Hyperinflation to Follow Deflationary Debt Unwind

By: Eric_deCarbonnel

In 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.
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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
http://www.marketskeptics.com

Eric is the Editor of Market Skeptics

© 2008 Copyright Eric deCarbonnel - All Rights Reserved
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