This article examines the respective risks of
deflation and hyperinflation. Although at first glance these two seem to
be at completely opposite ends of the monetary spectrum the article
explains how looming disaster brings them both within one false step of economic
management, and further explains how central bankers are eventually forced into
taking that step.
Here is a List of a few recent financial disasters - each beautifully contained by the central bankers:-
Long Term Capital Management
It takes deep pockets, great economic,
political and rhetorical skill, and lots of courage to face down these sorts of
[footnote]. Alan Greenspan was the man who managed it. He is
deservedly revered by other bankers who understand that
maintaining the international safety net is an extremely fine judgement, which,
as the table shows,
he has performed with great skill.
But it is very difficult for most of us to
understand exactly what Mr Greenspan is up to, why it is difficult, and where it
Inflation’s relationship to the supply of money
We mostly realise how an increasing supply of
money causes it to diminish in value and tends to produce rising prices. We are
also dimly aware that the relationship between issuing money and rising prices
feels linear, meaning that if governments issue 1% more money it will raise
prices by something like 1%.
This is a logical conclusion as long as money
remains the dominant medium of both storing and exchanging wealth. After all, if
there is a supply of 1% more money, and the same underlying things to buy with
it, then those things need to rise by 1% to use up the supply. Since there is no
evidence, and little likelihood, of our governments suddenly going completely
crazy and printing 1000 times the quantity of money that currently exists we
assume, because of approximate linearity, that there is little or no
risk of hyperinflation.
But one of the mysteries of historic
hyperinflations is that price rises massively outstrip the rate at which money
has been recently issued, which indicates the relationship between money
supply and inflation in some circumstances is not linear. We need to understand
how this happens if we are to appreciate latent hyperinflation risks.
Dollars are an attractive thing for people and businesses to own because they
tend to increase purchasing power, through the receipt of interest, just through
being deposited. Because dollars are attractive any loosely held ones get
snaffled up. Large numbers of people and businesses compete vigorously to win
loosely held dollars (the ones in the bank accounts of consumers) and as a
result dollars accumulate in lots of pockets. Wherever a dollar appears in
economic space there is a hungry accumulator of dollars somewhere nearby, and as long as we know
everyone is competing for them we are confident that our dollars will be able to
buy what we want.
A little high school
science provides an analogy. Suppose a dollar is a positively charged atom
existing in a world of negatively charged people. Like
static electricity the people attract the dollars.
At different times, depending upon the policy mix of central bankers, the
amount of positive electric charge on dollars - and hence their attractiveness -
varies. This is a consequence of governments being in control of money values,
as they are with all our central bank run currencies. If, like a large positive
charge, dollars store and gain lots of monetary value over time, then they
stick like glue in the pockets of their negatively charged owners. This sticky
money does not get spent, indeed the more rapidly it increases its purchasing
power the more sticky it becomes in pockets.
Overly sticky money diminishes economic activity and causes falling prices
and the phenomenon of deflation, because it profits people to put off their
spending for as long as possible.
Money created by central bank policy can be
injected into the economy to steadily reduce the positive charge on all dollars.
It achieves this by expanding the supply and decreasing the likelihood
of held money increasing its purchasing power through time, and this makes it
stick less in peoples’ pockets. By making it less sticky governments keep it circulating.
Supplying more money encourages people to spend
rather than save their money, and it stimulates economic activity.
It really is quite magical how this can work.
Governments can create economic activity at will simply by injecting new money
to weaken the glue which binds the already issued supply in peoples’ pockets.
But it operates a little like a drug. It is so easy and - while it behaves
linearly - appears to be so safe for such a long time that governments get to
rely on it as the trusted, and sometimes only mechanism necessary for economic
management. But underneath this process
can gradually approach a potential hyperinflation scenario. The electric
charge analogy can show us how.
As the tendency of money to increase in value merely through being held
diminishes towards zero its velocity around the economy increases because people
and businesses become ambivalent about holding and depositing cash. Like atoms
with no charge these dollars are not attractive, so they don’t settle on people.
At this stage economic activity - which is measured by the rate at which these
dollars are flying around - looks magnificent, but little of it is meaningful or
productive. What is happening is that because money has become a poor store of
value it encourages savers to trade into other assets. This is not consumption,
it is financial trading, or the acquisition of things with the intention to
secure wealth and make profits, and it draws attention to a currency which is
starting to lose its favoured status as a store of value.
Financial trading is not supposed to be included in measurements of
economic activity, but of course it often is. Unfortunately there is no handy
statistic to prove it, so we must guess at what sort of other things we would
see if this was what was happening.
Presumably we should
expect to see pleasantly large economic activity statistics, yet rather poor
corporate profits (unless of course they were fabricated by imaginative
bookkeeping). We should also see very poor savings aggregates across the
population and a tendency to accumulate debt as people started to believe that
borrowings will inflate out of existence. We should also see rising prices in
- like housing - representing the fall of money’s perceived value against those
alternative stores of wealth, and maybe even a boom in stock prices without an
underlying boom in profitability - so yields would disappear. We might even see people scratching their
heads about why a recovery was producing few jobs.
Redressing negative savings returns
If money becomes more likely to lose than gain value it is as if its charge
has switched, from positive to negative. Net of the benefits and
costs of holding money (e.g. interest, tax and anticipated inflation) money
is suddenly expected to return a lower purchasing power in the future than it
This happens from time to time without producing a disaster. The reason
is that depositors expect a negative net return on cash to precede an
imminent increase in interest rates. And this is what ordinarily happens, as
cheap money encourages spending and heats up the economy, which is soon cooled by a dose of higher rates
which suits the savers.
This hope will encourage savers that
the negative real return on their deposited cash is only temporary.
But there is a catch. The raising of rates can only be done when there is no risk of it causing
debt servicing problems for large numbers of borrowers. Otherwise different
risks arise. If, for example, after a long borrowing binge corporate debt is
high, public debt is high, and consumer debt is high, the increase of rates
(strengthening the monetary glue which keeps money in people’s pockets) and the
economic slowdown they should cause, now risks producing unserviceable debt and
large scale default. These can destroy savings as dramatically as
hyperinflation, only through its ugly sister deflation.
So Mr Greenspan, who has safely fought
inflation while debt was under control, now, with private, corporate and public
debt all at record levels, has to fight both hyperinflation and
deflation risks at the same time. Increasing interest rates will risk deflation. So to prevent a deflation he has to hold
rates low for long enough to allow a demand led recovery and an increase in
general financial strength. Only then can rates rise.
The negative return on cash is now likely to get worse before it gets better,
as real inflation (and taxes) outstrip any modest interest rate rises,
so the time has come to switch into assets
which will hold or accumulate purchasing power with greater reliability. Dollars
have become repellent. They are no longer the natural way of storing
value, and this has broken one of the key conditions which is required to keep a linear
relationship between money supply and inflation.
Negligible saving, increasing indebtedness, low interest rates, exploding asset
prices and weak economies all provide warnings of what is about to happen.
The chasm and the precipice on Mt Utopia
Alan Greenspan is tasked with guiding a weak climber - the ever-expanding currency
system - to the peak of Mt Economic Utopia.
To the left is the chasm of hyperinflation and to the right the precipice of
deflation, and the path narrows as it rises up to the distant summit.
On the lower sections of the mountain path it is wide enough to let our
guides turn us round. But the closer we get to the summit the more everyone
believes it is achievable. Mountaineers suffer the same problem.
They call it "Summit fever" and it claims far more lives than bad luck ever
did, by corrupting the powers of good judgement.
It takes a lot to turn one person away from a summit. Turning round a
happy crowd is quite impossible. They would rather believe the optimism of
the guides who talk of spectacular rates of ‘sustainable
growth’. They prefer government statisticians who add mandated public sector
expenditure into economic growth figures, and they listen to commentators who refer to ‘Goldilocks
economies’ and ‘productivity miracles’. So they buy more sports utility
vehicles on borrowed money and re-finance their houses.
Yet domestic economic
activity has no real growth, and high imports cause huge trade deficits. Savings rates diminish, financial instrument yields
evaporate, governments borrow and spend and call it ‘investment’, corporations report profits which have
nothing to do with earned cash, financial trickery permeates all levels of
society and credit is offered to an ever increasing set of less well qualified
borrowers, whether sovereign states, companies or individuals.
The majority cannot see these signs for what they are. Only a few miserable
realists look around and, seeing the dangers on both sides, turn back on their
own and face the cheerful smiles of those who continue on up.
It’s a long lonely walk down and there’ll be no-one waiting at the bottom to
cheer your safe return.