Are we looking at the wrong inflation model?
Exploding the Weimar myth and the meaning of a paper reserve currency
Robert Wutscher
The Shadow Economist
Feb 5, 2010
Abstract
In the first part of this essay I will show how money creation and the expansion of debt differs fundamentally between Weimar Germany and the present day United States. So much so that the simple reliance on the Weimar analogy for the purposes of predicting a hyper-inflationary outcome for the US is unwarranted.
In the second part I will delineate some of the dynamics of the US dollar as international reserve currency in comparison to the other currencies. I do this with reference to a short comparison to the constraint afforded under the former gold standard and modern day developments in China.
I end by showing the mechanism through which a world-wide deflation could unfold. This hinges upon movements in central bank reserves and the fulfilment of the same conditions which would have to be met on a country by country basis.
A short note on methodology
In theorising I think it is important to know when you are dealing with pure theory (thinking in terms of hypothetical parallel worlds) and actual practice. It is also important to know how to interrelate the two, without ever getting the two mixed up/intertwined. The same applies to differentiating fact from opinion and being able to suspend opinion from time to time. Not doing either of the above leads to spliced reasoning, where your argument leans more upon your particular bias than in being able to transcend the dualism we see so much of around us.
Fact can be further divided into empirical fact and that derived from deductive logic. Most writers today base their theories on empirical facts. The problem with theories based on empirical facts (as their foundation and starting point) is that they invariably only end up as rational explanations of events that have already occurred. They in effect often end up chasing their own tails. It is for this reason that I think a lot of modern day economists have been unable to forecast the current crisis and continue to misdiagnose the economic situation (perhaps busily developing new theories on the abundance of new empirical facts that are presenting themselves today). (1)
Whereas I try to keep opinion out of my theorising as much as possible, I recognise that it does creep in as soon as I start using analogies. That is why, even though they can be so useful in exposition, they can also be dangerous.
One could argue that my thesis supports deflation and therefore that is my opinion. However, a careful reading should reveal that I am only attempting to show the necessary conditions under which deflation “could” or “would” occur despite the best intentions of the Fed. It is up to the reader to make up his or her own mind as to the likelihood of the conditions I am alluding to and which of the “could” or “would” may be applicable (or any slight in logical deduction for that matter).
Stated explicitly, the principle conditions, where the rest becomes deductive logical reasoning, are:
- what I would call the “unwillingness to lend, spend and borrow syndrome”, where reference is to private individuals, not the public sector. One could further qualify this statement in that it is the “creditworthy” borrowers who become unwilling to borrow, thereby restricting the pool to whom banks are willing to lend to.
- Closely connected is the level at which the private debt (as opposed to public debt) becomes unsustainable.
The implications of both conditions have been more fully explained (a little) in two previous articles. (2)
I Anatomy of the Weimar inflation
The general consensus attributes Germany's war reparations and the general economic conditions following the War as the primary causes for the Weimar hyper-inflation. However, reviewing actual processes and motivations behind policy decision-making that led up to the policy of hyper-inflation leads me to question the appropriateness of this historical case study to the present day United States.
History books often state that the reason for the money printing was in order to meet reparation payments in marks. Whereas the treaty of Versailles did not state the exact amount of the payments - because this was still to be provided by the Allies at a much later date - it provided for the payment of 20 billion “gold” marks to be paid on account up to May 1921. (3)
If it was simply a matter of printing the money to effect payments for reparations, why did the Weimar government not just simply print the exact sum required by the Allies and leave it at that? Surely because the Allies would not accept “paper” marks. The Allies wanted “gold” marks, i.e., the equivalent in weight of gold for the final amount in total reparations.
The problem for the Weimar Germans was how to obtain that gold. Their problem was compounded by the worldwide price and wage deflation of 1920, loss of territories which included key industrial areas such as Upper Silesia and the loss of a proportion of their coal revenues already earmarked for the Allies.
I am not aware of any significant gold mines in Germany. The only way I can imagine that Germany could obtain its gold was through the export markets. Only a policy of competitive currency devaluation could provide the impetus for an attempt to capture export market share. That is why I believe it became necessary to print so much more paper marks in order to attract gold into the country with which the war reparations could be effected (through competitive price and wage reductions). Not because of a simplistic belief of an erosion in the value of its debts, which may certainly have been true in the local economic context, but not the international one! (4)
The US does not have the same problem. It owes the World paper or digital US dollars, not gold or any other currency. It also does not have the need to attract anything from abroad in fulfilment of its international obligations. Though this may sound somewhat facetious, the rest of the world is free to spend their dollar reserves on whatever they want. Some might argue that the US needs to attract savings from abroad. In the next section I will show why such an argument has it backwards, because of the world's demand for international reserves.
If the US had to decide on a deliberate policy of dollar depreciation (5), its motivations would be entirely different to that of the Weimar Germans. The Germans had to do it in order to obtain gold to effect reparation payments, the US does so in order to continue to claim a disproportionate share of the world's resources. Not for any repayment of amounts which remain denominated in US Dollars. It is able to do so because it is de facto still the world's reserve currency. I feel that writers generally do not appreciate the difference in dynamics that a reserve currency presents compared to a non-reserve currency. They often work under the same simplified assumptions for the US dollar as if it were just another international currency. (6)
The growth of the US money supply over most of its history since the Federal Reserve was instituted has been achieved on the back of “private” credit expansion; contrary to popular belief that the money has simply been “printed” by the Federal Reserve (in substance, this is only partly true following the crisis since 2008 and to the extent that the Fed has “accommodated” private credit expansion (7)). The increase in the public debt has mostly resulted from the crowding out of the private sector as well as from foreigners' appetites for reserves. By contrast, in the Weimar Republic we find no deep private credit markets (I assume not following the aftermath of the War), but only public debts whose increase correlated with that of the hyper-inflation in the currency in a direct causal connection. (8)
To compare the increase of the US public debt with that of Weimar Germany's is a gross conflation of underlying processes:
- the path of money creation through private credit extension in the fractional reserve banking system where there is voluntary lending and borrowing and
- the path of money printing, which incorporates government debt creation against an increase in the note circulation (and where there is no longer an effective bond market).
Whereas the Fed is veering ever closer to the second path, as I have argued in previous articles (2), once we have passed the point of willing lenders and borrowers, the excess private debt that has been built up over decades becomes a hurdle for the US. This hurdle has to be cleared first before its inflationary policies can regain their traction.
The problem of the US is ultimately one of an excess of private debt backed by over-inflated assets. The “value” of such assets form the foundation of itselastic currency. Its public debt, though interrelated, is an entirely different problem and should not be conflated.
The problem for the Weimar Germans was one of effecting an international obligation in gold that it did not own enough of. The explosion of its public debt was a direct consequence of having to obtain and secure reparation payments in gold. I shall deal with the different meaning of the US international debt obligation in the following section.
II Anatomy of a paper reserve currency
Mutual benefits of lifting the gold constraint
Having ones currency as international reserve places one at a great advantage to the rest of the world. One is able to appropriate a larger share of the world's resources. This is because by merely borrowing in that currency you can obtain any good priced internationally in that currency. Any other country would first have to acquire the international currency. Creating more of its own currency only makes it slide in value against that of the reserve currency.
Other countries want reserves and would be the poorer for it if the US had been running trade surpluses. Reserves serve as backing to a currency (for imports) in much the same way that gold performed this function by facilitating international trade in the past. Back then gold acted as a constraint by being shifted around between countries forcing them into paying back imports with exports (in terms of real goods) sooner rather than later. Else they would run out of backing to their money as gold would be drained out of their country.
Today the (much looser) constraint essentially only applies to non-reserve currency countries where the more that gets exported, the more can (theoretically) be imported. And the US is the willing repository of those (excess) exports. Of course it becomes a problem when such reserves become excessive (has anybody yet coined central bank reserves as a bubble?). It has become too easy for the world to accumulate reserves while the US has no need to accumulate any.
With gold as a constraint, there would at any point in time be those countries experiencing monetary inflationary effects while others would be experiencing monetary deflationary effects (because of gold flows), at least for as long as they do not balance their trade. (9) By removing gold and allowing for the continued expansion of the paper reserve currency, all countries could enjoy monetary inflationary effects all the time. The cost of this seems to be imperceptible (in fact, can you even see it?).
A discussion of the gold standard and further qualification of the above effects is beyond the scope of this essay. Suffice it to say that the gold constraint only poses problems because of the existence of central banks, where currency interventions try to prevent a sooner balancing of trade than later (through explicit centralised currency competitive behaviours of countries). In effect, with the removal of the gold constraint, countries seem to be able to engage in competitive currency management without the presence of any immediate adverse costs to other countries. We continue with a discussion of some of the imperceptible costs that appear to be emerging under the current system today.
Exchange rate dynamics
Whereas having its currency as international reserve provides the US with great power, foreigners hold the greater power in effecting their own exchange rates against it. If the US tried devaluing against all currencies it would be like fighting as an octopus or a hydra having to keep an eye on each of its many tentacles. Other nations get to decide on whether to follow US money supply growth or not. They do this not by buying or selling US dollars as may be simplistically assumed, but by deciding the extent to which they are willing to buy every dollar their exporters bring home. For this reason, the US cannot surprise the world with how much money it creates. The amount will be transmitted automatically to the world through an increase in its trade deficit. Countries that maintain relatively fixed exchange rates will feel this the most. (10)
We generally assume that because the Chinese are holding down the value of their currency relative to the US dollar that the US dollar must be undervalued. However, how does one know how much of that perceived undervaluation has not spent its effect on allowing for a more rapid industrialisation of China (at the cost of appeasing the US with more of the world's resources to consume)? It could just be that if the rate was not fixed and the US was not affording the Chinese an opportunity to accumulate reserves (by allowing for the expansion of its own money supply), that the rate in such a parallel world “could” be the same. What I am implying is that the depreciation of the US dollar may already be baked into the pie. This is because the Chinese have been expanding their own money supply by providing fresh Yuan in exchange for every dollar their exporters (net of importers) bring home. This would be necessary to maintain the fixed exchange rate. As to the effects of the changes in money supply, these could be vastly different at different times in different places. Particularly in the case where all that new money is driving investment as opposed to consumption, where prices and wages can be maintained at relatively lower rates during such an industrialisation phase. (11)
What I am not arguing is that the Yuan would not revalue should the Chinese central bank stop its intervention in maintaining the semi-fixed exchange rate. Of course it would in the same way that an elastic band would snap back after having been stretched around a corner. This is because of fundamental imbalances allowed to continue unchecked. But arguing that the US dollar is undervalued (relative to the parallel world of constraints) is a separate argument to arguing that the Yuan will appreciate upon free float. Another way perhaps to see this is in terms of a gold constraint. If gold convertibility had always been assured, the process (or the speed thereof) would have stopped long ago as there would not have been enough gold to flow out of the US as reflected in the growth of Chinese central bank reserves.
Willingness to fund US deficits or appetite for reserves?
I mentioned in the previous (Weimar) section that the increase in the US public debt has a lot to do with foreigners' appetite for reserves. Looking at it in this way does not mean it is simply a question of the “willingness” of foreigners to fund the US deficits. It is a question of when their appetite for reserves becomes satiated along with the benefits that reserve accumulation brings. I think writers place too much emphasis on the “current value” of central bank reserve assets, rather than acknowledging the benefits that are derived from the accumulation of those reserves.
A conflict over entitlements is brewing because the parties to the contract (of accepting the US dollar as international reserve currency) seem to have been unaware of all its ramifications. For example, giving the Chinese their value “in gold” in settlement of their US dollar reserve assets now would be like them having their cake and eating it too. If we were on a gold standard, the Chinese would not have been afforded the opportunity of as rapid an industrialisation. The indirect cost (almost imperceptible) for this to the Chinese has been for the benefit of the US, who have been able to appropriate a larger share of world resources. The problems do not end here because there have been further costs also to the US of this benefit; two being the loss of their own manufacturing base (or merely particular sections thereof) and a ballooning debt burden. One that was hidden by rising asset values (bubbles). In effect the US has entered into contractual obligations beyond the point of its ability to repay based on current productive capacities. The measure of determining objectively where that point might lie appears to be missing.
It is as if parties to a pact could only see mutual benefits, but no costs as these were papered over (with fiat money). The costs now emerging are difficult to resolve because the parties will have changed by payback time (younger generation not willing to bear the costs of their elders who benefited. Even worse, the elders are foreigners!).
As you can see, I have a problem with the notion that the value of the US dollar depends on the “willingness” of foreigners to fund its deficits. It is the same when people say that the value of the US dollar depends on the confidence in it. Whereas not strictly incorrect, such thinking does imply that if it is just a matter of confidence, then any means that restores such confidence is fully justified. In this way we subvert our common sense of values.
Only on the basis of a better and wider understanding and recognition of what the system has always meant can we design a monetary and political system that better prevents the subversion of common sense values. Not by laws founded on bans or any ones conception of what constitutes a good citizen, but ones that allow citizens to freely face up to the consequences of whatever their actions, both good and bad. The consequences should be allowed to be faced up as soon as possible so that lessons get learnt with the least amount of collateral damage and we can move on. Imposing bans and sanctions only results in subversion, equivalent to what Carl Jung would have said we do when we suppress things into the shadows of our subconscious. Whatever bad habits or motivations we have failed to fully integrate within ourselves and simply suppress will only crop up somewhere else or at another time. For example, it could manifest as an increasing dysfunction, confusion or loss of meaning or direction in our everyday lives.
III The possibility of a world-wide deflation
A reduction in the US trade deficit or a competition for more resources by other countries could trigger a deflationary outcome. This would be on the basis of excessive central bank reserves and excessive private debts. Central bank reserves are a small but indispensable part in the maintenance of excessive debt levels. I mean small, because to the extent that they are held within the US banking system, they help in propping up the money supply that has been multiplied through the fractional reserve banking system. (12)
If the Chinese wanted to dump their dollars, they would be more likely to do so by buying up resources at any dollar price than by dumping it on the foreign exchange markets. The irony is that despite the bidding up of dollar prices which is 1x price inflationary, the loss of US bank deposits would be 10x deflationary because of the money multiplier process shifting into reverse gear. (13)
By not doing so central banks provide the last stable reservoirs of US dollar liquidity reserves in the world. A contraction of world trade could lead to a reduction in central bank reserves depending on how policy makers choose to use their reserves in the face of such a decline in economic activity.
I mentioned earlier, rather facetiously, that the world was free to spend their dollar reserves on whatever they liked. For the monetary system as a whole, this will only work for as long as there are other depositors or willing lenders to take the place of the withdrawn deposits or treasury funding. In the case of withdrawn deposits we have deflation if nobody else is able to step in. I have already explained in previous articles how it is possible that withdrawing deposits and printing money can lead to liquidity contraction. Essentially this is because of the need to repay debt exceeding further willingness to continue borrowing and lending. This is the only motor that can get those reserves, with which US banks have recently been stuffed, out into the system again. There are many pundits who are simply waiting for the velocity of money to start itself up again.
To understand why this would also lead to deflation in other countries, one needs to consider the path of entry of such resources acquired through the central bank into the private sector. If the exchange rate is maintained, then the higher dollar prices of resources (because of increased bidding to get rid of dollars) results in more local currency being withdrawn by the central bank (locals have to pay for those resources in local currency in exchange for the dollars used to acquire them). This only poses a problem if that local economy can no longer generate additional monetary inflation by other means because of an unwillingness on the part of its own private citizens to borrow and lend any more.
The government is not constrained by an unwillingness to borrow and spend. That constraint has effectively been removed by leaving the gold standard. However, they are constrained by their ability to be productive. For this reason throwing more debt at debt can work. Only for as long as there is a supportive private sector, even if this support comes forced. As they say, it is better to have a tax problem than no tax problem at all (meaning no income either).
Conclusion
The ease afforded by a paper reserve currency has enmeshed the world in an entanglement of entitlements and hidden costs that are now starting to emerge.
Money has been losing its historical store of value function. Today it is essentially no more than a medium of exchange. It is as if the sun were to lose its light, throwing the world into darkness, no longer able to fulfil its enlightening role. Dark motives are able to gain the upper hand through the subversion of (former) common sense values. These relations, which occur beneath the fabric of our perceptions, are independent of the objective exchange value of the US dollar in relation to other currencies, where the planets simply continue to spin around a darkening sun. One could take this analogy further in that just as the universe is currently expanding, so too do all currencies expand along with the US dollar. They will continue to do so for as long as other countries continue to maintain an appetite for US dollar reserve accumulation. But astronomers also expect the universe to start to contract again!
Murphy has a new law: what expands must contract.
Notes and references:
(1) Readers further interested in methodology could read Hayek's Chapter I, pp 27-39 of his Monetary Theory and the Trade Cycle (1933), which provides a (much better) expansion of what I have mentioned. My own theorising basis on praxeology, a rather difficult concept to explain that would take me beyond the scope of this essay. It probably requires much more elucidation before it can be more widely understood. See note (12) below for a (partial) working example as you read through this essay.
(2) Posted on 321gold.com: “Why the Fed will fail” (Dec 22, 2009) and “Where does all the money go?” (Jan 27, 2010)
(3) Articles 232, 233, 235 of the Treaty of Versailles, 1919
(4) For ease of exposition I have left out many other factors. One interesting one was the payment of miners not to work for the French. So we also have idle money creation.
(5) Devaluation is a term reserved for fixed exchange rate systems. It seems perhaps to have become common usage lately to denote official intervention, which would have been only half the definition under the Breton Woods system.
(6) For example, an official devaluation of the Euro would result in the immediate alleviation of Euro debt burdens for the Europeans (higher value of Dollars held or immediate higher export earnings relative to local debt). For the US on the other hand an official devaluation would not change the nominal debt at all. It could after a process (rising Dollar prices for example), but processes are always conditional upon many other factors that should not be quickly simplified away or taken for granted.
(7) This accommodation has mainly been through open market operations which includes interest rate management, bond market interventions and what I referred to as 'incarnating' of digital dollars in order to meet physical demand for cash (Jan 27, 2010). To emphasise: money created “out of thin air” as many writers claim, necessitates the existence of willing borrowers and lenders. Even in the case of the government, always a willing borrower, there were always willing private lenders (including foreign central banks) at least always so before 2008.
(8) In the case of Zimbabwe you can take this one step further where the increase in the note circulation was probably not even reflected in an increase in the public debt (but this is more of an accounting issue of how you choose to account for the increase in the note circulation).
(9) Though a fuller explanation lies beyond the scope of this paper, I am not referring to “price” deflationary effects related to productivity gains for example. Monetary deflation can have other repercussions such as contracting net income through the money supply/net income interface as described on Jan 27, 2010.
(10) The US could technically surprise the world by buying foreign currencies directly on the open market, thereby driving down the value of the US Dollar. But what would be the point of that? Apart from angering other nations as the US would effectively be deflating their currencies, they could easily retaliate by simply printing more of their own currencies.
(11) Keynesians will recognise that this can be so on the basis of absorbing idle resources (there being limited constraint on the supply of labour from the countryside). I do not, however, encourage such thinking as I believe it can lead to many of the economic fallacies we currently hold, particularly when it comes to capital theory, without questioning the cause of idle resources in the first place.
(12) In 2008, the Fed averted this crisis from unfolding by providing US dollars to foreign central banks. [Note: returning to methodology, I do not “base” my theory on empirical evidence. That is why you see very little empirical facts or figures in my writing. The method I have adopted is only as useful or as strong as it can be corroborated by empirical evidence under the conditions hypothesized a posteriori.]
(13) It is 10x deflationary based on the outdated 10% cash reserve ratios used by many writers. Today, cash reserve ratios are probably closer to 2%, implying a 50x deflationary effect! We do not know the exact figure because of sliding scales and definitions of types of deposits subject to the rules.
###
Feb 5, 2010
Robert Wutscher
The Shadow Economist
email: rwutscher@telkomsa.net
The shadow
economist, Robert Wutscher, is a retired financial due diligence
specialist who has taken up the study of economics. His study
has turned to the shadow side of economics: what most economists
ignore, suppress or fail to account for in their models under
the light of mainstream economic consensus methodology. A rich
resource exists in many old economists who have passed away with
insights that do not sit comfortably in today's quantitative
models and with warnings/lessons of the past going unheeded.
The modern consensus methodology is primarily based on quantitative
methods and generally considers only economic aspects and assumptions
that are amenable to quantitative analysis, even if this can
only be done with abstraction of reality or of the mathematics
itself. It ignores other concepts essential to human decision
making, that may be too hard to quantify and that may be hidden
in the shadows of the aggregates and averages that form the edifice
of macroeconomics and econometrics.
The shadow
economist is new on the block and will generally challenge the
conventionally held wisdom even that of the gold bugs. He welcomes
constructive criticism. He can be reached at rwutscher@telkomsa.net
321gold Ltd
|
