Profiting During Times of Hyper Inflation

While I respect Mish as an economist, I have some reservations about the performance of property in a hyperinflation scenario.

You see, in a hyperinflation, the ‘price’ of anything (not just property) will go up in terms of fiat money (e.g. US dollars, Aussie dollars, Chinese yuan). The mass psychology of people in hyper-inflationary times is such that once they get hold of cash, they will want to get rid of it as soon as possible. I quote Professor Murray Rothbard, an Austrian School economist from the Ludwig von Mises institute in his book, What Has Government Done to Our Money?

At first, when prices rise, people say: “Well, this is abnormal, the product of some emergency. I will postpone my purchases and wait until prices go back down.” This is the common attitude during the first phase of an inflation. This notion moderates the price rise itself, and conceals the inflation further, since the demand for money is thereby increased. But, as inflation proceeds, people begin to realize that prices are going up perpetually as a result of perpetual inflation. Now people will say: “I will buy now, though prices are `high,’ because if I wait, prices will go up still further.” As a result, the demand for money now falls and prices go up more, proportionately, than the increase in the money supply. At this point, the government is often called upon to “relieve the money shortage” caused by the accelerated price rise, and it inflates even faster. Soon, the country reaches the stage of the “crack-up boom,” when people say: “I must buy anything now, anything to get rid of money which depreciates on my hands.” The supply of money skyrockets, the demand plummets, and prices rise astronomically. Production falls sharply, as people spend more and more of their time finding ways to get rid of their money. The monetary system has, in effect, broken down completely, and the economy reverts to other moneys, if they are attainable, other metal, foreign currencies if this is a one-country inflation, or even a return to barter conditions. The monetary system has broken down under the impact of inflation.

Thus, property can be a potential death-trap in hyper-inflationary times for these reasons:

(1) If prices of ‘things’ skyrocket faster than the price of property, then it means that property is losing value in real terms even though it is rising in nominal terms. In hyper-inflationary times, people would want to get rid of their cash ASAP. Buying ‘things’ with cash is the quickest way, rather than borrowing cash (assuming you can borrow cash in the first place) to buy property.

(2) Next, is it possible to borrow cash in hyper-inflationary times? Imagine you have a hoard of cash to lend in such a scenario. Prices are rising at an accelerating rate (in hyper-inflation e.g. Zimbabwe, prices rises by the hour). Therefore, nominal interest rates have to rise at an accelerating rate to break-even. Given a choice, would you rather lend your cash out or would you rather get rid of your cash ASAP to exchange for ‘things’?

Three things:

1) You’re forgetting the advantages of debt financed property. Rapid appreciation, even if its not in a real terms, is still protected by our debt loans in order to obtain the money. In essence, we’re hedging ourselves somewhat against general market inflation by obtaining constantly discounting debt. Obviously I don’t recommend purchasing a house and holding it with cash, you might as well buy stocks if thats the case.

2) Your ideas are good, but it can be applied to any asset class. If we concede that holding cash is the worst option, then what do we do? I’d argue property is the lesser of all the evils, if leveraged properly.

3) Well, obviously Zimbabwe is a banana republic with no controls and total anarchy, so I don’t know if its an apt example for Australia/any western country. Anyhow, I think you’ll find the 70’s is a good example of stagflation and mixed hyper inflation. Bank interest rates were extremely high though. No two times periods are ever alike, and I’d suspect more opportunities would present itself early in the trend to secure debt financing. Obviously, something will give later in the trend, but we’re all early birds getting the worm, right?

Hi Pineapple!

This is going to be a massive barrage of information… sorry.

I’m not sure whether we are in the same wavelength with regards to definitions…

First, we have to make sure what we mean by hyperinflation. If you mean it to be the 1970s stagflation scenario, then this is not what I mean. Yes, sure property may be good in such a scenario because there is some kind of order in the monetary system and financial system.

But if we mean hyperinflation to be a scenario whereby the monetary system breakdown (e.g. Zimbabwe, Weimar Germany, Hungary in the 1940s), then this is an extreme scenario, which I’m quoting Rothbard from.

You said,
You’re forgetting the advantages of debt financed property. Rapid appreciation, even if its not in a real terms, is still protected by our debt loans in order to obtain the money.

Yes, this will be advantageous to the borrower if he/she can get a loan in the first place. But who will want to lend money in hyperinflation? In hyperinflation, prices are rising literally by the hour (i.e. rising at an accelerating rate). Therefore, it is impossible to calculate the interest rates for the terms of the loan. If I have cash to lend, I would rather use it to accumulate ‘things’ or gold rather than lending it to anyone.

Furthermore, even if you can borrow money to buy property, would you want to do that in such an extreme scenario? (Note: if you can borrow money, it implies some kind of order in the monetary system.) Yes sure, your loan may be ‘protected’ by debt discounting, but in real terms, you are losing wealth in terms of opportunity cost. You will lose out because if you leverage your cash to gold (instead of property), you will gain much more purchasing power instead. For example, if Dick have $100,000 and Dick borrow $900,000 to buy property. On the other hand, Tom have $100,000 and borrow $900,000 to buy gold. In hyperinflation, let’s say property rises by 100% p.a. whereas gold rises by 200% p.a. Who is better off?

You said,
Your ideas are good, but it can be applied to any asset class. If we concede that holding cash is the worst option, then what do we do? I’d argue property is the lesser of all the evils, if leveraged properly.

Do you know that Zimbabwe has the world’s best performing stock market? The key Zimbabwe Industrials Index up some 595% since the beginning of the year and 12,000% over twelve months. This jump in share prices is far in excess of increases in consumer prices. While the country is crumbling, the Zimbabwean share speculator is keeping up much better than the typical Zimbabwean on the street.

I have not check out the figures, but I would say it’s very likely that Zimbabwean stocks perform much better than Zimbabwean property, simple because stocks are far much more liquid and divisible than property (e.g. you can sell off 1/1000th portion of your house to buy groceries). Furthermore, the transaction cost for stocks is far lower than the transaction cost for property.

My point is not to say that property is the worst choice in such an extreme scenario. Rather, in such times (when the monetary system is not working), gold is the best hedge. Property may be better than stocks or stocks may be better than property, but the least risky hedge is gold. That is the reason why Mish said that gold is a “standout,” while property is only a “winner.” As I said before in What should be your fundamental reason for accumulating gold?

We accumulate gold not just simply because we believe its ‘price’ is going up (though we think it is most likely to be so as a side effect—in case you are confused by what we mean, read on). This is because if we do so, the implication is that we are calibrating the value of gold in terms of units of fiat paper money (see Entrenched perception on the value of paper money). As we said before, money is fiat if it enjoys legal tender status through the authority of the government instead of through the choice of the free market. This means that fiat money is not backed by anything physically tangible—it derives its value from an elusive intangible called “confidence.” Simply put, fiat money is backed by nothing!

What if we lack complete confidence in fiat money [i.e. in hyperinflation]? In this case, the ‘price’ of gold in units of that fiat money [e.g. US/Aussie dollars] is irrelevant. For example, Zimbabwe is today suffering from hyperinflation (price inflation rate is 1600% from what we last read about) as its fiat currency is practically worthless. The ‘price’ of gold in Zimbabwean currency has skyrocketed. But really, if you are a Zimbabwean in Zimbabwe, will you really care about the ‘price’ of gold in Zimbabwean money? No, in such a situation, gold is a vastly superior form of money as its supply can never be conjured up into existence by the will of the central bank (or government if it controls the central bank). Thus, your desire for wanting to accumulate gold should be proportional to your lack of confidence in fiat currencies.

Once people loses the confidence of fiat paper money, it loses its value and function as money i.e. you wouldn’t be trusting it to store your wealth. When that happens, people will have to look for alternative money (e.g. cigarettes, foreign currency, gold, silver). Gold has historically been chosen by the free market of many civilizations as money, so your best bet may be to stick to gold, rather than any recent financial innovations (e.g. TIPS, stocks, etc).

Today, it is hard for modern people like us to think of money as being gold or silver (or at least warehouse receipts for gold or silver), but several hundred years ago, Macro Polo could not imagine money being fiat paper.

Talking about warehouse receipts for gold and silver: do you know that initially, the US dollar (or British pound, French franc) were warehouse receipts for gold? It was through the ravages of WW1, WW2, Great Depression of the 20th century, etc that we have money completely being fiat?.

You said,
Well, obviously Zimbabwe is a banana republic with no controls and total anarchy, so I don’t know if its an apt example for Australia/any western country.

You know what is the frightening thing about the US/Australia? We are behaving like the banana republic with regards to current account deficits and debts. In the US, you can include massive budget deficits. For example, look at Australia’s M3 money supply figure: it ballooned by 18% from September 2006 to September 2007! Can you imagine ‘printing’ so much money such that the total money supply increases 18% in one year? Then look at the total private debt versus GDP ratio. It’s now 160% for Australia. During the Great Depression, it’s only 80%. If this kind of behaviour goes on and on, I fear we are on the way to truly become a banana republic.

As Mish says, the credit crisis is going to lead to a very serious deflation, perhaps even rivaling the deflation of the Great Depression. In such a time of extreme stress, there is a possibility that a democracy will not be able to resist the route towards hyperinflation. Note: I am not predicting that this will happen imminently. But I’m sufficiently concerned that it may happen within our lifetime, given the global economic situation that we are experiencing right now which has no precedent in human history. Many traders and economists (e.g. Marc Faber) are baffled with what’s going on. It happened before in the roaring 1920s in Weimar Germany (which was a democracy before Hitler took over). At that time, Weimar Germany had colossal amount of unpayable debt. In a sense, this is the same situation that the USA is facing right now (if you include their mammoth unfunded medicare liability that this generation have to pay for the retiring baby boomer generation).

Yeah, my definition of hyperinflation would be more towards double digit+ numbers, not so much 1928 Germany or modern day Zimbabwe. The later are definite banana republics with a different loss of confidence that I don’t think is going to happen.

You ask who would lend money, but why wouldn’t they lend money? Why wouldn’t a lender try and print as much money as possible to potential borrowers? I don’t follow why you think money wouldn’t be lent.

“Once people loses the confidence of fiat paper money, it loses its value and function as money i.e. you wouldn’t be trusting it to store your wealth. When that happens, people will have to look for alternative money (e.g. cigarettes, foreign currency, gold, silver). Gold has historically been chosen by the free market of many civilizations as money, so your best bet may be to stick to gold, rather than any recent financial innovations (e.g. TIPS, stocks, etc).”

Well, if you’re really worried, buy a self sufficient farm house out in the middle of nowhere and live as your own separate economy :). Gold is a commodity which has a ‘flight from fright’ mentality, but you’re never really going to do very well for yourself even if you’re right, and if you’re wrong you’re going to blow a lot of money. To me, the financing trader thinker in me says this is a bad bet. Its like people withdrawing their life savings before Y2K in case something happens, keeping money as cash. The stupidity boggles; if the scenario does play out, what use is having a stock pile of money anyway? You think an anarchist world is really going to accept some ‘paper’? Capital preservation probably has more appeal when you have 8 digit bank accounts and you really don’t want to see it go to zero, in which case you just hedge and live a moderate life if the worst happens.

“You know what is the frightening thing about the US/Australia? We are behaving like the banana republic with regards to current account deficits and debts. In the US, you can include massive budget deficits. For example, look at Australia’s M3 money supply figure: it ballooned by 18% from September 2006 to September 2007! Can you imagine ‘printing’ so much money such that the total money supply increases 18% in one year? Then look at the total private debt versus GDP ratio. It’s now 160% for Australia. During the Great Depression, it’s only 80%. If this kind of behaviour goes on and on, I fear we are on the way to truly become a banana republic.”

Its all about confidence in the economic system and confidence in the dollar. The arbitrary amount % of money supply is kind of irrelevant, so long as business cycle can perform. There’s no accepted number by any economist or financier about what levels of debt can be ’sustained’. There’s speculation, but people thought we were going to bubble in the 70s, 80s, and 90s, and it still hasn’t happened yet, mostly because the underlying principles and business cycle balances seem to keep the economy in check. You can predict doom and gloom from the newest figure, but as soon as the scenario doesn’t play out, and in 5 years time the figure is even higher, you’ll just say “oh, now its really going to crash!”. Until there’s a disruption in the practices of trade, supply, and demand, there shouldn’t be an issue. And even if the currency or whatever collapses, its not the worth thing in the world, we just make a new one. Worked for Germany

As Mish says, the credit crisis is going to lead to a very serious deflation, perhaps even rivaling the deflation of the Great Depression. In such a time of extreme stress, there is a possibility that a democracy will not be able to resist the route towards hyperinflation. Note: I am not predicting that this will happen imminently. But I’m sufficiently concerned that it may happen within our lifetime, given the global economic situation that we are experiencing right now which has no precedent in human history. Many traders and economists (e.g. Marc Faber) are baffled with what’s going on. It happened before in the roaring 1920s in Weimar Germany (which was a democracy before Hitler took over). At that time, Weimar Germany had colossal amount of unpayable debt. In a sense, this is the same situation that the USA is facing right now (if you include their mammoth unfunded medicare liability that this generation have to pay for the retiring baby boomer generation).

Well, it did in Japan. Didn’t exactly cause any kind of loss of confidence in the yen, though, just a really screwed up business cycle. But living standard wise, they do fine. Hitler is an interesting historic tidbit, mostly because his rise is often misconstrued throughout history teachings. Hitler never won a majority, he only game to power as the Furor through endorsements from other parties, parties who thought he’d make a great charismatic figure head. The truth is, Germany economically was starting to recover by the time Hitler came in. Its always portrayed that Hitler took advantage of people at their weakest. Thats not really true at all, he took advantage on their dreams as they began looking back on the worst. People begun dreaming of a nationalistic, strong Germany again, with the economics coming back, and thats exactly what Hitler provided them.

Germany was going to war with Europe at some stage, regardless of debt, in my opinion. In fact, the war reparations was just a meager attempt by the powers to put a lid on Germany, so hopefully it’ll grow out of its dominating ways. After the Germanic states were trampled on for so long, and finally Prussia and the rest were joined, it was inevitable the philosophically proud Germans rose against the rest. Hindsight is nice, of course.

I’m not really an economist or historian though, so I’m not great at dreaming up scenarios. I can spot a coinflip in my favor, though

Hi Pineapple!

You ask who would lend money, but why wouldn’t they lend money? Why wouldn’t a lender try and print as much money as possible to potential borrowers? I don’t follow why you think money wouldn’t be lent.

Only central banks have the authority and mandate given by the government to print money. Lenders like you, me, loansharks and ordinary banks can’t print money legally. If so, all of us would be ‘rich’ by now, using our home bubblejet printers to print as much money as we want.

Let me explain in more detail. Suppose you are a bank and you have $1 million of spare cash under your pillow. Imagine, outside the bank, prices of everything are rising daily or even hourly i.e. prices are rising in accelerating rate. The first and biggest problem you have is what interest rate to lend your cash at. Should you follow the CPI rate? No, by the time CPI figures is out, it is already old news and prices would have skyrocketed at an accelerating rate. Should you follow the central bank’s cash rate? No, even at say, 6000% cash rate, this 6000% is below the accelerating rate of price increase, which means if you lend money at 6000%, you are lending at negative real interest rate i.e. you are lending at a loss. At the same time, you cannot afford to let this $1 million sit at your vault doing nothing because it is losing purchasing power rapidly as each day goes by. What can you do? What a fix! So, given 3 choices (1) lend out the cash anyway, (2) keep the cash under your pillow or (3) use the cash to buy anything and everything that it can buy right this very second, which choice would you choose?

So, can you see why no one would want to lend money in such an extreme scenario?

Gold is a commodity which has a ‘flight from fright’ mentality, but you’re never really going to do very well for yourself even if you’re right, and if you’re wrong you’re going to blow a lot of money.

Not true.

Firstly, gold is not a commodity in the same league as iron, zinc, copper because it has hardly any industrial use. Gold is not ‘consumed’ the way we consume copper, iron, wheat and barley. If gold is a consumable commodity, then its price would be close to worthless because there is hardly any industrial use for it. Yes, people turn gold into jewelery. But for what? To consume?

Since you are a trader based on technical analysis, let me ask you what is the basic assumption of technical analysis? In technical analysis, the basic assumption is that the market is efficient i.e. whatever publicly known information is already reflected in the price. That is, the price reflects all known and public information.

Now, look at the price of gold. It has been in an upward trend since 2000 at a low of US$260 till today at the price of around US$840. So, assuming that the price of gold reflects all publicly known information, what is the behaviour of the gold market telling us? As a technical analyst, you may not care what exactly the gold market is telling you, but at the very least, you should take note that it is telling you something.

Well, if you’re really worried, buy a self sufficient farm house out in the middle of nowhere and live as your own separate economy :).

You have to understand that pessimism has different levels:

The first level of pessimism believes that it is going to be so bad that all social order will break down, anarchy will reign, every economic/financial system will disappear. In that case, gold is useless because physical survival is the more important priority.

The other level of pessimism believes that although things are going to be very bad, there is still some level of social order and some semblance of economic/financial system working in order. In that case, gold will be very valuable. Example of such scenario is the Great Depression when although things are bleak, there is still a government going on, and social order is still in place. Zimbabwe right now is probably in this situation right now, but it looks that it may not last for long.

Its all about confidence in the economic system and confidence in the dollar. The arbitrary amount % of money supply is kind of irrelevant, so long as business cycle can perform. There’s no accepted number by any economist or financier about what levels of debt can be ’sustained’…

Again, you have to understand the difference between making predictions and understanding the concept of Black Swan. In Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Therefore, when contrarians are preparing for a crash, it does not necessary mean that they are predicting doom and gloom. Rather, they see the vulnerability of Black Swans and prepare for them.

This explains why government spends a lot of money preparing for disasters e.g. earthquakes, cyclones, etc. Base on statistical probability, disasters seldom happen. But does that mean we should completely ignore them? Why would parachutists pack a second reserve parachutes? Based on statistical probability, the likelihood of a parachute failure is extremely small. But does that mean we should completely ignore such a possibility?

This is the mistake many people in finance and economics are making. They label such disasters as six-sigma events and consequently completely ignore them. That’s why we have the Centro failure, sub-prime crisis, etc.

Let me give you a parable: Let’s say you are a turkey. Ever since you were born, humans had always fed you, took care of you and ensured that you were healthy and fat. In all your long life of 1000 days, humans were always your friend. Therefore, you forecast that the next 1000 days will be like the average of the past 1000 days—great care under the hands of your human friends. Life has always been good and you see no reason for otherwise in the future… Then on the 1001st day of your life, it was the eve of Thanksgiving Day. By Thanksgiving Day, you had became a meal for humans. Sad story. But to that poor turkey, the eve of the Thanksgiving day is the day of the Black Swan event. A Black Swan event is one in which it is highly improbable but has colossal impact.

You have to understand the critical difference between making predictions and preparing for Black Swans. I am not making predictions about what is going to happen in the future world economy or something like that. But the path that our nation are taking is leading us towards a destinations that preparations for Black Swans is worth it.

I suggest you read the book by Nassim Nicholas Taleb called “The Black Swan” Mind you, he is not a abstract academic. He makes his living as a trader in the financial market, earning his living by taking advantage of Black Swans.

Well, it did in Japan. Didn’t exactly cause any kind of loss of confidence in the yen,

The context of Japan is completely different- it is suffering from deflation, not hyperinflation that we are talking about.

Hitler never won a…

I don’t know how Hitler got into this discussion of hyperinflation…. I just mentioned him as a background to the historical context.

Sorry for this second post, but there is some things that I need to get clear off my chest…

Its all about confidence in the economic system and confidence in the dollar.
First, let me ask you, where do the confidence come from? If confidence is based on fantasy, can you really believe that confidence will remain for ever and ever till infinity?

There’s no accepted number by any economist or financier about what levels of debt can be ’sustained’.

Does absence of agreement on what is sustainable implies that anything and everything is sustainable in the long run regardless of what the underlying reality is? To make this point clearer, in page 55 of Nassim Nicholas Taleb’s book, The Black Swan, it talked about a common confusion: absence of evidence is not evidence of absence.

There’s speculation, but people thought we were going to bubble in the 70s, 80s, and 90s, and it still hasn’t happened yet, mostly because the underlying principles and business cycle balances seem to keep the economy in check. You can predict doom and gloom from the newest figure, but as soon as the scenario doesn’t play out, and in 5 years time the figure is even higher, you’ll just say “oh, now its really going to crash!”.

Refer to Failure to understand Black Swan leads to fallicious thinking

And even if the currency or whatever collapses, its not the worth thing in the world, we just make a new one. Worked for Germany

Do you think that by just making “a new one,” everything will work without removing the root behaviour of what caused the collapse in the first place? For example, this is what Zimbabwe is doing. They replaced the original Zimbabwe dollar with a ‘new’ Zimbabwe dollar (I think it’s around 1000 old dollar to be consolidated into 1 new dollar). Of course, it didn’t work because they were doing the same things prior to replacing their old dollar.

To me, the financing trader thinker in me says this is a bad bet.

No, have you heard of the asymmetric payoff strategy? Again, whether you should make a bet or not depends on (1) the probability multiplied by the (2) expected payoff. It will be an error to make a betting decision based solely on the probability alone without consideration of the payoff. For example, Nassim Nicholas Taleb, the author of the “The Black Swan,” he is a financial trader who specialises in profiting from Black Swans.

I hope these questions will sharpen your thinking… When it comes to trading and investing, the clearer our thinking is, the safer our wealth will be.

Technical Analysis doesn’t predict anything, and anyone who says it does is a snake oil salesman. Technical Analysis is taking advantage of assymetric opportunities in the supply/demand of securities by utilising the weakness or strength of certain market participants. Charting and all of that stuff is a load of crap, and I couldn’t tell you whether the market will be up or down next week, next year, or even tomorrow. Its just taking advantage of statistical plays based on the behavior of market participants, its not a model for the future or anything close to it.

Generally its difficult to make a mint off ‘black swan’ type predictions, mainly because you also need to know how its going to go down, not just ‘if’. Rarely is this stuff a nice graceful slide where you can call a top. and even getting your timing slightly off can mean wipe out.

Firstly, I don’t dispute your point about Technical Analysis not being about making predictions. In fact, the trend following philosophy (of Michael Covel is a major proponent) about ‘reacting’ to what is happening in the market.

What I was trying to put the point across is the underlying philosophy of Technical Analysis.

Generally its difficult to make a mint off ‘black swan’ type predictions, mainly because you also need to know how its going to go down, not just ‘if’.

It’s a fallacy to associate Black Swan with predictions. See Failure to understand Black Swan leads to fallicious thinking. The whole point of Black Swan theory is about understanding the perils and blindspots of forecasting and predictions. In fact, by definition, Black Swans is something that can’t be predicted.

Rarely is this stuff a nice graceful slide where you can call a top. and even getting your timing slightly off can mean wipe out.

Have you heard of the asymmetric payoff strategies?

Let me quote an excerpt from Nassim Nicholas Taleb:

The best description of my lifelong business in the stock market is “skewed bets”, that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price. In addition to my own empiricism, I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) gives me some form of advantage.

…

One such rare event is the stock market crash of 1987, which made me as a stock trader and allowed me the luxury of becoming involved in all manner of scholarship. Many traders aim to get out of harm’s way by avoiding exposure to rare events - a mostly defensive approach. I am far more aggressive than those traders and go one step further; I have organised my career and business in such a way as to be able to benefit from them. In other words, I aim at profiting from the rare event, with my asymmetric bets.

This guy is a highly unconventional trader. So unconventional that his strategies are very counter-intuitive (but that’s how he makes his money anyway).