The Breakdown - Lyn Alden’s Latest: Why Currency Devaluation Is Inevitable

Episode Date: September 20, 2020

On this week’s “Long Reads Sunday,” NLW reads macro analyst Lyn Alden’s latest: “A Century of Fiscal and Monetary Policy: Inflation vs Deflation” The article looks at: When monetary policy is effective versus when fiscal policy needs to take over  How short-term debt cycles add up to long-term debt cycles that have very different remedies Why long-term debt cycles inevitably end in default or devaluation  Why the conclusion of the last long-term debt cycle in the U.S. – the 1930s and 1940s – suggests that devaluation is the most likely outcome

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com, BitStamp, and nexo.io, and produced and distributed by CoinDes. What's going on, guys? It is Sunday, September 20th, and that means it's time for Long Reads Sunday. I'm going to keep the introduction this week very brief because our art. article is very long. It is by the one and only Lynn Alden. You've heard Lynn on this show and know how brilliant she is. I've called Lynn the breakout macro voice of the year, and I genuinely believe that's true. Nick Carter tweeted this piece and basically asked if there was anyone explaining

things in macro as well, and the topic is one of the most quintessential debates that we have right now. The piece is called A Century of Fiscal and Monetary Policy, Inflation versus Deflation, and I hope you enjoy it. There has been a lot of discussion lately about how effective monetary policy can be. In my view, the big debate between fiscal policy and monetary policy or inflation versus deflation mostly comes down to looking at a long

enough historical timeline to see the full context. The effectiveness of monetary policy, including interest rate manipulation and asset purchases, diminishes significantly when debt is high, interest rates hit the zero bound, and the money multiplier is low. The role of monetary policy doesn't stop then, but it takes a backseat to supporting fiscal policy. In essence, monetary policy is effective at putting the brakes on an economy, but bad at stimulating an economy, whereas fiscal spending has the opposite tilt. Let's dive into some history to see how it can apply in today's economy. In this context, rather than focusing on one quarter or even one year ahead, it's a high-level outline of some of the fiscal and monetary

environments that investors are likely to face as we head deeper into the 2020s. The precise path we take through this decade will depend on myriad fiscal policy choices, social outcomes, geopolitical events, and other variables. So rather than predict exactly how it will play out, we can start with certain observations and decision points and fill in details over time as we hit certain events. The short-term debt cycle. A lot of people are familiar with normal. normal five to 10-year business credit cycles. Most readers have lived through several of them. At the start of an economic expansion, businesses and consumers start to recover from the previous recession, and so they take on more debt and risk. As the expansion progresses, this higher

and higher level of debt and eventual over-investment from businesses and over-consumption from households make them increasingly leveraged and fragile. Asset prices generally move from cheap to expensive during this process as well. Eventually, some negative catalyst, external or self-imposed, combined with elevated debt levels, triggers an economic shock in a period of de-leveraging, which is recessionary. Policymakers usually respond by offering lower rates and fiscal stimulus to offset this otherwise deflationary period. Many defaults occur, the system cleans out some of the excesses of malinvestment and unproductive leverage, and then the cycle starts anew. The problem is that de-leveraging rarely reduces debt levels all the way back to where they

started in the cycle, in part due to that fiscal and monetary policy response. By the time the dust settles on the short-term de-leverging event, businesses will have collectively reduced some of their debt, but still have more debt than when they started the previous short-term cycle. However, monetary policymakers try to get the next business cycle going as quickly as possible, and so they reduce interest rates to lower levels and therefore encourage more debt accumulation. Corporate debt, as a percentage of GDP decreases during recessions, but keeps making higher lows and higher highs over the decades. And this is in significant part because interest rates reach lower and lower in each cycle and allow for that increased debt accumulation over time. This is driven in part by

monetary policymakers. Federal debt accumulation tends to run counter-cyclical to this trend. Federal debt increases swiftly during recessions because tax revenues fall due to lower economic output, and federal spending increases to offer extra unemployment benefits and stimulus. In other words, whenever the private sector de-leverages a bit, the public sector leverages up. This Keynesian approach is driven by fiscal policymakers. And so we have a string of short-term business cycles building up public and private leverage over decades, leading to something bigger. The long-term debt cycle. Fewer people are familiar with the long-term debt cycle because it only reaches a turning point every several decades, and we have to look back into boring history books to see the details.

To make it harder, history merely rhymes rather than repeating itself identically, so analysts have to take historical data and construct forward probabilities from it based on new conditions and notable differences from past analogs. After many of those short-term business cycles accumulate debt from one cycle to the next, to a higher and higher level, total debt in the system, federal, corporate, household, and other forms of debt, reaches extremely high levels, and interest rates run into the zero-back. and policymakers have trouble pushing them much below that threshold. The zero bound is where the magic starts to happen and things change. There were two long-term debt cycles over the past century.

The first one peaked in two stages in the 1930s and 1940s, and the second one peaked in two stages so far in the late 2000s during the 2008-2014 period and again in the 2020s. A normal amount of system-wide debt can be deleveraged nominally. People and businesses pay for their mistakes by losing money and filing for bankruptcy, creative destruction occurs, strong businesses, devour weak businesses, the dust settles, and the system can build up from there. However, a huge amount of system-wide debt equal to a few hundred percentage points of GDP, including up to the sovereign level, is basically impossible to de-leverage nominally because it crashes the whole system when attempting to do so, and creates a vicious cycle.

Instead, those peaks tend to be de-leveraged with a major expansion of the money supply. In other words, at the end of a long-term debt cycle, the denominator of currency goes up a lot more than the numerator nominal debt goes down. Long-term debt bubbles don't de-leverage like normal cycles. People often blame policymakers for printing money and other dovish things when a long-term debt cycle starts to go awry, but that's not where the key mistakes are made. Instead, the key mistakes were made in the decades that led up to the peak, with overuse of monetary policy usually accompanied by a set of poor fiscal policies

that encourage the buildup of debt in the first place. Once it's built up to that extreme level, including at the sovereign level, the options to deal with it are limited. More specifically, someone's liability is someone else's asset. When you default on a liability, you destroy someone else's asset. When people and institutions lose assets, they are harmed financially. And if they are leveraged against those assets, they can go bankrupt and their liabilities get destroyed as well. Similarly, when people get laid off from work, that reduces their consumption, which calls causes other businesses to lose revenue and lay off their employees as well, which further reduces consumption in the system. With a broad default and no fiscal policy response, several banks begin to

fail. This vicious cycle of asset price declines, job losses, and bankrupt businesses in turn reduces federal and state and local tax revenue, because wage income and investment income fall, which, if money printing to support public debt is not used and a balanced budget is instead maintained, means that either social programs need to be cut, which would reduce income to beneficiaries and thus also result in less consumption and tax revenue, or tax rates need to be increased, which takes away excess funds for private investment or consumption, and or sovereign bonds would default, which would render every bank in the country insolvent because those bonds are their safest assets. In a system with normal leverage, the natural de-leveraging process

can play out, and the system remains robust and solvent overall, eventually by and comes out stronger on the other side with the real market-driven recovery. In that scenario, banks don't crash, the sovereign isn't highly leveraged, only a manageable subset of businesses and households are highly leveraged problem areas, and they don't contaminate the whole system. However, in such a highly leveraged system at the peak of a long-term debt cycle, with debt that was only able to reach such extreme levels in the first place due to consistent policy intervention during the preceding decades, a series of initial defaults would start triggering a tidal wave of more defaults, and it would all collapse like a Jenga Tower because there is too much

debt relative to the amount of money in the system. So a hands-off policy approach works quite well in normal de-leveraging events, but it historically fails in major de-leverging events when debt is at extreme levels. Even the sovereign entity is highly leveraged, and a large percentage of people are reliant on government payments. Politicians and central bankers of monetary sovereign nations simply don't have an incentive to go that Jenga Tower deflationary collapse route, especially since it was in part due to their policy in the first place that debt was able to get so high. Therefore, a monetary sovereign system rarely, if ever gets to that point of collapsing in on itself in a prolonged deflationary spiral, because the reality when trying to de-leverage from such a high

level is that the collective human nature doesn't allow it for very long. Even if politicians were to attempt to take the pure austerity route and cut spending programs and let system-wide defaults happen, the economy gets more and more painful. And after a few years, people vote those politicians out of office in favor of politicians' promising stimulus. Another way of putting it is that a fiat regime rarely, if ever, collapses from a lack of printed fiat. When the zero bound for interest rates is reached and or sovereign debt is high and they run low on real private buyers of their sovereign debt, they print. If there is a historically high public and private debt level relative to the number of fiat currency units in the system, they increase the number of fiat currency

units in the system. Plus, socioeconomic factors start to get messy in those extreme economic environments. The peaks of long-term debt cycles tend to also come with peak levels of societal wealth concentration, where the gap between the super-rich and everyone else becomes wider than normal. Money ceases to move around the economy smoothly and reach people of all-income levels, and instead just concentrates near the top. A combination of tight fiscal policy and loose monetary policy tends to exacerbate that outcome. Populist politics then become more commonplace. And while some strands of it can be quite rational based on countering, prevailing policies that are rightly viewed as needing reform, there are also more dangerous or extreme strands that begin to emerge as well,

particularly if those initial or more rational strands go unaddressed. Policymakers historically face the choice of doing something to alleviate the financial burdens on the broad population or risking outright revolution. In other words, when the top 0.1% of a population have as much wealth as the bottom 90% of a population, meaning that an average member of the top 0.1% owns about 900 times as much wealth as an average member of the bottom 90%, politics tends not to be very smooth. Economic growth also tends to be slow and stagnant since the broad middle class is the engine of the economy.

It's interesting how the century-long wealth concentration cycle matched almost perfectly inversely with the centrally long interest rate cycle. Wealth concentration peaked during high levels of system-wide leverage and low interest rates and bottom during periods of low leverage and high inflation and high interest rates. And then there's the national security angle. Economic theories work well in closed system hypothetical scenarios. But what about open systems where international competitors exist? If one country decides to take the bitter medicine and go through a decade-long massive nominal

default and debt collapse, and let everything clean out nominally fair and square. During that whole process, they become vulnerable from a geopolitical and military point of view, compared to nations that instead choose to intervene with printed money and kick the can down the road and prop up their economies. So there's an inbuilt geopolitical incentive for policy makers to print. So historically, the difference between a nominal short-term de-leveraging event and a long-term de-leverging event is that the long-term version includes usually a significant component of currency devaluation. A cycle as old as time. In U.S. history, international history, and going back literally thousands of years to ancient Greeks and Mesopotamia, the common answer during generational peaks and debt levels, almost

inevitably, is that the currency itself eventually gets devalued by some extent instead of just a nominal debt collapse occurring. Even an example from 2,600 years ago captures today's situation in an eerily accurate way. This is from the lessons of history by Will and Ariel Durant in 1968. In the Athens of 594 BC, according to Plutarch, the disparity of fortune between the rich and poor had reached its height, so that the city seemed to be in a dangerous condition, and no other means for freeing it from disturbances seem possible but despotic power. The poor, finding their status worsened with each year, the government in the hands of their masters and the corrupt courts deciding every issue against them, began to talk of violent revolt. The rich, angry at the

challenge to their property, prepared to defend themselves by force. Good sense prevailed. Moderate elements including the election of Salon, a businessman of aristocratic lineage, to the supreme archonship. He devalued the currency thereby easing the burden of all debtors, although he himself was a creditor. He reduced all personal debts and ended imprisonment for debt. He canceled arrears for taxes and mortgage interest. He established a graduated income. tax that made the rich pay at a rate 12 times that required of the poor. He reorganized the courts on a more popular basis. He arranged that the sons of those who had died in war for Athens should be brought up and educated at the government's expense. The rich protested that his measures were

outright confiscation. The radicals complained that he had not redivided the land, but within a generation almost all agreed that his reforms had saved Athens from revolution. In a long-term debt cycle the leveraging process, nominal debts may only decrease partially, but currency that the debts are denominated in get devalued and expanded dramatically, either in terms of what was pegged to or in terms of price inflation, and the result is that the value of existing debt decreases relative to nominal GDP and other broad economic measures, rather than decrease by a lot nominally. In other words, as I said before, the denominator currency is often expanded to alleviate a system-wide generational debt problem rather than the numerator nominal debt levels

going down much. If we focus on U.S. history and separate total debt as a percentage of GDP into one, federal debt as a percentage of GDP with virtually no nominal default risk, and two, non-federal debt as a percentage of GDP that does have substantial nominal default risk, we can see that separate measures used. Non-federal debt as a percentage of GDP fell from 225% to 75% from peak to trough in the 1930s and early 1940s, which seems like a huge de-leveraging. However, in nominal dollar terms, non-federal debt only decreased by about 20% from peak to trough during that period. Instead, along with that partial nominal de-leveraging, the U.S. dollar value pegged to gold was reduced from $20.67 an ounce to $35 an ounce, combined with some degree of

fiscal stimulus and a big expansion of the monetary base, which reinflated the broad money supply in nominal GDP, and therefore reduced the debt to GDP and debt to M2 ratios. The numerator went down 20%, but the denominator skyrocketed. The economy improved from its 1932, 1933 lows as it moved deeper into the 1930s, but encountered another recession in 1937, which led to more stagnation. Importantly, the economy experienced outright deflation in the early 1930s and sharply shifted into a period of reflation in the mid-to-late 1930s after the gold peg was reduced and the monetary base was expanded, but the economy did not encounter outright high inflation. This was a non-inflation currency devaluation, meaning that currency was devalued relative to gold but was not devalued much

against broad prices in general, since the inflationary forces were counteracting an existing deflationary force of debt. Then, the U.S. entered the World War in the early 1940s and began massive deficit spending, partially monetized by the Fed buying a lot of treasuries. The Fed capped all treasury yields well below the prevailing inflation rate to inflate away part of their purchasing power, and the country's industrial production was tripled in five years. People often say the war brought the economy out of the Depression, however, that's only half true. The act of war itself was economically subtractive, losing irreplaceable lives and having their expensive equipment destroyed on foreign soil half a world away. But the productive infrastructure that the war forced the country to build

through federal deficit spending, which they were able to come home to and repurpose for domestic use, was hugely additive in terms of new technology and overall productivity in the subsequent peacetime economy. This was further boosted by the GI spending bill to get those soldiers trained or educated as they entered the domestic workforce. After the war, the federal debt never really de-leveraged much nominally, but they held nominal debt relatively flat for a while as nominal GDP caught up, partially from growth and partially from inflation, with interest rates capped by the Fed below the inflation rate. So again, it was a period of aggressive spending and currency devaluation, followed by a period of relative austerity, that reduced debt as a percentage

of GDP, this time at the federal level. In modern parlance, the war forced the 1940s to be a very M.MT-heavy decade in terms of fiscal and monetary policy, and the pandemic may be a catalyst to make the 2020s decade into a similar outcome, especially given the same long-term debt situation. In other words, an external catalyst changes the public perception and policymaker perception about fiscal deficits. In such a scenario of massive deficits in financial repression like the 1940s had, holders of currency and bonds were effectively partially defaulted on in real terms, often not nominal terms, especially at the sovereign level, and only got part of their purchasing power back. On the other end, debtors effectively got bailed out and only had to pay back a portion

of the purchasing power that was owed, even though they largely paid back the full nominal amount in many cases, but in weaker currency units. The 2020 half-one letter by Hershey, Capital found that over the past two centuries, 51 out of 52 countries that reached sovereign debt levels of 130% of GDP ended up, quote, defaulting, either through devaluation, inflation, restructuring, or outright nominal default, within a pretty wide spread of zero to 15 years or so after that point. Japan, as the largest creditor nation in the world currently, is one example out of 52 that has avoided that outcome versus the other 51 examples. Japan didn't fix their problem. With record debt to GDP, they likely just delayed and mitigated it far better

than most. Their sovereign debt as a percentage of GDP has continued to increase, pushing the previously known boundaries on how much debt a sovereign entity can hold. A way to think of that study is that sovereign debtors historically became partially insolvent with a 98% probability in the long run, when debt levels relative to GDP pass the event horizon into extreme territory of over 130% of GDP. But the actual event of outright currency devaluation can come shortly or quite a bit later. It's like the Titanic hitting an iceberg. Once struck, the outcome of sinking became almost inevitable, and yet the ship persisted in the state of being afloat and slowly sinking for quite a while. It became a question

of timing and, most importantly, acquiring lifeboats. Investors could have theoretically traded Titanic contracts in the meantime, with varying ups and downs in price based on news from the engine rumor from the captain about the state of the ship. Based on historical probability, that's mathematically what currency holders and bondholders are doing when a sovereign hits over 130% debt to GDP. They are buying bonds at record highs, aka record low yields, at a time when the sovereign is least likely to be able to repay its debt in real purchasing power terms over the next decade or two as some of those long bonds mature. Long-duration sovereign bonds with interest rates that are below the prevailing inflation rate are interesting traded vehicles due to their convexity.

but are problematic long-term buy-and-hold assets in those environments because they are likely to have negative real yields for quite a while. The vast majority of debts, public and private, are denominated in a specific amount of currency which has no intrinsic value. During a long-term debt crisis, the money supply gets greatly expanded to deal with that debt burden, and yet those pre-existing debts are still owed in a fixed amount of currency, so those debts get partially inflated away. That's the inherent nature of fiat currency. Its supply is infinitely flexible by policy-making, acres to the upside. Just like how buying stocks in overvalued equity markets often results in a loss of purchasing power over the next 10 to 20 years, lending and buying debt and even holding cash

with low interest rates during a debt bubble, often results in a loss of purchasing power over the next 10 to 20 years as well. What's going on, guys? I'm excited to share that one of this month's breakdown sponsors is crypto.com. Crypto.com offers one of the most cost-efficient ways to purchase crypto out there, as they've just waived the 3.5% credit card fee for all crypto purchases. What's more? With crypto.com's MCO Visa card, you can get up to 10% back on things like food and grocery shopping. When you buy gift cards with the crypto.com app, you can get up to 20% back. Download the crypto.com app today and enjoy these offers until the end of September. BitStamp is the original global cryptocurrency exchange. Since 2011, BitStamp has been the preferred

exchange for serious traders and investors. Trusted by over 4 million customers, including top financial institutions. BitStamp is built on professional grade trading technology. Their platform is powered by a NASDAQ matching engine, and their APIs are recognized as the best in the industry. Download the BitStamp app from the App Store or Google Play or visit bitstamp.net slash pro to learn more and start trading today. That's bitstamp.net slash pro.

In this crisis, many investors aim to keep and grow their digital assets. others seek to maximize the yield on their cash. NXO allows you to achieve exactly these two goals. The company offers instant crypto credit lines against all major cryptocurrencies, with interest rates starting from only 5.9% APR. NXO also lets you earn up to 10% annually on your Fiat and digital assets. What's more, interest is paid out daily, and you can add or withdraw funds at any time. Get started at nexo.io.

A century of U.S. monetary policy. monetary policy and fiscal policy historically have taken turns in how potent their effects are on the economy. During a booming economy, with banks happily lending for productive purposes and higher interest rates and inflation levels generally, monetary policymakers have the power to put on the brakes, or to lighten up when the economy softens, which means monetary policy has a lot of influence for better or worse. However, at the point when the zero bound is reached, monetary policy runs out of ammo with its interest rate tool, but can shift to expanding the monetary base aggressively, aka quantitative easing, which at first has some level of effectiveness to combat a deflationary shock and pick the banking system up off the ground,

but overall can't do much beyond that. QE can recapitalize banks from low reserves to high reserves, and it can offset a deflationary shock or liquidity crisis, and can prop up some asset prices to some extent, but it can't create sustained inflation or expansion of the broad money supply on its own. As debt builds up in the system, economic growth slows. and the money multiplier shrinks. The Great Depression and the Great Recession were during periods of significant money multiplier bottoms, which along with the zero bound being reached is what made them so different than every other normal recession. Even as monetary policy makers expanded the monetary base, the combination of currency and circulation and bank reserves, it doesn't make banks lend more,

so broad money supply doesn't grow as quickly as the monetary base. 1930s and 40s. The 1930s Great Depression was a difficult era because it wasn't just one recession. The worst point of it was in the early 1930s after the big crash, but as things gradually recovered, the economy hit another recession in 1937 and stagnated again and couldn't seem to get out of the slump. Even as the monetary base expanded, the monetary multiplier kept stagnating. Then World War II in the 1940s forced them to build a ton of productive industrial assets via massive federal deficit spending and financial repression, and existing debts were further devalued by inflation. The full scope of the Depression-era period characterized the initial crash,

and partial economic collapse, the subsequent rebound into further economic stagnation, and the eventual war and inflationary currency devaluation. 2010s and 2020s. Although not identical, the 2008 Great Recession was similar. Policymakers expanded the monetary base dramatically, and many people feared imminent inflation, but that expansion in the monetary base mostly just recapitalized the banking systems, brought banks from 3% reserve levels, up to 10% reserve levels, and didn't result in a lot of lending or broad money supply.

increase or economic growth. The economy superficially recovered from those 2009 lows, especially in terms of asset prices, but GDP growth was slow by historical standards throughout the cycle, and labor participation rate among prime age workers never fully recovered to pre-crisis highs. The economy eventually ran into the COVID-19 shock and stagnated again, with a starting point that was still highly indebted. This forced policymakers in 2020 to run deficits at a scale not seen since the 1940s, and it remains to be seen what the final outcome will be. The Limits of Monetary Policy Eventually, monetary policy of its own runs out of ammo, with rates at zero and aggressive

expansion of the monetary base happening, but little real lending, and little velocity of money or strong growth in broad money supply, or strong rebound in GDP. Further QE at that point can pump up asset prices, which can in some cases make wealth inequality worse, and can't do much about the real underlying economy. That is why, over the past six months since the pandemic further popped the existing debt bubble, several Federal Reserve officials have called for more fiscal response. This is somewhat unusual by tradition, because central bank policymakers are supposed to be relatively apolitical. However, they realize that their tools have run low, and so they point to Congress to do more. When fiscal policy takes over.

Macro-analysts often fall into a few camps. Some believe that QE is a outright inflationary, but it's not. Others believe that QE is never inflationary or even disinflationary, which is also incorrect. Instead, whether QE is inflationary or not, largely depends on whether it is accompanied by high fiscal spending, since QE's role in that environment is merely to recapitalize the banking system and monetize those fiscal deficits. In other words, many people correctly identify that a highly leveraged system, with banks not lending much, is inherently disinflationary. However, they must also consider fiscal policy response, which in extreme environments can go around the banking system and reinflate the economy out of an otherwise disinflationary

structural situation. Consumer price inflation can be caused by all sorts of policy and psychological reasons, but ultimately occurs because too much money is printed and spent relative to the productive supply of goods and services in the economy. In opposition to that, deflation is caused by technological progress and productivity improvement, excessive debt levels which constrain spending, and an abundance of supply of goods and services relative to both demand and the amount of money in the system. People often think that high money velocity is required for inflation, but for the most part it isn't. The 1940s only had a brief spike in money velocity, but currency lost a third of its purchasing power that decade through several spikes of high

inflation. The 1970s had weak money velocity but sustained high inflation. The 1990s, had a strong rebounded money velocity to multi-decade highs, but low inflation. If a ton of money is created, only a modest uptick in velocity is needed to start an inflationary cycle. Indeed, velocity ends up being a coincident indicator rather than something that happens first. Aggressive broad money expansion, often accompanied by some degree of supply limitation, is generally inflation. The long-term structural trend is towards lower inflation or outright deflation, and normally this would be a good thing. As humanities technology progresses in productivity improves, it would be natural for your money to buy more goods and services than it could

five or ten years ago rather than less. However, because we structured our economy around a debt-based system, deflation is viewed by policymakers as the biggest enemy, something to be fought off wherever it shows up. So they seek to counter that inherently deflationary trend with inflationary monetary and fiscal policy. After short-term interest rates hit the zero bound and the monetary base expands dramatically, monetary policy by itself basically runs out of ammo. So fiscal policy takes over in the form of massive deficits and a significant portion of those deficits become monetized, meaning that the Federal Reserve buys those Treasury securities by expanding the monetary base, aka printing money, rather than financing those deficits by existing currency holders actually

buying the Treasuries. That last part is an important distinction. The Treasury borrowing capital from sources of private capital in the economy and redeploying it elsewhere in the economy may or may not be stimulative, depending on how productive that spending is. However, when the Federal Reserve expands the monetary base to fund treasury expenditure as a form of debt monetization, and especially if it caps treasury yields below the prevailing inflation, it is a direct currency devaluation, destroying of debt in real terms, and inherently stimulative in a nominal sense. Whether it is stimulative in a real sense, meaning inflation adjusted, depends on how productively that capital is put to use.

This is because the fiscal authority is spending money without drawing that money from any private lenders. The money they are spending is being created. When the money multiplier was basically dead in the 1930s and 1940s and the economy was stagnating in a disinflationary environment, a huge amount of currency was printed and spent, while interest rates were cap below inflation and thus currency was devalued, and therefore the debts denominated in those currencies were devalued, fiscal policy took over and basically went around the normal bank lending system. The total ratio of debt to M2 in the system hit long-term secular peaks in 1933 in 2008, when rates hit the zero bound and the central bank expanded the monetary base. In the years after those 1933 and 2008 peaks,

there was a deleveraging event in debt versus M2, which was not very inflationary and was led primarily by monetary policy. After that stagnated for a while after the 1930s peak and ran into the next recession-slash-war, fiscal spending heated up and caused the next leg of devaluation, which was inflationary. After all, if policymakers realize they are in an environment of persistent currency disinflation from various trends, what do they do? They print currency. At first, it starts from monetary policymakers expanding the monetary base, but then it spreads to fiscal policymakers when the situation remains stagnant, since monetary policymakers, unlike fiscal policymakers, cannot directly spend. If fiscal policymakers realize the economy is stagnant, and if fiscal policymakers

realize the economy is stagnant and banks aren't lending, they can pass fiscal bills to go around the banks or through the banks by backstopping loans for them and get money directly to consumers or businesses, aka helicopter money. This could take the form of higher spending or it could take the form of unfunded tax cuts or both. Therefore, it's not really a left-leaning or right-leaning political phenomenon. Deficits can take the form of whatever the trending political view decides. The main consequence for policymakers to print and spend too much fiat currency with large deficits is that it can cause runaway inflation. So when inflation is measured to be low or even negative due to excessive debt in the system, they aggressively print and spend. Eventually they overshoot,

but that consequence comes with a lag and feels good at first. This is because at first they print during a period of low monetary velocity and high debts, but then when debts start to become devalued versus money supply, velocity picks up a bit, supplies of goods and services are limited, and inflation picks up. People often point to velocity as preceding inflation, but historically it's the opposite. Money velocity doesn't pick up until broad money supply ramps up and debt starts to get devalued versus that money supply. In other words, we can characterize parts of the long-term debt cycle as being times when monetary policy is dominant or fiscal policy is dominant. When system-wide debt is low, interest rates are fairly high, the economic growth rate is decent, banks are lending,

and inflation is a bigger risk than deflation, monetary policy makers take the front seat and fiscal policy takes a supporting role. Manipulating interest rates in that environment has a notable effect on inflation and lending borrowing behavior, and monetary policymakers have notable influence to choose between inflationary growth and disinflationary contraction. Fiscal policymakers, meanwhile, are constrained because large deficits in that environment more easily lead to higher inflation. The 1950s through the 2000s were characterized by monetary policy dominance in the United States. On the other hand, when system-wide debt is high, interest rates run into the zero bound, and measured inflation is very low, monetary policy runs out of ammo. At that point, currency devaluation and outright

fiscal expenditure, which the monetary authority purchases by increasing the monetary base, rather than the fiscal spending being drawn from real private lenders, becomes a more powerful tool for stimulus. Fiscal spending takes priority over monetary policy and leads it. The 1940s, and so far the 2020s, were characterized by fiscal policy dominance in the United States. What currency devaluation looks like? To provide a tangible example for bondholders, we can look at a history of U.S. currency devaluation. The money supply and velocity collapsed in 1930s when monetary policy ran into its limits, and it wasn't until fiscal policy took over with massive deficits, that velocity picked back up

and inflation started to show its head. At that point, monetary policy united with fiscal policy to hold rates below the prevailing inflation, while spending a lot of currency into circulation. which devalued a large portion of the existing debt bubble. Despite the U.S. reaching superpower status and creating strong underlying growth, cash savers and treasury holders lost a considerable portion of their purchasing power in the 1940s. The federal debt was therefore paid down as a percentage of GDP partially through inflation. All in all, there was a roughly four-decade period from the mid-1930s to the mid-1970s,

where 10-year treasuries were bought and held to maturity, spent most of their time in a state that failed to maintain their purchasing power versus consumer price inflation, and especially versus gold. During the 1940s, the war period of massive fiscal spending, the Fed capped rates below the prevailing inflation rate. Inflation was transient coming in spikes, and yet rates were capped at 2.5% or below. As a result, those treasuries were paid back nominally, but a full third of their purchasing power was lost due to inflation of both the money supply and consumer prices. In large part, this was how long-term debt cycle of the 1930s and 1940s was paid down. Treasury holders lost purchasing power, despite getting paid back in nominal terms,

because it was the currency itself that was devalued rather than the sovereign bonds being defaulted on. The same can basically be said for cash savers, anyone with a lot of currency exposure. The dollar peg versus gold was sharply reduced. Massive deficits were run to circulate currency into the economy, those deficits were in significant part monetized by the Federal Reserve, and the Federal Reserve capped Treasury yields below the prevailing inflation rate for a decade. As the dust settled and the debt was well on its way to being inflated away, they shifted away towards a period of relative austerity and stabilization, which along with the expanded industrial base is what made it a partial devaluation rather than a complete devaluation.

The memo to bondholders and currency holders was basically, thanks for playing, try again next time. investors would do well to watch for this phenomenon in the 2020s. The endgame for the current high-dead environment will likely involve a combination of high fiscal deficit spending, monetized by central banks, cash and treasury yields held persistently below the prevailing inflation rate, a trend shift from disinflation to inflation, and subsequently a period of currency devaluation. However, for investors and traders, this becomes a matter of timing. The timing and magnitude of fiscal policy will play the key role in inflationary or disinflationary outcome. Whenever they're spending aggressively, the near-term outcomes lean toward inflation.

Whenever they're grid-locked or employing austerity, the near-term outcome leans towards disinflation.