What Will It Be?


The current economic crisis can be characterized like many previous episodes: too many debt obligations and not enough monetary instruments to cover them. The current situation is fairly typical, in that there has been approximately three dollars in debt created for every dollar currently in existence. So what comes next? The Great Depression, the Weimar Inflation, complete collapse? These are a few scenarios of how things will play out over the coming months and years. We will explore these as well as the government’s likely response mechanisms.

The first, of course is the much discussed “hyperinflationary blowoff”. This scenario cures the problem by increasing both the money supply and by reaction, its velocity. In this case the government responds with stimulation, bailouts, borrowing, spending and regulation. Monetary authorities increase the money supply to fill the need for funds. All manner of spending and borrowing is encouraged. Typically quoted for this model is the German Weimar Republic which experienced hyperinflation during the 1920s. In order to meet the reparations requirements set forth in the Treaty of Versailles, the Weimar Republic printed an enormous quantity of money. It was in this environment that “wheelbarrow full of money to buy a loaf of bread” stories were born. This caused a dramatic increase in velocity as people spent money as fast as they received it. This crisis of confidence, once established, causes purchasing power to drop so precipitously that holding money becomes undesirable. Rising prices cause people to spend money as quickly as they get it.

During a hyperinflation, bank runs, alternate currencies, gold and silver or barter become the new standard. This is known as “capital flight”. People choose to store their capital in anything but the depreciating currency. Governments typically respond with capital, wage and price controls, as simply raising interest rates is insufficient. The crisis of confidence will not end until people are convinced to return their deposits to the banks. The well-known German hyperinflation occurred rather quickly between 1919 -1923. By early October 1923, prices were doubling every day. This episode finally ended abruptly when a “new” currency was introduced, wiping out the savings of all holders of the old monetary units. Recent similarities also exist in the current Zimbabwe experience.

The other extreme is the deflationary depression. It starts in the same place, three dollars in debt for every dollar in circulation. However, in this environment there is an acute shortage of money. Government responds with cutbacks. Taxes do not get paid and revenues plummet. Monetary authorities contract the money supply. Loans are called in, new ones are not made. Here is the Great (Deflation) Depression redux. Deflation is a sustained reduction in the velocity of money generally accompanied by a contraction of the money supply. In order to pay the bills, assets are sold at ever decreasing fire sale prices. The dollar gains in value as it takes fewer dollars to buy everything. Saving money, avoiding debt and curbed spending become the models to live by. Prices spiral down on all items. Everything will be cheaper tomorrow. Productive activity grinds to a halt, along with conspicuous consumption. Falling prices encourage people to save every dollar and delay expenditure.

During a deflationary depression bankruptcy, unemployment, foreclosure become the norm. Dollars become dear, return on assets go negative, consumers will hoard currency. Deflation is generally regarded as the opposite of hyperinflation. Currency holders and lenders demand serious premiums to release money. As general lending terms have grown in length, the pain associated with deflation has grown accordingly. Since deflation discourages spending, and the expectation is that future prices will be lower, it becomes prudent to withhold spending.

Deflation is a natural occurrence when growth in the money supply is not maintained at a rate equal to population growth, sphere of influence, and productivity increases. When this happens, the available amount of money per person or transaction falls, making money more valuable. That can actually cause defaults and discourage the ownership of assets like homes, land, and equities. It also amplifies payments on previously incurred debt. During the Great Depression, deflation ran around 9% per year. Imagine paying back a loan with money that’s worth 9% more each year. Not many mortgages would be paid and the entire nation would be in ruin as even those who owned property outright would have seen the value of it plunge by 2/3. Those with mortgages would mail in the keys. Eventually, all debt would be repaid at 33 cents on the dollar or so. Perhaps then the system might right itself but it would take decades. A variant on both of these scenarios is crash or no crash. In both instances it is possible to survive with the same monetary authorities and the same banking system. It is also possible that both episodes could end with a collapse of the commercial system. Although this is a possibility, it is a remote one at best.

I believe the Federal Reserve System will simply continue its existence in present form. The Congress will assent to an expanded role for the Fed system as a whole. The Fed will use these new powers to issue and solidify their position as the world’s monopoly source for dollars. They will then use “moderate inflation” to stimulate the economy. At 7 to 9% a year for 5 years you can strip from 35 to 40% off the value of a dollar. What should your investment strategy be. I believe in tangibles and equities. I would not be a holder of debt instruments. What role should numismatics play in your portfolio? I think 15 to 20% of your total investment dollars could be devoted to gold and silver coins. No matter which scenario plays out, coins belong in every portfolio.

Leave a comment

Your email address will not be published.