Inflation or Hyperinflation

Posted: March 14, 2011 in Debt, Inflation

Will we get a dose of Inflation or Hyperinflation here in the US? If we do, what will that mean for our economy and jobs?

We know that the world is drowning in too much debt, and it is unlikely that households and governments everywhere will be able to pay down that debt. Doing so in some cases is impossible, and in other cases it will condemn people to many hard years of labor to be debt-free. Inflation, by comparison, appears to be the easy way out for many policy makers.

Companies and households typically deal with excessive debt by.

  • Defaulting
  • Countries overwhelmingly usually deal with excessive debt by inflating it away.
  • While debt is fixed, prices and wages can go up, making the total debt burden smaller.
  • People can’t increase prices and wages through inflation, but governments can create inflation, and they’ve been pretty good at it over the years.
  • Inflation, debt monetization, and currency debasement are not new. They have been used for the past few thousand years as means to get rid of debt. In fact, they work pretty well.

John Mauldin points out the following below which are excerpts from his new book Endgame.

Take the example of Brazil, which is one of the world’s most recent examples of hyperinflation. This happened within our lifetimes. In the late 1980s and 1990s, it very successfully got rid of most of its debt.

Today, Brazil has very little debt, as it has all been inflated away. Its economy is booming, people trust the central bank, and the country is a success story. Much like the United States had high inflation in the 1970s and then got a diligent central banker like Paul Volcker, in Brazil a new government came in, beat inflation, produced strong real GDP growth, and set the stage for one of the greatest economic success stories of the past two decades. Indeed, the same could be said of other countries like Turkey that had hyperinflation, devaluation, and then found monetary and fiscal rectitude.

In 1993, Brazilian inflation was roughly 2,000 percent. Only four years later, in 1997 it was 7 percent. Almost as if by magic, the debt disappeared. Imagine if the United States increased its money supply, which is currently $900 billion, by a factor of 10,000 times, as Brazil did between 1991 and 1996. We would have 9 quadrillion U.S. dollars on the Fed’s balance sheet. That is a lot of zeros. It would also mean that our current debt of 13 trillion would be chump change. A critic of this strategy for getting rid of our debt could point out that no one would lend to us again if we did that. Hardly. Investors, sadly, have very short memories. Markets always forgive default and inflation. Just look at Brazil, Bolivia, and Russia today. Foreigners are delighted to invest in these countries.

After the Bretton Woods Agreement in 1948, when the world moved to a dollar standard only nominally backed by gold, and then after 1971, when the United States no longer made the dollar exchangeable for gold, something happened: We only got inflation. Figure 8.1 shows that inflation is the norm in a world of paper currencies. Central banks and governments have an inflationary bias. They can regulate monetary policy much more easily when interest rates are positive, so they prefer always to have some inflation in the system. In fact, there are very, very few examples of deflation after 1948 or 1971.

As Reinhart and Rogoff have shown us, authors of this time is different. The typical pattern is for banking crises to lead to sovereign defaults and for sovereign defaults to lead to inflation.

BANKING CRISIS (leads to) DEFAULT (which leads to) INFLATION

Figure 8.2, by Reinhart and Rogoff, captures very well how inflation typically follows external defaults, which typically follow banking crises.

Inflation and External Default

It is easy to see why this is the case. Every week, you can read a very respectable professor recommending monetizing deficits and having a free lunch. If only the world worked that way.

Hyperinflations are not caused by aggressive central banks. They are caused by irresponsible and profligate legislatures that spend far beyond their means and by accommodative central banks that lend a helping hand to governments.

What are the implications for the present day? Fiscal liabilities are the real threat that will lead to higher inflation, if central banks continue to monetize government liabilities. In the case of a monetization, governments with independently authorized central banks disavow the overly convenient slippery slope option of paying their bills by printing new currency. A government must pay down its liabilities with currency already in circulation or else finance deficits by issuing new bonds and selling them to the public or to their central bank to acquire the necessary money. For the bonds to end up in the central bank, it must conduct an open market purchase. This action increases the monetary base through the money creation process.

This process of financing government spending is called monetizing the debt. Monetizing debt is thus a two-step process where the government issues debt to finance its spending and the central bank purchases the debt from the public. The public is left with an increased supply of base money.

If we go into another downturn, will the Fed use its hammer again and provide more liquidity by monetizing even greater quantities of government liabilities? We hope not. Debt deflation is a terrible thing, but hyperinflation is even worse. We must remain vigilant that central banks maintain their independence.

Do you see inflation or hyperinflation in our future?


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