As we all know, the past two years have borne witness to the sharpest, most severe economic contraction since the Great Depression. Recent sets of economic data have suggested that the recession is abating, if not having ended already. Simultaneously, many economists have suggested that the extraordinary measures initiated by the Federal Reserve and other entities point toward another looming crisis: Inflation and the debasement of our currency. In my last letter, I argued this with respect to the current Dollar Carry Trade, and how that trade, while there may be corrections from time to time, will remain the trend as long as the practice of systematic devaluation remains in place. I believe the devaluation of the US Dollar will continue as long as Bernanke and Co. is running the show. At the same time, we need to pause before we immediately begin to convert our US Dollars into Australian Dollars or Norwegian Kroner (these countries are both already in the process of raising rates, refer to Charts 1 and 2 at the end). Indeed, inflation has its cons, but it has pros as well. The fact is that it has more pros than its evil stepsister, deflation. Additionally, the experience of Argentina from 1976-1991 reveals that inflation does not necessarily undo a society. It is necessary to consider the position of the United States within the world economy compared to other countries that have experienced high levels of inflation.
The last three generations of Americans have come to regard inflation as a fact of life. Retro advertisements that tout a bottle of Coca-Cola for 5 cents are now used as décor in countless households. Those over 60 recall purchasing candy and ice cream for pennies. Controlled inflation over time is an acceptable economic scenario. Rising asset prices make their way through the system, from stocks to real estate. For example, as prices gradually rise, it is easier for companies to report rising earnings year-over year. Good earnings result in higher stock prices. Such is the opposite in a deflationary scenario. Prices are forced lower, which forces companies to cut costs and lay off workers. This can become a vicious cycle (examples: US Great Depression and Japan Post-1990). Since Paul Volcker’s Fed was able to get inflation under control in 1981-83, it has been low and manageable for the longest stretch in history. In fact, in the five years leading up to the Credit Crisis, many economists, including Alan Greenspan, suggested that late 20th century banking practices had led to a new age dubbed “The Great Moderation,” in which volatility in inflation, GDP, unemployment and many other economic variables would be permanently low. The Credit Crisis and its implications have tossed this paradigm out the window.
The monetary base of the United States has been expanded more than ever before due to the Federal Reserve’s response to the Credit Crisis and subsequent recession. The end result of this will be higher inflation. In a letter to his (no doubt extremely happy) investors, hedge fund manager John Paulson argues, “the monetary base has expanded to an absolutely exponential degree. Typical year-over-year changes in monetary base were under 20%. When the crisis occurred, that year-over-year change skyrocketed to 128%. Additionally, the correlation between the monetary base and money supply is very close, almost 1:1 as the monetary base finds its way to the money supply.” What he means is that while the monetary base has swelled, the money supply has not, at least not yet. This is due to the velocity of money plunging, accelerating after the other Paulson (Hammerin’ Hank) allowed Lehman Brothers to go bankrupt. The heart of John Paulson’s argument is that inflation has lagged money supply growth by 2-3 years. Thus, now is the time to be preparing for it. In his case, he is currently raising outside money for, and placing $250 million of his net worth into a new Gold-centered hedge fund.
Examples in modern history show that even decades of inflation will not lead to the undoing of a nation, as many pundits may inevitably suggest in order to sell books, get face time on TV, etc. The Weimar Republic is not a good historical example, as the main trigger of the 1922 hyperinflation was the forced debts on the Republic via the Treaty of Versailles to pay for the rebuilding of Europe after World War I. Argentina is a better comparison in that it is not only more modern, but brought about by untamed government spending (sound familiar?) Additionally, the example of Argentina fits well in that it is still a proud, First World nation today after nearly twenty years of crushing inflation. Finally, the icing on the cake is that the US enjoys several economic advantages that Argentina did not. It is these advantages by which hyperinflation will likely never happen.
The South American nation of Argentina experienced steady inflation, including short bouts of hyperinflation, from 1976 to the early 1990’s (for perspective, refer to Figure 1). The Argentine Finance Ministry would initiate currency reforms in 1983, 1985, and finally in 1992. In the midst, the 1985 currency reform introduced a new currency, the Austral. After another round of hyperinflation in 1990-91, the 1992 currency reform introduced the “New” Peso. One New Peso equaled 100 billion pre-1983 pesos. The hyperinflation during this period was largely due to populist spending sprees, such were the legacy of Juan Peron and years of dictatorship. Other factors included building stadiums and improving infrastructure for the 1978 World Cup, and even waging a bold war they had no real chance of winning, the 1982 Falklands War. The money for these expenditures was essentially printed, contributing to the final inflationary spike that led to the 1983 currency reform. Seeing their savings and peso-denominated assets deteriorate, Argentines began to park large portions of their money in US Dollars. Wealthier Argentines sent their money to US Banks, while working class Argentines often kept $100 bills in safes. The country did have its problems. Poverty increased to around 40% in that time period, although it is markedly lower today. There were periods of rioting, although from an historical perspective they were roughly comparable to the US at some points in the 1960’s. No coup d’etat ever occurred. The first part of my point is that despite this decade and a half of difficulty, in addition to a more recent crisis in 2001, Argentina was and remains a First World country and G-20 member today. They have managed to short up their finances such that their Debt/GDP ratio is now lower than the US and many other industrialized countries.
Moreover, the United States, due to its position in the world and the accompanying economic interdependence of so many other nations, will likely never face the type of hyperinflation that defined life in Argentina for nearly twenty years. First and foremost, Argentina never had the advantage of their currency as a global reserve currency. The role of the US Dollar has gradually built up to the current economic interdependence between the US, Europe, Japan, and China, with particular emphasis on China. If the US Dollar enters a period of swift decline, these countries’ massive holdings of US debt will be reduced in value as well. This will be in addition to everything that is priced in USD (oil, food, other commodities) rising as the dollar is falling. This will not just be a US problem; this will be a global problem. We saw bits and pieces of this in early 2008 with the food riots that occurred in Latin America and the poorer regions of East Asia. In the off chance that we do have a currency crisis in the next five years, I personally think that we will see unprecedented efforts by governments worldwide to prop up the US Dollar. Central Banks will take measures to let their own currencies decline against the Dollar to keep it propped up until a new, global reserve currency can be introduced (this concept, highly interesting to me, is a possible topic for a future newsletter).
I believe we are looking at a decade or more of high deficits and higher inflation with neither likely to ever truly get out of hand (although the range of what constitutes “getting out of hand” is vast, especially among talking heads). Despite the massive 2009 budget deficit, the Public Debt/GDP ratio of the United States does not exceed that of the European Union or Japan (Japan is closing in on 200%!), and about a dozen other smaller countries. Don’t misinterpret, this trend needs to be reversed. The point is that we have a long way to go before we will really be in trouble relative to the current state of other world economies. Although not as dominant as before the introduction of the Euro, the health of the US Dollar is still vital to the global economy more than any other currency. Other countries are aware of this. The recent, colorful debate between Hu Jintao and President Obama over the former’s refusal to let his nation’s currency appreciate is more about the immediate situation than the future. If China immediately lets its currency appreciate, one of the immediate effects will be that some (not many, but some) manufacturing jobs could make their way back to the United States. Reversing this trend of the last twenty years could jeopardize the continued rise of the Chinese middle class. For this reason, while the yuan’s appreciation could help the US economy in the short-term, Jintao has no interest.
In the meantime, relax. Allocate 5-10% of your portfolio to precious metals and/or other commodities, and allocate more than that if you fear a currency crisis. Inflation and the debasement of our currency have resulted in 95% of the dollar’s purchasing power being erased since 1913. However, during that time the Dow has risen 12,000%. You only lose if you put your money under the mattress or in a simple checking account. Personally, I am a fan of Silver more than Gold as an inflation hedge, but this will also be the topic of a future newsletter. As long as Ben Bernanke has his way, we will not be doomed to a Japanese-style deflationary cycle. At the same time, we as a nation need to get our deficits under control in order to completely avoid an Argentina-style experience. Low inflation on a year-in year-out basis is acceptable. High inflation which could destroy the savings of middle-class citizens is not.
Respectfully Yours,
Matthew R. Green
12/10/2009
Charts 1 & 2
Chart 1 is Gold when priced in Australian Dollars; Chart 2 is Gold in USD. As you can see, Gold (or any other commodity) is actually down over the course 2009 when priced in AUD. This illustrates the AUD’s strength.
Figure 1 - Illustration of Inflation in Argentina 1975-1991
January 1975: Highest denomination is 1,000 Pesos.
Late 1976: 5,000 Peso note introduced.
1978: 10,000 Peso note introduced
Late 1981: 1,000,000 Peso note introduced
1983: First Currency Reform: 1 Peso Argentino = 10,000 Pesos
1985: Second Currency Reform: 1 Austral = 1,000 Pesos Argentinos
1992: Third Currency Reform: 1 “New” Peso = 10,000 Australes
Bottom Line: 1 1992 Peso = 100,000,000,000 Pre-1983 Pesos (100 Billion)
Source: International Monetary Fund
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