Money Mud Hyper Inflation

Analyst Thomas Coughlin Email [email protected] Released 1 July 2010

Money, Mud & Hyperinflation.TRAC Financial Group | Research

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ABSTRACTSince World War II, inflation has been engrained in Western society. It is embedded in our expectationsandwrittenintoourlegislation.InflationisthecultureoftheBabyBoomergeneration. Societyexpectspricestogoup,andisconvincedsomethingiswrongiftheydonot. The general fear of deflation is unfounded. Under the global fiat monetary system, to inflate or deflate is largely a policy makers decision. Amongst developed economies, deflation is invariably PublicEnemyNumberOne. The historically proven antecedents to hyperinflation currently exist to an overwhelming extent. Bankingcriseshavebeenshowntoordinarilyprecedecurrencycrashes.Currencycrashesresultin hightohyperinflation. Hyperinflationisthesinglelargestproblemaneconomycanfaceandshouldbeofextremeconcern for anyone who is positioned defensively for deflation. It leads to the systematic destruction of savings and if not confronted correctly, the total destruction of middleclass wealth. It empowers governments,butcanalsoenrichanyonewhoseesitcomingandpositionsthemselvescorrectly. Of greatest importance to the report, is an analysis of the ability to fight inflation. Evidence concludes, there is a limited capacity for developed economies to fight the onset of inflation, withoutbeingcrippledeconomically. This report delves into the key factors contributing towards the probability of high inflation, by providing a historical and present overview of the global monetary system; exploring historical empirical studies of crisis sequencing; examining the current inflationary forces, showing the key differences between now and the Great Depression; and evaluating the current economic and financial position, and performing a brief stress test displaying the limited ability for the Western Worldtofightinflationfromafinancial,economicandpoliticalstandpoint.

Wenaturallyimaginethatthespotonwhichweourselvesstandisfixed,andthatthethings aroundusmove.Themanwhoisinaboatseemstoseetheshoredepartingfromhim,anditwas thedoctrineofthefirstphilosophersthatthesunmovedroundtheearth,andnottheearthround thesun.Inconsequenceofasimilarprejudice,weassumethatthecurrencywhichisinallour hands,andwithwhichweourselvesare,asitwere,identified,isfixed,andthatthepriceofbullion moves;whereasintruth,itisthecurrencyofeachnationthatmoves,anditisbullion,thelarger articleservingforthecommerceoftheworld,whichisthemorefixed. HenryThornton,AnEnquiryIntotheNatureofthePaperCreditofGreatBritain,1802

July1,2010 MONEY,MUD&HYPERINFLATION

TABLEOFCONTENTSTABLEOFFIGURES.........................................................................................................................3 TABLEOFTABLES...........................................................................................................................4 1.0INTRODUCTION........................................................................................................................5 2.0MONETARYSYSTEMOVERVIEW...............................................................................................6 3.0FINANCIALCRISESANDTHEIRSEQUENCING.............................................................................8 3.1OVERVIEW.....................................................................................................................................8 3.2CRISISSEQUENCING......................................................................................................................9 3.3BANKINGCRISES.........................................................................................................................10 3.4CURRENCY&HYPERINFLATIONCRISES......................................................................................11 3.5DEFAULTTHROUGHINFLATION..................................................................................................13 4.0INFLATION&CURRENTINFLATIONARYFORCES....................................................................... 6 1 4.1OVERVIEW...................................................................................................................................16 4.2MONETARYPOLICY.....................................................................................................................16 4.3MONEYSUPPLY&MONETISINGDEBT .......................................................................................17 . 4.4DEFICITFINANCING.....................................................................................................................21 4.5ACOMPARISONTOTHEGREATDEPRESSION&THEFALLACYOFDEFLATION..........................23 4.6EXAMPLESOFINFLATIONTODAY...............................................................................................24 5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT................................................................... 7 2 5.1USGOVERNMENTFINANCIALPOSITIONANDFISCALOUTLOOK...............................................27 5.1.1FiscalChallenges..................................................................................................................30 5.1.2FiscalTightening...................................................................................................................32 5.1.3AgingPopulation..................................................................................................................34 5.1.4FedBalanceSheet................................................................................................................35 5.2GOVERNMENTDEBT...................................................................................................................36 5.2.1UnfundedLiabilities.............................................................................................................40 5.2.2OffBalanceSheetLiabilities.................................................................................................41 5.23ForeignOwnership...............................................................................................................41 5.3INTERESTRATES..........................................................................................................................44 5.3.1Overview..............................................................................................................................44 5.3.2RatingsAgencies..................................................................................................................44 5.3.3RisingEffect..........................................................................................................................46 TRACFINANCIALGROUP|0BTABLEOFFIGURES 1

July1,2010 MONEY,MUD&HYPERINFLATION 5.4TPOPULISTWAYOUT.................................................................................................................49 6.0CONCLUSION........................................................................................................................... 1 5 6.1KEYPOINTS .................................................................................................................................51 . 6.1.1MonetarySystemOverview ................................................................................................51 . 6.1.2FinancialCrisesandTheirSequencing.................................................................................51 6.1.3Inflation&CurrentInflationaryForces................................................................................52 6.1.4CurrentEconomicSituation&LimitedAbilitytoFight........................................................52 6.2CONCLUDINGREMARKS.............................................................................................................53 7.0BIBLIOGRAPHY........................................................................................................................ 6 5

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TABLEOFFIGURES Figure1:UnitedStatesCurrencyPurchasingPower,GDP,MonetaryBase&PublicDebt....................7 Figure2:Thesequencingofcrises..........................................................................................................8 Figure3:MedianInflationRate............................................................................................................12 Figure4:CurrencyCrashes...................................................................................................................12 Figure5:USMonetaryBase19902010...............................................................................................18 Figure6:USMonetarybase19182010...............................................................................................18 Figure7:MonetaryBase&StockMarketUS,Euro,UK&Swiss........................................................19 Figure8:$USPurchasingpower&Gold,19652010..........................................................................20 Figure9:DeficitFinancing.....................................................................................................................21 Figure10:AFRCommodityPricesIncrease..........................................................................................25 Figure11:AFRInflationPressures........................................................................................................25 Figure12:U.S.Fiscal&EconomicForecastErrors................................................................................29 Figure13:FederalandcombinedFederal,State,andLocalSurplusesandDeficits............................29 Figure14:PotentialFiscalOutcomes:RevenuesandCompositionofSpending.................................30 Figure15:USConsumptionShareofGDP..........................................................................................32 Figure16:U.S.IncomeShareofTop1%ofHouseholds.......................................................................33 Figure17:PersonalSavingRate,19822006.........................................................................................34 Figure18:TheNationalDebtasaPercentofGDP...............................................................................36 Figure19:TradeDeficitsvsFederalDebtIncreases($Billions)...........................................................37 Figure20:U.S.DebtHeldbythePublic................................................................................................37 Figure21:U.S.GovernmentDebtHeldbythePublic...........................................................................38 Figure22:DebtHeldbythePublicunderTwoPolicySimulations.......................................................38 Figure23:U.S.GovernmentDebt,Growth,andInflation,17902009.................................................39 Figure24:U.S.UnfundedLiabilities......................................................................................................40 Figure25:Budgetforecastedreceipts&Outlays.................................................................................40 Figure26:ForeignAssetsintheU.S.:NetCapitalInflow ....................................................................43 . Figure27:U.S.FederalFundsRate,19842010...................................................................................44 Figure28:DiminishingReturnsforEach$US1ofNewDebtintheUSEconomy.................................55

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TABLEOFTABLES Table1:TheTimingoftheTwinCrisesandFinancialLiberalisation....................................................10 Table2:"Default"throughInflation15001799...................................................................................14 Table3:"Default"throughInflation18002008...................................................................................15 Table4:AdvanceEconomiesPublicDebtLevels(asa%ofGDP).........................................................22 Table5:U.S.2011FederalBudget........................................................................................................27 Table6:U.S.Government'sFinancialPositionSnapshot.....................................................................28 Table7:FederalFiscalGapunderGAO'sAssumptions20102084......................................................31 Table8:FederalReserveBalanceSheet...............................................................................................35 Table9:U.S.BudgetInterestExpense................................................................................................47 Table10:InterestStressTest................................................................................................................48

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1.0INTRODUCTIONThe global economy is currently in a crisis cycle. Looking through the fog of war, being the daily volatility of global markets, reveals high confidence evidence to answer the profoundly important inflation/deflationdebate. After a global financial crisis and global recession, it is instinctive to be wary of deflationary conditions. A brief study of history shows financial crises have extraordinarily predictable sequencing, with past and present events giving probabilities for the future. However, past and present financial events naturally act as an intuitive diversion from the future probabilities. The currentprobabilityishyperinflation. It is intuitive for inflation to appeal to the general public as asset prices rise giving the illusion of prosperity.Itisalsointuitivetobelievethatpricesfallordeflatewhenproblemsemergeandpersist inaneconomy.However,whathappenswhencurrenciesdeflate?Possiblysimultaneously? Hyperinflationisthesinglelargestproblemaneconomycanfaceandshouldbeofextremeconcern for anyone who is positioned defensively for deflation. It leads to the systematic destruction of savingsandifnotconfrontedcorrectly,thetotaldestructionofmiddleclasswealth.Itempowersthe government,butcanalsoenrichanyonewhoseesitcomingandpositionsthemselvescorrectly. Thisreport: Explainsthecriticaldynamicsinfluencingthecurrentglobalmonetarysystem; Exploreshistoricalempiricalresearchoncrisissequencingandthederivedprobabilities; Examines the inflationary and deflationary forces that currently exist on a global macroeconomiclevel;and Evaluatesthecurrentmacroeconomicpositionandanalysesthecapacityforaglobalbattle againstinflation.

Itistheintentofthisreporttodelveintotheevidenceinawaywhichcanbeunderstoodbyall.By joining all the proverbial dots of materially significant evidence, high confidence forecasting probabilitieswillbederivedfortheglobaleconomyofthefuture. ThisisaMacroeconomicreport.TheUnitedStatesofAmericaarethesinglelargesteconomyinthe world and hold the global trade and reserve currency, the US Dollar. For this reason, dynamics among the US economy, government and currency, influence and provide telling signals for the broaderglobalmacroeconomicenvironment.

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2.0MONETARYSYSTEMOVERVIEWTheproblemwithfiatmoneyisthatitrewardstheminoritythatcanhandlemoney,butfoolsthe generationthathasworkedandsavedmoney. AdamSmith,18thCenturyScottishphilosopher Attheendfiatmoneyreturnstoitsinnervaluezero. Voltaire,18thCenturyFrenchwriterandphilosopher Nowforacrashcourseontoday'sglobalmonetarysystem. Theglobaleconomyoperatesinwhatistermedafiatmonetarysystem.Afiatmonetarysystemsis madeupofmoneythathasnointrinsicvalue.Thevalueofthepapermoneyiscontrolledbycentral bankschargedwiththeexclusivemonopolisingpowertoprintorissueitsnationalcurrency.When moremoneyisprintedandthesupplyofmoneyincreasesitnaturallyhaslessvalue,asthereismore moneyseekinglimitedresources.Thisequatestoarisingofnominalpricesforgoodsandservicesin limitedsupply.Thisphenomenonistermedinflation. Before the fiat system, global economies largely operated under the gold standard. This was repealedinAustraliain1915followingtheBritish.The$USbeingtheglobalcurrencyoftradesince theendofWWIIoperatedunderamodifiedversionofthegoldstandardtermedtheBrettonWoods system, until it was repealed under President Nixon in 1971. Under the gold standard money was convertibletotheequivalentvalueofgold. Withthe$USbeingtheglobaltradeandreservecurrencysincetheendofWWIIandtheonlymajor currencyleftonthegoldstandard,therepealingofitin1971,termedtheNixonShock,markedthe final chapter for the gold standard in the global economy. The repealing of the Bretton Woods systemultimatelyallowedtheUSFederalReserve(Fed)toprintmoneyoutofthinairtofinancethe US governments budget deficit, partially resulting from an expensive Vietnam War. High inflation ensuedthroughoutthe1970sofuptoapproximately20%perannum.Thatiscashlosingitsvalueor fallingby20%peryear. This inflation during the 70s and early 80s was not overly destructive for savings as interest rates wereabletoberisentocounterattacktheinflation.However,itisnotalwayspossible,forinterest ratestorise. Printing money is the loose terminology for debt monetisation, and is a form of central bank quantitativeeasing.Debtmonetisationgenerallyresultsfromacentralbankbuyingdebtfromeither agovernment,bankormorerecentlyothernonbankcorporations,withfreshlyprintedoutofthin air money. As Faber, (2009), states it makes no difference macroeconomically if a mafia boss producescounterfeiteddollarbillsinhiscellarortheFedprintsmoney. Figure1,graphicallyillustratesthemonetarydynamicsdiscussedabove,atplayintheUnitedStates.

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July1,2010 MONEY,MUD&HYPERINFLATION Figure1:UnitedStatesCurrencyPurchasingPower,GDP,MonetaryBase&PublicDebt

US Dollar

CivilWar

USFederalReserve BoardFormed 1original USDollar nowworth lessthan4 cents.

M2/M3=Amonetarybase/supplymeasure.

TheUSDollarheldthemajorityofitsoriginalvalueonthegoldstandarduntilthecentralbank,the USFedwascreatedin1913.TheintroductionoftheBrettonWoodssystemwasapartialfiatsystem and marked the beginning of the great slide in the US Dollar to today's price of approximately 4 cents of its original value. The graph also displays the great up move of GDP, money supply and publicdebtoverthelast50years.

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3.0FINANCIALCRISESANDTHEIRSEQUENCING3.1OVERVIEWTheworldhasrecentlybeenremindedoftheenduringlegacyoftheGlobalFinancialCrisis(GFC)by thecurrentEuropeansovereigndebtproblems.Justasfinancialandeconomichistoryhasshownus, there are common macroeconomic characteristics of financial crises, there is also common sequencingoffinancialcrises. Therearefivetypesofcrises: bankingcrises; currencycrashes; inflationoutbursts; externalsovereigndefault;and domesticsovereigndefault.

Sovereigndefaultsarethemostextremecrisisandobviouslynotallcrisesescalatetothatlevel.The remainingcriseshoweverhavenotbeenuncommonevenamongadvancedeconomies.Thissection ofthereportwillfocusontherelationshipsandsequencingofbanking,currencyandinflationcrises. Empiricalstudiesoffinancialcrisesgivemeasuredprobabilitiesfortheoutcomesfollowingabanking crisis. A prominent study by Kaminsky & Reinhart, (1999), on the linkages between banking crises andcurrencycrashesfoundthatattheonsetofabankingcrisis,withnothingelseconsidered,there isapproximatelya46%chanceofacurrencycrashthatfollows.Thisiswithnothingelseconsidered, and before escalating to a global credit crisis and a global financial crisis, as we have recently experienced. Bankingcrisesoftenleadtocurrencycrashes,inflationandoutrightsovereigndefault(Kaminsky& Reinhart,1999).Figure2,displaysthisnormalsequencing. Figure2:Thesequencingofcrises

Source:ThisTimeisDifferent,EightCenturiesofFinancialFolly,Reinhart&Rogoff

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July1,2010 MONEY,MUD&HYPERINFLATION Due to current events, it is worth mentioning at this juncture that divergences from the norm generally result from economies adopting variations of financial liberalisation. An economy that is trulyfinanciallyliberalisedhasfreeglobalisedmarkets,floatingforeignexchangerate,andacentral bank.TheindividualeconomiesofDubaiandGreecedonothavethesefeatures,sothesovereign debtcrisiscamefirst. Itshouldalsobeunderstoodthatmonetaryinflationoftenleadsacurrencycrash,thecurrencycrash then triggers a vicious and rapid inflationary spiral that will continue until a complete system overhaul. ReinhartandRogoff,(2009)state: Global financial crises can be so much more dangerous than local or regional ones. Fundamentally,whenacrisisistrulyglobal,exportsnolongerformacushionforgrowth. Conceptually,itisnotdifficulttoseethatforacountrytobepulledoutofapostcrisisslump is more difficult when the rest of the world is similarly affected than when exports offer a stimulus. Wehavehundredsofcrisesinoursample,butveryfewglobalones,and,asnoted,someof the earlier global crises were associated with wars, which complicates comparisons even further. Inconsideringaglobalfinancialcrisiswithaglobalfiatmonetarysystem,theworldisinunchartered territoryandfacestestingtimesahead.

3.2CRISISSEQUENCINGFinancial Liberalisation is the starting point for the financial crisis sequence, as DiazAlejandro, (1983),states"GoodbyeFinancialRepression,HelloFinancialCrash".Onceaneconomyisfinancially liberalised,banksgainaccesstoexternalcreditandbeginriskierlendingpractices.Adeteriorationin assetpricesfollowingaboomincreditleadstoaweakeninginbankbalancesheetsandthisoften leadstoabankingcrisis. Thenextstageofthecrisisbeginswhenthecentralbankprovidesbanksandotherinstitutionswith supportbyextendingthemcredit.Historyshowsthatmoreoftenthannot,thereisanabandonment of the support for the foreign exchange rate in order to act as the lender of last resort for the troubledinstitutions.Furtherpressureisplacedontheforeignexchangerateasmoneyiscreatedby thecentralbanktobringliquidityintofinancialmarketsandtoboostthereservesofbanks. Thecurrencydevaluationconsequentlycomplicatesthesituationinatleastthreeadditionalways: 1) thebalancesheetsofbankswithforeigncurrencyborrowingsaredeterioratedfurther; 2) inflationincreases;and 3) the risk of government debt default rises if the government has foreign currency denominateddebt. Atthispoint,thebankingcrisiseitherpeaksfollowingthecurrencycrashordeterioratesfurtheras the financial crisis marches the economy toward a domestic or external sovereign default. After a defaultoccursinflationdeterioratesevenfurther.(Reinhart&Rogoff,2009) TRACFINANCIALGROUP|4B3.0FINANCIALCRISESANDTHEIRSEQUENCING 9

July1,2010 MONEY,MUD&HYPERINFLATION Table 1, illustrates the connection between banking crises and currency crashes. Quite often a bankingcrisisleadstoacurrencycrash,whichinturnexacerbatesthebankingcrisis.Pleasenote,a balanceofpaymentcrisisisequivalenttoacurrencycrisis. CurrencyCrisis Table1:TheTimingoftheTwinCrisesandFinancialLiberalisation

Source:(Kaminsky&Reinhart,1999)

3.3BANKINGCRISESBanking crises almost invariably lead to sharp declines in tax revenues, higher deficits through bailoutsandfiscalstimuluses,andhigherinterestpaymentsduetoratingdowngradesandelevated risk premiums. Modern economies depend on sophisticated financial systems, and when banking systemsfreezeup,economicgrowthcanquicklybecomeimpairedorevenparalysed. Since WWII, themost commonpolicyresponsetoasystemicbanking crisis(inbothemergingand advanced economies) has been to engineer a bailout of the banking sector. In many cases such actionshavehadmajorfiscalconsequences,particularlyintheearlyphasesofthecrisis.Thetotal fiscaldamage,includingbothdirectandindirectcosts,isanorderofmagnitudelargerthantheusual


July1,2010 MONEY,MUD&HYPERINFLATION bank bailout costs. According to Reinhart & Rogoff, (2009), government debt rises on average by 86%duringthethreeyearsfollowingamoderndaybankingcrisis. Advanced economies exhibit a stronger inclination than emerging economies to resort to fiscal stimulusmeasuresinanattempttocushiontheeconomiceffects. All taken into account, the bailout of the banking sector, the shortfall in revenue, and the fiscal stimulus packages that have accompanied some of these crises result in the widening of budget deficits and an explosion of government debt. Considering this, it should not come as a surprise bankingcrisestypicallyleadtoothercrises. Atotalof18postwarbankingcriseshaveoccurredinthedevelopedworld.The"BigFive"banking crises are considered to be Spain 1977; Norway, 1987; Finland, 1991; Sweden, 1991; and Japan, 1992.(Reinhart&Rogoff,2009)

3.4CURRENCY&HYPERINFLATIONCRISESToanoverwhelmingextent,hyperinflationaryepisodesandcurrencycrasheshavetravelledhandin handacrossplaceandtime.Theyoperateinanegativefeedbackloop,continuallyfeedinguponeach otheruntilcompletereformisundertaken.Printingmoneyleadstoinflation,whichinturnleadstoa currencycrash,leadingtofurtherinflation,whichpotentiallyleadstosovereigndefault,leadingto furtherinflation. Whenitcomestomodernvintagefiatmonetarysystemfinancialcrises,inflationcanrapidlyspiral viciously out of control. The end result is the cataclysmically damaging economic phenomenon of hyperinflation. Interestingly, no emerging market in history, including the United States has managed to escape boutsofhighinflation.Moneycreationandinterestcostsondebtallenterthegovernment'sbudget constraint,andinafundingcrisis,asovereignwilltypicallygrabfromanyandallsources. AsReinhart&Rogoff,(2009),states: InflationratesweremuchlowerbeforeWorldWarI,asthiswasbeforecommonuseofthe modernpapercurrencyorotherwisereferredtoasfiatcurrency.Themedianinflationrates beforeWorldWarIwerewellbelowthoseofthemorerecentperiod:0.5percentperannum for15001799and0.71percentfor18001913,incontrastwith5.0percentfor19142006... Howeverspectacularsomeofthecoinagedebasementreportedthroughouthistory,without questiontheadventoftheprintingpresselevatedinflationtoawholenewlevel....Whenwe began to work on this book, in terms of the magnitude of a single conversion, the record holderwasChina,whichin1948hadaconversionrateofthreemilliontoone.Alas,bythe time of its completion, that record was surpassed by Zimbabwe with a tenbilliontoone conversion! Figure 3, shows the median inflation rate for all the countries in Reinhart & Rogoff's sample from 1500to2007.Note,theradicalspikeininflationinthetwentiethcenturycoincidingwiththespikein currencycrashesoverthesameperioddisplayedinFigure4. Historically,derivedprobabilitiesforacurrencycrashandhighinflationbecomeoverwhelmingwhen alldynamicsthatcurrentlyexistindevelopedeconomiesareconsidered.Everyapplicablebankand TRACFINANCIALGROUP|4B3.0FINANCIALCRISESANDTHEIRSEQUENCING 11

July1,2010 MONEY,MUD&HYPERINFLATION currencycrisislinkageidentifiedthroughoutnumerousacademicempiricalstudiesexistsrightnow today. Figure3:MedianInflationRate

Themedianinflationrate:Fiveyearmovingaverageforall countries,15002007. Sources:Giventhelongperiodcoveredandthelargenumberof countriesincluded,consumerprices(orcostoflivingindexes)are culledfrommanydifferentsources.

Figure4:CurrencyCrashesNapoleonicWars

Currencycrashes:Theshareofcountrieswithannualdepreciation ratesgreaterthan15percent.18002007. Sources:TheprimarysourcesareGlobalFinancialDataandReinhart andRogoff(2008a),butnumerousothersarelistedinappendixA.1. Note:ThespikeattheleftofthefiguremarkstheNapoleonicWars, whichlastedfrom1799to1815.

Source:Reinhart&Rogoff,(2009) FindingsbyVelasco,(1987),pointtofinancialsector problemsgivingrisetothecurrencycollapse. These findings concluded that when central banks finance the bailout of troubled financial institutionsbyprintingmoney,aclassiccurrencycrashfromexcessivemoneycreationensues.The globehasrecentlyhadunprecedentedglobalbankandcorporatebailouts. Krugman,(1979),assertsthatcurrencycrisescanbethebyproductofgovernmentbudgetdeficits. TheU.S.andthemajorityofdevelopedeconomiescurrentlyhavelargebudgetdeficits. DemirgucKunt and Detragiache (1998), identified countries with an explicit deposit insurance schemeareparticularlyatriskofcurrencycrises.Mostdevelopednationsenforcedthistoalarger TRACFINANCIALGROUP|4B3.0FINANCIALCRISESANDTHEIRSEQUENCING 12

July1,2010 MONEY,MUD&HYPERINFLATION extent to help fight the banking crisis. It increases government debt risk and thus increases the likelihoodofacurrencycrisis. Fischer,Sahay,&Vegh's,(2002),studyofHyperinflationfound: Since1957,inflationhasbeencommonplacethroughouttheworld.Basedonasampleof133 countries(foratotalofcloseto45,000observations),wefindthatmorethantwothirdsof thecountrieshaveexperiencedanepisodeofmorethan25%perannuminflation;morethan onethirdhasexperiencedepisodesinexcessof50percentperannum;closeto20percentof countries have experienced inflation in excess of 100 percent; and around 8 percent have experiencedepisodesofmorethan400percentperannuminflation.Theaveragedurationof highinflationisremarkablysimilarand,at34years,surprisinglylong. Higherinflationtendstobemoreunstable....wefindthat,asinflationrises,theprobability of inflation staying in the same range decreases and the probability that inflation will rise aboveitscurrentlevelincreases. Asexpected,thelongrunrelationshipbetweenmoneygrowthandinflationisverystrong. Thelongrunrelationshipbetweenfiscalbalanceandseigniorageissignificantandnegative. Intheshortrun,therelationshipisstrongforhighinflationcountriesbutinsignificantforlow inflationcountries. Periodsofhighinflationareassociatedwithbadmacroeconomicperformance.Inparticular, highinflationisbadforgrowth.

Seigniorageisthetermusedtoexplainthetaxationlikeeffectthatinflationhasonthepublicforthe benefit of the government. Snowdon & Vane, (2002), state: "In macroeconomics, seigniorage is regarded as a form of inflation tax, as paying for government services by issuing new currency (rather than collecting taxes paid out of the existing money stock) has the effect of creating a de factotaxthatfallsonthosewhoholdtheexistingcurrency,asaresultofitseffectivedevaluation throughtheintroductionofadditionalmoney." Reinhart&Rogoff,(2009),surmisethatthereexistsacommonparadoxwheregovernmentsoften increase inflation above and beyond the seignoragemaximising rate. What this means is that governments tend to increase inflation beyond the point at which it is beneficial to their budget. Faber,(2009),writes:"inflationisadynamicprocessanditisnotpossibletofixitat6%.Ifinflation increasesfromthecurrentlevelof,say,2%perannumto6%,itwilllikelythereafteracceleratetofar higherlevels". Evidenced by the many cases of hyperinflation with almost uncountable inflation rates, Faber's assertion that central banks and governments simply lose control of inflation once it gains speed, appearsundeniablycorrect.

3.5DEFAULTTHROUGHINFLATIONDuring the gold standard era, deflation and traditional style government debt defaults were the norm,nowduringthefiatcurrencyera,inflationarydefaultsarethenorm.Governmentliabilitiesare notindexed withinflation,thusa governmentisabletocovertlydefaultontheirdebt by inflating prices. The effect is simply this: money supply goes up; prices go up; liabilities stay the same. For


July1,2010 MONEY,MUD&HYPERINFLATION example,aninflationrateof50%wouldleaveadebtworth50%lessafterayear.Thisisobviously becausethevalueofthemoneyisworth50%less. Onceagain,lookingatReinhart&Rogoff,(2009),theelementsofaninflationarydefault: First, inflation has long been the weapon of choice in sovereign defaults on domestic debt and,wherepossible,oninternationaldebt.Second,governmentscanbeextremelycreative inengineeringdefaults.Third,sovereignshavecoercivepowerovertheirsubjectsthathelps themorchestratedefaultsondomesticdebt"smoothly"thatarenotgenerallypossiblewith internationaldebt.Forth,governmentsengageinmassivemoneyexpansion,inpartbecause theycantherebygainaseignoragetaxonrealmoneybalances(byinflatingdownthevalue of citizen's currency and issuing more to meet demand). But they also want to reduce, or evenwipeout,therealvalueofpublicdebtsoutstanding. Tables 2 and 3, illustrate the dominant role defaults through inflation have played across many economiessince1500.Note,theworstcasessincetheintroductionoffiatcurrencyandinparticular inthepostWWIIera.Alsonote,thatmostoftheworstboutsofhighinflationcamepostWWII. Source:Reinhart&Rogoff,(2009) A comparison of the inflation rates from tables 2 and 3 clearly display much higher inflation rates duringthemodernera. Duringtheyearofanexternaldefaulttheaverageinflationrateishighat33%.However,duringa domesticdefaulttheaveragerateis170%forthatyear.Afterthedefaultandintheyearsfollowing TRACFINANCIALGROUP|4B3.0FINANCIALCRISESANDTHEIRSEQUENCING 14 Table2:"Default"throughInflation15001799

July1,2010 MONEY,MUD&HYPERINFLATION inflation remains above 100%. Defaults and inflation clearly coexist in the majority of cases. (Reinhart&Rogoff,2009) Table3:"Default"throughInflation18002008

Source:Reinhart&Rogoff,(2009) TRACFINANCIALGROUP| 15


4.0INFLATION&CURRENTINFLATIONARYFORCES4.1OVERVIEWIf the governments devalue the currency in order to betray all creditors, you politely call this procedureinflation. GeorgeBernardShaw(LiteratureNobelPrizeWinnerandPoliticalActivist) Weliveinthispeculiarworldwhere3percentinflationisstabilitybutahalfpercentdeclineinthe priceindexisdeflation. PaulVolcker(FormerU.S.FederalReserveChairman) Therearetwotypesofinflation,monetaryinflationandpriceinflation.Theseformsofinflationare stronglylinked.Rapidmonetaryinflationleadstopriceinflation. The traditional Austrian school of thought focuses on monetary inflation, as this is the driver for priceinflation.Thereisasimplepremisebehindthis.Whenmoremoneyisprintedandthemoney supply of an economy is inflated, the value or purchasing power of the money erodes, requiring more of it to purchase goods and services. As fiat money has no intrinsic value, its value is determinedbyitssupply. Ludwig von Mises, the seminal scholar of the Austrian School of Economics, who witnessed the cataclysmicdamagehyperinflationinflictedonGermanyinthe1920s,assertsthat: Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenonthatisaninevitableconsequenceofinflation,thatisthetendencyofallprices andwageratestorise.Theresultofthisdeplorableconfusionisthatthereisnotermleftto signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk aboutsomethingthathasnoname,youcannotfightit.Thosewhopretendtofightinflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their venturesaredoomedtofailurebecausetheydonotattacktherootoftheevil.Theytryto keeppriceslowwhilefirmlycommittedtoapolicyofincreasingthequantityofmoneythat must necessarily make them soar. As long as this terminological confusion is not entirely wipedout,therecannotbeanyquestionofstoppinginflation.

4.2MONETARYPOLICYMonetarypolicyis undertakenbya centralbank toinfluencetheavailability andsupplyofmoney andcredit.Thisisconductedthroughtheutilisationofthreemaintools:Openmarketsoperations; discountrate;andreserverequirements. TheopenmarketoperationsistheFedsprinciplemonetarypolicytoolusedtoinfluencethefederal fundsrate,whichdeterminestherateatwhichbankslendtoeachother.Theseoperationstakethe formofpurchasesandsalesofUSTreasuryandfederalagencydebtsecurities.TheFedwillbuyor sellsecuritiesinordertomaintainthefedfundsrate.(U.S.FederalReserveBoard,2010) TRACFINANCIALGROUP|5B4.0INFLATION&CURRENTINFLATIONARYFORCES 16

July1,2010 MONEY,MUD&HYPERINFLATION Buyingsecuritieshastheeffectofdecreasingtheinterestrateandincreasingbankreserves.Selling securitieshastheeffectofincreasingtheinterestrateanddecreasingbankreserves. Openmarketoperationsareusedtomonetisedebt.Initssimplestformthishappensthroughthe centralbankpurchasinggovernmentdebtwithnewlyprintedmoney.

4.3MONEYSUPPLY&MONETISINGDEBTThe conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning...U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today,itselectronicequivalent),thatallowsittoproduceasmanyU.S.dollarsasitwishesat essentiallynocost.ByincreasingthenumberofU.S.dollarsincirculation,orevenbycredibly threateningtodoso,theU.S.governmentcanalsoreducethevalueofadollarintermsof goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a papermoney system, a determined government can alwaysgeneratehigherspendingandhencepositiveinflation.(BernankeB.S.,2002) QuotedbyBenBernanke,thechairmanoftheFederalReserve. VastquantitiesofmoneyarerequiredtobeprintedinordertofightoffPublicEnemyNumberOne, Deflation,andvastquantitiesofmoneycontinuetobeprinted. Figures 5,6 & 7, illustrate the dramatic monetary inflation in the U.S. and around the world. The mostrecentmeasureofthemonetarybaseintheU.S.,displayedinFigures5and6,showsthatsince theGFCeruptedthemonetarybasehasincreased150%.

TRACFINANCIALGROUP|5B4.0INFLATION&CURRENTINFLATIONARYFORCES 17

July1,2010 MONEY,MUD&HYPERINFLATION Figure5:USMonetaryBase19902010

Figure6:USMonetarybase19182010

And now a look at other developed regions as of August 2009 (they have increased further since then).


July1,2010 MONEY,MUD&HYPERINFLATION Figure7:MonetaryBase&StockMarketUS,Euro,UK&Swiss

Although being old data, Figure 7, displays global stock markets responding to monetary inflation. This representation helps illustrate that inflation, as Ben Bernanke purports, is a policy makers decision.Increasingthemoneysupply,willalwayseventuallytranslateintohigherprices,thusunder afiatmonetarysystempolicymarkersdeterminewhetherinflationistoexistornot. Inordertopreventaninflationinducedboomfromcollapsing,itisneverenoughtokeepcreditand moneystocksatcurrentlevels.Evergreaterdosesofcreditandmoneyareneeded. AsMarcFaber,2009states:"Butprinttheywillalldo,asthemesscentralbankshavecreatedcan only be cured through massive monetary inflation. Also, it should be obvious that the worse the messthatcentralbankershavecreatedwillbecome(notablytheUSFed),themoremoneywillbe printed."


July1,2010 MONEY,MUD&HYPERINFLATION Faber'sassertionhasbeenrecentlyevidencedthroughthe$US1trillionEuropeanCentralBank(ECB) bailoutofproblematicEuroeconomies.Itisimportanttonotethatcentralbanksareselffunded,So wheredoesthemoneycomefrom?Theprintingpress,oritselectronicequivalent,ofcourse. Foreignexchangeratesonlyshowtherelativeperformanceoftwocurrenciesagainsteachother.For insight into the value or purchasing power of a fiat currency we look to the price of gold denominatedinthatcurrency(seeFigure8). Figure8:$USPurchasingpower&Gold,19652010

Aspreviouslydiscussed,monetarysupplyinflationleadstoadevaluationofthecurrency,requiring moreofthedevaluedcurrencytobuyequalunitsofphysicalassets.Thepriceofgolddenominated in a certain currency, best represents the valuation of that currency. Cutting out speculative extremes as outliers, the inflation adjusted value of gold has remained essentially the same throughoutmodernhistory.Onewaytounderstandthisisatanypointintime1ounceofgoldbuys agoodqualitysuit.Thedemandandsupplyequationforgoldremainsrelativelystablecomparedto thedemandandsupplyequationforfiatmoney. Now we have identified the inflationary forces of money creation, we should also consider this coupledwithnegativerealinterestrates.TheUSFederalFundsrate(basetargetrate),iscurrently setat0.00%0.25%.Takingintoaccountinflation,thismeansthattheinterestrateisnegativein realterms.Meaningdepositorsandsaversarelosingmoneyandbeingpenalised.Wewillcomeback tointerestratesandthereasonswhytheycannotbeliftedspecificallyintheUS,undersection5.3 InterestRates.



4.4DEFICITFINANCINGPeterJeffreys,aveteranfundmanagerwhoisnowdirectorofIndependentRiskMonitoring,noted: There has never been a time in history when deficit financing, or quantitative easing, has not been followed by a period of rampant inflation. He warned the situation whereby WesterneconomieswerebeingbailedoutbytheChinesethroughtherecyclingofChinese currencyreservescouldnotlastforever.(Allen,2010) Federal budget deficits are financed by the issuance of government debt, in the form of treasury bonds,billsandnotes.Forthepurposeoflookingattheeffecttothemoneysupply,investorsofthis debtcanbebrokenupintotwodifferentgroups:1)thepublic;and2)thedomesticcentralbank. Whenthepublicbuysthegovernment'sdebt,itbecomesatruedebttothegovernment.Whenthe central bank buys the government's debt, money is printed, the money supply increases and inflationiscreated. The danger is when there is an upward trend for larger proportions of the deficit to be financed throughdebtmonetisation.Figure9,displaysthisprocess. On18March2009,theFederalReserveannouncedplanstopurchase$US300billioninUSTreasury overthenextsixmonths.ThiswasanopenandcleardirectionthattheFedwasmonetisingdebt. Economists in the field have been alerted to further unpublicised debt monetising that has been hidden by utilising currency swap lines with other central banks. Martenson, 2009 states, "The Federal Reserve has effectively been monetising far more U.S. government debt than has openly been revealed, by cleverly enabling foreign central banks to swap their agency debt for Treasury debt". DavidBuckner,awidelyrespectedacademic,expoundedthat,althoughforeigncentralbankswere buyingU.S.Treasurydebt,theFedwasbuyingapproximately50%ofitbackinthesecondarymarket tendayslater.(Buckner,2009) Dornbusch,Sturzenegger,&Wolf,(1990),stipulatethat: An extreme inflation can occur in a country where inflation has been repressed and where deficitfinancehasbuiltupamonetary"overhang".Inthiscase,thereisnotonlytheordinary flow problem in that the money supply is already too high relative to nominal income at TRACFINANCIALGROUP|5B4.0INFLATION&CURRENTINFLATIONARYFORCES 21 Treasury Bonds/Bills Issuedtopublic Figure9:DeficitFinancing BUDGETDEFICIT DebtMonetising FederalReserve BuyingTreasury Bonds

July1,2010 MONEY,MUD&HYPERINFLATION controlledprices.Oncepricesarefreedup,inflationgetsrapidlyunderway.Intheabsenceof strongstabilisingfactors,itcanbecomeextremeveryquickly. TheUnitedStatesisinthispositionrightnow.Representedbytheunprecedentedincreaseinmoney supply,asignificantmonetaryoverhandhasbeenbuiltup.Dornbusch,Sturzenegger,&Wolf,(1990), furtherstate: In counties that have little experience with high inflation... an inflation shock can set the houseonfireinnotime.Becausethefinancialstructureissounadaptedtoinflation,there will typically be an initial phase in which real balances rise rapidly as a result of deficit finance.Later,asescalatinginflationbecomesapparent,theflightfrommoneyintoforeign assetsacceleratesdramatically. FollowingDornbusch,Sturzenegger,&Wolf's,(1990)abovestatement: 1) TheU.S.andotherdevelopedeconomieshaveinmoderntimeshadlittleexperiencewith highinflation; 2) Theglobalfinancialcrisiswasasignificantlylargeshocktothefinancialsystem; 3) Wehaveseenarecoveryintheglobaleconomywhererealbalances,i.e.GDPhaverisen rapidly;and 4) Ithasbeennosecretthatthedevelopedworldhavebeendeficitfinancingthroughdebt monetisation,printingmoneylikemad. ThesefactorsfitDornbusch,Sturzenegger,&Wolf'shighinflationaryscenario. Table4,takenintoconsideration,itisignoranttothinkdevelopingeconomies(i.e.China)havethe resourcestolendatthecurrentratetodevelopedeconomies.Theshortfallfortherequireddeficit financewillcontinuetobemadeupthroughdebtmonetisation. Table4:AdvanceEconomiesPublicDebtLevels(asa%ofGDP) BudgetDeficit GrossDebt Australia Canada France Germany Greece Ireland Italy Japan Portugal Spain UK US 5.0 5.3 8.2 5.7 8.1 12.2 5.2 9.8 8.8 10.4 11.4 11.0Source:IMFFiscalMonitor,May2010

15.5 82.5 77.4 72.5 115.1 64.5 115.8 217.7 77.1 55.2 68.2 83.2



4.5ACOMPARISONTOTHEGREATDEPRESSION&THEFALLACYOFDEFLATIONTwo vastly different monetary systems contribute to a comparison of the GFC and the Great Depression not being possible. The Great Depression occurred during the gold standard monetary systemeraandtheGFCoccurredduringthefiatmonetarysystemera.Thesetwomonetarysystems havevastlydifferentmechanicsanddynamics. DuringhisstudiesoftheGreatDepressionBenBernanke,states: Recent research has provided strong circumstantial evidence for the proposition that sustaineddeflationtheresultofamismanagedinternationalgoldstandardwasamajor causeoftheGreatDepressionofthe1930s.(Bernanke&James,1990) Temin (1989), argues that structural flaws of the gold standard, combined with policy responses dictated "rules of the game", made an international monetary contraction and deflation almost inevitableduringthegreatdepressionera. ResearchbyHamilton(1987,1988),supportsthepropositionsthatcontractionarymonetarypolicies in France and the U.S. initiated the Great Slide of the depression, and that the defence of gold standardparitiesaddedtothedeflationarypressure. Bernanke&James,(1990),state: Thegoldstandardbased explanation oftheDepressionisinmostrespects compelling. The length and depth of the deflation during the late 1920s and early l930s strongly suggest a monetaryorigin,andtheclosecorrespondencebetweendeflationandnations'adherenceto the gold standard shows the power of that system to transmit contractionary monetary shocks. Bernanke & James, (1990), also assert, continuous banking panics under the deflationary gold standardmonetarysystemwasalargecontributortowardstheenduranceoftheGreatDepression. ThefederalresponseintheU.S.totheGFCwastwelvetimesgreaterin2008thantheentireGreat Depressionperiod.(French,2009)EvidencedaboveinFigure5,therehasbeenaninflationinmoney supplyratherthanadeflation,thatoccurredduringtheGreatDepression. Asanexampleoftheinfinitelylargeinflationarypowercentralbankspossessunderafiatmonetary system, the Financial Times newspaper reported the existence of a U.S. Federal Reserve staff memorandumthatmakesthecasefora5%federalfundsrate.Soyougetpaidmoneytoborrow and lose money on your deposits. This concept turns the conventional idea of credit and money upside down. In fact, during the height of the GFC, shortterm U.S. interest rates securities went belowzero. Recent policy actions indicate, deflation is Public Enemy Number One for central banks and governmentsworldwideandtheyhavethepowerandthetoolsinthewarchesttowinagainstit. Thisisfurtherevidencedby,Japaneseauthoritiesrecentlytoyingwiththeideaofoutlawingcashin thecountry.(French,2009)



4.6EXAMPLESOFINFLATIONTODAYFaber,(2009),writesthattheexplosionoftheU.S.currentaccountdeficitbetween1998and2007 (from$US150billionto$US800billion),isusuallydisregarded.Thisfloodingoftheworldwith$US hasledtocurrentaccountsurplusesinemergingeconomiesandtostrongpriceincreasesinthose countries. Faber,(2009),examinestherampantinflationthroughoutAsia,particularlyinproperty.Hestates: Sun Hung Kai Properties Ltd., the worlds largest developer by market value, raised the price of two penthouses in Hong Kong by 50 percent to a record HK$75,000 (US$9,700) a squarefootasdemandsurgesforluxuryapartments.Theunits willbeofferedforHK$300 million(US$39million)each..." DespitethedeflationaryimpactsofarisingAustraliandollar(overseasgoodsarecheaper),inflation hasrecentlybeenrearingitsuglyheadinalargewayinAustralia. BelowisaclippingfromarecentarticleintheAustraliannewspaper: Inflationrisksbuilding:survey AnindicatorofinflationinAustraliarosefortheeighthstraightmonthinJune,supporting theviewthatpricepressuresarebuilding. Italsobolsterstheviewthathigherinterestrateswillbeneededtooffsetthepressures. Inthe12monthstoJune,themonthlyinflationgaugeisup3.6percent,wellabovethe upperlimitoftheReserveBankofAustralia's23percentinflationtargetrange.(Rogow, 2010) Also consider the following specialist quotes from the Reuters News article, Australian inflation aboveforecasts(2010),on28April2010: BrianRedican,SeniorEconomist,Macquarie: It looks like inflation is troughing at a high level and the drivers of inlfation are now accelerating.That'satroublingoutlookfortheRBA...overall,theoutlookforinflationisnot goodandouthunchistheywilltakeanothersteptowardnormalnextweekandhike. StephenWalters,ChiefEconomist,JPMorgan: WhenyouextractthebeneficialimpactimpactofthehighAussiedollar,inflationwas1.5% onthequarter.Clearlythat'saprettyuglyresult.Whenwe'rejuststartingthenexteconomic upswing, to get inflation already high is troubling... certainly when you get the historical inflationprintthishighandadeterioriatingoutlook,itdoessuggestthatinterestratesare toolow." TRACFINANCIALGROUP|5B4.0INFLATION&CURRENTINFLATIONARYFORCES 24

July1,2010 MONEY,MUD&HYPERINFLATION SuLinOng,RBSCapitalMarkets,SeniorEconomist It was a reasonably strong report across the board. If you look at it, inflation is probably runninguncomfortablyhighatthisstageofthebusinesscycle. MichaelBlythe,ChiefEconomist,CBA The number are a tad on the high side. Certainly it will add to that level of discomfort the ReserveBankseemstohaveabouttheinflationoutlookrightatthemoment. Figure10:AFRCommodityPricesIncrease

Figure11:AFRInflationPressures

Figures 10 and 11, are news clippings from the front page of the Australian Financial Review. Inflation is clearly starting to become problematic in Australia. With the recent Australia dollar retreatthiswilladdafurtherupdrafttoinflation. In the U.S. and according to John Fritze, who writes for USA Today, an average family health insurance policy now costs more than some compact cars." The average cost of a family policy offeredbyemployerswas$US13,375thisyear,up5%from2008,theKaiserFamilyFoundationand the Health Research & Educational Trust survey found. By comparison, wages rose 3% over that TRACFINANCIALGROUP|5B4.0INFLATION&CURRENTINFLATIONARYFORCES 25

July1,2010 MONEY,MUD&HYPERINFLATION period, the study said "The trends are crushing millions of businesses and American families", SenateMajorityLeaderHarryReidofNevadasaid. Since1999,healthinsurancepremiumsforfamiliesrose131%,thereportfound,farmorethanthe general rate of inflation, which increased 28% over the same period. Overall, health care in the UnitedStatesisexpectedtocost$2.6trillionthisyear,or17%ofthenation'seconomy. The point is, apart from in Japan, you will be hard stretched to find any macroeconomic deflation casesthroughouttheworld.Consideringthis,itisfascinatingtothinkwhysomanypeoplefearit.



5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT5.1USGOVERNMENTFINANCIALPOSITIONANDFISCALOUTLOOKIn2009,theoverallU.S.federalbudgetdeficitreached9.9%ofGDP,thelargestsince1945(United StatesGovernmentAccountabilityOffice,2010).For2010,thebudgetdeficitisforecasttoincrease to10.6%.WhenlookingattheUSFederalBudget,itdoesnottakeaneconomistoraccountantto determinethattheUnitedStatesgovernmentisfinanciallytroubled. Receipts=$2,165billion Outlays=$3,721billion Receipts for the 2010 year are forecasted to only be 58% of outlays and the budget deficits are forecasttoremainfortheforeseeablefuture. Table5:U.S.2011FederalBudget

Source:OfficeofManagementandBudget,2010

ThebudgetispublishedusingBaselinefiguresthatfollowtheCongressionalBudgetOffices(CBO) baselineestimates. Revisitinginflation,Dornbusch,Sturzenegger,&Wolf,(1990),state: "A major shock to the budget, the terms of trade, or the exchange rate is an essential ingredient for high inflation. An event such as a political disturbance in its most extreme form,waroranabruptinternationalcreditrationingmaytriggertheinflation." Additionally, Krugman, (1979), asserts that currency crises can be the byproduct of government budgetdeficits. Whenacountryhastofinance10%ofitstotalGDPeachyear,veryfewwouldarguethatthisisa shock.

TRACFINANCIALGROUP|6B5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT 27

July1,2010 MONEY,MUD&HYPERINFLATION Table6:U.S.Government'sFinancialPositionSnapshot

Assets=$2,667.9 Liabilities=$(14,123.8) Equity=$(11,455.9)

Source:UnitedStatesGovernmentAccountabilityOffice,2009

The U.S. is entering a period when 1.8 taxpayers will be supporting each retiree, with historically extremebudgetdeficitsandabalancesheetthatreadsnegativeequityofUS$11.45trillion.(United StatesGovernmentAccountabilityOffice,2004).IftheUnitedStatesgovernmentwasacompanyit wouldhavebeenwounduplongagoforbeinghopelesslyinsolvent.However,theinventionofthe printingpressallowsittocontinueon. Withoutscrutiny,thefacevalueU.S.governmentfiguresandforecastsarealarming.However,the International Monetary Fund (IMF) staff present evidence questioning the accuracy of U.S. governmentforecastsandarguablypresentamoreobjectiveview. Celasun&Keim,2010fromtheIMFstate: TheOMB 1 remainssignificantlymoreoptimisticthanIMFstaffontheoverallfuturepathof therecovery.Thepastrecordofbudgetprojectionsshowsastrongtendencyforoptimistic budget forecasts. Past experience with official budget forecasts portrays a record of large deviationsbetweenprojectionsandoutturns...

1

U.S.OfficeofManagementandBudget


July1,2010 MONEY,MUD&HYPERINFLATION Celasun&Keim,(2010),furtherindicatethattheOMB'sbudgetprojectionshaveonlybeenrealistic twicesince1977,andthatwasonlyduetounexpectedeconomicturnarounds.ThisshowstheU.S. federalbudgethasbeengrouselyoptimisticforthemajorityofthelast33years. Figure12,illustratestheOMB'soptimisticbudgetforecasting,withtheredlinesbeingtheforecasts andtheblackbeingreality. Figure12:U.S.Fiscal&EconomicForecastErrors

Source:(Celasun&Keim,2010)

UnitedStatesGovernmentAccountabilityOffice(GAO),(2007),indicatethatsince1997theGAOhas beenstatutorilyrequiredtoauditthe U.S.governmentsannualconsolidated financialstatements. However,sinceengagementbytheU.S.government,theGAOhasremainedunabletoprovidean auditopiniononthefederalgovernment'sconsolidatedfinancialstatements. Ifanauditorcannotprovideanauditopinion,thismeanstheyareunabletoprovideanyassurance towardsthecorrectnessofthematerialtheyareauditing.PubliccompaniesinAustraliaarerequired toobtainanannualauditopinion.Iftheauditorbelievesthereismaterialerrorofmisstatementin thefinancialreportstheywillnotissueanauditopinion. The GAO in Figure 13, maps out both the Federal and Combined Federal, State and Local budget deficit forecast for the future. The Baseline forecasts are from CBO figures and the Alternative forecasts are the GAO figures. The Alternative forecast by the GAO use past and present trends projectedintothefuture. Figure13:FederalandcombinedFederal,State,andLocalSurplusesandDeficits

Baseline

Alternative



5.1.1FiscalChallengesTheGAOstates: Our longterm budget model has consistently shown that current fiscal policy is unsustainableovertimeasthepopulationagesandworkforcegrowthslows.(UnitedStates GovernmentAccountabilityOffice,2007) Many of the longterm challenges highlighted in past updates, including health care cost growthandtheagingpopulation,havealreadybeguntoaffectthefederalbudgetinsome casessoonerthanpreviouslyestimatedandthepressuresonlygrowinthecomingdecades. (UnitedStatesGovernmentAccountabilityOffice,2010) Additionally, all targets that the GAO has previously set for the U.S. Federal government have all expiredunattained(UnitedStatesGovernmentAccountabilityOffice,2007). TheIMFwarnsthatinordertoreducethebudgetdeficitthemajorcontributorwouldhavetocome from revenues, as discretionary spending outside of defence are near historical lows and a significant reduction to mandatory spending programs would be difficult to achieve. The required policy change in order to begin closing the budget deficit would require an adjustment that is significantly larger than anything that has occurred since the end of WWII. If this adjustment was delayedasizabledebtbuildupwouldcontinue.(Celasun&Keim,2010) AccordingtotheU.S.GAO,(2004),"Overthelongerterm,decliningpersonalsavings,coupledwith theoverallagingofthepopulation,presentssignificantchallengestomeetingthecommitmentsto SocialSecurity,Medicare,Medicaid,andothernationalpriorities" TRACFINANCIALGROUP|6B5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT 30 Figure14:PotentialFiscalOutcomes:RevenuesandCompositionofSpending

July1,2010 MONEY,MUD&HYPERINFLATION The most important consideration for Longterm fiscal spending is curbing health care costs, and there are no wellunderstood and easy solutions to this problem. The CBO frequently emphasises that serious reductions to costs could prove elusive and will require constant policy effort, experimentation,andimmensepoliticaldetermination.Afailuretoreducehealthcareentitlements before significant effects are felt from the aging population, will make the required changes even morepoliticallychallenging.(Celasun&Keim,2010) Using forecasted estimates, Figure 14 articulates the potential relationship between government expenditureandrevenue,showingamassivefiscalsqueezeifnodramaticactionistaken.TheGAO states: Assuming revenue remains constant at 20.2 percent of GDPhigher than the historical averageby 2030therewillbelittleroomforallotherspending,whichconsistsofwhat manythinkofasgovernment,includingnationaldefence,homelandsecurity,investmentin highways and mass transit and alternative energy sources. (United States Government AccountabilityOffice,2010) RepresentedinTable7,delayingausterityactionfor10yearswouldincreasethefiscalgapto11.0% of GDP. Thiswould mean a revenue increase of about 61% is required, alternatively a noninterest spendingcutofabout40%,orsomecombinationofthetwowouldberequiredtobringdebtbackto todayslevelby2084. Table7:FederalFiscalGapunderGAO'sAssumptions20102084

One thing is clear, the longer action is delayed in dealing with the medium to longterm fiscal outlook, the more disruptive and destabilising the eventual fiscal changes will be. (United States GovernmentAccountabilityOffice,2010) These fiscal changes eluded to by the GAO, can only come in the form of cutting government expenditure,equatingtoadefaultonpubliccommitments.Thistiesbacktotheinflationaryscenario aspolicymakerscanchoosenottodirectlydefault,butratherindirectlydefaultthroughthepopulist inflation route. More money in the system, means there is more money to pay for current commitmentsatpresentvalue.



5.1.2FiscalTighteningIncreasingtaxesorcuttinggovernmentexpenditurewouldlikelyspiraltheUnitedStateseconomy backintorecession.PleaseconsiderFigure15,showingthepercentageofdomesticconsumption contributingtooverallnationalGDP.Withconsumptionsohigh,generaltaxincreasesand expenditurecutswillwreakhavocontheconsumptiondependenteconomy.(Faber,2010) Figure15:USConsumptionShareofGDP

Source:GerardMinack,MorganStanley

ThomasPikettyandEmmanuelSaez,leadingeconomistsinthefieldofIncomeDistribution,recently releasedareportshowingtwothirdsofallU.S.incomegainsfrom2002to2007flowedtothetop 1%ofUShouseholds,givingthetop1%alargershareofincomeattheendof2007thanatanytime since1928(seeFigure16).Duringtheperiod,theaverageinflationadjustedincomeofthetop1%of householdssoaredby62%comparedtoagainofjust4%forthebottom90%ofhouseholds.(Feller &Stone,2009) AccordingtoHobson,extremewealthdisparityleadstotheparadoxicalsituationwherethoseatthe lowendoftheincomescalewouldbegladtoconsumebutarenotabletodoso,whilethoseatthe highendhavetheabilitytoconsumebutnotthedesire.(Faber,2010)


July1,2010 MONEY,MUD&HYPERINFLATION Figure16:U.S.IncomeShareofTop1%ofHouseholds

FurtherincreasesinGDPthroughconsumptionwillbeunlikely,considering: 1) U.S.domesticconsumptionisthelargestcontributortoGPDatover70%; 2) Consumptioniscurrentlyatthehighestlevelinrecordedhistory;and 3) Thewealthdisparitypicturehasthewealthiest1%holdingthemajorityofwealth. Additionally, general tax increases will greatly impact upon consumption and consequently the economy. The U.S. administration could potentially look to increase taxes on the rich, and this may help slightly.However,evidencealsosuggeststhattherichtendtomovetolowertaxjurisdictionswhen thishappens.(Faber,2010) So,withgovernmentexpendituresunlikelytobecutandwithmodesttaxrevenueincreases,further massive fiscal deficits accompanied by additional debt monetisation of the government's debt will betheorderoftheday.



5.1.3AgingPopulationTheagingpopulationtrendpresentssignificantfiscalchallengesfortheU.S.governmentatthemost economicallyinopportunetime.Thefiscalforcesofanagingpopulationaredramatic,astheyplace pressureonrevenueandinflateexpenditure. Theexpensesareinflatedthrough:healthcare,socialsecurityandpensionentitlements,andother necessary services for the elderly. Revenue is pressured from the decreasing relative size of the overall labour force. Approximately, 3.3 people currently pay into Social Security for every person receivingbenefits.By2030,thisratioisprojectedtodeclineto2.2;andby2080theratioisexpected tofallto1.8.(UnitedStatesGovernmentAccountabilityOffice,2004) TheUnitedStatesGovernmentAccountabilityOffice,2007asserts: The burgeoning federal deficitespecially in federal retirement programs such as Social SecurityandMedicareanddecliningcoverageofemployerprovidedpensionplanssuggest ashiftinresponsibilitytoindividualworkersforensuringanadequateandsecureretirement. Given current benefit and revenue streams, the federal retirement programs are unsustainableoverthelongrun,andthefederalgovernmentisgoingtohavetomakesome hardchoicesinreformingthem. Thedeclinemeansthatworkersapproachingretirementwillhavetomakeupthedifference inincomefromanothersource,mostlikelyfrompersonalsavingorextendingworklife. So,consideringtheUSFederalgovernment'sfiscalpositionandtheGAO'sfindings,theredoesnot appear to be any certainties with government assistance for baby boomers entering retirement. Further, the GAO warns that workers approaching retirement should provision for their own retirement and may need to stay in the workforce for longer than the typical age of 62. (United StatesGovernmentAccountabilityOffice,2007) Figure17,illustratestherunupinhouseholddebtdepletionofsavingsoftheU.S.public.Thebaby boomershavenotbeenprovisioningwellforretirement. Figure17:PersonalSavingRate,19822006

Source:(Faber,GloomBoom&DoomReport,2009)



5.1.4FedBalanceSheetThe Federal Reserve's balance sheet since the GFC has mushroomed. This represents continuing debtmonetisation,withtheFednowthelargestholderofU.S.Treasurydebt.DrRobertEisenbeis, Former Vice President of the Federal Reserve Bank of Atlanta, has highlighted a problem where a 0.7%interestraterisewouldwipeouttheremaining$55billionintheFederalReserve'sequity(see Table8). If the Fed was to further increase its Treasury bond holdings to what it is currently mandatorily permittedto,itwouldonlyrequirea0.4%rateincreasetowipeouttheequityinitsbalancesheet. ThismayservetoparalysetheFedinraisinginterestratestocombatinflation,asitsimplycannot afford to. The significance of this problem has been addressed and argued by U.S. congressmen, MarkKirk. Table8:FederalReserveBalanceSheet

Source:(TheFederalReserveBanks,2009)



5.2GOVERNMENTDEBTTheU.S.grossfederaldebtinMaysurpassed$US13trillion(87.6%ofGDP),withtheIMFexpecting gross debt to reach 100% of GDP in 2012. (Reynolds & Goodman, 2010) The trajectory of the increaseisdisplayedinFigure18. Figure18:TheNationalDebtasaPercentofGDP

Source:zFacts.com

Federalbudgetdeficits,asdescribedinsectionsabove,areeithermonetisedortheyareconverted intopubliclyhelddebt.However,Figure19indicatesthatthechangeinannualfederaldebtinthe U.S.isgenerallymuchlargerthanthefederalbudgetdeficit. Itemsthathavenotbeenbudgetedforareresponsibleforthis.Majoroffbudgetitemsincludewars ontheexpensesideandasocialsecurityfundingsurplusesontherevenueside.Thatiscorrectwars are not budgeted for, and as indicated in Figure 19 account for the majority of the additional increaseindebtoverthedeficitfinancing.


July1,2010 MONEY,MUD&HYPERINFLATION Figure19:TradeDeficitsvsFederalDebtIncreases($Billions)

Source:(ExecutiveOfficeofthePresendentoftheUnitedState,2009)

Figure20:U.S.DebtHeldbythePublic

Source:(Celasun&Keim,2010) TheIMFstaffdisplaytheOMB'soptimisticforecastingwithpubliclyheldU.S.debtinFigure20.1993 and1997arethetwooccasionssince1977wheretheirforecastsprovedtobepessimistic.Note,this isdebtheldbythepublicandnotgrossdebt. The IMF's economic projections indicate publicly held debt will reach 105% of GDP by 2020. This projection results from revenues forecasted to be slightly lower than projected by the OMB and expendituresignificantlyhigher,reflectingthehighercostsofdebtservicing.(Celasun&Keim,2010) ByutilisingstatisticalmodellingtheIMFhasplacedan80%probabilitythatdebtintheU.S.willbe higherthanthisAdministrationsprojectionof77%ofGDP.Theyfurther,givea20%probabilitythat debtwillexceedtheirprojectionof105%ofGDPby2020.(Celasun&Keim,2010) TRACFINANCIALGROUP|6B5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT 37

July1,2010 MONEY,MUD&HYPERINFLATION Figure21:U.S.GovernmentDebtHeldbythePublic

Source:(UnitedStatesGovernmentAccountabilityOffice,2009)

The GAO states, "absent policy changes the federal government faces an unsustainable growth in debt". Figure 21 and Figure 22, display the GAO's view on the trajectory of U.S. public debt. Figure 22, showsacomparisonoftheGAO'smodelcomparedwiththeCBO's. Figure22:DebtHeldbythePublicunderTwoPolicySimulations

TheAlternativesimulationis basedonhistoricaltrendsand policypreferences.

BaselineExtendedfollowsthe CongressionalBudgetOffices(CBO) January2010baselineestimates.



July1,2010 MONEY,MUD&HYPERINFLATION Faber,2009,states: Aneverincreasingquantityofgovernmentdebtwillhavetobeissuedjusttopaytheinterest on the existing government debt... within the next five years the US government will essentiallyberunningaPonzischeme,whichinevitablyleadstoafurtherdepreciationofa currencyspurchasingpowerandwilleventuallyleadtoacompletecollapseofthesystem. In a later report, Faber goes on to assert, that applying the U.S. Generally Accepted Accounting Principles(GAAP)totheU.S.government'sfinancialpositionshowsastarkerdebtpicture.TheU.S. government debt under GAAP is approximately 600%, dwarfing the 87.6% of gross Treasury debt. (Faber,2010) Reinhart & Rogoff, 2009 display in Figure 23, that when government debt increases, GDP growth slowsandinflationaccelerates. Reinhart&Rogoff,2009state: Weexaminetheexperienceoffortyfourcountriesspanninguptotwocenturiesofdataon central government debt, inflation and growth. Our main finding is that across both advancedcountriesandemergingmarkets,highdebt/GDPlevels(90percentandabove)are associated with notably lower growth outcomes...Seldom do countries simply grow their wayoutofdeepdebtburdens Figure23:U.S.GovernmentDebt,Growth,andInflation,17902009

Source:(Reinhart&Rogoff,2009)



5.2.1UnfundedLiabilitiesIf one was to consider future legislated mandatory commitments by the U.S. government to payments for health care and social security programs a liability, then the U.S. government debt picturedeterioratesfurther. James Quinn, who has identified himself as a senior director of strategic planning at a major U.S. university recently wrote a report on the so called unfunded liabilities in the U.S. Using forecasts fromtheGAOhebroughtthecommitmentsto2080backtopresentdayvalue.Figure24,showsthe unfundedliabilitiestobe$106.8trillionin2009. Figure24:U.S.UnfundedLiabilities

Source:2009SocialSecurityandMedicareTrusteesReports,JamesQuinn.

Unfundedliabilitiesarebeingdiscussedbecausetheyhavereceivedasignificantamountofmedia attention.Inmyview,theyarenotaliabilityaslegislationcanbechangedandthegovernmentdoes not pay interest on these future commitments. Rather, they are a budget item and as Figure 25 displays,theycontributedtothevastmajorityofbudgetoutlays. Figure25:Budgetforecastedreceipts&Outlays




5.2.2OffBalanceSheetLiabilitiesIn2008,thetwolargestmortgageprovidersintheU.S.,FannieMaeandFreddieMac,wereplaced into conservatorship. These companies were two of twelve Government Sponsored Enterprises (GSEs),toeventuallybeplacedintoconservatorship.ConservatorshipissimilartoNationalisationin thatthegovernmenttakescontrolofthecompany,howeverimpliesamoretemporarynaturetothe takeover. FannieMaeandFreddieMacownorguarantee53%ofthecountry's$US10.7trillioninresidential mortgages,equatingtoapproximately$US5.7trillion,accordingtoaJune10FederalReservereport (Woellert,2010).AccordingtoBarr,(2008),atthetimeofconservatorshipFannieMaeandFreddie Macownedorguaranteedjustover$US5trillioninhomeloans.FannieandFreddiehavealsosold $US1.4 trillion in mortgagebacked securities to the Fed during September 2008 (Woellert, 2010). Thisindicates$US2.1trillionofmortgageshavebeenoriginatedsinceSeptember2008topresent. Furthermore, in 2009, the two companies bought or guaranteed three quarters of all U.S. home loans.TheU.S.governmenthasbecomethelargestmortgagelenderinthecountryandexposedto animpairmentinmortgageassets(Shenn,2009).Thiscontinuousmortgageissuanceandrefinance, thatinsomecasesisforanamountgreaterthanthevalueofthehouses(Woellert,2010),exposes theU.S.governmenttoafurtherescalatingdebtburden,andultimatelyinterestrateriskonitsown debt. To date, the U.S. government has pumped $US145 billion into the two companies to keep them afloat.InAugust2009,theCBO2 calculatedthat$US389billionwouldberequiredinsupportuntil 2019. BarclaysCapitalInc.analystplacedthecosttothegovernmentashighas$US500billion,withEgan saying"Onetrilliondollarsisareasonableworstcasescenarioforthecompanies".Egan'sfirmhasa strongreputationforwarningclientsofimpendingfinancialcrises(Woellert,2010).EdwardPintoa formerchiefcreditofficeratFannieMaesaid"Itisthemotherofallbailouts". Phyllis Caldwell, chief of the Treasury's Homeownership Preservation Office, states the cost of supporting Fannie Mae and Freddie Mac "needs to be evaluated against the cost of not having a mortgage market". Meaning, if they are not supported by the government there will not be a mortgagemarketintheU.S. Beforeconservatorship,FannieMaeandFreddieMacreliedheavilyontheirabilitytoborrowmoney atlowratesofinterest.Nowconsequently,theyrelyontheabilityoftheU.S.governmenttoborrow atlowratesofinterest.

5.23ForeignOwnershipSincetheintroductionoftheBrettonWoodsagreementin1944,the$UShasbeenconsideredthe globalreservecurrency(Pento,2010).Asagreatdealofforeigntradeisconductedin$US,exporting economies have accumulated large $US investments or reserves. These investments have predominantly been made into U.S. Treasury debt securities, as they have been considered the safestasset. CongressionalBudgetOffice

2


July1,2010 MONEY,MUD&HYPERINFLATION Demand may be adversely affected for U.S. debt with a devaluation of: 1) U.S. Treasury debt securities; or 2) the $US. The Bank of International Settlements stated, "'Foreign investors in U.S. dollarassetshaveseenbiglossesmeasuredindollars,andstillbiggeronesmeasuredintheirown currency...asuddenrushfortheexitscannotberuledoutcompletely."(ThompsonFinancialNews, 2008) InSeptember2009,China,IndiaandRussiasaidtheywereinterestedinbuyingIMFgoldtodiversify theirdollardenominatedsecurities.On3November2009Indiapurchased200tonnesfromtheIMF, beingapproximately50%ofthe403tonnestheIMFhadforsale.(Gupta&Lesley,2009)Chinahas beensellingdownitsU.S.TreasurysecuritiessinceOctober2009from$US938.3billionto$US895.2 billioninMarch2010.(U.S.Treasury,2010) Considerthefollowingnewsarticlequotes: TheCrashof2013TheDailyCaller "TheChinesehavebeenbigbuyersofTreasuriesbutarenolongerrunningsurpluses,"said SocieteGeneraleeconomistAnetaMarkowska."Theyjustdon'thavethemarginaldollarsto recyclebackintotheTreasurymarket."IfChinaslowsorstopsbuying,itishardtovisualise what the U.S. Treasury could do to promote bond sales that are so essential to pay the interestonthegrowingnationaldebt.(Nagle,2010) ForeignerscutTreasurystakes;ratescouldriseAPBusiness The Treasury Department said foreign holdings of U.S. Treasury bills fell by a record $53 billioninDecember2009.Thattoppedthepreviousrecorddropof$44.5billioninApril2009. TheTreasuryreportshowedthatChinareduceditsholdingsofTreasurysecuritiesby$34.2 billioninDecember2009. "The Chinese are worried that we have unsustainable debt levels, and we do not have a policyfordealingwithit,"Meltzersaid. He said the Chinese worry that confidence in the US government's ability to repay its debt could erode. That would cause the value of Treasuries and the dollar to fall and lead to lossesonBeijing'sUSdebtholdings.(Crutsinger&Condon,2010) Foreign investors holding this U.S. debt also hold the currency risk associated with holding $US denominatedassets.AstheU.S.Treasurydebtissolarge,adryingupindemandforthisassetclass willadverselyaffectthe$US.Thispotentiallyleadstoaviciouscyclethatfeedsonitself. Ifthe$USwastofall,foreigninvestorsinU.S.Treasurieslosevalueintheirinvestment.Shouldthe $US continue to fall and the value of foreign assets continue to decline, then demand from foreignerswilllikelydiminishorevenreverse,astheseinvestorsareholdingassetsthatcontinueto decline in value. The lack of demand for U.S. Treasury debt and other U.S. assets results in less demand for $US, plus requires the Fed to print more money to finance the budget deficit. If this processbuildsmomentumandbeginsfeedingonitself,theresultisthedangerousdownwardspiral thateventuallyequatesinanalloutcollapseinthecurrency.


July1,2010 MONEY,MUD&HYPERINFLATION Figure26:ForeignAssetsintheU.S.:NetCapitalInflow

Negative!

AsseeninFigure26,althoughhavingrecentlyrebounded,therehasbeenasignificantandrapidfall in demand for U.S. assets. There have been record drops in foreign held U.S. Treasury securities, withChinasellingdownitsholdingssinceOctober2009.(U.S.DepartmentoftheTreasury,2010) This comes at a time when record levels of U.S. Treasury debt are being issued. This trend is dangerousandwillonlybringfurtherdebtmonetising.



5.3INTERESTRATES5.3.1OverviewFigure27:U.S.FederalFundsRate,19842010

Source:Yardeni.com

If the United States was an emerging market, since the GFC began, its exchange rate would have plummeted, interest rates soared and access to capital markets would have been suddenly lost. However, during 2007, the first year of the crisis, exactly the opposite happened. The U.S. dollar appreciatedandinterestratesfellasglobalinvestorsviewedtheU.S.ashavinglessrelativeriskthan other countries. Due to this safe haven perception global investors turned to U.S. Treasury securities,buyingthemwithanunquenchablethirst."Butbuyerbeware!Overthelongrun,theU.S. exchangerateandinterestratescouldwellreverttoform,especiallyifpoliciesarenotmadetore establishafirmbaseforlongtermfiscalsustainability."(Reinhart&Rogoff,2009) As illustrated in above sections, the problem is the United States: government; public; banks; corporations;andcentralbankcannotaffordhigherinterestrates. The U.S. federal funds rate was set at between 0.00% and 0.25%, despite this interest rate being negativeinrealterms(inflationadjusted),thisalonewasnotandstillisnotenoughtopickupthe economyandprovidetherequiredliquiditytothefinancialmarkets.

5.3.2RatingsAgenciesMoody's, the ratings agency states it will downgrade US debt when interest costs reach 18% of revenue(taxreceipts).(Nagle,2010) Thispresentsaninterestingsituationwhere,ifinflationpickedupandtheFederalReservewanted tofighttheinflationbyraisinginterestrates,itcouldpotentiallyresultinU.S.governmentinterest costsreaching18%ofrevenueandthereforehavingitsdebtdowngraded.Thiswouldhavetheeffect ofinterestratesrisingandthe$USfalling,asinvestorsbecomeconcernedaboutTreasurydebt. TRACFINANCIALGROUP|6B5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT 44

July1,2010 MONEY,MUD&HYPERINFLATION The United States government are clearly not happy with the level of power the rating agencies have.Considerthefollowheadlines: 04/02/2010UScreditratingatrisk,Moody'swarns(Telegraph) 15/03/2010Moody'sSaysUSDebtcouldtesttripleArating(TheNewYorkTimes) 13/05/2010RatingagenciesfacenewUSregulation(BBC) 13/05/2010USSenatevotestoboostcreditagencyregulation(Reuters) 17/05/2010CreditRatingCompaniesmaybeendangeredspecies(Bloomberg) 17/05/2010Thecrashof2013(TheDailyCaller)

ThereisanevidentwargoingonbetweentheU.S.governmentandtheratingagencies.Considerthe followingnewsclippings: UScreditratingatrisk,Moody'swarnsTelegraph Moody's says "Economic growth is very important to our assessment (of the sovereign rating),"StevenHess,Moody'sseniorcreditofficerinitssovereignriskdivision,toldReuters. "TheimplicationswouldnotbegoodiftheUSwereinforanaemicgrowthforsometimeto comebecausethegovernmentcouldhaveproblemsforrevenuegrowth."MrHesssaid. "We think that either economic growth has to be much more vigorous than the administrationisassumingsothatrevenueswouldbehigherortheyneedtodosomething furthertoincreaserevenuesorcutexpenditures,"MrHessContinued. Moody'ssaysU.S.debtcouldtestTripleArating "Growth alone will not resolve an increasingly complicated debt equation.' Moody's said. "Preserving debt affordability" the ratio interest payments to government revenue "at levels consistent with Aaa ratings will invariably require fiscal adjustments of a magnitude that,insomecases,willtestsocialcohesion." The administration of President Obama estimates that the United States deficit will rise to 10.6percentofGDPinthecurrentfiscalyear,thehighestsince1946. Thecrashof2013TheDailyCaller Moody'smanagingdirectorPierreCailleteausaid18%istheouterlimitofAAArating. Consideringtheselessthanoptimumconditions,Moody'snowestimatesthedebtservicewill hit22.4%ofrevenuein2013,signallytheUSdebtratingmightfallinthenextthreeyears. The bottom line is this, if the ratings agencies are still in existence, they will downgrade United StatesgovernmentdebtoncetheU.S.interestexpensereaches18%ofgovernmentrevenues.



5.3.3RisingEffect

Public BorrowingCostsIncrease DisposableIncomeDecreases

Business BorrowingCostsIncrease ProfitsDecrease

Banks AssetsImpaired ProfitsDecrease InterestRatesRise

Government BorrowingCostsIncrease BailoutCostsIncrease AssetsImpaired GSEAssetsImpaired SocialSecurityPaymentsIncrease TaxrevenuesDecrease

TheFederalReserve AssetsImpaired EquityonBalanceDestroyed


July1,2010 MONEY,MUD&HYPERINFLATION An increase in interest rates has a direct effect on the entire economy, plus has a follow through indirecteffect.TheU.S.governmentisnowparticularlyvulnerableconsidering: 1) 2) 3) 4) 5) Itshistoricallyhighdebtlevels; Itshistoricallyhighbudgetdeficit; Itsmulti$UStrillionholdingsinGSEsandotherconvertedprivatesectorassets; Thefiscalchallengesoftheagingpopulationandapotentialshrinkingoftheworkforce;and Potentialdowngradeingovernmentdebt.

WiththeMoody'sdebtdowngradeat18%ofgovernmentreceiptsinfocus,weconductedasimple interest rate stress test on the budget. Table 9, displays the outlays section of the U.S. federal budgetwiththeinterestexpenseforecasted. ItisworthnotingthatinTable9,theinterestrateisforecastedbythefederalgovernmenttoremain below5%forthenexttenyears.Thatisonly3%abovewhattheyarepayingnowwiththetarget rateat0%0.25%.Theyobviouslyexpectinterestratestoremainlowforalongtime. Table9:U.S.BudgetInterestExpense

Source:OfficeofManagementandBudget,2010


July1,2010 MONEY,MUD&HYPERINFLATION Table10:InterestStressTest2009 Receipts Debt held by public Net Int erest I nt er est R at e %of Receipt s 2,105 7,545 187 2 .4 8 % 8.88% 2 0 10 2,165 9,298 188 2 .0 2 % 8.68% 2 0 11 2,567 1 0,498 250 2 .3 8 % 9.74% 2 0 12 2,926 1 1,472 340 2 .9 6 % 11.62% 2 0 13 3,188 12,326 434 3 . 52 % 1 3.61% 2 0 14 3,455 13,139 516 3 .9 3 % 14.93% 2 0 15 3,634 1 3,988 586 4 . 19 % 16.13% 2 0 16 3,887 14,833 652 4 .4 0 % 16.77% 2 0 17 4,094 15,686 716 4 . 56 % 1 7.49% 2 0 18 4,299 16,535 779 4 . 71% 18.12% 2 0 19 4,507 17,502 844 4 .8 2 % 18.73% 2020 4,710 1 8,573 912 4 . 9 1% 19.36%

ST R ESS T EST 3 .0 0 % %of Receipt s 3 . 50 % %of Receipt s 4 .0 0 % %of Receipt s 4 . 50 % %of Receipt s 5. 0 0 % %of Receipt s 5. 50 % %of Receipt s 6 .0 0 % %of Receipt s 6 . 50 % %of Receipt s 7. 0 0 % %of Receipt s 226 10 . 9 7% 264 12 .9 3 % 302 14 .9 3 % 340 16 .9 8 % 377 19 . 0 7% 415 2 1.2 0 % 453 2 3 .3 8 % 490 2 5.6 0 % 528 2 7.8 8 % 280 13 .2 0 % 328 15. 6 2 % 377 18 .12 % 425 2 0 .6 8 % 474 2 3 .3 1% 524 2 6 .0 2 % 574 2 8 .8 1% 624 3 1.6 8 % 675 3 4 .6 3 % 319 12 . 6 8 % 375 15. 0 6 % 432 17. 53 % 490 2 0 .0 9 % 549 2 2 . 74 % 608 2 5. 4 8 % 669 2 8 .3 3 % 730 3 1. 2 7% 793 3 4 .3 2 % 350 11. 9 7% 413 14 . 2 7% 478 16 . 6 8 % 545 19 . 19 % 612 2 1. 8 0 % 682 2 4 . 52 % 753 2 7. 3 6 % 825 3 0 .3 2 % 899 3 3 .4 0 % 376 11.8 0 % 446 13 .9 9 % 51 8 16 . 4 1% 592 18 .9 6 % 669 2 1.6 2 % 747 2 4 .4 2 % 829 2 7. 3 6 % 91 2 3 0 .4 3 % 998 3 3 .6 6 % 399 11.54 % 475 13 .74 % 554 16 .0 3 % 636 18 .59 % 721 2 1.3 0 % 809 2 4 . 15% 901 2 7.16 % 996 3 0 .3 4 % 1,094 3 3 .6 9 % 421 11. 58 % 503 13 . 8 4 % 589 16 . 2 2 % 680 18 . 8 9 % 774 2 1. 73 % 872 2 4 . 74 % 975 2 7. 9 5% 1,082 3 1. 3 5% 1,194 3 4 .9 6 % 441 11. 3 5% 530 13 . 6 3 % 623 16 . 0 3 % 722 18 . 57% 825 2 1. 4 5% 934 2 4 . 53 % 1,049 2 7. 8 2 % 1,1 69 3 1. 3 4 % 1,296 3 5. 0 9 % 460 11.2 4 % 555 13 . 57% 656 16 .0 3 % 763 18 .6 4 % 877 2 1.6 3 % 997 2 4 . 8 5% 1,124 2 8 . 3 1% 1,259 3 2 .0 2 % 1,401 3 6 . 0 1% 478 11.12 % 579 13 .4 8 % 688 16 .0 0 % 804 18 .6 9 % 927 2 1.57% 1 ,059 2 4 .8 8 % 1,200 2 8 .4 7% 1,349 3 2 .3 5% 1 ,508 3 6 .54 % 498 11. 0 5% 606 13 . 4 5% 723 16 . 0 4 % 848 18 . 8 2 % 983 2 1. 8 1% 1,128 2 5. 2 7% 1,283 2 9 .0 4 % 1,449 3 3 . 14 % 1,627 3 7. 6 0 % 520 11. 0 4 % 635 13 . 4 9 % 761 16 . 15% 897 19 . 0 4 % 1,043 2 2 . 15% 1,202 2 5. 78 % 1,373 2 9 . 75% 1,558 3 4 . 10 % 1,757 3 8 . 8 5%

Source:TRACFinancialGroup

18%=DebtDowngrade =InterestRateleveldebtdowngradeoccurs Table10,assumesa2%reductioninreceiptsforevery1%interestrateincreaseoverthebudgeted interestrate.Considering,theextremeleverageoftheentireeconomy,webelievethistobevery modest. The real effect on receipts may well be a multiple of this. Additionally, the stress test includesaflowthroughofdebtatthesameinterestratefromtheprioryears. Using the U.S. administrations historically proven overly optimistic budget figures, the stress test clearlydisplaysthatthegovernmenthaslittleroomtomanoeuvrewithinterestrates,withoutbeing downgradedbytheratingagencies.WiththeIMFallocatingan80%chancethattheadministrations figuresareoverlyoptimistic,thatpresentsasituationwhereinterestratesintheUSsimplyhaveto remainlowtoavoidacrisiseruptingatanysignofpoordemandforTreasurydebt. ThismeanstheFedmustcontinuetobuyTreasurydebttokeepinterestrateslow,andatanysignof demand drying up for U.S. debt they must buy more. This is where the debt monetisation and inflationpicturesgetscompletelyoutofcontrol. There is no choice but for the Federal Reserve to continue to finance the budget deficit and monetise debt. The Fed is paralysed in their ability to fight any outbreak of inflation. Their only choice,whichtheydon'tseemtoounhappyabout,istocontinuetoinflatetheirwayoutofthedebt problem. In their open market operations the Fed normally only manipulates the shortdated Treasury securities.Therearenowsignstheyaretakingcontroloverthewholeyieldcurve.Meaningtheyare TRACFINANCIALGROUP|6B5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT 48

July1,2010 MONEY,MUD&HYPERINFLATION manipulating short, medium and longterm interest rates. The pegging or manipulation of interest rateslikethis,isaninflationarypolicywithaninevitableenduringlegacy. MarcFaberstates: The chances of the US government implementing tight monetary policies in the next few yearsareexactlyzero. Onceagovernmentembarksonhighlyexpansionaryfiscalpolicieswhichentailgovernment expenditures vastly exceeding revenues (leading to enormous budget deficits and soaring governmentdebt)andsimultaneousmonetisation(printingmoney),thereversalofthese inflationary policies becomes for all practical purposes impossible. Inflation and higher interestratesfollow. Anyupwardpressureoninterestratesbroughtaboutbythemarketparticipantswillactually forceacentralbankthatembarkedonmonetisationtomonetiseevenmore.(Faber,2010)

5.4TPOPULISTWAYOUTLet me emphasise at this juncture that the decision to inflate or deflate is a political one. Let's considerBenBernanke'swordsagain: The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning...U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today,itselectronicequivalent),thatallowsittoproduceasmanyU.S.dollarsasitwishesat essentiallynocost.ByincreasingthenumberofU.S.dollarsincirculation,orevenbycredibly threateningtodoso,theU.S.governmentcanalsoreducethevalueofadollarintermsof goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a papermoney system, a determined government can alwaysgeneratehigherspendingandhencepositiveinflation.(BernankeB.S.,2002) So,howwilltheUnitedStatesgetoutofthisdebttrap?Therearetwoways: 1) Directlydefaultonitscommitments;and 2) Inflateawaytherelativesizeofthedebts. Directdefaultinvolves,directlydefaultingonmunicipal,stateandfederalgovernmentdebts,and/or throughmuchsmallerentitlementpaymentstothepublic. Mises L., (2007), wrote: "The favour of the masses and of the writers and politicians eager for applause goes to inflation." Faced with the massive economic pain and unemployment of the millions,theU.S.havebegunandwilllikelycontinuedownthepopulistpathofinflatingawaythe debtwithmassivedebtmonetisation. Importantly,Fischer,Sahay,&Vegh,(2002),state: Those who argue that it might be wise to wait for hyperinflation before stabilising areor should bemaking a political and not an economic argument. The point is not that relative prices are more likely to be right when the inflation rate is high but that politicians are unlikely to move until the public is fully persuaded that the costs of inflation outweigh the costsofstabilising. TRACFINANCIALGROUP|6B5.0CURRENTPOSITION&LIMITEDABILITYTOFIGHT 49

July1,2010 MONEY,MUD&HYPERINFLATION AnotherveryimportantissueweneedtoconsideristhefactthattheU.S.holdtheglobalreserve currency. What this means is, essentially all U.S government debt i

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