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James:

The letter [from reader PNG] has severe mistakes and is fundamentally misleading – your readers deserve even more refutation before anyone is lulled into a false sense of security. To quote: “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.”

1. These numbers are incredibly far off the mark. Actually M1 is the narrow definition of money – the core money supply that the Fed controls. It just spiked from ~ 850 billion to ~1,010 billion ($1.01 trillion) in one month.
   So he’s off by a factor of 10 here. If the Fed printed (or created digitally) the hypothetical two trillion $ this would triple the M1 money supply. Three times as much money chasing goods would ignite hyperinflation very quickly…
2. And let’s not forget about the multiplier effect of fractional reserve banking! Even much smaller amounts of money creation are going to create serious inflation because we live with the fundamentally dishonest and unstable fractional reserve banking system. $10 deposited in a bank is used as “reserves” to loan out more than $100. (Banks are only obligated to keep less than 10% in reserves to pay depositors). Off by another factor of 10! Two trillion in new money becomes more than twenty trillion dollars in loans.
   Quoting again: “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.”
3. Actually money has velocity – it is spent, or changes hands, several times per year. The money supply multiplied by the velocity determines the amount of dollars bidding for the total supply of goods. E.g., $100 times a velocity, or turnover, of 10 times a year = $1,000 spent in one year. This $1,000 bids for the supply of goods, NOT just the $100.
   In the US (right now) velocity is moderate. In Zimbabwe it is incredibly fast. So looking at just the supply of money is only half of the equation when you look at the $ bidding up prices for goods.
4. There are lots of other mistakes here, but one last note is in order “That kind of inflation is literally unprecedented in otherwise functional economies” Crack open an encyclopedia, and look under W, for Weimar Germany! And don’t confuse cause with effect – economies become dysfunctional because of inflation – Argentina is a good place to start reading…

An aside – thanks to Dr. Gary North for making the link above freely available on the public section of his web site. Sign up for his free Reality Check newsletter if you’d like advance notice of economic trends based on real numbers. (BTW, I have no relation to Gary North, other than gratitude for giving me far more education than I paid for as a subscriber.) Yours truly, – OSOM

Jim:
Here are a couple of facts about inflation I’d like to share:

FACT: The US Federal Reserve is issuing loaned money at its discount window at the rate of $100 Billion per day which is $36 Trillion, annualized. The $100 billion daily rate is actually increasing each week. These quantities of money will never be paid back because the national debt is 10T$ which it took 95 years to accumulate. This is highly inflationary.

FACT: Every bank account has been guaranteed to $250,000 [more than twice the old limit] with unlimited funds to back up FDIC insurance. This will be highly inflationary, if banks fail. – J.K.

Jim:
Referring to the letter by PNG, “currency inflation expectations” and your response. I would like to quibble a great deal with PNG, and a little with you.

First, for reader PNG,

Week before last, the Fed increased the money supply by nearly 23% in one week. They have been increasing the supply by huge amounts weekly, but that one took the cake. Disregarding Jim’s accurate argument that there are other things to inflation, (e.g. velocity of money) simply multiplying 22% times 52 weeks gives a minimum annual inflation number of 1144%. The way the Fed has been “printing” money since Aug 17 this year, triple digit inflation is almost a given. (Not that the Fed can really “Print” money, but it can sure “Create”.)

The government is constantly changing the way it calculates inflation. Now they talk about “core” inflation, leaving out the “volatile” food and energy, etc. costs. Since when do we not need food and energy to survive? If one calculates inflation using exactly the same methods used during the Clinton administration, (as they do over at the “shadow stats” web site) you will note inflation is running well over 10% NOW, and it takes some time for newly “printed” money to work its way through the system to become inflation.

And for you, Jim,
I certainly agree with your observations about debt and derivatives. The world bank and others are coming up with estimates that the notional amounts of derivatives run in the order of 1.31 Quadrillion dollars. No one knows for sure. If any one of the three counterparties to a derivative default, then the notional amount owed becomes a real amount owed. To put that in perspective, the GNP of the entire world economy doesn’t run over $50 trillion. A bailout of $700 billion is peeing in the ocean because there are a lot more zeros in a quadrillion than in a billion. A quadrillion is a million billions. Parts of this house of cards are failing now, (your comment about Lehman’s explosion date of Oct. 21 is spot on) and the numbers are so huge that undoubtedly one will take down others in a row of dominoes effect. Lehman may be that first domino.

My quibble with you regards another possibility to inflation. In our fractional reserve banking system, every dollar “printed” by the Fed is normally multiplied by about 10 by the banking system (Theoretically it can be much more than 10) So to inaccurately describe in economic terms, the dollar bills “printed” by the Fed might be called M1. By the time that one M1 dollar makes its way through the banking system an additional 9 have been created via loans for any purpose to the average guy or company. That might be called M3. The commercial banks get one dollar but loan out ten. And there is no way of telling whether what you are spending is created by a commercial bank loan or was “printed” by the Fed, and in practice, normally it doesn’t matter. There are, however rules as to how much the banks can loan out based on reserves, which are normally the capital and accumulated profit. (Equity)

However, in special circumstances such as we now face, it does matter whether dollars are Fed created or commercial bank created. Normally, to make as much profit as possible, commercial banks will try to lend out every dollar they can. In the current situation there are two things that stop the commercial banks from lending. The first is they are scared silly, and rightly so. They have gone from worrying about the return on money to worrying about the return of money. No one can tell whether a bank is bankrupt or not, because IF they hold derivatives, those derivatives may suddenly become a giant liability. As well, all the major companies used derivatives freely, and they are suspect too. Ergo we have a credit crunch where the banks are afraid to lend, even to each other. The fractional bank multiplier (one in, ten out) is not working, contracting the M3, or money on the street. Very deflationary.

All these billions the banks are “writing off” come directly from their equity, or reserves. Since they can only lend out a certain multiple of their ‘reserves’, those reserves, or accumulated profit, are dropping like a rock because of the writeoffs. They must contract their lending to remain within the rules. So, it becomes an issue of the commercial banks being neither willing, nor able to lend.

The government allows certain borrowings from the central bank to be counted as reserves in time of turmoil, which hasn’t been a problem within the life span of most alive today. During 2007, and prior, US bank reserves ran in the order of $43 billion. The latest US figures I saw shows “non borrowed” reserves at minus $403 billion. The rest is government loans “counted” as reserves. Every bank in the US, and most of the rest of the world, is bankrupt. Well, there will be one or two prudent exceptions, but they will also likely be taken down too, if only because of the number of checks in circulation.

Suddenly those nine dollars of commercial bank created dollars are shrinking, and they can shrink even faster than the government can print. All this is highly deflationary, as the world found to its dismay in 1929. Why do you think Paulson has opted to buy equity in banks with a significant part of his $700 billion? It pumps their reserves, so they have the ability to lend. No one has mentioned how they can cause banks to have a willingness to lend.

My point is that so many assets are being destroyed, as they were in 1929, that a deflationary scenario is entirely possible. And deflation is a much meaner beast than inflation. I have previously forecast elsewhere an inflation followed by deflation until it is all Fed created money. Then it is Zimbabwe[-like situation for America], if the system holds together that long.

Like you, I much prefer a world of sleeping well at night, hot showers and lights that turn on at the flick of a switch. – Allen

Mr. Rawles;
In response to he recent post where another reader thought that triple digit inflation could only happen with $10 trillion per year increases in the money supply I would like to provide some further economic insight for your readers.

1. Prices are determined by supply and demand; therefore, a drop in demand for dollars can have a far greater effect than a increase in supply. Many people do not realize that in Germany the inflation rate was many times the rate of the increase in the money supply.
2. If the dollar loses its reserve currency status (currently being discussed) then international demand could fall off a cliff forcing half of the dollar supply back to the United States (100% inflation).
3. There is a time-lag for inflation. In the early days people expect price stability and so inflation is much lower in than the actual increase in supply. Over time people expect more and more inflation until it spirals out of control. It is a geometric function where most of the action takes place in a very short period of time. In other words, the huge increase in the money supply that resulted in home prices going up has not yet fully been priced into other goods and services.
4. A decrease in production (due to recession) decreases the supply of goods competing with existing money causing inflation.
5. Ever dollar FDIC pays out is inflationary; therefore, with the government backing almost everything these days every deflationary “force” is countered by inflationary government action. Ultimately, interest on the national debt will exceed the ability to tax… this is the end game for the dollar.

When you factor in these things, triple digit inflation does not take much time to get rolling. In fact, it can go from 10% (current) to 100% inflation in just a few weeks. I hope this material is useful for your readers. – Dan in Virginia

Jim,
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.