Hyperinflation and the Permanent Portfolio

[Lone Wolf]

Gumby and Adam1226 started discussing the challenges of dealing with severe inflation in this thread.  If you find this interesting, break out your Doomsday leather chaps... it's time to talk hyperinflation!

Hyperinflation for our purposes could simply be defined as very rapid, sustained, and typically accelerating inflation.  Zimbabwe, Weimar, Argentina are some famous examples but there are many, many more.  FWIW, I don't expect hyperinflation in the United States (although I do expect continued, persistent inflation.)

So what happens?  Clearly in a hyperinflation, long-term bonds are doomed.  Those are going to zero.  Depending on the prevailing interest rate, cash is also probably going to do very, very badly.  Stocks are likely to be poor performers.  This means that, as expected, it's all resting on gold's shoulders.

However, with the price of gold appreciating so rapidly in terms of dollars, the rapid arrival of rebalancing events could have you buying and buying into a worthless currency.  If gold were to go from $1,500 an ounce to $1,500,000, you'd crack the 35% band time after time, losing value the whole way.  In addition, you're going to pay 28% tax on each of these sales for your "gains".  (Do you see my finger quotes around "gains"?)

So what would you do if hyperinflation struck?  Would you take steps to avoid piling into a shaky currency and put off paying a collectibles tax?  And how would you "know" it was time for extraordinary measures?  Gumby mentioned the idea of mixing in Swiss Francs:

You would think so. But, it's important to keep in mind that gold tends to "pop" before severe inflation is entirely over. Inflation was still quite severe in 1982, but gold had already gone down because the worst of it was already over. You don't want to be that guy who holds onto too much gold for too long because gold can drop at a moment's notice. Besides, you could always rebalance into a more stable currency (Swiss Francs?) or a basket of currencies if you were so opposed to US Dollars. But, unless you move to another country, you're probably going to need those worthless US Dollars to buy your $39.0099/gallon gas.

[MediumTex]

I would just be excited to see my wages rising dramatically, even though they probably wouldn't be keeping up with price increases.

If you look at average wages in the U.S. they have gone nowhere for many years.

[AdamA]

So what would you do if hyperinflation struck?  Would you take steps to avoid piling into a shaky currency and put off paying a collectibles tax?  And how would you "know" it was time for extraordinary measures?  

I think I would do my best to stick to the PP.  It would be hard, but, as usual, I can't think of anything that would give me better protection.

[Gumby]

First off, you would probably see something like this happen...




...and then you would see something like this happen...



(Sweeping up the banknotes from the street after the Hungarian peng? was replaced in 1946)

Harry Browne got this call on his radio show. I can't recall which episode it was, but the caller was wondering how they would rebalance their gold fast enough if half of it was in Switzerland (as he was recommending at the time) and the other half was in a safe deposit box. Harry Browne thought it would be highly unlikely (though not impossible) that you'd ever have to rebalance more than once in any given crisis. He seemed to beleive that gold would come back down to earth once the worst of it was over.

Now, he wasn't exactly addressing "hyperinflation" in that Q/A session. But, it leads me to believe that by the time you realized that your currency was worthless, you'd probably have no choice but to rebalance into a totally different currency.

[moda0306]

I really wonder how much cash in a MM account or savings account would lag inflation.  That's probably a pretty big factor as to whether I could stick to the PP.

Has any country ever pulled out of a hyper inflation???  One could have a set of rules on how to keep an airplane in the air (PP earning value), but if the plane is going down with its wings chopped off you might just need to grab a chute.

I'd think Gumby's idea of a "next best" currency might be the best idea.  This isn't to say that the PP isn't working at this time... in fact a portfolio w/ 25% gold in hyperinflation should be considered a success, IMO.  I just wonder if there's a point at which a currency is certainly doomed.

In fact, I wonder if this is time we reevaluate HB's rule of using your "domestic currency" (or however he termed it).  If a country is experiencing hyperinflation, can that currency, now obviously hated to be held for more than a day, really be considered still to be your domestic currency?  Maybe in that state of flux, another common currency (or no true "common" currency... maybe bartaring) has developed.  This maybe creates a gray area for that rule that would imply not simply buying into a sure firestorm scenario.

[MediumTex]

Has any country ever pulled out of a hyper inflation???  One could have a set of rules on how to keep an airplane in the air (PP earning value), but if the plane is going down with its wings chopped off you might just need to grab a chute.

Hyperinflation is always a temporary event.  It may go on for a few months or years, but the value of the money reaches zero soon enough.

These events are relatively rare in modern times.  What is more common is sustained high inflation, but not what you would call hyperinflation.

Again, though, talking about hyperinflation with a reserve currency really doesn't make any sense.  There is not enough of any other currency in the world to sustain a hyperinflationary run on the U.S. dollar.  And would the rest of the world really want to give U.S. manufacturers such a gift as a severely devalued currency in an otherwise healthy economy (U.S. manufacturing has been doing relatively well in the last couple of years)?  Among other things, it would put China out of business almost overnight.  That seems farfetched to me.

[Gumby]

There are conspiracy theories that the Federal Reserve has a bunch of RED Dollar notes hidden in a bunker somewhere that could be helicoptered to banks across the country, overnight, if we ever experienced hyperinflation in this country. Each red dollar would be worth something like 1,000 times the face value of each typical note denomination.

It wouldn't surprise me if that was true. I think it would be irresponsible for them to not have backup currency notes ready to go.

See also: Hyperinflation Banknotes Collection

But MT is right. The hyperinflation scenario of the US Dollar doesn't seem likely. Severe or high inflation (or deflation) is much more likely.

[AdamA]

I think it would interesting to watch gold ETFs during such an event.

They would possibly be subject to so-called currency trapping, wherein you sell $10K of paper gold on Monday, and by the time you have access to your $10K on Wednesday or Thursday, it buys what $5K did on when you sold on Monday. 

Just another reason to hold some physical gold.

[moda0306]

So, here are my basic 3 questions:

1) Are MM & savings account interest rates keeping up with the hyperinflation... even close?  Did they in Argentina or Germany?

2) Has any country ever pulled out of or stabilized a hyperinflation (MT seems to think/assert no), or is it more akin to a plane going down without wings?

3) If you're experiencing hyperinflation, does the strong tendency to avoid the currency as a means of exchange imply that "your currency" is no longer your currency, and the rule of investing in cash/bonds denominated in your currency is no longer a valid rule.

Really, the whole discussion of hyperinflation is difficult to have and it's so hard to imagine that type of environment.  I agree with MT in its unlikelihood, and it almost changes the rules of how one should think of the PP (though I think in its wake the PP should be viewed as a resounding success), because the very implications of a rapidly declining currency, to me, would seem to change the rebalancing rules altogether, just as no wings chang the rules of trying to land an airplane.

Much more applicable and interesting, to me, are the implications of a sustained high inflation, but one driven by commodities, and lagged by short-term interest rates.  The idea that gold will rise during inflation, but ESPECIALLY when short-term rates lag inflation, implies (and has been proven by 1981) that the PP can have a misstep year if rates are corrected to handle it. As Gumby said, inflation was still bad in 1982, but raising rates reaffirmed the dollar as at least returning you a fair ROI for putting it in the bank.  That alone will undermine gold's ascent.  Not trying to hijack the thread... so back to hyperinflation we go.  Sorry.

[Lone Wolf]

I'd think Gumby's idea of a "next best" currency might be the best idea.  This isn't to say that the PP isn't working at this time... in fact a portfolio w/ 25% gold in hyperinflation should be considered a success, IMO.  I just wonder if there's a point at which a currency is certainly doomed.

Unquestionably.  The fact that you have 25% of your net worth in gold would put you head and shoulders above the rest of the crowd.  That's part of what would make it hard to let that gold go -- it's the only thing you have separating your portfolio from all the others (which are getting filleted right in front of you.)

Hyperinflation is by its very nature so chaotic that it's very difficult to get reliable data as to what happens on the inside.  I can't be the only one wondering what happens to the yield curve.  Would the government continue to issue 30-year bonds with inflation that high?  Even I might feel a certain visceral thrill to own 30-year government bonds that are dropping 50% interest payments. 

I think it would interesting to watch gold ETFs during such an event.

They would possibly be subject to so-called currency trapping, wherein you sell $10K of paper gold on Monday, and by the time you have access to your $10K on Wednesday or Thursday, it buys what $5K did on when you sold on Monday. 

Yes, even under normal circumstances "time is money".  Daily inflation in Zimbabwe got close to 100% (!) so even walking down the street to buy groceries after selling your gold at the coin shop could cost you. 

Overall, I think that I'd give serious thought to diversifying into a more stable currency but just following the basic PP recipe.  Having said that, if the dollar truly experienced a hyperinflation, a "stable currency" might be a bit hard to come by!  And yes, I do agree that hyperinflation here is extremely unlikely.  (Then again, I thought the same thing about deflation once, didn't I?)

[moda0306]

The inflation argument to me as an investor (as opposed to a wage-earner) basically comes down to whether interest rates are at least meeting/beating it.  If inflation were 5% per year, and treasury MM accounts were 7%, I'll take that environment over the current one.  If the problem we're seeing today is not so much overt inflation of the general price level, but inflation of commodities and lagging interest rates... I-bonds, even with 0% fixed, could prove extremely helpful in the future.

Part of me thinks part of the reason rates can be so low now is precisely because inflation is mostly stemming from commodities, and not "fun inflation" like housing and wages.  The idea of investing in commodities to sustain purchasing power is a lot scarier to most people than buying a REIT or refinancing their appreciating house.

Fortunately commodities are included in CPI calculations, and since I-bonds aren't dumbed down by existing in a liquid market full of finicky cash-lovers (like TIPS are), they're not priced at astronomical levels.

[moda0306]

Clive,

I think we may disagree on how gold behaves.  "Over the last 10 years" there might have been a reversion to a mean, but in a world of questioning fiat currencies, gold will move sharply in price to move more towards its "monetary value."

HB even referred to it as "leveraged" in its response to inflation.

Further, cash has shown the ability to keep pretty close track of inflation, and stocks usually benefit from moderate inflation.

If you're referring to hyper-inflation, if the dollar truly collapsed, and I had 25% of my portfolio in gold before the collapse, I'm willing to bet that its skyrocket in value even in terms of other currencies in the face of a collapsed economy would give me more purchasing power than I had with my 4x25 portfolio before... maybe that's a stretch, but the world would likely value gold at a whole new high.

[moda0306]

Clive,

I guess to expand on my former statement, copper will behave based on the supply and demand of it as a deteriorating (slowly) industrial commodity with various economically productive uses.

Gold will behave based on supply (most of which appears mined) and demand of it as a currency used for exchange.

In a world of reasonable economic growth and 3% inflation, copper may rise about 3% per year assuming no supply fluctuations.  Gold, during that same period, if peace, prosperity, stable fiat currencies (and their issuing governments) and lucrative real interest rates reign, may have a significant decrease in value since its industrial value is FAR less than its value as money.  People won't see it as a valid form of money the way they did earlier that year (possibly).

If that trend reverses, the 3% CPI inflation could be combined with social unrest, war, negative real interest rates, etc which really won't change anything for copper (necessarily), but gold will once again be "demanded" as a stable currency.

Imagine the U.S. was the only issuer of currencies, and the world just used ours.  If our currency collapsed, theoretically, gold (or gold-backed notes) could literally take over for all currencies.  It's a stretch to think this would ever actually be taken to that level, but when one considers its astronomical value as the worlds only medium of exchange, one would think that if you owned 25% of your portfolio in gold one day, and the next day the USD collapsed, you'd maybe even have more purchasing power than before, even with your worthless 75% of your portfolio.

Luckily, we live in a world with much less extreme likely possibilities, but it doesn't keep gold from working in a very different way than most commodities.  2008 is a perfect example of how a monetary vs industrial metal will react to financial crisis.

[MediumTex]

If commodities are included in CPI calculations, then with "low" CPI, something else must be deflating pretty heavily to counter the inflation in commodities. Could it be those little bits of green paper.

...or maybe those equity certificates?

...or more recently maybe all of those houses?

[moda0306]

Last thing... I swear.

I tend to view gold as a gun... in a world where no more guns can be built for whatever reason...  It's not physically possible.

Currently, a security system, a deadbolt, and a phone to dial 911 will protect you pretty well, which keeps the value of these guns reasonably moderate.  The risk of failure of these defenses does exist, but you don't need 100% of your portfolio invested in "guns" to protect yourself.  Most Americans rely on these home-defenses and don't bother with a gun.  If some sort of disaster strikes, the millions of people realizing that 911 doesn't pick up and their security system going to bring them help are now left in a position where they NEED a form of self defense, and all the ones they had relied upon completely failed.  Meanwhile, less savory people realize the system is broken, and commit far more acts of crime than they otherwise would have.  See the leveraged nature of this narrative?

The price of guns will then absolutely skyrocket.

Obviously an exaggeration, but that doesn't mean we don't all keep a gun in our closet, if not a few, knowing that someday it COULD be worth its weight in gold.

[moda0306]

Clive,

I'm having a bit of trouble deciphering your graph around year 2008, and which commodities are which, and I'm sure that other commodities have worked fine in the past, but if you really think we're in for a destabilizing currency collapse, do you really want to be in a basket of commodities or a monetary metal?

I agree with your assertion that selling gold into a hyperinflating currency would be stupid.  At the point of hyperinflation the wheels are off the bus, and thinking of it as your "domestic currency" at that point is flawed.

[Pkg Man]

...The price of guns will then absolutely skyrocket.

Obviously an exaggeration, but that doesn't mean we don't all keep a gun in our closet, if not a few, knowing that someday it COULD be worth its weight in gold.

But if you sold the trigger and hammer of your golden gun in the run up to the crisis to raise some funds to buy some 'cheap' stocks

Whilst a US hyperinflation event might seem most unlikely, the Fed/Government (whoever) seem to be positioning 'rules' commonly utilised in potential/actual hyperinflation events (restricting foreign currency/investment access...etc.) - in recent years most 'foreign' (to US) banks/investments simply wont accept US residents due to all of the restrictions/reporting requirements.

But hopefully we would be able to tell the difference between transitory inflation and hyperinflation.  If inflation is at 10% per year and gold causes me to hit a rebalance point, then I would rebalance.  If then inflation rises to 10% per month, I might very well choose to abandon the bands and not rebalance.  Granted, I would have lost a bit in the run up to hyperinflation, but I don't really see much alternative that does not involve predicting the future.

I suppose another way of stating it is that the PP, like the US Constitution, is not a suicide pact.

[Pkg Man]

Hindsight is a wonderful thing that I look forward to having some of tomorrow Perhaps easier said than done at the time.

Agreed.  But I tend to think hyperinflation is a bit like pornography, I know it when I see it.  I grant you that I could get burned in the intermediate period, and may rebalance out of gold into a depreciating currency, although I really don't see any way to completely avoid that possibility, without making an explicit bet that that is the version of the future that will unfold.  Perhaps having a VP consisting entirely of international stocks/bond and silver, as I do, could help. 

Other than that I'm open to suggestions.

[AdamA]

I suppose another way of stating it is that the PP, like the US Constitution, is not a suicide pact.

Are you sure?

Rebalancing might be key during a hyperinflationary period.  Germany still had a stock market after it's Weimar Republic hyperinflation.  A lot of those stocks did well...long term. 

I'm not sure about bonds or how they ultimately sorted out the cash situation.

Does anyone know?  I would love to see how a rebalanced German PP would have behaved during this time period. 

[Lone Wolf]

While it's obviously just a big steaming pile of speculation on my part, I'd guess that gold really could preserve your wealth in this situation if you played it right on your rebalance bands.  (Of course, I haven't yet decided what "right" means, so I've left myself a very nice loophole.)

There are lots and lots of dollars.  The market for dollars is a much bigger market than that of gold.  If the dollar ever got beat to hell by inflation, the "leverage" effect of gold would (IMO) save you.  That kind of damage to a reserve currency would raise the value of real money (gold) tremendously.

Does anyone know?  I would love to see how a rebalanced German PP would have behaved during this time period. 

Totally agree.  I'd love to geek out with a data set like that some time.  Clive, if you've got one stashed in that vault of yours, please share with the rest of the class!

Hard as it might be to sort it all out, it's nice that a) this is extremely unlikely to occur and b) the PP is one of only a few effective US-based allocations that would survive it.  I think I know which "lazy portfolio" would win the annual Paul Boyer contest that year. 

[MediumTex]

Bear in mind too when talking about Weimar Germany that there was nothing accidental about that.  The end of the WWI basically made hyperinflation more or less inevitable at some point because the WWI reparations were un-repayable without devaluation.

If Greece could, they would probaly be doing the same thing today. 

[AgAuMoney]

Bear in mind too when talking about Weimar Germany that there was nothing accidental about that.  The end of the WWI basically made hyperinflation more or less inevitable at some point because the WWI reparations were un-repayable without devaluation.

That's the official story published by the German gov't in Dec 1923.  And admittedly there were some big problems re. reparations, e.g. France and Belgium occupying the Rhur in Jan 1923 to extract reparations in kind (after the mark had devalued to 1/1000 of its original value).

However the reparations were less than 1/3 of the deficit spending from 1920 to 1923.  What were the other 2/3s which also contributed to the 1/1000 reduction in value of the mark?  And the bad inflation was yet to come, and it came, and it went, and Germany stabilized their currency and paid the reparations.  So what changed if not the reparations?

The only thing I have come up with is that the political and public will to do what needed to be done -- live within a budget -- finally became strong enough to make it happen.

Germany had been deficit spending since early in WW-I.  That ended with the end of the German hyperinflation which occurred about Nov 12, 1923, when the powers of the old Reichsbank were limited and the new Rentenbank was created.  The Reichsbank could no longer lend to the government, and the Rentenbank would not.

In other words, on Nov 12, 1923, Germany hit the debt ceiling and there was no more deficit spending.  At that time the Rentenmark was created as an accounting fiction and was stable enough that by Aug 30, 1924 the new Reichsmark was created equal in value to the Rentenmark and exchange of the old mark into the new mark was allowed.

It's always easy and politically correct to blame foreigners for the problems of one's own country.  We do it today and the veracity is likely no more true than it was in 1923 Germany.

[AgAuMoney]

Rebalancing might be key during a hyperinflationary period.  Germany still had a stock market after it's Weimar Republic hyperinflation.  A lot of those stocks did well...long term. 

I'm not sure about bonds or how they ultimately sorted out the cash situation.

I'm not sure that detailed, hard numbers exist.

Stocks recovered, if the companies survived.  Many did not, because cash (operating capital) was simply not available thru much of 1923 and they went bankrupt and/or sold out.  Prior to 1923 and after 1923 it was sane (but not easy).  But during 1923, bank deposits (savings, etc) and cash all became worthless.  Land and stocks sold, if you could find a buyer, for a fraction of their value because very few had the means to buy, and the sellers were desperate.  Remember sales were typically face to face, either the principals or their agents.  (Assuming today's electronic markets function in such a scenario, perhaps such undervaluation would be limited with the greater access of buyers and sellers to each other.  If electronic markets collapse I expect the situation to be far worse since we cannot cope without them and most people have only electronic assets.)

After all was stabilized then gov't debt was revalued to 2.5% of its face value (and mortgage debt was revalued to 25% of face but I don't know what happened to other types of debt).

This means that 50% of the PP would have lost essentially all value in about 10 months but it would take about 2 years to figure that out.

The most recent good example of hyperinflation is Zimbabwe.  Cathy Buckle writes a weekly (roughly) letter about life in Zimbabwe.  http://www.cathybuckle.com/  The most surprising thing to me was that access to cash is very difficult.  Even if you have it in the bank or foreign country, gov't limits how much you can get (trying to be fair to everyone who wants some) and those limits are often too small to buy food for a day, not to mention waiting in line to get it takes much of the day.

It was surprising to me how much Germany 1923, Zimbabwe 1990-2010, and the U.S. 1930-1945 were similar in that if you had cash you could survive and in some cases (germany and U.S.) you could position yourself very well for the future by acquiring land and stocks.  Of course, as shown by all three countries during and after the hard times, governments can be capricious and arbitrarily decide you don't deserve what you purchased and either undo the transaction(s) or confiscate assets as desired.

Zimbabwe got a lot better (still not 'fixed' and they do have other major problems) when they abandoned their own currency and legalized use of the U.S. dollar.  That's the recipe followed by most countries suffering currency collapse during the last half of the 20th century.  We'll see what happens in the 21st century.

[AgAuMoney]

Hypothetical scenario 1 :

Gold $400 ounce, US person buys a TV from a Japanese person for $400 or 1oz of gold.

US suffers strife in isolation and sees the USD collapse 90%. A US PP'er had $100 in each of stocks, LT, ST and gold and the $100 in gold has risen 10 fold to $1000, whilst the rest are near worth nothing ($30).
...
With Harry's suggestion to rebalance yearly and at any time that you notice a breach of 15/35 weighting bands, then there's a greater chance of a scenario 1 type outcome IMO through selling gold to buy increasingly worthless paper.

Agreed.  I think rebalancing only works while markets are somewhat sane.  When prices start making major moves (e.g. by Nov 1923 in Germany prices were doubling every week and such insanity is NOT rare in a currency collapse) it is best to take shelter and don't make major moves of your own.

Of course, another lesson from those times is it is essential to have cash on hand.  Cash in the bank is not sufficient.  So perhaps taking all or part of the 25% cash out of the portfolio and perhaps take the bond portion also as cash might even be considered prudent.  I think today cash in the bank is likely to fare better than it did then, if for no other reason than electronic transfers to pay bills, etc.  Of course, that system entirely broke down in Zimbabwe...  If it breaks down here, do you find a way and keep paying your mortgage?  Utility bills?  Property taxes?  Do they have a local office where you can take cash or gold coins to make a payment?  Or do you just hope for the best?

[MediumTex]

Bear in mind too when talking about Weimar Germany that there was nothing accidental about that.  The end of the WWI basically made hyperinflation more or less inevitable at some point because the WWI reparations were un-repayable without devaluation.

It's always easy and politically correct to blame foreigners for the problems of one's own country.  We do it today and the veracity is likely no more true than it was in 1923 Germany.

What I was getting at was more along the lines of living in a country that recently lost a world war and ran up a lot of debt in the process of losing it (including reparations) are probably much stronger candidates for hyperinflationary conditions than other countries, not that it is inevitable that hyperinflation will occur or that foreign powers are responsible.

If I had been living in Germany in that period I probably would have been very uneasy about the currency value, whether or not hyperinflation actually occurred.