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I read an interesting letter from John Mauldin today called Catching Argentinian Disease that focuses on the risk of hyperinflation in the United States. Much of the letter quotes Niall Ferguson’s recent book, The Ascent of Money, which I have not read. However, Mauldin makes some interesting arguments about the risk of our economy running into the hyperinflation risk as seen previously in Argentina or Brazil.

Printing Presses

To begin with, I highlight a popular article from Heritage.org explaining how the Obama budget undershoots an accurate estimate of our impending national deficit by nearly $4 Trillion.

“The White House’s mid-session budget review recently forecast that President Barack Obama’s budget would create $9 trillion in budget deficits over the next decade–more debt than America accumulated from 1789 through 2008 combined.  Yet even that figure likely understates the 10-year budget deficit by nearly $4 trillion. It completely excludes the proposed new health care entitlement, underestimates other costs, and fails to include the full price of major legislation that the President has endorsed.”

An even more popular image from Heritage of annual budget deficits explains it all:

If this is going to happen, we obviously run the risk of having to print a lot of money to cover this deficit. The risk of hyperinflation over the long term is difficult to pinpoint against today’s monetary actions. Mauldin tries to highlight that potential by pointing the risk at politics.

Political Hyperinflation

Mauldin quotes Ferguson,

“The economic history of Argentine in the twentieth century is an object lesson that all resources in the world can be set at nought by financial mismanagement… To understand Argentina’s economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon…”

“Inflation is a monetary phenomenon, as Milton Freidman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country’s political economy.”

Mauldin’s argument was that the US will not experience hyperinflation as long as the Fed maintains its independence. The Fed understands the risks of hyperinflation. First, however, the Fed must fight the current deflation. The Fed will continue to fight deflation “tooth and nail”, however in doing so the Fed does not necessarily have to buy government debt.

“They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.”

The risk, Mauldin argues, is that the government gets too much influence over the Fed and convinces the Fed to keep buying government debt. Mauldin does not think that will happen, but is quick to point out the possibility and potential economic fallout.

Mauldin’s conclusion is that “if the Fed starts to increase its buying of government debt above its initial commitment, then my ‘optimistic’ scenario of a very rough economic patch…is far too rose-colored. I do not think that will happen, but I can guarantee you, I and a lot of other people will be watching.”

So, what do we do to watch for hyperinflation risk?  We watch the Fed in two steps:

1. Read the FOMC Statements – every 6 weeks
2. Watch the Fed’s Balance Sheet – weekly

FOMC Statements

Now, the Fed has committed to buy a fixed amount of government debt in its quantitative easing program. It finished a program to buy $300 Billion of Treasuries just last month. The Fed initially committed to buy back $200 Billion of “Agency Debt” by the end of the year, however, as of November 4th’s FOMC statement, they will now buy back only $175 Billion by the end of the first quarter 2010. I find that statement to be encouraging as it is a step in the right direction.

In the Nov 4th statement, watch for this line: “To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.” The Fed will edit that line roughly in each statement going forward to give an indication of their goals.

Fed Balance Sheet

Next, you can watch what is currently on the Fed balance sheet and what they do each week.

Look for this section in the most recent balance sheet:

On the second to last line you will see where the Fed currently holds $141 Billion of Federal agency debt. This is of the $175 Billion they will purchase by the first quarter of 2010. That is the line to watch as they keep buying agency debt.

The Fed has also bought $298 Billion of U.S. Treasuries this year. You will also notice the Mortgage-backed securities are +$776 Billion since this time last year. Bernanke is taking that to $1.25 Trillion as stated above.

Hyperinflation Prepared

So, we watch the Fed statements and those lines in the balance sheet to keep an eye on how much governement debt the Fed is purchasing. If we see it increase over the announced levels, or if the Fed announces increases its intended government debt purchases in the next FOMC statements (next one: December 16th), we have to assume that government is swaying too much influence at the Fed.  This is the beginning of hyperinflation risk.

As Mauldin states, if that happens, you need to own assets, not cash: gold, foreign currencies, stocks. Real estate used to be a good hedge against inflation, but considering the state of that market, I would be very careful.  Hyperinflation is a small but real risk with the current state of our economy and our political atmosphere.  Preparation and early warning indicators are worth the effort.

*image source: heritage.org

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