Inflation Versus Hyperinflation

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I used to think that hyperinflation and inflation differed only in magnitude. However, a friend pointed out that they could be considered as arising from different processes. "Inflation" is often something done primarily for economic reasons, as a sort of "stimulus." "Hyperinflation" has, as its root, the policy of printing money to pay bills and debts.

FASB defines hyperinflation as a 100% increase in the CPI over three years. That works out to about 26% per year, which might not seem very "hyper." However, that is about the point at which a financial system ceases to function. Debt financing tends to collapse. There are still loans and interest rates, but the volumes are very low and rates very high. It basically amounts to loansharking. Even the government is unable to finance beyond about six months or a year, and not in large size. If a government becomes incapable of debt financing, it tends to revert to money-printing. Historically, when the domestic currency is not of enough quality to support debt finance, debt would be issued in foreign currency. All of Latin America got into the habit of borrowing in dollars. However, that option doesn't exist when it's the dollar itself whose quality falls below the minimum necessary for debt finance. The euro or yuan? I doubt it. A few oddballs might try debt denominated in gold, but the problem there is that, in a stiff inflation, the value of everything else collapses vs. gold so there's no way to pay the debt back unless you are a gold miner.

We saw before that most countries around the world have had some sort of hyperinflation. How did this happen? I can tell you how it didn't happen: there wasn't a Cabinet meeting in which everyone said: "Let's have a hyperinflation." It tends to get started when the government turns to the printing press for financial resources. What happens then? Probably, nothing much happens. This is amazing! The government can print money and there are no consequences. Politicially, this is like crack cocaine. Once the precedent has been set, there is hardly any financial need that is not met by the printing press. Eventually, the currency begins its collapse. But how to turn back? It is always possible to do so. You just have to stop printing money, and actually contract the monetary base to support the currency. Politically, this is unlikely. I say it is like Napoleon's Grand Armee turning around and going back to France after crossing the Niemen river into Russian Poland. You don't just say: "I've changed my mind, this is a bad idea." Bad ideas tend to play out to their dramatic conclusion.

It doesn't take too long before the policy of printing money makes it impossible to issue regular debt. Who would buy it? Thus, a policy which might start as a minor stopgap, alongside the regular issuance of debt, becomes the sole means of deficit financing. As the economy deteriorates, the real value of tax revenues declines. This happens for a number of reasons. First, people defer tax payments because the various penalties and charges on late payments (aligned for a non-hyperinflationary environment) are much less than the advantage gained by paying later in a devalued currency. Second, the legitimacy of government collapses in a hyperinflation, so people feel no moral imperative to pay taxes. Third, taxes designed for a non-hyperinflationary environment (capital gains taxes or income tax brackets not indexed to inflation for example) become ridiculously burdensome. Tax evasion soars. Fourth, hyperinflation makes people poorer, so the real value of tax revenue declines. All of this just increases the pressure on government finances, leading to more money-printing.

Something else happens in both a 1970s-style inflation and a hyperinflation: it is possible that, especially if inflation consistently exceeds expectations, the economy will actually have rather low unemployment. This was true in the "accomodation" phase around 1977-1979, and also true in Germany in 1921-22. Eventually--especially if combined with price controls, or unpayable taxes--hyperinflation may lead to economic collapse and unemployment of 30%-80%. During the low-unemployment phase, if there is one, governments will actually be afraid to stop inflating because they sense (correctly) that unemployment would soar. Once inflation expectations take hold, there is a recessionary effect from inflation that is below expectations. If someone borrows at 20%, expecting 18% CPI inflation, and the CPI turns out to be 5%, the debt can become very burdensome. Likewise, if a worker demands, and gets, a 50% pay rise to keep up with inflation, but inflation is only 20%, then the employer may end up laying people off to reduce labor costs.

Where are we today? I have a funny feeling that we have already crossed the Niemen, as far as hyperinflation goes. Although the various money-printing schemes that have arisen since autumn of last year have been justified on "stimulus" grounds, they are looking more and more like a funding mechanism (including funding for bank bailouts). They have a can't-go-back quality about them. Banks can't take any more garbage on their balance sheet, so the bank swaps are likely to stay for now. The purchases of Treasury and GSE debt could be reversed, but that isn't likely to happen as Ben Bernanke is not the kind of guy to dump a trillion dollars of paper on the market while the Treasury itself is trying to dump another trillion-or-two on unsuspecting bagholders. A bear market in bonds would be confirmed, which is not such a big deal itself but not considered acceptable right now. The double-whammy of higher Treasury rates and higher GSE/Treasury spreads (likely if there is selling of GSE debt) would mean another 100-200bps on mortgage rates, which would blow up whatever housing-related "Green Shoots" we have been fantasizing about recently. Instead, I think the Fed is going to continue to purchase Treasury bonds at the regular auctions, and probably in size larger than the $300B they talk about publicly. The more they do this, the less that regular purchasers (notably foreign governments) are interested in buying this debt.

Meanwhile, we see that California is going to go to "vouchers" or "IOUs" in about three days. Who says that state governments can't print money? There is a long history of this, throughout the 18th century, as I talk about in my book. These will amount to a sort of secondary currency. Argentine state governments did the same thing in 2001, the notorious "patacones." CNN counts at least 18 other states whose fiscal year starts July 1, that don't have a budget. In a few weeks, we could see "patacones" erupt across the country.

This illustrates the political consensus. California's government could find a way to cut spending. Given how much it has increased in recent years (46% increase in inflation-adjusted per-capita spending in 10 years -- how much have inflation-adjusted incomes risen during that time?) it would not be hard, in a practical sense, to reduce spending by perhaps 50% or so. However, it is so much easier just to print IOUs that that is what will happen. (California actually has a history of money-printing. It did a similar trick with the IOUs in 1992, which led to lawsuits from state employees.)

People tend to fixate on the clownish final stages of hyperinflation, when they're buying bread with bundles of billion-dollar banknotes. Actually, the damage is done much earlier. The first 10:1 decline in currency value is the worst, especially if it happens in a brief period like two years or so. (It would take about a 10:1 decline to produce a CPI of 26%+.) The second 10:1 decline, over another couple years, pretty much obliterates whatever remains of a financial system. That adds up to a 100:1 decline, or a 99% fall in the value of the currency. After that, it's all just comic book madness.


Nathan Lewis is the author of Gold: The Monetary Polaris (2013), and Gold: The Once and Future Money (2007).  

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