(Hyper)-Inflation, Deflation, HOCG and LOCG

It occurs to me more and more often that people have not the slightest idea of what inflation and deflation are, and what the consequences are for the investor. Also, few understand the difference between Inflation and what is defined as "hyperinflation".

The definitions of inflation and deflation will be skipped as these have been explained in detail earlier under academics.  It is important to remember that these design and excessive growth and decrease in money and credit and NOT rising or falling prices. Price evolution has to bee seen as  a possible consequence.

In economics, hyperinflation is inflation that is "out of control," a condition in which prices increase rapidly as a fiat paper currency loses its value. Formal definitions vary from a cumulative inflation rate over three years approaching 100% (Today, many goods exceed the 100%) to "inflation exceeding 50% a month." In informal usage the term is often applied to much lower rates. As a rule of thumb, normal inflation is reported per year, but hyperinflation is often reported for much shorter intervals, often per month.

The definition used by most economists is "an inflationary cycle without any tendency toward equilibrium." A vicious circle is created in which more and more inflation is created with each iteration of the cycle. Although there is a great deal of debate about the root causes of hyperinflation, it becomes visible when there is an unchecked increase in the money supply or drastic debasement of coinage, and is often associated with wars (or their aftermath - Iraq, Afghanistan), economic depressions, and political or social upheavals.

The reason why it can be so hard to ‘understand’ we have (hyper)inflation is that in a (hyper)inflationary cycle and certainly in the initial stage NOT ALL PRICES RISE. Some prices, by name of these of the HOCG will even tend to fall.

As explained by Von Mises, as a result of Fractional Reserve Banking, fiat money and inflation, at a certain point, the prices of HOCG (high order capital goods) tend to fall and those of LOCG (low order consumer goods) tend to rise. In other words, we have a (hyper)inflation cycle but we still see some prices fall. We have (hyper)inflation and deflation at the same time. Rather confusing.

The shift from HOCG to LOCG exists because of a misallocation of funds. In other words, funds that should have been used to improve the agriculture and to increase the energy supply, were misallocated to for example the real estate market, and were used in the dot.com and stock market bubbles. However, because of oversupply, at a certain point, the demand for HOCG dries up and as suppliers/manufactures  scramble to sell the overstock, interest rates go up and prices of HOCG come down.

Meantime, no or little attention has been paid to the LOCG. No new investments nor research were made (because of the misallocation of funds there was no incentive), existing installations/plants became inefficient and outdated. Politicians did not understand the problem either and used the mass psychology to earn votes by not allowing the construction of nuclear power and clean coal plants, by making it difficult and even impossible to drill for more oil and to built new petrochemical refineries. No attention was given to the failing supply of LOCG. At a certain point, we see a growing disequilibrium between supply and demand (Peak oil and food commodities) and we end up having an inelastic supply (peak oil) and a rising or stable demand for the LOCG . Prices start rising at an abnormal rate. There is inflation and sometimes hyperinflation.

Important is to understand that this is the direct result of Fractional Reserve Banking and fiat money creation by the banks and political authorities. In other words, they are at the very origin of the evil they are blaming the speculators for today.

A recession and depression starts and last until all of the misallocated funds have been recycled correctly into the LOCG. The longer the cleaning cycle is delayed by subsequent credit injections  by banks and politicians (more fiat money, more misallocations and more inflation), the stronger and pain fuller the cleaning action and potential crash of the HOCG and the recession and depression.

If authorities really mean to stop inflation, they should stop Fractional Reserve Banking and the creation of fiat money.

Disclosure: Author is long Gold and holds no stock positions

Comments

[bbzz24:]

Fancis,
Help me here! When the government expands money supply by 19% yoy (and thus pumps up inflation), is this hyperinflation? According to your definition it is not as it is not 'out of control' but rather 'by design'. On the other hand, when the government cannot do anything to contain inflation, it is 'out of control'.
So I can conclude that we do not experience hyperinflation but just inflation that is 'out of control' and 'by design'.
Phew. Now I know the government with these bright Harvard MBAs/MIT PhDs is on top of things.

2008 Jul 14 05:46 AM

[David Roskoph:]

The 5 trillion dollar question is being answered today by the extension of Reserve credit to Freddie and Fannie. Essentially attempting to fiat away the real estate deflation. The opportunity to stop the descent of America was forsaken for political expediency. In the same way every other central bank has destroyed its currency, so too is Ben Bernanke. Now that the Fed has allowed yet another bubble, they are going to be given more control in what is the ultimate "Peter Principle". Without leadership (of which none is now present) America is lost.

2008 Jul 14 11:02 AM

[Francis Sch...:]

I think this is the best answer to the question of bbzz24. Economicy is also psychology and sociology...a very complex science in fact.

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.
But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them. (Ludwig von Mises)

2008 Jul 14 11:59 AM

[carey_jim:]

Hyperinflation is a symptom of the breakdown of an economic system and not simply an overheating or poorly functioning economic system.

It usually occurs after wars, revolutions or natural disasters.

If water, for example, became very scarce as the result of war or a natural disaster, individuals who control the supply of water could ask any price they wanted, effectively sucking all money from the economy into their bank accounts until no more money was left.

People would either arrange for more paper money to be printed or start bartering for water until they had nothing left to barter.

Economists call this completely inelastic demand (0) but we don't need technical words to obscure the fact that commodities that are essential for life AND the economy, will command any price if they are in very short supply AND individuals are allowed to hoard them.

Socialism and government planning are not utopia, of course. The government could do little more than arrange an lottery or something similar to decide who gets water and who has to die of thirst. History doesn't provide any sterling examples of success. (For example, Hitler did an excellent job for about six years but we know what happened for the next six years.)

A free market system allows the price of water to reach hyperinflation levels and therefore for people to "compete" for scare commodities. (The strong, intelligent and already wealthy take everything from the weak, stupid and poor.)

Socialism distributes water to cronies, friends, relatives and allies and lets everyone else die of thirst.

It's the difference between the Weimar Republic and the Democratic People's Republic of (North) Korea.

On the bright side, America is a nation of traders and I don't think the system itself will break. It might have to go to the garage for an engine rebuild, however.

2008 Jul 14 12:13 PM

[jjc7477:]

The biggest problem with hyperinflation is how does one preserve wealth? I've recently read a book by Peter Schiff: "Crash Profits" which was written two years ago and is eerily matching almost step-by-step the issues we are facing today and addresses that very subject. I'd highly recommend reading it---and fast---we may be reaching a crescendo here very shortly.

2008 Jul 14 03:37 PM

[carey_jim:]

A quick comment on preserving wealth during a hyperinflation:

As with almost any other economic or natural disaster, hyperinflation is an opportunity for the strong, the wealthy and the intelligent to profit. The greater the catastrophe the great the opportunity.

Germany after World War I is a case study. Hitler rose to power on the backs of the less intelligent, weaker and poorer Germans who were, naturally, the majority and who were decimated by the more crafty and strong among them during the hyperinflation of the previous ten years.

Hitler accused the Jews of being part of this group of financial speculators, of course, and we know what happened to them.

So, I suppose the lesson to be drawn is that hyperinflation is a wonderful opportunity for intelligent and nimble people to build vast fortunes but the resulting hatred from such a massive separation of the many from their money and property can produce political chaos and danger for the new rich minority.

An ancient Chinese curse for one's enemies: "May you be condemned to live in interesting times."

2008 Jul 17 11:15 AM

[Francis Sch...:]

With the Weimar revolution, contrary to the general belief and what is written in history books, many large fortunes were lost! If somebody wasn't invested properly...he lost all he had...

2008 Jul 24 01:30 PM