Friday, October 19, 2012

FAQ for Hyperinflation Skeptics

This FAQ is for the frequently asked questions or objections common among hyperinflation skeptics.  The statements or questions in bold below are things hyperinflation skeptics say and my responses follow.

How is hyperinflation defined?
The International Accounting Standard of IAS 29 says there is hyperinflation when "the cumulative inflation rate over three years approaches, or exceeds, 100%.".  This works out to 26% per year.   There are many other definitions for hyperinflation but they almost all have something like "inflation over X per year" or "inflation over Y per month". People pick some level of price inflation as the cutoff between regular inflation and hyperinflation.  It is just the values for X or Y that differ.  Note that hyperinflation is not defined in terms of the money supply alone, since the velocity of money and GNP are also key factors in the price level during hyperinflation.  Hyperinflation is a process,  a positive feedback loop, that once entered is very hard to get out of. This process can go on for years. 

Is there a real chance the US dollar could get hyperinflation?
 Hyperinflation happens when government debt is over 80% of GNP and the deficit is over 40% of government spending. The US is at or near these numbers, so the danger of hyperinflation is real. What happens is that the more the central bank prints money and buys bonds the less other people want to hold bonds. But the less other people hold bonds, the more the central bank has to buy them so the government has enough money to spend. You get a positive feedback loop or death spiral. 

The government or central bank would never decide to have hyperinflation.
In over 100 cases of hyperinflation I don't believe there has ever been a single "decision to have hyperinflation". Hyperinflation is when things get out of control. It is not something central banks or government voted on. No group in government or a central bank has had a show of hands like "all in favor of hyperinflation raise your hands". Not the way hyperinflation happens.  Hyperinflation is a market response to government debt over 80% of GNP and deficit over 40% of spending when the central bank starts printing money and buying up government debt. Everyone thinks they just need to print a bit more money to make it through the next week or month and there is nothing else they can do since the government needs money to keep in operation. Nobody votes for hyperinflation. Nobody wants it. It just happens.

Why would the Fed suddenly print trillions of dollars?
More than $8 trillion of the $16 trillion debt matures in less than 12 months.   There is also the "excess reserves" that are earning interest, much like government bonds really.  If people stop rolling over bonds, and banks take out their excess reserves, then the government will need the Fed to print around $11 trillion in 12 months ($8 for short term bonds coming due,  $1+ for the current deficit, and around $2 for the excess reserves).   This bond panic and massive printing/buying by the central bank is how hyperinflation seems to typically start.  This $11 trillion is more than enough to start the hyperinflation feedback loop.

Hyperinflation would never happen in America!  
There were cases of hyperinflation in America's colonial period.   There was hyperinflation during the Revolutionary War.  Remember, "not worth a Continental"?  There was hyperinflation in the South during the Civil War.     I also think that if the US had not made it illegal to own gold in 1933 that the Fed would have gone bankrupt, because they did not really have enough gold to back all of the notes they had issued, and that paper money would have become worthless then too.   Hyperinflation is more common than most people realize.  The time periods from the Revolutionary War hyperinflation, to the Civil War hyperinflation, to the 1930s currency crisis, to now, are all similar.   To me this looks like some major currency crisis cycle is about due.

It seems like very few people really understand hyperinflation.
The math for hyperinflation is really not very complicated.   You should start with the equation of exchange and make one change to get:

P = M * V / Q

Where the terms are:
P = Price level
M = Money supply
V = Velocity of money, how many times money turns over in a year
Q = Real GNP

In hyperinflation the money supply is going up, the velocity of money is going up, and the real GNP is going down, all at the same time.  It is a tripple wammy that drives prices up really fast.

You have the cause and effect backward!
People will argue things like, "it is not the monetization that causes the loss of confidence, it is the loss of confidence that causes the monetization".  While someone else argues the other way.   I have also seen both sides of, "hyperinflation causes money printing, not money printing causes hyperinflation".

Hyperinflation is really a positive feedback loop.  It is a circle, a death spiral.  To argue about what comes first in hyperinflation is a bit like arguing which came first, the chicken or the egg.

But the US central bank is different!
There have been over 100 cases where the combination of a government spending way more than they got in taxes and a central bank printing money and buying their debt to help them out (often after changes in law or leadership) caused hyperinflation. What is the core difference in the US government or US central bank that anyone could think sets them apart from these 100 cases?

Why can't you stop hyperinflation by just having the central bank stop monetizing debt?
It seems obvious that if you just have the central bank stop buying government debt the hyperinflation would stop. The problem is that the government needs money to operate and is spending far more than what it gets in taxes and has debt around the size of the GNP.  The deficit is so large that cutting government or increasing taxes enough is not possible.  The only way the government can keep in operation, when other people stop buying their bonds or even rolling over their bonds, is if the central bank steps in. So the government always makes sure the central bank steps in.   This may take changing laws or replacing people at the central bank, or just ignoring laws, but the government will get the money or it is bankrupt.

How could the Fed on its own cause hyperinflation?
It is always the combination of the government spending far more than it gets in taxes and the central bank printing money and buying government debt (monetizing debt).   It is the two together that result in hyperinflation, not one alone.

Isn't hyperinflation a political event and not a monetary event?
 I think Milton Friendman was right when he said "inflation is always and everywhere a monetary phenomenon".  First off, hyperinflation is a process that can go on for years, not an event.   The exact cutoff point between regular inflation and hyperinflation is arbitrary, so it makes no sense to say that below 26% it is a monetary phenomenon and above 26% it is a political phenomenon.   

They have printed trillions without trouble so far, why would more be different?
It may help to read the storey about the straw that broke the camel's back again.  There are situations where a small amount of something is ok but lots is not.  There are lots of medicines that are helpful in small doses but deadly in large doses.  If 2 people go walking on some ice they might be fine but 50 people walking in the same area might break through.  Hyperinflation has a human element.  There is sort of a panic to get out of the bonds and then a panic to get out of the currency.  It is hard to say exactly when the panic will start, but I don't think anyone ever prints more than the GNP in one year without getting hyperinflation and certainly not 3 times the GNP.

Isn't the Fed trying to push money out like trying to push on a rope?
Some note that the Fed can not give money away or spend it and that banks only want to lend to  credit-worthy businesses but those and consumers are still deleveraging.  So then how can the Fed push money into the economy? The government has no real limit on the amount they can borrow and spend.  They have a debt limit but they increase it anytime they get close, so it is not a real limit.   This government deficit spending, financed by the central bank making new money, is the real source of inflation.

The US is very different from Weimar Germany or Zimbabwe!
Each case of hyperinflation is unique, so if you are looking for differences you will always find them.   You need to understand the similarities.  Hyperinflation happens because government debt gets over 80% of GNP and deficit gets over 40% of spending.   It does not matter how you get into that situation.  Hyperinflation works the same if you lose a foreign war,  a civil war, a dictator goes crazy, a government with excessive foreign debt, nationalizing too many businesses, rampant corruption, productive collapse, excessive regulation, a regime change, too many taxpayers fleeing high taxes, a massive depression, or whatever.  It just matters that the government is spending nearly twice what they get in taxes and has already borrowed more than is reasonable.   When they are in this situation they can not borrow more, except from the central bank under their control.  So they get the central bank to make money and "loan" it to them.  When the reality is the only way they can pay back that "loan" from the central bank is by first getting another "loan" from the central bank you are probably headed for hyperinflation.

Another problem is that people often compare the US before hyperinflation to some country during hyperinflation, which is not a fair comparison.   For example, after prices are shooting up and interest rates go up no banks will be making 30 year loans.   So people will say the fact that the US is making loans shows that it is different than some country with hyperinflation.  This is silly.  Of course a country that does not yet have hyperinflation is different from a county in the midst of hyperinflation.   When a country gets hyperinflation there are a number of stages it goes through.   Things are very different as hyperinflation progresses.  

Why would it matter if the US dollar was no longer the world reserve currency or oil was not priced in dollars?
Currencies are fungible, in seconds you can exchange any currency for any other currency, so you might think it does not matter what oil is priced in.   The US military burns lots of oil.  Right now the US can just print some money and get as much oil from the Arabs as they want.  If they could not do this but had instead to tax their people to get the money to buy oil it would be much harder.   Anyone who has an option to buy some amount of oil at some price in dollars 6 months from now will usually save up the money in dollars.   While they could save up the money in some other currency, there is a risk that the currency fluctuations over the next 6 months will be such that what they saved is not enough to buy the oil at that price.   So they can eliminate this currency risk by saving in dollars.   Having international commodities priced in dollars increases the demand for dollars.   If the Arabs and Chinese no longer took US dollars there is a good chance the US dollar would be headed for hyperinflation right away.

Why worry about the debt when interest rates are so low?
 The interest on the national debt is a big item when interest rates are at record lows.  When interest rates get back to normal levels the interest on the debt is clearly unsustainable.

Can't we wait till there are signs of inflation before doing anything?
Because the hyperinflation feedback loop is so strong it is hard to escape hyperinflation once it is started.  It is much easier to prevent it than to halt it after letting it start.  In other words, if you wait till hyperinflation starts it is probably too late.  
  
Hyperinflation predictions have been wrong so far, why take them seriously?
It is certainly true that anyone predicting hyperinflation of the US dollar before Sept 1, 2012 was wrong.   This does not mean that all predictions of US hyperinflation are wrong or nonsense.   It seems that all fiat money will come to an end at some point, it is just hard to say when.  Note that anyone predicting price deflation in the US has also been wrong.

Other countries are even worse off than the US.
Other countries have all sorts of problems too, so the US dollar may not drop against those other currencies.   Hyperinflation is not really about exchange rates.  If the Pound, Yen,  Euro, and Dollar were all getting 26% inflation the exchange rates could stay the same but we would still have hyperinflation.

Can't people just switch to another currency?
When there is hyperinflation in one country, say Zimbabwe dollar, the people there can switch to some other currency, like the US dollar, and life goes on.  The government will probably fight this but people will still do it.   However, the world reserve currency is different.   The central banks running other currencies use US dollars as their reserves.  If they want to prop up the value of their currency they spend some dollars buying their currency and their currency goes up.  But if US dollars become worthless, then they will not be able to hold up the value of their own currencies.  So soon after the US dollar fails, a bunch of other currencies will probably fail as well.

Why would the US central bank willingly destroy their currency?
If the Federal Reserve Notes become worthless then the Federal Reserve is probably done for, so why would they ever do such a thing?    Sounds logical.   But why did  that same logic not protect all  the other central banks from making hyperinflation?  The government writes the laws, appoints the people to the central bank, and controls the guns.  When the government is desperate for money from the central bank they get it.   But also remember that the central bank is created by the government.  If the government collapses  because  it does not have enough money to pay for things, the central bank will probably go down as well.  The survival of the central bank does depend on the survival of the government.   I think this is the core of why central bankers risk their currency to support their governments.

Doesn't the deleveraging of huge private debt prevent hyperinflation?
 If you define inflation and deflation in terms of the money supply, and you count bonds as part of the money supply, then you can easily predict deflation when people are deleveraging.   There is a big problem when it comes to hyperinflation though.   Hyperinflation is defined in terms of "price inflation" not money supply.   This is important because the velocity of money and the lowering of real GNP are big factors in hyperinflation.   If you count bonds as part of the money supply and just look at money supply and not prices then when prices start going up fast, and bond prices crash, you will see deflation.   In fact, at the start of all hyperinflations bond values crash, so this money supply view could see deflation when everyone else sees hyperinflation.   By using very different definitions of inflation/deflation it is possible for the deflationists to see deflation at the same time the hyperinflationists see hyperinflation.  But the history books will later say it was hyperinflation.

There has never been hyperinflation of the world reserve currency before!
It is only since 1971 that the world has had a fiat currency as a world reserve currency.  In the past it was always gold or silver or a currency convertible to gold or silver.   It is not possible to get hyperinflation when using gold and silver.  Hyperinflation happens to fiat currencies.

Don't we need more stimulus now and worry about the debt later?
The standard definition of GNP includes government spending.  So more government spending can increase the GNP number in the short term.  But it is not really helping and hurts in the long run.   In general anything that makes your government bigger hurts in the long run.   The government is an overhead on the productive parts of society.  The more the overhead the slower the growth rate

How could the US dollar get hyperinflation as long as international commodities are priced in dollars?
It may be that as inflation picks up the international commodities will no longer be priced in dollars.  Perhaps they will use Yuan or maybe they will use gold.  But it does seem doubtful that people will keep selling things in dollars when dollars are failing.  As fewer and fewer things are priced in dollars there will be less and less demand for them.  So the end of the dollar dominance will contribute to the hyperinflationary pressure.

Bonds are money so monetization does not increase the money supply!
There are many different definitions of the "money supply" and some of them include government bonds.   With such a definition, monetizing government debt (exchanging new money for government bonds) does not increase the money supply.   So it may seem that by choosing this definition of the money supply that monetization does not matter.

However, the price level should be understood from the equation of exchange.   It is not only the quantity of money but also the velocity of money and GNP that determine the price level.  If Grandma is holding a 30 year bond for the last 30 years, and you count that as money, the velocity of  this money is really low.  When the bond comes due and is replaced by cash the velocity of money is far higher.    With a money supply definition that includes bonds, hyperinflation is mostly about increasing money velocity.

With this type of definition of the money supply then deficit spending, which is financed by creating new bonds, is the reason the money supply is increased.     So the size of the deficit tells you how fast the money supply is increasing.   Here the blame for hyperinflation is put more on government deficits and less on the central bank.   Remember always that hyperinflation needs both deficits and monetization.    In this view, as long as the deficit is out of control the money supply is out of control.

While there is some flexibility in how you define the money supply, a correct view of reality has to match the many many historical cases of hyperinflation.   In historical cases of hyperinflation, monetization is the key part of what is going on, so it must make a difference in any correct theory.

If you can't predict the exact timing then you are no help to investors!
Hyperinflation is sort of a slow motion panic where people get out of bonds and then out of the currency altogether.  But as a human panic, it depends on humans, so hyperinflation is hard to predict with precise timing.  However, if bonds are paying 1% and going to suddenly lose more than half their value sometime in the next 10 years, then getting out years early is clearly a better plan than waiting.

Could the US gold prevent hyperinflation of the US dollar?
 Having assets could slow the hyperinflation a bit but it does not matter how much gold the US is holding if they are spending 50% more than they get in taxes. They will have to keep printing money, so there is not a finite amount of paper money.  With a constantly increasing quantity of paper money it is not possible to hold any fixed exchange rate of dollars to gold. It is the debt and deficit and the fact that when the government will always get the central bank to print money and buy government bonds when things get desperate that causes hyperinflation.  When France took the extensive church land holdings and used that to back a currency they still got hyperinflation.   If assets could prevent hyperinflation France should have been safe, but they were not.   The ongoing deficit meant there was not a finite amount of paper money.   I highly recommend this article on France's experience. A more recent example is hyperinflation in Iran even though they have huge amounts of oil, which should have protected them if gold could protect the US.

Bernanke says he is just temporarily monetizing debt.
You should not believe him.   He has to buy more and more to keep interest rates low enough that the government can handle the huge debt.  If he tried to sell the bonds he has the interest rates would shoot up and the government would not be able to afford the debt.

To get real hyperinflation you need lots of paper money and most US money is just electronic.
Anyone with electronic money can withdraw paper money.  The banks with electronic money at the Fed can withdraw paper money.  If the Fed did not have enough paper money they would have to print more.  Since electronic money can be converted to physical paper money, there is no real difference. 

The Fed could not print money fast enough to counter the deflationary forces.
In Zimbabwe they printed $100 trillion dollar notes.   Clearly the Fed could easily print $1 trillion dollar notes and buy up all bonds of all types.  Then there would be no deflationary pressure.   Also, since the Fed usually works on computers, it is even easier than printing up paper. 

Can you have deflation and hyperinflation at the same time?
Yes.  The typical definitions of deflation and hyperinflation are not opposites at all.  The deflationist define deflation as "a contraction in the total supply of money and credit" while hyperinflation is defined in terms of price levels.  When prices start shooting up loans will be for shorter periods and existing bond values will crash, so you can have a contraction in credit at the same time that prices are shooting up.  The deflationists and hyperinflationists can both be right at the same time.   But the deflation will only be for a short period and the hyperinflation longer and more dramatic. 

Hyperinflation is usually just a few bad years, why worry about it?
Hyperinflation destroys the middle class.  Saving are wiped out, retirement funds are wiped out, life insurance policies are worthless, etc.   It destroys the economy.   In Germany it really lead to Hitler coming to power and much more than a couple bad years.

Quantitative Easing is different than printing money!
I have a collection of over 100 euphemisms for "printing money".   If the Central Bank is making new money and buying government bonds it is monetizing debt.  It is replacing bonds with new money.   It does not matter if they do it on computers since money on computers can later be withdrawn as paper money.

I can see inflation in "debt free money" but how does it work in "debt money"?
If the central bank prints money and loans it into existence, some people call this "debt money".  The idea is that money comes into existence with a debt which should take it back out of existence when the debt is paid back to the central bank.  If the Treasury just printed money and spent it they call that "debt free money".  Clearly if the Treasury just printed and spent money you would get inflation but how does it work with "debt money"?  The key to understanding this is that governments don't really pay down their debts.  The way they pay back old bonds is by first selling new bonds.   If the government never really pays back the central bank then there is no real difference between "debt money" and "debt free money", at least as far as the government use of it.

The bankers control the Fed and it is against their interest to have hyperinflation.
The government really controls the Fed, just like in all the other cases of hyperinflation.  When the government is faced with a choice of closing its doors because it can not pay people or forcing the central bank to buy government debt they never choose to close their doors.  Note that if the government shuts down the central bank will shut down too.   So it is actually in their interest to prop up the government by buying their bonds.

You can't have hyperinflation when house prices are falling.
The idea is that during hyperinflation the price of everything must go up fast, so clearly with asset prices falling we can't have hyperinflation now.   This is not accurate.  You might argue that we don't have hyperinflation yet but this in no way protects us from having it in the next year or two.  Also, at the start of hyperinflation when interest rates have first shot up the asset types that are bought with long term loans will drop in value because you will not be able to get long term loans any more.  Eventually, when houses are bought with cash, house prices will go up with everything else.

You can't have inflation when there is high unemployment.
The 1970s proved this is not true yet many people continue to believe it. High unemployment is normal in hyperinflation.  The economy is a mess. 

Deflation is as big a danger as inflation.
 The graph below shows that when the US was on a gold or silver standard the probabilities for inflation and deflation were similar.  However, after 1933 when the dollar partially moved away from gold there was little deflaion.  After 1971, when the dollar became completely unbacked, there has been no more deflation.   It is wrong to use statistics from a time with gold money to predict dangers under a pure fiat money.  In pure fiat money the probability of inflation is far higher than that of deflation.




Low interest rates prove the market is not worried about hyperinflation.
The current low interest rates are because the Fed is artificially driving up the price of bonds, which lowers the interest rate.  This is not a market rate.  If the Fed were to stop buying bonds the rates would shoot up, particularly now after they have printed so much money in the last few years.  However, it does seem the market is not yet worried about hyperinflation.  When the Fed is buying bonds faster than the Treasury is issuing bonds, then the private market will be exiting bonds. 

What about debt deflation?
When the central bank loans money into existence there is more money.  Since demand deposits also count as money by most definitions, when   fractional reserve banks lend against demand deposits the money lent out and the demand deposit balance both count as money, so there is more money.  One definition of inflation is an increasing money supply.   If debts are being paid back faster than they are being created you could have the money supply decreasing, which is one definition of deflation.   When the government debt is going up by more than $1 trillion per year, this will eventually eclipse any finite amount of private debt that is being paid down.  At some point private debt will start increase again and the government will still be borrowing a trillion a year, so there will be lots of inflationary pressure.     It is hard to say when inflation will really kick in though.  Note that in fiat money "price deflation" is very unusual.

What causes the velocity of money to slow down or speed up?
The interest rates affect the velocity of money  and inflation rates affect the velocity of money.   If money earns 0% and inflation is 0% there is no hurry to get it to the bank or spend it.   If money is earning 20% you don't leave it under your mattress but put it in the bank where it moves on.  When prices are going up 20% per day you run from where you get paid to where you will spend your money.    The initial response to a central bank printing lots of money and lowering interest rates is for the velocity of money to go down.  This means that for awhile prices don't reflect the new money.  One of the positive feedback loops in hyperinflation is that as prices go up the velocity of money goes up, which further drives prices up, which further drives up the velocity, etc.

But our government is just borrowing, not printing and spending!
As people are paying back debts the total measured money supply can go down.  Since central banks loan money into existence it would seem that after the money was paid back to the central bank there would be no net inflation.  The big thing that this view overlooks is that governments never seem to pay down their debts.    In Weimar Germany and Zimbabwe the central bank was just loaning money into existence.    However, those governments could only pay back previous bonds by first getting money from selling new bonds.    The US central government debt has gone from like $9 trillion to $16 trillion in the last 4 years and at this point can only pay back existing bonds by first selling more bonds. During the hyperinflation people talk about the central bank is buying government bonds to stimulate the economy, stabilize interest rates, or show faith in the government.  After the hyperinflation is all over, people forget about the central bank buying bonds and just talk about how the government was just printing and spending money.  The historical narrative simplifies out the central bank so it becomes much clearer and looks so foolish.  However, this simplification makes is so that the next victim of hyperinflation does not see they are doing the same thing.   They think of the historical hyperinflations as just stupidly printing and spending money while their current government is just borrowing it.    So the same mistake is repeated again and again.

Others Questions
Feel free to ask other questions in the comments. I will move some of the best questions from the comments into this FAQ.  Also if one of my answers to a question does not seem satisfying enough, let me know.

1 comment:

  1. This helped to clarify some things for me. Thanks for the informative post!

    Cheers

    ReplyDelete