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Understanding the Difference Between Deflation and Hyperinflation: Deflationists Rebuttal

Economics / Deflation Feb 18, 2009 - 09:49 AM GMT

By: Eric_deCarbonnel

Economics Diamond Rated - Best Financial Markets Analysis Article1) The euro is going to crash against the dollar because European bank losses dwarf those in the US

This bit of logic proves that deflationists (those predicting deflation in the US) don't understand deflation. Whether or not European bank losses dwarf those in the US, it is the euro that will rally against the dollar. Why? Because the euro zone, unlike the US, is about to experience real, honest-to-god deflation. Ironically, Deflation is staring deflationists in the face, and they are too blind to see it.

Understanding the difference between deflation and hyperinflation

The root cause of deflation and hyperinflation is the same: a nation plagued by mountain of debt. This mountain of debt can be in form of a massive national debt, an insolvent financial system, or both. What determines whether a debt-plagued nation experiences deflation or hyperinflation is the response of that nation's monetary authority:

A) If the monetary authority does nothing while a country defaults on its debt, its banks go bankrupt, and its depositors see their savings wiped out, then that country will experience deflation.
B) If the monetary authority chooses to monetize a country's national debt, its banks' bad loans, or the savings of depositors at failed banks, then that country will experience hyperinflation.

The US in the 1930s as an example of deflation

When a series of banking panics rocked the US financial system in 1930s, the fed did nothing as thousands of banks failed. As a result, between 1929 and 1933, two out of every five banks in America collapsed, and depositors at those banks lost most of their savings, shrinking the US money supply. Why did the fed let so many banks go under? For one, the Fed could not by law directly lend to banks that did not belong to the Federal Reserve System, and most banks remained outside this system at the time. Furthermore, the fed was restricted on how much it could lend to its member banks: it could not, for instance, lend to banks on their real estate loan portfolios. Because of these regulatory restrictions (which have long since been removed), the fed was powerless to prevent the depression's cascading bank failures.

The following passage from the St. Louis Fed summarizes the US experience with deflation :

Starting in 1930, a series of banking panics rocked the U.S. financial system. As depositors pulled funds out of banks, banks lost reserves and had to contract their loans and deposits, which reduced the nation's money stock. The monetary contraction, as well as the financial chaos associated with the failure of large numbers of banks, caused the economy to collapse.

Less money and increased borrowing costs reduced spending on goods and services, which caused firms to cut back on production, cut prices and lay off workers. Falling prices and incomes, in turn, led to even more economic distress. Deflation increased the real burden of debt and left many firms and households with too little income to repay their loans. Bankruptcies and defaults increased, which caused thousands of banks to fail. In each year from 1930 to 1933, more than 1,000 U.S. banks closed.

Germany In 1920s as an example of hyperinflation

In 1920, German banks were insolvent and did not have the cash to honor checks. Since the German government itself was burned by its war debt and reparations payments, it could not borrow to bail out its banks. Furthermore, the government did not want to upset people with heavy taxes, and it feared a rise in the unemployment which would result from bank failures. As a result, Weimar Germany turned to the printing press to bail out its financial system, and its currency was brutally destroyed by hyperinflation.

The following passage from a 1970 report on Germany's currency collapse summarizes the German experience with hyperinflation :

In World War I, Germany -- like other governments -- borrowed heavily to pay its war costs. This led to inflation, but not much more than in the U.S. during the same period. After the war there was a period of stability, but then the inflation resumed. By 1923, the wildest inflation in history was raging. Often prices doubled in a few hours. A wild stampede developed to buy goods and get rid of money. By late 1923 it took 200 billion marks to buy a loaf of bread.

Millions of the hard-working, thrifty German people found that their life's savings would not buy a postage stamp. They were penniless. How could this happen in a highly civilized nation run at the time by intelligent, democratically chosen leaders?

The roles have now reversed

Today, the US is the nation facing hyperinflation as the fed monetizes debt, and the EU looks set for deflation as the ECB allows Europe's financial system to collapse. The reasons why is simple. Following the great depression, the US took steps to insure it would never experience deflation again, and Germany's experience with hyperinflation shaped the EU in a way to prevent hyperinflation from ever happening again.

The fallout of the US's experience with deflation include:

A) The rise and domination of Keynesian economics in the US. Keynesianism is the economic school of thought which gives such wisdom as “deficits are good” and “you can spend your way to prosperity”.
B) All US bank deposits are now fully insured by the FDIC. This alone makes deflation impossible in the US, as it forces the fed to either monetize banks' bad debt or monetize the deposits which were used to loan out the bad debt.
C) The fed's sweeping authority to bailout whoever they want, whenever they want, however they want.
D) Social security and Medicare, which makes a default on the US's national debt unthinkable as this would reveal that the baby boomers retirement savings are gone.
E) Free money for the unemployed! Unemployment benefits are being extended by 33 weeks to 59 weeks and the average $300 weekly benefits are being increased by $25. You can now receive a 17,000 annual salary for getting laid off , courtesy of the government's printing press.
F) massive federal and trade deficits.

The fallout of the Germany's experience with deflation include:

A) The "no bail-out" clause of the Maastricht Treaty (the treaty that led to the creation of the euro), which stipulates explicitly that neither the Community nor any Member State is liable for or can assume the commitments of any other Member.
B) The euro zone's lack of FDIC-type deposit insurance
C) The ECB's inflation fighting mandate.
D) Germany's 3,413 tonnes of gold reserves, the largest in the world (besides the US gold reserves, if they still exist), and the EU zone's 10,413 tonnes of gold reserves.
E) Germany's export oriented economy and trade surplus
F) Germany's long standing low-inflation policy
G) Germany's contempt for Keynesian economics. (a contempt I share)

The USD rally will end when Europe's financial system starts collapsing. Investors will realize that the EU won't print money to bail out its banks, and that will send the euro soaring against the dollar.

The dollar's and the euro's fate

Eighty years ago, at the most fevered moment of the German hyperinflation, the exchange rate between the dollar and the Mark was one trillion Marks to one dollar. This time around, it will be one trillion dollars to the euro ( assuming the Maastricht Treaty holds ).

As EU bank failures wipes out deposits and gold prices continue to rise (gold price rose during the great depression's deflation), eventually the value of the EU's outstanding currency will equal the value of its gold reserves. At that point, the EU will have the option of converting the euro into a hard currency, redeemable in gold.

2) Trade numbers show how China's dependence on international trade is smacking the daylights out of their economy.

Anyone who thinks things are going badly in China hasn't been paying attention

Optimism is growing in China . Economists now project that China will be the likely leader of an elusive worldwide economic recovery . China is the only economy in the world to see significant growth in credit to corporate and household sectors after September 2008: Chinese loan growth and money supply have surged this January . Bank lending is multiplying the effect of the government's spending in ways that wouldn't be possible in the United States and Europe, where banks are burdened by toxic assets. The Shanghai Composite Index of stocks has also climbed about 36% from November's lows

Falling imports don't mean Chinese consumers are spending less

The reason why imports to China crashed 43.1% percent in January is easy to figure out. Consider the following:

1) Consumers around the world are downshifting to discounters.
2) Over 95% of the merchandise in Chinese Wal-Mart stores is sourced locally .
3) China's undervalued currency makes all foreign imports artificially expensive.

From these three facts, it should be clear that downshifting by Chinese consumers is helping their economy while reducing imports. Furthermore, remember that 70% of the merchandise in US Wal-Mart stores is also from China, which means that downshifting by US consumers helps China too.

It is true that falling exports are causing pain in China

China's export sector is shrinking and this means millions of migrant workers are losing their jobs. However, the prospects for unemployed migrant workers are far better than they are for America's laid off workers. Unlike the US, China's service sector is experiencing double digit growth. This means that laid off workers are finding new jobs or starting their own companies. Furthermore, migrant workers and college graduates who are returning home will help boost consumption in inner China. These young workers/graduates will push their relatives to buy computers, cell phones, and other modern gadgets they have gotten used to. The standard of living for rural China will be going up.

China has begun major reforms of its social security net to boost spending.

For the last three decades, China has experienced excessive industrial expansion at the expense of consumption, with its consumption rate dropping from around 55 percent of GDP in the 1980s to merely 35 percent last year. The specter of high medical costs, coupled with the overall weak social safety net, has been discouraging Chinese from spending their money. As an example, Chinese government spending on health in 2006 amounted to less than 1% of the country's gross domestic product, ranking China 156th out of 196 countries surveyed. Medical reform has been deliberated by authorities since 2006, however China's battle with inflation has been taking priority over moving forwards with these reforms.

Now with the inflation threat temporarily faded, China is finally moving forwards with improvements to its social safety net. China has expanded social security and passed a new medical reform plan . Broad insurance coverage and social security will, over time, start to shift the balance in China away from savings and toward more consumption. China has irreversibly begun to break its “dependence” on US consumers.

Chinese authorities plan to boost rural spending to spur economic growth

To encourage rural consumption, China has implemented a nationwide program to provide 13% subsidies to rural residents on purchases of electronic goods such as cell phones, washing machines, personal computers, motorcycles, personal computers, water heaters and air conditioners.

The subsidy plan is working . Rural sales overtook urban sales for the first time in the company's history last year. Also, in the first 20 days of January, Chinese farmers bought more than 160,000 items of home appliances on government subsidies, 90 percent of the total in December.

China's focus on the consumption and standard of living of inner China is bad news for the US. When inflation goes out of control , Chinese officials will be faced with the choice of dropping its successful effort to promote domestic consumption or dropping its dollar peg (which has been unsuccessful at helping exporters).

The efforts to boost domestic consumption are working

Chinese consumers have been on a spending binge , bucking the global trend. Chinese domestic consumption is forecast to grow at about 20 percent in 2009.

The best place to see the diverging fortunes of the US and China is in a comparison between the US auto industry and the Chinese auto industry , which offers a stark contrast:

US auto industry:

  • About 1,000 GM, Ford, and Chrysler auto dealers went out of business last year, and about 2,500 more dealerships are expected to close in 2009.
  • Manufacturers are shelving plans to open new facilities.
  • Hundreds of suppliers are on the verge of going out of business in the next two months because US auto production has virtually stopped.

Chinese auto industry:

  • Dealerships have stopped offering discounts on 80% of their sales because of strong demand.
  • Manufacturers are investing in new plants and expanding workshop floors.
  • All Chinese auto makers are predicting growth for 2009, with some aiming to double their vehicle sales.

In January alone, Chinese battery and carmaker BYD sold 24,107 vehicles , up 80 percent from a year earlier.

It doesn't look like the “hard landing” is going to be in China…

3) China's treasury holdings are a much bigger problem for China than they are for the US.

I love this one. While it is true that China is having problems dealing with their massive dollar reserves, to then say that those reserves are a bigger problem for China then the US is hilarious.

Simply put, if you had to choose, which problem would you rather have?

A) China's problem of having “too much cash”
B) The US's problem of having “too much debt”

4) The US is facing a decade of falling prices

Droughts are plaguing the world's biggest agricultural regions , and the world is heading for a drop in agricultural production of 20 to 40 percent, depending on the severity and length of these droughts. Since the demand for agricultural commodities is relatively immune to developments in the business cycles (at least compared to that of energy or base metals), already rising food prices are headed significantly higher.

In fact, agricultural commodities NEED to head higher and soon, to prevent even greater food shortages and famine. The price of wheat, corn, soybeans, etc must rise to a level which encourages the planting of every available acre with the best possible fertilizers. Otherwise, if food prices stay at their current levels, production will continue to fall, sentencing millions more to starvation.

5) China is no more manipulating the yuan than the US is the dollar.

China's 2 trillion dollars of reserves are proof of manipulation. The process of building up foreign reserves puts downward pressure on a nations's domestic currency. So the yuan has been significantly undervalued as a result of China's reserve buildup.

The US, by contrast, has not been increasing or decreasing its foreign reserve, and therefore has not been manipulating its currency.

6) If China floated the yuan, it could easily get smashed like other export based economies.

A quick comparison of the fundamentals backing the yuan and the dollar should reveal how they would fare if the yuan was floated.

China's fundamentals:

  • At current exchange rates, China could use its 2 trillion dollar reserves to completely pay down its national debt and still have billions to spare. This means China is one of the only countries on Earth which has a positive net worth.
  • China is running record trade surpluses, averaging around 40 billion in the last four months.
  • China has one of the world's healthiest and strongest financial system .
  • China's economy is growing, with its service sector experiencing double digit growth.
  • Most of the world is dependent on China's cheap consumer goods
  • The Chinese budget is balancedT

The US fundamentals:

  • The US net worth is negative $11 trillion dollars (with unfunded commitments factored in = negative $53 trillion net worth)
  • The US has been running massive trade deficits for years.
  • The US financial system is completely insolvent
  • The US economy is collapsing, with both the service and manufacturing sector contracting rapidly.
  • The US is utterly dependent on the rest of the world for its basic consumer goods.
  • The US doesn't even remember what a balanced budget is.

If China drops its currency peg, the dollar is going to get killed.

For those who still think the yuan would crash if it was floated, I have a few questions: is that how you invest your money? Do you go looking for the company with the worst possible fundamentals? (Companies drowning in debt, with declining sales, and no growth prospects) Or do you invest your money in companies with strong fundamentals?

7) There is nothing else that's as good of an investment as the US dollar.

ANYTHING is better than the US dollar: Yuan, euro, yen, gold, silver, oil, food, art, etc… Even the British pound will be worth more against the dollar by the end of the year. (and the British pound isn't going to be worth much…)

By Eric deCarbonnel

Eric is the Editor of Market Skeptics

© 2009 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.

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