Is Deflation Really the Problem or Will
Hyper-Inflation Begin in 2014?
by the Curmudgeon and Victor Sperandeo
Deflation is characterized by sustained decreases
in prices of goods and services, which cause consumers and businesses to delay
spending since they rationally expect prices to be cheaper in the future. Japan’s economy has been dogged by two “lost
decades” of deflation. The concern now
is that the Euro-Zone could be next.
weak global inflation numbers have been a big surprise this year, especially in
the Euro-Zone. Last weekend's FT lead
story was Investors
wrestle with spectre of deflation. It was followed by several days of talk about
deflation risks, most notably IMF Chief Christine LaGarde's remarks at Davos.
LaGarde said that "Euro-Zone inflation, at 0.8%, remained way below the 2% target set by the European Central Bank (ECB) and that potential deflation risks must not be ignored." She also said there are now "new risks" to the global economy that center on how emerging economies respond to the winding down of QE in the U.S. and the problems facing economies whose inflation rate remains stubbornly below target.
ECB President Mario Draghi told the Davos audience that the fall in Euro-Zone inflation was primarily due to slowdowns in four heavily-indebted countries: Greece, Spain, Ireland and Portugal. He said the ECB was ready to act to counter deflation, but insisted it was not yet an issue. Draghi commented that Euro-Zone inflation is "subdued, and expected to remain subdued" for about two years. "The longer it stays at a low level, the more serious risk of deflation," he added.
inflation rate was 0.7% in January--down from 0.8% in December--Eurostat reported
on January 31st in its initial estimate.
That was significantly lower than economists had expected and
significantly below the region's 2% target rate. The “core” rate, which strips out energy,
food, alcohol and tobacco, was 0.8%- up from 0.7% in December. Some economists have argued that falling
inflation in the Euro Zone, coming after five years of recession or very slow
growth, means that there is an acute risk of deflation in Europe. That has led several analysts to predict an
interest rate cut at Thursday's ECB policy meeting.
on Deflation Risks:
have not done enough to explain the disinflation and deflation of last year –
let alone what is happening this year,” said Steven Major, Head of Fixed Income
Research at HSBC. “Policy makers have to be very careful. If the sign changes
on inflation numbers, and growth rates do not improve, debt sustainability will
become a real challenge in the Eurozone,” he added.
In an update to
the Washington Institute’s forecasts, the IMF observed that “risks to
activity associated with very low inflation in the advanced economies, especially
the euro area, have come to the fore.”
Lower than expected inflation would increase debt burdens and real
(inflation adjusted) interest rates.
over the longer term, deflation is definitely negative for equities,” said
Graham Secker, European Equity Analyst at Morgan Stanley. That was certainly true in the U.S depression
of the 1930s!
“There are a
lot of uncertainties in the Eurozone, such as the stress testing and asset
quality review of the banks, and that is holding back the economies and the
markets. The problems are structural and a Japanese-style deflationary
situation cannot be ruled out,” John Wraith, Bank of America Global Research
Strategist told the FT.
reports that German
inflation Below Expectations Signals Deflation Risk Stays. Prices fell 0.7 percent on the month and a
measure of inflation expectations dropped to the least since May 2012,
according to that article.
Telegraph article by Ambrose Evans-Pritchard is more blunt (and scary): World
Risks Deflationary Shock states,
"Half the world economy is one accident away from a deflation trap. The
International Monetary Fund says the probability may now be as high as
In a note to Dow Theory Letter subscribers, Richard Russell wrote,
"I think that the US is fighting the forces of deleveraging and deflation,
and I think the Fed is losing its battle against deflation. After spending trillions via quantitative
easing, the Fed has still been unable to push inflation to its desired level of
In an email to
the Curmudgeon, Michael Johannes, Columbia University Finance Professor wrote:
""We've already had the hyperinflation--it's been in financial asset
markets. I think there's a greater chance of real economy deflation (than
hyper-inflation), which would follow the usual (historical) pattern: excessive
central bank liquidity leads to mispriced assets (credit and equities) -->
leads to excess investment --> leads to excess capacity-->which leads to
defaults and the risk of deflation. In this case, it would be China and
emerging markets first. It would be no different than the tech boom and bust
followed by the housing bubble and mortgage meltdown."
risks became real, you would have to start pricing in a greater chance of
defaults and debt rescheduling,” said Christopher Iggo,
Sr Investment Manager at Axa
likely push the global economy into a steep depression. In that case, demand would collapse while
credit would freeze up and businesses would be starved of capital. That almost happened in the fall of 2008
after Lehman Bros went bankrupt.
In his seminal paper on Debt-Deflation and Depressions (1933), Irving Fisher wrote:
accordingly, that, at some point of time, a state of over-indebtedness exists,
this will tend to lead to liquidation, through the alarm of creditors or
debtors or both. Then we may deduce the following chain of consequences in nine
links: (1) Debt liquidation leads to distress setting and to (2) Contraction of
deposit currency. (3) A fall in the level of prices, in other words, a swelling
of the dollar. Assuming this is not interfered with by
reflation or otherwise..."
sentence is crucial because Fisher didn't imagine a central bank (i.e. the Fed)
could monetize so much U.S. debt to forestall deflation (QE from 2008 to the
present). And that brings us to the next
Deflation Antidote: Central Bank Debt
Monetization, Zero Interest Rates and Non-Bank Loans:
deflation really happen? We don't think
so. For sure, the world's major central
banks (Federal Reserve, ECB and BoJ) will step up the
pace of QE and likely make loans to non-banks- just like the Fed did during the
fall and winter of 2008. They will flood
the global financial system with "oceans of liquidity" to prevent
falling prices and debt defaults. Interest rates will stay at zero for an
extended period of time, as the Fed has repeatedly stated.
there's a huge risk to such global debt monetization - a loss of faith in paper
currencies or "fiat money." Accelerating Inflation if not hyper-inflation,
would quickly follow, as gold, commodities, food/agriculture, selected real
estate, timber, and other hard assets would skyrocket in price. Effectively, major currencies would lose
purchasing power and experience a de facto devaluation in terms of real assets.
Furthermore, Mr. Williams predicts a U.S. $ crash, followed by rising commodity prices and cost-push inflation that will usher in hyper-inflation. He says there is a 90% probability of that happening by the end of 2014. A very interesting interview with Mr. Williams, along with supporting quotes can be viewed here.
Victor has gone
on the record that hyper-inflation is statistically inevitable. Sperandeo presented a carefully researched
and meticulously documented talk on that topic at the Atlas Summit in July 2013. He said that public debt projections of OECD
countries are forecast to increase exponentially and, rather than default on
that debt, governments will resort to massive money printing to fight the next
global recession. That will quickly lead
to hyper-inflation, according to Victor (see update below). The video of his talk can be viewed here.
As the Curmudgeon has noted, I believe that hyper-inflation is inevitable, but its timing is uncertain. It is highly likely to be preceded by a brief (?) period of deflation and economic contraction, which would cause government deficits to soar and massive central bank money printing to follow.
As there is a lot of confusion over the concept of "hyper-inflation," especially when compared to (ordinary) inflation, let's clearly define those terms:
Inflation, as experienced in the 1970's, is "an increase in the volume of money and credit, relative to the goods and services being produced that result in a GENERAL PRICE INCREASE."
Hyper-inflation was defined by economist Phillip D. Cagan in 1956 in an article titled, "The Monetary Dynamics of Hyperinflation." It requires a monthly increase in the inflation rate (e.g. CPI) of 50%. This has only occurred 30 times in world history. (Cato Institute economist Steve Hanke counts ~53 instances, because he counts the same occurrence twice, i.e. if a monthly increase drops below 50% and then skips a month and is at or above 50% again.)
Hyper-inflation is much more severe than ordinary inflation. The record monthly inflation increase is July of 1946 in Hungary, when prices increased 1.295 x 10 to 16 *power. Or 129 quadrillion 500 trillion %. That's equivalent to prices doubling every fifteen hours and is nothing at all like traditional inflation!
Germany from 1920-23 is another example of hyper-inflation, where the monthly inflation rate increased 29,525.71% in one month! The sale of the existing WW I debt plus war reparations caused Germany to print money to pay it all.
Hyper-inflation is often the result of a catastrophic decline in the currency. If the currency in question (e.g. the U.S. $) declined by 50%, then prices would effectively double in real purchasing power. Let's examine the sequence of events that lead to hyper-inflation.
It all begins with a loss of confidence in a country's monetary unit. Like a run on a bank, the result is massive selling of sovereign debt (e.g. T-bonds and T-notes in the U.S.). To pay the sellers, the government resorts to printing paper money. While that money printing serves to reduce the debt in real (purchasing power) terms, it also instigates hyper-inflation when it becomes exponential.
To clearly understand hyper-inflation, one should not think of the actual supply of commodities (or stuff) versus their demand. Rather, hyper-inflation results from far too much newly created paper money, which fewer people are willing to accept for goods and services.
History shows that when a currency plummets steeply, it has never recovered. The Zimbabwe dollar is a recent example. It can't even be used as toilet paper in South Africa!
To understand why I think hyper-inflation is inevitable, look at the alarming increase in U.S. debt. In 1978, the U.S. total debt was $771,544 billion, but by December 2013 it was $17,226 Trillion! That is a 9.01% compounded growth rate for our country's total debt. In the next 10 years, at this growth rate, U.S. debt will be $40,817 Trillion. You can pick any longer term number of years and the outcome will be similar.
Can the U.S. debt be reduced (it was during the Clinton administration)? Not likely now. The dead locked, dysfunctional U.S. government couldn't even cut 2% (via the sequester) in a single year!
The timing of the onset of hyper-inflation seems impossible to predict. One has to guess when mass psychology will turn into a virtual "bank run" out of paper currency. Such an economic scenario is the worst of any possible, as it constantly reduces purchasing power and stops an economy dead in its tracks.
In the U.S., it seems that the desire for political power is so great that it's corrupting the country. This is seen by many distortions in reported economic statistics, which make the U.S. economy look better than it really is. Here are a few examples:
1. During his re-election campaign in 1991, George Bush Sr. switched the reporting of GNP to GDP so that U.S. economic growth would appear to be higher and would lead to more votes.
2. U.S. spending is often "Off Balance sheet" and not counted in budget deficit calculations, while revenue collected from the same entity is in the budget. Fannie Mae (government spending and revenue) is such an example.
3. The U.S. accounts for deficits on a cash basis, whereas every U.S. company has to use accrual accounting- taking into account unfunded liabilities.
The bottom line is that we really don't know the true financial condition of the U.S. government. A confluence of negative factors, including a relapse into recession when Fed bond buying stops, may cause major U.S. debt holders to sell part or all of their holdings. That would cause major re-allocations out of dollar assets. This is the where the future produces uncertainty to the 10th power and the real risk of hyper-inflation.
Till next time........................
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies. As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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