A Few Thoughts about the Journey to 0 …
Whether or not one advocates the use of paper money, one cannot help but be impressed (or just startled) by the enduring nature of the current paper money system. Perhaps this enduring nature is due to our collective naivety or perhaps it is a testament to the currency itself: – regardless, the irredeemable pure fiat dollar has persisted for decades. This contrasts with the paper currency systems of the past, for they were typically abandoned within a matter of years. Here, I outline one implication of this ‘stretched-out’ time-frame; namely, that the periods of market stress that lasted weeks or months in previous paper money systems might easily correspond to months or years of financial duress in the current one.
This Particular Paper Money System:
This particular irredeemable fiat currency system has been in place since the early 1970s. This is quite extraordinary when compared to the paper money systems of John Law, the German Reichsbank, the South Sea Company etc.
Perhaps this is a silly way of thinking about the issue, but if the stages that we’ve already experienced have been drawn-out when compared to previous paper money systems, the final stage (i.e. when the currency finally goes to 0) might also operate on a relatively drawn-out basis. Although such an empirical extrapolation might not be valid in itself, it certainly fits in with our analysis, thoughts and views here at greshams-law.com.
Intermittent Periods of Financial Duress as a Precondition to Monetary Debauchery:
As we explained in our recent article about the ‘art’ of monetary debasement, the manner in which the currency ‘should’ be debased is difficult, if not impossible, to ascertain in the modern-day governmental-commercial economic structure. Due to the plethora of supposedly ‘systemic’ industries that exist today, the task of debasing the currency requires a degree of foresight that central bankers do not have.
The result is that bouts of financial stress should assert themselves before central bankers figure out the ‘right’ manner in which to debase the currency. By that time, of course, it becomes progressively more difficult to counter the wave of panic that comes along with an established trend towards deflationary credit contraction.
[I use inverted commas for ‘should’ and ‘right’ above because, in fact, money-printing is not necessary or right. I merely intend to convey that, even with set of moral premises held by central bankers, the supposed task is just incredibly difficult or even impossible.]
Why does this matter?
One might easily say; who cares? The dollar et al. are going to 0 anyway? One might as well own things and avoid cash, right?
Indeed, if one modeled this monetary trend on those of the paper mark (of the Weimar Republic), the French Assignat etc., one might easily conclude that it’s best to hold – say – gold, and to short paper for the entire ride. However, once we grasp the fact that this paper money system has operated on a very long time-frame, and may continue to do so, then one might find that to hold such positions would only be appropriate for a minority of investors. For most investors (including those who manage collective investment schemes), the periods of financial stress may be intolerably deep and long for one to remain levered and long things / short money.
Even the Paper Mark of the Weimar Republic Experienced Grueling Rebounds:
As Constantino Bresciani-Turoni explained in the excellent book; ‘The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany‘ (available for free! at mises.org or at the greshams-law.com book store):
So long as the disturbance of the exchange exercised only a slow and partial influence on prices, an improvement of the exchange itself was possible and was actually experienced sometimes.
It would seem that these temporary periods of improvement in the paper mark had to be experienced before the profound and historic depreciation in the paper mark had the platform to really take hold. Moreover, just as may come to pass over the next 10-20 years, banking had to become a rather unfortunate business to be in:
The sudden rise of prices caused an intense demand for the circulating medium to arise, because the existing quantity was not sufficient for the volume of transactions…
At the same time the State’s need of money increased rapidly…
Private banks, besieged by their clients, found it practically impossible to meet the demand for money. They had to ration the casting of cheques presented to them. On some days they declared that they were obliged to suspend payments or open their offices for a few hours only. Panic seized the industrial and commercial classes, who were no longer in a position to fulfill their contracts. Private cheques were refused because it was known that the banks would be unable to cash them. Business was stopped. The panic spread to the working classes when they learned that their employers had no the cash with which to pay their wages…
A similar process seems to be in progress in the modern-day banking systems of the West. By 2007/2008, Western banks had become profoundly stretched (having experienced an enormous bubble). In the preceding bubble, bankers were tempted into producing vast quantities of ‘IOU money‘ (by extending credit liberally). So great was the accumulated credit production, that the money supply of today consists of mostly bank deposits (and indeed, these deposits are what most people associate with the word ‘money’). So, ‘the journey to 0′ for the current paper currencies of the world will likely involve profound stress where – just as during the early 20th Century – banks are besieged with redemption claims.
It is only after such periods of profound ‘scarcity of money’ that the hyperinflation of the paper mark was able to take hold in the Weimar Republic. [Of course, as I mentioned here, the circular dynamism was due to the fact that such ‘scarcity of money’ was brought on by a fall in the external value of the mark.]
The opinion, on this subject, formed in administrative circles, is clearly expressed in the following words of Helfferich: “To follow the good counsel of stopping the printing of notes would mean – as long as the causes which are upsetting the exchange rate continue to operate – refusing to economic life the circulating medium necessary for transactions, payments of salaries and wages etc. it would mean that in a very short time the entire public, and above all the Reich, could no longer pay merchants, employees, or workers. In a few weeks, besides the printing of notes, factories, miners, railways and post office, national and local government, in short, all national and economic life would be stopped…
The authorities therefore had not the courage to resist the pressure of those who demanded ever greater quantities of paper money…
They preferred to continue the convenient method of continually increasing the issue of notes, thus making the continuation of business possible, but at the same time prolonging the pathological state of the German economy…
Thus was the vicious circle established: the exchange depreciated; internal prices rose; note-issues were increased; the increases of the quantity of paper money lowered once more the value of the mark in terms of old; prices rose once more; and so on.
As can be seen from the emphasized part of the quote above (our emphasis), the continual increase in the supply of paper marks was a reaction to the supposedly ‘necessary’ demands from business and commerce. The point is that profound stresses are required as a prerequisite for profound money printing. To us, it seems extremely unlikely that the central planners of money (central bankers), would dare print aggressively until it is widely deemed to be necessary by the modern-day Helffreichs. Combine this with the fact that we are operating in a massively over-levered system that is moving in slow motion (compared to previous paper money systems), and one cannot help but conclude that most investors should anticipate the widespread anticipation of deflationary contraction before preparing for significant inflation (or hyperinflation).
So, considering that today, we are operating with one of the most persistent fiat currencies ever (it has outlasted the irredeemable paper mark by several decades!), and that we recently experienced a bubble in credit, we might reasonably expect periods of ‘scarcity of Federal Reserve notes’ to be both onerous and quite lengthy. Given that people seem to extrapolate the recent past into the future, this could bring about a scenario where the vast majority of speculators come to fear deflation. Since it pays to anticipate the anticipator, it may prove profitable to prepare for a world of deflation before preparing for profound inflation.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012