Inflation Fears Are Overblown
The U.
S.
and global economies have been flooded with massive, unprecedented amounts of liquidity.
This is exactly what many economists have feared for years.
Namely, that under pressure central banks would abandon all monetary discipline and simply print money to avoid a depression.
It looks like they have done just that.
And it isn't just the United States that is guilty of running the money printing presses at full speed.
European governments have approved a $5.
3 trillion bank rescue package.
This is more than the $3.
3 trillion economy of Germany.
And it is on top of the billions of euros pumped into the economy by the European central bank.
China has also spent heavily on an economic stimulus package.
It is working, but M2 in China grew at a 26% rate in April 2009 and 25.
7% in May.
Clearly the global economy is awash with liquidity.
Now we will find out if all the fears about fiat or paper money are justified.
We will discover if the fiat money system works or breaks down in a burst of unwanted, uncontrollable inflation.
During the great depression of the 1930s the United States and other developed countries were on the gold standard.
The amount of paper money that could be printed depended on how much gold was in the treasury vaults.
Studies in the 1960s and 1970s indicated that the countries that came out of the depression first and enjoyed the best recoveries were those that either abandoned or quickly modified the gold standard.
Never-the-less the gold standard prevailed until world war two.
After the war it was modified and replaced by what is called the Bretton Woods Agreement.
That agreement established a regime for establishing exchange rates.
The agreement introduced exchange rate flexibility but gold remained the principal backing for paper money.
The 1960s became the stress test for the Bretton Woods Agreement and it failed.
In the early 1970s President Nixon was forced to cut the final link between gold and the U.
S.
dollar.
The greenback was then freely traded on the world's currency markets.
The dollar went down year after year for the rest of the decade.
And inflation rose, reaching double digits in the early 1980s.
Gold enthusiasts argued that the dollar's decline in the 1970s was proof that fiat money cannot work.
Their problem is that other currencies did not suffer the same fate.
Fiat money worked in other countries.
In recent years it has worked remarkably well in China.
The dollar's fall and the rise of U.
S.
inflation in the 1970s looks more like a political and economic failure by the United States rather than a true test of fiat money.
In the 1980s the dollar stabilized, inflation came down and economies around the world prospered.
We have been through the collapse of communist economies, an Asian currency crisis, a couple of stock market plunges, the arrival of fast growing emerging economies, the birth of the euro currency, Japan's lost decades, the banking crisis of the early 1990s, the tech stock bubble and other tests.
The U.
S.
and global economies did not just survive those tests they prospered.
At least we prospered until the current financial crisis.
Now all those previous crises seem minor in comparison.
This financial crisis literally took the global economy to the edge of the abyss.
We have had a near depression experience.
This therefore is the first truly major stress test for the fiat or paper money system.
Will flooding the U.
S.
and global economies with money work? Will this bring an end to the recession and jump start a sustainable recovery? Will the central bankers have the strength and political support to mop up the excess liquidity as economies recover? The problem for investors is that we won't have a definitive answer to the inflation question for two or three years.
Inflation is the biggest long term risk.
That was true before the near depression of 2008 and the injection of massive amounts of liquidity.
And it will be true for years to come.
Central bankers have successfully reduced liquidity and stopped inflation for the last couple of decades.
But the amounts this time are much greater.
Still, the odds favor the central bankers.
They will have fundamentals on their side for quite a while.
We have excess capacity in all corners of the world.
It will be years before supply and demand reach inflationary levels again.
This means the central bankers have time to reverse course, sell assets and raise interest rates.
There are two aspects of money and inflation, quantity and velocity or rate of turnover.
In the 1970s when Paul Volker became Fed chairman the biggest issue was the high velocity of money.
In those days the Fed's balance sheet was not swollen by lending and asset purchasing.
The task was to slow down the rate of monetary turnover.
The tool used was interest rates.
Significantly higher interest rates made borrowing expensive and savings rewarding.
The velocity of money slowed and the economy tipped into recession.
The situation today is very different.
The velocity of money is too slow.
The Fed has slashed short term interest rates, but bank lending is still subdued and cash is being hoarded even though it earns practically nothing.
Under these circumstances there is zero inflation risk from the velocity aspect.
In fact everyone would be happier if the velocity picked up.
That would signal a sustainable recovery.
The risk that is bothering markets and economists is from the quantity aspect.
The Fed has been pumping money into the system by making loans and buying assets.
The Fed's balance sheet is swollen to unprecedented proportions.
At some point the Fed will have to reverse course and significantly reduce the quantity of money or risk a significant rise in inflation.
Fear mongers make it seem that reducing the quantity of money without sending the economy back into recession is a herculean task.
They are wrong.
Recovery and reducing the quantity of money will go hand in hand.
To reduce the quantity of money the Fed reverses its policy.
Instead of buying the Fed will sell the assets it recently bought.
When the Fed sells it receives money.
Once back in the Fed's hand the money is out of the system.
This is a simplification.
The process of buying assets at the Fed has been complex.
It will likewise be a complex process as the Fed sells assets.
Leave the details to the Fed.
What we need to understand is the enormous difference this time.
The Fed has no intention of holding on to the assets it has acquired.
In fact the Fed has already begun selling assets and letting loans mature.
To finish the job and get the quantity of money back down the Fed needs a reasonable recovery and stable financial markets.
The end of recession and onset of recovery not only are not inflationary they create the conditions that will allow the Fed to reduce the quantity of money quickly.
Inflation will not become a major issue until the velocity of money rises to a much higher level.
Given all that has happened from cautious consumers to higher bank lending standards that is probably years away.
Of course there can always be mistakes made.
Inflation could become a problem in countries that do not reduce the quantity of money in their economy.
But the major players, the United States, Europe and Japan are well positioned to mop up excess liquidity and prevent inflation.
They are also well positioned to raise interest rates if the velocity of money rises too much.
Inflation is not a current threat to investors' finances.
Hyperinflation, the destruction of a nation's currency, is a political rather than an economic risk.
The key to preventing destructive inflation is an independent central bank that is free to use the necessary tools to prevent inflation.
Politicians can be tempted to print money and keep interest rates low to satisfy voters.
That is what the United States did in the 1970s.
It was a mistake that cost President Carter his bid for a second term.
The United States did not stay on the road to ever higher inflation in the 1970s.
People do not like high inflation or nasty recessions.
Politicians who do not resist the inflation temptations risk losing their jobs.
The bottom line is that neither inflation nor hyperinflation is a real current risk.
They are possibilities worth monitoring, but not grounds for developing a financial strategy.
S.
and global economies have been flooded with massive, unprecedented amounts of liquidity.
This is exactly what many economists have feared for years.
Namely, that under pressure central banks would abandon all monetary discipline and simply print money to avoid a depression.
It looks like they have done just that.
And it isn't just the United States that is guilty of running the money printing presses at full speed.
European governments have approved a $5.
3 trillion bank rescue package.
This is more than the $3.
3 trillion economy of Germany.
And it is on top of the billions of euros pumped into the economy by the European central bank.
China has also spent heavily on an economic stimulus package.
It is working, but M2 in China grew at a 26% rate in April 2009 and 25.
7% in May.
Clearly the global economy is awash with liquidity.
Now we will find out if all the fears about fiat or paper money are justified.
We will discover if the fiat money system works or breaks down in a burst of unwanted, uncontrollable inflation.
During the great depression of the 1930s the United States and other developed countries were on the gold standard.
The amount of paper money that could be printed depended on how much gold was in the treasury vaults.
Studies in the 1960s and 1970s indicated that the countries that came out of the depression first and enjoyed the best recoveries were those that either abandoned or quickly modified the gold standard.
Never-the-less the gold standard prevailed until world war two.
After the war it was modified and replaced by what is called the Bretton Woods Agreement.
That agreement established a regime for establishing exchange rates.
The agreement introduced exchange rate flexibility but gold remained the principal backing for paper money.
The 1960s became the stress test for the Bretton Woods Agreement and it failed.
In the early 1970s President Nixon was forced to cut the final link between gold and the U.
S.
dollar.
The greenback was then freely traded on the world's currency markets.
The dollar went down year after year for the rest of the decade.
And inflation rose, reaching double digits in the early 1980s.
Gold enthusiasts argued that the dollar's decline in the 1970s was proof that fiat money cannot work.
Their problem is that other currencies did not suffer the same fate.
Fiat money worked in other countries.
In recent years it has worked remarkably well in China.
The dollar's fall and the rise of U.
S.
inflation in the 1970s looks more like a political and economic failure by the United States rather than a true test of fiat money.
In the 1980s the dollar stabilized, inflation came down and economies around the world prospered.
We have been through the collapse of communist economies, an Asian currency crisis, a couple of stock market plunges, the arrival of fast growing emerging economies, the birth of the euro currency, Japan's lost decades, the banking crisis of the early 1990s, the tech stock bubble and other tests.
The U.
S.
and global economies did not just survive those tests they prospered.
At least we prospered until the current financial crisis.
Now all those previous crises seem minor in comparison.
This financial crisis literally took the global economy to the edge of the abyss.
We have had a near depression experience.
This therefore is the first truly major stress test for the fiat or paper money system.
Will flooding the U.
S.
and global economies with money work? Will this bring an end to the recession and jump start a sustainable recovery? Will the central bankers have the strength and political support to mop up the excess liquidity as economies recover? The problem for investors is that we won't have a definitive answer to the inflation question for two or three years.
Inflation is the biggest long term risk.
That was true before the near depression of 2008 and the injection of massive amounts of liquidity.
And it will be true for years to come.
Central bankers have successfully reduced liquidity and stopped inflation for the last couple of decades.
But the amounts this time are much greater.
Still, the odds favor the central bankers.
They will have fundamentals on their side for quite a while.
We have excess capacity in all corners of the world.
It will be years before supply and demand reach inflationary levels again.
This means the central bankers have time to reverse course, sell assets and raise interest rates.
There are two aspects of money and inflation, quantity and velocity or rate of turnover.
In the 1970s when Paul Volker became Fed chairman the biggest issue was the high velocity of money.
In those days the Fed's balance sheet was not swollen by lending and asset purchasing.
The task was to slow down the rate of monetary turnover.
The tool used was interest rates.
Significantly higher interest rates made borrowing expensive and savings rewarding.
The velocity of money slowed and the economy tipped into recession.
The situation today is very different.
The velocity of money is too slow.
The Fed has slashed short term interest rates, but bank lending is still subdued and cash is being hoarded even though it earns practically nothing.
Under these circumstances there is zero inflation risk from the velocity aspect.
In fact everyone would be happier if the velocity picked up.
That would signal a sustainable recovery.
The risk that is bothering markets and economists is from the quantity aspect.
The Fed has been pumping money into the system by making loans and buying assets.
The Fed's balance sheet is swollen to unprecedented proportions.
At some point the Fed will have to reverse course and significantly reduce the quantity of money or risk a significant rise in inflation.
Fear mongers make it seem that reducing the quantity of money without sending the economy back into recession is a herculean task.
They are wrong.
Recovery and reducing the quantity of money will go hand in hand.
To reduce the quantity of money the Fed reverses its policy.
Instead of buying the Fed will sell the assets it recently bought.
When the Fed sells it receives money.
Once back in the Fed's hand the money is out of the system.
This is a simplification.
The process of buying assets at the Fed has been complex.
It will likewise be a complex process as the Fed sells assets.
Leave the details to the Fed.
What we need to understand is the enormous difference this time.
The Fed has no intention of holding on to the assets it has acquired.
In fact the Fed has already begun selling assets and letting loans mature.
To finish the job and get the quantity of money back down the Fed needs a reasonable recovery and stable financial markets.
The end of recession and onset of recovery not only are not inflationary they create the conditions that will allow the Fed to reduce the quantity of money quickly.
Inflation will not become a major issue until the velocity of money rises to a much higher level.
Given all that has happened from cautious consumers to higher bank lending standards that is probably years away.
Of course there can always be mistakes made.
Inflation could become a problem in countries that do not reduce the quantity of money in their economy.
But the major players, the United States, Europe and Japan are well positioned to mop up excess liquidity and prevent inflation.
They are also well positioned to raise interest rates if the velocity of money rises too much.
Inflation is not a current threat to investors' finances.
Hyperinflation, the destruction of a nation's currency, is a political rather than an economic risk.
The key to preventing destructive inflation is an independent central bank that is free to use the necessary tools to prevent inflation.
Politicians can be tempted to print money and keep interest rates low to satisfy voters.
That is what the United States did in the 1970s.
It was a mistake that cost President Carter his bid for a second term.
The United States did not stay on the road to ever higher inflation in the 1970s.
People do not like high inflation or nasty recessions.
Politicians who do not resist the inflation temptations risk losing their jobs.
The bottom line is that neither inflation nor hyperinflation is a real current risk.
They are possibilities worth monitoring, but not grounds for developing a financial strategy.
