“The US Dollar will almost certainly crash under the weight of unprecedented government debt and a reversal of decades-long globalisation trends”.
“Historically, when a nation’s debt exceeds its ability to repay even the interest, it can be assumed that the currency will collapse. Typically, governments exacerbate the situation by printing large amounts of currency notes in an effort to inflate the problem away, or at least postpone it. The greater the level of debt, the more dramatic the inflation must be to counter it. The more dramatic the inflation, the greater the danger that hyperinflation will take place. No government has ever been able to control hyperinflation. If it occurs, it does so quickly and always ends with a crash.”
“It’s safe to say that the EU, the US, and quite a few other jurisdictions are nearing currency crashes, and in all likelihood, the euro will go before the dollar. So, unless the EU has already prearranged a new euro, the US dollar might well be chosen as an immediate solution to the problem, as the US dollar is presently recognised and traded throughout Europe. Therefore, a relatively painless transfer could be made. However, the dollar, which is presently praised as being a sound currency, is really only sound in relation to the euro (and some other lesser currencies). Once its less stable brother, the euro, collapses, the dollar will be exposed. As the US dollar is a fiat currency and is on the ropes, the US (and any other country that is using the dollar as its primary currency when the time comes) will experience a currency emergency at the street level that will be unprecedented.”
“While the US Federal Reserve’s aggressiveness in easing financial conditions has succeeded in halting a further decline in the US economy, companies could still go bankrupt as they adapt to the new norm where work resumption must coexist with social-distancing measures because the Covid-19 crisis has persisted longer than expected. So, the question of whether there will be a financial crisis will depend on whether a major company will be the next to go bankrupt, and thereby result in a jump in the corporate default ratio, leading to a sovereign debt crisis.”
“Altogether, foreign countries own more than $6 trillion in U.S. debt. The two largest are China and Japan. If they dump their holdings of Treasury notes, they could cause a panic leading to collapse. China owns nearly $1 trillion in U.S. Treasurys.”
“A dollar collapse would create global economic turmoil. To respond to this kind of uncertainty, you must be mobile. Keep your assets liquid, so you can shift them as needed. Make sure your job skills are transferable. Update your passport, in case things get so bad for so long that you need to move quickly to another country. These are just a few ways to protect yourself and survive a dollar collapse.”
I don’t mean to alarm you, but according to a lot of commentators, the world is on the brink of a major crisis. No, not some highly-contagious and deadly virus. Apparently, we’re on the brink of witnessing the collapse of the global monetary system.
Each of the above are separate quotes from different articles published over the past 6 months. I’ll leave the authors names out – it doesn’t matter. They’re not all conspiracytheorist nutjobs – some high-profile mainstream economic commentators are responsible for some of the above. If they’re right, this clearly has profound economic implications and so it’s worth us taking some time to think seriously about these claims.
This “theme” isn’t new. Its been around for decades, although it really gained some traction during and after the Global Financial Crisis.
There are a few different variations to the story however the gist of the thesis is normally that reckless monetary policy, combined with increasingly reckless government fiscal policy is going to result is a collapse of the monetary system. Most are fixated with the United States, however as the above quotes illustrate, much of the world is apparently at risk of this outcome.
In order to understand and assess the validity of some of these concerns, we need to draw on our sound understanding of how the global monetary system works. As we’ll see, there will be a bit of “connecting the dots” across a number of themes.
Inflation
Let’s start here. What exactly is inflation and what causes it? Although we all experience inflation and have some understanding of it, its actually a rather abstract thing. Many economists salivate over the chance of debating the causes and effects of inflation.
As complicated as we could make it, we don’t need to get too carried away with our definitions. The following will do:
Inflation is a general increase in the prices of goods and services within an economy.
In the crudest sense, inflation is caused by demand for a product or service exceeding supply – too much money chasing a finite amount of goods and services.
Is inflation a bad thing? Well, that’s a controversial question. Let’s just say that from an economics perspective, a small amount of constant inflation is seen as a healthy part of a growing economy.
How is money created?
Given our definition of inflation, understanding where money comes from is critical.
To start, remember that in today’s fiat currency systems used in most nations, money isn’t “backed” by anything. The monetary system changed dramatically in 1971 when President Nixon closed the gold window. The “money supply” therefore isn’t influenced by any other factor such as gold reserves.
Secondly, remember that most transactions are now electronic. “Money” in today’s modern world has been reduced to numbers on screens. I see estimated for the volume of transactions completed in “cash” in developed nations at around 10-15%. In trying to grasp how the monetary system works, it’s often handy to think of the monetary system as a payments system. The payments system is largely electronic (except for those very few remaining non-electronic transactions), is regulated by the government and maintained principally by the private banking system.
Example – I wave my Mastercard at the paywave terminal at my local bar. The result is that money is moved from my account to the bar’s. If the bar banks with a different bank to me, the result is my bank transferring money to the bar’s bank.
The banking system basically has its very own bank – the central bank. The central bank works closely with private banks in the settlement of payments, acting as banker to the banks and “lender of last resort”.
The role of lending:
What happens when a bank makes a new loan to a customer? Say for simplicity it’s a personal loan to pay for some home renovations. The bank credits the customer’s account with the money. From an accounting perspective, two important ledger transactions take place:
The bank creates itself an “asset” – the loan.
The banks creates an identical “liability” – the cash on deposi
The money is in the banking system. The customer jumps on their internet banking and makes a payment to the builder who banks at a different bank. Via the banking payments system, some of that deposit is sent to the builder’s account and is now on deposit at the other bank.
Notice what happened when the loan was granted. Money was created. The act of granting the new loan creates bank deposits which equates to creating new money.
Banks don’t lend from reserves!
Understanding this is a key to understanding why many of the doomsday predictions are inaccurate.
Historically, there’s been an understanding that banks lend from their reserves – loaning out whatever they have in reserve, keeping a fraction to meet demand for withdrawals of money from customers: “Fractional Reserve Banking”.
Central banks around the world are busy trying to ease financial conditions by creating excess reserves. A popular term for it is “Quantitative Easing”.
If you believe in the notion of “fractional reserve banking”, this is a recipe for disaster. The banks will lend out all the reserves created in a tidal wave of new loans.
Its nonsense. To illustrate this, I like using the following hypothetical exchange between a bank middle-manager and CEO:
MM: Sir, do you have a moment? We have a bit of a problem…
CEO: Can it wait? I’m trying to arrange a golf game with the chief of our government regulation agency and one of the key voting members of the central bank…
MM: Err… not really sir… you need to know about this…
CEO: Okay then what’s the problem?
MM: Sir, it seems… (cough) we have too much money sir…
CEO: WHAT??
MM: Our reserve balances sir… they have exploded.
CEO: What… How… How did this happen?
MM: It’s the central bank sir… They have been aggressively buying the financial instruments like government bonds where we park our reserves… The end result has been an explosion in our cash reserve balances.
CEO: Good god! {mumbles “this is bad… this is bad…”} Okay… I want all the lending managers in the boardroom in 30 minutes. We need to lend all this money out immediately! Nobody is leaving the office today until our reserve balance has been loaned out to customers.
I hope we can agree this scenario is silly.
Banks in all western nations with floating fiat currencies and a central bank that targets interest rates are never “reserve constrained” – the central bank commits to providing the system with all the reserves needed to defend their target interest rate.
Banks are “capital constrained”. They are required to ensure they maintain sufficient capital adequacy to meet possible losses on lending activities. Even with capital adequacy provisions, banks know that if they make enough bad loans, they might cease to exist. They realise that maintaining stringent lending standards is paramount to their existence.
That’s not to say that banks always act with prudence. They can certainly go wild with lax lending standards fuelling a proliferation of dubious-quality loans. That was at the heart of the global financial crisis. But banks don’t simply make loans because they have reserves.
To summarise the key points above:
Banks create money by making new loans.
Banks don’t lend from reserves and therefore the amount of excess reserves in the system has no bearing on lending activity
Circling back to inflation, if we’re concerned with “too much money chasing too few goods and services”, then its logical that lending activity is an important factor in inflation. More lending activity = more new money into the economy.
But…
If we’re concerned that reckless central bank actions are going to bring down the system – don’t be.
We agree that some of the actions been taken by central banks around the world are not good. Indeed, some of what the US Federal Reserve are doing is basically illegal under their governing treaties. But they aren’t going to crash the system. Instead, what they basically do is distort financial markets.
One of the major side-effects observed is asset price inflation. Given already wealthy people are the main holders of financial assets, central bank actions have been exacerbating the already huge chasm between the “have’s” and “have-nots”.
If anything, this is what concerns me – the prospect of a popular revolt against the wealthy elites as their slice of the economic pie grows at the expense of those at the other end of the economic pecking-order. But I still feel worrying about this too much is unnecessary.
The role of taxation:
What exactly is taxation? Well, to put it bluntly, taxation is the government confiscating some of our money for the privilege of residing in the country.
What role does it serve in society? Well, its so that the government can spend money on things – roads, hospitals, unemployment benefits… things that collectively, as a nation, we have decided we want to provide to each other.
Accepting this concept, the government doesn’t create or control money as such – they just use ours.
Within this, the government has a solemn responsibility… It has the capacity to grant basically any individual or organisation with money – money that can be used to acquire real goods and services in the economy. The significance of this seems lost on many of today’s politicians… but I’m digressing a little bit here…
The other important aspect to realise is the government simply re-distributes money. When a government taxes, the basically drain money from the private sector. When they spend, they inject it back into the private sector.
When the government runs a deficit, they spend more than they take in via taxes. In other words, a government deficit results in more money in the private sector… more money chasing goods and services.
More money chasing a finite amount of goods and services results in the potential for inflation.
Referring back to those statements at the start, reckless government spending and rampant debt is cited as the cause of the coming crash. Before we pass judgement on the likelihood of this, let’s explore a few more relevant areas.
What gives money “value”?
Money, in essence, is a social construct that serves as a medium of exchange. It really doesn’t have any value.
This idea makes a lot of people very uneasy.
There are different theories about how money derives its value. One of the most popular ones is that the government forces the private sector to use it. Popular among the “Modern Monetary Theory” adherents is the concept that the government gives money its value by insisting it’s the only allowable method for paying taxes.
Its true that the government legislates on what is the “legal tender”. But it can’t instil any “value” to the currency.
I’ve long argued that it’s the private sector that gives currency its value. Value is derived from the productive capacity of the economy…its ability to innovate…to improve standards of living.
The government does still play an important role in this – they assist by creating frameworks for the private sector to thrive – by enforcing property rights, wisely spending tax revenue on infrastructure that enhances productivity and standards of living.
Anatomy of a hyperinflationary collapse:
So we’re on the brink of witnessing a hyperinflationary collapse in some of the world’s largest and most developed economies… What would that look like? Well, fortunately (or unfortunately), we have plenty of historical examples to learn from.
In fact, we’ve had one unfolding in recent years – Venezuela. Let’s briefly, crudely, explore their economic journey over the last 50 years or so. Venezuela has the world’s largest proven oil reserves and oil is the cornerstone of its economy.
The nation has long had a “socialist” flavour to government policies. The government has used its oil wealth to invest in public infrastructure such as transport, education and health care.
Given its reliance on oil exports to fund the government, understandably, the economy has had a tendency to fluctuate with the oil price. The ‘60’s and ‘70’s were good thanks to strong oil price and development of its oil infrastructure. The ‘80’s brought a decline in the oil price and hard times.
During the early 2000’s, the Chavez government, buoyed by revenues from a strong oil price, implemented various socialist economic initiatives. Whilst controversial, he was quite popular among many ordinary Venezuelans. Initiatives like significant increases in minimum wages and tighter rules for firing workers brought wide support.
Then there’s the innovative nation-building stuff. Confiscating private companies and farms into state ownership for the benefit of the people.
Many initiatives were well-intended, although corruption was ever-present as politicians enriched themselves via their positions. But predictably, the initiatives had a disastrous impact on the economy.
Scared off by the threat of asset confiscation, many international companies shut up shop. Companies were hesitant to hire new staff as the rules made making staff redundant difficult. Workers realised that they couldn’t really be fired and thus many businesses reported that 40% of their staff were absent on any given day.
Productivity and economic output crashed.
If you search through the history of hyperinflations you will see similarities in every one – a collapse in economic output. The collapse in output and capacity is usually the result of a major shock. War, famine, diabolical economic mismanagement…
“Money printing” and rampant government spending are features, but in a hyperinflationary collapse it’s a collapse in economic output that comes first.
Connecting the dots:
So… Inflation in a simple sense is about too much money chasing too few goods and services. If we’re on the lookout for inflation, we should be on the lookout for changes in either the amount of money in the economy or the amount of goods and services in the economy.
Bank lending activity influences the amount of money in the economy. Are we about to see an explosion in new lending activity in various developed nations?
Government deficit spending influences the amount of money in the economy. Are we about to see an explosion in deficit spending?
Regarding deficit spending, we should acknowledge that we have already seen an explosion in deficits in many nations. The question really is whether this will continue.
What’s the outlook for economic output? The Covid crisis has resulted in a significant hit to global output. I believe that it will take quite some time for most economies to rebound. But if you’re betting on a hyperinflationary collapse, history demonstrates that you’re actually betting on a significant further collapse in economic output.
The currency is going to collapse. Against what?
Its interesting… some commentators are convinced all currencies are going to collapse. This therefore begs the question – collapse against what?
The answer that’s so often given: Gold!
Above is the gold price (in US$ per ounce) going back to around when Nixon closed the gold window in 1971.
The recent rise to all-time highs has fuelled a lot of chatter – including a lot of these “hyperinflationary crash” predictions.
With the recent push to all-time highs, it looks like its been a solid investment. However, if you work it out, if you bought some at $200 in the mid ‘70’s, your cumulative return has really only been about 5% per year.
Add on your dividends/interest income/profit distributions. Oh, that’s right – you don’t get any.
Why the recent price rise? Has its value increased?
That’s a good question – what is an ounce of gold worth? No, don’t say about US$2,000 per ounce – that’s the price. What’s it worth? The answer is there is no answer. Gold doesn’t produce any cash flows and without cash flows to analyse, we cannot come up with a “value”.
A quote often attributed to legendary investor Warren Buffett is that gold “gets dug out of the ground in Africa… Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
It doesn’t do anything for that matter. In fact, if your preference is for physical gold bars (the only choice for any true gold bug), you need to pay for storage and insurance.
Last month we revisited some of the basics of investing. If you recall, the price of instruments move based on relative eagerness. Buyers have sure been pretty eager of late!
I don’t mean to poke fun too much at gold as an asset class. It has its place. Indeed, what you will hear many respected multi-strategy investment managers say is something to the effect of “we hold a small position – probably about 5% of assets – in gold. We feel that’s a sensible feature in our portfolios offering some diversification and potential positive return under certain conditions.” I share that general philosophy and the Aviator Macro Opportunities Fund has held gold at certain times.
I’ve been careful through this not to share much in terms of my opinion. The intent is to encourage you to think about what you believe will likely unfold. But in finishing, I’ll share my opinion:
We are not going to witness a hyperinflationary blow-up in any major developed nation.
No developed nation is even going to experience meaningful inflation in the coming few years.
The level of deficits in some nations (like the US) is concerning. But there’s so much slack in the economy that the economy can produce more goods and services in response to any higher demand fuelled from deficit spending.
The political environment in the US (and many other nations for that matter) is going to be characterised by a lot of hand-wringing about inflation and debt-default concerns.
The gold price will end up doing what it did during and after the global financial crisis – the current spike will end with a fall that gives up at least half its gains, followed by a lot of sideways.
Relative to one another, currencies will shift based on economic prospects, relative interest rates as well as stability – just like they always have!
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Inflated Claims
Inflated Claims
“The US Dollar will almost certainly crash under the weight of unprecedented government debt and a reversal of decades-long globalisation trends”.
“Historically, when a nation’s debt exceeds its ability to repay even the interest, it can be assumed that the currency will collapse. Typically, governments exacerbate the situation by printing large amounts of currency notes in an effort to inflate the problem away, or at least postpone it. The greater the level of debt, the more dramatic the inflation must be to counter it. The more dramatic the inflation, the greater the danger that hyperinflation will take place. No government has ever been able to control hyperinflation. If it occurs, it does so quickly and always ends with a crash.”
“It’s safe to say that the EU, the US, and quite a few other jurisdictions are nearing currency crashes, and in all likelihood, the euro will go before the dollar. So, unless the EU has already prearranged a new euro, the US dollar might well be chosen as an immediate solution to the problem, as the US dollar is presently recognised and traded throughout Europe. Therefore, a relatively painless transfer could be made. However, the dollar, which is presently praised as being a sound currency, is really only sound in relation to the euro (and some other lesser currencies). Once its less stable brother, the euro, collapses, the dollar will be exposed. As the US dollar is a fiat currency and is on the ropes, the US (and any other country that is using the dollar as its primary currency when the time comes) will experience a currency emergency at the street level that will be unprecedented.”
“While the US Federal Reserve’s aggressiveness in easing financial conditions has succeeded in halting a further decline in the US economy, companies could still go bankrupt as they adapt to the new norm where work resumption must coexist with social-distancing measures because the Covid-19 crisis has persisted longer than expected. So, the question of whether there will be a financial crisis will depend on whether a major company will be the next to go bankrupt, and thereby result in a jump in the corporate default ratio, leading to a sovereign debt crisis.”
“Altogether, foreign countries own more than $6 trillion in U.S. debt. The two largest are China and Japan. If they dump their holdings of Treasury notes, they could cause a panic leading to collapse. China owns nearly $1 trillion in U.S. Treasurys.”
“A dollar collapse would create global economic turmoil. To respond to this kind of uncertainty, you must be mobile. Keep your assets liquid, so you can shift them as needed. Make sure your job skills are transferable. Update your passport, in case things get so bad for so long that you need to move quickly to another country. These are just a few ways to protect yourself and survive a dollar collapse.”
I don’t mean to alarm you, but according to a lot of commentators, the world is on the brink of a major crisis. No, not some highly-contagious and deadly virus. Apparently, we’re on the brink of witnessing the collapse of the global monetary system.
Each of the above are separate quotes from different articles published over the past 6 months. I’ll leave the authors names out – it doesn’t matter. They’re not all conspiracytheorist nutjobs – some high-profile mainstream economic commentators are responsible for some of the above. If they’re right, this clearly has profound economic implications and so it’s worth us taking some time to think seriously about these claims.
This “theme” isn’t new. Its been around for decades, although it really gained some traction during and after the Global Financial Crisis.
There are a few different variations to the story however the gist of the thesis is normally that reckless monetary policy, combined with increasingly reckless government fiscal policy is going to result is a collapse of the monetary system. Most are fixated with the United States, however as the above quotes illustrate, much of the world is apparently at risk of this outcome.
In order to understand and assess the validity of some of these concerns, we need to draw on our sound understanding of how the global monetary system works. As we’ll see, there will be a bit of “connecting the dots” across a number of themes.
Inflation
Let’s start here. What exactly is inflation and what causes it? Although we all experience inflation and have some understanding of it, its actually a rather abstract thing. Many economists salivate over the chance of debating the causes and effects of inflation.
As complicated as we could make it, we don’t need to get too carried away with our definitions. The following will do:
Inflation is a general increase in the prices of goods and services within an economy.
In the crudest sense, inflation is caused by demand for a product or service exceeding supply – too much money chasing a finite amount of goods and services.
Is inflation a bad thing? Well, that’s a controversial question. Let’s just say that from an economics perspective, a small amount of constant inflation is seen as a healthy part of a growing economy.
How is money created?
Given our definition of inflation, understanding where money comes from is critical.
How does the monetary system work? We’ve discussed this previously. See:
Modern Monetary Theory
Monetary Policy Part 1
Monetary policy Part 2
To start, remember that in today’s fiat currency systems used in most nations, money isn’t “backed” by anything. The monetary system changed dramatically in 1971 when President Nixon closed the gold window. The “money supply” therefore isn’t influenced by any other factor such as gold reserves.
Secondly, remember that most transactions are now electronic. “Money” in today’s modern world has been reduced to numbers on screens. I see estimated for the volume of transactions completed in “cash” in developed nations at around 10-15%. In trying to grasp how the monetary system works, it’s often handy to think of the monetary system as a payments system. The payments system is largely electronic (except for those very few remaining non-electronic transactions), is regulated by the government and maintained principally by the private banking system.
Example – I wave my Mastercard at the paywave terminal at my local bar. The result is that money is moved from my account to the bar’s. If the bar banks with a different bank to me, the result is my bank transferring money to the bar’s bank.
The banking system basically has its very own bank – the central bank. The central bank works closely with private banks in the settlement of payments, acting as banker to the banks and “lender of last resort”.
The role of lending:
What happens when a bank makes a new loan to a customer? Say for simplicity it’s a personal loan to pay for some home renovations. The bank credits the customer’s account with the money. From an accounting perspective, two important ledger transactions take place:
The money is in the banking system. The customer jumps on their internet banking and makes a payment to the builder who banks at a different bank. Via the banking payments system, some of that deposit is sent to the builder’s account and is now on deposit at the other bank.
Notice what happened when the loan was granted. Money was created. The act of granting the new loan creates bank deposits which equates to creating new money.
Banks don’t lend from reserves!
Understanding this is a key to understanding why many of the doomsday predictions are inaccurate.
Historically, there’s been an understanding that banks lend from their reserves – loaning out whatever they have in reserve, keeping a fraction to meet demand for withdrawals of money from customers: “Fractional Reserve Banking”.
Central banks around the world are busy trying to ease financial conditions by creating excess reserves. A popular term for it is “Quantitative Easing”.
If you believe in the notion of “fractional reserve banking”, this is a recipe for disaster. The banks will lend out all the reserves created in a tidal wave of new loans.
Its nonsense. To illustrate this, I like using the following hypothetical exchange between a bank middle-manager and CEO:
MM: Sir, do you have a moment? We have a bit of a problem…
CEO: Can it wait? I’m trying to arrange a golf game with the chief of our government regulation agency and one of the key voting members of the central bank…
MM: Err… not really sir… you need to know about this…
CEO: Okay then what’s the problem?
MM: Sir, it seems… (cough) we have too much money sir…
CEO: WHAT??
MM: Our reserve balances sir… they have exploded.
CEO: What… How… How did this happen?
MM: It’s the central bank sir… They have been aggressively buying the financial instruments like government bonds where we park our reserves… The end result has been an explosion in our cash reserve balances.
CEO: Good god! {mumbles “this is bad… this is bad…”} Okay… I want all the lending managers in the boardroom in 30 minutes. We need to lend all this money out immediately! Nobody is leaving the office today until our reserve balance has been loaned out to customers.
I hope we can agree this scenario is silly.
Banks in all western nations with floating fiat currencies and a central bank that targets interest rates are never “reserve constrained” – the central bank commits to providing the system with all the reserves needed to defend their target interest rate.
Banks are “capital constrained”. They are required to ensure they maintain sufficient capital adequacy to meet possible losses on lending activities. Even with capital adequacy provisions, banks know that if they make enough bad loans, they might cease to exist. They realise that maintaining stringent lending standards is paramount to their existence.
That’s not to say that banks always act with prudence. They can certainly go wild with lax lending standards fuelling a proliferation of dubious-quality loans. That was at the heart of the global financial crisis. But banks don’t simply make loans because they have reserves.
To summarise the key points above:
Circling back to inflation, if we’re concerned with “too much money chasing too few goods and services”, then its logical that lending activity is an important factor in inflation. More lending activity = more new money into the economy.
But…
If we’re concerned that reckless central bank actions are going to bring down the system – don’t be.
We agree that some of the actions been taken by central banks around the world are not good. Indeed, some of what the US Federal Reserve are doing is basically illegal under their governing treaties. But they aren’t going to crash the system. Instead, what they basically do is distort financial markets.
One of the major side-effects observed is asset price inflation. Given already wealthy people are the main holders of financial assets, central bank actions have been exacerbating the already huge chasm between the “have’s” and “have-nots”.
If anything, this is what concerns me – the prospect of a popular revolt against the wealthy elites as their slice of the economic pie grows at the expense of those at the other end of the economic pecking-order. But I still feel worrying about this too much is unnecessary.
The role of taxation:
What exactly is taxation? Well, to put it bluntly, taxation is the government confiscating some of our money for the privilege of residing in the country.
What role does it serve in society? Well, its so that the government can spend money on things – roads, hospitals, unemployment benefits… things that collectively, as a nation, we have decided we want to provide to each other.
Accepting this concept, the government doesn’t create or control money as such – they just use ours.
Within this, the government has a solemn responsibility… It has the capacity to grant basically any individual or organisation with money – money that can be used to acquire real goods and services in the economy. The significance of this seems lost on many of today’s politicians… but I’m digressing a little bit here…
The other important aspect to realise is the government simply re-distributes money. When a government taxes, the basically drain money from the private sector. When they spend, they inject it back into the private sector.
When the government runs a deficit, they spend more than they take in via taxes. In other words, a government deficit results in more money in the private sector… more money chasing goods and services.
More money chasing a finite amount of goods and services results in the potential for inflation.
Referring back to those statements at the start, reckless government spending and rampant debt is cited as the cause of the coming crash. Before we pass judgement on the likelihood of this, let’s explore a few more relevant areas.
What gives money “value”?
Money, in essence, is a social construct that serves as a medium of exchange. It really doesn’t have any value.
This idea makes a lot of people very uneasy.
There are different theories about how money derives its value. One of the most popular ones is that the government forces the private sector to use it. Popular among the “Modern Monetary Theory” adherents is the concept that the government gives money its value by insisting it’s the only allowable method for paying taxes.
Its true that the government legislates on what is the “legal tender”. But it can’t instil any “value” to the currency.
I’ve long argued that it’s the private sector that gives currency its value. Value is derived from the productive capacity of the economy…its ability to innovate…to improve standards of living.
The government does still play an important role in this – they assist by creating frameworks for the private sector to thrive – by enforcing property rights, wisely spending tax revenue on infrastructure that enhances productivity and standards of living.
Anatomy of a hyperinflationary collapse:
So we’re on the brink of witnessing a hyperinflationary collapse in some of the world’s largest and most developed economies… What would that look like? Well, fortunately (or unfortunately), we have plenty of historical examples to learn from.
In fact, we’ve had one unfolding in recent years – Venezuela. Let’s briefly, crudely, explore their economic journey over the last 50 years or so. Venezuela has the world’s largest proven oil reserves and oil is the cornerstone of its economy.
The nation has long had a “socialist” flavour to government policies. The government has used its oil wealth to invest in public infrastructure such as transport, education and health care.
Given its reliance on oil exports to fund the government, understandably, the economy has had a tendency to fluctuate with the oil price. The ‘60’s and ‘70’s were good thanks to strong oil price and development of its oil infrastructure. The ‘80’s brought a decline in the oil price and hard times.
During the early 2000’s, the Chavez government, buoyed by revenues from a strong oil price, implemented various socialist economic initiatives. Whilst controversial, he was quite popular among many ordinary Venezuelans. Initiatives like significant increases in minimum wages and tighter rules for firing workers brought wide support.
Then there’s the innovative nation-building stuff. Confiscating private companies and farms into state ownership for the benefit of the people.
Many initiatives were well-intended, although corruption was ever-present as politicians enriched themselves via their positions. But predictably, the initiatives had a disastrous impact on the economy.
Scared off by the threat of asset confiscation, many international companies shut up shop. Companies were hesitant to hire new staff as the rules made making staff redundant difficult. Workers realised that they couldn’t really be fired and thus many businesses reported that 40% of their staff were absent on any given day.
Productivity and economic output crashed.
If you search through the history of hyperinflations you will see similarities in every one – a collapse in economic output. The collapse in output and capacity is usually the result of a major shock. War, famine, diabolical economic mismanagement…
“Money printing” and rampant government spending are features, but in a hyperinflationary collapse it’s a collapse in economic output that comes first.
Connecting the dots:
So… Inflation in a simple sense is about too much money chasing too few goods and services. If we’re on the lookout for inflation, we should be on the lookout for changes in either the amount of money in the economy or the amount of goods and services in the economy.
Bank lending activity influences the amount of money in the economy. Are we about to see an explosion in new lending activity in various developed nations?
Government deficit spending influences the amount of money in the economy. Are we about to see an explosion in deficit spending?
Regarding deficit spending, we should acknowledge that we have already seen an explosion in deficits in many nations. The question really is whether this will continue.
What’s the outlook for economic output? The Covid crisis has resulted in a significant hit to global output. I believe that it will take quite some time for most economies to rebound. But if you’re betting on a hyperinflationary collapse, history demonstrates that you’re actually betting on a significant further collapse in economic output.
The currency is going to collapse. Against what?
Its interesting… some commentators are convinced all currencies are going to collapse. This therefore begs the question – collapse against what?
The answer that’s so often given: Gold!
Above is the gold price (in US$ per ounce) going back to around when Nixon closed the gold window in 1971.
The recent rise to all-time highs has fuelled a lot of chatter – including a lot of these “hyperinflationary crash” predictions.
With the recent push to all-time highs, it looks like its been a solid investment. However, if you work it out, if you bought some at $200 in the mid ‘70’s, your cumulative return has really only been about 5% per year.
Add on your dividends/interest income/profit distributions. Oh, that’s right – you don’t get any.
Why the recent price rise? Has its value increased?
That’s a good question – what is an ounce of gold worth? No, don’t say about US$2,000 per ounce – that’s the price. What’s it worth? The answer is there is no answer. Gold doesn’t produce any cash flows and without cash flows to analyse, we cannot come up with a “value”.
A quote often attributed to legendary investor Warren Buffett is that gold “gets dug out of the ground in Africa… Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
It doesn’t do anything for that matter. In fact, if your preference is for physical gold bars (the only choice for any true gold bug), you need to pay for storage and insurance.
Last month we revisited some of the basics of investing. If you recall, the price of instruments move based on relative eagerness. Buyers have sure been pretty eager of late!
I don’t mean to poke fun too much at gold as an asset class. It has its place. Indeed, what you will hear many respected multi-strategy investment managers say is something to the effect of “we hold a small position – probably about 5% of assets – in gold. We feel that’s a sensible feature in our portfolios offering some diversification and potential positive return under certain conditions.” I share that general philosophy and the Aviator Macro Opportunities Fund has held gold at certain times.
I’ve been careful through this not to share much in terms of my opinion. The intent is to encourage you to think about what you believe will likely unfold. But in finishing, I’ll share my opinion:
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