Can Tightening Fight the Collateral Shortage?

Tyler Durden of Zero Hedge claims that any taper in QE will be a response to the collateral shortage — the fact that quantitative easing has stripped an important part of the market’s collateral base for rehypothecation out of the market. With less collateral in the market, there is less of a base for credit creation. The implication here is that quantitative easing is tightening rather than easing credit conditions. The evidence? Breakdown in the Treasuries market resulting in soaring fails-to-deliver and fails-to-receive:


Tyler notes:

Simply put, the main reason the Fed is tapering has nothing to do with the economy and everything to do with the TBAC presentation (rehypothecation and collateral shortages) and that the US is now running smaller deficits!!!

I don’t disagree with this. The ultra-low rate environment (that is still an ultra-low rate environment in spite of the small spike in Treasuries since murmurs of the taper began) on everything from Treasuries to junk bonds is symptomatic of a collateral shortage. Quantitative easing may ease the base money supply (as an anti-deflationary response to the ongoing deflation of the shadow money supply since 2008), but it tightens the supply of collateral.

The evidence on this is clear — expanding government deficits post-2008 did not bridge the gap in securities issuance that the financial crisis and central bank interventions created:


The obvious point, at least to me, is that it seems easier and certainly less Rube Goldberg-esque to fight the collateral shortage by running bigger Federal deficits until private market securities issuance can take its place. Unfortunately quantitative easing itself is something of a Rube Goldberg machine with an extremely convoluted transmission mechanism, and fiscal policy is not part of the Fed’s mandate.

But I am not sure that tightening can fight the collateral shortage at all. The money supply is still shrunken from the pre-crisis peak (much less the pre-crisis trend) even after all the quantitative easing. Yes, many have talked of the Federal Reserve inflating the money supply, but the broadest measures of the money supply are smaller than they were before the quantitative easing even started. This deflation is starting to show up in price trends, with core PCE falling below 1% — its lowest level in history. Simply, without the meagre inflation of the money supply that quantitative easing is providing, steep deflation seems highly likely. I don’t think the Fed can stop.


Explaining Hyperinflation

This is a post in three sections. First I want to outline my conception of the price level phenomena inflation and deflation. Second, I want to outline my conception of the specific inflationary case of hyperinflation. And third, I want to consider the predictive implications of this.

Inflation & Deflation

What is inflation? There is a vast debate on the matter. Neoclassicists and Keynesians tend to define inflation as a rise in the general level of prices of goods and services in an economy over a period of time.

Prices are reached by voluntary agreement between individuals engaged in exchange. Every transaction is unique, because the circumstance of each transaction is unique. Humans choose to engage in exchange based on the desire to fulfil their own subjective needs and wants. Each individual’s supply of, and demand for goods is different, and continuously changing based on their continuously varying circumstances. This means that the measured phenomena of price level changes are ripples on the pond of human needs and wants. Nonetheless price levels convey extremely significant information — the level at which individuals are prepared to exchange the goods in question. When price levels change, it conveys that the underlying economic fundamentals encoded in human action have changed.

Economists today generally measure inflation in terms of price indices, consisting of the measured price of levels of various goods throughout the economy. Price indices are useful, but as I have demonstrated before they can often leave out important avenues like housing or equities. Any price index that does not take into account prices across the entire economy is not representing the fuller price structure.

Austrians tend to define inflation as any growth in the money supply. This is a useful measure too, but money supply growth tells us about money supply growth; it does not relate that growth in money supply to underlying productivity (or indeed to price level, which is what price indices purport and often fail to do). Each transaction is two-way, meaning that two goods are exchanged. Money is merely one of two goods involved in a transaction. If the money supply increases, but the level of productivity (and thus, supply) increases faster than the money supply, this would place a downward pressure on prices. This effect is visible in many sectors today — for instance in housing where a glut in supply has kept prices lower than their pre-2008 peak, even in spite of huge money supply growth.

So my definition of inflation is a little different to current schools. I define inflation (and deflation) as growth (or shrinkage) in the money supply disproportionate to the economy’s productivity. If money grows faster than productivity, there is inflation. If productivity grows faster than money there is deflation. If money shrinks faster than productivity, there is deflation. If productivity shrinks faster than money, there is inflation.

This is given by the following equation where R is relative inflation, ΔQ is change in productivity, and ΔM is change in the money supply:


This chart shows relative inflation over the past fifty years. I am using M2 to denote the money supply, and GDP to denote productivity (GDP and M2 are imperfect estimations of both the true money supply, and the true level of productivity. It is possible to use MZM
for the money supply and industrial output for productivity to produce different estimates of the true level of relative inflation):

Inflation and deflation are in my view a multivariate phenomenon with four variables: supply and demand for money, and supply and demand for other goods. This is an important distinction, because it means that I am rejecting Milton Friedman’s definition that inflation is always and only a monetary phenomenon.

Friedman’s definition is based on Irving Fisher’s equation MV=PQ where M is the money supply, P is the price level, Q is the level of production and V is the velocity of money. To me, this is a tenuous relationship, because V is not directly observed but instead inferred from the other three variables. Yet to Friedman, this equation stipulates that changes in the money supply will necessarily lead to changes in the price level, because Friedman assumes the relative stability of velocity and of productivity. Yet the instability of the money velocity in recent years demonstrates empirically that velocity is not a stable figure:

And additionally, changes in the money supply can lead to changes in productivity — and that is true even under a gold or silver standard where a new discovery of gold can lead to a mining-driven boom. MV=PQ is a four-variable equation, and using a four-variable equation to establish causal linear relationships between two variables is tenuous at best.

Through the multivariate lens of relative inflation, we can grasp the underlying dynamics of hyperinflation more fully.


I define hyperinflation as an increase in relative inflation of above 50% month-on-month. This can theoretically arise from either a dramatic fall in ΔQ or a dramatic rise in ΔM.

There are zero cases of gold-denominated hyperinflation in history; gold is naturally scarce. Yet there have been plenty of cases of fiat-denominated hyperinflation:

This disparity between naturally-scarce gold which has never been hyperinflated and artificially-scarce fiat currencies which have been hyperinflated multiple times suggests very strongly that the hyperinflation is a function of governments running printing presses. Of course, no government is in the business of intentionally destroying its own credibility. So why would a government end up running the printing presses (ΔM) to oblivion?

Well, the majority of these hyperinflationary episodes were associated with the end of World War II or the breakup of the Soviet Union. Every single case in the list was a time of severe physical shocks, where countries were not producing enough food, or where manufacturing and energy generation were shut down out of political and social turmoil, or where countries were denied access to import markets as in the present Iranian hyperinflation. Increases in money supply occurred without a corresponding increase in productivity — leading to astronomical relative inflation as productivity fell off a cliff, and the money supply simultaneously soared.

Steve Hanke and Nicholas Krus of the Cato Institute note:

Hyperinflation is an economic malady that arises under extreme conditions: war, political mismanagement, and the transition from a command to market-based economy—to name a few.

So in many cases, the reason may be political expediency. It may seem easier to pay workers, and lenders, and clients of the welfare state in heavily devalued currency than it would be to default on such liabilities — as was the case in the Weimar Republic. Declining to engage in money printing does not make the underlying problems — like a collapse of agriculture, or the loss of a war, or a natural disaster — disappear, so avoiding hyperinflation may be no panacea. Money printing may be a last roll of the dice, the last failed attempt at stabilising a fundamentally rotten situation.

The fact that naturally scarce currencies like gold do not hyperinflate — even in times of extreme economic stress — suggests that the underlying mechanism here is of an extreme exogenous event causing a severe drop in productivity. Governments then run the printing presses attempting to smooth over such problems — for instance in the Weimar Republic when workers in the occupied Ruhr region went on a general strike and the Weimar government continued to print money in order to pay them. While hyperinflation can in theory arise either out of either ΔQ or ΔM, government has no reason to inject a hyper-inflationary volume of money into an economy that still has access to global exports, that still produces sufficient levels of energy and agriculture to support its population, and that still has a functional infrastructure.

This means that the indicators for imminent hyperinflation are not economic so much as they are geopolitical — wars, trade breakdowns, energy crises, socio-political collapse, collapse in production, collapse in agriculture. While all such catastrophes have preexisting economic causes, a bad economic situation will not deteriorate into full-collapse and hyperinflation without a severe intervening physical breakdown.

Predicting Hyperinflation

Hyperinflation is notoriously difficult to predict, because physical breakdowns like an invasion, or the breakup of a currency union, or a trade breakdown are political in nature, and human action is anything but timely or predictable.

However, it is possible to provide a list of factors which can make a nation or community fragile to unexpected collapses in productivity:

  1. Rising Public and-or Private Debt — risks currency crisis, especially if denominated in foreign currency.
  2. Import Dependency — supplies can be cut off, leading to bottlenecks and shortages.
  3. Energy Dependency — supplies can be cut off, leading to transport and power issues.
  4. Fragile Transport Infrastructure — transport can be disrupted by war, terrorism, shortages or natural disasters.
  5. Overstretched Military — high cost, harder to respond to unexpected disasters.
  6. Natural Disaster-Prone — e.g. volcanoes, hurricanes, tornadoes, drought, floods.
  7. Civil Disorder— may cause severe civil and economic disruption.

Readers are free to speculate as to which nation is currently most fragile to hyperinflation.

However none of these factors alone or together — however severe — are guaranteed to precipitate a shock that leads to the collapse of production or imports.

But if an incident or series of incidents leads to a severe and prolonged drop in productivity, and so long as government accelerates the printing of money to paper over the cracks, hyperinflation is a mathematical inevitability.

The Gold Standard?

Paul Krugman doesn’t believe that the gold standard was a remedy to the ills of the Great Depression:

A while back I read Lionel Robbins’s 1934 book The Great Depression; as I pointed out, it was a Very Serious Person’s book for its era. Its solution was a return to the gold standard — which would have made things worse — and free trade, which was basically irrelevant to the problem of insufficient demand.

In fact, the gold standard is almost universally shunned (with a few notable exceptions) among academic economists. In a recent survey of academic economists, 93% disagreed or strongly disagreed with this statement:

If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.

When we look at the Great Depression, we need to look at things on two levels: the causes, and the symptoms. Keynesian economists — particularly Krugman, Eichengreen, etc — are focused primarily on the symptoms, particularly depressed demand, and debt-deflation. Certainly, the gold standard is not a cure for the symptoms of an economic depression.

Trying to administer austerity after a crash like 1929 or 2008 is simply a road to more pain, and a deeper depression.

The principal attraction to the gold standard is to limit credit expansion to the productive capacity of the economy. But we know very clearly that — in spite of a gold standard — there was enough credit expansion during the 1920s for a huge bubble in stocks to form.

Ultimately — even with a gold standard — if a central bank or a government, (or in the most modern case, the shadow banking system) decide that the money supply will be drastically expanded, then limits on credit creation like the gold standard (or in the modern case, reserve requirements) will be no barrier.

The amusing thing, though is that gold — perhaps because of its history as money, perhaps because of its scarcity, and almost certainty because of its lack of counter-party risk — is as strong as ever. In a global financial system where the perception of debasement of currency is widespread, gold thrives. In an era where shareholder value is thrown under the bus in the name of CEO-remuneration, where corporations are perennially mismanaged, and where profit is too-often derived from bailouts and subsidies, gold thrives. It is a popular investment both for individual investors and for non-Western central banks.

The Federal Reserve’s monetary intransigence probably did prolong the Great Depression. Certainly there were other factors — including Hoover raising taxes.  But none of that really matters now. Certainly, it is impossible that the United States — under its current monetary regime— would ever return to the gold standard. Gold’s role has changed. It is no longer state money. It is a stateless instrument thriving in a negative real-rate environment.

And unlike state monies whose values are subject to the decisions of states, gold will always be gold.

The Inevitability of Default?

From Buttonwood:

While Greece continues to inch its way towards a [now completed] deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue.

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that “the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”

Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

It’s nice to know I’m not just one lone voice in the wilderness.  But I think most readers already knew most of this. There is significant empirical evidence that when the problem is excessive systemic debt, neither austerity nor inflation are sufficient tools to really reduce the debt. Austerity tends to bring the problem to a head, while inflation tends to kick the can down the road. The latter may stabilise the system, but as we have seen in Japan, this does not necessitate recovery. If we want real debt erasure, we need measures that really erase debt.

By building a new system we can open a window onto whole new world of possibilities for reform. One possibility is the return of Glass-Steagall-style separation between investment and retail banking, and a complete ban on complex derivatives contracts.

And there is nothing morally wrong with default. Investors in government debt should do their due diligence, and be aware that for all the political bleating and obsequious promises from politicians, ratings agencies and Warren Buffet there is always a risk of default with sovereign debt. Debt is only ever as good as its issuers ability to generate sufficient revenues.

There was never any guarantee that this era of unrestrained credit creation, globalisation, job migration and American imperialism could go on forever.

Does the Fed Control the Money Supply?

It depends how you define money.

The Federal Reserve controls the monetary base, and has vastly increased it as a result of quantitative easing:

But that’s not the same thing as the money supply. The money supply is controlled by fractional lending by the banking institutions. More “money” comes into existence as more credit is extended. Banks can lend and lend and lend the monetary base up to the reserve requirement (ten times the monetary base, at present). You’d think that profit-hungry banks would lend all the way up to the reserve requirement, but right now that isn’t the case — a huge amount of the monetary base is sitting unused as excess reserves:

This means that while the monetary base has tripled, the money supply (M1) has not surged nearly as much:

But there is a much bigger factor here; M1 only deals with the obvious side of money supply — lending by financial institutions to businesses and consumers. There exists another banking system between banks and hedge funds where credit expansion takes places much less directly and obviously, via securitisation and rehypothecation — for example collateralised-debt-obligations (CDO), mortgage-backed-securities (MBS), etc. Here’s a recent chart of credit creation via these pseudo-monies:

Simply, the Fed’s huge expansion of the monetary base has still failed to prevent the contraction of this strange and exotic part of the “money” supply stemming from the 2008 Lehman incident, and surely to be significantly worsened by the ongoing implosion in Europe. It has failed to prevent the sector from deflating and sucking down the wider economy.

In the years preceding 2008 the definition of “money” became extremely loose. When securities made up of sub-prime mortgages which are in arrears comes to pass for “money” — and came to stand on balance sheets as debt — it should have been painfully obvious that modern finance had mutated into an uncontrollable monster, and that no amount of quantitative easing could prevent prevent the inevitable credit contraction from blown-up asset prices tanking.

The shadow banking sector was never “too big to fail”; it was too monstrous to succeed.