This article was written in 2010 after the 2008 Great Recession kicked off. It was my response to commentators who were raising the specter of high inflation and hyperinflation. Instead of inflation we got deflation as many of the boom phase investments were substantially devalued. These malinvestments resulted in a serious contraction of economic activity and lending, and much of the money printing stimulus (euphemistically called “Quantitative Easing”) lay in Excess Reserve accounts at the Fed. Looking back, it’s a good explanation of hyperinflation and is applicable to today’s economy.
I have been reading a lot lately about the coming hyperinflation in America. Among those I’ve read are Mr. Shadowstats John Williams, John Hussman, Jim Quinn, commentators on Zero Hedge, and Mr. Gloom Doom and Boom himself Marc Faber. My favorite philosopher, Nassim Taleb has also taken up the hyperinflation case. And I didn’t forget Jim Rogers, Peter Schiff, and others.
The Case for Hyperinflation
All the writers base their hyperinflation argument on America’s out of control federal deficits and spiraling debt, poor economy, reluctance to raise taxes, loss of control over the money supply, and that at some future tipping point the government and the Fed have only one alternative to prevent a run on US Treasurys, and that is massive quantitative easing (QE). QE is just another way to say the Fed prints money to buy federal debt. Another way to say that is that the Fed is monetizing federal debt.
That tipping point, they say, is when investors lose faith in Treasurys because they fear sovereign default and they start dumping them, and then bond prices collapse. This collapse will bring about worldwide financial panic, a run on other sovereign debt, and the dollar will decline drastically. The Fed will have no choice other than to prop up the market by buying Treasurys and to do that they will have to print money (monetize the debt), probably massively, which will spiral into hyperinflation.
Some commentators bring in arguments about trade balances, balance of payments, lack of exports, low US savings, and other mercantilist ideas to justify their case for hyperinflation.
Hyperinflation is not a far-out speculation. Whenever countries experience hyperinflation the causes are usually the same and hew close to the above circumstances. In any fiat money economy hyperinflation is possible. Only a gold monetary standard has held back profligate regimes from printing money in hyperinflationary quantities.
That said, hyperinflation is something that is easy to say, makes headlines, but is more difficult to achieve.
The question is not is it possible, but is it probable in America today. In my opinion the circumstances make the probability low.
Why Our Problems Could Lead to Inflation
I am not in disagreement with the hyperinflationists’ basic analysis of the Fed, the government, or the economy. All the bad things they describe are real. I won’t go into them in detail here but here are the basic problems we face:
- We are still in a recession and we will probably stay in recession for “the foreseeable future” as the Fed likes to say.
- Government revenues have fallen off.
- Massive government spending has resulted in massive deficits.
- The deficits are being funded by debt.
- Credit is still very tight and money supply has been shrinking.
- The CPI is low, but asset values such as real estate are still declining.
- Unemployment is high and will probably go higher.
- Massive Keynesian fiscal stimulus (federal spending) has had no lasting effect.
- Government social benefit programs (Social Security, Medicare, Obamacare, federal pensions, etc.) are underfunded and their costs will climb dramatically.
- Federal taxes now take about 30% of our economy.
- Federal debt is at about 90% of GDP and is rising.
- It is likely the Fed will engage in large amounts of QE to stimulate the economy, especially if unemployment grows.
This is not a healthy outlook for America.
There are two other factors that we need to consider.
The first is that governments like inflation, at least at moderate levels. Unbelievably, but true, people initially believe in the illusion of prosperity that rising prices from inflation brings. For most debtors the more the dollar is debased the easier it is to pay back debts issued in pre-inflation times. In fact inflation is just another tax on your wealth; governments are paying for stuff at a hidden discount. Savers and creditors lose.
Second, Americans don’t like to be taxed. While they like their benefits, they don’t want to pay for them. The sea change in America is not the dislike of taxes, but the love of the Nanny State. While people cynically say that Social Security won’t be around for them, they haven’t saved enough for retirement or medical care, and they are counting on it.
This presents a dilemma for our leaders. If they raised taxes sufficient to cover their expenses, we would kick them out of office (more on this below). On the other hand since our politicians can’t seem to cut spending, they will continue to borrow.
The answer to their dilemma is inflation.
What is Inflation and Hyperinflation?
Inflation is always a monetary phenomenon. Inflation is when central banks print more money than people desire to hold. The result of inflation is that all prices go up. If tomorrow everyone in the economy had 2X the dollars than they have today, prices would double. No one is wealthier; they just have more pieces of green paper. That is inflation.
Inflation is not caused by a lack of goods or too much demand, or demand-pull. For example, if the price of oil goes up, that’s not inflation. In that case, if we buy the same amount of gasoline as before, it means we will have less money to spend on other goods which goods will decline in price because of lower demand.
Governments print consistently and constantly so that their currency is continually debased. It would take you $22 to buy what $1 could buy in 1913 (the year the Fed was established).
Money is an economic good and it too is subject to supply and demand factors. Generally if people see all prices continually rise because of an increase in money supply, they will choose to get rid of dollars and hold assets. If prices are continually falling, people desire to hold money because it is becoming more valuable relative to assets.
When inflation is an ongoing phenomenon, prices continually rise, money buys less (is debased), and people don’t want to hold on to their devaluing dollars so they spend them. They want goods or assets or gold: i.e., the things that are rising in price, which is another way of saying the dollar is devaluing. Interest rates also go up as banks seek to offset the devaluation of dollars to be repaid in the future.
Hyperinflation is just an extreme case of inflation. Normally during high inflation central banks at some point slow the presses, let their economies fall into recession or depression, and the economy repairs itself. These boom-bust business cycles are being constantly created by central banks.
But what if the central bank doesn’t want to stop inflation? What if the politicians don’t want the economy to go into recession and expose their reckless fiscal behavior? In that case sovereigns print more and more currency to catch up with rising prices. It is like a feedback loop. The more they print, the higher prices go, so they have to print even more. Spending the currency becomes a mission. Perhaps prices double every month, or increase daily. Hyperinflation is when money printing is so great, that people lose faith in currency. People ignore their currency and barter, or gold or foreign currencies are used for transactions. Generally orderly commerce breaks down, goods become scarce, social order breaks down, and people suffer.
Why Does Hyperinflation Occur?
Aside from the mechanics of hyperinflation, why does it happen? Why do they keep printing? Aren’t the central bankers and politicians smart enough to understand what is happening? The answer to that last question is, in those countries, apparently, no.
In every modern case of hyperinflation the decision to inflate was a political one, not an economic one. In almost every case hyperinflation followed a war or a coup or some massive political change such as the end of the Soviet empire or the rise of a dictator or a populist-socialist takeover, and other political unrest.
In the 20th Century there were quite a number of hyperinflationary events. I used the Wikipedia list of modern hyperinflations (Since WWI) and researched the political circumstances of each country. The circumstances can be put into three rough categories: post-war disruption, post-Soviet collapse, and socialist-populist regimes.
For example we all know what happened in Germany after WWI when politicians, mostly socialists, blamed all their problems on reparations and continued to print so much money that it resulted in the famous cash-in-a-wheelbarrow photos. They literally had no clue what they were doing.
The post-Soviet empire collapse is easier to understand as former communist/socialist regimes fought for power and struggled with economic policy. Many of these countries have reformed or were forced to reform their monetary and fiscal policies.
Many of the socialist-Marxist regimes were Latin American populist governments who employed “revolutionary” anti-capitalist nostrums for economic policy. Chile (Allende) and Argentina are good examples. Argentina has had years of high inflation to hyperinflation since 1980. In Africa most countries were a mixture of strongmen with socialist-Marxist policies. I am not suggesting that these were pure socialist governments, but rather the typical situation where the government seizes or controls large parts of industry and issues regulations controlling much economic activity.
These hyperinflations all had one common denominator: during a period of instability, spending was used as a political tool and it got out of hand. I understand that the circumstances of each country were different and that it is perhaps unfair to say, lump Israel in with Argentina. But each country faced political factors that created instability or a national crisis; the government spent heavily to gain popular support, and resorted to the printing presses to pay for their spending.
Zimbabwe was the 21st Century’s first and one of the most spectacular examples of hyperinflation. It lasted almost two years and devastated their economy. Marxist dictator Commander Robert Mugabe, in King Lear fashion, believed he could ignore the laws of economics, but at the end of it, they had printed a 100 Trillion Dollar note (1014). At the end, their dollar increased year-over-year by 89,700,000,000,000,000,000,000 percent.
Here is the sad history of Zimbabwe. Robert Mugabe moved to solidify his power after the white minority signed a peace agreement in 1980. His internal security army, trained by North Koreans, eliminated opposition and committed mass murder in rebellious Matabeleland (estimates run up to tens of thousands of Ndebele killed). These goons still protect his regime. Mugabe’s “war veteran” supporters eventually grew restless at his empty political promises and economic failures, and threatened his political base, so he pushed out the remaining white farmers who owned most (70%) of the land, confiscated their property, and redistributed it to members of his ZANU party. Political and economic freedoms disappeared, food production collapsed, exports collapsed, food became scarce, and this once prosperous country was in shambles. Mugabe turned to the printing presses to pay for political largesse. He ordered his finance minister to keep printing money. The result was hyperinflation. Eventually their currency was abandoned and barter, the rand, and the US dollar were used instead. The economy and social structure broke down. As a result, the standard of living collapsed, life expectancy went from 57 to 34, malnutrition stunted children, HIV/AIDS cases are about the highest on the continent, and people fled the country. Everything Mugabe touched turned brown. Hyperinflation stopped when Mugabe dollarized the economy.
[Zimbabwe still faces high inflation, but the star of hyperinflation today is Venezuela under a socialist regime that has destroyed their economy.]
Will Hyperinflation Happen in America?
Will hyperinflation happen here? It is possible but unlikely and improbable.
I listed above 12 serious economic problems America faces. The list is not exhaustive but it is accurate. While they are serious, they do not necessarily guarantee hyperinflation.
As an exercise in hypotheticals, I extrapolated from the above 12 issues a kind of worse-case scenario for a potential hyperinflation setup:
- Government spending continues unabated, running up higher and higher deficits.
- To reduce deficits, taxation increases to, say 45% of GDP.
- As a result of high taxation, GDP declines, reducing tax revenues.
- The government floats even more debt to make up the new revenue losses.
- Interest rates on Treasurys increase substantially because of less demand due to market-perceived sovereign risk.
- The Fed starts buying large amounts of Treasurys in order to meet revenue shortfalls and to “stabilize the market” (i.e., monetizing the debt for a different purpose than they are now doing).
- Inflation takes off as the new money hits the economy and prices rise.
- Inflation risk causes interest rates to rise further.
- The debt is not being paid down with inflated dollars.
- Other major nations become fiscally more conservative thereby reducing the US’s status as the reserve currency.
- US sovereign credit ratings are downgraded.
These circumstances would lead to high inflation and panic in the bond markets. Whether it would spiral into hyperinflation is possible, but unlikely. More on this below.
Let’s go back to the political circumstances that existed in previous incidents of hyperinflation. We aren’t emerging from a devastating war nor have we gone through massive societal and governmental restructuring that occurred in the post-Soviet nations.
That leaves us with social unrest driven by socialist economic and political failures. But our Nanny State is not experiencing the populist political and economic upheaval that would result from the nationalization of basic industries, state control of the economy, price and wage controls, seizure of wealth, and political intimidation and tyranny that were the trademarks of the Latin American countries. While many on the Right would like to cast Obama in this role, it is not the case.
But let’s assume that my potential hyperinflation setup does happen; for hyperinflation to occur you would then have to believe in something like the following additional political scenario:
President Obama and the Democrats have complete control of Congress, say 75 seats in the Senate. They would continue to appoint leftist justices to the Supreme Court á la FDR and achieve a clear majority. Then they would perpetuate their power through massive spending programs to reward Democratic constituencies. They would raise the pay and pensions of the unions and government workers, substantially raise the minimum wage, dramatically raise payments to middle-class and lower Social Security recipients, increase taxes to confiscatory levels on “big corporations” and the “rich,” offer “free” health care for the “poor,” nationalize (directly or through total regulation) communications, energy, transportation, drug companies, and defense production in order to “bring down costs.”
As the economy slowed down further and unemployment (U-3) reached 20%+ levels, there would be massive political unrest and people would march in the streets. The military would be called out to maintain order in large cities from rioting and looters. In order to placate the masses, more government aid would be offered, more federal WPA-type projects would be created, and people would be “put to work.”
In order to pay for all this, federal debt would explode far beyond what we are now experiencing and the new Fed chairman would accommodate the government by monetizing the debt. Fed rules prohibiting the Fed from directly buying Treasury debt would be abolished. Inflation would exceed 20% and keep rising until it got to hyperinflation.
Let’s stop for a moment and catch our collective breaths.
Those things aren’t happening here. I’m not saying they couldn’t happen but that’s not our current path.
There are economic and political reasons why I don’t think hyperinflation would occur.
- The political winds are changing and I think the Democrats will lose their majority in at least one House in November. For purposes of this discussion, I think the Republicans would be better than the Democrats. With the political sentiment shifting to a more fiscally responsible government, I think further massive spending is unlikely.
- In order for the bond market to panic, investors would have to determine that the US would default on its debt. While one could argue that we don’t have the ability to pay off our debt, that is true of almost all nations. The more significant question is: can the US pay interest on its debt and continue to refinance its existing debt? The answer is yes. This is what buyers of US Treasurys look at when they buy our debt: the likelihood of sovereign default. While the situation in the US is not favorable with out of control federal spending, we still have a gilt-edge rating on our debt. More importantly, we have the ability to raise taxes in order to cover interest on our debt.
If we had a world crisis tomorrow where would investors send their money? So far it has been the US (for example, the eurozone sovereign debt crisis). I’m not saying this couldn’t change, but for now, money flows here.
- While I think Ben Bernanke is wrong on most things, as a student of Milton Friedman he does understand hyperinflation and the risks of printing money. I think most of Obama’s senior economic advisers all understand this point as well. In fact I almost all central bankers around the world understand the mechanics of hyperinflation. The exceptions would be those anti-democratic socialist regimes where monetary policy in just another tool of political policy. I think it is political science fiction to think that the Fed or any politician would let hyperinflation happen here.
But let’s go further and assume that my hypothetical factors do occur and we have high inflation which is spiraling out of control toward hyperinflation. What would be the government’s response?
- Impose temporary price and wage controls.
The last time they tried that was in 1971 with Nixon. It didn’t work then and won’t work now, but the purpose will not be so much to control prices, but rather to prepare the ground for their further actions to stop the crisis. I would give this 6 months at the most.
- Freeze the Treasury bond market.
Again, this is a temporary measure while the world organized to support our markets and the dollar.
- Establish a moratorium on Treasury debt repayment by extending all short-term maturities for 90 days.
Another temporary hold. Holders of our debt would unanimously agree to this. Otherwise their value of their Treasury holdings would significantly decline.
- Arrange for massive foreign support of the dollar and Treasurys.
The last thing our trading partners want to see is America crash and burn. International trade would very quickly dry up as the financial markets were in chaos. America still has a unique status with the dollar as the international reserve currency. You would see an immediate massive, coordinated support of Treasurys and the dollar by the EU, Japan, China, the UK, and others. Recall that hyperinflation doesn’t happen overnight. Jean-Claude Trichet recently said that the EU had prepared well ahead of time for a possible sovereign default in the eurozone, so they would be well aware of the need to act.
- Raise the Fed Funds rate, drive up the cost of money.
This is the Volcker solution which is to just stop printing money. He raised the Fed Funds rate from 11.2% in 1979 to a peak of 20% by June 1981. Inflation (and stagflation) disappeared. This is the solution to any hyperinflation.
After the markets cooled down, prices stabilized, and inflation subsided, controls would be lifted and life would go on. This would also sink the economy for a while, but that is better than hyperinflation and the social and political disintegration that it brings.
I respect many of the writers who believe that we will experience hyperinflation. A number of them are, like me, students of Austrian theory economics. I think most of them are unrealistic on this issue. At this point none of the economic or political factors required to set off hyperinflation are present. It is quite a leap of fancy to say we are certain to have hyperinflation.