two giant government-sponsored mortgage finance companies—
could cost U.S. taxpayers hundreds of billions of dollars. Fannie
and Freddie were not really private nor purely public—perhaps the
worst type of hybrids imaginable. Indeed, both followed a classic
public-private partnership (socialist) business model—one that
privatizes profits and socializes losses. This was a train wreck
waiting to happen. Not surprisingly, the Cato Institute’s Economic
Freedom of the World, 2008 Annual Report records a significant
fall in the economic freedom index for the U.S.
Given these developments and the squeeze that the credit
crunch has put on the U.S. economy, some people have been
shocked that the U.S. dollar has staged a spectacular rally against
the euro. But in the world of exchange rates, it takes two to tango.
Expectations about Europe’s economic prospects have turned
negative. Super-negative European expectations, relative to those
in the U.S., have pushed the dollar up by over 14% from July 15
to September 11, 2008. And not surprisingly, commodity prices
(measured by the Commodity Research Bureau’s Spot Index)
have tumbled by 9% over the same period. But consumer price
and producer price indexes remained
at elevated levels, registering year-overyear
increases in August of 5.4% and
9.6%, respectively.
Now the U.S. is on a razor’s edge
between deflation and inflation. This
requires one to think through how each
of these scenarios might unfold.
The prospect of a debt deflation
begins when a central bank pushes
interest rates below where the market
would have set them. This is exactly
what the Federal Reserve did. In July
2003, the Fed funds interest rate target
was pushed to a record low of 1%, where
it stayed for a year. This set off a credit
boom which fueled a massive increase
in leverage. Over the past year, we have
witnessed financial stress, a stampede
to deleverage and an economic slowdown.
These events could be the precursors
of a classic debt deflation.
It would take
the following course:
Debt liquidation would lead • to
distress selling.
• As loans are paid off, a contraction
in demand deposits would ensue.
• This would slow down the velocity
of money circulation.
• This would cause a fall in the
general level of prices.
• This would lead to a further fall in
the net worth of businesses and an increase in bankruptcies.
• A fall in profits, often resulting in losses, would also occur.
• This would lead to a reduction in output, trade and
employment.
• These losses, bankruptcies, and unemployment would
generate pessimism and a loss in confidence.
• These waves of pessimism would result in more hoarding
and further reductions in the velocity of money circulation.
• The debt deflation process would eventually run its course,
but only after asset prices have hit bargain basement levels.
Economists of the Austrian school of economics term this
type of debt deflation a “secondary deflation”. If the forces of a
secondary deflation are strong enough, a central bank’s liquidity
injections are rendered ineffective by what amounts to private
sector sterilization. When people expect prices to fall, their
demand for cash increases and soaks up central bank liquidity
injections. This phenomenon characterized Japan’s economy
during most of the 1990s.
But what if the Federal reserve—fearing a secondary deflation,
as they feared (incorrectly) a mild deflation in late 2002—pushed
the Fed funds rate lower (now it’s 2%)
and turned on the inflation switch
by monetizing more debt? Given the
growing mountain of government debt,
there is virtually an unlimited potential.
It’s a scenario worth thinking about.
To appreciate how the process
would work in the extreme, consider
what’s happening in Zimbabwe, the first
country to realize a hyperinflation (an
inflation rate of 50% or more per month)
in the 21st century. The government of
Zimbabwe issues debt and the Reserve
Bank of Zimbabwe monetizes it by
printing Zimbabwe dollars. While
the RBZ produces a lot of currency,
statistics on the quantity of currency in
circulation and the inflation rate are in
short supply. The most recent official
data for currency in circulation were for
January 2008, and inflation data were
last released for June 2008. To remedy
that shortcoming, I have developed a
hyperinflation index for Zimbabwe.
As indicated in the accompanying
table [not included], the monthly inflation rate on
September 5, 2008 was 9,914%. That’s
a whopping annual inflation rate of 36
billion percent.
To effectively trade currencies,
commodities, or for that matter, any
assets, traders must build alternative
scenarios—like those for deflation or
inflation. To give the scenarios life, probabilities must be attached
to each of them. The resulting array can then be used to inform, in
part, one’s trading activities.
Fortunately, three books are hot off the presses that will
greatly assist all traders who wish to engage in the necessary task
of scenario building. The authors are all market-tested veterans
with first-class minds and experienced hands.
• Brendan Brown, Bubbles in Credit and Currency: How
Hot Markets Cool Down. New York & London: Palgrave
Macmillan, 2008.
• Mohamed El-Erian, When Markets Collide: Investment
Strategies for the Age of Global Economic Change. New York:
McGraw-Hill, 2008
• David M. Smick, The World is Curved: Hidden Dangers to
the Global Economy. New York: Portfolio/Penguin Group
(U.S.A.), 2008.
Steve H. Hanke is a Professor of Applied Economics at The Johns
Hopkins University in Baltimore and a Senior Fellow at the Cato
Institute in Washington, D.C.
