Changing The Rules Of The Game By Inflation

``The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price.”-James Grant, Little logic to bond world amid current risk phobias

Inflationary or deflationary outcome will ultimately be decided politically.

If the US government decides to safeguard its currency and allow for these market adjustments to occur, then there could be a deflationary unwind. However, this isn’t going to be politically palatable.

Yet, given the extent of the recent aggressive policy maneuvers, the penchant to use up all the available arsenal by the US Federal Reserve or by the President elect Obama (e.g. to engage in the “single largest investment program”) and or their respective ideological underpinning, all these tilts the risks towards greater than expected inflation, if not hyperinflation.

For us, deflationists have been underestimating the government’s capability to destroy their currency. It doesn’t take complex mathematical equations to do so. It only takes basic universal economic laws-exponential growth of supply of money relative to goods or services.

So far, Fed Chair Ben Bernanke’s outline to deal with this ‘deflation’ problem has gradually been implemented according to his playbook. In a worst case scenario, Mr. Bernanke in his 2002 speech elaborated the nuclear option (underscore mine),

``But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Applied today, the problem is to devalue against what?

During the great depression, the US dollar devalued against gold, but today’s monetary system which has no gold for its anchor, has nothing to devalue against.

``Unlike fiscal policy, which encourages other countries to "free ride" on any US expansion, the attraction of US monetary expansion is that it will force a global response. When the United States expands its money supply, thus putting pressure on the dollar to weaken, Asia and the United Kingdom will quickly follow suit to prevent their currencies from strengthening,” wrote Peter Boone and Simon Johnson for Peterson Institute for International Economics (emphasis mine).

In other words, once the political path has been chosen, then either a global currency war ensues, where all countries will be massively printing money in a race to the bottom or the global central banks undertake a coordinated approach – a new monetary standard that would allow for such devaluation to take place by using an anchor, possibly arising from IMF’s Special Drawing Rights SDR (as suggested per George Soros), a multilateral based currency, or partial reactivation of gold’s convertibility.

However, gold is unlikely to be a priority considering that it would seriously hamper the global political leadership’s power, as it would limit or hamper government expenditures.

Moreover, perhaps we can’t have the typically known “US dollar crisis” simply because if the central banks who are major currency reserve holders decide to head for the exit doors or liquidate all at the same time or simultaneously, there won’t be any buyers, not the private sector or not the US government itself, which makes these an unlikely event.

So the most likely path will be a change in the rules of how the games are played, and this would most likely involve a rather big dose of inflation.