Simit Patel

We recently compared the crisis with the Argentinian peso in 2001/2002 with the current situation surrounding the US dollar, and postulated that the US would follow down the Argentinian path.

The current situation in Iceland also fits the bill of a currency crisis (also referred to as an inflationary depression). To illustrate this point, let's compare the factors leading up to the crisis in the Icelandic krona with the conditions of the US macroeconomy:

1. Like the US, Iceland de-regulated much of its banking sector in the '90s.
2. Like the US, Iceland then proceeded to target low interest rates. This resulted in a large amount of borrowing and spending, which resulted in a credit-based boom.
3. In both countries, de-regulation allowed for greater securitization -- meaning the loans that enabled this credit-based boom were re-packaged and sold to debt buyers all over the world. This resulted in a scenario where much of Iceland's wealth was owned by foreigners.
3. Like the US, Iceland also experienced the contraction forecasted by the Austrian business cycle theory, which we recently discussed.
4. In both countries, this resulted in a deflationary spiral: significant declines in equities markets, bank failures, and contracting GDP.

To learn more about the factors leading up to the Icelandic currency crisis, I recommend this article from CNN.

Now in Iceland, like in Argentina, the true breaking point came when its central bank became insolvent. The result was a complete lack of confidence in Iceland's ability to repay; essentially, Iceland had defaulted. The result has been a run on the Icelandic krona, which has lost half its value in just a few months time.

Government Response

Or should I say, there has been a partial run on the Icelandic krona -- for the government has put currency controls in place, after raising interest rates. Citizens of Iceland will find it difficult to legally exchange their krona for a foreign currency unless they are travelling.

Proposed solutions include integrating Iceland into the Eurozone, which would help stabilize Iceland, continue international trade, and help ensure that lenders are repaid, argue its proponents.

Social Response

Icelanders have united in protest against the government, in much the same way Argentinians did after their currency crisis. Thus far in the United States, criticism and dissatisfaction with the government handling of this crisis have risen significantly, though street protests remain at relatively low levels.

Market Response

The collapse of the Icelandic krona is the biggest event, as it devalues all assets denominated in the krona, as was the case in Argentina. A key difference between the US dollar and all other currencies, though, is that the US dollar is the world reserve currency. It will be interesting to see if Iceland enters the Eurozone as a solution to this crisis; if so, it paves the way for the creation of a world currency to be proposed as the solution to a crisis in the US dollar.

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uahmed

Hello Simit,

Great article!!! One would think people would learn from history about deregulation!! lol.

I think the idea of a world currency is really interesting because the forex markets would be gone and the games of politics would start. I wonder how people would who to make the leaders of the central bank?

Keep up the good work!!!

Ali

Simit Patel

Hi Ali,

Thanks for your comment. I think we may see a world government, or a more influential role for supranational organizations like the UN, World Bank, NATO, IMF, if a world reserve currency were to be created.

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Airelon

Love your thoughts Simit, but it's really hard for me to grasp that anyone is still even remotely grasping at the inflationary model right now. It's hard to convey tone in a typed message, so imagine I'm saying what I am right now with a smile on my face. In other words, I have no malice whatsoever.

Reason I say that, is because I've made comments in the last week to those in the inflationary camp, and people have become EXTREMELY pi**ed off at what I thought were completely benign comments. So I mean no disrespect here.

* * *

The Austrian / Vienna school has some good points, and some valid economic observations and 'mantra's. Some of which I hold to. Some. Such as the mantra of "will this have the effect you intend" and it's similarities in base foundation model to the Lucas Critique. But it's only one school of economics, and one that is not followed too heavily by published economists.

I don't really fit into any one model (I find that economic neutrality is extremely profitable), although if you had to fit me somewhere, I'd probably be closest to the New Classical approach (I maintain that though similiar, New Classical is different enough to not be considered a descendant of neo-classical)

I mean honestly? I'll give the inflationists this much: they are persistent. We're in the midst of the worst deflationary spiral since the Great Depression, and people are still talking about inflation?

Despite the money supply being increased, the available money supply HAS contracted. This isn't temporary, and the United States world reserve currency really can't be applied to what has occured in Iceland. It's comparing apples to BMW's. Icelands economy is so small, that it could almost be considered part of the Lucas Critique in it's preference input to the world stage. Iceland. I mean ... seriously ... Iceland.

The money supply has contracted, because one of the most important pieces of an inflationary model is not present. The public does not have access to the increase in money supply, and much of the increase in that supply? Is already gone. There's no way it ever will reach the public. As I mentioned? It's already gone.

But when prices on stocks, homes, and everything else continued to deflate? Then the next step in deflation took hold. The big banks could not make a profit, no matter what they did because they over-leveraged themselves. In other words, they didn't have the money on hand to cover their liabilities.

So the Fed just started handing money over to them.

But here's the thing? That money just kept their books level. They were 'over-leveraged', or they had liabilities far beyond their cash.

And in the end, although the money supply was increased? The money supply actually contracted. Which is what you see at the beginning of deflation, and is the reason for the U.S. Dollars rise. It's completely dizzying when you think about it, since the Fed is printing money like it's going out of style; but follow me here.

The Banks provided the contraction to the money supply. When the TED spread exploded notably through the LIBOR and the flight to the treasuries, the banks were taking the money given to them by the Fed at a reasonable rate, and hoarding it. They weren't even lending to each other. They were just trying to keep their books balanced. So it never got to the consuming public, although the money supply increased. So the banks in essence, worked as the 'contraction' factor in the money supply, although ironically, the money supply increased dramatically.

And the debt? I mean, sometimes ones bring up the U.S. debt as if that's somehow important. Seriously ... the U.S. has held TWICE as much debt as it currently does, and has paid it off no problem. The debt sucks right now. But it's not as if we've never been here before. I maintain that the critical juncture we're at right now, and where we are going? Has EVERYTHING to do with individual preference building. Once again, the Lucas Critique. Those who have no education regarding economics, making decisions.

Now we're at the next stage of deflation ... which I pray doesn't take hold, but it looks like it's getting to that stage where it will be too late.

It all goes back to the Lucas Critique, ironically enough (considering that the inflationists prefer the Vienna school, which builds it's logic on so much of that model)

The businesses that are out there are NOT moving their stock. They can't move it. No matter what they do, they can't turn a profit. Price mechanism principles are forcing their hand, but the consumer preference was set back in March during the inflationary period. No one is changing their habits. And credit is gone.

Now if they go out of business? If they reach that stage? Then with unemployment where it's at, the deflation will only become more severe. Because no one will have income to purchase, and therefore with these companies going out of business? Their stock doesn't just 'disappear' when they are gone. For example, all of the cars sitting in lots ready to go to dealers? If a car company goes under? It won't mean that those cars disappear. They will have to be auctioned off - in a market in which no one can afford to buy them, because everyone is out of work.

In other words: the entire macroeconomic flow will then have MORE supply in the system, which further exacerbates the deflationary 'supply glut'.

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Simit Patel

Hey Airelon,

No disrespect perceived; always good to have a discussion on this issue, as it can affect one's trading/investing philosophy quite a bit. Interestingly, though, it always strikes a fire in people, which is why some folks probably overreacted to your analysis. Though I tend to think those make the best discussion threads!

Depends on how you're calculating money supply. Using MZM, money supply has been up and down over the past few months; the most recent numbers for October are up slightly from the numbers from September (stats can be compared here). This is, of course, a lagging indicator, but in my opinion, it shows that de-leveraging has thus far not proven to be conclusively deflationary. Inflationists who expect inflation after de-leveraging is done may cite this.

Depends how you look at it. The deleveraging we've seen over the past few months that has reversed longer-term trends like dollar weakness/gold bullishness, could also be seen as a temporary retracement within a longer trend.

The money not reaching consumers because no one is lending is true, and is a strong argument for deflation. However, I do view the current debt as a problem, especially as all indications are that it is going to continue to grow. And for me, this is the critical issue. The US government has made it clear that deficit spending is not a concern. I view this as very dangerous, because I do not think the world can continue to lend to the US for much longer. When the world appetite for Treasuries disappears, and if the US government is still issuing Treasuries and still as insolvent as it currently is, then I would expect a run on the dollar -- just like how Argentina and Iceland experienced a run on their respective currencies. This run was preceded by interest rate hikes, which I think we may see in 2009, as an attempt to stimulate demand for Treasuries.

Argentina and Iceland may be smaller economies, but I think the basic principle of a central bank being insolvent leading to a run on the currency is still valid and can apply to the US as well. As US consumption tends to play a big part in how the global economy works, this decoupling may be more painful than a decoupling on the Argentinian peso or the Icelandic krona. So perhaps it will take longer, rather than what happened with the krona and the peso, which lost more than half their value in just a couple months.

A run on a currency is devaluation via demand destruction rather than devaluation via supply inflation. So I would expect dollar devaluation even if there is deflation of the money supply. However, in the case of Argentina, the end result was that the money supply ended up being inflated as well, which is I think what we'll see in the United States as well, and I think is a more likely occurrence in the event of a central bank failure.

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Unregistered

"And the debt? I mean, sometimes ones bring up the U.S. debt as if that's somehow important. Seriously ... the U.S. has held TWICE as much debt as it currently does, and has paid it off no problem. "

- when and how?

Airelon

Very much agreed.

Sorry took me a while to reply to this post. I was sick Monday, and I'm still recovering.

But for inflation to occur, that money has to make it's way to the consuming public. With unemployment going through the roof (the next stage in deflation), they're not going to get their hands on the increase in money supply. And since they insisted on keeping all CDO derivative markets completely invisible (while all the time praising the concept of transparency)? It's exceedingly difficult to know exactly how much of that money is still there, and how much is already gone to the ghost of deleveraging. For any cash used for deleveraging? That money is already gone. It was simply used for solvency's sake, to keep the books 'even'.

I sort of think this is trying to use technical analysis to predict, rather than react. Technical analysis (trends) cannot predict geo-political events. What happens, is trends form as events warrant, and then the illusion of prediction forms. But the market could, at this point, go either way. I tend to react, rather than predict.

But that's the key issue right there: "When the world appetite for Treasuries disappears". That's a really, really, really big "when". I hear people say that, as if it's already a forgone conclusion. And don't believe for a second, that the Fed will not do exactly what Britain did with the Pound, if that eventuality comes to pass. If you read any of the Fed papers, I think you'd agree with me on that score. If. Sadly, it will have the same results.

And again, the debt. What is debt right now? 88%? 93%? We've been at 125% of what we've produced, and we paid it off. We could pay off 180% of GDP. With guys like Volcker at the economic helm in the new administration? Regardless of what comes to pass (Trust me, when I see the signs of inflation, I'll be the first one aboard ) it should prove to be a very, very, very interesting time.

It will pay to be very nimble ...



It just seems odd to me that so many people are still paying so much mind to Milton Friedmans ideas, after this catastrophe. I mean, don't get me wrong. The man was a genius. His contributions were tremendous. But nearly every idea he had that applies to the current situation has proven itself false. And let's not forget his mistake of 1982 / 1983 when he was epileptic on "hyperinflation that was coming". After a point, he refused to talk about it any further.

That's why I do not try to predict. For exactly that reason. Instead, I trade according to the environment that we are currently in. When I see the markets reflect an inflationary cycle? I trade that.

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Simit Patel

Depends how you're defining inflation. In the technical sense, I would define inflation as an increase in the money supply. You can then debate what money supply indicators are correct; increasingly I prefer MZM, as I've found it correlates well to USD value, but there are other money supply indicators as well that many deflationists prefer.

Other factors outside of money supply, such as currency value and employment, are not always dependent upon money supply inflation/deflation. For instance, I think the money supply will expand while unemployment will continue to rise. So perhaps what I many refer to as stagflation.

I consider myself a trend following trader, and concur. So I look for opportunities to trade what I perceive to be the longer term trend (going back to 1999), which I perceive to be money supply inflation and dollar devaluation. Right now USDJPY fits both my fundamental and technical trend outlook, which is why I'm in a USDJPY trade.

True, I view rate hikes as the first step, and the re-introduction of Volcker as an indication of that possibility. I don't think Volcker is going to be able to save the day, just as rate hikes in Argentina and Iceland did not prevent central bank insolvency and a corresponding run on the currency. I am thus expecting a gradual run on the dollar over the next four years. Of course, I'll look for technical confirmation of that in order to ensure I am following the trend.

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