While some people are worried whether QE3 will be initiated so they can reap some profits there are others who are worried that hyperinflation might suddenly happen and destroy their wealth. Because I received a few emails from such nervous investors and businessman from Europe and USA, I have decided to dedicate this post to them and assure them that even though money printing is risky and causes hyperinflation, we have nothing to worry about in Europe and USA.
Hyperinflation is one of the worst systemic risks. People and investors usually avoid holding much cash because they believe that hyperinflation might destroy it and they are partly right in their assessment. The only problem with that assumption is that there are specific causes that result in hyperinflation and cash might be a good option for now, even for those that hold euros.
There have been 28 episodes of hyperinflation in national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz, professor emeritus of economics at the University of Basel, has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, "Monetary Regimes and Inflation: History, Economic and Political Relationships" Bernholz analyzes the 12 largest episodes of hyperinflation - all of which were caused by financing huge public deficits through monetary creation. His conclusion: The tipping point for hyperinflation occurs when the government's deficit exceeds 40% of its expenditures and is funded by money printing.
USA
The expected USA deficit in 2012 is $1.2 trillion while expenditures are expected to be $3.6 trillion. The government deficit is only 31% of the expenditures and is mainly funded by normal purchases of Treasuries and not money printing. As I do not expect QE3 soon, or even in 2012 contrary to the widespread beliefs, we will revisit the hyperinflation case in USA again next year or when USA initiates new QE. I believe that even in case there is an yearly QE, if it is less than 20% of the government expenditures or less than $720 billion for a period of one year that would still be not hyper-inflationary. Moreover, in discussing this problem we have to be taken into account that a big part of the debt circulate abroad. This together with the fact that huge amount of dollar assets are owned especially by the central banks of China, Japan, and the Oil producers - may pose other and later dangers. But that is not a risk related to hyperinflation if the FED does not buy the debt from these sellers by money printing. Currently, it seems that Japan and UK absorbs the sells of Treasuries of China and Russia. The Oil producers are also increasing their US debt holdings. There is presently no danger of a hyperinflation in the United States. We should also not forget that USA controls the reserve currency and could easily create some kind of external shock that could increase the appetite for Treasuries and USD artificially. For example, FED could stop its swap lines with other central banks and could create USD shortage in times of turmoil. That will result in risk-off, sell-off of all assets and will boost the appetite for safe-havens like USA Treasuries and USD.
Europe
Where Europe stands in terms of hyperinflation risk? The eurozone (EZ) as a whole is still better financially than USA. Of course after few countries exist the eurozone and default on their obligations, most EZ banks will have to be saved by their governments and the EZ finances will weaken significantly. Still the deficit today is around 6% of GDP, and it is less than 12% of the expenditures which are about 53% of the EZ GDP. So even if we view the recent LTRO injections as some kind of money printing attempts, they can not result in hyperinflation because the deficit itself is too small compared to the expenditures. Therefore there is no hyperinflation risk right now but just the opposite, the EZ and especially the PIIGS are facing hyperdeflation. Right now Greece is in great depression and the Euro acts as a gold standard for the Greek economy because it can't print money. Therefore it is safe to conclude that the EUR will not implode, still it might weaken compared to the USD significantly but it will not implode.
UK
UK is expected to state budget deficit of 9.4% in 2011 or £140 billion. The current QE of BOE is for £325 billion and covers more than 2 times the deficit. That is because UK has debt to roll that nobody would buy, so the BOE is the only buyer. The expenditures stand at £683 billion in 2011. It seems that BOE monetize the whole deficit but the deficit itself is about 20% of the expenditures. Unsurprisingly, ever since, inflation in the United Kingdom has consistently overshot the Bank of England's own forecasts. It seems, they don't see a connection but in reality they fund their deficit twice. The risk of inflation in UK is very high because nobody can fund the country but only the BOE. The risk of hyperinflation is still low because the expenditures are not big relatively to the economy, still if they continue to increase that would be dangerous.
Japan
Japan's deficit will be about 41% of it's expenditures in 2012 according to the Budget for FY2012 by the Ministry of Finance. It seems that most of the deficit will be funded by the QE that BOJ runs at $374 billion. While Japan still has deflation, it recently increased its deficit monetization and even declared an inflation target. Now the public only have to wait to see how this experiment will end, for me the result is known: a currency devaluation and risk of a total currency collapse. It is extremely important to note Bernholz's conclusion. Hyperinflations are not caused by aggressive central banks. They are caused by irresponsible and profligate legislatures that spend far beyond their means and by accommodative central banks that lend a helping hand to governments. In the Japan's case, it seems that the government puts pressure on the BOJ and soon the central bankers will have no option but to monetize like crazy even twice the deficit as in UK, because there will be no buyers of the debt Japan needs to roll-over. It seems that Japan is the only developed country that is exposed to hyper-inflationary risk right now.
In conclusion, the tipping point for hyperinflation occurs when the government's deficit exceeds 40% of its expenditures and the deficit is funded by money printing. According to my research the USD and EUR will not be destroyed by hyperinflation for now, if ever. The currencies that are the most risky are the YEN and the GBP. Hyperinflation could happen in Japan at any time. UK prints twice its deficit and the GBP is at risk of significant devaluation. Investors should avoid holding YEN and GBP.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
