The Currency Bubble

What is a Currency Bubble? I’ll get to that.

Nobel Laureate Paul Krugman, has spent much time recently talking about the US entering a liquidity trap. Please forgive me for the temporary heresy, but he might be onto something. He is wrong on the details and the solution, but I think he’s right about the direction of the economy.

I am going out on a little limb here, so I will give updates in the future. Bookmark this post so that you can taunt me if I’m wrong.

What is a liquidity trap?

A liquidity trap is the theory that claims that during an era of both falling prices (deflation) and very low interest rates, like today, that the Federal Reserve is powerless to stop a shrinking economy because you can’t lower interest rates below zero. As prices fall, people hold onto their cash. Then, businesses can’t sell their merchandise and start laying people off. Investment falls. More hoarding of cash. More layoffs. Et cetera… Mr. Krugman claims this is like a black hole that we can only escape through massive government stimulus.

Why is this wrong?

I see no reason why individuals cannot continue to make appropriate business decisions in a period of falling prices. His theory is based on “sticky” prices and wage rates. As long as the government does not interfere, prices and wages will fall along with the general price level.

What is going on with prices?

Prices are falling. The most dramatic drops are in gasoline and houses. Other items are falling significantly as well. According to the AP “Core consumer prices, which exclude food and energy, fell by 0.1 percent last month, the first drop in core prices in more than a quarter-century”

There is also evidence that prices will continue to fall. There is a financial instrument referred to as TIPS. A TIPS is a bond with a principle amount that varies with inflation. The TIPS yield is a decent approximation for the real rate of interest. When you subtract the TIPS yield from the Treasury yield, you get an approximation for expected inflation. In recent history, this spread has hovered around 2%-2 ½%. Recently, however, this number has turned negative, coming in at -0.68% the last time I checked. This is not dramatic deflation, but it suggests that the market believes that the overall price level (more specifically the CPI) will fall over the near future.

Why are prices falling?

I believe that we may be headed into what I dub a “currency bubble.” There are few places to invest money to stay liquid and expect a positive return. Home prices are falling, stock prices are falling, even gold prices have been falling. When the general price level begins to fall, holding cash actually offers a positive rate of return. Why buy a TV that costs $1000 today when it may only cost $950 next month?

For Europeans, the value of the Euro and the Pound have been plummeting as well. If you lived in France and bought U.S. dollars on Sept. 22 and converted them back to euros on Oct. 22, you would have made a 15% return on your money. If you look at a historical chart of Euro/Dollar exchange rates, you can see that the recent appreciate is rather sudden and severe. As the dollar has increased in value, foreigners can make money (in euros) by simply buying and hoarding dollars.

If people continue both of these practices, this reduces the overall level of dollars in the economy. There will be fewer dollars chasing ample goods. Prices will continue to fall. If people begin to extrapolate and speculate on these recent trends, as I believe human beings have a tendency to do (but not always), this will create a bubble inflating cycle where more hoarding leads to lower prices which increases the rate of return on more hoarding.

If we are in a Currency Bubble, how do we get out?

Doing nothing is fine. All bubbles burst. Eventually people will start wanting to buy things with their hoarded cash. There is a limit to the deprivation to which people will subject themselves. As they do, deflation will begin to slow down. The rate of return for holding cash will drop, and the people with the strongest time preferences will begin to spend. By iteration, deflation will lessen more and more until the market reaches a tipping point where expected profits of hoarding cash vanish. At that point, I suspect that there will be a sudden inflation back to the long-term price trend (equivalent to the growth in money supply).

Why should we do nothing?

If we try to print our way out of a currency bubble, the inflation correction will be more severe, as increasing the money supply dramatically will move up the long-term price trend. If we try to spend our way out of a currency bubble, a la Paul Krugman, it would only help ease the price bubble by hurting economic output.

Right now, we have super low interest rates, deflation, less spending, more purchases of the dollar by foreigners, and the specter of confiscatory tax policies coming. I feel confident in my prediction, so let me know if I am way off in my logic.