Thursday, February 10, 2011

Is America Poised for a Hyperinflationary Event?

Article by: Michael Pollaro

It is a long standing proposition of many, supported on both theoretical and historical grounds, that one of the surest roads to hyperinflation is one grounded in a government whose answer to every economic and social problem is to borrow and spend the problem away, supported by central bank able, willing and ready to finance the effort.  That support is of course to simply print the money through which to buy the debt so issued by the government – what is euphemistically called monetizing the debt – thereby exploding the supply of money and eventually trashing its value.
So, given the extraordinary borrowing needs of the U.S. government, currently being supported by a Federal Reserve whose QE II asset purchase program is large enough to finance 100% of the government’s funding requirements through at least June, we thought we would take a look at the prospects for a hyperinflationary event in America.  And while we think hyperinflation – defined as the total destruction in the value of the U.S. dollar – is a low probability event, a lot, and we do mean a lot more monetary inflation most definitely is not.  You see, when you have a government that seems reluctant to change its borrow and spend policies in any meaningful way teamed up with a central bank chaired by a man who thinks that loose fiscal and monetary policies are the springboard for a downtrodden economy, you have a recipe for a whole heap of monetary inflation.  Indeed never has a U.S. central bank been chaired by a man who is more certain that loose fiscal and monetary policies are exactly what an economy mired in excess productive capacity and high unemployment requires to make things right.

Before we discuss the prospects for hyperinflation, some preliminaries…

First, U.S. government debt is being here defined as the debt of the U.S. Treasury plus the debt of the government-sponsored agencies Fannie Mae and Freddie Mac (popularly called agencies).  Inclusion of the latter may appear to be a bit of a stretch, but its inclusion in the U.S. government’s debt footings is obvious.  Creations of the U.S. government, these government-sponsored enterprises and their debt obligations have always been implicitly backed in varying forms by the full faith and credit of the U.S. Treasury, a backing made explicitly clear to any and all doubters when on December 24th 2009, in the depths of the credit crisis, the U.S. government gave the government-sponsored enterprises unlimited access to the Treasury essentially until further notice.  We wonder why anyone would have thought anything different, that when push came to shove the U.S. government would protect its own, make this implicit guarantee an explicit one and the debt of Fannie Mae and Freddie Mac the defacto debt of the U.S. government.

Second, it is common practice to measure a government’s burden on the economy by comparing the government’s debt to the nation’s productive output or GDP.  And while we agree that over the long haul it is a nation’s productive prowess that provides the means necessary to pay the government’s debt obligations, we think it is more instructive to compare those debt obligations to the nation’s savings.  You see, it’s a nation’s savings, its willingness to defer consumption that makes the government’s borrow and spend programs possible.  All other things equal, an economy that consumes much and saves little is an economy that cannot long afford a borrow and spend government.  The crucial question then in any proper examination of a government’s burden on the economy is this… is the nation’s pool of savings large enough to fund the government’s borrowing requirements, for how long and at what rate of interest?

Third, the Federal Reserve is not the only stateside institution that has the power to monetize the U.S. government’s debt.  Because of our government protected, fractional reserve banking system, they have a partner – the private banking system – which can and does buy U.S. treasury and agency securities, paying for those securities simply by crediting the bank accounts of the sellers.  That’s right, by printing money just like the Federal Reserve.

With those preliminaries dispensed, let’s get to the question at hand…

Is Hyperinflation coming to America?

Let’s start with a long term look at U.S. government borrowing and debt trends through 3Q 2010, the latest available data:

And now the trend in the U.S. government’s take of America’s net private savings (NPS):

In 1960, the first year of this study, the U.S. government was taking a mere 5% of the nation’s net private savings. It’s now taking the whole lot and then some, in 2009 setting a post WWII high of 3.4 times the nation’s savings.  At a trend take rate of 1.5 times the nation’s savings, the U.S. government debt burden is going in the wrong direction and fast.  Simply said, the U.S. government is overwhelming the capacity of American savers to fund the government’s borrow and spend programs.

Overwhelming the nation’s savings you say?  Then how do you explain this:

Good question.  If the U.S. government was truly overwhelming the nation’s savings then why is the interest rate on the benchmark 10-year treasury trading near historic lows?  While the answer to this question is a bit complicated, we think it has a lot to do with foreign creditors’ appetite for U.S. government debt:

Beginning in 1984, when the rate on the 10-year treasury was still testing historic highs, foreign creditors began stepping up their purchases of U.S. government debt.  In so doing, they’ve been an increasing source of funds for the U.S. government and a major reason for these historically low rates of interest.  From a low of roughly 10% in 1984, foreign creditors have taken their share of the U.S. government’s outstanding debt to 33%.  Indeed, since 1984 they’ve funded 35% of the U.S. government’s borrowing needs, and since 1995 an eye-popping 50%.  In no uncertain terms, they’ve given the U.S. government one heck of a helping hand.

Now, because foreign creditors have stepped into the financing mix in such a big way, the Federal Reserve hasn’t had too.  In fact, because of their help the Federal Reserve has been able to take an increasingly smaller amount of the government’s debt.  And private banks, they too have been backing away right along with the Federal Reserve.  With their Federal Reserve lender of last resort back-stops firmly in place, supported of course by the Federal Reserve’s printing press, they’ve simply had less and less need to hold low-yielding U.S. government debt as liquid reserves.

 Have a look:

The numbers say it all.  Federal Reserve plus private bank share of U.S. government debt outstanding has been on a steadily declining path since the late 1970s, from a high of 45% in 1977 to low of 15% in 2008, when the financial crisis and subsequent government bailouts finally forced the Federal Reserve to help fund the resultant spike in U.S. government debt.

Not a perfect mirror image of what foreign creditors have been doing, but we’d say pretty darn close:

So then, if the Federal Reserve and its private banking partners are not monetizing U.S. government debt, one can hardly say we have the seeds for an explosion in the supply of money, never mind a hyperinflationary event.

And as you would expect, the numbers bear it out:

This is not to say that America hasn’t seen some pretty impressive rates of growth in the money supply over these last 30 years.  But we think that growth rate is a far cry from what might have been if foreign creditors were not gobbling up the U.S. government’s debt at such voracious rates.  Indeed, a quick look at the monetization rates seen during the 1960s and 1970s, when foreign creditors were a far less important part of the government’s financing mix, suggests that we would have seen much, much higher rates of monetary inflation these past 30 years, and especially the last 15 years, if not for foreign creditors.

Returning to the question at hand, given the U.S. government’s proclivity to attack every economic and social issue with borrow and spend programs, is America poised for a hyperinflationary event, or if not hyperinflation enough monetary inflation to bring the U.S. dollar to the brink?   Well, as you might surmise, we think that’s going to have a lot to do with what foreign creditors do next, for a strong case can be made that without the help of foreign creditors; i.e., if they stopped buying U.S. government debt, or worse still began to sell, America is looking down the barrel of a loaded gun.

To better frame this question let’s posit the state of America without the help of foreign creditors.  What would we have…
  1. A deeply and increasingly indebted U.S. government, a government that even though it currently sports a total debt plus unfunded liability tab of some $130 trillion shows no pause in its borrow and spend policies; a government that borrows roughly 40 cents of every dollar it spends and worse still is currently peeling off about 20 cents of every tax dollar to pay the interest on its outstanding debt (even at these historically low interest rates); and a government that because of a savings-challenged America will be dependent on the money printing powers of the Federal Reserve and its private banking partners to not only fund its borrow and spend programs but to print enough money to keep interest rates from rising and exploding its entire budget.
  2. A Federal Reserve Chairman loathe to see interest rates rise – an event we think is a fait accompli if foreign creditors take their leave – and likely to buy as much government debt, to print whatever money necessary to keep interest rates in check.  And if all that monetization also helps fund a few government spending programs aimed at supporting what will sure to be a struggling economy as foreign funding exits, we’d bet he’d say so much the better.
  3. In the face of that struggling economy and resultant dearth of profitable investment opportunities and heightened liquidity concerns, a private banking system looking to buy safe, albeit lower yielding investments like U.S. government debt.  With essentially zero cost short-term money being provided to the banking system via the Federal Reserve’s QE programs, even low yielding U.S. government securities can provide fat profits to the banking system when they’re bought in size.
  4. Again, in the face of that struggling economy and in contrast to the current anti Federal Reserve ground swell, we think a U.S. government, supported by a restive and in many cases similarly indebted voting public, cheering the Federal Reserve Chairman on.  At least until the value of the U.S. dollar becomes a national issue.
As to the impact this will have on the supply of money, we’re thinking something analogous to a coiled spring.  Hyperinflation?  It’s possible, but we’re not so sure the power trust will take things that far, if only to save themselves.  But if foreign creditors exit, a whole heap of monetary inflation is virtually assured.
And what about those foreign creditors and the likelihood that they take their leave?  For several reasons, reasons which more and more appear to be coming to a head, we think they just might.  Not today, not tomorrow, but we think it’s coming.  Indeed, the recent moderation in foreign appetite for U.S. government debt these past two years juxtaposed against the surge in Federal Reserve monetization activities suggests it may already being starting.