Saturday, February 12, 2011

What in the heck is hyperinflation, really?

Lots of pundits in the economic news talk about hyperinflation but few take the time to discuss what the term actually means.  Unfortunately, I believe many of them have no clue what hyperinflation really is.  In this post I will break it down into terms that are both accurate and simple.

Before delving into hyperinflation, please take a second to review what inflation actually is.  Rising prices is not inflation although it is often a symptom of inflation.  If you live on a small island and all the land becomes developed then you have to expect the prices of real estate to rise simply because land has become scarce.  Is this inflation?  Of course not.  It’s supply and demand, one of the most basic economic principles.  Value derives from scarcity and so when things we want become scarce we have to pay more for them.  Thus, rising prices is not inflation.

Inflation is actually an increase in the money supply relative to the stuff for sale in the economy.  The money supply consists of the monetary base (the money created by the Federal Reserve) PLUS the true value of all debt in the economy at any given time.  Note that inflation can cause prices to rise and in the long run it generally has that effect.

So from this explanation it logically follows that hyperinflation is caused by government printing up money and taking on debt at a really, really rapid pace, right?  As it turns out, no, this is not right even though this is the context in which most economic writers tend to discuss hyperinflation. 

During hyperinflation, the value (the buying power) of the money falls at a breathtaking rate.  In extreme examples, the buying power of the currency can reach zero.  If there was really a mathematical relationship between hyperinflation and the increase in the money supply then it would take an infinite increase in money supply in order for the currency to go to zero.  Of course it is impossible to print and borrow to infinity so the math clearly shows that the direct link is not there.

So if increasing the money supply is not the direct cause of hyperinflation then what is?  Well, the first thing people have to stop and realize is that our money has no intrinsic value.  I didn’t say it has no value, only that the value isn’t intrinsic.  The value is only what people believe it to be.  Our money lost all intrinsic value when Nixon closed the gold window in 1971.  Before that time it was possible to convert dollars into gold bullion at the rate of $35/Troy oz.  After that time you could bring 20 truckloads of $100 bills to the government and you would not get one single speck of gold from them in return.  That lack of convertibility made the money intrinsically worthless overnight even if most of the people haven’t figured it out yet and thus continue to behave as if the money has value.  Since that time, money only has the value that people perceive it to have.  If ever there comes a day that people perceive that the money has no value then it will indeed have no value.

Hyperinflation is the process by which people begin to wake up to the fact that the money has no value.  Hyperinflation occurs when people realize en masse that they are being conned and as a result they begin requiring a lot more of the currency in exchange for their goods and services.  In extreme cases, such as Zimbabwe and Weimar Germany after WW1, people become so aware of the scam that they stopped accepting the money at all.

Again, the money never had any intrinsic value if it wasn’t convertible by the issuing authority into something of value upon being presented with demand to do so by those holding the currency.  The fact that people treat such money as if it had value doesn’t change the fact.  People traded Enron shares and smiled at their Madoff account statements as if they had value well past the point that they in fact had no real value but that blissful ignorance didn’t change the fact that they really had no value.  Hyperinflation is, at the end of the day, nothing more than a partial or complete loss of confidence in the currency which, in extreme cases, causes it to trade at its intrinsic value of zero.  Yes, it is generally caused by abuses performed by the authority issuing the currency but it could happen for a variety of reasons not related to massive new printing.  For example if a government were to default on its debt promises then it would cause a big loss of confidence in that government and in the money it controlled.  That would certainly lead to a bout of hyperinflation like it recently did in Iceland.

Perhaps a short story will help communicate this fact.

Let’s say a criminal owns a big casino.  The first thing he does is go out and buy a bunch of colored plastic chips so that people can buy them and then use them to play at the gaming tables.  People are willing to do this because those are the owner’s rules – he does not accept real money at his tables – only the plastic chips provided by the house.  People are told that if they are ever tired of playing they can cash out and get dollars back.  The fact that those chips are supposed to be backed by dollars gives them confidence to use the chips in the first place.  In other words, the chips are convertible into dollars when players demand that the issuing authority -the casino owner- do so.

Now, this particular casino is so massive that people never need to leave.  They have a room there, eat at restaurants there, buy clothing, get married and have kids there.  They even work there.  Because of this they live their whole lives in the casino. 

But over time the casino owner, a notorious criminal, steals all of the money that players had used to buy chips with over time.  Of course, he doesn’t tell the players this and they continue living and playing blissfully with the casino chips.  Of course, if they ever try to cash out then they would find out that the chips had become worthless because there is no longer any money available to buy them back.  Even though the chips are actually worthless, they are still traded within the casino for room and board, clothing at the shops, etc.  People haven’t tried to cash out and are thus clueless about the loss of convertibility of the chips into dollars.

Whenever the owner shows up and wants to buy clothing or to eat, he simply manufactures more chips and spends them on what he wants.  He wants to be popular and he also wants to keep people in the casino so he is well known for buying meals (he is particularly fond of the pork dinner) and round after round of drinks at the bar.  Everyone looks up to him and respects him because he is so generous.  Of course it’s easy to be generous when you don’t have to work for your money but the real reason for the owner's generosity is so that people hang around hoping to get something for nothing.

This goes on for many years.  As the owner continues to print more chips, things begin to cost more chips in the casino thanks to the magic of inflation - the number of chips floating around the casino increases relative to the amount of goods and services to buy.  Over time, rooms go from 10 chips per night to 20.  A meal goes from 2 chips to 4 and so on.  But it happens slowly over time and while this is happening a day’s wage goes up from 40 to 80 chips so people still retain much of their buying power even though prices are going up.  Because of this, nobody complains about rising prices.

Once in awhile, someone tries to leave the casino.  He/she is tired of the same old thing, tired of living under someone else’s house rules, and tired of seeing the casino owner have unlimited spending power without doing any work.  It is clear that something is badly amiss.  So the person goes up to the cashier with a bucket of chips saying “cash me out”.  Of course there is no cash and so casino security takes the person out back, administers a good beating and threatens a short and painful life if anyone else is told about the incident.

Over time, more and more people leave and they get the same treatment.  Eventually, some of the people decide not to be intimidated and they begin talking about what they know and word begins to filter its way back into the casino.  At first, the people in the casino -especially the long term residents- laugh it off.  The owner is too generous and too nice a guy to ever do anything like what the “conspiracy nut jobs” accuse him of.  And that bit about the casino being broke is so ridiculous!   HA! HA! HA!  After all, look at all of the well dressed, well fed people running around the casino!  Ain’t no poverty here!  Of course what the people don’t know is that the casino owner has been borrowing food and clothing from other trusting souls in the outside world and selling these things within the casino at a significant discount.  Those loaning the goods assume that they will be repaid some day because they look at all the activity going on in the casino and assume it means the casino owner is making a bundle.  Of course, if they had any brains they would realize that if the casino owner was rich he would have no need to borrow from others to keep those in the casino fed and clothed…

Eventually, however, the evidence about the bankruptcy of the casino builds.  One day, several concerned casino patrons decide to test the system once and for all.  They get together as a group and approach the cashier cage with their chips, all demanding to cash out at once.  The owner sends security (who have recently adopted uniforms reminiscent of jackbooted fascist regimes of the past) but the dissenting group is too big to take down.  The resulting commotion causes a scene and, within a very short span of time, everyone gains awareness that the casino in fact does not have any money to back the supposed value of the chips. 

Over the coming days and weeks people begin trying to exchange their chips for something of value because they have lost confidence in the value of the chips.  At some point there are so many people bidding up prices of food, suits, hotel rooms, etc. that the prices skyrocket due to the sudden demand.  It’s not that people suddenly needed more food or clothing but rather that they wanted to exchange the chips which they realized to be valueless for something of real value.  In other words, they begin to hoard stuff very rapidly.

Finally the day comes when people simply stop accepting chips in trade for anything.  At this point everyone has come to the realization that they have been conned and there are no more suckers willing to take worthless chips in return for food and clothing or other things of real value.  The chips are just cheap plastic and the casino owner has stolen all the money that was supposed to be backing them.  Despite the fact that people have been trading chips for years and years within the casino, their buying power has gone to zero in very short matter of time.

That, my friends, is the truth about hyperinflation and now you know why the government kept filling the media with requests for everyone to "have confidence" during the first wave of the financial melt down that ended in March 2009.  Without confidence the system will collapse because any confidence game needs the patsies to be confident for it to work.  This is also why nobody can predict when hyperinflation will arrive;  the mood of the people is a difficult thing to predict.  The only thing that is fairly predictable is that you can't fool all the people all the time and at some point you can't fool any of the people any of the time.  Given the rate at which people are waking up, that day will likely come in the next decade and perhaps a lot sooner.  The point of mass awareness is always sped up by government's demonstrated lack of ability to fulfill its promises.  Lots of promises have been made to retiring boomers that cannot be fulfilled and so that is the most likely trigger for the mass awakening IMO.
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