The Great Reflation: The Age of Inflation

The Great Reflation: The Age of Inflation

My interest in studying financial and economic history started evolving when I came across a wonderful book by CFA Institute Research Foundation named “Financial Market History” 2/3 years ago. After studying this, I understood how important it is to understand the financial market history, policies, regulations, and investors’ behaviors. Then, I came across another fascinating book by Ray Dalio, The Big Debt Crises. It is a 3 part book and I have read the first part and never finished the rest 2 parts. I will re-read the first part and then all the parts of the book. I am also waiting for his upcoming book, The changing world order. My interest in economic history escalated during this pandemic of COVID-19 and I came across another fascinating research publication by CFA Institute. The name of the book is “Insights into the Global Financial Crisis“. The book is an anthology of past financial crises starting from the 1907 US Banking crisis.

It was edited by Laurence B. Siegel and forwarded by Rodney N. Sullivan, CFA. Laurence B. Siegel is the research director of The Research Foundation of CFA Institute. I have read his book this February named “Fewer, Richer, Greener: The Prospects for Humanity in an Age of Abundance”. A fascinating book. I must recommend reading the book to you.

While studying the “Insights into the Global Financial Crisis“, I came across the term “The Great Reflation Experiment” by J. Anthony Boeckh. I immediately collected the book and marked it as “want to read” in my Goodreads account. 

One might ask, why I need to study economic or financial history. The answer is it is extremely important because one must have a mental framework of how markets work, and how to integrate into these framework indicators which reflect the various forces that drive markets. Without that, the investor is like a boat on the ocean without a rudder, with the direction determined by whichever way the wind is blowing.

In a world of stability, buy-and-hold investment strategies can be very successful. In the financial world of the future, they will be an even bigger disaster than the decade after the dot com bubble. Stock prices suffered two 50 percent declines in the eight years from 2000 to 2008. The Standard & Poor’s 500 index by late 2009 was still almost 25 percent below the level of 10 years before. Those who were content with 5 percent returns on money market funds in 2007 are now looking at returns of less than one half of 1 percent. In other words, people relying on short-term money market funds have seen their income cut by 90 percent. Experience with markets over a long period teaches humility. 

A framework of analysis for understanding markets is not the same as building a model or set of indicators fitted to back data. I can assure you, from a lot of experience, that they always break down. An eclectic approach that is based on common sense, strong logic, and objective data, balanced by right-brain intuition and lots of curiosity, is what works best. The investment world will never be deterministic, never amenable to scientific models, at least for any period of time. Some approaches work well in some periods, other approaches in other periods. Successful investors not only know how to think outside the box but, from experience, know what to pay attention to in each market environment.

The financial market history teaches us many lessons that are appropriate for today. Investors can never hope to be successful without an understanding of what has happened before and why. This will be critical in understanding what will happen in the future. The term investor includes anyone who owns a home, owns a business, or invests in stocks, bonds, or mutual funds. 

Yesterday, after finishing the book “Good Economics for hard times by Abhijit Banerjee and Esther Duflo, I started reading the book “The Great Reflation”. I just read the first 10% of the book and will talk about that. The book was written in the aftermath of the 2007-08 subprime mortgage crisis. I will include some comments from the book along with my own comments and will try to connect those with the theories we study in economics. 

The first question is what does it mean by the term “Reflation”. 

The purpose of the great reflation is to pump new life into the economy after a near-death experience. That is what the US govt did in the aftermath of the 2007-08 financial crisis. The government has thrown an avalanche of new money into the economy and the financial system. And this is exactly the same thing going on currently due to the COVID-19 but on a bigger scale. The US government already injected $3 trillion into the system to fill up the hole and it may not be enough. They may need to inject more money in the coming days to protect the economy. The term great reflation means the government ’ s massive monetary and fiscal stimulus program to stop the possible death spiral of the economy.  The aim of the Great Reflation was to abort a potential depression, repair balance sheets, and generate economic recovery. It was an unprecedented experiment executed during the 2007-08 financial crisis. The central banks are doing the same (There is no other choice and the previous experiment showed some success) on a bigger scale during the COVID-19 period.

The first chapter of the book is “The Age of Inflation”. Investors need to understand the historical context of inflation because the roots of inflation are long and deep, and it will not be easily ended.

What is Inflation?

Many of us think that inflation is just a rise in prices, but it ’ s not that simple. Inflation does cause prices to rise, but it is important to be clear on which prices. Inflation is a process that begins with an increase in money and credit above what is needed for the production of goods and services. The second stage — rising prices — is actually a consequence of the first stage of inflation and that is what confuses a lot of people.

There are two types of rising prices. 

Increase in Consumer Prices: Inflation can cause an increase in prices we pay for things we consume or use on a regular basis — food, haircuts, gasoline, washing machines. This is usually measured by the consumer price index (CPI), and it indicates whether there is a general rise in the cost of living. We refer to this as CPI inflation. In a general CPI type of inflation, the real value of debt declines as prices rise.

Increases in Asset Prices: inflation can raise the prices of assets we own or may want to own. For example, we can think of inflation  raising the prices of homes, stocks, bonds, gold and silver, and foreign currencies.  These types of assets don ’ t necessarily move together or even in the same direction, nor does CPI or general inflation have to move in the same direction as asset prices.

To understand asset inflation, think of money and credit inflation as water coming out of a giant hose that has been stuck in the ground. The water must come out somewhere, but you can ’ t be sure where. When the hose pumps out money, eventually some prices will have to rise. If CPI inflation is weak and falling, the pressure must flow to assets and push their prices up.

Whenever there is inflation, whether it be in asset prices or the CPI, there is always a central bank to be found; and the central bankers are responsible for the integrity of the money, and that means responsibility for not creating too much of it.

central bankers are very concerned when the CPI or some variant moved up rapidly. But they paradoxically failed to understand that asset inflation is far more dangerous.

Major asset inflations, paradoxically, occur when the rate of generalized price inflation is falling and often very low. This is referred to as disinflation.  

Deflation,  in contrast, is the term used to denote an actual decline in the price level. Severe deflation is a terrible disease because it is associated with recessions, depressions, mass bankruptcies, and high structural unemployment.

Disinflation played a key role in the asset inflations of the 1920s and the nineteenth century. Disinflation was of critical importance after the 1970s for three main reasons. First, central banks had shifted temporarily to very restrictive monetary policies as a result of the dramatic rise in the CPI during that decade. Second, the cold war began to wind down after the late 1980s. Wartime spending is always inflationary; its ending is deflationary. Third, globalization opened up trade with rapidly developing low – wage, export-oriented countries like China.

During the almost 30-year period after 1982, interest rates fell steadily to low levels in a series of waves, triggering a borrowing binge. The U.S. government under Ronald Reagan started to run huge budget deficits which, at the time, caused mistaken fears of a new rise in CPI inflation. However, instead of pushing domestic prices up, the deficits resulted in a flood of cheap imports, leading the United States into a huge negative trading balance with foreign countries. 

We can visualize this by thinking of Wal -Mart sourcing vast and growing amounts of goods from China at lower and lower prices, which it then passed on to its customers. The result was falling CPI inflation, as excess U.S. spending was deflected overseas, and China became the workshop for the United States and much of the rest of the world. Note that Bangladesh was a net beneficiary of this Wal-Mart sourcing. This is why Bangladesh was not being affected after the 2007-08 crisis. Rather, Bangladesh Garment Sector was benefited due to the Wal-Mart sourcing. 

Price inflation in the United States went down, and China created tens of millions of new low – wage jobs. It seemed like a win-win development.

Globalization, rapid growth, and a high savings rate in developing countries had another major effect: Their total savings rose rapidly and the savers were happy to lend virtually unlimited amounts to the United States so it could pay for the flood of new imports. The large inflow of foreign savings allowed the United States to save much less and borrow more, all the time pushing U.S. interest rates down. This, in turn, further stimulated the frenzy of U.S. borrowing and spending.

Central banks have no real mandate to restrict money and credit creation to stop asset inflation. Their focus, as we said before, has traditionally been on keeping money stable in terms of the cost of living. Disinflation brings great benefits and almost always marks a time of prosperity and well – being. Interest rates are falling, asset prices are rising, and business activity and employment are strong. Everybody seems to be a winner. 

To understand the origin of inflation, we need to understand the fiat money system. 

Fiat Currency

Money without an anchor to something of solid value is called fiat money. It is money that is in the form of paper, or a book entry in a financial institution. The traditional anchor to prevent excesses was gold, and to a lesser extent, silver. The anchor provides a constraint on central banks. They can print paper but they cannot print gold or silver. With the discipline that comes with gold or silver backing, monetary expansion can exist only to the extent that central banks have additional metallic reserves. It is normal for countries to go on a fiat paper money system temporarily during major wars to finance huge military expenditures. The United States did it during the Civil War and the United Kingdom did it during the Napoleonic Wars. After such wars, what inflation that had occurred was brought back down by the return to a disciplined monetary standard. However, after World War I, the authorities badly bungled the attempt to go back to an externally disciplined system. The gold standard was reestablished at a price for gold that did not take into account the wartime inflation of money and credit, the rise in commodity prices, and the general cost of living. Hence, the value of gold reserves was inadequate to support stable growth, and central banks felt they had to supplement their gold reserves with foreign currencies.  This proved to be a disaster for a system that was already fragile because of war reparations, hyperinflations in the early 1920s (The mark-dollar exchange rate rose from 4.2 to one in 1914 to a peak of around 4.2 trillion marks to the dollar by November 1923. At its height, prices were rising so fast that waiters had to climb on tables to call out new menu prices in restaurants every half hour) in belligerent countries, and widespread political instability. The inclusion of foreign currencies in reserves in the late 1920s aided and abetted the credit inflation and asset bubbles that led to the 1929 stock market blow-off. When the crash came, followed by bank failures, central banks yanked their currency holdings out of other central banks by asking for conversion into gold.

Why did the Central Banks used to peg with Gold?

central banks ran to gold because they didn’t trust each other, a lesson that may become relevant today. As the budget deficit ballooned, trust fell even further and no central bank risked losing gold. Countries were then pushed into contractionary policies, such as tax increases, government expenditure cuts, tighter monetary policy, and trade protection, even as economies sank. As a result, the gold standard was blamed for causing the Depression.

After the Second World War, the authorities avoided some of the mistakes of the post – World War I period. As a result, we got 15 years of relative stability under the Bretton Woods system, which was a mutation of the gold exchange standard of the 1920s. By agreement, the United States pegged the dollar to gold at $35 per ounce, and other countries pegged their currencies to the dollar. It provided stability as long as the U.S. dollar was scarce and had the appearance of enduring value.

What Happened during the 1960s?

in the 1960s the first of the postwar asset bubbles formed and the U.S. dollar came under pressure as foreign central banks became concerned with U.S. deficits, too much monetary expansion, and the Keynesian policies of President John F. Kennedy’s economic advisers. Their view was that governments should stimulate the economy to get full employment and that a little inflation was acceptable if you could create a few more jobs. Significantly, the free market price for gold rose above the   $ 35 per ounce peg for the first time. The future value of the dollar had now become suspect, and hence the Bretton Woods system was no longer viable.

For most of the 1960s, the United States wrestled with the impossible problem of how to keep the dollar/gold-based Bretton Woods system intact while at the same time ignoring market pressure for monetary discipline in the United States. The market won, as it always does in the end: Controls to hold back the consequences of monetary inflation ultimately break down. They are like a dam to hold back running water; eventually the water will find a way around. The markets finally forced the United States to break the link to gold and float the dollar in August 1971, a watershed event in world monetary history. The dollar fell sharply, triggering the greatest peacetime rise in the cost of living in U.S. history. The CPI rose at a 15 percent rate at its peak. The experience was pretty traumatic. Articles on hyperinflation regularly appeared in the press. Cynical money managers extolled the virtues of moving to a log cabin in the woods and loading up on canned food, gold coins, and machine guns for protection against the anticipated mobs!

Ray Dalio expected the stock market to plummet when he watched President Nixon speaking to the nation and told the world that the dollar would no longer be tied to gold. He said, “I was clerking on the floor of the New York Stock Exchange at the time, and that Monday morning I went on the floor expecting pandemonium with stocks falling and found pandemonium with stocks rising.  Because I had never seen a devaluation before I didn’t understand how they worked.  Then I looked into history and found that on Sunday evening March 5 President Franklin Roosevelt gave essentially the same speech doing essentially the same thing which yielded essentially the same result over the following months (a devaluation, a big stock market rally, and big gains in the gold price), and I saw that that happened many times before in many countries, including essentially the same proclamations by the heads of state. ”

Paul Volcker, the chairman of the Federal Reserve, came to the rescue and will probably always remain the most revered central banker in the Fed ’ s history. He courageously gave inflation and the economy a cold bath with very tight money. This created a serious recession and high unemployment but brought interest rates and the CPI down sharply.

With the great success of Paul Volcker in taming down inflation to a manageable level, the Fed started growing the money supply rapidly during the 1980s. Monetarists were very influential at the time,  and they kept forecasting (wrongly) a major rise in general prices. The explanation was that confidence in U.S. money had returned and people were prepared to hold a lot more of it.

Because the CPI and interest rates were falling, no one paid much attention to the surge in credit. It continued to accelerate in a series of waves, with market crashes occurring along the way — 1987, 1990, 1997 – 1998, 2000 – 2002. After each bubble burst, the Fed stepped up its expansion of money and credit inflation.  After the panic of 2008 – 2009, the Fed moved to once again reflate; but this time its efforts, combined with fiscal stimulus and bailout money, have dwarfed anything ever seen before in peacetime. This is why we call it the Great Reflation. 

Why Do We Have Inflation?

Money, as we explained before, is at the root of all inflation.  When there are no effective brakes on the monetary system, the creation of too much money and credit inevitably follows. And in the modern world, there is a central bank to be found whenever there is inflation. The political authorities are the ones that ultimately pull the trigger.

Why Politicians want to have inflation?

There are political advantages of having inflation in the short term. The central bank is merely the tool of governments when push comes to shove. Almost always governments would like interest rates a little lower, credit a little easier, and the economic environment more supportive to financing their deficits so they can spend more money.

Politicians inflate to save their own necks, either when economic conditions turn the people against them or to finance wars, lavish public works, or other expenditures that cannot be financed with higher taxes. Whenever there is inflation, there are always political promises that it will be temporary and the people are told that they should not be concerned because they will be the beneficiaries of better times.

Investors should never forget that politicians unless they are elected on a hard money platform following disillusionment with inflation,  will always be tempted to buy short – term popularity when economic and financial conditions are difficult, even though experience demonstrates that all inflations end in disaster. Ultimately, the public discovers it got only “the glitter, not the gold. ”   Nor should people forget that, if there are no effective brakes built into the monetary system, the creation of excess money is all too easy a temptation for politicians.

The Inflation Process

Lenin, in referring to the consequences of inflation, may have said it better than anyone:   “ The best way to destroy the capitalist system is to debauch the currency. ”

Extreme forms of general inflation are called hyperinflation when money becomes worthless. Fortunately, these are rare in developed countries and always occur during major wars or in their aftermath when the government has no tax revenue because the productive system has been destroyed. The central European powers all experienced hyperinflation after World War I. More recently, the only countries that have experienced hyperinflation are economic basket cases like Zimbabwe.

Even though hyperinflation is rare in advanced economies, that doesn’t mean that CPI inflation cannot rise to dangerous levels. As we pointed out earlier, it did reach 15 percent in the United States at the end of the 1970s and an even higher rate in some other countries at that time, and that was enough to create havoc in financial markets and near panic among a large part of the population.

How Central Banks Create Money?

Central banks — formerly called banks of issue — are at the center of the money and credit creating process through their monopoly of the issuance of paper currency and, more importantly, through the requirement that commercial banks must hold reserves in the form of deposits at the central banks. These reserves are assets of commercial banks and liabilities of the central bank.  They are normally set as a certain proportion of bank assets. The ratio limits the growth in commercial bank assets and liabilities. The latter are mainly deposits, which together with Federal Reserve notes make up the money supply.

The main liabilities of the central bank are composed of currency held by the public and reserves held by commercial banks. Therefore, it is important to watch what the central bank is doing with its balance sheet. When it is adding to its assets, its liabilities must be rising, and hence the money and credit generating engine is expansionary. When the engine runs too fast it causes inflation.

The Federal Reserve expanded its balance sheet after the crisis. The unprecedented explosion in Federal Reserve credit reflects the Fed ’ s response to the liquidity crisis by buying securities with all kinds of risk attached in order to bail out the financial system. The monetary base, which reflects the reserves of commercial banks when the Federal Reserve creates credit. It is also called high – powered money because it lies at the heart of the money and credit – generating process for the economy as a whole. It shows clearly the vast magnitude of high octane money that has been created by the central bank.

The Fed’s emergency response to the crisis was an absolute necessity to avoid a complete meltdown of the financial system. All the central banks are doing the same thing on a bigger scale to fend off the deflationary pressure from the COVID-19.

However, the Fed must reverse the massive liquidity injections as soon as borrowing and lending start to normalize if it hopes to achieve long – term stability. The reality was that the recovery was fragile, and the tightening policy sent the economy and stock market into a tailspin and ratcheted up the fiscal deficit even further.

The global financial system is and will remain flawed as long as it is based on fiat paper money. Lots of proposals to fix this have been floating around for years, but trying to do it immediately after a banking collapse and near depression would be a high – wire act. It would be better left to a time when conditions are more stable if that is possible. In the near term, the lesser risk is letting reflation push asset prices higher, which improves balance sheets—a key objective of reflation efforts. In 2009, the rise in asset prices, while substantial, should be thought of as a recovery from very depressed levels, not yet a new bubble.

Thank you for reading the long read. I will continue to study the book and I will share more topics. If you have any thoughts or questions, feel free to share. 


The Great Reflation by J. Anthony Boeckh

The Changing World Order, by Ray Dalio

The Economist

The thoughts and excerpts shared are for informational and educational purposes only and is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Any such offering will be made pursuant to a definitive offering memorandum. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors which are necessary considerations before making any investment decision. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, where appropriate, seek professional advice, including legal, tax, accounting, investment, or other advice. 

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