Explaining the gold standard, the Euro, Default, Deflation, and Hyperinflation

Summary: As Europe’s governments (and perhaps the US as well) repeat the economic policies of 1929-32, this guest post by Andres Drobny (see bio at the end) warns of the consequences. Government leaders back then did the best they could with the economic theory then available; today’s leaders have no excuse.

Contents

This is written as a dialog, somewhat like those of Plato.

Smart Guy #1 asks about the coming inflation
Andres replies: about the Gold Standard, the Euro, and Deflation
Default and hyperinflation
Our situation today
A discussion about the policy response to excess debt
About the author
For more information

(1) Smart Guy #1 asks about the coming inflation

While I see some near term deflation, I the inflation I expect long term may come sooner rather than later. US inflation is printing at 3.9% headline, 2.1% core; European Inflation is 3.0% and has been rising; and EM Inflation is about double those. Every central bank in the world is running administered rates at -2% to -3% real (which is almost unprecedented). For the possible result see Michael Murphy’s “Is Default Deflationary?“, Seeking Alpha, 4 December 2011 — Excerpt:

I take a behavioral approach in my book, Survive the Great Inflation: How to Protect You Family, Your Future and Your Fortune from the Worst Fed Regime Ever. I contend that Fed Chairman Ben Bernanke is an expert on deflation and an avowed enemy of deflation, and will do everything in his power to prevent it. His power includes an unlimited checkbook, right up to the day people and governments refuse to accept the U.S. dollar for goods and services. Those who say: “The Fed is out of bullets” take the chance of facing a central bank firing squad any day that, as we learned on November 30, has many bullets left, indeed.

Furthermore, I believe that one of the biggest of those bullets is sovereign defaults because a default extinguishes debt. Deflationary pressures come from debts, interest rate burdens and the austerity required to pay the interest and reduce the debt. As demonstrated repeatedly, most recently by Iceland, default relieves deflationary pressure faster than trying to repay the debt.

(2) Andres replies: about the Gold Standard, the Euro, and Deflation

Towards the end of the roundtable last week one participant suggested that the financial crisis will end only after the US abandons its fiat currency regime and returns to a gold standard. I’ve heard that argument from Ron Paul and commentators on Fox News. Occasionally the idea even gets out to the Lamestream media.

My complaint is not that there is something intrinsically wrong with the concept of a gold standard — or that of fixed, pegged, or floating peg currency systems. All systems have their deficiencies. Of course fiat currency systems and flexible exchange rate regimes have problems. Overshooting is more likely in such regimes, which probably means more bubble and bust cycles. Things seemed more stable under the original Bretton Woods regime than the current Bretton Woods II system {see Wikipedia}. That, I think, was one of the points made by that participant.

But in making his argument, and with what I’ve heard in the media and cyberworld, a crucial point is missed. The government must set the peg to gold accurately, avoiding the mistake the UK made in April 1925. If set too high you get a deflationary bias. Too low a rate can generate an inflationary bias. That’s the risk today. Germany is cheap within the Euro area, so if they save the system, the Bund could be dogs’ meat.

The Euro system didn’t start that way. Germany started expensive in the euro area; Greece and the other peripherals started cheaply. They lost competitiveness over time, presumably because underlying German productivity was higher. Unless Germany accepts higher inflation, the peripherals have to experience deflation — falling wages and prices — to keep up. That’s what the Euro area problems are all about.

This leads to a wider point with a gold standard system. The member countries need to experience reasonably convergent economic performance. Otherwise trouble will eventually emerge. If economic performance across member countries is ‘sufficiently’ divergent, then a gold standard can create real havoc. As we’ve just seen in the Euro area.

That’s also why people around the world complain about the Chinese and Asian currency levels. By fixing them low to the US Dollar (USD), they keep the USD standard alive (though their ever-increasing purchase of Treasury debt as foreign reserves), and thus constrain the adjustment mechanism until a big enough crisis emerges. One-time revaluations (increasing the RMB vs. the USD) aren’t the right answer here. The crawling peg (periodic small increases) is likely to prove better unless Chinese productivity growth softens towards US and global levels (faster wage inflation in China also helps equilibrate things). That issue is for another day.

So, alas, a gold standard is hardly a panacea. Even if you fix the currency at the ‘right’ level, trouble will eventually come if countries diverge in underlying productivity trends. It’s inevitable. Sorry. There’s no silver bullet.

(3) Default and hyperinflation

Now, regarding your specific comments regarding default and hyperinflation: of course default (involuntary deleveraging) is faster than protracted voluntary deleveraging. And, yes, the great hyperinflations were apparently initiated by default, followed by budget deficits that were money financed. Absolutely.

And, default releases the indebted. They no longer must pay back the debt, though they will now be left with little to no funding to spend over their income levels. But at the cost of the creditor taking a hit. And the potential that they will pull credit lines from the next guy. Someone has to pay for the losses.

But it’s simply a fallacy to suggest that the deflationary effects are ‘extinguished’. Sometimes they are only just starting. Like on 15 September 2008. That’s when default starts a domino effect.

You see, it’s not about the initial default or deleveraging, but the policy response to the phenomenon. What’s led in the past to hyperinflation, or protracted depressions for that matter, is the policy response that followed a default. In 2001, Argentina defaulted and then devalued by 300% and got some inflation, and good growth. Iceland is another example. Typically these examples are of small countries.

At the other extreme is the 1930’s, where the policy response was all wrong. They tightened as budget deficits rose and the gold system came under scrutiny. Much of the private sector debt was truly extinguished! Yet it took 10 years of real hardship (the great depression) before things really got tough — and the awful saga of WWII in the 1940s. That boom to bust cycle was hardly fast, nor effective. It was one of the world’s greatest disasters. Quick default didn’t reduce deflationary pressures, nor speed up the adjustment.

(4) Our situation today

So far in our great experiment we are in between these outcomes. A historically large debt bubble has bust and created a historic requirement for deleveraging. Governments have responded with a policy stimulus of historic proportions. This has stretched out the process, leaving us vulnerable over time — but preventing the worst ravages of deflation.

I hope you are right about inflation. Inflation provides the best way out of a debt crisis, especially if we avoid another wrenching process of historic proportions. I hope there’s enough stimulus out there so that inflation becomes the next problem.

But what if there is not enough stimulus? The policy makers don’t seem confident they’ve done enough. If the authorities haven’t provided enough stimulus to stop deflation or policy tightening becomes acceptable around the globe, then things must get a lot worse before the monetary and fiscal spigots get turned on all the way.

So your instincts may well be proven right in the long run. In the end game. But the specific path by which we get to hyperinflation is crucial. It’s an old point. As Keynes warned long ago, you may be right about the long run, but may not be in a position to actually experience it! This was in criticism, before the fact, of the classical laissez faire position of just letting a bust work its way through.

I have been agnostic about whether the policy makers will succeed here. It depends on policy.

Recently policy has been pretty ugly, adding to the risks of another deflationary spiral. The adherence to Europe’s version of the gold standard, at a time of clear divergence in economic trends by member states, is a crucial part of that. So too is the chorus inside the US arguing for tighter money, or fiscal austerity. It’s the 1931-32 mistake. This might well eventually end up in hyperinflation. But probably via an ugly deflationary accident along the way.

(5) A discussion about the policy response to excess debt

Smart Guy #1:

I agree that the deflation/inflation cycle (whether it lasts a millisecond, a quarter, year, or my lifetime) largely depends on government policy. As you suggest, the debate between Austerity and Prolificacy dates back to at least Mellon/Roosevelt — and surely before.

The Inflation Targeting literature (which goes back 3,000 years to the Hippocratic Oath, which states “first do no harm”), suggests that rather than trying to manage the economy via monetary policy, the “best” society can hope for in terms of monetary policy is that the policy makers minimize the uncertainty investors face when making long term capital investments (ie, volatility in the price of outputs generated by their fixed investment) by simply targeting stable current inflation (at about 2%).

“Best” here means the highest productivity, lowest long run unemployment, highest real wages, highest real returns on capital, etc. I assume Bernanke agrees, given his place at the nexus of this literature. He obviously waivers when practicality interposes, as recently when he alluded to “flexible inflation targeting” and [paraphrased] “dual mandate, including addressing high unemployment”.

The ECB (ie, Bundesbank) obviously has focused on price stability. How will they choose when faced with the choice between “no Euro” and a “soft Euro”?

Andres replies:

I don’t believe you are right about the ‘inflation targetting’ literature. It’s the opposite. You are supposed to inflate aggressively if you are targeting inflation and enter a deflation. Bernanke has done precisely what monetarists, including Milton Friedman, have always advocated.

Keynesians argue that this may not be enough and that fiscal stimulus should also be used. It is dangerous to suggest that policy should remain steady in an environment of default risk. Though obviously not as dangerous as the crazy argument for sound money in a high default risk environment — the idea, heard all too often these days, that monetary and fiscal policy should be tightened now.

SG#2 replies:

This is an excellent explanation of how imbalances ultimately need to be reduced by adjustments in currency and relative inflation rates. Adding large debts to this only makes the adjustments that much harder because debt is priced in nominal terms. Allowing for the debts to be reduced over longer time frames by way of inflation is always more palatable than a hard default politically. Part of this is explained by the fact that 99% of the world are debtors and therefore benefit from this approach. Creditors perceive the inflation as a violation of their social contract and thus pine for “real money” like gold or “price discovery” though hard defaults.

I am very skeptical of both these options but they always “appear” attractive ex ante. Further those who argue for this purity are usually able to persuade some of the debtor class to follow this because of its philosophical appeal, or the perception that anything is better than the long slog. This describes the challenge for the political class in the West: avoiding the perception of a quick solution. Bernanke warned that the toughest thing would be to stay the course for a long time. Any path we take will create economic volatility, another issue as well.

Andres replies:

We agree. The political aspect adjustment after a bubble consists of distributing the losses across groups or classes.

But — adding large amounts of public sector debt to keep up demand as private sector deleveraging occurs does help with the adjustment. The biggest creditors — Germany and China and Japan — should do the bulk of the stimulus. That would help resolve imbalances around the globe while limiting the deflationary tendency of a deleveraging process. That is more important than the specific currency regime. I’d rather see another round of China and German fiscal stimulus than changes to currency parities.

(6) About the author

Andres writes the Drobny Global Monitor, acting as the thought leader of the DGA membership circle — helping to keep the discussion intellectually honest, highly focused and profitable.

Before starting Drobny Global Advisors in 1999, Andres Drobny served as Chief Strategist and proprietary trader at Credit Suisse First Boston in London and NY from 1992-1998. While at CSFB, Andres was also on the Global FX Management Committee and a partner in the Leveraged Investment Fund. Prior to CSFB, Drobny was Chief Economist and Head of Research at Bankers Trust London. Before entering the financial markets, Andres was an academic economist at Cambridge and the University of London.

Andres Drobny holds a PhD in Economics from King’s College Cambridge, a Masters from London School of Economics and a Bachelors from Tufts University. When not in front of his Bloomberg, Andres can be found playing soccer or hanging out with friends at his compound in Venice Beach.

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