Posted August 2010 -
Hyperinflation: What It Will Look Like (Gonzalo Lira)
Essentially,
I argued that Treasury bonds are the New and Improved Toxic Assets. I
argued that, if there was a run on Treasuries, the Federal
Reserve—in its anti-deflationary zeal, and its efforts to prop up bond
market prices—would over-react, and set off a run on commodities. This, I
argued, would trigger hyperinflation.
People aren’t blind or stupid, even if they often act that
way. People are worried—they’re worried about the current state of
affairs: Massive quantitative easing,
toxic assets replaced by the full faith and credit of the U.S. government
in the shape of Treasuries,
fiscal debt which cannot possibly be repaid,
a second leg down in the Global Depression that
seems endless and only getting worse—people are
scared.
However, there were two issues that many readers had
a hard time wrapping their minds around, with regards to a
hyperinflationary event:
The first was, Where does all the money come from, for
hyperinflation to happen? The question wasn’t
put as baldly as that—it was wrapped up in sophisticated discussions about
M1, M2 and M3 money supply, as well as clever talk about the velocity of
money—the acceleration of money—the anti-lock brakes on money. There were
even equations thrown around, for good measure.
But stripped of all the high-falutin’ language, the question was, “Where’s
all the dough gonna come from?” After all, as we know from our history
books, hyperinflation involves people hoisting bundles and bundles of
high-denomination bills which aren’t worth a damn, and tossing them into
the chimney—’cause the bundles of cash are cheaper than firewood. If the
dollar were to crash, where would all these bundles of $100 bills come
from?
The second question was, Why will commodities rise,
while equities, real estate and other assets fall?
In other words, if there is an old fashioned run on a currency—in this
case, the dollar, the world’s reserve currency—why would people get out of
the dollar into commodities only, rather than into equities and real
estate and other assets?
Apart from what happened with the Weimar Republic in
the 1920’s, advanced Western economies have no experience with
hyperinflation. (I actually think that the
high inflation that struck the dollar in the 1970’s, and which was
successfully choked off by Paul Volcker, was in fact an incipient bout of
commodity-driven hyperinflation—but that’s for some other time.) Though
there were plenty of hyperinflationary events in the XIX century and
before, after the Weimar experience, the advanced economies learned their
lesson—and learned it so well, in fact, that it’s been forgotten.
However, my personal history gives me a slight edge in this
discussion: During the 1970's–’73, Chile experienced
hyperinflation, brought about by the failed and corrupt policies of
Salvador Allende and his Popular Unity Government. Though I was
too young to experience it first hand, my family and some of my older
friends have vivid memories of the Allende period—vivid memories that are
actually closer to nightmares.
The causes of Chile’s hyperinflation forty years ago were
vastly different from what I believe will cause American hyperinflation
now. But a slight detour through this history is useful to our current
predicament.
To begin: In 1970, Salvador Allende was elected president by roughly a
third of the population. The other two-thirds voted for the centrist
Christian Democrat candidate, or for the center-right candidate in roughly
equal measure. Allende’s election was a fluke.
He wasn’t a centrist, no matter what the current hagiography might claim:
Allende was a hard-core Socialist, who headed a Hard Left coalition called
the Unidad Popular—the Popular Unity (UP, pronounced “oo-peh”). This
coalition—Socialists, Communists, and assorted Left parties—took over the
administration of the country, and quickly implemented several “reforms”,
which were designed to “put Chile on the road to Socialism”.
Land was expropriated—often by force—and given to the workers.
Companies and mines were also nationalized,
and also given to the workers. Of course, the farms, companies and mines
which were stripped from their owners weren’t inefficient or ineptly
run—on the contrary, Allende and his Unidad Popular thugs stole farms,
companies and mines from precisely the “blood-thirsty Capitalists” who
best treated their workers, and who were the most fair towards them.
Allende’s government also put UP-loyalists in management positions in
those nationalized enterprises—a first step towards implementing a
Leninist regime, whereby the UP would have “political control” over the
means of production and distribution. From speeches and his actions, it’s
clear that Allende wanted to implement a Maoist-Leninist regime, with
himself as Supreme Leader.
One of the key policy initiative Allende
carried out was wage and price controls. In
order to appease and co-opt the workers, Allende’s regime simultaneously
froze prices of basic goods and services, and augmented wages by decree.
At first, this measure worked like a charm: Workers had more money, but
goods and services still had the same old low prices. So workers were
happy with Allende: They went on a shopping spree—and rapidly emptied
stores and warehouses of consumer goods and basic products. Allende and
the UP Government then claimed it was right-wing, anti-Revolutionary
“acaparadores”—hoarders—who were keeping consumer goods from the workers.
Right.
Meanwhile, private companies—forced to raise worker
wages while maintaining their same price structures—quickly went bankrupt:
So then, of course, they were taken over by the Allende government, “in
the name of the people”. Key industries were put on the State dole, as it
were, and made to continue their operations at a loss, so as to satisfy
internal demand. If there was a cash shortfall, the Allende government
would simply print more escudos and give them to the now State-controlled
companies, which would then pay the workers.
This is how hyperinflation started in Chile. Workers
had plenty of cash in hand—but it was useless, because there were no goods
to buy.
So Allende’s government quickly instituted the Juntas de Abastecimiento y
Control de Precios (“Unions of Supply and Price Controls”, known as JAP).
These were locally formed boards, composed of loyal Party members, who
decided who in a given neighborhood received consumer products, and who
did not. Naturally, other UP-loyalists had preference—these Allende
backers received ration cards, with which to buy consumer goods and basic
staples.
Of course, those people perceived as “unfriendly” to Allende and the UP
Government either received insufficient rations for their families, or no
rations at all, if they were vocally opposed to the Allende regime and its
policies.
Very quickly, a black market in goods and staples
arose. At first, these black markets
accepted escudos. But with each passing month, more and more
escudos were printed into circulation by the Allende government, until by
late ’72, black marketeers were no longer accepting escudos. Their mantra
became, “Sólo dólares”: Only dollars.
Hyperinflation had arrived in Chile.
(Most Chileans, myself included, find ourselves both amused and irritated,
whenever Americans self-righteously claim that Nixon ruined Chile’s
economy, and thereby derailed Allende’s “Socialist dream”. Yes, according
to Kissinger’s memoirs, Nixon did in fact tell the CIA that he wanted
Chile’s economy to “scream”—but Allende did such a bang-up job of fucking
up Chile’s economy all on his own that, by the time Richard Helms got
around to implementing his puissant little plots against the Chilean
economy, there was not much left to ruin.)
One of the effects of Chile’s
hyperinflation was the collapse in asset prices.
This would seem counterintuitive. After all, if the
prices of consumer goods and basic staples are rising in a
hyperinflationary environment, then asset prices should rise as
well—right? Equities should rise in price—since more money is chasing
after the same number of stock. Real estate prices should rise also—and
for the same reason. Right?
Actually, wrong—and for a simple reason: Once basic
necessities are unmet, and remain unmet for a sustained period of time,
any asset will be willingly and instantly sacrificed, in order to meet
that basic need.
To put it in simple terms: If you were dying of
thirst in the middle of the desert, would you give up your family heirloom
diamonds, in exchange for a gallon of water? The answer is obvious—yes.
You would sacrifice anything and everything—instantly—in order to meet
your basic needs, or those of your family.
So as the situation in Chile deteriorated in ’72 and into ’73, the stock
market collapsed, the housing market collapsed—everything collapsed, as
people either cashed out of their assets in order to buy basic goods and
staples on the black market, or cashed out so as to leave the country
altogether. No asset class was safe, from this sell-off—it was
across-the-board, and total.
Now let’s return to the possibility of hyperinflation in
the United States:
If there were a sudden
collapse in the Treasury bond market, I argued that sellers would take
their cash and put them into commodities. My reasoning was,
they would seek a sure store of value. If Treasury bonds ceased to be that
store of value, then people would invest in the next best thing, which
would be commodities, especially precious and industrial metals, as well
as oil—in other words, non-perishable commodities.
Some people argued this point with me. They argued many different
approaches to the problem, but essentially, it all boiled down to the
argument that commodities and precious metals have no intrinsic value.
Actually, I think they’re right. In a strict sense, only oxygen, food and
water have intrinsic value to human beings—everything else is superfluous.
Therefore the value of everything else is arbitrary.
Yet both gold and silver have, historically, been considered valuable.
Setting aside a theoretical or mathematical construct that would justify
the value of gold and silver, look at it from a practical standpoint: If I
went to a farmer with five ounces of silver, would he give me a sack of
grain? Probably. If I offered him an ounce of gold for two or three pigs,
would he give them to me? Again, probably.
Where there is a human society, there is a need to exchange. Where there
is a need to exchange, a medium of exchange will soon appear. Gold and
silver (and copper and brass and other metals) have served that purpose
for literally millennia, but then they were replaced by paper.
Right now, there are two forms of paper currency: Actual dollars, and
Treasury bonds. One is a medium of exchange, the other a store of value.
If Treasuries—the store of value—were to collapse in price, and the
Fed—as I predict—tried everything in its power to at least initially prop
up their prices, would those sellers who managed to get out of Treasuries
in time then turn around and invest in even dodgier bits of paper, like
stocks? Or REIT’s? Or even precious metal ETF’s?
No they would not: They would get out of Treasuries—supposedly the
“safest” investment there is—and get into something even safer—something
even more tangible: Actual commodities. Not ETF’s, not even
futures (or anything else that entails counterparty risk)—sellers of
Treasuries would get into actual, hard commodities. Because if suddenly
even the safest of all investment vehicles is now unsafe, do you really
want to get behind the wheel of an even more unsafe vehicle, like stocks
or corporate bonds or ETF’s? I mean, c’mon: If Treasuries crash, what else
might crash?
That’s why people in a Treasury panic would buy commodities. This
ballooning of non-perishable commodities would be as a means to store
value. Because that’s what people do in a panic—they batten down
the hatches, and go into what’s safest. When the stock markets tanked in
the Fall of ’08, where did all that sellers’ cash go? To
Treasuries—because it was then considered the safest store of value.
Commodities suffered in comparison—gold took a bit of a hit, as did the
other precious metals—but Treasuries ballooned as the equities markets
tanked.
But if Treasuries—the ultimate store of value—now tanked? If the last
sure-thing in paper-based stores of value took a hit, where would people
go to both store value, and have ready access to that value?
Commodities. And this rush to commodities, I argued, would trigger
hyperinflation.
Now, I said I would answer two questions—one was why commodities would
outpace all other asset classes in a Treasury panic and subsequent
hyperinflation. The other question was, “Where’s all the dough to feed my
fireplace gonna come from, in a hyperinflationary event?”
The first wave of dollars in a hyperinflationary event will come from
people’s savings accounts.
If Treasuries tank, and the markets all barrel into commodities, then
prices will rise for regular consumers—this should not be a controversial
inference. What would consumers do, with suddenly much higher gas prices,
and soon much higher food prices? Simple: They’ll bust open their piggy
banks, whatsoever those piggy banks might happen to be: 401(k)s, whatever
equities they might have, etc.
But if the higher consumer prices continue—or become worse—what will
happen to the 320 million American consumers? They’ll start buying more
gas now, rather than wait around for tomorrow—and the market will react to
this. How? Two way: Prices of commodities will rise even further—and asset
prices will fall even lower.
Again, the man in the desert, the diamonds, and the water: If American
consumers are getting hit at the gas station and the supermarket, they’ll
start selling everything so as to buy gas, heating oil (most especially)
and foodstuffs. The Treasury panic will thus be transferred to the average
consumer—from Wall Street to Main Street by way of $15 a gallon gas
prices, and $10 a gallon heating oil prices.
All other consumer prices would soon follow the leads of gas, heating oil
and food.
In the above bit of Chilean history, I described how the Allende
government printed up escudos to make up for the shortfall in nationalized
businesses that was produced by their policy of hiking wages, while at the
same time fixing prices.
This is a completely different way to hyperinflation than the way I
envision it for the American economy—but once the American economy gets
there, the effects of hyperinflation will be exactly the same: People will
try to get out of assets in order to get hold of commodities. To get all
eccy about it, money velocity would approach infinity, as money supply
remains (at first) fixed, yet in the panic over commodities, aggregate
demand as measured by aggregate transactions goes vertical.
Would there be Federal government intervention of some sort? Most
definitely—people would be screaming for it. Would food rationing be
implemented? Probably, and probably by way of the current Food Stamps
program. Troops on the streets, protecting gas stations and supermarkets?
Curfews to prevent looting? Palliative dollar printing? Yes, yes, and very
likely yes.
That last bit—palliative dollar-printing: That’s the key. When
palliative dollar-printing happens, it will be the final stages of
hyperinflation—it’s when sensible people ought to realize that the crisis
is almost over, and that a new normal will soon appear. But this stage
will be fucking awful.
Palliative dollar printing will take place when the Federal government
simply runs out of options. Smart economists will get on CNBC and argue
that, “The velocity of money is destroying the economy—we must expand the
currency base!” It’ll sound logical, but palliative money-printing will be
a policy option born out of panic. The final policy option. It won’t be
done for evil conspiratorial reasons—always remember Aphorism #6 (“Never
ascribe to malice what can be explained by incompetence.”). It’ll be
carried out because of fear and panic.
A whole boatload of fools in Washington, on seeing this terrible
commodity-driven crisis unfold, with consumer prices shooting the moon,
will scream for dollars to be printed—and their rationale will be
perfectly reasonable, I can practically hear it now: “We've got to get
cash into the hands of the average American citizen, so he or she can buy
food and heating oil for their families! We can’t let Americans starve and
freeze to death!”
Palliative money-printing will take place—hence the average American
family will likely be using bundles of $100 bills to fire up the chimney
that hyperinflationary winter.
Hoo-Ah.
Now, this fairly Apocalyptic scenario is simultaneously horrifying, and
exciting as all get out. Hell, why do you think disaster movies are so
popular? Shit blowing up is way cool! That's why Roland Emmerich gets paid
the big bucks, God bless ‘im.
But for sensible people,
Apocalypse is a distraction—it’s not the main event. For sensible people
who want to be prepared, Apocalypse represents opportunities.
A true story: In ’73, at the height of the Allende-created
hyperinflation, an uncle of mine, who was then a college student, was
offered an apartment in exchange for his car. That’s right—an apartment.
He owned a crappy little Fiat 147—a POS if ever there was such a thing—but
cars in Chile in the middle of that hyperinflation were so scarce, and
considered so valuable, that he was offered an apartment in exchange. To
this day, my uncle still tells the story—with deep regret, because he
didn’t follow through on the offer: “That Fiat was in the junkyard by ’78,
but that apartment still stands! And today it’s worth nearly a half a
million dollars!” Actually, I think it’s worth a bit more than that.
Another true story: A banker friend of mine manages the assets of a
fabulously wealthy 70-something gentleman, whom I'll call Alfredo. In
1973, Don Alfredo was a youngish man, just starting out, with a degree in
engineering but no money—until he inherited US$3,000 from a deceased aunt.
Alfredo realized that the $3,000 were in a sense worthless: He couldn’t
buy anything with them, and it wasn’t enough for him to leave the country
and start over someplace else. After all, even then, $3,000 was not that
much money.
So he took those $3,000, went down to the stock exchange, and spent all
of it on Chilean blue-chip companies: Mining companies, chemical
companies, paper companies, and so on. The stock were selling for
nothing—less than penny stock—because of the disastrous policies of the
Allende government. His stock broker at the time told him not to buy
stocks, as Allende’s government, it was thought, would soon nationalize
these companies as well.
Alfredo ignored his broker, and went ahead with the stock purchases: He
spent all of his $3,000 on buckets of near-worthless equities.
On September 11, 1973, the commanders in chief of the four branches of the
Chilean military staged a coup d’état. Within a year, Alfredo’s stock had
rebounded about ten-fold. Since then, they’ve multiplied several
thousand-fold—yes: Several thousand-fold. Don Alfredo has lived off of
that $3,000 investment ever since—it’s what made him a multi-millionare
today.
He realized, of course, that either those blue-chip companies would be
nationalized by Allende—in which case he would lose all his $3,000
inheritance, which really wouldn’t change his fortunes very much—or
somehow a new normal would arrive in Chile. Since the $3,000 couldn’t buy
him anything, he took a gamble—and won.
What do these two true stories tell us? Simple: Buy when there’s blood on
the streets.
That’s Baron de Rothschild’s famous line—but it hides a key insight, one
which should be highlighted perhaps even more forcefully than the line
itself:
Even in the midst of Apocalypse, things will get better.
That’s something people don’t quite seem to understand. In fact, it’s why
teenagers tragically kill themselves over some girl or boy: They don’t
realize that, no matter how bad things are now, they will get better
later. To repeat:
Even in the midst of Apocalypse, things will get better.
I’m not repeating this insight as an empty comfort to my readers—I’m
saying it as a trading strategy. When things are at their crazy worst,
when everyone believes the Apocalypse is well nigh here, that’s when thing
are about to turn for the better. This applies to every
situation—including and most especially in a hyperinflationary situation.
Why? Simple: Because hyperinflation—by definition—cannot last.
Because people need a stable medium of exchange. So if the
currency goes up in flames in a hyperinflationary fire, of course there
will be a period of terrifying instability—but it will pass. Either the
currency will be repaired somehow (as Volcker repaired the dollar back in
1980–’82). Or the currency will be completely and irrevocably trashed—and
then be replaced by something else. Because—to insist—people need a stable
medium of exchange.
If Treasuries tank and commodities shoot up so high that they essentially
break the dollar, civilization will not come crashing down into anarchy.
At worst, there’ll be a three-four years of hell—economic hell. Financial
hell. But then things will settle down into a new normal.
This new normal might well have unsavory characteristics. I tend to be a
pessimist, and just glancing through history, I can see that just about
every period of hyperinflation has been stabilized by some subsequent form
of autocratic or totalitarian government. The United States currently has
all the legal decisions and practical devices to quickly transition into
an authoritarian or totalitarian regime, should a crisis befall the
nation: The so-called PATRIOT Acts, the Department of Homeland Security
Agency, the practical suspension of habeas corpus, etc., etc.
But as I said in my previous post, and reiterate here: Speculations about
the new normal are pointless at this time. The future will happen soon
enough.
What I do know is, One, a hyperinflationary event will happen,
following the crash in Treasuries. Two, commodities will be the go-to
medium for value storage. Three, all asset classes will collapse in short
order. And Four—and most importantly—civil society will not collapse along
with the dollar. Civil society will stumble about like a drunken sailor,
but eventually right itself and carry on with a new normal.
During that stumble, opportunities will present themselves....
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