The Death Spiral of Fiat Money

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During a presentation today at the Adam Smith Institute, economist Kevein Dowd, a visiting professor at the Pensions Institute, Cass Business School in London, told his audience:

Fiat money is entering its death spiral…

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What’s behind Dowd’s thinking? He wrote this last December:

Sooner rather than later, it will dawn on investors that Treasuries are over-valued and confidence in the Treasuries market will crack: one possibility is that rising inflation expectations or higher deficits will then push up market interest rates, causing bond prices to falter and then fall; an even more imminent prospect is that some combination of the Fed’s quantitative easing and yawning Federal budget and U.S. balance of payments deficits will cause a further decline in the dollar that makes foreign holders of Treasury bonds lose confidence in their investments. In either case, there is then likely to be a rush to the exits – a flight from Treasuries on a massive scale – forcing up interest rates in general and inflicting heavy losses on bondholders, especially on those holding long-term bonds.

• The collapse of the Treasuries market will cause the banks’ previously profitable ‘gapping’ adventure to unravel with a vengeance: the very positions that yielded them such easy returns will now suffer swingeing capital losses. Confidence in the banks – never strong since the onset of the crisis – will collapse (again) and we will enter a new (and severe) banking crisis.

• The bursting of the Treasuries and financials bubbles will then feed through to the junk bond bubble: the collapse in the Treasuries market and the renewed banking crisis will lead to sharp falls in the values of corporate bonds and sharp rises in credit spreads. Highly leveraged firms will then default in droves, the junk bond market will collapse and LBO activity will dry up.

We also have to consider the nontrivial knock-on effects: the Treasuries collapse will trigger an immediate financing crisis for governments at all levels, and especially for the federal government, and one which will likely involve the downgrading of its AAA credit rating, and so further intensify the government’s by-then already chronic financing problems. Nor should we forget that these financial tsunamis are likely to overwhelm the Federal Reserve itself: the Fed has a highly leveraged balance sheet that would do any aggressive hedge fund proud; it too will therefore suffer horrendous losses and is likely to become insolvent. The events of the last three years will then look like a picnic.

There is also the problem of resurgent inflation. For a long time, the U.S. has been protected from much of the inflationary impact of Federal Reserve policies: developments in IT and the cost reductions attendant on the outsourcing of production to east Asia had the impact of suppressing prices and masking the domestic impact of Fed policies. Instead, these policies produced a massive buildup in global currency reserves: these have increased at 16% per annum since 1997-98 and caused soaring commodity prices and rampant inflation in countries such as India (current inflation 16%) and China (maybe 20%, judging by wage inflation, and definitely much higher than official figures acknowledge) whose currencies have been (more or less) aligned to the dollar. U.S. inflation was already rising by 2008 (annual rate 3.85%), but this rise was put into reverse when bank lending and consumer spending then fell sharply. However, there are good reasons to think that inflation will soon take off again: (1) The combination of booming commodity prices and a depreciating dollar (trade-weighted dollar exchange rate index down 15% since March ’09) means that imports will cost more in dollar terms and this must inevitably feed through to U.S. inflation. (2) Rising labor costs in the Asian economies mean that the outsourcing movement is coming to an end and even beginning to reverse itself, and with it the associated cost reductions for American firms that outsource to Asia. Most importantly, (3), there is the huge additional monetary overhang created over the last couple of years (or, to put it more pointedly, the vast recent monetizations of government debt), the impact of which has been held temporarily in check by sluggish conditions over 2009-2010, but which will must eventually flood forth – and, when it does, inflation is likely to rise sharply.

Once inflation makes a comeback, a point will eventually come where the Fed policy has to go into sharp reverse – just like the late 1970s, interest rates will be hiked upwards to slow down monetary growth. The consequences would be most unpleasant: the U.S. would experience the renewed miseries of stagflation – and a severe one at that, given the carnage of a renewed financial crisis and the large increases in money supply working through the system. Moreover, as in the early 1980s, higher interest rates would lead to major falls in asset prices and inflict further losses on financial institutions, wiping out their capital bases in the process. Thus, renewed inflation and higher interest rates would deliver yet another blow to an already gravely weakened financial system.

Reprinted with permission from Economic Policy Journal.

2011 Economic Policy Journal

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