Note: This post is intended for an audience for whom it is obvious that we are fast approaching the end game of the dollar collapse.
The question of the day is how will it all end? Are we going to enter a deflationary era a la the UK and Japan when their economies collapsed? Or have the printing presses been charged up too much that a hyperinflationary collapse a la the Weimar Republic is the only option? Deflationary collapse or hyperinflationary collapse – that’s the question. That there will be a collapse is quite obvious to anyone with some grounding in the Austrian school of thought.
Introduction
The world is awash in debt, with debt being used to buy debt, and further used as collateral to buy still more debt. The Federal Reserve currency notes, those physical dollars you hold in your hand, represent a debt obligation of the Fed. When you deposit those notes in your bank account, you become an unsecured creditor of the bank. That’s the first two levels of the debt pyramid. Those deposits are borrowed by other individuals, to fund a four-year long party at a resortcollege education, home purchase, credit card purchase etc. That’s debt level three. These loans are then securitized and sold to financial institutions worldwide, mostly pension funds or asset management firms. Ideally, that should mark an end to the debt pyramid, but it doesn’t happen that way.
The securitized loans are used as collateral by traders who borrow money to speculate on these and other debt instruments. This is called leveraging, and adds another layer of debt called margin debt. On top of this, traders speculate on debt instruments without even having to purchase them, on the futures and options market. As these represent claims on the underlying asset, it is a higher level of debt, and the one which is most vulnerable to price fluctuations of the underlying asset`. These go under the term derivatives.
So, to recap, the different levels of debt are:
Level 1: The Federal Reserve currency note
Level 2: Bank Deposits
Level 3: Retail loans (securitized)
Level 4: Margin Debt
Level 5: Derivatives
The funding, in the accounting books, for all these layers of debt comes from accounting entries made by the banking system and the central bank, through a system known as fractional reserve banking. Under this system, debt can be used as collateral to fund still more debt. The higher the level, the greater the pyramiding possibilities.
The Debt Pyramid
Follow the Money
In America’s Great Depression, Murray Rothbard analyses the money supply in that period in terms of controlled factors and uncontrolled factors. The controlled factors are under the control of the Federal Reserve, the uncontrolled factors are not. It’s easy to spot the movement of the controlled factors of the money supply.
QE, QE and more QE
Bernanke has fired up the printing presses and added assets to the Fed’s balance sheet in response to the 2008 crisis (GFC). Also, the borrowing costs from the banking system have been lowered thanks to the zero interest rate policy (ZIRP). How do these controlled factors impact the debt pyramid?
Market Reaction to the GFC
As the asset bubble in real estate burst, many homeowners went underwater. Simultaneously, the labour market underwent a drastic change as the rate of unemployment, especially among young college graduates, shot up. This pricked the student loan bubble. These are obvious examples of uncontrolled factors.
To predict what comes next, we should simply follow the money accounting for both sets of factors.
My Analysis
I’ll break this up into different parts addressing different factors. It is quite impossible to predict their interplay and know with any degree of certainty what will happen.
The retail debt market
Debt matures. If old debt is not replaced with new debt as it matures, the retail debt market will shrink. As the value of the collateral shrinks, so will margin debt and derivatives. However, the caveat here is that debt instruments are sensitive to interest rates. ZIRP would have made some debt more valuable. Nevertheless, debt must be retired and as the rate of growth in consumer credit is not keeping pace with maturing debt, the retail debt market will shrink. Also, the debt obligations which will not be honoured have to be written down, adding to the shrinkage.
Government bonds
All government spending is consumption. Therefore, we can say with confidence that government spending leads to price inflation, which will be most likely to manifest itself in the sectors where the spending goes to. The price inflation need not be seen in absolute terms; economic theory tells us that prices will be higher than they would otherwise have been.
The Fed purchase of government bonds props up this price inflation. With the Fed adding to the demand for government bonds, it is causing a price inflation in the bond market too. We can call this the bond market bubble.
Mortgage bonds
Banks hold a lot of toxic MBS, which, if marked-to-market, would result in several bankruptcies. To prevent this, they are using the newly created reserves to shore up their capital so that they can withstand the debt write-off which is inevitable. This points to slower retail loan growth. At close to zero interest rates, lending is no longer profitable for the banks and is not worth the risk. We can therefore predict a slowdown in the retail loan market (and predict the growth of check cashing services).
Institutional debt
With the value of collateral increased due to the Fed’s actions, institutions are in a position to take on greater levels of margin debt for trading. They are also well positioned to profit from derivatives.
Firms which are yield-hungry to fund liabilities such as pensions, annuities etc. need to embrace riskier options as yields have plummeted. This buoys up the equity market, which has already got a boost from lower discount rates on future cash flows. Hence, the stock market bubble.
Corporate debt
With the availability of cheap financing, corporates can issue junk bonds to finance acquisitions. They can also take on debt for share buybacks, netting investors a better return (debt is a cheaper source of financing than equity) and pushing up stock prices further.
We can now take a look at scenarios involving changes in the controlled factors.
QE in all its forms ends
It is inevitable that yields will start rising as the government keeps adding debt to fund its deficit but the demand drops off. Coupled with the de-dollarization of the world, this would accelerate the dollar collapse. If yield rises to 18% as it did under Volcker, the US govt will be effectively bankrupt. On top of this, the bond price drop would seriously dent the asset value of the Social Security Fund, and the problem with meeting the unfunded liabilities will be revealed. A stock market drinking the QE Kool-Aid will also be brought back to Earth and the highly leveraged financial institutions sitting on a combined quadrillion dollars of derivatives won’t like it one bit.
Therefore, it is impossible that QE will end, and the markets will remain calm, unless….
Extend maturity of debt
As proposed in an IMF paper, the US government can simply declare that 30-day T-bills will be converted into 30-year T-Bonds, by executive order. This will halt the collapse temporarily, but would also cause investors worldwide to drop T-bonds like hot potatoes. The Fed would have to start monetizing the debt if the government is to continue on this deficit financing spree.
Which means, it is impossible for QE to well and truly end. Hello, hyperinflation?
Seize pension funds
Already tried by Poland, Argentina etc. The risk is that once done, capital will leave faster than you can say Jack Robinson.
Bank bail-in/deposit tax
Same problem as above. Cannot work unless…
Impose Capital Controls
We’re already there. FATCA is capital control, a penning of the sheep for the shearing. Coupled with making relinquishment/renunciation of citizenship an onerous process and hitting the ones who go through with it with an exit tax, the framework is already in place.
So it is quite possible that a pension fund seizure or bank deposit seizure will take place.
All this still doesn’t tell us whether the dollar is going to enter hyperinflation or there is going to be a deflationary collapse. Let’s take a look at the conditions necessary for hyperinflation to occur.
1. People should lose faith in the value of the dollar
Need to watch out to see how far the de-dollarization of world commerce continues, and whether Russia and China act to dump Treasuries. Even then, Empires don’t go out with a bang but with a whimper, so this would be a long drawn-out process. And several weaker currencies would collapse along the way, boosting the dollar with their dying breaths, as a tribute to King Dollar
2. Inflation -> Mass inflation -> Hyper-inflation
The entire process took 10 years in Germany, and the US is a bigger economy with a vastly different geopolitical landscape than Germany was at that time. This would indicate that massive money printing led hyperinflation will be several years in the making and the signs should show up in the obvious places. So far, QE has merely offset the deflation a normal collapse would have wrought
3. Bond market collapse and bank failures
This would probably increase the demand for mattress safes and physical cash rather than collapse the currency. People need to lose faith in the currency, not in the banking system or the government. Also, such a collapse might spur increased saving and boost the demand for dollars
To sum up, the conditions necessary for hyperinflation to occur don’t seem to be manifesting themselves. We now turn to conditions necessary for deflation to occur.
1. Stop printing
A debt based monetary system has only two practical choices – expansion of the money supply, or contraction of the money supply. The former produces inflation and the latter produces deflation. The third choice, a stable money supply, would imply the creation of new debt to offset the retirement of old debt and no more. With debt of differing maturities contracted in the market, an uncontrolled factor for the Federal Reserve, this is an option we can remove from our analysis
A collapse is inherently deflationary, as the value of debt is marked down. Any collapse in the market will usher in deflation, unless it is counteracted by fresh infusions of credit. This was the situation faced by the Fed in 2008, and they responded with massive money printing. So far, they have averted deflation. As deflation increases the real value of government debt, making it harder to repay, and takes some of the sting off taxes, it is not politically convenient
For deflation to happen, credit creation should not exceed credit contraction. There is some evidence that this is actually the case. Banks have been reluctant to lend even after the Fed infused funds into the banking system post-2008. It may be that with close to zero interest rates, lending is no longer attractive for banks. This is a deflationary force which is already playing out
2. Liquidate debt
Forced liquidation due to insolvency would be deflationary. Given the amount of distortion in the financial markets, this seems a possibility. Any explosion in the derivatives market could move this from possibility to reality
The score seems to be in favour of a deflationary collapse.
Implications
There is room for yields to fall further
Cash is king – investors will move from risky assets to cash since cash will adequately safeguard purchasing power
Real interest rates will once again enter positive territory, affecting PV calculations. Financial assets dependent on cheap money will be in for a shock
Commodities: typically tends to fall as the currency strengthens, with the notable exception of the 1930s