The Debate over Hyperinflation

There is an ongoing debate over whether the current secular contraction will resolve in a deflationary era or an inflationary one. Even the FOMC has recently announced in its policy statement that prices are not rising fast enough for its taste, which is truly an extraordinary thing to say for a central bank, given that the rather Orwellian official propaganda line has always been to portray it as an 'inflation fighter' – apparently it is now afraid of being too successful in that particular department.

 

For the purpose of this article, we want to leave the question of whether deflation or inflation are more likely to become prevalent in the future aside for the moment and concentrate on what has become a sub-set of this debate, namely the topic of hyperinflation.

Many of the people who come down on the 'pro- inflation' side of the debate, i.e. those who maintain that the Federal Reserve and other central banks have both the ability and willingness to implement a highly inflationary policy, have been stymied by the continued lack of evidence of rising prices for goods and services. Lately it has become fashionable to make a kind of conceptual jump from inflation to hyperinflation, and asserting in the process that the two are inherently distinct phenomena (instead of one being an extension of the other). To our knowledge this trend was – inadvertently we believe – set in motion by Jim Sinclair, who was in all likelihood misunderstood due to his sometimes byzantine manner of expressing himself.

The way we understand Sinclair's argument, he merely wants to stress that 'slack in the economy', 'excess capacity', iow. the so-called 'output gap' and other facets of economic weakness which are regularly cited by mainstream economists and central banks alike as to why 'inflationary pressures will remain low', are definitely not a reason not to expect inflation. If indeed we understand Sinclair's meaning correctly, then we definitely agree with him on this point. The way he puts it is: 'hyperinflation is a currency event'. This is just another way of saying that it is a monetary phenomenon, first and foremost, i.e., the end result of currency debasement by means of a too loose monetary policy.

What prompted us to delve into the subject here was a recent article on Zerohedge by one Gonzalo Lira (it is quite funny that someone writing about inflation goes by the name of 'Lira' – the name of the late, perennially inflating Italian currency) regarding the events of 1979, when Paul Volcker became Fed chairman and set out to smother the then raging inflationary outbreak. Lira speculates that the late 1970's were probably a period when the danger of hyperinflation was incipient, an assessment with which we would tend to agree. Below we discuss what we do and what we do not agree with in Lira's article.

Lira writes:

 

Because of the Oil Shock, the inflation index rose to a peak of 15%—yet unemployment also exploded, reaching almost 11%. This combination of unemployment and inflation was what gave the period its name—stagflation: “Stagnant inflation”.

 

The 'oil shock' certainly could be termed one of a number of trigger events along the way, but a price signal due to supply problems is by itself not sufficient to create inflation. If the money supply had remained stable, the rising oil price would have caused prices elsewhere in the economy to decline – no general increase in prices would have been possible.

Furthermore, if you want to be technical about it, 'stagflation' – a term coined in 1965 by British parliamentarian Iain McLeod in a speech to the House of Commons, describes 'inflation combined with economic stagnation' – which is a more common phenomenon than is generally held.

 

Of Keynesians and Monetarists

In the late 1960's and throughout the 1970's, when the 'stagflation' phenomenon occurred, it left the then dominant Keynesian economists who had previously believed the combination of a weak economy and a rising general price level to be impossible at a loss to explain what had happened and the Chicago monetarist school rose in prominence as a result.

It is probably also no coincidence that the preeminent Austrian economist Friedrich A. Hayek won his Nobel prize for economics in 1974. Clearly the Austrian school offered the by far best explanations for the 'stagflation' experience, alas, since Austrian economists were seen as inimical to the establishment, the central bank directed fiat money system and the welfare/warfare state more generally, their advice was probably not really welcome. Instead, the monetarists were seen as the 'safer' economic advisers and their influence increased as the 1970's wore on. As Hans-Hermann Hoppe once remarked (in 'Natural Elites, Intellectuals and the State'):

 

“[The] seemingly unstoppable drift toward statism is illustrated by the fate of the so-called Chicago School: Milton Friedman, his predecessors, and his followers. In the 1930s and 1940s, the Chicago School was still considered left-fringe, and justly so, considering that Friedman, for instance, advocated a central bank and paper money instead of a gold standard. He wholeheartedly endorsed the principle of the welfare state with his proposal of a guaranteed minimum income (negative income tax) on which he could not set a limit. He advocated a progressive income tax to achieve his explicitly egalitarian goals (and he personally helped implement the withholding tax). Friedman endorsed the idea that the State could impose taxes to fund the production of all goods that had a positive neighborhood effect or which he thought would have such an effect. This implies, of course, that there is almost nothing that the state can not tax-fund!”

 

This harsh assessment of the Chicago School was apparently shared by Ludwig von Mises, who once walked out of a Mont Pelerin meeting announcing 'You're all a bunch of socialists'.

It is quite ironic that nowadays, the supply-siders as they are also called, enjoy the reputation of representing the epitome of economic liberalism. This shows the great extent to which statism has become the fundamental econo-political guiding principle of our times, just as Hoppe contends.

In terms of their support for low taxes , free trade and the free market (with unfortunately a number of rather decisive 'exceptions') , the Chicago school proponents are certainly a lot closer to the Austrians than the Keynesians or neo-Keynesians are. There is a big difference between Milton Friedman, Jude Wanninski , Arthur Laffer and people like Paul Krugman, Alan Blinder and John Samuelson, to name a few. It is however what these schools of economic thought agree on that represents the problem – indeed, it could well be argued that the Chicago School's support for a central bank directed fiat money is what has ultimately brought us to the current juncture (namely a grave secular economic contraction).

Let's get back though to Lira's article and the 1970's.

 

Economic History vs. Economic Theory and the Problem of Definitions

Lira launches into a description of economic history, this is to say various economic data and their behavior during the 1970's. Note here that when he speaks of 'inflation' he is not referring to the increase in the money supply, but instead to its effect: rising prices. Lira recounts how the rise in prices as calculated by the government's CPI measure kept accelerating into 1980 and how unemployment rose with a considerable lag in the wake of the 'double dip' recession induced by Volcker's tight monetary policy, which ultimately ended the inflationary episode. So far so good. Then it get's really confusing.

Lira tries to explain what he actually means when he speaks of inflation:

 

“A quick note on terms— by the word “inflation”, I mean two distinct things: One is the macro-economic event whereby prices rise, due to the expansion of both the economy and the credit environment, which bids up the prices of consumables. This sense is used in opposition to the other three macro-economic events, deflation, disinflation, and hyperinflation. The other meaning of the word “inflation” — or what I sometimes call the inflation index or sometimes the CPI number — is simply the actual percentage rise in prices in an economy, regardless of whether the cause is inflationary or hyperinflationary.”

 

As far as we are concerned, not one of these things is inflation. As Ludwig von Mises has pointed out, the authorities and their courtier intellectuals managed to pull off a neat propaganda trick by sowing this type of confusion. In 'Planning for Freedom', a collection of Mises essays, we find this pertinent quote:

 

“What people today call inflation is not inflation, i.e., the increase in the quantity of money and money substitutes, but the general rise in commodity prices and wage rates which is the inevitable consequence of inflation.”

 

In other words, today's widely accepted usage of the term inflation is really confusing cause and effect.

Lira is not only falling prey to confusing cause and effect, his 'explanation' as to his personal usage of the term is not really an explanation. It is nigh impossible to extract any meaning from it and must leave the reader confused. Inflation is two distinct things? Which ones? A rise in prices and a rise in prices? There are no 'different types of inflation'. Inflation is what it is – an increase in the supply of money.

As we have noted before, it is due to the manner in which inflation's effects percolate through the economy and the often widely different real economic fundamentals accompanying an inflation that people have difficulty recognizing its pernicious consequences. In an attempt to grapple with that problem numerous terms have been invented to describe the various immediately observable effects. One of these is e.g. the term 'disinflation' mentioned by Lira in passing. This is meant to describe an period during which the general price level rises, albeit with the price rises exhibiting a loss of momentum year after year.

All of this confusion can be avoided by using the term inflation in its true meaning. Once one does that, one can proceed to attempt to explain why the observable effect of inflation on the 'general price level' is not always similar and often exhibits considerable lag times.

The concept of 'economic expansion bidding up prices' meanwhile is simply nonsense. An expanding economy, ipso facto, produces more goods and services than a contracting one. If the money supply is stable and the economy expands, prices do not rise – they fall. In fact it is the very aim of human action to economize, this is to say to produce more output with the same inputs – what is in other words known as increasing productivity, which is a result of saving and investing in a lengthening of the production structure. Assuming we had a stable money supply, the one thing by which we would notice that the economy is actually expanding would be a rise in real incomes – i.e., the same amount of money income would tend to buy more goods and services over time.

Lira then inadvertently proceeds to show why economic history is really not a good substitute for sound economic theory. This is so because any given time period one looks at is marked by so many different factors that are influencing the economic backdrop that it is nigh impossible to isolate cause-effect vectors from the data alone. Essentially this is a problem akin to that faced by central planners: the economy is not a machine, but rather the totality of the actions of millions of individuals , whose knowledge, expectations, wants, and so forth differ and are widely dispersed. It is not possible to arrive at proper conclusions by means of a simply analyzing statistical data – one needs to base the analysis on sound theory.

When considering a monetary policy induced phenomenon like rising prices, there is for instance a considerable lag time involved between the increase in the money supply and its easily observable effects. This time lag between cause and effect in turn is not fixed, but varies from case to case.

Lira asserts the following in this context:

 

"Note how money supply played no role whatsoever in the inflationary period 1978–1983. Consider the following table:

 


 

 

 


 

“Increase in the money supply was both inverse to high inflation levels some years (like Jan. ‘75) and inverse to relatively low inflation levels in other years (like Jan. ‘77). But it also tracked high inflation levels other years (Jan. ‘82) as well as low inflation levels in still other years (Jan. ‘86). Therefore, one cannot make any type of meaningful correlation between money supply and inflation levels, at least not insofar as the period 1974 to 1986. I would further argue that, if money supply is expanding within mundane historical bounds, then to claim it is either a necessary or (much less) a sufficient condition to affect the inflation index at some indeterminate point in the future is just not accurate. When inflation was indisputably on the rampage—1980—money supply had increased by a mere 8.34%: The low end of the curve. Yet inflation that year was over 13%—even in the teeth of Volcker’s medicine.”

 

Leaving aside for a moment that M2 is not an especially good measure of the money supply since it includes credit securities that are not media of exchange, this assertion makes no sense.

There can be no rise in the general price level without a preceding increase in the supply of money. The only reason why the annualized increases in the money supply in Lira's table above do not precisely correlate with the measurement of the annualized rate of change of CPI (which in turn is a questionable statistic) is that it takes time for newly created money to percolate through the economy. When the money supply is increased, it is not as though the same percentage of money were just added to every existing bank account – new money is entering the economy at specific points, and then spreads from there over time.

Note by the way as an historical aside – although Lira does not mention this anywhere in his article – under Volcker the Fed not only hiked the Federal Funds rate sharply, but it adopted a policy of targeting the growth rate of the money supply. This was a result of the rising influence of the supply side economists and their prescriptions, among which the targeting of money supply growth rates was one. The Fed dropped this policy again in 1984. Until then, stock and bond market traders were glued to the weekly money supply data the same way they are today glued to the unemployment report.

We must again stress why it is so important to use the correct definition of inflation (i.e., inflation is an increase in the money supply). The reason is that inflation has a variety of effects, of which an eventual increase in the 'general price level' is only one. For one thing, price increases resulting from inflation will be uneven – this is in the nature of the beast. After an increase in the money supply has taken place, some prices may still be falling for reasons not connected with the inflationary policy, while others will already be rising sharply. The inflation effect most damaging to the economy's structure is in fact the distortion of relative prices , which leads to malinvestment of capital.

Furthermore, the economic backdrop is quite important in determining which of the effects of an inflationary policy will likely predominate and where in the economy the sharpest price increases will most likely occur.

For instance, it would be quite erroneous to assume that beginning with Paul Volcker's chairmanship, the Fed ended its inflationary policy. The opposite is true – during most of the 1980's, 1990's and especially the 2000ds, money supply growth went through the roof. However, due to a large increase in economic productivity occasioned by the advent of the computer industry and the opening up of the previously closed economies of the former Eastern Bloc, the adoption of economic reforms in China and the concomitant sharp increase in world trade, the price effects of the inflationary policy mostly centered on asset prices and the prices of non-tradable sectors (consider e.g. the large price increases in education and health services in this context). So even though price indexes such as CPI remained fairly tame (the calculation of CPI was redefined several times, which tended to lower it markedly relative to the older methodology), there were definitely inflationary effects visible. The central bank focus on the ill-defined 'general price level' to the exclusion of asset prices indeed helped to increase the pace of inflation enormously. Under a stable money, prices for goods and services would have fallen due to the large jump in industrial productivity – they haven't done that because monetary inflation has been so vast.

 


 

Money TMS ('broad' US true money supply, via Michael Pollaro, pdf) shows that inflation has been a permanent policy – the early 80's under Volcker were the only period during which a marked slowdown in money supply growth occurred, with yearly measures of growth even turning negative between 1981 and 1982.

 


 

The computer industry (and ancillary industries like telecommunications and others) itself is a notable exception insofar as it has experienced such rapid productivity increases that they actually managed to outpace the effect of monetary inflation on prices – prices in the industry have fallen markedly over time.

 

The Events of the 1970's

In explaining the events of the 1970's – money supply growth leading to sharp increases in consumer prices and a large increase in nominal interest rates – one must consider the specific circumstances of the time. After WW2, the Bretton Woods agreement had specified that the US dollar would be used as the world's reserve currency, with the stipulation that foreign central banks could exchange their dollar holdings for gold at a specified price on demand – a 'gold exchange standard'.

By the mid 1960's, when Lyndon B. Johnson's infamous 'guns and butter' policy was implemented, welfare and warfare spending coupled with loose monetary policy soon led to the supply of dollars becoming too big relative to the gold stock. Some countries, notably France, actually demanded gold delivery. From the late 1960's onward, market participants began to bet that it would be impossible to keep the gold exchange standard in place at the then prevailing price of $35 per ounce of gold. Ever larger amounts of gold where bought by investors in Europe, exerting upward pressure on the dollar price of gold. Initially central banks tried to defend the fixed exchange rate between the dollar and gold, with operations such as the 'London gold pool' and an embargo on South African gold exports.

Eventually, in August of 1971, Johnson's successor Richard Nixon 'closed the gold window', or to put it less politely, decided the US would unilaterally decide to default on its gold exchange promise.

In truly Orwellian fashion, Nixon blamed 'international speculators for waging an all out war on the dollar', and lied that he instructed the treasury secretary to only 'temporarily suspend the convertibility of the dollar into gold', 'in the interest of stability'. Only 'foreign money traders would be harmed' whereas 'American workers would be able to look forward to a stable dollar that would buy tomorrow what it buys today'. Nixon also announced a 10% import surtax on the same day in order to 'remove the unfair edge of foreign competition'. Listening to this with the events that followed in mind, it is almost as though the speech had been crafted by a stand-up comedian with a very black sense of humor:

 


 

Nixon suspends gold convertibility of US dollar and announces 10% surtax on imports.

 


 

According to this 'inflation calculator' the dollar lost more than 50% of its buying power over the next 9 years. What cost $100 in 1971 when Nixon sold his default as 'an action to create a stable dollar' set you back by $203 in 1980. So much for the promises of politicians!

Also on this fateful day, Nixon decided to once again give that old stand-by of inflationists throughout history a whirl, price controls:

 


 

Nixon announces price controls.

 


 

It is probably not an exaggeration to call Nixon the Diocletian of the US empire – the man who exemplifies the beginning of the end – the moment when the decline phase began, due to a mixture of military overstretch and inflationary monetary policy. Later under Carter, selective price control policies were still imposed in the form of 'guidelines':

 


 

Carter's 'Inflation Advisor' Alfred Kahn talks about price guidelines.

 


 

In this historical context it is easy to envisage how confidence in the dollar evaporated, especially with Arthur Burns at the helm of the Federal Reserve. Burns was appointed by Nixon in 1970, and was known to be politically pliable. Nixon wanted to ensure his reelection in 1972, and believed an easy money policy to be the key thereto. Burns in turn was afraid that a tighter monetary policy would raise unemployment and while Nixon implemented his price controls, Burns engaged concurrently in an inflationary monetary policy.

Understandably this economic and monetary policy mixture had the exact opposite effect of that officially intended, in that it undermined faith in the currency rather profoundly. Given that the dollar's convertibility to gold had been suspended, there was suddenly nothing left to anchor the dollar's value – all pretense in that respect had been removed. When the first oil price shock occurred in 1973, Nixon's price controls could no longer be implemented and the Burns Fed accommodated the oil price increase by continuing to run a loose policy.

To come back to Lira's contention that by the late 1970's, the situation had deteriorated to the point of an incipient hyper-inflation, this is probably true. Consider that in the 1970's the large productivity increases that computerization of the economy later bestowed were not yet in sight and the suddenness of the oil supply shock did represent a significant economic challenge. The troubles of the economy were then increased manifold by Nixon's ad hoc edicts and his administration's vast deficits.

People at the time began to realize, bit by bit that the inflationary policy was deliberate and here to stay. Once this kind of expectation sets in, the money concerned begins to lose its value more rapidly. In the modern-day central banker vernacular, 'inflation expectations had become unanchored' – almost literally in this case.

Lira describes Volcker's exertions as praiseworthy, and Volcker certainly managed to break the back of the 1970's inflation psychology by actually temporarily lowering the money supply and accepting that bubble activities that depended on easy money would have to be liquidated. The 'double dip' recession of the early 1980's was actually the economic healing process that Volcker's predecessors had never allowed to occur. The end result was an economy that managed to expand again from a far more solid footing. However, in hindsight it is clear that Volcker rescued the very fiat money system that has been able to inflate the supply of money and credit into the blue yonder ever since. A mixed blessing indeed!

Lira gushes:

 

“As far as I am concerned, he [Volcker, ed.] ought to have a white marble statue thirty feet high, placed prominently on the Mall in Washington, D.C., eye to eye with the other great heroes of the Republic.”

 

We certainly wouldn't go that far. If not for Volcker, the fiat money era would likely have ended then and there after all. Instead, it has been extended by another thirty fateful years. Consider as the 40 year anniversary of Nixon's gold default approaches, that the funded portion of US government debt has increased from $400 billion to nearly $13.5 trillion, while the true money supply has increased from about $500 billion to $ 6.8 trillion – the increase of TMS in the course of the past four quarters alone was greater than the entire money stock that existed anno 1971 (in terms of M2, $633 billion in 1971 became $8.65 trillion as of August 2010).

Unfortunately, money does not equal wealth – the standard of living for the average American in terms of real wealth has been stagnant since the pure fiat money era began.

 

How Hyperinflation Happens

Since there have been quite a few historical incidences of hyperinflation, most recently the Zimbabwe hyperinflation, one can easily discern the common features characterizing these events.

First of all, as Ludwig von Mises noted, a precondition for the 'crack-up boom' (the German term for this phenomenon is perhaps even more descriptive: 'die Katastrophenhausse', which literally means the 'catastrophic rally') is that people begin to view the inflationary policy as a permanent feature and increasingly reject the money concerned as a viable medium of exchange – a 'flight into real goods' begins and the monetary system breaks down.

This can of course only happen if the quantity of money is continually increased. Here are several pertinent paragraphs from 'Human Action' where Mises discusses 'The Anticipation of Expected Changes in Purchasing Power' (Human Action, chapter XVII, Indirect Exchange):

 

He who buys, buys for future consumption and production. As far as he believes that the future will differ from the present and the past, he modifies his valuation and appraisement. This is no less true with regard to money than it is with regard to all vendible goods. In this sense we may say that today's exchange value of money is an anticipation of tomorrow's exchange value. The basis of all judgments concerning money is its purchasing power as it was in the immediate past. But as far as cash induced changes in purchasing power are expected, a second factor enters the scene, the anticipation of these changes.

 

Mises then goes on to describe how the process of inflating the quantity of money can get out of hand, as expectations of declining purchasing power take hold and lead to an ever increasing discount of the value of money relative to goods:

 

“The characteristic mark of the phenomenon is that the increase in the quantity of money causes a fall in the demand for money. The tendency toward a fall in purchasing power as generated by the increased supply of money is intensified by the general propensity to restrict cash holdings which it brings about. Eventually a point is reached where the prices at which people would be prepared to part with "real" goods discount to such an extent the expected progress in the fall of purchasing power that nobody has a sufficient amount of cash at hand to pay them. The monetary system breaks down; all transactions in the money concerned cease; a panic makes its purchasing power vanish altogether. People return either to barter or to the use of another kind of money.”

 

Students of past hyperinflation events will immediately remember that in every single one of them, an official of the monetary authority eventually publicly pronounced the need to print more currency in order to 'alleviate an impending cash shortage' – which in turn only serves to intensify the inflationary expectations already prevalent.

As Mises further explains:

 

“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796 and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.”

 

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796 and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.”

If one looks at two historic hyperinflation events that are fairly widely known – the Weimar and the Zimbabwe hyperinflations, there was a distinct combination of factors at work in both cases. Both events started out as relatively mild cases of inflation, comparable to what the US experienced in the late 60's/early 70's. In both cases, government debt rose rapidly and was increasingly monetized by the central bank. In both cases the economy lost a significant part of its production structure due to political interference. In Germany's case it was the allied occupation of the Rhineland which aimed to force Germany to keep up its war reparation payments, while in Zimbabwe it was the forced nationalization of commercial farms in the name of race equality. This undermined the economy's potential to produce real wealth, so that the government's fiscal position became ever more dubious. Promptly government in both cases began to increasingly rely on central bank monetization of its debts – a process that in turn vastly increased the supply of money and consequently undermined its value.

So we see that an important factor is usually the inability of the government to garner enough tax revenue to continue to pay its obligations without resorting to the printing press. This soon solidifies expectations of economic actors of an accelerating decline in the purchasing power of money, leading to the 'self-fulfilling prophecy effect' that marks the tipping point between an inflation that can still be tamed and one that develops into a run-away crack-up boom. Also, as the decline in the money unit's purchasing power accelerates, government tends to print ever more currency in order to alleviate cash shortages.

Below you find a measurement of the decline of the Zimbabwe dollar's purchasing power during the hyperinflation phase compiled by Steve Hanke of John Hopkins University for the Cato Institute.

As can be seen, the value of the Zimbabwe dollar declined quite sharply every month from early 2007 onward, although there were at the beginning still months when it appeared to temporarily stabilize.

However, it seems from this that once the price rises jumped into double digit territory on a monthly basis, the spiral of repudiation of the currency was well underway and had in fact become unstoppable. Note how the decline in purchasing power eventually accelerated ever more, until the price increases happened so fast that the Zimbabwe dollar effectively could no longer serve as a viable medium of exchange.

 


 

Hanke Hyperinflation Index for Zimbabwe (HHIZ)

Date

Index

Infl.Rate/Month

Infl. Rate/Year

5-Jan-07

1.00

13.70%

 

2-Feb-07

1.78

77.60%

 

2-Mar-07

3.14

76.70%

 

5-Apr-07

6.90

56.20%

 

4-May-07

6.75

-2.15%

 

1-Jun-07

20.70

207.00%

 

6-Jul-07

53.00

60.40%

 

3-Aug-07

49.10

-7.29%

 

7-Sep-07

82.50

70.60%

 

5-Oct-07

219.00

165.00%

 

2-Nov-07

642.00

193.00%

 

28-Dec-07

2,010.00

61.50%

215 000%

25-Jan-08

2,250.00

11.80%

 

29-Feb-08

8,260.00

259.00%

 

28-Mar-08

17,7×103

115.00%

 

25-Apr-08

57,1×103

222.00%

 

30-May-08

442×103

498.00%

 

26-Jun-08

23,6×104

5,2×103%

41,4×103%

4-Jul-08

49,2x 104

3,74×103%

93×106%

11-Jul-08

81,8×104

2,080.00%

167×106%

18-Jul-08

122×104

1,030.00%

250×106%

25-Jul-08

157×104

566.00%

317×106%

29-Aug-08

6,33×105

3,19×103%

9,69×109%

26-Sep-08

794×109

12,4×103%

471×109%

3-Oct-08

3,57×1012

15,4×103%

1,630×1012%

10-Oct-08

32,3×1012

45,9×103%

11,6×1012%

17-Oct-08

1,07×1012

493×103%

0,3×1015%

24-Oct-08

124×1015

15,6×106%

26,1×1015%

31-Oct-08

24,6×1018

690×106%

3,84×1018%

7-Nov-08

4,89×1021

15,2×109%

593×1018%

14-Nov-08

853×1021

79,6×109%

89,7×1021%

 


 

Sources: Imara Asset Management Zimbabwe and author’s calculations.

A table by Steve Hanke showing the progression of the Zimbabwe hyperinflation episode.

 


 

The Current Situation

In the final few paragraphs of his article, Lira compares the 1970's situation with the current one, arguing that the philosophy of the current Fed chairman Bernanke and his explicit aim to 'avert deflation' will eventually lead to a build-up of inflationary pressures which due to the weak economy won't be counter-acted in time.

Apart from the fact that he repeats the wrong contention that 'no money supply increase is needed to bring this about' (on the contrary, it is the sine qua non), the scenario is not entirely unreasonable.

Market forces are at present exerting deflationary pressures as new lending to the private sector has declined relative to the tendency to pay back debt. Banks are reluctant to extend new loans and private borrowers are equally reluctant to apply for new loans. In a fractionally reserved system this will tend to reduce the amount of fiduciary media, i.e. deposit liabilities, since the payback of a loan extinguishes whatever additional deposit money was created from thin air when it was granted. If left to its own devices, the market would likely have deflated the money supply considerably since 2008.

However, governments and central banks everywhere have countered this tendency by vastly increasing government debt and the monetization thereof. In addition, the Fed has monetized mortgage backed and agency securities. To the extent that such securities were bought from non-banks, new deposit money was created directly by the central bank. Commercial banks meanwhile have preferred to leave a large part of the proceeds from the monetization exercise on deposit with the Fed in the form of 'excess reserves' – these are precautionary cash balances that have been built up in view of the short term funding problems banks experienced during the crisis – as long as the banks fear more capital impairment from loan delinquencies, they will probably try to hold on to these balances. As long as they remain with the Fed, this money is not circulating in the economy and can exert no inflationary effects. However, unless the Fed eventually drains these excess reserves, they represent a large potential source of inflation. Furthermore, banks have begun to very actively shift their asset base toward government securities, i.e. they are now lending to what is arguably still regarded as the safest debtor.

The weak economy has meanwhile reduced the government's tax revenues just as spending has been ramped up in accordance with Keynesian principles. Should the Fed continue to monetize government debt in ever greater quantities (at the moment it is merely keeping the size of its balance sheet at the same elevated size by buying government debt in quantities equal to the run-off from the maturation and prepayments of the mortgage securities it holds) in its bid to 'fight deflation', then it is in the realm of the possible that things could one day get out of hand. In all likelihood the Fed will be prepared to tolerate a period of rising prices if it feels constrained from tightening monetary policy due to weak economic activity (remember Arthur Burns and his reluctance to tighten policy as he feared a rise in unemployment might result).

To cut it short, the mixture of private sector deflationary pressures, economic weakness, enormous government deficits and extremely loose monetary policy is one where things can easily go wrong due to a miscalculation on the part of the authorities.

Importantly, a secular bust following a huge credit and asset bubble can not possibly be anything but painful. Contrary to the popular view that loose monetary policy and heavy government spending assist the economy to get through it, they actually make it worse as even more scarce resources are misdirected and wasted. Certainly inflationary policy and deficit spending can for a while create an 'accounting figment' of a growing economy, but neither can create real wealth – the alleviation of economic pain they seemingly produce is an illusion. As soon as the spending and inflation are cut back, the economy resumes the interrupted contraction, as malinvested capital is once again liquidated. This is precisely the type of fundamental economic backdrop where political pressures are likely to lead to more and more currency debasement, with the attendant risk of an eventual repudiation of the currency. This is however unlikely to just happen overnight without warning. If the quantity of money is inflated enough to lead to accelerating inflationary effects it will still take time for the psychological conditions to change so drastically as to produce a monetary catastrophe. In our view we are still far away from such conditions, i.e. it would be possible by a voluntary abandoning of the inflationary policy to prevent this outcome.

Lastly, we would be remiss not to mention the arguments of those expecting a deflationary outcome based on the decline in private sector debt. One argument is that the Fed will refrain from going 'too far' as it would undermine its own power if it were to destroy the currency it issues. Robert Prechter on the other hand argues it will react to deflationary pressures stemming from a credit collapse too timidly and too late, due to its cumbersome bureaucratic decision making process and will only manage to induce inflationary effects after a contraction of the money supply and the attendant decline in prices has occurred.

The problem with these lines of argument is that the Fed's independence can easily be revoked if the government were to regard it as too reluctant to inflate (e.g. the Nixon administration exerted a great deal of pressure on the Arthur Burns-led Fed and it certainly got its way), i.e. the Fed could be politically commandeered. Also, while it is true that the institution is cumbersome and reactive rather than proactive, one should not underestimate the Bernanke-led Fed's often stated determination to 'avert deflation' – something it wants to do even now when in terms of TMS growth in the wake of its post boom policies to date no deflation is even remotely in sight yet. So perversely it is precisely because the Fed fears deflation that its tolerance towards rising inflation expectations is likely to increase.

One thing is already certain: after 40 years of a pure fiat money system with dollar-denominated debt as the chief monetary 'reserve asset' held the world over, we have experienced monetary chaos just as one would expect. Whatever happens next, a sudden outbreak of monetary and fiscal rectitude must be considered a rather unlikely outcome in light of the evidence and the prevailing economic orthodoxy.

 


 

“Increase in the money supply was both inverse to high inflation levels some years (like Jan. ‘75) and inverse to relatively low inflation levels in other years (like Jan. ‘77). But it also tracked high inflation levels other years (Jan. ‘82) as well as low inflation levels in still other years (Jan. ‘86). Therefore, one cannot make any type of meaningful correlation between money supply and inflation levels, at least not insofar as the period 1974 to 1986. I would further argue that, if money supply is expanding within mundane historical bounds, then to claim it is either a necessary or (much less) a sufficient condition to affect the inflation index at some indeterminate point in the future is just not accurate. When inflation was indisputably on the rampage—1980—money supply had increased by a mere 8.34%: The low end of the curve. Yet inflation that year was over 13%—even in the teeth of Volcker’s medicine.” “Increase in the money supply was both inverse to high inflation levels some years (like Jan. ‘75) and inverse to relatively low inflation levels in other years (like Jan. ‘77). But it also tracked high inflation levels other years (Jan. ‘82) as well as low inflation levels in still other years (Jan. ‘86). Therefore, one cannot make any type of meaningful correlation between money supply and inflation levels, at least not insofar as the period 1974 to 1986. I would further argue that, if money supply is expanding within mundane historical bounds, then to claim it is either a necessary or (much less) a sufficient condition to affect the inflation index at some indeterminate point in the future is just not accurate. When inflation was indisputably on the rampage—1980—money supply had increased by a mere 8.34%: The low end of the curve. Yet inflation that year was over 13%—even in the teeth of Volcker’s medicine.”
 

 

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4 Responses to “The Debate over Hyperinflation”

  • JasonEmery:

    Eric de Carbonnel posted an interesting theory on his (apparently now defunct) ‘Market Skeptics’ blog in 2009. He thought that a combination of late season soybean damage in the USA, as a well as a loss of capital (world wide) for farming operations, due to the 2008 financial crisis, would lead to a horrible food shortage, and that this would lead to hyper inflation in the USA.

    A big part of his reasoning was that food importing nations would be forced to let their currencies strengthen versus the dollar, in order to be able to keep people from starving. With inflation already skyrocketing in China, I think this might be the year.

    Unlike last year, when the usa entered a drought period with exceptionally good soil moisture, this year America’s soil has very little margin for error, in terms of rainfall. We either get average or better rainfall over the next six months or we get a horrible harvest and then drastically higher food prices. If it is the latter, they will have no choice but to let the Renminbi strengthen considerably. Then, it’s all over for the dollar.

  • vincecate:

    I have a simple simulation (17 nodes) that shows how too much debt and deficit can result in hyperinflation. It is web based, so easy to use. You can change inputs and run the simulation again and again. You can copy the whole thing and make any changes you want to the formulas.

    http://howfiatdies.blogspot.com/2013/03/simulating-hyperinflation.html

  • Bearster:

    Thanks for writing a great article. It amazes and stupefies me that Lira’s piece got as much attention (and traction) as it did. It was confusing, and committed the error that I think of as the Underwear Business Plan (http://en.wikipedia.org/wiki/Gnomes_(South_Park)):
    Phase 1: Collect Underpants
    Phase 2: ?
    Phase 3: Profit

    In this case, it’s:
    Phase 1: a glitch in oil prices
    Phase 2: ?
    Phase 3: everyone rushes to empty their bank accounts

    Clearly people have done Phase 3 in Germany and Zimbabwe, etc. But to understand why, one can’t look at aggregates or statistics to understand the cause. There is not a direct relationship between money supply and prices. As you point out, productivity increases would cause falling prices if the money were stable.

    I think it is much more about falling productivity, especially of the things people need like food and energy. If productivity falls (due to credit crunches, regulations, labor protectionism, etc etc) and if it falls below the level that can supply food to the population, then obviously people will bid up prices to any level until they run out of money. Not because they are choosing to reject the currency per se, or certainly not at first, but because they simply need food.

  • Thucydides:

    Thanks for the best writeup I have yet seen on this subject. Sometimes I wonder whether we are headed for an eventual global simultaneous hyperinflation, as governments everywhere refuse to allow adjustments and keep creating a series of larger and more frequent bubbles. The current market runup in equities, commodities, and bonds has the feel of the first impacts of inflation.

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