America's Hyperinflation

This is my 100th post.

It's only appropriate that I write something a little controversial.

Recently, I had the opportunity to meet a very successful (but discreet) wealth manager. He asked for my prediction of what would happen in the next five years (I think it was a test). My answer was "America will hyperinflate". Firstly, I think I may have failed that particular test. But secondly, I think that there is an argument to be made here.

Because when I got home later, I pulled a Google search on "America's Hyperinflation", and what I got was a string of articles on Forbes and Business Insider and a couple of other less name-droppable sites, all portending the swan-song of the Fat Lady in the spangly dress.

And for the record, this would not be her first hyperinflation swan-song. After both the War of Independence and the American Civil war, the USA (or, at least, some of her states) went through a period of hyperinflation. It may not have been hyperinflation by the conventional quantitative definition*, but it was hyperinflation nonetheless. Because the difference between inflation and hyperinflation is more ideological that quantitative:

Inflation is a rise in prices. Hyperinflation is the loss of faith in a particular currency as a medium of exchange, as expressed by excessive rates of inflation.

The question then is: how does a citizenry lose faith in their currency?

The Common Factors 

1. A weak government, without the parliamentary majority and/or the ability to make and enforce changes in policy.
2. Limited ability of the government to raise money through debt issues (either due to poor credit ratings or lack of lenders' capital or both).
3. The tax system is intractable, corrupt, or poorly policed.
4. The government is running a large fiscal deficit (they're spending more than they bring in)

What these factors essentially mean is that the government's finances are stretched. Not that they are bankrupt or insolvent - just that they walk a financial tight line. In the same way that your Macdonald's burger flipper has a budget plan down to the last cent, with a maxed credit card and a double mortgage on his mother's apartment. No room for luxuries there.

This leaves the economy vulnerable to "fiscal shocks".

The Steps Toward Hyperinflation

1. A "fiscal shock" takes place. This is unplanned and unbudgeted-for expenditure. So, for example, a terrorist attack sends the country on a campaign of retribution. Or a sudden increase in the oil price requires government intervention in the form of subsidies to smooth out the impact on voters. 
2. This expenditure needs to be financed. Owing to factors outside of the country's control (such as a lack of global liquidity due to a global slowdown), the government is unable to borrow money to finance the expenditure. And because of the nature of its tax laws and the lack of a solid parliamentary authority to change them quickly, the tax base cannot be expanded to carry the short-term deficit.
3. The government authorities then approach the Reserve Bank, and request that they, as the monetary authorities, lend them the money. They are, after all, the lender of last resort.
4. The government authorities get their money, in the form of freshly-typed balances in their bank accounts (most people assume that money creation is a notes and coins thing - it isn't: today, most money creation is electronic).
5. The money enters the economy, and you have the standard story of more cash chasing the same amount of goods, demand and supply forces play out, and you have a rise in the general level of prices.

At this point, everything still seems a bit manageable. It's just one fiscal shock. The solution was only temporary. And if anything, the sudden flush of liquidity has caused some expansion in the target industries (in the examples given, weapon manufacturers and oil importers), a nice ripple effect, and everyone feels a little prosperous. 

But there are some issues still at play that may not have played out yet:

• Generally, taxes are based on the returns earned in the past year. If inflation has played its role, by the time tax season arrives, the taxes collected have had their real value eroded. So the economy at large has experienced a lessening in its tax burden - which turns out to be even more stimulative. But for the government, its tax revenues have worsened - so its fiscal deficit is growing (after all, its expenses are keeping line with inflation - where its tax revenues are falling behind).
• Fiscal shocks financed by quantitative easing are not generally looked upon with favour by lenders. It's unlikely that there will be any more freedom with the debt.
• We have assumed that the fiscal shock has been a once-off anomaly. This is rarely the case - wars, for example, can't be paid for as an upfront package. Neither can oil subsidies.

So the conclusion of the fiscal shock episode is that the government is, if anything, worse off than before. And they're now even more vulnerable to fiscal shocks.

Then the inevitable happens: another fiscal shock occurs. But the status quo has not, because the government is weak and divided and unable to enact pre-emptive economic safeguards to change it. So the process repeats itself.

When Fiscal Shocks Happen Too Close Together

1. The inflation rate begins to climb more than expected.
2. The government's finances are further strained with the rise of inflation: tax revenues are falling (as their historical base loses value with inflation), and debt costs now incorporate a premium for expected inflation, making borrowing more expensive.
3. More frequently, the normal demands for government expenditure require a trip to the Reserve Bank. 
4. People begin to suspect that the government is adopting Reserve Bank borrowing (money creation) as a fiscal policy, and begin moving their cash balances into real assets (the loss of faith in the currency).
5. At the same time, holders of real assets start to increase their selling prices in anticipation of replacement cost, in an attempt to pre-empt the inflationary erosion on the cash received.
6. Inflation rises even further.
7. As the effect snow-balls, investors begin to take out bets against the currency (for example, leveraging their positions in the inflating currency). There is now a growing vested interest in the inflation.
8. Hyperinflation.

The Key Points

1. The episode can easily begin with a government policy that starts by being popular.
2. Hyperinflation becomes inevitable when the general population starts trying to reduce cash balances (which is not to say "physical bank notes" so much as "the money in bank accounts").

So now, the question is, what about America?

The Points in Favour of Hyperinflation

1. The US Government is split down bipartisan lines. There has been no real agreement between the Democrats and the Republicans on fiscal policy even when the times have been desperate (for example - the debt ceiling debacle).
2. In particular, tax policy regime change has been awkward.
3. The American Government has borrowed to previously unheard-of levels.
4. Its fiscal spending plans are set to increase exponentially over the next few years - particularly the programs that cater to the elderly and the sick (who are mostly elderly) as the population ages. 
5. The country runs a massive fiscal deficit.
6. Americans have a superhero mentality that likes to get involved in all things nuclear and bugger the economic consequences. A North Korea or an Iran could very easily become another Afghanistan or another Iraq or another Vietnam or another Gulf war.

The Points in America's Favour

1. The US dollar is the global currency of reserve. The world has a vested interested in not letting it go down.
2. When America's sovereign rating was cut, yields on its debt went down. That's not expected - and makes America almost Giffen-like in its economic authority**.
3. If the fiscal shock did come from a war-type scenario, Americans have a history of uniting behind a president/government, regardless of political party affiliation (after all, they voted Bush Jr. in for a second term).

So to sum up: do I honestly think that the US dollar will be debased? 

Look - I don't think that it would happen deliberately. But I do think that countries do strange things in a "Time of War". And the current economic position of the USA does not have a historical precedent. 

The trouble is that crisis economics is not the same as normal economics. When crisis hits, people panic, and there's fear and adrenalin and all manner of instinctive responses. What happens if there's a sudden crisis?

All the risk factors are in play. And it could all go very stupidly wrong.

* The conventional quantitative definition of hyperinflation comes from Phillip Cagan's academic paper in 1956: summarised as "hyperinflation occurs when inflation rates rise above 50% for more than a month". But the definition is arbitrary - and what it really did was allow Mr Cagan to limit his field of study to the seven hyperinflations that followed the World Wars. So actually, that definition looks less arbitrary and more like a convenience that limited his work load. Why we stick to it now is, I guess, economic hubris.


** A Giffen good experiences higher demand when its price increases. For example, amongst the poor, a rise in the price of bread will often cause an increase in demand for it - people need bread, and if it goes up in price, the reaction is to cut back spending on other foods and buy more bread. Maybe the American dollar, as the world's reserve currency, will have higher demand as it devalues - because of the implications that the debasement will have on the rest of the world's economy?

Inflation: Yes, It's a Tax

Recently, I was reading an article in the Economist about the potential danger of imminent inflation in the USA. And it occurred to me that, for most people, inflation (the general rise in prices) is just something that happens. It's something that trade unions dislike, and politicians worry about. It also has something to do with the Reserve Bank and interest rates. But it's a bad thing.

And it can be a very bad thing indeed, because inflation can be used as a tool. In the past, inflation has been used to keep countries in a state of civil collapse. The worst inflation on record (in Hungary after World War II) was forced upon the Hungarian people by the Soviets (at least, according to a number of economic scholars). Lenin talked about debasing the currency as being the easiest way to overthrow a regime. And the worst part is that inflation inevitably runs out of control, once people start to expect it. The real question: how is inflation generated to those levels that it brings a country to a state of collapse? 

If we're going to ask that question, we should probably back-track and ask "What causes inflation?" Any good economics student should tell you that it happens in one of two ways:

1. Manufacturers have to spend more to produce their goods (say, for example, the oil price goes up - well that increases the cost of manufacturing and distribution across the board); or
2. People want to buy more goods (ie. they wish to spend more).

Generally, inflation-targeting Reserve Banks try to control the second one (they can hardly influence the oil price), and they attempt to do so with interest rates - incentivising people to save with higher interest rates (thereby lowering their demand, and slowing the price rise), or incentivising people to borrow with lower interest rates (thereby increasing investment and economic growth). 

A crucial assumption underlies this process: a consistent and predictable money supply. And that makes sense, because generally, only Reserve Banks are able to print money (they are the "Monetary Authorities") - and they are reasonably independent of the "Fiscal Authorities" (being the government).

Two key definitions then:

1. Monetary Policy: refers to the Reserve Bank's decisions around interest rates (they have the power to set a base interest rate), money supply (they have the power to print money) and exchange rates (they are the central repository of foreign reserves - or money denominated in foreign currency).
2. Fiscal Policy: refers to the Government's decisions around the Budget. That is, what they are going to spend money on, and where they are going to get the money to finance their spending.

What does this have to do with tax?

The "Fiscal Authorities" (the government) safeguard the public good: spending money on defence and national health and schooling and so on. But all this spending needs to be financed somehow - just as I need a job in order to pay my rent. Governments have some choices:

1. Collect taxes (the equivalent of earning a salary - that is, being paid by the public for the service it provides)
2. Borrow (obviously - the equivalent of taking out a loan or buying on credit)
3. Print money (or, more accurately, get the Reserve Bank to print the money)

For number 3, there is no real individual equivalent - I do not have the option of creating money out of nothing. But the monetary authorities are the virtual orchard of money-producing trees. And when the fiscal authorities can't collect taxes properly, or collect enough taxes, and they've run up their debt to the point where they can't borrow any more, compelling the monetary authorities to "create" money begins to look like an attractive option. 

And what happens when you suddenly start creating money? Well, the government spending ripples the new money into the rest of the economy, and more money means that people want to spend more. You have people with the ability to buy more, without a change in what's available to buy. So it's a seller's market, and they put up their prices: inflation.

Which indirectly begins to work like a tax. If you have money in the bank - you may have the same physical amount; but in real terms, you can't buy what you used to. Effectively, your spending power is confiscated and used to fund government spending. Now that's quite handy - rather than having collection agencies, the government can just suspend the independence of the Reserve Bank, and tax everyone immediately by pressing "print" on the presses.

And contrary to popular belief, we're not talking about coins and notes. No - the majority of money creation (these days) is electronic. In effect, you delete the old account balance in the bank records, and type in a new one - only limited by the number of zeros you can type. 

Right now, it's all sounding very efficient. Sod a collection agency. But if you take the process a couple of steps further, what generally happens is:

1. Because people are people, we like to pay as little tax as possible. 
2. And because inflation only affects cash, people attempt to hold as little cash as possible, investing in "real assets" (property, cars, shares on the stock exchange, foreign currency, non-perishables/commodities, etc).
3. Sellers, expecting inflation because of the current monetary policy, increase prices again to compensate for future inflation (in economic terms, this is referred to as "adaptive expectations").
4. Some take the tax avoidance a step further, realising that if they buy real assets with borrowed money, inflation will erode the real value of their debt - and they will, in effect, be taxing their lender.
5. Generally, those in 4 are the wealthy - because they have physical property to stand collateral for their borrowings.
6. The increased demand for real assets drives prices up further.
7. The increased inflation drives up the adapted expectations of sellers, who push prices up still further.
8. Inflation gains its own momentum, and begins to spiral out of control (it's around this time that we start calling it hyperinflation).
9. Civil collapse as everyone panics and no one wants to hold cash.

But the inflation has some interesting implications - particularly given the state of the First World today:

1. As money loses its value, so does anything that has a fixed monetary value.
2. Government Debt has a fixed monetary value. 
3. As time goes on, Government Debt is eroded.

To use an example: let's say that the price of a loaf of bread is $1, and I have a loan from the bank of $10,000. Inflation drives the price of bread up to $100 (and this is not as drastic as it sounds - it was exponentially worse in the recent Zimbabwean Hyperinflation). Initially, I owed the bank 10,000 loaves of bread (in real terms). Post inflation, I owe them 100 loaves. Sure - I pay more for bread - but my salary would also have to increase in response to inflation while my debt remains unchanged.

So, in conclusion, who wins with inflation:

1. The Government - its domestic borrowings are eroded, and it has an efficient taxation system to fund its spending.
2. The Rich - who can borrow and hedge against inflation, as well as profit off it.
3. Borrowers - whose debts are eroded by inflation
4. Manufacturers - who have their largest investments in stock and machinery

And who loses:

1. The Government - as actual taxes are paid in arrears, inflation erodes the real value of taxes. Eventually, the Government loses all sources of revenue other than money creation.
2. The poor - who cannot borrow and therefore cannot hedge themselves against inflation.
3. Pensioners - who collect fixed pensions, which are then eroded by inflation.
4. Savers - whose bank balances are eroded by inflation.
5. Wage-earners - because wage adjustments tend to lag behind inflation, like a dog chasing its tail.

Effectively, inflation becomes a tax on the poor, the working middle class, the elderly and the financially conservative. 

And what drives this type of inflation? Money creation. Or, in journalistic terms, when Reserve Banks engage in quasi-fiscal activities and/or "quantitative easing".

So when American Economists start to argue that a short burst of inflation might be good for their economy - it's all a bit concerning.