• This post will explore whether the current financial crisis may ultimately lead to global inflation, a theory advocated by James Grant, Hayman Capital and various other investors.
• The most compelling arguments for global inflation are as follows: (i) the world is dramatically overlevered; (ii) to rescue insolvent banks and stimulate economies, governments will either print money or incur large governments debts; (iii) at some point in the future, increasing fiscal deficits and debt-to-GDP ratios will lead governments to print money to deal with their unwieldy debt loads and (iv) defaults and currency collapses at some of the weakest sovereigns will result in devaluations that, via competitive devaluation, will spread globally to virtually all countries, debasing the vast majority of currencies relative to gold.
• While the long-term future for fiat money may look bleak, it’s less clear whether global inflation would take hold in the near-term or further into the future. Global overcapacity and credit contraction are currently exerting a strong deflationary pull on consumer prices.

In the last post, I wrote about the risk of a significant depreciation of the US dollar. I didn’t really specify against what it would depreciate, and because my email focused on the US current account deficit, it implied a collapse against the currencies of surplus countries like China or Japan. There is an alternative theory that believes that virtually all of the major currencies face a dismal future, and that it’s not so much other currencies that the dollar will collapse against, but gold. This post is about that theory. It’s espoused by the likes of James Grant, who writes in his most recent newsletter that he is bearish on “the U.S. dollar, euro, pound, Swiss franc, yen and Zimbabwean dollar. We hate them all, with appropriate analytical nuances. Show us a monetary asset whose value is not subject to government debasement and we will show you a Krugerrand.” John Paulson disclosed heavy bets in gold in Q1. Buffett has said that “one likely consequence” of recent government policy is “an onslaught of inflation”. And while Buffett has rarely had fond things to say about gold, I’d point out a few lines from his Berkshire letter from 1979, when inflation was rampant:

“…our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil. We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.”

So let’s lay out what I believe is the most compelling argument on why most currencies may depreciate significantly against gold and other goods and materials that can’t be produced by government printing presses.

Rather than plagiarizing other people’s thoughts, I’ll post a few of the best links I’ve come across arguing why fiat currencies may be doomed.

First, there is Hayman Capital’s March letter: http://www.scribd.com/doc/13057976/Hayman-Capital.

Second, I’d browse through Nouriel Roubini’s blog. http://www.rgemonitor.com/blog/roubini/.

Roubini does NOT necessarily argue that we’re in for rampant future inflation. He just says that it’s possible. For instance, he writes about “the risk that monetization of fiscal deficits will lead to inflationary pressures after two years of deflationary pressures.” Or he writes: “The burden of trillions of dollars of additional public debt in the US and other advanced economies will be a medium term drag on growth. High debt levels may be financed only with default (an option that advanced economies have not followed in recent decades), a capital levy on wealth, the use of the inflation tax to wipe out the real value of public debt or a painful increase in regular taxes or reduction in government spending.”

Roubini’s stance is that while inflation is possible and could very well happen, it’s not a foregone conclusion because the government can still choose not to use the printing press to resolve the financial crisis. It is fun to call the Fed chairman ‘Helicopter Ben’ and draw cartoons of him flying around Manhattan dropping dollar bills on Wall Street. But on page 2 of the attached materials, I’ve shown the US year-over-year growth in money supply (M2) over the past 40 years. While double the level of several years ago, it’s still under 10%. Fed money creation has been reduced by credit contraction in the lending sector, so the total money supply isn’t ballooning quite yet.

Nevertheless, the argument for inflation is not about what has been happening, but about what will happen.

I spent some time downloading data from the IMF data and statistics website. I wanted to confirm the often-discussed global leverage metrics for myself, and I also wanted to see how today’s leverage compares with 10 years ago, and 20 years ago. The results are on page 1 of the attached materials. First though, let me caveat that I’m not an expert on how the IMF classifies bank institutions; their methodology is confusing; and this isn’t an academic paper. Take the numbers with a grain of salt.

However, directionally, it’s quite clear that the past 20 years has witnessed steady global leveraging such that we’re now at debt-to-GDP levels, globally, that are unprecedented. By my count, Ireland’s total bank assets relative to GDP grew from 80% in 1985 to 740% in 2007. UK went from 170% to 430%. Spain went from 120% to 240%. Iceland’s meteoric rise from 40% to 440% rendered the island insolvent last September. Global private market debt to GDP has gone through the roof.

What’s a sustainable debt-to-GDP level for the world? I don’t know. But with asset prices having dropped dramatically since 2007, we’ve reached a point where a lot of debtors are having trouble paying a lot of creditors. A large number of the world’s banks are insolvent. As Hayman discusses, it’s natural to expect governments to rescue many of those banks, rather than allowing them to develop into the type of zombie banks that plagued Japan during the 1990s. Governments may nationalize banks, shift problem loans onto government balance sheets, guarantee certain assets, print money to make depositors whole, print money to re-inflate asset values, print money to boost capital ratios, etc.

So we’ll either see a significant rise in the global money supply and experience inflation immediately, or we’ll witness rapid increases in sovereign debt to finance these rescue plans. If the latter occurs, we could see scenarios in the future where countries begin debasing their currencies to deal with their unwieldy government debt loads.

It’s important to keep in mind that when a few countries devalue their currencies, other countries typically follow suit. During the Great Depression, global devaluation began with Austria, which was the first country to suffer banking crises serious enough to bankrupt the entire country. It abandoned the gold standard in early 1931 by implementing exchange controls. Germany and Hungary followed soon thereafter. Then England dropped the gold standard several months later, allowing the sterling to lose a third of its value against gold in 3 months. More than 20 other countries did the same in early 1932. The US followed in 1934. Czechoslovakia in 1934. Belgium in 1935. Then finally France, the Netherlands and Switzerland in 1936. When a country devalues its currency, it immediately becomes more competitive due to its lower cost structure and reduced imports. Its improved terms of trade puts pressure on the balance of payments of other countries. So even if the US remains responsible, raises taxes and cuts spending to deal with its burgeoning government debt, it would still struggle to keep the dollar worth the same quantity of gold if the UK and several other countries were to devalue. As previously discussed, virtually every advanced country is overlevered, at least compared to historical standards. To imagine that all of these countries would responsibly raise taxes and trim their spending in order to deal with increasing deficits and a much larger government debt load, instead of simply printing more money, seems a bit unrealistic. And we haven’t even considered the possibility that numerous countries suffer Iceland-like collapses, leading to more immediate devaluation.

This begs the question: just how bad are current government finances globally, and how much worse are they going to get? In March, the IMF released a report titled “The State of Public Finances”, which analyzed the impact of the credit crisis on government balance sheets. On page 3, we can see in Figure 5 that government debt as a % of GDP has been steadily increasing since 1980, from 40% for the G-20 advanced countries to 80% today, to a projected 100% in 2010. The IMF report includes various projection scenarios. The “base case” assumes a V-like recession where government deficits improve from 8% of GDP in 2009 for these same advanced countries to around 4% in 2014. In a “prolonged slowdown” scenario, which exhibits a 2 percentage-point decline in growth relative to the baseline starting in 2009, shows government deficits remaining around 9% of GDP in 2010 and 2011, before improving to 6% of GDP in 2014. Total government debt to GDP rises to 120% for the advanced G-20 countries. In a more serious scenario with higher interest rates and higher bank insolvencies, that ratio rises to 140% in 2014 (see Figure 8 on page 3 of the attached materials).

Given that I’d choose the more serious prolonged slowdown scenario as the most realistic one, is a 140% debt-to-GDP scenario sustainable? The existence of large government debt-to-GDP ratios does not necessarily mean that governments will print money to repay their debts. Figure 10 on page 3 shows government-to-debt ratios for various countries. The US and UK reduced debt-to-GDP ratios dramatically from post-World War II to today. There are two notable differences between the current period and that period. First, the growth outlook for advanced economies is less rosy than it was following World War II, given that the current recession may devolve into a multiyear era of deleveraging similar to Japan from 1990 to 2003. Second, most countries with rapidly expanding government debt also have increasingly burdensome pension and health care costs on the horizon.

As we’ve seen in Japan, a financial crisis can dramatically increase government debt. From 1990 to today, Japanese government debt-to-GDP has risen from 70% to 170%. One can say: hey, Japan sustained a massive debt-to-GDP increase without resorting to printing money to overcome its debt burden, so why can’t we? In fact, that’s exactly what Paul Krugman says here. I just think it’s one thing when a single advanced country has a financial meltdown during a time when all other advanced economies are enjoying a long-term secular boom, and another thing when virtually all advanced economies are suffering banking crises, global deleveraging, declining / stagnant GDP, and high government debt-to-GDP ratios at the same time. The concern, again, is competitive devaluation. If a handful of advanced economies collapse, default or print money to deal with their debts, it’s reasonable to expect devaluations (relative to gold) in most of the remaining economies. A 10%+ inflation scenario is quite possible.

A final point: even if you’re convinced by the global inflation argument, there remains the matter of timing. We’re experiencing deflation now, and money supply hasn’t begun surging quite yet. It took 18 years for Japan to grow from a 70% debt-to-GDP ratio to 170%. As bearish as Hayman is on fiat currencies, he specifically says that he’s not expecting inflation in the “immediate” future, but rather is concerned about the “potential inflationary time bomb that grows as governments continue to borrow”. Will that time bomb explode in 2010, 2012 or 2015? 2020?

Also, some believe that we won’t have to wait for government debt-to-GDP ratios to become unwieldy before we see global inflation. Helicopter Ben and central bankers of other countries could conceivably press too hard on the accelerators in 2009 and 2010, triggering inflation before government finances even have the opportunity to become unmanageable. I wouldn’t rule that out.

I’ll end with an intelligent passage on inflation/deflation from Roubini’s recent “Green Shoots or Yellow Weeds?” column:

“The rapid and massive monetization of fiscal deficits – that has been pursued by central banks this year – is not yet inflationary in the short run as there are massive deflationary forces in the world given the slack in goods markets and labor markets; also the collapse in the velocity of money implies that the excess liquidity has been so far hoarded by banks in the form of excess reserves. But if central banks don’t find a clear exit strategy from very easy monetary policies – that have led to the doubling or tripling of monetary base in the US alone – eventually either goods prices inflation and/or another dangerous asset and credit bubble will ensue when the global economy gets out of this severe recession. And some of the recent rise in equity prices, commodity prices and other risky assets prices is already clearly liquidity driven rather than being fully justified by the improving economic fundamentals.

Inflation may indeed become the path of least resistance for policy makers as it is easier to run the printing presses and cause inflation rather than pass politically difficult tax increases or spending cuts in Congress or other legislative bodies. But inflation is not a cheap solution to high public debts and the debt deflation problems of the private sector. If central banks were to allow the inflation genie out of the bottle allowing expected inflation and actual inflation to rise from low single digits to high single digits to double digits at some point a painful Volcker-style recessionary disinflation policy (like the one in 1980-82) would have to be implemented to break the back of inflation expectations and bring back the inflation genie expectation into the bottle. Thus, central banks destroying a quarter of century of achievement of price expectation stability and low inflation credibility to reduce the real value of public and private debts would be a costly solution to these debt problems.”

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