The Breaking Point

by James Dale Davidson

  Many, like Jeff Nielson, will tell you that the result to expect is hyperinflation. They point to the great German hyperinflation of the Weimar era. They point to Zimbabwe, always an entertaining spectacle. (I carry a 100 billion Zimbabwean dollar bill in my wallet.) But while a currency note for $100 billion Zimbabwe dollars is an interesting curiosity, on a par with a two-headed frog, much would have to change before you would see hyperinflation in the United States.

  I don’t deny that desperate central bankers may, indeed, long to gas up the helicopters in a last-ditch attempt to save the tottering edifice of debt by showering big crowds with bucketloads of freshly printed notes.

  But they run into a problem in trying to distribute digital money from a helicopter. I suppose they could scatter iPhones preloaded with digital money programmed to disappear if you don’t spend it within thirty days. Such devices certainly could not be dropped from a great height, for the obvious reasons.

  And I doubt it will ever happen. To the best of my knowledge, there has never been an episode of hyperinflation that began in an economy where the majority of the money supply was borrowed into existence.

  Will They Abolish Cash or Print More of It?

  Before hyperinflation could overtake the United States, there would have to be a transition period while ever-greater amounts of currency were dumped into circulation. This would represent a major about-face as the high priests of the status quo are now talking about increasing the already predominant role of the banking system in creating money.

  In my view, the utter fragility of the system makes it unlikely that the authorities would risk the transition period that would be required to move from 90 percent credit-based money to a system incorporating a greater circulation of currency. The problem is that the largely insolvent system would implode if a lot of digital money were converted into physical cash. And here we are not talking about the commonplace observation that illiquid banks cannot honor the simultaneous withdrawal of deposits if many wish to withdraw at once.

  This is a much more acute problem, illustrated by run-on money market funds. When $500 billion, about a quarter of money market investments, were withdrawn in just four weeks in 2008, the market seized up, threatening the liquidity of commercial paper. Of course, a major part of the problem was that the pioneering money market mutual fund, the Reserve Fund, broke the buck when it had to write off short-term paper issued by Lehman Brothers after the firm declared bankruptcy.

  The result was a run on the shadow banking system. This undercut the market for commercial paper—money market mutual funds were afraid to compound the maturity mismatch between their obligation to redeem shares immediately on demand and commercial paper with maturities of up to thirteen months. As liquidity in the market evaporated, the money market funds backed away from buying commercial paper.

  The resulting drop in demand for commercial paper prevented companies from rolling over their short-term debt, raising the specter of an acute liquidity crisis. The prospect of companies being unable to issue new debt to repay maturing debt implied that many would default on their obligations and perhaps even have to file for bankruptcy protection. That was in 2008. But the Fed and other central banks still fret that the demand for cash by investors seeking to protect themselves could compound debt deflation, as many investors catch up with John Exter’s insight that as more and more debt is compounded, digital money becomes less safe.

  That explains why Andy Haldane, chief economist of the Bank of England, has been beating the drums for a cashless society. He wants to eliminate cash as a way of circumventing the “zero bound” so central banks could lower interest rates substantially below zero. Haldane also argues that abolishing cash would make it easier for central banks to raise the general level of inflation to 4 percent, which he favors as a cushion against deflation in the future. As Allister Heath put it in the Telegraph of London, Haldane’s concerns about a possible massive shock to global demand led to his desire to reduce the risk of “prices plunging too far into deflation.”19 In other words, the attack on cash is a crucial feature of financial repression. With no cash in circulation, you could not escape the penalty of negative interest rates by hiding your money under the mattress.20

  And without cash, I would argue, you could not get hyperinflation. If 100 percent of money were borrowed into existence, the open short interest in the dollar would be 100 percent, and a deflationary short squeeze would be inevitable.

  Doubling down on credit expansion means digging ourselves deeper into a deflationary hole. It never made good sense to multiply debt at twice the rate of income growth. And it makes even less sense to increase the multiple of debt growth, as income growth stalls, which is happening in many economies. The McKinsey Global Institute reported this tidy detail: total world debt has grown by $57 trillion since 2008.21 That is a compound annual growth rate of 7.3 percent. Meanwhile, world GDP, as calculated by official sources, grew by no more than about $15 trillion at a compound growth rate of 3.2 percent. Debt grew more than twice as fast as income.

  And of course, another fatal flaw in the plan for infinite credit expansion is the patently evident fact that there is not an infinite stock of good collateral (too many Cosmos mines), and there are not infinitely liquid markets in which to hypothecate, rehypothecate, and redeem highly leveraged collateral. That’s why Glencore debt prices were plunging as I wrote, along with the high-yield debt of the world. Long before the Fed starts monetizing dirty underwear, the whole system will have succumbed to deflationary collapse.

  Meanwhile, the longer the Ponzi credit expansion continues, the more it turns out that principally the same collateral is overmortgaged by being pledged in multiple transactions. When the system devolves into crisis once more, as it did in 2008, it will soon become evident again that the derivative linkages calmly enshrined in instruments such as credit default swaps are fragile and subject to rapid devaluation, as the $85 billion bailout of AIG demonstrated.

  Hyperinflation arises only with the wholesale printing of currency. As indicated above, currency currently accounts for a small fraction, about 10 percent, of the US money supply. Most of our money has been spun out of bank credit. Hyperinflation is exceedingly unlikely, as a high rate of monetary depreciation limits the incentive of banks to undertake further lending. If money is rapidly losing value, the payoff from the banker’s “extravagant privilege” of creating money through the fractional reserve system falls. That is why you don’t see hyperinflation engineered solely through bank credit.

  Hyperinflation erupts with the direct creation of currency on a massive scale. For example, the 1923 hyperinflation in Germany was the result of runaway deficit spending funded by ever-increasing print runs of banknotes. By mid-1923, Germany had more than 30 paper factories, almost 1,800 banknote printing presses, and 133 companies with government contracts to print and issue banknotes. Printing currency was notoriously one of the few profitable industries in Germany in that troubled time. The money printers lived up to their contracts. By November 1923, a loaf of bread cost 200 billion marks.

  You’ll know you need to start worrying about hyperinflation when the government buys more high-speed presses to crank out paper money on a vast scale. That may happen. But if it ever does, you will see it beginning long before it advances as far as global deflationary meltdown has already advanced. If hyperinflation is a problem, it is a problem for the future. The more immediate problem you face is the tidal wave of global deflation that could sweep you away.

  How do you protect yourself? As is so often the case, simpleminded clichés are likely to lead you astray. You are told that gold is a hedge against inflation but not deflation. I agree with the late John Exter that gold is the ultimate hedge against deflation.22 Exter warned that the more debt money that was created, the more quantitative easing, the bigger the drag on economic activity, and thus the more severe the ultimate deflation would be. Exter believed the deflationary crash ahead will make the 1930s look like a
boom. Referring to gold, he suggested, “Buy it now while it’s still cheap,” as it will be the best investment to own when the crash occurs.

  Exter was preternaturally alert to the implications of continued credit expansion in magnifying deflationary forces in the economy. He foresaw that, as the terminal crisis of the credit supercycle took shape, the excess proliferation of derivative claims would set in motion a powerful deflationary adjustment.

  Exter’s Precarious Inverted Pyramid

  He saw that investors, slowly at first, then in greater numbers, would desert the more derivative and illiquid expressions of wealth in favor of more basic and liquid assets.

  Yes, gold and silver are natural resources that are produced in costly and elaborate processes like other commodities. But as monetary metals they are in a different category than met coal, iron, copper, aluminum, nickel, and zinc. When you mine for gold, you are mining for liquidity.

  Exter did not believe that the decision of how the overburden of debt would be liquidated was ultimately a political choice: he thought it would be resolved by the market. He is best known today for “Exter’s Inverse (or Inverted) Pyramid,” or simply “Exter’s Pyramid,” by which he sought to harness intuition about how deflation would unfold.

  Exter’s Pyramid has the appearance of an Egyptian pyramid standing precariously upside down on its apex. Its layers are organized in an inverse relation to safety. The sketchiest and least safe assets are at the top, with safety increasing as you move down the pyramid. The widest layer represents the hundreds of trillions, if not a quadrillion, of dollars’ worth of derivatives, like credit default swaps, currency swaps, collateralized debt obligations, and mortgage-backed securities. According to the Bank for International Settlements, 55 percent of collateralized debt obligations (CDOs) now being issued are based on leveraged loans.

  Exter’s Inverted Pyramid is top-heavy, with the upper levels comprising precarious derivatives—financial claims that are furthest removed from the physical world and the least liquid. Think also of unfunded government liabilities (the soon-to-be-worthless promises of politicians), small business assets, real estate, collectibles, OTC stocks, commodities, municipal (muni) bonds, corporate bonds, listed stocks, government bonds, treasury bills, and physical currency notes. Ultimately, at the inverted apex of the pyramid sits gold, the asset of preference in a deflationary collapse.

  Gold is an asset that is not someone else’s liability. Presumably, silver fits somewhere near the inverted apex of the pyramid in a thin layer somewhere above gold. Exter did not mention silver, but the logic of his argument is quite clear.

  It is also worth noting that derivative items at the top of the inverted pyramid have highly inflated values that, in aggregate, greatly exceed the value of all privately owned tangible assets on Earth. The notional value of paper markets vastly exceeds the underlying physical assets from which they are derived. Further to this, the leveraged derivatives entail liabilities that dwarf the equity of the banks and other entities that issue them, so that for all intents and purposes their recovery value could approach zero.

  252 Ounces of Gold Purchased on the Comex for Every Deliverable Ounce of Gold

  Consider the example of “paper gold.” It has been alleged for many years that physical gold borrowed from the vaults of central banks has been sold over and over again like producer shares in Springtime for Hitler, as imagined by Mel Brooks. But “paper gold” has another meaning as well. Zero Hedge reported on September 16, 2015, that “the number of paper claims through open futures interest for every ounce of deliverable gold” on the Comex had soared to 252. In other words, there was only one ounce of deliverable gold to satisfy every 252 paper claims through open futures interest. (You can see why Exter recommended acquiring physical gold to protect yourself in a bankrupt world.)

  The deflationary collapse is working its way from the periphery to the center. Most people in the United States are still in denial. They imagine that the wizards at the Federal Reserve will concoct some new expedient for juicing credit when the music stops. Don’t hold your breath. With a new record high of 252 ounces of gold claims on the COMEX (Commodity Exchange, Inc.), a division of the New York Mercantile Exchange (NYMEX) for each ounce of deliverable gold, even before the crisis hits the headlines, it is clear that you may be unable to count on delivery of futures purchases of gold.

  Or to put it another way, the real price of gold is destined to go higher in a deflationary environment precisely because the deflationary liquidity pressures may force the sellers of paper gold claims to buy large quantities for delivery. Or default. Be that as it may, it underscores the drawbacks of relying on the leverage in futures trading to profit from “paper gold.” That is why I recommend that you purchase actual gold and warehouse it in safe vaults outside the banking system in Switzerland. For more information, contact Johny Beck, partner, Matterhorn Asset Management AG at jb@goldswitzerland.com. Their websites are www.goldswitzerland.com and www.matterhorngold.com.

  Remembering the Great Depression

  It is little remembered today that the depression that began after 1929 in the United States began much earlier for commodity-producing countries at the periphery. Commodity prices peaked between 1927 and 1928. Most of the commodity-producing countries entered the Great Depression before the US stock market crashed. Argentina and Australia, for example, peaked in 1927 and were already in depression in 1928. The same goes for Brazil, Mexico, Uruguay, and Chile. In addition, a number of European countries were in depression in 1928, including Germany, along with some peripheral European countries like Bulgaria and Finland.

  Apparently, some investors have done their homework. Others must have intuited that they could gain greater safety by shifting investments into dollars—the reserve currency of the fading hegemonic power. Though it may be bankrupt, it is still the closest approximation of safety among fiat currencies in a bankrupt world.

  The Can Has Run Out of Road

  The artificial economy, leveraged on fictitious capital spun out of thin air, has been stimulated to little better than sporadic episodes of pseudogrowth. Recurring bubbles have been successively inflated to gain another short lease on life, while the powers that be struggle to invent some expedient to expand credit even further in a world already saturated in debt.

  I foresee limited prospects for kicking the can much farther down the road. So there you have my confession about why I am one of the “idiots” who expects the collapse of the insanely inflated global credit boom in the vortex of deflation.

  Those glossy Vamp fingernails you see everywhere are pointing to deflationary debt collapse. They may yet point up to the emergency Federal Reserve helicopters hovering overhead. But if so, that is a story for another day.

  Look out below.

  Notes

  1 http://www.forbes.com/sites/leesheppard/2013/10/06/fashions-leading-economic-indicator/#787caf804448.

  2 Cox, Chris, and Bill Archer, “Why $16 Trillion Only Hints at the True U.S. Debt,” Wall Street Journal, November 28, 2012, http://www.wsj.com/articles/SB10001424127887323353204578127374039087636.

  3 http://usawatchdog.com/america-in-worse-fiscal-shape-than-detroit-professor-laurence-kotlikoff/.

  4 http://www.bloomberg.com/news/articles/2015-09-15/dollar-gaining-like-1980s-evokes-plaza-accord-angst-before-fed.

  5 http://www.sermonaudio.com/new_details.asp?ID=38473.

  6 McLean, Bethany, and Peter Elkind, Enron: The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (New York: Penguin, 2003), 132–33.

  7 Chanos, James, “Hedge Fund Strategies and Market Participation” (Prepared Statement to US Securities and Exchange Commission: Roundtable on Hedge Funds panel discussion, Thursday, May 15, 2003).

  8 “The Mismatch Point: The Rise of the Dollar Will Punish Borrowers in Emerging Markets,” The Economist, March 21, 2015.

  9 “Shadow Banking in China: Battling the Darkness,” The Economist, May 10, 2014.


  10 Dobbs, Richard, Susan Lund, et al., “Debt and (Not Much) Deleveraging,” http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging.

  11 http://www.zerohedge.com/news/2015-09-23/welcome-newer-normal-your-complete-guide-world-which-fed-no-longer-control.

  12 http://www.washingtonpost.com/news/wonkblog/wp/2015/03/24/how-china-used-more-cement-in-3-years-than-the-u-s-did-in-the-entire-20th-century/.

  13 http://davidstockmanscontracorner.com/chinas-25-trillion-debt-bubble-fracturing-bad-loans-mount-at-big-four-banks/. Note that the $21 trillion estimate is at the low side of the McKinsey calculation discussed above.

  14 http://davidstockmanscontracorner.com/chinas-monumental-ponzi-heres-how-it-unravels/.

  15 “World Steel in Figures 2014,” World Steel Association, Evere, Belgium, https://www.worldsteel.org/dms/internetDocumentList/bookshop/World-Steel-in-Figures-2014/document/World%20Steel%20in%20Figures%202014%20Final.pdf.

  16 https://www.reddit.com/r/AskEngineers/comments/1z02k9/what_is_the_life_expectancy_of_a_skyscraper/.

  17 Durden, Tyler, “A Major Bank Just Made Global Financial ‘Meltdown’ Its Base Case: The Worst the World Has Ever Seen,” Zero Hedge, September 9, 2015, http://www.zerohedge.com/news/2015-09-12/major-bank-just-made-global-financial-meltdown-its-base-case-worst-world-has-ever-se.

  18 Stockman, David, “The Worldwide Credit Boom Is Over, Now Comes the Tidal Wave of Global Deflation,” Zero Hedge, August 3, 2015.