Edward Harrison here. Yves is away at the INET conference I was unable to attend. So I will post a few articles in her absence. This is one I wrote yesterday at Credit Writedowns. I look forward to your comments. If you want to post comments on twitter instead of down below, you can reach me here.
I don’t like talking about hyperinflation because it veers into the fringe element of discussion. But, in the blogosphere you often hear vague references to it. So I thought I would take this on. This post came together in response to an appearance I had on the Max Keiser show. I was talking to Max about precious metals, currency debasement and hyperinflation. Max was pushing the view that the U.S. was on its way to hyperinflation due to its reckless monetary policy. I argued against this view. The video is in the original post at Credit Writedowns, but let me argue my case here.
People arguing that hyperinflation is around the corner usually are pushing this view because of an ideological bias against fiat money. This is a bias I share because I believe that fiat money allows excessive money creation that winds up as a credit super bubble – and our experience over the past 40 years demonstrates this. However, I don’t let this bias get in the way of my analysis of the economics of the situation. I have a better understanding of the fiat money system because I am not anchored in a gold-standard mentality when looking at the constraints on government in the fiat money system and the types of events that lead to hyperinflation. The hyperinflation talk is a gimmick used to push a particular ideological viewpoint. While I share that viewpoint and don’t like fiat money, I am not a fear monger, so you won’t see pushing an ideological agenda which has the economics wrong.
Here are a few bullet points that are salient for understanding fiat money and hyperinflation.
- The Gold Standard is based on a fixed exchange rate of currency to the price of gold. This is crucial to understanding the difference to a fiat money system. I would argue that fixed exchange rates, while less volatile than floating rates, are an example of central planning, meaning government rather than market forces decides how much the currency is worth vis-a-vis other currencies and gold.
- Gold is thought by many to have intrinsic value such that tethering money to it creates an arbitrage opportunity which limits money creation. If too much money is created, debasing the currency, arbitrageurs would redeem their money in gold instead of in currency causing a depletion of gold reserves. If government had enough gold to back its money, then that would not be a problem. However, if they had inflated the money supply, government would run out of gold as arbitrageurs converted currency into gold. In a gold standard money system, currency has value because of its government-decreed convertibility into gold, an asset which has a value independent of the currency. Money loses its value when users of currency opt to convert that money into gold and government is unable to meet that convertibility due to the excessive creation of money not backed by gold. Note, that the reason this arrangement works without creating inflation is because there are limited supplies of gold. If you discover boat loads of gold (or silver) in Peru and ship it back to Spain, you get inflation and currency debasement as government increases the supply of money in concert with the availability of gold.
- Fiat money has no intrinsic value. It simply represents a liability of government, an IOU. The only promise government makes is to repay the holder of that liability with another IOU of equivalent nominal amount in whatever money form the government decides: it could be coins, bonds, paper currency or electronic credits. Because money is created by government, this means government faces no solvency constraints in its own currency since it could always fulfill its IOU liability by creating more money. There may be political motives in defaulting on those liabilities, however. I call this the Ecuador risk factor. See "Bill Gross: Deficit Hawk, Bond Vigilante".
- Why accept fiat money, if it has no intrinsic value? There are two reasons. The first is a derivative of the second. Most people understand that since money operates as a medium of exchange, one accepts it because it is universally accepted. Legal tender laws give government monopoly as national money creators eliminating any competition in the medium of exchange. But of course, this is a circular infinite regress argument for why people accept money. Certainly, it is true that U.S. dollars were already established as a medium of exchange and legal tender when the U.S. went off the gold standard. But the Reichsmarks created after the Weimar inflation had no installed base of users. Given the previous hyperinflation, clearly there was ample reason for currency revulsion. So you can consider this argument a necessary but not sufficient precondition. What makes the universal acceptance stick is that government accepts its own money to expunge liabilities to it. In plain English, fiat money has value because it is the only money you can use to pay taxes. Remember, government is the only entity in society that can coerce any and everyone in its jurisdiction to accept a liability. Taxes are coercive, meaning they are not a voluntary arrangement between two parties like a mortgage. Government tells you that you must pay. If you don’t, you suffer the consequences. This means you need government’s money to expunge your tax liability. The fact that this money is also the medium of exchange only entrenches its use. So the tax liability is a necessary pre-condition for fiat currency to work, something I will return to.
So what about Hyperinflation?
Weimar Germany 1919-1923
After World War I, every nation which fought was broke because of the war’s cost. No country had enough gold assets to repay the billions of dollars they owed. And this was a multilateral problem. For example, Britain could not repay its debts to the US until the other Allies repaid their debts to Britain. The Americans were not sympathetic. The prevailing desire was recovering the over $25.5 billion the US had loaned to other nations during the war.
As a result of these debts, the war’s victors laid out draconian terms to punish the Germans in the Treaty of Versailles in 1919. War reparations were one third of Germany’s spending. Therefore, Germany’s budget deficit was half of GDP. (The situation in Iceland due to Icesave’s collapse comes to mind here). And to make things even worse, reparations were in a foreign currency.
It’s not as if the Germans could print off a bunch of Reichsmarks to make good on their reparations (The Reichsmark is the more legitimate currency that came into being after the hyperinflation). When the Germans defaulted on their obligations, the Belgians and the French moved in and occupied the Ruhr region, Germany’s industrial heartland. The result was widespread strikes and idled productive capacity. Afterwards, demand for goods in Germany far outstripped the productive supply.
So, with a huge portion of tax revenue going to pay reparations in foreign currency, the German government turned to the printing presses to make good on its domestic obligations. The surge in money supply and the lack of productive resources led to hyperinflation and collapse.
The key to Weimar’s hyperinflation was two-fold.
- The German government had a large foreign currency debt obligation.
- The German economy lost huge amounts of productive capacity causing prices to soar as demand outstripped supply.
While the facts in Zimbabwe are different, the underlying causes for hyperinflation were the same: foreign currency obligations and a loss of productive capacity.
Zimbabwe had established Independence from Britain in 1980. Yet, by the late 1990s 70% of productive arable land was still held by the small minority 1% of white farmers in the country. After years of talk about redistribution, in 2000, the President Robert Mugabe began to redistribute this land.
The redistribution process was a disaster, both legally and economically. Many whites fled as violence escalated. The result was an enormous decline in Zimbabwe’s agricultural production. With agricultural production having plummeted, Zimbabwe was forced to pay to import food in hard currency.
Meanwhile, the government turned to the printing presses to fulfil its domestic obligations. as in Germany, the foreign currency obligations, the loss of productive capacity and the money printing was a toxic brew which ended in hyperinflation.
-Hyperinflation in the USA, May 2010
As you can see from the two most severe cases of hyperinflation, the problem in each case was a loss of productive capacity, foreign currency liabilities, and a loss of the ability to tax. When the economy is overheating, traditionally we think of interest rates, the price of money, as the mechanism which government could use to slow things down and bring inflation to heel. However, fiscal policy is effective here. If government increases taxes, it cools the economy and reduces consumption, relieving the pressure on productive capacity. Thus, the loss of the ability to tax is central in hyperinflation.
In the German example, the Germans had a huge foreign currency liability that it had to pay, meaning it could not make good on the liability by printing money. It was a currency user as far as these liabilities went. Meanwhile, with productive capacity limited, the government was then unable to ease price pressure through the tax lever. The shortage of goods drove up prices inexorably and the government was forced to turn to the printing press in order to meet its domestic obligations.
In the Zimbabwe example, taxes were again central. Unable to recoup enough tax revenue and with large foreign currency obligations and a loss of productive capacity, the government resorted to printing money in an environment where prices were rising.
So, hyperinflation has very specific preconditions that are not apparent in the U.S..
- No foreign currency liability: The U.S. dollar is the world’s reserve currency so the U.S. can pay for trade goods in U.S. dollars. The U.S. does not have a peg to gold or some other currency which acts as a de facto foreign currency liability. And the U.S. government has substantially no foreign currency liabilities. All of the debt is issued in domestic currency.
- Price pressures are still anchored: While commodity prices are rising, they are rising in all currencies, not just in USD. Moreover, their rise will create demand destruction before any hyperinflation could occur. Why? Unemployment is high and capacity utilization is low, meaning there are no inflationary pressures on that front to help push inflation higher before demand destruction sets in.
- Currency revulsion has not set in: Tax compliance is high in the U.S. We are not talking about Russia, Greece or Argentina where government has had a difficult time in raising tax. Moreover, as the USD is still the world’s reserve currency, there has been no freefall sell off of dollars, nor do I anticipate any in the near-to-medium term.
In short, there will be no hyperinflation in the U.S. any time soon. As to fiat money and the need for a new world order, that is a separate topic to take up at a later date.