"I'm not upset that you lied to me, I'm upset that from now on I can't believe you" - Friedrich Nietzsche
Even though the US dollar history is like a dishonest Goldsmith Banker issuing more receipts for gold than he has gold, central banks around the world continue to hold US dollars as reserves. The US continues to print more, stealing value from countries around the world with each new dollar printed. It is fundamentally unfair for the US to get real wealth from billions of poor people around the world in exchange for giving them pieces of paper, and then to devalue those pieces of paper by printing more all the time. As other countries realize they are being ripped off because they are using and holding dollars they will reduce their exposure to dollars. When central banks do this they call it diversifying reserves. As this happens the value of the dollar will crash.
Below we take a brief look at the history of this cycle and then look at the current situation.
<! 1671-38 = 1633> <! 1619 to 1622 there was european wide debasement of coins during 30 years war from 1618 to 1648> <! 1636 tulipmania>
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crying upthe value of real silver coins. In effect British pound was devalued in America because in America you could not convert it to a pound of silver. So in 1704 Queen Anne's Proclamation attempted to force the American colonies to accept British paper money with no more devaluation than 33% relative to real silver.
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Since there was not really enough gold to back all the paper money (only 40%), some people and countries started getting out their gold while the getting was still good. Rather than admit the Ponzi gold scheme had failed, in 1933 President Roosevelt confiscated private gold and no longer let people exchange paper money for gold or own gold. When they took people's gold they paid them $20.67 in paper and then shortly after raised the price to $35/oz (so they really paid people $0.59 for every $1 worth). Foreign countries could exchange gold at $35/oz and for awhile after this gold flowed into the US.
The Fed's paper changed over the years from gold certificates to Federal Reserve Notes backed by nothing. In has been suggested that they be renamed to "Federal Reserve Accounting Unit Devices", or FRAUDs for short.
If the government had not outlawed gold, more and more people would have turned in their paper dollars for gold coins until the Fed either ran out of gold or closed up. At this point the remaining paper money would have rapidly become worthless. This would have been a 3rd period of hyperinflation in American history. Along with the Revolution and Civil War, with between 70 and 80 year spacing. If the US gets hyperinflation in the next few years it should really count as America's 4th hyperinflation, with similar spacing.
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In the last 12 months the US government has spent $2 trillion more than it took in and printed over $1 trillion. Before this the record deficit was about $0.5 trillion and most of that was borrowed not printed. With this much printing, fewer people are willing to lock their wealth in US dollar debt. When the government can not borrow as much, it will print more.
The people that are still buying government debt are buying short term debt. This means that if interest rates go up the interest payments on the US debt will go up. In the past much of the debt was in 20 year and 30 year fixed rate bonds, but not so much these days. Many of the US consumers have variable rate mortgages. As interest rates go up their payments will go up. This will lead to more defaults. These two problems keep the Fed from letting interest rates rise. But keeping them low means more money printing.
In each of the above American economic collapses there was too much paper money for the amount of gold and people lost confidence in the paper. Today the US paper money dwarfs the US gold. In 1895 the government could be saved with $65 million in gold, today all the US obligations are more like $65 trillion, a million times higher.
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"Insanity in individuals is something rare - but in groups, parties, nations and epochs, it is the rule." - Friedrich Nietzsche
"We learn from history that we do not learn from history." - Georg Wilhelm Friedrich Hegel
"The present is a mystery only to those who slept through history." - unknown
"History may not repeat itself, but it rhymes." - Mark Twain
"There is nothing new except what is forgotten." - Rose Bertin
"Problems cannot be solved at the same level of awareness that created them." - Albert Einstein
It is interesting that paper money has a long history of failing, not just in the US. Several failures happened when empires fell. There is no history of paper working well, paper money has always failed.
Is 38 years how long it takes for new generations of Americans to forget the past and trust paper money?
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Barry Bannister has noticed a cycle in the ratio of stocks / commodities where it goes up for 15 to 20 years and then down for 15 to 20 years. In fact, some of his transition points, like 1933 and 1971, are the same dates used in this article. So a pair of his up and down cycles seems to line up with the 38 year cycle discussed here. This makes sense, because people trusting paper money also trust stocks, and people wanting gold also like commodities.
Similarly Fred Harrison has an 18 year cycle that is also somewhat similar.
In 1925 the Russian author Nikolai Kondratiev published a book called "The Major Economic Cycles" which led to some later authors calling the cycles Kondratiev waves. I like Mish's explanation of K-cycles. In 1938, during Stalin's Great Purge, Kondratiev was tried and sentenced to 10 years in jail, then executed by firing squad the same day the sentence was issued.
The theory of Generational Dynamics has cycles about twice as long as mine. Also see blog. The idea is that the elders of any generation have learned wisdom through experience which helps them to govern society and keep it on the most productive course. As the elders are replaced by the next generation a vast pool of knowledge is lost. Mistakes of old are then repeated anew so lessons can be learned again.
The Schwartz Hypothesis that price instability due to monetary policy causes financial instability fits well with America's historical record. It is tested against many of the same events covered in this article.
In Henry Petroski's book Success Through Failure he notes that there is a 30 something year cycle for bridge collapses. It seems that success breeds hubris and catastrophe nurtures humility and insight. So the longer people go without a failure the more confident they get, till they fail again. And other engineering fields like spacecraft and nuclear power plants have a similar pattern. The patterns of failure go way back.
Dan Denning writes about The End of the Super Cycle in Fiat Money.
The long term Elliott Waves seem to be connected with monetary changes.
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The government and Federal Reserve have been able to keep economist saying that government printing money makes the economy grow. The truth is the US economy was more stable and grew faster before the Federal Reserve. By printing money the government takes wealth from everyone who has dollar savings, so it helps government grow faster. This is the Inflation Tax. The US was able to extract a moderate Inflation Tax from people all around the world for the last 38 years.
There is a story that if you slowly heat a pot of water with a frog in he will not jump out. But if you heat it too fast he will jump.
Recently the US printing of money has increased to such a rate that the rest of the world is now worried they are losing value too fast by holding US dollars. The dollar has lost nearly half its value compared to other paper currencies in about 10 years and more than 10% in the last few months. With US bonds paying 1% per year and the dollar dropping by about 1% per month, holding US bonds is foolish. When the US prints another $1 trillion, it is stealing this much value from all the existing dollar holders. Over time people around the world will realize the US dollar is in trouble. Countries are starting to realize that a world financial system where the US can steal wealth from all the players is just not fair. As the world gets rid of their US dollars, the value of US dollars will drop more. The more it drops the more people will be in a hurry to dump their dollars. This could result in the dollar falling faster over the next 10 years or in a sudden panic or dollar crash where everyone is rushing for the exits at once.
If there are $6 trillion dollars outside the US and the US inflates the money supply by 10% it has stolen $600 billion from these people outside the US. This is about the level of the US military budget. So a case can be made that the US inflation tax on the rest of the world pays for the US military which can then dominate the world.
It would be a mistake to assume that since the Roman dinar, the Spanish reale, and the British pound each took many years to lose reserve currency status that the dollar fall will be slow. Back then they did not have instant worldwide information flow, computers with automatic trading software, etc. While it would be wrong to say that This Time Is Different, the collapse will probably set a new speed record for reserve currency collapses.
The US ability to quietly take wealth from dollar reserves all around the world was like the Golden Goose. But now they have pushed too far and that golden goose is going to die.
People or countries do not pay any inflation tax on their gold and silver holdings. This is where the frog is free.
A nation-state taxes its own citizens, while an empire taxes other nation-states. By this logic America is an empire, since it collects an inflation tax from much of the world.
If something cannot go on forever, it will stop. --Stein's Law.
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But what is in it for other countries that peg to the dollar? What is their angle or incentive to peg to the dollar? In the Caribbean we have the East Caribbean Central Bank that produces the East Caribbean Dollar which is pegged at 2.6882 to the dollar. This uses an Orthodox Currency Board. When they print EC dollars they exchange them for US dollars and then buy short term US treasuries. In this case they always have enough treasuries that they could convert all EC dollars back to US dollars. So the EC dollar can be fully backed this way.
Now the fun part is that the central bank gets to keep any interest they earn on the treasuries. Also, as dollars come flooding into the Caribbean they will get to print more EC dollars and increase the number of dollars they earn interest on (though probably they are worth less each). So the interest the bank earns on the reserves is the "cut" or incentive they get by pegging to the dollar.
When the US holds interest rates down at 1% and the dollar is dropping in value more than that most years, it is much less fun for the other central banks to peg to the dollar than when it was at 5%. If the orthodox method is costing them their nest egg of reserves, they have to look for non-orthodox methods. And watching gold go up in value much more than 1% per year for the last 10 years starts to make the 1% US bonds look foolish. In general with such low US rates, central banks would be better off to leave the US dollar MLM scheme and do something else. They can change their pegs to another currency or basket of currencies where they can earn more interest, or buy gold which is going up in value. Organizations often do what is in their own interest.
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Now assuming people around the world still used dollars as their reserve currency and the international trading currency, what would happen? People in the US would on average have more money than people in other countries. People in the US would import lots of stuff from other countries. People in the US would be less motivated to work and want higher wages when they did work. People in the US would spend more money. The US would have a trade deficit as money flowed out to buy stuff from other countries.
Because of this jobs that could be done in another country with cheaper labor would migrate to other countries. So manufacturing jobs and even some engineering and software jobs would go offshore. Only service jobs, that could not relocate, would stay in the US.
There is actually a precedent for this sort of thing. When Spain was taking gold from the New World they were making lots of new gold money. The result was that people in Spain bought more stuff from outside Spain, etc.
When the US makes new money and spends it on Americans it has the same net effect as if they had just mailed it out to people.
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Some people have claimed that it would take the Gulf States many years to replace the dollar as the currency oil is priced in. This is a peculiar claim since Iraq and Iran switched to non-dollar sales in short order (Iraq before the war). As should be expected with a dropping dollar, Iran says it profited from switching to non-dollar oil sales. Other countries can see this and switch quickly too.
Imagine that central banks currently had their assets as 60% Dollars and 30% Euros. If the value of the dollar were to drop in half, then they would have equal value in Euros and Dollars without changing anything.
For thousands of years gold and silver have been used as a store of value. Imagine a central bank with 10% in gold and 90% in dollars. If the dollar goes down by 2 and gold up by 5 it could suddenly have most of its assets in gold.
The point is that the dollar could be replaced as the dominant reserve asset even without central banks ever selling their dollars, just by dropping in value. Several times in the past the dollar has dropped significantly in value in a just a few short years.
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The way an orthodox currency board pegs to the dollar, as explained in the US Dollar Multi-Level-Marketing Scheme, is to print more of the local currency and buy dollars if the local currency gets too high, and use the reserves of dollars to buy up local currency if the local currency gets too low. When they print local currency and buy up dollars they take on the inflation problem that the US should have had, so they have let the US export inflation. However, there are always non-orthodox options for pegging a currency.
One option is to change the peg to some other currency, like the Euro. Another option is to peg to a basket of currencies, like Kuwait does.
Another option is to keep the peg to the dollar, but instead of buying dollars to buy gold. If gold holds value better than dollars then the value of the reserves will be higher than needed. However, if the price of gold in dollars goes down, then the bank would not have enough reserves to fully back the peg. If the central bank was very confident that gold was going up, or the dollar was going down, they could decide to at least partly buy gold instead of dollars.
A counterexample to the claim that pegged countries must keep buying US dollars is China. China basically stopped buying in May 2009 and yet kept their peg till June 2010
Pettis makes a related claim when he says says, "It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them." There are a couple flaws with his logic. First, foreigners could cash in their holdings as their short term treasuries came due. Since most are short term now, foreign holdings could decline very fast. The Fed would print money to cover each bond that came due. The second is that the Fed could buy them directly instead of another foreigner.
A country that had more reserves than it needed to back its currency, maybe because its gold reserves went up in value or because it devalued its currency, could use some of its central bank reserves. This does increase the risk that if its reserves drop in value it might not be able to maintain the exchange rate peg that it was, but it is not impossible to use the reserves, as Pettis claims.
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While this is sort of true on a theoretical level, it overlooks important practical reasons that people want to have their reserves in the currency they buy things in. Imagine your reserves are in dollars but you buy things in gold. If the price of gold measured in dollars doubles then the buying power of your reserves is cut in half. You have a big currency risk if you don't have your reserves in the same currency you trade in. It is easier and safer to plan for the future if you are saving in the same currency you are spending in.
The other big issue is that if oil is priced in dollars then the US can buy as much oil as it needs to import by just printing more dollars. This is on the order of $500 billion per year if oil is at $70/barrel and $1 trillion/year if oil is at $140/barrel. Imagine oil and other international commodities were priced in gold and nobody accepted dollars for international trade. In that case the US would need to export enough extra stuff or use up their reserves of gold to buy oil. In this case the demand for dollars and their relative value would be far lower than it is today.
Having global trade priced in dollars makes the demand for dollars as reserves much higher, and so their value much higher, than it would be otherwise. And it makes it far easier for America to pay for imports.
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It is interesting that Adam Smith noted long ago that governments usually inflate away their debt. Also, high debt levels weaken a country or empire and can even cause it to fail.
This Time is Different: Eight Centuries of Financial Folly shows that after governments bail out banks and other companies one should expect a sovereign debt crisis a few years later.
A bubble pops when the supply of the asset becomes sufficient to overcome demand and lower the price. So in the Dot Com bubble there were lots of new companies selling shares. In the real estate bubble there was huge production of new houses. In the bond and dollar bubble there is record junk bond sales and huge production of new dollars in QE2. At some point this supply will be more than the demand and the value will plummet.
There are those who think gold is a bubble. Gold production only increases the world total holdings of gold by about 1% per year. So while gold prices can go down, they don't have the usual dynamics of production increasing till it overwhelms demand and pops a bubble. It is trivial for the Fed to increase the number of dollars by 10% in one year but it is nearly impossible to increase the amount of gold by even 2% in one year. So it is far easier to pop the dollar than to pop gold.
There is just no way that a 30 year bond at 4% is a good long term investment when they are printing more than a trillion new dollars each year. This bond bubble will pop.
Let me speculate about when the bond bubble will pop. For the last 30 years interest rates have been going down which has increased bond values. I think the bond bubble will pop when interest rates start going up and bond values start dropping. So when will that be? Probably when inflation starts going up. So when will that be? Probably after the dollar starts going down. So when will that be? Don't know, but it could start anytime now.
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We will not have any more crashes in our time. In 1930 he said others predicted a decline in prosperity for the next decade but he thought that was wildly mistaken; however, it was Keynes that was wildly mistaken. Other Keynesian economists had no idea the current mess was coming. The Federal government and the Federal Reserve make sure their economists are Keynesians. Keynesians think printing money is good. The government likes having economists say it is good to print money, since the government gets to spend the money it prints.
The Austrian Economists vs Keynesians is really private economists vs government economists. The Keynesian theory has a few clear problems, like assuming that investment is fixed so savings does nothing, or that the impact of government spending on the economy is always the same, even if it is spent on bridges to nowhere.
The original Keynesian theory is that the government should print more money and spend more money during bad times but contract the money supply during good times. This is a countercyclical policy. In real life governments find it very hard to run budget surpluses in the good times to pay down the deficits from bad times, and few do that. Now the Post Keynesian Economics Theory, like the Neo-Chartalism think that printing money all the time is good. They go so far as to claim all growth is from government printing money.
Krugman, A Keynesian, tries to downplay Austrian economics by calling it Hangover Theory. However, Mish shows how clueless Krugman is as an economist to not understand how bubbles impact so many different things that when they crash many things are hurt.
Now in 2002 Krugman called for making a housing bubble. He said, To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble. So he well knows that the Fed printing money could cause a housing bubble, he recommended it.
This same Keynesian wrote about how economists did not predict the economic trouble but fails to mention that Austrian economists, who think printing money causes troubles, did predict the trouble. It is a bit amazing that in 2002 Krugman can recommend the Fed make a housing bubble and then say nobody could have predicted the bubble would pop.
A good scientists throws out a theory that can not predict results and is contradicted by the evidence.
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If government has a minimum wage rate that makes it so employers can not make money off some people at that rate then those people will be unemployed. Most people think the minimum wage law is helping people, so one should never expect the government to admit that the minimum wage law causes unemployment, but it does. In a similar way, mandated health care, higher taxes, more regulation, carbon taxes, etc. cause unemployment.
When you inflate the money supply you lower the real wages. As the inflated money reduces the real wages more and more, at some point employers will be able to make money by hiring some of the unemployed. So the way printing money reduces unemployment is by reducing the real wages.
It would be far easier on society if they would just lower the minimum wage rate; however, politically that is much harder to do.
Today many benefits, salaries, and wages are indexed to inflation. So this does not work nearly as well as it used to. It also does not work so well because many countries, like China, have their currency pegged to the dollar, so as the dollar goes down so do the other currencies.
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However, people know inflation hurts them and don't want inflation. In fact, the Misery Index is defined as the sum of the inflation rate and unemployment rate. Part of the law governing the Fed requires that they maintain stable prices. So at any sign of inflation, say oil at $140/barrel, causes the Fed to contract the money supply. So if the extra money causes inflation the extra money is cut off. So the extra money can only keep flowing as long as it does not go into things the Fed measures as part of inflation with the bogus CPI. So in the US printing money can't really lower the real wages the way Keynes was thinking.
It is much easier for the extra money to keep flowing if it goes into stocks, or foreign investments, or gold, or oil, or anything that is not currently in the CPI. So taking housing out of the CPI during the bubble helped let them keep printing money.
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Chartalism is older than Keynesianism and is in fact mentioned favorably in the first few pages of Keynes 1930 book, "A Treatise on Money". The name "Chartalism" derives from the Latin charta, as in chart, paper, or writing. Chartalism advocates paper or fiat money. Even back in the 16th century there were debates between Metalists vs Anti-metalists or Chartalists. The "Modern Monetary Theory" or MMT is a modern Chartalism, so I have them both in the same section here. MMT is attempting to describe the real monetary system in use since any tie to gold was dropped in 1971.
The MMT economists point out that a sovereign government that issues its own fiat currency is never really revenue constrained or insolvent. It can always print more money. The government may have setup rules to limit the printing of money, but those rules could be changed or ignored by the same government. To think about the big picture of what is going on we can ignore the details of the current self imposed constraints. In fact, MMT guys view the creation of fiat money as part of "the government" even if the current rules claim it is not (they hate the term "printing money"). A government that can make fiat money is very different from a normal household that clearly goes bankrupt if it spends more than it takes in for too long.
Since the government can make all the money it wants, the government could operate just fine even if it burned all the money it collects as taxes or from selling bonds. You can also just define the money supply as money outside government so that it is as if it was destroyed when it goes to the government. In the MMT view, the reasons for taxes are to provide demand for the fiat money and to reduce aggregate-demand/inflation.
Similarly, the government selling bonds is not really to raise money, but to temporarily reduce aggregate demand to help control inflation. It is the equivalent of taxing people now and then later issuing them a stimulus check. So the net effect of a bond, or a tax and then stimulus check, is to temporarily reduce aggregate-demand/inflation.
Another way to look at government bonds is to compare them to private bonds. If we imagine that the government burns the money it gets from a bond sale but a private company spends it, then to the extent that savings goes into government bonds, instead of private bonds, it reduces aggregate demand.
In this view debt is not such a feared thing because clearly the government could nationalize the central bank and wipe out the debt by printing as much money as needed. Also, if the government runs a surplus it reduces the money supply and could cause a recession. In fact some would rather not have the government issue any bonds but simply make the money it needed. Some argue that in reality the government is not going to tax our grandkids to pay back the debt, they are going to just create money to pay it off. Some view the selling of bonds as a holdover from before the time of fiat money and something that should come to an end.
So the only limiting thing on government spending is really just the danger of inflation.
The MMT guys view money as being created by government deficit spending. Since governments essentially never pay back debts to the central bank, this is correct. They also say that government deficit spending allows private net savings increases. This is true in nominal terms.
To me the above parts of MMT are just another way of looking at what is the reality of governments with fiat money. It focuses on nominal amounts and not adjusting for inflation but mostly it is just a different way of talking about things, but not really different. Again, I think it is good to be able to see things as MMT people see them.
However, the MMT guys then go on and have some real differences. They look at the equation of MV=PY or total money supply times velocity equals price level times GDP and then say total money supply does not impact prices since velocity can change and GDP is not constant. Well, there can be a little bit of change in velocity or GDP but we have seen government spending going from millions, to billions, to trillions, so price levels have gone up. They also think that there is some full employment level and if the government adds money so all the stuff produced at this full employment level is purchased that it will not cause inflation, but if they go over that level then it causes inflation. Thinking that there is some abrupt change at a particular spending level seems silly. It is not so discrete, much more continuous.
The MMT guys think that with floating exchange rates countries do not need reserves. There are some big problems with this view. Outside the US, which as the international reserve currency is a special case, other countries all feel they do need to keep reserves. Part of the reason is they need to be able to buy oil and other international commodities, without which life in their country could become very hard. The reason many Asian countries have such high reserves now is because they experienced the troubles that not having high reserves can cause during the Asian Financial Crisis. Reserves are an important part of stabilizing a currency and economy.
The MMT guys seem to make a big deal out of the fact that most money is just computer entries and never really printed. I don't think it matters if the money is really printed or just an entry in a computer. If everyone with entries in the computers went down to a bank and took out their money, then the Fed would have to really print the money. This might take weeks or months, but the Fed would print the money listed on the computers. So the fact that they have not yet printed it makes no real difference.
In the end the Chartalists and MMT guys both favor fiscal stimulus for any problems. So their main conclusion is the same as the Keynesians. The difference is that Chartalist/MMT guys favor fiscal stimulus even when there are no problems while Keynes thought the government needed to run a surplus in good times. So in some sense they are even more in favor of printing money than Keynesians, and I will lump them in with other Keynesians from here on.
The place where the Chartalists go wrong is not understanding how a government that prints money goes bankrupt. They say things like, " The overriding point, however, is that a sovereign government can always fund its liabilities as long as they are denominated in the currency that it issues under monopoly conditions". It is true that unlike a corporation or a household it does not run out of money. Saying that a government can always print more money is like saying that a corporation can always print more share certificates. The problem is if they are really bankrupt nobody wants them. The transition during which the market is rejecting a government paper money is called "hyperinflation". At the end of this process the government is clearly bankrupt as nobody takes their money for anything.
Imagine the government payments are supporting 40% of the population, either as employees or welfare/foodstamps. Further imagine that half of that money the government spends is newly printed money. Then if the money they print becomes worthless they can not support that 40% of the population in the lifestyle to which they have become accustomed. The "liabilities" of a government are not just amounts of currency. We call this type of bankruptcy hyperinflation. This happens to governments all the time. Once this starts with the dollar it is probably less than 2 years till the end of the dollar. To help MMT folks everywhere I have written up hyperinflation in MMT terms.
A government that prints money has a very different type of bankruptcy than a household, but not as far different from a corporation. As long as a corporation is doing well it can create and sell more shares of stock, which are like the currency for that corporation. However, when things go bad the currency for that corporation becomes worthless and it can not get any more money by making any more shares. Same thing when people lose confidence in a government currency.
Rodger Wilson notes that after government finances get a bit better there is usually a recession. This is because during a bubble governments collect more taxes than normal and after a bubble pops there is a recession.
MMT is mostly a different way of looking at things. In that spirit I suggest the following. Think of governments that issue currencies like corporations issuing shares. A government tax creates a demand for currency (MMT view). Imagine the company never pays a dividend and only does share buybacks to create demand for their shares (common these days). In this case the goverment currency and corporate shares are really very similar. A company or a government has 3 choices to raise capital:
In the next section I attempt to explain hyperinflation in MMT terms.
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In MMT the government uses taxes to provide a demand for the currency and both taxes and bonds as tools to manage aggregate demand and inflationary pressures. In a nutshell, in hyperinflation these two tools fail, inflation gets out of control, and the desire for the currency drops off.
First I would like to point out that in the Wikipedia article on Inflation in the Weimar Republic it say, "The monetary policy at this time was highly influenced by Chartalism, and was notably criticized at the time from economists ranging from John Maynard Keynes to Ludwig von Mises". Many economist could tell Chartalism was leading Germany toward hyperinflation.
Imagine a government that keeps inflation under control by suppressing aggregate demand with bond sales and taxes each equal to about 1/3 of government spending.
Next imagine that bond holders move into short term bonds, and then bond sales drop off. At this point, the government could either cut back spending, create more fiat money, increase interest rates, or raise taxes. Some call the point where it might still be possible to avoid hyperinflation the Havenstein moment. The government has so much debt that trying to improve bond sales by raising interest rates is very painful with the higher interest payments, so that option does not look good. The rules/obligations/politics of the government make it far easier to create more fiat money than to really cut spending or increase taxes enough. It is almost like there is no real choice and it creates more money. As they print more money less people want to buy bonds. If bond sales go all the way to zero then the total fiat money creation per year will have to double and the aggregate demand suppression will have been cut in half.
Now as inflation is going up the taxes people are paying on last years income are not as large in real terms, and the economy may be in trouble, further reducing taxes. So taxes are not suppressing aggregate demand as much as they used to. With no bond sales and reduced taxes, the government would have to more than double taxes to get aggregate demand down to where it used to be. However, this is just not possible. More and more people are in hardship because of the high inflation, so demands on existing government programs are going up.
As people get worried they move from long term bonds into short term bonds. If the bonds are mostly short term they can come due very fast, so the delayed aggregate demand all shows up suddenly. If you think of government debt as a dam holding back demand, hyperinflation can start when this dam breaks. At this point people are all rushing to spend their money before prices go up any further, which shows up as an increase in aggregate demand and higher velocity of money. People and companies are in a panic. However, the government is forced to make more fiat money (probably just adjusting account balances and not real paper) because of all the safety nets etc. It has to make fiat money to cover the full deficit and all of the bonds coming due. The bonds coming due in one year could be several times the total taxes, so it is not possible to increase taxes enough to destroy money fast enough to make up for the new money from paying the bonds.
Maybe the government tries price controls, but that would just create shortages and a huge black market that paid no taxes. The German hyperinflation price controls meant all kinds of businesses could not make money and had to shut down making things far worse. Many people dismiss the German hyperinflation, saying it was caused by war reparations and we don't have those. However, war reparations were only 11.8% of the German governments budget in 1921. Black markets may not use the local fiat currency, so as the economy moves underground demand for the currency could be reduced, further causing the value to go down.
In the MMT view taxes provide demand for a currency. But in hyperinflation taxation has problems. First, imagine there is a 25% income tax but you pay it 4 months after the end of the year. If your salary is going up with inflation at 100% per month then by the time you pay your taxes it is like nothing. Also, as more and more of the economy is in the black market, it is not taxed. The inability to tax means the inability to provide a demand for the currency.
The hyperinflation feedback loop runs out of control. After this goes on for awhile nobody uses the local currency as a "store of value" any longer. And awhile longer and nobody will accept the currency for anything. This is hyperinflation. This is bankruptcy for a government that can print all the fiat money they want.
The math for hyperinflation is the same in MMT as in other theories. But notice this is not the math for normal inflation, so MMT authors who say Hyper-inflation is just inflation big-time are not correct.
A small thing could trigger the initial collapse in bond sales. For example, if Obama were seen reading a book on MMT that might be enough to start a collapse in bond sales.
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MMT folks say, "When inflation starts the government simply has to increase taxes and thereby destroy more money". For regular inflation this statement is simple and true; however, for hyperinflation this statement is clueless and foolish. But MMT people don't usually understand the difference between regular inflation and hyperinflation.
If people stop buying the government bonds then suddenly the government has to print new fiat money to cover the whole deficit as well as all the bonds that come due. If bonds are short term it is easy for this to be several times the existing taxes per year. It is simply not possible to increase taxes sufficiently to destroy money fast enough. Most MMT people just don't get this.
Another common MMT error is, "solvency is never an issue for a government that issues its own currency". At the end of hyperinflation a government still issues its own currency, but nobody will accept it as payment for anything. So this claim is clearly not true.
Another error MMT people make is saying something like to pay off the national debt the government can just change some numbers in a computer, no big deal. It is fun to have a whole new way of thinking and talking about economic issues, but it still needs to fit the evidence of the real world. MMT people seem not to be aware that many other governments have already run experiments on monetizing debt. We know what happens when you do this. If the whole national debt were monetized at once you would get hyperinflation for sure. I think MMT people need to watch this 1 minute Feynman video explaining science.
Another error MMT people make is something like, quantitative easing is just swapping bonds for bank reserves, it is not printing money. Again, MMT people think accounts on computers are different than accounting done with physical paper. If a bank requested to withdraw physical paper money from their excess reserves, the Fed would have to give them paper money. If the Fed did not have enough already, it would have to print more. The fact that they first credited an account on a computer, instead of first printing, does not change the impact of what is going on.
MMT people often count government bonds as money. But they are not the same. A 30 year bond can go up and down in value as interest rates change. In the real world things are priced in money, not 30 year bonds. They point out that a 1 day bond is not much different than money, and even a 3 month bond is not all that different. In MMT terms, a bond is delaying demand, so the shorter the term the less it really does. But if you watch the value of a 30 year bond go up and down relative to dollars, you can't say they are the same. MMT people will say gold is not money because you can't use it at the supermarket. Well, you can't use 30 year bonds at the supermarket either.
Another basic error is that MMT people think the government can get something for nothing by printing money. They believe that the economy can be improved just by printing more money. If you accuse them of believing that you can "print prosperity" they will deny it, but printing to a better economy and printing to prosperity are about the same thing. Their view is that as long as there is unemployment the government can make more money without anything bad happening, like prices going up. Many times in history people have thought this, for example, the Greenbackers could only see good in printing money.
MMT people want lots of new fiat money, but insist that they are not advocating "printing money". They have to do this because most everyone understands that just printing more money can not really create more real wealth and leads to inflation. This is similar to the Fed saying "Quantitative Easing" instead of printing money. The MMT guys argue that much of the money is just accounts in computers and not actually printed. That the Fed is using computers to keep track of accounts without always really printing money does not change the problem. When governments spend more than they get in taxes and from net bond sales they make up the different by creating money. It does not matter if you call it, "money out of thin air", "seigniorage", "making money", "printing money", "quantitative easing", "QE", "issuing fiat currency", "adding to bank reserves", "spending without borrowing", "debasement", "expanding the Fed's balance sheet", "just monetary policy", "monetization", "liquidity operations", "deficit accommodating", or "that thing which will not be named", it lowers the value of the currency.
There are basically just 3 guys pushing MMT. These are Bill Mitchell, Rodger Mitchell, and Warren Mosler. They claim that everyone else gets the wrong answers because they don't really understand how the modern monetary system works. While these 3 don't even agree on what MMT theory is, they seem to think they understand it and nobody else does. It is not that it is just a different language to them, they think others are wrong.
MMT focuses on which account names are debited and credited and misses out on understanding the big picture of what is going on. While talking about accounts being debited and credited they won't mention the obvious fact that new fiat money is being created. They also don't look at the history of previous experiments in fiat money creation, which is a sad history really.
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Printing new money in the reserve currency country is different from your typical Keynesian situation. The US actually transfers wealth to the US when they print new money. Imagine that half the existing dollars are inside the US and half are outside the US and the US prints another trillion dollars. With time the existing dollars will be worth less, so half the loss will be outside the US and half inside, but all of the gain will be inside. So there really is a net gain to the US by printing money, but this is not what Keynes was talking about. It is doubtful that the rest of the world will put up with high levels of this forever.
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In Jan 1933 the US had $4,279 million worth of gold. With the Fed's "money multiplier" of 2.5 they could have had around $10.7 billion in paper money back then. The Fed no longer reports M3; however, at shadowstats.com they estimate about $15 trillion today. So today we have more than 1,000 times more paper money. Gold is around 50 times more expensive and silver around 20 times more. To get to 1,000 times gold would have to go up by a factor of 20 and silver by a factor of 50. If the dollar became much less of a reserve currency, and gold and silver became important reserve currencies again, these kinds of factors could happen.
John Williams of ShadowStats.com said, " If the methodologies of measuring inflation in 1980 had been kept intact, gold would have to hit $7,150 to be the equivalent of the 1980 record. "
The US monetary base is about $2 trillion. There is about $14 trillion in government bonds. If people did not buy new bonds but wanted cash, then the government would have to print another $14 trillion, raising the monetary base to $16 trillion, or a factor of 8 higher. If there was no fear of future printing, this might just devalue the dollar by a factor of 8.
American workers are paid much higher than many countries. The US GDP per capita is $46,400 while the world average is only $10,400. The world average is brought up by the US, so statistics for the rest of the world alone would be lower still. If the dollar were to keep dropping till US workers were competitive with the average country it might need to drop by a factor of 5 or more.
Using the MZM measure of money supply we have gone from around $1 trillion in 1980 to about $10 trillion now. So gold and silver going up by a factor of 10 from their prices in the 70s seems reasonable. Also about a factor of 40 from when they stopped making silver dollars.
The real problem is that if the dollar devalues by a factor of 5 or 8 it may never be able to stop devaluing. It could enter the hyperinflation currency death spiral. Saving a currency once it enters hyperinflation is nearly impossible.
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From Japan's point of view, having their yen:dollar exchange rate go from 300:1 to 100:1 means the value of their large dollar reserves went down by a factor of 3. It is as if the US repudiated 2/3rds of their debt to Japan. This was not good for Japan. And, contrary to many claims, a factor of 3 change in the exchange rate did not fix the trade imbalance between the US and Japan.
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Imagine a government prints some money, loans it to someone, then gets paid back, and then burns the money. After this sequence there would be the same amount of money in existence that there was at the start. Understanding this the Real Bills Doctrine that printing money was ok as long as it was loaned out as good debts that would get paid back in a short time period makes sense. The inflation comes only if the bank is printing money and not getting sufficient collateral.
If you do this for large amounts and long periods then during the time the loan is out there is more money in circulation, which is inflation. And when the debt is paid off there would be deflation.
If the person who got the loan never pays it back, then there will be permanent inflation. People understand that the US government will not really pay back the Fed. When the Fed gives money to the Treasury it is viewed as permanently inflating the money supply and called monetizing the debt, which is a type of quantitative easing.
In the 1920s most of the new money went to margin loans to buy stock. As the stock prices went down the amount people could borrow was reduced and they had to pay back part of their loans.
Back in the 1914 to 1933 time-frame for every $1 the Fed had in circulation they had to have $0.40 in gold. If everyone took out their gold there would only be 40% as much money, which is deflation. So stock prices going down and people turning in paper for gold were deflationary.
This time much of the money was loaned out for houses and highly leveraged derivatives that turned out to be bad debt. So the money is not getting paid back to banks. The banks in turn are going bankrupt and not paying back the Fed. So there is not nearly the deflationary pressure this time as during the 30s.
In Bernanke's Helicopter Drop Paper he points out that if a government in a gold money system had a magic machine that could make infinite amounts of gold coins from nothing, and used it a lot, that the value of gold would go down. Almost everyone understands that if gold were not so rare it would not be so valuable and if it was as plentiful as sand it would be cheap like sand. Having a printing press that makes dollars in a fiat money system is just like a magic machine that makes gold in a gold money system. If you make lots the value of each unit will go down.
Imagine lots of criminal organizations with printing presses that can make perfect counterfeit dollars, indistinguishable from government made US paper money. Further imagine that these organizations print/spend trillions of new dollars into existence. What would happen? Clearly the value of the US paper money would drop fast. It is the increase in amount of money that makes it worth less, no matter if the government or counterfeiters print it.
There are those that think that if the total value of all US assets
drops by some trillions of dollars that it is the same as if the
money supply has dropped by that amount and so deflationary.
This is not exactly correct. If a house goes up in value it
does not cause inflation and if it goes down in value it does
not cause deflation. However, the amount of money that the
banks can borrow from the Fed does go up and down with asset values
of the collateral they have for the loans on their own balance sheets.
So if home owners treat their house like an ATM, then with help from a
bank and the Fed,
asset values can impact the money supply,
but it is not a direct link. But when the economy is bad and
people are losing jobs they can not borrow as much money,
which can cause deflation.
When the Fed buys fixed rate 30 year mortgages at 4% interest, it is
not getting good value. If interest rates go to 8% these
will lose about half their value. Interest rates will probably
go higher than that. So buying these weakens the Fed's balance
sheet and so weakens the backing for the dollar.
Buying long term debt that will be decreasing in value is a
violation of the
Real Bills Doctrine.
Before 1971 the money of the world had some tie to gold but after then
it has not. Under a real gold standard (prior to 1914) people
went 100 years without
inflation and had times where prices went down some. Given advances in
productivity it is reasonable to expect prices to go down.
Since leaving gold in the 70s we have had high inflation unlike anything
ever seen under a real gold standard.
Given that inflation does not extend back into the gold period it
seems wrong to expect deflation from the gold period to extend into
the fiat period.
People who argue we are in for deflation,
count defaults as deflationary since they reduce the total credit.
But if the central bank is not getting paid back then default is not deflationary.
Some people argue that since the Fed and banks loan money into existence
they can not really increase the money supply if people are not willing
to borrow more or the banks are not willing to lend more. People say
the banks are just sitting on the cash.
Those that argue this way forget that the government
has an insatiable appetite for borrowing and spending.
2008 the Fed started paying banks interest on reserves at the Fed.
So the banks can earn interest either from the Fed
or from the Treasury.
This new Fed paying interest bit has helped confuse most people.
One should really view the Fed as part of the government and the
banks as lending their cash to the government (either Fed or Treasury).
So the truth is the banks loaned their cash to the government instead
of private entities, not that they are sitting on it.
This is called
crowding out. It is not good for business or the economy.
Another argument is that although the banks have lots of "excess reserves"
they can not really loan out this money as they are capital constrained and not reserve constrained.
Since banks are not
even if they have extra reserves they are in no position to
make new loans.
So banks are not able to
use fractional reserve lending to increase the money supply.
Since banks may make 10 times or more the credit that they have
in reserves, it would be inflationary if they made loans, but
they are not.
Mish presents this argument and it is a strong case for deflation
for some period of time.
However, the Fed is doing everything
possible to get at least some banks to be very profitable.
Even letting them "extend and pretend" and "mark to fantasy".
So deflation from this seems only for a limited time,
ending when the banks start really lending again.
Some people argue that we can not get inflation while there is still
high unemployment. These people will often babble about "cost-push inflation"
or "demand-pull inflation" but inflation is an increase in the money
supply and anyone who says different is confused.
The US had high inflation and high unemployment in the 1970s,
so any claim that you can't get inflation when there is unemployment
is contradicted by history and should be either ignored or laughed at.
Some people argue that with housing prices and stocks down that the value
of the dollar is clearly up. But this is not true either. As interest
rates go up the yield on bonds goes up and the price of existing bonds goes down.
To have competitive earnings or
dividends at the new higher interest rates the price of stocks has to go down,
and the P/E down. At first stock prices go down due to increasing inflation.
After this initial adjustment period, a long enough time at
stable inflation rates will tend to drive stock prices up.
Some note that a slowing of the
velocity of money
can also contribute to
This does not seem to feed on itself in any way or explode into a big problem.
So the slowing seems to be a limited impact change that
continuous printing of money always eventually overpowers.
Peter Schiff points out
if defaulting on a loan destroyed the money then the Fed could
let everyone default and pay off all the loans and there would be
no problem or change in the money supply. If that really worked
you can bet they would be doing it.
Peter also points out that if you view gold as the only real money
then there is deflation. It takes fewer and fewer grams of gold
to buy things as gold gets more expensive in terms of dollars.
predicts that after an asset bubble pops there is a short
period of deflation and then high inflation.
There is a limited amount of deflationary pressure and no
limit to the amount of money the government can print, so
deflation is at most a temporary issue. The longer term
danger is high inflation. In fighting the deflation by
printing money the government sets things up for high inflation.
often the case that deflation precedes hyperinflation, for example Germany
had 50% deflation right before the start of hyperinflation in the 1920s.
Another point is that the prices of different groups of things act
differently in hard times or as you head into hyperinflation.
People always need to buy food, even if prices have gone up.
But some things are optional and people will buy less in hard times.
So the prices on the luxuries can drop in hard times.
Housing and rents tends to drop in price because people can get by
on a smaller house or apartment, or moving in with friends or parents.
So housing is a place where people will cut expenses if they have to.
So there is a good chance we see inflation in the things we really
need and deflation in the optional things. Government statistics
lump everything together which will average out the deflationary
and inflationary items. So government statistics can easily report
less inflation than the average person is feeling on the stuff they
Some people think there are hundreds of trillions in assets losing
value, so that the Fed making a few trillion will not be enough
to counteract this. The
total value of all public companies in the world is only
about $50 trillion,
so who do they think owns these hundreds of trillions?
The problem is that people hear of
hundreds of trillions in notional value of derivatives
and think this is a real value. It is not.
is the amount that the thing derivative is derived from, but
not the value of the derivative. So some insurance of
interest payments on a 2 year $1 million loan at 1% might
only cost $1000, but the notional value is $1 million.
My view is that there is a delay
from when they print money till the
effects of the monetary inflation result in price inflation.
Also, I think that the total pay-down on debt (not counting
defaults) is less than the $1.5 trillion increase by the
Federal government each year. So I don't think the money
supply is really contracting any more.
So in the short term there could be some price deflation, in particular
for optional things and housing. But that after this period, which
I think is less than 4 years, there will be serious inflation,
in particular for the necessities like food and energy. But
no matter what, I expect gold and silver to become more valuable
compared to the US dollars. This is both because of the eventual
inflation and because I expect the dollar to have a smaller role
as a reserve currency.
Go to index.
Other theories of inflation
Fiscal theory of the price level
the idea is that unsustainable government deficits
will require future inflation. This clearly applies to the USA.
When the Fed buys fixed rate 30 year mortgages at 4% interest, it is not getting good value. If interest rates go to 8% these will lose about half their value. Interest rates will probably go higher than that. So buying these weakens the Fed's balance sheet and so weakens the backing for the dollar. Buying long term debt that will be decreasing in value is a violation of the Real Bills Doctrine.
Before 1971 the money of the world had some tie to gold but after then it has not. Under a real gold standard (prior to 1914) people went 100 years without inflation and had times where prices went down some. Given advances in productivity it is reasonable to expect prices to go down. Since leaving gold in the 70s we have had high inflation unlike anything ever seen under a real gold standard. Given that inflation does not extend back into the gold period it seems wrong to expect deflation from the gold period to extend into the fiat period.
People who argue we are in for deflation, like Mish, count defaults as deflationary since they reduce the total credit. But if the central bank is not getting paid back then default is not deflationary.
Some people argue that since the Fed and banks loan money into existence they can not really increase the money supply if people are not willing to borrow more or the banks are not willing to lend more. People say the banks are just sitting on the cash. Those that argue this way forget that the government has an insatiable appetite for borrowing and spending. In 2008 the Fed started paying banks interest on reserves at the Fed. So the banks can earn interest either from the Fed or from the Treasury. This new Fed paying interest bit has helped confuse most people. One should really view the Fed as part of the government and the banks as lending their cash to the government (either Fed or Treasury). So the truth is the banks loaned their cash to the government instead of private entities, not that they are sitting on it. This is called crowding out. It is not good for business or the economy.
Another argument is that although the banks have lots of "excess reserves" they can not really loan out this money as they are capital constrained and not reserve constrained. Since banks are not solvent even if they have extra reserves they are in no position to make new loans. So banks are not able to use fractional reserve lending to increase the money supply. Since banks may make 10 times or more the credit that they have in reserves, it would be inflationary if they made loans, but they are not. Mish presents this argument and it is a strong case for deflation for some period of time. However, the Fed is doing everything possible to get at least some banks to be very profitable. Even letting them "extend and pretend" and "mark to fantasy". So deflation from this seems only for a limited time, ending when the banks start really lending again.
Some people argue that we can not get inflation while there is still high unemployment. These people will often babble about "cost-push inflation" or "demand-pull inflation" but inflation is an increase in the money supply and anyone who says different is confused. The US had high inflation and high unemployment in the 1970s, so any claim that you can't get inflation when there is unemployment is contradicted by history and should be either ignored or laughed at.
Some people argue that with housing prices and stocks down that the value of the dollar is clearly up. But this is not true either. As interest rates go up the yield on bonds goes up and the price of existing bonds goes down. To have competitive earnings or dividends at the new higher interest rates the price of stocks has to go down, and the P/E down. At first stock prices go down due to increasing inflation. After this initial adjustment period, a long enough time at stable inflation rates will tend to drive stock prices up.
Some note that a slowing of the velocity of money can also contribute to deflation. This does not seem to feed on itself in any way or explode into a big problem. So the slowing seems to be a limited impact change that continuous printing of money always eventually overpowers.
As Peter Schiff points out if defaulting on a loan destroyed the money then the Fed could let everyone default and pay off all the loans and there would be no problem or change in the money supply. If that really worked you can bet they would be doing it.
Peter also points out that if you view gold as the only real money then there is deflation. It takes fewer and fewer grams of gold to buy things as gold gets more expensive in terms of dollars.
The Ka-Poom Theory predicts that after an asset bubble pops there is a short period of deflation and then high inflation. There is a limited amount of deflationary pressure and no limit to the amount of money the government can print, so deflation is at most a temporary issue. The longer term danger is high inflation. In fighting the deflation by printing money the government sets things up for high inflation. It is often the case that deflation precedes hyperinflation, for example Germany had 50% deflation right before the start of hyperinflation in the 1920s.
Another point is that the prices of different groups of things act differently in hard times or as you head into hyperinflation. People always need to buy food, even if prices have gone up. But some things are optional and people will buy less in hard times. So the prices on the luxuries can drop in hard times. Housing and rents tends to drop in price because people can get by on a smaller house or apartment, or moving in with friends or parents. So housing is a place where people will cut expenses if they have to. So there is a good chance we see inflation in the things we really need and deflation in the optional things. Government statistics lump everything together which will average out the deflationary and inflationary items. So government statistics can easily report less inflation than the average person is feeling on the stuff they really buy.
Some people think there are hundreds of trillions in assets losing value, so that the Fed making a few trillion will not be enough to counteract this. The total value of all public companies in the world is only about $50 trillion, so who do they think owns these hundreds of trillions? The problem is that people hear of hundreds of trillions in notional value of derivatives and think this is a real value. It is not. The notional value is the amount that the thing derivative is derived from, but not the value of the derivative. So some insurance of interest payments on a 2 year $1 million loan at 1% might only cost $1000, but the notional value is $1 million.
My view is that there is a delay from when they print money till the effects of the monetary inflation result in price inflation. Also, I think that the total pay-down on debt (not counting defaults) is less than the $1.5 trillion increase by the Federal government each year. So I don't think the money supply is really contracting any more. So in the short term there could be some price deflation, in particular for optional things and housing. But that after this period, which I think is less than 4 years, there will be serious inflation, in particular for the necessities like food and energy. But no matter what, I expect gold and silver to become more valuable compared to the US dollars. This is both because of the eventual inflation and because I expect the dollar to have a smaller role as a reserve currency.
Go to index.
So by the Real Bills Doctrine, or the Quantity Theory of Money, or the Fiscal Theory of the Price Level, the US dollar is headed for inflation.
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Richer people pay a higher percentage in taxes. Inflation makes it look like people are richer, so puts them into a higher tax bracket. So Obama said he would not increase taxes on people making less than $250,000 but he could never get enough money out of the few making more than that. So if he prints enough money then after inflation lots of people will be making more than $250,000.
During the "boom times" when asset values are going up and lots of people
think they are getting rich, or inflationary times,
government tax revenues do well.
Not only does government get to spend the money they print,
the side effects of inflation on taxes are good for government,
though bad for their subjects.
By a continuing process of inflation, government can confiscate,
secretly and unobserved, an important part of the wealth of their citizens.
- John Maynard Keynes
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When the US sells bonds to the Central Bank of China it takes some dollars out of circulation. This can hide away some dollars so they can print more without causing trouble. But it is only temporary, as the Chinese will some day turn in the bonds for cash.
In particular the country with the reserve currency can sort of write checks that are not cashed for a long time but when they are cashed it is very painful.
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Also, there is still many trillions of US dollars out there, so in no way can you say "everyone has already sold their dollars". And the 30 year bond is around 4%, which it won't be when everyone is really negative on the dollar.
On TV most people are saying gold is a bubble or that it is dangerous to buy gold after it has gone up so much. The truth is most people these days have never even seen a gold coin, let alone invested in gold. So contrarian investing would still be to buy gold.
One evidence people have used to claim there is a gold bubble is all the "cash for gold" parties going on. But at these the public is selling gold to a buyer. In a bubble the public would all be buying something, not selling.
The real bubble is in US government debt. As interest rates go up (where else can they go from zero on the short term to 4% on the 30 year) the bond values will go down.
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First off, there is a problem with any asset that only seems valuable if nobody sells it. The value is not real. It is probably a bubble that is about to pop. You really don't want to hold something that you can not sell.
The problem with this logic is that even if one country does not sell, other countries can. In particular, even if one does not sell, the US will still be printing and spending another trillion every year. So the longer they wait the less value they will get when they sell. For Russia, or Brazil, or Saudi Arabia, or any country, retirement fund, etc. the sooner they sell the better. Each is much better off to be the first to sell than the last to sell. In this situation it is more rational to sell than to wait.
This is a bit like the Prisoner's dilemma. In this prisoners would be better off if they all kept quiet, but that is not what happens.
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The Fed saying they can stop printing any time is just like an alcoholic saying they can quit any time.
The truth is that the Federal budget is out of control. In October of 2009 the federal government spent $2.30 for every $1.00 they took in. There will be more than a trillion dollar deficit every year going forward. The Federal government will sell bonds for the amount of the deficit plus any bonds coming due. Investors have gotten out of long term bonds, mostly buying short term, so many come due all the time. The Fed will buy any bonds not bought by anybody else. If they did not, the Federal government would change the laws governing the Fed or the people running it till they did.
The government spending is out of control and the Fed will keep printing as fast as the government needs.
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The delay even makes sense. Initially as the central bank prints money and buys bonds they are forcing the interest rate down. As Hussman shows, lower interest rates result in a lower velocity of money. Using the equation of exchange we can see how initially the lower velocity of money can sort of compensate for the higher quantity of money, so prices may not go up much. However, a substantial increase in the money supply that is not followed by an exit strategy will eventually result in price inflation. Then the central bank will try to fight inflation by not printing so much money. But if they are not printing money and buying bonds the interest rates will go up. And as the interest rates go up the velocity of money goes up (again Hussman). This time the equation of exchange shows, an increasing velocity of money will tend to push up prices. So it can be hard to "put the inflation genie back in the bottle".
Milton Friedman explained that a central banker that did not understand the delay between printing money and inflation could act like a fool in the shower. If you just look at the current inflation rate you may think it is ok to print more money even though so much has already been printed that high inflation is coming.
Keynesians reason about what happens when they print more money with the assumption that most people don't understand what is going on. In the 1920s and 1930s, when people's parents and grandparents had been using gold money, this was clearly true. You had people in German with piles of money who could not understand why it was worthless. But today, when people's parents and grandparents lived through the 1970s, people know that if you print too much money it will not be worth as much. If people have piles of US dollars they will understand that the Fed printed too much money. So Keynesian reasoning seems fundamentally flawed.
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A central bank is supposed to only loan out money, so it can theoretically get all the money back and not cause any permanent inflation. In fact, since it is charging interest it can pull in lots of dollars as interest payments. Clearly a bank that can charge interest and print money out of thin air will be very profitable, and so able to pull in lots of dollars. So it is much easier to maintain the value of paper money when all money is only loaned out. In fact, theoretically there are not enough dollars out to pay back both the loan and the interest, since the dollars printed is only equal to the loans created. So as the central bank makes more and more on interest the dollars should become scarcer and scarcer and so more valuable. So deflation is at least theoretically an easy thing to get with a central bank system.
Where this central bank system breaks down is when the central bank loans new paper money out to banks, companies, governments that go bankrupt and don't pay back. These dollars are then out in the wild and inflationary. Buying toxic assets that can not be sold for the price paid is a similar thing. The biggest breakdown is that the government is not really going to ever pay the loans back.
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When a government's debt level is over 80% of GNP and the deficit is over 40% of government spending it is probably headed for hyperinflation. What happens is that people are not confident of the long term prospects, so move into short term debt. Then some people stop rolling over their bonds and get cash as the bonds come due. This causes the government to need to print more money. But the more money it prints the less people want to hold its bonds. But the less people want to holds its bonds the more money it has to print. So you get into a positive feedback loop called hyperinflation where things get out of control. As things progress it not only has to print money for the full deficit, but also for any bonds that come due. This can be a huge amount of printing. With a large deficit and lots of bonds coming due it is not possible to increase taxes enough or reduce spending enough and so the government is forced to print. Once a government is in a situation where it is forced to print significant quantities of money it can get hyperinflation. This is a common occurrence even in modern times. The math for hyperinflation is not very complex. There are typical stages hyperinflation goes through.
Most people can't imagine the USA having hyperinflation. However, many great nations have had hyperinflation. Even America has had it twice already, first during the revolution and then in The South during the civil war. There are good reasons to expect the US will get hyperinflation again soon. It seems the US has gone so far down the path toward hyperinflation that it will not be possible to avoid it.
In most countries the central bank has some kind of reserves to support the currency. So if the currency is too low, they buy up some of their own currency, using their reserves, to support the value. The US reserves are mostly in bonds. The problem is the Fed has moved into long term bonds which can drop in value as interest rates go up. So the value of the bonds can drop so that they do not have the ability to buy back as many dollars as there are out there. If other countries stared to unload their dollars there is nothing the US could do to that would support the value of the dollar. At that point it will be like rats leaving a sinking ship.
With unusually low interest rates the interest on the US national debt was $454 billion in 2008 while total taxes are about 4 times that. So around 25% of the taxes are needed just for the interest, even at these amazingly low interest rates. If interest rates double or triple it would be clear to everyone that the US has no chance of using taxes to pay down the debt.
Peter Bernholz wrote a book called Monetary regimes and inflation: history, economic and political relationships . Bernholz studied 29 cases of hyperinflation and says that hyperinflation follows after the debt gets over 80% of GNP and deficit gets over 40% of spending for a few years. You can see some of Bernholz information here.
There are many routes to get into the hyperinflation positive feedback loop (war, dictatorship, democracy, revolution). But once in it what do you have to do to stop it? Bernholz page 193 says, “A necessary condition to stop hyperinflation is to end money creation for the purpose of financing budget deficits of the government, its agencies and the losses of firms owned or controlled by it. For this purpose a strict limitation of these deficits is necessary.” If the only way to stop hyperinflation is to stop printing for the deficit, it seems very clear what the core problem is in hyperinflation, printing for the deficit.
Once it becomes more obvious, the US will probably have a few budget cuts and some hyper-taxation of "the rich" to try to hold off hyperinflation, but it won't work. Most of the US budget is mandatory spending, so it is not possible to cut enough. The taxes are already so high that, as the Laffer Curve explains, raising rates will not increase revenues much. Interesting to note that back in 1901 J. Shield Nicholson said the same thing as Laffer. Higher taxes will also cause more capital and rich people to flee the US. By hurting bond sales and lowering GNP this helps bring on hyperinflation.
Someone has noticed that if we called it Super Hyper Inflation Trauma the initials would be interesting.
One of the most common claims is "the powers that be would not make hyperinflation because it would be bad for them". There are two problems with this. First, hyperinflation is when events cause government money printing to get out of control. I don't think any of the 100+ cases have been planned ahead of time. Second, actually, if someone knew for sure there was going to be hyperinflation, they could make very good money. Never attribute to malice that which can be adequately explained by stupidity.
Another claim is that people were predicting hyperinflation last year and it did not happen so they are wrong and should be ignored. However, with bonds paying about 0% per year and having the prospects of losing 90% of their value very quickly in hyperinflation, getting out years early is better than being at all late.
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Capital flight and hyperinflation go together. As the capital flees a country the government is no longer able to borrow money and has to start printing.
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The currencies can catch themselves after they devalue compared to gold to where the central banks gold reserves can match the currency issued. In many banks the gold reserves are only like 5% of their reserves, so the currency would have to devalue by a factor of 20 before the gold could support the currency. The US claims it has around $300 billion in gold. They have fought any audit of this so there is some doubt that they really have it. The US has been known to loan gold to companies that go bankrupt. However, if they had it and held onto it till the price of gold went up by 20 times or more then they could use that gold to support the US dollar. If they use the gold earlier they would just lose all the gold.
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In India, where so many people buy gold, the average person will seem much richer compared to the world average, after worldwide hyperinflation. It will be much easier for them to start using gold as money, since it is so widely held.
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For more details on the stages of hyperinflation, and historical examples, I highly recommend Monetary regimes and inflation: history, economic and political relationships by Peter Bernholz.
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If you understand the above 3 points, then simple math and a standard economics formula shows how these 3 factors combine to cause prices to go up much faster than the money supply alone. The effect of printing money on prices becomes non-linear in hyperinflation. A 10% increase in money does not mean just a 10% rise in prices, it becomes much more. This non-linear effect is why hyperinflation is so "out of control".
Another non-linear change is when governments go from "rolling over" existing bonds and funding a large part of their budget deficit with new bonds to having to pay off bonds that come due and not being able to sell new bonds or "roll over" bonds. This is particularly painful if most of the bonds are short term so they come due quickly. This makes a sudden and drastic increase in the amount of money the government must print.
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The reserve currency of most of the world is really controlled by a single human being, Ben Bernanke. It is pure lunacy to have a system that puts so much power in a single human. After enough different humans are tried over the years we are bound to find one who ruins the currency. So given the situation, it is worth looking at who that human is.
In 2004 during the real estate bubble, Bernanke gave a speech titled "The Great Moderation" where he praised the Fed for doing a good job. As the trouble approached Bernanke had no idea the current mess was coming. As late as Apr 2008 Bernanke said, "A recession is a technical term. I'm not yet ready to say whether or not the U.S. economy will face such a situation." He was Incredibly, Uncannily Wrong. Having 1,000 Keynesian economists working for him just helped him be wrong. Mish put it well with, "The result of Bernanke's blind allegiance to mathematical gibberish is that in spite of his PhD, he could not see a housing bubble that was obvious to anyone using a single ounce of common sense." When asked about the danger of a housing bubble he said that " we have never had a decline in housing prices on a nationwide basis". A student of the Great Depression should have known this was not correct. There is a page with much more on Bernanke.
A common flaw that generals make is "fighting the last war". Since the generals studied what happened in the last war, they tend to use the strategies and tactics that worked well back then. The problem is that when the situation has changed the methods of dealing with it must change as well.
Anna Schwartz says Bernanke is fighting the last war. Bernanke has agreed that the Fed caused the Great Depression. He said, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." Bernanke gives the impression that the gold standard and not printing money fast enough was the problem in the Great Depression. If you read his papers he says the miss-managed "inter-war gold standard" of $2.5 paper dollars for $1 gold but convertible at 1 for 1 was the problem. That was not a real gold standard but a Ponzi-gold-standard.
The root problem of the Roaring 20s and Great Depression was a Ponzi scheme by the Federal Reserve where they only had $0.40 worth of gold for each $1 in paper and said each $1 in paper was redeemable for $1 in gold. The increase in money led to a stock bubble. When people tried to exchange their paper in the Ponzi-gold-standard for gold the government had bank holidays and then made it illegal for people to own gold. So it was the Fed pushing bad money on the USA and then the government stealing the people's gold that caused the trouble, not a real gold standard or printing money too slowly.
For many years now the Fed has been printing money and the government has been borrowing huge amounts. Now with Obama it has exploded. The Fed is buying up toxic assets for more than they are worth. When the Fed increases the money supply this way they do not get an asset that could be later sold to reduce the money supply. So they are devaluing the money. When the Fed is devaluing the money it makes sense to borrow money from the Fed and convert it to other currencies and invest outside the US. Loaning dollars out that will be repaid later with cheaper US dollars is not as sensible. Once again the Fed has mucked up our money, but this time not by a small factor.
Bad money causes huge problems for the economy. The Fed is again printing money fast and making bad money. A problem caused by too much bad money will not be fixed by making more bad money. Bernanke seems to always want to print more money, so he does not seem like the ideal person to be controlling the worlds reserve currency.
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Obama ran as the candidate for the common man. But once in he has given hundreds of billions of dollars to rich bankers in poorly run or crooked companies while taxing honest and decent folks more. Rich people can invest so that inflation does not hurt them, but poor people will see their wages not able to buy as much. Middle class will see their variable rate mortgages go up so that their monthly payments go up. The coming inflation is really the most regressive tax possible. As Daniel Webster said, "Of all the contrivances devised for cheating the laboring classes of mankind, none has been more effective than that which deludes him with paper money." The anti-business rhetoric and actions drives investment away, dropping the value of American companies and real estate. This hurts retirement funds and job opportunities for all Americans. It is not because of Bush that the market crashed when it looked like Obama was going to win.
Obama is taking America down the The Road To Serfdom that Friederich Hayak wrote about in 1944. More and more government control leads to less and less freedom till eventually you have tyranny. The statist ideas of government controlling the economy have been tried many times under names such as Fascism, Communism, or Socialism. America should learn from the sad results of these other experiments and not repeat them.
The private sector has to pay for the government in one way or another (taxes, bonds, inflation). The bigger the government gets as a percentage of the total economy the harder it is on the private sector to support the government. As a country's government gets bigger, the overburdened private sector becomes less attractive as an investment, so capital flows away to better countries. An overburdened private sector also means the future ability of the government to pay its bills without printing money becomes more doubtful. Both of these hurt the value of the currency for that country. An important study shows that cutting government spending and cutting taxes help an economy grow.
A big reason the Great Depression lasted so long and that the current mess is looking so bad is regime uncertainty. In a capitalist system investors know the rules and can invest based on reasonable predictions of the future. Today many CEOs can's stand Obama. When a government is frequently changing the rules it is better to invest someplace else. Like Hoover and FDR, Obama is "working hard to fix the economy", and in doing so he is messing it up. It was only after the government focused on WW2, and stopped troubling the economy so much, that the US recovered from the Great Depression.
Many people have criticized Obama for being against capitalism. He has claimed he supports capitalism while 77% of investors surveyed think he is anti-business. Obama's defense is claims like, "The auto bailout is a very politically unpopular decision that was made that, from my vantage point, is pro-business". This shows a fundamental misunderstanding. This type of thing is not "pro-business", it is "pro-AIG" and "pro-GM" but is not good for business in general as taxes/inflation/debt will go up. After this taxes on banks and anyone making over $250,000 per year went up (small business owners). When the government takes money from productive parts of the economy and gives it to poorly run or crooked companies it hurts the overall economy. Giving taxpayer money to AIG or GM is certainly not capitalism, it is corporatism as in the New Deal. I think Obama is a corporatist. The government needs to put those using fraud to take billions of dollars from people in jail, not give them more billions.
Obama's cabinet has the least private experience by far. They don't understand that small business owners are troubled by high taxes, regulations, red tape, etc. produced by government since they were never in that position. They don't seem to even listen to business people, just try to vilify them and add health care and carbon tax to their already heavy load. Most new jobs are created by successful small business owners, but these guys typically make over $250,000 per year, so they are right in Obama's cross-hairs. Not understanding what they are doing, the Obama team will be surprised when no private jobs are created.
Forbes makes an interesting case for Obama being an anti-colonial fighting the fight of his father against the capitalist imperialist powers.
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However, when it came to money and business cycle theory Friedman believed in governments printing money almost like a Keynesian and claimed the theory caused harm. Friedman thought Keynes was a better economist than Mises. Friedman did not understand that the Fed created the bubble economy of the 1920s which resulted in the crash. It seems he did not understand that the 1914 to 1933 rules for the Fed limited it to $2.5 dollars for every $1 worth of gold it had and thought the Fed should have just printed more money during the recession.
Friedman is in stark contrast to the real capitalist economists, the Austrian economists, who see the government messing with the money supply as causing both the bubbles and the crashes. They advocate sound money. Because, when the price of money is rigged, the market isn't free.
Rothbard explains that Friedman supported government in macro-economics and capitalism in micro-economics, which is sort of half support of capitalism.
It is a sad legacy for Friedman that hyperinflation is probably coming because Bernanke is such a fan of Friedman. It is ironic that the US government is destroying the currency, the economy, and capitalism in America using advice from someone who is thought of as a great supporter of capitalism.
Very late in his life he said that he thought Bernanke was good but that you should not have an institution that depends on one man being good, that his first choice would be to end the Federal Reserve.
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An honest money is one that people can not just randomly make more of. Gold and silver are the natural candidates for this as they have worked for around 5,000 years.
Gresham's Law says that "Bad money drives out good under legal tender laws". If creditors have to accept paper money as equal payment to that of gold money, then the gold will be used somewhere else where it can command a higher value.
In a free market Gresham's law works the other way, Good money drives out bad. People would rather hold a stable currency than one that is dropping in value. Sometimes they do so even when it is illegal.
In the US Ron Paul introduced the Free Competition in Currency Act in 2007 and again in 2009. If private money became legal in the US, it would probably drive out the government paper money.
Between countries there is no legal tender law forcing people to use bad money. They can choose whatever they want to use as money. In this situation it makes sense for them to switch from US dollars to gold. No country wants to have their wealth stolen from them when they can prevent it.
John Law explained in 2006 why gold would remonetize. I recommend reading what he wrote. John Law is not the author's real name, John Law is famous for a failed French experiment in paper money. The author seems to also write as Mencius Moldbug and has written a more recent paper on the same topic and also has a blog called unqualified-reservations.
Game theory predicts that central banks will move to gold and remonetize it. This will drive the price up in terms of dollars.
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Gold and silver are sound money. If one country is holding some gold they don't have to worry about some other country printing more and stealing the value of their gold. If gold is used between countries to settle payments then no single country gets to print currency and buy as much international goods as they want without exporting stuff of a similar value. The current world imbalances would not happen if gold was used as money between countries.
In the US, from 1933 to 1974 it was illegal to own gold. These 41 years broke most Americans from thinking of gold as money. However, the 5,000 year tradition of gold as money was not so badly broken in the rest of the world.
There is a reason that people say as good as gold.
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Under the current system where the US has the Exorbitant Privilege of being able to print paper money that is used all around the world, there is no natural balancing force. The US can keep printing money to pay for imports and never run short.
But the more money the US prints, then the more people in the US have. The wages inside the US then seem very high compared to the rest of the world. So the printing of paper money inside the US drives jobs overseas. Gold does not do this (except when Spain took lots of gold from the New World).
The balance of payment issues don't get so out of balance if gold is used between countries. If money is gold, then you can't keep buying things if you are not also selling things.
Back in the 1960s Robert Triffin explained why using a national currency as the international reserve currency would fail. This is now called the Triffin Dilemma. The basic problem is that more and more money will be created till at some point people will lose confidence in it. The issuing country, the US, gets real stuff by printing money, so they print more and more till other countries get fed up and put an end to it. But this instability does not happen if gold is used for international payments.
So the US imbalances are large. In 2006 about 6.5% of GDP. At 5 or 6% of GDP this imbalance is around 20% of exports. So the US is importing 20% more than it is exporting. This is unsustainable.
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Another way to look at fractional reserves is as "creating money". Demand deposits count as money. People assume they can spend it at any time. If a bank sold a 5 year bond for $100,000 and then made a 5 year loan for $100,000 it is not creating money. But in fractional reserve banking things are different. Imagine a bank gets a $100,000 demand deposit and loans out $90,000 on a 10 year loan and the person that gets the loan puts it in another bank as a demand deposit. In this situation both the $100,000 demand deposit and the $90,000 demand deposit count as part of the money supply. So the bank has sort of increased the money supply by $90,000. Note this could be repeated many times. There is a fraud in this system though. With demand deposits everyone is theoretically allowed to take out their money at the same time, but there is not enough money for everyone to take out their demand deposits at the same time. In that situation everyone expects the Fed to print lots of money and "provide liquidity" to the banks (loan them lots of money). This is part of what happened recently.
The government has a reserve requirement that they can change at any time. This requires the bank to keep a certain amount of money sitting around unused, maybe 10%. But since it can change, it really keeps banks from doing the safe thing of 100% matching of the duration of their deposits and loans. So once again we see that some government law has unintended consequences.
Sometimes people say "debt is money". I don't say that because if debts were funded by deposits of the same duration debt would not be involved with money creation. However, if all debts come from fractional reserve banks making long term loans from demand deposits, then the total amount of debt can tell you how much money the banks have created.
I think the right way to look at bank crashes is as an FAA agent, or Engineer, or Programmer would. Figure out why bank crashes happen, locate the design defect (lending long term on short term deposits) and fix the core problem so it does not happen again. A new law saying that all loans much be against deposits of the same duration would fix it. Of course this is not how US government changes to financial regulations worked at all.
For more information see a detailed explanation of the mystery of banking.
This leads to a pattern of trouble that repeats over and over in history:
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A "solvency crisis" on the other hand is when the total value of the loans is less than the total value of the deposits.
Anna Schwartz says the current problem is a solvency crisis, not a liquidity crisis. The problem is that so many loans have gone bad that banks can not cover their deposits, even if all the remaining loans paid off. A liquidity crisis can be handled by the Fed loaning the bank money which can then be paid back. However, in a solvency crisis money given to banks can not be paid back. When the Fed gives money to banks that is not paid back it is inflationary. But people are treating the current mess like it was a liquidity crisis.
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Imagine that $100 million company had higher earnings than $100 million in bonds did. Then you could sell some bonds, buy the company use part of the company earnings to pay the bonds and pocket the rest. This is a Leveraged Buyout.
Imagine that people were paying more for a company that earned $10 mil than for bonds that earned $10 mil. Then you could form a company that sold shares and bought bonds. It would then have better earnings than companies of its market cap and yet lower risk and so be a better investment. Many "dot com" companies took the money from their IPOs and put it into bonds, giving them earnings that looked reasonable.
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In the US a company's earnings are taxed and then when a shareholder gets paid dividends those same profits are taxed a second time. In the 1980s some people noticed that companies can deduct from their earnings any interest expenses they pay to bond holders. Since taxes are reduced, a company was sort of worth more in the hands of bond-holders than in the hands of shareholders. This caused a boom in leveraged buy outs.
Imagine there is a company that has $10 million in pre-tax profits and the current P/E is 10 and interest rates are 10%. Further imagine that this company has taxes of 40%. So after taxes of $4 million the profits are $6 million and with a P/E of 10 it is valued at $60 million. Imagine it pays the whole $6 million out as dividends to shareholders.
Imagine we start a new company and sell $60 million in bonds and buy that company. Now the interest on the bonds is $6 million, so our company has $10 million in pre-tax profits from the company we bought and $6 million in expenses. So net we have $4 million in profits. After 40% taxes, or $1.6 mil, we still have $2.4 million per year of new found money.
So if we move $60 million worth of investors from stock holders to bond holders, they can still get the same $6 million per year (but as bond interest instead of stock dividends) and we make $2.4 mil per year. The key to this trick is that taxes were reduced from $4 mil to $1.6 mil because the bond interest is a pre-tax expense. If we can buy the company for anything under $100 million we could make a profit. At $100 million the earnings would just cover the bond interest and the government gets no taxes. With enough others trying to do this we might bid the price of the company up from $60 mil to $100 mil, or up 67%.
In this kind of environment there is huge money in doing "leveraged buy outs" and "mergers and acquisitions". This will tend to drive up the stock prices too, as this method of reducing taxes increases the real value. But the government is losing tax revenue from this trick. So on October 14-16 the House Ways and Means Committee proposed legislation to ban leveraged buyouts and hostile mergers. The market crashed October 19-20, 1987. The proposed law change and market crash are very much related.
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Assuming that you accept the main conclusion of this article, that paper money is going to go down in value, what should we expect the stock market to do?
One line of thinking is that companies represent real value, far more so than paper money, so as paper money goes down the value of the stocks should go up. In hyperinflation you are much better off owning companies with real assets than just paper money.
Another possibility though. If inflation starts and interest rates go up, then by the P/E argument (see 2 sections back) we would expect stocks to go down, at least at first.
Another issue is that during the housing bubble the whole country thought they were better off and spent more money. So all kinds of companies found it easier to make profits. With this gone, all kinds of companies are going to have a harder time making profits. So the stock market could go lower.
Another effect is that the whole US will be worse off when the US can not just print money and get stuff from other countries. The US will suddenly have a hard time buying oil or things from China when it has to export as much as it imports. So all kinds of US companies will be in hard times as US citizens are in hard times. So this will be bad for the market.
The US government is growing and will be increasing taxes, which hurts company profits, which hurts stock values. Also, with the mandated health care and other government regulations the US is not as good a location to run a business. As a country moves more toward a government controlled economy it is not as good for investors to put their money there. So investors will probably be investing more outside the US and this will cause stocks to go down too.
A big question is do we expect to first see a gradual rise in inflation, or will we just suddenly get a devaluation of the dollar? I don't know.
While there are many good reasons for the stock market to go down, the risk of sudden dollar devaluation and so rising stock prices in terms of dollars, makes going short on the market in dollars dangerous. However, shorting the market it terms of gold could be very reasonable. You might sort of do this by going long gold and short the market.
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The US government requires that these funds invest in government debt. However, the Federal Reserve is usually holding interest rates artificially low by printing money and lending it out. So it is often the case that the real inflation rate (though maybe not bogus CPI measure) is higher than the interest rate. So instead of increasing in real value the forced investment is a loser. It is as if money were robbed from the Social Security fund and transfered to the government.
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Fannie Mae and Freddie Mac are really owned by and fully backed by the US government at this point (effectively nationalized). So when the Fed buys bonds from these it is really the same as buying Treasury debt. While everyone knows that if the Fed buys Treasury debt it is monetizing the debt which will cause inflation, people don't yet seem to realize that the Fed buying FM&FM debt is also monetizing debt. They also ignore FM&FM when looking at foreign holdings of government debt.
The Fed is also paying interest to banks to get them to hold excess reserves off the market. This is about the same as if the banks had bought Treasury bonds and the money was off the market. It is best to just think of The Fed, The Government, and FM&FM as all inside the same box. Just think about what is going in or out of that box.
The net is the Fed is creating over $1 trillion in new money per year and over $1 trillion in money is ending up with the treasury each year. But if the new trillion went directly from the Fed to the treasury people would panic.
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Another point. If you have a small government that is taxing at 10% of GNP but spending at 20% of GNP we can imagine that it just increases taxes and balances the budget. However, if a government is taxing at 30% of GNP and spending at 60% it is really not reasonable to double taxes. So spending twice what you get in taxes is much more dangerous for a big fat government.
The US government has made a big increase in their future mandatory expenses with the health care changes. So the deficit situation looks to be getting worse, not better.
Krugman also points out that if GDP is growing at higher rate than the debt interest rate that interest alone is not making debt/GDP ratio worse. While this statement is true, it ignores a few big problems. First, the whole Federal deficit is growing the debt, not just the interest. The whole deficit is around $1.5 trillion. With around $15 trillion debt this means the debt is growing by around 10% per year, which is much higher than the GDP growth rate. The second problem is that the GDP may not even grow for awhile. The third problem is that interest rates can and will go up. Interest rates are amazingly low right now but there is no way they will stay so low. Since most government debt is short term now it is like the government has an adjustable rate mortgage, as soon as rates go up they have to pay higher interest and the deficit will grow even larger. They will have to print more money, which will drive up rates more, which will lead to even larger deficits and even more printing, etc.
Even Obama said, " The long-term deficit and debt that we have accumulated is unsustainable".
Krugman has a model showing that if the debt gets too high you get hyperinflation. However, he thinks the US is nowhere near the danger level. The big flaw with his model is that it ignores the huge deficit problem and only looks at servicing the debt. Given that the article is subtitled "When do deficits cause inflation?" it is amusing that he ignores the deficit problem. But the deficit is around 10% of GDP. Of this 10% about 8% is structural and only 2% is debt servicing (at current low interest rates). There is so much mandatory spending in the Federal budget that the deficit is huge and nearly impossible to fix. Krugman is only modeling the 2% of GDP problem and ignoring the 8% of GDP problem. If there was no structural deficit problem then the current debt level would be sustainable. If he modeled the full deficit then he would show the US is dangerously close to hyperinflation.
It is amusing that Krugman was very worried about the deficit when it was much smaller in 2003.
I also wrote about debt level comparison to WWII on my blog.
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The market cap for the whole US stock market is about $15 trillion. So a US government deficit of $1.5 trillion per year is like having to borrow enough money to buy all US public companies every 10 years.
The US deficit is unsustainable.
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"Britain's then Chancellor of the Exchequer, Harold Macmillan, advised his Prime Minister Anthony Eden that the United States was fully prepared to carry out this threat. He also warned his Prime Minister that Britain's foreign exchange reserves simply could not sustain a devaluation of the pound that would come after the United States' actions; and that within weeks of such a move, the country would be unable to import the food and energy supplies needed simply to sustain the population on the islands."
Some say this marked the end of the British imperial power and the start of America as a "superpower". The GNP of America at about $14 trillion is about double that of China's GNP of around $7 trillion. However, if the exchange rate between dollars and Yuan were to change by more than a factor of 2 we would then measure China as the larger economy. China has enough US bonds that if they were to start selling them, and let the Yuan rise, the ratio would probably change by much more than a factor of 2. If China threatens to sell US bonds it can influence America.
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Financial crises preceded both the American secession from the British and the Southern secession from the USA. The current crisis has some chance of being followed by secession of some states. Senator Tom Coburn said that every great republic has died over fiscal issues.
When the states got together and created the Federal Government they agreed to a certain set of limitations on what it could do. In the 200+ years it has grown well past the originally specified agreement. The US oath of office is to defend the constitution. But over the years it is ignored more and more. In 1920 the US passed an amendment to the constitution to prohibit alcohol but now they would just claim that the "general welfare clause" or the "interstate commerce clause" gives them the power. Previous presidents would not assume a position at the UN because that would violate the constitution, but Obama is ignoring this. Another example is that the new health care bill bought votes from two states by making special exemptions for those states, which violates the constitution's requirements that citizens in all states are treated equally. In fact, the heath care legislation violates the constitution in several ways. In the past the constitution limited the powers of the Federal government, but if they can force everyone to buy a service or product then they can do anything and the constitutional limits are ignored from now on. In many ways the USA is losing the tradition of Rule of Law. This is a very bad thing. Not staying within the limits of the constitution is one of the main complaints of the Tea Party movement.
The Federal Reserve has the power to impose an inflation tax on people. The Fed is theoretically a private company. The people running the Fed are not elected by the voters. Taxation without representation was one of the reasons for the first American Revolution.
As a backlash to overreaching Federal government, states rights movements are growing across America. People are talking about taking the 10th.
There are growing secession movements in some states. The states have many legitimate reasons to say the Federal Government is in violation of the terms of agreement and terminate the agreement. If there comes a time when paper money from the Federal government for unemployment, welfare, food stamps, Social Security, Medicare, etc. is so devalued that it no longer is enough to take care of people, then states may decide they are better off eliminating payments to the Federal government and taking care of their own people. If Texas, Alaska, and New Hampshire were to leave, then the remaining states would have a higher debt load per capita. So the prospects of the government paying debts without inflation would go down, devaluing the money even more.
Benjamin Franklin said, " When the people find that they can vote themselves money, that will herald the end of the republic."
Alexis De Tocqueville, wrote a similar warning in "Democracy in America" (1835): "The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money." The US has reached this point.
It is interesting that thousands of years ago Plato wrote in The Republic about democracies naturally coming to an end, "And so tyranny naturally arises out of democracy, and the most aggravated form of tyranny and slavery out of the most extreme form of liberty?". Democracies can vote an end to themselves, so the people can no longer vote things back to the way they were. Plato does not discuss any solution to this problem.
When a currency collapses people often resort to using gold or silver, or some form of barter. When this happens "sales tax" and "income tax" hardly exist. If person A trades some eggs for some corn from person B, who would pay sales tax or income tax and how much? With checks, credit cards, and big companies like Walmart there is a paper trail so the government can enforce taxes. If two individuals swap some eggs and corn there will be no paper trail and no enforceable taxes. If the currency has failed the government does not get much by printing more of it. A government with a failed currency and little taxes coming in will not be able to borrow money. If the government money a tax collector gets paid with is not enough to feed his family, he will probably leave for other work. When a currency fails a government's very existence is at risk. Many governments and empires have failed as their currencies failed.
It is sometimes said that there have not been any successful secession movements in America since the secession from the British; however, this is not exactly correct. West Virginia seceded from Virginia, Nevada seceded from the Utah Territory, also Texas and California seceded from Mexico. The civil war changed American thinking on secession.
America's Declaration of Independence states, "That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it,[...]". This attitude has meant that the US has supported self determination movements around the world. It would be hypocrisy to forbid this inside the US, though the idea of Perpetual Union from the Articles of Confederation seems to do so.
Insurgency, revolution, secession, and counter insurgency make for interesting times. Historically, paper money does not retain value well through such conflicts.
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The graphic above comes from a paper with lots of data showing that the larger the government the slower the economic growth rate. Also, this report shows big government is bad for growth.
This makes sense. Most of government spending is really an overhead that the productive parts of the economy must pay for somehow (taxes, bonds, inflation). Things like courts, police, roads, etc. are good things, but they can be viewed as overhead costs for the economy. The more that is lost to these overheads the less the productive parts of the economy have to invest in growth.
In the short term a government spending lots of money can make it look like things are prosperous. But this is similar to a family looking prosperous because it has borrowed a lot of money and spent it. Short term things look good but long term they are worse off.
Another way to look at it is that they define GDP to be consumption + investment + government spending, so clearly increasing government spending helps GDP in the short term. Then we get guys like Krugman who look at short term data and almost say, I just knew if the government got bigger we would increase the GDP. But this does not help long term growth. It really distorts the economy away from productive things.
There is a good video of Milton Friedman on Freedom vs Tyranny & Misery.
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Another admirable limited government experiment is the Swiss Confederation which was founded in 1291, over 700 years ago. Most of this time the government was limited and avoided the many wars going on around it.
Also, the Dutch Republic, or "Republic of the Seven United Provinces", lasted from 1581 to 1795 or more than 200 years. This 3rd case also had sovereign powers cooperating.
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If there is no government at all then the odds are you bypass limited government and go straight to oppression. The first guy to form a gang and start taking tribute can grow his power. The more territory he covers the more income he has, the more gang members he can support, and the harder it is for anyone to resist their power. It is a snowballing leech. Soon the gang is really a government. Anarchy does not last.
Any territory really needs to be defended around the perimeter. Wars are usually fought mostly on "fronts". Since the area goes up with the square of the width and the perimeter only linearly, the larger the leech the better its ratio of tribute to perimeter. So the bigger it gets the harder it is to resist. So any small area of anarchy is also likely to be taken over by an adjacent country with a higher concentration of military power.
Power can form from inside or be imposed from outside, but either way, Anarchy is much less stable than a limited government. We have examples of limited governments lasting hundreds of years. Anarchy power vacumes are filled very fast.
There is an interesting paper called War, peace, and the size of countries by Alberto Alesinaa and Enrico Spolaore. It looks at the dynamics that determine country sizes.
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A death tax of 55% means that after the government taxes a small business and its owner all his life, when he dies the government takes another 55% of his assets. Now to pay this tax the kids will have to sell the business or heavily mortgage it. Big corporations do not die and so do not pay death taxes. So the payback for buying a small business is longer and better for a big corporation than another individual. Over time the tax policy destroys small family businesses and pushes them into the hands of large corporations. The government is destroying small farms and small businesses which create most of the jobs.
If the government takes half their money when alive and another half when they die, the government is taking around 3/4 of their life earnings. It is like they are 3/4ths slaves. It is amazing that so many people stay in such a situation when they could leave.
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Warren Buffet said the trade problem needs to be solved or the US dollar will have a large devaluation. He also proposed a solution. Basically he suggest issuing Import Credits to US exporters and requiring importers to have credit to be able to import. There would be a market in Import Credits. The net effect would be to subsidize exports and add to the cost of imports. But it might be possible for the US to balance trade this way.
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In America much of the borrowing is from foreigners and indirectly new money from the Fed. Hyperinflation comes when a bloated government can no longer borrow and has to print money. Japan was at the mercy of their own citizens, who had a strong tradition of saving. That the citizens did not have the money to spend was deflationary. Saving at near 0% when real inflation is higher is not reasonable, but traditions like saving change slowly. After 2 decades it seems to be changing. America is at the mercy of foreigners who can easily change where they put their money. It will not take them 2 decades to move their money to someplace where it makes more sense. America is much closer to Hyperinflation now than Japan was in 1990.
While Japan did a lot of quantitative easing, Japan unwound their quantitative easing, (see figure 10). The Fed bought toxic assets that it will not be able to sell when it needs to.
The yen has appreciated against the dollar from 360 in 1971 to 80 in 1995. Since world trade is mostly in dollars, as the yen got stronger against the dollar people in Japan saw prices for world commodities going down. Basically the US has been printing dollars faster than Japan has been printing yen. Even so there has been only tiny amounts of deflation, nothing like when the US Ponzi-Gold standard was breaking in the Early 30s.
Today Japan, with debt over 200% of GNP and much lower savings rates than in the past, may be closer to hyperinflation than the US. Defaulting to non-voting foreigners can help your local economy, you get ride of a debt burden. However, Japan owes this debt to their own citizens, including the ones that are retiring. Defaulting to your own retiring voters, who you need to take care of anyway, does not provide any gain to the local economy. Defaulting to your own voters, when you can print money, is unheard of. It won't happen. Japan will print money and pay off these loans. As they do, the value of the yen will fall fast, people will flee the yen, and they will get hyperinflation.
Here is a quote from Black Swan, who posts on Mish's blog, about what is different between the US case and the Japanese case: "Demographics and a massive trade surplus vs a massive trade deficit come to mind. America's 100% higher unemployment rate could also be a factor. No immigration vs massive immigration might also be construed as a difference, as could Japan's lack of cities like Detroit, East St. Louis, Gary, NOLA, Camden, NJ and Bell, Ca. Other that those differences, and Japan's lack of illiteracy and oil dependence, I can't thing of much else."
If people save 15% of their money and then loan it to the government it controls inflation about the same as if the government had an extra 15% tax on the people. But since the US does not save at the high rates that Japan did, they can not do the same trick.
It seems that debt over 80% of GNP and deficit over 40% of government spending leads to hyperinflation (see Bernholz). Japan did not have such high deficits.
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This reminds me of how after WW-II the US was able to get countries to peg their currencies to the dollar in part because it was going to be giving countries aid. So for a few years the US handed out aid and then for many years it has stolen value from currencies pegged to the dollar via their dollar reserves.
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Now if things happen orderly and gradually then the brokerage margin requirements will be sufficient and the shorts collateral will cover their position. But in the event of a currency crash, and gold shooting up fast, the margin requirements might not be enough. Imagine that over a weekend the dollar crashed and the price of gold in dollars went up by a factor of 8. The brokers would not be able to get enough from the shorts to cover the GLD positions, so they might not be able to honor the GLD holders positions.
The point is that holding an ETF puts you at risk for the broker failing in some way as well as the originator of the ETF having a problem. But it seems only about 5% of GLD is really shorted, so it may not currently be a big risk. Looking at short interest is a good idea though.
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In a free market the supply and demand for any product match at the market price. However, when there are price ceilings there is a reduction in supply and an increase in demand so supply does not equal demand and there is a shortage. So if your government passes price controls you can expect long lines and shortages and an underground economy.
The following paragraph is a quote from mises.org about experiences with price controls during the American revolution:
George Washington's revolutionary army nearly starved to death in the field thanks to price controls on food that were imposed by Pennsylvania and other colonial governments. Pennsylvania specifically imposed price controls on "those commodities needed for use by the army," creating disastrous shortages of everything needed by the army. The Continental Congress wisely adopted an anti-price-control resolution on June 4, 1778 that read: "Whereas it hath been found by experience that limitations upon the prices of commodities are not only ineffectual for the purpose proposed, but likewise productive of very evil consequences--resolved, that it be recommended to the several states to repeal or suspend all laws limiting, regulating or restraining the Price of any Article." And, write Schuettinger and Butler, "By the fall of 1778 the army was fairly well provided for as a direct result of this change in policy."
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But they don't seem to be doing things the way I would. The EU central bank has changed their rules so that Greek junk bonds can be used as collateral for getting Euros from the central bank. This is a violation of the "Real Bills" method. The Greek junk bonds could default leaving the central bank with not enough backing for all the Euros they issue, leading to inflation.
And they are attempting to force all European countries to bail out Euro countries. Taking money from better run countries and giving it to badly run countries will hurt the overall economy of Europe.
The basic plan is for the ECB to buy up low quality Euro bonds that will probably default and sell high quality Euro bonds. So in order to keep from printing Euros to support the Euro, which clearly is silly, the ECB is destroying its balance sheet to support the Euro. This is equally silly though not as clear. For a central bank to maintain the value of its currency it needs to have high quality assets, or Real Bills. All the ECB is really doing is supporting countries that are borrowing and spending too much at the expense of the people holding Euros. The Euro had been increasingly used as a reserve currency, but this trend will probably reverse now that the ECB is breaking rules and no longer makes the Euro look like a safe bet.
Not surprisingly, after the ECB started breaking its own rules, the value of the Euro started going down and Iran and other countries started getting out of the Euro. If they can't follow the rules after only 10 years, there is little reason to hope the Euro will still be around in another 10 years. In fact many economists are now saying the Euro will be dead in five years.
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Rather than go into hyperinflation, congress would shutdown the government. Perhaps. But there are millions of people who depend on money from the Federal government.
The big banks control the central bank and they would not allow hyperinflation because it would hurt them. Maybe. I see two problems with this line of reasoning. First, at the end of the day the government makes the laws and can change the laws. If they think the central bank should buy up government debt and it is not doing so, they can well change the laws. The second flaw in this logic is that the big banks can make money in hyperinflation by buying gold. So they can take care of themselves just fine.
The graphs showing a big jump in the money supply look so bad because anything growing as a percentage looks like it is sloping upward but if you plot the money supply on a log scale the current time does not look unusual.
Gold and silver look cheap compared to the past because they are not monetary items any more. If they don't become monetized their prices will go down from here.
Effectively the world is paying the US to be the worlds policeman by using US dollars. So it is not that the other countries are losing money on dollars, it is that they are paying for a service that they value. Paying the protection money this way just hides it from the common man.
If the US pulled their troops home from more than 150 countries around the world the savings could go a long way towards balancing the budget.
By this 38 year cycle the trouble was in 2009 and we are through. So nothing more to worry about.
The 38 year cycle is just too exact to be believable. Real trends involving humans should not be so precisely timed.
Some of the fat in government is due to public unions. The unions have pressured the politicians to where government jobs pay much more than private jobs. As things get desperate, it should be possible to cut government expenses by cutting the salaries of public employees.
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But what I am predicting here is hyperinflation of the US dollar. Hyperinflation is something that has happened many times around the world with paper money. It has even happened twice in America's history. Real hyperinflation (where inflation rates are reported for less than year time periods) only happens with un-backed paper money. The US has only had around 50 years of experience with un-backed paper money. With 2 hyperinflation periods starting during these years, we can estimate an average chance of starting hyperinflation when on un-backed paper money in America of about 4% per year. I think it is safe to say that the US economy is more messed up than on average and the risk of hyperinflation is higher now than this average. While I don't think we can be certain that hyperinflation is coming, it seems like a high enough probability that people should take it into consideration. Certainly investing in a 30 US bond with a 4% rate seems very foolish.
Looking at other cases of hyperinflation it does not seem to cause a breakdown in civilization or apocalyptic situation. There can be some increase in crime, particularly if people had been depending on the government for support. But in other hyperinflation cases it was relatively easy for people to use some other currency. People in Argentina and Zimbabwe could use US dollars when their local currency was failing.
If paper money everywhere is failing then this is extra difficult. Also, this will be the first time that the international trading and reserve currency fails. And hyperinflation could be particularly bad on modern big cities. So this hyperinflation is probably worse than the typical one. I do think there is a chance that the US Federal government either falls away, or is greatly reduced in size (like half the share of the GNP it currently is). But I don't think US state or local governments are at risk of failing entirely.
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This information is education in nature and, therefore, is not intended to constitute investment advice and should not be interpreted as a recommendation to purchase, sell or hold a particular security. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal situation of each individual investor.
But if things play out the way it looks to me, then doing some of the following ahead of time might ease the pain:
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! http://online.wsj.com/article/SB10001424052748703615104575328981319857618.html?mod=djemEditorialPage_h Keynesian dead end>