Since World War II, inflation has been engrained in Western society. It is embedded in our expectations and written into our legislation. Inflation is the culture of the Baby Boomer generation. Society expects prices to go up, and is convinced something is wrong if they do not.

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 Public Enemy Number One.

The historically proven antecedents to hyperinflation currently exist to an overwhelming extent. Banking crises have been shown to ordinarily precede currency crashes. Currency crashes result in high to hyper‐inflation.

Hyperinflation is the single largest problem an economy can face and should be of extreme concern 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 middle‐class wealth. It empowers governments, but can also enrich anyone who sees it coming and positions themselves correctly.

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, without being crippled economically.

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 World to fight inflation from a financial, economic and political standpoint.

‐ Henry Thornton, An Enquiry Into the Nature of the Paper Credit of Great Britain, 1802

5.3.3 Rising Effect .......................................................................................................................... 46

5.4 T POPULIST WAY OUT ................................................................................................................. 49

7.0 BIBLIOGRAPHY ........................................................................................................................ 56

Figure 5: US Monetary Base 1990‐2010 ............................................................................................... 18

Figure 6: US Monetary base 1918‐2010 ............................................................................................... 18

Figure 7: Monetary Base & Stock Market ‐ US, Euro, UK & Swiss ........................................................ 19

Figure 8: $US Purchasing power & Gold, 1965 ‐ 2010 .......................................................................... 20

Figure 9: Deficit Financing ..................................................................................................................... 21

Figure 10: AFR Commodity Prices Increase .......................................................................................... 25

Figure 11: AFR Inflation Pressures ........................................................................................................ 25

Figure 12: U.S. Fiscal & Economic Forecast Errors ................................................................................ 29

Figure 13: Federal and combined Federal, State, and Local Surpluses and Deficits ............................ 29

Figure 14: Potential Fiscal Outcomes: Revenues and Composition of Spending ................................. 30

Figure 15: US Consumption ‐ Share of GDP .......................................................................................... 32

Figure 16: U.S. Income Share of Top 1% of Households ....................................................................... 33

Figure 17: Personal Saving Rate, 1982‐2006......................................................................................... 34

Figure 18: The National Debt as a Percent of GDP ............................................................................... 36

Figure 19: Trade Deficits vs Federal Debt Increases ($ Billions) ........................................................... 37

Figure 20: U.S. Debt Held by the Public ................................................................................................ 37

Figure 21: U.S. Government Debt Held by the Public ........................................................................... 38

Figure 22: Debt Held by the Public under Two Policy Simulations ....................................................... 38

Figure 23: U.S. Government Debt, Growth, and Inflation, 1790‐2009 ................................................. 39

Figure 24: U.S. Unfunded Liabilities ...................................................................................................... 40

Figure 25: Budget forecasted receipts & Outlays ................................................................................. 40

Figure 26: Foreign Assets in the U.S. : Net Capital Inflow ..................................................................... 43

Figure 27: U.S. Federal Funds Rate, 1984‐ 2010 ................................................................................... 44

Figure 28: Diminishing Returns for Each $US1 of New Debt in the US Economy ................................. 55

Table 2: "Default" through Inflation 1500‐1799 ................................................................................... 14

Table 3: "Default" through Inflation 1800‐2008 ................................................................................... 15

Table 4: Advance Economies Public Debt Levels (as a % of GDP) ......................................................... 22

Table 5: U.S. 2011 Federal Budget ........................................................................................................ 27

Table 6: U.S. Government's Financial Position Snapshot ..................................................................... 28

Table 7: Federal Fiscal Gap under GAO's Assumptions 2010‐2084 ...................................................... 31

Table 8: Federal Reserve Balance Sheet ............................................................................................... 35

Table 9: U.S. Budget ‐ Interest Expense ................................................................................................ 47

Table 10: Interest Stress Test ................................................................................................................ 48 

The 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/deflation debate.

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 current probability is hyperinflation.

It is intuitive for inflation to appeal to the general public as asset prices rise giving the illusion of prosperity. It is also intuitive to believe that prices fall or deflate when problems emerge and persist in an economy. However, what happens when currencies deflate? Possibly simultaneously?

Hyperinflation is the single largest problem an economy can face and should be of extreme concern 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 middle‐class wealth. It empowers the government, but can also enrich anyone who sees it coming and positions themselves correctly.

This report:

1. Explains the critical dynamics influencing the current global monetary system;
2. Explores historical empirical research on crisis sequencing and the derived probabilities;
3. Examines the inflationary and deflationary forces that currently exist on a global macroeconomic level; and
4. Evaluates the current macroeconomic position and analyses the capacity for a global battle against inflation.

It is the intent of this report to delve into the evidence in a way which can be understood by all. By joining all the proverbial dots of materially significant evidence, high confidence forecasting probabilities will be derived for the global economy of the future.

This is a Macroeconomic report. The United States of America are the single largest economy in the 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 broader global macroeconomic environment.

‐ Adam Smith, 18th Century Scottish philosopher

‐ Voltaire, 18th Century French writer and philosopher

Now for a crash course on today's global monetary system.

The global economy operates in what is termed a fiat monetary system. A fiat monetary systems is made up of money that has no intrinsic value. The value of the paper money is controlled by central banks charged with the exclusive monopolising power to print or issue its national currency. When more money is printed and the supply of money increases it naturally has less value, as there is more money seeking limited resources. This equates to a rising of nominal prices for goods and services in limited supply. This phenomenon is termed inflation.

Before the fiat system, global economies largely operated under the gold standard. This was repealed in Australia in 1915 following the British. The $US being the global currency of trade since the end of WWII operated under a modified version of the gold standard termed the Bretton Woods system, until it was repealed under President Nixon in 1971. Under the gold standard money was convertible to the equivalent value of gold.

With the $US being the global trade and reserve currency since the end of WWII and the only major currency left on the gold standard, the repealing of it in 1971, termed the Nixon Shock, marked the final chapter for the gold standard in the global economy. The repealing of the Bretton Woods system ultimately allowed the US Federal Reserve (Fed) to print money out‐of‐thin‐air to finance the US government’s budget deficit, partially resulting from an expensive Vietnam War. High inflation ensued throughout the 1970s of up to approximately 20% per annum. That is cash losing its value or falling by 20% per year.

This inflation during the 70s and early 80s was not overly destructive for savings as interest rates were able to be risen to counter‐attack the inflation. However, it is not always possible, for interest rates to rise.

Printing money is the loose terminology for debt monetisation, and is a form of central bank quantitative easing. Debt monetisation generally results from a central bank buying debt from either a government, bank or more recently other non‐bank corporations, with freshly printed out‐of‐thin‐air money. As Faber, (2009), states "it makes no difference macro‐economically if a mafia boss produces counterfeited dollar bills in his cellar or the Fed prints money."

Figure 1, graphically illustrates the monetary dynamics discussed above, at play in the United States.

M2/M3 = A monetary base/supply measure.

The US Dollar held the majority of its original value on the gold standard until the central bank, the US Fed was created in 1913. The introduction of the Bretton Woods system was a partial fiat system 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 public debt over the last 50 years.

The world has recently been reminded of the enduring legacy of the Global Financial Crisis (GFC) by the current European sovereign debt problems. Just as financial and economic history has shown us, there are common macroeconomic characteristics of financial crises, there is also common sequencing of financial crises.

There are five types of crises:

1. banking crises;
2. currency crashes;
3. inflation outbursts;
4. external sovereign default; and
5. domestic sovereign default.

Sovereign defaults are the most extreme crisis and obviously not all crises escalate to that level. The remaining crises however have not been uncommon even among advanced economies. This section of the report will focus on the relationships and sequencing of banking, currency and inflation crises.

Empirical studies of financial crises give measured probabilities for the outcomes following a banking crisis. A prominent study by Kaminsky & Reinhart, (1999), on the linkages between banking crises and currency crashes found that at the onset of a banking crisis, with nothing else considered, there is approximately a 46% chance of a currency crash that follows. This is with nothing else considered, and before escalating to a global credit crisis and a global financial crisis, as we have recently experienced.

Banking crises often lead to currency crashes, inflation and outright sovereign default (Kaminsky & Reinhart, 1999). Figure 2, displays this normal sequencing.

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 truly financially liberalised has free globalised markets, floating foreign exchange rate, and a central bank. The individual economies of Dubai and Greece do not have these features, so the sovereign debt crisis came first.

It should also be understood that monetary inflation often leads a currency crash, the currency crash then triggers a vicious and rapid inflationary spiral that will continue until a complete system overhaul.

Reinhart and Rogoff, (2009) state:

Financial Liberalisation is the starting point for the financial crisis sequence, as Diaz‐Alejandro, (1983), states "Goodbye Financial Repression, Hello Financial Crash". Once an economy is financially liberalised, banks gain access to external credit and begin riskier lending practices. A deterioration in asset prices following a boom in credit leads to a weakening in bank balance sheets and this often leads to a banking crisis.

The next stage of the crisis begins when the central bank provides banks and other institutions with support by extending them credit. History shows that more often than not, there is an abandonment of the support for the foreign exchange rate in order to act as the lender of last resort for the troubled institutions. Further pressure is placed on the foreign exchange rate as money is created by the central bank to bring liquidity into financial markets and to boost the reserves of banks.

The currency devaluation consequently complicates the situation in at least three additional ways:

1) the balance sheets of banks with foreign currency borrowings are deteriorated further;

2) inflation increases; and

3) the risk of government debt default rises if the government has foreign currency denominated debt.

At this point, the banking crisis either peaks following the currency crash or deteriorates further as the financial crisis marches the economy toward a domestic or external sovereign default. After a default occurs inflation deteriorates even further. (Reinhart & Rogoff, 2009)

Table 1, illustrates the connection between banking crises and currency crashes. Quite often a banking crisis leads to a currency crash, which in turn exacerbates the banking crisis. Please note, a balance‐of‐payment crisis is equivalent to a currency crisis.

3.3 BANKING CRISES

Since WWII, the most common policy response to a systemic banking crisis (in both emerging and advanced economies) has been to engineer a bailout of the banking sector. In many cases such actions have had major fiscal consequences, particularly in the early phases of the crisis. The total fiscal damage, including both direct and indirect costs, is an order of magnitude larger than the usual bank bailout costs. According to Reinhart & Rogoff, (2009), government debt rises on average by 86% during the three years following a modern day banking crisis.

Advanced economies exhibit a stronger inclination than emerging economies to resort to fiscal stimulus measures in an attempt to cushion the economic effects.

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 banking crises typically lead to other crises.

A total of 18 post war banking crises have occurred in the developed world. The "Big Five" banking crises are considered to be Spain 1977; Norway, 1987; Finland, 1991; Sweden, 1991; and Japan, 1992. (Reinhart & Rogoff, 2009)

Historically, derived probabilities for a currency crash and high inflation become overwhelming when all dynamics that currently exist in developed economies are considered. Every applicable bank and currency crisis linkage identified throughout numerous academic empirical studies exists right now today.

Source: Reinhart & Rogoff, (2009)

Findings by Velasco, (1987), point to financial sector problems giving rise to the currency collapse. These findings concluded that when central banks finance the bailout of troubled financial institutions by printing money, a classic currency crash from excessive money creation ensues. The globe has recently had unprecedented global bank and corporate bailouts.

Krugman, (1979), asserts that currency crises can be the by‐product of government budget deficits. The U.S. and the majority of developed economies currently have large budget deficits.

Demirguc‐Kunt and Detragiache (1998), identified countries with an explicit deposit insurance scheme are particularly at risk of currency crises. Most developed nations enforced this to a larger extent to help fight the banking crisis. It increases government debt risk and thus increases the likelihood of a currency crisis.

Fischer, Sahay, & Vegh's, (2002), study of Hyperinflation found:

1. Since 1957, inflation has been commonplace throughout the world. Based on a sample of 133 countries (for a total of close to 45,000 observations), we find that more than two‐thirds of the countries have experienced an episode of more than 25% per‐annum inflation; more than one‐third has experienced episodes in excess of 50 percent per annum; close to 20 percent of countries have experienced inflation in excess of 100 percent; and around 8 percent have experienced episodes of more than 400 percent per annum inflation. The average duration of high inflation is remarkably similar and, at 3‐4 years, surprisingly long.
2. Higher inflation tends to be more unstable. ... we find that, as inflation rises, the probability of inflation staying in the same range decreases and the probability that inflation will rise above its current level increases.
3. As expected, the long‐run relationship between money growth and inflation is very strong.
4. The long‐run relationship between fiscal balance and seigniorage is significant and negative. In the short run, the relationship is strong for high inflation countries but insignificant for low inflation countries.
5. Periods of high inflation are associated with bad macroeconomic performance. In particular, high inflation is bad for growth.

Seigniorage is the term used to explain the taxation like effect that inflation has on the public for the 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 facto tax that falls on those who hold the existing currency, as a result of its effective devaluation through the introduction of additional money."

Reinhart & Rogoff, (2009), surmise that there exists a common paradox where governments often increase inflation above and beyond the seignorage‐maximising 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: "inflation is a dynamic process and it is not possible to fix it at 6%. If inflation increases from the current level of, say, 2% per annum to 6%, it will likely thereafter accelerate to far higher levels".

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, appears undeniably correct.

During the gold standard era, deflation and traditional style government debt defaults were the norm, now during the fiat currency era, inflationary defaults are the norm. Government liabilities are not indexed with inflation, thus a government is able to covertly default on their debt by inflating prices. The effect is simply this: money supply goes up; prices go up; liabilities stay the same. For example, an inflation rate of 50% would leave a debt worth 50% less after a year. This is obviously because the value of the money is worth 50% less.

Once again, looking at Reinhart & Rogoff, (2009), the elements of an inflationary default:

A comparison of the inflation rates from tables 2 and 3 clearly display much higher inflation rates during the modern era.

During the year of an external default the average inflation rate is high at 33%. However, during a domestic default the average rate is 170% for that year. After the default and in the years following inflation remains above 100%. Defaults and inflation clearly coexist in the majority of cases. (Reinhart & Rogoff, 2009)

‐ George Bernard Shaw (Literature Nobel Prize Winner and Political Activist)

‐ Paul Volcker (Former U.S. Federal Reserve Chairman)

There are two types of inflation, monetary inflation and price inflation. These forms of inflation are strongly linked. Rapid monetary inflation leads to price inflation.

The traditional Austrian school of thought focuses on monetary inflation, as this is the driver for price inflation. There is a simple premise behind this. When more money is printed and the money 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 determined by its supply.

Ludwig von Mises, the seminal scholar of the Austrian School of Economics, who witnessed the cataclysmic damage hyperinflation inflicted on Germany in the 1920s, asserts that:

The open market operations is the Feds principle monetary policy tool used to influence the federal funds rate, which determines the rate at which banks lend to each other. These operations take the form of purchases and sales of US Treasury and federal agency debt securities. The Fed will buy or sell securities in order to maintain the fed funds rate. (U.S. Federal Reserve Board, 2010)

Buying securities has the effect of decreasing the interest rate and increasing bank reserves. Selling securities has the effect of increasing the interest rate and decreasing bank reserves.

Open market operations are used to monetise debt. In its simplest form this happens through the central bank purchasing government debt with newly printed money.

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, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper‐money system, a determined government can always generate higher spending and hence positive inflation. (Bernanke B. S., 2002)

Quoted by Ben Bernanke, the chairman of the Federal Reserve.

Vast quantities of money are required to be printed in order to fight off Public Enemy Number One, Deflation, and vast quantities of money continue to be printed.

Figures 5,6 & 7, illustrate the dramatic monetary inflation in the U.S. and around the world. The most recent measure of the monetary base in the U.S., displayed in Figures 5 and 6, shows that since the GFC erupted the monetary base has increased 150%.

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

In order to prevent an inflation‐induced boom from collapsing, it is never enough to keep credit and money stocks at current levels. Ever‐greater doses of credit and money are needed.

As Marc Faber, 2009 states: "But print they will all do, as the mess central banks have created can only be cured through massive monetary inflation. Also, it should be obvious that the worse the mess that central bankers have created will become (notably the US Fed), the more money will be printed."

Faber's assertion has been recently evidenced through the $US1 trillion European Central Bank (ECB) bailout of problematic Euro economies. It is important to note that central banks are self‐funded, So where does the money come from? The printing press, or its electronic equivalent, of course.

Foreign exchange rates only show the relative performance of two currencies against each other. For insight into the value or purchasing power of a fiat currency we look to the price of gold denominated in that currency (see Figure 8).

Now we have identified the inflationary forces of money creation, we should also consider this coupled with negative real interest rates. The US Federal Funds rate (base target rate), is currently set at 0.00% ‐ 0.25%. Taking into account inflation, this means that the interest rate is negative in real terms. Meaning depositors and savers are losing money and being penalised. We will come back to interest rates and the reasons why they cannot be lifted specifically in the US, under section 5.3 Interest Rates.

"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 Western economies were being "bailed out by the Chinese" through the recycling of Chinese currency reserves "could not last forever". (Allen, 2010)

Federal budget deficits are financed by the issuance of government debt, in the form of treasury bonds, bills and notes. For the purpose of looking at the effect to the money supply, investors of this debt can be broken up into two different groups: 1) the public; and 2) the domestic central bank.

When the public buys the government's debt, it becomes a true debt to the government. When the central bank buys the government's debt, money is printed, the money supply increases and inflation is created.

The danger is when there is an upward trend for larger proportions of the deficit to be financed through debt monetisation. Figure 9, displays this process.

On 18 March 2009, the Federal Reserve announced plans to purchase $US300 billion in US Treasury over the next six months. This was an open and clear direction that the Fed was monetising debt.

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".

David Buckner, a widely respected academic, expounded that, although foreign central banks were buying U.S. Treasury debt, the Fed was buying approximately 50% of it back in the secondary market ten days later. (Buckner, 2009)

Dornbusch, Sturzenegger, & Wolf, (1990), stipulate that:

-- Posted Thursday, 11 November 2010 | Digg This Article