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:
*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.
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
- A weak government, without the parliamentary majority and/or the ability to make and enforce changes in policy.
- Limited ability of the government to raise money through debt issues (either due to poor credit ratings or lack of lenders’ capital or both).
- The tax system is intractable, corrupt, or poorly policed.
- 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
- 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.
- 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.
- 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.
- 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).
- 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 beany 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
- The inflation rate begins to climb more than expected.
- 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.
- More frequently, the normal demands for government expenditure require a trip to the Reserve Bank.
- 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).
- 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.
- Inflation rises even further.
- 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.
The Key Points
- The episode can easily begin with a government policy that starts by being popular.
- 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
- 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).
- In particular, tax policy regime change has been awkward.
- The American Government has borrowed to previously unheard-of levels.
- 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.
- The country runs a massive fiscal deficit.
- 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
- The US dollar is the global currency of reserve. The world has a vested interested in not letting it go down.
- 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**.
** 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?
- 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.