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Bernholz, Monetary Regimes and Inflation, 5 [ClearOnMoney]
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Commentary

Bernholz, Monetary Regimes and Inflation, 5

23 Jul 2010 by Jim Fickett.

Hyperinflations are caused by excessive budget deficits – there is no other conclusion possible in light of the historical record. A fundamental feature of hyperinflations is that other, good currencies are overvalued, relative to prices, and the real value of all money in circulation goes almost to zero, compared to its value before the inflation. This means much of commerce is based on barter and, though pushed underground by extreme penalties, the use of foreign currencies or precious metals. There are ways, if one is prepared, to survive even hyperinflations.

Chapter 5 is quietly titled, “Characteristics of hyperinflations”. The dispassionate tone made it, for me, that much more horrifying to read. The chapter is almost as long as the previous four put together and is, in some sense, the culmination of the book (though there is much more to come).

The style chosen is an interesting one. Bernholz does not comment directly on the suffering involved. Rather, he writes carefully and objectively about quantitative traits of hyperinflations, but intersperses his writing with quotes from other authors that illustrate the ruin. So he keeps his academic tone, while at the same time showing us just how difficult the experience can be. The cumulative effect of the many quotes make a very strong impression.

In earlier chapters Bernholz has shown that as inflation rises, and people want to be rid of money that will soon lose its value, exchange rates react more quickly and steeply than prices. In hyperinflations this trend goes to extremes: people want to hold anything else of value in preference to money that is losing its value daily, and so the real value of all the money in circulation, measured, say, in gold, falls to near zero. People are reduced to barter or, if at all possible, to using another currency.

Of course the government is desperate to prevent the use of another currency, so extreme penalties are imposed (20 years in chains for the second offense, during the French hyperinflation). Yet indirect evidence suggests that in most cases other currencies are used despite the penalties, and increasingly so as the inflation worsens.

An obvious question is how hyperinflations arise. Bernholz shows that extreme budget deficits (typically at least 40% of expenditures, or 30% of GDP, but sometimes much worse) are always associated with hyperinflations and, though there is a vicious circle, with inflation and deficit each making the other worse, the budget deficits always come first. He thus concludes – and it is very hard to argue with the historical evidence – that excessive budget deficits are the cause.

There is a lesson in this point for our own times. Many have argued that since it is not a rational strategy for the government to try to reduce its debt through inflation, inflation cannot be a serious danger. The historical record says otherwise. First the politics lead to excessive spending and then, when borrowing cannot fill the gap, money printing is used as the only way to fund current spending. In other words, the great danger is not a thought-out strategy to devalue debt, but rather the temptation, on the part of politicians, to spend more in order to buy votes. That temptation is always with us, so never say never.

Bernholz goes very briefly into the political side. The treatment is not very complete and no details are given, but he asserts that there are three scenarios for the political situation to get out of hand:

  • War, civil war, or the breakdown of a regime (e.g. French revolution)
  • A populist push for easy prosperity, which then becomes addictive (Berhnolz does not offer an example; current Venezuela comes to mind)
  • A government dependent on foreign funding finds that funding cut off

It is this last category that comes closest to our own situation. Although Bernholz has in mind actual transfers, not borrowing, the fact that the US dollar is the world's primary reserve currency means that our foreign borrowing has very low current cost, and acts almost like a transfer. The most realistic scenario for serious inflation in the US would be a sudden loss of confidence in the dollar, which would in turn raise borrowing rates so high that the deficit could no longer be funded in the usual way.

The extreme events of the last three years have led to some speculation that we will face anything from high inflation to the breakdown of society. I think it is a mistake to either (1) engage in such speculation without some real evidence and objective thinking, or (2) dismiss such ideas out of hand, as impossible. At some point I hope to write a bit about what kinds of unpleasant scenarios might actually be worth hedging for.

In the meantime, if you do think hyperinflation could happen at some point in the US, this chapter has some lessons on how you might get through it.

  • Most investments lose most of their value; the wealthy usually lose almost everything; forget about anything like normal investing strategies
  • Food takes a central role in the barter system; if you really think hyperinflation is coming, maybe you should buy a farm and hire the help to run it
  • Good information is central; inflation proceeds in fits and starts, and no one knows how to set prices rationally; staying on top of what is really happening is key
  • Exchange rates go to extremes, and good money from outside may buy 100 times what it normally would; if you have assets outside the country and a foreign partner, you might make out very well
  • Inflation wipes out debt; don't own bonds, and buy that farm with the smallest down payment you can manage
  • Price controls are prevalent – be a renter, not a landlord

I'll close, as does the chapter, on the only silver lining for such a disaster:

Just because of the unexpected event that money, which had formerly been the most stable object, lost its value day by day, men estimated more highly the real values of life - work, love, friendship, art and nature. The whole people lived more intensively than before in the midst of the catastrophe. Boys and girls hiked in the mountains and came back burned by the sun; restaurants with dancing music operated until late into the night; new firms and shops were founded; I myself believe I have never lived and worked more intensively than during these years … We have never the loved the arts more in Austria than during those chaotic years just because we felt that only the eternal within us remained as the really stable in view of the betrayal on the part of money. (Stefan Zweig)

Previous chapter reviews

Bernholz, Monetary Regimes and Inflation, 1: This post is a review of the first chapter of Monetary Regimes and Inflation, by Peter Bernholz. Already in this first, introductory chapter it is clear that all material will be treated in an insightful manner and illustrated from the author's broad knowledge of history.

Bernholz, Monetary Regimes and Inflation, 2: The main message of Chapter 2 is that governments have a natural tendency to deficit spending and inflation, and inflation is only absent if somehow the hands of the leaders are bound. This happens most dependably with a gold standard, but an independent central bank, or a fixed exchange rate with another stable currency, can also help.

Bernholz, Monetary Regimes and Inflation, 3: Inflation can occur even under a precious metal standard, either by influx of more of the metal from abroad or, more usually, by debasement of the currency. Debasement has been accompanied, for thousands of years, by price and exchange controls. These never prevent inflation and hoarding, but do cause market disruption and considerable suffering. A precious metal standard can be introduced, and maintained for long periods, if it is in the economic interest of a government. The merchant city-states of Venice and Florence provide an example.

Bernholz, Monetary Regimes and Inflation, 4: There are several features typical of most moderate inflations. For example (1) the money supply typically rises earlier and faster then the price of better money, which rises earlier and faster than the prices of goods and services. And (2) because the money supply rises before unit values decrease, an economic stimulus is often an early effect.