In the old days our currencies were at least partly backed by hard assets such as gold or silver. However, since President Nixon abandoned convertibility of the USD to gold in 1971, we have a global system of fiat currencies. Fiat money is legal tender issued by a government or rather its central bank. It is not backed by any physical commodity but only by the entity that issues it and is therefore based on trust. 

Since the Great Financial Crisis 2007-09 the world’s main central banks have more than doubled their assets and created well over USD 10 trillion in new unbacked money out of nothing. A central bank usually creates money by purchasing securities (especially government debt) or foreign currency from a commercial bank and booking the securities/currencies under assets and an equal amount in the account of the commercial bank held with the central bank under liabilities. This is nothing else than a balance sheet expansion. There is no limit on how much money a central bank can “print” and how much government debt it can “monetize” (= finance). 

Supported by very low interest rates and urged by politicians and central bankers, commercial banks have equally created trillions of dollars in new money. Contrary to a general misconception commercial banks do not require deposits from savers to issue loans. Instead they fabricate new money out of nothing by lending to companies and individuals. Equal to central bank’s money creation this is nothing else but a balance sheet expansion as the loan amount is booked as “loans to customers” under assets and at the same time as “deposits from customers” under liabilities.

Whereas the global money supply has been expanding aggressively, GDP growth has only been moderate. According to the Organisation for Economic Co-operation and Development (OECD) from 2008 to 2018 narrow money (currency and overnight deposits) has grown by 9% per year and broad money (narrow money plus deposits, money market fund shares and debt securities of up to 2 years) has still increased by 6.1%. In contrast GDP growth has been merely 3.4% per year. Accordingly, the World Bank finds that the share of broad money in global GDP has gone up from about 100% to 125% (as a side remark in 1971 when the U.S. ended convertibility of the USD to gold it was only 60%). One would expect that the divergence between monetary and economic growth has caused inflation to soar. However, most Western countries report only very low inflation.

One reason why inflation has not skyrocketed in many Western countries is the continued existence of deflationary factors. In the past the shift of production to low cost countries has generated strong downward pressure on the price of many products. However, as most production has already been moved abroad the future impact will be much less and could even reverse if trade wars widen. Nowadays deflationary pressure emanates from zombie companies that are artificially kept alive by cheap credit and sell their products at very low prices or even at a loss. Once economic conditions deteriorate many such companies will be forced to severely downsize or go out of business which should stir inflation. Some researchers also mention the aging population as a deflationary factor but this is highly contested as some papers come to the opposite conclusion.

Another reason why inflation in many Western countries has not shot up is the current bubble in asset prices. Instead of investing the newly created money in lucrative projects with a lasting positive effect on GDP much of it was used to purchase assets. This has boosted the prices of stocks, bonds and real estate to new record levels. In the financial media they call this asset appreciation, I call it asset inflation. The consumer price index published by governments only partially considers increases in the value of residential real estate. Price rises in commercial and industrial real estate as well as stocks and bonds are not included at all. Even though rising asset prices are not immediately causing consumer price inflation they will eventually impact the prices of goods. For instance, higher real estate prices increase the leasing cost for offices and factories and this will eventually be included in the price calculation of all products. And if companies borrow money to buy back their own shares (to boost the stock price and thereby generate generous bonuses for top management) increased interest payments will increase cost. It takes a while until higher assets prices are fully transformed into higher prices for goods and services but eventually it happens. In recent years the effects have become more and more obvious around the world.

According to OECD data for the period 2008-2018 average annual inflation was 1.6% in the USA and 1.3% in the Euro zone. In view of rapidly rising cost for housing, health care, education, local services (e.g. handicraft businesses and restaurants) and other items in most developed nations these numbers are difficult to believe. Indeed, as there is no universally accepted standard to measure inflation it is highly questionable whether the official figures are trustworthy. How does one adjust for changes in technology, customer preferences, package sizes, quality and durability of goods as well as many other factors? What are the right components in a “representative” shopping basket? And what is the appropriate share of each component? The bureaus that report inflation have a lot of leeway and this gives governments the opportunity to manipulate the official inflation numbers.

For the U.S. the website www.shadowstats.com calculates its own inflation rates by applying previously used methodologies of the U.S. government. It arrives at inflation rates that are 2 – 8 percentage points (not percent) higher than the official figures. Even though there is severe and partly justified criticism of the approach used by Shadowstats there is for sure more than just a grain of truth in their numbers. Even though no similar website exists for the EU there are many indications that the official European inflation figures are also too low. The reported rate of inflation is more a politically expedient number than an accurate reflection of reality as no politician wants citizens to know that their “hard” currency is rapidly losing value. It is shocking that the official data is rarely questioned but instead widely used by central banks and analysts. If you feed economic models that are already determined by biased or unrealistic assumptions with inaccurate data it is no wonder that the resulting policies cause havoc to the economy.

Inflation benefits borrowers especially when coupled with ultra-low interest rates as is currently the case. Governments, big corporations with easy access to cheap credit and speculators who buy assets on leverage (i.e. by borrowing part or all of the investment amount) are the big beneficiaries of todays distorted markets. Middle-class citizens who bought a house/apartment 5-10 years ago and now enjoy not only strong capital gains but also low mortgage rates are also profiting from the current central bank policies. On the other hand, employees who receive pay raises with a time lag and only in line with the official (i.e. understated) rate are victims. Inflation also penalizes savers who nowadays face both: Low/negative annual interest payments and a dilution of their principal. To save adequately for retirement has become very difficult if not impossible for large segments of the population.

Today many families are already suffering from rapidly rising prices that are not offset by corresponding salary increases. With monetary expansion continuing, the effects of higher asset prices slowly seeping into the real economy and deflationary pressure contained we can expect inflation to soar. Even though large parts of the population face a serious reduction in their standard of living politicians and central bankers continue to promote more inflation. They justify unconventional monetary policies such as low/negative interest rates and Quantitative Easing as necessary to avoid the “evil of deflation” and to achieve a “healthy” 2% rate of inflation. Whereas economists usually use highly sophisticated mathematical and econometric models to justify their proposals no such model has been put forward to justify the 2% target. There is not even a sound qualitative explanation why we need to aim for 2%. There have been deflationary periods in history with higher economic growth than we see today so why is there such a fear of deflation? The answer is very simple, because of our unsustainable level of debt. To find lasting solutions to our debt problem which would require far-reaching reforms and many unpopular measures. Instead our politicians have decided to take the easy way and inflate our debt away by creating trillions of dollars out of nothing. Let the successor deal with the highly detrimental consequences.

Even though central banks are accelerating monetary expansion this does not necessarily mean that the prices of goods will go up continuously in the future. Whereas some analysts see hyperinflation on the horizon, others expect a lurch into deflation. Proponents of the inflation theory argue that current monetary expansion gradually destroys the value of money. If monetary experiments such as negative interest rates and quantitative easing are continued and even intensified, trust in the value of fiat currencies will rapidly erode. Once we get to the point where confidence in the omnipotence of our governments and central banks evaporates inflation will soar and the real (though not necessarily the nominal) value of many assets that derive their value from fiat currencies will plummet. The accompanying tensions will make a reset of our financial system inevitable. If you think this is impossible please check history. It has happened on many occasions before even in the developed world and it will surely happen again.

Advocates of the deflation theory point out that a sharp economic shock could cause a deep recession with rapidly falling asset prices, pay freezes and mass unemployment. With bleak prospects prevailing, companies would try to pay off debt quickly instead of borrowing money to invest in equipment and research. And even if some companies were interested in investing, most commercial banks would hardly take the risk to provide them with new loans. Money supply would drop more than GDP and deflation would emerge. The Great recession at the beginning of the 1930s is an example of such a deflationary period that caused great pain to large segments of the population.

It is impossible to know exactly what will happen and when. A lot will depend on the measures taken by our politicians and central bankers. If they take bold and timely decisions, they might be able to avert both hyperinflation and stifling deflation. But based on their track record we doubt that they will manage the crisis properly. If they act too late and too carefully to a major disturbance that suddenly pops up, a deflationary shockwave around the world is likely to ensue. On the other hand, if they overreact by flooding the economy, that only produces a limited amount of goods, with enormous quantities of new money (e.g. helicopter money handed directly to consumers) hyperinflation is a real option.

Currently asset and consumer inflation continue to grow strongly. We can image a scenario in which a sudden economic, political or environmental shock will trigger asset prices to decline rapidly while consumer prices remained stagnant or slightly deflationary. Central banks might then unleash a “mega” monetary stimulus program that would stop and reverse the decline in asset prices but also cause hyperinflation in the prices of consumer goods and eventually a full reset of our monetary system. In the current first phase it is good to hold stocks and real estate while the value of cash is decreasing. In the second phase you would incur very substantial losses with stocks and real estate while holding cash would create positive real returns. In the last phase the possession of stocks and real estate would cushion the negative impact of hyperinflation whereas the value of cash would rapidly go to zero.

Certain assets can be either winners or losers depending on whether there is inflation or deflation. The only certain loser of the scenario described above is the average citizen who will be crushed by soaring inflation and might experience mortgage foreclosure during the deflationary period resulting in the loss of the family home.

Only truly outstanding investors and insiders are able to time the market correctly. The average middle-class person (and also the average certified financial advisor) is not. Therefore, make sure that your portfolio can withstand longer periods of both deflation as well as inflation/hyperinflation and also a reset of the whole financial system.

 

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