When Money Dies

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November 16 – Wall Street Journal (Damian Paletta and Carol E. Lee): “White House officials are in advanced internal discussions about a plan to replace the sweeping spending cuts set to begin in January with a smaller, separate package of targeted spending cuts and tax increases… They would cut spending by roughly $100 billion next year, and then for eight additional years… Democrats and Republicans have separately tried to design plans to replace the sequester. The discussions are just one part of a complicated set of possibilities as Washington deals not only with the looming spending cuts but also the expiration of the Bush tax cuts and other traditional year-end priorities, such as finding a way to halt the scope of the Alternative Minimum Tax… By postponing the sequester cuts, Washington would essentially push off a number of large deficit-reduction decisions into mid-2013.”

Finally, the post-election “fiscal cliff” predicament has arrived at our doorstep. I’ll assume at this point that tough negotiations unfold over the coming weeks. There are clearly “irreconcilable” and “deep philosophical” differences between the two sides. The democrats and the republicans just see the world quite differently, as do competing political factions around the globe. And, right along with global policymakers, I think it’s safe to assume that Washington will resort to the popular (and habit-forming) “kick the can” strategy of extending stimulus measures and postponing structural reform. The markets were encouraged by Friday’s conciliatory political tone.

It’s been 14 years of chronicling history’s greatest Credit Bubble. From early on, the Bubble thesis was dismissed and ridiculed. More recently (April ’09), the thesis that the Treasury market had succumbed to Bubble dynamics was denounced by a well-known strategist as “intelligentsia,” suggesting it was removed from real world market analysis. Over the years many have castigated my analytical framework as “theoretical” and “academic,” although I do not recall anyone ever seriously challenging the analysis. I today believe more strongly than ever in the profound ramifications of the Macro Credit Analysis Framework and historic Bubble thesis.

For much of the past 14 years, while I have been documenting the greatest Credit inflation the world has ever experienced, policymakers and Wall Street strategists have been fixated on the “scourge of deflation.” The “Keynesians” (aka Inflationists) have used post-Bubble “mopping up” strategies to repeatedly resuscitate and promulgate history’s greatest Credit inflation. Amazingly, the disease has been misdiagnosed virtually from day one. More amazingly, no one will even contemplate a reexamination; just stronger narcotics. The great risk has not been – and it’s not today – either deflation or inflation.  The risk has fully materialized – and it’s the unavoidable downside of a runaway global Credit Bubble and financial mania. 

Over the years, I’ve often been asked to predict how this will all end: will it be either hyperinflation or deflation? My response has always been “we’ll have to carefully monitor how things unfold.” From my perspective, there have been two critical unknowns. First, I’ve never felt comfortable predicting to what extent global policy measures would be used to prolong the Bubble (Fed balance sheet on the way to $10 TN?). Second, I’ve believed it’s unknowable as to how long extraordinarily speculative financial markets would play along. There has been a crucial interplay at work between aggressive “activist” policymaking and sustained confidence in the suspect financial claims piling up virtually all over the world.

I highly recommend Adam Fergusson’s classic “When Money Dies – The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany.” It’s just a wonderfully written account of a most-catastrophic inflationary cycle. This recommendation is not, though, an indication that I’m leaning toward the hyperinflation outcome. The relevance today of “When Money Dies” rests with it having so clearly illuminated the profound financial, economic, social and political costs associated with major inflationary cycles. And once this cycle gathered momentum, there was nothing to hold it back. Inflationary psychology, as it has a strong propensity of doing, was self-reinforcing and pathologic. Then, as the cycle progressed, various constituencies supportive of ongoing inflation gained only greater power. Weimar policymakers were stunningly clueless as to the consequences of their money printing.

Mr. Fergusson explained with great insight how, in the end, the inflationary cycle could not be concluded without horrendous pain and upheaval. The inflation had profoundly destroyed and redistributed wealth. The underlying economic structure had been badly maligned by distorted price structures and dysfunctional resource allocation. People’s confidence in money, policy, democracy, Capitalism and civil society had been shattered.

No two inflationary cycles are alike. Each is nuanced, with different types of Credit instruments, modes of financial intermediation, methods of speculation, fallacies, malfeasance, policy doctrines and economic structures. At the same time, I would argue that inflationary cycles also share important common ground that is critical to a better understanding of today’s unique global inflationary cycle. To be sure, the longer they last the deeper the maladjustment to economic structures. They also always invite destabilizing speculation. And the longer the cycle is allowed to unfold, the greater the redistribution of wealth and associated social/political consequences. While this important reality is masked throughout the inflationary boom, Credit Bubbles are powerful yet seductive machines of wealth destruction. Importantly, various constituencies develop that are determined to perpetuate inflationary excess, complete with flawed policy doctrines and fallacious theories. And the grander the cycle the more conspicuous the necessity for perpetually postponing the inevitable day of reckoning.

The Weimar Germany hyperinflation is infamous for unbelievable money printing ($1 to 42,000 TN marks!). The “Roaring Twenties” and Japan 1980’s Credit inflations were notable for seemingly tame “inflation” that worked to confuse and disable policymakers. All three, however, shared deeply impaired financial and economic structures. All three saw runaway inflationary excess late in the cycle. And, in hindsight, all experienced devastating system impairment during the inflationary boom’s waning months.

The current inflationary boom is unique. It is global in nature unlike anything previously experienced. The global Credit Bubble completely engulfed the “dollar reserve” global financial “system.” The massive inflation of dollar financial claims fomented a corresponding historic inflation in various currency Credit systems worldwide. Unprecedented global Credit inflation has been fueled by a globalized system of electronic “money” and Credit. This prolonged cycle has been unique in terms of a global Credit expansion unconstrained by a monetary anchor, gold backing or even restraint imposed by bank reserve and capital requirements. It’s been runaway non-productive debt growth on a scale never before seen.

The global nature of this Credit inflation has been responsible for atypical inflationary manifestations. Importantly, unhinged global Credit has ensured an historic investment boom. Manufacturing capacity, especially technology production throughout Asia, has ensured an endless supply of computers, televisions, cell phones, Ipads, electronics, communications technologies, etc. Technological innovation has also spurred digital and downloadable media and content, with “globalization” and the “technology revolution” ensuring that historic Credit inflation has not for the most part translated into worrying consumer price inflation. Yet this has in no way diminished the distortions and risks associated with the current inflationary cycle.

Indeed, generally quiescent “CPI” has ensured that policymakers and most analysts have remained comfortably oblivious throughout this most protracted inflationary period. Credit systems have, in general, inflated in tandem globally. The corresponding synchronized currency devaluation has also worked somewhat to synchronize – to balance out - inflationary effects. The collapse of the German mark in international trading played a profound role during the Weimar hyperinflation. Today, powerful global central banks intervene aggressively in order to stabilize trading relationships between the major currencies. This has worked magically to mask imbalances and distortions. Importantly, it has also worked to perpetuate them, while delaying badly-needed financial and economic adjustment.

There is a reasonable chance that we are again near a critical Credit Bubble inflection point.  Inflations need ongoing monetary fuel. Indeed, it is the nature of major inflations that they require ever-increasing amounts of “money” and Credit. Today’s aged global Credit Bubble requires massive and ever-increasing quantities of global Credit expansion. For three years now, we’ve watched the unfolding downside of the Credit cycle in Europe. More recently, developing economies have weakened, especially in China, India and Brazil. Perhaps there will even be a little fiscal tightening here at home. As such, it is not a sure thing that sufficient new global Credit will be forthcoming.

For the past two years, Europe has been playing the role of “marginal” Credit provider. Private-sector Credit growth has plummeted throughout much the region, although this has been countered by aggressive policy interventions. First, there were the Greek, Irish and Portuguese bailouts – and later more Greek bailouts. Then a bigger EFSF and an ESM. This was followed by the $1.3 TN long-term Refinancing Operations (LTRO) – with a notably short half-life. As the European - and global - crisis began to spiral out of control this past summer, the world was introduced to the “do whatever it takes” Draghi Plan and “QE infinity” from the Bernanke Fed (and others). And a not-so-funny thing happened: global risk markets rallied abruptly – only then to trade unimpressively.

Today, the CRB Commodities index (down 3.8% y-t-d) trades at about the same level as it did two years ago. Despite troubling geopolitical developments in (throughout) the Middle East, crude (down 11% y-t-d) trades near the level from three years ago, despite a significant decline in Iranian crude production. The industrial commodities trade poorly. Global equities markets are showing vulnerability, and it is as well worth noting that Credit spreads and risk premiums generally have begun to widen. That such “non-inflationary” market reactions unfold just months after desperate inflationary policy measures is worthy of consideration.

I have in the past noted an important peculiarity of this global inflationary cycle: Rather than the more conventional currency printing press, the Global Credit Bubble has been fueled in large part by (electronic-entry) marketable debt instruments. This has created key advantages in terms of this cycle’s durability and longevity. For one, it has tended to isolate the greatest inflationary effects within the global securities and asset markets. Second, this dynamic has provided policymakers with incredible power to intervene in the markets to bolster confidence and spur the ongoing inflation of financial instruments (both quantity and price).

But any inflationary cycle “advantage” comes with a significant downside. For one, never in the history of mankind has an inflationary cycle so spurred and rewarded financial speculation. Global risk markets have evolved into essentially one historic policy-induced speculative Bubble. Financial speculation was nurtured into one gigantic “crowded trade,” which manifested into the dysfunctional “risk on, risk off” trading dynamic. Increasingly aggressive policy responses over too many years created a speculation monster that will not be easily contained or tamed.

As noted above (and in previous CBBs), a Credit Bubble is sustained only through ever-increasing quantities of “money” and Credit. The greater the Bubble, the greater the required policy response to sustain the inflation. But, importantly, the greater the policy measures imposed the greater the market reaction – and the greater the market reaction the greater the necessity for even bigger policy interventions in the future. I’ve posited that there’s an element of central banks “fighting a losing battle.”

There was talk this week of the need for even larger monthly QE from the Fed. The markets also anxiously await the firing up of Dr. Draghi’s bazooka. A new Japanese government could see the Bank of Japan further crank up their white-hot electronic printing press. With new leadership in China, perhaps they’ll be ready to push further on the accelerator. It all seems rather late-cycle to me. And, I’ll suggest, a loss of confidence in all these electronic journal entries - the global financial system more generally – is this historic cycle’s greatest vulnerability. As we witnessed not many years ago, one day everyone is so enjoying the dance party and the next they’re fighting for the exits. It’s a spiking the punch rather than removing the punchbowl dilemma.

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About Douglas Noland