Central bank to conduct bond purchases through bankrupt Greek banks, then the situation would be similar to the scenario I put forward. Soon after, there would likely be a failed bond auction.

The primary dealers (which are not all US based banks) and the US Fed are doing what they are doing now in the face of strong demand for US government bonds. My scenario is based on what happens when demand for US government bonds begins to fall.

List of primary dealers: http://www.newyorkfed.org/markets/pride ... rrent.html

Greece does not have a Central Bank that prints money, other than the European Central Bank which does indeed print the money Greece uses, and is exactly the same scenario as the U.S. Fed buying U.S. debt on the secondary market and the U.S. Fed using policy to encourage U.S. Banks to buy U.S. debt.

The U.S. government additional Debt issued each year is currently in the range of 1 Trillion to 1.5 Trillion each year.

A country's government debt is often broken down between external debt sold to investors outside the United States and Internal Debt sold to investors inside the United States. Growth in external debt effectively stopped several years ago, with the One Trillion dollars ( printed and ) invested by the U.S. Fed in U.S. debt bought on the secondary market replacing what previously were annual increases in external debt.

Internal U.S. debt has continued to grow, and there are indeed larger pools of money internal to the United States that can absorb 1 Trillion to 2 Trillion in additional U.S. debt each year for a few more years at the expense of the private economy and the private citizens. Public and Private Pension funds have Trillions in investments they can transfer from private sector debt to U.S. government debt for example. U.S. Bank deposits currently loaned to private companies are another source of funds as are new deposits in U.S. banks from foreign sources and from U.S. depositors moving money from less safe investments.

Where are internal investors within the United States going to invest that is safer than insured deposits in U.S. Banks and safer than U.S. debt? When people fear economic collapse they will seek safety. U.S. Debt, U.S. Bank deposits, mattresses, gold all meet these criteria.

It is the private economies financing needs that will be sacrificed before the U.S. Government bond market, as long as current FED and U.S. government policies remain in place.

This can not continue forever, but it can continue for a few more years if a crisis, such as wide spread U.S. bank runs and U.S. bank failures does not occur first.

[Higgenbotham]

This is an interesting discussion, but I just want to add this to it:
You're describing the situation in purely mainstream macroeconomic
terms. But keep in mind that as soon as there's a period of sharp
deflationary shock, the following will happen:

1. There will be a worldwide financial panic, which will throw
standard macroeconomics out the window.

2. There will be the first actions of war. Remember that WW II didn't
start in 1941 -- it began in 1931 with Japan's invasion of Manchuria.

Once those things start happening, anything can happen. As I've said
many times in the past, whether the U.S. is a debtor or creditor
nation will immediately become irrelevant, because countries will stop
lending to each other or paying each other, which means that
effectively no one owes anyone anything (at least until after the
war), and all countries start from scratch. Thus America at this time
will be in the same situation as America in 1941.

Many of the scenarios you're describing discuss mainstream economics
after global panic and war actions have begun, and that's not entirely
realistic. Your scenarios have to account for sharp geopolitical
developments.

I would say this much for sure. Prior to about a year ago, it was difficult for me to imagine any immediate scenario for "hyperinflation", say within 18 months (I don't recall the exact time I put on it). Now it's not so hard to come up with likely scenarios that are just a bit over the horizon. I would agree that a lot can change in 12-18 months in this kind of environment. As a practical matter, I'm not making investments that would benefit from a "hyperinflation" because these scenarios are a bit too far out, but at the same time I am no longer saying it can no longer happen.

[Higgenbotham]

Internal U.S. debt has continued to grow, and there are indeed larger pools of money internal to the United States that can absorb 1 Trillion to 2 Trillion in additional U.S. debt each year for a few more years at the expense of the private economy and the private citizens. Public and Private Pension funds have Trillions in investments they can transfer from private sector debt to U.S. government debt for example. U.S. Bank deposits currently loaned to private companies are another source of funds as are new deposits in U.S. banks from foreign sources and from U.S. depositors moving money from less safe investments.

Where are internal investors within the United States going to invest that is safer than insured deposits in U.S. Banks and safer than U.S. debt? When people fear economic collapse they will seek safety. U.S. Debt, U.S. Bank deposits, mattresses, gold all meet these criteria.

It is the private economies financing needs that will be sacrificed before the U.S. Government bond market, as long as current FED and U.S. government policies remain in place.

This can not continue forever, but it can continue for a few more years if a crisis, such as wide spread U.S. bank runs and U.S. bank failures does not occur first.

This is the reason I gave Vince about 18 months ago as to why demand for US government bonds could remain strong for some time into the future (at that time). When we were discussing this, I went into the Fed Flow of Funds report and listed the trillions of dollars available for investment into US Treasuries. That is posted in one of these threads.

To answer your specific question, "Where are internal investors within the United States going to invest that is safer than insured deposits in U.S. Banks and safer than U.S. debt?" the answer is nowhere yet in the big big picture. As I said here within the past couple days, the pools of higher rated securities are not yet large enough to absorb all this money. But in the meantime 2 things can happen. One is these pools of money can become significantly smaller due to a stock market crash, bankruptcies and exhaustion of funds to pay ongoing expenses. The second is that the credit rating of the US could deteriorate faster than the credit rating of other available securities.

[Reality Check]

...
2. There will be the first actions of war. Remember that WW II didn't
start in 1941 -- it began in 1931 with Japan's invasion of Manchuria.

Once those things start happening, anything can happen. As I've said
many times in the past, whether the U.S. is a debtor or creditor
nation will immediately become irrelevant, because countries will stop
lending to each other or paying each other, which means that
effectively no one owes anyone anything (at least until after the
war), and all countries start from scratch. Thus America at this time
will be in the same situation as America in 1941.

I believe there some important points here.

The difference between internal, and external, government debt.

Countries can control internal debt. Example: FDR terminated the right of American citizens to turn their paper money in for gold during the 1930s.

United States external debt has, for all practical purposes, stopped growing after the financial crisis of 2007/2008.

At that same time he maintained the link between U.S. paper money and gold for foreigners, but initially dramatically devalued the U.S. dollar relative to gold, and then continued to devalue it slowly, but frequently there after.

By contrast countries such as France abandoned their currencies link to precious metals.

The U.S. did borrow money to prepare for, and fight, World War II.
I am not certain, but I would speculate some of that money came from overseas investors.

The United States, and Great Britain, unlike other countries such as Russia and China, did repay their pre-war and war debt.

It may, or may not, be coincidence that the United States and Great Britain became the banking capitals of the world after World War II.

[OLD1953]

While bonds are considered to be more or less liquid, I've noted in the past that inflation from excessive bond creation tends to show up at bond maturity dates or when the economy begins to take off and people pull their money out of safe havens and back into investments.

If bonds were regarded as unsafe, the same scenario would apply, people would be pulling out of bonds and buying whatever they thought was safer than bonds, which would of course result in price increases and inflation.

The Fed money drops are creating a condition where they'll be raising interest rates to high levels to remove money from circulation at some point in the future. This won't be good for the economy or for the middle class.

[John]

More fodder for the inflation/deflation debate:



http://blogs.ft.com/money-supply/2012/0 ... inflation/

[vincecate]

More fodder for the inflation/deflation debate:

I have still not seen a single example of double digit yearly deflation in a pure fiat currency. There you have many examples of double and triple digit *monthly* inflation. Just looking at these statistics, it sure seems like inflation is the bigger risk in a pure fiat currency.

[John]

More fodder for the inflation/deflation debate:

I have still not seen a single example of double digit yearly deflation in a pure fiat currency. There you have many examples of double and triple digit *monthly* inflation. Just looking at these statistics, it sure seems like inflation is the bigger risk in a pure fiat currency.

It's a generational Crisis era. I'm still waiting to see an
example of hyperinflation during the previous global
Crisis era, the 1930s.

[vincecate]

More fodder for the inflation/deflation debate:

I have still not seen a single example of double digit yearly deflation in a pure fiat currency. There you have many examples of double and triple digit *monthly* inflation. Just looking at these statistics, it sure seems like inflation is the bigger risk in a pure fiat currency.

It's a generational Crisis era. I'm still waiting to see an
example of hyperinflation during the previous global
Crisis era, the 1930s.

It is an American Crisis era. The American crisis of the Revolutionary War had hyperinflation and the American Crisis of the Civil War had hyperinflation. Why don't these examples count? Is it because there were wars then? But you are predicting a war this time too, right? So after the war starts then we could get hyperinflation?

The world was still on a gold standard going into the 1930s crisis. You don't get hyperinflation when on gold. It is a paper money problem. Since we are on paper money now you should look at the crisis eras with paper money to see how paper money works in a crisis.