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Hyperinflation to Follow Deflationary Debt Unwind

Economics / Stagflation Nov 20, 2008 - 09:56 AM GMT

By: Eric_deCarbonnel

Economics Best Financial Markets Analysis ArticleIn the investor community, there currently exists the belief that hyperinflation is impossible because of the deflationary debt unwind now underway. However, this logic is based on the flawed assumption that the money supply is the only important factor when determining inflation or deflation. This ignores the fact that for nations heavily dependent on foreign imports, like the US and Iceland, the purchasing power of the currency is the most important determinant of inflation/deflation.

The Conventional Wisdom

Some very smart people who have done an excellent job covering the credit crisis have bought into the deflation-means-no-inflation argument. For example, Professor Depew at Minyanville reports that Five Things You Need to Know: Why Not Hyperinflation? : (emphasis mine)

Almost every day I get notes wondering, "Why not hyperinflation?"

This is a good question. I'll try and explain why I believe a deflationary debt unwind is now underway, and why I believe it will be many years before we should start worrying about inflation again. In fact, by the time inflation becomes a legitimate concern, I expect the vast majority of people will find it as outrageous to worry about inflation then as found it outrageous last year when I made deflation one of my Five Themes for 2008.

While it is true, as those anticipating hyperinflation argue, the Fed and global central banks are making record amounts of credit available, that is only one side of the credit equation.

The assumption is that this record-breaking credit expansion means risk assets (stocks, commodities, etc.) will all skyrocket and the U.S. dollar will get destroyed. But what hyperinflationists fail to realize is that for an inflation (of either the tame or hyper variety) to take place, one must have both the means (credit from the fed and banks) and the motive (the desire to take on more debt) for credit expansion. For over a year now we have had record amounts of the former, but none of the latter. ...

And Mike Shedlock also expresses this view on his blog .

Deflation Is Here

There is no longer any debate (at least there should not be). Industrial Bond Yields Strongly Support Deflation Thesis .

10 year to 30 year Gap Narrows

I could see by the action in treasuries that players were betting the gap would widen and the yield curve would steepen. However, I never understood why those bets were made.

Someone from one of the big brokerage houses emailed me last week saying the yield curve would steepen. My response was "Why should it?"

The reason for my statement was that one month and 3 month Treasuries were already trading at or near zero. The Fed Funds rate was effectively trading at zero as well. There is no more room for the Fed to cut other than symbolically. OK. The Fed is going to cut by at least 50 basis points in December. Then what?

In the midst of the biggest consumer led recession since the great depression, there is simply no reason to expect treasury yields to rise. Banks are hoarding cash and any cash infusions from the Fed will likely go straight into treasuries or perhaps used for mergers.

A bet on the yield curve to steepen is a bet the economy improves. Why should it? An even better question is "How low do 10 year and 30 yields go?" Certainly 3% or lower on the 10 year and even 30 year are in the realm of possibilities. That's how nasty this recession is likely to get.

Simply put, Professor Depew, Mike Shedlock, and others who think that hyperinflation is impossible and that rates on long dated treasuries will continue to fall are dead wrong. The US's deflationary debt unwind will cause the dollar to collapse driving up the cost of imports (oil) and inflation, as has happened in Iceland.

The Iceland example

As a result of the global deflationary debt unwind, Iceland's three biggest banks, Kaupthing Bank, Landsbanki Island and Glitnir Bank have collapsed under the weight of about $61 billion in debts, and its stock market fell has fallen 81% so far this year. Meanwhile, employment has also plummeted as the collapse of the financial sector and large layoffs since October have resulted in a complete standstill in the construction industry. Most importantly, the deflationary collapse has caused the Krona, Iceland's currency, to crash which leading to hoarding of goods at supermarkets and an inflation of 16%. The financial crisis has left Icelanders in a state of shock .

The Iceland example shows how a nation can experience deflation (crashing stock, bond, and real estate markets) while also experiencing high inflation due to a currency collapse (soon to be hyperinflation when it allows its currency to float again).

Similarities between Iceland and the US

Like Iceland, the US heavily dependent on imports, the most important being oil. Also, thanks to outsourcing, this dependence has grown dramatically in the last few years as a large part of our industrial production moved overseas.

Like Iceland, the US has accumulated an enormous amount of external debt relative to its GDP. As various sectors of our economy shrink or disappear (financials/automakers), this ratio will continue to worsen.

Like what happened in Iceland, our deflationary collapse is going to severely damage our US economy, leaving the US with few resources to service its debt. At this very moment, confidence in major US banks is crashing, along with their stock prices, bringing the US one step closer to following in Iceland's footsteps and nationalizing its financial sector

Yes, the US can print dollars, the world reserve currency, which gives it an advantage Iceland didn't possess. However, this is of little help in averting a dollar collapse. Already, foreign investors are shunning all US assets except treasuries . When falling tax revenue and ever-growing bailouts destroy foreigner's trust in the last US asset they consider safe, an exodus out of the dollar will begin.

US treasuries are not safe

Deflation and deleveraging will not prevent hyperinflation. The falling value of dollar will drive up prices despite the consumer's weakening purchasing power.

A bet on the yield curve steepening is a bet that the dollar will collapse, and this bet makes sense.

By Eric deCarbonnel

Eric is the Editor of Market Skeptics

© 2008 Copyright Eric deCarbonnel - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Eric deCarbonnel Archive

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25 Dec 08, 07:37

Hyperinflation will not occur. An increase in the money supply (even a substantial one) does not NECESSARILY mean inflation. This has been proven time and time again. Japan's lost decade. 1982 to 1983 United States.

Besides, most of the money that the Fed has supplied is * * already gone * * . It cannot make it's way to the public, and therefore the price spiral begin (necessary for hyperinflation) because the money is not there to get to the public. It disappeared to the void of deleveraging.

03 Jul 09, 21:30
Iceland was no hyperinflation


It isn't going to happen. Period.

Why? Because of the very example you stated. IF that scenario occurs, they will do exactly what so many of us have said they will do in that scenario. It's exactly what Iceland did (funny how this article did not update itself and reveal the rest of the story) They will crank the rate up on the currency to near 20%, and DESTROY what's left of the credit markets.

Because that, they know - means that central banking can continue to exist.

Hyperinflation is NOT inflation rates of 20% or 30%. It's rates of 2000% 4000% 8000% And they KNOW that if they allow that to happen? Then they are committing suicide to the future of central banking. And THAT, they will not allow to happen. They are not dumb. They are not Zimbabwe or Russia. They will not allow a price wage spiral to begin. They will not allow competing currencies within the economy. And they WILL defend the currency. Iceland has already proven what you are likely to see in the United States ...

21 Sep 09, 21:33

There are various definitions of hyperinflation.

The difference is that Iceland was a small country that had received bailout money from the IMF.

Who controls the imf? The US.

What currency does imf primarily hold? Us dollars

According to Schacht the currency commissioner of Weimar Germany the hyperinflation was caused by Foreign speculators primarily from Britain and France shorting the mark with money lent out by the privately owned Reichsbank and other private banks, this eventually lead to confidence crisis and collapse in the value of the German Mark.

Now take a look at the world today, if there is a run on the dollar there are trillions and trillions of dollars already in the hands of foreigners. If there ever is a run on the dollar and those positions were dumped you could have the dollar would go the way of the Icelandic Krona, so it would at least halve or go even lower if it is shorted.

Now if the US government decides to default on all of its obligations and issues a new dollar currency available to the domestic economy only then it would probably only get as bad as iceland not weimar. Of course the banking system would have to collapse too, but that is another story.

In Iceland's case they are now forcing icelanders to convert their currency before they buy a product abroad.

So if US dollars are no longer accepted as a means a trade due to a confidence crisis, the US will have to convert their currency which will put downward pressure on the dollar and raise the value of another currency.

So it really depends on confidence at the end of the day.

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