With the Fed set to consider various monetary policy options during its September 20-21 meetings, there has been much debate among economic and financial commentators surrounding the potential consequences of additional quantitative easing (QE).
One potential policy option which I have highlighted in previous articles and which has captured many people’s attention is the possibility that the Fed could institute a “bond peg” or a “cap” on long-term interest rates. The Fed would do this through an open-ended commitment to buy as many long-term Treasury bonds as is required to keep rates at a predetermined rate. Some have suggested that the Fed could target a rate below 2.0% on the 10-year Treasury Bond.
In the face of such expectations, it will be useful to consult the historical experiences of other nations that have engaged in the practice of purchasing government securities on a mass scale. These historical experiences suggest that there are very substantial limits in terms of how far a central bank can go with such a policy without provoking very high rates of inflation or even hyper-inflation.
In this article, we shall examine the case of Weimar Germany.
A Brief History of Weimar: Precursors To Inflation
Historically, there have been certain fundamental “precursors” that have appeared in nations that have experienced high inflation and/or hyper-inflation. These precursors were clearly evident in Weimar Germany.
- Economic contraction and unemployment. During several years after WWWI, Weimar Germany’s economy experienced a brutal contraction and associated unemployment.
- High debt and deficits. The German economy was burdened with unmanageable levels of debt. The crushing burden of reparations payments combined with the spiraling the growth of government expenditures (e.g. unemployment insurance and various social welfare programs) to deal with the economic crisis, the German government was not able to balance its budget.
- Debt monetization. The German government was only able to finance its deficit spending though a process that has been called “debt monetization” supported by the central bank: The German central bank essentially created new money and purchased debt securities issued by the government. In principle, the Weimar arrangement was not altogether unlike modern day QE in the U.S.
- Shrinking money multiplier. The money multiplier shrinks when expansion of the monetary base coincides with a slower rate of expansion (or even contraction) of broader indicators of the money supply such as M1, M2 or M3. This phenomenon occurs essentially because expansion of the monetary base does not lead to an expansion of credit and the concomitant expansion of the money supply.
- Moderate inflation or deflation despite rapid growth of monetary base. At first, despite massive increases in the monetary base, the rate of inflation was relatively moderate in Germany. Whatever inflation existed during those years was generally due to war-related shortages than being demand-driven. Indeed, in 1920, despite rapid monetary expansion, Germany experienced severe deflation and the mark actually appreciated in value greatly relative to foreign currencies.
- Cash hoarding. The cause of this external (FX) and internal (domestic prices) appreciation of the mark was skyrocketing money demand caused by fear and risk-aversion. There was a massive “flight to safety” as individuals and companies slashed consumption and production and hoarded cash for precautionary reasons.
The Inflationary Inflection Point In Weimar Germany
The pre-inflationary history of Weimar Germany is mirrored by many other nations that have subsequently experienced high inflation or hyperinflation. At first, contrary to the simplistic dictates of the Quantity Theory of Money (QTM) and its offshoots such as Monetarism, the rapid expansion of the monetary base through the process of “debt monetization” does not lead to inflation. In an economic contraction, extreme risk aversions leads to precautionary savings and associated cash hoarding and deleveraging. Thus, in the absence of strong aggregate demand, although there can be important swings in relative prices, generalized inflation does not gain a strong or broad foothold in the economy.
However, the history of Weimar Germany, as well as that of other nations such as Argentina and Brazil in the 1970s, demonstrates that the process of “debt monetization” can reach a critical inflection point in which inflationary expectations rise quickly and inflation “explodes,” seemingly out of nowhere, virtually from one day to the next.
This critical inflection point is reached when an event or events occur that start to cause a loss of faith in the currency. As confidence in the currency is eroded individuals and businesses that had been hoarding cash start to “disgorge” it in anticipation of future price increases.
For example, take an individual that has been accumulating money in a savings account at very low interest for precautionary reasons. Now, suppose that this person starts to sense that the price of a car or house could soon rise. When this occurs, the person will be spurred to rapidly make the purchase before prices and/or interest rates rise. Related to the above phenomenon, as interest rates rise, individuals rush en masse to borrow and “lock in” low rates on loans for cars, homes and etc.
The loss of confidence in the currency stimulate spending at an accelerated pace as people disgorge hoarded funds. The increase in spending (i.e. monetary velocity) causes aggregate demand to outstrip supplies in key areas of the economy and the “spark” of inflation is ignited. As inflation accelerates, so to does the rate of de-hoarding and expenditure, until the inflationary process spirals out of control. Indeed, once inflationary expectations get going, they tend to feed on themselves, and the cycle between inflationary expectations and price rises can spiral out of control.
But what specifically catalyzes this initial loss in confidence in the currency? Historically, there have been several catalysts. In virtually in all historical cases there has been a common catalyst that has often combined with one or two others to spark the initial erosion of confidence in the currency: Central bank purchases of government bonds (particularly long-term bonds (^TNX, ^TYX, IEF, TLT) at interest rates that are below the actual and expected future rate of inflation.
In part 2 of this series, we shall see exactly how and why this catalyst plays out.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT and long TBT and SBND