Today In Silver

In a recent post called Peter Schiff Was Wrong, Mike Shedlock (Mish) of SitkaPacific Capital Management takes fellow money manager Peter Schiff to task for getting just one thing right in the past year, that the U.S. stock markets would crash. Schiff, however, apparently did not pursue a short play against the U.S. equities but rather put his clients into long investments in foreign stocks and commodities, which have actually fared worse. Mish goes on to lay into Schiff quite brutally and I’d say he seems to be right for the most part except when he starts to lecture about hyperinflation.

Far from future hyperinflation, claims Mish, we (I assume he means the U.S. but perhaps he is including the whole world) are actually in the midst of undeniable deflation that will continue for perhaps another 10 years. To support this, Mish points out the economy sure looks, feels, walks and talks like there is deflation. Also, the bottom is very far down because the top was very far up. Various articles and charts are trotted out to demonstrate this. And yet I’m not convinced. Maybe it’s because these arguments are too sensical, as if purpose-built for consensus. Let’s take a closer look.

First, we’ll point out that Mish bolsters his case using an analysis he did early last December based on stale Federal Reserve data. According to Mish, the chart of the St. Louis Fed’s Base Money Change % From a Year Ago shows that the current increase in monetary base is not a big deal compared to the Great Depression. Unfortunately, his chart is a bit dated as it represents Fed activity only through October, which is just a few weeks after things started to unravel. Mish may wish to look at the updated version of the chart to see if the current expansion in the monetary base has historical precedent (click to enlarge):

Clearly this is not your average liquidity operation, even by Great Depression standards. The real question of course is whether or not the current spike will be offset by a spike in the opposite direction. To answer that, I think one need only look at the result of the reversal in monetary base expansion during the 1930’s, which likely contributed to a second recession that extended the Great Depression another few years.

Next, let us examine Mish’s claim that banks are contracting credit. Mish sure looks to be on solid ground with this one based on everything we read and hear, but it turns out that M1 actually grew at a seasonally adjusted rate of 39.6% between September and December 2008 and M2 grew at a pace of 18.4%. I’m not paying attention to M3 since it is not a major component of bank credit expansion but I’ll wager it has been growing at a healthy clip as well. Thus, banks might very well be tightening credit in some sectors but they are still lending on a net basis.

Moreover, Mish is adamant that the $800 billion of bank reserves currently held in the system (still being kept aloft by the updraft of Bernanke’s helicopter rotor) will never get loaned because banks will get as ridiculously stingy with their lending at the bottom as they got ridiculously generous at the top. While this might be one of the neatest economic theories based purely on symmetry that I have yet to run across, I wouldn’t count on it happening for the simple reason that it ignores the cumulative effect of government bailouts and guarantees. When something is infinitely elastic like government spending, it is unreasonable to expect normal distributions and reversions to the mean. The bottom line is that banks will enthusiastically lend at positive interest when they effectively have zero capital at risk, which is a condition that can be easily achieved via government interference.

Note that at a reserve ratio of 10%, $800 billion of bank reserves can be fractionally multiplied into $8 trillion of credit and new money supply at the M1 and M2 levels. The Fed may try to put its foot down well before that happens but it could be too late if the monetary expansion is already snowballing by then. In addition, the Fed will find it quite difficult to “sterilize” the excess bank reserves because it will soon be  forced to start buying U.S. Treasuries in order to cap long-term interest rates.

Perhaps Mish hasn’t heard that the federal budget deficit will be something like $1 trillion this year? If China, Japan and other big exporters were in great shape they might perhaps continue their recent pace of buying a few hundred billion dollars of Treasuries every year. But we are talking trillions here and the export “tigers” simply don’t have the dollar reserves to swallow that much Treasury paper.

Maybe the Fed and Treasury can hold out until June, July or even later, but at some point in the next few months they will have to start running the printing press. We aren’t talking helicopters here either; printing press money gets the job done immediately. Under these circumstances it is preposterous to think that the Fed will be able to maintain control over $800 billion of bank reserves.

What I’m describing above  is of course a template for hyperinflation. No, not Zimbabwe or Weimar hyperinflation but something still quite serious — like entrenched double digit annual price increases with periodic spikes (perhaps reaching triple digits) capped by sequential and increasingly ineffective price controls. This will be more severe than the late 1970s since neither interest rates nor monetary contraction will be available as policy tools.

Now please don’t get me wrong, I’m not saying the U.S. dollar will collapse to zero as Peter Schiff and many others claim. I do, however, think that it could break down to the .5200 level on the Dollar Index especially if depressed worldwide economic conditions and inflationary pressures spark a global race to devalue currencies. This could take the shape of very unusual looking “trade wars”: instead of imposing punitive tariffs or embargoes, trading partners would aggressively seek to buy the cheapest goods from each other. This may result in export quotas erected to make sure that critical supplies are adequate for domestic markets but I would expect global trade to still expand overall. Such “trade wars” would be quite effective in devaluing currencies while also offsetting some of the resultant inflationary effects on import prices.

Ultimately, the relative weakness of the U.S. dollar in the years ahead will not reflect poorer economic conditions in the U.S. compared to the rest of the world — I expect the U.S. will actually start to recover sooner than most other countries — but rather the massive amount of debt owed by Americans. A substantial portion of this debt is foreign owned. It cannot be serviced under the original terms. It cannot be defaulted upon as long as the U.S. dollar remains the world’s reserve currency. Therefore it will need to be “inflated away”. I’m fairly certain the little men behind the curtain are all too aware of this reality, even if they won’t admit it. Even if Mish won’t admit it.

silverax Windbag Wisdom