by Walter J. (John) Williams
Historical U.S. Inflation: Why Hyperinflation Instead of Deflation
Fire and Ice
Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.
– Robert Frost
As to the fate of the developing U.S. great depression, it will encompass the fire of a hyperinflation, instead of the ice of deflation seen in the major U.S. depressions prior to World War II. What promises hyperinflation this time is the lack of monetary discipline formerly imposed on the system by the gold standard, a fiscally bankrupt federal government and a Federal Reserve dedicated to debasing the U.S. dollar. The Fed’s efforts at liquefying the system have been extreme, yet broad liquidity is in monthly — soon to be annual — decline. Where the Fed’s systemic actions have generated temporary apparent systemic stability, the weakening annual growth in the broad money supply, and continued extreme Fed efforts at systemic liquefaction, suggest that the systemic solvency crisis is far from over.
The following two graphs measure the level of consumer prices since 1665 in the American Colonies and later the United States. The first graph shows what appears to be a fairly stable level of prices up to the founding of the Federal Reserve in 1913 (began activity in 1914) and Franklin Roosevelt’s abandoning of the gold standard in 1933. Then, inflation takes off in a manner not seen in the prior 250 years, and at an exponential rate when viewed using the SGS-Alternate Measure of Consumer Prices in the last several decades. The price levels shown prior to 1913 were constructed by Robert Sahr of Oregon State University. Price levels since 1913 either are Bureau of Labor Statistics (BLS) or SGS based, as indicated.
The magnitude of the increase in price levels in the last 50 years or so, however, visually masks the inflation volatility of the earlier years. That early volatility becomes evident in the second graph, where the CPI history is plotted using a logarithmic scale. Seeing such detail is a particular benefit of using such a plot, although the full scope of what is happening may be lost to those not used to thinking log-based.
The logarithmic scale was used here at reader request. The pattern of the rising CPI level, however, still looks rather frightening even in the modified form. Further, since inflation ideally is something that is flat over time — not compounding like the population and related series that grow with it — I do not have any issue with using a non-log scale for the visual impact of what is happening.
Persistent year-to-year inflation (and the related compounding effect) did not take hold until post-Franklin D. Roosevelt. Additionally, the CPI level reflects purchasing power lost over time for those holding dollars, which is cumulative, and which has reached extremes (as will be discussed shortly) due to the late-era compounding effect. If my assessment is correct on where this is headed, the log-based graph shortly will look like the arithmetic-based graph, as was seen the latter months of the Weimar circumstance.
Indicated by the newly visible detail in the second graph are the regular periods of inflation — usually seen around wars — offset by periods of deflation, up through the Great Depression. Particular inflation spikes can be seen at the time of the American Revolution, the War of 1812, the Civil War, World War I and World War II (which lacked an ensuing, offsetting deflation).
The inflation peaks and the ensuing post-war depressions and deflationary periods, tied to the War of 1812, the Civil War and World War I, show close to 60-year cycles, which is part of the reason some economists and analysts have been expecting a deflationary depression in the current period. There is some reason behind 30- and 60-year financial and business cycles, as the average difference in generations in the U.S. is 30 years, going back to the 1600s. Accordingly, it seems to take two generations to forget and repeat the mistakes of one’s grandparents. Similar reasoning accounts for other cycles that tend to run in multiples of 30 years.
Allowing for minor, average-annual price-level declines in 1949, 1955 and likely 2009, the United States has not seen a major deflationary period in consumer prices since before World War II. The reason for this is the same as to why there has not been a formal depression since before World War II: the abandonment of the gold standard and recognition by the Federal Reserve of the impact of monetary policy — free of gold-standard system restraints — on the economy.
The gold standard was a system that automatically imposed and maintained monetary discipline. Excesses in one period would be followed by a flight of gold from the system and a resulting contraction in the money supply, economic activity and prices.
Faced with the Great Depression, and unable to stimulate the economy, partially due to the monetary discipline imposed by the gold standard, Franklin Roosevelt used those issues as an excuse to abandon gold and to adopt close to a fully-fiat currency under the auspices of what I call the debt standard, where the government effectively could print and spend whatever money it wanted to.
Roosevelt’s actions were against the backdrop of the banking system being in a state of collapse. The Fed stood by twiddling its thumbs as banks failed and the money supply imploded. A depression collapsed into the Great Depression, with intensified price deflation. Importantly, a sharp decline in broad money supply is a prerequisite to goods and services price deflation. Messrs Greenspan and Bernanke are students of the Great Depression period. As did Mr. Greenspan before him, “Helicopter Ben” has vowed not to allow a repeat of the 1930s money supply collapse.
Where the Franklin Roosevelt Administration abandoned the gold standard and its financial discipline for the debt standard, twelve successive administrations have pushed the debt standard to the limits of its viability, as seen now in the continuing threat of systemic collapse. Now the Obama Administration has to look at abandoning the debt standard (hyperinflation) and starting fresh.
The effect of the post-Roosevelt policies has been a slow-motion destruction of the U.S. dollar’s purchasing power since the gold standard was abandoned in 1933. The magnitude of purchasing power lost over the decades can be lost again in a matter of days.
Please note in the above table that gold and the Swiss franc were held constant by the gold standard versus coins in 1914 and 1933. The data are from the Federal Reserve Board, Bureau of Labor Statistics and from SGS data and calculations.
“Helicopter Ben” on Preventing Deflation. Federal Reserve Chairman Ben Bernanke picked up his various helicopter nicknames and references as the result of a November 21, 2002 speech he gave as a Fed Governor to the National Economists Club entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” The phrase that the now-Fed Chairman Bernanke likely wishes he had not used was a reference to “Milton Friedman’s famous ‘helicopter drop’ of money.”
Attempting to counter concerns of another Great Depression-style deflation, Bernanke explained in his remarks: “I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States …”
As expounded upon by Bernanke, “Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.”
“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” The full text of then-Fed Governor Bernanke’s remarks can be found at: Fed Report
Bernanke initiated his anti-deflation actions back in 2008, but they have not worked fully as advertised. While the systemic solvency crisis has been contained at least temporarily in key areas, and depositor funds have not suffered heavy losses, the broad money supply now is in monthly decline, soon to be year-to-year decline, but not yet in collapse. Back in September 2008, the Fed started dropping cash from helicopters, as shown in the graphs of the monetary base. As shown in the two graphs of level and year-to-year change, Bernanke’s spiking of the monetary was extraordinary and was without precedent. As seen in the recent renewed spike in the monetary base to historic levels, the Fed has been panicking anew. The fall-off in year-to-year growth is just due to year-ago comparisons where growth also was spiking sharply. Despite a still active fleet of choppers, systemic liquidity and solvency remain in deep trouble.
The monetary base remains the Federal Reserve’s primary tool for impacting money supply growth. As has been the case for the bulk of the extraordinary expansion of the monetary base since late-August 2008 — an increase of 129% — the monetary base growth, however, has not been reflected meaningfully in money supply growth. Such remains due to banks placing high levels of excess reserves with the Fed, instead of lending the funds into the normal flow of commerce.
The SGS-Ongoing M3 estimate (the Fed abandoned reporting its broadest money supply measure, M3, back in March 2006) has been contracting month-to-month for five months through November 2009, with annual growth slowing as shown in the M3 graph. M3 appears destined to turn negative year-to-year in December 2009, on both a nominal (as displayed in the graph) and inflation-adjusted basis. Such would be a leading indicator for an economic downturn in normal times and would foreshadow a significant turn for the worse in the current, severe economic contraction during first-half 2010. As discussed in the Money Supply Special Report, the Fed always can drive the economy into a downturn, with contracting money supply, but the reverse does not always work.
Inflation and Slowing/Contracting Money Growth. The Fed’s efforts at currency debasement have been reflected in a weakening of the U.S. dollar’s value in foreign exchange markets. In theory, though, slowing or outright contraction in broad money supply growth should be reflected in slower inflation or outright deflation. As with most economic theories, however, there often are simplifying assumptions that may not be appropriate under certain circumstances. Money supply, for example, works best as a predictor of inflation in a closed system, as was seen with Zimbabwe.
In the case of the United States, however, significant dollars are held outside the country, where shifting dynamics may have significant impact on U.S. inflation. To the extent that foreign holdings of U.S. dollars are in stasis, with demand and supply in balance, then the circumstances of the simplified money supply model tend to work. The dollar’s global position, though, is not in balance, particularly with the Fed working to debase the U.S. currency: to create inflation.
One distortion up front is in the U.S. currency in circulation, as reported in the narrowest money supply measure, M1. More than half of the $860 billion reflected in recent M1 reporting is physically outside the United States in “dollarized” countries and elsewhere.
Separately, as reported by the Fed in its second-quarter 2009 flow-of-funds analysis, foreign holders of U.S. assets have something in excess of $10 trillion in liquid dollar-denominated assets that could be dumped at will into the global and U.S. markets. In perspective, U.S. M3 is somewhat over $14 trillion.
Helping to fuel those holdings, the Fed has been using the excess reserves deposited with it by U.S. banks to buy troubled mortgage-backed securities from financially stressed institutions, and some of the institutions benefitting likely are located outside the United States.
As excess dollars get pumped into the global markets, a shift in the tide against the U.S. dollar gets reflected in a weakening exchange rate, which in turn spikes dollar-denominated commodity prices, such as oil. That effect has been seen in recent months, with the result that U.S. consumer inflation has started to resurface, not from strong economic demand and a surging domestic money supply, but from distended monetary policies and a global glut of dollars encouraged by the U.S. central bank.
Demand and supply affect the U.S. dollar. Supply soars and demand shrinks with the increasing unwillingness of major dollar holders to continue holding the existing volume of U.S. currency and dollar-denominated assets, let alone to absorb new exposure.
Therein lies a significant threat to near-term U.S. inflation. Heavy dumping of the U.S. dollar and dollar-denominated assets would be highly inflationary to U.S. consumer prices. It also likely would activate heavy Fed intervention in buying unwanted U.S. Treasuries. When the Fed moves to buy Treasuries as the lender of last resort — to monetize U.S. debt well beyond anything seen to date — that also would tend to trigger renewed growth in the otherwise flagging broad money growth.
In order to get the broad money supply to grow, the federal government has to spend and borrow more money, where the Fed will have to buy large quantities of the Treasury’s securities, monetizing the federal debt. The liquidity action to date has been primarily buying otherwise illiquid mortgage-backed securities off the balance sheets of troubled banks. The domestic banks in turn have leant substantial excess reserves back to the Fed, rather than lending into the normal stream of commerce, which would spike the money supply and otherwise be something of an economic positive.
The Fed remains the U.S. Treasury’s lender of last resort. Panicked dollar selling and dumping of dollar-denominated paper assets — particularly U.S. Treasuries — likely would force the Fed’s hand in a rapid monetizing of Treasury debt.
Early Impact of Dollar Debasement. The currency, oil and gold markets have seen extreme volatility in the last year or so. After seeing significant selling, the dollar soared during the breaking solvency crisis, due to massive manipulation and largely covert central bank intervention, position liquidations that required U.S. dollars and some surviving safe-haven status of the U.S. currency. In tandem with the dollar’s strength, oil and gold prices fell sharply.
Now, as reflected in the monthly average value of the U.S. dollar in Swiss francs, gains seen since the historic dollar low in early-2008 have evaporated. In turn, oil prices have rebounded from their recent lows, though they still are well shy of last year’s historic high. Reflecting the inflationary pressures from a weaker dollar and higher oil prices, ongoing solvency issues for the United States, and continued dollar debasement efforts by the Federal Reserve, the price of gold has recovered recent losses and is pushing new highs. Irrespective of any near-term volatility, both dollar weakness and gold strength remain solid long-term bets.
U.S. Government Cannot Cover Existing Obligations
The U.S. Treasury publishes annual financial statements of the United States Government, prepared using generally accepted accounting principles (GAAP), audited by the General Accountability Office (GAO) and signed off on by the U.S. Treasury Secretary. The 2009 statements, originally scheduled for publication this month, have been delayed to February 2010.
GAAP-accounting is what major U.S. corporations use. Such statements usually include liabilities for retired employees’ pensions and health care obligations. Yet, the Bush Administration (as likely will continue to be the case with the Obama Administration) argued that unfunded Social Security and Medicare obligations should remain off the government’s balance sheet, claiming that the government always has the option of changing the Social Security and Medicare programs. That said, there still is no political will in Washington to go public with the concept of eliminating or substantially cutting those programs.
The federal government’s GAAP-based financial statements show the actual annual fiscal deficit careening wildly out of control. Including the annual changes in the net present value of unfunded liabilities, the fully-GAAP-based annual 2008 deficit was $5.1 trillion dollars, versus the official cash-based $455 billion. The 2009 actual shortfall likely was around $8.8 trillion, instead of the official cash-based $1,417 billion. Again, the largest portion of GAAP-based versus the cash-based difference is in accounting for the net present value, and the year-to-year changes in same, for unfunded Social Security and Medicare liabilities, etc. The results are summarized in the accompanying table, showing various deficit, debt and obligation measures.
The government’s finances not only are out of control, but the actual deficit is not containable. Put into perspective, if the government were to raise taxes so as to seize 100% of all wages, salaries and corporate profits, it still would be showing an annual deficit using GAAP accounting on a consistent basis. In like manner, given current revenues, if it stopped spending every penny (including defense and homeland security) other than for Social Security and Medicare obligations, the government still would be showing an annual deficit. Further, the U.S. has no potential way to grow out of this shortfall.
As shown in the first of three graphs following the table, U.S. federal obligations are so huge versus the national GDP that the country’s finances look more like those of a banana republic than the world’s premiere financial power and home to the world’s primary reserve currency, the U.S. dollar. Total federal debt and obligations at the end of the 2009 fiscal year on September 30th, likely were close to $75 trillion, or more than five times total U.S. GDP. The $75 trillion includes roughly $12 trillion in gross federal debt, with the balance reflecting the net present value of unfunded obligations.
If not for the special position the United States holds in the world, its debt — U.S. Treasuries — likely would be rated as below investment grade, instead of triple-A. Major rating agencies have hinted at possible longer-term rating issues on Treasury securities.
A downgrade, though, is not likely, as long as U.S. Treasuries are denominated in U.S. dollars and as long as they are used as the benchmark for the triple-A rating. Such ratings usually are an opinion as to the risk of default. Treasuries denominated in U.S. dollars are not likely to face actual default, so long as the Treasury and Fed can create dollars to pay off the face amounts of the obligations. While a three-month Treasury at the moment may be safe, I would not want to bet on receiving anything close to full value on a 10-year Treasury note or 30-year Treasury bond.
As shown in the second of the three graphs, most U.S. Treasury issuance of recent years, thorough 2007, has been purchased by investors outside the United States. Not only have these investors been taking a hit in terms of the value of the U.S. dollar, but also they face meaningful devaluation risk in the near future.
As issuance has increased along with rising hesitancy in holding U.S. Treasuries, post-crises, the portion of new issuance covered by foreign investors has started to drop off sharply. Again, the Fed remains the buyer of last resort for U.S. Treasuries, and it has the ability to operate through surrogates at home and abroad.
The graph above gives some scope of as to the size of foreign held assets issued by the U.S. Treasury, or questionably guaranteed by it. They are among a pool of over $10 trillion dollars that could be dumped in a panicked dollar selling environment.
Part IV published tomorrow.
I extend by deep thanks to the various readers who have raised questions and provided ideas and material. As always, please feel free to offer your comments or raise your questions by e-mail to firstname.lastname@example.org.
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