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The debasement of world currency: it is inflation, but not as we know it

April 9, 2001

Peter Warburton is the author of ‘Debt and Delusion’, Penguin, 2000.

More than twenty years ago, I was a research officer in a forecasting unit at the London Business School. We called ourselves international monetarists then and we had a model that determined the inflation rate from the growth of money stock per unit of output, with long and variable lags. The value of a currency was determined, in the long run, by its monetary growth per unit of output in relation to that of the rest of the developed world. Being a young man, I was heavily into econometrics – or economic tricks, as some would have it – and our research group published papers showing how well this model fitted the data of that time. Basically, we had it sown up. We knew how to predict inflation; we knew the equilibrium value of currencies and the untidy realities of economic life were mopped up in the balance of payments. We felt sure that if the authorities could regulate the growth of the money supply, all would be well. How wrong we were.

By the mid-1980s, central bankers had begun to enjoy a measure of success in controlling inflation, not by strict regulation of the money supply, but as a by-product of financial de-regulation and the liberalization of credit. Even allowing for the lapses of 1988-90, there was a growing confidence that the battle against inflation was won. Throughout the 1990s, economists were absorbed by the issue of the permanence of low inflation, as measured by the annual change in a weighted basket of consumer goods and services, the CPI. But was inflation dead, or merely sleeping? Residual fears that it may only be a long sleep led the US authorities to establish the Boskin commission, whose charge was to deliver inflation a heavy blow to the head. Stunned into submission, the CPI took a long while to stir from its slumbers and did not do so until higher oil prices came along last year. However, it is far from certain that this surge will persist, and quite conceivable that it will recede later in the year in response to weakness in the real economy. To all intents and purposes, inflation in its popular form looks dead or comatose.

The paradox of disconnection

During these past 15 years, the Anglo-American economies (US, UK and Canada) have experienced episodes of weak growth in broad money (M2 or M3) with moderate inflation (in the early-1990s) and episodes of strong monetary growth with little measured inflation of consumer prices, as now. As a result, most economists have given up on the monetary aggregates as a useful guide to anything important. Government economists, who have remained skeptical of monetary transmission mechanisms throughout, feel especially vindicated. They argue that, if double-digit money supply growth can sit happily alongside a 2% or 3% inflation target and an appreciating currency, then surely the argument is settled.

I no longer regard myself as a monetarist, but I retain a deep respect for the behaviour of bank liabilities and their close substitutes. There are some things that only money can do. However, there are many other things that credit can do just as well. The avalanche of non-bank credit that has swept across the economic landscape over the past 20 years has altered it beyond recognition. On the one hand, it has enabled the monetary aggregates to grow much more slowly than the credit aggregates, helping to keep inflation lower. On the other hand, the non-bank credit avalanche has enabled a furious pace of fixed investment in physical assets that has promoted structural global excess capacity in virtually all manufactured products and exerted downward pressure on product prices. The particularly vigorous investment in information and communications technology has served a dual purpose, through the spectacular lowering of capital goods prices and by connecting disparate market participants to a common network and database.

And what of the periodic bouts of monetary excess, in late-1998, late-1999 and again over the past 3 months? These can be explained by the increasing fragility of the financial system. The more obvious are the system’s weaknesses, the greater is the fear of collapse and the larger the demand for liquidity within the financial markets. In these stressful episodes, it is the financial markets themselves that are the principal driving force behind the monetary expansion. Hence, there is relatively little monetary impact on the product and labour markets, that is, on prices and wages.

In this way, we can arrive at a crude understanding of the paradox of disconnection: how volatile and often rapid monetary growth rates can be consistent with seemingly low and stable inflation outcomes. In the US, the annual price deflator for GDP has been below 2.5% in every year since 1991. Consumer price inflation has been no higher than 3% in every year since 1991. In Canada, the record is slightly better; in the UK, slightly worse. To parody Paul Samuelson’s quip about the productivity ‘miracle’, credit excesses are visible everywhere except in the inflation figures. Time and time again, respected commentators and analysts have warned of the approaching inflationary backlash from the credit and monetary excesses, only to be humiliated and discredited by events. This is not because their instincts were at fault, but because they were looking in the wrong place.

However, this does not explain the strength of the US dollar: surely the value of the dollar in relation to euros and yen has to collapse under the weight of excessive money supply growth and a huge external payments deficit? Well, I certainly thought so as recently as December 1999 when I wrote a bulletin for Flemings entitled ‘US dollar: selling the silver and leasing the gold’. Now, I’m not so sure. I am coming round to the view that the external value of all major currencies is eroding and that this general erosion is able to substitute for at least a portion of the decline that one might expect in a particular currency versus its peers. Allow me to explain.

The loss of a stable numéraire

In the physical world, there are constants that serve as dependable benchmarks against which to observe natural phenomena. Examples are the velocity of a falling object, the freezing point of water and the time taken for one rotation of the earth on its axis. In the economic and financial world, this degree of precision is lacking. Instead, we content ourselves with approximations, indices and averages. We pride ourselves in knowing the difference between an inflation rate of 2% per annum and 2.5% per annum. Small deviations of outcomes from expectations can trigger dramatic trading in financial instruments and result in the transfers of billions of dollars between investments. Yet, in the financial realm, can we really be sure of the value of anything?

Monarchs of old, when hard-pressed for finance, would debase their precious metal currency by reducing its weight or by mixing in base metals to create an alloy. Hey, presto! They were able to increase the money supply and buy more munitions and enlist more soldiers. By this deceit, they separated the face value of the currency from its inherent value, derived from the scarcity value of the gold or silver. These debased coins were, of course, the forerunners of our modern monies whose face value is established by government fiat or decree. The face or nominal values of the notes and coins in circulation with the public greatly exceed their inherent or commodity values, and do not purport to have stable ratios with them.

In the post-war period, economists have compensated for the lack of a commodity base (eg gold standard) for a currency by constructing weighted indices of commonly purchased items. The rationale for the purchasing power approach is that the supply of consumables is constrained by the availability of scarce resources such as land, capital equipment and labour services. Because the supply of these resources is finite, then an excessive growth in the stock of domestic monetary assets would give rise to an inflation of the market prices of the consumables. Hence, if consumer prices are constant, then this is a positive indication that the money supply is not growing too rapidly and that the internal value of the currency is being maintained. Countries with stable price levels, or equivalently low inflation rates, would also be expected to have currencies that held their external value with each other, and steadily gained in value versus countries with higher inflation rates.

The fatal flaw in the ‘inflation target’ mentality

Unfortunately, there is a giant flaw in this logical structure. Restraining the growth of the money supply does not prohibit the excessive expansion of the credit system, unless banks have a credit monopoly and operate only as lenders rather than investors. An excessive expansion of credit can create an environment where the factors of production – land, capital and labour services – appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

Where is the flaw? It lies in the fantasy that the stock of borrowings (of all types) can somehow be divorced from the money stock. The physical representation of the abundant supply of credit to producers and consumers lies in the over-production of goods and services. When this has occurred on a global basis, then a point is reached when it becomes impossible to find new export markets and the degree of spare capacity begins to rise. Profit-seeking companies will be compelled to shut down capacity and lay off staff in order to restore ailing profitability. The financial counterpart is the erosion in the ability of borrowers to service their debts. In the limit, the construction of excess capacity gives rise to debt default, as the idle portion of capacity does not earn an income and cannot service the debt that financed its construction.

However, since all debt is borrowed money, in order to write off a debt, it is necessary to destroy part of the money supply. It may be that the debt was structured as a bond issue rather than a bank loan; it doesn’t matter. The bondholders exchanged money balances for those bonds when they acquired them. If the bond is cancelled, this money is lost. Actual and impending losses give rise to a desire for additional liquidity in the financial system. Here, only money will do.

Central banks are engaged in a desperate battle on two fronts

What we see at present is a battle between the central banks and the collapse of the financial system fought on two fronts. On one front, the central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold, oil, base metals, soft commodities or anything else that might be deemed an indicator of inherent value. Their objective is to deprive the independent observer of any reliable benchmark against which to measure the eroding value, not only of the US dollar, but of all fiat currencies. Equally, their actions seek to deny the investor the opportunity to hedge against the fragility of the financial system by switching into a freely traded market for non-financial assets.

It is important to recognize that the central banks have found the battle on the second front much easier to fight than the first. Last November, I estimated the size of the gross stock of global debt instruments at $90 trillion for mid-2000. How much capital would it take to control the combined gold, oil and commodity markets? Probably, no more than $200bn, using derivatives. Moreover, it is not necessary for the central banks to fight the battle themselves, although central bank gold sales and gold leasing have certainly contributed to the cause. Most of the world’s large investment banks have over-traded their capital so flagrantly that if the central banks were to lose the fight on the first front, then their stock would be worthless. Because their fate is intertwined with that of the central banks, investment banks are willing participants in the battle against rising gold, oil and commodity prices.

Central banks, and particularly the US Federal Reserve, are deploying their heavy artillery in the battle against a systemic collapse. This has been their primary concern for at least seven years. Their immediate objectives are to prevent the private sector bond market from closing its doors to new or refinancing borrowers and to forestall a technical break in the Dow Jones Industrials. Keeping the bond markets open is absolutely vital at a time when corporate profitability is on the ropes. Keeping the equity index on an even keel is essential to protect the wealth of the household sector and to maintain the expectation of future gains. For as long as these objectives can be achieved, the value of the US dollar can also be stabilized in relation to other currencies, despite the extraordinary imbalances in external trade.

The US dollar is not as vulnerable as it may appear

The key to understanding how this can happen is to consider how little information the flow of funds accounts provides about the true ownership of assets and liabilities. As far as the US external capital account is concerned, hedge funds based in the Caribbean are overseas investors. The activities of overseas branches of US commercial banks are also considered to be foreign transactions. Also, London, and Zurich are clearing-houses for all manner of nominee accounts and anonymous trusts. Around two-thirds of all US bonds recorded as UK-owned belong to UK entities representing non-residents. To fear that foreign investors will one day abstain from fresh investment in US financial assets, leaving the current account deficit uncovered and the US dollar prone, is to suppose that foreigners are the sole instigators of these external financial flows in the first place. It is quite likely that a substantial proportion of these external flow-demands for US corporate bonds and equities are, in fact, US-originated. US residents’ subscriptions to leveraged hedge funds reappear as foreign investment in US securities. US commercial banks’ overseas branches borrow in euros locally to invest the proceeds in US bonds, playing the yield curve.

Thinking in these terms, a collapse of the US dollar versus the euro appears much less likely. It may still occur, but more plausibly in the context of cancelled credit lines and forced asset disposals. The obvious example is the slump in the US dollar against the yen in 1998 as the hedge funds lost their credit lines from Japanese banks and were compelled to unwind their carry trades.

Beneath the surface, the values of the dollar, the yen and the euro have been eroded simultaneously by the over-extension of credit. The latent losses in the credit system, emanating from non-performing loans and defaulting bonds, represent a charge against the value of the currency, as surely as if the edges of the notes and coins had been trimmed away. There has been a reduction in the quality of credit rather than an increase in the quantity of money (net of write-offs). The search is on for a valid yardstick, a measure of monetary value that has not been (and cannot be) distorted by central banks’ firefighting and wrecking tactics.

The search is on for the perfect hedge

What would be the ideal characteristics of such a numéraire? First, it would be in fixed physical supply. Second, it would be resistant to weather-related influences. Third, its ownership would be diffuse, rendering futile any attempt to restrict supply through a non-competitive structure. Fourth, it must be freely tradable. Fifth, there would be no futures or options markets attached to it.

Finally, I list some of the candidates, in no particular order. Each seems promising, yet none of them seems to me to satisfy fully all five of the requirements above.