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Austrians on Deflation

January 30, 2014 1 comment

A commenter on an older post about hyperinflation says the following:

“deflation is not the end of the world, and there are different kinds of deflation, too.”

Then he posts links to a bunch of Austrian posts about inflation and deflation. They are highly confused and I want to go through them point by point. First though, let me say that I agree there are different types of deflation. This is what I have been trying to say all along. If money were an organic and decentralized phenomenon, then there would most likely be steady mild (price) deflation at most times. This is altogether different from what happens when we have a central bank regime which encourages a highly leveraged society and then tightens monetary policy (or fails to loosen it sufficiently to keep the leveraging going). I’m not confusing these two, Austrians are confusing them. When they say “deflation is not the end of the world” they (seemingly) are talking about the first kind. But they say this in contexts which have nothing to do with that type of regime.  They don’t see the difference.  Deflation in a highly leveraged economy is the end of the world.  Read more…

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More on Hyperinflation

January 14, 2014 Leave a comment

There is a piece on Mises.org that sums up the confusion among Austrians and conservative more generally about hyperinflation.   For those of you who don’t know me I am a libertarian and don’t like the idea of a central bank but I think this hyperinflation stuff is seriously misguided and bad for the liberty movement.  There is a lot deal with here.

First, the article clearly states what the author means by hyperinflation.

Hyperinflation leads to the complete breakdown in the demand for a currency, which means simply that no one wishes to hold it. Everyone wants to get rid of that kind of money as fast as possible. Prices, denominated in the hyper-inflated currency, suddenly and dramatically go through the roof.

This is important to point out because there is a standard sequence that these arguments usually follow in which the hyperinflation side changes their definition in the middle, talking about what a dollar bought a hundred years ago and claiming that we have actually had hyperinflation all this time (look at the comments to see what I mean).  But steady single-digit inflation over decades is clearly not what they have in mind when they talk about hyperinflation so let us get that out of the way up front.

Now I will concede that if the Federal Reserve secretly wanted to create a hyperinflation, it is possible that they could.  But the argument here seems to be that they will do so accidentally because they “do not understand the true nature of money and banking.”  The narrative put forth begins when foreigners suddenly decide they don’t want to hold dollars any more.  I don’t think this is likely to happen in the near future but it is possible so let’s take that as a starting point and evaluate the hyperinflation case.  I will take it one step at a time.

Is it possible that the Fed could prevent a hyperinflation?

Simply put, the answer is yes.  The Fed inflated the money supply in the first place by buying financial assets (mainly government debt).  They can take money out simply by doing the opposite.  There is no reason to believe that they could not reign in inflation in this way if it were running higher than they wanted.

Would the Fed accidentally create a hyperinflation?

The author doesn’t even argue that it would be impossible for the Fed to prevent a hyperinflation.  Rather, he argues that they would mistakenly compound the inflation because of their commitment to low interest rates.

Committed to a low interest rate policy, our monetary authorities will dismiss the only legitimate option to printing more money — allowing interest rates to rise.

Frankly, this betrays a total ignorance of the Fed’s stated policy goals.  They are not committed to low interest rates.  They are essentially committed to a certain inflation rate and they change interest rates to try to hit their inflation target.  They have been keeping rates low and doing quantitative easing because they are falling short of that target.  If inflation suddenly shot up, they would be thrilled to let rates rise.  This way of thinking opens up a big can of worms including such Scott Sumner classics as “never reason from a price change” and “low rates don’t mean easy money” but you don’t even have to start down that path before the hyperinflation argument falls apart on this count.

Inflationary recession?

This claim is very peculiar.

Only the noninflationary investment by the public in government bonds would prevent a rise in the price level, but such an action would trigger a recession.

Presumably, the investment in government bonds to which he is referring here would be due to the bonds the Fed would have to sell to soak up the excess liquidity which was driving the inflation.  But this would not cause a recession in an environment of hyperinflation.  It is true that if the Fed did this when inflation was not running above trend it would likely cause a recession.  To understand why this is (and why the hyperinflation argument is mistaken) see this post.  But the premise is that there is a bunch of new money flooding domestic markets driving prices up which we need to take out of the system to prevent a hyperinflation.  This produces a lot of slack for the Fed to contract the money supply without causing a recession.

Also this makes no sense.

Instead, the government will demand and the Fed will acquiesce in even further expansions to the money supply via direct purchases of these government bonds, formerly held by our overseas trading partners. This will produce even higher levels of inflation, of course.

Buying government bonds is normal expansionary monetary policy but he gives no reason whatsoever explaining why the Fed would do this in the midst of a sudden dramatic inflation, he just arbitrarily says that they would.  There is no logical connection here, he’s basically just saying “then the Fed will create some more inflation for no apparent reason.”

Feedback effects?

In addition to the strange response assumed by the Fed, the author imagines a lot of reinforcing feedback effects which layer more inflation on top of the original inflation but these also make no economic sense.  For instance:

State and local governments will also be under stress to increase the pay of their public safety workers or suffer strikes which would threaten social chaos. Not having the ability to increase taxes or print their own money, the federal government will be asked to step in and print more money to placate the police and firemen.

This is profoundly confused.  He starts by saying that the domestic economy is flooded with currency previously held by foreigners.  This extra money drives prices up.  Then he claims that people demand higher prices (wages are a price) and so the government has to print more money to pay them and that causes more inflation.  Here is another example.

 Goods will disappear from the market as producer revenue lags behind the increase in the cost of replacement resources.

There is no reason to think that producer revenue would lag behind the increase in the cost of replacement resources.  The extra money would cause increased demand for final goods and services which would increase their price.  This would increase the demand for intermediate goods and services and raise their prices but it is silly to think that it would somehow raise them so much that downstream buyers would not be able to afford them.  This is the kind of classic confusion that kids in introductory econ get into when they say “demand increases which increases price which decreases demand.”  There seems to be no concept of market equilibrium underlying this, it’s “reasoning from a price change” on steroids.

Similarly, it is arbitrary and incorrect to say that state and local governments would “not have the ability to raise taxes.”  If the price of everything doubles, property taxes double, income taxes double, they would automatically raise twice as much in taxes.  No need to print more money here.

An alternate story

The thing that is so frustrating about this hyperinflation myth is that most of the story would go from making no sense at all to making perfect sense if you just took out inflation and replaced it with deflation.  Think about it.

Either because of or in spite of Fed policy, demand for money suddenly increases and velocity and prices go down.

Workers in both government and the private sector refuse to alter their union contracts to reduce their compensation.

Companies are forced to lay off workers because they can’t pay them less.  Many can’t find work because of minimum wages, government mandated benefits etc. (“sticky wages” in Keynesian speak) and end up on the government dole.

State and local governments lose tax revenue but their government workers–and more importantly their debt–is just as expensive as ever so they have to be bailed out by the Federal government.

Workers who maintain work but at lower wages can’t pay their mortgages which are as expensive as ever so they have to be bailed out.

As people realize that prices are falling, they stop borrowing money which causes the money supply to contract further.

Eventually, the Federal government has to basically buy everything with newly printed money to keep the whole country from collapsing.  It is seen as the absolutely necessary, proper, patriotic, and ethical thing to do…..

The reason I think that Austrians can’t see this is that they are committed to arguing that inflation is bad and deflation is not.  A hundred years ago they made this argument against creating the Federal Reserve and they were right then.  But now that we have had the Federal Reserve for a century, things are different.  They are still trying to mash that old argument together with the current facts and what they end up with is totally incoherent.

But you don’t have to believe in hyperinflation to think the Federal Reserve is a bad idea.  The reason that deflation is dangerous is because of the Federal Reserve (here’s how, in case you missed it above).  We’ve got a fever and the only cure is more government.  We got the fever from the Federal Reserve.  But we (conservatives/libertarians) are in denial about having the fever.  The medicine is killing us slowly but if we stop taking it the disease will kill us quickly.  The first step is to admit we have a problem

 

 

Why Hyperinflation is Not a Threat II: Debt and Anti-Debt

January 16, 2013 5 comments

Last time I told you that money does not represent a debt from the Federal Reserve and that even if it did, it would not serve as an anchor for the real value of a dollar because the assets of the Fed are also denominated in dollars.  So what does money really represent and what does anchor the real value of a dollar?

In the past, paper money was created by banks.  You could take gold or silver or something of the sort to a bank and they would give you a bank-note which could be redeemed at any time for some quantity of gold or silver or the like in the future.   As long as people generally trusted the health of the bank, they could trade the notes instead of the gold or silver which was somewhat more convenient and also allowed for an “elastic” money supply (I’ll postpone a discussion of that topic).  Originally, the government got involved in money essentially by assuming the same job as a bank.  They would trade dollars for gold and gold for dollars at a given rate.  In this scenario, money represents a debt from the bank or the government to the holder of the note.  The gold or silver or other real good which backed the money is a sort of “anti-debt.”  It is the means by which these debts can be extinguished.

Today, money is not backed by gold or silver or anything in this manner.  The process of money creation is of an altogether different nature. There are a few different ways it is done but they amount to essentially the same thing.

If you buy a government bond, that represents a debt from the government to you.  It is redeemable at a fixed time for a fixed amount of dollars.  The dollars you use to buy the bond do not represent a debt from you to the government.  They represent the means by which the government can extinguish its debt to you.  At the appointed time, the government must produce the requisite amount of dollars to retire your bond or else default on its debt.  The number of dollars required to do this at that time does not depend on variables such as the price level, rate of inflation, real interest rates, GDP, etc..

If you sell a government bond to the Federal reserve, the debt which the government owed you is transferred to the Federal Reserve.  The dollars which the Fed prints and gives to you represent the means by which that debt can be extinguished.  The Fed doesn’t owe you anything, the government owes the dollars to the Fed.  When the bond comes due, the government must either get dollars from taxes or issuing more bonds in order to retire that bond, or, as they normally do, just issue another bond and give it to the Fed, which cuts out the middleman (you).

Alternatively, the Fed can loan to a bank.  When a bank borrows dollars from the Fed, it’s not the Fed that owes the bank, it is the bank that owes the Fed.  The dollars, again, represent the means with which the bank is able to extinguish this debt.  The principle is the same, in either case, the dollar is created and traded for debt.  In both cases, the debt is from someone else to the Fed and the dollar is not the debt but the “anti-debt.”  This is an important distinction between modern fiat money and traditional bank-notes which, at one time were backed by gold or silver.

To see how this provides an anchor for the value of a dollar, we must go a step farther.  If the Fed loans to a bank, that money becomes part of the bank’s reserves.  If you sell a government bond to the Fed, you most likely deposit the money which you get in return in the bank and it becomes part of bank reserves.  Alternatively, you may spend it on something else, but in this case the person to whom you pay the money most likely deposits it and it becomes part of bank reserves.  I can drag this out through as many steps as you please, but the point is that most of this base money will end up as bank reserves.

The money which the Fed creates and which is able to extinguish Federal Reserve debt is the money base.  Some of this ends up in people’s wallets but most of it ends up in bank vaults (or accounts with the Fed which amount to the same thing).  The base money that ends up in bank vaults acts exactly like gold did in the old system.  It is anti-debt.  The banks then issue bank credit on top of this which is debt.  This bank credit takes the form of checking accounts, saving accounts, certificates of deposits and so forth.  If you deposit a $20 bill in the bank and they add $20 to your checking account balance, this is a modern form of bank credit.  It is redeemable at any time at the bank for $20 in cash.  Again, the cash is the anti-debt into which this bank credit is convertible.

And just like people could use bank-notes to transact, we now can use this modern bank credit.  You can go to the store, buy a gallon of milk and pay with a check or a debit card.  At the end of the day, the store will deposit the check with their bank and their bank will settle any balance that arises with your bank by transferring cash, just like in previous times banks would have settled by transferring gold.  So what we typically call “money” and what we use to buy things is made up of both base money (currency) and bank credit.  The bank credit represents a debt of base money from the bank.  The base money is anti-debt opposing some debt with the Federal Reserve.

But not all bank credit is created from depositing currency.  The majority of it is created in opposition to a new debt to the bank.  This process is just like the one described above when the Fed creates base money.  Someone goes to the bank and wants a loan.  The bank may give them a loan in the form of bank credit. Alternatively, the story often goes that the bank lends cash and the borrower spends it and the then whoever they gave it to puts it in their bank and their bank lends some of it as cash and this process continues.  It makes no difference which story you tell.  The result is that bank credit increases the quantity of what we call money beyond the quantity of base money created by the Fed.

This increase in money comes with an increase in debt.  This is the key.  The debt is nominally denominated. In order to pay it off, someone must produce a fixed quantity of dollars.  If they don’t pay their debts, there are usually undesirable consequences.  Usually those consequences involve the loss of some real property.  If you don’t pay your mortgage, the bank takes your house.  If you don’t pay your car loan, they take your car.  If a business doesn’t pay their debts, they go bankrupt and the creditors take their assets.  It is all of these assets securitizing all of the debt which is created in the process of creating our money that provides a real anchor for the value of a dollar.

Maintaining a stable value for the dollar depends on maintaining a balance between the quantity of money and the quantity of debt.  The reason that the hyperinflation scenario described by many Austrians and conservatives, in which people lose confidence in the dollar and stop accepting it and the value plummets, never happens is because people with debt need those dollars to pay off their debt.  They won’t just decide not to take them.  If some people suddenly lost confidence in the dollar and decided not to hold any, those people with debt would be happy to take them off of their hands.  In fact they would compete over those unwanted dollars.  If someone owed $10,000 on their car, and not paying would result in the loss of the car, then they would be willing to trade any possession they own which they value less than the car for $10,000, including some quantity of their labor (or the car for any amount of dollars greater than $10,000).  In this way, all of those assets–the houses, cars, boats, businesses, etc.–which secure all of our debt are “backing” the dollar.  Dollars are convertible into these assets at a fixed rate.  It’s just that this rate varies from person to person, there’s no “car standard” or “house standard” so it’s not obvious to people.

What’s more, the process by which money is created, destroys money when reversed.  In other words, when people pay off their debt, the money supply decreases.  Now here’s the kicker.  Here is M2 (base money plus most forms of bank credit).  Here is total credit market debt owed.  Notice that total debt is about five times the size of M2.  Now consider what would happen if people did the opposite–that is, if people decided that they didn’t want to hold debt any more.  They start deleveraging and the money supply starts to contract.  As this happens the price level starts to fall.  There are different ways to explain it but they amount to the same thing, people compete for the dollars that they need to pay down their debt by offering other goods and services at a more favorable rate.  As the money supply contracts, it gets harder and harder to get the dollars required to pay off debt.  The prices of goods fall but the value of debt remains the same since it is nominally denominated.  Since there is more debt than money, it is impossible for everyone to get out of debt, some people will have to default.  This can result in a mad scramble to get the limited quantity of dollars so as not to be left bankrupt and with no real assets.

This is a deflationary scenario and this is the true danger which constantly hangs over our economy.  This is exactly what started to happen in 2008.  Notice in the graph of total debt, that it begins falling short of the trend right before the recession.  This is why the government stepped in and started throwing borrowed money at the economy to stop the bleeding.  When the private sector isn’t willing to borrow enough to keep the money supply growing fast enough to keep up with (artificial) inflation expectations and hold off this contraction, the government has to do it.  I’m not saying this is desirable or natural or unavoidable.  It’s an artificial problem we have brought on ourselves but if we really want to have any chance of fixing it, we have to understand what’s really going on.  We can’t just complain about the debt and ignore the system that makes it necessary.  If conservatives every got into power and actually tried to balance the budget without completely reforming the monetary and financial system, it would cause a recession that would discredit conservatives and free-market economics for a generation (at least) and probably destroy the Republican party.

Why Hyperinflation is Not a Threat Part I: Fed Accounting (yawn…)

January 12, 2013 5 comments

Part two will be a bit more exciting, but I want to provide some background first.  I know I’ve been over this before but it’s been a while and this is probably the most widespread misunderstanding among conservatives and libertarians.  And it’s not just about inflation, if the movement would start to think about money in this way, a lot of other things which are currently misunderstood would start to become clear I think.

The standard view of money is that it’s just paper that is out there circulating, backed by nothing.  We take it because we expect other people to take it.  They take it because they expect others to take it and so on.  Somehow, because we all keep expecting each other to continue taking it, it just keeps circulating.  This is essentially what they say in introductory economics textbooks (I don’t have one handy or I would quote it).  This logic, quite frankly, is economic nonsense.  But many on the right, sensing that this doesn’t seem like a stable situation, come to the conclusion that we are in constant danger of “losing confidence” in the money.  If a few people become unwilling to hold money, or if the Fed expands the money supply too much, the value of the dollar will go down and others will decide not to hold money and this will drive the value down further and eventually everybody would be trying to get out of their dollars and their value would plummet.

This is exactly what would happen if that story were true, that system would have broken down the moment the government tried to get it started.  A slightly more sophisticated, though also misguided, approach is to say that money is “backed” by the assets of the Federal Reserve.  Here is an example. 

What backs the money in the present irredeemable paper system?  Start by considering this brief anecdote.  Joe buys some equipment from John, to be paid Net 30.  We say that Joe owes John $10,000.  Next month, Joe comes back and gives the money to John.  Joe is out of debt, but has the debt been extinguished? No.  The debt has been transferred.  Now the Federal Reserve owes John the money.

But this is not true.  If you hold a $20 bill, the Fed doesn’t owe you $20.  The Fed doesn’t owe you anything.  The story goes that the dollars represent a debt from the Fed to you which is backed by the assets of the Fed which are mainly government securities.  Now to some extent, dollars are convertible into government securities because there is a market for them and the Fed, to some extent, supports this market by standing ready to buy or sell securities if the price moves outside of some range.  But this is not a debt.  The Fed is not legally obligated to trade you government securities for your dollars.

What’s more, this theory does not establish any anchor for the real value of a dollar since the securities held by the Fed are denominated in dollars.  So even if $20 in cash were legally convertible into a $20 treasury bill, this would not do anything to fix the value of a dollar.  If people did suddenly decide not to hold dollars the value of the T-bill would plummet along with the value of the cash.

I think part of the confusion surrounding the nature of money is due to the way the accounting is done.  In accounting, every debit must be offset by an equivalent credit.  When the Fed prints a hundred dollars and uses them to buy a $100 T-bill, they debit the asset “T-bills.”  This must be offset by a credit.  The way they choose to account for this is to credit a liability account representing notes outstanding.  We call this a liability because in accounting terms, this account behaves just like a liability.  A credit to this account offsets an increase in other assets caused by increasing the amount of notes outstanding and debiting it offsets a decrease in assets caused by decreasing the notes outstanding (selling assets and retiring the money).  But legally they do not represent a liability in the sense that we usually think about one.  There is no obligation to redeem these notes.

Alternatively, imagine I ran a counterfeiting ring and kept diligent accounting records (I’m not trying to make a moral connecting between the Fed and counterfeiting, just an accounting connection).  I print $1000 and buy a big-screen TV.  I account for this by debiting the asset account “consumer electronics” $1000 and crediting the revenue account “counterfeiting revenue.”  When I prepare my income statement at the end of the quarter, this revenue will become profit which will increase (credit) “owner’s equity” by $1000.  Now, of course, I could sell the TV.  Let’s say I can still sell it for $1000.  If I do this and burn the money that I get, I would have to credit “consumer electronics,” and debit some expense account, let’s call it “burning money expense.”  Then at the end of the quarter, this would be treated as a loss and would decrease (credit) owner’s equity.

The Fed doesn’t account for money creation in this way, I presume for a few reasons.  By calling the notes outstanding a liability, they do not get converted to profit periodically, they remain on the balance sheet.  My hypothetical counterfeiting operation was for the purpose of generating profit.  I (hypothetically) don’t really care how many of my notes are circulating.  The purpose of the Fed’s operations, at least partially, is to manage the money supply.  So they need to keep track of how much money is out there, so it doesn’t make sense to close out that account periodically.  Furthermore, the Fed may, theoretically, at any time need to reduce the amount of money in order to achieve their goals, whatever those may be.  This means that they must remain in a position to do so at all times.  Calling their asset accumulation profit and remitting it to the treasury would not allow them to remain in a position to contract the money supply whenever they wished.  Also, it would probably look worse to have to tell people the actual amount of real wealth that the Fed is channeling to the Federal Government.  (Though in our current perpetual “fiscal cliff” environment, there may be many who sort of wish people would notice as this profit generated by the Fed could essentially wipe out the national debt, if we wanted to.  More on that later.)

But just like I am not obligated to sell my TV back and burn the money, the Fed is under no obligation to redeem dollars for treasuries or any other asset.  And even if they were, it would not establish a “real anchor” for the value of the dollar.  So what does provide such an anchor?  More on that in the next post.

 

 

Why are Austrians Obsessed with Hyperinflation?

July 24, 2012 14 comments

In WordPress, next to your “top posts,” it tells you the top searches that led people to them.  Next to my recent post on monetary economics I noticed the following search: “why are Austrians obsessed with hyperinflation?”  So I tried that search to see what came up and guess who is number 1 (me)! However, the post that it links to is not all that enlightening by itself.  So I figured I would give the people what they want and just answer this question directly.

Austrians are obsessed with hyperinflation because they don’t get how money is created in this country.  And I am saying this as someone who is morally and philosophically sympathetic with them.  But they have a model of money creation in their minds which is not accurate.  They can only see a system where the government just prints money and spends it.  In this system, we would be in great danger of hyperinflation for exactly the reasons they say.  Namely, the tendency of the government to print and spend more and more money would cause the money supply to expand constantly driving the value of that money down until eventually people decide to flee the currency in anticipation of this drop in value and then the value starts to drop dramatically and this causes a rush for the exits and so on.  In this scenario, all the things they say are correct including the stuff about inflation being a stealth tax on people who hold money, and the notion that governments can “inflate away” their debt.  The problem is that this is not the system we actually have.

What we have is a central bank (the Federal Reserve) which prints money and lends it.  This is entirely different from just printing and spending.  Notice that they do buy things with the money but what they buy are government securities.  In other words, they buy debt, which is the same as lending it.  When the debt matures (or when they sell it) the money goes back to the Fed.  This is completely different from the system outlined above because every dollar created also creates a counterbalancing debt.  This means that the money they put out there isn’t just out there forever, it is like each dollar is really a boomerang which they throw out but eventually comes flying back to the Fed.

But since they lend it with interest, when it comes back, it is even bigger than when they threw it out in the first place.  And that additional money which comes back to them has to come from somewhere which means they have to constantly throw out more and more to keep the quantity out there large enough that it can flow back to them fast enough to retire the debt without upsetting the inflation expectations they have cultivated.  The way it breaks down is not with them printing too much money but rather with them not printing enough to keep this cycle going.  In other words, it ends with a deflationary spiral, not an inflationary spiral.  This is far worse because not only does it mean that we lose all our money but we actually lose all of our stuff which is collateralizing all of these loans.  Or to put it another way (emphasis added):

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property – until their children wake-up homeless on the continent their fathers conquered.

–Thomas Jefferson 1802