Hyperinflation or deflation?

This weekend, ZeroHedge noted an interesting working paper from Cato Institute titled "World Hyperinflations". Hyperinflation is defined there as a yearly price inflation rate of 50 percent or more and it contains a list of the worst known examples. Apart from the yearly inflation rate, which in the worst cases amounts to completely unfathomable numbers, they have also included hyperinflation measures that are easier to grasp, such as the daily rate of price inflation and how fast the prices doubled when the inflation rate was at its peak. In Hungary 1946 the prices doubled in 15 hours, in Zimbabwe 2008 they doubled in 24.7 hours, in Yugoslavia 1994 they doubled in 1.41 days and in Germany 1923 they doubled in 3.7 days.


However, the examples of hyperinflation from Cato Institute are simply not relevant parallels for today's situation. The economies that have been hit by hyperinflation have been mostly cash based. Today, however, most of the money supply has been created as credit. Less than ten percent of the money supply in developed economies consists of debt-free money. Instead we mostly have "debt money". ECB, IMF and others extend credit to the PIIGS countries, not cash. The Federal Reserve does not create a large amount of cash, but creates a heap of credit. Debts have to be repaid at some time, or disappear through default. In addition you have to pay interest on your debt, and even though interest rates in many countries are currently extremely low, they are not negligible for most debt.

Many get the concepts mixed up and think that "money printing" by creating more credit will have the same effect as creating more money by physically printing more cash. The Fed:s "Helicopter Ben" Bernanke is famous for saying in 2002 that they have access to a printing press (or its electronic equivalent) for money, and in theory could prevent deflation by distributing freshly printed cash by helicopter, but this is not what has happened during the past few years. If the world's central banks had created new debt-free money either through physical printing or through creating new electronic account balances without any demand for repayment, then I would have worried about hyperinflation. Instead the central banks have created new "money" as credit to compensate the defaults which have been forced by the financial crisis. What has happened is that the debt as simply been redistributed (largely to tax payers)

 This is why I still, as long as the current monetary policies continue, do not see any large inflation threats (and definitely not hyperinflation), but instead a big deflationary threat, when the sum of credit becomes too large in relation to the size of the real economy. When debtors can no longer keep up with debt payments, creditors are forced to accept credit write-downs, which lead to a diminishing money supply (which is the definition of deflation). Greece's creditors have already been forced to do this, as well as creditors to US housing loans.

Surely the list of hyperinflations from Cato Institute is interesting, but mostly for those who study the history of monetary policy. When the piles of credit floating around the world have been broken down, which will surely take many years, it might be relevant for certain countries to study historical examples of hyperinflation, but today I cannot see any such countries among the world's most important economies. Even in countries like China it's credit that has grown most over the last years. It is often said that it's not "different this time", but one thing that makes today's situation different from all historical parallels is that we have a global system of "credit money", where the total amount of credit is many times larger than ever before. This is a translation of an article from my Swedish blog.

The R Word

Some really bad US job statistics hit the news this Friday. Non-farm payrolls were -4000 jobs instead of the expected +100,000. This is the first time in four years that job growth was actually negative. On top of that the preliminary figures for June and July were revised downwards substantially. And, to make matters worse, 592,000 people left the workforce, meaning that they have probably given up trying to find a job. Now the "R word" is sure to come any day soon - recession.

Treasury Secretary Henry Paulson's comments on the job statistics are priceless. He's desperately trying to instill comfort when this news has probably convinced even the most hardened optimists that the US economy will make a hard landing, and pessimists now predict a crash landing. Some quotes:

"it takes a while for confidence to return"

"A while" - ha - it will probably take years to sort this mess out.

"The economy will continue to grow in the second half of the year"

Oh yeah? That would be sensational. First this "unexpected" drop in jobs, and then he expects us to get another surprise when we suddenly see job growth again in September or October. Does he actually believe this himself?

Paulson, who had a regular breakfast meeting with Fed Chairman Ben S. Bernanke today, said he had "great confidence'' in the central bank.

"Helicopter Ben" is probably glad to hear that there's still at least one person who has not lost confidence in him.

"But I feel quite strongly that we have a resilient economy."

Well, let's hope that, but don't bet on it. Things might break quicker than Paulson can say "resilient economy".

The Mortgage Situation
Higher unemployment will of course lead to more people falling behind on their mortgage payments. Foreclosures have already hit an all-time high of 0.65 percent during the second quarter of this year, making this the third consecutive quarter in which a record is set. Delinquencies are also up - 14.82 percent of subprime loans are behind in their payments, but delinquencies in the prime area are also up from 2.58 to 2.73 percent. Expect this to turn worse.

Housing prices are sinking, partly because it has become much more difficult to get a loan. More foreclosures will also mean more houses for sale on an already saturated market. Expect housing prices to sink much more.

To make matters worse for the poor foreclosed home-owners, if the house sells below the amount of the loan, and the rest of the loan is forgiven by the lender, the amount forgiven is taxed as income for the borrower. This could lead to really serious problems for many people who are already in trouble.

There have been proposals (notably from George W. Bush) to bail out home-owners in some way to alleviate the effects of the current housing mess. However, with a recession coming on, where is the government going to find funds for such a bailout? A recession means less tax money coming in, so the only alternative is to borrow money. But borrow from whom? Most Americans don't have any surplus to put into US bonds, and foreign investors will be unwilling to invest more in US government paper if there is a major inflation risk. And that brings me to the subject of...

Inflation
Apart from moving the stock markets down, the bad jobs news on Friday also took the US dollar down by more than 0.6 percent. The US dollar index (against other currencies) is now definitely below 80 and has now broken its 15-year low. Expect it to fall further unless some miracle news turns up. This means that all imported stuff will be more expensive in the USA.

To counter this bad trend for the US$, the only thing the FED could do would be to increase the interest rate, but what's really needed to alleviate the current domestic economic situation is an interest rate cut, which is what everyone expects the FED will announce on September 18. So the FED basically has its hands tied behind its back when it comes to fighting inflation.

Besides, there are two inflation factors over which the FED has no control - food and energy. I know that the "core inflation" figures the FED prefers to watch exclude food and energy, but in the real world food and energy prices have strong effects on the economy. People just cannot live without them. Food prices are rising sharply, as I have said before, due to a global shortage of wheat and other grains. President Bush could do something about this inflation factor, however, by cutting all subsidies to the grain-to-ethanol business. Of course this would mean a disaster for that business, but it would probably be a big help in fighting inflation. Though I don't expect him to do this, since he's too committed to it.

Oil prices are also rising, in case anybody failed to notice. On this Tuesday (11 September) OPEC will have a meeting to decide their production quotas. It is highly improbable that they will increase their production, since they probably cannot (this has been thoroughly analysed at The Oil Drum). OPEC will probably keep production at the current level, thereby keeping world market prices high. This means that the slightest disruption in this tight market could send oil prices upwards. Goldman Sachs already expects oil prices to hit $95/barrel this year (they're at about $75 now).

Many Companies in (Potential) Trouble
The current credit crunch is also a severe threat to the economy. Even if the FED lowers its rates, many loans (commercial and private) are tied to the LIBOR. The 3-month LIBOR is currently up to 5.70 percent, thereby increasing interest payments for all loans tied to it. It has also become much harder to actually get a loan. Outstanding commercial paper has contracted by nearly $300 billion over the last four weeks (source: Credit Bubble Bulletin). So many businesses will have a hard time due to either higher interest payments, lack of funding, or both.

Of course, all businesses connected to the housing boom are in even worse trouble. For example home builder Beazer received notices of default this week from a bondholders' group, while luxury home builder Hovnanian reported losses for the fourth quarter in a row.

For mortgage lenders you can watch the Implode-o-meter to see them going down one by one. The biggest one, Countrywide Financial, announced on Friday that they will cut 12,000 jobs (20% of their workforce).

Countrywide also seem to have been into some shady stuff too. They even seem to have neglected sending required paperwork to the IRS. Is this the beginning of another Enron-style scandal?

It is also getting harder for mortgage lenders to get funding. Citigroup announced that their First Collateral Services unit won't accept new clients for "warehouse" credit lines, which provide cash to mortgage banks so they can fund home purchases and refinancings. Does this also imply that Citigroup sees problems with their current clients? How many bad housing loans are actually connected to Citigroup in some way?

Citigroup also might have other troubles. Like many other banks, they have so-called SIVs (Structured Investment Vehicles) and conduits, which operate separately from the bank and are not on its balance sheet, but generate investment profit (hopefully) for the bank. According to Wall Street Journal, Citigroup "owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management". If these SIVs start going bad Citigroup might have to help them out or take on some of their losses. Now according to Wikipedia, Citigroup, apart from being the world's largest bank is also the world's largest company (by assets), so hopefully they can sort out quite large amounts of problem debt.

Zimbabwe Breaking Down

Zimbabwe is in big trouble. They have just failed to raise money to pay for 36,000 tonnes of wheat, which is currently sitting in the harbour of Beira in Mozambique. Zimbabwe needs about 450,000 tonnes of wheat per year, but are currently producing less than 80,000. This is because of insufficient power available for irrigation. Agricultural production has fallen sharply over the last decade. Besides, Zimbabwe lacks foreign currency to pay for diesel and petrol needed for power generation, tractors, etc.

The prospects for this country are bleak. Just take a look at the following figures:

• Official inflation rate currently at more than 7600%. This means that what cost $1 a year ago now costs $77!
• Unemployment rate of 80%.
• More than 40% of the population have HIV/AIDS.
• Life expectancy is 37 years for men, 34 years for women - lowest in the world.
• 25% of the population have fled abroad. Another 4% are displaced within the country.

The political mess is just getting worse, with human rights violations in every imaginable area. It's just a matter of time before the country disintegrates in riots and civil war, as I see it.
Someone said "Any society is just nine missed meals from anarchy". If no grain shipments reach Zimbabwe soon they will be there soon.

Harvests, Floods and Droughts

News is just out that North Korea has been hit by floods with hundreds dead and widespread damage. Tens of thousands of hectares of farmland have been destroyed. This means a bad harvest this year for a country that already needs to import grain during good years. North Korea usually does not readily admit having problems, so the fact that they ask for help probably means the situation is really bad. Read more about it in IHT.

The floods that have hit two-thirds of Bangladesh for the last three weeks are now receding, but have destroyed nearly 133,000 tonnes of rice that was about to be harvested. Read more about it in Daily India. These floods have also hit nearby Bihar in India, damaging crops on more than 1 million hectares and destroying food grain stocks. Read more about it in Daily India.

On the bright side, it can be noted that Afghanistan has doubled its production of cereals in the six years since the Taliban regime fell, according to an article from FAO.

However, global stockpiles of wheat are at 30-year lows, and the price of wheat has climbed 34 percent this year. Maize (corn) and wheat are being used as feedstocks for ethanol plants both in Europe and USA, which has driven up the price of these grains. Other food crops have also increased in price, either because they are used to produce biodiesel, e.g. canola/rapeseed, or because higher prices for corn and wheat have made farmers sow more of these and less of other crops. The prices of meat and dairy products have also risen, because the animals are fed on grain. All this will of course lead to higher food prices, which will have a number of effects.

- Emergency food relief programs for places like Bangladesh, Bihar and North Korea will cost more, leading to tight budgets for aid organisations.

- Higher food prices mean higher inflation. "Core" inflation in the USA excludes both food and energy, but this inflation measure is a scam - who can survive without food and energy? Look at the real price inflation figures instead.

- Higher food prices lead to consumers having less money left to buy other stuff. Good for mother nature, because less consumption means less resources used up. Bad for our consumer-driven economy.

The current trends of more grain converted into ethanol and harvest problems in many places in the world are likely to continue, sending food prices still higher. Add an ever-increasing world population and things are starting to look pretty grim.

Now one of the easiest things the world could do to improve the current food situation would be to stop the whole grain to ethanol business. I doubt whether the grain to ethanol industry would actually survive if it were not for government subsidies.

Additionally, it is doubtful that converting grain to ethanol actually produces any net energy gain to speak of. To produce the ethanol you need a lot of energy. Diesel to run the tractors, natural gas to produce fertilisers, more diesel for transports, etc. An important concept for all fuels is EROEI (Energy Return On Energy Invested), i.e. how much energy you need to put in to get your fuel. For crude oil EROEI is very high, about 10 to 1 for good fields. This means that you need to use the energy equivalent of one barrel of oil for every ten barrels produced. This energy is used for drilling, transports, etc. There are a number of studies of the EROEI of grain to ethanol, and they all show an EROEI close to 1. This means that you actually have to input nearly as much energy as you get out of the whole process. Some studies show an EROEI of 1.2, which means that the ethanol only contains 20% more energy than all the inputs. Is it really worth all the adverse side effects of rising food prices to get that measly extra energy? Other studies (e.g. by Patzek and Pimentel) even show that grain to ethanol has an EROEI below 1, which means you actually loose energy in the process!

In any case, even if it turns out grain ethanol has an EROEI greater than 1, we would need so much farmland to grow enough grain to feed all our cars that there simply isn't that much farmland!

So, please, could all governments stop their subsidies to the grain to ethanol business now.