America's Disinflationary Future?
by: Jake Huneycutt 


  • The US could suffer from a low-growth, disinflationary future, similar to Japan after the collapse of the Japanese asset bubble.
  • Policies of the Federal Reserve, such as QE, have increased the likelihood of disinflation.
  • QE incentivizes short-term investment at the expense of long-term investment.
  • Interest rate suppression results in a cycle of subdued returns, lower investment, and lower growth.
  • Fed policies that have suppressed interest rates will increase likelihood of future issues with pension funds, resulting in austerity (higher taxes and / or lower benefits).

The United States is in danger of falling into a disinflationary, low-growth trap. It's the same perpetual trap that Japan fell into by the mid 1990s. And the policies of US Federal Reserve Bank are the primary culprit.

In 2008, the Federal Reserve launched its first quantitative easing program in the wake of the US financial crisis. The program initially focused on mortgage-backed securities, but shifted to US treasury bonds by March 2009. QE might have been thought of as an "emergency measure" at the time, but here we are nearly six years later, and the Fed is just now winding down the program. I'm not 100% convinced this is the end, either, as the Fed has gone down this path before in late 2009 and mid 2011, only to restart the program again.

QE's supporters have argued the program is necessary to stimulate a weak economy. QE's fiercest detractors have often argued that the size and scope of QE would result in massive and uncontrollable inflation.

My position differs from both of these common views. Rather than generating inflation, I view QE as disinflationary. Or to be more precise, QE has a near-term inflationary impact on asset prices, but over the long term, it has a disinflationary impact due to its reversionary nature, incentives favoring resource misallocation, and tendency to knock down long-term returns on investment.

Recall Newton's Third Law of Motion:
"When one body exerts a force on a second body, the second body simultaneously exerts a force equal in magnitude and opposite in direction on the first body."
We may not be talking about physics, but the principle holds true in economics, as well.

When the Federal Reserve knocks down interest rates, it benefits borrowers, such as large corporations, banks, and real estate investment trusts ["REITs"]. Yet, there is always an "equal and opposite reaction." On the opposite side of the equation are savers, such as pension funds, retirees, endowments, mutual funds, the Social Security Trust Fund, etc.

QE's supporters have attempted to argue that the program "expands the pie" by creating more economic growth, but there's no evidence to support this thesis. What's more likely is that the program sacrifices long-term growth in the name of short-term growth. Moreover, there is a redistributionary aspect, with the borrowers increasing their profits, while the lenders reduce theirs. This is especially true given the zero-bound rate environment, where QE results in lower interest rate spreads.

The impact on savers may not be immediately apparent, for reasons I'll get into later. However, my basic thesis is that by knocking down interest rates, QE reduces the long-term rate of return, disincentivizing future investment. In essence, it promotes short-term investment (with subpar returns), at the expense of long-term growth.

Allocation and Misallocation

To understand why QE creates disinflation, we must first understand the concept of "malinvestment," or that is, the misallocation of resources. QE's main objective is to create economic growth by increasing lending. In order to do this, it attempts to lower costs for borrowers by knocking down the rate of return on alternatives to loans (e.g. treasury bonds).

This is an allocation preference that favors debt-driven growth. However, businesses and individuals that take on debt tend to have certain characteristics.

For a lender, the ideal loan is one where [a] there is greater certainty in cash flows, [b] there is a "creditworthy" borrower with a long-term track record, and [c] there is an asset to seize in case of default. In short, the ideal borrower is a large, mature company with stable cash flows that owns lots of real estate, machinery, or heavy assets with tangible value. The opposite of that would be a young start-up company, with inexperienced leadership, many intangible assets, and lots of uncertainty.

Hence, by favoring debt-driven growth, QE benefits certain assets over others. REITs and restaurants, for instance, benefit more directly from QE than say a biopharmaceutical R&D firm that relies almost exclusively on intangible know-how. That said, QE's tendency to knock down returns on one class of assets will eventually make other classes of investments more attractive, as well. For this reason, it's not a stretch to argue that while QE may have initially benefited hard assets more, the current venture capital boom may also be partly fueled by QE.

Yet, the general trend is the same. QE drives up asset prices, which then reduces the overall rate of return over time. This creates higher risk and makes the economy more vulnerable. While the US housing bubble was fueled more by conventional monetary policy, it was very similar in nature.

Rising Prices, Lower Returns

Let's model out a hypothetical scenario to illustrate the basic concept. This hypothetical asset costs $100 million to build, produces $9 million in annual cash flows in perpetuity, and will sell for exactly the same price in 10 years (for simplicity's sake). Our firm has a required rate of return of 20% and the current interest rate is 6%. We'll assume that assets of this variety are normally funded by 75% debt and 25% equity.

With a 6% interest rate and 75% debt financing, our asset will have a slightly negative NPV of $1.75 million. The IRR is around 18%, a bit below our 20% hurdle rate. As a result, we'll choose not the build the asset under these parameters.

Now, let's assume the Federal Reserve conducts a series of quantitative easing measures that knock down market interest rates, first to 5%, then to 4%, and finally to 3%. With a lower 5% interest rate, the project now has an IRR of 21%, and therefore meets the 20% hurdle rate requirement. Thus, QE changed our decision to build. We can also see the progression as the rate continues to fall. With a 4% interest rate, the IRR increases to 24% and with a 3% interest rate, the IRR jumps all the way to 27%, with an NPV of $6.1 million. Suddenly, an investment that initially looked subpar looks spectacular.

(click to enlarge)

Is this ideal for the overall economy, though? As returns increase on this asset class, more investors move in and push the returns right back down.

Supply and Demand

Now that we can earn a 27% IRR (well above the 20% target), a lot more investors want a share of the pie. These investors flood in and knock the IRR back down. This is achieved by bidding up the prices on the underlying assets.

How far will the IRR fall? It should fall back to at least 20% (our original required rate of return), but in reality, it will probably fall even further. Since the Fed has knocked down all interest rates, that means investors will eventually have fewer avenues to make a 20% return, and they'll begin to accept lower returns. Instead of 20%, they might be willing to take 17% (a conservative guess), or maybe even 15% or 12%, as the spread between the safest and riskiest investments begins to shrink.

In our example, in order to knock the IRR back down to 20%, the price of the underlying asset would need to rise 24% to $124 million. If we get more aggressive and knock the IRR down to 17%, the price must rise to $138 million. If we knock the IRR down to 12%, the price should surge 70% to $170 million. Yet, we should note that in all of these examples, the cash flows remained exactly the same. The only difference is that it costs much more to obtain the stream of cash flows.

(click to enlarge)

My examples may even be understating the impact. As interest rates go down and asset prices go up, banks are more likely to allow higher leverage ratios, further jacking up IRRs, which then leads to even higher prices.

This is how bubbles are created!

There are two possible outcomes. Either the market prices fall to push returns back up (i.e. a market correction) or returns continue to stay subdued. The latter outcome is of particular interest, as the Federal Reserve's policies indicate an extreme aversion to a market correction. However, I want to show why "return suppression" is an even bigger problem.

Equal and Opposite Reactions: The Savings Dilemma

Let's focus on the other side of the equation: the savers. In spite of generating lower long-term returns, QE initially looked good for savers since it created a flurry of capital gains from asset price increases.

This created the illusion of growth. However, over the long term, the logical outcome is subdued returns, which worsens the condition of savers. In application, QE does not look that different from a company that invests in a low-return project to boost short-term profitability. The company's earnings surge initially, but due to lack of prudent long-term investment, there's stagnation beyond that.

As far as savers go, the state public pension funds are worth examining in particular. This chart below shows the funded status of state public employee pension funds at the end of FY 2012.

Many of these pensions are severely underfunded, in spite of the great stock market environment of the past several years. For instance, Kentucky's funded level was only 46.8% and Illinois was only at 40.4% as of the end of 2012.

(click to enlarge)

Next, we should take a look at the actuarial assumptions of these pension funds. More often than not, public employee unions have negotiated unrealistic assumptions with friendly politicians. The US average is around 7.7%, with several states coming in at 8%. These returns will become increasingly unrealistic the longer the Federal Reserve continues to suppress interest rates.

So now let's combine this information and get a sense of how QE may be impacting savers. Let's examine a hypothetical state pension fund that is 80% funded with an 8% actuarial return assumption. Let's assume that even during a normal environment, 7% is much more realistic than 8%. The fund has two options: increase risk to try to get to 8% or accept 7%. In this example, the fund will opt for the safe option. (Though, we should note that many funds get themselves into trouble by opting for the "higher risk" option.)

The fund will earn 7% for the first two years in our scenario. After that, a central bank will enact quantitative easing that knocks down interest rates. For Years 3 - 4, the fund will earn 6% maintaining the same level of risk. In Years 5-6, that falls to 5%, and for Years 7 - 10, the returns falls to 4%.

Now, let's model that against a "normal scenario" where the fund simply earns 7% the entire time.

The results can be seen in the chart below. At the end of the 10-year period, the "normal environment" fund ends up with $196.7 million in investments versus $165.9 million for the QE scenario, that's a difference of about $30 million. The "normal environment" fund is 72.9% funded at the end of ten years, and the QE scenario fund is only 61.5% funded.

(click to enlarge)

This is a pretty big difference over a 10-year time frame and this exact situation is going on across America right now. Of course, the actual results will be much lumpier than this, and may involve a stock market bubble and subsequent crash at some point.

It's not merely the public employee pension funds suffering. All savers will see subdued long-term returns as a result of QE. However, the state pension funds showcase what's happening on a grand scale. As these pension funds become increasingly underfunded, state governments will be forced to decide whether to cut benefits, raise taxes, or use a combination of the two policies. Tax increases and benefit cuts are both disinflationary, since they reduce private investment and consumer spending.

The overall logic goes like this: QE boosts short-term asset investment and higher prices, but this leads to subdued investment returns over the long term. These subdued returns result in less spending and investment in the future, which reduces future economic growth. Weaker economic growth results in weaker demand for loans, which is disinflationary.

International Concerns

It's worth noting that the policies of the US central bank are only one piece of the puzzle. Even if US policies promote low growth and disinflation, the rest of the world can significantly alter that equation. For instance, if Europe sees high growth, that will likely result in more global trade, which will be good for US growth.

Unfortunately, given the current state of the world, this scenario seems unlikely. The Eurozone looks even more dysfunctional than the US right now. Meanwhile, China continues to show more signs of weakness, which could further drag down global growth.

There are some bright spots around the world, such as East Africa, but it's difficult to imagine that this would be enough to offset the massive issues in Europe, the US, and China. For this reason, while there are some possible external factors that could drive greater US growth, I'm not terribly optimistic about them in the near-term future (i.e. the next 3-5 years). I view the "international environment" to be more likely to promote disinflation in the US.

How the Status Quo Could Change

Certainly, there's a possibility that shifts in policies could change (or exacerbate) the current disinflationary track. Let's focus on a few areas: Fed policy, taxes and spending, and regulation.

Fed policy is the simplest to deal with. While I've argued that the Federal Reserve has suppressed interest rates for a long time, the problem is that they have created a Catch-22. If the Feds raise interest rates, a significant market correction becomes much more likely. This may be beneficial long-term, since it will force returns to move back upwards, but it would also likely create a recession and invoke much short-term pain. Conversely, if the Feds continue down the current track, low returns will continue to harm pensions, resulting in higher taxes, lower spending, and subdued private investment. All of this is to say, I'm not sure that the Fed can "re-engineer" the US economy away from disinflation at this point. They are stuck in a mess of their own creation.

The greater hope for growth comes in the government policy sphere. On the regulatory front, Dodd-Frank reforms could be beneficial to long-term growth. While QE generally incentivizes lending, Dodd-Frank has created a semi-exception to the rule in residential housing. Why is this bad? Because it's another example of policy skewing natural economic decisions. Economically we are saying corporate lending is good, but mortgage lending is bad. This has resulted in a booming corporate environment, but a stagnant residential lending market. For this reason, a reversal or significant reform to Dodd-Frank could help unlock economic value and create greater long-term growth. It unfortunately will not stop the Fed's problematic policies, however, so no guarantees that it wouldn't also create another housing bubble.

The other obvious area that could change the status quo is taxes and spending. This can go many ways. We could see pro-growth reforms, such as a lower corporate tax, and a streamlined income tax code. These reforms would likely stimulate long-term growth. We could also see larger budget deficits, which create inflation. I won't go into details on this, except to say that we've seen declining budget deficits over the past few years due to a few trends:

(1) The stimulus act of 2009 created a temporary surge in spending but has since been tapered,

(2) Small Federal spending cuts (e.g. the sequester),

 (3) Higher Federal taxes on payroll, income, capital gains, and healthcare,

(4) Cyclical factors have resulted in increased profitability, therefore increasing tax revenues

These factors have combined to knock the US Federal budget deficit from 10% of GDP in 2009 to 3.5% of GDP in 2014. A reversal of this could fuel more significant inflation. Conversely, a continued trend towards a balanced budget would be disinflationary, unless accompanied by pro-growth reforms. I mention this neither to say it's good nor bad, merely to say it is.

(click to enlarge)

Overall, I think it's unlikely that the Federal government changes its current course. We probably won't see any major shifts in tax or regulatory policy over the next few years. The Federal Reserve is a little less predictable, but given the current ideology there, I suspect that we will continue down the current track of ZIRP and monetary "stimulus" any time there's the slightest hint that the economy is seeing lower growth. In sum, the status quo is likely to continue for at least 2-3 more years.

Investment Takeaways

While this article may seem to present a lot of gloomy information, I would say don't lose hope.

The key is to make rational investment decisions. Many investors have done quite well in Japan in spite of the poor investment environment of the past two decades. Even if the US is headed for perpetual low growth, there will still be many good investments out there. Patience is required, however.

My biggest point of advice is to never lose sight of risk and reward. With a surging stock market, it's easy to convince one's self that "all is rosy," rather than realizing that prices are being driven by factors other than business fundamentals. The best investments have low downside risk and good upside reward potential. Higher prices imply higher risk. Good investments have existed in every market environment, including the tech bubble of 2000, and even the 2007 market. However, they are much more difficult to find in those types of inflated markets.

Keep away from high-flying stocks with insane multiples. This includes the Zillows (NASDAQ:Z), Teslas (NASDAQ:TSLA), and Netflixes (NASDAQ:NFLX) of the world. Even if these are good / great companies, the valuations are simply insane, and this has become common with a lot of tech stocks. This may be indirectly related to QE.

Keep a little extra cash on the side. Don't go overboard and hold 100% cash, but holding 10%, 20%, or 30% cash in your portfolio is completely reasonable right now given the macro risks. That way, if we get a significant correction, you'll have a good deal of extra cash to deploy to find stocks at more attractive valuations.

While it's possible that the Federal Reserve and the Federal government could reverse course, I do not envision it happening soon. For this reason, I see it as more likely that the disinflationary environment continues, with interest rates slowly falling, and the Dollar gaining strength. Be both cautious and opportunistic. Look for attractive investment ideas, but have a mindset of focusing more on capital preservation.

Review & Outlook

China’s Missing Business Cycle

A slowdown will make the real health of the economy clearer.

Oct. 22, 2014 7:03 p.m. ET

China's former central bank governor Dai Xianglong speaks at an international forum on China and globalization on June 15, 2000 in Beijing. Agence France-Presse/Getty Images 

News that China’s GDP grew at 7.3% in the third quarter, its slowest rate since early 2009, is stirring renewed fears about the health of the world’s second-largest economy. As euro-zone economies flail and the U.S. recovery underwhelms, most analysts don’t want to think about China falling out of bed.

So they aren’t. The consensus view among China-watchers is that the country has undergone a shift into a slower phase of its development. Having banished the business cycle, Beijing will maintain steady growth, albeit at a slightly less blistering rate.

It’s true that the last time China’s economy slowed for a significant period was more than a decade ago. But there is good reason to suspect that the wise men of Beijing haven’t repealed the laws of economic gravity. In particular, the costs of state-directed growth are emerging in the form of an enormous debt overhang from the post-2008 credit binge.

Beijing can still goose investment at critical moments and try to engineer a soft landing. The central bank has recently eased credit controls and injected liquidity into the banking system, leading to an uptick in new lending in September. Supreme leader Xi Jinping also laid out a creditable program to reinvigorate economic reform at last November’s Third Plenum meeting. Privatization of smaller state-owned enterprises continues and private firms are increasing their share of the economy.

Yet most of the reform initiatives have erred on the side of caution, or have been mainly cosmetic.

More worrying is the way the financial system has reverted to statism over the last six years as the government encouraged banks to lend and corporations to borrow.

China’s credit statistics now look strikingly similar to those of Japan in the late 1980s and South Korea in the mid 1990s. When catch-up growth based on urbanization and imported technology falters, the East Asian development model encourages the use of leverage as a substitute fuel.

That can lead to a balance-sheet recession or even a financial crisis. Once a slowdown starts, problem loans come to the surface. There is some evidence this is happening in China, although the totals remain relatively small.

One reason Chinese banks look healthy is that the government continues to bail out failing companies and local governments rather than let them default. The latest example is the troubled solar-panel maker Chaori, which was rescued by a state-owned firm this month. The aptly named Great Wall Asset Management guaranteed 788 million yuan ($129 million) of Chaori’s bonds.

Beijing might be able to engineer and finance another restructuring of the banking system to avert a crisis. But as with the last bank recapitalization in the early 2000s, wiping the slate clean involves warning the banks that this is their proverbial last supper. With no more easy credit to prop up growth, China will have to reconcile itself to the vicissitudes of the business cycle.

October 23, 2014 10:19 am
Volatility tests the nerve of dollar bulls
100 dollar notes currency US dollar bills©Dreamstime

Dollar bulls have hit a rocky patch. Buying the US currency has been the favoured trade of currency investors since last year’s “taper tantrum”, when the Federal Reserve said it would ease its bond-buying scheme as the economy showed signs of improvement.

Now, investors are arguing that last week’s “flash crash” in US bond yields was a wake-up call that volatility will make buying the dollar a trickier trade in the weeks and months to come.

“I expect volatility to rise and sentiment to continue to ebb and flow but ultimately still expect the dollar to strengthen, albeit with a lot of disappointment along the way,” says Matthew Cobon, a currency investor at Threadneedle.

The dollar index rose more than 7 per cent in the three months to the start of October to hit its highest level in more than four years, buoyed by expectations the US would tighten interest rates sooner than other major economies. The contrast with the eurozone has been particularly stark, with the European Central Bank instead stressing a shift towards asset purchases to stave off the threat of deflation.
Yet the dollar has hit a rocky patch. Concerns from Fed officials that the US currency was too strong at the start of October had already seen the dollar index fall 2 per cent from its peak this month. Last week’s flash crash in US bond yields, which investors say was probably driven by jitters over the health of the eurozone and gloomy prospects for global growth, as well as overcrowded trades, meant it lost more ground.

Yet investors say the bullish case for the US currency is still hard to ignore. Analysts argue that even if the Fed raises rates later than previously expected and the domestic economy is dented by lower global growth, the economic divergence between the US and many other major economies will still hold.
“The good thing is it doesn’t take much tightening for the dollar to stand out versus zero rates as far as the eye can see,” says Alan Ruskin, a strategist at Deutsche Bank.


October 23, 2014, 4:14 AM ET

Don’t Blame Central Banks for Wealth Gap

LONDON—A senior Bank of England official Thursday pushed back against critics who claim central bank policies only benefit the wealthy.

Those critics say ultralow interest rates and central-bank asset purchases have fueled a surge in asset prices without spurring durable economic growth, benefiting the rich yet doing little for the wider economy.
Ben Broadbent, the U.K. central bank’s deputy governor for monetary policy, said in a speech to the Society of Business Economists in London that the actions of central banks aren’t sufficient to explain the low level of interest rates across much of the developed world and nor are they sufficient to explain the behavior of prices for assets including stocks and bonds.

His remarks add to a lively debate over the wisdom of central banks’ crisis-fighting measures and also highlight a renewed focus in policy circles over widening disparities in wealth and income.

“I read a lot of economic commentary that says interest rates are low because central banks have chosen to keep policy rates low and that this has pushed up the price of risky assets, benefiting only those who happen to already own them. I’m not sure either of these is true,” Mr. Broadbent said, according to a text of his remarks.

Mr. Broadbent said central bank policy rates are low because the rate of interest required to keep output stable and inflation subdued in most economies has declined. This so-called natural rate of interest has been falling for 20 years, he said, driven by excess savings seeking a home and a rise in investor appetite for safer returns, often those from government bonds. Ageing populations have reinforced these trends, he said.

Mr. Broadbent said this “remorseless” decline in the natural rate of interest in countries such as the U.K. has meant that central bank policy rates have had to fall sharply to keep output on track and price growth stable.

 In the U.K., the BOE’s benchmark rate has been pegged at 0.5%–a record low in the central bank’s 320-year history–for more than five years to lift growth and keep annual inflation close to the BOE’s 2% target.

 Keeping policy rates at historic levels would have hurt growth and pushed up unemployment, he said.

“An official interest rate that might once have been considered inflationary is now contractionary,” Mr. Broadbent said.

Mr. Broadbent said low rates and asset purchases may have benefited holders of assets such as bonds but that is to be expected if assets are unevenly distributed. He added asset prices are ultimately determined by factors other than monetary policy.

“Over time, trends in real asset prices are determined by real non-monetary forces: we may occasionally be prominent actors but it’s someone else who’s written the script.”

He noted that central bank policies haven’t had a similar effect on incomes as on wealth. In the U.K. at least, the share of national income going to labor, as opposed to wealth, has remained broadly stable for decades.

Mr. Broadbent didn’t discuss the outlook for U.K. monetary policy in detail in his remarks, beyond saying the decline in the natural rate of interest reinforces his belief that when interest rates in the U.K. do rise, any increase will be “gradual and limited.” Investors expect the BOE to begin tightening policy in the third quarter of next year.

Mr. Broadbent added it is unclear whether a turnaround in the global economy or a sustained pickup in productivity growth will be sufficient to start pushing the natural rate of interest higher again. But he said whatever does cause such a rise, “it is unlikely to be the arbitrary whim of central bankers.”

The Many Roads to Currency Ruination

Frank O. Trotter, Executive Vice President - EverBank

Total abject failure. Mad Max. Breakdown of society. Chaos.

How’s that for an upbeat start?

Failure is a tough thing to talk about, particularly here in the US where it’s all about optimism. What’s the best? Who's the fastest? Where should I put my money for the highest return?

But examining failures can help us avoid mistakes. So let’s take a tour of a few currencies and money systems that fell apart. We’ll learn some principles of sound money and hopefully, have a little fun.

What Is Money?

Even though we don’t think about it every day, we all know that money is a fiction. It is a medium of exchange – a token we pass back and forth instead of bartering, and a store of value that keeps score of our assets and debts. It is based on belief and faith—nothing more.

At times, money has been metals or tobacco or wampum. There are the famous Yap Island stones. At other times, like today, paper tokens with no intrinsic value stand in as money.

As we’ll see, people and societies have always experimented with money.

So, What Is a Failure?

One obvious sign of failure is that a currency is no longer usable as a medium of exchange or a store of value. It becomes worthless to everyone.

Currencies that create chaotic or unproductive behavior are also failures. Often, the collapse of a currency forces, or perhaps acknowledges, economic collapse.
What Are the Usual Causes of Currency Failure?

Aside from currencies that went extinct because their countries were conquered , there are two main reasons for failure—and they’re at opposite ends of the same spectrum.

On one side, we have a lack of supply. Maybe there aren’t enough coins to go around. Maybe the money supply is constrained. Price mechanisms can remedy this situation, but usually, society will shift to substitutes. If there’s not enough gold or silver, people will use tin, cows, or cigarettes. I won’t spend any more time on this because it’s so rare today.

On the other side of the spectrum, we have too much supply. In 9 out of 10 cases, overissuance has been due to war, because war is expensive.

As it still is today, joining the military has historically been one way out of a difficult situation. Joining the military was a way for a serf or pauper to make it big. Soldiers are usually paid—and paid relatively well—to put their lives on the line. Historically, soldiers have insisted on being paid in gold, delivered to the front or to a verified recipient on time.

Like today, this cost is usually above and beyond what the sovereign had in the vault. So the ruler had to borrow. Or cheat.

Cheating normally took the form of what I’ll call debasement—removing value from the currency by using smaller quantities of precious metals per coin. There was also the gangland approach of “borrowing” from the nobility or church.

Token debasement is about guessing the location of the edge of the cliff. Insert the right amount of tokens into the economy and it runs smoothly. A few more and maybe things will be okay. Too much and everything falls apart. Since tokens as currency have no intrinsic value or physical constraint on issue, there is always the temptation to keep making more. Surely increasing the money supply just a little bit more won’t hurt. Will it?


With over 600 extinct currencies, including over 150 that died due to overissuance or debasement, there are a lot of examples to choose from. I’ll go over a few below.

But first, let’s play a game. I’ll provide a series of hints through the rest of the article, and you try to guess the failed currency system. Hint #1: The ruler followed his father into power.

Failure #1: A currency can become worthless even when it contains precious metals.

The denarius in Rome is a great example. Around the year 0, it was 100% silver and was used throughout the empire. By 50 AD, it was 94% silver; in 100 AD, 85%. By 244 AD, just 5%.

Finally, when its silver content fell to less than 1%, the denarius was rejected by nearly everyone as a means of payment. Case closed.

Hint #2: The ruler waged a war without raising taxes and, in fact, initiated a tax cut.

Failure #2: Ineffective medium—the currency just doesn’t cut it.

In early Virginia, there was no specie, and the use of wampum had run its course. There was, however, a lot of tobacco. So in 1642, the colony declared tobacco its currency.

The problems started almost immediately. Among other troubles, some people tried to hide poor-quality tobacco leaves between decent ones. Virginia instituted bond warehouses so it wouldn’t get a bad reputation with its neighbors. But it was never able to solve the problem of fungibility, and the system collapsed.

Hint #3: His administration attempted to boost economic growth and employment by funding public works.

Failure #3: John Law

We should refer to Ponzi schemes as Law schemes, and stimulus spending as Lawsian instead of Keynesian. John Law was a pre-Keynes Keynesian.

Let’s compare John Law’s core beliefs with a modern commentator.

John Law
Paul Krugman
If money supply was increased by issue of bank notes for productive loans.
If we could manage 4 or 5 percent inflation over that stretch, so that prices were 25 percent higher.
If money supply was increased by issue of bank notes for productive loans.
The real value of mortgage debt would be substantially lower than it looks on current prospect.
The value of the money should remain the same.
And the economy would therefore be substantially farther along the road to sustained recovery.


Hmmm. John Law got into French finance to help clean up Louis XIV’s war debts from the War of Spanish Succession. An array of books, papers, and academic careers have been dedicated to the analysis of this disaster, much like the Great Depression. The abridged version is that French coins were replaced first with paper issued by France, then shifted to new banks, then moved to shares in Compagnie de l’Occident that promoted the Louisiana Company and Mississippi companies, resulting in a speculative boil much worse than our modern tech and housing bubbles.

After the scheme imploded, it was said that French people could not use the word for “bank” for nearly 150 years without adding a pejorative. Law was sent into exile.

One more hint, then I’ll reveal the answer: He confiscated gold and silver from citizens and replaced it with paper currency, issued briskly.

And the answer is…

Kublai Khan.

After taking over from his father, Ghengis, Kublai Khan (no known relation to the great squash players) consolidated control of China and the surrounding territories. He issued the first known unbacked paper money in recorded history in 1227.

The visiting Marco Polo reported that initially it was all going pretty well. The empire was prospering and there was enough “money” to stimulate economic activity.

But ultimately, inflation set in as Khan issued too much currency to pay for wars and to keep the populace happy. Polo’s final commentary noted that the system totally collapsed into chaos.

Another one bites the dust.

At the end of the day, currencies usually collapse due to overissuance. We have all worried since the US Federal Reserve began its quantitative easing that maybe this time we were going too far. But the massive expansion of the monetary base has not—yet—created hyperinflation or anything like it.

Will it happen eventually? If only we could predict the future.

I am still concerned that when and if the economy truly enters expansion, nasty inflation could return quickly. If it does, the decline of the US dollar will likely be the result.
But until this occurs, we will wait and watch. And of course, maintain a diversified portfolio.

October 24, 2014 6:54 pm

Putin unleashes fury at US ‘follies’

Neil Buckley

Russian President Vladimir Putin attends a meeting of the Valdai International Discussion Club in the Black Sea resort of Sochi, Russia, Friday, Oct. 24, 2014. The United States is destabilizing the global world order by trying to enforce its will, Russian President Vladimir Putin declared Friday, warning that the world will face new wars if Washington fails to respect the interests of other countries. (AP Photo/RIA-Novosti, Mikhail Klimentyev, Presidential Press Service)©AP
Russian President Vladimir Putin attends a meeting of the Valdai International Discussion Club in the Black Sea resort of Sochi

Russian president Vladimir Putin on Friday accused the US of undermining the post-Cold War world order, warning that without efforts to establish a new system of global governance the world could collapse into anarchy and chaos.

In one of his most anti-US speeches in 15 years as Russia’s most powerful politician, Mr Putin insisted allegations that its annexation of Crimea showed that it was trying to rebuild the Soviet empire were “groundless”. Russia had no intention of encroaching on the sovereignty of its neighbours, he insisted.
Instead, the Russian leader blamed the US for triggering both Crimea’s breakaway from Ukraine and thousands of deaths in the war in the east of the country, by backing what Mr Putin called an armed coup against former president Viktor Yanukovich in February.

“We didn’t start this,” Mr Putin said. Citing a string of US-led military interventions from Kosovo to Libya, he insisted the US had declared itself victor when the Cold War ended and “decided to … reshape the world to suit their own needs and interests”.

“This is the way the nouveaux riches behave when they suddenly end up with a great fortune – in this case, in the shape of world leadership and domination. Instead of managing their wealth wisely … I think they have committed many follies,” he told a conference of foreign academics and journalists at an Olympic ski venue near Sochi.

The speech was one of Mr Putin’s most important foreign policy statements since he surprised the west in Munich in 2007 by accusing the US of “overstepping its boundaries in every way” and creating new dividing lines in Europe.
Some commentators speculated that it reflected Moscow’s fury after US President Barack Obama recently ranked Russia alongside the Islamic State of Iraq and the Levant, known as Isis, and the Ebola virus among the top three global threats. But his tone surprised even supporters.

“Very tough about the US, first time so [tough],” tweeted Margarita Simonyan, editor in chief of the ardently pro-Kremlin RT television channel. “Our answer to B Obama.”

Mr Putin signalled he believed the US and Russia should draw a line under recent events and sit down with other big economies to redesign the system of global governance along “multipolar” lines.

While he conceded this could be a lengthy and gruelling task, Mr Putin warned the alternative could be serious conflicts involving major countries. He also evoked the danger of a new Cold War-type stand-off, saying existing arms control treaties risked being violated.

Any effort to bring the two countries together for talks, however, could be complicated by the west’s insistence that Russia’s annexation of Crimea is an illegal occupation, and by Moscow’s anger over resulting EU and US sanctions.

Mr Putin said the sanctions undermined world trade rules and globalisation, but said Russia was a strong country that could weather the measures, and would not “beg” to get them lifted.

The Russian president suggested the UN could be “adapted to new realities”, while regional “pillars” of a new system, such as Russia’s own planned Eurasian Union of ex-Soviet states, could help enhance security.
But he insisted such moves were only necessary since the US had ridden roughshod over existing rules – for example when it invaded Iraq without UN Security Council backing.

“If the existing system of international relations, international law and the checks and balances … got in the way of [US] aims, this system was declared worthless, outdated and in need of immediate demolition,” he said.

The strength of Mr Putin’s language also took US listeners aback. Addressing a question to the president after his speech, Toby Gati, a former White House official under President Bill Clinton, said she “did not recognise” as her own country the one the Russian president claimed to be describing.

Middle East

31 Egyptian Soldiers Are Killed as Militants Attack in Sinai


OCT. 24, 2014

EL ALAMEIN, Egypt — Two attacks on Egyptian military positions in the Sinai Peninsula on Friday killed at least 31 soldiers, according to security officials and the state news media.
The first attack killed at least 28 soldiers, making it the deadliest assault on the Egyptian military in many years and the biggest defeat in its 15-month battle against Sinai-based Islamist militants that began with the military’s ouster of President Mohamed Morsi of the Muslim Brotherhood in July 2013. At least 28 others were wounded, the state news media said.
The scale of the attack underscored the difficult challenge the Egyptian government continues to face in re-establishing firm control of northern Sinai, near the border with Israel and the Gaza Strip.
Egyptian officials have said repeatedly that they have largely contained the insurgency there, but the complexity of Friday’s attack, said to involve multiple vehicles and heavy weapons, suggested that the militants were growing more sophisticated.
President Abdel Fattah el-Sisi, who led the military takeover last year, convened an emergency meeting of Egypt’s top generals in response to the attack. He declared a state of emergency in parts of Sinai, including a curfew from 5 p.m. to 7 a.m.
In Washington, Jen Psaki, a State Department spokeswoman, said in a statement that “the United States strongly condemns the terrorist attack.” She added, “The United States continues to support the Egyptian government’s efforts to counter the threat of terrorism in Egypt as part of our commitment to the strategic partnership between our two countries.”
The first, larger attack took place about 2 p.m. Friday near the town of Sheikh Zuwaid, a hub of Islamist militancy where insurgents sometimes set up their own temporary checkpoints on the highways. The target of the attack was a heavily guarded army checkpoint at a desert-road intersection known as Karm al Qawadis, where the military typically keeps six armored vehicles, two tanks and a tent camp, residents said.
Unlike most previous attacks, this one was carried out in two stages. A car bomb initially killed as many as 18 soldiers, according to residents and security officials. Then, when soldiers rushed to the scene, armed men on foot and in a vehicle opened fired, killing at least 10 more.
A Sinai official told The Associated Press that the militants used rocket-propelled grenades, among other weapons. A mortar round set off a second explosion by striking a tank containing explosives and ammunition.
The second attack occurred about three hours later, in the nearby town of El Arish, the provincial capital, according to the Egyptian state media. Militants opened fired on a military checkpoint there and killed three more soldiers.
Western diplomats briefed on intelligence reports have said privately for weeks that the level of antigovernment violence in northern Sinai was rising again, despite the contrary claims of Egyptian officials. Attacks by militants in Sinai have killed hundreds of soldiers and police officers since last year’s takeover, and including Friday’s attacks the militants have killed more than 40 this week alone, according to the Egyptian state media.
Militants have also continued to set off bombs periodically in Cairo. An explosion this week near Cairo University wounded at least 11 people — six of them security officers. A bomb outside the Foreign Ministry late last month killed two police officers.