Rebalancing into a black hole

[melveyr]

Hey gang,

I love the PP, but I have been reflecting on one weakness in the strategy. I have been reading "When Money Dies" which is about the Weimar Republic's hyperinflation and I don't think the orthodox PP would have protected an investor against the collapse in the currency.

Investors would have been shoveling money out of gold/stocks into government paper the whole way down. Because there is no limit to how far a currency can decline in value, you get a black hole effect. If you are a disciplined PP investor adhering to the strict rebalancing bands, you perpetually shovel money into the government paper.

I see some posters comment that the most you would lose if any asset went to zero is 25%, but that is not true if you are rebalancing.

I think an elegant solution is to have a small VP of assets that are not denominated in government paper. I will probably have a small VP with world equities and silver (mainly because I get enjoyment out of the junk coins).

Using a VP to protect against this is the only way out of this black hole effect. Even if you had a portfolio of 90% gold and 10% government paper with rebalancing bands, your portfolio value would still approach zero in real terms as you shoveled money into the black hole.

What do you guys think? I am by no means expecting hyperinflation but I like thinking about extreme outcomes.  :)

[AdamA]

Hey gang,

I love the PP, but I have been reflecting on one weakness in the strategy. I have been reading "When Money Dies" which is about the Weimar Republic's hyperinflation and I don't think the orthodox PP would have protected an investor against the collapse in the currency.

Investors would have been shoveling money out of gold/stocks into government paper the whole way down. Because there is no limit to how far a currency can decline in value, you get a black hole effect. If you are a disciplined PP investor adhering to the strict rebalancing bands, you perpetually shovel money into the government paper.

I see some posters comment that the most you would lose if any asset went to zero is 25%, but that is not true if you are rebalancing.

I think an elegant solution is to have a small VP of assets that are not denominated in government paper. I will probably have a small VP with world equities and silver (mainly because I get enjoyment out of the junk coins).

Using a VP to protect against this is the only way out of this black hole effect. Even if you had a portfolio of 90% gold and 10% government paper with rebalancing bands, your portfolio value would still approach zero in real terms as you shoveled money into the black hole.

What do you guys think? I am by no means expecting hyperinflation but I like thinking about extreme outcomes.  :)

Good point, but have you (or anyone) looked at the numbers?  I wonder how someone would have actually done had that followed the PP during (and beyond) that time in Germany.  Granted, it probably wouldn't matter if you wound up stuck in East Germany. 

[Gumby]

We discussed this a few months ago. Clive (who usually deletes his comments for privacy reasons, so don't expect to find too much in the old conversation) warned us that rebalancing into a hyperinflation oblivion would be problematic — though, you'd be far better off than your neighbors.

However, I believe many PP-holders here felt that you would probably rebalance into a more stable currency once hyperinflation was evident — when you saw your home country's paper money littering the streets. I believe rebalancing into Yen and/or a basket of currencies — when hyperinflation becomes a very real concern — is one way to avoid the hyperinflation black hole.

[gizmo_rat]

If you're holding currency in a country that's starting to look a bit dodgy you might simply switch out of that currency into another for a relatively small cost.

What's the quickest way to park cash in a range of foreign currencies ?

Not that I'm planning to do so, but it's something I think I should know how to do.

[moda0306]

I'd say it's about as simple as looking at Harry's rule on carrying "domestic currency" more in spirit than in semantics.  If hyperinflation is happening, it's hard to argue that you even have a domestic currency in functional terms.

In this case, I think that rule can be broken, semantically, to be followed in spirit.

Also, since we're lucky enough to have the world's reserve currency, I'd say in the event of a crisis gold will be much more useful to us than it was to Zimbabwe or Weimar Germany.  It will absolutely explode, and probably do well in real terms as well.

[MediumTex]

Are we concerned that the U.S. dollar is going to be the one to experience true hyperinflation?

That seems farfetched to me, especially in the midst of a once in a lifetime deleveraging event.

[Gumby]

Are we concerned that the U.S. dollar is going to be the one to experience true hyperinflation?

That seems farfetched to me, especially in the midst of a once in a lifetime deleveraging event.

I'm not concerned over the next few years. Hyperinflation is usually triggered by a total economic collapse, foreign denominated debt, war or a collapsing government:

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Despite our problems, the US seems unlikely to experience hyperinflation right now. But, of course, any of these triggers could happen down the road.

If we ever start to owe debt in foreign denominations, or in gold, (i.e. currency that we can't print at will), then we'll know we're in trouble. But, for the moment, debt denominated in Dollars is in very high demand.

[stone]

Clive "In order to avoid even a 15% or so single currency exposure pulling down the whole excessively through rebalancing, its important not to rebalance between the different currencies too frequently - perhaps rebalancing between currencies no more than once each year or even every other year, and perhaps subject to some 'is this a reasonable action' check."

Clive's suggestion was exactly what I thought when I read melveyr's original post. Doesn't HB actually recommend only ever reviewing (contemplating rebalancing) once a year? If you take as one of the "rules" that no rebalance should be repeated within a year (or perhaps two?) then wouldn't that provide a lot of protection? Hyperinflations by their very nature can not be sustained for long.

[craigr]

There is an element of judgment involved in these decisions as well. If the situation were that the US Govt. were near dissolution, a war was about to take place, the capital controls were being implemented, etc. then don't rebalance into dollar assets. But we at least get that option because not 100% of our funds are in dollars.

The Permanent Portfolio is nice because it gives you options to flexibly respond to extreme events.

[MediumTex]

There is an element of judgment involved in these decisions as well. If the situation were that the US Govt. were near dissolution, a war was about to take place, the capital controls were being implemented, etc. then don't rebalance into dollar assets. But we at least get that option because not 100% of our funds are in dollars.

The Permanent Portfolio is nice because it gives you options to flexibly respond to extreme events.

That's a great point.

If there is a riot outside your house, the electricity and water have been turned off and you can hear explosions in the distance, there is nothing that says you MUST rebalance your portfolio.

[AdamA]

Are we concerned that the U.S. dollar is going to be the one to experience true hyperinflation?

That seems farfetched to me, especially in the midst of a once in a lifetime deleveraging event.

MT--

I agree with you, but to play devils advocate...

Yes, we are in the midst of a once in a life time deleveraging event, but isn't it our response to it that will determine whether we have inflation or deflation?

I mean, you don't get hyperinflation b/c the economy is healthy.  What prompted it in Germany, or Zimbabwe?  Big debts, right?

[Gumby]

I mean, you don't get hyperinflation b/c the economy is healthy.  What prompted it in Germany, or Zimbabwe?  Big debts, right?

No. Take another look at the chart above. Every single one of the hyperinflations in the modern era were set in motion by either a combination of regime change, civil war, or foreign-denominated debt. Hyperinflation (at least since 1900, where there is good data) has never happened from just money printing alone or "big debts".

[stone]

To add to what Gumby said, "big debts" in your own country's free floating fiat currency seem to act in a mildly deflationary way. Japan has gov debt of 250% GDP. This is kind of undiscovered territory as such a scenario has not been put to the test historically. Perhaps Japan will go to >250000% GDP government debt and then have zero yield perpetual bonds??? M0 and M2 may then be exactly the same. Companies might all have cash reserves and no debt (as Apple and many Japanese companies do now). Households may have ever larger cash savings and no debt extrapolating from what the Japanese do now.

[moda0306]

Gumby,

I'd also add that the whole "no fiat currency has sustained" comments need a bit of perspective.  First of all, many gold-standard currencies have collapsed as well.  Mostly because the government collapsed.  Could have gotten gold in exchange for the currency?  Yes, but who knows towards the end of things... after all, a gold standard is just another promise that can be broken.

Is there any history on the last days of gold-pegged currencies and whether you could get the gold that had been promised to you (methinks many of the government actions during the great depression should be good reason to assume the only true gold standard is gold in your hands).

I wonder if these gold-pegged vs fiat collapses were truly any different... a collapse of the government in one way or another (war, regime change... sound familiar) or a loss of sovereignty (foreign-denominated debt) that brings a country (and all its promises) to its knees, regardless of whether it decided to go gold vs fiat.

I'm not trying to make this into another gold standard debate topic, but give some perspective (or at least ask some valid questions) on the topic of fiat currencies.  I think people just assume collapse is inevitable based on some very simple but persuasive gold-buggery propaganda (often asking for your hard-earned CASH, not gold, in return for their advice).

That said, the black-hole rebalancing debate is a fun one, however fruitless it will prove in my lifetime.

[stone]

moda, I agree that a gold standard currency has risk. For me a gold standard currency with government debt constitutes foreign denominated debt (gold is "foreign currency") and so has a great credit risk. As you say debt pegged to gold is not gold and the peg is just waiting to be broken.

[AdamA]

Gumby,

I'd also add that the whole "no fiat currency has sustained" comments need a bit of perspective.  First of all, many gold-standard currencies have collapsed as well.  Mostly because the government collapsed.  Could have gotten gold in exchange for the currency?  Yes, but who knows towards the end of things... after all, a gold standard is just another promise that can be broken.

Good post, Moda.

I'd also add that the British Pound is still "sustaining." 

[AdamA]

I mean, you don't get hyperinflation b/c the economy is healthy.  What prompted it in Germany, or Zimbabwe?  Big debts, right?

No. Take another look at the chart above. Every single one of the hyperinflations in the modern era were set in motion by either a combination of regime change, civil war, or foreign-denominated debt. Hyperinflation (at least since 1900, where there is good data) has never happened from just money printing alone or "big debts".

Why do so many people fail to understand this?

I've heard so many seemingly logical arguments for inflation, or even hyperinflation, in the US, from supposed experts.

How come none of them distinguish between foreign-denominated debt and debt owed in US dollars?  It seems very logical (now that you've pointed it out).

[moda0306]

Adam,

And I also don't like the fact that many somehow ignore the other factors within a government outside of the monetary ones, trying to make a causation argument for the collapse of all fiat currencies.

Take away the gold and military and "prosecutorial clout" that our government currently has, and yes, you could start to imagine how all forms of government promises, from private property to social security to currency value, could be questioned.

We simply don't live in that world, though.  Not only do we have absolutely massive military might, our government holds a lot of the very asset that's perfect for inflation fears.  I think one nice thing to understand is that taxation is what gives our currency value (as well as the legal tender laws), not to mention all the contracts currently in place that demand future payment of US dollars (contracts enforced by the aforementioned government with massive military and gold reserves).  The very people that complain about our currency being confetti often go on to claim that taxation is theft... oddly, its taxation that probably prevents the self-fulfilling hyperinflationary spiral that's "sure to come."

Further, the fact that our money printing adventures manifest themselves in the form of QE, which take off the market some supply of the very thing that is supposed to punish us for printing money (our bonds), and throw in a massive deleveraging, then I just don't get the inflationary certainty out there.  Our government simply isn't going to be punished for malinvestment the way a corporation or household is.  In fact, if "punishment" is identified by borrowing costs, then our goverment is probably rewarded for its mistakes more than punished for them, for the malinvestment and moral hazards it may induce in the private sector will later come back to bite the holders of the private debt, creating a rush back into treasuries.  Is it unfair? Almost certainly in many ways, but government is an entity we trust first and foremost to bomb those who would do us harm... life, property and all... so I'm not so much concerned with the morality of its actions (in terms of my investing strategy) as much as I'm concerned with cause and effect, and protecting my wealth.  That's where I think most people derail themselves on this topic.

[moda0306]

I've officially hijacked this thread.

Back to black-hole investing.

I've actually found it hard to wait out the 15/35 bands.  It's easy to say that's what should be done, but in a $100k portfolio, seeing something I like shrink to $15k would be tough!

I'm sure the mentality during high-inflation periods is precisely the opposite, though.

[MediumTex]

It seems like the whole currency collapse dynamic is the result of a combination of political, economic and monetary mismanagement.  Without mismanagement on all three fronts, it seems like it's hard to kill a currency.

I wonder if a currency has ever collapsed of a country with the world's most powerful military.  No matter what else happens, a country with a powerful military can always rent out its military bandwidth to parties needing protection and who are willing to pay for the service.  This arrangement between the U.S. and certain middle eastern countries is probably part of the reason that the U.S. dollar has remained as strong as it has in recent decades.

Many say that when we went off the gold standard in 1971 we promptly went on a de facto "oil standard".

[moda0306]

I would love to see a documentary on the history of currency done by somebody with a balanced perspective and without too many political axes to grind.

[stone]

moda michael-hudson has written some interesting stuff about the history of money. I'm not sure he would pass everyone's "no political axe to grind" test though. That said, historical facts are historical facts.
http://michael-hudson.com/2003/03/the-c ... rspective/

[Gumby]

It seems like the whole currency collapse dynamic is the result of a combination of political, economic and monetary mismanagement.  Without mismanagement on all three fronts, it seems like it's hard to kill a currency.

I wonder if a currency has ever collapsed of a country with the world's most powerful military.  No matter what else happens, a country with a powerful military can always rent out its military bandwidth to parties needing protection and who are willing to pay for the service.  This arrangement between the U.S. and certain middle eastern countries is probably part of the reason that the U.S. dollar has remained as strong as it has in recent decades.

I really think this is why we have a ridiculously overfunded military. The nightmare scenario for our currency is that a country, or group of countries, would somehow agree to no longer accept dollars for things that we want from them. Having a strong military makes our dollars not only more appealing from a promise/liability perspective, but it also makes doing business with us a necessity in terms of preserving regional stability. If a country (or countries) refused to accept dollars, they would either feel the full force of our military, or be abandoned from its protection. Mind you, I don't like this approach. It just seems to be the reality of the dangerous world we live in. The US is basically an 'Crime Boss' for the planet — threatening that "accidents might happen" for those countries who don't offer their generous cooperation.

[stone]

From what I can see, the US became the global super power because in the early 20th century it didn't indulge in war mongering whilst everyone else was. That left the US prosperous and productive when everyone else was screwed up by war. The US is losing its grip now because it is diverting so much to its military and allienating would be allies by war mongering.- just a counter argument .

[Gumby]

Why do so many people fail to understand this?

I've heard so many seemingly logical arguments for inflation, or even hyperinflation, in the US, from supposed experts.

How come none of them distinguish between foreign-denominated debt and debt owed in US dollars?  It seems very logical (now that you've pointed it out).

It has to do with the politics or agenda of the supposed experts. Many are influenced by their own agenda or political leanings. Many don't even realize it. It's a lot easier for a Congressman, pundit, or a political party member to argue that we can't afford to [insert monetary policy here] because it will result in [insert scary monetary phenomenon here]. Most of their supporters will believe it without challenging their argument. Repeated enough times and becomes a pseudo-truth.

If they happen to leave out the fine details of what actually causes those scary monetary phenomenons, it only makes their case stronger. You see this every single day in politics. And the media just "reports" on it, spreading the misinformation. So it soon becomes a pseudo-truth in our society. Everybody knows that printing results in hyperinflation, right? But, there's more to it than that.

Now... that doesn't mean that you can't make the argument successfully that printing results in hyperinflation. Most people just tend to leave out the entire narrative when they try to make it.

Here's one example of a more complete narrative where printing might result in hyperinflation:

Banks take huge risks and need bailouts.
 ...then...
Government prints a lot of money to provide liquidity and stimulate the economy.
 ...then...
Unemployment rises as government response doesn't work
 ...then...
Civil unrest increases. (Occupy Wall Street, Occupy Oakland, etc.)
 ...then...
Government becomes unable to stimulate the economy as Deflation takes hold
 ...then...
The government's central bank runs out of bullets.
 ...then...
Government chooses austerity as a solution to Deflation.
 ...then...
Civil unrest increases. Local governments fail, or become overwhelmed.
 ...then...
Banks begin to fail by the dozen as liquidity becomes an issue.
 ...then...
FDIC is underfunded and becomes overwhelmed.
 ...then...
More printing ensues to prop up banks and provide liquidity.
 ...then...
Foreign countries become increasingly nervous about the government's stability and the stability of its currency.
 ...then...
Foreign countries start demand payment for goods in gold, Saudi riyal, or Yen.
 ...then...
Government prints more and more money to borrow gold, Saudi riyal, or Yen, to pay for goods.
 ...then...
Civil unrest increases. Civil war takes hold: It's the 99% against the 1%.
 ...then...
Government prints more and more money to pay for goods in foreign-denominated currency.
 ...then...
Citizens lose faith in the government, and regime change takes hold
 ...then...
Currency hyperinflates as currency becomes more and more worthless.

Now, that is a sort of crazy mad-max/nightmare scenario that is unlikely to happen to the US. And there may be obvious flaws in my domino-effect explanation. Not to mention that there are a hundred different outcomes at any step of the way in that narrative.

But, if countries begin to demand foreign-denominated payment in exchange for goods and services, then you will know that we are in trouble.

My point is that when someone says that printing results in hyperinflation, a number of things have to happen for that to become true. Most people haven't actually thought those steps through — they just believe the initial cause always leads to the predicted effect. But, it's not always the case.