Wednesday, October 20, 2010

Where Is The Hyperinflationary Tipping Point?

With all the money printing going on at the Fed, why is the Fed having trouble creating inflation in the economy?

One of the reasons is that asset values are rapidly declining. This leads to a collapse in available sources of consumer credit. For instance, now that home values have fallen, home equity lines are not available. Existing lines are gradually being paid down or defaulted on.

Fed liquidity programs such as TARP, which swaps cash for mortgage backed securities, is going into equities and not into new loans. It also seems to be about the only liquidity entering the system. The rest of the liquidity sits on the bank balance sheets, unable to find a home in an asset bubble. Bank lending needs an asset bubble to get into the economy because Banks are too conservative to lend like venture capitalists. They only really want to lend against assets, which are all falling in price due to the aftermath of the once great asset bubble. Since banks only want to lend against assets, decreased collateral values means decreased credit.

SO where is all this going? Bernanke will buy treasuries forever and the interest on the national debt will slowly drift higher until exactly what happens? What is the proper equivalent economic situation? Is it the Weimar hyperinflation, as so many pundits state? No, Weimar owed its debt to external creditors in foreign currency and its economy was largely destroyed by the French occupying the industrial region of Germany after non-payment of reparations.

The equivalent is actually Argentina in the 80s. Why?

* Excess government debt denominated in local currency
* No Currency Controls (Yet)
* Functioning, but inefficient economy
* Reasonably politically stable.

There's a great postmortem on all this over at the World Bank:

Public Sector
"Debt Distress" in Argentina, 1988-89

The most interesting parts of the paper:

6. common characteristicsof the Primavera and B8 Plans.

Many observers noted the parallels with the Primavera Plan
even at the outset of the BB Plan, and there are evident
retrospective parallels. Both failed because they sought to
stabilize a macroeconomy burdened with excessive, and exces-
sively expensive, public-sector debt by having the public sector
take on more debt. The architects of both plans were fully
aware of the contradiction:they felt their only hope of avert-
ing public-sector bankruptcy was to borrow time at high interest
rates, win sufficient confidence to bring down the interest
rates, and then carry out structural reforms quickly enough to
enable the public sector to pay the interest and, ultimately,
the principal.

The orders of magnitude of the aggregates involved made
this approach dauntingly difficult. With monthly interest rates
on the order of 5 per cent, domestic debt totalling US$7 bil-
lion, and monthly GDP running at US$5 to $6 billion, the monthly
interest bill of US$350 million was 6 to 7 per cent of GDP.

Even after the massive devaluation and public-sector price in-
creases of July 1989, the non-interest public-sector surplus was
barely positive at best. It may have reached 2 or 3 per cent of
CDP in November 1989. An additional increase of 3 or 4 percent-
age points in the non-interest surplus -- whether through ex-
penditure reductions or tax increases -- would have strained the
economy severely at a moment when it was emerging from the dis-
array induced by the hyperinflation. Even if successfully im-
plemented, such fiscal improvements might have had short-term
contractionary consequences so sharp that they might have dimin-
ished private saving, which might in turn have inc.reased
domes-tic interest rates. (The peculiar hydraulics of Argentina's
macroeconomy made this possible: demand for broad money depended
positijvel on interest rates and the public sector itself was
heavily indebted at high interest rates.)

Interest-rate determination in the Primavera and
BB Plan contexts clearly operated rather differently from usual.
In conventional settings, borrowers and lenders presumably come
to market with real "reservation"interest rates based on their
propensities to borrow and lend, then negotiate nomii4a!
rates by taking account of exogenous anticipated
reserva-tion interest
inflation. In a financial system as open as Argentina's, lend-
ers' opportunity cost is governed by anticipated devaluation and
external interest rates.
High interest rates induce private
lenders to ration, because high rates make borrowers more likely
to default. Where the public sector owes the debt, however, the
nature of the market changes. A public sector can promise any
nominal interest rate as long as it has unquestioned capacity to
inflate. Knowing this, private lenders can demand any interest
rate from the public sector they collectively wish. The public
sector can place debt at any interest rate the market demands,
effectively financing the interest by placing additional debt.

6.4. As Argentina's public sector borrowed from the private
sector, a perverse distress cycle resulted. The public sector
rolled over its loans and borrowed increasing amounts from the
private sector to pay the private sector its interest; the pub-
lic sector then borrowed still more to service still more debt.
A regressive transfer resulted, from inflation- and convention-
al-tax payers to lenders. The process finally broke down be-
cause the capitalization of interest rapidly increased lenders'
portfolio holdings of austral-denominated assets: once they
elected to balance their portfolios by acquiring more foreign
exchange, they bid down the value of the austral and bid up in-
terest rates. At this point, higher interest rates could only
increase anticipated exchange-rate depreciation. In such cir-
cumstances, financial-market participants, observing higher in-
terest rates, are apt to conclude that the Government will soon-
er or later have to inflate to pay the interest, that everyone
else's inflation expectations are rising on similar reasoning,
and that hers or his should therefore rise as well.

In Argentina, when monthly interest hit between 6 and 7 percent of GDP, money started moving into foreign exchange very quickly causing a currency devaluation downward spiral.

Since money won't rush into Yuan because its pegged and the Chinese currency is not convertible, where will it rush into? Gold? Commodities? A Europe with raised interest rates? At some point though, there is going to be so much money being made passively on U.S Treasury interest that it won't be capable of being recycled into the U.S economy and will start to flow out to foreign exchange and into foreign property(?) and stock market bubbles.

Perhaps at some point, taxes and commodity prices will get so high that imports will slow to a trickle and the entire velocity of money will be absorbed in paying interest and non-discretionary budget items on the national debt. The fed will be buying all treasuries at negligible interest rates. Now what? Well then you might start to see a carry trade further weakening the dollar, but this isn't really the kind of thing that gets out of hand. It's more likely to create a long slow deflationary misery of the trajectory that Japan followed as the domestic market is starved for debt as the banks look to engage in the carry trade.

Over the following years, the yield on U.S assets continues to fall and investment money goes elsewhere as the long slow slog of wage and asset deflation and business decline continues. The other countries will handle the rise in commodity prices better because they are far more efficient per dollar of GDP. This will continue until production costs eventually equalize, which could be never, at least with how much debt there is to service.