The government and Fed only control a small portion of the total supply of money and credit
[Editor’s note: The following article originally appeared on March 16 on the blog Futronomics, hosted by Matt Stiles.]
I get a lot of emails and questions from readers and friends about whether I think the U.S. Dollar could collapse and start a bout of terrible hyperinflation. The questions are usually stemmed from watching an interview on TV with extremely biased energy/gold analysts. People who have every reason to sell you on hyperinflationary doom in order to make themselves a quick buck. I have no respect for these people, so I will not publish their names. They know who they are. I call them the "opportunistic hyperinflationists."
But there is another group of "inflationists" who I do respect greatly. Guys like Peter Schiff, Jim Rogers, Doug Casey and Jim Puplava. These guys have spent years, if not decades, railing against the growing debt bubble and warning that it would end badly. A large faction of the Austrian School of Economics (of which I consider myself a student) had been doing the same. They are the "ideological hyperinflationists."
However, this group of economists/pundits/analysts have been terribly wrong in predicting how this debt bubble would unfold. And I am certain that they will continue to be wrong as it continues and reaches its ultimate conclusion. Typically, these folks have a fundamental dislike of our current system of currency. The feel it is immoral, illegal by the U.S. constitution and is doomed to failure as all paper currencies have been since the beginning of civilization. I agree with them on all counts. But as a function of their dislike for paper money, they have been enchanted by its most obvious replacement: gold. They carry it around with them and flash it at interviews. They become walking salesmen for the return to a gold standard. And they point to a rising price of gold as proof that they have been right all along.
They haven't and aren't.
Their arguments are usually the same. That in order for the massive amounts of debt to be repaid, the Federal Reserve and other central banks are going to have to resort to monetizing that debt via the "printing press." Their claims are well documented. Even the chairman of the Federal Reserve has promised to do this, should it prove necessary, earning him the nickname "Helicopter Ben" (after promising to drop money from helicopters to prevent deflation). And it appears he has already started. We can see it in their own figures. By now, I'm sure all of my readers are familiar with the Monetary Base "Hockey Stick" graph below that shows how the Fed has essentially doubled the monetary base in just a few short months. This, claim the inflationists, is visual evidence that hyperinflation is already occurring and will inevitably start showing up in everyday prices:
Another common claim by these folks is that inflation is running at far higher levels than what is reported by the very flawed CPI measurement. For proof of this claim, they'll point to John Williams' "Shadowstats" counting of inflation in charts like the one below. It shows that if we only counted inflation like we did pre-Clinton Administration, inflation would be much higher than we're told.
In this article, I will explain why these arguments are wrong.
Money and credit
First and foremost is the apparent misunderstanding of the differences between money and credit. At times, they may appear to have the same characteristics. At other times they act completely opposite from one another. As an economy is expanding, an increase in the total amount of credit would appear to have the same effect as an increase in physical dollars because credit is widely accepted as an equal to money. In a sense, they are the same. They are both "fiduciary media" (in english they are both a representation of something else, rather than having intrinsic value themselves). But when the economy is contracting, the prospect of default is thrown into the equation. When this happens, money increases in value relative to credit. Money is more valuable than credit because in the event of default, the physical dollar holders are king. Yes, the U.S. treasury could default on it's obligations. Holders of treasury bonds would get a big, fat zero, while holders of physical currency would still have a claim. In effect, they act similar to a preferred share as opposed to common stock. They are a step above in terms of priority.
It is often said that we live with a "fiat currency" or with "paper money." This is not entirely accurate. A very small portion of our total supply of money and credit is in the form of physical currency. It depends on how you count it, but regardless, it is under 10% of the total. This is what differentiates our monetary system with that of Zimbabwe or Weimar Germany circa 1920's. Their economies were based on nearly 100% physical currency because nobody would accept the promises of government in order to issue credit.
The vast majority of our money supply is in the form of electronic credit. Electronic credit can be destroyed, while physical notes issued by a central bank cannot. This is why deflation is possible in a credit based monetary system, but not in a paper based monetary system.
There are hundreds of trillions of dollars floating around the world in credit. Much of that is an insurance contract on top of another insurance contract, on top of a securitized mortgage, on top of an asset. The total value of all the aggregate claims on the asset vastly outnumber the value of the asset itself. That is what this crisis is about at its very heart. Picture an inverse pyramid with assets occupying the bottom bit, securitized mortgages in the middle, and credit derivatives at the top. A stable economy would have a right-side-up pyramid with assets occupying the bottom, etc.
Our problem now, is not that the assets are going to go to zero. It's the value of the much larger derivatives and mortgages that back the assets going to zero. Their values were derived from faulty computer models that grossly underestimated risk in the underlying asset, but more importantly in the ability for a counterparty to make good on their promise in the event of a default. The counterparties, like AIG or Citi, issued 30 or 40 times more in insurance than there were in assets to back them up. Their models told them that the possibility of all the different assets declining at the same time was negligible, therefore justifying such enormous leverage. Now that the assets have fallen by at least 20-30%, the holders of the securities that were tied to them want to be paid for their insurance. Only there's nothing to pay them with. So the people that hold these contracts are trying to get rid of them as fast as they can, and for whatever price, because they fear that if the counterparty goes belly-up, they'll get nothing. If they can sell, they take the loss. If not, they keep the asset off their balance sheet in what's known as a SIV (Special Investment Vehicle) until they can be sold. While they are kept off the balance sheet, they are still considered to be worth 100% of their original value.
The total amount of these assets is far greater than the equity banks have and their sum represents future losses that eventually need to be realized. No, the value of these assets is not completely nil - because the value of the underlying assets are not nil. But for all intents and purposes, it might as well be zero because it dwarfs their tangible equity.
That was a very long-winded explanation of what the difference is between "money" and "credit" but it is essential to understand this difference. Not only if you want to be an econo-weenie like myself, but in order to understand the very essence of our economy, banking or investing. Any other information is essentially useless unless you can wrap your mind around this concept.
So the next time you hear that the Federal Reserve is "printing money," please do not automatically assume that they are printing physical notes. They are creating electronic reserves (credit) to support the balance sheets of the big banks. There is absolutely nothing inflationary about this. The banks are simply taking it and using it to cancel out their derivative losses or are hoarding it in order to prepare for future losses. Previously, banks would have used the electronic reserves to go out and make 10x that amount in loans to consumers or businesses (in reality the order was the other way around - loans first, then reserves). That is not the case anymore, and until the bad assets are completely liquidated, it will not be the case again.
Thus far, we have a total of $9.7 Trillion dollars in total government/central bank assistance in the United States. An amount equal to that and more has been provided by their counterparts around the world. More is promised. But the fact remains that the minimal inflationary impact these actions have are negligible in comparison to the amount of "problem assets" being devalued around the world. Much of it is just in guarantees - that is, more insurance. The Federal Reserve will offer to swap good assets for bad. All this does is cancel out debt from somewhere else. It's like moving money from one pocket to another. The act of putting money in your right pocket does not make you any richer.
All in all, the central banks are not nearly as powerful as they'd have you believe. The amount of the total money supply that is controlled by them is minimal. They won't tell you that. They'd prefer you to think that just by them moving their lips they can affect the entire economy's decision making processes. It simply ain't so.
This begs the question: why is gold going up? Who knows. It has a mind of it's own. But if it really only moved due to inflation concerns, it wouldn't have declined 75% over two inflationary decades (80's, 90's) would it? If inflationary concerns were real, we would see TIP yields rising along with the gold price. They're not. We'd also be seeing other typical inflation hedges rising - like property prices. That is obviously not the case. A better explanation is that gold is rising because of increased instability. People want to own a little bit "just in case." As they should. But an even better explanation is that it is going up because it is going up. Pure speculation.
No matter how much credit is issued, it cannot make up for the massive contraction elsewhere. The net result will be deflation - even though it will be less than it would be without any interventions. Japan has discovered this over the last two decades - and they had huge demand for their exports, whereas the current situation is global. America discovered this in the 30's - and they had a far smaller debt burden than now. We will discover the same.
Will the U.S. Dollar collapse?
Closely tied to the belief in imminent hyperinflation and a skyrocketing gold price is the misplaced belief that the U.S. Dollar is on the brink of collapse. Essentially, they are one and the same. Many of my arguments against hyperinflation are the same against a dollar collapse. But there is even more evidence stacked against such an occurrence.
Ultimately, the Dollar will end up at zero - but that is not going to happen any time soon, and I would argue is likely decades away. Until then, the massive amounts of deleveraging will increase our appetite for dollars to pay back debt. There is too much credit in the system, and as we rid ourselves of it slowly, we need to acquire dollars. A large portion of the credit derivatives I mentioned above are denominated in dollars even though the underlying asset may be priced in another currency. This is a theoretical short position on the dollar. A "carry trade" in other words. It must be unwound, just like the Yen carry trade.
This is what is meant when we call the U.S. Dollar the world's "reserve currency." Most people hear the word "reserve" and automatically conclude that because many other countries hold the dollar as their primary currency in their foreign exchange "reserves," that is what is meant by "reserve currency." It is not. Total foreign exchange reserves of dollars are far smaller than total foreign credit contracts denominated in U.S. Dollars (reserves worldwide are "only" ~4.6 Trillion). It is the reserve currency because it is the default currency for international trade and commerce in general. In order for that to change, 100's of trillions in contracts would need to be re-written. Not practical.
As such, demand for U.S. Dollars will persist.
Additionally, the U.S. Dollar is not alone in its state of affairs with an overindebted government and central bank getting itself in all sorts of trouble. In fact, nearly every other currency has the same issues facing it. And even though the numbers aren't quite as dire elsewhere, they are far more likely to collapse than the U.S. Dollar due to the reserve status. Fair? No. But neither is life.
In summary, there are many multiples more debt than capital in the world economy. Debt is being liquidated and will continue to do so until it reaches a sustainable level relative to capital. The process of this debt liquidation puts a higher value on dollars relative to debt, thus ensuring an oversupply of dollars is impossible.
Stay tuned for Part 2 of this article
This article was written by a member of the Stockhouse community.
Read more Stockhouse articles by Matt Stiles.
To read more work by Matt Stiles, visit the blog Futronomics.
