Monday, July 26, 2010

The Death of Paper Money

A very sobering article from Ambrose Evans-Pritchard at The Telegraph.
Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot).

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.

People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

Some might smile at the Bank of England "surprise" at the recent the jump in Brtiish inflation. Across the Atlantic, Fed critics say the rise in the US monetary base from $871bn to $2,024bn in just two years is an incendiary pyre that will ignite as soon as US money velocity returns to normal.

Morgan Stanley expects bond carnage as this catches up with the Fed, predicting that yields on US Treasuries will rocket to 5.5pc. This has not happened so far. 10-year yields have fallen below 3pc, and M2 velocity has remained at historic lows of 1.72.
Read the rest here.

P.S. I have just discovered that the book mentioned in the article, Dying of Money (Jens O. Parsson) is available in its entirety online here. The book can be read for free.


gdelassu said...

It is an interesting article and I thank you for pointing it out. Nevertheless, to paraphrase Mark Twain, the rumors of paper money's death are greatly exaggerated. As Scott Sumner says:

"If you need to drain a trillion in base money out of the system in one day—you do it. Indeed if an outbreak of inflation were to occur, I could get rich by going long on CPI futures, with no risk. I seriously doubt there will ever arise an economic scenario where I could become rich at no risk...

"There are dozens and dozens of developed countries. How many have experienced double digit inflation in the past 20 years? There’s a reason for that."

John (Ad Orientem) said...
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John (Ad Orientem) said...

I think you greatly underestimate the difficulty of soaking up excess liquidity. Taming inflation is not like throwing a light switch on or off. Consider the problems faced in the early 1980's when we finally decided to break the runaway inflation of the period. It required a massive hike in interest rates at the FED which precipitated the worst economic downturn post 1930's until the current one. It took years to get inflation under control and inflicted untold misery.

Given our current economic crisis do you really believe the FED can or will begin a massive tightening when the CPI begins to rise (as it surely will)?

I also think you misunderstand what inflation is. Inflation is simply printing more money than can be either backed by something tangible or supported through the normal expansion of the economy or population. Rising prices are not inflation. They are a symptom of inflation, and usually a rather late one. The great inflation of the 1970's and 80's began in the 1960's with Jack Kennedy's massive tax cuts that were not paid for. This was followed by our involvement in Vietnam which was also run as an "off the books" war. During this period the FED adopted an extremely accommodating monetary policy which remained in place until the arrival of Paul Volker.

What is going on now is simply a replay of the same story. In short, I have seen this movie before and I know how it's going to end. We have racked up a level of debt that is completely unsustainable. I do not for one minute have any confidence in the Washington pols having the political backbone to undertake draconian spending cuts and steep tax hikes over many years. This leaves us with two choices. Default or print money.

Many countries have faced the same problem throughout history. We are far from unique here. And we will do what all of the others have done. We will print money. Indeed we already are. The base monetary supply (M1) has more than doubled since 2008.

That is inflation.

Right now the CPI is being held down by a combination of very high unemployment and the deleveraging that is occurring among those still employed. But this is temporary. Money is akin to a force of nature. It wants to move. The inflation is currently showing up in the massive distortions being seen in the financial markets where we have the bizarre scene of both the stock market and the bond market rallying at the same time for more than a year.

But again all of this is temporary.

You ask how many countries have had double digit inflation (presumably you mean as measured in CPI) in the last twenty years? The correct time frame should be the last forty years as that is when the world adopted a system of fiat currency. The answer is quite a few, including the United States.

Also you should take a look at charts showing the loss in purchasing power of the major currencies since 1970. It is a rather sobering sight.