Inflation, deflation, gold and currencies

[Reality Check]

Next, the demand for US government bonds falls. The reason demand falls is some combination of the following: ... the market perceives that tax collections are too low and are not likely to improve, the market perceives that the US government has behaved irresponsibly by failing to cut spending in the past ...

All these have already occurred over the past three years. The FED has become that largest holder of U.S. debt exceeding both China and Japan. The FED increased it's holdings from hundreds of billions by more than one thousand Billion more in just one year.

[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.
...
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. This is now the point at which the Federal Reserve is "printing money" and this is a response to the failure of the bond market. Technically, up to this point, it cannot be proven that the Fed has "printed money" consistent with hyperinflation because it cannot be proven that there would have been a failed bond auction without Fed intervention, as interest rates have remained low and by all indications demand for US government bonds has remained strong.

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 Central Bank.

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

[Higgenbotham]

... Let's say the collapse of the Euro begins to accelerate and first there is a panic out of Euros and also there is a panic out of stocks and into US dollars and government bonds. The value of the dollar and bonds rise. There is deflation. Once this occurs, as has been stated before, the profits of US corporations go negative and there are mass layoffs. Tax revenues fall. More people go on unemployment, food stamps, Medicaid, etc. The deficit widens. This is now the point of maximum deflationary pressure. ...

Why would this be the point of maximum deflationary pressure? What you are describing is the start of an economic death spiral into severe depression, not the bottom. I might buy the argument that some currency other than the U.S. dollar would gain favor, but the deflationary pressure would continue to grow, meaning demand for real assets would continue to decrease, and thus the real price of those assets would continue to decrease.

It's because we are measuring deflation in terms of US dollars. It would continue to be an economic death spiral, but along with that death spiral we would be seeing the death of the world reserve currency because there would be less and less to support it.

[Higgenbotham]

Next, the demand for US government bonds falls. The reason demand falls is some combination of the following: ... the market perceives that tax collections are too low and are not likely to improve, the market perceives that the US government has behaved irresponsibly by failing to cut spending in the past ...

All these have already occurred over the past three years. The FED has become that largest holder of U.S. debt exceeding both China and Japan. The FED increased it's holdings from hundreds of billions by more than one thousand Billion more in just one year.

The Fed has only taken a fraction of the new debt off the market. The market has taken the rest of it and the value of US government bonds has risen. The Fed has done studies indicating that the amount of bond purchases they have done has lowered interest rates perhaps 0.3 to 0.5%. Since interest rates have fallen more than that since the Fed has done their purchases, we can conclude that the demand for US government bonds outside of the Fed has risen, not fallen.

[Higgenbotham]

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

[Reality Check]

... Let's say the collapse of the Euro begins to accelerate and first there is a panic out of Euros and also there is a panic out of stocks and into US dollars and government bonds. The value of the dollar and bonds rise. There is deflation. Once this occurs, as has been stated before, the profits of US corporations go negative and there are mass layoffs. Tax revenues fall. More people go on unemployment, food stamps, Medicaid, etc. The deficit widens. This is now the point of maximum deflationary pressure. ...

Why would this be the point of maximum deflationary pressure? What you are describing is the start of an economic death spiral into severe depression, not the bottom. I might buy the argument that some currency other than the U.S. dollar would gain favor, but the deflationary pressure would continue to grow, meaning demand for real assets would continue to decrease, and thus the real price of those assets would continue to decrease.

It's because we are measuring deflation in terms of US dollars. It would continue to be an economic death spiral, but along with that death spiral we would be seeing the death of the world reserve currency because there would be less and less to support it.

Which is just another way of saying that the U.S. dollar could experience hyperinflation, and/or collapse, at the same time there is accelerating deflation.

Depending on the assumptions and definitions you use events that appear to be contradictory can occur at the same time.

Gold and Real Estate like land could become worth less in real terms while at the same time the U.S. dollar is experiencing hyperinflation, because there are simply less people with less real money and thus less demand for things like real property.

In the 1930s houses simply sat empty or were occupied by "care takers" or squatters and raw land sold for 5 cents, 25 cents and 50 cents an acre.

The difference between the 1930s and now, is that the U.S. dollar was the most stable major currency in the world being credibly backed by gold with the British Pound coming in second being credibly backed by Silver for part of the 1930s.

[Reality Check]

The Fed has only taken a fraction of the new debt off the market. The market has taken the rest of it and the value of US government bonds has risen. The Fed has done studies indicating that the amount of bond purchases they have done has lowered interest rates perhaps 0.3 to 0.5%. Since interest rates have fallen more than that since the Fed has done their purchases, we can conclude that the demand for US government bonds outside of the Fed has risen, not fallen.

There are two reasons why that is misleading.

First, while it is true that the FED has only taken a "fraction" of the additional U.S. debt issued during that time off the market, it has been a huge fraction.
And that is still true even if you only count the direct actions the FED took. Specifically the FED buying an additional one Trillion in U.S. Debt during a three year period when the U.S. Government was only issuing an additional One and One half Trillion per year. That represents more than twenty percent. That is a huge percentage of U.S. debt purchased directly. More than enough to be a market mover.

But the indirect effect is even larger. U.S. Banks have Trillions in deposits guaranteed by U.S. taxpayers which have been steered to buying more U.S. debt while calling in loans to U.S. businesses,

The FED will loan money to banks at near zero interest rates if they put up U.S. debt as collateral thus encouraging banks to buy U.S. Bonds and Notes rather than loaning to private business.

Money is flowing from less safe investments into "safe" U.S. Bank deposits and "safe" U.S. debt. Both of which end up in U.S. debt. Money must go somewhere, what is the more safe alternative in the minds of investors during a deflationary period ?

As the economy shrinks during an economic depression the amount of new private debt issued will drop and a larger percentage of the Trillions of deposits in U.S. banks will be available to buy U.S. debt and borrow money against it from the U.S. Fed. Further it is reasonable to assume the FED will also "bail out" some loans to private businesses guaranteed by U.S. government agencies similar to how the FED has bailed out mortgage loans ( and Mortgage Backed Securities ) insured by "Agencies".

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.

[Higgenbotham]

I'd written above about the studies that have been done to estimate the effects of QE on long term interest rates. The study quoted below has attached to it a chart showing the estimated effect of QE on the 10 year treasury bond over time. Most of the studies I've seen are pretty much in this 0.3 to 0.5% range for the long term bonds, whether they are done by the Fed or by independent researchers outside the Fed.

These studies can then be compared to the actual interest rates on the bonds and when the effects attributed to the Fed are removed, we still see that interest rates would have fallen, indicating strong demand for bonds.

So this gives the specific backup for the statement I made that demand for long term US government bonds outside of the Fed has risen to date.

Figure 2 summarizes the model's predictions of portfolio-balance effects from the Fed's large-scale asset purchases. In this figure and those following, the lines plot the effects of the asset purchase program compared with a situation in which the Fed does not purchase assets. When the first phase of the program initially is announced, the 10-year Treasury yield drops by about half a percentage point (50 basis points). During the next few quarters, yields begin to move back towards baseline until pushed lower by the introduction of the next two phases of the program. The program's effect on longer-term Treasury yields fades quickly after late 2010 primarily because the portfolio-balance effects wane as portfolio renormalization draws nearer. The notches in the curve reflect the introduction of changes in the asset purchase program, which we assume were unanticipated by market participants beforehand.

http://www.frbsf.org/publications/econo ... 11-03.html

[Higgenbotham]

Which is just another way of saying that the U.S. dollar could experience hyperinflation, and/or collapse, at the same time there is accelerating deflation.

Depending on the assumptions and definitions you use events that appear to be contradictory can occur at the same time.

Gold and Real Estate like land could become worth less in real terms while at the same time the U.S. dollar is experiencing hyperinflation, because there are simply less people with less real money and thus less demand for things like real property.

In the 1930s houses simply sat empty or were occupied by "care takers" or squatters and raw land sold for 5 cents, 25 cents and 50 cents an acre.

The difference between the 1930s and now, is that the U.S. dollar was the most stable major currency in the world being credibly backed by gold with the British Pound coming in second being credibly backed by Silver for part of the 1930s.

Yes, I agree with all of that, especially the part about "less people with less real money". What could also be true is that we see "hyperinflation" in terms of electronic dollars, but continuing deflation in terms of paper dollars. I'm not real crazy about using the word hyperinflation to describe what we're talking about here.

[John]

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.