Here's one for all you economic philosophers and "bond market vigilante"-types. The question I'm currently turning over in my mind is this: can the U.S. experience hyperinflation, or will the possibility of such an extreme inflationary spiral be held in check by the bond markets?
The current thinking on the possibility of the United States experiencing hyperinflation seems to be split between those who say it can (and likely will at some point in the future), and those who feel it cannot, for precisely the reason stated above.
I spent part of the weekend reading some of Richard Russell's recent remarks, and part of his June 20 newsletter dealt with this very topic.
Russell is of the opinion that, as far as hyperinflation goes, "it can't happen here" because of the size and depth of our present-day bond market and money markets.
He also feels that if inflation were to really heat up, the bond market would "start to crumble" and things would generally start to fall apart. Interest rates would go higher, the stock market would collapse, and business would begin to fall apart. This in turn would cause inflation to disappear as all manner of assets begin to deflate, or so the story goes.
While I hold Richard Russell and his writing in the highest regard, I must say that I have to wonder about his reasoning on this issue. I am just not sure that I would agree with it.
I am still struggling with the answer to these issues, but something about this argument strikes me as rationalization. So we have a very powerful and well-developed bond market. Does that mean that it would survive the final stages of a rapidly escalating inflationary cycle or keep such a cycle at bay?
The theory of the bond market vigilantes holds that bond traders will sense inflation and mitigate its effects by pushing interest rates higher, thereby keeping central banks and governments relatively honest.
The main problem with the theory of the bond vigilantes these days is that no one can seem to find them. Whether they've been overrun by non-traditional forces or have simply disappeared has been a recurrent theme for discussion in recent years.
I've heard some very insightful arguments concerning the bond vigilantes and their eventual return, but I've yet to read of their ability to stop an impending hyperinflation in its tracks.
Also, if the government were to issue bonds in excess of the amount people were willing or able to lend, they could simply monetize the debt by selling their bonds to the central bank, who, in turn, would print the money needed to pay for them.
Creating money out of thin air is, of course, an inflationary exercise. Taking this method to its extreme would provide the impetus for a hyperinflationary episode.
So far I've seen nothing to suggest that bond investors, or anyone outside of governments or money-controlling agencies, have the power to overcome an over-issuance of money and credit, or an impending hyperinflation.
In the meantime, if anyone can tell me (in plain English) why the bond markets have the power to stop a U.S. hyperinflation in its tracks, I'd be interested to hear the explanation.
Monday, July 09, 2007
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8 comments:
I agree with you. The Fed can determine short and long rates because of their ability to buy up any long-term debt from government bonds to mortages. If they keep real long and short rates negitive for a prolonged period of time, then hyperinflation is very possible. I don't see why smart people don't understand this point. What is their answer to it?
Deflation is also possible. There will come a day when inflation is undenyable and I could certainly see atleast an attempt at saving the dollar. After the pain is bad enough they will go back to printing money. Inflation -> Bad Recession -> Hyper Inflation
We need to distinguish between what the Fed can do, and what it will do.
As you point out, the fed can monetize every asset in existence, thereby generating hyperinflation. But would it? And how would the market and government respond?
If the Fed did let loose a monetary flood, investors would dump dollar denomenated assets and buy up foreign assets. The Fed would have to then choose between buying every domestic asset in existence -- effectively creating a communist state -- or letting domestic asset prices collapse. I don't see the first choice as politically feasible, so the government would step in to stop the Fed, interest rates would soar, and hyperinflation would be terminated.
Reader Tom writes:
David,
I am ex Bond trader who spent the last 20 years trading Government Zeros at Morgan Stanley. The Bond vigilantes left the business in the middle 90's and were replaced by traders that focused all their energy selling bonds to foreigners. Now the bond market is computerized and their are few traders that will stand up in a crises (like 1987) and make markets in a critical environment.
I do not think that the broker/dealer community is prepared or even interested in buying debt in a rapidly rate increasing environment. The buyer of last resort will be the Fed. A la Wiemar regime!! We will see fireworks in the US bond market soon.
Reader Dave writes (excerpt):
David,
I am not an excerpt on this topic, but I did a lot of research on actual hyperinflations that have occured in other countries to get some idea of what happens.
Richard's argument appears to be a "we are too big to fail" type of argument. I would counter that the size and deapth of the bond market is not preventing hyperinflation, maybe just holding it off until the tipping points are reached for that particular currency/banking/finacial system.
The reality is that we have a government that has basically tapped out its ability to directly tax us without causing major political trouble. This government has made financial obligations in the range of $57 Trillion. This sum of money is now growing larger just on its own compounding interest. These are future obligations, so they have not come due yet. A lot of it is SSI, and Medical, so, these are going to be checks that go striaght into the money supply. This is not money going to some off shore hedge fund.
Anyone making the argument that we are not at serious risk for a hyperinflationary meltdown needs to make a far better case than a "we are too big to fail" type of argument.
In other words, if the U.S. was not to go into a hyperinflationary melt down under these terms and conditions, it would be the first time a country had not experience this type of event. We would be the single and only exception.
So far we are being rescued only due to being the reserve currency of the world. Once that goes away, I do not see how our Bond Market can absorb that kind of roll.
Once the Fed starts pegging interest rates and buying their own bonds, we no longer have a bond market, so we no longer have Bond Vigilantes, so problems in the economy are not going to be stopped by things that no longer exist.
I think the Bond Vigilantes have been replaced in part with Exchange Market Vigilantes and so the Dollar keeps dropping. This would be much more noticeable if it weren't for all currencies following an inflationary path, but since they are, we also have to supplement these vigilantes with Commodity Market Vigilantes, Gold Market Vigilantes, Real Estate Market Vigilantes, Stock Market Vigilantes and vigilantes anywhere where the Fed or offshore Feds cannot inflate.
"Water seeks it's own level", so good luck, EC
I have read Russell for years & I too was puzzled by his comments on hyperinflation. I thought about it & don't think he has a major conviction - he hasn't mentioned it before. He just believes more strongly in deflation.
Hyperinflation is a rare phenomenon and is therefore unlikely, but that is not to say it won't happen in the US, in fact the conditions are in place for it to occur. In fact you could argue because of the size of the Bond market it is more likely than before - reliance on foreign borrowing, lack of domestic savings, technical insolvency of nation's accounts etc.
I still don't think it likely because for hyperinflation to become a society-wide issue (eg Weimar Germany, Zimbabwe 5000%+ rates of inflation), the Fed would have to print money in an out of control fashion. That would be so economically suicidal that I think they would rather write off the debt(containable single digit inflation for years?) or default on their loans if the worst came to the worst and reconstitute them somehow.This would be curtains for the dollar of course.(Buy Gold!)
One thing about inflation that is hard to cope with (especially when Governments hide the true cost of living increases) is the nominal price of assets keep going up eg housing, stock markets, profits, pay, fine art etc
but it is hard to deflate by the true cost of living .
When you look at the S+P 500 in Euros since 2000, it has only recovered 38% of its value not 100% as depreciating dollars would have you believe.
BTW I traded US Treasury Bonds for years and there never were any vigilantes and in 1987 there was no market in Treasuries for a couple of days. All the market makers were instructed to just work orders & not make markets such was the confusion, volatility & disruption at the time.
Oh another thing about the FED & its so called omnipotence & control of the economy. When push comes to shove they can only influence where the Government liablilities are held - in the public domain or in the private sector, not the total amount.
See http://hussman.net/html/fedirrel.htm
for detailed explanation. Most of the effectiveness of the Fed comes from the crediblity of the insitution .
Things purchased with long-term debt (housing, factories, college educations) will fall in value until they become affordable to people with cash and short-term loans. Commodities and consumer goods will skyrocket. For example, right now a median home price of $200,000 is the equivlant of about 200 tonnes of rice. As inflation heats up, the price of a house will fall to 100 tonnes of rice, then 50 tonnes, then 10 tonnes. By then rice will probably cost $100 a pound. When the hyperinflation is in full swing, nothing will be purchased with credit.
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