Hyperinflation Vs. Deflation
There's a Buzz in the air...
Editor's Note: The following is an exchange of ideas among Minyanville professors from 4/21/06 on the Buzz and Banter. The debate centers on the probabilities we could see either hyperinflation or deflation in the United States. There is no precise and generally accepted formal definition of hyperinflation, though it is typically "loosely" defined as inflation that has moved beyond central bank control due to unchecked increases in the money supply or devaluation of the currency. Deflation is most often viewed as a rise in the purchasing power of money with respect to a "basket" of goods and services, but different economic schools have somewhat different views on what truly constitutes deflation.
Scott Reamer - 10:07 am
Deja Vu all over again...
Just heard on GE television a stealthy hyper-bullish call. One of the advisors being interviewed says he thinks the current market setup is better than the 1982 low and he expects over the next five years we could see the market outperform the five year period from 1982-1987 (pointing to monetary and fiscal stimulus as the principle reasons). Thus, tacking on the 222% gain from the 1982 low to the 1986 peak, we have, voila...
Where (and when) have I heard that before?
Position in GE
Todd Harrison - 10:13 am
Your Delta Tau Chi Pledge name is....Hoover!
Succo and I had this discussion last night during Succofest:Part Deux. We both agreed that stock market discussions can't be viewed in a vacuum.
It is conceivable that the Dow Jones tacks on a monster gain....IF the dollar substantially devalues. While I know "you know," it's important for Minyans to understand that equity levels must be viewed vis a vis their basis of valuation.
There are other obvious implications (higher rates) but it's a discussion worth reiterating as we fit the pieces together.
John Succo - 10:26 am
I just want to clarify a few things about that last comment.
There is no direct connection between a dollar devaluation and higher stock prices. It is only ONE possible scenario.
The Fed, nor any other central bank, cannot force the market to take credit, they can only make it available. If the market does not want to take credit there is little central banks can do about it.
Another scenario is that the dollar devalues against other currencies (it is already being devalued against commodities), but U.S. rates increase substantially in response and stocks decline substantially.
I fully acknowledge the scenario that central banks hyper-inflate, the market takes the credit, and speculates with it in all forms of paper and hard assets.
But equal if not higher in probability is that despite devaluations, credit rolls over and deflation in paper assets ensues regardless.
Either way, real wealth is not being created, it is being destroyed.
Scott Reamer - 10:49 am
A great addendum Todd. It makes all the difference in the world in what terms one values that DOW 36,000 target. My point is not simply that DOW 36,000 would mean a 222% increase in "equity wealth" for holders of the industrials, but rather: (1) the implications for psychological herding manifest in someone feeling confident enough to make that argument on national television. I am not looking at what the 'news' here says so much as what it means. And it means remarkable bullishness.
More than once I have written about the mean and motive argument: The idea that in order to speculate, people need the means and the motive to bid up negotiated financial instruments (or houses, or beanie babies). Mean is credit; the motive is bullish herding on the part of the crowd. BOTH run in cycles (scale invariant, leptokurtotic, non-Gaussian, power-law behaved cycles I might add).
John's points below about the deflation/inflation argument (which remains THE ONLY argument to have regarding the bullish vs. bearish theses) speak to the 'real' underlying reason for DOW 36,000. The destruction of real (dollar-denominated) wealth that would 'go along' with DOW 36,000 remain blissfully unacknowledged by our fearless (literally - I mean fearless) television prognosticator: rampant inflation (in assets OR goods) leads to the destruction, also, of culture, freedoms, and civil society; leads to tyranny. In EVERY historical context it has done just that.
So DOW 36,000, achieved through the destruction of the USD (against commodities , against consumer goods, against real estate, against stocks, etc.), comes with an egregiously heavy price. [see chart of the DOW in Gold terms here.]
And who wants that trade?
Bennet Sedacca - 11:21 am
While we're at it, what would happen to bonds in a hyper inflationary environment?
And I think we can all define Dow 36,000 as hyper inflationary. If the dollar were to fall, or even free-fall, it is possible, as the famed Marc Faber of Gloom, Boom and Doom report has mentioned many times that we would enter a period of hyperinflation.
This would mean that we would abandon a 'strong dollar' (it sure looks strong on a 5 year chart down 40%.........) and let's say trades at 50, not 88. So foreigners, who are up to their eyeballs in Treasuries (the 50-55% level of Treasury ownership is kind of a cap and has enhanced the $400,000,000,000 a year in buying in corporates) demand a higher rate on their assets. Could the dollar become a true fiat currency?
WE would all feel rich as gold, other commodities and stocks could go to truly high levels.
The one asset class you wouldn't wanna own if you lived here? Bonds.....Imagine what rate of interest foreigners would demand in that case. That is the conundrum, IMHO, that faces Boom Boom. If the economy weakens and he LOWERS RATES and DXY gets hammered, could it happen? Food for thought.
Kevin Depew - 11:37 am
Hyperinflation vs. Deflation
John's post and Scott's posts below provide excellent summations of what is at stake in the debate between hyperinflation and deflation. Recently I read an argument making the case that because the U.S. is a net debtor nation there can be no deflation. But as Scott and John both noted, that argument assumes that there will always be demand for credit. I disagree. As I have written before, I believe a secular shift away from credit demand and toward debt repudiation is underway. If that thesis is wrong, then of course hyperinflation is a greater possibility than deflation.
Given a choice between the two, the Fed would prefer inflation over deflation, but their chosen path can only succeed in a secular or cyclical environment favoring credit demand. They are simply too late. At least, I hope they are.
The positive aspect of deflations (yes, there is a silver lining) is that they are cleansing affairs, and after the cleansing free market systems begin again from stronger bases. If you look at the consequences of hyperinflation, however, the aftermath is nothing short of grim.
Ultimately, although probabilities in my opinion favor deflation, what could force hyperinflation, anyway? One word: War. There is much at stake today. Sometimes policy actions by governments seem to make little sense. They sometimes seem illogical.
Now this is just one opinion, and it may be quite wrong, but if viewed through the prism of a worldwide battle between deflation vs. hyperinflation, who wins and who loses in each case, then policy actions across the globe suddenly begin to make sense.
Scott Reamer - 11:43 am
Professor Reamer -
I think this deflation vs. hyperinflation may get back to the haves and the have nots. How does the upper class fare best? Pretty obvious. It seems that it's the 'lower class' that gets burned on hyperinflation.
And if Bernanke is as true blue Princeton as I think, then he's already decided. I was in the deflation camp, but I don't think they'll let it. And I agree about the social consequences.
They key to your argument is "let it": The fed are not omnipotent actors, able to control the time preferences of all (or even the majority) of economic actors in an economy. It is the MOTIVE of the folks that receive the credit that is so utterly important. Toward this end the action in the housing market and the consumer credit numbers is absolutely essential to understanding where the balance of the argument comes down.
The fed can't inflate unless people (and corporations) WANT the credit. Traders, Wall Street: they ALWAYS want to speculate, so that's why the "free" money the fed has been sending out have made their way into financial instruments that can be bought on leverage and NOT into the real economy. But not everyone (thank goodness) in the US is a trader. As a result, it's THEIR time preferences (desire to take on more credit) that matters.
The end game is the same, as you accept. But the path there makes all the difference in terms of how we both prepare for, and survive thru, that end game. Which is why I think it remains THE only question to ask and answer. All others being entirely secondary.
Bennet Sedacca - 11:59 am
Professor Sedacca -
I am trying to reconcile in my own mind how such a scenario could lead to hyper inflation in stock prices: If foreigners finally balked at the dollar and interest rates spiked, how does an economy with 50% of its profits derived from finance not collapse?
Prior global examples, whether it is 1920's Germany or 1980's Latin America, did not include economies that were so levered to interest rates. The housing market would surely collapse and so would consumer spending.
I would think that past hyperinflations were accompanied at least by nominal gains in profits, but I see recessionary hyperinflation as a more likely outcome due to our economy's huge reliance on leverage and spending to generate profits. Any thoughts?
Great question. Yes, we would not care what our assets were worth to OTHERS, only to ourselves. They (foreigners) would demand higher rates in order to hold all of our debt. Imagine, just for a second, where rates would be if they hadn't been there to soak up all of our debt to date? See what I mean?
Bennet Sedacca - 12:32 pm
And how does all of this hyperinflation/deflation play into the picture for municipalities??
No one talks much about credit risk in munis because of their inherent taxing power in the case of State General Obligation bonds or revenues from 'essential services' like water/sewer bonds.
But, underneath, the picture isn't as pretty as one would think. The 'underlying' ratings of most municipalities are falling, just like in corporates (for perspective, when I started in 1981 there were 35 AAA rated companies - I believe there are now 5). So they rely on AMBAC, MBIA, FGIC, etc. to insure them, otherwise there wouldn't be enough buyers, IMHO. If we had a bout of either hyperinflation OR deflation, it would hurt many of the weaker issuers.
In addition, they are in awful shape for the same reason General Motors (GM) and Ford (F) are dying a slow death. They pay on average (this is an estimate from a recent Barron's article) 75% of their worker's health care costs.
This is why we stick to bonds with underlying (IOW, ratings WITHOUT credit assistance) of AA or better pre-refunded bonds - see bond basics for definitions. Again, food for thought, but it is why we DON'T stretch for that last 10-20 basis points of yield to sacrifice 100% of principal.
Position in various municipal bonds
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