The earliest signs are developing of hyperinflation, more correctly
described as a collapse of the purchasing power of all the major government
currencies.
Central bankers are almost certainly unaware of this danger, partly
because their chosen statistics fail to capture it, but mostly because
conventional monetary economic theory is lacking in this regard.
This article draws on the evidence of extreme overvaluations in equities
and bonds worldwide, and concludes the explanation lies increasingly in a
greater perception of risk against holding cash, or bank deposits. Risk
relationships between cash and assets are inverting, due to failing monetary
policies and escalating counterparty risk with the banks.
There are of course subplots involved, such as the real and imagined
rigging of markets by central banks, and the bullish confidence that gives to
buyers and holders of investments. Then there is the unanimous assumption
that interest rates must not and therefore will not be permitted to rise.
Extreme one-way bets aside, the overriding reason for valuation disparities
is becoming more consistent with the downgrading of cash, rather than a
revaluation of assets. If this was happening to money’s relationship with
goods and services, economists would begin to worry about inflation,
stagflation, and even hyperinflation.
Why asset inflation matters
Because today’s price inflation is mainly confined to assets, no one worries.
Instead investors rejoice in the wealth effect. Assets are excluded from the
consumer price indices, so the danger of a fall in the purchasing power of
money in respect of assets does not appear to exist. This does not mean that
the problem can be ignored. But if the reason behind rising markets is a
flight from cash, we should begin to worry, and that point in time may have
arrived. If so, we should stop rejoicing over our increasing wealth, and
think about the future purchasing power of our currencies.
Confining the estimation of price inflation to selected finished goods and
services is a myopic mistake. It was originally for econometric convenience
that consumer purchases became so categorised, but it is misleading to assume
that for the consumer there is any such clear categorisation between the
purchase of different items. In pure economics there can be no distinction
between the purchase of an item of food, a capital good, or the lending of
money which is used by someone else to purchase capital assets and use as
working capital. The exclusion of partially depreciated second-hand goods is
equally illogical. All purchases are purchases, full stop.
Not only do the neo-Cambridge economists and econometricians of today
ignore this fundamental error in their attempts to construct measures of
price inflation, central bankers and the whole investment community make a
further omission without even realising it, and that is to assume that money
has a constant value in all transactions. This is hardly surprising, because
we account in money, and we pay our taxes on profits measured in it.
These two important errors distort all economic analysis and can have
serious consequences.
Asset inflation is increasingly spilling over into commodities, the
feedstock for final goods. It has also been inflating services, for example
driving up the wage rates in building trades and raising agency commissions.
This effect has been developing since the last financial crisis began to
recede, and has accelerated with the reversal of falling commodity prices.
The official line, that there is almost no price inflation, is misleading
markets, the general public, and economic planners themselves as well.
Investors act rationally
It is becoming clear that some investors are showing a growing preference
for investment assets over bank deposits. Analysts unquestioningly believe
that this preference is not a vote against money, but is driven by a desire
to profit from investment. This is correct for regulated managers of mutual
funds, who are required by their mandates to generate valuation profits in
absolute or relative performance terms.
Others, particularly the very rich with a close eye on their own finances,
are beginning to take a different view. They observe the share prices of the
banks that owe them money, and worry. Private bankers in Europe are
reportedly trying to persuade their very-rich customers not to withdraw
substantial funds. Anyway, transferring deposits from one bank to another
doesn’t protect you against systemic risk, so you must buy something, such as
a short-dated government bond or gold, to get rid of your money and transfer
the risk to others.
The principal danger to these wealthy investors is a pick-up in the
inflation rate, but at the moment, talk is exclusively of deflation and
systemic risk, not inflation. However, raw material prices have been rising
noticeably this year, reversing the trend of the last few. Unless commodity
prices start falling materially and soon, they are certain to drive up
recorded price inflation, despite the lack of economic activity in the
advanced economies. Eventually, central banks will have to respond by raising
interest rates, undermining government bond markets and the valuation of all
asset classes that refer to them.
The flight from cash, for the moment at least, reflects in large part
systemic risks. However, we cannot say that a collapse of the banking system
will definitely happen unless interest rates rise to reflect the falling
purchasing power of fiat currencies. Only then can we be much more certain of
a general financial immolation, accelerating the flight from bank deposits.
For the moment, markets have gone nap on deflation. Deflationary
conditions are necessary for the future monetary expansion required to rescue
the banks, the economy, or both. Most investors appear to be as sure of this
outcome as they were that the UK would choose to remain in the EU. The error
here is to have little or no understanding that price inflation can coexist
with contracting business activity.
Monetary inflation, particularly when it becomes extreme, actually
guarantees a contraction in economic activity, because it withdraws
purchasing power from the masses. This is why the early warning signs of
asset price inflation from a declining preference for money should be taken
very seriously. And as the effect spreads into the consumer price index, so
too will a wider rejection of money in favour of goods.
It could easily develop into what the Austrian economist, Ludwig von
Mises, described as a crack-up boom, the final flight out of money in
preference for goods. We are not yet hoarding toilet paper and baked beans,
but the prospect that we will be driven to do so has already been signalled
to us.
The views and opinions expressed in this article are those of the
author(s) and do not reflect those of Goldmoney, unless expressly stated. The
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