Hyperinflation is on everyone’s lips today. Investors are scared to death that they will wake up one morning and look out the window only to find that the world has devolved into a monetary Venezuela. In this fantasy world, desperate people will frantically shuttle around huge stacks of rapidly depreciating cash in wheelbarrows, all while looking in vain for a business or shop that will exchange their increasingly worthless fiat for something – anything – of value.
Unsurprisingly, I have a different opinion.
I think the developed world is currently experiencing a multi-decade long “soft” depression, where economic growth, wages and consumer demand all remain stagnant. In this scenario it is disinflation, not hyperinflation, that we need to watch out for. Disinflation is defined as a monetary phenomenon in which inflation is still positive, but tends to move asymptotically towards zero over time. It is important to note that disinflation is distinct from deflation, where prices tend to decline over time.
For now, though, it is hyperinflation that has caught the imagination of nervous investors. In February 2021, genius hedge fund manager Michael Burry (who was favorably portrayed in the movie The Big Short) publicly warned that the United States is going down the same hyperinflationary road as Weimar Germany. Since then, the financial media has been filled with breathless articles about how we are teetering on the brink of a dollar collapse as we transition into a hyperinflationary regime.
But I want to focus on one specific article I recently read titled Trading “Project Zimbabwe”. It was written by “Kuppy” of the Adventures in Capitalism blog. I’ve referenced him before in a post I wrote in the summer of 2020 called Money Printer Go Brrr – The Hyperinflation Myth That Won’t Die. I chose to highlight his latest work because it is typical of the hyperinflationary scare genre that is so popular right now.
I’ll excerpt a few choice quotes below:
“I like to joke with friends that if they want to hedge their portfolio, they should buy the 2022 SPY $1,000 call [with a strike nearly 2.5x current levels] because they probably do not have enough right-tail [inflation] protection. They roll their eyes or laugh a bit, but this is only because they have not studied the period we are about to go through.”
The author then follows up with this gem:
“Part of what is so misunderstood about the Weimar period is the extreme volatility. Traditional charts simply show an index going parabolic. Even log charts look rather similar. However, there were multiple dramatic market crashes along the way. There were many speculators who recognized what was happening, pressed too hard and got liquidated during one of these crashes. Others survived the margin calls but sold out through sheer panic. Even if you know the road-map, you can get whipsawed.”
Then he finally knocks it out of the park:
“I have written about this multiple times in the past year, but put selling is literally the gift that keeps on giving…in a world where JPOW has eliminated the left tail, yet retail investors are crazily overpaying for calls, implicitly juicing put implied volatilities, why would I do much else but write puts with my capital?”
This investment strategy is a huge red flag to me. I have a fair amount of experience with options and writing puts is effectively writing an insurance policy. You are pledging to bail out the put buyer if anything goes wrong with the underlying stock. It doesn’t matter whether it is an adverse political event, generalized financial collapse or company specific fraud – the put writer will be forced to deliver cash and take devalued shares in return.
It is akin to picking up nickels in front of the proverbial steamroller. Everything might go swimmingly well for years at a time, only to have your carefully constructed strategy spin apart in a couple days dominated by “impossible” multi-sigma moves. Financial history is littered with the corpses of similar trading strategies that, although back-tested perfectly over a 5, 10 or 20 year time period, nonetheless failed spectacularly within a few years of their implementation.
My philosophy is that if you write put options on overvalued or junk stocks you will, sooner or later, end up being the proud owner of a portfolio full of those same loathsome stocks.
Now Kuppy is no fool. So why is he so enthusiastic about a trading strategy that has bankrupted countless speculators before him, especially when he understands the concept of tail risk? What is really going on here?
In my opinion, Kuppy is getting rich by speculating. He, along with most other market participants, has discovered that you can throw your money at almost anything during our ubiquitous Everything Bubble and still make good money. But the problem with participating in a financial bubble is that it is a case of easy come, easy go. You will inevitably lose any money you’ve made if you don’t cash out. But cashing out means walking away from future easy gains and few people have the intestinal fortitude to do that.
Therefore, most speculators resort to rationalizing their bubble antics instead.
The conventional wisdom right now is not that we are experiencing a series of obscene bubbles rife with grave financial risk, but instead that we are facing the progressive, accelerating debasement of the U.S. dollar. This renders savings, conservative investing and prudence ineffective – indeed downright stupid – but only if the hyperinflationary narrative is true.
Unfortunately for Kuppy and company, I think disinflation is a far more likely monetary outcome over the course of the 2020s. And if disinflation doesn’t happen, then deflation (not hyperinflation) is next in line as being the most likely result!
I hold this unpopular opinion for a multitude of reasons.
First, it must be unequivocally stated that commercial banks, not the Federal Reserve, have been the unquestioned driver of money creation in the United States since World War II. A commercial bank is just a fancy term for any deposit-taking institution that also engages in fractional reserve lending. In our modern world, governments located in developed economies made a deal with the devil whereby politicians effectively outsourced money creation to the commercial banking system. This means that it is private bank loan creation that drives growth in the money supply, not the Fed printing up new reserves via quantitative easing.
U.S. banking system loan growth from 1953 to 2020.
Photo Credit: Alhambra Investments
As you can see from the chart above, private lending in the United States has been anemic ever since the 2008 Financial Crisis. And why wouldn’t it be? Consumers and small businesses that might need or want a bank loan are already debt-saturated. Everybody has much weaker balance sheets than they did just 20 or 30 years ago. Most banks take one look at the credit risks involved and sensibly walk the other way.
As a result, the growth in borrowing in our economy is currently driven by governments, government agencies and mega-corporations – all of which have relatively strong balance sheets and direct access to capital markets. But floating a new bond issue through an investment bank isn’t fractional reserve lending; hence it results in no new money supply growth.
I would be much more sympathetic toward inflation fears if we did not have any good data on the subject.
However, we have two modern counterfactuals that cast doubt on an inflationary outcome: Japan and the Euro area. Both of these economies lowered their interest rates to zero (or below zero in some cases) and had central banks that engaged in rampant balance sheet expansion. Regardless, inflation rates in both regions have been perennially lower than in the United States for many years running with no prospects for an imminent change in the situation.
The U.S., Japan and Europe have been engaging in remarkably similar fiscal and monetary policies for some time now. Disinflation, sometimes devolving into outright deflation, has dominated in the latter two cases. So why in the world would we expect there to be a different outcome in the U.S.?
Securities markets agree with my assessment as well. Both U.S. Treasury bonds and the foreign exchange market have been remarkably sanguine about the future of the U.S. dollar. If hyperinflation – or even simply elevated inflation – was lurking on the horizon for the dollar, you would expect bond investors to be a little skittish about tying up their money for 10 years at a nominal yield of only 1.5%.
Yet that is the going yield-to-maturity on a 10 year U.S. Treasury note as of June 2021. It sure smells like disinflation to me.
Naysayers claim that the Fed’s $120 billion per month purchases of Treasury and agency debt invalidate any pricing signals coming from the bond market. But it is important to note that out of the approximately $4.5 trillion of net new Treasury issuance in 2020, only around $2.4 trillion was purchased by the Federal Reserve. The free market happily absorbed the other $2.1 trillion with nary a complaint – and all at or near record low yields.
And that leads us to our next problem.
Economists really don’t have a proper definition for the U.S. dollar and, therefore, can’t accurately measure its supply. I know, I know…the green paper stuff in your wallet is dollars. That is absolutely true, but physical currency makes up a tiny fraction of the dollars in existence. Most dollars these days are purely digital in nature, existing only as a series of 1s and 0s in some database.
Not only that, but dollars don’t even have to be domestic to be considered dollars. The Eurodollar market refers to all the U.S. dollars that are deposited or domiciled outside of the United States. These are typically concentrated in tax havens like the Cayman Islands, the City of London, Switzerland, Singapore, etc., but they can reside in any foreign locality. The Eurodollar market is massive and has a huge influence on interest rates and international capital flows.
In any case, we don’t have a good definition of exactly what a dollar is. After much contemplation, I’ve come to the conclusion that the commonly cited monetary aggregates published by the Federal Reserve – M0, M1, M2, MZM, etc. – are far too narrow in their scope to be useful.
The closest I’ve come to a good definition is this: the dollar is a currency unit that can extinguish U.S. tax liabilities and dollar-denominated debts.
But even that leaves a lot of wiggle room.
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Is your money market fund dollars? Probably not, considering that it holds short-term corporate or government debt (which is a pledge to pay dollars in the near future, but not quite yet).
How about an Amazon gift card? It might be denominated in dollars, but you sure can’t pay your income taxes with one.
And what about stable-coin crypto-currencies like Tether? They are pegged to the dollar and (purportedly) backed by reserves, but they ultimately aren’t dollars either.
In spite of these monetary instruments clearly not being dollars, they can all act very cash-like under many circumstances. During the good times, these cash-substitutes (which are typically privately issued) proliferate, leading investors to falsely believe there is far more money in the economy than there actually is. But when the bad times come and people need money, they quickly discover that cash-like doesn’t always mean cash.
As you can see, this gets very messy, very quickly.
It also leads to the next reason I believe disinflation is in our future rather than rampant inflation: deflating asset bubbles. Bubbles are both self-referential and self-reinforcing due to their intrinsic nature. Persistently rising prices in an asset class (any asset class) gradually draw in more and more speculators who believe they are making a one-way bet. Eventually, even otherwise conservative investors buy-in, deluding themselves into thinking they are prudently investing when they are really gambling.
Although primarily financial creatures, bubbles create a host of real world side-effects in the mainstream economy. The first is the infamous wealth effect, where investors spend lavishly on vacations, home improvements and fancy dinners because they feel flush with unrealized portfolio gains derived from skyrocketing asset markets. This is the transmission mechanism that the Federal Reserve is explicitly targeting with its reflation-oriented, low interest rate policy.
Unfortunately, the wealth effect is much less powerful than central bankers originally believed. Rich people own most of the world’s assets, but have already bought as many Greek islands, Rolex watches and bottles of vintage wine as they care too. Piling another million or two on top of their already prodigious mountains of wealth is unlikely to spur much more consumption. On the other hand, your average 401-k investor with a 9 to 5 job is probably not going to splurge on a new $50,000 SUV just because his Apple stock netted him a cool 10 grand.
But where bubbles really do goose the real economy is in respect to employment and wages!
The investment banks that are cranking out worthless technology IPOs by the dozen need an army of bankers, lawyers, accountants and marketers to do the grunt work involved. Likewise, our gargantuan housing bubble is keeping an entire fleet of real estate agents in the lifestyle to which they have become accustomed.
Perhaps most interestingly, the profitless prosperity companies – Netflix, WeWork, Tesla and others like them – are directly pumping up employment in a big way. These are often good jobs that deliver high salaries and generous bonuses. Private equity is the typical funding mechanism for pre-IPO profitless prosperity firms. And much like workers in investment banking and hedge funds, private equity employees also receive generous compensation.
Taken together, it is clear that the true transmission mechanism for low-interest rate fueled bubbles is through the salaries and bonuses they provide to those employed in bubble sectors. These strong wages help keep consumption and, by extension inflation, higher than it would be otherwise – probably much higher.
Of course, we must naturally ask ourselves what happens when our dear bubbles inevitably burst?
It is difficult to see how it couldn’t be a massacre. Layoffs will be widespread and disproportionately hit bubble employees making relatively high salaries. The freshly unemployed will be forced to tap equity portfolios and retirement accounts in order to put food on the table, but those securities will be worth much less due to falling markets. Many formerly middle-class peoples’ houses will be repossessed as continuing to pay the mortgage, property taxes and insurance will prove to be untenable.
This is the stuff of nightmares. It is the reason the Federal Reserve is so frightened that the bubbles they’ve created will collapse, dragging the economy down with it.
Here is the kicker though. The inflation rate in the U.S. since the 2008 Financial Crisis has been anemic at best. And this is with the benefit of the Everything Bubble pumping up employment and wages. In fact, the United State’s prominent position as bubble factory to the world is probably one of the only reasons why our inflation rate has been consistently higher than in either Europe or Japan.
It isn’t too difficult to imagine a near future where the bubbles stop bubbling and disinflation or deflation results.
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There are other good reasons to expect disinflation, of course.
The rapid expansion of private sector debt during the 2020 COVID debacle springs to mine. Additional borrowings by large corporations, small businesses, landlords and their tenets (leases are just another form of debt) will all weigh on future economic consumption. All that new debt will eventually have to be repaid (with interest) or defaulted upon – a highly disinflationary prospect.
We can expect tax rates to climb in the future as well. This will be driven by the need for the U.S. government to appear at least somewhat responsible in the face of continually escalating deficits. Tax increases, even if insufficient to close the budget gap, will be a powerful signal to markets that the government will not spend itself into ruin.
But tax increases reduce consumption in an economy and contribute to deflationary impulses. Rising taxes on corporate profits would be especially devastating because so many investors have come to expect the companies they invest in to pay little to no tax. However, I think the generational low for such taxes came with the passage of the 2017 Trump tax cut, when U.S. corporate taxes were dropped to a flat 21%. Higher corporate taxes are almost a given in the current political environment, which will contribute substantially to future disinflation.
I would like to note, however, that disinflation does not mean that prices drop. On the contrary, I think it highly likely that nominal prices will be higher 5 years, 10 years or 20 years from now.
And I’m no inflation denier, either.
2021 has seen a major upward adjustment in prices due to the lingering supply-chain disruptions caused by the COVID pandemic. These price increases are very real and very sticky too. We won’t be giving them back, short of falling into a severe deflationary spiral.
Disinflation merely means that going forward we are likely to see slow, modest price increases, rather than dramatic, galloping ones.
The important take away from all this inflation/disinflation/hyperinflation talk is that the best way to protect yourself is to have a healthy cash cushion and to invest in reasonably priced assets. The cash part is easy enough, even if relatively boring. Finding reasonably priced assets in our massively overvalued markets is much harder.
This is where antiques, bullion, art and gemstones can play a vital role in your portfolio. These are the asset classes that time forgot. While financial pundits are hysterically shrieking about hyperinflation, many tangible assets have been curiously ignored by bubble-obsessed investors.
But their loss is your gain.
Because they are so cheap, a prudent investment in fine antiques or bullion will do well in almost any conceivable monetary future. And it doesn’t matter whether we ultimately face disinflation, deflation or hyperinflation, tangibles will navigate them all with equal aplomb.
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