Thursday, June 14, 2012

Inflation or Deflation - Between the devil and the deep blue sea - Part 2

So let's continue with Part 2 of my post on the two ends the world is staring at "Deflation and Inflation".  to Part 1 can be read here (Link).

To summarise in Part 1 I had discussed that:

- I defined inflation  as an increase in credit supply and base money and deflation as vice versa (not just increase or decrease in WPI/CPI index which is nothing but one of the symptoms where inflation might show up)
- Inspite of the loose monetary policies from various Central Banks around the world it's deflation that we should be more worried about for the time being and not very inflation or hyperinflation.
- This is because most of the countries are reaching the end point of credit demand either because of demographics or because of high existing indebtedness

Now for Part 2:

The currency debauchery story that is floating around has been partly due to the arrogance shown by Bernanke in one of his now famous helicopter drop speech (Link) where he mentions how Central Banks can counter deflation by simply dropping dollar bills from the helicopter. Well to be fair the wordings are not his own but I have also read the same lines in one of the articles written by Milton Friedman. in any case as I indicated before that this story is on the same lines the new paradigm before the 2000 bust or the globalization gain story pre 2008.

This is not to say that this world would not be hit by the hyperinflationary monopolised fiat currency collapse but for that to happen we have to first hit the deflationary milestone. Let me explain:

Even if Bernanke & Milton Friedman have expressed their desire to drop dollar bills from the helicopter, under the current existing accounting and legal framework within which the Fed is working they cannot do that. As of now the interest rates are already 0 or close in all developed world so every year because people are already saturated with debt, the natural tendency of the credit market is to unwind the excesses thus taking this world towards deflation. To avoid such a scenario most of these Central Banks intervene and buy Government debt, agency paper, some Central Banks like Japanese and Swiss also buy some Stock index ETF's. However for now let me consider the case of Fed, as per the legal sanction currently it can buy Government debt and Agency paper. By doing this they do two things:

- The savings go in various instruments including debt, commodities, stocks etc. so the Fed is removing some quantity of these instruments from the market and thus lifting the price of stocks, commodities etc.
- As some debt is removed the yields across all asset classes go down thus making it to appear that the cost of capital has come down (atleast on the surface) leading to some credit growth.

This phenomena can continue with the moderate rate of success till the world doesn't go into another downturn as part of the natural business cycle leading to a slowdown or decline in the credit growth and when that happens under the Fed is going to come short as there may not be enough of these instruments that the Fed would be able to buy soon enough to stop the credit unwind leading to a deflationary spiral.

However then would the time in my opinion that these legal and accounting sanctions of the Fed would be modified leading the Fed to realise it's long time dream "Dropping the Dollar Bills from the Helicopter" and here is how it may happen:

During 2008 when the world saw for the first time ever a decline in net credit under the special bill passed by US Senate the Fed bought not just government debt and agency paper but also lot of other garbage on banks balance sheets, while this helped the banks to stabalise but the US public was still indebted.

So maybe next time when such a cycle hits with an even bigger force the Fed may be authorised to buy the mortgage debt and credit card debt directly of the US public directly from US  banks. Now this debt  could be recast partially by extending maturity decreasing interest rates and part of it could be forgiven, ofcourse that would mean that the Fed liabilities i.e. the US dollar bills would be against technically an NPA. However please remember that Fed can't really go broke as it has the access to in Bernanke's words "the printing press". So yes to avoid the ignominy of classifying these assets as NPA's the US government may come in and issue very long term 0 coupon bonds. 

What would this whole thing accomplish, well this is a practical way that tantamounts to the "Bill Dropping" thing that the Fed wants to do. Once this exercise is complete the US citizens would not just be free of the debt load but the deflation would have stopped and most of the media would have proclaimed the people at the Fed to be geniuses once again. So with the US citizens free of debt load and their expectations set at the fact that the Fed and government is there to bail them out would begin another credit cycle and that in my opinion is what would start the world into the hyperinflationary currency debauchery endgame.

Let me add that the changes in world monetary system is nothing new and it happens every 40-50 years. The world got off the gold standard in 1930s (during the great depression), then it was the end of Bretton Woods system in 1971. In my next article I would discuss some common myths in the currency markets.......

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