Letter Re: Currency Inflation Expectations for the US

You recently wrote: “The Treasury will undoubtedly be forced to monetize a good portion of the National Debt. This is effectively creating money out of thin air. Each new dollar so created will dilute the purchasing power of the dollars that are already in circulation (Both paper and electronic “dollars”.) This wholesale dollar fabrication will be outrageously inflationary. Be prepared for double digit and then triple digit inflation in the next few years.”

Let’s say the Treasury just invents another two trillion dollars by printing currency and forgiving loans. Let’s say they do that every year for the next five years. How much inflation would that create?
The absolute maximum inflation rate from this example is about 20%, because there’s ten trillion dollars in circulation already. But in practice, the additional money dilutes the much larger pool of value represented by goods and services. This must be true because the entire money supply isn’t enough to buy everything that is for sale.
So the two trillion would get divided into that pool, which is several times larger than the money supply (I can’t find a reliable figure), and therefore the potential for inflation here is actually several times smaller than 20%.

Your prediction of triple-digit inflation is simply impossible unless the government starts printing tens of trillions of dollars worth of currency, every year.
You’ve led yourself astray here for (at least) two reasons:
You think that what’s happening in Zimbabwe can happen here. It can’t. Almost all of Zimbabwe’s economy is channeled through its government. The vast majority of the population is unemployed. The value of goods and real property in the Zimbabwean economy is small, and much of that value isn’t even really participating in the local economy. So the government’s injection of money into the economy is very large with respect to the total value of the economy, and high inflation results. None of these conditions exists in the US, and none is even remotely possible in the next several years. The worst case here is that US per-capita productivity and property values decline by, say, 50% over several years– roughly what happened in the Great Depression– which could potentially result in several years of 10%-to-20% inflation.

But that worst case doesn’t have much to do with the government expanding the money supply. That influence, as I described earlier, can be only in the range of 4% to 5%. The larger numbers are only possible in a Great Depression-type event if the underlying value of property declines dramatically.

Your other mistake is that you [over-estimate] the true magnitude of the current economic problems. Only two parts of the national economy is in trouble– banking and home construction. Between them, they don’t account for a large part of the total economy. They aren’t destroyed, either, merely depressed by some significant fraction. People still need banks and houses. So, bottom line, we’re looking at nothing more than a several-percent decline in the true value of the economy.

Stop [over-stating the inflation risk]. Tell people how to prepare for 10% to 15% inflation if you must. But stop these outrageous predictions of 100%+ inflation. That kind of inflation is literally unprecedented in otherwise functional economies, and there is no reason to suppose the United States economy will become dysfunctional to that level. Thanks, – PNG

JWR Replies: I really do wish that today’s economic problems were restricted just to financial institutions and home construction. But the great unraveling that I’m talking about involves so much more. It involves the derivatives casino that now exists in every major industry and service field. Most of this has built up in just the last 10 years.

Look back at what I wrote about “disappearing counterparties” in the derivatives articles that I’ve been posting for the past two years. This seems to be starting to happen, here and now, right before our eyes. Our friend Tom over at The Contrary Investor’s Cafe alerted me to this brief news item from England, which I will take the liberty of quoting in full:

D-Day Looms for Lehman Contracts
A fresh shockwave from the collapse of US investment bank Lehman Brothers could hit home on Tuesday when complex insurance contracts worth hundreds of billions are settled, it was reported.
Around 360 billion US dollars (£208bn) in so-called credit default swap (CDS) contracts are due to be paid off following the company’s failure.
A CDS essentially acts like an insurance policy against defaults on corporate bonds or loans.
It is a form of derivative contract, gaining a “derived” value from the performance of the bond it is based on.
But because Lehman went bust, those selling CDSs to insure against default on its corporate bonds will be forced to stump up the cash to buyers.
Tuesday is the D-Day for the complex web of transactions. A City source told the Sunday Telegraph: “Everyone will be watching the situation and wondering what’s going to happen.”
AIG, the insurance giant which was one of the biggest sellers of CDS products, is thought to have large exposure to Lehman Brothers and was bailed out by the US Government last month.
The Treasury has pumped in more than 120 billion US dollars (£70bn) into the stricken firm so far.
Other insurers of Lehman’s debt are thought to be hedge funds, who created and sold CDSs as a lucrative revenue-raising exercise in better times.
Although CDSs were originally designed as insurance products to allow investors to hedge against the risk of default, traders have also used them as speculative tools.

Thankfully, the derivatives market is very orderly and every risk has a very tidy counterbalance. So when all is said and done those really big notional numbers don’t mean a lot in the real world. They are just bookkeepers digits tallied at the end of a derivative play. And unless a counterparty does something very odd or downright stupid (a la LTCM), or vanishes, via bankruptcy (a la Bear Stearns) then all of those contracts end up with a very tidy zero sum gain at the conclusion. But the $64 Trillion question is this: What if a lot of major corporations holding derivatives contracts start to go under? Like GM, Monsanto, BP, or United Airlines. How many derivatives contracts are currently in play? Hundreds of trillions of dollars. One estimate was $190,000 USD for every person on the planet. (“The value of the derivatives market is 22 times the GDP of the entire world.”) What happens if and when big corporations go under, leaving their counterparties twisting in the breeze? Nobody knows. This is an imponderable because the derivatives universe was just a fly speck by comparison the last time there was a major recession, and hedging on this scale didn’t even exist the last time there was a global depression.

I’m talking about widespread corporate and municipal bankruptcies causing an avalanche of derivatives contract defaults and subsequent ripples through all the world stock, bond, commodity, real property, lending, currency, and insurance markets.Some might call this inconceivable, but I don’t.

All that I can say is that if things do start to unravel on a more grandiose scale, then I hope that someone is going to have the supreme courage to declare “Jubilee“, and start the entire financial system over from scratch. (“Every seventh year you shall grant a remission of debts” – Deuteronomy 15: 1). Because without a Jubilee, even Gideon Gono couldn’t come up with the cash needed to settle the mountain of debts and derivatives.

What is at the core of the current financial mess? The heart of man is desperately wicked. (See Jeremiah 17:9, and Mark 7:20-23.) In our generation, there are some people that have built a new Tower of Babel. It is a Tower of Debt. And being greedy, they didn’t limit themselves to tangibles. They heaped up impossibly large conceptuals on top of it all. But unfortunately the derivative contract conceptuals have a tangible bottom line.

On Tuesday October 21, 2008 (or soon after), we’ll get to see how much the value of the Lehmans contracts will get marked down, and whether Uncle Sugar will step in wit a fresh dump truck full of money to “calm the markets.” If the net settlement on those CDS contracts (backed by very dubious CDO “assets” of still declining value) exceeds $30 Billion USD, then every financial stock around the world might plummet. Ditto for every large insurance company involved in the CDS follies. It may be one of those “emperor sans cullottes” moments, or one of those Minsky moments. Helicopter Ben Bernanke will need a whole fleet of helicopters to tidy this up.

I really hope that I’m wrong in pronouncing this warning, because I really like sleeping soundly at night, and hot showers and lights that turn on with the flick of a switch.