The Lamb has always been fascinated by the concept of hyperinflation — the rapid and extreme rise in the price of goods and services — (and by Michigan Football’s inability to stop a spread offense, but that’s another story).  The most fundamental causes of (hyper)inflation are an increase in the supply of money and/or a (corresponding) decrease in that money’s value.

Perhaps the most dramatic example of hyperinflation occurred in Germany during 1923-24.  Following World War I, the Allies forced Germany to sign the punitive Treaty of Versailles.  Among other things, the Treaty forced Germany to admit responsibility for the war and to pay for its damages.  The German economy, in tatters following the war, was unable to generate enough money to pay its debts.  The country embarked on a crash course of currency creation, running its printing presses non-stop.

This had the effect of quickly eviscerating the value of the German currency.  At the beginning of 1923, it took 9000 German Marks to buy one U.S. dollar.  One year later, the rate was 100 trillion marks to the dollar.  The country was futilely attempting to print its way out of debt, but only succeeded in making its currency next to worthless:

In Germany one morning in early 1924, a woman was on her way to the bakery to buy bread for her family.  Suddenly, a man accosted her, grabbing the bag she was dragging behind her which carried the trillions of marks she needed to buy bread.  As she begged him to return her money, he emptied the bills onto the street and replied, “Keep the money, I just want the bag.”

One Trillion Marks -- Almost Enough For Bread in 1924

Segue back to this side of the pond.  Congress has passed and the President has signed the now (in)famous $700 billion bailout/stimulus/rescue plan.  Now, $700 billion (the final tab could be less) may not be huge when compared to our roughly $14 trillion economy.  Yet, this spending/printing of dollars is all too typical of America’s solution to economic problems (see 1980’s Chrysler loan guarantee, 1989’s Savings & Loan bailout, and this year’s massive Bear Stearns backstop and AIG rescue, just to name a few).  Uncle Sam has even committed money to protecting over $2 trillion in money market fund assets — see the post 2 + a + 7 = 50,000,000,000.

One may argue that the Feds undertook a similar strategy in the 1930’s to counteract the consequences of the Great Depression, with relatively few ill effects from runaway inflation.  While we can debate the wisdom of New Deal programs, the fact is that the United States was a creditor nation then (an idea that is a distant memory now) and, more importantly, was on the gold standard.  Our current system of fiat money leaves us far more susceptible to a rapid decrease in the value of the dollar.

The Fed, under its last two Chairmen, has been more concerned with deflation than inflation.  They have targeted a low federal funds rate, or as The Lamb calls it, “growth at any cost.”  In fact, Fed Chairman Bernanke has given speeches bemoaning the dangers of deflation. Unfortunately, by the time inflation rears it ugly head the next time, it may already be too great to contain.

The deadweight loss created by the Troubled Asset Relief Program (TARP) is just the latest in a tragedy of financial errors — see the post Brother, Can You Spare 7 Trillion Dimes? And when considered alongside our roughly $800 billion current account debt (cumulative trade deficits) and our $10.1 trillion national debt (not to mention future expenditures for entitlement programs like Medicare and Social Security), you get total debt of nearly 80% of the U.S. gross domestic product (GDP) and rising…

Now, not even The Lamb, as long-term bearish as he is on the U.S. Dollar, believes that we are on the cusp of hyperinflation.  Though the Dollar has been on a terrible slide this decade (see chart below of the U.S. Dollar Index, courtesy of fxstreet.com), it has shown signs of life the past few months.

Look Out Below.....

However, the recent strengthening of the greenback is due largely to the ubiquitous need of corporations and banks to make outright purchases of needed dollars that they are unable to borrow in the credit markets for their ongoing financing activities.  The dollar may very well continue to rise until lending in the money markets returns to equilibrium.

But if/when the dollar restarts its slide, it may be swift. That may be a good time to put The Lamb’s Rule #7 into action — If you’re gonna panic, make sure you’re the first.

Severe inflation would have a few tertiary advantages for some.  Homeowners’ existing fixed-rate mortgages would effectively be wiped out as the dollar’s value plummeted, essentially producing mortgage-free homes.  Other hard assets, from cotton to coffee and from silver to soybeans, would also rise in value on a dollar-basis.  Those that owned these “real” assets would enjoy a modicum of protection from the ravages of breakneck inflation.

However, there would be a catastrophic downside.  Interest rates would soar and those lenders that hadn’t already been forced into bankruptcy would be wary of lending at all but the most punitive of terms.  Furthermore, the price of goods and services would soar as sellers sought to stay one step ahead of our crashing currency.  Commerce would screech to a halt.

Let’s remember, a slowing economy, even a recession, is not the end of the world.  It’s called the business cycle.  This country, actually most countries, go through periods of economic contraction.  This is a natural way for the economy to build a stronger and more stable base from which to maintain long-term growth.  As painful as economic slowdowns might be, they are far less deleterious than the flip side — runaway price increases.  See Zimbabwe’s current 531 billion percent inflation as a savage example.

Call The Lamb Chicken Little, but he’ll take a weak economy every now and then if it means he’ll never be emptying out a bag packed with cash just to make it easier to carry.

Disclosure: The Lamb owns UDN and CYB, two exchange-traded funds expressing bearish views on the U.S. Dollar.  The Lamb also owns GLD, a trust that buys and holds gold bullion.

The Lamb’s beautiful and brilliant wife scored 770 out of a possible 800 (99th percentile) on the GMAT, the standard entrance exam for aspiring Business School students.  While she would tell you that the above equation solves to:
a = 49,999,999,991, The Lamb sees a deeper meaning.

Money market funds, also referred to as 2(a)7 funds because of the SEC rule number which dictates what investments they can make, have traditionally been seen as one of the safest investments available.  Typically, all money market funds must keep investment maturities to a maximum of 397 days and their overall weighted average maturity must be less than or equal to 90 days.

Following fears of a run on the nation’s money market funds, the Treasury announced today that it will utilize all $50 billion of the Exchange Stabilization Fund (ESF) to ensure that over $2 trillion worth of money market funds does not decline in value, known as “breaking the buck.”  The primary role of the ESF is to maintain the stability of the United States dollar.  This has become even more critical since the country was taken off the gold standard in the 1970’s and now relies solely on “fiat” money.  While one would assume that Congress could authorize the replenishment of the ESF, The Lamb believes that this prospective insuring of money market funds is a dangerous move that risks moral hazard if not accompanied by new limits on money funds’ investments.  If money funds offer large institutional accounts Uncle Sam’s good name along with yields higher than what they can get from commercial bank deposits whose FDIC insurance is limited to just $100,000, where do you think they are going to put their money?  Not in commercial banks.  Sudden outflows from banks could cause a liquidity squeeze that dwarfs that experienced by the investment banks and other funds this past week.

While The Lamb noted in his “Fannie, Freddie, and Sam” post from early last week that a broad failure of money market funds “would all but freeze short-term funding for most global financial institutions” he is nevertheless aghast at this recently proposed bailout.  This is not simply the indemnification from losses on debt implicitly backed by the federal government.  No, no.  This is forcing all taxpayers to make up for any loss of principal on investments that individuals and institutions voluntarily make.  These investors know, or at the very least should know, what assets are held in the funds in which they invested– the information is freely available from any public 2(a)7 fund.  Investors should refer to The Lamb’s Rule #2– Know and understand what you own.

Under this new proposal, what’s to stop every money fund in this country from pushing the duration and credit envelopes in the search for higher yields and greater incentive fees?  Heads, they win; tails, no one loses– except of course for you, The Lamb, and every other taxpayer.

Make no mistake, The Lamb believes that if we had had a run on money funds, as it appeared yesterday, it could have been the beginning of the end.  What’s a better solution?  If the Federal Government decides to insure money market funds because it fears a run and its disastrous ramifications, fine.  But how about getting paid significantly (not just a few basis points) for providing the insurance?  Banks are charged for the privilege of deposit insurance, so why shouldn’t money funds be charged, and charged commensurately with the risk they take?  For the privilege of FDIC insurance, Uncle Sam requires banks to pay a fee, keep adequate reserves on hand, submit to examinations, and undertake other expensive regulatory tasks.  Due to their structure, money funds that want this new insurance should be required, among other things, to take less risk.  For starters, how about forcing them to decrease their average maturity from a maximum of 90 days to just 30 days?  Yes, this will decrease yields for investors.  But if investors want/need to have their investments insured by Uncle Sam, then make them pay for the privilege.  If they don’t want to pay for it, then let them invest elsewhere.

*UPDATE*

On 9/21/08 from bloomberg.com:

The Treasury said in a statement late yesterday it would limit its $50 billion plan for insuring money-market funds to those held by investors as of Sept. 19, excluding any subsequent contributions.

The American Bankers’ Association, which had expressed concern about the plan last week, praised the move, saying it would eliminate an incentive for savers to shift out of bank accounts into money-market funds. The Treasury put no limit on the money-market fund insurance, while the Federal Deposit Insurance Corp. protects bank deposits up to $100,000.

“If all money market mutual funds had been included with the government guarantee moving forward, this proposal would have threatened to take money out of local FDIC-insured banks,” Edward Yingling, president of the ABA in Washington, said in a statement.