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 Rick's Picks
How Would Dollar Act in a
Deflation?
Rick Ackerman
Jan 13, 2006
Excerpt from
Rick's Picks (website).
You can subscribe here.
My remarks yesterday concerning
deflation elicited some insightful responses from readers. I'd
planned to publish the best letters without comment, but the
one below, from Greg Payne, is sufficiently provocative to warrant
special handling. My reply follows, along with some further comments
from the redoubtable Bob Hoye of Institutional
Advisors. Bob is one of the very few forecasters who has
been correctly bullish on the dollar as it has continued for
more than a year to vex an almost unanimously bearish consensus.
Here is Payne's letter, which raises questions concerning
how the dollar might be expected to perform in a global financial
crisis. He writes as follows:
"I am what you describe as a 'lurker' and am not particularly
interested in short-term pivot trading, or any kind of short-term
trading activity. I am, however, very interested in the long-term
resolution of the Ponzi-scheme that is the American, and now
even the global, financial economy. This is why I'm taking this
opportunity to ask you to clarify your deflation thesis.
Ponzi 'Cure'
"I too am on the side of a final resolution by deflation.
As you point out, even if hyperinflation is successful in wiping
out the nominal values of the debt pyramid, the result of this
will still be the elimination of the debt structures behind that
pyramid, so that the pyramid is effectively no longer standing,
and therefore deflated. Put another way, the Ponzi scheme of
accelerating credit is built by inflation, and can only eventually
be reversed by deflation.
"Still, I'm not sure that your conclusions about the U.S.
dollar follow directly from your deflation thesis. As I understand
it, the rising-dollar argument is that, barring the hyperinflation-then-deflation
resolution, a deflation that involves debt repayment and/or default
would increase demand for U.S. dollars to settle the loans. But
does this not focus on just one dynamic of a correcting financial
economy in isolation of all others?
Closing of Gold Window
"I believe you are suggesting that the U.S. dollar will
rise in deflation relative to other currencies (I certainly don't
think you're suggesting it will rise relative to commodities).
But throughout the great inflation (regardless of how far back
we date it, but I'd go at least back as far as before the Plaza
Accords, or even to the closing of the gold window in 1971) the
U.S. dollar has certainly not fallen relative to other currencies,
which should be the natural corollary to your prediction.
"A lot depends, of course, on the dynamics at play with
the other currencies against which the dollar is compared. For
example, wouldn't the massive short-yen / long-dollar carry trade
have to be wound up in a deflation? And wouldn't this increase
demand for yen, causing the yen to rise?
"My expectation is that even as the debt pyramid deflates,
the price of commodities and finished goods will increase - i.e.
much the opposite dynamic to that which has been the norm over
the past 20 years or so (excepting the beginnings of commodity
price inflation in the last five years). To my mind that is the
best (and maybe the only) way to predict the effects of the unwinding
of the great financial bubble: the opposite of what was happening
while it was building.
All Paper Will Fall
"I think it is a significant challenge to guess at how the
major paper currencies of the world will perform relative to
one another in this environment. But I don't see how this performance
is critical to a thesis of deflation. What is critical is that
all paper will fall in value relative to physical goods. This
implies price inflation at the same time as we have monetary
deflation.
"If deflation is first preceded by hyperinflation, the dynamic
need not necessarily change. Hyperinflation will only be successful
if America's foreign creditors play along. This means they too
will have to hyperinflate their currencies to keep the 'stable
disequilibrium' in place and keep capital flowing to America.
In this environment, again, it is difficult to predict the relative
values of the world's rapidly depreciating currencies (though
commodity-producing countries' currencies should do well),
and likely not even very important. As in deflation without hyperinflation
the paper value of physical goods will increase dramatically.
"So this is how I understand the complex beast that is today's
virtual financial economy and the outlook for its eventual resolution.
If you could address my comments about your U.S. dollar prediction,
I would be most grateful. Despite my lack of interest in pivot
points, I find your writing on the general economy very insightful."
Deflation Paradox
My response:
"Thank for your insightful letter. The questions you've
raised bear directly on the most perplexing and paradoxical aspect
of the coming deflation -- namely, how can deflation occur in
a world that is drowning in bogus money? Never before have the
world's major currencies been completely hollowed of value as
they are now, so it seems both reasonable and logical to infer
that the next episode of deflation really and truly will be different.
But different in what ways? In my scenario, the dollar will continue
to strengthen as we approach the endgame of hyper-leveraged,
global financial speculation. Symptomatically, the implosion
of this bubble will be felt most acutely by speculators as an
increase in their real debt burden. This is the same as saying
that their need for dollars will become increasingly urgent over
time. This is essentially what Bob Hoye has been saying, and
I agree with him.
Mafia Money
But what might it imply down the road for a dollar that long
ago reached the threshold of intrinsic worthlessness? My guess
is that, with the almost infinitely vast supply of credit dollars
eliminated by bankruptcy liquidations, the relatively few physical
dollars remaining (including scads of $100 dollar bills salted
away by Russian Mafiosi and South American drug lords) will retain
much -- though not all -- of their current value relative to
goods and services, if not to commodities. The "full-faith-and-credit
backing" behind these dollars may be tattered at that point,
but the residual ability of working Americans to pay down debt
should be sufficient to elevate the dollar in stature, and in
value, relative to every other country's currency (they are just
IOUs, remember, not "money").
For most of these countries, exports to the U.S. are, economically
speaking, a life-or-death concern. In the wake of a collapse,
that is why no country would dare do anything that might "harden"
its currency. The implication, then, is that, even with the world
economic system in smoldering ruin, the Olympiad of competitive
devaluations will continue, redounding to the relative
strength of the dollar.
'Collapse' Not Imponderable
Once more question to ponder: Would a deflationary collapse necessarily
alter an already worthless dollar's status as legal tender? My
guess is that it would not that the dollar would still
be accepted as payment in most or all transactions, and that
essential goods and services would become relatively less affordable
than they are now. But I have my doubts that we'll see gold at
$10,000 an ounce or anything close to that, since, as the saying
goes, you can't eat gold.
Finally, it should be noted that the phrase "deflationary
collapse" does not describe some abstract event with consequences
that are too complex for us to predict or imagine. To the contrary,
although the sociological and geopolitical contours of a Second
Great Depression are as yet unforeseeable, the economic consequences
are anything but: an increase in poverty, joblessness and homelessness.
For the broad middle class, it would mean "simply"
dealing with a $300,000 mortgage on a $75,000 home. If such scenes
of hardship should come to pass, paper dollars and coins could
conceivably function precisely as they do now. The only difference,
of course, is that the credit turbocharger would be absent from
the system.
And here, with the final word, is Bob Hoye:
"History suggests that both private and central bank inflation
of credit depends upon prices going up. Also, it seems not to
matter whether the speculation occurs in a fiat or gold-standard
country. In the 1720 bubbles England was effectively on gold
and France wasn't.
Law's Printing Presses
"In England, intense speculation expanded credit against
stocks and real estate, while in France John Law was fueling
the mania with eight printing presses running in Paris.
Naturally everyone leveraged up, and once the asset prices stopped
going up the margin clerks took over. Their job descriptions
are vastly different to those of reckless central bankers.
"Every era of rampant speculation in financial or tangible
assets has inevitably collapsed and the senior currency has eventually
become chronically strong relative to most currencies, and commodities
most of the time. This has been the case following all five of
the eras of great asset inflations, from the early 1700s to ours.
Asset Rollover
"As for my own view, I just don't have the imagination or
ego to say that this time it is different. So the focus now should
be on this intense phase of speculation exhausting itself and
as in so many similar examples, this will be marked by asset
prices, both financial and tangible, rolling over.
"Some entertainment can be provided by considering that
most likely it won't be the dollar that will be repudiated --
the deluded "management" of the dollar will be
repudiated."
***
Rick Ackerman
email: publisher1@rickackerman.com
***
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