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Thursday, June 02, 2011

Is hyperinflation coming?

Some say yes. Shadowstats.com has a March 2011 report titled "Hyperinflation Special Report." It states:

"GAAP-based (generally accepted accounting principles) accounting then showed total federal obligations at $50 trillion—more than four-times the level of U.S. GDP—that were increasing each year by GAAP-based annual deficits in the uncontainable four- to five-trillion dollar range.  Those extreme operating shortfalls continue unabated, with total federal obligations at $76 trillion—more than five-times U.S. GDP—at the end of the 2010 fiscal year.  Taxes cannot be raised enough to bring the GAAP-based deficit into balance, and the political will in Washington is lacking to cut government spending severely, particularly in terms of the necessary slashing of unfunded liabilities in government social programs such as Social Security and Medicare."

Even if our government taxed every penny of wealth of every citizen in the nation, it wouldn't meet this obligation, estimated at $70 trillion. And even if all Americans were willing to go to work for the government without getting paid, to pay off our national debt, we know this would just encourage further spending sprees by those in Congress.

I'd heard that even if the incomes of everyone in the United States making over $100,000 were seized, taxed at 100%, it still wouldn't cover the budget deficit for this year at $1.6 trillion.

Propping up the Ponzi

The vast amount of money owed isn't a problem if the Fed simply buys up the government's debt, using freshly minted (or created into existence digitally) dollars.

The Treasuries that the Federal Reserve buy allows Fedgov to keep on functioning, despite the huge gap between tax receipts and expenditures. The gap is growing as receipts decline, due to massive tax breaks, and expenditures increase due to unfunded wars and "entitlements."

The scheme does break down when interest rates go up, or a sovereign debt downgrade happens. In their debate Tuesday over extending the debt ceiling, some members of Congress actually cited the S&P's reports on the possibility of a reduction in our nation's credit ranking, an event which would overnight make borrowing much more expensive.

If a debtor, even the size of our government, has too much debt then its creditors will react. Most often lenders demand more interest income in exchange for accepting the higher risk level associated with government debt.

If interest rates for government debt go up, other forms of debt issued by the private sector must necessarily go up. The reason for this effect is simple: if the government can print money to pay back its creditors, there's no credit risk at all. In reality, no matter how much debt Fedgov sells, it can simply print up the cash when they mature. On the other hand private corporations and states must actually accumulate the revenue by which they pay back their bondholders.

The relationship between the Fed and the banks creates a negative status quo, allowing the US government to borrow far more than other debtors ever could, given the total amount owed and questionable ability to pay it back, except through printing it. The method that allows the borrowing to continue unabated is when bond proceeds are rolled over, reinvested in the new debt.

Purchasers of US government bonds often use maturing AAA Treasuries and agency debt to buy newly issued AAA government debt. This replenishment function allows the debtor to keep borrowing, and disguising to the creditor his dependency.

The creditor in this situation becomes co-dependent, nurturing the debtor's habit to the point they feel obligated to continue to invest in Treasuries, or else bad things can happen. Of course there's the possibility that a financial entity choosing to cash out could be "Lehman'ed" or denied the privilege of borrowing new money from the Federal Reserve. Keep funding government through purchases of its debt--whatever its attractiveness--and your place at the trough will remain assured.

Another risk inherent in cutting off the debt addict is the possibility that the entire debt could become worthless, a write-off. As it is, the tax receipts drawn through the government offer enough to pay off the interest. US government borrowing in this respect is an interest-only proposition, as the total amount of debt--revalued to net present value--exceeds the ability of the US to repay.

Bad debts considered good

One way to cope that a lender can cope with debts that can't be repaid is to deny it. The best example of this might be from Japan's banks. From the beginning of the so-called Lost Decade, Japanese banks steadfastly refused to write off bad debt they were owed, largely from established clients in with huge investments in soured commercial real estate.

Rather than cut off their clients, the banks opted to preserve relations--a euphemism for looking the other way. It was easier on the bank's strained balance sheets to maintain the presumption that the bad loans weren't bad. If the loans were revalued to their market value, the losses would impact the banks' profit and loss statements and their stock market performance.

In some cases the banks went so far as to actually make new loans to their existing clients no matter what their creditworthiness. Better to preserve the illusion that their biggest clients were the best than to put into question the quantity of debt they'd lent, an issue that would reflect very poorly on the bank.

Relationship banking, with a price

Why is the Japanese example so important? An image-conscious industry, banks in particular are prone to bury their losses and misrepresent the credit quality of their holdings when it helps them. This is especially true for mortgage-backed securities. If the houses can't be sold for anything near their stated value, the banks have to recognize massive losses. Instead, it's easier to hide the scope of mortgage credit quality decline, and far more prudent as home mortgages provide the bulk of a bank's collateral. To qualify for government assistance, banks need to make home loans. The more mortgages a bank has on its books, the more it can borrow, then lend.

Home loans made in the past--many with a lack of caution--need to be preserved on the banks' books or they lose their chief source of collateral that allows them to draw more capital from the Federal Reserve and federal lending programs. Naturally, when the values of the mortgages unwind, so too does the stability of the bank's overall portfolio, as it needs to maintain a certain percentage of its outstanding loans in cash, a task made hard-to-impossible when the banks' main source of capital--mortgages--are constantly losing value.

This fear of marking-to-market may explain why banks are content to keep mortgages locked down rather than offer them for resale at prices far lower than the original mortgage, a process that would require them to recognize their losses. And considering the capital that they draw on from each mortgage may be levered nine or ten times, the amount of outstanding loans are vulnerable to capital requirements. According to the federal lending scheme, once the collateral banks use to borrow--the mortgages they lend--drop in value, vast portions of a bank's lending portfolio must be reevaluated based on the risk once the underlying collateral dissipates.

Banks borrow. Without that ability, they couldn't make money, especially in a declining real estate market like ours today or Japan's in the recent past. So it's the mechanism--a scheme really--that allows banks to borrow using mortgages as collateral that continues to threaten the economy.

Any effort to stimulate spending by loaning more to the banks has actually done nothing to help the economic recovery. Quantitative easing has failed to produce real economic gains; it may however have stymied even worse outcomes than slow growth we're now seeing in the U.S..

One big reason for the failure of so much easing to stimulate the economy is that the stimulus isn't getting into the hands of spenders. Nor is it going in to the purchase of new homes--new home starts have declined, there are fewer buyers as well. Where did the money go? To balance the books of the banks. The need to recapitalize was based on a decline in the real value of their mortgage holdings. With mortgages worth so much less, banks could only absorb the cash to cover tightening loan loss provisions--requirements imposed on banks in times of a deteriorating credit environment.

Back in the roaring mid-00's, Freddie and Fannie had no problem pumping vast sums into the mortgage market through the banks. Housing values were climbing, demand was higher, as evidenced by the number of starts. People were working and able to buy more house (more than they could afford in many cases.)

That all changed when the housing market went bust. To make matters worse, the decline of the financial economy meant the real economy went with it. Housing, you see, isn't just another industry; it's a bell weather of the general economy. Look around you and see how many people worked in housing at the peak of the bubble. Many are currently unemployed--most seem to have left the new home construction business permanently.

Of course the damage to the real economy carried over to the banks, who saw profits on mortgage-backed securities turn sour, and even worse, many of these debt instruments were/are impossible to value and thus illiquid, at least until Bernanke and the Fed agreed to accept them in exchange for AAA Treasuries, in what was a outright transfer of risk from the private sector to the public.

Of course all that crap the banks pawned off on the Federal Reserve is toxic. Just like the commercial real estate debt that the Japanese banks carried, the MBSs were concealed from public view, where the public or bank shareholders might give pause to what they were told about their valuations.

And now the Federal Reserve has to keep buying government debt to manage the completely unsustainable deficit. The mortgage securities they bought at the height of the financial crisis languish deep in some Federal Reserve vault, unable to be sold and thus unable to be valued.

An asset of indeterminate value is worth far less than a low price, meaning that the Fed and everyone concerned would be better off--although not in the short run--to open their books to the world and create a market for all the MBSs where price levels can be determined. Otherwise the motive to obfuscate will continue, and weaken the Federal Reserve's fiscal condition.

Finding religion

One area where help could be bestowed on this process is through the nomination of Harvard professor Elizabeth Warren to a post of power, a move which the Republicans and Wall Street have vigorously resisted. By putting Warren in charge of at least some of the much-needed regulatory reform, a new precedent concerning transparency can be set.

Without creating a means to sell these depreciated securities, the assets on which they're based, the houses themselves, become illiquid. Foreclosures become questionable. Even the banks' own MERS computer system can't identify the paper trail establishing rightful legal ownership of property. Apparently during the boom years, everyone was in too much of a hurry to actually follow proper procedure, as determined as so many issuers of the original mortgages were to sell them off. So vast numbers of mortgages were bundled then sold to anyone who'd buy them.

Now, trying to reestablish who actually owns the properties has become uncertain in many cases. Besides, since the mortgages are bundled and distributed to different buyers, no single security holder can claim exclusive ownership of any single property. Legally trying to foreclose can therefore become a thorny issue.

All the while Fedgov has done all it can to insulate the banks from excessive risk-taking and borrowing during the boom years. Of course, handouts from the Federal Reserve (which found their way into the central bank of Libya no less) just encourage more risky behaviors. Rather than punish those who took too much risk, the consequences are mollified, undoubtedly encouraging more poor decisions by bankers and more systemic risk as all those bankers start swapping derivatives among themselves, thereby allowing new bubbles to be created for short-term profit--precisely the problem that got us into the 2008-9 mess.

How can it not happen again? How can the perfect storm come apart? It's possible to make our dollars stronger if enough of them are destroyed. If housing gets bad enough, and homes lose value, it's possible to shrink the money supply--a phenomena that just happened. Money--or, to be more accurate, bank credits--actually disappear, making the dollars out there worth more, a deflationary happening. Couple the drooping housing prices with broad unemployment and you have a recipe not for inflation but deflation.

The other side

Mike Shedlock, writing in The Market Oracle, makes a compelling case that hyperinflation isn't happening, nor will it any time soon in his article "Hyperinflation Nonsense Continues."

Among his many salient points, Shedlock explains that "Currencies are fungible" thus it doesn't matter what currency countries want to trade in. Dollars are worth in other currencies what they're worth and the dollars don't need to be actually held. With financial transactions occurring simultaneously the only consideration of whether to trade in dollars or not is the cost of exchanging them for local currency.

Hyperinflationists might add that if the US dollar is constantly losing value it doesn't make sense to hold a stash of dollars but rather use the dollar for the purpose of calculating cross-currency transactions only. In this regard, it doesn't matter what the dollar is worth persay, only what it's worth at any given time.

In this respect the dollar isn't so much an international reserve currency as a entry field on a calculator.

Mr. Shedlock goes on to quote monthly CPI using the government's figures--a proposition that got me going to shadowstats, above. The numbers appearing there are quite different than the government's on everything from unemployment to GDP. Shedlock criticizes high inflation expectations, while ignoring the fact that the government can avoid billions by understating CPI, due to the higher yields it'd be forced to pay on its TIPS, not to mention Social Security COLA increases. Evidence of motive to understate inflation isn't the same as understating inflation but it isn't a leap...

The real meat of the issue is whether economic activity slows enough to forestall the massive devaluation of our currency. If housing values collapse far enough, the total measure of money shrinks. We saw this on the upside in the housing market when money supply increased as housing supply increased. Home loans allowed the increase in values to increase the money supply. The same mechanism works in reverse: when housing bottoms, people own less, and they can't borrow. Capital dries up.

Shedlock makes the point that the loss of so much capital will "act as an economic drag for a long time." If for instance people are deeply enough in debt, without jobs, or with mortgages of declining value, neither an increase in available credit nor increased government borrowing/spending will be enough to cause hyperinflation.

Shedlock ascribes hyperinflation to political forces not economic ones. He may be right but I think the Austrian school is correct when it states that Washington, D.C. is increasingly the central focus of our economy. With the federal government hiring so many, increasingly the American people's economic future is tied to the efficacy of government borrowing operations. To finance the unsustainable, Fedgov turns to the Federal Reserve and banks.

Paradoxically, it's the bankers and overseas creditors who might force fiscal discipline on Washington. By forcing Fedgov to pay interest on what it borrow, the value of the dollar might be preserved and hyperinflation downgraded to mere inflation. The IRS taxing scheme was set up to allow the US to pay its debts off. Without taxes, a Lincoln-era greenback might become the money of the land, a currency issued directly by Congress that bears no interest. So the banking constituency provides a constraint on federal spending. The interest rate mechanism of course means the more Fedgov borrows, the more interest its lenders make. Yet without interest, the borrowing could go on ad nauseum, kind of like it does today, with near-zero interest rates propelling the spending spree.

Chances are, until interest rates rise and punish the borrowers, fiscal restraint is impossible. In this respect, financing federal spending through the private Federal Reserve cartel may yet offer some protection to the value of our money. Even so, I'd say that the shock created by spending cuts--"starving the beast"--will bring sufficient social turmoil capable of generating a political force capable of bringing rise to hyperinflation. Once the people realize Medicare and Social Security cuts are coming, they'll look for scapegoats. Above all, politicians will for political reasons avoid the backlash and spend freely, essentially bribing the voter.

Now as even Mr. Shedlock agrees, the economic damage create by political turbulence provides a more likely source of hyperinflation. At that time, it won't matter whether or not hyperinflation has begun. It will only matter if it's too late to salvage the empire's currency, once the empire has no more credit nor the political will to make the sacrifices necessary to stop spending too much. Printing money will simply become the great political expedient.


Recent comments at OpEdNews.com are here and here, with the latter being about the Executive branch power grab.

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