On Hyperinflation

I was on the Max Keiser show 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 below, but let me argue my case first.

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.

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  • 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.
  • 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.

  1. The German government had a large foreign currency debt obligation.
  2. The German economy lost huge amounts of productive capacity causing prices to soar as demand outstripped supply.

That’s Weimar.

Zimbabwe

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.

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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..

  1. 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.
  2. 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.
  3. 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.

Watch our segment from about 10 minutes into the video below.

Enjoy.

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20 Comments
  1. dvdhldn says

    “As to fiat money and the need for a new world order, that is a separate topic to take up at a later date.”

    Look forward to this.

  2. dvdhldn says

    “As to fiat money and the need for a new world order, that is a separate topic to take up at a later date.”

    Look forward to this.

  3. Anonymous says

    > a loss of the ability to tax

    Regardless of the government’s ability to tax, the US is currently experiencing a loss in the willingness to tax. The result is the same, though: the loss of one important defense against hyperinflation.

  4. Anonymous says

    > a loss of the ability to tax

    Regardless of the government’s ability to tax, the US is currently experiencing a loss in the willingness to tax. The result is the same, though: the loss of one important defense against hyperinflation.

  5. Anjon Roy says

    Totally with you on this line: “People arguing that hyperinflation is around the corner usually are pushing this view because of an ideological bias against fiat money”

    Having been good friends with some hard-core hard money guys for many years, I can completely relate to that statement. It’s almost a religious thing, an all-encompassing meta-narrative that some of these guys have a loyalty for.

    Great write-up and appearance on MK’s show! You sure do have a diversity of outlets between Roubini’s RGE, Yves’ Naked Cap, the dolts on CNBC, and Mad Max Keiser! I’m a fan of Max. He’s very smart and entertaining, not completely sure what to make of him. He seems a bit of an “anarchist hard money” type, different from other hard-money types who tend to be traditional Austrian right-wingers (Ron Paul), conspiracy guys (Alex Jones), paleocons. etc.

    I know you’ve been on his show before, but is the 1st time you had a significant difference/debate with Max on his show?

    1. Edward Harrison says

      I don’t normally disagree that much with @maxkeiser. I disagree on hyperinflation, but it goes to the ‘degree of inflation’ and the policy response. I certainly think there already is a level of currency revulsion occurring right now. That’s why gold is increasing in price. That’s why silver is increasing in price. And I expect this to continue.

      On the other hand, I also acknowledge that gold and silver are appreciating against all other currencies as well. So, this is a generalized fiat currency revulsion. The question then is what is the policy response to inflation? We have already seen the ECB move against inflation. So we know that the general policy response will not be inaction. The ECB is more hawkish than the Fed and the BoE but their move tells you that eventually the others would have to move as well if inflation continues upward.

      See my post here for more on that:
      http://pro.creditwritedowns.com/2009/06/central-banks-will-face-a-scylla-and-charybdis-flation-challenge-for-years.html

      As I recently reiterated:

      ” all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
      As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.”

      http://pro.creditwritedowns.com/2011/04/a-few-brief-comments-on-americas-fiscal-choices.html

      People like Max and Marc Faber are saying the money printing will continue and there will be no policy response. I am saying that there will be a response – and one that causes the debt deflationary to kick in before inflation expectations become unanchored.

      1. Anjon Roy says

        Thanks for the great analysis Ed!

        Sounds similar to the aftermath of the South Sea Bubble in the early/mid 1700s. After the bubble crashed, they had a series of mini-depressions/stagnation that went on for years and years, which cumulatively were the equivalent of a depression. Different from 1930s when you had a “nuclear bomb” followed by a very strong snapback (accept for the policy induced retrenchment in 1937). Like Japan post 1990 – or your post “recession is over but the depression has just begun” which i assume is referring to this multi-year/decade of stagnation

        btw- what do you make of Max and the SLA’s take on JP Morgan / silver? Is JP Morg really in that much trouble? Do they really have a huge short position?

        1. Edward Harrison says

          Definitely outside my area of knowledge on the SLA.

  6. Anjon Roy says

    Totally with you on this line: “People arguing that hyperinflation is around the corner usually are pushing this view because of an ideological bias against fiat money”

    Having been good friends with some hard-core hard money guys for many years, I can completely relate to that statement. It’s almost a religious thing, an all-encompassing meta-narrative that some of these guys have a loyalty for.

    Great write-up and appearance on MK’s show! You sure do have a diversity of outlets between Roubini’s RGE, Yves’ Naked Cap, the dolts on CNBC, and Mad Max Keiser! I’m a fan of Max. He’s very smart and entertaining, not completely sure what to make of him. He seems a bit of an “anarchist hard money” type, different from other hard-money types who tend to be traditional Austrian right-wingers (Ron Paul), conspiracy guys (Alex Jones), paleocons. etc.

    I know you’ve been on his show before, but is the 1st time you had a significant difference/debate with Max on his show?

    1. Edward Harrison says

      I don’t normally disagree that much with @maxkeiser. I disagree on hyperinflation, but it goes to the ‘degree of inflation’ and the policy response. I certainly think there already is a level of currency revulsion occurring right now. That’s why gold is increasing in price. That’s why silver is increasing in price. And I expect this to continue.

      On the other hand, I also acknowledge that gold and silver are appreciating against all other currencies as well. So, this is a generalized fiat currency revulsion. The question then is what is the policy response to inflation? We have already seen the ECB move against inflation. So we know that the general policy response will not be inaction. The ECB is more hawkish than the Fed and the BoE but their move tells you that eventually the others would have to move as well if inflation continues upward.

      See my post here for more on that:
      http://pro.creditwritedowns.com/2009/06/central-banks-will-face-a-scylla-and-charybdis-flation-challenge-for-years.html

      As I recently reiterated:

      ” all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
      As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.”

      http://pro.creditwritedowns.com/2011/04/a-few-brief-comments-on-americas-fiscal-choices.html

      People like Max and Marc Faber are saying the money printing will continue and there will be no policy response. I am saying that there will be a response – and one that causes the debt deflationary to kick in before inflation expectations become unanchored.

      1. Anjon Roy says

        Thanks for the great analysis Ed!

        Sounds similar to the aftermath of the South Sea Bubble in the early/mid 1700s. After the bubble crashed, they had a series of mini-depressions/stagnation that went on for years and years, which cumulatively were the equivalent of a depression. Different from 1930s when you had a “nuclear bomb” followed by a very strong snapback (accept for the policy induced retrenchment in 1937). Like Japan post 1990 – or your post “recession is over but the depression has just begun” which i assume is referring to this multi-year/decade of stagnation

        btw- what do you make of Max and the SLA’s take on JP Morgan / silver? Is JP Morg really in that much trouble? Do they really have a huge short position?

        1. Edward Harrison says

          Definitely outside my area of knowledge on the SLA.

  7. T Lan says

    Until we see wages going hyper, it ain’t happening IMHO

  8. T Lan says

    Until we see wages going hyper, it ain’t happening, IMHO. By the way, enjoyed your responce.

  9. Anonymous says

    It is interesting that this fiat currency discussion occurred after a segment on Zynga’s virtual currency. One wonders what MK would make of BitCoin which uses rigorous mathematics to make it as impossible to inflate as gold. I get the feeling that his ideology only has room for gold, and perhaps silver, to be considered as real money. Virtual currencies, even those that are deflationary by design, are now probably too tainted by association with electronic fiat tricks of Goldman and the arbitrary credit systems of Farmville.

  10. Anonymous says

    It is interesting that this fiat currency discussion occurred after a segment on Zynga’s virtual currency. One wonders what MK would make of BitCoin which uses rigorous mathematics to make it as impossible to inflate as gold. I get the feeling that his ideology only has room for gold, and perhaps silver, to be considered as real money. Virtual currencies, even those that are deflationary by design, are now probably too tainted by association with electronic fiat tricks of Goldman and the arbitrary credit systems of Farmville.

  11. Lawrence Tout says

    Dear Edward
    you are so naive. The world, let alone the USA, has never been balanced on a sharper knife-edge. Your pontifications totally disregard the house of cards that is the current global financial system of today. It disregards the total connectivity of world finance and world markets. It disregards the lightning speed of money in this digital age. It disregards the huge leverage employed within the system. It disregards a hell of a lot of the current shit we now find ourselves buried neck-deep in.

    Hyperinflation, and the road towards it, can be hastened by any number of minutae but the underlying cause is an irrepairable loss of confidence in fiat. When all is linked, and built on sand, it will only take a tremor of sufficient magnitude to bring down the whole house. Hyperinflation is not around the corner or a long way off. It is a ninja-black-swan-on-acid that will strike any time it pleases.

    Plenty prior to yourself have said it could never happen here. The only problem today is that HERE is EVERYWHERE.
    rgrds
    LT

    1. Edward Harrison says

      Lawrence, I didn’t say hyperinflation could NEVER happen to the U.S.. I said it won’t happen in the near term. There are a lot of events that would have to come together to get hyperinflation.

      Also you’re apparently not reading this post in context as regular readers do. See the last two posts:

      http://pro.creditwritedowns.com/2011/04/anchoring-inflation-expectations.html
      http://pro.creditwritedowns.com/2011/04/stiglitz-proposes-new-reserve-currency.html

      You also might like to see Casey Research’s piece on gold:
      http://pro.creditwritedowns.com/2011/04/gold-mania-are-we-there-yet.html

  12. Lawrence Tout says

    Dear Edward
    you are so naive. The world, let alone the USA, has never been balanced on a sharper knife-edge. Your pontifications totally disregard the house of cards that is the current global financial system of today. It disregards the total connectivity of world finance and world markets. It disregards the lightning speed of money in this digital age. It disregards the huge leverage employed within the system. It disregards a hell of a lot of the current shit we now find ourselves buried neck-deep in.

    Hyperinflation, and the road towards it, can be hastened by any number of minutae but the underlying cause is an irrepairable loss of confidence in fiat. When all is linked, and built on sand, it will only take a tremor of sufficient magnitude to bring down the whole house. Hyperinflation is not around the corner or a long way off. It is a ninja-black-swan-on-acid that will strike any time it pleases.

    Plenty prior to yourself have said it could never happen here. The only problem today is that HERE is EVERYWHERE.
    rgrds
    LT

    1. Edward Harrison says

      Lawrence, I didn’t say hyperinflation could NEVER happen to the U.S.. I said it won’t happen in the near term. There are a lot of events that would have to come together to get hyperinflation.

      Also you’re apparently not reading this post in context as regular readers do. See the last two posts:

      http://pro.creditwritedowns.com/2011/04/anchoring-inflation-expectations.html
      http://pro.creditwritedowns.com/2011/04/stiglitz-proposes-new-reserve-currency.html

      You also might like to see Casey Research’s piece on gold:
      http://pro.creditwritedowns.com/2011/04/gold-mania-are-we-there-yet.html

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