Inflation is a process: 1960-80 Edition

One observation I recently received concerned about how US Federal Reserve policies allegedly produced an “immediate inflation” in the 1970s (via stagflation) while today’s massive over $4 trillion of balance sheet expansion as of December 2013 hasn’t produced the same effect.

graphics via the CNN

Well inflation don’t just appear, like a genie, from nowhere. Inflation is a process.

This applies as well to during the 1960s to 1980s

From Wikipedia: (bold mine)

In 1944, the Bretton Woods system fixed exchange rates based on the U.S. dollar, which was redeemable for gold by the U.S. government at the price of $35 per ounce. Thus, the United States was committed to backing every dollar overseas with gold. Other currencies were fixed to the dollar, and the dollar was pegged to gold.

For the first years after World War II, the Bretton Woods system worked well. With the Marshall Plan Japan and Europe were rebuilding from the war, and foreigners wanted dollars to spend on American goods – cars, steel, machinery, etc. Because the U.S. owned over half the world's official gold reserves – 574 million ounces at the end of World War II – the system appeared secure.

However, from 1950 to 1969, as Germany and Japan recovered, the US share of the world's economic output dropped significantly, from 35 percent to 27 percent. Furthermore, a negative balance of payments, growing public debt incurred by the Vietnam War and Great Society programs, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued in the 1960s. The drain on US gold reserves culminated with the London Gold Pool collapse in March 1968.

By 1971, America's gold stock had fallen to $10 billion, half its 1960 level. Foreign banks held many more dollars than the U.S. held gold, leaving the U.S. vulnerable to a run on its gold.

By 1971, the money supply had increased by 10%. In May 1971, West Germany was the first to leave the Bretton Woods system, unwilling to devalue the Deutsche Mark in order to prop up the dollar. In the following three months, this move strengthened its economy. Simultaneously, the dollar dropped 7.5% against the Deutsche Mark. Other nations began to demand redemption of their dollars for gold. Switzerland redeemed $50 million in July. France acquired $191 million in gold. On August 5, 1971, the United States Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against "foreign price-gougers". On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland left the Bretton Woods system. The pressure began to intensify on the United States to leave Bretton Woods.

The above chart from economagic reveals that price inflation didn’t just “appear”. 

The US government had already indulged in monetary inflation as far back in the advent of the 1960s (as seen via M2 blue line). Meanwhile price inflation (CPI red line) began its upward trek only 5 years after. (both are measured via % change from a year ago).

When the Bretton Woods era came to a close, US M2 soared in two occasions. This  led to accompanying spikes in CPI which resulted to ‘stagflationary’ recessions.

Former Fed Chair Paul Volcker was widely credited for wringing out inflation by massively raising interest rates. Although Dr. Marc Faber already noted that the supply side glut from the early inflation has began to impact prices and that Mr. Volcker’s action may have complimented on this adjustment phase. The US economy had 3 agonizing recessions in the late 1970s to the early 1980s following the monetary experiment from the Nixon Shock before the imbalances brought about by previous monetary inflation had been reversed.

The point is inflation is a process which undergoes different stages

As the late Austrian economist Percy Greaves Jr. explained in simple layman terms

The first stage of inflation is when housewives say: "Prices are going up. I think I had better put off buying whatever I can. I need a new vacuum cleaner, but with prices going up, I'll wait until they come down." During this stage, prices do not rise as fast as the quantity of money is being increased. This period in the great German inflation lasted nine years, from the outbreak of war in 1914 until the summer of 1923.

During the second period of inflation, housewives say: "I shall need a vacuum cleaner next year. Prices are going up. I had better get it now before prices go any higher." During this stage, prices rise at a faster rate than the quantity of money is being increased. In Germany this period lasted a couple of months.

If the inflation is not stopped, the third stage follows. In this third stage, housewives say: "I don't like flowers. They bother me. They are a nuisance. But I would rather have even this pot of flowers than hold on to this money a moment longer." People then exchange their money for anything they can get. This period may last from 24 hours to 48 hours.

From the US ‘stagflationary’ experience, market developments combined with policy actions prevented the third stage (crack-up) boom from transpiring. But the policy tradeoff had been to induce harrowing periods of recessions.

Some notes:

-The foundation of the stagflation era of 1970s went as far back to the inflationary policies by the Fed during the early 1960s. The sustained inflationist policies eventually led to consumer price inflation.

-US inflationist policies largely due to the Vietnam war and US welfare (New Society) programs put an end to the Bretton Woods Standards.

-Recessions are necessary to reverse previous monetary abuse. The Bust serve as necessary medicine and therapy for the inflationary boom ailment.

There are also other factors that influence price inflation. For one, productivity growth from globalization helped reduced the impact of US Federal Reserve policies in the post Volcker era. This has been wrongly construed as the Great Moderation.

The massive explosion in the growth of the asset markets supported by debt that have also been instrumental in shifting the nature of the impact of inflation since a lot of monetary inflation today have been absorbed by asset markets (trillion dollar derivatives, bond markets, currency markets, etc...).

Bottom line: Just because statistical consumer price inflation seem subdued today, doesn’t mean there won’t be price inflation tomorrow or sometime in the future.

As one would note from the experience of the 1970s when price inflation emerges, it comes rather quickly. 

And in my view, the highly volatile financial markets today are symptoms such transition, but in a different light: asset inflation boom morphing into asset bust.

The next question is how will central bankers and the government react? Will their response lead to a crack-up boom (ruination of a currency via hyperinflation) or deflationary depression? I call this the von Mises Moment

Quote of the Day: The goal of Nixon Shock is to get foreign governments to hold US debts

Nixon unilaterally abolished the monetary agreement established in 1944 at Bretton Woods, New Hampshire. At that meeting, the United States, Great Britain, and other Western nations established a new monetary order. It would be supported by the United States Treasury. The United States Treasury would guarantee that any central bank or foreign government could buy gold from the Treasury at a price of $35 per ounce.

The goal of the Treasury was simple: to get foreign governments to hold Treasury debt instead of gold. Because Treasury debt was supposedly as good as gold, foreign governments and central banks could hold Treasury debt instead of holding gold. This enabled the United States government to run fiscal deficits, and foreign governments and central banks financed a portion of this debt. They did so by creating their own domestic currencies out of nothing, and then using these currencies to buy U.S. dollar-denominated debt, meaning U.S. Treasury debt. It was a nice arrangement. Foreign governments and foreign central banks gained an interest rate return on holding treasury debt, which they could not get by holding gold. Yet the dollars that they were being promised by the Treasury were supposedly as good as gold.

This is an extract from Austrian economist Gary North’s article in remembrance of the Nixon Shock or the closing of the Bretton Woods Gold Exchange Standard 42 years ago today.  

This shift towards the fiat money US dollar standard regime magnifies the Triffin Dilemma, where recent improvements in US trade and budget deficits could mean trouble ahead for global markets and economies.

Will the Triffin Dilemma Haunt the Global Financial Markets?

As measured by the Dow Jones Industrials US equity benchmark suffered their first loss in 7 weeks. Are these signs of fatigue or are these signs of an overheating or climaxing bubble? 

My impression is should US markets begin to wilt in earnest, then current downdraft in Asian markets are likely to intensify.

The US reportedly posted a substantial 22% reduction in the deficits of her trade balance owing to record exports and to a shrinking oil import bill according to the Wall Street Journal[1]. 

Shrinking US trade deficits can signify a symptom of unsustainable imbalances from the current monetary order, the US dollar standard.

The US dollar remains the largest international foreign exchange reserve with over 60% share (right window[2]).

International currency reserves are over $10 trillion with the US Dollar also having the biggest share (left window). Perhaps a big segment of the undisclosed reserve currency may also be in US dollars.

Over 50% (right window) of the $12 trillion (left window[3]) of international debt securities has been denominated in US dollars.

The point of this exercise is to demonstrate of the world’s continuing dependence on the US dollar as medium of exchange and as reserve currency.

Yet the US dollar standard seems to operate on the principle of the Triffin Dilemma, formulated by the late Belgian American economist Robert Triffin.

The eponymous theory by Mr Triffin elucidates of the economic conflict emanating from a world reserve currency particularly on meeting short term-domestic interests as against long term international objectives[4]

Under the Triffin dilemma, the issuing reserve currency makes it easy for a nation to consume more goods and services via an overvalued currency.

The same overvalued currency easily allows for financing of either budget deficits and or trade deficits, aside from having more latitude in “determining multilateral approaches to either diplomacy or military action”[5].

In short, a reserve currency provides the issuer the privilege of an interim “free lunch” or to quote the French economist Jacques Rueff “deficit without tears”[6]

One of the other side effects of the Triffin dilemma has been the intense deepening of the financialization of the US economy[7]. 

Instead of producing goods, the US economy evolved towards shuffling of financial papers partly required by foreigners to recycle their dollar holdings. As one would note, the gist of expansion of financialization came as the US dollar became unhinged from the Bretton Wood System in August 1971.

Of course the other side effect of the Triffin dilemma has been the growing frequency of global bubble cycles as evidenced by the greater incidences of global banking crises since the Nixon Shock of 1971

Aside from the massive accumulation of reserve currency by foreigners that would eventually undermine the reserve currency status, a dynamic which the world seems headed for, an equally detrimental factor to a reserve currency status is the proportional devaluation that would shrink these deficits.

Mr. Triffin actually articulated the problems of the Bretton Woods System where the failed system seemed to have validated his thesis. 

In a testimony before the US congress in November 1960, Mr Triffin argued that “If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.[8]”

Given the deep reliance by global markets and global economy on the US dollar system, improving US trade deficits are likely to extrapolate to reduced liquidity in the ex-US global system. Such dynamic will only provide more muscle or ammunition for bond vigilantes, and equally, would mean a tightening of a system deeply dependent on the largesse of US dollar steroids from US authorities.

In the recent past, a reduction in the deficits of US trade balance coincided with strains in the global ex-US equity markets as measured by the MSCI[9] (lower pane)

Diminishing trade deficits here functioned as symptoms to dot.com bubble bust and to the 2008 Lehman bankruptcy. When financial markets collapsed as consequence to a bubble, international trade grinded to a near halt. This led to a substantial reduction of US trade deficits. Thus the narrowing trade balance coincided with recessions.

The causal flow may or could be reversed today; perhaps reduced liquidity from US exports of her currency the dollar may incite instability in the global financial markets.

The effect of shrinking liquidity on the global system will likewise affect US corporations. With 34% of the revenues of US S&P 500 companies coming from non-US sales[10], the adverse effect is that shrinking global liquidity will eventually land on US shores.

And it’s not just trade deficits that has contracted, US budget deficits have also dwindled to 4.2% of the GDP from 7.7% a year ago[11]. So this could be a one-two punch against the global markets and economy. And should the FED taper, such will exacerbate on the effects of the Triffin Paradox.

Will the European Central Bank, the Bank of Japan, the Bank of England and the People’s Bank of China fill in the vacuum from improving US twin deficits?

Or will Triffin’s ghost haunt the global financial markets?

Interesting times indeed.

---

[1] Wall Street Journal Oil Boom Helps to Shrink U.S. Trade Deficit by 22% August 6, 2013

[2] The European Central Bank THE INTERNATIONAL ROLE OF THE EURO July 2013 p.19

[3] The European Central Bank, op cit., p23

[4] Wikipedia.org Triffin dilemma

[5] See The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency April 20, 2009

[6] Jacques Rueff, The Monetary Sin of the West, Mises.org

[7] Wikipedia.org Financialization

[8] IMF.org The Dollar Glut Money Matters: An IMF Exhibit—The Importance of Global Cooperation System in Crisis (1959-1991)

[9] MSCI.com World Ex-US MSCI Index Performance

[10] Businessinsider.com CHART: The S&P 500 Is Not The US Economy, May 10, 2013

[11] National Forex Calculated Risk; US Deficit is Shrinking August 10, 2013

Video: F.A. Hayek at BBC (Masters of Money)

Glad to see the great F. A. Hayek go mainstream

  

Somewhere in the video, Paul Krugman (Darth Vader) said that "unregulated banking and financing system is prone to financial crisis". Really? 

 

(the number of banking crisis since the Nixon Shock; chart from the World Bank) 

Jeffrey Sachs (Count Dooku) said that one of Hayek’s “badly failed” predictions is that of Hayek’s claim that “moving to a social welfare society would eat away at the health of democracy”. Really? 

To use the US as example,

chart from Heritage Foundation

from yesterday’s chart of the day

Maybe all these has nothing to do with America’s growing police state?

Or perhaps Professor Hayek had been just too early.

The US Dollar Standard on its 40th Year

Known as the Nixon shock, the US dollar-Gold convertibility was closed in August 15, 1971, that’s 40 years ago.

How this came about, Cato’s Dan Griswold explains, (bold highlights mine)

In a surprise televised speech on Sunday evening, August 15, 1971, the president announced that he would immediately impose wage and price controls, slap a 10 percent duty on imports, and suspend the international convertibility of the U.S. dollar into gold. All were to be temporary measures, of course, to promote jobs, dampen inflation, and combat “international money speculators” betting against the dollar. (You can read the entire speech here.)...

The centerpiece of the Nixon Shock was its controls on prices. In a market economy, freely fluctuating prices are the nervous system that coordinates supply and demand. Yet in one of the more chilling statements delivered by a U.S. president, Nixon told the nation that evening,

“I am today ordering a freeze on all prices and wages throughout the United States for a period of 90 days.

The price controls did tame inflation temporarily, but it came roaring back within three years to double-digit levels and persisted through the 1970s because of loose monetary policy. A tight lid on a boiling tea pot can only contain the steam for a time before it explodes.

The controls continued on gasoline, causing artificial shortages (as price controls usually do) symbolized by gas lines during the 1970s. Only when President Reagan finally lifted the controls on oil and gasoline in 1981 did the specter of short supplies finally disappear. (The 10 percent import surcharge did prove to be temporary, lasting only until the end of 1971.)

Closing the gold window was arguably inevitable given the lack of monetary discipline by the U.S. central bank. By 1976, the dollar and other major currencies were floating freely, which has turned out to work rather well, as Milton Friedman predicted it would. It also turned out that pressure on the dollar to depreciate was not driven by speculators after all but by the surplus of dollars that had been created to finance the Vietnam War and the Great Society.

The lessons:

One lesson of the Nixon shock is that if politicians are granted “emergency powers” they will tend to abuse them in situations that were never envisioned when the powers were originally granted. A second lesson is that “temporary” measures have a habit of becoming permanent. The big lesson is that the power of politicians over the economy should be limited. Any request for temporary emergency powers should be greeted with the deepest skepticism.

Of course there is another more important lesson: 40 years ago TODAY, ONE US dollar is now only worth 18 cents of buying power.

From the BLS

82 cents of every dollar accounts for how much worth of resources that has been surreptitiously and illicitly transferred from her citizenry to the US government and their cronies. This represents 40 years of mass deprivation, deception and delusion.

And to consider, the CPI inflation may have even been grossly underestimated as the method to compute this has changed over the years or as argued by John Williams of the Shadow Statistics via substitution, hedonic regression and etc… here

Henry Ford was right when he said

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

It’s been 40 years of infamy.