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Let us Consult the Oracle

I have been talking about the Ponzi-scheme nature of our fiscal and monetary system since 2008.  Now according to a recent Wall Street Journal article, it looks like Warren Buffet is beginning to agree with me. 

Based on what I see happening around the world, currencies are a poorer bet than they have been for some time. If inflation ever really gets in the saddle it gets very unpredictable. Faith in institutions can break down.”

To understand the significance of this, recall that Ponzi-schemes break down as soon as people realize that they are eventually going to break down.  I have been saying for a while that it only takes a few important people getting spooked (especially if they do so publically) to touch off a catastrophic currency crisis.  Now here is Warren Buffet (who, if you haven’t heard, is a fairly important person) publicly expressing concern over currencies.  Now I’m not saying this will necessarily be the thing that does it, but we’re starting to see the signs.

So let’s dig a little deeper into these comments.  First notice the last paragraph in the article. 

“He warned warned [sic] that Greece faced added pressures because it had borrowed in euros and dollars, currencies it could not control, unlike–for instance–the U.S. As long as the U.S. borrows in dollars there’s no possibility of default, he said. “You don’t default when you can print your own currency.”

The important thing to realize here is that when you print your way out of debt you essentially are defaulting on your debt.  If you buy a government bond, and then the government has to inflate the currency to pay you, even though you get the amount of dollars you were promised, they aren’t worth as much as you expected them to be.  If you expect this to happen, you will demand a higher nominal interest rate to compensate you for the expected inflation.  This will make it more expensive for government to borrow, which will make them have to inflate the currency more which will cause you to demand a higher rate etc.  In other words, once inflation “really gets in the saddle,” it can be a very explosive process.  So it would be unwise to infer that our ability to print money should remove any fears of default on sovereign debt. 

The second thing to notice is that there is one important difference between this type of default and the more conventional default faced by Greece.  When governments default via inflation, the cost does not fall entirely on bond holders.  Currency is itself a debt.  It is just a debt that government obligates other people to pay.  When they print a lot of money, everyone who holds money pays the price.  Essentially this acts as a tax on holding money.  The fact that it is a tax that can be easily and quickly raised in order to pay off debts does make debt a little less scary than otherwise, since the potential default will be subsidized by the rest of the public (except for debtors…).  But while this makes bonds somewhat more attractive, it carries another troublesome side effect.  

If the government defaults in this way, it will take the currency down with it.  This means the decrease in concern over default in the bond market is just transferred to currency markets.  In other words, if you think this may happen, you will be less willing to hold money.  In economic jargon this is referred to as an increase in the velocity of money.  When velocity increases, it also causes inflation (see equation of exchange).  This source of inflation is, to some extent, beyond the control of the monetary authority and can lead to the same negative effects (an increase in nominal interest rates, causing higher borrowing cost, causing higher inflation expectations, causing lower velocity etc.).  In other words, the threat of inflationary default gives reason to be “‘more bearish’ on the ability of currencies to hold their value over time.” 

The final important point to notice here is that in none of these remarks does he mention the dollar.  He is talking about currency in general.  A lot of people like to take comfort in the fact that the Euro is in even worse shape than the dollar.  First, I’m not convinced that this is true since the inability of individual countries like Greece to devalue the currency when they get into trouble actually makes the Euro less volatile than it would be otherwise.  Nonetheless Europe is in deep trouble and it is still unclear what will ultimately be the fate of that currency.  This is causing the dollar to gain some strength as some investors flee the Euro.  

There is a seemingly widespread belief that there is a global demand for money that is highly inelastic and that if one currency has problems, that demand will be transferred to another currency.  This belief leads to the conclusion that the degree to which we can inflate our ponzi scheme is only limited by the restraint employed by other governments and central banks in inflating their ponzi schemes.  It is worth noting that this would be true if currencies were backed by a real asset (like gold) as they were for most of human history, so maybe it is a left-over instinct from days gone by.  But in a world of fiat money, it is possible for the demand for all currencies to dry up simultaneously.  All this requires is for people to start feeling, like Warren Buffet, that it is probably a better idea to hold real assets than paper money and all currencies can go down together.  We should be less consoled that Europe is making us look good at the moment and more concerned that they are providing a glimpse into our near future.

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  1. May 30, 2010 at 6:44 pm

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    • Free Radical
      May 30, 2010 at 11:27 pm

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  1. May 7, 2010 at 8:01 pm

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