This is how money dies

Many investors are expecting a financial collapse in 2013. It’s a nervy time!

On Friday, I suggested that many await the collapse alongside a government bond market breakdown. And it’s true – if the great bond bubble were to burst, it would be goodnight Vienna.

But to my mind, it’s looking increasingly like there won’t be a classic bust in this market. As I argued on Friday, the central banks have got the bond market covered.

In response to Friday’s Right Side, some readers pointed out that the central banks can do many things – but they cannot control inflation. And inflation could be the great undoing of the bond market.

This is serious stuff. And definitely worthy of a response, so in today’s Right Side, I am going to look at the impact inflation could have on the fragile British economy.

The scene is set for an inflation blow-up

Now, I never suggested that inflation will be purged just because the bond market avoids its date with destiny. And yes, I know that in the past inflation and a bond collapse have gone hand-in-hand.

But what seems to be brewing is the seemingly impossible. That is, the scene is set for inflation, yet no bond blow-up!

Before we consider how this plays out, we need to consider the exact definition of ‘inflation’…

Some say inflation is the increase in official money supply… and by gum, we’ve had plenty of that!

Others say inflation is the increase in retail prices – of course, that’s another can of worms in itself. Which prices do you use? And crucially, which mathematical construction do you use for the index? It’s a debate that’s certainly raging today.

Science versus faith

But there’s a whole other concept to inflation. A school of thought that says inflation isn’t some sort of scientific concept, or even anything that lends itself to measurement. Inflation is in the eye of the beholder and comes down to faith. Specifically the public’s faith in paper currency.

Needless to say, the central banks don’t view inflation in this light. For them inflation falls very much into the realms of science, measurability and predictability.

They run carefully crafted computer simulations that they believe model how inflation should work. They allow them to meddle endlessly with the money supply in the belief that inflation will toe the line.

But I believe there’ll come a point when the public simply loses faith in the currency. Some say that will be when we head into hyperinflation – and it’s right to draw a distinction between the normal type of inflation (which can be corrected) and the ‘lost-faith’ type.

However you like to define it, it’s happened many times throughout ancient and modern history. It’s just that, in the West, we haven’t seen it for a while. Why? Because the broad public has faith in our currencies.

But the public won’t remain asleep forever. There will be a wake-up call. And we need to be ready for it…

The four warning signs

It’s hard to measure faith in currency – that’s why the central banks don’t bother. But there are some warning signs – I’ve got four of them:

First, we need to keep an eye on what I call the ‘inflation indicators’. Watch out as energy and precious metals prices start to move to new highs. The rich and powerful will lose faith first and they’ll be tucking away real assets (if they haven’t already started!).

If you see gold move swiftly over $2,500, or Brent crude oil heading towards $150, then start to look out for the next signs…

The second thing to keep an eye on is volatility in the markets. Now, I’ve already suggested that this will be met head on by the central planners. And the way they deal with markets going the wrong way is to print more money and prop them up. So we’re looking out for volatility followed by an escalation in quantitative easing (QE) to pay for it all.

As I said, in the West, most investors are unfamiliar with ‘lost-faith’ currency inflation. Some may have read about it – but there’s precious little first-hand experience. What we need is a reminder. So the third thing to look out for is a rupture in a Western currency. Iceland and Hungary have come pretty close over the last few years – local residents will tell you all about the benefits of holding gold!

So far, these breakdowns haven’t been big enough for most investors to notice. What we need is a biggie – Japan perhaps?

My colleague Simon Popple has certainly lost his faith in currency. He is so convinced of a massive financial collapse, he has already invested half of his life savings into one niche gold investment. Now, you may find that shocking, I know I did at first, but then he explained to me exactly why he didn’t even consider his strategy high-risk.

He is confident that his strategy could be the single most lucrative investment on the planet.

You can find out more about Simon’s strategy here.

The fourth thing to look out for is what the economists call the ‘velocity of money’. It’s a rather arcane measure that attempts to quantify how quickly money races round the economy. The idea is that as inflation hots up, people spend money as soon as they get it. Why sit on cash if you believe it’ll buy you fewer goods in the future?

Losing faith in cash…

Now clearly, if we get to the stage where the public doesn’t like to hold cash, then we’ve got big problems. But this is actually a progression that’s already started. Think about how investors have been moving cash into equities. Myself included! It’s a sign that cash is no longer treated with the reverence it once deserved. How many more investors are starting to lose faith?

I suspect we’ve still got a few years ahead of us before all faith is lost. And there is, of course, still time for a u-turn on central bank policy. I don’t think it’ll happen, but technically there’s still time.

To my mind, the bond market can be held in check. The gilt market is a rigged game, after all.

Over time, I expect increasing numbers of people to lose faith. And as they do, the four indicators will come into play: commodity prices, market volatility, increasing QE, a currency crack-up and ultimately a dash out of cash.

But for the moment, let’s not get too excited. It’ll take quite a while to destroy the faith in currency that’s taken over half a century to build.

For now keep calm and carry on. I will. But I’ll be watching out for those four warning signs. I suggest you do too.

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  • 4caster

    Inflation was defined long ago as an increase in the supply of money and credit that leads to a general rise in prices. According to Milton Friedman, the Nobel prizewinning economist, it is “always and everywhere a monetary phenomenon”. It does not include a price increase caused by a sudden imbalance of supply and demand for a particular product, e.g. an oil shock, unless the supply of money and/or credit is expanded to accommodate the sudden price rise. But in this day and age, the definition is changed to cover whatever the writer or speaker wants it to mean.

  • Peter Kellow

    Well, I thought it was a long time since anyone took seriously anything Friedman said. And “Nobel Prize winning” should be a badge of shame for economists

    Inflation is not so complex as Bengt makes out. I have said many times in these posts (no one ever listens) that you have to distinguish shopping basket inflation, which the BoE measures, and asset price inflation. Of course there are many different types of assets but they all tend to respond to similar pressures although differentially at different times.

    Shopping basket inflation is not affected by the money supply and never has been. This is provable empirically. There are plenty of times when the money supply moved and shopping basket inflation did not. The reason for this is simple. In the shopping basket economy the velocity of money is very elastic.


  • Peter Kellow

    Asset price inflation is very tied to the money supply. Again just look back over history, eg since 2000.

    If you don’t think shopping basket inflation is “in the eye of the beholder and comes down to faith”, Bengt, try living on the average wage.

    For people with enough money to have a portfolio, shopping basket inflation is irrelevant. Only asset prices matter to them.

    With regard to currencies, shopping baskets will always have to be paid with currency. And assets are always going to have to be valued in a currency unless you want to exchange assets by barter. In this way the central banks have investors over a barrel like wage earners. And they know it. Never write off currencies

  • Nicholas

    Very interesting. Yes, I agree that the bond market appears to be fixed but few seem to appreciate that the gold market is too. It is very easy for a cartel to agree to sell gold when it reaches a certain price – say $1790. What then happens? If the cartel is powerful enough, the gold price drops overnight to, say $1450. Then they gradually buy it back again – not all at the same time because this would be too obvious. They get the price and the next day it is much cheaper. There seems to me to be nobody (other than God Himself) who can stop this process. Admittedly, as long as not all big bankers are in the same cartel together there is hope. The QE people don’t want gold to compete with or scupper their fiat money programme. Why? because gold is real money and fiat money isn’t. They don’t want anyone to say “The emperor has no clothes” when it suits them to be in agreement that he does.

  • washburn8992

    I have been confused about this for so long. There may be inflation but it is clearly not yet showing. It is my belief that normal rules no longer apply and that debt dynamics have assumed a life of their own. The internet, papers, books and pundits are all divided.

    It is clear however that no one wants to talk about how this all ends. You either assume that money printing can last forever or that one day it stops. What happens when it stops, where would you want to be ?

    Either from inflation, deflation or just plain exhaustion, the west is laying down it’e weary head.

    So sad the swansong.

    Hang on to your gold, but will even that be enough.

  • bengt

    peter K,

    I agree almost wholeheartedly with what you say….

    But, surely asset price inflation ultimately flows into retail prices – we see it all the time in the trio of energy, soft and hard commodities.

    And the fact that poorer members of society are suffering, while rich ‘portfolio holders’ gain, kind of seems to prove the point that inflation is, indeed, in the eye of the beholder…

    As you say, the hedge fund managers aren’t going to notice a 25% increase in the price of bread. But by-heck, his portfolio of commodities does pretty well! – it’s all in the eye of the beholder???


  • ubear

    Inflation _is_ a monetary phenomena, the Austrian Economists say this too, where it gets complicated is how QE and Fractional Reserve (Ponzi Fraud) debt interact.

    The base currency can be increased by QE; however this can take time to “trickle down” all the privileged (rich) fiat and goods arbitrage middlemen, until it offers harmful inflation to the poorer parts of society and pushes them further into debt. The far bigger effect comes from Fractional Reserve (fraudulent debt “Money” creation) which can multiply the effects of base currency many times (fraudulent monetary inflation) during lax lending time (booms), and can shrink rapidly during credit crunches (bust) and tightening lending (fraudulent monetary deflation).

    The whole process is basically a money pump from the poorer parts of society and sovereign bond holders, to the rich and government, until sovereign bond suckers and/or the population have enough and rebel!

  • Aff

    I agree with those who are saying ‘inflation’ is when the money supply expands, which is happening on unprecedented scale in the biggest central banks. There is no doubt they are creating inflation.

    Price rises (not really ‘inflation’) will follow and already is much higher than reported by govt stats which have been tweaked to underreport over the years. Signs of this are apparent in higher energy bills and even such things as horse meat turning up in burgers. The blame will be pointed at all sorts of things in mainstream media except the central bank actions.

    When confidence disappears currency will be an unwanted asset, velocity of money will ramp up as hyperinflation begins.
    The fools think they are controlling every market, they are not. Forces are building like a pressure cooker.

    I agree purchasing physical gold is not a risk, its not an investment either. It is protection.

  • Roger

    When velocity of money is low, like it is now, governments need to pump money to maintain circulation. If velocity increases, will it be possible for money supply to retreat? All current argument is that when velocity is UP, the money supply stays on. I do not know if that is the case, in fact, no body knows.

  • Fed

    Finally, only the gold!

  • Mayer Rothschild

    hasten the global collapse. THAT is what you watch for. That is the ONLY predictor of time frame.

  • JREwing

    Yes but not all paper currencies will collapse. What happens to the Norwegian Krone? What about the Canadian Dollar (flawed yes but about to collapse no)? The “dash out of cash” will happen to the currency under stress at THAT time – the Yen, then the Euro, then Sterling and then the US Dollar etc (perhaps also the Yuan).

  • Noel Falconer MEcon

    I have a million-fold more respect for Milton Friedman – whose books I have read and, I flatter myself, begun to understand! – than for a mental midget who plays the man because he’s incapable of playing the ball.

    Which said, there are indications that the present shambles could diverge, most violently moreover. Huge amounts of money have been issued but are being concealed by central-bank smoke and mirrors. If it leaks – and it’s appallingly likely to leak! – one deluge could trigger another, and on and on. We are playing with fire and are even complacent about it.

  • Rich in name only

    I could have this wrong, but isn’t the first warning Gold rapidly rising to £2500, not $2500?

    If the latter happens then the Dollar is toast and Sterling is ‘safe’?

  • Boris MacDonut

    #14 Gold is down 4% in the past year. When do you expect a rapid rise to £2,500? Today it is at about £1,050.

  • Le Brit

    Years ago I was taught that inflation is too much money chasing too few goods.The situation today is that all the created money is held on banks balance sheets and it is not sloshing around in the general economy. Add to this very low wage settlements (below inflation) and you do not have any drivers other than imported inflation which we have now due to the pound weakening and China exporting their cost increases. Once the banks move the money they have into the general economy then inflation will rise substantially. Somehow I do not think this will happen because there is far too much debt about and nobody wants to borrow.
    Another scenario is huge wage demands a le 1970s then we do have the potential for inflation it depends how long the lid can be kept on the pressure cooker before people are on the streets demanding a wage they can live on. I think there is a lot more mileage in the current situation before it is resolved.

  • Rich in name only

    Hi #15

    My point was that the article states that Gold hitting $2500 is a warning sign, however I would imagine most of the readers of this article have their savings in Sterling, so the warning sign should be Gold hitting £2500, not $2500….IMHO.

    BTW.. I hope the price of Au ‘falls’ further, because I want to top up.

  • Colin Selig-Smith

    Recommend you all watch the currency pairs. I find the 6 month & long term charts most helpful.

    JPY, GBP, CNY, EUR vs USD, and gold.

    Gold has basicaly been tracking the USD for the last year. Now the JPY and GBP have started falling vs USD in order to boost domestic export competitiveness and QE3 on the USD will gradually let the air out of the USD we’ll see gold gradually creep up. Oh unless the debt ceiling thing totally explodes but I don’t expect that.