Inflation…
It’s on our minds… Yours, too.
That’s judging by the feedback we’ve been getting from readers in the Legacy Research mailbag.
The Consumer Price Index (CPI) is Washington’s official measure of inflation.
And earlier this month, we got news that it’s running hot. In May, the CPI was up 5% over where it was in May 2020.
That’s the biggest jump since August 2008, right before the global financial crisis.
So for this week’s dispatch, I reached out to one of the world’s top authorities on inflation, Steve Hanke.
As you’ll see, he believes inflation is “stickier” than most mainstream economists… the Biden administration… and the Federal Reserve would have you believe.
World-Renowned Currency Expert
Steve’s resume as a currency expert is too long to detail in full here.
But he’s a Professor of Applied Economics at Johns Hopkins University.
He’s also director of the Troubled Currencies Project at the Cato Institute, where he is senior fellow.
Its mission is to keep an accurate measure of fiat currency inflation around the world by looking at black-market exchange rates… not the official, and often highly manipulated, figures.
Steve also served on President Reagan’s Council of Economic Advisers.
He’s also a successful currency and commodity trader. In 1995, Toronto Trust Argentina in Buenos Aires, where he served as president, was the world’s best-performing fund. It rose 79% for the year.
Steve is also a well-known currency reformer, who has designed more measures to remedy troubled fiat currencies than any other living economist.
He helped set up new currency regimes in Argentina, Estonia, Bulgaria, Bosnia and Herzegovina, Ecuador, Lithuania, and Montenegro.
And he’s held senior appointments in the governments of many other countries, including Indonesia, Venezuela, Albania, Kazakhstan, the United Arab Emirates, and Yugoslavia.
I’m delighted that Steve agreed to share his view on inflation with Legacy Inner Circle members.
Bitcoin Skeptic
Steve is also a bitcoin skeptic. And he has strong views on whether the cryptocurrency is ready to take over from the inflating U.S. dollar, which we covered in our conversation.
So, if you’re a dyed-in-the-wool bitcoin believer, as I know many of our members are, consider this a “trigger warning.”
Steve makes some interesting – and controversial – points about bitcoin adoption.
They may not jive with the views of Legacy bitcoin bulls Teeka Tiwari and Nick Giambruno. But that’s fine. We always welcome thought-provoking ideas… even if we don’t agree with them.
And don’t worry… You can have your say by writing us at [email protected].
Don’t hold back. We welcome the good, the bad, and the ugly in terms of reader feedback.
Listen to the audiocast version of my conversation with Steve by clicking on the image below.
You can also read the transcript. I’ve edited it lightly for flow. I’ve also added some useful explainers.
Transcript of Q&A With Steve Hanke
Chris Lowe: I’d like to steer our conversation today in two related directions.
First, I want to talk to you about the inflation numbers we’ve been seeing. In particular, the May year-over-year 5% jump in the Consumer Price Index (CPI).
[The Consumer Price Index (CPI) is a measure of the average change over time in the prices for a basket of goods and services.]
Then I’d love to hear your thoughts on bitcoin (BTC), and whether you see it as a viable alternative to fiat currencies.
Let’s kick off with the inflation question. Is it going to stick around? Or is it transitory?
Steve Hanke: Some of the recent statistics do have transitory qualities. The so-called base effect is one.
A year ago, due to the COVID-19 crisis, we had low levels of inflation. And if you’re calculating percentage changes off a low base, you get a high number. That’s just arithmetic.
But the base effect won’t last. It will be gone in a couple of months.
There are other transitory things in the picture right now. Those are also connected to the pandemic. The economy is restarting. But supply chains have been disrupted, and they’re a bit slow getting off the mark. So there are isolated shortages of certain items, and with shortages come price jumps.
But the Fed is trying to manage our inflation expectations. Its view is that all these higher prices we’re seeing are transitory.
But that’s not the case, because of monetarism. Specifically, the MV = PY equation. In other words, money supply times velocity equals price times real GDP.
[The velocity of money is the rate at which money is exchanged in an economy.]
I don’t want to get too deep into the weeds, but M2 is the broadest measure the Fed uses to track the U.S. dollar money supply. And if you use this measure in the MV = PY equation, what I call the “golden growth rate” for the money supply should be about 7%-8% per year. That would be the rate that would allow the Fed to hit its inflation target (P in the equation) of 2% per year.
Just what has the money supply growth rate been?
Well, for the last 17 months, the average annual growth rate in M2 has been about 20% per year. So we’ve had the money supply growing more than double the golden growth rate.
What happens with such a huge monetary injection?
First, with a lag of about one to nine months, asset prices go up. And of course, asset prices have gone up.
We had the money injection starting in early 2020. And asset prices have been strong, including speculative assets such as bitcoin and other cryptocurrencies.
Second, you see the economy taking off. The lag between the monetary injection and this stage is about 6 to 18 months.
We’re into that second phase now. The economy is opening and cranking up.
Third, consumer price inflation sets in. This phase happens somewhere between 12 to 24 months after the monetary injection.
The duration of these lags is hard to predict. But we know inflation is coming. We’ve had this huge growth in the money supply over the last 17 months. So inflation is already baked in the cake.
Next year, we’ll have an inflation rate a little below 5%. Then in 2023 and 2024, it will pick up. It’ll be a little below 6% per year.
There’s some truth in the idea that the current inflation we’re seeing contains some transitory elements. Indeed, a lot of transitory things are occurring.
But the next punch we’ll get is a monetary one. That’s because the money supply has been growing so rapidly.
So that’s the inflation picture… We’ve got quite a bit of inflation in the system already. And given the lag associated with monetary injections, we know it will last at least through 2024.
Chris: Before we move off the subject, where does velocity come into this?
That’s part of your equation. It’s money supply times velocity that determines inflation.
Steve: Velocity is GDP divided by the money supply. It measures how fast dollars are changing hands in the economy. And velocity collapsed when COVID-19 hit.
But the money supply increased tremendously.
Critically, the collapse in velocity is a temporary thing. From now until the end of 2024, velocity will pick up.
So we’ll get a double whammy. The money supply has gone up already. Velocity will go up next.
Chris: Is that people spending more, and the same dollars traveling through the economy at a faster pace?
Steve: Yes, more rapid circulation of dollars in the economy. And as the economy opens, people have a huge amount of spending power in reserve. Over the last 17 months, bank deposits have risen in lockstep with the rate of growth in money supply measured by M2 – about 20% per year.
Chris: Just so I have this clear… you’re saying that, although there may be transitory factors, there is an underlying monetary phenomenon going on here.
Steve: That’s right. But the transitory factors you’re reading about in the newspaper are of little interest.
Journalists get excited about them. And the Fed is leaning hard on the transitory narrative. They don’t want people to get spooked. They don’t want them thinking inflation is getting out of control. Because that makes inflation worse.
Let’s say you’re running a business. If you think inflation is going to be about 5% or 6% per year, what do you do?
You start hiking your prices.
Then your workers say, “Gee, if we’re going to have inflation of 5% or 6% per year, I want a wage increase.”
Chris: That’s a frightening prospect. And it’s great to get your input on it.
Switching to the other topic I want your thoughts on, we’re hearing a lot of people claiming that bitcoin is a good place to be in this kind of environment.
That’s due to the hard cap of 21 million bitcoins. It’s also because of its deflationary monetary schedule – bitcoin’s supply tapers off over time.
[About every four years, the reward given to bitcoin miners is cut in half. This halves the rate at which new bitcoins enter circulation. This “halving” is built into the bitcoin code.]
Last week, El Salvador passed legislation that makes bitcoin legal tender along with the U.S. dollar, which is the currency over there now.
The government there seems to be trying to avoid U.S. dollar inflation. They’re saying, “We can’t control the money supply, so we’re going to go on this bitcoin standard to protect ourselves.”
What do you think about what’s going on in El Salvador? Do you believe bitcoin falls into the category of an inflation-proof asset, like gold?
Steve: As you said, the algorithm is set up so that the supply of bitcoin is completely inelastic and fixed. And that’s correct.
The false conclusion people draw is, “Gee, bitcoin’s price has to go up forever. If the supply function is completely vertical and inelastic, there’s only one place for prices to go. And that’s up.”
But that’s looking only at supply… and ignoring demand.
Since the fundamental value of bitcoin is zero, if the demand suddenly withers away – it could be because a superior cryptocurrency enters the market – demand could dry up completely.
In that case, the price goes to zero, even though the supply is completely inelastic.
You must look at supply and demand. Where the scissor blades cross – the demand and supply curves – that’s where the price is going to be.
And right now, the reason the price is so volatile is precisely because the supply function is rigid. It’s inelastic.
As far as El Salvador goes, the president of El Salvador, and the Congress who approved this legal tender status for bitcoin, have entered
This is going to make that dollarized little economy in El Salvador extremely vulnerable.
The big problem with bitcoin is it’s not used to purchase goods and services, for most transactions.
It’s hardly used. And it’s difficult and costly to use.
This is a problem with cryptos in general… People want real legal tender. They want greenbacks.
The argument is people send remittances to El Salvador… They want a cheap way to do that… And they assert that bitcoin is the answer.
Well, that’s not actually true. To convert bitcoin to U.S. dollars in an ATM in El Salvador costs about 8%.
To send a Western Union (WU) wire of dollars down to El Salvador – it depends on exactly how you’re sending it with Western Union – but the fee is between zero and 4%.
So the argument that this would make it cheaper to send remittances is phony.
You probably have some guy in Russia advocating for it because he wants to take his bitcoin to El Salvador, cash out, and get greenbacks.
If a lot of people do that, it will be like a vacuum cleaner sucking up all the greenbacks in El Salvador. The whole economy would collapse.
Chris: The Salvadoran government says it’s going to set up a trust and use it to guarantee the dollar value of bitcoin transactions. Meaning it will step in if bitcoin loses value, say, between when a Salvadoran émigré sends money home and when it arrives.
If bitcoin has crashed in that time, the idea is that the government would plug the gap with dollars out of the trust.
Steve: It’s ridiculous. The demand is thousands of factors greater than any kind of liquidity facility the government could set up. They’ll suck the thing dry in two seconds. The whole thing is ridiculous.
My guess is that dark forces are behind El Salvador’s move. And not only in El Salvador. There are rumblings in Paraguay, and even some rumblings in Panama. They want to make bitcoin legal tender. But the whole idea is so absurd…
The scenario is that the dollar will collapse, and the only safe place is bitcoin. But bitcoin has famously high volatility. It depends on what hour you’re looking at the price chart. The price goes all over the place.
Bitcoin is designed to be unstable. As I said earlier, its supply is totally inelastic. The only way the market for bitcoin can adjust to even tiny changes in demand is through price. There’s no quantity adjustment. It’s just price.
Chris: You’re saying bitcoin’s limited supply is a driver of volatility because you can’t accommodate more demand through more supply?
Steve: That’s right. There’s no way you can adjust, except through price.
Chris: So Steve, what’s your prediction for bitcoin? Some of my colleagues see a bright future ahead for bitcoin as a kind of digital gold. And the idea that it’s taking over from gold as a store of wealth is setting in.
Steve: I know this will be controversial to some of your readers. But bitcoin is destined to approach its fundamental value at some point.
When, I have absolutely no idea.
But its fundamental value is zero.
[Note from Chris: You can follow Steve on Twitter (@steve_hanke). He now has 337,000 followers and is ranked by Focus Economics as the 6th most influential economist in the world.]