Understanding Inflation and Hyperinflation–Part 1

Inflation is the economic tool of choice for overly indebted governments and their central banks to “extend” worldwide growth and “pretend” that the current global economic environment is sustainable. Hyperinflation occurs when a central bank’s efforts to prop up a currency run out of control. It is an extreme case of inflation and a nightmare for anyone living through it.

The world is drowning in too much debt. That fact is well documented. It is very unlikely that governments will be able to pay down that debt. Doing so in some cases is impossible – the level of debt is just too high (i.e. the United States), and in other cases it will condemn their citizens to many years of painful sacrifice to be debt free.

Inflation, by comparison, is perceived to be the easy way out by government policy makers. Companies and families usually deal with too much debt by defaulting and declaring bankruptcy, while sovereign nations overwhelmingly deal with debt by inflating it away.

That is the true power of a fiat currency. While debt is fixed, the value of a country’s currency is not. Fiat currency, such as the U.S. dollar, will increase and decrease (mostly decrease) in value over time. This decrease in the value of the currency makes that country’s debt burden smaller. Think of it this way – you borrow a dollar from a friend. By the time you pay your friend back that dollar has devalued to 80 cents – you’re ahead of the game. You got the full purchasing power of the dollar you borrowed, but you only had to pay back 80 cents. Pretty good deal huh! Our government does that to you and me every day.

Individuals or companies cannot devalue a currency or increase prices and through inflation, only governments can. And they have become extraordinarily good at it over the years. Inflation and currency debasement are not new. They have been used for the past few thousand years as means to get rid of debt. And in some cases, they work pretty well.

You don’t even have to go that far back to see how high inflation (hyperinflation) works at eliminating debt. Consider Brazil which is one of the world’s most recent examples of hyperinflation. In the late 1980s and 1990s, Brazil successfully inflated away most of its debt.

This is part of the standard inflation playbook. It has even been used successfully in the United States. You may remember that the United States had high inflation in the 1970s and then got a diligent central banker – Paul Volcker, who raised interest rates, produced strong real GDP growth, and set the stage for one of the greatest economic booms in our nations history.

In 1993, Brazilian rate of inflation was roughly 2,000 percent. Only four years later, in 1997 it was seven percent. Almost, as if by magic, the country’s debt disappeared. Today, Brazil has very little debt. Its economy is booming and the country is a success story.

Imagine if the United States increased its money supply, which is currently $960 billion, by a factor of 10,000 times, as Brazil did between 1991 and 1996. We would have more than nine quadrillion U.S. dollars in circulation. That is a lot of zeros. It would mean that our current debt of $14 trillion would be chump change.

You might assume that employing this strategy for getting rid of our debt would have consequences. What sane person would ever lend money to us again? But, think again. Investors 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.

Money printing and monetization of government debt are used when real growth fails. It has worked in countless emerging market economies (Zimbabwe, Ukraine, Tajikistan, Taiwan, Brazil, etc.). We could even use it in the United States to get rid of all our debts. It would take a few years, and it would destroy the accumulated wealth of millions of Americans, but it would eliminate our public debt burden.

After we inflate away our debts, in steps a savior, a new central banker like Paul Volcker to kill inflation. We could then become a success story like Brazil.

I am not recommending sustained inflation or hyperinflation as an economic policy tool. But now even serious economists are recommending inflation as a solution to our debt crisis. High, prolonged inflation would accomplish much of the governments goal of eliminating, or at least, gaining control of its debt. The powerful deflationary forces at work in the world today give Ben Bernanke and the Federal Reserve easy justification for their continued “quantitative easing”.

The International Monetary Fund’s top economist, Olivier Blanchard, has argued that central banks should target a higher inflation rate than they do today to avoid the possibility of deflation. Economists like Paul Krugman, a Nobel Prize winner, and Blanchard argue that central banks should raise their inflation targets to as high as four percent. Paul McCulley argues that central banks should be “responsibly irresponsible.” There are, however, problems with inflation as a policy tool.

An Inflation Tale

Nothing about the future is set in stone. Actions taken today do not inevitably lead to certain outcomes down the road, because something can happen tomorrow, or next week, or next year, that will negate what happened today. History seldom repeats itself – exactly. But this story about post-war Germany should make you take notice. The implications for our government’s monetization efforts are a little frightening.

At the beginning of World War I, Germany went off the gold standard. The government suspended the right of its citizens to redeem their currency (the mark) for gold and silver. That set the stage for massive currency inflation. The quantity of marks in circulation quadrupled during the war. Prices however did not keep up with the inflation of the currency supply. The effects of the currency inflation were not felt because the German people saved every penny they could lay their hands on, mainly out of fear and uncertainty. So even though the German government was pumping tons of currency into the system, no one was spending it.

But by the war’s end, confidence improved and the currency that had been hoarded by German citizens flooded into circulation creating price inflation.

Just before the end of the war, the exchange rate between gold and the German mark was about 100 marks per ounce. By 1920 the exchange rate was fluctuating between 1,000 and 2,000 marks per ounce – 10 to 20 times higher. Retail prices skyrocketed.

With war reparations to pay, the German government continued to print money at an astounding rate. In mid 1922 everything changed the economy began to collapse. The German people lost confidence in their currency. They realized if they hung onto their currency for any length of time they’d get burned – rising prices would wipe out their purchasing power.

To understand the scope of the German inflation maybe it’s best to start with something basic… like a loaf of bread. (To keep things simple we’ll substitute dollars and cents in place of marks and pfennigs.)  In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents.  Two years later it was 19 cents.  Two years more and it sold for 22 cents.  By 1919 it was 26 cents.  Now the fun begins.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35.  By the middle of 1922 it was $3.50.  At the start of 1923 it rocketed to $700 a loaf.  Five months later a loaf went for $1200.  By September it was $2 million.  A month later it was $670 million (wide spread rioting broke out).  The next month it hit $3 billion.  By mid month it was $100 billion.  Then it all collapsed.

Let’s go back to “marks.”  In 1913, the total currency of Germany was six billion marks.  In November of 1923 that loaf of bread we just talked about cost 428 billion marks.  A kilo of fresh butter cost 6000 billion marks. That kilo of butter cost 1000 times more than the entire money supply of the nation just 10 years earlier.

How Could This Happen? In 1913 Germany had a solid, prosperous, advanced culture.  Like much of Europe it was a monarchy (under the Kaiser).  Then, following the assassination of the Archduke Franz Ferdinand in Sarajevo in 1914, the world moved toward war.  Each side was convinced the other would not dare go to war.  So, in a global game of chicken they stumbled into the Great War.

The German General Staff thought the war would be short and sweet and that they could finance the costs with the post war reparations that they, as victors, would exact.  The war was long.  They lost and, thus, it was they who had to pay reparations rather than receive them.

When things began to disintegrate, no one dared to take away the punchbowl.  They feared shutting off the monetary heroin would lead to riots, civil war, and, worst of all communism.  So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.

People’s savings were suddenly worthless.  Pensions were meaningless.  If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months.  People demanded to be paid daily so they would not have their wages devalued by a few days passing.  Ultimately, they demanded their pay twice daily just to cover changes in trolley fare.  People heated their homes by burning money instead of coal.  (It was more plentiful and cheaper to get.)

The middle class was destroyed.  It was an age of renters, not of home ownership, so thousands became homeless.

But the cultural collapse may have had other more insidious effects.

It was still the era of arranged marriages.  Families scrimped and saved for years to build a dowry so that their daughter might marry well.  Suddenly, the dowry was worthless – wiped out.  And with it was gone all hope of marriage.  Girls who had stayed prim and proper awaiting some future Prince Charming now had no hope at all.  Social morality began to collapse.  The roar of the roaring twenties began to rumble.

Belief in systems, governmental or otherwise, collapsed.  With its culture and its economy disintegrating, Germany saw a fringe character named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting.  And then came World War II.

I’d like to close this review with a statement from a man whom many consider (probably incorrectly) the father of modern inflation.  John Maynard Keynes wasn’t writing about some abstract economic issue; he was talking about Germany as it was setting itself on a path of self-destruction. Here’s what Keynes said on the topic in 1919:

 

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.  By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.

“To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.

“Lenin was certainly right.  There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.

Can Hyperinflation Happen In the United States?

A true hyperinflation tale. Could this be what’s in store for us? The parallels are ominous.

On this day in 1922, the German Central Bank and the German Treasury took an inevitable step in a process which had begun with their previous effort to “jump start” a stagnant economy. Many months earlier they had decided that what was needed was easier money. Their initial efforts brought little response. So, using the governmental “more is better” theory they created more and more money.

But economic stagnation continued and so did the money growth. They kept making money more available. No reaction. Then, suddenly prices began to explode unbelievably, but perversely, not economic activity.

So, on this day government officials decided to bring the currency in line with market realities. They devalued the mark. The new value would be 2 billion marks to a dollar. At the start of World War I the exchange rate had been a mere 4.2 marks to the dollar. In simple terms you needed 4.2 marks in order to get one dollar. Now it was 2 billion marks to get one dollar. And thirteen months from this date (in late November 1923) you would need 4.2 trillion marks to get one dollar. In ten years the amount of money had increased a trillion fold.

Numbers like billions and trillions tend to numb the mind. They are too large to grasp in any real sense. A million dollars is enough to pay you $500 per week for 40 years without benefit of interest. To get a billion dollars you would have to set aside $500,000 dollars per week for 40 years. And a trillion would require $500 million every week for 40 years. Even with these examples, the enormity is difficult to grasp.

To understand the scope of the German inflation it’s best to start with something basic….like a loaf of bread. (To keep things simple we’ll substitute dollars and cents in place of marks and pfennigs.) In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents. Two years later it was 19 cents. Two years more and it sold for 22 cents. By 1919 it was 26 cents. Now the fun begins.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50. At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went for $1200. By September it was $2 million. A month later it was $670 million (wide spread rioting broke out). The next month it hit $3 billion. By mid month it was $100 billion. Then it all collapsed.

Let’s go back to “marks”. In 1913, the total currency of Germany was a grand total of 6 billion marks. In November of 1923 that loaf of bread we just talked about cost 428 billion marks. A kilo of fresh butter cost 6000 billion marks. As you will note that kilo of butter cost 1000 times more than the entire money supply of the nations just 10 years earlier.

How Could This All Happen? – In 1913 Germany had a solid, prosperous, advanced culture and population. Like much of Europe it was a monarchy (under the Kaiser). Then, following the assassination of the Archduke Franz Ferdinand in Sarajevo in 1914, the world moved toward war. Each side was convinced the other would not dare go to war. So, in a global game of chicken they stumbled into the Great War.

The German General Staff thought the war would be short and sweet and that they could finance the costs with the post war reparations that they, as victors, would exact. The war was long. The flower of their manhood was killed or injured. They lost and, thus, it was they who had to pay reparations rather than receive them.

Things did not go bad instantly. Yes, the deficit soared but much of it was borne by foreign and domestic bond buyers. As had been noted by scholars…..“The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits.” In layman’s English that means foreign bond buyers said – “Hey this is a great nation and this is probably just a speed bump in the economy.” (Can you imagine such a thing happening again?)

When things began to disintegrate, no one dared to take away the punchbowl. They feared shutting off the monetary heroin would lead to riots, civil war, and, worst of all communism. So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.

Currencies, Culture And Chaos – If it is difficult to grasp the enormity of the numbers in this tale of hyper-inflation, it is far more difficult to grasp how it destroyed a culture, a nation and, almost, the world.

People’s savings were suddenly worthless. Pensions were meaningless. If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months. People demanded to be paid daily so they would not have their wages devalued by a few days passing. Ultimately, they demanded their pay twice daily just to cover changes in trolley fare. People heated their homes by burning money instead of coal. It was more plentiful and cheaper to get.

The middle class was destroyed. It was an age of renters, not of home ownership, so thousands became homeless.

But the cultural collapse may have had other more pernicious effects.

Some sociologists note that it was still an era of arranged marriages. Families scrimped and saved for years to build a dowry so that their daughter might marry well. Suddenly, the dowry was worthless – wiped out. And with it was gone all hope of marriage. Girls who had stayed prim and proper awaiting some future Prince Charming now had no hope at all. Social morality began to collapse. The roar of the roaring twenties began to rumble.

All hope and belief in systems, governmental or otherwise, collapsed. With its culture and its economy disintegrating, Germany saw a guy named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting. And then came World War II.

We close with a statement from a man whom many consider the father of modern inflation, with his endorsement of deficit spending. Here’s what John Maynard Keynes said on the topic:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.
To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.
Lenin was certainly right. There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.