The purpose of this piece is to very briefly connect what is happening now to what has happened throughout history as covered more comprehensively in my book Principles for Dealing with the Changing World Order.
It seems to me that people who received a lot of money and credit and felt richer, central bankers and central government officials who created a lot of money and credit and said that it wouldn’t create a lot of inflation, and people who believed what these officials said would all do well to review the lessons from history.
More specifically, this time around (i.e., since early April 2020) central banks (most importantly the Fed) and central governments (most importantly the US government) gave people, organizations, and state and local governments a huge amount of money and credit, and now most everyone is surprised that there is a lot of inflation. What is wrong with these people’s thinking?
Where is the understanding of history and the common sense about the quantity of money and credit and the amount of inflation?
History has repeatedly shown that people tend to have a strong bias to believe that the future will look like a modestly modified version of the past even when the evidence and common sense point toward big changes.
I believe that’s what’s going on and that we are in the part of the cycle when most people’s psychology and actions are shifting from deeply imbued disinflationary ones to inflationary ones.
For example, people are just beginning to transition from measuring how rich they are by how much “nominal” (i.e., not inflation-adjusted) money and wealth they have to realizing that how rich they are should be measured in “real” (i.e., inflation-adjusted) money and wealth.
From studying history, and with a bit of common sense, we know that when people shift their perceptions in that way, they change their investment and non-investment behaviors in ways that produce more inflation and that make central banks’ difficulties in balancing inflation and growth harder.
For example, people realize that cash is a trashy investment rather than a safe one, that virtually all debt assets (i.e., bonds) are bad, that inventories and forward coverage should be built up to protect against inflation, and that cost-of-living adjustments should be built into contracts to protect against inflation—all of which make upward inflation pressure more intense.
Think of bond investors. Prices rose for over 40 years and yields declined to lousy levels (in both nominal and real terms), and they accepted them. Now they still have those lousy yields (though slightly better than when they were at the absolute lows) plus they are now experiencing price losses. After that huge 40+ year bull market in bonds, imagine how many investors are complacently long and beginning to get stung, and imagine how their behaviors could change to become sellers of bonds, and imagine the effects that would have.
The total amount of bonds that would then have to be sold would equal the new bonds offered plus those being sold—a gigantic amount. When the supply is greater than the demand, either a) the interest rate has to go up to the point that it curtails the demand for credit, which weakens the economy, or b) the central banks have to print money and buy enough of the debt to bridge the gap, which cheapens the value of money and raises inflation. Whether it’s tighter or looser, it won’t be good.
We know from studying history and a bit of common sense that these developments will make central bankers’ jobs in trying to balance growth and inflation much more difficult and these things (i.e., higher inflation, tighter money, and their impact on markets and the economy) will have disruptive political and social implications that will make managing the inflation-growth and debtor-creditor trade-offs much more difficult.
All of this has happened many times before for the same ol’ timeless and universal cause/effect relationships. If you want to see the linkages and the historical cases more clearly and more comprehensively, I suggest that you read Chapter 3 (“The Big Cycle of Money, Credit, Debt, and Economic Activity”) and Chapter 4 (“The Changing Value of Money”) in my book Principles for Dealing with the Changing World Order.
Several excerpts from these chapters can be found below.
“While money and credit are associated with wealth, they aren’t the same thing as wealth. Because money and credit can buy wealth (i.e., goods and services), the amount of money and credit you have and the amount of wealth you have look pretty much the same. But you cannot create more wealth simply by creating more money and credit. To create more wealth, you have to be more productive. The relationship between the creation of money and credit and the creation of wealth is often confused, yet it is the biggest driver of economic cycles. Let’s look at it more closely.
There is typically a mutually reinforcing relationship between the creation of money and credit and the creation of goods, services, and investment assets that are produced, which is why they’re often confused as being the same thing. Think of it this way: there is both a financial economy and a real economy. Though they are related, they are different. Each has its own supply-and-demand factors that drive it. In the real economy, supply and demand are driven by the amount of goods and services produced and the number of buyers who want them. When the level of goods and services demanded is strong and rising and there is not enough capacity to produce the things demanded, the real economy’s capacity to grow is limited. If demand keeps rising faster than the capacity to produce, prices go up and inflation rises. That’s where the financial economy comes in. Facing inflation, central banks normally tighten money and credit to slow demand in the real economy; when there is too little demand, they do the opposite by providing money and credit to stimulate demand. By raising and lowering supplies of money and credit, central banks are able to raise and lower the demand and production of financial assets, goods, and services. But they’re unable to do this perfectly, so we have the short-term debt cycle, which we experience as alternating periods of growth and recession.
Then of course there is the value of money and credit to consider, which is based on its own supply and demand. When a lot of a currency is created relative to the demand for it, it declines in value. Where the money and credit flow is important to determining what happens. For example, when they no longer go into lending that fuels increases in economic demand and instead go into other currencies and inflation-hedge assets, they fail to stimulate economic activity and instead cause the value of the currency to decline and the value of inflation-hedge assets to rise. At such times high inflation can occur because the supply of money and credit has increased relative to the demand for it, which we call “monetary inflation.” That can happen at the same time as there is weak demand for goods and services and the selling of asset so that the real economy is experiencing deflation. That is how inflationary depressions come about. For these reasons we have to watch movements in the supplies and demands of both the real economy and the financial economy to understand what is likely to happen financially and economically.
For example, how financial assets are produced by the government through fiscal and monetary policy has a huge effect on who gets the buying power that goes along with them, which also determines what the buying power is spent on. Normally money and credit are created by central banks and flow into financial assets, which the private credit system uses to finance people’s borrowing and spending. But in moments of crisis, governments can choose where to direct money, credit, and buying power rather than it being allocated by the marketplace, and capitalism as we know it is suspended. This is what happened worldwide in response to the COVID-19 pandemic.
Related to this confusion between the financial economy and the real economy is the relationship between the prices of things and the value of things. Because they tend to go together, they can be confused as being the same thing. They tend to go together because when people have more money and credit, they are more inclined to spend more and can spend more. To the extent that spending increases economic production and raises the prices of goods, services, and financial assets, it can be said to increase wealth because the people who already own those assets become “richer” when measured by the way we account for wealth. However, that increase in wealth is more an illusion than a reality for two reasons: 1) the increased credit that pushes prices and production up has to be paid back, which, all things being equal, will have the opposite effect when the bill comes due and 2) the intrinsic value of a thing doesn’t increase just because its price goes up.
Think about it this way: if you own a house and the government creates a lot of money and credit, there might be many eager buyers who would push the price of your house up. But it’s still the same house; your actual wealth hasn’t increased, just your calculated wealth. It’s the same with any other investment asset you own that goes up in price when the government creates money—stocks, bonds, etc. The amount of calculated wealth goes up but the amount of actual wealth hasn’t gone up because you own the exact same thing you did before it was considered to be worth more. In other words, using the market values of what one owns to measure one’s wealth gives an illusion of changes in wealth that don’t really exist. As far as understanding how the economic machine works, the important thing to understand is that money and credit are stimulative when they’re given out and depressing when they have to be paid back. That’s what normally makes money, credit, and economic growth so cyclical.”
“History has shown that we shouldn’t rely on governments to protect us financially. On the contrary, we should expect most governments to abuse their privileged positions as the creators and users of money and credit for the same reasons that you might commit those abuses if you were in their shoes. That is because no one policy maker owns the whole cycle. Each comes in at one or another part of it and does what is in their interest to do given their circumstances at the time and what they believe is best (including breaking promises, even though the way they collectively handle the whole cycle is bad). Since early in the debt cycle governments are considered trustworthy and they need and want money as much as or more than anyone else does, they are typically the biggest borrowers. Later in the cycle, new government leaders and new central bankers have to face the challenge of paying back debts with less stimulant in the bottle. To make matters worse, governments also have to bail out debtors whose failures would hurt the system—the “too big to fail” syndrome. As a result, they tend to get themselves into cash flow jams that are much larger than those of individuals, companies, and most other entities. In virtually every case, the government contributes to the accumulation of debt with its actions and by becoming a large debtor itself. When the debt bubble bursts, the government bails itself and others out by buying assets and/or printing money and devaluing it. The larger the debt crisis, the more that is true. While undesirable, it is understandable why this happens. When one can manufacture money and credit and pass them out to everyone to make them happy, it is very hard to resist the temptation to do so. It is a classic financial move. Throughout history, rulers have run up debts that won’t come due until long after their own reigns are over, leaving it to their successors to pay the bill.
Printing money and buying financial assets (mostly bonds) holds interest rates down, which stimulates borrowing and buying. Those investors holding bonds are encouraged to sell them. The low interest rates also encourage investors, businesses, and individuals to borrow and invest in higher-returning assets, getting what they want through monthly payments they can afford.
This leads central banks to print more money and buy more bonds and sometimes other financial assets. That typically does a good job of pushing up financial asset prices but is relatively inefficient at getting money, credit, and buying power into the hands of those who need them most. That is what happened in 2008 and what happened for most of the time until the 2020 coronavirus-induced crisis. When money printing and purchasing of financial assets fail to get money and credit to where they need to go, the central government borrows money from the central bank (which prints it) so the government can spend it on what it needs to be spent on. The Fed announced that plan on April 9, 2020. That approach of printing money to buy debt (called “debt monetization”) is vastly more politically palatable as a way of shifting wealth from those who have it to those who need it than imposing taxes because those who are taxed get angry. That is why central banks always end up printing money and devaluing.
When governments print a lot of money and buy a lot of debt, they cheapen both, which essentially taxes those who own it, making it easier for debtors and borrowers. When this happens to the point that the holders of money and debt assets realize what is going on, they seek to sell their debt assets and/or borrow money to get into debt they can pay back with cheap money. They also often move their wealth into better storeholds, such as gold and certain types of stocks, or to another country not having these problems. At such times central banks have typically continued to print money and buy debt directly or indirectly (e.g., by having banks do the buying for them) while outlawing the flow of money into inflation-hedge assets, alternative currencies, and alternative places.
Such periods of “reflation” either stimulate a new money and credit expansion that finances another economic expansion (which is good for stocks) or devalue the money so that it produces monetary inflation (which is good for inflation-hedge assets, such as gold, commodities, and inflation-linked bonds). Earlier in the long-term debt cycle, when the amount of outstanding debt isn’t large and there is a lot of room to stimulate by lowering interest rates (and failing that, printing money and buying financial assets), there is a strong likelihood that credit growth and economic growth will be good. Later in the long-term debt cycle, when the amount of debt is large and there isn’t much room to stimulate, there is a much greater likelihood of monetary inflation accompanied by economic weakness.
While people tend to believe that a currency is pretty much a permanent thing and that “cash” is the safest asset to hold, that’s not true. All currencies devalue or die, and when they do, cash and bonds (which are promises to receive currency) are devalued or wiped out. That is because printing a lot of currency and devaluing debt is the most expedient way of reducing or wiping out debt burdens.
Most people worry about whether their assets are going up or down; they rarely pay much attention to the value of their currency. Think about it. How worried are you about your currency declining? And how worried are you about how your stocks or your other assets are doing? If you are like most people, you are not nearly as aware of your currency risk as you need to be.
So, let’s explore currency risks.
ALL CURRENCIES ARE DEVALUED OR DIE
Of the roughly 750 currencies that have existed since 1700, only about 20 percent remain, and all of them have been devalued.
If you went back to 1850, as an example, the world’s major currencies wouldn’t look anything like the ones today. While the dollar, pound, and Swiss franc existed in 1850, the most important currencies of that era have died.
In what is now Germany, you would have used the gulden or the thaler. There was no yen, so in Japan, you might have used the koban or the ryo instead. In Italy, you would have used one or more of six currencies. You would have used different currencies in Spain, China, and most other countries as well.
Some were completely wiped out (in most cases they were in countries that had hyperinflation and/or lost wars and had large war debts) and replaced by entirely new currencies. Some were merged into currencies that replaced them (e.g., the individual European currencies were merged into the euro). And some remain in existence but were devalued, like the British pound and the US dollar.
WHAT DO THEY DEVALUE AGAINST?
The goal of printing money is to reduce debt burdens, so the most important thing for currencies to devalue against is debt (i.e., increase the amount of money relative to the amount of debt, to make it easier for debtors to repay). Debt is a promise to deliver money, so giving more money to those who need it lessens their debt burden.
Where this newly created money and credit then flow determines what happens next. In cases in which debt relief facilitates the flow of this money and credit into productivity and profits for companies, real stock prices (i.e., the value of stocks after adjusting for inflation) rise.
When the creation of money sufficiently hurts the actual and prospective returns of cash and debt assets, it drives flows out of those assets and into inflation-hedge assets like gold, commodities, inflation-indexed bonds, and other currencies (including digital). This leads to a self-reinforcing decline in the value of money.
At times when the central bank faces the choice between allowing real interest rates (i.e., the rate of interest minus the rate of inflation) to rise to the detriment of the economy (and the anger of most of the public) or preventing real interest rates from rising by printing money and buying those cash and debt assets, they will choose the second path.
This reinforces the bad returns of holding cash and those debt assets. The later in the long-term debt cycle this happens, the greater the likelihood there will be a breakdown in the currency and monetary system. This breakdown is most likely to occur when the amounts of debt and money are already too large to be turned into real value for the amounts of goods and services they are claims on, the level of real interest rates that is low enough to save debtors from bankruptcy is below the level required for creditors to hold the debt as a viable storehold of wealth, and the normal central bank levers of allocating capital via interest rate changes (which I call Monetary Policy 1, or MP1) and/or printing money and buying high-quality debt (Monetary Policy 2, or MP2) don’t work. This turns monetary policy into a facilitator of a political system that allocates resources in an uneconomic way.
There are systemically beneficial devaluations (though they are always costly to holders of money and debt), and there are systemically destructive ones that damage the credit/capital allocation system but are needed to wipe out debt in order to create a new monetary order. It’s important to be able to tell the difference.”