Hyperdeflation: The Emerging Threat

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The world has never seen hyperdeflation, except after a hyperinflation. In theory, it shouldn't exist.

Central banks have opened the door to hyperdeflation, though, with their negative interest rate policies.

Although they theoretically can't exist, negative bond yields are now spreading rapidly around the globe.

Depending on definition, circumstance and central bank action, hyperdeflation could happen.

While most people are familiar with the term hyperinflation, few have ever heard the term hyperdeflation. There's good reason for that. While hyperinflation has existed a few dozen to several hundred times in financial history (depending on its definition, there is more than one), hyperdeflation has never occurred except in the immediate aftermath of a hyperinflation. Can it occur independently and are we at risk for it? If so, what would should an investor do?

In order to answer these questions, it's first necessary to determine what the definition of hyperdeflation should be. There is no clear-cut answer, as is also the case with hyperinflation. There term hyperinflation was coined by Phillip Cagan in the 1950s and he arbitrarily (and absurdly) defined it as an inflation rate of 50% a month. He was writing about the mega inflation that followed World War II in Eastern Europe and East Asia. (There also were mega inflation that followed World War I and the fall of communism in Eastern Europe. Along with South America, it has been one of the two major hyperinflation hot spots on the globe in the last hundred years). Cagan's definition included both a rate (50%) and a time period (per month). There is no reason that time is inherently necessary.

What Cagan actually defined was a fast hyperinflation. If hyperinflation is defined as a currency losing almost 100% of its value or on a trajectory to do so, then hyperinflation can occur over any period of time. The 150-year inflation in the Roman Empire would then qualify as a hyperinflation, albeit a slow hyperinflation. I have covered this material in detail in my books on investing. So, hyperdeflation doesn't have to happen in a few months or a couple of years, but could be a slow drain on the economy over many decades.

The extremely high rate Cagan set for hyperinflation also has little practical value. It is way beyond the point where inflation becomes disruptive in the average consumer's life. If you were living in a country with 50% inflation per year (let alone a month), you would feel that you were experiencing hyperinflation. The International Accounting Standards Board agreed and set the bar even lower in IAS 29, where it stated that a cumulative rate of inflation reaching or approaching 100% over a three-year period required special accounting treatment.

There also is a mathematical issue in trying to transfer hyperinflation descriptions to hyperdeflation. No matter how we wish to define hyperinflation, the smaller changes happen in the beginning and accelerate toward the end (they accelerate at a rapidly increasing rate in fast hyperinflation). The same pattern needs to be followed in a hyperdeflation. Since deflation is some form of a general price decrease (there are a number of possible definitions, just as there are for inflation), 100% or greater rates are not possible since prices would become negative. Inflation rates, on the other hand, can go to infinity. Hyperdeflation rates have to be small, which is not the case with hyperinflation rates, which have to be large.

There is little if any economic literature on hyperdeflation. This shouldn't be surprising. In the modern world, where all governments use fiat currency (currency not backed by any hard assets) and can print any desired amount, hyperdeflation is theoretically impossible. Even deflation itself is unlikely to exist. Since the global adoption of Keynesian economic policies after World War II, deflation has indeed almost completely disappeared, despite having existed for long periods in the 19th century. Something has broken in the financial system recently, though, that has opened the door to this bizarre phenomenon.

Central banks in Europe and Japan have adopted negative interest rates and this has caused them to spread quickly throughout the bond markets of the world. These also are theoretically impossible, but they exist, so the old rules of classical economics cannot be considered to apply any longer. In this case, anything goes and anything can happen. The worst-case scenario would be another global financial crisis like the one in 2008. This would plunge U.S. rates into negative territory and create a self-reinforcing feedback loop that continually drove rates lower worldwide. Central banks could of course stop this if they took the appropriate corrective action. This should be scant comfort for anyone who is familiar with central bankers.

What's an investor to do? Negative interest rates indicate a bond bubble and hyperdeflation would indicate that the bubble would get worse, so bond prices would go up substantially (some possible ETFs for this are: TLT, LQD, AGG, IEF, BND, SHY, BSV, BIV, VCIT and IEI). Bonds would be the place to be over stocks. The exception would be industries that borrow heavily and would benefit from the abnormal interest rate environment. Utilities would be a good example of this (some possible ETFs are: XLU, FXU, VPU and IDU). Interestingly, there is some research indicating that gold does well in deflation as well as inflation (some ETFs for this are: GLD, IAU, OUNZ and DGL). Keep in mind that silver tends to trade along with gold. As interest rates have become increasingly negative and spread from country to country in 2016, bonds, utilities and gold have all done well.

We are living in unusual times. Other than for isolated, brief moments, negative interest rates have never been seen before in the financial system. A number of other unexpected oddities are likely to arise. Investors need to consider the unlikely and unexpected as future possibilities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.