Guest Post: Liquidity Drowning the Meaning of Inflation?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

On Monday, Sheldon Filger wrote an article in the London Telegraph stating that the U.S. economy risks the dire prospect of hyperinflation:

… though not downgrading the danger of deflation, I believe policymakers are ignoring other factors regarding this economic and financial condition. Furthermore, the U.S. government and Federal Reserve in particular, are taking steps to “cure” deflation that will inevitably lead to hyperinflation, which in the long-term may prove far more destructive to the long-term health of the U.S. economy.

History demonstrates that deflation is not a permanent condition. Market forces, unencumbered by fiscal and monetary intervention, eventually restore pricing equilibrium. At a certain point prices of major durables such as homes are low enough to encourage new categories of consumers to enter the marketplace. As demand is restored, prices stabilize and then resume their upward ascent. It is all a question of time. However, key decision-makers in the United States are not paragons of patience. They want deflation cured immediately, which explains why the U.S. Treasury and Federal Reserve are hell-bent on policies that are guaranteed to be inflationary. The question is how bad will inflation ultimately be.

Massive quantitative easing by the Fed is pouring trillions of U.S. dollars into the money supply, essentially conjured out of thin air. This is being done without transparency, the rationale being that frozen credit markets require a vast expansion of the money supply in an attempt to get the arteries of commerce flowing again. Similarly, the U.S. government is spending vast amounts of money it does not have, with the Treasury Department selling unprecedented levels of government debt in a frantic effort to fund the wildly expanding U.S. deficit. These two forces, quantitative easing and multi-trillion dollar deficits, are the core ingredients of an explosive fiscal cocktail that I believe will ultimately lead to hyperinflation.

What exactly is hyperinflation? Economists disagree on a common definition, so I will offer one myself. Double-digit inflation extending over a period of at least two years would arguably be a hyperinflationary period. It can get much worse, witness Weimar Germany in the early 1920’s and Zimbabwe at present. The most recent experience the United States had with this unstable economic condition was in 1981, when the annual CPI rate exceeded 13%. The cure was draconian; Federal Reserve Chairman Paul Volcker engineered a severe economic recession that created the highest level of U.S. unemployment since the Great Depression — until now. The federal funds rate, currently near zero, rose to above 20% under Volcker’s harsh discipline. Eventually high inflation was purged out of the system and economic growth was restored, however the monetary regimen was punitive for several years.

The current monetary and fiscal policies being enacted by the key economic decision-makers in the United States are laying the groundwork for a far more dangerous inflationary environment than anything encountered by Paul Volcker.

The explosive growth in the money supply and government debt is simply unsustainable without severe inflation. It must be kept in mind that the Federal government is not the only public authority engaged in massive deficit spending.

Throughout America, state, county and municipal governments are faced with imploding tax revenues and lack the ability or political flexibility to cut services to a level commensurate with revenue flows. Both the Fed and the public sector are engaging in a reckless gamble; borrow like crazy in the hope that this overdose of economic stimulation will restore growth to the economy and normal tax revenues, leading to a decreased and sustainable level of public sector indebtedness.

If one believes that the policymakers running the Federal Reserve, Treasury and Federal government, the same architects of the Global Economic Crisis, are smart enough to now get everything right, perhaps we may escape the worst consequences of their turbo-charged fiscal and monetary policies. However, there are growing indications that global investors and the broader market are beginning to reach a far more sobering assessment.

In an interview with Bloomberg News, Bill Gross, co-chief investment officer of PIMCO (Pacific Investment Management Company) suggested that the coveted AAA credit rating U.S. government debt now benefits from will eventually be downgraded. “The markets are beginning to anticipate the possibility of a downgrade,” Gross said.

China, the major purchaser of Treasuries and holder of $1 trillion of U.S. government debt, is already on record as expressing concern for the integrity of its American investments, and has begun actively exploring alternatives to the U.S. dollar as the primary global reserve currency. These moves by China are not based on fears of expropriation of its U.S. assets, but focuses on the specter of hyperinflation destroying much of the value of assets denominated in U.S. dollars. No doubt China’s economic experts are well aware of the growing number of economists who are convinced that the U.S. will be unable to service its rapidly expanding debt burden without significant inflation. Inflation in monetary terms means the erosion of the intrinsic value of the American dollar.

What is most frightening about the policy moves being enacted by the Fed and Treasury is that their actions may not be a reckless gamble after all. They may have come to the conclusion that only hyperinflation will enable the United Sates to avoid national insolvency. In effect, they may be pursuing the exact opposite course undertaken by Paul Volcker in the early 1980’s. If that is their prescription for the dire economic crisis confronting the U.S., then one must conclude that Ben Bernanke, Timothy Geithner and Larry Summers have learned nothing from history. Once the spigot of hyperinflation is tuned on, it becomes a cascading torrent that is almost impossible to switch off, and which in its wake inflicts inconceivable levels of economic, political and social devastation. Before it is too late, President Obama should put the brakes on his economic team’s dangerous gamble with the haunting specter of hyperinflation. If he fails to act in time, a hellish prospect may be his economic and political legacy.

On Tuesday, the Telegraph’s Ambrose Evans-Pritchard reports that China has warned a top member of the US Federal Reserve that it is increasingly disturbed by the Fed’s direct purchase of US Treasury bonds:

Richard Fisher, president of the Dallas Federal Reserve Bank, said: “Senior officials of the Chinese government grilled me about whether or not we are going to monetise the actions of our legislature.”

“I must have been asked about that a hundred times in China. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States,” he told the Wall Street Journal.

His recent trip to the Far East appears to have been a stark reminder that Asia’s “Confucian” culture of right action does not look kindly on the insouciant policy of printing money by Anglo-Saxons.

Mr Fisher, the Fed’s leading hawk, was a fierce opponent of the original decision to buy Treasury debt, fearing that it would lead to a blurring of the line between fiscal and monetary policy – and could all too easily degenerate into Argentine-style financing of uncontrolled spending.

However, he agreed that the Fed was forced to take emergency action after the financial system “literally fell apart”.

Nor, he added was there much risk of inflation taking off yet. The Dallas Fed uses a “trim mean” method based on 180 prices that excludes extreme moves and is widely admired for accuracy.

“You’ve got some mild deflation here,” he said.

The Oxford-educated Mr Fisher, an outspoken free-marketer and believer in the Schumpeterian process of “creative destruction”, has been running a fervent campaign to alert Americans to the “very big hole” in unfunded pension and health-care liabilities built up by a careless political class over the years.

“We at the Dallas Fed believe the total is over $99 trillion,” he said in February.

“This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them,” he said.

His warning comes amid growing fears that America could lose its AAA sovereign rating.

I doubt America will lose its AAA sovereign rating, but $99 trillion of unfunded liabilities can bring the world’s biggest economy closer to that day of reckoning.

But not all Fed presidents fear inflation. Last Thursday, Boston Federal Reserve Bank President Eric Rosengren said the risk of deflation is currently more of a concern than inflation:

Between inflation and deflation, my concerns are currently more weighted toward deflation,” Rosengren said in response to audience questions after giving a speech to the Worcester Economic Club.

He added that the size of the Fed’s balance sheet — which has more than doubled in the financial crisis — was “not a situation we want to be in, it’s a situation we need to be in” given the severity of the crisis.

Answering a separate question, Rosengren said that due to the global nature of the crisis “in the short-run it will be hard to have export-led growth.”

Rosengren is not a voter in 2009 on the Federal Open Market Committee, the Fed’s policy-setting panel.

Indeed, if you look around the world, you see that Japan, the U.K., and other countries are grappling with deflation.

So why is the U.S. bond market on edge? Isn’t all this talk of hyperinflation absurd? The Financial Ninja is back and he writes that with each interest ticker higher, another “green shoot” dies:

“There isn’t enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there,” -Kyle Bass

FN: Giddy talk of “green shoots” has completely drowned out a more sober and rational assessment of the global situation. Random statistical noise in various minor economic indicators have over the past two months resulted in wild exclamations of “the worst is definitely over”.

It most certainly is not.

With every major economy in the world attempting to solve this economic crisis with both loose monetary and fiscal policy, it was only a matter of time before the global credit markets would reach their limits.

These limits have almost been reached.

The long end of every curve of every major economy has been steadily climbing. The rate of change has now accelerated and interest rates on these important benchmarks have now reached “pre-crisis” levels. In a ZIRP world this is definitely a bad sign. Formerly respectable governments from the US to the UK have gone the “banana republic” route and started monetizing their debts in a desperate attempt to prevent long rates from rising, to no avail. A veritable tsunami of debit issuance now sits just over the horizon, waiting to dumped on a crippled and saturated global debt market.

The UK will eventually lose it’s coveted triple ‘AAA’ rating and the US cannot be far behind. Rising rates will drag everything from mortgage rates to credit card rates higher. Everything from residential and commercial real estate to businesses will feel the pain of higher borrowing costs. The central banks of the world have no more real options left. They’ve lowered the rates they control to zero and have flooded the financial system with liquidity. Their balance sheets are now swollen with toxic assets and outright debt monetization won’t bring rates down.

The ECONOMPICDATA blog asks, Can we inflate ourselves out of this mess?, and concludes

Thus, the concern I have is that inflation won’t be driven through via wage increases (where at least workers salaries are keeping up), but by a spike in the price of commodities. If inflation concerns = dollar concerns = commodity spike, then that impossible stagflation may be possible once again.

We may be in the early stages of asset inflation in stocks and commodities. It’s too early to tell, but it is worth keeping in mind that asset inflation can transpire as liquidity makes its way through the financial system.

Finally, writing in the Asia Times, Henry C K Liu writes that liquidity is drowning the meaning of ‘inflation‘:

The conventional terms of inflation and deflation are no longer adequate for describing the overall monetary effect of excess liquidity recently released by the US Federal Reserve, the nation’s central bank, to deal with the year-long credit crunch.

This is because the approach adopted by the Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liquidity is to inject more liquidity in the form of both new public debt and newly created money into the economy and to channel it to debt-laden institutions to reflate a burst debt-driven asset price bubble.

The Treasury does not have any power to create new money. It has to borrow from the credit market, thus shifting private debt into public debt. The Fed has the authority to create new money. Unfortunately, the Fed’s new money has not been going to consumers in the form of full employment with rising wages to restore fallen demand, but instead is going only to debt-infested distressed institutions to allow them to deleverage from toxic debt. Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand.

Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions deleverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. Deleverage reduces financial costs while increasing cash flow to allow zombie financial institutions to return to nominal profitability with unearned income and while laying off workers to cut operational cost. Thus we have financial profit inflation with price deflation in a shrinking economy.

What we will have going forward is not Weimar Republic-type price hyperinflation, but a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold, only to lose more of it at the next market meltdown, which will come when the profit bubble bursts.

Hyperinflation is fatal because hedging against it causes market failures to destroy wealth. Normally, when markets are functioning, unhedged inflation favors debtors by reducing the value of liabilities they owe to creditors. Instead of destroying wealth, unhedged inflation merely transfers wealth from creditors to debtors. But with government intervention

in the financial market, both debtors and creditors are the taxpayers. In such circumstances, even moderate inflation destroys wealth because there are no winning parties.

Debt denominated in fiat currency is borrowed wealth to be repaid later with wealth stored in money protected by monetary policy. Bank deleveraging with Fed new money cancels private debt at full face value with money that has not been earned by anyone, that is with no stored wealth. That kind of money is toxic in that the more valuable it is (with increased purchasing power to buy more as prices deflate), the more it degrades wealth because no wealth has been put into the money to be stored, thus negating the fundamental prerequisite of money as a storer of value.

This is not demand destruction because decline in demand is temporarily slowed by the new money. Rather, it is money destruction as a restorer of value while it produces a misleading and confusing effect on aggregate demand.

Thinking about the value of any real asset (gold, oil, and so forth) in money (dollar) terms is misleading. The correct way is to think about the value of the money (dollars) in asset (gold, oil) terms, because assets (gold, oil, and so on) are wealth. The Fed can create money, but it cannot create wealth.

Central bankers are savvy enough to know that while they can create money, they cannot create wealth. To bind money to wealth, central bankers must fight inflation as if it were a financial plague. But the first law of growth economics states that to create wealth through growth, some inflation needs to be tolerated.

The solution then is to make the working poor pay for the pain of inflation by giving the rich a bigger share of the monetized wealth created via inflation, so that the loss of purchasing power from inflation is mostly borne by the low-wage working poor and not by the owners of capital, the monetary value of which is protected from inflation through low wages. Thus the working poor loses in both boom times and bust times.

Inflation is deemed benign by monetarism as long as wages rise at a slower pace than asset prices. The monetarist iron law of wages worked in the industrial age, with the resultant excess capacity absorbed by conspicuous consumption of the moneyed class, although it eventually heralded in the age of revolutions. But the iron law of wages no longer works in the post-industrial age in which growth can only come from mass demand management because overcapacity has grown beyond the ability of conspicuous consumption of a few to absorb in an economic democracy.

That has been the basic problem of the global economy for the past three decades. Low wages even in boom times have landed the world in its current sorry state of overcapacity masked by unsustainable demand created by a debt bubble that finally imploded in July 2007. The whole world is now producing goods and services made by low-wage workers who cannot afford to buy what they make except by taking on debt on which they eventually will default because their low income cannot service it.

All the stimulus spending by all governments perpetuates this dysfunctionality. There will be no recovery from this dysfunctional financial system. Only reform toward full employment with rising wages will save this severely impaired economy.

How can that be done? Simple. Make the cost of wage increases deductible from corporate income tax and make the savings from layoffs taxable as corporate income.

I agree with Henry Liu, unless we get wage increases across all OECD nations, I wouldn’t count on a sustained global economic recovery, or on the hyperinflation we’ve seen in the past. But asset bubbles and another market meltdown look inevitable as excess liquidity finds its way into the global financial system. When this happens, don’t say nobody predicted it. You’ve been warned.

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  1. Independent Accountant

    I’ve been expecting higher inflation as a result of Zimbabwe Ben’s actions for about two years. I think Richard Fisher is the Fed’s “bad cop” or “Trojan horse”. He’s not what he appears to be.

  2. bb

    modern day governments are ponzi schemes. the nutty professor believes that by arificially inflating asset prices, he can keep the illusion of ever growing prosperity alive. quite the contrary: his actions lead to loss of confidence in the unit of valuation, the usd. this ponzi will fall like any other that was.

  3. Jeff Burton

    Make the cost of wage increases deductible from corporate income tax

    They already are, or what am I missing?

  4. Coop

    It’s scary to hear them talk about high inflation as something they can control. It’s very easy for it spin out of control.

    I love reading Henry Liu, he makes a lot of sense, and is usually right on with his predictions.

    It seems that the choice is either 1) default on debt or 2)inflation to make the debt easier to pay. Default on debt would probably destroy the empire, so inflation seems to be the way to go. I doubt the average person will see their salaries rise enough to cover inflation.

    It looks like Japan all over again, where the corporations are doing well, but the people suffer. We hear a lot about Japan as an economic powerhouse, but very little how the average Japanese person is doing, and I don’t think it’s all that great.

  5. mxq

    nice piece. the biggest catalyst to inflation i would guess would be the mercantilist countries finally let their currencies float freely. Wages/living standards would rise concomitantly with currencies and thus labor would become more expensive.

  6. Alan

    So the last bout of hyperinflation in the US paved the way for one of the biggest bull markets in US history – whats the problem here?

  7. Hugh

    I too like Henry Liu’s analysis no doubt because it is close to my own view.

    Basically, the financial industry was allowed to go on a massively destructive binge in its “creation” of a huge and unsustainable unreal paper economy. The collapse of this has been followed by a massively destructive response by the government and Fed to resurrect this paper world.

    What Liu is pointing out is that there is no way this can be done and no reason to do it. The real solution is to be found in the real world. It is to give real wages to real workers so that they can create real consumption of real supply.

    What is so amazing is that this should be considered amazing at all.

  8. MC7447a

    Henry Liu’s writing is long and rambling, but he does show a lot of knowledge and foresight. In 2005, when mainstream economists were deliberating the question “Alan Greenspan: Great Chairman or Greatest Chairman?”, he was one of his harshest critics, calling him the Wizard of Bubbleland. This series is a great read:

  9. slugworks

    "It looks like Japan all over again, where the corporations are doing well, but the people suffer. We hear a lot about Japan as an economic powerhouse, but very little how the average Japanese person is doing, and I don't think it's all that great."


    Indeed, it isn't great at all. In fact, it's pretty bad.

    Check out Alex Kerr's book, Dogs & Demons. It's mostly about the dark side of modern Japanese culture, but it addresses the relevant fundamental economic causes of their malaise.

    A Japan-style outcome is the *best case* scenario for our current banking collapse, and that's already very bad, as Kerr demonstrates.

    To contemplate worse, we have to mix in some Great Depression of course, but also some Russia, Argentina, etc.

    I have no idea how this will all turn out, but it can't be good. Green shoots my foot.

  10. PCJ

    I’m surprised that you all like this article by Henry Liu. It seems to me that he does little more than state and re-state the obvious, e.g.:
    “Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster….” “Deflates” in this sentence is imprecise. Liu probably means by it that there is a fall in the price of commodities. “Deflation,” however, is a technical term used to describe a drop in the quantity of money in circulation. Now, to be sure, it is likely that in a deflationary economy there would be a drop in commodity prices. But this does not seem to be what Liu is saying, or if it is, he is being rather unclear. To rewrite the sentence with simple words produces something like this:
    “a fall in demand for commodities leads to a fall in the price of commodities ….”
    As re-stated, the statement is true but obvious.
    Adding the rewritten part to the next phrase in the sentence gives this: “a fall in demand for commodities leads to fall in the price of commodities….but not enough to restore demand…..”
    “Restore demand” surely means: restore demand for commodities, i.e. cause a rise in the demand for commodities. Re-writing again gives:
    “A fall in demand for commodities leads to fall in the price of commodities, but the fall in the price of commodities is not enough to cause a rise in the demand for commodities…….”
    All true but much ado about nothing. Demand falls — things get cheaper because demand is falling. Yep. That’s what happens when demand falls until it stops falling.
    Next, out of the blue, Liu throws in phrase starting with “because: “….because aggregate wages are falling faster.” I guess he means: aggregate wages are falling faster than the price of commodities. To clear this up again, it seems to me that he is saying that the price of labor is falling faster than the price of commodities.

    I defy anybody to tell me what THAT implies or even means.

    Maybe he is talking about an elasticity of some sort or another, as in: a percentage change in the price of labor causes …eh….something to happen …… as measured by a percentage change in the price of commodities?

    If I had to take a guess, I would say that Liu’s point is that people not earning as much money as they used to earn spend less on commodities as they used to spend. Duh.

    There is not much meat in the sentence I looked at, nor in the rest of the article. Analysis makes meat disappear like the Cheshire cat — only what is left behind is not a smile suspended in air but a heavy load of “attitude.”

  11. juan

    Next, out of the blue, Liu throws in phrase starting with “because: “….because aggregate wages are falling faster.” I guess he means: aggregate wages are falling faster than the price of commodities. To clear this up again, it seems to me that he is saying that the price of labor is falling faster than the price of commodities.

    I defy anybody to tell me what THAT implies or even means.that both commodity prices [‘commodity’ in the broader sense of any thing or service produced to be sold] and price of labor power [wages] can fall simultaneously but at differing rates – leading to [greater] immizeration of the laboring population, especially if/when wages are driven below the reproduction cost of labor.
    Which ‘implies’ an expansion of the informal sector as former [and many current] workers are forced into various types of petty commodity production, crime, etc., which then brings up the urban growth mike davis covered in ‘planet of slums’ and potential for greater ‘accumulation through dispossession’ [recognizing the latter cannot be sufficient to simultaneously valorize an expanded mass of means of production and of fictitious capital].

    this is not all so hypothetical and, like financial hypertrophy, relates to what has been a transcyclic systemic crisis which, if anything, has been exacerbated by neo-liberal policies.

  12. juan


    I don’t think that anyone would seriously call U.S. inflation rates during the 1970s ‘hyperinflation’ and the long bull market had more to do with rate of return differentials which favored flows into the financial, something Volker helped along but had deeper roots than monetary policies and, over time, became institutionalized.

    [far as i know, only Dumenil and Levy have done a study of postwar profit rate differentials in the U.S.:
    The Real and Financial Components of Profitability (USA 1948-2000), 2004]

  13. Dee

    I've given Liu's article some thought and I think his idea of recycling is a good one. However, I would target the low-middle income earners. Instead of wages it would be a living allowance? The living allowance could be tax deductible. I don't know if I I like the second suggestion.

    Wal-mart handed out bonuses didn't they? $400? Isn't a drug company covering scripts to laidoff workers? I think the headline read 'Free Viagra'?? I remember the headline but not where I read it from, sorry. Both are a form of stimulus.

    When Liu was using 'deflating aggregate wages' I believe he was right. Labour has had to cut back hours. Not all supply is being destroyed.

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