Hyperinflation Part IV: Great Depression Coming

November 12, 2010

Part IV of IV by Walter J. (John) Williams

Even with the government’s spending, debt and obligations running far beyond the ability of the government to cover with taxes or the political willingness of the government to cut entitlement spending, the inevitable inflationary collapse, based solely on these funding needs, possibly could have been pushed well into the next decade. Yet, the printing presses already are running, and the Fed is working actively to debase the U.S. dollar. Actions already taken to contain the systemic solvency crisis and to stimulate the economy, plus the ongoing devastating impact of a severe economic contraction on tax revenues, have set the stage for a much earlier crisis. Risks are high for the hyperinflation beginning to break in the year ahead; it likely cannot be avoided beyond 2014.

It is this environment of rapid fiscal deterioration and related massive funding needs, the U.S. dollar remains open to a rapid and massive decline and to the dumping of U.S. Treasuries. The Federal Reserve would be forced to monetize significant sums of Treasury debt, triggering the early phases of a monetary inflation. Under such circumstance multi-trillion dollar deficits rapidly would feed into a vicious, self-feeding cycle of currency debasement and hyperinflation.

Lack of Physical Cash. The United States in a hyperinflation would experience the quick disappearance of cash as we know it. In Zimbabwe, there was the back-up of a well-functioning black market in U.S. dollars, but no such back-up exists in the United States. Shy of the rapid introduction of a new currency and/or the highly problematic adaptation of the current electronic commerce system to new pricing realities, a barter system is the most likely circumstance to evolve for regular commerce. Such would make much of the current electronic commerce system useless and add to what would become an ongoing economic implosion. It also could take a number of months to become reasonably functional.

Some years back, I happened to be in San Francisco, having dinner with a former regional Federal Reserve Bank president and the chief economist for a large Midwestern bank. Market rumors that day had been that there was a run on a major bank in the City by the Bay. So I queried the regional Fed president as to what would be happening if the rumors were true.

He had had some personal experience with a run on banks in his region and explained how the Fed had a special team designed to handle such a crisis. The biggest problem he had had was getting adequate cash to the troubled banks to cover depositors, having to fly cash in by helicopters to meet the local cash flow needs.

The troubled bank in San Francisco, however, was much larger than the example cited, and the former Fed bank president speculated that there was not enough cash in the vaults of the regional Federal Reserve Bank, let alone the entire Federal Reserve System, to cover a true run on deposits at the major bank.

Therein lies an early problem for a system headed into hyperinflation: adequate currency. Where the Fed may hold roughly $200 billion in currency outside of roughly $50 billion in commercial bank vault cash, the bulk of roughly $860 billion in currency outside the banks is not in the United States. Back in 2000, the Fed estimated that 50% to 70% of U.S. dollar cash was outside the system. That number probably is higher today, with perhaps as little as $250 billion in physical cash in circulation in the United States, or roughly 1.7% of M3. The rest of the dollars are used elsewhere in the world as a store of wealth, or as an alternate currency free of the woes of unstable domestic financial conditions. Those conditions would change severely in the event of a U.S. hyperinflation.

Given the extremely rapid debasement of the larger denomination notes, with limited physical cash in the system, existing currency would disappear quickly as a hyperinflation broke.

For the system to continuing functioning in anything close to a normal manner, the government would have to produce rapidly an extraordinary amount of new cash, and electronic commerce would have to be able to adjust to rapidly changing prices.

In terms of cash, new bills of much higher denominations would be needed, but production lead time is a problem. Conspiracy theories of recent years have suggested the U.S. Government already has printed a new currency of red-colored bills, intended for some dual internal and external U.S. dollar system. If such indeed were the case, then there might be a store of “new dollars” that could be released at a 1-to-1,000,000 ratio, or whatever ratio was needed to make the new currency meaningful, but such would not resolve any long-term problems — as seen in the multiple Zimbabwe devaluations — unless it was part of an overall restructuring of the domestic and global financial and currency systems and unless the U.S. government could put its fiscal house in order.

From a practical standpoint, however, currency would disappear, at least for a period of time in the early period of a hyperinflation.

Where the vast bulk of today’s money is not physical, but electronic, however, chances of the system adapting there are virtually nil. Think of the time, work and effort that went into preparing computer systems for Y2K, or even problems with the recent early shift to daylight savings time. Systems would have to be adjusted for variable, rather than fixed pricing, credit card lines would need to be expanded daily, the number of digits used in tallying dollar-denominated transactions would need to be expanded sharply. I have had assurances from some in the computer field that a number of businesses have accounting software that can handled any number of digits.

From a practical standpoint, though, the electronic quasi-cashless society of today likely also would shut down early in a hyperinflation. Unfortunately, this circumstance rapidly would exacerbate an ongoing economic collapse.

Barter System. With standard currency and electronic payment systems non-functional, commerce quickly would devolve into black markets for goods and services and a barter system. Gold and silver both are likely to retain real value and would be exchangeable for goods and services. Silver would help provide smaller change for less costly transactions. One individual I met indicated that he had found airline bottles of scotch to be ideal small change in a hyperinflationary environment.

Other items that would be highly barterable would include bottles of liquor or wine, or canned goods, for example. Similar items that have a long shelf life can be stocked in advance of the problem, and otherwise would be consumable if the terrible inflation never came. Separately, individuals, such as doctors and carpenters, who provide broadly useable services, already have services to barter.

A note of caution was raised once by one of my old economics professors, who had spent part of his childhood living in a barter economy. He told a story of how his father had traded a shirt for a can of sardines. The father decided to open the can and eat the sardines, but he found the sardines had gone bad. Nonetheless, the canned sardines had taken on a monetary value.

Howard J. Ruff, who has been writing about these problems and issues since Nixon closed the Gold window, rightly argues that it will take some time for a barter system to be established, and suggests that individuals should build up a six-month store of goods to cover themselves and their families in the difficult times. Such is within the scope of normal disaster planning in some areas of the country (for example, I sit almost on top of the Hayward Fault).

Financial Hedges. During these times, safety and liquidity remain key concerns for investments, as investors look to preserve their assets and wealth through what are going to be close to the most difficult of times. Those who can preserve their wealth and maintain liquidity will have the ability to take advantage of extraordinary investment opportunities after the crises pass.

Gold and Silver. In a hyperinflation, gold and silver would be primary hedging tools that would retain real value and also be portable in the event of possible civil turmoil. At some point, the failure of the world’s primary reserve currency will lead to the structuring of a new global currency system. I would not be surprised to find gold as part of the new system, structured in there in an effort to sell the new system to the public.

Real Estate. Real estate also would provide a basic inflation hedge, but it lacks the portability and liquidity of gold. That could become an issue if the political environment shifted so radically that ownership of private property became impossible.

Currencies. Having some funds invested offshore — outside of the U.S. dollar — would be a plus in circumstances where the government might impose currency or capital controls. I look at the Swiss franc, the Canadian dollar and the Australian dollar as currencies likely to maintain their purchasing power against the U.S. dollar. Any suggestions here in terms of currencies, gold and silver, etc. are for holding same over the long term. Near-term price volatility remains a risk in most markets.

Taking on Debt. Inflation is supposed to be the debtor’s friend, where debtors, like the U.S. government, end up paying off their obligations in cheap dollars. A note of caution is offered here. The current circumstances are extraordinary. Borrowers should consider their ability to carry debt through extremely difficult economic times, including possible loss of employment, etc., before high inflation might kick in. Consider, too, the U.S. government recently has intervened in altering terms and conditions of mortgages. Could a radical political change end up recasting the terms of personal obligations?

TIPS. The U.S. Treasury offers securities where yields and principal get adjusted regularly for the rate of inflation. In a hyperinflation, price changes can be so rapid that the principal and/or yield adjustment would lag enough so as to make the adjustments worthless. The reporting lag in calculating the adjusting CPI index — if it even could be calculated — still would wipe out investors, unless the Treasury became particularly creative and began benchmarking to spot gold or such, but nothing like that is in place.

As to the potential rapidity of price change, consider some anecdotal evidence. One story out of Weimar Germany involved buying an expensive bottle of wine for dinner. The empty bottle was worth more as scrap glass the next morning than it had been worth as a full bottle of wine the night before. Anther story involved negotiating the price and paying for a meal, before sitting down, as the price of the meal would be higher by the time it was finished.

Equities. While equities do provide something of an inflation hedge — revenues and profits get expressed in current dollars — they also reflect underlying economic and political fundamentals. I still look for U.S. stocks to take an ultimate 90% hit, peak-to-trough, net of inflation, during this period. Where all stocks are tied to a certain extent to the broad market — to the way investors are valuing equities — such a large hit on the broad market will tend to have a dampening effect on nearly all equity prices, irrespective of the quality of a given company or a given industry.

The following graph shows the year-end Dow Jones Industrial Average in current terms, as well as adjusted for SGS-Alternate Consumer Inflation. While stocks may rally based on high inflation, in inflation-adjusted terms, a bear market remains a good shot. An early-hyperinflation DJIA at 100,000 could be worth 1,500 in today’s terms.

Closing Comments

Other Issues. A hyperinflationary great depression would be extremely disruptive to the lives, businesses and economic welfare of most individuals. Such severe economic pain could lead to extreme political change and/or civil unrest. What has been discussed here remains well shy of a comprehensive overview of all possible issues, but rather at least has raised some questions and touched upon some likely consequences. No one can figure out better than you the peculiarities of this circumstance and how you, your family and/or your business might be affected. Using common sense remains the best advice I can give.

These matters will continue to be expanded upon in SGS Commentaries, as circumstances and subscriber reactions dictate.

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 johnwilliams@shadowstats.com.

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