Monthly Archives: February 2016

The Markets Go to Rehab: The Interview

Earlier this week I had the pleasure to discuss a recent post, “The Markets go to Rehab”, with Malcolm Palle, founder of the Mining Maven. If you would like to listen to the interview, you can click on the Soundcloud box below.

Recent market action highlights that the markets are increasingly dependent on an easy money environment. The question for investors is whether the Fed will stay the course (continue to tighten monetary conditions, i.e. send the markets to rehab) or buckle under the pressure and fail to shut off the tap. The issue is complicated by the extraordinary expansion of the monetary base over the past eight years and the problems that will be created if the Fed does not reverse this expansion.



Economic Challenges and Market Extremes

February 16, 2016

big picture

In periods of heightened market volatility, one of the great challenges for investors is keeping their eye on the big picture. While there are many immediate and much discussed threats to the global economy, including weakness in China, geopolitical conflict in the Middle East and a possible banking crisis in Europe, the key threats to the long-term economic prosperity of the Western World have changed little over the past few months.

The view of The Money Enigma is that the United States, Europe and Japan have balance sheet problem. Over the past twenty to thirty years, policy makers have attempted to “borrow growth” from future periods through a combination of unsustainable monetary and fiscal policy. This “frontloading” of economic growth and the distortions associated with this frontloading represent the greatest threat to the economic future of these regions.

In the first section of this week’s article, we will discuss some of the long-term charts that illustrate this point. Avid followers of macroeconomics will be familiar with many of these long-term economic charts. However, while familiarity may breed complacency, familiarity doesn’t make these charts any less extraordinary.

In the second section of this article, we will consider the implications of these problems for financial markets more generally, including a handful of key charts that indicate extraordinary divergences and extremes by historical standards. Some of these charts may be less familiar and hopefully they will cast some light on the opportunities that are present in the markets today.

The Big Economic Picture: Trouble in Paradise

The first chart may not seem to shout “trouble” but if you look closely it does highlight a serious issue: the rate of long-term economic growth appears to have slowed markedly in the United States.

US GDP growth rate

Source: Trading Economics, US GDP annual growth

Over the past ten years, the US has struggled to reach previous trend levels of economic growth: recent peaks in growth are lower, while the recent trough in growth was the worst in 50 years. Put simply, trend growth seems to have fallen by roughly 1% per annum over the past decade.

While the difference between 2% and 3% real economic growth might not seem like much, a small difference in the economic growth rate compounded over a long period of time makes a tremendous difference to general economic wellbeing. As Nobel Prize winning economist Robert Lucas, Jr. noted when he was discussing the difference in economic growth rates across different countries, “The consequences for human welfare involved in questions like these are simply staggering: once one starts to think about them, it is hard to think about anything else.”

This pattern of lackluster growth can be seen more clearly in other major countries such as France. France is a relative success story in Europe, i.e. it is doing better than Spain, Italy and the other Mediterranean states, and yet economic growth is anaemic.

france gdp growth

Source: Trading Economics, France GDP Annual Growth Rate

More notably, Japan has spent the past twenty years struggling to generate any sort of sustained economic growth.


Source: Trading Economics, Japan GDP Annual Growth Rate

What makes this slowdown in economic growth all the more remarkable is that it has largely occurred during a time when unprecedented fiscal and monetary policy has been implemented, policy explicitly designed at boosting rates of economic growth. In simple terms, the Western World has been taking huge risks with its balance sheet in order to keep its income statement looking healthy.

We can see this marked balance sheet deterioration across a range of charts. First, let’s look at the explosion of government debt in the United States.

us debt to gdp


While the chart above will be very familiar to most, it is still a remarkable chart. In the wake of the 2008 economic crisis, Federal government debt in the United States skyrocketed to levels not seen since the end of WWII. Nearly eight years since the crisis began, there has been no significant reduction in that debt.

This situation is echoed in Europe where, despite all the talk about austerity, virtually no progress has been made in reducing public debt.

Euro debt to GDP

Source: ECB

Concerns about the sustainability of the fiscal situation in Europe have begun to resurface again as indicated by CDS spreads across a range of countries. In the chart below, Deutsche Bank calculates the annual probability of default on government debt using the yield on 5-year CDS spreads.

CDS Europe

Source: Deutsche Bank

Meanwhile, the fiscal situation in Japan goes from the absurd to the ridiculous with total public debt as a ratio of GDP continuing to surge higher.


Source: Trading Economics

While many (Keynesian) economists believe that current levels of government across the Western World are sustainable, the view of The Money Enigma is that these levels of government debt do pose a real risk to the value of the fiat currencies issued by these major nations (“Does the National Debt Impact the Value of the Dollar?”).

Government debt plays a critical but complex role in the determination of the rate of inflation (“Government Debt and Inflation”). If the markets suddenly decide that current levels of public debt are not sustainable, then it could result in a sudden surge in the rate of inflation across the Western World.

Meanwhile, not only have governments issued more debt, but they have also issued more “equity”. Over the past eight years, the US monetary base has quintupled in size. The view of The Money Enigma is that this expansion in the monetary base represents, in effect, a massive issuance of equity (see “Money as the Equity of Society”). More specifically, the Fed has massively expanded the number of claims against the future economic output of the United States.

USMB 080216


Critically, while the Fed argues that it has begun the process of “normalizing” monetary policy, the Fed has made no progress to date in reducing the size of the monetary base. Indeed, the view of The Money Enigma is that the current round of interest rate rises by the Fed are largely just a distraction from the real issue, namely, the size of the US monetary base (“The Interest Rate Rabbit and the Base Money Elephant”).

In summary, the West has a balance sheet problem. The explosion in government debt and base money that has occurred over the past ten years is unprecedented in peacetime history. Not only has this balance sheet recklessness failed to drive a marked acceleration in the rate of economic growth, but it has also created an environment of increasing reliance upon government intervention in the financial markets.

The Markets: Some Fascinating Charts

In last week’s post, “The Markets Go to Rehab”, we discussed the increasing reliance of markets on the easy money policies of the major central banks. Nowhere is this dependency seen more clearly than in a chart of the S&P 500 relative to the US monetary base.

USMB vs S&P500 (1)

A quick look at this chart would suggest that fundamentals no longer matter, i.e. the direction of the equity market is solely determined by Fed policy. However, if fundamentals still do matter (and eventually they will), then the US equity markets do have one key problem ahead of them: valuation.

The problem for equity markets is not so much that the price/earnings ratio of the market is still relatively high by historical standards, but that corporate profit margins are extended at a time that revenue growth is hard to come by. More specifically, profit margins not only appear to have peaked, but remain very high when judged against historical standards.

corporate profit margins


While the US equity market is close to one extreme, the global commodities market is flirting with another. Unfortunately, long-term indices than can accurately present a clear picture of the overall commodities market are rare. Nevertheless, the following inflation-adjusted chart of the oil price does provide some sense of where commodities are in a long-term historical context.

oil price infl adjusted

Source: MacroTrends

While it is true that the oil price is not at all time record lows in inflation-adjusted terms, the point needs to be made that “Peak Oil” is still a real phenomenon in the sense that large, low-cost deposits are becoming harder to find and those that exist are being gradually depleted. In this context, the price of oil does look low by historical standards. [Those that would argue that shale represents a source of low cost oil clearly have never read a cash flow statement or balance sheet].

Oil also looks cheap in the context of gold. The gold to oil ratio is at a new high, indicating that oil is very cheap in gold terms, at least measured by history.

gold to oil

Source: MacroTrends, gold to oil ratio

The flipside of this coin is that gold is expensive in crude oil terms. However, gold appears to be cheap relative to other major financial assets, most notably, equities

gold to S&P500

Source: MacroTrends, gold to S&P 500

Finally, a good measure of the pessimism in the gold sector is the performance of gold stocks relative to the commodity itself.

xau to gold

Source: MacroTrends, XAU to gold ratio

This last chart indicates that gold stocks are very cheap relative to gold, at least measured by this rough historical standard. More surprisingly, gold stock valuations remain subdued despite the fact that the oil price, a major input cost, has collapsed.

The Markets Go to Rehab

February 9, 2016


“My name is The Market and I’m a Fedaholic.”

Since the Fed raised interest rates in December, many market participants must be feeling as though they just went cold turkey. In less than two months, the S&P500 is down nearly 10%, the VIX has surged and the gold price, the barometer of falling economic confidence, has risen sharply off its lows.

The bad news is that this is just the beginning of a long and painful process. Over the past ten years, global markets have become addicted to a combination of drugs. Now, for the first time in nearly a decade, the market is facing the real possibility that those drugs are denied.

The first drug is low short-term interest rates. In truth, the markets have been experimenting with this drug for many years, so much so that much of its potency has worn off.

fedfunds 080216

The second drug, a far more dangerous and potent drug, is monetary base expansion. Monetary base expansion has been used by the Fed to suppress long-term interest rates. Long-term rates have a far more potent impact on equity markets than short-term rates because the long-term risk free rate is a key input into the required cost of long-term risk capital, a key factor in the determination of stock prices.

USMB 080216

Any attempt to wean the market from these drugs is going to be difficult. Indeed, saying that it will be “difficult” is like saying that breaking an addiction to heroin is “difficult”.

Breaking and recovering from a serious drug addiction is a process, a long and painful process. Breaking the markets addiction to the Fed drug cocktail will involve many difficult and painful steps and is unlikely to be a simple, linear process.

Moreover, equity market investors who think, “the worst may be over”, are in for a rude shock. We will discuss the economics of this in more detail shortly, but first a simple analogy.

Let’s imagine that the market is the drug addict and the addict is being dragged off to rehab. The view of The Money Enigma is that the Fed’s action in December was the equivalent of getting the addict into the car and fastening the seat belt. Not only have the markets not begun the process of rehabilitation, they haven’t even reached the rehab center.

The first series of Fed rate hikes that are expected this year (2016) are the equivalent of getting the addict to the door of the rehab center. But the real rehabilitation process doesn’t begin until the Fed begins to reduce the size of the monetary base.

The big question for investors over the next two years is not so much whether the Fed will drive the markets to the rehab center, i.e. whether the Fed will raise the fed funds rate by 100-150 basis points, but whether the Fed will have the courage to get the markets out of the car and into the rehab center when they arrive at the door, i.e. will the Fed actually reduce the size of the monetary base.

If the Fed buckles under the pressure of the screaming addict in the back seat of the car and decides not to drag the addict out of the car, or worse, turns the car around before they even get to the rehab center, then the long-term future for the addict becomes dire. We will discuss this alternate future at the end of this article, but first, let’s discuss the market’s addiction to “easy money” and the path to sobriety.

The Growth of an Addiction

It has been widely noted by many market commentators that the direction of the global equity markets has become increasingly dependent upon Federal Reserve policy over the years.

Back in the 1990s and 2000s, the market became increasingly reliant on the economic stimulus created by manipulations in the fed funds rate. As Washington became increasingly dysfunctional and unable to provide clear leadership regarding economic stimulus, the markets turned to the their friends at the New York Fed and convinced the Fed that their primary role was to smooth out the economic cycle, particularly on the downside.

The Fed, under the leadership of Alan Greenspan, was more than happy to take on its new celebrity status and the Greenspan Fed created an art form of justifying sharp moves in the fed funds rate under the premise that “the Fed knows best”.

For our purposes, what is interesting about this first drug (manipulation of the short-end of the interest rate curve) is that it primarily operated through the impact it would have on lending and economic growth. In other words, this drug operated somewhat indirectly upon stock prices: lower interest rates drove higher lending and economic growth that boosted confidence in the long-term cash flows of equity securities.

The problem with this first drug is that the addict (the markets) became so accustomed to it that lost its potency. During the 2008 crisis, the Fed cut the fed funds rate to zero, but this alone wasn’t enough to provide the rush that the market (and the economy) needed to overcome the fallout from the excesses that had occurred over the previous two decades (notably, Tech Boom 2000 and Housing Boom 2006).

What was the Fed to do? They came up with a new drug: quantitative easing or “QE”.

Quantitative easing is a much more potent drug than simple fed funds rate manipulation because it acts as a direct shot in the arm for the equity markets. Whereas old school fed funds rate manipulation tended to act indirectly upon the financial markets, QE had a very direct impact upon the securities markets.

Why is this the case? Well, in order to understand how QE acts on stock prices, we need to go back the basics of securities valuation. Those that are interested in a detailed discussion of this topic should read “Has the Fed Created the Conditions for a Market Crash?” But for now, we will just touch on the key points.

In essence, the price of a business depends upon the sum of the discounted future cash flows of that business. There are two keys items that determine this calculation: (a) the future cash flows of the business and (b) the discount rate.

As discussed earlier, manipulation of the fed funds rate operated primarily by influencing the first item in that calculation, expected future cash flows. When the fed lowered short-term interest rates, economic growth would rise and people become more optimistic about the long-term path of future cash flows for the market.

QE is different because it acts directly upon the second item in our calculation, the discount rate. Why does QE have a greater impact on the discount rate than changes in the fed funds rate? QE is more potent because stocks are long duration assets, i.e. the value of the typical stock depends critically upon long-term expected cash flows.

What is the discount rate used to discount these long-term future cash flows? The long-term required return on risk capital. QE acts by forcing down the long-term risk free rate, thereby lowering the long-term required return on risk capital.

In other words, QE acts as a direct shot in the arm for equity markets. By expanding the monetary base and using this money to buy long-term government debt, the Fed forces up not only the price of “safe” assets (debt) but also the prices of “risky” assets (stocks).

If you don’t believe that this theory is plausible and you doubt the impact of monetary base expansion on the stock market, then I would encourage you to have a hard look at this next chart that plots the recent growth in the monetary base against the recent performance of the S&P 500 (all data is from the St. Louis Fed).

USMB vs S&P500 (1)

The Markets are Tweaking

The view of The Money Enigma is that the recent volatility experienced in global financial markets represents just the beginning of a long withdrawal process. In simple terms, the markets are “tweaking” as they begin to come off the “easy money” high.

Indeed, there is a strong analogy that can be made between the use of monetary base expansion and the markets dependence upon that stimulus and the experience of the typical methamphetamine addict. More specifically, monetary base expansion (or “money printing”) is a potent drug that creates exhilarating highs and debilitating lows.

We can apply the seven stages of addiction model for methamphetamines to the market cycle associated with easy money. As described in an article published in July last year, “Monetary Base Expansion: The Seven Stages of Addiction”, there are seven stages in the easy money cycle.

In the first stage, “the Rush”, the immediate pressure of an economic crisis is relieved by central bank intervention in the markets, i.e. creating money and using this money to buy bonds.

In the second stage, “the High”, the markets are in a more optimistic state and decide that the risks of monetary intervention (drug use) are low, i.e. “this time is different” and “we can handle it”.

In the third stage, “the Binge”, the overconfidence created by the first experimentation (QE1) leads to a period of poorly controlled use of the drug (QE23/QE3), or a “binge”. Typically, this is the point where the user becomes delusional and aggressively overconfident. (Does the chart below suggest any of this type of behavior in the last few years?)

s&p500 090216

Today, we find ourselves in the fourth stage, “Tweaking”.

Tweaking occurs as the level of the drug in the users system begins to decline below a critical level. For the markets, the Fed’s first interest rate rise in December triggered the realization that the easy money drug cocktail is going to be slowly withdrawn. In essence, the Fed has bundled the markets into the car and told them they are going to rehab.

In the tweaking phase, addicts become increasingly nervous and erratic. The market volatility over the past couple of months is symptomatic of this kind of behavior. But this is unlikely to be the worst part of the experience.

In the fifth phase, appropriately called “the Crash”, the positive impacts of the drug wear off and the addict, at least temporarily, becomes unable to complete the simplest of tasks, i.e. market failure occurs, at least temporarily.

What would it take for the markets to enter the “Crash” phase? It isn’t entirely clear. Will the Fed need to reduce the size of the monetary base before the cost of capital resets and the markets fall accordingly? Or will simply the promise of monetary base reduction and a few more interest rate rises be enough to trigger such an event?

Nevertheless, while the precise path to recovery may not be clear, the markets will need to go through the recovery process at some point, a process that involves not just a “Crash” phase, but also prolonged “Hangover” and “Withdrawal” phases.

Undoubtedly, there are those that will argue that the market is a discounting mechanism and the withdrawal of monetary stimulus is “priced in”. While this may be true about the upcoming series of Fed rate hikes, it seems unlikely to be true when applied to the possible reversal of QE over the next 3-5 years. Not only is a reversal of QE a more distant possibility, but also it still isn’t clear that market participants really understand how QE acts on the long-term cost of risk capital and how a reversal of QE will significantly raise this cost of capital, thereby placing the equity markets under enormous pressure.

If it doesn’t sound like a good future, it isn’t. But, what happens if the Fed doesn’t “normalize” monetary policy, i.e. if the Fed doesn’t raise rates and substantially reverse QE? What if the Fed doesn’t force the markets into rehab? What if the Fed doesn’t even make it to the rehab center? Well, then a worse long-term fate awaits the markets.

The Addict that Didn’t Make It

In the media, we hear a lot of stories about addicts that have recovered from their terrible and self-inflicted drug addictions. What we don’t hear about as often are the ones that don’t make it. Amy Winehouse, writer of the song “Rehab”, was one the famous exceptions to this rule.

Perhaps this bias in the media has contributed to the idea, not endorsed by The Money Enigma, that “drugs are OK, I can deal with it, after all, I can always go to rehab and get clean just like the celebrities do”.

Interestingly, this same sense of recklessness and self-confidence seems to be a hallmark of the historical experimentation with money printing. No society starts the process of money printing believing that it will all end in disaster. Rather, money printing is always presented as a necessary solution to a crisis and, at least in the initial phases, it is generally met with widespread popular approval.

Unfortunately, monetary base expansion is an experiment that seldom ends well. Just like drugs, the problem with monetary base expansion wouldn’t be so serious if the experiment was truly a “one off”. But inevitably, experiments with temporary expansions in the monetary base end up becoming permanent addictions to higher levels of money creation.

If you go back to early 2009, you might remember that QE1 was promoted by the Fed as an emergency solution to a crisis that genuinely threatened global financial markets, i.e. it was a temporary response to a temporary problem. Similarly, QE2 and QE3 were advertised as temporary measures to get the US economy back on track. All of these were noble goals, but the problem is that, nearly seven years later, none of these “temporary” measures have been reversed.

Why does this matter? Well, the problem with permanent expansions of the monetary base is that, sooner or later, they have a severely negative impact on the value of fiat money and, as the value of fiat money falls, prices as expressed in money terms rise.

The view of The Money Enigma is that fiat money represents a proportional claim against the future economic output of society (see “Theory of Money” section). What this means in practice is that the value of fiat money depends upon expectations regarding the long-term future path of two variables: real output and the monetary base. The value of fiat money is positively correlated to long-term expectations regarding real output and negatively correlated to long-term expectations regarding the size of the monetary base.

If an expansion in the monetary base is expected to be temporary, then this will have little impact on the value of fiat money. However, if an expansion in the monetary base is expected to be permanent in nature, then this will have an immediate negative impact on the value of money.

Moreover, if an expansion in the monetary base that was advertised as “temporary” suddenly becomes “permanent”, then the value of money can collapse quite quickly, triggering a dramatic acceleration in the rate of inflation.

And here, in a nutshell is the problem for the Fed and the addict in the back seat of the car. If the Fed sends the markets to rehab, it will be an unpleasant experience for financial markets and the economy, but at least a “survivable” experience. However, if the Fed flinches and fails to send the markets to rehab, then the dollar will collapse and the rate of inflation in the US will soar. In this second scenario, the Fed will lose control of the economic agenda and the markets will find that living with the drug is worse than living without it.

What Causes Deflation? Is Deflation Likely to Occur?

February 2, 2016 – The Money Enigma


Over the past few years, the word “deflation” has become as popular as the word “inflation” in discussions of financial market risk. But does deflation really represent a risk to the world economy at this time?

The view of The Money Enigma is that inflation poses a much greater risk to the global economy than deflation at this point in time. While severe deflation is a real possibility under a gold standard, such as existed in the 1930s, the fact is that severe deflation is an unlikely outcome under a fiat money regime.

In order to understand why this is the case, we will attempt to answer a few basic questions about deflation.

First, what are the primary causes of deflation? Second, why is deflation more likely to occur under a gold standard than it is under a fiat money regime? Third, what factors are likely to prevent an outbreak of severe deflation across Western economies over the next few years?

Deflation: Why Do Prices Fall?

Let’s begin with some basic microeconomics.

Every price is a relative expression of market value. More specifically, a price measures the market value of one good in terms of the market value of another good. Therefore, at the most basic level, a price can fall for one of two reasons: either, (a) the market value of the first good falls, or (b) the market value of the second good rises.

Think about this in simple terms. Imagine you live in a barter economy with no money and two goods, apples and bananas.

If one apple is three times more valuable than one banana, what is the price of apples in banana terms? Clearly, it is three bananas. If the market value of an apple is three times the market value of one banana, then you will have to offer three bananas in order to buy one apple. The ratio of exchange, bananas for apples, is three to one. Hence the price of apples in banana terms is three.

Now, why might the price of apples, as measured in banana terms, fall?

Well, there are two possible reasons.

First, apples may become less valuable. If apples become less valuable, then it will require fewer bananas to purchase an apple and the price of apples in banana terms will fall.

This much is obvious. What is less obvious is that the price of apples may fall for a second and just as important reason: bananas may become more valuable.

If bananas become more valuable, then it will require fewer bananas to purchase an apple. For example, if there is a sudden shortage of bananas, then we might find that apples and bananas are now of equal value. What happens to the price of apples? It falls. If bananas become more valuable such that one banana and one apple are now of equal value, then the price of apples will fall from three bananas to one banana!

Price as Ratio of Two Market Values

In summary, the basic microeconomic principle is that in any exchange of two goods, the price of the transaction depends upon the market value of both the primary good (in this case apples) and the measurement good (in this case, bananas).

Now, let’s apply this principle to a modern money-based economy.

The price of a good, in money terms, depends upon both the market value of the good itself and the market value of money.

Price and the Value of Money


Therefore, in a money-based economy, the price of a good will fall if either, (a) the value of the good itself falls, or (b) the value of money rises.

Let’s think about point (b) for a moment. The price of an apple in money terms depends upon both the value of apples and the value of money. Let’s imagine that today an apple is twice as valuable as a dollar. What is the price of apples? The answer is two dollars.

Now, what happens if, all else remaining equal, money becomes more valuable? For example, one year later the value of a dollar, as measured in absolute terms, has doubled while the value of an apple has remained the same. What is the new price of apples? The answer is one dollar. One dollar is now just as valuable as one apple.

In this example, the price of apples falls, not because apples became less valuable in an absolute sense, but because apples became less valuable in a relative sense, i.e. relative to the value of money.

The key point is that, at a microeconomic level, the price of a good can fall for one of two different reasons: either, (a) the market value of the good falls, or (b) the market value of money rises. Readers who are unclear on this point are encouraged to read “The Measurement of Market Value: Absolute, Relative and Real” and “A New Economic Theory of Price Determination”.

Moreover, we can extend this microeconomic concept to a macroeconomic discussion of deflation.

In simple terms, falling prices across the economy can be caused either by (1) a fall in the market value of goods and services, or (2) a rise in the market value of money.

Ratio Theory of the Price Level

Once again, the first part of that statement is rather obvious. If there were a sudden collapse in aggregate demand, then you would expect good and services to become “less valuable”. In the diagram below, a sudden shift to the left in the aggregate demand curve will lead to a fall in the overall market value of goods (denoted “VG).

Goods Money Framework

However, what most economists and market commentators fail to do is to think about the implications of a weak economy on the right hand side of the diagram immediately above. While a weak economy will almost certainly lead to a fall in the market value of goods (VG falls), a weak economy could also lead to fall in demand for money leading to a lower market vale of money (denoted “VM). Importantly, if the value of money VM falls more than the value of goods VG, then the ultimate outcome is not deflation but inflation!

Deflation: Gold Standard versus Fiat Money Regimes

The problem with most “inflation or deflation” debates is that the participants don’t recognize the simple notion that price is a relative expression of market value.

Any meaningful discussion of deflation must consider not only the forces acting upon the market value of goods (oil price, output gap, etc.), but also the forces acting upon the market value of money (expectations regarding future output growth and base money growth).

More specifically, any genuine discussion regarding the prospect for deflation needs to recognize that while deflation is a real possibility under monetary systems based on the gold standard, widespread and persistent deflation represents a very unlikely event under most fiat money regimes.

Nowhere is this better illustrated than in a comparison of inflationary outcomes in the United States in the early 1930s and the late 1970s.

While economists may debate the exact circumstances surrounding these two different periods, the fact is that both periods where characterized by severe economic weakness, falling economic confidence and rising rates of unemployment. Yet the inflationary outcomes in both periods were vastly different: in the 1930s, prices collapsed; in the 1970s, prices soared.

While many economists may attempt to blame rising prices in the 1970s on OPEC and the oil shock, the view of The Money Enigma is that these two different periods experienced two very different outcomes primarily because of the different nature of the monetary regimes that existed at that time.

In the 1930s, the United States operated on a gold standard. The value of each US Dollar was fixed to a certain amount of gold. In effect, this meant that the market value of each US Dollar was tied to the market value of gold: if the value of gold rose, then the value of the Dollar rose.

In the early 1930s, the “perfect storm” for deflation occurred. First, there was a sudden collapse in aggregate demand, a collapse that was triggered by the excesses of the 1920s. This collapse in aggregate demand led, as one would expect, to a massive decline in the market value of goods and services generally.

In itself, this event was highly deflationary. However, another important factor was in play at that time. As the financial system became increasingly unstable, demand for gold rose: as the market value of gold rose, the market value of the US Dollar also rose! Why? The market value of money rose because the value of money was directly tied to the value of gold.

Now, think about this in the context of our earlier discussion. If the price level is a relative measure of the market value of goods and the market value of money, then what creates the “perfect storm” for deflation? A collapse in the value of goods and a surge in the value of money!

Ratio Theory of the Price Level

In the early 1930s, the gold standard created the perfect set up for a collapse in prices. First, aggregate demand collapsed, leading to a fall in the market value of goods (VG falls). Second, demand for gold rose due to financial instability, leading to a rise in the market value of gold and a commensurate rise in the market value of money (VM rises). The value of goods, as measured in money terms collapsed, and the US economy entered a period of severe deflation.

Now, let’s contrast this with what happened in the late 1970s.

In the 1970s, the US economy experienced both an aggregate demand and aggregate supply shock. In terms of our Goods-Money Framework, the aggregate demand and aggregate supply curves both shifted to the left. The net impact on the market value of goods VG was probably a modest rise.

However, the view of The Money Enigma is that the modest rise in the market value of goods during the 1970s can not fully explain the high levels of inflation that were experienced during that time. Rather, some other factor was at play: a fall in the market value of money VM.

Why did the value of money fall in the 1970s? Well, in 1971, President Nixon ended the convertibility of gold into dollars. Suddenly, the value of the US Dollar was no longer tied to the value of gold and the value of the US Dollar began to decline sharply. As economic confidence in the long-term prospects of the United States declined, the US Dollar began to loss value.

The key point is that in the 1970s, under a fiat regime, economic weakness led to a decline in long-term economic confidence and a decline in the value of money. In contrast, in the 1930s, under a gold standard, economic weakness actually led to a rise in the value of money because the value of money was tied to the value of gold.

This difference explains, more than any other factor, why high levels of inflation plagued the 1970s, while the 1930s experienced severe deflation.

In summary, in order to have a sensible discussion regarding the risk of deflation, we must consider not only the obvious impact of a fall in aggregate demand upon the value of goods, but the nature of the prevailing monetary regime and how economic weakness may impact the value of money under that regime.

The Likelihood of Deflation in 2016 and Beyond

While many market commentators are obsessed by the possibility of deflation, the fact of the matter is that a prolonged period of deflation is a very unlikely under the current fiat money regime that exists in the United States.

As we look ahead into first half of 2016, there is little doubt that economic weakness, most notably a slowing of growth in China and a fall in oil prices, will contribute to a decline in the market value of goods. However, these factors are unlikely to be sufficient to drive a severe decline in prices in the United States.

A prolonged and/or severe period of deflation requires another key factor that is unlikely to occur over the next few years: a rise in the value of money.

As discussed above, one of the primary drivers of the deflation that occurred in the 1930s was a rise in the value of money. In the early 1930s, the value of money was tied to the value of gold. The financial instability of the early 1930s drove up the value of gold and, consequently, the value of money, creating a perfect storm for deflation.

This outcome is very unlikely to occur over the next few years. Indeed, the view of The Money Enigma is that we are much more likely to experience the exact opposite of this, i.e. the US will experience a rapid decline in the value of money and a surge in prices.

The key difference between the 1930s and today is this: in the 1930s, the value of money was tied to the value of gold; today, under the existing fiat money regime, the value of money is directly linked to confidence in the long-term economic future of society.

Over the past few years, the US Dollar has been riding high on optimism regarding the long-term economic outlook for the United States. In essence, most people are optimistic regarding the 30-year economic outlook for the United States, despite the structural weaknesses that were exposed in the 2008 financial crisis and the government credit rating crisis in mid-2011.

However, recent events suggest that optimism in regards to the long-term economic outlook may have peaked. More specifically, the beginning of monetary policy “normalization” by the Federal Reserve has already disturbed the financial markets, despite the fact that this first move by the Fed represents at best what might be described as a “baby step”.

As the Fed continues on its current path, it is almost inevitable that economic disruption will occur and the markets will begin to question the long-term future of the United States. If confidence in the long-term future of the US is damaged, then the value of the US Dollar could decline sharply and prices, as expressed in USD terms, could rise suddenly.

Why is the value of fiat money tied to confidence in the long-term future of society? In essence, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. As long-term confidence weakens, a proportional claim on the long-term future output of society becomes less valuable.

Readers who are interested in this general concept should read the “Theory of Money” section of the website and/or a recent post titled “What Factors Influence the Value of Fiat Money?”

Under a fiat money regime, a period of global economic weakness is a necessary, but not sufficient, condition to generate deflation. Therefore, a prolonged period of deflation in the United States is unlikely over the next few years. Rather, it is much more likely that the US Dollar will decline in value over the next few years, at least as measured in absolute terms, and that inflation in the United States will accelerate.