The Inflation / Deflation Debate

This is not a topic we wanted to get into yet, but it seems that the market has forced our hand. It can be complex and so simple it's mind boggling. Work through this slowly. Make sure you understand it. Direct people that you think need to understand it to read it. Without understanding these concepts, you will be fooled and fooled very soon.

The Value of the Dollar and Floating Exchange Rates
As we've commented on numerous times before, the US stock markets and global commodity markets are not trading on fundamentals, but are instead trading on whether the dollar falls or rises.

Ever since Richard Nixon was forced to cut the US from the gold standard in 1971, the US, like most countries in the world, has been on a floating currency system. In short, currencies have value only relative to other currencies and are completely tradeable on currency exchanges. Much like stocks, in practice, currencies represent the value of the country relative to other countries and tend to show the flow of capital among countries. Those countries with strong economies and positive fundamentals tend to have stronger currencies. In addition, countries with low inflation expectations and high interest yields on government bonds (we'll discuss this more below) attract buyers.

In some cases, like Canada, Australia, and Norway, the value of those currencies is heavily dependent on their primary economic industries--commodities.

The bottom line is that one currency only has value relative to another currency, and the value depends on lots of factors and the general psychology of currency traders.

Although not perfect, the US Dollar Index (USDX) is one way of measuring the dollar against the currencies of the US' major trading partners, including the European Union, Canada, Japan, Great Britain, Sweden, and Switzerland.

By measuring the USDX, we are looking at the perceived value of the US relative to other key trading partners. It's not perfect, but it's a reasonable sign of things to come.

Currently, we are technically at support levels and have been bouncing for the last two days (today being an exception). Stocks have been rising opposite the USDX, so today stocks have bounced. The question we are forced to answer is one of market psychology. Why, exactly, is the dollar up or down, and since the stock market is moving opposite the currency, what does that mean? We'll attempt to determine that below.

Treasury Auctions
We have also see a couple of essentially failed Treasury auctions this week on the 2-year and 5-year notes. The 7-year auction is today, and the results may be crucial. This is what is forcing us to put this piece together so quickly.

The debt markets, notably government debt, are the largest markets in the world. They dwarf the size of the stock markets.

When you buy a bond, you're buying debt. You're buying an IOU that states that the government will pay back your money in a given period of time (2 years, 5 years, or 7 years in reference to this week's auctions) with interest.

Government debt is usually considered a very solid investment. After all, they have millions of citizens that they can tax and pay off the debt (worst case, they can just print the money, but as a bond holder, that's bad for you because it causes inflation). In most cases, it's much less risky than loaning your shady, out of work cousin Lenny money for a car, right? If the government starts to print money, the amount of interest they have to pay rises or no one wants to accept the bonds.

As the maturity (the amount of time you have to hold the bond) on bonds gets longer, so does the risk. After all, what kind of interest rate would you want to give the US government your money for 30 years? You have to trust that the government is going to make good decisions and that when you get your money back, it's purchasing power (aka, it's "store of value") has not been significantly eroded (ie, inflated away by printing too much money). After all, if you're going to loan money to the government, you want to be better off for it, right?

So if you loan the government money for 30 years, you want a higher interest rate than if you loan the government money for 1 year. Your risk is higher, so you want a better return.

The rate of interest of government bonds (Treasuries) from the short term to the long term is the "yield curve." The further out on the yield curve you go, the higher the interest rate you expect.

Since every dollar created is backed by debt issued by the government, which is in turn backed by a promise (IOU) that the government will make good on its payments with interest, which is in turn backed by the government's ability to tax its citizens, then all currencies (money) are backed solely by debt. When they say "money is debt," this is what they mean.

The government auctions off bonds to raise money for government spending when taxes are not enough to cover the cost of running government programs (whether they are welfare programs, retirement programs, or funding wars). As discussed yesterday, the auctions for the 2-year and 5-year have not gone well. We'll get back to this in a minute.

Printing Money
As the credit crisis has hit, more and more governments around the world have been trying to raise money to pump into their economies. They have also been purely printing money. The way money is printed in the modern economy is that the Central Bank (ie, the Federal Reserve, the Bank of England, the European Central Bank, etc) buys the government bonds of its own country. It does this with money it creates out of nothing. It may sound ludicrous, but when the Federal Reserve buys bonds auctioned by the US government Department of the Treasury, it simply creates the dollars necessary to do so. When they say "money is created out of thin air," this is what they mean.

In modern parlance, no self-respecting government or central bank would refer to this as "printing money." That has negative connotations (and rightfully so). They refer to it as "quantitative easing" or "QE."

[Side note: A central bank can technically buy anything. Government bonds, mortgage backed securities, and paper clip purchases all imply that the central bank will print money out of nothing to complete the purchase. Often, when the government cannot find other buyers of its bonds but it needs money, the central bank will buy the bonds with newly printed currency. This is also referred to as "monetizing the debt."]

Economic Schools of Thought
It is impossible to do justice to the fundamental schools of thought on economics in such a short space. It is also impossible to draw conclusions about the direction we're taking without bringing them up. Please bare with this brief and very incomplete description...

The Austrian economists believe in the gold standard because it limits the amount of money that can be created based on the amount of gold owned by the nation. Since you can't just print gold, this imposes a practical limitation on the total annual amount of global currency creation that is capped at the amount of annual gold mining production.

The Keynesians and monetarists (Friedmanites) believe that gold, to quote Keynes himself, is a "barbarous relic." Both schools of thought opt to try and manage the economic fluctuations of the natural business cycle of the economy by having the government add or subtract money and credit in the economy at the right time. The Austrians believe this only fuels speculation and malinvestment.

Keynsians seek to add credit into the economy when the economy weakens and remove credit from the economy when it heats up. This way, government compensates for the poor economy by temporarily "propping it up" in bad times.

Friedmanites advocate manipulating the money supply instead of interest rates to accomplish much the same goal.

The Great Inflation/Deflation Debate
And now we come to the crux of it--the Great Inflation/Deflation Debate.

There has been an debate raging for years now on what happens in the situation that the world, and in particular, the United States, now finds itself in. The two camps are the inflationists and the deflationists.

The inflationists argue that, much like Argentina in 2001, the Weimar Republic in German in the 1920s, or even modern day Zimbabwe, that the constant increases in money supply (inflation) and artificially low interest rates will eventually destroy the currency (remember our discussion of supply and demand as it applies to currency?). Central to this idea is that as politicians continue to promise more than they can deliver, they will find a way to print money to make it happen. This will ultimately make each unit of currency worth less, which leads to a loss of confidence and a panic flight away from the currency to real, tangible things (like commodities) that cannot be inflated away.

The deflationists argue, on the other hand, that the modern world is not about printing money as much as it is the supply of credit. We live in a credit-based economy. So for any country to print more money, in reality the rest of the world has to allow it. Otherwise, the value of the currency (as a floating, freely traded security) will fall too far, and no government in its sane, right mind would allow that. So instead, countries will have to borrow the money by auctioning government bonds (Treasuries in the US). There is a free market check on the ability of any country to borrow--at some point their bond auctions will not be received well, and they will essentially fail. That will stop government spending since no government in its right mind would just print the money, and if credit is collapsing in the economy, the result will be deflation.

Phew. Hopefully that made some sense. Bottom line is that the inflationists believe that the government cannot and will not be stopped when it comes to printing money, and that the end result is a collapse in the currency. In this case, the currency is worth less and there is a panic to real things. They cite Argentina, the Weimar Republic, and the historic fact that all fiat (non commodity based) currencies have been destroyed over time.

The deflationists believe that the floating currency exchange system and the rejection of government bonds will stop governments from destroying their currency. They cite Japan and the multi-decade "deflationary" spiral.

[Quick side note: Japan printed a lot of money and lowered rates. That's not deflation. However, investors opted to take zero-interest-rate Japanese yen-based loans and invest the money in other areas of the world. The result was inflation outside of Japan. Don't confuse cause and effect! We'll touch on this more later as we discuss a possible upcoming US dollar carry trade.]

The Dredd Viewpoint
We tend to believe that both sides have solid points, but in the end, inflation must win out.

Why?

Can you imagine a scenario where the US government comes out and states that they are going to shut government down, including Medicare/Medicade, military, and Social Security programs because no one will buy bonds? Are you nuts? No politician would ever be reelected.

At the same time, the US debt is so large and growing that it cannot be paid of by taxation alone.

Debtor nations must have inflation. They need it because inflation erodes the debt. Plus, the nation can always just print currency to pay its costs. This should ultimately be reflected in the USDX as the supply of dollars rising becomes known relative to other currencies.

The other option is default. In a default, the government cannot pay its debts and refuses to print the money. In that case, the exchange value of the currency (ie, USDX) should fall because the currency is like the stock of the country.

So the end game in deflation or inflation is the same in fiat currencies--loss of confidence.

Why Is It Today So Critical?
Usually, when a government debt (Treasury) auction fails, the stock market drops. It's a vote of lack of faith in recovery of the economy if the government cannot get more money to stimulate and carry out its goals.

However, today we have a massive stock market rally. As usual, the USDX is down. It has only dipped slightly and is above support, but the market has had a monster rally, and continues to on any dollar weakness.

Remember that nothing is trading on fundamentals. Everything has been trading opposite the USDX, and the USDX has fallen to key support. In our opinion, the issue at hand with the stock market is NOT about economic recovery, but it is about inflation and the destruction of the dollar.

From this viewpoint, a failed Treasury auction may be taken as a sign that faith in the US government is waning. In this case, other countries may be of more interest to currency traders. In other words, a failed auction may be a "no confidence" vote in the US government, which would affect the currency more than most of its companies, which are, in fact, international companies. Those companies may be profitable if they can sell products to other countries. Thus, they are worth more than the US government, and conversely, the stock of the US government which is the dollar.

Conclusion
This is, believe it or not, a simplified view of things. But it is important to note that we are at an extremely critical junction now that you won't hear about anywhere else.

Today, we see weakness in bond auctions and in the dollar with bullish action in the stock markets. Is this the beginning of a massive dollar sell-off? If so, will it create massive inflation in the United States, including possibly hyperinflation?

Stay tuned.