Hyperinflation FAQ

by: Vincent Cate

It is difficult to say exactly when hyperinflation will hit a currency. However, I am convinced that the danger level is so high for most fiat money that it is worthwhile for everyone to increase their understanding of hyperinflation. This is the first part of a Hyperinflation FAQ for frequently asked questions or objections about hyperinflation. The statements or questions below are in bold and my responses follow.

How is hyperinflation defined?

The International Accounting Standard of IAS 29 says there is hyperinflation when "the cumulative inflation rate over three years approaches, or exceeds, 100%."This works out to 26% per year. There are many other definitions for hyperinflation but they almost all have something like "inflation over X per year" or "inflation over Y per month". People pick some level of price inflation as the cutoff between regular inflation and hyperinflation. It is just the values for X or Y that differ. Note that hyperinflation is not defined in terms of the money supply alone, since the velocity of money and GNP are also key factors in the price level during hyperinflation. Hyperinflation is a process, a positive feedback loop, that once entered is very hard to get out of. This process can go on for years.

Is there a real chance the US dollar could get hyperinflation?

Hyperinflation happens when government debt is over 80% of GNP and the deficit is over 40% of government spending. The US is at or near these numbers, so the danger of hyperinflation is real. What happens is that the more the central bank prints money and buys bonds the less other people want to hold bonds. But the less other people hold bonds, the more the central bank has to buy them so the government has enough money to spend. You get a positive feedback loop or death spiral.

The government or central bank would never decide to have hyperinflation.

In over 100 cases of hyperinflation I don't believe there has ever been a single "decision to have hyperinflation". Hyperinflation is when things get out of control. It is not something central banks or government voted on. No group in government or a central bank has had a show of hands like "all in favor of hyperinflation raise your hands". Not the way hyperinflation happens. Hyperinflation is a market response to government debt over 80% of GNP and deficit over 40% of spending when the central bank starts printing money and buying up government debt. Everyone thinks they just need to print a bit more money to make it through the next week or month and there is nothing else they can do since the government needs money to keep in operation. Nobody votes for hyperinflation. Nobody wants it. It just happens.

Why would the Fed suddenly print trillions of dollars?

There can be a panic to get out of bonds. There may be $3 trillion in bonds coming due in the next 12 months that might not get rolled over if people started not trusting bonds (I am trying to nail down how much short term the public holds, separate from the Fed and Social Security). There is also the "excess reserves" of around $2 trillion that are earning interest, much like government bonds really. The current deficit of around $1 trillion would also have to be financed with new money if nobody but the Fed was buying bonds. Altogether this would be something like $6 trillion over 12 months.

Hyperinflation would never happen in America!

There were cases of hyperinflation in America's colonial period. There was hyperinflation during the Revolutionary War. Remember, "not worth a Continental"? There was hyperinflation in the South during the Civil War. I also think that if the US had not made it illegal to own gold in 1933 that the Fed would have gone bankrupt, because they did not really have enough gold to back all of the notes they had issued, and that paper money would have become worthless then too. Hyperinflation is more common than most people realize. The time periods from the Revolutionary War hyperinflation, to the Civil War hyperinflation, to the 1930s currency crisis, to now, are all similar. To me this looks like some major currency crisis cycle is about due.

What is the math for hyperinflation?

The math for hyperinflation starts with the equation of exchange and with one transformation you get:

P = M * V / Q

Where the variables are:

P = Price level

M = Money supply

V = Velocity of money, how many times money turns over in a year

Q = Real GNP

In hyperinflation the money supply is going up, the velocity of money is going up, and the real GNP is going down, all at the same time. It is a triple whammy that drives prices up really fast.

You have the cause and effect backward!

People will argue things like, "it is not the monetization that causes the loss of confidence, it is the loss of confidence that causes the monetization". While someone else argues the other way. I have also seen both sides of, "hyperinflation causes money printing, not money printing causes hyperinflation".

Hyperinflation is really a positive feedback loop. It is a circle, a death spiral. To argue about what comes first in hyperinflation is a bit like arguing which came first, the chicken or the egg.

Why can't you stop hyperinflation by just having the central bank stop monetizing debt?

It seems obvious that if you just have the central bank stop buying government debt the hyperinflation would stop. The problem is that the government needs money to operate and is spending far more than what it gets in taxes and has debt around the size of the GNP. The deficit is so large that cutting government or increasing taxes enough is not possible. The only way the government can keep in operation, when other people stop buying their bonds or even rolling over their bonds, is if the central bank steps in. So the government always makes sure the central bank steps in. This may take changing laws or replacing people at the central bank, or just ignoring laws, but the government will get the money or it is bankrupt.

How could the Fed on its own cause hyperinflation?

It is always the combination of the government spending far more than it gets in taxes and the central bank printing money and buying government debt (monetizing debt). It is the two together that result in hyperinflation, not one alone.

Isn't hyperinflation a political event and not a monetary event?

The root cause of hyperinflation is politicians spending far more than they get in taxes. In this sense hyperinflation is a political problem. However, I think Milton Friedman was right when he said "inflation is always and everywhere a monetary phenomenon". First off, hyperinflation is a process that can go on for years, not an event. The exact cutoff point between regular inflation and hyperinflation is arbitrary, so it makes no sense to say that below 26% it is a monetary phenomenon and above 26% it is a political phenomenon.

I think the idea that hyperinflation, where the monetary unit rapidly becomes worth less and less, is not a monetary event is not only wrong but dangerous. This wrong idea keeps people from understanding what is really going on. For example, Modern Monetary Theory (MMT) as it stands does not explain hyperinflation. They do not see any tipping point, positive feedback loop, sudden risk, or danger of inflation getting out of control. They think that you could always just make a bit less money if inflation got too high. Instead of admitting the problem with the theory (lots of experimental evidence of inflation getting out of control) they just say hyperinflation is a political event not a monetary event. This is like science with a bit of magical thinking, just wrong.

The US is very different from Wiemar Germany or Zimbabwe!

Each case of hyperinflation is unique, so if you are looking for differences you will always find them. You need to understand the common characteristics. Hyperinflation happens because government debt gets over 80% of GNP and deficit gets over 40% of spending. It does not matter how you get into that situation. Hyperinflation works the same if you lose a foreign war, a civil war, a dictator goes crazy, a government with excessive foreign debt, nationalizing too many businesses, rampant corruption, productive collapse, excessive regulation, a regime change, too many taxpayers fleeing high taxes, a massive depression, or whatever. It just matters that the government is spending nearly twice what they get in taxes and has already borrowed more than is reasonable. When they are in this situation they can not borrow more, except from the central bank under their control. So they get the central bank to make money and "loan" it to them. When the reality is the only way they can pay back that "loan" from the central bank is by first getting another "loan" from the central bank you are probably headed for hyperinflation.

Another problem is that people often compare the US before hyperinflation to some country during hyperinflation, which is not a fair comparison. For example, after prices are shooting up and interest rates go up, no banks will be making 30 year loans. So people will say the fact that the US is making loans shows that it is different than some country with hyperinflation. This is silly. Of course a country that does not yet have hyperinflation is different from a county in the midst of hyperinflation. The real trick is recognizing the circumstances that lead to hyperinflation.

When a country gets hyperinflation there are a number of stages it goes through. Things are very different as hyperinflation progresses.

Other countries are even worse off than the US

Other countries have all sorts of problems too, so the US dollar may not drop against those other currencies. Hyperinflation is not really about exchange rates. If the Pound, Yen, Euro, and Dollar were all getting 26% inflation the exchange rates could stay the same but we would still have hyperinflation.

Where do the debt 80% of GNP and deficit 40% of spending numbers come from?

Bernholz did a study of 29 cases of hyperinflation and looked at the circumstances that lead up to them. He found that the best predictor of hyperinflation were these numbers for debt and deficit.

There has never been hyperinflation of the world reserve currency before!

It is only since 1971 that the world has had a fiat currency as a world reserve currency. In the past it was always gold or silver or a currency convertible to gold or silver. It is not possible to get hyperinflation when using gold and silver. Hyperinflation happens to fiat currencies.

Is this all there is?

There are many more questions and answers on hyperinflation that will come in future articles on Seeking Alpha.

While fiat money is created out of thin air, no alchemy yet can make gold out of nothing. So while any paper money always has some risk of becoming worthless, the same is not true for gold and silver. So let me conclude this first article by saying that when fiat money is at risk of failing, the "hard money", gold and silver, seems to do well.

Disclosure: I am long SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own physical gold and silver.